Capital Markets and Portfolio Theory

Roland Portait From the class notes taken by Peng Cheng

Novembre 2000

2

Table of Contents

Table of Contents
PART I 1 Standard (One Period) Portfolio Theory . . . . . . . . . . . . . . . . . . . . . 1

Portfolio Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.A Framework and notations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.A.i No Risk-free Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.A.ii With Risk-free Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 1.B Efficient portfolio in absence of a risk-free asset . . . . . . . . . . . . . . . . . . . . . . 6 1.B.i Efficiency criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 1.B.ii Efficient portfolio and risk averse investors . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 1.B.iii Efficient set . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 1.B.iv Two funds separation (Black) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 1.C Efficient portfolio with a risk-free asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 1.D HARA preferences and Cass-Stiglitz 2 fund separation . . . . . . . . . . . . . . 14 1.D.i HARA (Hyperbolic Absolute Risk Aversion) . . . . . . . . . . . . . . . . . . . . . . . . 14 1.D.ii Cass and Stiglitz separation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Capital Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 2.A CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 2.A.i The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 2.A.ii Geometry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 2.A.iii CAPM as a Pricing and Equilibrium Model . . . . . . . . . . . . . . . . . . . . . . . . . 19 2.A.iv Testing the CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 2.B Factor Models and APT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 2.B.i K-factor models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 2.B.ii APT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 2.B.iii Arbitrage and Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 2.B.iv References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

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PART II Multiperiod Capital Market Theory : the Probabilistic Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 3 Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 3.A Probability Space and Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 3.B Asset Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 3.B.i DeÞnitions and Notations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 3.C Portfolio Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 3.C.i Notation: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 3.C.ii Discrete Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 3.C.iii Continuous Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

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AoA, Attainability and Completeness. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 4.A DeÞnitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 4.B Propositions on AoA and Completeness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 4.B.i Correspondance between Q and Π : Main Results . . . . . . . . . . . . . . . . . . . 35 4.B.ii Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Alternative SpeciÞcations of Asset Prices . . . . . . . . . . . . . . . . . . . . . . . . . . 39 5.A Ito Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 5.B Diffusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 5.C Diffusion state variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 5.D Theory in the Ito-Diffusion Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 5.D.i Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 5.D.ii Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
5.D.iii Redundancy and Completeness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 5.D.iv Criteria for Recognizing a Complete Market . . . . . . . . . . . . . . . . . . . . . . . . 44

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PART III State Variables Models: the PDE Approach. . . . . . . . . . . . . . . . 45 6 7 Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Discounting Under Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 7.A Ito’s lemma and the Dynkin Operator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 7.B The Feynman-Kac Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 The PDE Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 8.A Continuous Time APT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 8.A.i Alternative decompositions of a return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 8.A.ii The APT Model (continuous time version) . . . . . . . . . . . . . . . . . . . . . . . . . . 51 8.B One Factor Interest Rate Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 8.C Discounting Under Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Links Between Probabilistic and PDE Approaches . . . . . . . . . . . . . . . 55 9.A Probability Changes and the Radon-Nikodym Derivative . . . . . . . . . . . 55 9.B Girsanov Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 9.C Risk Adjusted Drifts: Application of Girsanov Theorem . . . . . . . . . . . . 56

8

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PART IV The Numeraire Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 10 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 11 Numeraire and Probability Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 11.A Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 11.A.i Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 ii

Table of Contents 11.A.ii Numeraires . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.B Correspondence Between Numeraires and Martingale Probabilities . 11.B.i Numeraire → Martingale Probabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.B.ii Probability → Numeraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.C Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

61 62 62 63 63

12 The Numeraire (Growth Optimal) Portfolio . . . . . . . . . . . . . . . . . . . . . . . 65 12.A DeÞnition and Characterization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 12.A.i DeÞnition of the Numeraire (h, H) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 12.A.ii Characterization and Composition of (h, H) . . . . . . . . . . . . . . . . . . . . . . . . 65 12.A.iii The Numeraire Portfolio and Radon-Nikodym Derivatives . . . . . . . . . . . . 69 12.B First Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 12.B.i CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 12.B.ii Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 PART V Continuous Time Portfolio Optimization. . . . . . . . . . . . . . . . . . . . 72 13 Dynamic Consumption and Portfolio Choices (The Merton Model) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 13.A Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 13.A.i The Capital Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 13.A.ii The Investors (Consumers)’ Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74 13.B The Solution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74 13.B.i Sketch of the Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74 13.B.ii Optimal portfolios and L + 2 funds separation . . . . . . . . . . . . . . . . . . . . . . 77 13.B.iii Intertemporal CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 14 THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 14.A Transforming the dynamic into a static problem . . . . . . . . . . . . . . . . . . . . 80 14.A.i The pure portfolio problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 14.A.ii The consumption-portfolio problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 14.B The solution in the case of complete markets . . . . . . . . . . . . . . . . . . . . . . . . 83 14.B.i Solution of the pure portfolio problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 14.B.ii Examples of speciÞc utility functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 14.B.iii Solution of the consumption-portfolio problem . . . . . . . . . . . . . . . . . . . . . . 86 14.B.iv General method for obtaining the optimal strategy x∗∗ . . . . . . . . . . . . . . . 87 14.C Equilibrium: the consumption based CAPM . . . . . . . . . . . . . . . . . . . . . . . . 88 PART VI STRATEGIC ASSET ALLOCATION . . . . . . . . . . . . . . . . . . . . . . . 90 15 The problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 16 The optimal terminal wealth in the CRRA, mean-variance

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and HARA cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 16.A Optimal wealth and strong 2 fund separation. . . . . . . . . . . . . . . . . . . . . . . 92 16.B The minimum norm return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 17 Optimal dynamic strategies for HARA utilities in two cases . . . . 93 17.A The GBM case. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 17.B Vasicek stochastic rates with stock trading . . . . . . . . . . . . . . . . . . . . . . . . . 93 18 Assessing the theoretical grounds of the popular advice . . . . . . . . . 94 18.A The bond/stock allocation puzzle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 18.B The conventional wisdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 REFERENCES 95

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PART I Standard (One Period) Portfolio Theory

Chapter 1

Portfolio Choices

Chapter 1 Portfolio Choices

1.A

Framework and notations

In all the following we consider a single period or time interval (0 1), hence two instants t = 0 and t = 1 Consider an asset whose price is S(t) (no dividends or dividends reinvested). The return of this asset between two points in time (t = 0, 1) is: R= S (1) − S (0) S (0)

We now consider the case of a portfolio. and distinguish the case where a riskless asset does not exist from the case where a risk free asset is traded.

1.A.i

No Risk-free Asset

There are N tradable risky assets noted i = 1, ..., N : • The price of asset i is Si (t), t = 0, 1. • The return of asset i is Ri = Si (1) − Si (0) Si (0) 2

Chapter 1

Portfolio Choices

• The number of units of asset i in the portfolio is ni . The portfolio is described by the vector n(t); ni can be >0 (long position) or <0 (short position). • Then the value of the portfolio, denoted by X (t), is X (t) = n0 · S (t) with n (0) = n (1) = n (no revision between 0 and 1), the prime denotes a transpose. S (t) stands for the column vector (S1 (t), ..., SN (t))0 • The return of the portfolio is: X (1) − X (0) X (0)

RX =

• Portfolio X can also be deÞned by weights, i.e. ni S (0) X (0)

xi (0) = xi =

(Note that xi (1) 6= xi ). Besides the weights sum up to one: x0 · 1=1 where x= (x1 , x2 , ..., xN )0 and 1 is the unit vector. • The return of the portfolio is the weighted average of the returns of its components:

RX = x0 R

3

Chapter 1

Portfolio Choices

Proof
X (1) X (0) n0 S (1) X (0)
N X ni Si (1) Si (0) · X (0) Si (0) i=1 N X i=1 N X i=1

1 + RX

= = =

=

xi ·

Si (1) Si (0)

=

xi · (1 + Ri )
N X i=1

= 1+

xi Ri

Q.E.D.

• DeÞne µi = E [Ri ] and µ= (µ1 , µ2 , ..., µN ) , then: µX = E (RX ) = x0 µ • Denote the variance-covariance matrix of returns ΓN×N = (σ ij ), where σ ij = cov (Ri , Rj ), then: var (RX ) = var (x0 R) = x0 Γx N N XX = xi xj σ ij
i=1 j=1

0

1.A.ii

With Risk-free Asset

We now have N +1 assets, with asset 0 being the risk-free asset, and the remaining N assets being the risky assets.

4

Chapter 1

Portfolio Choices

• S0 (1) = S0 (0) · (1 + r) with r a deterministic interest rate. • Again we can deÞne the portfolio in units, with n= (n0 , n1 , n2 , ..., nN )0 • The portfolio can be similarly deÞned in weights: xi = ni S (0) X (0)

for the N risky assets (i = 1, 2, ..., N ), and x0 = 1 − Note that now x0 · 1 6= 1
N X i=1

xi

where x= (x1 , x2 , ..., xN )0 denotes the weights in the N risky assets. • The return of the portfolio is: RX = x0 r +
N X i=1

xi Ri = r +

N X i=1

xi (Ri − r)

The term (Ri − r) is the excess return of asset i over r. Moreover: µX = E (RX ) = r + x0 π where π is the risk premium vector of the E (Ri − r) • Also denote ΓN×N as the variance-covariance matrix of the risky assets, then: var (RX ) = x0 Γx Γ is always positive semi-deÞnite (meaning that ∀x, x0 Γx ≥ 0). In some cases it is positive deÞnite (∀x 6= 0, x0 Γx > 0).

that

DeÞnition 1 Assets i = 1, 2, ..., N are redundant if there exist N scalars λ1 , λ2 , ..., λN such P
N i=1 λi Ri

= k, where k is a constant. Then the portfolio λ is risk-free.

Proposition 1
The N assets i = 1, 2, ..., N are not redundant iff singular or invertible). Γ is positive deÞnite (i.e. non-

5

Chapter 1

Portfolio Choices

Proof
Assume that the assets are redundant, then there exist N scalars λ1 , λ2 , ..., λN such that PN i=1 λi Ri = k. Consider the portfolio deÞned by the weights λ. The variance of its return = var (k) = 0 = λ0 Γλ, i.e. Γ is singular and not positive deÞnite. Conversely if Γ is singular and not positive deÞnite there existP non 0 vector λ such that λ0 Γλ = 0; Then the return of a N portfolio λ has zero variance and i=1 λi Ri = k Q.E.D.

Remark 1 In the following sections we will assume that the assets are non-redundant (it is always possible to “drop” redundant assets if any).

1.B

Efficient portfolio in absence of a risk-free asset

1.B.i

Efficiency criteria

DeÞnition 2 Portfolio (x∗ , X ∗ ) is efficient if ∀y, σY < σX ∗ ⇒ µY < µX ∗ and σ Y =
σX ∗ ⇒ µY ≤ µX ∗

Consider any efficient portfolio (x∗ , X ∗ ) and let variance(RX ) = k x∗ solves the optimization program (P ) : max E [RX ]
x

s.t. x0 Γx = k ; x0 1 = 1

The Lagrangian is: µ ¶ θ θ L x, , λ = x0 µ − x0 Γx − λx0 1 2 2 ¡ ¢ The Þrst order condition ∂L = 0 writes: ∂x µ − θΓx∗ −λ1 = 0
N X j=1

or equivalently, for i = 1, .., N : µi = λ + θ x∗ σ ij j

6

Chapter 1

Portfolio Choices

Remark that these Þrst order conditions are necessary and also sufficient for the solution being a maximum since the second order conditions hold (L(x) is strictly concave -Γ positive deÞnite). Theorem 1
A portfolio (x, X) is efficient iff there exist two scalars λ and θ such that for all i = 1, 2, ..., N : µi = λ + θ · cov (Rx , Ri )

Proof
The necessary and sufficientP condition for x to be efficient is that it satisÞes the Þrst order condition: for all i: µi = λ + θ N x∗ σij . We then have: j=1 j µi = λ+θ
N X j=1

x∗ cov (Ri , Rj ) j 
N X j=1

= λ + θcov (Ri , RX ) Q.E.D.

= λ + θ · cov Ri,

x∗ Rj  j

Remark 2 The second term can be considered as the additional required rate of return (risk premium), proportional to cov (Ri , RX ). Remark 3 If cov (Ri , RX ) = 0, then µi = λ. Remark 4 Also note:
var (RX ) =
N N XX i=1 j=1 N X i=1 N X i=1

xi xj σij 
N X j=1

=

xi · cov Ri ,

xj Rj 

=

xi · cov (Ri , RX )

The covariance term cov (Ri , RX ) indicates the contribution of asset i to the total risk of the portfolio. Therefore, additional required rate of return should be proportional to this induced risk which is what is stated in the theorem. Moreover cov (Ri , RX ) appears to be the relevant measure of risk for any asset i embedded in the portfolio X.

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Chapter 1

Portfolio Choices

1.B.ii

Efficient portfolio and risk averse investors

DeÞne another optimization program (P 0 ), equivalent to (P ) : ¶ µ θ 0 0 0 (P ) max x µ− x Γx s.t. : x0 1 = 1 2 ( (P ) and (P 0 ) yield the same solutions since they have the same Lagrangian) (P 0 ) writes, equivalently: θ M ax E [RX ] − var (RX ) , s.t. : x0 1 = 1 2 In (P 0 ) θ is interpreted as a given risk-aversion while in (P ) it is an unknown lagrangian multiplier. In (P ) we are given σ 2 and we solve for θ and λ as functions of σ 2 . In (P 0 ) we X X are given the risk-aversion parameter θ and solve for σ 2 as function of θ. X The Þrst order conditions of (P’) write as for (P): µ − θΓx∗ −λ1 = 0 (with only one multiplier for (P 0 )) • Consider the case of minimum variance portfolio where θ = ∞, i.e. 1 min x0 Γx s.t. : x0 1 = 1 2

The Lagrangian is then: 1 L (x,λ) = x0 Γx − λx0 1 2 Call k1 the solution. The Þrst order condition gives: Together with the constraint k01 1 = 1 gives: λ= Thus: k1 = λΓ−1 1 1 = 0 −1 · Γ−1 1 1Γ 1 1 10 Γ−1 1 Γk1 − λ1 = 0

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Chapter 1

Portfolio Choices

1.B.iii

Efficient set

DeÞnition 3 The Efficient Set is the set of all x∗ that obey the Þrst order condition. Equivalently, it is the set of all x∗ that solve the optimization program (P 0 ) ∀θ ≥ 0.

