A Sensitivity Analysis of the Long-Term Expected Utility of Optimal Portfolios

Abstract

This paper discusses the sensitivity of the long-term expected utility of optimal portfolios for an investor with constant relative risk aversion. Under an incomplete market given by a factor model, we consider the utility maximization problem with long-time horizon. The main purpose is to find the long-term sensitivity, that is, the extent how much the optimal expected utility is affected in the long run for small changes of the underlying factor model. The factor model induces a specific eigenpair of an operator, and this eigenpair does not only characterize the long-term behavior of the optimal expected utility but also provides an explicit representation of the expected utility on a finite time horizon. We conclude that this eigenpair therefore determines the long-term sensitivity. As examples, explicit results for several market models such as the Kim-Omberg model for stochastic excess returns and the Heston stochastic volatility model are presented.

Keywords: portfolio optimization, sensitivity analysis, spectral analysis, ergodic Hamilton-Jacobi-Bellman equation, Hansen-Scheinkman decomposition

JEL Classification: G11, C61