Finance Stochast.

7, 245262 (2003)
c Springer-Verlag 2003
An optimal consumption model
with stochastic volatility
Wendell H. Fleming
1
, Daniel Hern andez-Hern andez
2
1
Division of Applied Mathematics, Brown University, Providence, RI 02912, USA
(e-mail: whf@cfm.brown.edu)
2
Centro de Investigaci on en Matem aticas, Apartado Postal 402, Guanajuato, Gto. 36000,
M exico (e-mail: dher@cimat.mx)
Abstract. We consider an optimal consumption and investment model in continu-
ous time, which is an extension of the original Mertons problem. In the proposed
model, the asset prices are affected by correlated economic factors, modelled as
diffusion processes. Writing the value function in a special form, it can be seen
that another optimal control problem is involved and studying its associated HJB
equation smoothness properties of the original value function can be derived as
well as optimal policies.
Key words: Stochastic volatility, portfolio optimization, factor modelling, mean
reverting
JEL Classication: C6, E2, G1
AMSSubject Classication(1991): 60F17, 60J20, 65U05, 90A09, 90C40, 93E20
1 Introduction
In this paper an extension of the classical Merton optimal investment-consumption
model is considered, in which volatility of the risky asset is stochastic. As in the
Merton problem, the goal is to choose consumption and investment controls which
maximize total expected discounted HARA utility of consumption. See [4], [11].
The dynamic programming method is used to analyze this portfolio optimization
problem.
The problemis formulated in Sect. 2. Stochastic volatility enters via dependence
on an economic factor Y
t
of the coefcient (Y
t
) in the risky asset price dynamics
(2.1). The factor Y
t
is an ergodic Markov diffusion process, which satises the
Manuscript received: November 2001; nal version received: May 2002
246 W. H. Fleming, D. Hern andez-Hern andez
stochastic differential Eq. (2.2). The Brownian motions which appear in (2.1) and
(2.2) may be correlated. By a change of probability measure argument, this portfolio
optimization problemis reduced to a stochastic control problemwith state Y
t
which
obeys the controlled state dynamics (2.10). The controls in this problem are the
fraction u
t
of wealth X
t
in the risky asset and the consumption rate c
t
as a fraction
of X
t
.
The dynamic programming equation for this stochastic control problem is the
nonlinear differential Eq. (3.8), and the corresponding optimal investment and con-
sumption policies u

(y) and c

(y) are described in Theorem3.4. The main goals of

the paper are to show that the value function W(y) is the unique positive classical
solution to (3.8) with W(y), W(y)
1
and W
y
(y) bounded, and to verify optimal-
ity of the policies u

(y), c

(y). Two cases are considered. In Sect. 3 the HARA

parameter is positive, and < 0 in Sect. 4.
The proofs depend on several estimates for W, W
1
and W
y
, which are ob-
tained by analytical and stochastic control arguments. It is easy to obtain bounds
for W(y) and W(y)
1
, which follow from (2.15) and (2.17). The main effort is
to obtain bounds for the derivative W
y
(y). For this purpose, an articial bound
[u
t
[ M is introduced. For the corresponding value function W
M
(y), bounds for
W
M
y
(y) are found which do not depend on M. It then turns out that W = W
M
for large enough M. A preliminary bound for W
M
y
is obtained from inequality
(2.21) for the corresponding nite time horizon. This is followed by bounds for
W
M
y
in Sects. 3 and 4, rst on any nite interval [y[ R and then for [y[ large. In
deriving derivative bounds, it is often convenient to use the logarithmic form (3.10)
of the dynamic programming equation. This is a differential equation satised by
Z = lnW. Since W
1
is bounded, upper bounds for [Z
y
[ imply upper bounds for
[W
y
[.
If the Brownian motions in Eqs. (2.1) and (2.2) are independent, then the optimal
investment control policy is known in advance. See (5.1). In this case, the arguments
to justify dynamic programming can be much simplied and are sketched in Sect. 5.
Several other authors have considered portfolio optimization models in which
the interest rate r, the mean return or the volatility coefcient in (2.1) may
depend on a Markov diffusion process Y
t
. References [1], [7] and [13] consider the
problem of maximizing the expected HARA utility of wealth X
T
at a nal time T,
with consumption omitted from the model. See also [2], where the discrete time
version of this problemis studied. In his forthcoming Brown University PhDthesis,
T. Pang considers investment-consumption problems in which the factor Y
t
is the
riskless interest rate, with and constant. His work relies on different methods
from those used in the present paper.
The model (2.1)(2.2) for stochastic volatility is of the kind considered by
Fouque-Papanicolaou-Sircar [10]. They found good empirical evidence to justify
their model. Moreover, empirical data indicate that volatility often varies on a faster
time scale than the time scale for the asset price dynamics (2.1). This property is
exploited in [10] to obtain corrections to the Black-Scholes formula for pricing
derivative securities, when stochastic volatility is taken into account. The prob-
lem of optimizing expected HARA utility of terminal wealth is considered in [10,
An optimal consumption model with stochastic volatility 247
Sect. 10.1], and an approximate solution for rapidly varying stochastic volatility is
obtained.
In this paper, we assume that the factor Y
t
is known when the controls u
t
, c
t
are chosen. If Y
t
cannot be observed, one has a stochastic control problem in which
Y
t
is a hidden state and risky asset prices are observed. In [10, Sect. 10.1], an
approximate solution to the terminal wealth problemis also found in this case, when
volatility varies rapidly. There is a gap between the optimum achievable when Y
t
is known and when it is hidden.
2 Formulation of the problem
We consider a stochastic dynamic model for optimal consumption on an innite
time horizon. At each time t the investor divides his wealth X
t
between a risky
asset and a riskless asset and decide his rate for consumption. The prices P
t
of the
shares in the risky asset uctuate randomly according with the diffusion process
dP
t
= P
t
dt +(Y
t
)P
t
dW
1
t
. (2.1)
Here Y
t
represents an economic factor with a strong ergodicity property or mean
reversion. We assume that the factor Y
t
can be observed by the investor. Diffusion
processes in which and may depend on economic factors are often used in
nance to model different kinds of phenomena, like random varying interest rates
and stochastic volatility. See [1], [10], [13]. In this paper we consider stochastic
volatility, with constant . The dynamics of Y
t
are given by
dY
t
= g(Y
t
)dt +
_
dW
1
t
+ (1
2
)
1
2
dW
2
t
_
(2.2)
with Y
0
= y R and 1 1. The processes W
1
and W
2
are independent
Brownian motions with respect to the -algebra T
t
dened on a probability space
(, F, P). Specic assumptions on () and g() will be given later.
Let r, with > r, be the interest rate paid by the riskless asset, u
t
be the
fraction of wealth invested in the risky asset and c
t
X
t
be the rate at which wealth
is consumed. We assume that u
t
takes values in the control set |, which can be
(, ) or a nite interval, while c
t
0. Then, X
t
satises
dX
t
= X
t
_
(r + ( r)u
t
c
t
)dt +u
t
(Y
t
)dW
1
t

