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Mathematics

journal homepage: www.elsevier.com/locate/cam

environment: Theoretical and empirical studies

Charles I. Nkeki

Department of Mathematics, Faculty of Physical Sciences, University of Benin, P. M. B. 1154, Benin City, Edo State, Nigeria

article info a b s t r a c t

Article history: This paper considers a theoretical and an empirical study of an optimal pension fund in

Received 28 March 2017 an inflation environment in which the consumption–portfolio selection problem of an

Received in revised form 21 June 2017 investor who faces both diffusion and jump risks was analyzed. Since the time horizon

of a pension fund management is relatively long, we put into consideration four back-

JEL classification:

ground risks which include inflation, interest rate, investment and income risks. A pension

G11

plan member (PPM) is expected to contribute continuously a time-consistent proportion

G12

C02 of his income into the scheme. These contributions are invested into a market that is

C22 characterized by multiple risk-free assets (which include riskless bonds and bank deposit

C61 accounts), stocks and index bonds. The risky assets (stocks and index bonds), interest rates

and income process are assumed to follow a jump–diffusion process. Real wealth for the

Keywords: plan member is considered. The resulting Hamilton–Jacobi–Bellman equation was solved

Optimal pension fund

using dynamic programming approach. From which, the optimal consumption and optimal

Inflation environment

Consumption

investments with jump risks were obtained. Empirical data were collected from Nigeria

Jump risks Stock Exchange; National Bureau of Statistics, Nigeria; and Bursary Department, University

Income risk of Benin, Nigeria. The analyses of the data were carried out using SPSS package in order

to obtain the needed information for the parameters in our derived models. The resulting

models for optimal portfolio and consumption were solved using MatLab and Mathematica

software. We found that inflation, interest rate and income risks have significant influence

on the investor’s portfolio values in the risky assets. We also found that as the risk averse

coefficient increases, consumption increases and vice versa. Furthermore, we found that

an increase in income can lead to an increase in the portfolio risks and vice versa.

© 2017 Elsevier B.V. All rights reserved.

1. Introduction

This paper focuses on solving problems faced by countries in Africa and many other countries of the World that are

adopting defined contribution pension scheme. Today, there are general increase in prices of goods and services, lack of

price control, varying interest rates by financial institutions, price processes experiencing jump–diffusions and so many

other problems. All of these will go a long way to affect the plan member savings in pension scheme. We intend to provide

both theoretical and empirical analyses of these problems as it relates to pension plan.

In Nigeria for instance, consumer prices in recent time are experiencing continuous jumps from January 2016 to June

2016. In January 2016, the inflation rate was 9.6%, in February, inflation rate was 11.4%, March, 12.8%, April, 13.7% and as

at June 15, inflation rate has risen to 15.6%. It is the highest inflation rate in over 6 years, as cost of items such as food,

housing, utilities and transport surged as a result of 67 percent increase in the prices of gasoline, see [1]. Fig. 1 shows bar

chart of inflation rate in Nigeria from June 2015 to June 2016. At the moment, Nigeria is ranked number 7 highest inflation

http://dx.doi.org/10.1016/j.cam.2017.07.018

0377-0427/© 2017 Elsevier B.V. All rights reserved.

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 229

Fig. 2. Nigeria Consumer Price Index from June 2015 to June 2016 as by the National Bureau of Statistics, Nigeria as at June of 2016.

rate in Africa and number 12 in the World. The highest in the World is South Sudan with an inflation rate of about 290.30%,

followed by Venezuela with 180.90%, according to the National Bureau of Statistics, Nigeria as at June of 2016. In Nigeria, the

Consumer Price Index (CPI) measures changes in the prices paid by consumers in Nigeria for a basket of goods and services

over time in day-to-day living. CPI in Nigeria increased to 198.30 Index Points as at June, 2016 from 192.99 Index Points in

April of 2016. CPI in Nigeria averaged 77.79 Index Points from 1995 to 2016, reaching an all time high of 198.30 Index Points

in June of 2016 and a record low of 14.36 Index Points in January of 1995 as reported by the National Bureau of Statistics,

Nigeria in June 2016. Fig. 2 shows the bar chart of CPI as reported by the National Bureau of Statistics, Nigeria as at June of

2016. Since inflation rate and stocks are generally experiencing jumps, we must model and assume that our CPI, interest

rate, index bonds and stocks follow jump–diffusion processes. This paper aims at providing both theoretical and empirical

studies of pension fund management in which the environment is made up of general jump in CPI, index bonds, interest

rate, income and stocks prices.

We now give the highlights of our research work as follows:

2. jump–diffusion interest rate and jump–diffusion income process are considered

3. consumer price index is allowed to follow jump–diffusion process

4. multiple riskless assets, multiple index bonds and multiple stocks are considered

5. optimal investment and optimal consumption are obtained

6. empirical data were used to analyze the resulting models

7. real wealth and consumption plan for a PPM are considered

8. four background risks: interest rate, inflation, investment and income risks are considered

230 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

The remainder of this paper is structured as follows. In Section 2, we present the literature review on our problem.

Section 3 presents the model formulation, jump–diffusion interest rate, nominal income and asset price processes. In

Section 4, we present the wealth and consumption processes. The real wealth dynamics is presented in Section 5. In Section 6,

we present investment strategies. Section 7 presents the optimal policies. In Section 8, we present the empirical results of

our problems. Section 9 concludes the paper.

2. Literature review

This paper is centered on the following: interest rate, inflation index, asset allocation, and jump–diffusion process. Hence,

the literature review on our problem is structured in the following three subsections:

• second, asset allocation,

• last, jump–diffusion process.

A classical dynamic optimization model proposed by [2], assumes a market structure with constant interest rate. But, for

pension funds being a long term management, the assumption of constant interest rates will be unrealistic in practice. [3]

considered a simple diffusion model for a risk-free interest rate that depends upon one factor or source of randomness. [4]

considered the stochastic short term interest rate process and assumed that the process follows the Cox–Ingersoll–Ross

dynamics. [5] and [6] choose the interest rate dynamics that follows [7] specification of the term structure, while [8]

chooses the affine term structure by using the methodology of [4]. [9] proposed the benefits with stochastic behavior of

other variables, such as interest rate and salaries. [10] used a stochastic dynamic programming approach to model a DC

pension fund in a complete financial market with stochastic investment opportunities and two background risks: income

risk and inflation risk. He gave a closed form solution to the asset allocation problem and analyzed the behavior of the optimal

portfolio with respect to income and inflation. [11] modeled inflation index that involves inflation uncertainty. They assumed

that the inflation rate follows the Ornstein–Uhlenbeck process.

[12] studied the rate of return guarantee under defined contribution pension plans. They derived an explicit formulae

to value guarantees using martingale pricing theory. They concluded that when the pension plan provides rate of return

guarantees, the plan provider cannot ignore the impact of the participants frequent modification behaviors. [13] considered

the formulation and studied a continuous time stochastic model of optimal asset allocation for a DC pension fund with a

minimum guarantee. There are extensive literature that exist on the area of accumulation phase of DC pension plan and

optimal investment strategies. This can be found in [5,10,14–23]. For optimal portfolio and life-cycle of a PPM consumption

plan, see [24–28] and [29].

2.3. Jump–diffusion

The prices of goods and services in most part of the World today are experiencing jumps. In Nigeria for instance, interest

rate, bond prices, income process, stock prices and consumers price index are following jump–diffusion processes, hence

the purpose of this study. Many authors have studied jump–diffusion processes as it relates to financial and non-financial

disciplines. Our focus is literature on jump–diffusion as it relates to finances. [30] considered jump–diffusion processes in

continuous time. They emphasized mainly on the jump-amplitude distributions and development of more suitable models

using parameter estimation for the market in one phase. They further applied the resulting model to a stochastic optimal

investment in a second phase. The proposed developments include uniform jump-amplitude distributions and time-varying

market parameters. In their paper, they considered a riskless asset, a stock (with the stock was allowed to follow a jump–

diffusion process), interest rate, drift and volatility were assumed to be constants. [31] considered an optimal consumption

and portfolio control strategies for a jump–diffusion stock process with log–normal jumps. They found that a computational

solution can be obtained for an optimal consumption and portfolio policy problem in which the underlying stock satisfies

a geometric jump–diffusion and both the diffusion and jump amplitude are log-normally distributed. Their objective was

to maximize the expected, discounted utility of terminal wealth and the cumulative discounted utility of instantaneous

consumption. It was asserted that the jump–diffusion allows for a more realistic distribution, skewed toward negative jumps

and having leptokurtic behavior in which the tails are thicker so that the distribution will be more slender around the peak

than normal. They considered a stock with the stock allowing to follow jump–diffusion process and drift, volatility, jump

size and jump intensity were all time-dependent. [32] emphasized on jump-amplitude distributions by developing more

appropriate models using parameter estimation for the market. They proposed a method of parameter estimation, this time

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 231

for weighted least squares of the difference between theoretical and experimental bin frequencies. The weights were chosen

by the theory of jump–diffusion simulation which was applied to bin frequencies. In their paper, they considered a stock

with the stock allowing to follow jump–diffusion process and drift, volatility, jump size and jump intensity were all time-

dependent as well. [33] applied jump–diffusion process to the growth and treatment of brain tumors using a distributed

parameters model. The model includes three coupled reaction diffusion equations which involve the tumor cells, normal

tissue and the drug concentration. [34] proposed an alternative option pricing model. The model involved the stock prices

that follow a diffusion model with square root stochastic volatility while the jump model follows log-uniformly distributed

jump amplitudes in the stock price process. They further allowed stochastic-volatility to follow a square-root and mean-

reverting diffusion process. They further considered a stock price process that follows a jump–diffusion process with constant

interest rate.

[11] derived the optimal time-dependent portfolio allocation strategy by putting into consideration a long-term stock

market, term structure as well as inflation risk for a defined contribution pension scheme. They further benchmark common

long term defined contribution asset allocation strategies relative to the optimum in order to the assess welfare implications

for varying investment horizons and risk aversions. They found that the outcome of utility heavily depends on whether the

risk aversion of the investor is estimated appropriately. [35] analyzed the consumption and portfolio selection problems

of an investor that are exposed to both Brownian motion and jump risks. They introduced orthogonal decompositions to

determine the optimal portfolio in a closed form. They established the optimal policy that will enable the investor focus on

controlling his exposure to the jump risk. In their paper, they considered a riskless asset and a stock with the stock allowing

to follow jump–diffusion process and drift, volatility, jump size and jump intensity were all time-invariant. [36] considered

dividend optimization problem for an insurer with a jump–diffusion risk process in the presence of fixed and proportional

transaction costs. They constructed and obtained explicitly the value function together with the optimal policy, under a

risk-neutral assumption for the insurer. They further discussed the expected time to the first dividend payment when the

optimal strategy is employed. The underlying asset was allowed to follow a jump–diffusion. [37] considered the optimal

portfolio problems based on the asset price process satisfying a jump–diffusion stochastic differential equation. They derived

the efficient frontier of the optimal portfolio selection problem. They provided a generalization of the work of [38] in the

case of stochastic process and then incorporated jump in their assets prices. But, [38] did not considered asset price process

with a jump–diffusion equation. They considered a riskless asset and multiple stocks with time-dependent interest rate.

[39] developed an optimal timing for annuitization along three approaches. These approaches include the mutual fund in

which the individual invests before annuitization, and it was modeled by a jump diffusion process, the stopping time was

used to maximized the market value of future cash-flows and a solution was proposed in terms of expected present value

operators. They showed that the non annuitization region was either delimited by a lower or upper boundary, in the domain

of time-assets return. They further gave necessary conditions under which these mutually exclusive boundaries exist. They

also proposed a method of computing the probability of annuitization. [40] compares the two different kinds of retirement

plans: a defined benefit (DB) and a defined contribution (DC) plan. They established the tradeoffs and compare these two

plans in a utility-based framework.

None of the above papers address a pension fund management with time-dependent contribution rate, jump–diffusion

interest rate and jump–diffusion income process, jump–diffusion consumer price index, multiple riskless assets, multiple

index bonds, multiple stocks, real wealth and consumption processes. In this paper, we intend to address these problems as

it affects pension plan in the World today.

3. The models

In this section, we present the jump–diffusion interest rate, financial market models in a jump–diffusion and inflation

environment, jump–diffusion income and nominal and real wealth processes.

