Optimal investment under partial information and robust VaR-type constraint

TL;DR

This paper investigates optimal investment strategies under partial information and robust VaR constraints, revealing that optimal wealth depends on the evolution of estimated market risk and regulatory perceptions.

Contribution

It extends utility maximization models by incorporating partial information and robust regulatory constraints, providing explicit solutions under these complex conditions.

Findings

Optimal wealth is a decreasing function of state price density.

Regulatory constraints influence the shape of the optimal investment strategy.

The solution accounts for stochastic behavior of the market risk estimate.

Abstract

This paper extends the utility maximization literature by combining partial information and (robust) regulatory constraints. Partial information is characterized by the fact that the stock price itself is observable by the optimizing financial institution, but the outcome of the market price of the risk $\theta$ is unknown to the institution. The regulator develops either a congruent or distinct perception of the market price of risk in comparison to the financial institution when imposing the Value-at-Risk (VaR) constraint. We also discuss a robust VaR constraint in which the regulator uses a worst-case measure. The solution to our optimization problem takes the same form as in the full information case: optimal wealth can be expressed as a decreasing function of state price density. The optimal wealth is equal to the minimum regulatory financing requirement in the intermediate economic states. The key distinction lies in the fact that the price density in the final state depends on the overall evolution of the estimated market price of risk, denoted as $\hat{\theta}(s)$ or that the upper boundary of the intermediate region exhibits stochastic behavior.