, (2.3)
with initial condition X
0
= x > 0.
Denition 2.1 A pair (u, c) is an admissible strategy if they are T
t
-progressively
measurable processes such that
P [t > 0 : [u
t
[ A
1
, 0 c
t
A
2
] = 1,
where the constants A
1
and A
2
may depend of the strategy. We denote the set of
admissible strategies as /.
248 W. H. Fleming, D. Hern andez-Hern andez
In Denition 2.1, the probability space and family T
t
of algebras is given.
Since there are optimal control policies which are feedback functions of Y
t
, the
particular choice of probability space and T
t
turns out not to be important.
For (u, c) /, X
t
> 0 for all t 0 with solution
X
t
= xexp
_
rt +
_
t
0
_
( r)u
s
c
s

1
2
u
2
s

2
(Y
s
)
_
ds
+
_
t
0
u
s
(Y
s
)dW
1
s
_
. (2.4)
We consider hyperbolic absolute risk aversion (HARA) utility function with pa-
rameter < 1, with ,= 0. Then, the objective is to maximize expected discounted
utility of consumption on the innite horizon
J(x, y; c, u) = E
_

0
1

e
t
(c
t
X
t
)

dt, > 0 (2.5)

over the set of admissible strategies /. Let V (x, y) be the value function, which
we anticipate to have the form V (x, y) =
x

W(y) for some function

W. Under
suitable conditions we shall characterize

W as the value function of another optimal
control problem.
Throughout we assume the following:
Assumption A
The functions and g belong to C
1
(R) and:
(i)
y
is bounded and
l
()
u
for some constants
u
>
l
> 0;
(ii) g
y
is bounded and there exists k > 0 such that g
y
k.
2.1 Classical Merton problem
When () = is constant in (2.1) we obtain the classical Merton problem. In
this case the corresponding value function V depends only on x, and the above
representation holds with

W constant, i.e.
V (x) = C
x

, (2.6)
where C is a constant, whenever >
_
r +
(r)
2
2(1)
2
_
.
If | = (, ), then
u

=
r

2
(1 )
(2.7)
c

=
(
(r)
2
2
2
(1)
+r)
1
. (2.8)
are optimal controls. Moreover, C = (c

)
1
. See [3],[8].
An optimal consumption model with stochastic volatility 249
2.2 Finite time horizon problem
Now we go back to the original problem and will try to motivate the form of the
function

W. Let T > 0 be arbitrary and, for each (u, c) /, dene the nite
horizon functional
J(x, y; c, u, T): =E
_
T
0
1

e
t
(c
t
X
t
)

dt
=E
_
T
0
x

e
t
c

t
e
rt+

t
0
[(r)u
s
c
s

1
2
u
2
s

2
(Y
s
)]ds+

t
0
u
s
(Y
s
)dW
1
s
dt
=
x

E
_
T
0
e
t
c

t
e
rt+

t
0
[(r)u
s
c
s
]ds+
(1)
2

t
0
u
2
s

2
(Y
s
)ds
dt
=
x

J(y; c, u, T), (2.9)

with

J dened implicitly from (2.9). The second equality follows from (2.4), while
the third equality follows from a change of measure, using the Girsanov transfor-
mation, with Radon-Nikodym derivative
d