In this subsection, we begin by describing our financial models. Let (Ω , F , P) be a probability space and W̄ (t) =

(Wr (t), WI (t), WS (t), WY (t))′ = (W (t), WY (t))′ defined on a given filtered probability space (Ω , F , F(F ), P), where

W (t) = (Wr (t), WI (t), WS (t)),

Ft = σ (W (s), WY (s) : s ≤ t) and F(F ) = {Ft : t ∈ [0, T ]}, is a j + m + n + 1-dimensional Brownian motions with

respect to interest rate risks, inflation risks, stock market risks and an income risk, respectively at time, t and W (t) is a

j + m + n-dimensional Brownian motions with respect to interest rate source of risks Wr (t), an j-dimensional Brownian

motions, inflation source of risks WI (t), an m-dimensional Brownian motions and stock market source of risks WS (t),

n-dimensional Brownian motions, at time t. P denotes the real world probability measure, T the retirement time, the sign

‘‘′ ’’, denotes transpose and, 1 = [1, 1, . . . , 1] ∈ Rm .

Let Pr (t), PI (t) and PS (t) be Lévy pure jump processes with respect to interest rates, index bond and stock, respectively with

Lévy measure λl,r νl,r (dzl,r ), l = 1, 2, . . . , Mr , λk,I νk,I (dzk,I ), k = 1, 2, . . . , MI and λi,S νi,S (dzi,S ), i = 1, 2, . . . , M, where zl,r is the

jump size of interest rate l, zk,I is the jump size of index bond k, zi,S is the jump size of stock i, λl,r ≥ 0, l = 1, 2, . . . , Mr are fixed

parameters representing the jump intensities of interest rates, λk,I ≥ 0, k = 1, 2, . . . , MI are fixed parameters representing

232 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

the jump intensities of index bonds and λi,S ∫≥ 0, i = 1, 2, . . . , M are fixed parameters representing the jump intensities of

stocks. The measures ∫νl,r , νk,I and νi,S satisfy R min(1, |zl,r |)νl,r (dzl,r ) < ∞, l = 1, 2, . . . , Mr , R min(1, |zk,I |)νk,I (dzk,I ) < ∞,

∫

k = 1, 2, . . . , MI and R min(1, |zi,S |)νi,S (dzi,S ) < ∞, i = 1, 2, . . . , M, it implies the jumps have finite variation. Now, for any

measurable subsets Ql,r ∈ R, Qk,I ∈ R and Qi,S ∈ R, λl,r νl,r (Ql,r ) = λl,r Q νl,r (dzl,r ), λk,I νk,I (Qk,I ) = λk,I Q νk,I (dzk,I ) and

∫ ∫

l ,r k,I

λi,S νi,S (Qi,S ) = λi,S νi,S (dzi,S ), measures the expected number of jumps, per unit of time, whose sizes belong to Ql,r , Qk,I

∫

Qi,S

and Qi,S , respectively. If νk,I (Qk,I ) = ∞, it is necessarily for the case of small jumps, since νk,I (Qk,I ) < ∞ provided Qk,I does

not include 0, so also for interest rates and stocks. The economy-wide jump amplitude

Pr (t)

[ ]

P(t) = PI (t) ,

PS (t)

with Pr (t) = [P1,r (t), P2,r (t), . . . , PMr ,r (t)]′ , PI (t) = [P1,I (t), P2,I (t), . . . , PMI ,I (t)]′ and PS (t) = [P1,S (t), P2,S (t), . . . , PM ,S (t)]′ ,

scaled respectively on interest rates basis by the scaling factors Jl,r (t , r), l = 1, 2, . . . , Mr , index bond basis by the scaling

factors Jk,I (t , r), k = 1, 2, . . . , MI and on stock prices by the scaling factors Ji,S (t , r), i = 1, 2, . . . , M.

Since occurrence of jump process and Brownian motion are independent, we therefore assume that the individual jump

processes in P(t) and the individual Brownian motions in W (t) are mutually independent.

There is a special case where by ∑Nthe vector P(t)∑ is a compound Poisson∑ process. This occurs where there are a finite number

r (t) NI (t) NS (t)

of jumps of all sizes and Pr (t) = j=1 Z j , P I (t) = m=1 Z m , and PS (t) = n=1 Zn , where Nr (t) is a scalar Poisson process with

intensity parameter λr = (λ1,r , . . . , λMr ,r ) , NI (t) a scalar Poisson process with intensity parameter λI = (λ1,I , . . . , λMI ,I )′ and

′

NS (t) a scalar Poisson process with intensity parameter λS = (λ1,S , . . . , λM ,S )′ , and the Zj′ s are independent and identically

distributed (i.i.d.) random jump amplitudes with law νr (dzr ) independent of Nr (t). It therefore implies that the interest

′

rate processes follow a jump–diffusion. Similarly, the Zm s are independent and identically distributed (i.i.d.) random jump

amplitudes with law νI (dzI ) independent of NI (t). It also follows that the inflation-linked bond price processes follow a jump–

diffusion. In the same vain, Zn′ s are i.i.d. random jump amplitudes with law νS (dzS ) independent of NS (t). It also follows that

the stock price processes follow a jump–diffusion.

Remark 1. Note that dtdW (t) = dtdP(t) = dP(t)dW (t) = 0, (dP)m (t) = dP(t), dW (t)dWY (t) = ρY (t)dt, dP(t)dPI (t) =

dP(t)dPY (t) = dP(t).

We give the generalized form of interest rate dynamics in the following subsection.

The assumption of constant or stochastic interest rate for a long time investment such as pension plan, to some extent

is unrealistic. Interest rate may experience jump in one time or the other. Hence, in this paper, we assume that our interest

rate is a jump–diffusion process. Let each Pl,r (t), l = 1, . . . , Mr be a Lévy pure jump process with Lévy measure λl,r νl,r (dzl,r ),

λl,r > 0, l = 1, . . . , Mr for interest rates, where zl,r is the jumpsizes of interest rate l. We assume that the Lévy pure jump

processes and the Brownian motions are mutually independent and that the sum of the jumps has support on (−1, ∞). The

function Jrl (t_, τ ) is scaling of the l′ s jump at time t.

We assume an j-dimensional interest rate since most financial institutions, have different interest rates and risk measures

for any deposits. For instance, First bank of Nigeria PLC pays interest of about 5%, Eco Bank 6.5%, Unity Bank 8% for an amount

below ten million naira and 10% for an amount above ten million naira, United Bank of Africa PLC 6%, Guarantee Trust

Bank of Nigeria PLC 5.5%, Fidelity Bank 7.5%, ASUU-UNIBEN Multipurpose Co-operative Society 10% and UNIBEN Faculty

of Agriculture Multi-Purpose Co-operative Society Ltd 10%. The value of these rates may vary over time due to some macro-

economic and micro-economic factors such as inflation, nature disasters, government policy etc.

We consider first a general j-factor model for the forward interest rates fw (t_, τ ), w = 1, 2, . . . , j that follows a jump–

diffusion process and the dynamics is given by:

j Mr w

∑ ∑

dfw (t , τ ) = κw (t , τ )dt + σfw,q (t , τ )dWr ,q (t) + Jrw,q (t_, τ )dPw,r ,q (t),

(1)

q=1 q=1

τ ∈ [0, T ], fw (0, τ ) = f0,w , w = 1, 2, . . . , j,

where κw (t , τ ) is the expected growth rate of the forward interest rate w at time τ , σfw,q (t , τ ), q = 1, 2, . . . , j is the volatility

of forward interest rate w at time τ and Jrw,q (t_, τ ) is the scaling of the w jump for forward interest rate at time τ .

If f (t , τ ) = (f1 (t , τ ), f2 (t , τ ), . . . , fj (t , τ ))′ satisfies (1), then the j numbers of spot rates satisfy

where Jr (t_, τ ) = (Jr1 (t_, τ ), 0m , 0n ), 0m and 0n are Mr by MI and Mr by M zero matrices, Wr (t) = (Wr ,1 (t), Wr ,2 (t),

. . . , Wr ,j (t))′ , WI (t) = (WI ,1 (t), WI ,2 (t), . . . , WI ,m (t))′ , WS (t) = (WS ,1 (t), WS ,2 (t), . . . , WS ,n (t))′ , ψ (t , τ ) = (κ1 (t , τ ), κ2 (t , τ ),

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 233

. . . , κj (t , τ ))′ , η(t , τ ) = (σr (t , τ ), 0jm , 0jn ), 0jm and 0jn are j by m and j by n zero matrices, σr (t , τ ) a j by j matrix, Jr1 (t_, τ ) a j

by j diagonal matrix, and

∂

{

ψ (t , τ ) = f (t , τ )|τ =t + ψ (t , t),

∂τ

σr (t) = σf (t , t).

Suppose that Jr1 (t_, τ ) is a zero matrix i.e., interest rates do not experience any jumps, then (2) reduces to the following

j-factor stochastic interest rates:

Here, we consider the asset return, price index dynamics and Merton’s problem of maximizing the infinite-horizon

expected utility of consumption by investing in n stocks, m index bonds and j riskless assets at times t ∈ [0, ∞). We assume

j riskless assets because most financial institutions, have different interest rates for any deposits.

The fund manager manages the jump–diffusion fund contributed by a PPM in the planning interval [0, T ], by means of a

portfolio characterized by

B2jD (t , r) = denote the price process of a bank deposit jD at time t,

Zk (t , r) = denote the price process of an index bond k at time t, and

Si (t , r) = denote the price process of a stock i at time t, .

I(t , r) = denote the price index at time t driven by a jump–diffusion process

and has the dynamics

(4)

+ σ3 (t , r)dWS (t) + J1,I (t , r)dPI (t)), I(0) = I0 > 0,

where the function J1,I (t , r) is scaling jump at time t. Since a country should be measured by a single price index, we take the

average of the interest rates, r(t) and r̄(t). We now express µI (t , r) = 1j r(t)1 − 1j r̄(t)1 + σ1 (t , r)θr (t , r) + σ2 (t , r)θI (t , r) +

σ3 (t , r)θS (t , r) which is the expected inflation index at time t, σ1 (t , r) = (σ1,r (t , r), σ2,r (t , r), . . . , σm,r (t , r)) is the volatility

of price index with respect to source risk, Wr (t), σ2 (t , r) = (σ1,I (t , r), σ2,I (t , r), . . . , σm,I (t , r)) is the volatility of price index

with respect to source of inflation risks, WI (t) at time t, σ3 (t , r) = (σ1,S (t , r), σ2,S (t , r), . . . , σn,S (t , r)) is the volatility of price

index with respect to source of stock market risks, WS (t) at time t, θr (t , r) = (θr ,1 (t , r), θr ,2 (t , r), . . . , θr ,j (t , r))′ is the market

price of interest rate risks at time t, θI (t , r) = (θI ,1 (t , r), θI ,2 (t , r), . . . , θI ,m (t , r))′ is the market price of inflation risks at time

t, θS (t , r) = (θS ,1 (t , r), θS ,2 (t , r), . . . , θS ,n (t , r))′ is the market price of stock risks at time t, rl (t) the instantaneous interest

rate for riskless asset l at time t and there is no default risk, and satisfies (2), r̄l (t) real interest rate for riskless asset l at

time t,

θr (t , r)

( )

θ (t , r) = θI (t , r) (5)

θS (t , r)

is the market price of risks and σZ (t , r) = (σ1 (t , r), σ2 (t , r), σ3 (t , r)) with the volatility vector of the price index correlated

with interest rate σ1 (t , r) ∈ [Rj × [0, T ]], inflation, σ2 (t , r) ∈ [Rm × [0, T ]] and volatility vector of price index correlated

with stock price, σ3 (t , r) ∈ [Rn × [0, T ]]. Here, we assume that the consumer price index may be affected by the fluctuation

of interest rates, inflation and stock prices. Note that if consumer price index is affected by inflation alone, it then follows

that σ1 (t , r) = 0 for all t, r and θS (t , r) = 0 for all t, r. Again, if there are no jumps, then J1 (t , r) = 0. (4) can be expressed as

follows:

dI(t , r) = I(t_, r) (µI (t , r)dt + σZ (t , r)dW (t) + JZ (t , r)dP(t)) ,

(6)

I(0) = I0 > 0,

where JZ (t , r) = (0Mr , J1,I (t , r), 0M ), 0Mr is zero vectors of Mr dimensions, 0M is zero vector of M dimensions, J1,I (t , r) =

(J1 (t , r), 0, . . . , 0) ∈ RMI .

