Solving the Non-Linear Dynamic Asset Allocation Problem: Effects of Arbitrary Stochastic Processes and Unsystematic Risk on the Super Efficient Portfolio Space

Document Type

Article

Publication Date

1-2009

Abstract

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.

Comments

University of Connecticut Department of Economics Working Paper Series; 2009-04.

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