Which role for longevity bonds in

optimal portfolios
Francesco Menoncin∗
August 31, 2005

Abstract
A longevity bond pays coupons which are proportional to the survival
rate of a given population. In such a way the longevity risk becomes
hedgeable on the financial market. In our model there are: (i) a longevity
bond as a derivative on the population survival rate, (ii) a bond as a
derivative on the stochastic instantaneously riskless interest rate, and (iv)
a stock. In such a framework we demonstrate that the amount of wealth
invested in the longevity bond reduces the portfolio weight of the bond
without affecting the weight of the stock. In particular for the log-investor
the wealth invested in the longevity bond is entirely deducted from the
wealth invested in the bond.

JEL classification: G11.

Key words: longevity risk; dynamic programming.

∗ Dipartimento di Scienze Economiche, Università degli Studi di Brescia, Via S. Faustino,

74/B, 25122 - Brescia, Italy. Tel: 0039-0302988806. Fax: 0039-0302988837. E-mail:

menoncin@eco.unibs.it

1
1 Introduction and conclusion
In 2005 a new financial instrument, called "longevity bond" has been issued by
the European Investment Bank (EIB). The EIB is rated AAA by Standard &
Poor’s and Aaa1 by Moody and the new issue is part of its objective to promote
economic and social cohesion within the EU.
For the longevity expertise and reinsurance capacity, the EIB relies on Part-
nerRe while the financial component of the longevity bond is managed by the
BNP Paribas. In particular, BNP Paribas acts as structurer, manager and
book-runner for the longevity bond and markets it; furthermore it enters into a
swap with EIB to convert its fixed interest, longevity-linked obligations under
the bond into the floating obligations, free of longevity risk, that are required
by the EIB when raising funding.
The longevity bond pays a coupon given by the product between a fixed
amount of money (£50,000,000 for the whole issue) and the cumulative survival
rate measured on a Welsh cohort of males aged 65 in 2003. This asset has a 25
year time to maturity.
Let us show an example in Table 1 where the cumulative survival rate is the
product between all the previous survival rate (for instance, in 2007, 96.345%
is obtained through 0.99 × 0.988 × 0.985).

Table 1: Coupon structure of a longevity bond

Year 2005 2006 2007
Mortality rate 1% 1.2% 1.5%
Survival rate 99% 98.8% 98.5%
Cumulative
survival rate 99% 97.812% 96.345%
Coupon (on £1,000) 990 978.12 963.45

As it can be immediately see from Table 1, when the survival rate increases,
the longevity bond coupon decreases (and vice versa). This makes the longevity
bond the suitable asset for hedging against the so-called longevity risk, which
consists in experiencing a survival rate higher than the prospective one.
Even if the hedging role the longevity bond can play in pension fund and
insurance portfolios is evident, it is more difficult to determine the exact amount
of this bond that must be hold in optimal portfolios.
This work is aimed at determining this optimal amount of longevity bond in a
framework with a perfectly competitive, arbitrage free and frictionless financial
market for an economic agent who want to maximize the expected utility of
his wealth at the moment of his death. In particular, we follow the traditional
route to use the stochastic dynamic programming technique (Merton, 1969,
1971) leading to a suitable (non-linear) partial differential equation. For the
method called “martingale approach” the reader is referred to Cox and Huang
(1989, 1991), and Lioui and Poncet (2001).
Some closed form solutions for this problem have been found in the litera-