The index bond (also referred to as inflation-linked bond) defined in terms of I(t , r) is

1

∫T

Z (t , r) = e− m τ r̄(t)1ds I(t , r) (7)

which pays the price index at maturity. Finding the differential of both sides of (7), we have

1

dZ (t , r) = Z (t , r)[( r(t)1 + σZ (t , r)θ (t , r))dt + σZ (t , r)dW (t) + JZ (t , r)dP(t)],

m (8)

Z (0) = z0 .

Here, (8) represents the dynamics for a single index bond.

234 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

But, according to Nigerian Pension Reform Act 2014, some proportion of the PPMs investment must be allocated to bonds

(both risky and riskless bonds), stocks and fixed deposits in Nigerian banks, see Part XII, Section 86, Subsections (a)–(i),

Cap.I24, LFN, 2004 of Nigerian Pension Reform Act, 2014. In this paper, we are interested in the spread of the proportion

allocated to index bond to multiple index bonds, i.e., m numbers of index bonds, j numbers of riskless bonds, n numbers of

stocks and the remainder in fixed deposit accounts. We will give the dynamics of the multiple riskless assets (riskless bonds

and bank fixed deposits), stocks and index bonds at time t in the following subsection.

The dynamics of riskless assets (which include jB riskless bonds, B1 (t) with interest rate r1 (t) and for jD bank fixed deposits,

B2 (t) with interest rate r2 (t)), m index bonds and n stocks are given respectively as follows:

where B(t) = (B1 (t), B2 (t)), r(t) = (r1 (t), r2 (t)), r1 (t) = (r11 (t), r12 (t), . . . , r1jB (t)), r2 (t) = (r21 (t), r22 (t), . . . , r2jD (t)),

B1 (t , r) ∈ RjB and B2 (t , r) ∈ RjD . Note that r1 (t) and r2 (t) satisfy (2).

The stock price process Si (t , r), i = 1, 2, . . . , n at time t which is governed by a jump–diffusion stochastic differential

equation (SDE) with time-dependent and interest rate-dependent coefficients is given as

j m

∑ ∑

dSi (t , r) = Si (t_, r)(ϕi (t , r)dt + σri,q (t , r)dWr ,q (t) + σBi,k (t , r)dWI ,k (t)

q=1 k=1

n M

(10)

∑ ∑

+ σSi,l (t , r)dWS ,l (t) + JSl,i dPl,S (t)), i = 1, 2, . . . , n

l=1 l=1

with Si (0) = Si0 , i = 1, 2, . . . , n, Si (t , r) > 0 for each i, where ϕi (t , r) is the diffusive drift term of stock i at time t, σri,q (t , r)

is the volatility of stock i in state q arising from interest rate risks, σBi,k (t , r) is the volatility of stock i in state k arising from

index bonds risks, σSi,l (t , r) is the volatility of stock i in state l arising from stock market risks, each Pl,S (t) is a Lévy pure jump

process with Lévy measure λl,S νl,S (dzS ), l = 1, . . . , M, where zS is the jump-size of the stock price and JSl,i , i = 1, 2, . . . , n,

l = 1, 2, . . . , M is the scaling factor.

Using (8), we have the k number of index bond price as

j

∑

dZk (t , r) = Zk (t_, r)((rk (t) + σZ r k,q (t , r)θI ,q (t , r)

q=1

m n

∑ ∑

+ σZ I k,k (t , r)θI ,k (t , r) + σZ S k,i (t , r)θS ,i (t , r))dt

k=1 i=1

j m (11)

∑ ∑

+ σZ r k,q (t , r)dWr ,q (t) + σZ I k,k (t , r)dWI ,k (t)

q=1 k=1

n MI

∑ ∑

+ σZ S k,i (t , r)dWS ,i (t) + Jl,Ik dPl,I (t)),

i=1 l=1

Re-writing (10) and (11) in compact form, we have:

multiple stock dynamics:

dS(t , r) = S(t_, r) (ϕ (t , r)dt + σ (t , r)dW (t) + J(t , r)dP(t)) ,

(12)

S(0) = S0 ∈ Rn ,

where the vector ϕ (t , r) = (ϕ1 (t , r), ϕ2 (t , r), . . . , ϕn (t , r))′ is expected growth rate of stocks at time t, J(t , r) = [0Mr ×Mr ,

0MI ×MI , JS (t , r)], σ (t , r) = (σr (t , r)ρr (t), σB (t , r)ρB (t), σS (t , r)ρS (t)) is the diffusive volatility matrix vector and ρr (t), ρB (t)

and ρS (t) are the correlation coefficients at time t with respect to interest rates, index bonds and stocks, 0Mr ×Mr is an Mr by

Mr zero matrix, 0MI ×MI is an MI by MI zero matrix, σr (t , r), σB (t , r) and σS (t , r) are the volatility of stocks with respect to

interest rates, index bonds and stocks at time t, σr (t , r)ρr (t) is an n by j matrix, σB (t , r)ρB (t) is an n by m matrix, σS (t , r)ρS (t)

is an n by n matrix and JS (t , r) is an n by n diagonal matrix.

multiple index bonds denoted by Z̃ (t , r):

(13)

Z (0) = z0 ∈ Rm ,

where σL (t , r) = (σZ r (t , r), σZ I (t , r), σZ S (t , r)) and JL (t , r) = (0Mr ×Mr , JI (t , r), 0M ×M ), σZ r (t , r) is an m by j matrix, σZ I (t , r) is

an m by m matrix, σZ S (t , r) is an m by n matrix and JI (t , r) is an m by m diagonal matrix.

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 235

In a defined contribution scheme, the plan member contributes continuously a time-dependent proportion of his or her

jump–diffusion income to the pension scheme, and the contributions are in turn invested in some suitable underlying assets

available in the market. Let Y (t , r) be the nominal income process of a PPM that is correlated with m number of inflation-

linked bonds and n number of stocks at time t, then Y (t , r) is driven by the following jump–diffusion stochastic differential

equation:

dY (t , r) = Y (t_, r) (β (t , r)dt + σY (t , r)dW (t) + JY (t , r)dP(t) + aY (t , r)dA(t)) ,

(14)

Y (0) = y0 > 0,

where β (t , r) := q(t , r) + βY (t , r) + βw (t , r) ∈ R+ is the expected growth rate of the income and is made up of three compo-

nents where the first part q(t , r) is caused by the inflation, second part βY (t , r) is the mandatory yearly growth rate (for those

salary earners) and the other part βw (t , r) is resulted from other factors, such as economy growth or increased welfare. The

volatility σY (t , r) = (σY1 (t , r), σY2 (t , r), σY3 (t , r)), where σY1 (t , r) = (σY11 (t , r), σY12 (t , r), . . . , σY1j (t , r)) is volatility vector of

the income of a PPM arising from the uncertainty of interest rates, Wr (t), σY2 (t , r) = (σY21 (t , r), σY22 (t , r), . . . , σY2m (t , r)) is

volatility vector of the income of a PPM arising from the uncertainty of inflation markets, WI (t), σY3 (t , r) = (σY31 (t , r), σY32

(t , r), . . . , σY3n (t , r)) is volatility vector of the income of a PPM arising from the uncertainty of stock markets, WS (t), σY4 (t , r)

the volatility of the income process arising from the source of income risk, WY (t) a 1-dimensional Brownian motion, at time

t. The jump process of the PPM’s salary is given by JY (t , r) = (JY1 (t , r), JY2 (t , r), JY3 (t , r)), where JY1 (t , r) ∈ RMr is the jump

process arising from interest rate, JY2 (t , r) ∈ RMI is the jump process arising from inflation markets, JY3 (t , r) ∈ RM is the

jump process arising from stock markets at time t. The vector aY (t , r) = (σY4 (t , r), JY4 (t , r)) with the entries σY4 (t , r) ∈ R and

JY4 (t , r) ∈ R, where σY4 (t , r) is the volatility of PPM’s salary with respect to WY (t) and JY4 (t , r) ∈ R is the jump component

of the income at time t with respect to the jump income PY (t) is a 1-dimensional process and A(t) = (WY (t), PY (t))′ .

Suppose that the time-dependent proportion k(t , r) ∈ R+ of the income process is a contribution rate of the PPM into

the scheme at time t, then c(t , r)Y (t , r) is the amount of fund contributed into the scheme by a PPM at time t.

The asset price processes that make up the portfolio components are discussed in the following subsection.

We consider in the next section, the wealth process.

Let K (t , r) be the investment process at time t. The PPM consumes continuously at the rate C (t , r) at time t.

Definition 1. The amount of fund invested in stocks, S(t , r) and index bonds Z̃ (t , r) at time, t are define respectively as

and

Define the weight vector

where φB (t) ∈ Rm is the fraction of K (t , r) invested in bond classes (riskless and risky bonds) at time t and φS (t) ∈ Rn is the

fraction of K (t , r) invested in stock classes (bank fixed deposits and risky stocks) at time t, it then follows that

is the amount invested in riskless bonds at time t. Note that if ∆B0 (t , r) = 0m , it implies that the entire amount allocated to

bond classes is invested in index bonds. In this paper, we allow ∆B0 (t , r) > 0m . The quantity

is invested in riskless assets at time t, where we assume that n = m = j = jB = jD and ∆(t , r) = (∆I (t , r), ∆S (t , r)).

236 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

Before expressing the dynamics of the wealth process of a PPM, we will first give the following definition.

Definition 2. Let C be the set of admissible strategies and C∆ and Cc with respect to investment and consumption, respectively

be subsets of C . We say:

(i) ∆ ∈ C∆ if

∫ T

E ∆(t , r)∆(t , r)′ dt < ∞, (15)

0

where E is the expectation operator and ∆(t , r) is a control process adapted to filtration {Ft }t ≥0 , Ft -measurable.

(ii) C ∈ Cc if

∫ T

E C (t , r)2 dt < ∞. (16)

0

The process C (t , r) is also a control process adapted to filtration {Ft }t ≥0 , Ft -measurable. We now give the dynamics of

investment and wealth processes of the PPM at time t.

In the absence of any income flows from outside PPM’s contributions, the wealth, starting with the initial endowment k0 ,

K (t , r) at time t is given by the following dynamics:

dK (t , r) = (K (t_, r)φ (t)r(t) + ∆(t , r)α (t , r))dt + ∆(t , r)Σ (t , r)′ dW (t)

(17)

+ ∆(t , r)Jm (t , r)′ dP(t), K (0) = k0 ∈ R+ ,

where Σ (t , r) = (σL (t , r), σ (t , r)), Jm (t , r) = (JL (t , r), J(t , r)) and α (t , r) = (σL (t , r)θ (t , r), ϕ (t , r) − r2 (t))′ .

Since a PPM start to make flow of contributions k(t , r)Y (t , r) into the scheme at time t and assume continuous

consumption at the rate C (t , r) from the wealth generated at time t, then we have the following definition:

Since it is expected that at the beginning of the planning horizon there will be no outflow of consumption i.e., C (0) = 0,

we now have the following definition.

∫ t

C (t , r) = C (s, r)ds.

0

Unlike the assumption in literature that the contribution rate of a plan member in pension scheme is always constant, in

this paper, we assume that the contribution rate is time and interest rate dependent.

dX (t , r) = (X (t , r)φ (t)r(t) + ∆(t , r)α (t , r) + k(t , r)Y (t_, r)(β (t , r) − φ (t)r(t))

− (1 − φ (t)r(t))C (t , r))dt + (∆(t , r)Σ (t , r)′ + k(t , r)Y (t_, r)σY (t , r))dW (t)

(19)

+ (∆(t , r)Jm (t , r)′ + k(t , r)Y (t_, r)JY (t , r))dP(t) + k(t , r)Y (t_, r)aY (t , r)dA(t),

X (0) = x0 ∈ R+ .

Proof. Finding the differential of both sides of (18) and using (14) and (17), we have the wealth dynamics as follows:

dX (t , r) = (K (t_, r)φ (t)r(t) + ∆(t , r)α (t , r) + k(t , r)Y (t_, r)β (t , r) − C (t , r))dt

+ (∆(t , r)Σ (t , r)′ + k(t , r)Y (t_, r)σY (t_, r))dW (t) + (∆(t , r)Jm (t , r)′

(20)

+ k(t , r)Y (t_, r)JY (t , r))dP(t) + k(t , r)Y (t_, r)aY (t , r)dA(t),

X (0) = x0 ∈ R+ .

