Worst-case portfolio optimization in a market with bubbles
Belak, Christoph, Christensen, Sören and Menkens, Olaf
(2016)
Worst-case portfolio optimization in a market with bubbles.
International Journal of Theoretical and Applied Finance, 19
(2).
p. 1650009.
ISSN 1793-6322
We investigate a utility maximization problem in the presence of asset price bubbles. At random times, the investor receives warnings that a bubble has formed in the market which may lead to a crash in the risky asset. We propose a regime switching model for the warnings and we make no assumptions about the distribution of the timing and the size of the crashes. Instead, we assume that the investor takes a worst-case perspective towards their impacts, i.e. the investor maximizes her expected utility under the worst-case crash scenario. We characterize the value function by a system of Hamilton-Jacobi-Bellman equations and derive a coupled system of ordinary differential equations for the optimal strategies. Numerical examples are provided.