Ratcheting with a bliss level of consumption (Q2329672)

This paper deals with the consumption and portfolio selection problem of an infinitely-lived agent who has a quadratic felicity function and does not tolerate a decline in consumption. It is considered the agent who optimizes the following utility function \(U=E[\int_0^{\infty}\exp\{-\beta t\}u(c_{t})dt]\), where \(\beta>0\) is the subjective discount rate, \(c_{t}\) is the agent's rate of consumption at \(t\), \(c_{s}\geq c_{t}\) \(\forall s\geq t\geq 0\), and the felicity function \(u(c)=c-Rc^2\), \(R>0\). The agent operates in a frictionless market with one risk-free asset and one risky asset. It is assumed that the risk-free interest rate \(r>0\) is a constant and the price \(S_{t}\) of the risky asset at time \(t\) evolves according to \(dS_{t}/S_{t}=\mu dt+\sigma d B_{t}\), where \(\mu>r\). The agent's wealth process evolves according to the following dynamics \(dX_{t}=[r X_{t}+\pi_{t}(\mu-r)-c_{t}]dt+\sigma \pi_{t}d B_{t}\), \(X_0=x>0\), where \(\pi_{t}\) is the dollar amount invested in the risky asset at time \(t\). The agent's optimization problem is following: given \(c_{0-}\ge 0\) and \(X_0=x>0\) it is considered the utility maximization problem \(V(x,c_{0-})=\max_{(c,\pi)}E[\int_0^{\infty} \exp\{-\beta t\}(c_{t}-Rc^2_{t})dt\vert X_0=x]\) subject to given wealth dynamics. The authors have derived the optimal consumption and investment strategy in the closed-form by using the martingale method.