P
dP

F
T
= exp
_

_
T
0
u
s
(Y
s
)dW
1
s

1
2

2
_
T
0
u
2
s

2
(Y
s
)ds
_
.
Under the new measure

Pthe process B
t
:= W
1
t

_
t
0
u
s
(Y
s
)ds is a Brownian
motion adapted to T
t
. This argument is valid since u is bounded. This transfor-
mation was also used in [6] and [7], where the criterion to be optimized is expected
HARA utility of an investors nal wealth.
Given (u, c) admissible, dening the process z
t
:= t + rt +
_
t
0
_
(
r)u
s
c
s
_
ds +
(1)
2
_
t
0
u
2
s

2
(Y
s
)ds, write

J(y; c, u, T) =

E
_
T
0
c

t
e
z
t
dt.
Case < 0.
Dene the value function
W(y, T) := inf
c,u

J(y; c, u, T).
Observe that under the change of measure, the dynamics of Y
t
are:
dY
t
= [g(Y
t
) +u
t
(Y
t
)]dt +dZ
t
, (2.10)
with Z
t
a Brownian motion.
250 W. H. Fleming, D. Hern andez-Hern andez
Then, we expect that the function

W corresponds to the value function
W(y) := inf
u,c

E
_

0
c

t
e
z
t
dt, (2.11)
which should coincide with

W(y) := lim
T
W(y, T). Observe that
J(x, y; c, u) J(x, y; c, u, T) =
x

J(y; c, u, T),
which implies

W(y) W(y, T) and hence

W(y)

W(y). Also, it follows
immediately that

W(y) W(y). Thus, for each y R,

W(y)

W(y) and

W(y) W(y). (2.12)
Later we shall prove that equality holds.
Now we shall start to put into rigorous basis the main properties of the value
functions W(y, T) andW(y). Inorder todothis, we will assume that the control sets
are bounded intervals, i.e. the consumption process c
t
takes values in ( := [c
l
, c
u
],
with 0 < c
l
< c
u
< , and u
t
|
M
:= [M, M]. These bounds on u
t
and c
t
will be removed later.
The corresponding dynamic programming equation associated with W(y, T)
is
W
T
+W = g(y)W
y
+

2
2
W
yy
+ inf
cC
[cW +c

] + inf
uU
M
[r + ( r)u +
1
2
u
2

2
(y)]W +u(y)W
y
. (2.13)
The equation for W(y) is (2.13) with W
T
= 0.
Taking u
s
= 0 and minimizing

J with respect to admissible c
t
0, we get the
upper bound
W(y) K
1
, with K
1
:=
_
r
1
_
1
.
Observe that the constant function W
+
:= K
1
, with K
1
as chosen, solves for all
c 0 the partial differential inequality
W
+
g(y)W
+
y
+

2
2
W
+
yy
cW
+
+c

+rW
+
,
which implies, via Feynman-Kac formula, that W(y) W
+
(y).
Now we shall get a positive lower bound. Since
r + ( r)u
1
2

2
(y)u
2
r + ( r)u
1
2

2
l
u
2

( r)
2
2(1 )
2
l
+r =:
l
, (2.14)
An optimal consumption model with stochastic volatility 251
for each admissible consumption process c
t
0, we get z
t
t
_
t
0
c
s
ds,
with :=
l
, and then

J(y; c, u, T)

E
_
T
0
e
t
c

t
dt,
where d
t
= c
t

t
dt, with initial condition
0
= 1. Together with this ODE,
dened for each strategy c
t
0, we can dene the auxiliary pure consumption
minimization problem:
v(, T) := min
c
.
_
T
0
e
t
c

t
dt.
The corresponding dynamic programming equation is
v
T
+ v = min
c0
_
cv

+ (c)

_
,
and adapting the same ideas to solve the classical Merton problem it can be seen
that v(, T) =

w(T), with w solving the ODE:

w
T
+ w = (1 )w

1
.
Moreover, as T , w(T)

1

1
. See [5], p. 161. Since W(y, T)
v(1, T) = w(T), the above argument implies the existence of T
1
and K
2
> 0 such
that, for T T
1
, W(y, T) K
2
. Thus, for T T
1
, we get the uniform bounds:
K
2
W(y, T), W(y) K
1
(2.15)
Remark 2.1 Note that if c
l
K
1
1
1
and K
1
1
2
c
u
, the inmum with respect
to c in (2.13) is achieved for c

= W
1
1
(y) [c
l
, c
u
], and hence we can let
the articial constraint set ( to be either [c
l
, c
u
] or [0, ). Throughout we shall
assume that these constraints for c
l
and c
u
hold and take ( = [0, ). Moreover,
the constants K
1
and K
2
do not depend on the bound M for [u
t
[.
Case > 0.
The corresponding value functions W(y, T), W(y) are dened as:
W(y, T) := sup
c,u

