On using shadow prices in portfolio optimization with transaction costs (Q990383)

The purpose of this paper is to study the maximization of the expected logarithmic utility from consumption over an infinite horizon in the presence of proportional transaction costs. Previously, utility maximization problems are typically solved by stochastic control or martingale methods. In a paper by \textit{M. H. A. Davis} and \textit{A. R. Norman} [Math. Oper. Res. 15, No. 4, 676--713 (1990; Zbl 0717.90007)], stochastic control theory was used to solve these problems with proportional transaction costs. This paper shows that the dual approach for frictionless markets can be used for deriving a candidate solution and verify Merton's problem with logarithmic utility and transaction costs. The authors establish a link between the optimal policy and shadow price, which only appears to hold for logarithmic utility. In Section 2, the authors present the general setup and derive the free-boundary problem that characterizes the solution in Section 3. The authors verify the candidate solution in Section 4.