Equilibrium investment strategy for a defined contribution pension plan under stochastic interest rate and stochastic volatility (Q2292015)

Given is the process \((W_R(t), W_S(t), W_L(t))\), where \(W_R,W_S, W_L\) are standard Brownian motions, \(W_R\) is independent of \((W_S(t), W_L(t))\) and \(W_S\) and \(W_L\) are correlated. A financial market is modelled as \(d S_0(t) = R(t) S_0(t)\; d t\) with a stochastic interest rate \[ d R(t) = (a - b R(t))\;d t - \sqrt{\eta_1 R(t) + \eta_2}\;d W_R(t)\;, \] where \(a,b, \eta_1, \eta_2 > 0\). Then the price of a zero coupon bond with maturity at \(T\) follows the BSDE \[ \frac{dB(t,T)}{B(t,T)} = R(t)\;d t + \sigma_B(T-t)\sqrt{\eta_1 R(t) +\eta_2} ( \lambda_R \sqrt{\eta_1 R(t) + \eta_2}\;d t + d W_R(t)) \] for an appropriate function \(\sigma_B(s)\). A risky asset is modelled as \begin{align*} \frac{d S(t)}{S(t)} = & R(t)\;d t + \sigma_S \sqrt{\eta_1 R(t) + \eta_2} (\lambda_R \sqrt{\eta_1 R(t) + \eta_2}\;d t + dW_R(t))\\ &{}+ \nu L(t)\;d t + \sqrt{L(t)}\;d W_L(t) \end{align*} with the stochastic volatility process \[ d L(t) = \alpha (\delta - L(t))\;d t + \sigma_L \sqrt{L(t)}\;d W_L(t)\;. \] The constants \(\alpha,\delta \sigma_S, \sigma_L, \nu > 0\) are positive, too. The contribution rate of a pension plan is stochastic, \begin{align*} \frac{d C(t)}{C(t)} = &\mu \;d t + \sigma_1^C \sqrt{\eta_1 R(t) + \eta_2} (\lambda_R \sqrt{\eta_1 R(t) + \eta_2}\;d t + d W_R(t))\\ &{}+ \sigma_2^C (\nu L(t)\;d t + \sqrt{L(t)}\; d W_S(t))\;, \end{align*} where \(\mu, \sigma_1^C, \sigma_2^C > 0\). The pension fund has a target value \[ Z(T) = \int_T^{T'} z_0 B(T,s) e^{g(s-T)} \frac{w-s}{w-T} \;d s\;, \] where \(T < T' \le w\) and \(T'\) is the random time of death with the distribution \(P[T' > s \mid T' > T] = (w-s)/(w-T)\). The surplus of the contract can be invested in the risky asset and in a rolling bond. Call the investment strategy by \(\pi\). The goal is now to maximise the Markovitz type expected utility \[ \phi(t,x,r,l) = E_{t,x,r,l}[ X^\pi(T) - Z(T)] - \frac\gamma2 \mathrm{Var}_{t,x,r,l}[X^\pi(T) - Z(T)]\;, \] where \(X^\pi\) is the surplus process under the investment strategy \(\pi\), and \(X(t) = x\), \(R(t) = r\) and \(L(t) = l\). This optimisation problem is solved and the optimal strategy is found.