Optimal tracking portfolio with a ratcheting capital benchmark

Lijun Bo, Huafu Liao, Xiang Yu

Research output: Journal article publicationJournal articleAcademic researchpeer-review

Abstract

This paper studies finite horizon portfolio management by optimally tracking a ratcheting capital benchmark process. It is assumed that the fund manager can dynamically inject capital into the portfolio account such that the total capital dominates a nondecreasing benchmark floor process at each intermediate time. The tracking problem is formulated to minimize the cost of accumulated capital injection. We first transform the original problem with floor constraints into an unconstrained control problem, but under a running maximum cost. By identifying a controlled state process with reflection, the problem is further shown to be equivalent to an auxiliary problem, which leads to a nonlinear Hamilton-Jacobi-Bellman (HJB) equation with a Neumann boundary condition. By employing the dual transform, the probabilistic representation, and some stochastic flow analysis, the existence of a unique classical solution to the HJB equation is established. The verification theorem is carefully proved, which gives a complete characterization of the feedback optimal portfolio. The application to market index tracking is also discussed when the index process is modeled by a geometric Brownian motion.

Original languageEnglish
Pages (from-to)2346-2380
Number of pages35
JournalSIAM Journal on Control and Optimization
Volume59
Issue number3
DOIs
Publication statusE-pub ahead of print - 24 Jun 2021

Keywords

  • Nondecreasing capital benchmark
  • Optimal tracking
  • Probabilistic representation
  • Running maximum cost
  • Stochastic flow analysis

ASJC Scopus subject areas

  • Control and Optimization
  • Applied Mathematics

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