J(y; c, u, T) and W(y) := sup

u,c

E
_

0
c

t
e
z
t
dt, (2.16)
and, assuming that > 0, instead of (2.15), we have the uniform bounds
K
1
W(y, T), W(y) K
2
. (2.17)
The associated HJB equation for W(y, T) is
W
T
+W = g(y)W
y
+

2
2
W
yy
+ sup
cC
[cW+c

]
+ sup
uU
M
[r + ( r)u
+
1
2
u
2

2
(y)]W+u(y)W
y
. (2.18)
252 W. H. Fleming, D. Hern andez-Hern andez
Now we shall prove that, regardless the sign of , W(, T) is Lipschitz for T
xed. Given y, y initial conditions and (u, c) /, let Y
t
,

Y
t
be the corresponding
solutions of (2.10) with z
t
as above when

Y
t
replaces Y
t
. Then

J( y; c, u, T)

J(y; c, u, T) =

E
_
T
0
c

t
(e
z
t
e
z
t
)dt

E
_
T
0
c

t
e
z
t
(1 e
z
t
z
t
)dt

E
_
T
0
c

t
e
z
t
( z
t
z
t
)dt. (2.19)
On the other hand, when [u
t
[ M,
z
t
z
t
=
( 1)
2
_
t
0
u
2
s
(
2
(

Y
s
)
2
(Y
s
))ds
[( 1)[M
2

u
[
y
[
_
t
0
[

Y
s
Y
s
[ds,
and, since sample paths of

Y
t
Y
t
are continuously differentiable,
d[

Y
t
Y
t
[
2
= 2(

Y
t
Y
t
)[g(

Y
t
) g(Y
t
) +u
t
((

Y
t
) (Y
t
))],
which implies
[

Y
t
Y
t
[
2
[ y y[
2
2k
_
t
0
[

Y
s
Y
s
[
2
ds + 2M[[[
y
[
_
t
0
[

Y
s
Y
s
[
2
ds.
Using Gronwalls inequality we obtain
[

Y
t
Y
t
[ [ y y[e
2(kM|||
y
|)t
. (2.20)
Then,
z
t
z
t

[( 1)[M
2

u
[
y
[
2(k M[[[
y
[)
(1 e
2(kM|||
y
|)t
)[ y y[,
and the r.h.s. of (2.19) is less or equal K[ y y[

J( y; c, u, T) for some constant K

depending on T and M.
From the above estimates, it follows that
[W( y, T) W(y, T)[ K

K[ y y[, (2.21)
with K

= K
1
when < 0 and K

= K
2
when 0 < < 1.
We point out that, when
k M[[[
y
[ > 0, (2.22)
K does not depend on T. Next lemma summarize some straightforward conse-
quences of this.
An optimal consumption model with stochastic volatility 253
Lemma 2.1 Assume (2.22). Then, W(, T) and

W() are Lipschitz, and W(y, T)

W(y) when T uniformly in compact sets.

Obviously (2.22) holds when the correlation coefcient = 0. This condition
is not very satisfactory when ,= 0 and, in this case, a different argument will be
used in Sect. 3 to obtain a Lipschitz bound for

W independent of M, when the
HARA parameter > 0. However, to study the case when < 0 this condition
will be useful. These results are presented in Sect. 4.
3 Correlated case, positive HARA parameter
In this section we consider that the HARAparameter belongs to the interval (0,1).
We shall characterize the value functions W(y, T) as smooth solutions of the HJB
Eq. (2.18) and study its asymptotic limit when T and M .
3.1 Constrained case
Throughout this subsection we shall assume that the control set | = |
M
for some
M > 0 xed. The proof of the next theorem can be found in Appendix E of [5].
See also Theorem IV.4.3 and Remark IV.4.1 in [8], p. 169.
Theorem 3.1 W(y, T) is the unique bounded classical solution of (2.18) with
initial condition W(y, 0) = 0.
Next theorem states the main properties of the limit function

W and character-
izes smooth solutions of the steady state PDE:
w = g(y)w
y
+

2
2
w
yy
+ (1 )w

1
+1(y, w, w
y
), (3.1)
with
1(y, p, q) = sup
uU
M
_

_
r + ( r)u +
1
2
u
2

2
(y)
_
p +u(y)q
_
. (3.2)
Theorem 3.2 Let
l
be dened as in (2.14), and assume that =
l
> 0.
Then
(i)

W is a classical solution of (3.1) with

W and

W
1
bounded.
(ii)

W(y) = W(y), for each y R, where W is as in (2.16).
Proof (i) First we shall get an estimate for the partial derivative W
T
(y, T). Let
T > 0 xed but arbitrary. Noting that z
t
t, for each (c, u) / and T

> T
we have

J(y; c, u, T

)

