Optimal Discrete Ratchet Consumption

40 Pages Posted: 29 Oct 2011 Last revised: 15 Mar 2012

See all articles by John G. Watson

John G. Watson

Financial Engines, Inc.; Stanford Graduate School of Business

Jason S. Scott

Financial Engines, Inc.

Date Written: March 14, 2012

Abstract

Dybvig [1995] finds optimal spending and investment strategies for a perpetual endowment that has no tolerance for spending declines. His spending rule is a ratchet --- spending never decreases, but has a substantial chance of increasing. We find the ratchet consumption rule for an investor with a finite planning horizon. We maximize an expected utility that eschews pending declines, yet permits a range of choices for felicity and time preference functions. For optimality, a spending rule must be paired with an investment rule. Here, we investigate dynamic investment strategies --- we treat consumption as a derivative security and derive formulas for its delta-hedge.

Keywords: Ratchet, consumption, investment, floor, leverage

JEL Classification: C61, D11, D91, G11, H31, J26

Suggested Citation

Watson, John G. and Scott, Jason S., Optimal Discrete Ratchet Consumption (March 14, 2012). Available at SSRN: https://ssrn.com/abstract=1950676 or http://dx.doi.org/10.2139/ssrn.1950676

John G. Watson (Contact Author)

Financial Engines, Inc. ( email )

1050 Enterprise Way
Sunnyvale, CA 94089
United States

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305
United States

Jason S. Scott

Financial Engines, Inc. ( email )

1050 Enterprise Way, 3rd Floor
Sunnyvale, CA 94089
United States

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