Optimal Investment and Consumption When Regime Transitions Cause Price Shocks

Posted: 7 Nov 2016

See all articles by Andrew Lim

Andrew Lim

National University of Singapore (NUS) - Department of Decision Sciences; National University of Singapore (NUS) - Department of Finance; National University of Singapore (NUS) - Institute for Operations Research and Analytics

Thaisiri Watewai

Chulalongkorn University - Department of Banking & Finance

Date Written: Novemeber 2012

Abstract

This paper concerns optimal investment and consumption with CRRA utility when there is event risk. Events are modeled by transitions in a finite state Markov chain, but unlike traditional regime switching models, transitions not only change the instantaneous return statistics but are accompanied by jumps in the price at the instant of transition. Optimal investment and consumption policies are characterized using stochastic control methods and computed by solving a system of ordinary differential equations and a convex optimization problem. We show that optimal policies are significantly different from those of traditional regime switching or jump-diffusion problems and that the cost of ignoring transition price shocks can be substantial.

Keywords: Event Risk, Regime Switching, Defaultable Bonds, Jump Processes, Optimal Investment and Consumption, Stochastic Control

JEL Classification: G01, G11

Suggested Citation

Lim, Andrew E. B. and Watewai, Thaisiri, Optimal Investment and Consumption When Regime Transitions Cause Price Shocks (Novemeber 2012). Insurance: Mathematics and Economics, Vol. 51, No. 3, November 2012, Available at SSRN: https://ssrn.com/abstract=2865189

Andrew E. B. Lim

National University of Singapore (NUS) - Department of Decision Sciences ( email )

NUS Business School
Mochtar Riady Building, 15 Kent Ridge
Singapore, 119245
Singapore

National University of Singapore (NUS) - Department of Finance ( email )

Mochtar Riady Building
15 Kent Ridge Drive
Singapore, 119245
Singapore

National University of Singapore (NUS) - Institute for Operations Research and Analytics ( email )

Singapore

Thaisiri Watewai (Contact Author)

Chulalongkorn University - Department of Banking & Finance ( email )

Thailand

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