J(y; c, u, T) =

E
_
T

T
c

t
e
z
t
dt
c

u
_
T

T
e
t
dt
c

u
e
T
(T

T).
254 W. H. Fleming, D. Hern andez-Hern andez
This implies that W(y, T

) W(y, T) c

u
e
T
(T

T), and taking T

=
T +h, h > 0, dividing both sides by h and letting h 0, we get
0 W
T
(y, T) c

u
e
T
. (3.3)
While the bound on W
y
(y, T) obtained in (2.21) depends on M and T, let us
showby a different argument that if we x 1 < R < , then [W
y
(y, T)[ is bounded
independent of M and T for [y[ R 1. Let Z(y, T) = lnW(y, T). Then
Z
T
+ = g(y)Z
y
+

2
2
Z
yy
+

2
2
(Z
y
)
2
+r +
M
(y, Z
y
) + (1 )e

Z
1
,
with
M
(y, p) := max
uU
M
( r)u +
1
2
u
2

2
(y) + u(y)p. Since the
last three terms in the above equation are greater than or equal zero, we get
Z
T
+ g(y)Z
y
+

2
2
Z
yy
+

2
2
(Z
y
)
2
. (3.4)
Suppose that Z
y
(y, T) has a local maximum or minimum at y with [ y[ R.
Then Z
yy
( y, T) = 0. Letting
1
= max[g(y)[ : [y[ R, from (2.17) and (3.4),
at y,

2
2
(Z
y
)
2

1
[Z
y
[
2
0
for some
2
, which implies that
[Z
y
( y, T)[ C(R), (3.5)
with C(R) independent of M and T. On the other hand, the mean value theorem
and (2.17) imply that there exist y

(R, R + 1) and y
+
(R 1, R) such
that
[W
y
(y

, T)[ K
2
, [Z
y
(y

, T)[
K
2
K
1
.
Therefore, if y

y y
+
, [Z
y
(y, T)[ max
K
2
K
1
, C(R), and hence, for [y[
R 1,
[W
y
(y, T)[ max
K
2
2
K
1
, K
2
C(R). (3.6)
Since W(y, T) is a classical solution of (2.18), estimates (2.17), (3.3) and (3.6),
imply that, for [y[ R 1, [W
yy
(y, T)[ is uniformly bounded (independent of
M and T). Moreover, since 1(y, w, p) is locally Lipschitz, Arzel a-Ascoli theorem
implies that, through some subsequence T
n
, W(, T
n
)

W() uniformly
on compact sets, as well as its rst and second derivatives. Hence,

W C
2
(R) and
it is a solution of (3.1).
(ii) Let y R. The inequality

W(y) W(y) is clear, so we shall prove only the
reverse inequality. Given an admissible strategy (u, c) /, by using Feynman-Kac
formula,

W(y)

E
_
T
0
c

t
e
z
t
dt +

E[

W(Y
T
)e
z
T
] (3.7)
An optimal consumption model with stochastic volatility 255
Letting T , we have that

W(y)

E
_

0
c

t
e
z
t
dt, since the last term on
the r.h.s. of (3.7) goes to zero when T . This implies that

W(y) W(y).
Furthermore, considering the feedback control policies
u(y) =argmax
uU
M
_

_
r+( r)u +
1
2
u
2

2
(y)
_

W(y)+u(y)

W
y
(y)
_
c(y) =

W(y)
1
1
equality is obtained in (3.7). Note that u and c are bounded and locally Lipschitz.
This argument shows the optimality of the policies u and c. .
Straightforward calculations show that

V (x, y) :=
x

W(y) is a solution to the

Hamilton-Jacobi equation
v +
1
2

2
v
yy
+g(y)v
y
+ sup
uU
M
,cC
_
[r+(r)u c]xv
x
+
1
2
u
2

2
(y)x
2
v
xx
+ x(y)v
xy
+
1

_
= 0 , (3.8)
with ( as in Remark 2.1. The verication argument, in the proof of Part (ii) of the
previous theorem, and (2.9) can be used to prove that

V is equal to the original
value function V . This implies, in particular, that

W = W.
3.2 Unconstrained case
Throughout this subsection we shall denote by W
M
the value function W dened
in (2.16) corresponding to the constrained set | = |
M
. Next we shall study its
asymptotic properties when M .
Let W(y) := lim
M
W
M
(y), which exists since M W
M
(y) is increas-
ing. Note that bounds (2.17) also hold for W.
Theorem 3.3 Suppose that > 0. Then, W is a positive classical solution of the
PDE:
W = g(y)W
y
+

