Optimal Tracking Portfolio with A Ratcheting Capital Benchmark

TL;DR

This paper develops a mathematical framework for optimal portfolio tracking with a ratcheting capital benchmark, transforming the problem into a solvable HJB equation and providing explicit feedback strategies.

Contribution

It introduces a novel approach to handle floor constraints via a dual transform and reflection, leading to a complete characterization of optimal strategies.

Findings

Existence of a unique classical solution to the HJB equation.

Explicit feedback optimal portfolio derived.

Application to market index tracking with geometric Brownian motion.

Abstract

This paper studies the 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 non-decreasing 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, however, 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 the unique classical solution to the HJB equation is established. The verification theorem is carefully proved, which gives the 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.