34 3 Utility Maximisation on Finite Probability Spaces

We note that it is natural from an economic point of view to require that

the marginal utility tends to zero, when wealth x tends to infinity, and to
infinity when the wealth x tends to the infimum of its allowed values. The
infimum of the allowed values, i.e., of the domain {U > −∞} of U , may
be finite or equal to −∞. In the former case we have assumed w.l.g. the
normalisation that this infimum equals zero.
We can now give a precise meaning to the problem of maximising expected
utility of terminal wealth. Define the value function
u(x) := sup EP [U (x + (H · S)T )] , x ∈ dom(U ), (3.1)
H∈H

where H runs through the family H of trading strategies.

The optimisation of expected utility of wealth at a fixed terminal date
T is a typical example of a larger family of portfolio optimisation problems,
where one can also include utility of intermediate consumption and many
other features. We only consider the prototypical optimisation problem (3.1)
above. The duality techniques developed for this case can easily be adapted
to variants of it.
The value function u(x) is called the indirect utility function. Economically
speaking it indicates the expected utility of an economic agent at time T for
given initial endowment x, provided she invests optimally in the financial
market S.
We shall analyze the problem of finding, for given initial wealth x, the

optimiser H(x) ∈ H in (3.1) at two levels of difficulty: first we consider the
case of an arbitrage-free complete financial market S. In a second step, we
generalise to arbitrage-free markets S, which are not necessarily complete.

3.1 The Complete Case

We assume that the set Me (S) of equivalent probability measures under which
S is a martingale, is reduced to a singleton {Q}. In this setting consider the
Arrow-Debreu assets 1{ωn } , which pay 1 unit of the numéraire at time T ,
when ωn turns out to be the true state of the world and pay out 0 otherwise.
In view of our normalisation of the numéraire St0 ≡ 1, we get the following
relation for the price of the Arrow-Debreu assets at time t = 0:
 
EQ 1{ωn } = Q[ωn ] =: qn ,
and by Corollary 2.2.12 each such asset 1{ωn } may be represented as 1{ωn } =
Q[ωn ] + (H n · S)T , for some predictable trading strategy H n ∈ H.
Hence, for fixed initial endowment x ∈ dom(U ), the utility maximisation
problem (3.1) above may simply be written as

N
EP [U (XT )] = pn U (ξn ) → max! (3.2)
n=1