Solving the Non-Linear Dynamic Asset Allocation Problem: Effects of Arbitrary Stochastic Processes and Unsystematic Risk on the Super Efficient Portfolio Space
Kwamie Dunbar ()
No 2009-04, Working papers from University of Connecticut, Department of Economics
In this paper we propose a methodology that we believe improves the effectiveness of several common assumptions underlying Modern Portfolio Theory's dynamic optimization framework. The paper derives a general outline of a stochastic nonlinear-quadratic control for analyzing and solving a non-linear mean-variance optimization problem. The study first develops and then investigates the role of unsystematic (credit) risk in this continuous time stochastic asset allocation model where the wealth generating process has a non-negative constraint. The paper finds that given unsystematic risk, wealth constraints and higher order moments the market price of risk is non-constant and the investor's optimal terminal return may be lower than previously indicated by a number of classical models. This result provides a convenient solution to practitioners seeking to evaluate competing investment strategies.
Keywords: Dynamic Optimization; Credit Risk; Mean-Variance Analysis; Linear Quadratic Control; Credit Default Swaps; Capital Market Line; Gram-Charlier expansion; unsystematic risks (search for similar items in EconPapers)
JEL-codes: C02 C15 G0 G10 (search for similar items in EconPapers)
Pages: 38 pages
New Economics Papers: this item is included in nep-cfn and nep-ore
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Persistent link: https://EconPapers.repec.org/RePEc:uct:uconnp:2009-04
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