Recall that the Þrst order condition for (P 0 ) is: µ − θΓx∗ −λ1 = 0 DeÞne risk tolerance b as the inverse of risk aversion, i.e. θ Then x∗ can be solved as: ¡ ¢ x∗ = b −1 µ − λ1 θΓ b= 1 θ θ

To Þnd λ, use the constraint 10 x∗ = 1, i.e.

Then:

1 = 10 x∗ ¡ ¢ = 10 · b −1 µ − λ1 θΓ b 0 Γ−1 µ − θλ10 Γ−1 1 = 1 b θ1 b b b 0 Γ−1 µ − θλ10 Γ−1 1 = θθ θ1 10 Γ−1 µ−θ λ= 10 Γ−1 1

or:

This solves for λ:

Then: ¡ ¢ x∗ = b −1 µ − λ1 θΓ µ ¶ 10 Γ−1 µ − θ −1 = b θΓ µ− ·1 10 Γ−1 1 µ ¶ 10 Γ−1 µ Γ−1 1 b −1 µ − = 0 −1 + θΓ ·1 1Γ 1 10 Γ−1 1 9

Chapter 1

Portfolio Choices

We recognize in the Þrst term the minimum variance portfolio (k1 ) and we call k2 the second term: k1 k2 Γ−1 1 = 0 −1 1Γ 1 · ¸ 10 Γ−1 µ −1 µ − 0 −1 ·1 = Γ 1Γ 1 x∗ = k1 + b 2 θk

Then the solution of (P ) writes:

Since the expected return x∗0 µ is linear in b and the variance is quadratic in b in θ θ, 2 the (σ , R) space the efficient portfolios are represented by the efficient frontier, which is a parabola. Each point on the efficient frontier corresponds to a given θ, θ the slope of the parabola at this point being equal to 2 (the shadow price in (P ) of the constraint on variance). In the (σ, R) space the efficient frontier is an hyperbola. 1.B.iv Two funds separation (Black)

Note that k01 1 = 1 and x∗0 1 = 1, therefore k02 1 = 0. Any efficient portfolio is thus the sum of k1 (the minimum variance portfolio) and k2 which is a zero weight (zero investment) portfolio. As it could be expected, an investor with a zero risk tolerance will hold only k1 ; If he has a positive risk tolerance b he will add a risk θ b in order to increase the expected return. The efficient set can taking the form θk2 now be caracterized as: o n ∗ ∗ b ∀b > 0 ES = x |x = k1 + θk2 θ

Theorem 2
Consider any two efficient portfolio x and y:

1. 2. 3.

Any convex combination of x and y is efficient, i.e.∀ u ∈ [0, 1] , ux+ (1 − u) y ∈ ES Any efficient portfolio is a combination of x and y (not necessarily a convex combination) The whole parabola (efficient and inefficient frontier) is generated by (all) combinations of x and y 10

Chapter 1

Portfolio Choices

Proof • Since x∈ ES and y∈ ES, for some positive bX and b Y , we have: θ θ θ x = k1 + bX k2 y = k + bY k θ
1 2

Let z = ux + (1 − u)y, then: = k1 + bZ k2 θ

h i z = [uk1 + (1 − u) k1 ] + ubX + (1 − u) bY k2 θ θ

• Let z∈ ES, then z = k1 + bZ k2 for some bZ > 0. For any x∈ ES and θ θ y∈ ES: h i ux + (1 − u) y = k1 + ubX + (1 − u) bY k2 θ θ By equating bZ to ubX + (1 − u) bY we get: θ θ θ u∗ = Then the combination u∗ x + (1 − u∗ ) y = z
Q.E.D.

With bZ > 0, we can conclude that z∈ ES. θ

bZ − bY θ θ bX − bY θ θ

1.C

Efficient portfolio with a risk-free asset

Consider Þgure 1 where the upper branch of the hyperbola EFR represents, in the (σ, E) space, the efficient portfolios in absence of a riskless asset. Assume now that exists a risk free asset 0 yielding the certain return r. M stands for the tangency point of the hyperbola EFR with a straight line drown from r representing asset 0. Point M represents a portfolio composed only of risky assets, called the tangent portfolio. 11

Chapter 1

Portfolio Choices

E EFR M r X

σ

• Efficient frontier in presence of a riskless asset

Figure 1.1.

12

Chapter 1

Portfolio Choices

1. 2.

Proposition 2 Asset 0 is efficient Consider any portfolio X. Any combination of 0 and X yielding R = uRX + (1 − u) r, lies on the straight line connecting 0 and X in the (σ, E) space Any feasible portfolio which representative point is not on r − M (such as X) is dominated by portfolios in r − M. The straight line r − M is the efficient frontier and is called the Capital Market Line (Tobin’s Two-fund Separation) Any efficient portfolio is a combination of any two efficient portfolios, for instance 0 and M Any efficient portfolio writes: ¡ ¢ θΓ x∗ = b −1 µ−r1

3.

4. 5.

6.

The tangent portfolio (m,M ) is:

¡ ¢ m = bM Γ−1 µ−r1 θ 1 bM = ¡ ¢ θ 0 −1 1Γ µ−r1 Proof
1, 2, 3, 4 are standard and easy to prove. Let us proove 5 and 6: x∗ ∈ ES solves: ¡ ¢ θ max 1 r + x∗0 µ − r1 − x∗0 Γx∗ 2 µ − r1 = θΓx∗ Then: x∗ ¢ 1 −1 ¡ µ − r1 Γ θ ¡ ¢ = b −1 µ − r1 θΓ = 1 ¡ ¢ µ − r1

The Þrst order condition is:

¡ ¢ θ The tangent portfolio is an efficient portfolio, therefore, m= bM Γ−1 µ − r1 . Also: m0 1 = 1, then: bM = θ 10 Γ−1

Q.E.D.

13

Chapter 1 θ: Remark 5 Given a risk tolerance b

Portfolio Choices

• b < bM , the portfolio is long in 0 and m θ θ • b > bM , the portfolio shorts 0 θ θ Remark 6 We deÞne later the market portfolio as a portfolio containing all the risky assets present in the market (and only risky assets). In absence of riskless asset the market portfolio is efficient iif its representative point belongs to the hyperbola EFR. In presence of a risk free asset the necessary and sufficient condition for the market portfolio to be efficient is that it coincides with the tangent portfolio m (which is the only efficient portfolio of EFR, in presence of a risk free asset). Would all investors face the same efficient frontier (it would be the case under homogeneous expectations and horizon) and would they all follow the mean-variance criteria, they would all hold combinations of 0 and M and the tangent portfolio M would necessarily coincide with the market portfolio.

1.D

HARA preferences and Cass-Stiglitz 2 fund separation

A rational agent (in the sense of Von Neumann-Morgenstern) should maximize the expected utility of wealth E [U (W )].

1.D.i

HARA (Hyperbolic Absolute Risk Aversion)

A utility function U (W ) belongs to HARA class if it writes: · ¸1−γ γ W b+ U (W ) = θ 1−γ γ

Some restrictions are imposed on the coefficients γ and b and the domain of θ deÞnition. The absolute risk tolerance (ART) and absolute risk aversion (ARA) are: ART = 1 ARA U0 = − 00 U W = b+ θ γ 14

Chapter 1

Portfolio Choices

and the relative risk tolerance (RRT) is: RRT = In particular: 1. b=0⇒ θ b θ 1 + W γ

U (W ) =

We obtain CRRA, i.e. constant relative risk aversion. A limit case of CRRA is obtained for γ = 1 which can be showed to be equivalent to the Log utility 2. γ = −1 ⇒ U (W ) = W − i.e. the quadratic utility function. 3.

W 1−γ 1−γ

W2 2b θ

Using a quadratic utility function implies a mean-variance criteria; Indeed: b min var (RX ) s.t. E [RX ] = E (and x0 1 = 1) 2 b ⇔ min E [RX ] s.t. E [RX ] = E (and x0 1 = 1) i h b ⇔ min E [X 2 (1)] s.t. E [X (1)] = X (0) · 1 + E ⇔ min E[X 2 (1)] − λE [X (1)] £ ¤ 1 ⇔ max E X (1) − λ X 2 (1)
2

4.

Three undesirable features of the quadratic utility:
for W > b θ!)

— Saturation at W = b (for that wealth U (W ) = W − Wb is maximum; U (W ) decreases θ 2θ — ARA increasing with wealth (it is commonly admitted that ARA decreases for most
agents).

— Indifference to skewness (only the two Þrst moments of W matter), whereas most
investors actually like skewness.

1.D.ii

Cass and Stiglitz separation

Cass and Stiglitz showed that all HARA investors sharing the same exponential 15

Chapter 1

Portfolio Choices

parameter γ can build their optimal portfolios by mixing the two same funds. When a risk free asset exists it can be chosen as one of the two funds. Since all quadratic (mean-variance) investors exhibit the same γ(= −1) Tobin and Black 2 fund separation are particular cases of Cass and Stiglitz separation. Cass and Stiglitz conditions on the utility functions for separation to hold for investors sharing the same exponential parameter are summarized in the following table @r ∃r Complete Market (under complete markets ∃ r) class wider than HARA Incomplete Market quadratic or CRRA2 HARA

2

in the particular case of CRRA one fund suffices (for a given γ the portfolio is the same for all W

16

Chapter 2

Capital Market Equilibrium

Chapter 2 Capital Market Equilibrium
2.A CAPM

2.A.i

The Model

Consider again N risky assets (a risk free asset may exist or not). The market value of asset i is Vi , then (by deÞnition of the market portfolio) it’s weight in the market portfolio is: Vi mi = PN Vi

i=1

The return of the market portfolio is:

RM = m0 R

Hypothesis 1 (H) : The market portfolio M is efficient.

Remark 7 The market portfolio would be efficient if all investors would hold efficient portfolios (since a combination of efficient portfolios is efficient).

Theorem 3
(General CAPM )

1.

If (H) is true, then there exist θ and λ such that, for i = 1, ..., N : µi = E [Ri ] = λ + θcov (RM , Ri )

2.

Conversely, if there exist θ and λ such that, for i = 1, ..., N : µi = λ + θcov (RM , Ri ), then (H) is true. 17

Chapter 2

Capital Market Equilibrium

Proof
The proof comes directly from Theorem 1. Q.E.D.

Remark 8 θ can be interpreted as the risk aversion of the average (representative) investor. Remark 9 CAPM holds for any portfolio (x, X). Indeed, call RX its return and consider the case where no risk free asset exists (x0 1 = 1) : E [RX ] = = =
N X i=1 N X i=1 N X i=1

xi µi xi (λ + θcov (RM , Ri )) xi λ + θ Ã
N X i=1

xi cov (RM , Ri )
N X i=1

= λ + θcov RM ,

xi Ri

!

= λ + θcov (RM , RX )
with weight x0

Remark 10 The proof follows the same lines when the portfolio contains a risk free asset Remark 11 λ and θ are the same for all assets or portfolios Remark 12 For the market portfolio:
µM Therefore: θ= Then: µi = λ + θcov (RM , Ri ) · ¸ µ −λ = λ + M2 cov (RM , Ri ) σM µM − λ σ2 M = λ + θcov (RM , RM ) = λ + θσ2 M

18

Chapter 2 DeÞne:

Capital Market Equilibrium

βi =

cov (RM , Ri ) σ2 M

Then we may write the CAPM equation in the alternative form: E [Ri ] = λ + β i (µM − λ)

Consider any portfolio z with β Z = 0: βZ = ⇔ ⇔ ⇐⇒ ⇔ 0 cov (RM , RZ ) = 0 cov (m0 R, z0 R) = z0 Γm = 0 z ⊥Γm z ∈ [vect (Γm)]⊥

vect [v1 , v2 , ..., vN ] is the set of all linear combinations of v1 , v2 , ..., vN , or linear subspace generated by v1 , v2 , ..., vN . The dimension of [vect (Γm)]⊥ is thus N − 1 and there are an inÞnity of 0-beta portfolios. Now, from the general CAPM, we would have: λ = µZ ; Thus: Corollary 1 (0−beta CAPM) If M is efficient, for any zero beta portfolio or asset Z: E [Ri ] = µZ + β i (µM − µZ ) Corollary 2 (Standard CAPM) : If there exists a risk-free asset yielding r (which is a particular zero beta asset) E [Ri ] = r + β i (µM − r) Note that µZ = r for any zero beta portfolio or asset.

2.A.ii missing

Geometry

2.A.iii

CAPM as a Pricing and Equilibrium Model

e e • For a security delivering V (1) at time 1(the pdf of V (1) is given, thus e e E(V (1)) and cov(V (1) , RM ) are known), what is its price V (0) at time 0? 19

Chapter 2

Capital Market Equilibrium

Let’s assume that there exists a risk-free asset, then: h i à ! e E V (1) e V (1) = E [1 + R] = 1 + r + θcov , RM V (0) V (0) with θ= Then: h i ³ ´ e e E V (1) = (1 + r) V (0) + θcov V (1) , RM V (0) = h i ³ ´ e (1) − θcov V (1) , RM e E V 1+r µM − r σ2 M

and

i.e. V (0) is the present value of its certainty equivalent at time 1 discounted at the risk-free rate. However this asset may be an element of the market portfolio M (unless this claim is in zero net supply ..) and therefore the previous pricing formula is not a closed form general equilibrium relation. • In fact CAPM is an equilibrium condition stemming from the demand side; The equilibrium price can only be otained by specifying the supply side (in the previous example the supply was a right on an exogeneous cash ßow X). General equilibrium requires a speciÞcation of the supply of all securities traded in the market. — Consider the N risky assets together and we look for their equilibrium prices. We
e assume Þrst an inelastic supply. Assume that asset i delivers Vi (1), an exogenous cash ßow, at time 1, what is its price at time 0? h i ! Ã · ¸ e E Vi (1) e µM − r Vi (1) =1+r+ , RM cov Vi (0) σ2 Vi (0) M

For i = 1, 2, ..., N . We have N equations with N unknowns Vi (0) (i = 1, ..., N ). ´ ³e PN e V (1) (1 + RM = P i=1 Vi (0) allows to compute µM , σ2 , cov Vi (1) , RM as functions of the N M Vi (0) i=1 i Vi (0))

— Consider again the N risky assets and an elastic supply with constant returns to scale,
where the joint pdf of the Ri is given and independent of the scale Vi (0) to be invested in ”technology i”. The CAPM determines the scale Vi (0) of investment in technology i

20

Chapter 2 by the equations:

Capital Market Equilibrium

µi = E [Ri ] = r + and 1 + RM =

·

¸ µM − r cov (RM , Ri ) σ2 M

PN

i=1 Vi (0) · (1 + Ri ) PN i=1 Vi (0)

2.A.iv

Testing the CAPM

One remark about this important empirical topic. Testing the CAPM is equivalent to testing (H). However, how should we deÞne the market portfolio and how to measure the market return? Usually the market portfolio is proxied by stock (plus bond) indices. But results on stock indices do not include all assets in M (non tradable assets, art,..). Hence we test the efficiency of the index and not that of M (Roll’s Critique).

