Optimal Portfolios Under Bounded Shortfall

Risk and Partial Information

Ralf Wunderlich
1
, Jorn Sass
2
and Abdelali Gabih
3
1
Mathematics Group,Zwickau University of Applied Sciences, Germany
ralf.wunderlich@fh-zwickau.de
2
RICAM, Austrian Academy of Sciences, Linz, Austria
joern.sass@oeaw.ac.at
3
Dept. of Mathematics and Computer Science, Leipzig University, Germany,
abdelali.gabih@math.uni-leipzig.de
1 Introduction
This paper considers the optimal selection of portfolios for utility maximizing in-
vestors under a shortfall risk constraint for a nancial market model with partial
information on the drift parameter. It is known that without risk constraint the dis-
tribution of the optimal terminal wealth often is quite skew. In spite of its maximum
expected utility there are high probabilities for values of the terminal wealth falling
short a prescribed benchmark. This is an undesirable and unacceptable property e.g.
from the viewpoint of a pension fund manager. While imposing a strict restriction to
portfolio values above a benchmark leads to considerable decrease in the portfolios
expected utility, it seems to be reasonable to allow shortfall and to restrict only
some shortfall risk measure.
A very popular risk measure is value at risk (VaR) which takes into account
the probability of a shortfall but not the actual size of the loss. Therefore we use
the so-called expected loss criterion resulting from averaging the magnitude of the
losses. And in fact, e.g. in Basak, Shapiro [1] it is shown that the distribution of the
resulting optimal terminal wealth has more desirable properties.
We use a nancial market model which allows for a non-constant drift which is
not directly observable. In particular, we use a hidden Markov model (HMM) where
the drift follows a continuous time Markov chain. In [13] it was shown that on market
data utility maximizing strategies based on such a model can outperform strategies
based on the assumption of a constant drift parameter. Extending these results to
portfolio optimization problems under risk constraints we obtain in Theorem 2 and
3 quite explicit representations for the form of the optimal terminal wealth and the
trading strategies which can be computed using Monte Carlo methods.
For additional topics such as stochastic interest rates, stochastic volatiliy, mo-
tivation of the model, Malliavin calculus, aspects of parameter estimation, and for
more references concerning partial information see [8, 9, 13]. For an control theoretic
approach see Rieder, Bauerle [12].
582 Ralf Wunderlich, Jorn Sass and Abdelali Gabih
For more background, references and results on optimization under risk con-
straints see e.g. Basak, Shapiro [1], Gundel, Weber [7], Lakner, Nygren [11], and
[3, 4, 5].
We acknowledge support from the Austrian Science Fund FWF, P 17947.
2 An HMM for the Stock Returns
Let (, A, P) be a complete probability space, T > 0 the terminal trading time, and
F = (F
t
)
t[0,T]
a ltration in A satisfying the usual conditions. We consider one
money market with interest rates equal 0 (to simplify notation) and n stocks whose
prices S = (S
t
)
t[0,T]
, S
t
= (S
1
t
, . . . ,S
n
t
)

evolve according to
dS
t
= Diag(S
t
)(
t
dt + dW
t
) , S
0
IR
n
,
where W = (W
t
)
t[0,T]
is an n-dimensional Brownian motion w.r.t. F, and is the
non-singular (n n)-volatility-matrix. The return process R = (R
t
)
t[0,T]
is dened
by dR
t
= (Diag(S
t
))
1
dS
t
.We assume that = (
t
)
t[0,T]
, the drift process of the
return, is given by
t
= BY
t
, where Y = (Y
t
)
t[0,T]
is a stationary, irreducible,
continuous time Markov chain independent of W with state space {e
1
, . . . ,e
d
}, the
standard unit vectors in IR
d
. The columns of the state matrix B IR
nd
contain the
d possible states of
t
. Further Y is characterized by its rate matrix Q IR
dd
, where

k
= Q
kk
=

d
l=1,l =k
Q
kl
is the rate of leaving e
k
and Q
kl
/
k
is the probability
that the chain jumps to e
l
when leaving e
k
.
Since the market price of risk,
t
=
1

t
=
1
BY
t
, t [0,T], is uniformly
bounded the density process (Z
t
)
t[0,T]
dened by dZ
t
= Z
t

t
dW
t
, Z
0
= 1, is
a martingale. By d

P = Z
T
dP we dene the risk-neutral probability measure.