2
ture. In particular, we refer to the works of Kim and Omberg (1996), Wachter
(1998), Chacko and Viceira (1999), Deelstra et al. (2000), Boulier et al. (2001),
Zariphopoulou (2001) and Menoncin (2002). In all these works the market
structure is as follows: (i) there exists only one stochastic state variable (the
riskless interest rate or the risk premium) following the Vasiček (1977) model or
the Cox et al. (1985) model, (ii) there exists only one risky asset, (iii) a bond
may exist. Some works deal with a complete financial market (Wachter, 1998,
Deelstra et al., 2000, and Boulier et al., 2001) while others are dealing with
an incomplete market (Kim and Omberg, 1996, Chacko and Viceira, 1999, and
Menoncin 2002).
In this paper we keep the market structure presented in the cited works
but we take into account a stochastic terminal date. Richard (1975) already
solved this kind of problem but using a deterministic law for the terminal date.
Here, instead, the law which describes the behaviour of this stochastic variable
is stochastic itself and so a new risk that must be hedged in introduced in the
analysis. In such a framework a closed form solution to the optimal allocation
problem is quite hard to find since the longevity risk is typically independent of
the financial risks. The presence of a longevity bond makes this risk hedgeable.
We plan to widen our analysis to the case of a pension fund where the con-
tributions and pensions must be added to the equation describing the behaviour
of the pension managed wealth.
Our result shows that for an investor described by a log-utility function the
amount of money that must optimally invested in the longevity bond is entirely
deducted from the ordinary bond without changing the weights of the stock
and the riskless asset. In particular the stock does not play any role in hedging
against any risk since it just plays a speculative role.
When the investor is described by a constant relative risk aversion utility
function then the previous result is subject to a more technical condition we are
able to show in a quasi-explicit form.
The rest of the paper is structured as follows. Section 2 shows the model we
will work on and in particular describes the financial market containing: (i) a
state variable given by the stochastic riskless interest rate, (ii) a riskless asset,
(iii) a bond (as a derivative on the riskless interest rate), (iv) a stock, and (v) a
longevity bond. In Section 3 the optimal portfolio for the agent maximizing the
expected utility of his utility at his death time is computed and the role of the
longevity bond is highlighted. In particular we present the comparison between
the optimal portfolios with and without the longevity risk. Some technical
computations are left to an appendix.

3
2 The model
2.1 The financial market
In our economy there exists only one state variable given by the riskless interest
rate which is assumed to follow a mean reverting process:

dr (t) = α (β − r) dt − σ r dWr , (1)

r (t0 ) = r0 .

Such a model describes the behaviour of an interest rate whose instantaneous

variance is σ 2r and which tends to return towards its mean level β with a strength
measured by α (all these parameters are constant). We recall that the solution
to the differential Equation (1) for any t ≥ t0 exists in a closed form
³ ´ Z t
−α(t−t0 ) −α(t−t0 )
r (t) = r (t0 ) e +β 1−e − e−α(t−u) σ r dWr (u) . (2)
t0

On the financial market there are two assets:

1. a riskless asset which pays the instantaneous riskless interest rate r (t) and
whose value G (t) follows

dG (t) = G (t) r (t) dt, (3)

G (0) = 1,

2. a zero coupon bond which can be seen as a derivative on the interest rate:
it is well known that in a complete financial market the price of any asset
coincides with the expected present value of its future cash flows under
the so-called martingale equivalent measure (Q). Since the zero coupon
bond pays just one monetary unit at expiration (in T ), its value B (r, t)
can be written as
h UT i
B (r, t, T ) = EQ
t e − t r(s)ds
,

and its dynamics is

∂B (r, t, T )
dB (r, t, T ) = B (r, t, T ) r (t) dt − σ r dWrQ .
∂r (t)

Now, from Equation (2), we can immediately check that

" Z T #
∂B (r, t, T ) UT ∂r (s)
= −EQ t e
− t r(s)ds
ds
∂r (t) t ∂r (t)
1 − e−α(T −t) Q h − U T r(s)ds i
= − Et e t ,
α

4
 and so, under the hypothesis that the market price for the interest rate
risk (ξ r ) is constant, we can finally write1

dB (t, T )
= (r (t) + C (t, T ) σ r ξ r ) dt + C (t, T ) σr dWr , (4)
B (t, T )

dove
1 − e−α(T −t)
C (t, T ) ≡ ,
α
3. a risky asset (a stock) whose price S follows

dS (t)
= (r (t) + σ S ξ S + σ Sr ξ r ) dt + σ Sr dWr + σ S dWS , (5)
S (t)
S (0) = S0 ,

where ξ S is the constant market price for the stock own risk source (the
Wiener processes WS and Wr are assumed to be independent without any
loss of generality).