2.B

Factor Models and APT

2.B.i

K-factor models

Hypothesis 2 There exist K factors, Fk , k = 1, 2, ...K with 1. 2. 3. Fi ⊥ Fj E [Fk ] = 0 var (Fk ) = σ 2 k
such that for i = 1, 2, ..., N : Ri = µi +
K X

β ik Fk + ²i

k=1

where E [²i ] = 0 and ²i ⊥ ²j ⊥ Fk . In vector form: RN×1 = µ + βN×K FK×1 + ² = µ +
K X k=1

β 0 Fk + ² k

21

Chapter 2 with β k being the kth row of β.

Capital Market Equilibrium

• In practice, we should have large N and small K, so that in estimating the variance-covariance matrix, cov (Ri , Rj ) =
K X k=1

β ik β jk σ 2 k

we only need to estimate K terms of σ 2 and run N regressions for estimating k the β ik . • In CAPM or in the Markowitz model, without the factor decomposition, we need to estimate N (N − 1) /2 terms. • A Particular case: K = 1 boils down into the market model that writes: Ri = µi + β i F + ²i Then: RM =
N X i=1 N X i=1 N X i=1

mi µi + F

mi β i +

mi ²i

= µM + F

Since the innovation terms diversify and β M = F = RM − µM and

PN

i=1

mi β i = 1:

Ri = µi + β i [RM − µM ] + ²i Note that the Ri are linked through [RM − µM ] (since cov (Ri , Rj ) = β i β j σ 2 ). M Also, β i [RM − µM ] is the systematic risk, and ²i is the unsystematic (diversiÞable) risk; only systematic risk should be priced (CAPM).

2.B.ii

APT

We assume that the returns are generated by a K factors linear process previously deÞned that writes: 22

Chapter 2

Capital Market Equilibrium

R = µ + +βF + ² = µ +

K X k=1

β k Fk + ²

Recall that β k is an N dimensioned column vector with an ith component equal to β ik DeÞnition 4 A zero investment portfolio, deÞned by the amount of wealth, x, invested in each asset, satisÞes:
x0 1 = 0 V (0) = 0 V (1) = x0 R

The last equation can be veriÞed since: V (1) =
N X i=1

xi (1 + Ri ) =

N X i=1

xi +

N X i=1

xi Ri = x0 R

DeÞnition 5 An arbitrage portfolio is a zero investment portfolio with x0 R ≥ 0 almost
surely and E [x0 R] > 0.

Absence of arbitrage (AOA) prevails if no arbitrage portfolio can be constructed i.e: x01 = 0 and x0R ≥ 0 a.s. implies x0R = 0 a.s. (or equivalently implies E(x0R) = 0) Theorem 4
(AP T ) In AoA there exist K + 1 scalars such that: µ = λ0 1 + λ1 β1 +... + λK βK or µi = λ0 + λ1 β i1 + ... + λK β iK

• λ0 is the required rate of return without systematic risk. • λk is the market price of risk k. • λk β ik is the risk premium imposed to security i because it has a risk k of intensity β ik . 23

Chapter 2

Capital Market Equilibrium

Proof
Consider any well-diversiÞed zero investment portfolio satisfying: x0 1 = 0 x0 β k = 0 hence: h ³ ´i⊥ x is any element of vect 1,β1 , β 2 , ..., β K RX = x0 R = x0 µ + = xµ
0 K X

or x⊥ 1 or x⊥βk for k = 1, ..., K

Also x0 ² = 0 (since it is well diversiÞed); Then:

Fk x0 β k + x0 ²

k=1

Since x0 µ is certain, in AoA x0 µ must be zero (if x0 µ > 0 then x is an arbitrage portfolio and if x0 µ < 0 then −x is an arbitrage portfolio). Thus: x0 µ = 0 or x⊥µ, which means that µ is orthogonal to any element x of [vect(1, β 1 , β 2 , ..., β K )]⊥ , i.e. µ ∈ vect(1, β 1 , β 2 , ..., β K ) implying that exist K + 1 scalars such that : µ = λ0 1 + λ1 β 1 + ... + λK β K Q.E.D.

• In the particular case where there is a risk-free asset, then: µ0 = λ0 = r and µi = r + λ1 β i1 + ... + λK β iK

2.B.iii

Arbitrage and Equilibrium

• Equilibrium implies AoA, but the inverse is not true. • AoA conditions do not involve utility functions.

24

Chapter 2

Capital Market Equilibrium

2.B.iv

References

Dumas-Allaz, 1995 ; Demange-Rochet, 1992.

25

PART II Multiperiod Capital Market Theory : the Probabilistic Approach

Chapter 3

Framework

Chapter 3 Framework

3.A

Probability Space and Information

We consider the usual probability triplet (Ω, F, P ), where F is a σ-algebra on Ω representing the observable events at time T .

Information in the period [0, T ] is represented by a Þltration {Ft }t∈[0,T ] , where Ft is the set of observable events at time t (represented by a σ−algebra), and the sequence {Ft }t∈[0,T ] satisÞes the ”usual” conditions: F0 = {null events and a.s. event} (s < t) ⇔ (Fs ⊂ Ft ) FT = F \ Fs = Ft
t>s

In the discrete time setting, all transactions take place at discrete points, i.e., t = 1, 2, ..., T . In the continuous time setting, transactions take place continuously, i.e., t ∈ [0, T ].

We assume a frictionless market, continuously open in the continuous time framework.

27

Chapter 3

Framework

3.B

Asset Prices

3.B.i

DeÞnitions and Notations

There are N + 1 assets traded in the market, one being the locally risk-free asset, denoted by 0, and the remaining N being the risky assets. The prices of those assets are noted Si (t) ( for i = 0, 1, ..., N ); S(t) = (S1 (t), .., SN (t))0 or (S0 (t), S1 (t), .., SN (t))0 (depending on the context) is the N (or N + 1) dimensional column vector of asset prices. Without loss of generality it will generally be assumed that Si (0) = 1 It is assumed for the time being that there is no dividend, or that a dividend is reinvested in the asset that delivers it. 1. In the discrete time case S0 (t) = S0 (t − 1) [1 + r (t − 1)], with r (t − 1) being the locally risk-free rate in [t − 1, t] , known at time t − 1 but unknown before. Remark that S0 (t + 1) = S0 (t)(1 + r(t)) is random at t − 1 since r(t) is unknown. 2. In the continuous time context:

• r(t) is stochastic but Ft -adapted. For a risk-free asset: dS0 = S0 rdt or S0 (t) = e with S0 (0) = 1. • For a risky asset we will usually assume that prices follow Ito processes: dSi = Si µi dt + Si σ i 0 dw with risk induced by w, the vector of standard Brownian Motions. Technical conditions (e.g., the integrability conditions) apply. If Si follows Ito process, we preclude jumps. If jumps are involved, however, then a rather general assumtion is that Si follows a semi-martingale process. A slightly more speciÞc assumption is that asset prices follow processes that yield a.s. Right Continuous and Left Limited (RCLL) paths. When considering the possibility of 28
Rt
0

r(u)du

Chapter 3

Framework

jumps we will assume RCLL processes for the asset prices to avoid the soÞstication of semi martingales3 . • It is worthwhile to note that Ito processes ⊂ RCLL ⊂ Semi − martingales. • Most of the results of the next chapter (On AOA and completeness) hold in the semi-martingale case.

3.C

Portfolio Strategies

3.C.i

Notation:

• n(N+1)×1 the vector of the N+1 numbers of assets ; xN×1 the vector of N weights on risky assets • S(N+1)×1 the vector of the N+1 asset prices • X (t) = n0 (t)S(t) the value of the portfolio at t • (n,X) or (x,X) a strategy 3.C.ii Discrete Time

[t − 1, t[ is period t − 1;at time t S(t) is set and, just after, n(t) is choosen • During period t − 1, the value of the portfolio will evolve:

X(t) − X(t − 1) = n0 (t)S(t)−n0 (t − 1)S(t − 1) = n0 (t − 1) [S(t) − S(t−1)] + S0 (t) [n(t) − n(t − 1)]

R Consider the integral: φ (u) dS. In a regular integral of this form dS is inÞnitesmal, while in a jump process it can assume some Þnite value somewhere.
3

The Þrst term in the right hand side of the equation, n0 (t − 1) [S(t) − S(t−1)], is the gain during the period [t − 1, t[ , and is represented as g(t − 1, t).

29

Chapter 3

Framework

The second term can be deemed as the net cash inßow added to the portfolio at time t. Indeed it can be decomposed into two terms: −S0 (t)n(t − 1), the value of assets sold at time t, and S0 (t)n(t), the algebric value of assets purchased (may be <0 if sales> purchases).

• The cumulative gain in [0, t], deÞned for t = 1, ..., T , can be represented as: G(t) =
t X u=1

g(u − 1, 1)

DeÞnition 6 (Self-Þnancing Portfolio) When at each time t the net inßow is 0, the strategy
is said to be self-Þnancing, i.e., if (n,X) is self-Þnancing, then: X(t) − X(t − 1) = g(t − 1, t) = n0 (t − 1) [S(t) − S(t−1)] and X(t) = X(0) + G(t)

• Let Si (t) be the value of asset i at time t, and S0 (t) be the numeraire, then the discounted value of i is: Si (t) Sid = S0 (t) • Self-Þnancing is independent of the numeraire used; In particular (n,X) self-Þnancing implies: £ ¤ X d (t) − X d (t − 1) = n0 (t − 1) Sd (t) − Sd (t − 1) 3.C.iii Continuous Time

• The gain process in [t, t + dt) is deÞned as: and G(t) =

dG(t) = n0 (t)dS(t)
t

Z

dG(u) =
0

Z

t

n0 (u)dS(u)
0

30

Chapter 3

Framework

• The change of the portfolio value is found to be:

dX = d (n0 (t)dS(t)) = n0 (t)dS(t)+S0 (t)dn0 (t)+dn0 (t)dS(t) = n0 (t)dS(t)+dn0 (t) [S(t)+dS(t)]

with the Þrst term in the right hand side of the equation being the period gain dG(t) and the second term the net inßow at t + dt. • Again, in a self-Þnancing strategy: dX(t) = dG(t), and X(t) = X(0) + G(t); As in the discrete time case, the self Þnancing property as well as the expression of the gain do not depend on the choosen numeraire .

31

Chapter 4

AoA, Attainability and Completeness

Chapter 4 AoA, Attainability and Completeness
4.A DeÞnitions

DeÞnition 7 strategy (n,X) is admissible if: 1. 2. 3. n(t) is Ft adapted and satisÞes some technical conditions4 . X(t) ∈ L1,2 . (This is an additional condition imposed sometimes) X(t) is bounded from below to avoid doubling Strategies5 . DeÞnition 8 A is the set of admissible strategies DeÞnition 9 A0 = { Self-Þnancing and admissible strategies} We now work with A0 , i.e., ∀ (n,X) ∈ A0 , dX = n0 dS.
4

(a) G(t) =

(c) (predictability of n (t)) n(t) ∼ LCRL so that if there is a jump in S(t), rebalancing must take place in t+ but never in t− , the latter being equivalent to insider trading, i.e., a rebalancing, or jump, in n(t) takes the advantage of a jump in S(t) that has just occured. This condition is not necessary when S(t) is continuous.
5

(b) (Integrability) Rt i. 0 kn0 (u)k2 du< ∞ a.s. Rt ii. 0 |n0 (u)| du< ∞ a.s.

Technical conditions on n(t) : , when asset prices follow RCLL processes R
t 0

n0 (u)dS(u) must be deÞned for S(t) ∼ RCLL

In a Doubling Strategy the gambler bets 2 when losing 1 and bets 4 when losing 2...

32

Chapter 4

AoA, Attainability and Completeness

It is also possible to deÞne a strategy by a vector of weights xN×1 . The weight of the risk-free asset in the portfolio is then 1 − x0 1. DeÞnition 10 (a,A) is an arbitrage if: 1. 2. 3. 4. (a,A) ∈ A0 . A(0) = n0 (0)S(0) =0, (i.e., zero initial investment). A(T ) ≥ 0 a.s. (i.e., non-negative cash ßow at the end). E [A(T )|F0 ] > 0 There is an arbitrage opportunity each time that a strategy (x, X) in A0 dominates another strategy (y, Y ) in A0 (i.e. X(T ) ≥ Y (T ) a.s. and E[X(T )] ≥ E[Y (T )] for the same initial investment X(0) = Y (0); or X(T ) = Y (T ) a.s.with X(0) < Y (0)). Arbitrage is built by being long in (x, X) and short in (y, Y ). Example 1 X(T ) ≥ S0 (T ) = e
RT
0

r(u)du

a.s.; E(X(T ) − S0 (T )) > 0 and X(0) = 1

Example 2 X(T ) = K, a constant, while X(0) < KBT (0) where BT (0) denotes the value
at time 0 of a zero-coupon bond yielding 1 at time T.

The previous considerations imply: Proposition 3
In AoA, all self-Þnancing and admissible portfolios yielding a.s. the same terminal ¢ ¡ value must require the same initial investment, i.e. ∀ (x,X) ∈ A0 and ∀ y,Y ∈ A0 with X(T ) = Y (T ) a.s., then in AoA: X(0) = Y (0). e DeÞnition 11 CT is a contingent claim if

1. 2. 3.

e CT ∈ L1,2 (Þnite mean and variance).

e CT is FT measurable.

DeÞnition 12 C , {the set of contingent claims}

e (goes with hypothesis on admissible strategies) CT is bounded from below.

33

Chapter 4

AoA, Attainability and Completeness

Example 3 The terminal values of N + 1 primitive assets are contingent claims. Example 4 ∀A ∈ FT , the indicator function 1A is a contingent claim.
e e e DeÞnition 13 CT ∈ C is attainable if ∃ (c,C) ∈ A0 with C(T ) = CT a.s.. We say CT is

DeÞnition 14 Ca = {attainable contingent claims} DeÞnition 15 Cn = {non-attainable contingent claims} DeÞnition 16 The market is (dynamically) complete when all contingent claims are attainable, i.e., Ca = C or Cn = ∅.

e attained by (c,C) or (c,C) yields CT .

Remark 13 Market completeness is unrealistic in discrete time, but less unrealistic in continuous time. In continuous time the possibility of rebalancing at each point of time allows a much larger spanning. When completeness is obtained through continuous rebalancing, the market is said “dynamically” complete.

