Cost-efficiency in Incomplete Markets

TL;DR

This paper extends the concept of cost-efficiency from complete to incomplete markets, showing that optimal portfolios for diversification-loving preferences are perfectly cost-efficient and can be rationalized via expected utility.

Contribution

It introduces the notion of perfect cost-efficiency in incomplete markets and demonstrates its equivalence to solutions of expected utility problems.

Findings

Optimal portfolios for diversification-loving preferences are perfectly cost-efficient.

Perfect cost-efficiency is equivalent to the payoff being rationalizable as an expected utility solution.

Main results from complete market theory extend to incomplete markets with adaptations.

Abstract

This paper studies the topic of cost-efficiency in incomplete markets. A payoff is called cost-efficient if it achieves a given probability distribution at some given investment horizon with a minimum initial budget. Extensive literature exists for the case of a complete financial market. We show how the problem can be extended to incomplete markets and how the main results from the theory of complete markets still hold in adapted form. In particular, we find that in incomplete markets, the optimal portfolio choice for non-decreasing preferences that are diversification-loving (a notion introduced in this paper) must be "perfectly" cost-efficient. This notion of perfect cost-efficiency is shown to be equivalent to the fact that the payoff can be rationalized, i.e., it is the solution to an expected utility problem.