OPTIMAL PORTFOLIO UNDER STATE-DEPENDENT EXPECTED UTILITY

Carole Bernard, Steven Vanduffel () and Jiang Ye
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Carole Bernard: Grenoble Ecole de Management, Department of Accounting, Law and Finance, 12 Rue Pierre Sémart, 38000 Grenoble, France†Vrije Universiteit Brussel, Department of Economics and Political Sciences, Pleinlaan 2, 1050 Bruxelles, Belgium
Jiang Ye: #x2020;Vrije Universiteit Brussel, Department of Economics and Political Sciences, Pleinlaan 2, 1050 Bruxelles, Belgium

International Journal of Theoretical and Applied Finance (IJTAF), 2018, vol. 21, issue 03, 1-22

Abstract: We derive the optimal portfolio for an expected utility maximizer whose utility does not only depend on terminal wealth but also on some random benchmark (state-dependent utility). We then apply this result to obtain the optimal portfolio of a loss-averse investor with a random reference point (extending a result of Berkelaar et al. (2004) Optimal portfolio choice under loss aversion, The Review of Economics and Statistics 86 (4), 973–987). Clearly, the optimal portfolio has some joint distribution with the benchmark and we show that it is the cheapest possible in having this distribution. This characterization result allows us to infer the state-dependent utility function that explains the demand for a given (joint) distribution.

Keywords: Optimal portfolio choice; state-dependent utility; cost-efficiency; portfolio theory; expected utility theory; loss aversion; prospect theory (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1142/S0219024918500139

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