Abstract

http://ssrn.com/abstract=263336
 
 

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Stochastic Intertemporal Optimization In Discrete Time


Wendell H. Fleming


Brown University - Division of Applied Mathematics

Jerome L. Stein


Brown University - Division of Applied Mathematics; CESifo (Center for Economic Studies and Ifo Institute)

September 2000

CESifo Working Paper Series No. 338

Abstract:     
The standard literature concerning intertemporal optimization in international finance is based upon certainty equivalence, and ignores risk and uncertainty. It therefore is not helpful concerning risk management and evaluation of the risk involved in the holding of international short-term debt. We solve a modification of the standard model of intertemporal optimization in discrete time, in an environment where the return to capital is stochastic. We impose the constraint that there be no default on the short-term debt. Thereby we derive benchmarks for optimal foreign debt, which will not be defaulted. We do not claim that the optimal debt is the same as the actual debt incurred. Witness the defaults and debt crises. Insofar as the actual debt exceeds the benchmark, the risk of default is increased. The main reasons for a deviation between the actual debt and the optimal debt is that the borrower is overly optimistic about the distribution function of the return to investment, and does not optimize subject to a "no default" constraint. We also consider an intertemporal optimization model involving extreme prudence. The lender, who may be an institutional investor, has infinite risk aversion and will only lend for projects where the profitability of the investment is almost sure. In this case also, we derive the optimal debt, which is our benchmark for risk management.

Number of Pages in PDF File: 23

JEL Classification: D61, D81, D9, F34

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Date posted: March 28, 2001  

Suggested Citation

Fleming, Wendell H. and Stein, Jerome L., Stochastic Intertemporal Optimization In Discrete Time (September 2000). CESifo Working Paper Series No. 338. Available at SSRN: http://ssrn.com/abstract=263336

Contact Information

Wendell Fleming
Brown University - Division of Applied Mathematics ( email )
Providence, RI 02912
United States
Jerome L. Stein (Contact Author)
Brown University - Division of Applied Mathematics ( email )
Providence, RI 02912
United States
401-863-2143 (Phone)
401-863-1355 (Fax)
CESifo (Center for Economic Studies and Ifo Institute)
Poschinger Str. 5
Munich, DE-81679
Germany
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