2
2
W
yy
+ (1 )W

1
+rW
+W
( r +(y)
W
y
W
)
2
2(1 )
2
(y)
. (3.9)
Proof Since W
M
is a smooth solution of (3.1) and satises estimates (2.17) and
(3.6) independent of M, it follows that [W
M
yy
[ is bounded independent of M for
[y[ R 1 for each 1 < R < . Therefore, W
M
W and W
M
y
W
y
uniformly in compact sets as M . Further, for [y[ R1, the supremum in
the denition of 1(y, W
M
(y), W
M
y
(y)) (see (3.2)) is achieved at
u(y) =
r
(1 )
2
(y)
+
W
M
y
(y)
(1 )(y)W
M
(y)
256 W. H. Fleming, D. Hern andez-Hern andez
for M large enough, and hence 1(y, W
M
(y), W
M
y
(y)) converges uniformly in
compact sets to
rW +
W
2(1 )
2
(y)
( r +(y)
W
y
W
)
2
.
This implies, using (3.1), that W is a classical solution of (3.8). .
In order to characterize W as the unique solution of (3.8) we need some esti-
mates on W
y
. This will also allow us to obtain an optimal strategy for the innite
horizon unconstrained problem (2.16).
Let g(y) := g(y) +
(r)
(1)(y)
, which derivative is given by g
y
(y) = g
y
(y)
(r)
y
(y)
(1)
2
(y)
. From Assumption A it follows that there exists a constant

k such
that
g
y

k. (3.10)
Lemma 3.1 Suppose that (3.9) holds with

k > 0. If W is a positive classical
solution of (3.8) with W and W
1
bounded, then W
y
is bounded.
Proof Let Z(y) = lnW(y). Then, Z is a bounded classical solution of
= g(y)Z
y
+

2
2
Z
yy
+

2
Z
2
y
+ (1 )e

Z
1
+(y), (3.11)
with

:=
_
1(1
2
)
1
_1
2
and (y) = r +
(r)
2
2(1)
2
(y)
.
Since Z is in C
2
(R) and satises (3.10), it follows that Z belongs to C
3
(R).
Now, suppose that Z
y
(y) has a positive maximumat y = y
1
. Then Z
yy
(y
1
) = 0 and
Z
yyy
(y
1
) 0. By differentiating (3.10) with respect to y, we have when y = y
1
0 g
y
Z
y
e

Z
1
Z
y
+
y
.
Let b > 0 be a lower bound for e

Z
1
, and denote by [[ [[ the supremum norm.
Then
(

k +b)Z
y
(y
1
) [[
y
[[.
Similarly, if Z
y
(y) has a negative minimum at y = y
2
, then
0 g
y
Z
y
e

Z
1
Z
y
+
y
,
and hence
(

k +b)[Z
y
(y
2
)[ [[
y
[[.
Thus, [Z
y
[ (

k + b)
1
[[
y
[[ whenever Z
y
has either a positive maximum or
a negative minimum. Since liminf
|y|
[Z
y
(y)[ = 0, because Z is bounded, this
implies that Z
y
(y) is bounded on R. In fact,
[[Z
y
[[
[[
y
[[

k +b
.
.
An optimal consumption model with stochastic volatility 257
Remark 3.1 (a) The proof of the lemma only requires that (3.9) holds, with

k > 0,
for large values of [y[. Note that, since estimate (3.6) is independent of T, it
holds for W
y
as well.
(b) Under the weaker assumption that

k+b > 0 the statement of the lemma remains

true.
(c) In view of Assumption A, the hypotheses of the lemma impose growth condi-
tions for . Observe that the second term of the derivative of g is in terms of
and its derivative, and, when it is small enough,

k > 0.
Next we present a verication result.
Theorem 3.4 Under the conditions of Theorem 3.3 and Lemma 3.1, the value
function W dened in (2.16), with | = (, +), is the unique classical solution
of (3.8) with W, W
1
and W
y
bounded. Moreover,
u

(y) =
r
(1 )
2
(y)
+
W
y
(y)
(1 )(y)W(y)
and c

(y) = W
1
1
(y)
are optimal feedback policies.
Proof Suppose that

W is a positive classical solution of (3.8) with

W,

W
1
and

W
y
bounded. Next we verify that

W = W, with W as in (2.16). It sufces to
consider control policies (u, c) / such that

E
_

0
c

t
e
z
t
dt < .
Since c

t
c

l
> 0, this implies that

E
_

0
e
z
t
dt < , and hence

Ee
z
T
0 as
T through some sequence. Now, from Feynman-Kac formula,

W(y)

E
_
T
0
c

t
e
z
t
dt +

Ee
z
T
W(Y
T
), (3.12)
and, since the last term on the r.h.s. is greater than or equal to zero, then

W(y)

E
_

0
c

t
e
z
t
dt. We conclude that

W(y) W(y).
Now dene u

(y) and c

(y) as in the statement of the theorem, with W(y)

replaced by

W(y). Note that this strategy belongs to /, since

W,

W
1
and

W
y
are bounded. Then, (3.11) holds with equality for this strategy, and, since its last
term on the r.h.s. goes to zero when T , we obtain, letting T ,

W(y) =

E
_

0
(c

t
)

e
z

t
dt W(y).
Thus,

W(y) = W(y) and u

(y), c

(y) are optimal control policies. .