E
will denote expectation with respect to

P. Girsanovs Theorem guarantees that
d

W
t
= dW
t
+
t
dt denes a

P-Brownian motion. The denition of R yields
R
t
=
_
t
0
BY
s
ds + W
t
=

W
t
, t [0,T] . (1)
We consider the case of partial information meaning that an investor can only ob-
serve the prices. Neither the drift process nor the Brownian motion are observable.
Only the events of F
S
, the augmented ltration generated by S, can be observed and
hence all investment decisions have to be adapted to F
S
. Note that F
S
= F
R
= F

W
.
A trading strategy = (
t
)
t[0,T]
is an n-dimensional F
S
-adapted, measurable
process which satises
_
T
0

t

2
dt < . The wealth invested in the i-th stock at
time t is
i
t
and X

t
1

t
is invested in the money market, where (X

t
)
t[0,T]
is
the corresponding wealth process. For initial capital x
0
> 0 it is dened by dX

t
=

t
(
t
dt + dW
t
), X

0
= x
0
. A trading strategy is called admissible if P(X

t

0 for all t [0,T]) = 1. By Itos rule
X

t
= x
0
+
_
t
0

s
d

W
s
, t [0,T] . (2)
A utility function U : [0,) IR{} is strictly increasing, strictly concave, twice
continuously dierentiable, and satises the Inada conditions lim
x
U

(x) = 0,
Optimal Portfolios Under Bounded Shortfall Risk and Partial Information 583
lim
x0
U

(x) = . Moreover, we impose as a technical condition that the function

I = (U

)
1
satises E[Z
T
I(yZ
T
)] < and E[Z
2
T
|I

(yZ
T
)|] < for all y > 0.
We want to maximize the expected utility of the terminal wealth X

T
but also
constrain the risk that the terminal wealth falls short of a benchmark q > 0. The
shortfall risk is measured in terms of the expected loss, which is computed by aver-
aging the loss (X

T
q)

w.r.t. the risk neutral measure

P.
For given x
0
> 0, q > 0 and > 0, the bound for the shortfall risk, we thus want
to
maximize E[U(X

T
)] s.t.

E[(X

T
q)

]
over all admissible trading strategies . We will denote an optimal strategy by

and the corresponding wealth process by X

. The expected loss corresponds to the

price of a derivative to hedge against the shortfall. So by paying now, one can hedge
against the risk to fall short of q. In [5] we also consider a generalized expected loss
criterion where the measure

P used for the averaging of the loss (X

T
q)

is replaced
by some arbitrary measure equivalent to P.
To determine optimal trading strategies we have to nd a good estimator for the
drift process. By (1) we are in the classical situation of HMM ltering with signal Y
and observation R, where we want to determine the lter E[Y
t

F
R
t
] = E[Y
t

F
S
t
]
for Y
t
. By Theorem 4 in [4], Bayes Law, and using 1

d
Y
t
= 1 we get
Theorem 1. The lter
t
= E[Y
t
| F
S
t
] (for Y ), the unnormalized lter E
t
=

E[Z
1
T
Y
t
| F
S
t
] (for Y ) and the conditional density
t
= E[Z
t
| F
S
t
] (lter for Z
t
)
satisfy
t
=
t
E
t
,
1
t
= 1

d
E
t
, and
E
t
= E[Y
0
] +
_
t
0
Q

E
s
ds +
_
t
0
Diag(E
s
)B

)
1
dR
s
, t [0,T].
Moreover,
1
t
=

E[Z
1
t

F
S
t
] and
1
t
= 1+
_
t
0
(BE
s
)

)
1
dR
s
, t [0,T].
3 Optimal Trading Strategies
One has to take care about selecting the bound for the shortfall risk. Choosing a
value which is too small, there is no admissible solution of the problem, because the
risk constraint cannot be satised. In [5] we nd that the risk constraint is binding
for (,) where = max(0,q x
0
) and is the expected loss of the optimal
terminal wealth of the Merton problem, i.e. the optimization problem without risk
constraint.
The dynamic portfolio optimization problem can be splitted into two problems
- the static and the representation problem. While the static problem is concerned
with the form of the optimal terminal wealth the representation problem consists in
the computation of the optimal trading strategy.
The next Theorem gives the form of the optimal terminal wealth. The proof
which can be found in [5, Section 5] adopts the common convex-duality approach by
introducing the convex conjugate of the utility function U with an additional term
capturing the risk constraint.
584 Ralf Wunderlich, Jorn Sass and Abdelali Gabih
Theorem 2. Let (,), then the optimal terminal wealth is
X

