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Semi-analytical solutions for dynamic portfolio choice in jump-diffusion models and the optimal bond-stock mix

Yi Hong and Xing Jin

European Journal of Operational Research, 2018, vol. 265, issue 1, 389-398

Abstract: This paper studies the optimal portfolio selection problem in jump-diffusion models where an investor has a HARA utility function, and there are potentially a large number of assets and state variables. More specifically, we incorporate jumps into both stock returns and state variables, and then derive semi-analytical solutions for the optimal portfolio policy up to solving a set of ordinary differential equations to greatly facilitate economic insights and empirical applications of jump-diffusion models. To examine the effect of jump risk on investors’ behavior, we apply our results to the bond-stock mix problem and particularly revisit the bond/stock ratio puzzle in jump-diffusion models. Our results cast new light on this puzzle that unlike pure-diffusion models, it cannot be rationalized by the hedging demand assumption due to the presence of jumps in stock returns.

Keywords: Finance; Optimal portfolio selection; Jump-diffusion models; HARA utility functions; Bond-stock mix (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:eee:ejores:v:265:y:2018:i:1:p:389-398