DeÞnition 17 A pricing formula π maps C onto R. To be viable, π must satisfy: 1. e e0 π is linear, i.e., ∀λ1 , λ2 , CT ∈ C, and CT ∈ C: ³ ´ ³ ´ ³ ´ e e0 e e0 π λ1 CT + λ2 CT = λ1 π CT + λ2 π CT

2.

3.

³ ´ eT ≥ 0 a.s. ⇒ π CT ≥ 0 e (a) C ³ ´ e e (b) CT = 0 a.s. ⇒ π CT = 0

e ∀CT ∈ C

DeÞnition 18 Π = {π|π viable}

e e (Viability or Compatibility Condition) ∀ (x,X) attaining CT (i.e., X(T ) = CT a.s.): ³ ´ e π CT = X(0)

34

Chapter 4

AoA, Attainability and Completeness

DeÞnition 19 Two probability measures P and Q are equivalent if they have the same null
sets (the impossible as well as the certain events are the same for P and Q)

DeÞnition 20 An adapted stochastic process is a martingale if at each point of time the
(conditional) expectation of a future value is the current value i.e:

Z(t) is a martingale if E[Z(t)/F s ] = Z(s) for any s and t such that 0 ≤ s ≤ t ≤ T DeÞnition 21 Q = Q|Q ∼ P and ∀ (x,X) ∈ A0 , E Q
n h
X(T ) S0 (T ) |F0

o X(0) = S0 (0) . Equivalently, Q is a set of P -equivalent probability measures Q under which the asset 0 discounted asset X(T prices X d (T ) = S0 (T) are martingales. )

i

h i X(T It should be noted that X(0) 6= E P S0 (T) |F0 because investors are risk-averse ) and expect a return different than the risk-free rate r (usually higher since, in general, holding a risky asset increases the risk of their portfolio). However, this does not mean that there is no such a probability measure as Q that yields Qmartingale discounted prices. In the following we will consider the problems: • Are Q and Π empty? • What is the relation between Q and Π ?

4.B

Propositions on AoA and Completeness

Recall in the following that S0 (0) = 1 4.B.i Correspondance between Q and Π : Main Results

Theorem 5
Assume Q and Π are not empty. There exists a one-to-one relation between Q and Π.

• Q → π Q , deÞned by:

³ ´ e e ∀CT ∈ C : π Q CT = E Q 35

"

e CT |F0 S0 (T )

#

Chapter 4

AoA, Attainability and Completeness

• π → Qπ , deÞned by: ∀A ∈ FT : Qπ (A) = E Q [1A ] = π (1A · S0 (T )) Proof
Let us begin by showing that π Q is a viable pricing system. Indeed:

1.

2.

³ ´ e e ∀CT ≥ 0 a.s., π Q CT ≥ 0;Indeed:

e π Q is linear (because the expectation operator E is linear), i.e., ∀XT ∈ Ca a e and ∀YT ∈ C : # " ³ ´ e e Q λXT + µYT e e π Q λXT + µYT = E S0 (T ) " # " # e e λXT µY T Q Q = E +E S0 (T ) S0 (T ) ³ ´ ³ ´ e e = λπ Q XT + µπ Q YT ³ ´ eT > 0 ⇒ πQ CT = E Q e C " # eT C >0 S0 (T ) " # e CT =0 S0 (T )

and

3.

e e (Compatibility Condition) ∀ (x,X) attaining CT , i.e., X(T ) = CT a.s.., ³ ´ e π Q CT = X(0); Indeed: ³ ´ e π Q CT = EQ
Q

³ ´ eT = 0 a.s. ⇒ πQ CT = E Q e C

¸ X(T ) = E S0 (T ) £ d ¤ = E Q X (T )|F0 = X(0)

" ·

e CT S0 (T )

#

since Q yields martingale discounted prices 36

Chapter 4

AoA, Attainability and Completeness

4.

It has been shown that π Q is a viable pricing formula that maps Q into Π. Moreover, this mapping is injective, i.e., ∀Q0 6= Q and Q0 , Q ∈ Q, π Q0 6= π Q . Indeed: Q0 Q ∃A ∈ FT s.t. Q0 (A) 6= Q (A) 0 ⇐⇒ E Q [1A ] 6= E Q [1A ] 1A S0 (T ) π Q (1A S0 (T )) = E S0 (T ) Q = E [1A ]
Q

6= ⇒

Consider a contingent claim 1A S0 (T ): · ¸

and π Q0 (1A S0 (T )) = E
Q0
0

= E Q [1A ]

·

1A S0 (T ) S0 (T )

¸

Therefore we obtain different prices for this particular contingent claim, hence, π Q0 6= πQ . 5. The proof ends by checking that when π is a viable price system Q (A) = π (1A · S0 (T )) deÞnes a probability measure which has the same null sets than P .
Q.E.D.

Corollary 3 Q = ∅ ⇐⇒ π = ∅ Corollary 4 Q is a singleton ⇐⇒ π is a singleton

1. 2. 3.

Theorem 6 In AoA, a viable pricing formula on Ca exists and is unique. Market is complete and AOA ⇐⇒ Q is a singleton ⇐⇒ Π is a singleton AoA ⇐⇒ Q 6= ∅ ⇐⇒ Π 6= ∅ Proof : 37

Chapter 4

AoA, Attainability and Completeness

e 1. Assume AoA and consider any CT ∈ Ca attained by (x,X). Because ´ the ³ eT by π CT = e compatibility condition it is only possible to deÞne the price of C ¡ ¢ X (0). If another strategy y,Y attains f T , X(0) = Y (0) because AOA, Hence C there is only one viable pricing of an attainable claim under AOA. 2. Under AOA, if the market is complete all claims are attainable, hence there is one and only one viable price for any contingent claim in C. 3. Under AOA and incomplete markets there are an inÞnite number of viable prices for a non-attainable contingent claim (Π 6= ∅ but is not a singleton). When AOA does not prevail no pricing system meets the compatibility condition, hence Π is empty. 4.B.ii Extensions

4.B.ii.a

Extension I.

e • — At time 0, π CT = E Q

e Consider CT ∈ Ca attained by (x,X) and consider Q ∈ Q: — At time s ∈ [0, T ]:
³ ´ h
e CT S0 (T ) |F0

i

· S0 (0) = E Q

h

e CT S0 (T ) |F0

i

= X (0)

· ¸ ³ ´ Q X (T ) eT = E |Fs · S0 (s) πs C S0 (T ) X (s) · S0 (s) = S0 (s) = X (s)

4.B.ii.b

Extension II.

The portfolio is not self-Þnancing: • — Assume an adapted and integrable dividend payment δ (t) in [t, t + dt], then:
X (0) =
Q E0

(Z

T

0

h i Rt RT δ (t) e− 0 r(u)du dt + X (T ) e− 0 r(u)du

)

— Assume a cumulative dividend stream dD (t) in [t, t + dt], then:
X (0) =
Q E0

(Z

T

0

h i Rt RT dD (t) e− 0 r(u)du dt + X (T ) e− 0 r(u)du

)

38

Chapter 5

Alternative SpeciÞcations of Asset Prices

Chapter 5 Alternative SpeciÞcations of Asset Prices
5.A Ito Process

There are N + 1 assets in the market: • r (t) being the adapted, locally risk-free rate, asset 0 is the corresponding risk-free asset with: dr = αr (t) dt + σ 0r (t) dw
Rt
0

dS0 (t) = S0 (t) r (t) dt ⇔ S0 (t) = e At t : dr (t) is not known, but dS0 is known. • The N risky assets follow the process:

r(u)du

dS = α (t) dt + Ω (t) dw Z t Z t ⇔ S (t) = S (0) + α (u) du + Ω (u) dw
0 0

or for the i

th

asset dSi =αi (t) dt + Ω0i (t) dw

where wM×1 is the vector of standard Brownian Motions and αN×1 (t) and ΩN×M (t) are the two adapted processes Ω0i is the ith row of Ω. The coefficients of all these Ito processes are stochastic processes that satisfy integrability conditions. • In terms of returns: dRi = or in vector form: dR = µ (·) dt+Σ (·) dw 39

dSi = µi (·) dt + σ 0i (·) dw Si

Chapter 5

Alternative SpeciÞcations of Asset Prices

where σ 0i is the ith row of Σ, the diffusion matrix. Equivalently:
t 2 1 Si (t) = Si (0) e 0 [µi (.)− 2 kσi (.)k ]du+

R

Rt
0

σ 0 (.)dw i

The integrability conditions on the coefficients are: Rt Rt (IC) |µi (.)| du and 0 kσ i (.)k2 du deÞned a.s for 0 i = 1, ..., N They will be refered as the integrability conditions (IC) in the following chapters • Ito process yields continuous sample paths, but they are not necessarily Markovian.

5.B

Diffusions

• S(t) follows a diffusion process if: dS = α (t, S (t) , r(t)) dt + Ω (t, S (t) , r(t)) dw or dSi =αi (t, S (t) , r(t)) dt + Ω0i (t, Si (t) , r(t)) dw or dR = µ (t, S (t) , r(t)) dt+Σ (t, S (t) , r(t)) dw or, equivalently
t 2 1 Si (t) = Si (0) e 0 [µi − 2 kσi k ]du+

R

Rt
0

σ 0 dw i

The process for the risk-free rate is: dr = µr (t, r, S) dt + σ 0r (t, r, S) dw with the coefficients (α (·) , µ (·) , Ω (·) , ..), being a deterministic function of stochastic variables r, S and the deterministic t. • The diffusion process is an Ito process, hence it exhibits continuous sample paths. Moreover it is Markovian since the next increment depends on t and S(t) , r(t) only. • Technical conditions to be satisÞed bythe coefficients of a diffusion process are the Lipschitz condition and the linear growth condition. 40

Chapter 5

Alternative SpeciÞcations of Asset Prices

5.C

Diffusion state variables

The state of the economy is deÞned by L state variables Y obeying the diffusion SDE: dY = αY (t, Y (t)) dt + ΩY (t, Y (t)) dw (the coefficients meet the integrability conditions). The dynamics of all the Þnancial variables depend on (t, Y (t)) ,i.e: dR = µ (t, Y (t)) dt+Σ (t, Y (t)) dw ; dr = µr (t, Y) dt + σ 0r (t, Y) dw Remark that - The processes are Markovian - The simple diffusion case is a particular case of the state variable diffusion case (where S and r are the state variables); the state variable diffusion case is a particular case of the Ito case. 5.D Theory in the Ito-Diffusion Case

All the results on AOA, martingale measures, viable prices, completeness,.., presented in the case of RCLL asset prices and LCRL strategies hold of course when they follow Ito or diffusion processes (which are continuous). We present in the following some speciÞc results valid in these last cases. 5.D.i Framework

• Assume the usual probability triplet [Ω, F , P ] . • Let wM×1 denote the sources of uncertainties. The observable events at t are the events w(t0 ) ≤ a for all t0 ≤ t and all the real vectors a: roughly, information at t is represented by the path of w between 0 and t. {Ft , t ∈ [0, T ]} ≡ F w is then called the Þltration generated by w. • dR = µ(t)dt+Σ(t)dw and dSi = Si µi dt + Si σ 0i dw ; dr = αr (t) dt + σ 0r (t) dw ; the coefficients (µ(t), Σ(t), ..) are F w − adapted and satisfy the integrability conditions. • Let Γ (·) denote the instantaneous variance-covariance matrix, then: Γ = dRdR0 dt Σdw · dw0 Σ0 = dt 0 = ΣΣ 41

Chapter 5

Alternative SpeciÞcations of Asset Prices

• Let C be the set of contingent claims deÞned as L2 , as previously. If X, Y ∈ C, then E [XY ] is a scalar product and C is an Hilbert space • A strategy can be deÞned by weights on risky-assets xN×1 . The strategy will be denoted by (x,X) and the weight of the risk-free asset in the portfolio would be x0 = 1 − x0 1 • (x,X) is self-Þnancing if f dX X = x0 rdt + x0 dR = rdt + x0 (dR−rdt1) i.e., the increment in value comes only from returns. Equivalently: dX = µX dt + x0 Σdw X with ¡ ¢ µX = rdt + x0 µ−r1 5.D.ii Martingales

Theorem 7
(martingale representation theorem, stated without proof ). Consider any F w -adapted Martingale Z(t) : there exists an integrable process β M×1 (·) such that, for t ∈ (0T ) : Rt dZ = β 0 (t)dw(t) Z(t) = Z0 + 0 β0 (.)dw ⇐⇒

In particular, for any (x, X) in A0 , under any Q ∈ Q: dXd = β 0 dw (X d = X/S0 ) X and dX = r(t)dt+β 0 dw X We will see later that the probability change (from P to Q for instance) changes only the drift of the process but not the diffusion term (this follows from Girsanov theorem stated further on). Since this diffusion part would be x0 Σdw for a d portfolio (x, X),we can write under Q: dX d = x0 Σdw and dX = r(t)dt + x0 Σdw X X 5.D.iii Redundancy and Completeness

d

0 dimensional vector λ(t) = (λ1 , λ2 , ..., λN ) such that λ0 dR=α (t) dt a.s., i.e., a linear combination of risky assets gives a locally risk-free result.

DeÞnition 22 The N + 1 assets are redundant at time t if there exists a non zero N -

42

Chapter 5

Alternative SpeciÞcations of Asset Prices

• Without losing generality, assume λ0 1=1 • In AoA, α (t) = r (t)

Proposition 4
The assets are not redundant if f Rank (Σ) = N, or, equivalently, iff the N rows of Σ are linearly independent, or iff Γ is a positive deÞnite (invertible) matrix for all t a.s..

Proof
Assume that the assets are redundant, i.e., λ0 dR = λi θ i = − λN gives: dRN = γdt + Apply the processes followed by Ri : γ µN dt + σ0 dw=edt + N For all dw; This implies: σ0 = N
N−1 X i=1 N−1 X i=1 N−1 X i=1

PN

i=1 λi dRi

= α (t) dt. Then deÞning

θi dRi

θi σ0 dw i

θi σ 0 i

i.e., the N th row of Σ is a linear combination of the other rows. Therefore, Rank (Σ) < N . Q.E.D.

Remark 14 A result follows directly: a necessary condition for the assets to be non-redundant
is M ≥ N.

Theorem 8
Assume AOA, that M = N , that the coefficients are adapted w.r.t. the Þltration F w generated by w and that the N + 1 assets are non-redundant (hence Rank (Σ) = N ∀t a.s..), then the market is complete w.r.t.. the Þltration F w .

