54 3 Utility Maximisation on Finite Probability Spaces


investment as the FN −1 -measurable function  hN defined by  hN = SNh−1 . Eco-
nomically speaking, the value  hN SN −1 of the proportion of the investment in
the stock is constant, while the number  hN of stocks in the portfolio depends
on the current stock price SN −1 : it is simply inversely proportional to SN −1 .
To compute uN −2 (x), note that this step again is reduced to the analysis of
the one step problem at times {N − 2, N − 1}, where we now have to replace
the original utility function U (x) by the conditional utility function uN −1 (x).
This is just the principle of dynamic programming which reduces to an obvious
fact in the present context. Hence
uN −2 (x) = sup { E [uN −1 (x + h∆SN −1 )] | h ∈ R}
= c2U U (x).
By induction we conclude that
−t
ut (x) = cN
U U (x), t = 0, · · · , N,
so that we obtain in particular for the value function u(x) = u0 (x)
u(x) = cN
U U (x). (3.46)
In order to compute the parameters of the optimal investment strategy,
we now assume that there is a fixed horizon T > 0 such that N ∆t = T and
1
we let N → ∞, so that ∆t = N T
→ 0. As above we define u  = σ∆t 2 + ν∆t,
d = −σ∆t 2 + µ∆t. We have found in (3.40) that
1

βν 2
cU = 1 − ∆t + o(∆t)
2σ 2
so that  
T βν 2 T
cN
U = c ∆t
U = exp − + o(1).
2σ 2
 T
The optimal investment strategy X t (x) for initial wealth x > 0 is
t=0
given by
t
Xt (x) = x + 
ht ∆St
n=1
where
t−1 (x)
X

ht = 
k
St−1
and as in (3.42)
h (1 − β)ν
 1
k = + O(∆t 2 ) = (3.47)
x σ2
is the ratio of the current wealth X t−1 (x) invested into the stock. We thus
find the discrete version of the well-known “Merton-line” investment strategy
[M 90]; the latter applies to the continuous time limit, i.e., the Black-Scholes
model.