Cone-Constrained Continuous-Time Markowitz Problems
Vienna University of Technology
ETH Zürich - Department of Mathematics
June 4, 2012
Swiss Finance Institute Research Paper No. 12-25
The Markowitz problem consists of finding in a financial market a self-financing trading strategy whose final wealth has maximal mean and minimal variance. We study this in continuous time in a general semimartingale model and under cone constraints: Trading strategies must take values in a (possibly random and timedependent) closed cone. We first prove existence of a solution for convex constraints by showing that the space of constrained terminal gains, which is a space of stochastic integrals, is closed in L2. Then we use stochastic controlmethods to describe the local structure of the optimal strategy, as follows. The value process of a naturally associated constrained linear-quadratic optimal control problem is decomposed into a sum with two opportunity processes L± appearing as coefficients. The martingale optimality principle translates into a drift condition for the semimartingale characteristics of L± or equivalently into a coupled system of backward stochastic differential equations for L±. We show how this can be used to both characterise and construct optimal strategies. Our results explain and generalise all the results available in the literature so far. Moreover, we even obtain new sharp results in the unconstrained case.
Number of Pages in PDF File: 44
Keywords: Markowitz problem, cone constraints, portfolio selection, mean-variance, hedging, stochastic control, semimartingales, BSDEs, martingale optimality principle, opportunity process, E-martingales, linear-quadratic control
JEL Classification: G11, C61
Date posted: June 15, 2012
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