Using (18), we have the following:

dX (t , r) = (X (t , r)φ (t)r(t) + ∆(t , r)α (t , r) + k(t , r)Y (t_, r)(β (t , r) − φ (t)r(t))

− (1 − φ (t)r(t))C (t , r))dt + (∆(t , r)Σ (t , r)′ + k(t , r)Y (t_, r)σY (t , r))dW (t)

(21)

+ (∆(t , r)Jm (t , r)′ + k(t , r)Y (t_, r)JY (t , r))dP(t) + k(t , r)Y (t_, r)aY (t , r)dA(t),

X (0) = x0 ∈ R+ . □

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 237

(21) represents the nominal wealth of a PPM at time t. But, pension plan is relatively long period of time and considering

nominal wealth will be unrealistic since the investor cares about the utility of the real wealth level as the purchasing power

of her nominal wealth is diminished by the inflation. Hence, the real income and wealth processes are discussed in the

following sections.

In this section, we consider the real wealth for a PPM. Here, we assume that the fund manager is interested in the utility

of her real wealth level since the purchasing power of the nominal wealth is diminished by the inflation. The real wealth is

simply the ratio of the nominal wealth to the price index. Again, we will express the portfolio process as fraction of wealth,

since it is advantageous to express the pension fund dynamics in terms of fraction of wealth instead of amount of shares

invested in each asset.

Definition 5. The real wealth of the investor, X̄ (t , r) at time t is defined as the ratio of the nominal wealth to the price index.

Mathematically,

X (t , r)

X̄ (t , r) = .

I(t , r)

X (t , r)

( )

dX̄ (t , r) = d = X̄ (t , r)[φ (t)r(t) + π (t , r)α (t , r)

I(t , r)

+ k(t , r)y(t , r)(β (t , r) − φ (t)r(t)) − (1 − φ (t)r(t))c(t , r) − µI (t , r)

+ σZ (t , r)σZ′ (t , r) − (π (t , r)Σ (t , r)′ + k(t , r)y(t , r)σY (t , r))σZ′ (t , r)

− ρY (t)k(t , r)y(t , r)σY4 (t , r)σZ (t , r)′ ]dt + X̄ (t , r)(π (t , r)Σ (t , r) (22)

+ k(t , r)y(t , r)σY (t , r) − σZ (t , r))dW (t) + X̄ (t , r)[(1 − J1 (t , r))

(π (t , r)Jm (t , r)′ + k(t , r)y(t , r)JY (t , r)) + JZ (t , r)JZ (t , r)′

X (0)

− JZ (t , r)]dP(t) + X̄ (t , r)k(t , r)y(t , r)aY (t , r)dA(t), = x̄0 ∈ R+ ,

I(0)

with ρY (t) = (ρY1 (t), ρY2 (t), ρY3 (t)).

dX (t , r)

= (φ (t)r(t) + π (t , r)α (t , r) + k(t , r)y(t , r)(β (t , r) − φ (t)r(t))

X (t_, r)

− (1 − φ (t)r(t))c(t , r))dt + (π (t , r)Σ (t , r)′ + k(t , r)y(t , r)σY (t , r))dW (t) (23)

+ (π (t , r)Jm (t , r) + k(t , r)y(t , r)JY (t , r))dP(t) + k(t , r)y(t_, r)aY (t , r)dA(t),

′

X (0) = x0 ∈ R+ ,

∆(t ,r)

where π (t , r) = indicates the fraction of portfolio given by the jump–diffusion wealth process at time t ∈ [0, T ] and

X (t ,r)

π (t , r) = (πB (t , r), πS (t , r)) and πB (t , r) = ∆XI(t(t,,r)r) and πS (t , r) = ∆XS(t(t,,r)r) are fraction of portfolio invested in index bonds and

Y (t ,r)

stocks respectively, at time t. y(t , r) = X (t ,r) indicates the fraction of wealth given by the jump–diffusion income at time

t ∈ [0, T ].

C (t ,r)

c(t , r) = X (t ,r) indicates the fraction of wealth taken by consumption at time t.

By the application of Itô formula for quotient rule and using (6) and (23), we have the following

X (t , r)

( )

dX̄ (t , r) = d = X̄ (t , r)[φ (t)r(t) + π (t , r)α (t , r)

I(t , r)

+ k(t , r)y(t , r)(β (t , r) − φ (t)r(t)) − (1 − φ (t)r(t))c(t , r) − µI (t , r)

+ σZ (t , r)σZ′ (t , r) − (π (t , r)Σ (t , r)′ + k(t , r)y(t , r)σY (t , r))σZ′ (t , r)

− ρY (t)k(t , r)y(t , r)σY4 (t , r)σZ (t , r)′ ]dt + X̄ (t , r)(π (t , r)Σ (t , r) (24)

+ k(t , r)y(t , r)σY (t , r) − σZ (t , r))dW (t) + X̄ (t , r)[(1 − J1 (t , r))

(π (t , r)Jm (t , r)′ + k(t , r)y(t , r)JY (t , r)) + JZ (t , r)JZ (t , r)′

X (0)

− JZ (t , r)]dP(t) + X̄ (t , r)k(t , r)y(t , r)aY (t , r)dA(t), = x̄0 ∈ R+ ,

I(0)

238 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

where ρY (t) = (ρY1 (t), ρY2 (t), ρY3 (t)). The correlation coefficient between interest rate risks and income risks is given by

ρY1 (t) ∈ Rj , between inflation risks and income risks is given by ρY2 (t) ∈ Rm and between stock risks and income risks is

given by ρY3 (t) ∈ Rn . □

Note that the fraction of wealth invested in the riskless assets is given by

π0 (t , r) = (π0B (t , r), π0S (t , r)) = (1 − k(t , r)y(t , r) + c(t , r))φ (t) − π (t , r), (25)

where π0B (t , r) and π0S (t , r) are fraction of wealth invested in riskless bonds and banks fixed deposits respectively, at

time t.

For the sake of simplicity, from now on we will not indicate the functional dependences, unless it is necessary to do so. It

now follows that (24) will become:

( )

X

dX̄ = d = X̄ [φ r + πα + ky(β − φ r) − (1 − φ r)c(t , r) − µI + σZ σZ′

I

− (π Σ ′ + kyσY )σZ′ − ρY kyσY4 σZ′ ]dt + X̄ (π Σ ′ + kyσY − σZ )dW (t)

(26)

+ X̄ [(1 − J1 )(π Jm′ + kyJY − JZ )]dP(t) + X̄ kyaY dA(t),

X (0)

= x̄0 ∈ R+ .

I(0)

It is expected that PPMs should consume continuously throughout his lifetime. Then the goal of the fund manager

is to select a portfolio and consumption weight processes (c(s, r), π (s, r))t ≤s≤∞ that maximizes the expected utility of

consumption in an infinite horizon, where discounted rate of consumption is ξ and it measures the PPMs preference rate of

consumption. Now, the expected utility of consumption is given by

[∫ ∞ ]

U(t , X̄ , r) = sup Et e −ξ s

V (c(s, r))ds , (27)

c(s,r),π (s,r);t ≤s≤∞ t

subject to the dynamics of his real wealth (26), and with X̄ (t , r) given and total interest rate dynamics 1r(t) using (2)and

1 ∈ Rm a unit vector. In other words, we solve the following problem:

⎧ [∫ ∞ ]

⎪

⎪U(t , X̄ , r) = sup E t e−ξ s

V (c(s , r))ds ,

c(s,r),π (s,r);t ≤s≤∞

⎪

t

⎪

⎪

⎨s.t .

⎪

⎪

⎪

[ ] [ ] [ ] (28)

1r dW dP

Φ ,

⎪

d = mdt + M +

⎪

⎪

X̄ dWY dPY

⎪

⎪

⎪

⎪

⎪

X̄ (0) = x̄0 , 1r(0) = 1r0 ,

⎩

where

1ψ

⎡ ⎤

⎢ ⎥

m=⎢ ⎥

1η

[ ]

0

M= ,

X̄ [π Σ ′ + kyσY − σZ ] X̄ kyσY4

[ ]

1Jr 0

Φ= .

X̄ [(1 − J1 )(π Jm

′

+ kyJY − JZ )] X̄ kyJY4

The scalar variables 1r and X̄ = x represent the two state variables and the elements of π (t , r) represent the m and n

control variables and c(t , r) represents a control variable.

Here, we adopt the stochastic dynamic programming and the suitable form of Itó’s formulae for semi-martingale

processes to obtain our Hamilton–Jacobi–Bellman equation that characterized the optimal solutions to the fund manager’s

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 239

1

− (π Σ + kyσY )σZ′ − ρY kyσY4 σZ′ ]Ux + 1ηη′ 1′ Urr + x(π Σ ′ + kyσY − σZ )η′ 1′ Urx

2

1 1

+ x (π Σ + kyσY − σZ )(π Σ + kyσY − σZ )′ Uxx + x2 k2 y2 σY24 Uxx

2 ′ ′

2

∫ ∞ 2

+ [U(t , x, 1r + 1Jr1 ) − U(t , x, 1r)]λr νr (dJr ) (29)

−1

∫ ∞

+ [U(t , x + x((1 − J1 )(π Jm′ + kyJY − JZ ))) − U(t , x)]λν (dJ)

−1

∫ ∞

+ λY [U(t , x + xkyJY4 ) − U(t , x)]νY (dJY ) + e−ξ t V (c(t , r))

−1

with the transversality condition limt −→∞ E [U(t , X̄ , r)] = 0, see [2] and [35], where λν (dJ) = (λr νr (dJr ), λI νI (dJI ),

λS νS (dJS ))′ ,

λr νr (dJr ) = (λ1,r ν1,r (dJr ), λ2,r ν2,r (dJr ), . . . , λj,r νjr ,r (dJr )),

λI νI (dJI ) = (λ1,I ν1,I (dJI ), λ2,I ν2,I (dJI ), . . . , λm,I νm,I (dJI ))′ ,

∂U ∂U ∂2U ∂U

λS νS (dJS ) = (λ1,S ν1,S (dJS ), λ2,S ν2,S (dJS ), . . . , λn,S νn,S (dJS ))′ , λY ∈ R. We denote Ut ≡ ∂t

, Ur ≡ ∂r

, Urr ≡ ∂r2

, Ux ≡ ∂x

,

∂2U ∂2U

Urx ≡ ∂r∂x

and Uxx ≡ ∂ x2

.

The standard time-homogeneity argument for the case of infinite-horizon problems stipulates that

[∫ ∞ ]

eξ t U(t , X̄ , r) = sup Et e−ξ (s−t) V (c(s, r))ds

{c(s,r),π (s,r):t ≤s≤∞} t

[∫ ∞ ]

= sup Et e−ξ u V (c(s + u, r))du

{c(t +u,r),π (t +u,r):0≤u≤∞} 0

[∫ ∞ ]

= sup E0 e−ξ u V (c(u, r))du

{c(u,r),π (u,r):0≤u≤∞} 0

≡ L(t , X̄ ),

which is independent of time and the optimal control is Markov. Hence, U(t , X̄ ) = e−ξ t L(t , X̄ ) and (29) reduces to the

following equation for the time-homogeneous value function L:

1

− (π Σ ′ + kyσY )σZ′ − ρY kyσY4 σZ′ ]Lx + 1ηη′ 1′ Lrr + x(π Σ ′ + kyσY − σZ )η′ 1′ Lrx

2

1 1

+ x2 (π Σ ′ + kyσY − σZ )(π Σ ′ + kyσY − σZ )′ Lxx + x2 k2 y2 σY24 Lxx

2 2

∫ ∞

+ [U(t , x, 1r + 1Jr1 ) − U(t , x, 1r)]λr νr (dJr ) (30)

−1

∫ ∞

+ [L(t , x + x((1 − J1 )(π Jm′ + kyJY − JZ ))) − L(t , x)]λν (dJ)

−1

∫ ∞

+ λY [L(t , x + xkyJY4 ) − L(t , x)]νY (dJY ) + V (c(t , r)) − ξ L(t , X̄ ),

−1

The maximization problem in (30) separates into one for c(t , r) , with first-order condition

= (1 − φ r)

∂ c(t , r) ∂x

240 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

0 = sup{xπ α Lx − xπ Σ ′ σZ′ Lx + xπ Σ ′ η′ 1′ Lrx + x2 π Σ ′ (π Σ ′ + kyσY − σZ )′ Lxx

π

∫ ∞ (31)

+ [L(t , x + x((1 − J1 )(π Jm′ + kyJY − JZ ))) − L(t , x)]λν (dJ)}.