Proof 43

Chapter 5

Alternative SpeciÞcations of Asset Prices

Assume that the number of non redundant assets is equal to the number of brownians: N = M . Consider any contigent claim CT . We must proove that it is attainable by some strategy (n, X) in A0 . We use all along this proof a martingale measure Q ∈ Q and asset 0 as numeraire. Therefore we consider the discounted prices and values Sd and X d (which. are Q-martingales) Their dynamics, under Q, write: dSd = Ω (t) dw. T We consider also the Q-martingale C d deÞned as: C d (t) = E Q [ SC(T ) /Ftw ]; Remark 0 T that C d (T ) = SC(T ) . We know (from martingale representation theorem) that a 0 Rt process β Mx1 exists such that: C d (t) = C d (0) + 0 β 0 (t)dw a.s. Consider a strategy (n0 , n, X d ) (n represents here the N-dimensional vector of numbers of risky assets contained in the portfolio and n0 the number of riskless securities) satisfying at each time t the relations: (S) n0 (t)Ω(t) = β 0 (t); X d (0) = C d (0) Such a strategy is possible and is unique; Indeed: (S) is a system of M equations for N unknowns n0 (t) which yields the unique solution : n(t) = [Ω0 (t)]−1 β(t) since M = N and Ω is a square non singular matrix (the assets are non redundant); X d (0) = C d (0) sets the required initial investment. In a second step n0 (t) can be choosen in order to satisfy the self Þnancing condition. Then X d (t) is a Q-martingale and its dynamics write (under Q): dX d = (.)dt+ n0 (t)dS =n0 (t)Ω(t)dw = β 0 (t)dw = dC d with X d (0) = C d (0) ⇔ d C d (t) = X d (t) for any t ∈ (0T ) Hence (n, X d ) duplicates C d (t) and reaches CT , This implies that (n, X) reaches CT . Any contingent claim is thus attainable (by only one strategy) and the market is (exactly) complete. When M > N it is not possible, in general, to solve the system (S), hence it is not possible to duplicate any CT , and therefore the market is not complete. QED 5.D.iv Criteria for Recognizing a Complete Market

• Check the non-redundancy condition, i.e. check Rank (Σ) = N. • Check if M = N — M > N , the market is not complete — M = N , the market is exactly complete if f the assets are non redundant — M < N , necessarily there are redundant assets

44

PART III State Variables Models: the PDE Approach

Chapter 6

Framework

Chapter 6 Framework
The state of the economy depends on a vector Y of state variables • Let wM×1 denote the M -Brownian Motions vector and Y L×1 denote the L-state variables vector with ³ ´ dY = µY (t, Y(t))dt + ΩL×M t,Y(t) dw Y(t) represent the random variable, Yt will denote a particular realization at t • We consider N + 1 ”primitive” securities (one risk-free, N risky). The returns of the N risky assets follow the diffusion process: dRN×1 = µ(t, Y(t))dt + ΣN×M (t, Y(t))dw or, for a single asset: dSi = µi (t, Y(t)) dt + σ 0i (t, Y(t)) dw Si

dRi =

(σ 0i is the ith row of Σ) • The risk-free rate follows the diffusion process: dr (t) = µ0 (t, Y(t)) dt + σ 0r (t, Y(t)) dw The price of the locally riskless asset follows: dS0 = r (t) S0 (t) dt 46

Chapter 6

Framework

• The diffusion process implies continuous sample paths and Markovian properties; • In addition to the N+1 primitive assets we will deal with an indeterminate number of other assets (derivatives, funds, contingent claims). Consider X(t) one of them, a contingent claim attainable through (x, X). Since S0 (t) is a Q-martingale, if the state of the economy at t is Yt (the realization at t of Y(t) is Y t ) : · ¸ · ¸ Q X (T ) Q X (T ) E |Ft = E |Y(t) =Y t S0 (T ) S0 (T ) X (t) = f (t, Yt ) = S0 (t) The price at t of the claim writes thus: X (t) = ϕ (t, Y t ) • The particular case where L = M and Ω is invertible will sometimes be considered .

47

Chapter 7

Discounting Under Uncertainty

Chapter 7 Discounting Under Uncertainty
7.A Ito’s lemma and the Dynkin Operator

Recall that we consider the variables Y satisfying; dY = µY (t, Y)dt + ΩL×M (t, Y) dw Consider v (t, Y) : [0, T ] × RL → R, with v ∈ C 1 w.r.t. t and v ∈ C 1,2 w.r.t. Y. Ito’s lemma writes in alternative forms: ¶0 µ ∂v ∂v 1 ∂2v dv = dt + dY+ dY 0 dY ∂t ∂Y 2 ∂Y∂Y 0 This gives: " # M L L L L X ∂v X ∂v X ∂v 1 X X ∂ 2v + dv = µ + Vij dt + ω ij dwj ∂t ∂Yi Yi 2 i=1 j=1 ∂Yi ∂Yj ∂Yi j=1 i=1 i=1

with Vij being the common term of V , ΩΩ0 . DeÞne the Dynkin operator as:
t DY v =

Et [dv] dt L L L ∂v X ∂v 1 X X ∂ 2v = + µ + Vij ∂t ∂Yi Yi 2 i=1 j=1 ∂Yi ∂Yj i=1

then the dynamics of v can be simpliÞed in notations as: ¶0 µ ∂v t dv = (DY v)dt + Ωdw ∂Y

7.B

The Feynman-Kac Theorem

Consider Y and v (t, Y) as previously deÞned. For given functions of µ (t, Y (t)), b δ (t, Y (t)), and l (Y), we try to Þnd the solution to the following problem (PDE 48

Chapter 7

Discounting Under Uncertainty

with its limit condition): P DE {
t DY v + δ = µv b v (T, Y) = l (Y)

Feynman-Kac theorem:
as an expectation: v (t, Y t ) = E
P

The solution of the previous P DE can be written
Ru
t

½Z

T

t

δ (u) · e

µ(x)dx b

du + l (YT ) · e

RT
t

µ(x)dx b

|Y (t) = Yt

¾

The Þnancial interpretation of this is: • v is the price of a Þnancial asset giving a dividend stream of δ and a terminal value of l (Y) • µ is the required rate of return b •
t DY v+δ v

t is the expected instantaneous return with (DY v)dt being the capital gain and δ(t)dt the dividend during the period [t, t + dt].

The PDE states that the expected return is equal to the required µ; Its solution b is the conditional expected value of the ”discounted” stream of dividends + the terminal value, the discount rate being µ. This is also CIR(1985), lemma III. b Feynman-Kac theorem provides a link between the PDE approach and the martingale approach. However since we do not know the required expected return µ b the PDE or its solution interpreted as a discounting at rate µ does not give the b value v. But in the following we are going to provide an APT condition on µ. b

49

Chapter 8

The PDE Approach

Chapter 8 The PDE Approach
8.A Continuous Time APT

8.A.i

Alternative decompositions of a return

Consider an asset yielding a dividend stream of δ and a terminal value of l (Y). We have derived that: µ ¶0 ∂v t dv = (DY v)dt + Ωdw ∂Y Divide both sides by v gives: 1 dv 1¡ t ¢ = DY v dt + v v v 0 = µv dt + σ v dw µ ∂v ∂Y ¶0 Ωdw

t Here µ = 1 DY v can be considered as the expected rate of return and σ 0v = v ¢ ¡ 1 2v σ v , σ v , ..., σ M the volatility vector or sensitivity w.r.t.. w. v

Also, deÞne

1 ψ = µv − v then

µ

∂v ∂Y

¶0

µY

µ ¶0 dv 1 ∂v = µv dt + Ωdw v v ∂Y µ ¶0 ¤ 1 ∂v £ = µv dt + dY−µY dt v ∂Y µ ¶0 1 ∂v = ψdt + dY v ∂Y 50

Chapter 8

The PDE Approach

More explicitly we get two alternative decompositions of the return: X dv = µv dt + σ i dwi v v i=1
L M

1 X ∂v = ψdt + dYi v i=1 ∂Yi
1 ∂v v ∂Yi

• σ i is the sensitivity of the return of asset v w.r.t. wi and v w.r.t. Yi .

the sensitivity

8.A.ii

The APT Model (continuous time version)

In the following (·) denotes (t, Y(t)). The following proposition is the continuous time version of APT and can be justiÞed as the discrete time version. Proposition 5
(APT)

1.

There exist M scalars: λ1 (·) , λ2 (·) , ..., λM (·) such that, for any asset (value v return stream= δ , required expected instantaneous return = µ): X δ (·) + µ (·) = r (·) + λi (·) σ i (·) v v i=1 λi (·) is the market price of the risk wi and is the same for all assets. The equation above can be deemed as a decomposition of the expected rate of return into the riskless rate and M risk premiums: λi (·) is the market price of risk (MPR) wi ; The MPR vector λ is the same for all assets.
M

2.

There exist L scalars: θ1 (·) , θ 2 (·) , ..., θ L (·) s.t., for any asset: X δ 1 ∂v (·) + µ (·) = r + θj (·) (·) (·) v v ∂Yj j=1 This is an alternative decomposition of the expected rate of return with L risk premia (relative to risks Y ). θj is the market price of risk (MPR) Yj , and is also the same for all assets. We will drop (·) in the following for simplicity 51
L

Chapter 8

The PDE Approach

A direct result then follows: θL×1 = ΩL×M λM×1

• In the particular case that L = M and then Ω is invertible, λ can be solved as: λ = Ω−1 θ • Furthermore, if we apply APT to the ith primitive asset: dRi = µi dt + σ 0i dw µi = r + σ 0i λ where σ 0i is the ith row of Σ. • In vector form: µ = r · 1+Σλ This equation may be used in two ways: - To obtain the required returns µ for a given MPR λ.Then, the returns of the primitive risky assts follow: dR= [r(.)1 + Σ(.)λ(.)]dt + Σ(.))dw - To obtain (or estimate) the MPR λ assuming that the risk premiums µ − r1 are known (or estimated). This is only possible when Σ is invertible (M = N and non redundant assets, implying market completeness), in which case: ¡ ¢ λ = Σ−1 µ − r1

Under incomplete markets an inÞnite number of MPR vectors λ are compatible with the risk premia on the primitive securities. • It is important to note that:
t DY v + δ 1 =r+ v v

µ

∂v ∂Y

¶0

θ

This PDE means that the expected rate of return equals the required rate of return. It must be followed by any asset in a world described by Y. The only difference between assets is the boundary condition v (T, Y) = l (Y) speciÞc to each asset. Example 5 In the Black-Schole’s framework Y = S, L = M = N = 1,for a call: l(Y ) =
(Y − K)+ , λ = (µ − r)/σ

52

Chapter 8

The PDE Approach

Example 6 A one factor interest rate model with a stochastic risk-free rate r, which is
also the state variable. Only bonds are considered and one bond is sufficient (the others are redundant), therefore, L = M = N = 1. We consider such models in the following section.

8.B

One Factor Interest Rate Models

• — L = M = 1, and now Y1 =r — dS0 = S0 r (t) dt — Let BT (t, r (t)) be the price of a zero coupon bond at t that delivers 1 at T . The — Several BT may be traded (but they are redundant). — dr = a √ − r] dt + σr (t, r)dw. In Vasicek model σ r (t, r) = σ constant, and in CIR model [b
σr = σ r duration of the bond is then T − t

• Write the expected rate of return by applying APT:
t 1 ∂BT Dr BT =r+ θ BT BT ∂r

This gives: ∂BT ∂BT ∂BT 1 ∂ 2 BT + σ2 + a (b − r) = rBT + θ r ∂t 2 ∂r2 ∂r ∂r with the boundary condition that BT (T ) = 1 ∀T . • The PDE can be solved in both Vasicek and CIR settings. 8.C Discounting Under Uncertainty

Consider the PDE:
t DY v

+ δ = rv +

µ

∂v ∂Y

¶0

θ ; LC : v(T, Y) == l(Y)

where LC stands for Limit Conditions. We have: µ ¶0 µ ¶0 ∂v ∂v 1 0 ∂ 2v ∂v + µY + dY dY + δ = rv + θ ∂t ∂Y 2 ∂Y∂Y0 ∂Y 53

Chapter 8

The PDE Approach

or, equivalently: ∂v + ∂t µ ∂v ∂Y ¶0 h i 1 ∂ 2v dY=rv−δ µY − θ + dY0 2 ∂Y∂Y0

Note that left hand side of this equation can be interpreted as the Dynkin operator b computed w.r.t. a drift (µY −θ) different from µY . Hence now deÞne Y (t) = Y (t) i h b and dY (t) = µY − θ dt + Ωdw, we now have an equivalent but simpliÞed writing:
t DY v + δ = rv b

By Feynman-Kac, the solution is: ½Z T ¾ ´ ³ R R − tu rdx − tT rdx b P b δ·e du + l(Y(T )) · e |Y (t) = Y (t) = Yt v t, Y t = E t h i b and Y (t) = µY − θ dt + Ωdw • Note that we now discount with r instead of µ! (CIR 1985, lemma IV) We can safely state that the value of any asset is the expected discounted value of future cash ßows with r as the discount factor provided that the drift of Y is adjusted by the MPR of the risks Y, which is θ. Alternatively we could express the valuation formulae in function of the MPR λ of the risks w (substitute in the formulae Ω λ for θ)

54

Chapter 9

Links Between Probabilistic and PDE Approaches

Chapter 9 Links Between Probabilistic and PDE Approaches
As usual, we start from the probability space (Ω, F , P ). We say that a probability measure is equivalent to another iff they have the same measure zero sets, i.e., Q ∼ P if f Q(A) = 0 ⇔ P (A) = 0 (A ∈ F). 9.A Probability Changes and the Radon-Nikodym Derivative

1.

Proposition 6 If Q ∼ P , then there exists a random variable ξ which is F measurable with E P [ξ] = 1 and ξ > 0 a.s. such that ∀A ∈ F: Z Q (A) = ξ ($) dP ($)
A

Then ξ = 2.

dQ dP

= E P [1A · ξ]

and is called the Radon-Nikodym derivative of Q w.r.t. P .

Any ξ FT measurable, with E P [ξ] = 1 and ξ > 0 a.s. is a valid Radon Nikodym derivative, meaning that a new probability measure Q can be deÞned by dQ = ξ or Q (A) = E P [1A · ξ] ∀A ∈ F (and Q ∼ P ). dP Proof

• We proove only part 2. We check Þrst that Q is a probability measure; Indeed: Q (Ω) = E P [1Ω · ξ] = E P [ξ] = 1 Moreover, for A ∩ B = ∅, Q (A ∪ B) = = = = E P [1A∪B · ξ] E P [(1A + 1B ) · ξ] E P [1A · ξ] + E P [1B · ξ] Q (A) + Q (B) 55

Chapter 9

Links Between Probabilistic and PDE Approaches

• We check that Q ∼ P ; Indeed, since ξ > 0 a.s.., Q (A) = E P [1A · ξ] = 0 ⇔ P (A) = E P [1A ] = 0
Q.E.D.

