A consumption-investment model with state-dependent lower bound constraint on consumption

TL;DR

This paper develops a method to solve a lifetime consumption-investment problem with a wealth-dependent lower bound constraint, providing explicit strategies and analyzing the impact of long-term versus short-term consumption preferences.

Contribution

It introduces a transformation technique to handle state-dependent control constraints and derives explicit optimal strategies in a complex stochastic control setting.

Findings

Optimal strategies depend on long-term versus short-term consumption preferences.

Explicit solutions are provided for homogeneous constraints.

The value function is shown to be third-order continuously differentiable.

Abstract

This paper studies a life-time consumption-investment problem under the Black-Scholes framework, where the consumption rate is subject to a lower bound constraint that linearly depends on her wealth. It is a stochastic control problem with state-dependent control constraint to which the standard stochastic control theory cannot be directly applied. We overcome this by transforming it into an equivalent stochastic control problem in which the control constraint is state-independent so that the standard theory can be applied. We give an explicit optimal consumption-investment strategy when the constraint is homogeneous. When the constraint is non-homogeneous, it is shown that the value function is third-order continuously differentiable by differential equation approach, and a feedback form optimal consumption-investment strategy is provided. According to our findings, if one is concerned with long-term more than short-term consumption, then she should always consume as few as possible; otherwise, she should consume optimally when her wealth is above a threshold, and consume as few as possible when her wealth is below the threshold.