1. Investment Performance Measurement, Risk Tolerance and Optimal Portfolio Choice Marek Musiela, BNP Paribas, London

2. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 2 Joint work with T. Zariphopoulou (UT Austin) Investments and forward utilities, Preprint 2006 Backward and forward dynamic utilities and their associated pricing systems: Case study of the binomial model, Indifference pricing, PUP (2005) Investment and valuation under backward and forward dynamic utilities in a stochastic factor model, to appear in Dilip Madan’s Festschrift (2006) Investment performance measurement, risk tolerance and optimal portfolio choice, Preprint 2007

3. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 3 Contents Section 1Investment banking and martingale theory Section 2Investment banking and utility theory Section 3The classical formulation Section 4Remarks Section 5Dynamic utility Section 6Example – value function Section 7Weaknesses of such specification Section 8Alternative approach Section 9Optimal portfolio Section 10Portfolio dynamics

4. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 4 Investment banking and martingale theory Mathematical logic of the derivative business perfectly in line with the theory Pricing by replication comes down to calculation of an expectation with respect to a martingale measure Issues of the measure choice and model specification and implementation dealt with by the appropriate reserves policy However, the modern investment banking is not about hedging (the essence of pricing by replication) Indeed, it is much more about return on capital - the business of hedging offers the lowest return

5. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 5 Investment banking and utility theory No clear idea how to specify the utility function The classical or recursive utility is defined in isolation to the investment opportunities given to an agent Explicit solutions to the optimal investment problems can only be derived under very restrictive model and utility assumptions - dependence on the Markovian assumption and HJB equations The general non Markovian models concentrate on the mathematical questions of existence of optimal allocations and on the dual representation of utility No easy way to develop practical intuition for the asset allocation Creates potential intertemporal inconsistency

6. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 6 The classical formulation Choose a utility function, say U(x), for a fixed investment horizon T Specify the investment universe, i.e., the dynamics of assets which can be traded Solve for a self financing strategy which maximizes the expected utility of terminal wealth Shortcomings The investor may want to use intertemporal diversification, i.e., implement short, medium and long term strategies Can the same utility be used for all time horizons? No – in fact the investor gets more value (in terms of the value function) from a longer term investment At the optimum the investor should become indifferent to the investment horizon

7. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 7 Remarks In the classical formulation the utility refers to the utility for the last rebalancing period There is a need to define utility (or the investment performance criteria) for any intermediate rebalancing period This needs to be done in a way which maintains the intertemporal consistency For this at the optimum the investor must be indifferent to the investment horizon Only at the optimum the investor achieves on the average his performance objectives Sub optimally he experiences decreasing future expected performance

8. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 8 Dynamic performance process U(x,t) is an adapted process As a function of x, U is increasing and concave For each self-financing strategy the associated (discounted) wealth satisfies There exists a self-financing strategy for which the associated (discounted) wealth satisfies

9. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 9 Example - value function Value function Dynamic programming principle Value function defines dynamic a performance process

10. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 10 Weaknesses of such specification Dynamic performance process U(x,t) is defined by specifying the utility function u(x,T) and then calculating the value function At time 0, U(x,0) may be very complicated and quite unintuitive It depends strongly on the specification of the market dynamics The analysis of such processes requires Markovian assumption for the asset dynamics and the use of HJB equations Only very specific cases, like exponential, can be analysed in a model independent way

11. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 11 Alternative approach – an example Start by defining the utility function at time 0, i.e., set U(x,0)=u(x,0) Define an adapted process U(x,t) by combining the variational and the market related inputs to satisfy the properties of a dynamic performance process Benefits The function u(x,0) represents the utility for today and not for, say, ten years ahead The variational inputs are the same for the general classes of market dynamics – no Markovian assumption required The market inputs have direct intuitive interpretation The family of such processes is sufficiently rich to allow for analysis optimal allocations in ways which are model and preference choice independent

12. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 12 Differential inputs Utility equation Risk tolerance equation

13. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 13 Market inputs Investment universe of 1 riskless and k risky securities General Ito type dynamics for the risky securities Standard d-dimensional Brownian motion driving the dynamics of the traded assets Traded assets dynamics

14. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 14 Market inputs Using matrix and vector notation assume existence of the market price for risk process which satisfies Benchmark process Views (constraints) process Time rescaling process

15. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 15 Alternative approach – an example Under the above assumptions the process U(x,t), defined below is a dynamic performance It turns out that for a given self-financing strategy generating wealth X one can write

16. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 16 Optimal portfolio The optimal portfolio is given by Observe that The optimal wealth, the associated risk tolerance and the optimal allocations are benchmarked The optimal portfolio incorporates the investor views or constraints on top of the market equilibrium The optimal portfolio depends on the investor risk tolerance at time 0.

17. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 17 Wealth and risk tolerance dynamics The dynamics of the (benchmarked) optimal wealth and risk tolerance are given by Observe that zero risk tolerance translates to following the benchmark and generating pure beta exposure. In what follows we assume that the function r(x,t) is strictly positive for all x and t

18. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 18 Beta and alpha For an arbitrary risk tolerance the investor will generate pure beta by formulating the appropriate views on top of market equilibrium, indeed, To generate some alpha on top of the beta the investor needs to tolerate some risk but may also formulate views on top of market equilibrium

19. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 19 No benchmark and no views The optimal allocations, given below, are expressed in the discounted with the riskless asset amounts They depend on the market price of risk, asset volatilities and the investor’s risk tolerance at time 0. Observe no direct dependence on the utility function, and the link between the distribution of the optimal (discounted) wealth in the future and the implicit to it current risk tolerance of the investor

20. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 20 No benchmark and hedging constraint The derivatives business can be seen from the investment perspective as an activity for which it is optimal to hold a portfolio which earns riskless rate By formulating views against market equilibrium, one takes a risk neutral position and allocates zero wealth to the risky investment. Indeed, Other constraints can also be incorporated by the appropriate specification of the benchmark and of the vector of views

21. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 21 No riskless allocation Take a vector such that Define The optimal allocation is given by It puts zero wealth into the riskless asset. Indeed,

22. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 22 Space time harmonic functions Assume that h(z,t) is positive and satisfies Then there exists a positive random variable H such that Non-positive solutions are differences of positive solutions

23. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 23 Risk tolerance function Take an increasing space time harmonic function h(z,t) Define the risk tolerance function r(z,t) by It turns out that r(z,t) satisfies the risk tolerance equation

24. RISK TOLERANCE AND OPTIMAL PORTFOLIO CHOICE 24 Example For positive constants a and b define Observe that The corresponding u(z,t) function can be calculated explicitly The above class covers the classical exponential, logarithmic and power cases