Optimal investment and consumption when regime transitions cause price shocks

Andrew E.B. Lim and Thaisiri Watewai

Insurance: Mathematics and Economics, 2012, vol. 51, issue 3, 551-566

Abstract: This paper concerns optimal investment and consumption with CRRA utility when there is event risk. Events are modeled by transitions in a finite state Markov chain, but unlike traditional regime switching models, transitions not only change the instantaneous return statistics but are accompanied by jumps in the price at the instant of transition. Optimal investment and consumption policies are characterized using stochastic control methods and computed by solving a system of ordinary differential equations and a convex optimization problem. We show that optimal policies are significantly different from those of traditional regime switching or jump-diffusion problems and that the cost of ignoring transition price shocks can be substantial.

Keywords: Event risk; Regime switching; Defaultable bonds; Jump processes; Optimal investment and consumption; Stochastic control (search for similar items in EconPapers)
JEL-codes: G01 G11 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:insuma:v:51:y:2012:i:3:p:551-566

DOI: 10.1016/j.insmatheco.2012.07.011

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