−1

It is imperative to note that Lxx must be strictly negative. Again, the second order condition holds if the following Hessian

matrix

H = x2 Lxx ΣΣ ′

is negative definite. Since ΣΣ ′ is a variance–covariance matrix, we have that ΣΣ ′ is a positive definite matrix. It then follows

that H can only be negative definite matrix if and only if Lxx < 0. This shows that as the utility function V is concave in x, the

value function L becomes a strictly concave function in x (see [9]). It follows that the matrix ΣΣ ′ is invertible.

Let c ∗ (t , r) denote the optimal fraction of wealth consume at time t and π ∗ (t , r) = (πB∗ (t , r), πS∗ (t , r)) denote the tensor

of optimal fraction of wealth invested in the index bonds and stocks at time t. From (30), we obtain the following: Given

wealth x, the optimal consumption choice is therefore obtained as follows:

)−1 (

∂V ∂ L(t , x)

( )

c ∗ (t , r) = (1 − φ r) . (32)

∂c ∂x

In the pure diffusive case, λZ = 0 and we obtain the variational form of Merton solutions

′∗ −(α − Σ ′ σZ′ )Lx − Σ ′ η′ 1′ Lrx − xΣ ′ (kyσY − σZ )′ Lxx

π = (Σ ′ Σ )−1 . (33)

xLxx

We must be specific about the utility function V so as to determine the optimal portfolio weights, wealth and value function.

1−δ eh(t ,r)

Consider an investor with the following value functions, L(t ; x, r) = 1−γ 1

x1−γ eh(t ,r) and V (c(t , r)) = c 1−δ with CRRA

coefficients γ , δ ∈ (0, 1) ∪ (1, ∞), where δ and γ are constant relative risk aversion parameters with respect to consumption

1−δ

and wealth processes respectively and L(T ; x, r) = 1−γ 1

x1−γ and V (c(T , r)) = c1−δ .

Next, we find the partial derivatives of L(t , x, r) with respect to t, r, x, rx, rr and xx as follows:

1

Lt (t , x, r) = x1−γ ht (t , r)eh(t ,r) = L(t , x, r)ht (t , r) (34)

1−γ

1

Lr (t , x, r) = x1−γ hr (t , r)eh(t ,r) = L(t , x, r)hr (t , r) (35)

1−γ

1

Lrr (t , x, r) = x1−γ [h2r (t , r) + hrr (t , r)]eh(t ,r) = L(t , x, r)[h2r (t , r) + hrr (t , r)] (36)

1−γ

′

+ kyJY − JZ )), r)

1 (40)

= x1−γ [(1 − J1 )(π Jm

′

+ kyJY − JZ )]1−γ eh(t ,r)

1−γ

1

L(t , x + xkyJY4 , r) = x1−γ [x + xkyJY4 ]1−γ eh(t ,r) (41)

1−γ

1 1

L(t , x, r + 1Jr ) = x1−γ eh(t ,r +1Jr ) = x1−γ eh(t ,r) eh(t ,1Jr ) (42)

1−γ 1−γ

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 241

Fig. 3. Contribution rate of a PPM who chooses to invest in First Bank of Nigeria PLC and Federal Government of Nigeria Bond. The information used in

plotting this graph are given in Table 1.

Substituting the partial derivatives (34)–(39) and the value functions (40)–(43) into (30), we have the following partial

differential equation (PDE):

ht (t , r) + 1ψ hr (t , r) + [φ r + πα + ky(β − φ r) − (1 − φ r)c(t , r)

−µI + σZ σZ′ − (π Σ ′ + kyσY )σZ′ − ρY kyσY4 σZ′ ](1 − γ )

1

+ 1ηη′ 1′ [h2r (t , r) + hrr (t , r)] + x−1 (π Σ ′ + kyσY − σZ )η′ 1′ (1 − γ )hr (t , r)

2

1 1

− (π Σ ′ + kyσY − σZ )(π Σ + kyσY − σZ )′ γ (1 − γ ) − k2 y2 σY24 γ (1 − γ )

2 2

∫ ∞ ∫ ∞ (44)

+ [eh(t ,1Jr1 ) − 1]λr νr (dJr ) + λY [(1 + kyJY4 )1−γ − 1]νY (dJY )

−1 −1

∫ ∞

+ [(1 + ((1 − J1 )(π Jm′ + kyJY − JZ )))1−γ − 1]λν (dJ)

−1

(1 − γ )c(t , r)1−δ

+ − ξ = 0.

(1 − δ )x1−γ

But, the PDE (44) depends on the state variable x. To eliminate it, the following interesting result must hold.

k(t , r) = . (45)

y(t , r)

Definition 6 tells us that the contribution of a PPM depends on the inflation risk, optimal investment in both index bonds

and stocks, and income risks at time t. It implies that PPM will want to know all of this at a particular time before he or

she decides on what to contribute into the scheme at time t. This confirms our earlier assumption that the contribution rate

depends on time, interest rate and other market forces.

Fig. 3 shows the contribution rate of a PPM for every value of portfolio in Federal Government of Nigeria Bond and First

Bank of Nigeria PLC.

7. Optimal policies

To be more specific, consider for simplicity a model in which the common jumps are identically distributed, that is,

νq (dzq ) = ν (dz) for all q = 1, . . . , Mr , νk (dzk ) = ν (dz) for all k = 1, . . . , MI and νl (dzl ) = ν (dz) for all l = 1, . . . , M . We

define m̄λ = (Mr λr , MI λI , M λS )′ such that λr is the arrival rate of jump for interest rate with Mr of jumps, λI is the arrival

rate of jump for inflation with MI number of jumps and λS the arrival rate of jump for stocks with M number of jumps.

242 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

c ∗ (t , r) = arg max gc (t , r),

c(t ,r)

where gc (t , r) = −(1 − φ r)c(t , r) + (1−δ )x1−γ

= 0.

{π (t ,r)}

Σ ′ η′ 1′ hr (t , r)

g(π , r) = π α − π Σ ′ σZ′ + π − xπγ Σ ′ (π Σ ′ + kyσY − σZ )′

x (47)

+ G(((1 − J1 )(π Jm′ + kyJY − JZ ))m̄λ) = 0,

∫∞

and G(((1 − J1 )(π Jm

′

+ kyJY − JZ ))m̄λ) = − −1

[1 − (1 + ((1 − J1 )(π Jm′ + kyJY − JZ )))1−γ ]λν (dJ).

Since the objective function g is time dependent, so it follows that any optimal solution will be time dependent.

Furthermore, the objective function is state dependent, so any optimal solution will also be state dependent. In other words,

′

any optimal π ∗ (t , r) will not be time invariant that is, it will be dependent on time and state. Finally, the objective function

g is strictly concave and hence always has a unique maximizer.

1

c ∗ (t , r) = [(1 − φ (t)r(t))x(t)−γ eh(t ,r) ]− δ . (48)

( ∂ V )−1 1 ∂L

Proof. As to the optimal consumption policy, with ∂c

(ỹ) = ỹ− δ and ∂x

= x−γ eh(t ,r) , we have

1

c ∗ (t , r) = [(1 − φ (t)r(t))x(t)−γ eh(t ,r) ]− δ . □ (49)

It then follows that the terminal consumption (i.e., when t = T ) will be

1

c ∗ (T , r) = [(1 − φ (T )r(T ))x(T )−γ ]− δ , (50)

since h(T , r) = 0 as we shall see later in this work. At t = 0, we have

1

c ∗ (0, r) = [(1 − φ (0)r0 )x̄0 eh(0,r) ]− δ .

−γ

(51)

We now carry out the sensitivity analysis of c ∗ (T , r) by finding its partial derivatives with respect to γ and δ :

1

∂ c ∗ (T , r) [x(T )−γ (1 − φ (T )r(T ))]− δ log(x(T ))

= . (52)

∂γ δ

1

∂ c ∗ (T , r) [x(T )−γ (1 − φ (T )r(T ))]− δ log(x(T ))−γ (1 − φ (T )r(T ))

= . (53)

∂δ δ2

From (52), we have that

1

∂ c ∗ (T , r) (1 − φ (T )r(T ))− δ log(x(T )) ∂ c ∗ (T , r)

(i) lim = ; (ii) lim = 0. (54)

γ −→0 ∂γ δ γ −→∞ ∂γ

(54)(i) shows that if individual investor’s relative risk averse coefficient is zero, individual investor will still be willing to

consume even above her wealth level, provided all other parameters remain fixed. (54)(ii) tells us that if individual investor’s

relative risk averse coefficient is infinite, there will be no consumption at that level. That is, as individual investor’s relative

risk averse coefficient increases, rate of consumption decreases and vice versa.

Similarly,

∂ c ∗ (T , r) ∂ c ∗ (T , r)

(i) lim = +∞; (ii) lim = 1. (55)

δ−→0 ∂δ δ−→∞ ∂δ

(55)(i) tells us that as individual investor’s preference rate of consumption decreases, rate of consumption increases and

vice versa. (55)(ii) shows that no matter how large individual investor’s preference rate of consumption will be, rate of

consumption will be bounded by unit. Observe in Fig. 4 that the eight graphs behave in a similarly manner.

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 243

Fig. 4. The optimal final consumption level given the value of the final wealth and interest rate, where γ = 0.2, δ = 0.25 and φB = (0.1, 0.1, 0.11, 0.11),

φS = (0.1, 0.12, 0.16, 0.2).

We now check that the transversality condition holds. By substituting in the optimizers X̄ ∗ (t , r) and c ∗ (t , r) into (27), and

then taking expectations of both sides, we find

[∫ ∞ ]

lim E [U(t , X̄ , r)] = lim E

∗

e −ξ s

V (c (s, r))ds = 0.

∗

(56)

t −→∞ t −→∞ t

In this subsection, we consider the optimal investment strategies for a plan member at time t.

Jm m̄λ(ΣΣ ′ )−1 Jm

′

m̄λ

( )

′∗ 1

π = 1− ((ΣΣ ′ )−1 α + (1 − γ )(Σ −1 σZ )′ )

γ Σ −1 m̄λ(Σ −1 m̄λ)′

Jm m̄λ(ΣΣ ′ )−1 Jm

′

m̄λ

( )

1 hr

+ 1− ((Σ −1 η)′ + γ ky(Σ −1 σY )′ ) (57)

γ Σ m̄λ(Σ m̄λ)

−1 − 1 ′ x

(kyJY − JZ )m̄λ(ΣΣ ′ )−1 (Jm′

m̄λ) a(ΣΣ ′ )−1 (Jm′

m̄λ)

+ + .

Σ −1 m̄λ(Σ −1 m̄λ)′ (1 − J1 )Σ −1 m̄λ(Σ −1 m̄λ)′

Proof. We commence by obtaining the first-order condition. The first-order condition for π is obtained as

Σ ′ η′ 1′ hr (t , r)

α − Σ ′ σZ′ + − γ Σ ′ (π Σ ′ + kyσY − σZ )′

x (58)

+ (1 − J1 )Jm′ m̄λĠ(((1 − J1 )(π Jm′ + kyJY − JZ ))m̄λ) = 0.

We now define the scalar a = ((1 − J1 )(π Jm

′

+ kyJY − JZ ))m̄λ. Then substituting

[ ]

a

− γ Σ′ − (kyJY − JZ )m̄λ (m̄λ)−1 (Jm′ )−1 Σ = −γ Σ ′ π ′ Σ

1 − J1

in (58), we have that a must satisfy the following:

1 1

− (1 − J1 )((ΣΣ ′ )−1 α )(Jm m̄λ) + (1 − J1 )(Σ −1 σZ )′ (Jm′ m̄λ)

γ γ

1 h r (t , r)

− (1 − J1 )(Σ −1 η)′ (Jm′ m̄λ) + a + (1 − J1 )(kyJY − JZ )m̄λ

γ x (59)

− (1 − J1 )ky(Σ −1 σY )′ (Jm′ m̄λ) + (1 − J1 )(Σ −1 σZ )′ (Jm′ m̄λ)

1

− (1 − J1 )2 Σ −1 m̄λ(Σ −1 m̄λ)′ Ġ(a) = 0,

γ

244 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

′∗ 1 1−γ 1 hr

π = (ΣΣ ′ )−1 α − (Σ −1 σZ )′ + (Σ −1 η)′

γ γ γ x

(60)

1

− ky(Σ −1

σY ) + ′

(ΣΣ ) ′ −1

(1 − J1 )Jm m̄λĠ(a).