T
= f(
T
) = f(
T
; y

1
,y

2
) :=
_

_
I(y

T
) for
T
(0,z]
q for
T
(z,z]
I( (y

1
y

2
)
T
) for
T
(z,).
where I = (U

)
1
, z =
U

(q)
y

1
and z =
U

(q)
y

1
y

2
.
The real numbers y

1
, y

2
> 0 solve the equations

Ef(
T
; y
1
,y
2
) = x
0
and

E(f(
T
; y
1
,y
2
) q)

= .
The solution of the above system of equations exists and is unique.
If E[|U(X

T
)|] < then X

T
is the P-almost sure unique solution.
For the solution of the representation problem we can proceed as in [13, Section4]
to nd the optimal trading strategy. Since f(z) is not dierentiable at z and z we
have to use some approximation arguments to show that the chain rule for the
Malliavin derivative yields D
t
f(
T
) = f

(
T
)D
t

T
, where f

is dened piecewise on
the intervals (0,z], (z,z], (z,]. The proof of the following theorem can be found in
[5, Section 7]. It uses the Martingale Representation Theorem and Clarks Formula
in ID
1,1
, see Karatzas, Ocone, Li [10].
Theorem 3. Let X

T
L
2
(

P) and I

(y
T
) L
p
(

P) for all y > 0 and some p > 1.

Then for the optimal strategy it holds

t
= (

)
1

E[f

(
T
) D
t

T
| F
S
t
], where
D
t

T
=
2
T
_
BE
t
+
_
T
t
(D
t
E
s
)B

)
1
dR
s
_
,
D
t
E
s
= BDiag(E
t
) +
_
s
t
(D
t
E
u
)Qdu +
_
s
t
(D
t
E
u
)Diag
_
B

)
1
dR
u
_
.
4 Numerical Example
We consider a nancial market with n = 1 stock with d = 2 states of the drift
b
1
= 0.74 and b
2
= 0.36, volatility = 0.25, rates
1
= 15,
2
= 10, horizon
T = 1, initial capital x
0
= 1, benchmark q = 0.9 and bound = 0.05. i.e. after one
year we would like to have still 90% of our initial wealth with at most an expected
loss of 0.05. From 10 million simulated paths we estimate for logarithmic utility
the parameters y
1
and y
2
and estimate the expectations of the terminal wealth, its
utility and the shortfall risk. The results are given in Table 1, where we compare the
above values with the pure stock portfolio and the optimal portfolio for the Merton
problem which contains no risk constraint.
The expected loss of the pure stock strategy nearly coincides with the prescribed
bound = 0.05 while the Merton strategy exhibits a much larger risk measure of
nearly 4. The constrained strategy has a slightly lower expected utility as well as
expected terminal wealth than the unconstrained optimal strategy while it clearly
outperforms the pure stock investment. Figure 1 shows the estimated probability
Optimal Portfolios Under Bounded Shortfall Risk and Partial Information 585
0.5 1 1.5 2 2.5 3
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
q
Atom P ( X
T
*
= q ) = 0.40
Pure Stock
Unconstrained
Risc Constraint
Fig. 1. Distribution of terminal wealth
Table 1. Estimated expectations of terminal wealth, its utility and expected loss
exp. term. wealth expected utility expected shortfall
E[X
T
] E[U(X
T
)]

E[(X
T
q)

]
pure stock 1.095 0.049 0.053
unconstrained (Merton) 1.789 0.227 0.182
with risk constraint 1.512 0.186 0.050 =
density functions of the terminal wealth considered above. Additionally, on the hor-
izontal axes the expected terminal wealth E[X
T
] for the considered portfolios are
marked.
The gure clearly shows the reason for the large expected loss of the Merton
portfolio. There is a large probability for values in the shortfall region [0,q). On the
other hand there are considerable tail probabilities leading to the high expectation
of the terminal wealth as well as its utility. For the constrained portfolio probability
mass from that shortfall region but also from the tail is shifted to build up the
atom at the point q (benchmark). This results in a slightly smaller expectations of
the terminal wealth and its utility. According to Theorem ?? the atom at q has the
size P(X

T
= q) = P(z <
T
z). In the density plot it is marked by a vertical line
at q.
The optimal strategy can be evaluated using the representation given in Theorem
3 by an Monte-Carlo approximation of the conditional expectation from a suciently
large number of paths of
t
and the Malliavin derivative D
t

T
. These paths can be
obtained via numerical solution of the SDEs given in Theorem 1 and 3. A more
detailed analysis of the strategies and application to market data will be the topic
of forthcoming papers.
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