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Optimal payoffs under state-dependent preferences

Abstract : Most decision theories, including expected utility theory, rank-dependent utility theory and cumulative prospect theory, assume that investors are only interested in the distribution of returns and not in the states of the economy in which income is received. Optimal payoffs have their lowest outcomes when the economy is in a downturn, and this feature is often at odds with the needs of many investors. We introduce a framework for portfolio selection within which state-dependent preferences can be accommodated. Specifically, we assume that investors care about the distribution of final wealth and its interaction with some benchmark. In this context, we are able to characterize optimal payoffs in explicit form. Furthermore, we extend the classical expected utility optimization problem of Merton to the state-dependent situation. Some applications in security design are discussed in detail and we also solve some stochastic extensions of the target probability optimization problem.
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https://halshs.archives-ouvertes.fr/halshs-01118540
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Submitted on : Thursday, February 19, 2015 - 12:20:44 PM
Last modification on : Thursday, January 14, 2021 - 1:21:13 PM

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Carole Bernard, Franck Moraux, Ludger Rüschendorf, Steven Vanduffel. Optimal payoffs under state-dependent preferences. Quantitative Finance, Taylor & Francis (Routledge), 2015, 15 (7), pp.1157-1173. ⟨10.1080/14697688.2014.981576⟩. ⟨halshs-01118540⟩

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