Optimal Portfolio Choice with Path Dependent Labor Income: The Infinite Horizon Case

Abstract

We consider an infinite horizon portfolio problem with borrowing constraints, in which an agent receives labor income which adjusts to financial market shocks in a path dependent way. This path-dependency is the novelty of the model, and leads to an infinite dimensional stochastic optimal control problem. We solve the problem completely, and find explicitly the optimal controls in feedback form. This is possible because we are able to find an explicit solution to the associated infinite dimensional Hamilton-Jacobi-Bellman (HJB) equation, even if state constraints are present. To the best of our knowledge, this is the first infinite dimensional generalization of Merton's optimal portfolio problem for which explicit solutions can be found. The explicit solution allows us to study the properties of optimal strategies and discuss their financial implications.

Keywords: optimal portfolio choice, stochastic delay differential equations, labor income, human capital, hedging demand

JEL Classification: G11, G13