An Exact Connection between Two Solvable SDEs and a Nonlinear Utility Stochastic PDE

Abstract

Motivated by the work of Musiela and Zariphopoulou [Backward and forward utilities and the associated pricing systems: The case study of the binomial model, in Indifference Pricing, Princeton University Press, Princeton, NJ, 2005--2009, pp. 3--44], we study the Itô random fields which are utility functions $U(t,x)$ for any $(\omega,t)$. The main tool is the marginal utility $U_x(t,x)$ and its inverse expressed as the opposite of the derivative of the Fenchel conjugate ${\widetilde U}(t,y)$. Under regularity assumptions, we associate an $\mbox{SDE}(\mu, \sigma)$ and its adjoint SPDE$(\mu, \sigma)$ in divergence form whose $U_x(t,x)$ and its inverse $-{\widetilde U}_y(t,y)$ are monotonic solutions. More generally, special attention is paid to rigorous justification of the dynamics of inverse flow of an SDE, so that we are able to extend to the solution of similar SPDEs the decomposition based on the solutions of two SDEs and their inverses. The second part is concerned with forward utilities, consistent with a given incomplete financial market, that can be observed but given exogenously to the investor. As in [M. Musiela and T. Zariphopoulou, Backward and forward utilities and the associated pricing systems: The case study of the binomial model, in Indifference Pricing, Princeton University Press, Princeton, NJ, 2005--2009, pp. 3--44], market dynamics are considered in an equilibrium state, so that the investor becomes indifferent to any action she can take in such a market. After having made explicit the constraints induced on the local characteristics of the consistent utility and its conjugate, we focus on the marginal utility SPDE by showing that it belongs to the previous family of SPDEs. The two associated SDEs are related to the optimal wealth and the optimal state price density, given a pathwise explicit representation of the marginal utility. This new approach addresses several issues with a new perspective: the dynamic programming principle, risk tolerance properties, and inverse problems. Some examples and applications are given in the last section.

Cite this work

No public copy is stored for this record, so only the metadata is cited.

Stored only when both papers are in the corpus — 39 citations exist upstream.

Papers that cite the same references — the relational fallback while embeddings are still backfilling.