Optimal dividends under a drawdown constraint and a curious square-root rule

TL;DR

This paper investigates optimal dividend payout strategies under a drawdown constraint, solving a complex control problem and deriving strategies that interpolate between classical and ratcheting constraints, with numerical illustrations and limit results.

Contribution

It introduces a two-curve strategy framework for dividend optimization under drawdown constraints, providing explicit solutions and conditions for optimality, including a novel limit behavior as maximum dividend rate increases.

Findings

Two-curve strategies are optimal under certain conditions.

The optimal strategy interpolates between classical and ratcheting constraints.

A simple limit form emerges when the maximum dividend rate tends to infinity.

Abstract

In this paper we address the problem of optimal dividend payout strategies from a surplus process governed by Brownian motion with drift under a drawdown constraint, i.e. the dividend rate can never decrease below a given fraction $a$ of its historical maximum. We solve the resulting two-dimensional optimal control problem and identify the value function as the unique viscosity solution of the corresponding Hamilton-Jacobi-Bellman equation. We then derive sufficient conditions under which a two-curve strategy is optimal, and show how to determine its concrete form using calculus of variations. We establish a smooth-pasting principle and show how it can be used to prove the optimality of two-curve strategies for sufficiently large initial and maximum dividend rate. We also give a number of numerical illustrations in which the optimality of the two-curve strategy can be established for instances with smaller values of the maximum dividend rate, and the concrete form of the curves can be determined. One observes that the resulting drawdown strategies nicely interpolate between the solution for the classical unconstrained dividend problem and the one for a ratcheting constraint as recently studied in Albrecher et al. (2022). When the maximum allowed dividend rate tends to infinity, we show a surprisingly simple and somewhat intriguing limit result in terms of the parameter $a$ for the surplus level on from which, for sufficiently large current dividend rate, a take-the-money-and-run strategy is optimal in the presence of the drawdown constraint.