We consider the problem of maximizing expected utility from terminal wealth for a power investor who can allocate his wealth in a stock, a defaultable security, and a money market account. The dynamics of these security prices are governed by geometric Brownian motions modulated by a hidden continuous time finite state Markov chain. We reduce the partially observed stochastic control problem to a complete observation risk sensitive control problem via the filtered regime switching probabilities. We separate the latter into a pre-default and a post-default dynamic optimization subproblems, and obtain two coupled Hamilton-Jacobi-Bellman (HJB) partial differential equations. We prove existence and uniqueness of a globally bounded classical solution to the pre-default HJB equation, and give a verification theorem characterizing each value function as the solution of the corresponding HJB equation . We provide a detailed numerical analysis showing that the investor increases his stock holdings as the filter probability of being in the high growth regime increases, and decreases his credit risk exposure when the filter probability of being in the high default risk regime gets larger. We find that the investor increases the fraction of overall wealth invested in the risky asset when the information gain coming from receiving price observations is higher .
We consider the problem of maximizing expected utility for a power investor who can allocate his wealth in a stock, a defaultable security, and a money market account. The dynamics of these security prices are governed by geometric Brownian motions modulated by a hidden continuous time finite state Markov chain. We reduce the partially observed stochastic control problem to a complete observation risk sensitive control problem via the filtered regime switching probabilities. We separate the latter into pre-default and post-default dynamic optimization subproblems, and obtain two coupled Hamilton-Jacobi-Bellman (HJB) partial differential equations. We prove existence and uniqueness of a globally bounded classical solution to each HJB equation, and give the corresponding verification theorem . We provide a numerical analysis showing that the investor increases his holdings in stock as the filter probability of being in high growth regimes increases, and decreases his credit risk exposure when the filter probability of being in high default risk regimes gets larger .
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from terminal wealth
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the pre-default
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a verification theorem characterizing each value function as the solution of the corresponding HJB equation
the corresponding verification theorem
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detailed
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stock holdings
holdings in stock
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the high growth regime
high growth regimes
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the
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regime gets larger. We find that the investor increases the fraction of overall wealth invested in the risky asset when the information gain coming from receiving price observations is higher
regimes gets larger