2.2 The longevity bond

A longevity bond is defined as the asset paying a coupon which is strictly propor-
tional to the survival rate of a given population taken in a given moment. This
is the ideal asset for hedging the longevity risk of a pension fund. In fact, while
the population which subscribed to the fund increases its longevity, the fund
risks to have to pay pensions for longer and longer periods. Nevertheless, the
increasing in longevity also means an increasing in the longevity bond coupons.
In this way, the higher pensions can be paid through the higher coupons.
If we call (t px ) the amount of people of a given population at time x who
have survived for t periods (i.e. till time x + t) then the value of the longevity
bond expiring in T can be written as
"Z #
T Us
EQ
t (s px ) e− t
r(u)du
ds .
t

In our framework, for the sake of simplicity and without loosing any gener-
ality, we take into account a zero coupon longevity bond whose value L (t, T ) is
given by h U i
− tT r(u)du
L (t, T ) = EQ
t (T p x ) e .

There is no loose of generality since it is evident that the longevity bond

is just a linear combination of zero coupon longevity bonds (i.e. it can be
1 Werecall that, under the conditions of the Girsanov Theorem, the process dWrQ = ξ r dt +
dWr is a Wiener process.

5
replicated on the financial market). We highlight that when at time x the
chosen population is composed by agents having the same age (let us say age
x), and the starting value (0 px ) is normalized to 1, then (t px ) can be interpreted
as a survival probability.
When this survival probability evolves according to a deterministic path then
the value of a longevity bond is strictly proportional to the value of a bond. In
this case there would not be any need for creating a longevity bond since it
could simply be replicated by holding an amount of bond equal to (t px ).
Accordingly, we are mainly interested in the case where the survival prob-
ability is stochastic. Here, we model the survival probability as a stochastic
process described by the following equation

d (t px ) = −λ (t, x) (t px ) dt + (t px ) σ p (t, x) dWp , (6)

(0 px ) = 1,

where the boundary condition means that the probability that an agent who is
alive survives just right now is, of course, one. Furthermore, λ (t, x) is the so-
called "force of mortality". Here Wp is a Wiener process which is independent
of Wr .

Remark 1 The stochastic differential equation we have written for the evolu-
tion of (t px ) in (6) does not prevent the survival probability to be higher than 1.
Nevertheless, the definition of (t px ) can be slightly modified in order to allow its
value to be in the set R+ (instead than in the set [0, 1]). In fact, we can define
the so-called "odds" (Od (t, x)) as the number of survived agents over the num-
ber of non-survived agents.2 In this case we can write (with the normalization
of the population to 1)
(t p x ) ³ ´
Od (t, x) = = (t px ) + O (t px )2 ,
1 − (t px )
and, for sufficiently low values of the survival probability,

Od (t, x) ' (t px ) .

We can immediately see that the value of Od (t, x) varies between zero and infin-
ity (since (t px ) must belong to [0, 1]). Accordingly, a geometric Brownian motion
seems to be suitable for describing Od (t, x) and, since (t px ) is an approximation
of Od (t, x), we can write the behaviour of (t px ) as in Equation (6). Thus, we
can think of (t px ) as the odds of the event "survival" which approximates the
survival probability.

We underline that both the drift and diffusion of the process in (6) could be
stochastic. Nevertheless, if they were driven by Wiener process which are inde-
pendent of both Wp and those already presented in the financial market, then
2 This method for quoting the frequencies of events is used by the bookmakers.

