Elasticity approach to portfolio optimization (Q1423714)

Portfolio investment problems in a continuous-time setting are studied. In previous papers, including Merton (1969, 1971) with a stochastic control technique, and Pliska (1986), Cox \& Huang (1989, 1991) and Karatzas, Lehoczky \& Shreve (1987) with a martingale approach, the portfolio problems were formulated with respect to the assets which belong to the investor's opportunity set. Here, it is shown that an investor actually optimizes elasticities, and duration, if we take a stochastic interest rate. The elasticity approach is used to portfolio optimization. Application of a two-step procedure: 1) one has to determine the optimal elasticity; 2) a strategy is computed which tracks this elasticity, gives the solution to portfolio problems. The author's method is applicable both to the stochastic control approach and the martingale approach.