′

γ

From (59), we have that

′

m̄λ) (1 − γ )(Σ −1 σZ )′ (Jm

′

m̄λ)

Ġ(a) = − +

(1 − J1 )Σ −1 m̄λ(Σ −1 m̄λ)′ (1 − J1 )Σ −1 m̄λ(Σ −1 m̄λ)′

(Σ −1

η) (Jm m̄λ)hr (t , r)

′ ′

γa

− + (61)

x(1 − J1 )Σ −1 m̄λ(Σ −1 m̄λ)′ (1 − J1 )2 Σ −1 m̄λ(Σ −1 m̄λ)′

γ (kyJY − JZ )m̄λ γ ky(Σ −1 σY )′ (Jm′ m̄λ)

+ + .

(1 − J1 )Σ m̄λ(Σ m̄λ)

− 1 −1 ′ (1 − J1 )Σ −1 m̄λ(Σ −1 m̄λ)′

) {(ΣΣ ′ )−1 α + (1 − γ )(Σ −1 σ )′ }

Jm m̄λ(ΣΣ ′ )−1 Jm

′

m̄λ

(

′∗ 1 Z

π = 1− ′ hr

γ Σ −1 m̄λ(Σ −1 m̄λ)′ +(Σ −1

η)

+ γ ky(Σ −1

σY )′

x (62)

(kyJY − JZ )m̄λ(ΣΣ ′ )−1 (Jm

′

m̄λ) a(ΣΣ ) (Jm m̄λ)

′ −1 ′

+ + . □

Σ −1 m̄λ(Σ −1 m̄λ)′ (1 − J1 )Σ −1 m̄λ(Σ −1 m̄λ)′

Observe that (62) is made up of four parts. The first part is the Merton’s portfolio with jump, the second part is the

jump risks hedging portfolio, the third part is a hedging portfolio value of the two classes of risky assets and the last part

is proportional to a, which is a control parameter that measures how much of this portfolio value the investor is willing to

take. We now give the break down and comprehensive interpretations of every component of (62):

Jm m̄λ(ΣΣ ′ )−1 Jm

′

m̄λ 1−γ Jm m̄λ(ΣΣ ′ )−1 Jm

′

m̄λ

( ) ( )

′∗ 1

π = (ΣΣ ′ )−1 α 1− + (Σ −1 σZ )′ 1−

γ Σ −1 m̄λ(Σ −1 m̄λ)′ γ Σ −1 m̄λ(Σ −1 m̄λ)′

δ1 δ2

Jm m̄λ(ΣΣ ′ )−1 Jm

′

m̄λ Jm m̄λ(ΣΣ ′ )−1 Jm

′

m̄λ

( ) ( )

1 hr

+ (Σ −1 η)′ 1− + ky(Σ −1

σY )

′

1−

γ x Σ −1 m̄λ(Σ −1 m̄λ)′ Σ −1 m̄λ(Σ −1 m̄λ)′ (63)

δ3 δ4

kyJY m̄λ(ΣΣ ) ′ −1

(Jm m̄λ)

′

JZ m̄λ(ΣΣ ) ′ −1

(Jm m̄λ)

′

a(ΣΣ ) ′ −1 ′

(Jm m̄λ)

+ − + .

Σ −1 m̄λ(Σ −1 m̄λ)′ Σ −1 m̄λ(Σ −1 m̄λ)′ (1 − J1 )Σ −1 m̄λ(Σ −1 m̄λ)′

δ5 δ6

It shows that it is optimal to invest the PPM’s contributions in a portfolio that comprises of seven components:

1. a speculative portfolio δ1 proportional to the market price of risk corresponding to the two risky assets, stocks and

index bonds through the relative risk averse index γ1 ,

2. an inflation diffusion risk hedging portfolio δ2 proportional to the diffusion term of the inflation index through the

1−γ

relative risk averse index γ ,

3. an interest rate diffusion risk hedging portfolio δ3 proportional to the diffusion term of the interest rate and inversely

proportional to the optimal wealth process through the cross derivative of function h with respect to the interest rate

r and the relative risk averse index γ1 ,

4. an income diffusion risk (or a preference-free) hedging component δ4 proportional to the diffusion term of the income

risks and the contribution process,

5. an income jump risk hedging component δ5 proportional to the jump term of the income risks and the contribution

process,

6. an inflation jump risk hedging portfolio δ6 proportional to the jump term of the inflation index,

m a(ΣΣ ′ )−1 (J ′ m̄λ)

7. a hedging portfolio value (1−J )Σ −1 m̄λ(Σ −1 m̄λ)′ of the two classes of risky assets and a a control parameter that measures

1

how much of this portfolio value the investor is willing to take,

8. risk-free funds holding the riskless assets only.

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 245

Corollary 1. Suppose that the portfolio is free from interest rate risk i.e., σr (t) ≡ 0 or η(t) ≡ (0, 0, 0), then (63) becomes

Jm m̄λ(ΣΣ ′ )−1 Jm

′

m̄λ

( )

′∗ 1

π = 1− [(ΣΣ ′ )−1 α + (1 − γ )(Σ −1 σZ )′ ]

γ

Σ −1 m̄λ(Σ −1 m̄λ)′

(64)

(kyJY − JZ )m̄λ(ΣΣ ′ )−1 (Jm′

m̄λ) a(ΣΣ ′ )−1 (Jm

′

m̄λ)

+ + .

Σ m̄λ(Σ m̄λ)

− 1 − 1 ′ (1 − J1 )Σ m̄λ(Σ −1 m̄λ)′

−1

Proposition 5. Suppose that the Lévy measure generates asymmetric positive and negative jumps, then

1

[ ]

1 (22 3 (3 + A2 + 3B(λ− − λ+ ))) 1

a= −2A + 1

+ (4Φ ) 3 . (65)

6 Φ3

Proof. The Lévy measure is allowed to generate asymmetric positive and negative jumps. By following [35] approach, we

consider a Lévy measure such that

λ+ dz /z, if z ∈ (0, 1]

{

ν (dz) = (66)

− λ− dz /z, if z ∈ [−1, 0)

λ λ

where λ+ = m̄S λ+ and λ− = m̄S λ− with λS + > 0 and λS − > 0. Setting γ = 2, we have that G(a) = −λ+ log(1 + a) −λ− log(1 − a)

and (59) becomes a cubic equation in a:

with solvency constraint |a| < 1, where A = − 21 (1 − J1 )((ΣΣ ′ )−1 α )(Jm m̄λ) + 1

2

(1 − J1 )(Σ −1 σZ )′ (Jm′ m̄λ) − 1

2

(1 −

h (t ,r)

J1 )(Σ η) (Jm m̄λ

−1 ′ ′

+ (1 − J1 )(kyJY − JZ )m̄λ − (1 − J1 )ky(Σ σY ) (Jm m̄λ) + (1 − J1 )(Σ σZ ) (Jm m̄λ) and B =

) rx −1 ′ ′ −1 ′ ′ 1

2

(1 −

J1 )2 Σ −1 m̄λ(Σ −1 m̄λ)′ . The optimal solution to (59) is indeed solvable in closed form under the solvency constraint:

1

[ ]

1 (22 3 (3 + A2 + 3B(λ− − λ+ ))) 1

a= −2A + 1

+ (4Φ ) 3 , (68)

6 Φ3

where Φ = (−2A3 + 27B(λ− + λ+ ) + 9A(2 + B(λ+ − λ− )) +

√

□

We observed that if

− 21 ((ΣΣ ′ )−1 α )(Jm m̄λ) + 12 (Σ −1 σZ )′ (Jm′ m̄λ) − 21 (Σ −1 η)′ (Jm′ m̄λ) hr (tx ,r) + (kyJY − JZ )m̄λ− ky(Σ −1 σY )′ (Jm′ m̄λ) + (Σ −1 σZ )′ (Jm′ m̄λ)

= − 21 (1 − J1 )(λ− − λ+ )Σ −1 m̄λ(Σ −1 m̄λ)′ , it implies that the investor has no exposure to jump risk. This is due to the fact

that jumps in one investment are used to hedge or offset jump risks in another investment.

8. Empirical results

In this section, we give the numerical results of our problem. One of the major challenges faced by fund managers is what

fraction of wealth should be invested in one portfolio or the other. Nigeria Pension Reform Act stipulates that more of the

investment portfolio should be invested in bonds and fixed deposits and small past of the portfolio should be invested in

stock. In this paper, we allow 75% of the investment fund to be invested in bonds (both risky and riskless bonds) and the

remaining 25% in stocks (including bank deposit accounts) and each of the investment class is not equally weighted. Inflation

data from the International Monetary Fund from 1980 to June 14, 2016 were collected and analyzed, data for four banks,

which include First Bank of Nigeria PLC (FBN), Guarantee Trust Bank of Nigeria PLC (GTB), United Bank of Africa PLC (UBA),

Zenith Bank of Nigeria PLC (Zenith) as well as four government of Nigeria bonds, referred to as: BOND 1, BOND 2, BOND 3 and

BOND 4 were collected from Nigerian Stock Exchange, Sapele Road Benin City, Edo State, Nigeria from March 2006 to June

16, 2016. In order to obtain the expected growth rate and salary risks of a PPM, data from the salary chart of Academic Staff

of Nigeria University, 2009 was obtained from Bursary Department, University of Benin, Benin City, Edo State, Nigeria. The

data were analyzed using the SPSS package. Table 1 shows the mean and standard deviation (SD) of the bonds and stocks

and Table 2 shows the jump sizes. We assume that for every investment in risky bond there are corresponding riskless

bonds, risky stocks and bank fixed deposit accounts. This to a great extent will diversify risks associated with the investment

(which is our hedging strategy). Note that in this section, we assume that the portfolio strategies are free from interest rate

risks.

246 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

Table 1

Mean and SD of bonds and stocks.

Bond Mean SD Stock Mean SD

BOND 1 12.0733 1.64051 FBN 28.9614 13.36671

BOND 2 14.4008 1.45157 GTB 19.0368 8.34097

BOND 3 12.5142 1.79795 UBA 21.7460 15.58661

BOND 4 12.8608 1.37605 Zenith 25.1496 14.43704

Interest rate: FBN 5%,GTB 5.5%, UBA 6% and Zenith 6.5%.

Table 2

Jump size of bonds and stocks.

Bond Jumpsize Jump rate Stock Jump size Jump rate

BOND 1 4.35 0.189130 FBN 06.68 0.058087

BOND 2 5.84 0.253913 GTB 11.70 0.146250

BOND 3 5.91 0.256957 UBA 24.48 0.249796

BOND 4 4.69 0.203913 Zenith 11.80 0.119192

For inflation:

• φB = (0.1875, 0.1875, 0.1875, 0.1875), φS = (0.0625, 0.0625, 0.0625, 0.0625),

• where φ = (φB , φS ), φB and φS are weights for bonds and stocks respectively,

• ρY = (0.010, 0.010, 0.010), inflation jumpsize = 5.4,

• number of jump MI = 35, λ1 = 0.154286,

• JY4 = 0.0102 is the expected rate of income jump.