• The intuition behind the changing of probability is that, by considering the probability of an event as a mass, the probability, or the mass, is changed by multiplying a positive ξ ($) (dQ ($) = ξ ($) dP ($)). • Also, ∀X with E P [X] < ∞, E Q [X] = E P [X · ξ].

9.B

Girsanov Theorem

Consider the m-dimensional Brownian Motion w under the probability measure P , the Þltration Ft (t ∈ (0, T )) generated by w, and the m-dimensional adapted Rt process λ(·) that satisÞes integrability conditions ( 0 kλ (s)k2 ds deÞned,..). Theorem 9
(Girsanov Theorem) a) DeÞne ξ (t) = e− 2 0 kλ(s)k ds− 0 λ (s)dw , then ξ (T ) is a valid Radon-Nikodym derivative: (meaning that: ξ (T ) is FT measurable; E P [ξ] = 1; ξ ≥ 0 a.s.); Moreover ξ (t) is a P-martingale. Rt e b) DeÞne Q ∼ P by dQ = ξ (T ), then w (t) , w (t) + 0 λ (s) ds is a standard QdP Brownian Motion.
1

Rt

2

Rt

0

9.C

Risk Adjusted Drifts: Application of Girsanov Theorem

Consider: dR = µdt + ΣN×M dw We had: µ = r·1 + Σλ 56

Chapter 9

Links Between Probabilistic and PDE Approaches

Therefore: dR = [r·1 + Σλ] dt + Σdw We now look for a probability measure Q under which the dynamics of R have a Si drift of r·1 (then the asset 0 denominated values S0(t) would be Q-martingales). (t) We know that Q exists and is unique when the market is complete. Proposition 7
Consider the probability Q , equivalent to P , deÞned by the Radon-Nikodym derivative:
RT Rt 0 2 1 dQ = e− 2 0 kλ(s)k ds− 0 λ (s)dw dP

where λ(·) is the market price of risk. Then the instantaneous Q−expected return of Si any self-Þnancing asset is r. Moreover, asset 0 denominated values S0(t) (as well as (t) the asset 0 denominated values of self Þnancing portfolios Q is thus a risk neutral probability.
X(t) S0 (t)

) are Q-martingales.

Proof
e By Girsanov Theorem, w (t) , w (t) + e dw (t) Rt
0

λ (s) ds is a Q-martingale, then:

We now deÞne:

, dw (t) + λ (t) dt e ⇒ dR = [r·1 + Σλ] dt + Σ · [dw (t) − λ (t) dt] e ⇒ dR = r·1·dt + Σ · dw (t) S (t) b S (t) , S0 (t) = d log = = S 1 + σ 2 dt S0 2 S 1 dS dS0 1 2 − − σS dt + σ 2 dt S S0 2 2 S dS − rdt S
b dS(t) b S(t)

with dS0 (t) = S0 rdt. Therefore: d (S/S0 ) S/S0

If the drift of

dS S

is r, then the drift of

will be zero! Thus, by changing the probability
S(t) S0 (t)

measure from P to Q, the asset 0 denominated values Q.E.D.

are Q-martingales.

57

Chapter 9

Links Between Probabilistic and PDE Approaches

Remark that when the set of primitive securities is complete (N = M and Σ ¡ ¢ is invertible) only one λ (λ= Σ−1 µ − r1 ) is compatible with the primitive returns. Under incomplete markets an inÞnite number of λ’s are compatible with the assumed return dynamics and an inÞnite number of risk free probabilities can be constructed.

58

PART IV The Numeraire Approach

Chapter 10

Introduction

Chapter 10 Introduction
Choose asset 0 as numeraire; then: Si (t) b Si (t) , S0 (t)

We have seen previously that:

• In AoA, there exists a set of probabilities Q under which the 0-denominated prices are martingales. • Q is a singleton if f market is complete. In this case, write Q as P0 ; P stands as usual for the true probability. 0 is not a compelling choice for numeraire. Alternatives include BT (t). Then, the Si forward adjusted probability yields martingale prices Si∗ (t)= BT(t) (t) The intuition behind the change of numeraire is expressing the value of an asset in units of another asset.

60

Chapter 11

Numeraire and Probability Changes

Chapter 11 Numeraire and Probability Changes
11.A Framework

11.A.i

Assets

• Asset returns follow are Ito process following the SDE: dR = µdt + Σdw dS0 = rS0 dt dr = µr dt + σ r dw The coefficients (µ, Σ, µr , σ r ) are stochastic but satisfy ”Ito” technical conditions • Assume N ≤ M, where N is the number of non-redundant risky assets, and M is the number of Brownian Motions.

11.A.ii

Numeraires

DeÞnition 23 A viable numeraire is an admissible self-Þnancing portfolio with positive values a.s., i.e., (n, N) is a viable numeraire if: (n, N ) ∈ A0 N (t) > 0 a.s.
Rt
0

Example 7 S0 (t) = S0 (0)e

r(u)du

Example 8 BT (t) = price at t of a zero-coupon bond yielding $1 at T

61

Chapter 11

Numeraire and Probability Changes

11.B Correspondence Between Numeraires and Martingale Probabilities

11.B.i

Numeraire → Martingale Probabilities

We have studied 0 → P0 , now consider any viable numeraire n and the correspondence n → Pn . DeÞnition 24 Pn stands for the set of probabilities equivalent to P yielding n-denominated o n
martingale prices: Pn = Pn ∼ P |∀ (x, X) ∈ A0 , X(t) is a Pn martingale N(t)

Proposition 8
For any admissible numeraire (n, N ) and Pn :

1.

There is a one-to-one correspondence between P0 (the set of risk-neutral probabilities) and Pn . Moreover, ∀P0 ∈ P0 , P0 → Pn is given by: N(T ) S0 (0) dPn = · dP0 S0 (T ) N(0) and ∀Pn ∈ Pn , Pn → P0 is given by: dP0 S0 (T ) N(0) · = dPn N(T ) S0 (0)

2.

Pn 6= ∅ ⇔ AoA ; Pn is a singleton ⇔ market is complete Proof 1. Consider a viable numeraire (n, N ). Without loss of generality assume N(0) = S(0) = 1. N(T Let ξ = dPn = S0 (T) · S0 (0) . ξ is a viable numeraire; indeed it satisÞes the three dP0 ) N(0) requirements: (i) ξ is FT -measurable (since N (T ) and S0 (T ) are FT -measurable); (ii) ξ > 0 a.s. (since N (T ) and S0 (T ) are > 0 a.s.); N(t) N N(0) (iii) EP0 (ξ) = 1; Indeed, since S0 (t) is a P0 martingale: EP0 ( S0(T ) ) = S0 (0) . There(T ) ³ ´ N(T fore EP0 (ξ) = EP0 S0 (T) · S0 (0) = 1. ) N(0) Then ξ deÞnes uniquely a probability Pn ∼ P0 . Moeover such Pn belongs to Pn ; 0 indeed, for any (x, X) in A : 62

Chapter 11

Numeraire and Probability Changes
X(0) S0 (0) = S0 (0) N(0) dP0 that 1/ξ = dPn

N(T X(T EPn ( X(T ) ) = EP0 ( X(T ) ξ) = EP0 ( X(T ) S0 (T) S0 (0) ) = EP0 ( S0 (T) ) S0 (0) = N(T ) N (T ) N(T ) ) N(0) ) N(0) X(0) , N(0)

hence X is a PN -martingale. An analogous argument shows N deÞnes the correspondance between Pn and P0 and the two sets are thus in a one to one relation through this procedure. 2. Follows from 1. and from the fact that 2. is true for P0 Q.E.D. More generally, given any (n, N ) and (n0 , N 0 ) ∈ N , there is a one-to-one correspondence between Pn and Pn0 deÞned by: dPn0 N 0 (T ) N(0) = · dPn N(T ) N 0 (0) with the possible assumption that N (0) = N 0 (0) = 1 11.B.ii Probability → Numeraire

Let us state the following without proof Proposition 9
For any probability Q ∼ to P there exists a numeraire nQ such that the nQ −denominated values of all admissible and self-Þnanced assets or portfolios are Q-martingales. This numeraire is unique (up to a scale factor). The uniqueness of this martingale numeraire prevails even in incomplete markets and when asset prices follow semi-martingales

11.C

Summary

• In AoA: — There exists a set P0 of probabilities equivalent to P (the true or historical probability)
such that ∀P0 ∈ P0 and ∀(x,X) ∈ A0 (the set of admissible and self-Þnancing strategies), X(t) the S0 (t) denominated price S0 (t) is a P0 -martingale.

— P0 is a singleton when the market is complete. — DeÞne N as the set of all admissible numeraires. Then N ∈ N iff (n,N) ∈ A0 and
N (t) > 0 a.s..

— ∀ (n,N ) ∈ N there exists Pn ∼ P such that ∀Pn ∈ Pn and ∀(x,X) ∈ A0 , the N (t)
denominated price
X(t) N(t)

is a Pn -martingale.

63

Chapter 11

Numeraire and Probability Changes

— In the general case, given any (n, N) and (n0 , N 0 ) ∈ N , there is a one-to-one
correspondence between Pn and Pn0 deÞned by: N 0 (T ) N(0) dPn0 · = dPn N (T ) N 0 (0) with the possible assumption that N (0) = N 0 (0) = 1

— Conversely, ∀Q ∼ P , there exists a unique numeraire NQ such that the NQ denominated
prices are Q-martingales.

• Then why not consider a portfolio (h,H) that yields martingale prices under the true probability P ? This question is addressed in the following section.

64

Chapter 12

The Numeraire (Growth Optimal) Portfolio

Chapter 12 The Numeraire (Growth Optimal) Portfolio
12.A DeÞnition and Characterization

12.A.i

DeÞnition of the Numeraire (h, H)

DeÞnition 25 The numeraire portfolio is the unique portfolio (h, H) ∈ N such that ∀(x, X) ∈
A0 ,
X(t) H(t)

is a P -martingale, i.e.:

Et

·

¸ X(T ) X(t) = H(T ) H(t)

where Et [·] = E [·|Ft ] is the conditional expectation computed with the true probability.

The price of the asset is then given as: X(t) = H(t) · Et with
H(t) H(T )

·

X(T ) H(T )

¸

often being referred to as the “discount factor” or the “pricing kernel”.

(h, H) is also called the “growth optimal portfolio” (Merton), the “log-optimal portfolio”, and the “numeraire portfolio” (Long). 12.A.ii Characterization and Composition of (h, H)

1.

Theorem 10 (h, H) is the strategy that maximizes the expected log of the terminal wealth W (T ), i.e. it solves the program:
(x,X)∈A0

max E0 [log X (T )]

65

Chapter 12

The Numeraire (Growth Optimal) Portfolio

2. 3. 4.

(h, H) maximizes the expected growth rate in [0, T ] Consider 0 < T < T 0 , the strategy (h, H) that maximizes E [log W (T 0 )] also maximizes E [log W (T )] (the so-called “myopic property” of log) (h, H) dominates (in probability) asymptotically any other strategy in A0 , i.e. ∀(x, X) ∈ A0 : lim Pr oba [H (T ) − X (T ) > 0] = 1
T →∞

Remark 15 However, this probabilistic domination does not mean that limT →∞ E0 [U (H (T ))] > E0 [U (X (T ))] for all well-behaved utility function U and all (x, X) ∈ A0 : the statement that all investors should choose (h, H) in the long run is not valid.

Proof

1.

Starting with the same initial investment H(0) = X(0), H(T ) is preferred by the log investor to X(T ); indeed, by Jensen’s Inequality for concave functions and the fact that (h, H) is a P numeraire, ∀(x, X) ∈ A0 · ¸ · ¸ X (T ) X (T ) ≤ log E E log H (T ) H (T ) X (0) = log H (0) = 0 (since X(0) = H(0) = 1) Therefore: E log H (T ) ≥ E log X (T ) i.e. (h, H) maximizes the expected log of terminal wealth.

2.

DeÞne the (annualized) growth rate in [0, T ] as r0,T such that X (T ) = er0,T ·T = eR0,T X (0) or : r0,T =
log[X(T )]−log[X(0)] ; T

then 2 is obvious.

3.

Obviously, R0,T 0 = R0,T + RT,T 0 66

Chapter 12

The Numeraire (Growth Optimal) Portfolio

Maximizing E [R0,T 0 ] then implies a two-step maximization procedure: max E [R0,T ] and max E [RT,T 0 ].
Q.E.D.

The previous results are also valid for semi-martingale prices, but in the following, it is assumed that prices and rates of return follow Ito process, i.e. dR = µdt + Σdw dr = µr dt + σ r dw with R an N × 1 vector, Σ an N × M matrix with rank N (there is no redundant asset, so N ≤ M ), and the coefficients obey the usual technical conditions so that there exists a solution for the SDE. Theorem 11
The composition of h is: £ ¤ h = Γ−1 µ − r·1

with Γ = ΣΣ0 being an invertible N × N matrix.

Proof
Because the Log utility is myopic, optimizing over (t,T ) implies optimizing over [t, t + dt] ;In [t, t + dt] max Et [log X (t + dt)]
x x x

⇔ max Et [log X (t + dt) − log X (t)] ⇔ max Et [d log X] By Ito’s lemma, d log X =
dX X

1 2

dX X

Therefore, the maximization program is now:

= (1 − x0 · 1) rdt + x0 Σdw £ ¤ª © = r + x0 µ − r·1 dt + x0 Σdw

¡ dX ¢2
X

. It is also known that:

With dwdw0 = I · dt

© £ ¤ª 1 max Et [d log X] ⇔ max r + x0 µ − r·1 dt − x0 Σdwdw0 Σ0 x x x 2 ½ ¾ £ ¤ 1 max Et [d log X] ⇔ max r + x0 µ − r·1 − x0 Γx dt x x 2

67

Chapter 12

The Numeraire (Growth Optimal) Portfolio

Leave out dt and apply the Þrst order condition gives: ¤ £ ¤ £ µ − r·1 − Γh = 0 ⇔ h = Γ−1 µ − r·1 Q.E.D.