258 W. H. Fleming, D. Hern andez-Hern andez
4 Correlated case, negative HARA parameter
In this section we shall obtain similar results to those presented in previous section
when the HARA parameter is less than zero.
Again, we consider rst the constrained case, i.e. when | = |
M
for some
M > 0. Note that the statement of Theorem 3.1 also holds in this case for the
corresponding HJB Eq. (2.13). The proof of the next result is based in standard
estimates from parabolic PDEs and we will just sketch it.
Theorem 4.1 Assume that Condition (2.22) holds. Then,

W(y) is a classical so-
lution of
w = g(y)w
y
+

2
2
w
yy
+ (1 )w

1
+1(y, w, w
y
), (4.1)
with 1 dened as
1(y, w, p) := inf
uU
M
[r + ( r)u +
1
2
u
2

2
(y)]w +u(y)p
Sketch We know from Lemma 2.1 that W(y, T) converges uniformly on compact
sets to

W(y) when T . Further,

W is Lipschitz. Since
1(y, w, p) := inf
uU
M
[r + ( r)u +
1
2
u
2

2
(y)]w +u(y)p
is locally Lipschitz, standard Holder estimates from parabolic PDEs (see, for in-
stance, Appendix E in [5],[12]) imply that there exists a sequence T
n
such
that W
y
(y, T
n
)

W
y
(y) and W
yy
(y, T
n
)

W
yy
(y), that is, the limit function

W C
2
(R) and it is a solution of (4.1). .
To study the unconstained case, | = (, +), we observe that, for each
y R, the inmum in the denition of 1 is attained at
u

(y) =
r
(1 )
2
(y)
+


W
y
(y)
(1 )(y)

W(y)
(4.2)
for M large enough. Since (2.15) also holds for

W, if

W
y
is bounded, then

W is a
classical solution of (3.8) for [[ small enough. Theorem 4.2 makes this idea more
precise. Observe that the HJB equation for the unconstrained case (3.8) is the same
for positive or negative.
Theorem 4.2 There exist M
0
> 0 and > 0 such that

W is a classical solution
of (3.8) for M > M
0
and [[ .
Proof The main step will be to obtain a bound for

W
y
independent of M. Let us x
1 < R < . Then, we will prove that [

W
y
(y)[ is bounded independent of M for
[y[ R1. Let Z(y) = ln

W(y). Then, from Theorem 4.1, Z solves the equation
= g(y)Z
y
+

2
2
Z
yy
+

2
2
(Z
y
)
2
+r +
M
(y, Z
y
) + (1 )e

Z
1
,
An optimal consumption model with stochastic volatility 259
with
M
(y, p) := max
uU
M
( r)u +
1
2
u
2

2
(y) +u(y)p. Since

M
(y, p) (y, p) :=
( r +(y)p)
2
2(1 )
2
(y)
,
we get
g(y)Z
y
+

2
2
Z
yy
+

2
2
(Z
y
)
2
+r +(1)e

Z
1
+
( r)
2
2(1 )
2
(y)
, (4.3)
with g(y) := g(y) +
(r)
(1)(y)
and

:=
_
1(1
2
)
1
_1
2
as in (3.10).
Then, the same steps followed for the derivation of (3.6) can be adapted to get
the estimate
[

W
y
(y)[ max
_
K
2
1
K
2
, K
1
C(R)
_
, (4.4)
for [y[ R 1, with C(R) independent of M.
We shall next prove that

W
y
(y) tends to 0 as [y[ at a rate which does
not depend on M. We will consider only the case y > 0; when y < 0 the same
argument can be adapted. Suppose that

W
y
has a positive local maximumat y = y
1
.
Then,

W
yy
(y
1
) = 0, and since the last term in (4.1) is less than or equal zero, and
(2.15) holds for

W,
g(y
1
)

W
y
(y
1
) C
1
,
for some C
1
> 0. Since g
y
k < 0, g(y
1
) < 0 for y
1
large, and
[g(y
1
)[

W
y
(y
1
) C
1
. (4.5)
Now, let Z = ln

W, and suppose that Z
y
has a negative local minimum at y
2
.
Then Z
yy
(y
2
) = 0, and from (4.3) it follows that for some C
2
> 0,
g(y
2
)Z
y
(y
2
) (y
2
) C
2
.
Since g(y
2
) < 0 for y
2
large, we get
[ g(y
2
)[[

W
y
(y
2
)[ C
2

W(y
2
) C
2
K
1
. (4.6)
Let us show that given > 0 there exists R

which does not depend on M such

that
[

W
y
(y)[ < for all y > R

. (4.7)
Since 0 < K
2


W(y) K
1
, for each n = 1, 2, , there exists y
n
(n, 2n)
such that
[

W
y
(y
n
)[
K
1
K
2
n
and
[Z
y
(y
n
)[ =
[

W
y
(y
n
)[

W(y
n
)

K
1
K
2
nK
2
.
260 W. H. Fleming, D. Hern andez-Hern andez
If

W
y
has a positive local maximum at y
1n
> y
n
, then by (4.5) and Assumption
A(ii), there exists b
1
such that for large enough n

W
y
(y
1n
) <
b
1
n
.
Similarly, by (4.6) there exists b
2
> 0 such that if Z
y
has a negative local minimum
at y
2n
> y
n
, then for large enough n
Z
y
(y
2n
)
b
2
n
.
From these inequalities we obtain (4.7).
Fromthe above, it follows that u

(y) (dened in (4.2)) is bounded by a constant

which does not depend on M. Let M
0
> [[u

[[. Then, for each M M

0
, the
inmum in 1 will be attained at u

, and substituting it in (4.1), we obtain (3.8).