0.108 −0.131 −0.069 −0.065

⎛ ⎞

⎜−0.131 1.035 −0.316 −0.301⎟

σS = ⎝ . (69)

−0.069 −0.316 0.455 −0.256⎠

−0.065 −0.301 −0.256 0.503

The coefficient of correlation matrix is obtained as follows:

1.000 0.390 −0.309 −0.279

⎛ ⎞

⎜ 0.390 1.000 −0.461 −0.417⎟

ρ=⎝ . (70)

−0.309 −0.461 1.000 −0.536⎠

−0.279 −0.417 −0.536 1.000

It then follows that

0.108000 0.051090 0.021321 0.018135

⎛ ⎞

⎜0.051090 1.035000 0.145676 0.125517⎟

σS ρS = ⎝ . (71)

0.021321 0.145676 0.455000 0.137216⎠

0.018135 0.125517 0.137216 0.503000

The matrix σS ρS is not vanishing since its determinant is 0.0214538 which is not equal to zero. Therefore,

0.535070 −0.413097 −0.263651 −0.168769

⎛ ⎞

⎜−0.413097 1.044650 −0.262586 −0.174154⎟

(σS ρS )−1 =⎝ . (72)

−0.263651 −0.262586 2.475230 −0.600201⎠

−0.168769 −0.174154 −0.600201 2.201350

The covariance matrix for the bonds is

0.077 0.012 −0.072 −0.007

⎛ ⎞

⎜ 0.012 0.184 −0.094 −0.083⎟

σB = ⎝ . (73)

−0.072 0.094 0.219 −0.100⎠

−0.007 −0.083 −0.100 0.230

The coefficient of correlation matrix for bonds is obtained as follows:

1.000 0.103 −0.557 −0.055

⎛ ⎞

⎜ 0.103 1.000 −0.469 −0.404⎟

ρB = ⎝ . (74)

−0.557 −0.469 1.000 −0.450⎠

−0.055 −0.404 −0.450 1.000

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 247

Fig. 5. Optimal terminal consumption versus optimal wealth for γ = 0.5, δ = 0.6.

0.077000 0.001236 0.040104 0.000385

⎛ ⎞

⎜0.001236 0.084000 0.044086 0.033532⎟

σB ρB = ⎝ . (75)

0.040104 0.044086 0.217000 0.045000⎠

0.000385 0.033532 0.045000 0.230000

The matrix σB ρB is not vanishing and has the determinant of 0.026787. It implies that the matrix σB ρB is invertible.

Fig. 5 shows the relationship between optimal consumption and optimal real wealth at the terminal time. We observe

that as wealth increases, consumption increases alongside.

Table 3 shows the index bonds and stocks portfolio values, portfolio values in riskless bonds and in bank fixed deposits

accounts, as coefficient of investors relative risk averse varies, for c = 0.1, k = 0.5, y = 0.4 and a = 5 remain fixed. We

found that:

1. the higher the value of γ the lower the portfolio values in Bonds 1, 2, 3 and 4, FBN, GTB, UBA and Zenith and higher the

portfolios in the riskless assets, and vice versa. This implies that as the investor’s coefficient of CRRA increases more

of the fund should remain in the riskless assets and less fund should be in the risky assets

2. the higher the value of γ , for the class of riskless Bond: RB 3 yields the highest portfolio values, followed by RB 2, then

RB 1 and RB 4 have the least values. It implies that if investors must invest in risky bond, Bond 4 must be considered

first, followed by Bond 1 and so on. For the class of bank deposit: More fund should be fixed with FBN, followed by

UBA, then Zenith, last GTB. Looking at the poor returns from stocks as γ increases, GTB remains viable up to the point

γ = 0.5. We therefore remark that if investors must invest in stocks, GTB should be considered first

3. individual investors with lower coefficient of risk aversion should consider investing in FBN, GTB, UBA, Zenith, Bonds

1, 2, 3 and 4, otherwise their investment should remain in the riskless assets while individual investors with high

coefficient of risk averse should consider investing in riskless assets otherwise the investment should remain in the

risky assets

4. overall, RB 3 and GTB are the most promising assets, hence more of the PPM’s contributions should be invested into

these assets to ensure maximum returns at retirement

5. those who must invest in FBN must ensure that their investment remain in FBN fixed deposits account.

Table 4 shows change in portfolio values in both the riskless and risky assets as a (a control parameter that measures how

much of this portfolio value the investor is willing to take) changes for c = 10%, k = 50%, y = 20% and γ = 3.0 remain

fixed. We found the following:

1. as the value of a increases, the portfolio values in the risky assets increase and vice versa

2. as the value of a increases, investment in the riskless assets decreases and vice versa.

Table 5 shows the portfolio values in risky and riskless assets as the contribution rate changes for y = 40%, γ = 3.0,

γ = 3.0 remain fixed. It is observed that as contribution rate increases, the portfolio values in the risky assets increase and

the values of the riskless assets decrease, and vice versa. It was further observed that the portfolios in the riskless bonds

remain positive as contribution rate increases.

248 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

Table 3

Portfolio value for different values of γ .

γ Bond πB Stock πS RB πB0 FD πS0

0.5 BOND 1 5.5862 FBN 2.5599 RB 1 −5.4089 FBN −2.5122

BOND 2 5.8248 GTB 0.8064 RB 2 −5.6556 GTB −0.7479

BOND 3 7.0197 UBA 1.0468 RB 3 −6.8595 UBA −0.9838

BOND 4 5.0557 Zenith 1.1423 RB 4 −4.8874 Zenith −1.0865

1.0 BOND 1 0.9281 FBN 0.7740 RB 1 −0.7508 FBN −0.7263

BOND 2 0.9596 GTB 0.3600 RB 2 −0.7904 GTB −0.3015

BOND 3 1.1687 UBA 0.4326 RB 3 −1.0085 UBA −0.3696

BOND 4 0.8517 Zenith 0.4894 RB 4 −0.6834 Zenith −0.4336

2.0 BOND 1 −1.4010 FBN −0.1189 RB 1 1.5783 FBN 0.1666

BOND 2 −1.4730 GTB 0.1368 RB 2 1.6422 GTB −0.0783

BOND 3 −1.7568 UBA 0.1254 RB 3 1.9170 UBA −0.0624

BOND 4 −1.2502 Zenith 0.1629 RB 4 1.4185 Zenith −0.1071

3.0 BOND 1 −2.1774 FBN −0.4166 RB 1 2.3547 FBN 0.4643

BOND 2 −2.2839 GTB 0.0624 RB 2 2.4531 GTB −0.0039

BOND 3 −2.7319 UBA 0.0230 RB 3 2.8921 UBA 0.0400

BOND 4 −1.9509 Zenith 0.0541 RB 4 2.1192 Zenith 0.0017

4.0 BOND 1 −2.5655 FBN −0.5654 RB 1 2.7428 FBN 0.6131

BOND 2 −2.6893 GTB 0.0252 RB 2 2.8585 GTB 0.0333

BOND 3 −3.2195 UBA −0.0282 RB 3 3.3797 UBA 0.0912

BOND 4 −2.3012 Zenith −0.0003 RB 4 2.4695 Zenith 0.0561

5.0 BOND 1 −2.7985 FBN −0.6547 RB 1 2.9758 FBN 0.7024

BOND 2 −2.9326 GTB 0.0029 RB 2 3.1018 GTB 0.0556

BOND 3 −3.5121 UBA −0.0589 RB 3 3.6723 UBA 0.1219

BOND 4 −2.5114 Zenith −0.0329 RB 4 2.6797 Zenith 0.0887

6.0 BOND 1 −2.9537 FBN −0.7142 RB 1 3.1310 FBN 0.7619

BOND 2 −3.0947 GTB −0.0120 RB 2 3.2639 GTB 0.0705

BOND 3 −3.7071 UBA −0.0793 RB 3 3.8673 UBA 0.1423

BOND 4 −2.6516 Zenith −0.0547 RB 4 2.8199 Zenith 0.1105

7.0 BOND 1 −3.0646 FBN −0.7567 RB 1 3.2419 FBN 0.8044

BOND 2 −3.2106 GTB −0.0226 RB 2 3.3798 GTB 0.0811

BOND 3 −3.8464 UBA −0.0940 RB 3 4.0066 UBA 0.1570

BOND 4 −2.7517 Zenith −0.0702 RB 4 2.9200 Zenith 0.1260

11.0 BOND 1 −3.3066 FBN −0.8495 RB 1 3.4839 FBN 0.8972

BOND 2 −3.4633 GTB −0.0458 RB 2 3.6325 GTB 0.1043

BOND 3 −4.1504 UBA −0.1259 RB 3 4.3106 UBA 0.1889

BOND 4 −2.9701 Zenith −0.1041 RB 4 3.1384 Zenith 0.1599

RB stands for Riskless Bond and FD stands for Fixed Deposit. We take consumption to be 10%, k = 50%, y = 40% and a = 5.

Table 6 shows the portfolio values for varying value of the income rate for k = 0.5, γ = 3.0, a = 5 remain fixed.

1. It is observed that an increase in income can lead to an increase in the portfolio risks and vice versa. We found that

a 1% increase in income rate can lead to 0.4665% increase in the portfolio value in Bond 1 and 0.549% decrease in

riskless Bond 1. Also, a 1% increase in income rate can lead to 0.49% increase in portfolio value in Bond 2 and 0.51%

decrease in the portfolio value in riskless bond 2. Bonds 3 and 4 increase by 0.59% and 0.42% as income rate increases

by 1% and the corresponding riskless assets decrease respectively by 0.60% and 0.44%.

2. Similarly, we found that a 1% increase in income rate can lead to 0.1265% increase in the portfolio value in FBN and

0.1326% decrease in the corresponding fixed deposit. Again, 1% increase in income rate can lead to 0.042% increase in

portfolio value in GTB and 0.0170% decrease in the portfolio value in the corresponding fixed deposit. UBA and Zenith

increase by 0.0225% and 0.082% respectively as income rate increases by 1% and the corresponding riskless assets

decrease by 0.0295% and 0.106%.

3. We found that inflation risk and income risk contribute tremendously to the reduction of the portfolio values in the

riskless assets.

Table 7 is made up of three compartments and it shows the optimal terminal consumption of the investor at varying values

of optimal terminal real wealth (X ∗ (T )), investor’s relative risk averse coefficient γ and preference rate of consumption δ

provided k = 0.15, y = 0.4, a = 0.2 are held fixed. The following were found:

1. from the first compartment, as optimal wealth increases, consumption increases alongside;

2. from the second compartment, as γ increases, consumption increases drastically;

3. from compartment three, as δ increases, consumption decreases and vice versa;

4. as the risk averse coefficient increases, consumption increases. This shows that as PPM’s taste to consume decreases

optimal consumption decreases and vice versa.

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 249

Table 4

Portfolio value for different values of a.

a Bond $πB Stock πS RB π0B FD π0S

5 BOND 1 −2.1751 FBN −0.4165 RB 1 2.3524 FBN 0.4642

BOND 2 −2.2830 GTB 0.0627 RB 2 2.4522 GTB −0.0042

BOND 3 −2.7311 UBA 0.0239 RB 3 2.8913 UBA 0.0391

BOND 4 −1.9504 Zenith 0.0543 RB 4 2.1187 Zenith 0.0015

10 BOND 1 −2.1728 FBN −0.4165 RB 1 2.3501 FBN 0.4642

BOND 2 −2.2821 GTB 0.0630 RB 2 2.4513 GTB −0.0045

BOND 3 −2.7302 UBA 0.0247 RB 3 2.8904 UBA 0.0383

BOND 4 −1.9498 Zenith 0.0545 RB 4 2.1181 Zenith 0.0013

15 BOND 1 −2.1705 FBN −0.4164 RB 1 2.3478 FBN 0.4641

BOND 2 −2.2812 GTB 0.0633 RB 2 2.4504 GTB −0.0048

BOND 3 −2.7292 UBA 0.0256 RB 3 2.8894 UBA 0.0374

BOND 4 −1.9492 Zenith 0.0547 RB 4 2.1175 Zenith 0.0011

20 BOND 1 −2.1681 FBN −0.4164 RB 1 2.3454 FBN 0.4641

BOND 2 −2.2803 GTB 0.0636 RB 2 2.4495 GTB −0.0051

BOND 3 −2.7283 UBA 0.0265 RB 3 2.8885 UBA 0.0365

BOND 4 −1.9486 Zenith 0.0549 RB 4 2.1169 Zenith 0.0009

25 BOND 1 −2.1658 FBN −0.4163 RB 1 2.3431 FBN 0.4640

BOND 2 −2.2794 GTB 0.0639 RB 2 2.4486 GTB −0.0054

BOND 3 −2.7274 UBA 0.0273 RB 3 2.8876 UBA 0.0357

BOND 4 −1.9481 Zenith 0.0551 RB 4 2.1164 Zenith 0.0007

30 BOND 1 −2.1635 FBN −0.4163 RB 1 2.3408 FBN 0.4640

BOND 2 −2.2786 GTB 0.0642 RB 2 2.4478 GTB −0.0057

BOND 3 −2.7265 UBA 0.0282 RB 3 2.8867 UBA 0.0348

BOND 4 −1.9475 Zenith 0.0553 RB 4 2.1158 Zenith 0.0005

35 BOND 1 −2.1612 FBN −0.4163 RB 1 2.3385 FBN 0.4640

BOND 2 −2.2777 GTB 0.0645 RB 2 2.4469 GTB −0.0060

BOND 3 −2.7256 UBA 0.0290 RB 3 2.8858 UBA 0.0340

BOND 4 −1.9469 Zenith 0.0555 RB 4 2.1152 Zenith 0.0003

We take consumption to be 10%, k = 50%, y = 20% and γ = 3.0.

