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Quantile optimization under derivative constraint

Zuo Quan Xu

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Abstract: This paper studies a new type of quantile optimization problems arising from insurance contract design models. This type of optimization problems is characterized by a constraint of \emph{infinity}-dimension, that is, the derivatives of the decision quantile functions are bounded. Such a constraint essentially comes from the "incentive compatibility" constraint for any optimal insurance contract to avoid the potential severe problem of moral hazard in insurance contract design models. By a further development of the author's relaxation method, this paper provides a systemic approach to solving this new type of quantile optimization problems. The optimal quantile is expressed via the solution of a free boundary problem for a second-order nonlinear ordinary differential equation (ODE), which is similar to the Black-Scholes ODE for perpetual American options and has been well studied in literature theoretically and numerically.

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Date: 2018-03
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