Finally, note that choosing [[ small enough Condition (2.22) holds for M = M
0
.
.
An analogous version of the verication Theorem3.4 also holds for < 0. The
proof follows the same lines, except that inequality (3.11) is in the reverse sense.
As in Theorem 3.4, the verication argument gives again uniqueness of

W among
classical solutions of (3.8) with

W,

W
1
and

W
y
bounded.
5 Uncorrelated case
In this section we present some simplications of the previous sections when the
correlation parameter = 0. We will only present the case when the HARAparam-
eter is negative to avoid repetitions. Under this assumption it is possible to get in
a more direct way similar results to those already obtained. In particular, there is an
easy way to get a uniform bound for W
y
, and a simple argument shows optimality
of u

t
in (5.1), with no use of dynamic programming. Throughout this section the
control set corresponding to the fraction of wealth invested in the risky asset will
be | = (, ).
Let us rst describe the modications to our model when = 0. Observe that in
this case independence of Brownian motions W
1
and W
2
implies that the dynamics
of the state process Y
t
remains the same after the change of measure

P , i.e. (2.2)
and (2.10) are the same. Now, writing the z
t
process as
z
t
= t +rt
_
t
0
c
s
ds +
_
t
0

2(1 )
( r)
2

2
(Y
s
)
ds
+
( 1)
2
_
t
0

2
(Y
s
)
_
u
s

r
(1 )
2
(Y
s
)
_
2
ds,
one conclude that, since u
t
does not affect the dynamics of the state process and
< 0,
u

t
=
r
(1 )
2
(Y
s
)
(5.1)
An optimal consumption model with stochastic volatility 261
is an optimal control for the functional

J(y; c, u) =

E
_

0
c

t
e
z
t
dt, for y, c xed.
Then, evaluating

J(y; c, u) in the optimal control u

t
, we get a new functional

J, which we want to minimize,

J(y; c) : =

J(y; c, u

)
=

E
_

0
e
t
c

t
e

t
0
(Q(Y
s
)c
s
)ds
dt
=

E
_

0
c

t
e
z
t
dt,
with Q(y) :=r+
1
2
(r)
2
(1)
2
(y)
and z
t
= t+rt
_
t
0
c
s
ds+
_
t
0

2(1)
(r)
2

2
(Y
s
)
ds.
From Assumption A,

E
_

0
e
t
c

t
e

t
0

r+
1
2
(r)
2
(1)
2
l
c
s

ds
dt

J(y; c)

E
_

0
e
t
c

t
e

t
0

r+
1
2
(r)
2
(1)
2
u
c
s

ds
dt,
and taking the inmum with respect to admissible c, the value of the left and right
side correspond to the constant C in (2.6), with equal to
l
and
u
, respectively.
Denote by C(
l
) and C(
u
) these constants. Then,
C(
l
) W(y) C(
u
)
and
x

C(
u
) V (x, y)
x

C(
l
).
The Lipschitz property of W(, T) and W() can be obtained, but without
restricting the control set |. Observe that, given y, y initial conditions for the state
process, the set of inequalities (2.19) also hold, with

J instead of

J and z
t
instead
of z
t
, i.e.,

J( y; c)

J(y; c)

E
_

0
c

t
e

z
t
(

z
t
z
t
)dt.
In this case, using Assumption A and (2.20) in the second and third inequality,

z
t
z
t
=
( r)
2
2(1 )
_
t
0
_
1

2
(

Y
s
)

1

2
(Y
s
)
_
ds

[
y
[
u
( 1)
4
l
_
t
0
[

Y
s
Y
s
[ds

[
y
[
u
( 1)k
4
l
[ y y[,
which implies

W( y) W(y)

[
y
[
u
( 1)k
4
l
C(
u
)

y y

.
262 W. H. Fleming, D. Hern andez-Hern andez
The same arguments can be used to get the Lipschitz property of W(, T).
The HJB equation associated with W has the form:
W = gW
y
+

2
2
W
yy
+ inf
c0
[cW +c

] +QW.
The inmumon the r.h.s. is achieved at W
1
1
(y), and substituting it, we can rewrite
this equation as
W = gW
y
+

2
2
W
yy
+ (1 )W

1
+QW. (5.2)
The next result is a consequence of Theorem 4.2.
Corollary 5.1 W(y) is a classical solution of (5.2) and it is unique in the class of
positive, bounded Lipschitz functions.
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