Solving the Non-Linear Dynamic Asset Allocation Problem: Effects of Arbitrary Stochastic Processes and Unsystematic Risk on the Super Efficient Portfolio Space
In this paper we propose a methodology that we believe improves the effectiveness of several common assumptions underlying Modern Portfolio Theory’s dynamic optimization framework. The paper derives a general outline of a stochastic nonlinear-quadratic control for analyzing and solving a non-linear mean-variance optimization problem. The study first develops and then investigates the role of unsystematic (credit) risk in this continuous time stochastic asset allocation model where the wealth generating process has a non-negative constraint. The paper finds that given unsystematic risk, wealth constraints and higher order moments the market price of risk is non-constant and the investor’s optimal terminal return may be lower than previously indicated by a number of classical models. This result provides a convenient solution to practitioners seeking to evaluate competing investment strategies.
Dunbar, Kwamie, "Solving the Non-Linear Dynamic Asset Allocation Problem: Effects of Arbitrary Stochastic Processes and Unsystematic Risk on the Super Efficient Portfolio Space" (2009). Economics Working Papers. Paper 200904.