Mind the Cap! -- Constrained Portfolio Optimisation in Heston's Stochastic Volatility Model

Marcos Escobar-Anel, Michel Kschonnek and Rudi Zagst
Authors registered in the RePEc Author Service: Marcos Escobar Anel ()

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Abstract: We consider a portfolio optimisation problem for a utility-maximising investor who faces convex constraints on his portfolio allocation in Heston's stochastic volatility model. We apply the duality methods developed in previous work to obtain a closed-form expression for the optimal portfolio allocation. In doing so, we observe that allocation constraints impact the optimal constrained portfolio allocation in a fundamentally different way in Heston's stochastic volatility model than in the Black Scholes model. In particular, the optimal constrained portfolio may be different from the naive capped portfolio, which caps off the optimal unconstrained portfolio at the boundaries of the constraints. Despite this difference, we illustrate by way of a numerical analysis that in most realistic scenarios the capped portfolio leads to slim annual wealth equivalent losses compared to the optimal constrained portfolio. During a financial crisis, however, a capped solution might lead to compelling annual wealth equivalent losses.

Date: 2023-06
New Economics Papers: this item is included in nep-rmg and nep-upt
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Journal Article: Mind the cap!—constrained portfolio optimisation in Heston's stochastic volatility model (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:2306.11158

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