PSAHARA Utility Family: Modeling Non-monotone Risk Aversion and Convex Compensation in Incomplete Markets

TL;DR

This paper introduces PSAHARA utility functions to model non-monotone risk aversion and convex compensation in incomplete markets, deriving explicit optimal controls and analyzing their implications for risk-taking and portfolio performance.

Contribution

It develops a new class of utility functions, PSAHARA, capturing non-concavity and non-differentiability, and provides explicit optimal control strategies in incomplete markets.

Findings

Convex compensation induces high risk-taking behavior.

PSAHARA portfolios are risk-seeking with high returns and volatility.

Explicit optimal control formulas are derived and analyzed.

Abstract

In hedge funds, convex compensation schemes are adopted to stimulate a high-profit performance for portfolio managers. In economics, non-monotone risk aversion is proposed to argue that individuals may not be risk-averse when the wealth level is low. Combining these two ingredients, we study the optimal control strategy of the manager in incomplete markets. Generally, we propose a wide family of utility functions, the piecewise symmetric asymptotic hyperbolic absolute risk aversion (PSAHARA) utility, to model the two ingredients, containing both non-concavity and non-differentiability as some abnormalities. Technically, we propose an additional assumption and prove concavification techniques of non--concave utility functions with a left unbounded domain in incomplete markets. Next, we derive an explicit optimal control for the family of PSAHARA utilities. This control is expressed into a unified four-term structure, featuring the asymptotic Merton term. Furthermore, we provide a detailed asymptotic analysis and numerical illustration of the optimal portfolio. We obtain several key insights, including that the convex compensation still induces a great risk-taking behavior in the case that the preference is modeled by SAHARA utility. Finally, we conduct a real-data analysis of the U.S. stock market under the above model and conclude that the PSAHARA portfolio is very risk-seeking and leads to a high return and a high volatility.