Corollary 5 (h,H) is instantaneously mean-variance efficient, hence homothetical (proportional) to the tangent portfolio (m,M), i.e. h = 1 m kt ¡ ¢¤ £ = 10 · Γ−1 µ − r·1 m 1 ¡ ¢ 10 · Γ−1 µ − r·1

with

kt = and

(the weights in m sum up to one while in h they don’t; h is a combination of m and asset 0). We have not excluded the possibility that N < M . But now assume that N = M ; then:

¡ ¢ m = kt Γ−1 µ − r·1

Corollary 6 When the market is complete and ΣN×N is invertible, the market price of risk can be derived as a function of the risk premia6 :
¡ ¢ λ = Σ−1 µ − r·1

The composition of the numeraire portfolio can now be expressed in terms of λ as: £ ¤ h = Γ−1 µ − r·1 £ ¤ = Σ0−1 Σ−1 µ − r·1 = Σ0−1 λ
6

When the market is not complete, λ cannot be explicitly speciÞed. For the ith asset, for instance,
M X

µi − r =

σij λj

j=1

With N < M , the system of N equations does not yield an unique solution for λ1 ,...,λM

68

Chapter 12 Moreover, dH H = = = = = Therefore:

The Numeraire (Growth Optimal) Portfolio

¡ ¢¤ £ r + h0 µ − r·1 dt + h0 Σdw h ¢0 ¡ ¢i ¢0 ¡ ¡ r + Σ0−1 λ µ − r·1 dt + Σ0−1 λ Σdw ¡ ¢¤ £ r + λ0 Σ−1 µ − r·1 dt + λ0 Σ−1 Σdw ¢ ¡ r + λ0 λ dt + λ0 dw ´ ³ r + kλk2 dt + λ0 dw
t 2 1 H(t) = e 0 {r+ 2 kλk }du+

R

Rt
0

λ 0 dw(u)

2 The risk premium, as well as the instantaneous return variance of (h, H), are kλk .

12.A.iii

The Numeraire Portfolio and Radon-Nikodym Derivatives

• The Radon-Nikodym derivative has been shown to be the ratio of two numeraires, i.e. N 0 (T ) N(0) dPn0 · = dPn N(T ) N 0 (0) and usually with the assumption that N(0) = N 0 (0) = 1. • Consider the risk neutral probability P0 and the corresponding numeraire S0 : dP0 S0 (T ) = dP H(T ) =
RT RT
0

e

r(u)du R

T 0 2 1 e 0R {r+ 2 kλk }du+ 0 λ dw(u) RT 0 T 1 2 = e− 0 2 kλk du− 0 λ dw(u)

This result was obtained previously through a different approach (see Girsanov theorem) 12.B First Applications

69

Chapter 12

The Numeraire (Growth Optimal) Portfolio

12.B.i

CAPM

Theorem 12
Consider S ∈ A0 with: dS S dH H (CAPM) In AoA: = µS dt + σS dwS o n = r + kλk2 dt + σ H dwH µS − r 1 kt σ HS = σHS = = 1 σ MS kt

µM − r σ2 M = σS σH dwS dwH

Proof
S(t) H(t)

is a P -martingale, therefore it should have zero drift. By Ito’s lemma: dS dH dS(t) = − + dH(t) S H µ dH H ¶2 − dS dH S H

The drift term is: o n µS − r + kλk2 + kλk2 − σHS = 0 µS − r = σHS (The rest remains to be proved). Q.E.D.

Therefore:

12.B.ii

Valuation

• ∀ (x, X) ∈ A0 with X(T ) = XT a.s., X(t) = Et

·

H(t) XT H(T )

¸

70

Chapter 12

The Numeraire (Growth Optimal) Portfolio

RT RT 0 2 1 H(t) = e− t {r(u)+ 2 kλk }du− t λ dw(u) H(T )

is called as the “pricing kernel” or the “state price deßator”. It’s product with H(t) P ($), i.e. H(T ) P ($), is the “Arrow-Debreu price”. • For a security with terminal cash ßow XT and a dividend stream δ(t)dt, the pricing formula is: · ¸ ·Z T ¸ 1 δ(t) X(0) = Eo XT + Eo dt H(T ) 0 H(t) with the discount factor Rt Rt 0 2 1 1 = e− 0 {r(u)+ 2 kλk }du− 0 λ dw(u) H(t) In the certainty (riskless) case, 1 = e−rt H(t)

71

PART V Continuous Time Portfolio Optimization

Chapter 13

Dynamic Consumption and Portfolio Choices (The Merton Model)

Chapter 13 Dynamic Consumption and Portfolio Choices (The Merton Model)

13.A

Framework

13.A.i

The Capital Market

We consider a diffusion-state variables model.

Let L be the number of state variables and Y be the vector describing the states of the economy, with dYL×1 = µY (t, Y(t)) · dt + ΩL×M (t, Y(t)) · dwM×1

• There are N + 1 assets in the economy. The returns of the N risky assets follow the diffusion process: dRN×1 = µ (t, Y(t)) · dt + ΣN×M (t, Y(t)) · dwM×1 73

Chapter 13

Dynamic Consumption and Portfolio Choices (The Merton Model)

and the riskless return follows: dr = µr (t, Y(t)) · dt + σ 0r (t, Y(t)) · dw
Rt
0

S0 (t) = e

r(u)du

• The usual technical (integrability) conditions and a frictionless and continuously open market are assumed.

13.A.ii

The Investors (Consumers)’ Problem

where the Þrst term in the right hand side of the equation is the gain of the portfolio, the second term Consumption, and the third term Income.

For an investor with wealth X(t) at time t, the Budget Constraint in [t, t + dt] is: © £ ¤ ª dX = X(t) r(t) + x0 (t) µ(t)−r(t) · 1 dt + x0 (t)Σdw − c(t)dt + y(t)dt

• The optimization program, denoted by M, is: ½Z T ¾ (M) max Et U (c (u) , u) du + B (X (T ))
c,x t

s.t. the Budget Constraint

where U (·) and B (·) are both utility functions (B (·) may be interpreted as the utility of a bequest). They are state independent but they do depend on t. Additional restrictions imposed on U (·) and B (·) are: — U (·) and B (·) are strictly concave. — U 0 (0) and B 0 (0) = ∞ ; U (0) and B (0) = −∞ so as to preclude negative consumption
or bequest.

13.B

The Solution

13.B.i

Sketch of the Method

74

Chapter 13

Dynamic Consumption and Portfolio Choices (The Merton Model)

1.

The indirect utility function7 J(t, Xt , Y t ) is the solution (value function) to the objective maximization program M with Xt and Yt being the realization of X(t) and Y(t) at time t and the additional constraint that returns follow the previously speciÞed process. Consider the period (t + dt, T ). Whatever has been done in [t, t + dt], which yields X (t + dt), we optimize between [t + dt, T ], hence deriving a utility J(t + dt, X (t + dt) , Y (t + dt)). Let Et be the conditional operator E(·/Xt ,Y t ).Then at time t, we maximize Et [U (c (t) , t) dt + J(t + dt, X (t + dt) , Y (t + dt))]. To express the fact that J(t + dt, X (t + dt) , Y (t + dt)) depends, through X(t + dt),on the choice (c(t), x(t)) made at t for (t, t + dt), we write it also: J c,x (t + dt, X + dX, Y + dY) Now write the maximization program M as: max Et [U (c (t) , t) dt + J c,x (t + dt, X + dX, Y + dY)]
c,x

2.

3.

⇔ ⇔ ⇔ ⇔

max Et [U (c (t) , t) dt + J c,x (t + dt, X + dX, Y + dY) − J (t, X (t) , Y (t))] c,x h ³ ´ i c,x max Et U (c (t) , t) dt + DY J dt c,x h ³ ´i c,x max Et U (c (t) , t) + DY J
c,x c,x

max ψ (c (t) , x(t), t, X (t) , Y (t))

— The difference J c,x (t + dt, X + dX, Y + dY) − J (t, X (t) , Y (t)) is nothing else but the — The maximum of U (·) dt + J (t + dt) is J (t), therefore, the maximum obtainable value
of ψ (·) is zero.

c,x Dynkin operator DY J applied to J for given values c and x of the control variables at t. c,x ψ (c (t) , x(t), t, X (t) , Y (t)) stands for Et [U (c (t) , t) + DY J]

The Dynkin operator applied to J (t, X, Y) writes:
c,x DY

X 1 1 XX (J) = Jt + JX µX + JXX σ 2 + JYi JYj dYi dYj + JX JYj dXdYj X 2 2 i=1 j=1 j=1

L

L

L

In the simple static framework the indirect utility is deÞned as follows: Given unit price pi and wealth y, the optimal allocation (x∗ , x∗ , ..., x∗ ) on N goods is derived from the direct utility 1 2 P N function V (x1 , x2 , ..., xN ) by maxx V s.t. y = pi xi ; The solution, (x∗ , x∗ , ..., x∗ ), is function of y 1 2 N and P The indirect utility function J (y, P), is then deÞned as V (x∗ , x∗ , ..., x∗ ) i.e: the maximum 1 2 N utility that can be derived with a wealth y given the prices P

7

75

Chapter 13

Dynamic Consumption and Portfolio Choices (The Merton Model)

where: £ ¡ ¢¤ µX = X r (·) + x0 µ (·) − r (·) 1 − c (t) σ 2 = X 2 x0 Γx X Γ = ΣΣ0 dYdY0 = ΩΩ0 dt, with ΩΩ0 = V or: dYi dYj = Vij dt dXdYi = X (x0 Σdw) Ω0i dw = Xx0 ΣΩi dt where Ω0i is the ith row of Ω. The problem is now:
c,x max{U (c, t) + DX,Y (J)} c,x

or equivalently (c∗ (t) , x∗ (t)) solve: max ψ (t, c, x; X (t) , Y (t))
c,x

Recall that the maximum of ψ(·) is zero; We obtain thus two equations (Bellman conditions): max ψ (t, c, x; X (t) , Y (t)) = ψ (t, c∗ (t) , x∗ (t) ; X (t) , Y (t)) = 0
c,x (1) (2)

• (a) The Þrst equation implies the Þrst order conditions: ∂ψ (t, c∗ (t) , x∗ (t) ; X (t) , Y (t)) = 0 ∂c and ∂ψ (t, c∗ (t) , x∗ (t) ; X (t) , Y (t)) = 0 ∂x (b) The second equation implies that the PDE governing J is: ³ ∗ ∗ ´ c ,x ∗ U (c , t) + DX,Y (J) = 0 76

Chapter 13

Dynamic Consumption and Portfolio Choices (The Merton Model)

with limit condition: J (T, X, Y) = B (X)

The PDE governing J (theoretically) determines J, which in turn allows the comc,x putation of ψ (via DY (J) computed previously). Then the Þrst order conditions will determine the optimal (c∗ (t) , x∗ (t)). This methodology yields only in some few cases a closed form solution for the optimal portfolio x∗ , but it allows to prove that it has the general form presented in the following paragraphs.

13.B.ii

Optimal portfolios and L + 2 funds separation

Proposition 10
The optimal portfolio as a solution of program M writes: x∗ (·) = A (·) h + where
L X k=1

Ak (·) hk (·)

• A (·) is the relative Risk Tolerance deÞned as: A≡− 1 JX · X JXX

• Ak depends on the indirect utility function and is its sensitivity w.r.t. dYk • h is the (instantaneously mean-variance efficient, ...) log optimal portfolio studied in a previous chapter: ¡ ¢ h = Γ−1 µ − r1

• hk (k = 1, 2, ..., L) are hedge portfolios with a return perfectly correlated with dYk ; they are aimed to hedge against unfavorable shifts of the investment opportunity set induced by movements of Yk . Proof
Follows from the Bellman conditions (1) and (2) (see Merton) Q.E.D.

77

Chapter 13

Dynamic Consumption and Portfolio Choices (The Merton Model)

Corollary 7 When L stands for the number of state variables on which the investment
opportunity set depends, any optimal portfolio is a combination of the following L + 2 funds: {0, h, h1 , h2 , ..., hL }. Moreover, the funds are the same for all the investors with a ”well behaved” utility function: This result is an ”L + 2 funds separation”.

• Two particular cases: (a) r is constant and Si are geometric Brownian Motions. Then L = 0 and we have 2-fund separation. (b) r is stochastic and is the only state variable, so L = 1 and we obtain 3-fund separation.

13.B.iii

Intertemporal CAPM

Consider Þrst the particular case where r is constant and Si are geometric Brownian Motions. Therefore L = 0 and we have 2-fund separation: x∗ (·) = A (·) h All investors hold a mix of the same funds 0 and h, though this mix depends on their individual risk tolerance A (·).

• Recall that the log-optimal portfolio h is homothetical to the instantaneously tangent portfolio m: h=λ·m where m is the tangent portfolio containing only risky assets. Since all investors hold the same risky portfolio m,this portfolio is the market portfolio: all investors hold instantaneously mean-variance efficient portfolios and m is instantaneously mean-variance efficient. Hence an instantaneous version of CAPM holds: — ∀S :
µS − r = β S (µm − r) where βS = cov (dRS , dRm ) var (dRm )

78

Chapter 13

Dynamic Consumption and Portfolio Choices (The Merton Model)

Consider now the general case with L state variables (and thus L + 2 fund separation). The generalized CAPM writes: µS − r = β m (µm S − r) +
L X k=1

β k (bk − r) S µ

where µk is the expected rate of return of the hedge portfolio hk , and b βk = S cov (dRS , dRk ) var (dRk )

79

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)

Chapter 14 THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)
14.A Transforming the dynamic into a static problem

We will assume in the following that: • The market is AoA • S follows a multivariate Ito process: dR=µ(·)dt + Σ(·)dw 14.A.i The pure portfolio problem

In this section the market may be incomplete Let us specialize the Merton problem into a pure portfolio decision: max E [U (XT )] x ¡ ¢¤ ½ dX £ = r (·) + x0 µ − r1 dt + x0 Σdw X s.t. X (0) = X0 where U (XT ) = B (XT ) is the concave bequest function, and the Þrst constraint ∗ is the self-Þnancing condition. The solution of M is (x∗ , X ∗ ), with X ∗ (T ) ≡ XT . Also consider program P involving two optimization steps (P1 ) and (P2 ): (P1 ) :
XT ∈L2

and

max E [U (XT )] ( a h XT ∈ C i s.t. E XT | F0 = X0 HT

∗∗ (P2 ) : Find (x∗∗ , X ∗∗ ) attaining XT

80

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)

∗∗ ∗∗ The solution to (P1 ) is the random contingent claim XT . But since XT ∈ C a (i.e. the set of attainable contingent claims), it is attainable through at least one strategy (x∗∗ , X ∗∗ ) ∈ A0 with X ∗∗ (0) = X0 .

1. 2. 3.

Proposition 11 The solution X ∗ (T ) obtained through (M) solves (P1 ) The solution (x∗∗ , X ∗∗ ) obtained through (P) solves (M)
∗ ∗∗ Under ’mild’ technical conditions (e.g., U (·) strictly concave), XT = XT a.s..

