Portfolio optimization under the Value-at-Risk constraint

Abstract

In this paper we analyse the effects arising from imposing a Value-at-Risk constraint in an agent's portfolio selection problem. The financial market is incomplete and consists of multiple risky assets (stocks) plus a risk-free asset. The stocks are modelled as exponential Brownian motions with random drift and volatility. The risk of the trading portfolio is re-evaluated dynamically, hence the agent must satisfy the Value-at-Risk constraint continuously. We derive the optimal consumption and portfolio allocation policy in closed form for the case of logarithmic utility. The non-logarithmic CRRA utilities are considered as well, when the randomness of market coefficients is independent of the Brownian motion driving the stocks. The portfolio selection, a stochastic control problem, is reduced, in this context, to a deterministic control one, which is analysed, and a numerical treatment is proposed.

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