56 3 Utility Maximisation on Finite Probability Spaces

so
 
βν 2 T
N
wU = exp − + o(1)
2ασ 2
 
ν2T
= exp + o(1).
(1 − α)2σ 2
1
In this new scaling the factor 1−α makes perfect sense economically: when
α → 1, i.e., the investor is less and less risk averse, the factor wU N
becomes
large: the investor then appreciates highly the possibility to invest in the
financial market. If α → −∞, i.e., the investor is more and more risk averse
N
and the factor wU tends to one: in this case the investor has little appreciation
for the possibilities offered by investments
 into
 the risky stock.
ν2T
Note that the function α → exp 2(1−α)σ2 is continuous for α ∈]−∞, 1[ so
that the limiting behaviour as α tends to zero,  is not
 a puzzle any more; in the
N ν2T
case α = 0 one easily verifies that wU = exp 2σ2 indeed yields the certainty
equivalent in the case of the logarithmic utility function U (x) = log(x).
Example 3.3.6 (The trinomial model (N periods)). We now extend the
one-period trinomial model, example 3.3.4, to the N period setting similarly
as we just have done for the binomial model.
Let 0 < m < 1 and (ηt )N t=1 i.i.d. random variables, defined on some
(Ω, F , P) such that P[ηt = −1] = 1−m 2 , P[ηt = 0] = m, P[ηt = 1] =
1−m
2 . Let
S0 = 1 and, for t = 1, · · · , N define inductively
⎧
⎨ St−1 (1 + u), if ηt = 1,
St = 0, if ηt = 0,
⎩  if ηt = −1.
St−1 (1 + d),
The analysis of the maximisation of expected utility of terminal wealth
now is entirely analogous to the situation of the binomial model: using the
notation from the preceding examples, the optimal investment strategy again
consists in investing the constant proportion 
1
k = (1−β)ν
σ2 + O(∆t 2 ) of current
wealth found in (3.47) into the stock. For the value function utri (x) we find
utri (x) = (ctri N
u ) U (x)
 
(1 − m)βν 2 T
= exp − U (x) + o(1)
2σ 2
tri N
and for the “certainty equivalent” (wU ) , defined analogously as in the pre-
ceding example, we obtain
 
tri N (1 − m)ν 2 T
(wU ) = exp + o(1).
(1 − α)2σ 2
The verifications are simply a combination of the arguments of Exam-
ples 3.3.4.