Portfolio optimization under convex incentive schemes

DOI10.1007/S00780-014-0236-9MaRDI QIDQ2255013zbMATH OpenOpenAlexFDO

Publication date 6 February 2015

Published in Finance and Stochastics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1109.2945

dual problem incentive scheme Malliavin calculus nonconvex optimization portfolio optimization principal-agent problem stochastic optimization

Mathematics Subject Classification ID

Applications of stochastic analysis (to PDEs, etc.) (60H30) Portfolio theory (91G10) Optimal stochastic control (93E20)

Abstract: We consider the terminal wealth utility maximization problem from the point of view of a portfolio manager who is paid by an incentive scheme, which is given as a convex function

g

of the terminal wealth. The manager's own utility function

U

is assumed to be smooth and strictly concave, however the resulting utility function

U c i r c g

fails to be concave. As a consequence, the problem considered here does not fit into the classical portfolio optimization theory. Using duality theory, we prove wealth-independent existence and uniqueness of the optimal portfolio in general (incomplete) semimartingale markets as long as the unique optimizer of the dual problem has a continuous law. In many cases, this existence and uniqueness result is independent of the incentive scheme and depends only on the structure of the set of equivalent local martingale measures. As examples, we discuss (complete) one-dimensional models as well as (incomplete) lognormal mixture and popular stochastic volatility models. We also provide a detailed analysis of the case where the unique optimizer of the dual problem does not have a continuous law, leading to optimization problems whose solvability by duality methods depends on the initial wealth of the investor.

Review text

The paper considers the problem of optimizing the terminal wealth of a portfolio of assets from the perspective of the fund's manager. The manager has his utility function \(U\), which fulfills standard assumptions (i.a. is concave) but is paid according to an incentive scheme \(g(W_T)\), which is a convex function of the terminal wealth. Consequently, the manager seeks to maximize the expected value of the function \(\bar{U}=U \circ g\), which is neither concave, nor convex. The authors consider three problems with the following value functions: the initial problem \(u(x) = \sup E[\bar{U}(W_T)]\), the concavified problem \(w(x) = \sup E[\bar{U}^{**}(W_T)]\) and the dual problem \(v(x) = \inf E[\bar{U}^{*}(Y_T)]\), where \(\bar{U}^{*}\) is the convex conjugate of \(\bar{U}\), \(\bar{U}^{**}\) is the biconjugate (and concavification) and \(Y\) belongs to the set of dual processes to the processes of admissible wealth in the initial problem. The main theorems of the article concern the existence and uniqueness of the solution to these three problems. The authors prove the existence of the dual problem and give a characterization of it using the set of local martingale measures. Moreover, they show that if the terminal value of the optimal solution to the dual problem, \(\hat{Y}_T\), has a continuous distribution, then there exists a unique solution to the concavified problem, and it coincides with the solution to the initial problem. The authors consider the problem of optimizing terminal wealth in the standard one-dimensional Black-Scholes model and in several incomplete models: lognormal mixture model and models of stochastic volatility. They give conditions under which the assumption about the continuity of \(\hat{Y}_T\) is fulfilled.

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