CLOSED‐FORM SOLUTIONS FOR OPTIMAL PORTFOLIO SELECTION WITH STOCHASTIC INTEREST RATE AND INVESTMENT CONSTRAINTS

Jerome Detemple and Marcel Rindisbacher

Mathematical Finance, 2005, vol. 15, issue 4, 539-568

Abstract: We examine the portfolio choice problem of an investor with constant relative risk aversion in a financial market with partially hedgeable interest rate risk. The individual shadow price of the portfolio constraint is characterized as the solution of a new backward equation involving Malliavin derivatives. A generalization of this equation is studied and solved in explicit form. This result, applied to our financial model, yields closed‐form solutions for the shadow price and the optimal portfolio. The effects of parameters such as risk aversion, interest rate volatility, investment horizon, and tightness of the constraint are examined. Applications of our method to a monetary economy with inflation risk and to an international setting with currency risk are also provided.

Date: 2005
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