PORTFOLIO OPTIMIZATION WITH JUMPS AND UNOBSERVABLE INTENSITY PROCESS

Nicole Bäuerle and Ulrich Rieder

Mathematical Finance, 2007, vol. 17, issue 2, 205-224

Abstract: We consider a financial market with one bond and one stock. The dynamics of the stock price process allow jumps which occur according to a Markov‐modulated Poisson process. We assume that there is an investor who is only able to observe the stock price process and not the driving Markov chain. The investor's aim is to maximize the expected utility of terminal wealth. Using a classical result from filter theory it is possible to reduce this problem with partial observation to one with complete observation. With the help of a generalized Hamilton–Jacobi–Bellman equation where we replace the derivative by Clarke's generalized gradient, we identify an optimal portfolio strategy. Finally, we discuss some special cases of this model and prove several properties of the optimal portfolio strategy. In particular, we derive bounds and discuss the influence of uncertainty on the optimal portfolio strategy.

Date: 2007
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