Merton problem in a discrete market with frictions

Souhail Chebbi, Halil Mete Soner

Research output: Contribution to journalArticle

3 Scopus citations

Abstract

We study the classical optimal investment and consumption problem of Merton in a discrete time model with frictions. Market friction causes the investor to lose wealth due to trading. This loss is modeled through a nonlinear penalty function of the portfolio adjustment. The classical transaction cost and the liquidity models are included in this abstract formulation. The investor maximizes her utility derived from consumption and the final portfolio position. The utility is modeled as the expected value of the discounted sum of the utilities from each step. At the final time, the stock positions are liquidated and a utility is obtained from the resulting cash value. The controls are the investment and the consumption decisions at each time. The utility function is maximized over all controls that keep the after liquidation value of the portfolio non-negative. A dynamic programming principle is proved and the value function is characterized as its unique solution with appropriate initial data. Optimal investment and consumption strategies are constructed as well.

Original languageEnglish (US)
Pages (from-to)179-187
Number of pages9
JournalNonlinear Analysis: Real World Applications
Volume14
Issue number1
DOIs
StatePublished - Feb 1 2013
Externally publishedYes

All Science Journal Classification (ASJC) codes

  • Analysis
  • Engineering(all)
  • Economics, Econometrics and Finance(all)
  • Computational Mathematics
  • Applied Mathematics

Keywords

  • Dynamic programming
  • Market friction
  • Merton problem

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