Proof

1.

∗ XT meets the constraints of (P1 ). Indeed,
∗ — XT ∈ C a since it is attainable through x∗

— X ∗ (t) being the value process of a self-Þnancing strategy,
i.e. E · ¸ X ∗ (T ) | F0 = X (0) = X0 H (T )

X ∗ (t) H(t)

is a P -martingale,

Hence X ∗ (T ) meets the constraints of (P1 ). but, since X ∗∗ (T ) is the solution of (P1 ): E [U (X ∗∗ (T ))] ≥ E [U (X ∗ (T ))]

2.

On the other hand, (x∗∗ , X ∗∗ ) is self-Þnancing and feasible (thereby satisfying the constraints of M) and (x∗ , X ∗ ) solves M, so: E [U (X ∗∗ (T ))] ≤ E [U (X ∗ (T ))] We can conclude from the two last inequalities that: E [U (X ∗∗ (T ))] = E [U (X ∗ (T ))] Thus X ∗ (T ) solves (P1 ) and (x∗∗ , X ∗∗ ) solves (M)

3.

∗ ∗∗ (proof by contradiction) Suppose XT and XT are not equal a.s.. Then there exists a subset D of Ω with strictly positive measure where ∀$ ∈ D ∗ ∗∗ XT (ω) 6= XT (ω) ∗∗ X ∗ + XT b XT ≡ T 2

Consider

81

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)

b XT is attainable by a buy-and-hold strategy with initial weight 1 in (x∗ , X ∗ ) 2 and 1 in (x∗∗ , X ∗∗ ). Because of the strict concavity of U (·), ∀$ ∈ D: 2 µ ∗ ¶ ³ ´ ∗∗ XT + XT bT U X ≡ U 2 ∗ ∗∗ U (XT ) + U (XT ) > 2
∗ ∗∗ Since ∀$ ∈ Ω − D, XT (ω) = XT (ω): h ³ ´i E [U (X ∗ )] + E [U (X ∗∗ )] T T ∗ ∗∗ b E U XT > = E [U (XT )] = E [U (XT )] 2 That is to say that there exists a feasible and attainable strategy which yields ∗ ∗∗ a higher expected utility than either XT or XT . This is in contradiction with our maximization programs M and (P1 ).

Q.E.D.

The static program (P1 ) can be interpreted as a static choice of a contingent claim, or a self-Þnancing strategy, out of an inÞnite number of them with a static h ∗ i budget constraint E X (T)) | F0 = X0 H(T 14.A.ii The consumption-portfolio problem

• The dynamic program M writes: ·Z T ¸ M : max E U (c (t) , t) dt + U (XT ) x, c 0 ¡ ¢ ¢ ¤ £¡ ½ dX = X r + x0 µ − r1 dt + x0 Σdw − c (t) dt s.t. X (0) = X0 • The static program P writes: —
(P1 ) : max E
XT ,c

"Z

T

U (c (t) , t) dt + U (XT )
T

s.t. : E0

"Z

0

0

# XT c (t) dt + = X0 H (t) H (T )

#

82

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)

∗∗ Call XT the solution of (P1 ) ∗∗ — (P2) : Þnd (c∗∗ (t), x∗∗ (t)) yielding a Þnal wealth = XT a.s.

• This problem is conceptually similar to the pure portfolio problem, although more general. As in the pure portfolio problem the solutions of M and P ”coincide”.

14.B

The solution in the case of complete markets

In this section the market is assumed dynamically complete 14.B.i Solution of the pure portfolio problem

Here we assume that U (·) is strictly concave and differentiable; Therefore U 0 is decreasing and U 0−1 exists (we write V ≡ U 0−1 ) Since the market is complete all contingent claims are attainable (C a =L2 ). Thus, (P1 ) becomes: (P1 ) : max E [U (XT )] · ¸ XT s.t. : E0 = X0 HT
XT ∈L2

Theorem 13
∗∗ The solution XT of (P1 ) writes: ∗∗ XT

=V

µ

θ HT ¶¸

for some θ such that: E0 · 1 V HT µ θ HT = X0

Proof

83

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)

• We prove the theorem is a discrete (countable) state space Ω. Our optimization program is now: X (P01 ) : max p ($) U (XT ($))
XT ($) $∈Ω

s.t. : The Lagrangian writes: L (XT , θ) = X

$∈Ω

X

p ($)

XT ($) = X0 HT ($)

$∈Ω

p ($) U (XT ($)) − θ

$∈Ω

X

p ($)

XT ($) HT ($)

By Þrst order condition, for all $ in Ω:
∗∗ p ($) U 0 (XT ($)) − θ

p ($) =0 HT ($) ¶

hence, for all $:
∗∗ XT

($) = U

0−1

µ

θ HT ($)

where θ is such that the budget constraint is satisÞed: · µ ¶¸ 1 0−1 θ E0 U = X0 HT HT • The more general proof for continuous measurable state space Ω involves calculus of variations (Euler Theorem).
Q.E.D.

∗∗ Remark 16 The optimal terminal wealth XT is the solution to (P1 ). The optimal portfolio

strategy x∗∗ as solution to (P2 ) remains to be found. This is, however, a difficult task.

∗∗ XT > 0 a.s.. In general, to make the problem ’more realistic’, an additional constraint such as ∗∗ ∗∗ XT > K a.s. may be involved. It can be shown that in this case the solution is XT , attainable ∗∗ with an initial wealth =X0 − P without constraint, plus a put on XT with strike K (P is the price of this put).

∗∗ Remark 17 XT may be negative, although for some utility functions, such as CRRA,

84

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)

14.B.ii

Examples of speciÞc utility functions

Example 9 Log utility:
U (X) = ln X Then: U 0 (X) = and U 0−1 (Y ) = By Þrst order condition: θ 1 ∗∗ = H XT T where θ satisÞes: E0 or · 1 0−1 U HT µ θ HT ¶¸ = X0 1 Y 1 X

θ= Thus:

1 X0

∗∗ XT = X0 HT

This is an alternative way of Þnding that (h, H) is log optimal

Example 10 CRRA utility:
U (X) = Then: U 0 (X) = X γ−1 By Þrst order condition:
∗∗ (XT )γ−1 =

1 γ X γ

θ HT
1 ¶ γ−1

or:
∗∗ XT

=

µ

θ HT

Note that for γ = 0, the CRRA utility becomes the log utility.

85

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)

Example 11 Quadratic utility:
U (X) = X − where q is the risk tolerance. The solution writes:
∗∗ XT = q −

1 2 X 2q

θ HT

So the optimal portfolio would consist of a long position in q units of zero coupon bond and a 1 short position in H(t) .

14.B.iii

Solution of the consumption-portfolio problem

The static program (P1 ) writes: (P1 ) : max E
XT ,c

U (c (t) , t) dt + U (XT ) ·Z T ¸ c (t) XT s.t. : E0 dt + = X0 H (T ) 0 H (t)
0

·Z

T

¸

Consider a discrete (countable) state space Ω. The Lagrangian writes: ·Z T ¸ X L (XT , c (t) , θ) = p ($) U (c (t, $)) dt + U (XT ($))
$∈Ω 0

−θ By Þrst order condition:

$∈Ω

X

p ($)

·Z

T

0

c (t, $) XT ($) dt + H (t, $) HT ($)

¸

· ¸ ∂L θ 0 ∗∗ = p ($) U (c (t)) − =0 ∂c ($, t) H (t) and · ¸ ∂L θ 0 ∗∗ = p ($) U (XT ($)) − =0 ∂XT ($) HT ($) U 0 (c∗∗ (t)) = θ H (t)

Thus:

86

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)

and
∗∗ U 0 (XT ) −

θ HT

Note that since H (0) = 1, U 0 (c∗∗ (0)) = θ

14.B.iv

General method for obtaining the optimal strategy x∗∗

Consider the case of state variable model where the state is described by Y (t): dY (t) = µY(t) (·) dt + Ωdw

• The method can be sketched as follows: (a) By martingale property: X (t) = H (t) E
∗∗

µ

∗∗ XT | Yt H (T )

≡ Ψ (t, Y t )

The difficulty comes from the computation of Ψ (t, Yt ). Apply Ito’s lemma: dX ∗∗ dΨ = ∗∗ X Ψ 1 = [·] dt + Ψ µ ¶0

∂Ψ ∂Y

Ωdw

(b) Note also that (x∗∗ , X ∗∗ ) is a portfolio strategy, so: dX ∗∗ = [·] dt + x∗∗0 Σdw X ∗∗ (c) Therefore, by identiÞcation: 1 x Σ= Ψ
∗∗0

µ

∂Ψ ∂Y

¶0

When M = N and Σ is invertible: µ ¶0 1 ∂Ψ ∗∗0 x = ΩΣ−1 Ψ ∂Y 87

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach)

which determines x∗∗0 provided that Ψ is known. More powerful tools (e.g., Maliavin calculus) are useful for solving this problem.

14.C

Equilibrium: the consumption based CAPM

Recall that: U 0 (c∗∗ (t)) = This implies (by differentiation): [·] dt + U 00 (c∗∗ (t)) dc∗∗ = − θ dH [H (t)]2 θ H (t)

Dividing through by U 0 (c∗∗ (t)) and use the Þrst order condition again gives: [·] dt + or: −c∗∗ From CAPM we have: ∀S µS − r = σ HS µ ¶ 1 dS dH = cov , dt S H Thus: 1 µS − r = cov dt or: µ dS U 00 (c∗∗ ) dc∗∗ , −c∗∗ 0 ∗∗ ∗∗ S U (c ) c ¶ dH U 00 (c∗∗ ) dc∗∗ + [·] dt = 0 (c∗∗ ) c∗∗ U H dH U 00 (c∗∗ (t)) ∗∗ dc = − 0 (c∗∗ (t)) U H

· ¸ 00 ∗∗ ∗∗ U (c ) µS − r = −c σ c∗∗ S U 0 (c∗∗ )

This is the Consumption based CAPM (CCAP M ). Remark 18 The [·] dt term does not enter the covariance for it is deterministic. 88

Chapter 14

THE ”EQUIVALENT” STATIC PROBLEM (Cox-Huang, Karatzas approach) h i 00 ∗∗ (c ) −c∗∗ U 0 (c∗∗ ) is the relative risk aversion of the representative agent. U

Remark 19

89

PART VI STRATEGIC ASSET ALLOCATION

Chapter 15

The problems

Chapter 15 The problems

91

Chapter 16

The optimal terminal wealth in the CRRA, mean-variance and HARA cases

Chapter 16 The optimal terminal wealth in the CRRA, mean-variance and HARA cases
16.A Optimal wealth and strong 2 fund separation

16.B

The minimum norm return

92

Chapter 17

Optimal dynamic strategies for HARA utilities in two cases

Chapter 17 Optimal dynamic strategies for HARA utilities in two cases
17.A The GBM case

17.B

Vasicek stochastic rates with stock trading

93

Chapter 18

Assessing the theoretical grounds of the popular advice

Chapter 18 Assessing the theoretical grounds of the popular advice
18.A The bond/stock allocation puzzle

18.B

The conventional wisdom

94

Chapter 18

Assessing the theoretical grounds of the popular advice

References
ARTICLES
• BAJEUX I. , R. PORTAIT, 1992, Méthodes probabilistes d’évaluation et modèles à variables d’état: une synthèse, Finance • BAJEUX I, R. PORTAIT, 1997, The numeraire portfolio : A new perspective on Þnancial theory, European Journal of Finance December • BAJEUX I., R. PORTAIT, 1998, Dynamic asset allocation in a mean-variance framework, Management Science November • BAJEUX I. JORDAN J. and R. PORTAIT, 1999, Dynamic asset allocation for stocks, bonds and cash • BAJEUX I. JORDAN J. and R. PORTAIT, 2000, An asset allocation puzzle : comment. Forthcoming, American Economic Review • CANNER N., N.G. MANKIW AND D.N. WEIL, 1997, An asset allocation puzzle, American Economic Review. • COX J. and C.F. HUANG, 1989, Optimal consumption and Portfolio policies when asset prices follow a diffusion process, Journal of economic Theory , 49. • COX J., J, INGERSOL and S.ROSS., 1985, An intertemporal general equilibrium model of asset prices, Econometrica ,53 • DYBVIG P. and C.F. HUANG, 1989, Nonnegative wealth, AOA and feasible consumption plans, Review of Financial studies vol 1, number 4 • GEMAN H., EL KAROUI N. and ROCHET J.C, 1995, Changes of numeraire arbitrage and option prices, Journal of Applied Probabilities, 2 • HANSEN L.P. and RICHARD S., 1987, the role of conditioning information in deducing testable restrictions implied by dynamic asset pricing models, Econometrica, vol 55, N◦ 3, 587-613. • HARRISON J.M. and K. KREPS, 1979, Martingales and arbitrage in multiperiod security markets, Journal of Economic Theory, 20. • HARRISON J.M. and S. PLISKA, 1981, Martingales and the Stochastic integrals in the theory of continuous trading, Stochastic processes and their applications ,11 95

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Assessing the theoretical grounds of the popular advice

• HE H. and PEARSON N.D., 1991, consumption and portfolio policies with incomplete markets and short sale constraints, Journal of Economic Theory, 54, 259-305. • KARATZAS, I., J. LEHOCZKY and S. SCHREVE, 1987, Optimal Portfolio and Consumption Decisions for a “Small Investor“ on a Finite Horizon,. SIAM Journal of Control and Optimization , 25 , 1157-86. • LONG, J.B., 1990, The Numeraire Portfolio, Journal of Financial Economics, 26, 29-69 • NGUYEN P. and R.PORTAIT, 1999, Dynamic Mean Variance Efficiency and Asset Allocation with a Solvency Constraint; Forthcoming, Journal of Economics Dynamics and Control • RICHARDSON, H., 1989, A Minimum Variance Result in Continuous Trading Portfolio Optimization, Management Science, Vol 35, N◦ 9

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• DEMANGE G, ROCHET JC, 1992, Méthodes mathématiques de la Þnance, Economica • DUFFIE D, 1996, Dynamic asset pricing theory Princeton University press. • DUMAS B, ALLAZ B, 1995, Les titres Þnanciers, PUF (English version available) • KARATZAS I, SHREVE S, 1999, Methods in Mathematical Finance, New York: Springer Verlag. • KARATZAS I, SHREVE S, 1991, Brownian motion and stochastic calculus, New York: Springer Verlag. • MERTON R., 1992, Continuous time Finance, Oxford : Basil Blackwell. • MUSIELA M, RUTKOWSKI M, Martingale methods in Þnancial modeling, Applications of Mathematics, Springer, 19

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