Value-at-risk constrained portfolios in incomplete markets: a dynamic programming approach to Heston’s model

Marcos Escobar-Anel (), Yevhen Havrylenko () and Rudi Zagst ()
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Marcos Escobar-Anel: Western University
Yevhen Havrylenko: Technical University of Munich
Rudi Zagst: Technical University of Munich

Annals of Operations Research, 2025, vol. 347, issue 3, No 5, 1265-1309

Abstract: Abstract We solve an expected utility-maximization problem with a Value-at-risk constraint on the terminal portfolio value in an incomplete financial market due to stochastic volatility. To derive the optimal investment strategy, we use the dynamic programming approach. We demonstrate that the value function in the constrained problem can be represented as the expected modified utility function of a vega-neutral financial derivative on the optimal terminal wealth in the unconstrained utility-maximization problem. Via the same financial derivative, the optimal wealth and the optimal investment strategy in the constrained problem are linked to the optimal wealth and the optimal investment strategy in the unconstrained problem. In numerical studies, we substantiate the impact of risk aversion levels and investment horizons on the optimal investment strategy. We observe a $$20\%$$ 20 % relative difference between the constrained and unconstrained allocations for average parameters in a low-risk-aversion short-horizon setting.

Keywords: Portfolio optimization; Hamilton Jacobi Bellman equations; Utility maximization; Investment management; Stochastic volatility; 91G10; 49L20 (search for similar items in EconPapers)
Date: 2025
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DOI: 10.1007/s10479-024-06390-x

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