Table 5

Portfolio value for different values of k.

k Bond πB Stock πS RB π0B FD π0S

0.05 BOND 1 −3.0144 FBN −0.6442 RB 1 3.2272 FBN 0.7014

BOND 2 −3.1618 GTB 0.0433 RB 2 3.3648 GTB 0.0269

BOND 3 −3.7846 UBA −0.0170 RB 3 3.9768 UBA 0.0926

BOND 4 −2.7046 Zenith 0.0175 RB 4 2.9066 Zenith 0.0494

0.1 BOND 1 −2.9212 FBN −0.6189 RB 1 3.1300 FBN 0.6751

BOND 2 −3.0641 GTB 0.0454 RB 2 3.2634 GTB 0.0235

BOND 3 −3.6675 UBA −0.0125 RB 3 3.8562 UBA 0.0867

BOND 4 −2.6208 Zenith 0.0216 RB 4 2.8190 Zenith 0.0441

0.2 BOND 1 −2.7347 FBN −0.5683 RB 1 2.9356 FBN 0.6224

BOND 2 −2.8689 GTB 0.0498 RB 2 3.0606 GTB 0.0165

BOND 3 −3.4334 UBA −0.0034 RB 3 3.6150 UBA 0.0748

BOND 4 −2.4532 Zenith 0.0298 RB 4 2.6439 Zenith 0.0334

0.3 BOND 1 −2.5481 FBN −0.5177 RB 1 2.7412 FBN 0.5697

BOND 2 −2.6736 GTB 0.0541 RB 2 2.8578 GTB 0.0096

BOND 3 −3.1993 UBA 0.0057 RB 3 3.3737 UBA 0.0629

BOND 4 −2.2856 Zenith 0.0380 RB 4 2.4688 Zenith 0.0228

0.4 BOND 1 −2.3616 FBN −0.4671 RB 1 2.5468 FBN 0.5169

BOND 2 −2.4783 GTB 0.0584 RB 2 2.6550 GTB 0.0027

BOND 3 −2.9652 UBA 0.0148 RB 3 3.1325 UBA 0.0510

BOND 4 −2.1180 Zenith 0.0461 RB 4 2.2938 Zenith 0.0121

0.5 BOND 1 −2.1751 FBN −0.4165 RB 1 2.3524 FBN 0.4642

BOND 2 −2.2830 GTB 0.0627 RB 2 2.4522 GTB −0.0042

BOND 3 −2.7311 UBA 0.0239 RB 3 2.8913 UBA 0.0391

BOND 4 −1.9504 Zenith 0.0543 RB 4 2.1187 Zenith 0.0015

We take consumption to be 10%, a = 5, y = 20% and γ = 3.0.

From Tables 3–6, we observe that the portfolio values in the risky bonds remain negative (except when 0 < γ ≤ 1

in Table 3) and portfolio values in the riskless bonds remain promising. It therefore follows that all the proportion of the

investment allocated to the risky bonds should be withdrawn and invested in the riskless bonds most especially when γ > 1.

250 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

Table 6

Portfolio value for different values of y.

y Bond πB Stock πS RB π0B FD π0S

0.2 BOND 1 −3.0144 FBN −0.6442 RB 1 3.2272 FBN 0.7014

BOND 2 −3.1618 GTB 0.0433 RB 2 3.3648 GTB 0.0269

BOND 3 −3.7846 UBA −0.0170 RB 3 3.9768 UBA 0.0926

BOND 4 −2.7046 Zenith 0.0175 RB 4 2.9066 Zenith 0.0494

0.4 BOND 1 −2.9212 FBN −0.6189 RB 1 3.1300 FBN 0.6751

BOND 2 −3.0641 GTB 0.0454 RB 2 3.2634 GTB 0.0235

BOND 3 −3.6675 UBA −0.0125 RB 3 3.8562 UBA 0.0867

BOND 4 −2.6208 Zenith 0.0216 RB 4 2.8190 Zenith 0.0441

0.6 BOND 1 −2.8279 FBN −0.5936 RB 1 3.0328 FBN 0.6487

BOND 2 −2.9665 GTB 0.0476 RB 2 3.1620 GTB 0.0200

BOND 3 −3.5505 UBA −0.0079 RB 3 3.7356 UBA 0.0807

BOND 4 −2.5370 Zenith 0.0257 RB 4 2.7315 Zenith 0.0388

0.8 BOND 1 −2.7347 FBN −0.5683 RB 1 2.9356 FBN 0.6224

BOND 2 −2.8689 GTB 0.0498 RB 2 3.0606 GTB 0.0165

BOND 3 −3.4334 UBA −0.0034 RB 3 3.6150 UBA 0.0748

BOND 4 −2.4532 Zenith 0.0298 RB 4 2.6439 Zenith 0.0334

1.0 BOND 1 −2.6414 FBN −0.5430 RB 1 2.8384 FBN 0.5960

BOND 2 −2.7712 GTB 0.0519 RB 2 2.9592 GTB 0.0131

BOND 3 −3.3164 UBA 0.0011 RB 3 3.4944 UBA 0.0689

BOND 4 −2.3694 Zenith 0.0339 RB 4 2.5564 Zenith 0.0281

We take consumption to be 10%, a = 5, k = 10% and γ = 3.0.

Table 7

Optimal terminal consumption.

X ∗ (T ) C ∗ (T , r) γ C ∗ (T , r) δ C ∗ (T , r)

50 26.2384 0.10 4.1651 0.2 1.8064 × 109

100 46.7514 0.40 294.5156 0.4 4.2502 × 104

500 178.7598 0.50 1217.90 0.6 1.2179 × 103

1000 318.5138 0.55 2476.60 0.8 206.1591

5000 1217.90 0.60 5036.10 1.0 71.0169

9. Conclusion

This paper presented theoretical and empirical studies of optimal pension fund in the presence of inflation, interest rate,

income and equity risks. The optimal consumption and portfolio strategies for an investor who faces both diffusion and

jump risks were analyzed. The risky and the riskless assets are classified into two classes: the class of risky assets which

comprises of risky bonds and stocks, and class of riskless assets which is made up of riskless bonds and bank deposits. A

time-consistent proportion of income contributed into the scheme was obtained. The optimal investment with uniform

jumps and optimal consumption are obtained. It was found that the portfolio process is made up of four parts: the first

part is the Merton’s portfolio with jump, the second part is the jump risks hedging portfolio, the third part is a hedging

portfolio value of the two classes of risky assets and the last part is the component that is proportional to a which is a control

parameter that measures how much of this portfolio value the investor is willing to take. We also found that given γ = 2, if

− 21 ((ΣΣ ′ )−1 α )(Jm m̄λ) + 12 (Σ −1 σZ )′ (Jm′ m̄λ) − 21 (Σ −1 η)′ (Jm′ m̄λ) hr (tx ,r) + (kyJY − JZ )m̄λ− ky(Σ −1 σY )′ (Jm′ m̄λ) + (Σ −1 σZ )′ (Jm′ m̄λ) =

− 21 (1 − J1 )(λ− − λ+ )Σ −1 m̄λ(Σ −1 m̄λ)′ , the investor will no longer be exposed to jump risks. In this paper, we found from

the empirical study that

1. inflation and income risks contribute tremendously to the reduction in the investor’s portfolio values in riskless assets

2. as PPM’s taste to consume decreases, optimal consumption decreases and vice versa

3. as the investor’s coefficient of CRRA increases, more of the fund should remain in riskless assets and less fund should

be in the risky assets

4. overall, RB 3 and GTB are the most promising assets, hence more of the PPMs contributions should be invested into

these assets to ensure maximum returns at retirement.

Here, we provide analytical solution to the highly non-linear partial differential equation (PDE) (i.e., our HJB equation).

In general, there is no existing analytical method to solving a highly nonlinear PDE. But, in this paper, we are going to solve

it by making some assumptions.

C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252 251

Suppose that Definition 6 holds, then our HJB equation (44) becomes

1

− µI − ρY (σZ − π Σ ′ )σY−1 σY4 σZ′ ](1 − γ ) + 1ηη′ 1′ [h2r (t , r) + hrr (t , r)]

2

∫ ∞

1

[eh(t ,1Jr1 1 ) − 1]ν (dJr )

′

− ((σZ − π Σ )σY ) σY4 γ (1 − γ ) + λr

′ −1 2 2

2 −1

∫ ∞

−1 1−γ (76)

+ λY [(1 + (σZ − π Σ )σY )JY4 − 1]νY (dJY )

∫ ∞−1

+ [(1 + ((1 − J1 )(π Jm′ + (σZ − π Σ )σY−1 )JY ) − JZ )1−γ − 1]λZ νZ (dJZ )

−1

(1 − γ )c(t , r)1−δ

+ − ξ = 0.

(1 − δ )x1−γ

(76) can be re-expressed as follows:

1

ht (t , r) + 1ψ hr (t , r) + 1ηη′ 1′ [h2r (t , r) + hrr (t , r)] + F (t , π ) = 0, (77)

2

where F (t , π ) = −ξ + [φ r + πα + (σZ − π Σ ′ )σY−1 (β − φ r) − (1 − φ r)c(t , r) − µI − ρY (σZ − π Σ ′ )σY−1 σY4 σZ′ ](1 − γ ) −

((σZ − π Σ ′ )σY−1 )2 σY2 γ (1 − γ ) + λr −1 [eh(t ,1Jr1 1 ) − 1]ν (dJr ) + λY −1 [(1 + (σZ − π Σ )σY−1 )JY − 1]νY (dJY ) + −1 [(1 + ((1 −

1

∫∞ ′ ∫∞ 1−γ ∫∞

2 4 4

(1−γ )c(t ,r)1−δ

J1 )(π Jm

′

+ (σZ − π Σ )σY−1 )JY ) − JZ )1−γ − 1]λZ νZ (dJZ ) + (1−δ )x1−γ

.

We now set hrr = (hr )2 , so that (77) becomes

2

Solving the following ODE hrr = (hr ) , we have a solution of the form:

{

(79)

h(T , r) = 0,

Finding the partial derivative of h(t , r) in (79) with respect to t, r and rr, and then substituting into (78), we have the

following ordinary differential equation (ODE):

D′ (t) E ′ (t)r 1ηη′ 1′ E(t)2

A′ (t) − − +

D(t) + E(t)r D(t) + E(t)r (D(t) + E(t)r)2

(80)

1ψ D(t) 1

− + F = 0, E(T ) = , A(T ) = 0, D(T ) = 0.

D(t) + E(t)r r

We now set A′ (t) = 0 and D′ (t) = 0, so that (80) now becomes

E ′ (t)r 1ηη′ 1′ E(t)2 1ψ D(t) 1

− + − F = 0, E(T ) = , (81)

cD + E(t)r (cD + E(t)r)2 cD + E(t)r r

where A(t) = cA and D(t) = cD . Solving (81), we have

T

1ηη′ 1′ E(s)2

∫ ( )

1 1

E(t) = + 1ψ E(s) − − F (cD + E(s)r) ds.

r r t cD + E(s)r

It then follows that

T

1ηη′ 1′ E(s)2

[ ∫ ( ) ]

h(t , r) = cA − ln cD + 1 + 1ψ E(s) − − F (cD + E(s)r) ds . (82)

t cD + E(s)r

We now have that

T

1r ψ − 1ηη′ 1′ − Fr 2

[ ∫ ( ) ]

h(t , r) = − ln 1 + E(s)ds .

t r

252 C.I. Nkeki / Journal of Computational and Applied Mathematics 330 (2018) 228–252

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