6
the market could not be complete any longer. We stress that assuming both λ
and σ p are stochastic and can be spanned on the financial market just compli-
cates the analysis without introducing any insight. Accordingly, we assume λ
and σ p as deterministic functions. Furthermore, we highlight that taking σ p = 0
and λ stochastic would not be correct since the value of (t px ) is not known from
t to t + dt. In fact, if σ p where zero, then we would assume that, given λ (t, x)
we perfectly know (t+dt px ) which is not true.
For any t0 ≤ t the solution to Equation (6) exists in a closed form:
Ut Ut
−
(t px ) = (t0 px ) e t0 (λ(s,x)+ 12 σp (s,x)2 )ds+ t0
σ p (s,x)dWp (s)
. (7)

Under the martingale equivalent measure Q, the dynamics of L (t, T ) must

be
∂L (t, T ) ∂L (t, T )
dL (t, T ) = L (t, T ) r (t) dt − σr dWrQ + (t px ) σ p (t, x) dWpQ .
∂r (t) ∂ (t px )

From Equations (2) and (7) we can immediately check that

" Z T #
∂L (t, T ) U
Q − tT r(u)du −α(u−t)
= −Et (T px ) e e du
∂r (t) t

1 − e−α(T −t) Q h UT i
= − Et (T px ) e− t r(u)du ,
α
and
· U
¸ h U i
∂L (t, T ) Q ∂ (T px ) − tT r(u)du 1 − tT r(u)du
= Et e = EQ
t (T p x ) e ,
∂ (t px ) ∂ (t p x ) (t p x )

so that we can finally write3

dL (t, T ) ¡ ¢
= r (t) + C (t, T ) σ r ξ r + σ p (t, x) ξ p dt+C (t, T ) σ r dWr +σ p (t, x) dWp ,
L (t, T )
(8)
where we immediately see that when the survival probability is not stochastic
(i.e. σ p = 0) then L cannot be distinguished from B.

2.3 The market price of risk

In the previous sections we have assumed that the market price of risk is a
constant (vector). Here, we show that this is actually the case. We recall that
the market price of risk ξ is defined as the process which solves the matrix
equation
Σ0 ξ = µ − rA, (9)
recall that the Girsanov Theorem allows us to conclude that dWpQ = ξ p dt + dWp is a
3 We

Wiener process and the martingale equivalent measure Q.

7
where Σ is the volatility matrix of the asset prices, µ is the vector containing
the drifts of the asset prices, and A is the vector containing the asset prices. In
our case we have three risky assets whose prices follow Equations (4), (5), and
(8). Thus, we can write
£ ¤
A0 = B (t, T ) L (t, T ) S (t) , (10)
0
£ ¤
ξ = ξr ξp ξS , (11)
 
B¡ (t, T ) (r (t) + C (t, T ) σ r ξ r ) ¢
µ =  L (t, T ) r (t) + C (t, T ) σ r ξ r + σ p (t, x) ξ p  , (12)
S (t) (r (t) + σ S ξ S + σ Sr ξ r )
 
B (t, T ) C (t, T ) σ r 0 0
Σ0 =  L (t, T ) C (t, T ) σ r L (t, T ) σp (t, x) 0 , (13)
S (t) σ Sr 0 S (t) σS

and Equation (9) is trivially verified by the three constants ξ r , ξ p , and ξ S .

2.4 The rolling bonds

The bonds we have dealt with in the previous sections have a fixed expiring date
T . Nevertheless, the optimization problem we will solve in the following section
has an infinite time horizon which is not consistent with a fixed expiring date.
Instead, we should have a so-called rolling bonds with a fixed time-to-maturity.
Such a bond (whose price we call BT ) should follow

dBT (t)
= (r (t) + CT σr ξ r ) dt + CT σr dWr , (14)
BT (t)

where CT is independent of time and if given by

1 − e−αT
CT ≡ ,
α
where T is the constant time-to-maturity.
In the same way, a rolling longevity zero coupon bond would follow

dLT (t) ¡ ¢
= r (t) + CT σ r ξ r + σ p ξ p dt + CT σ r dWr + σ p dWp . (15)
LT (t)

In our market with a riskless asset, a zero coupon bond B, and a zero coupon
longevity bond L, we can demonstrate that any portfolio strategy involving the
two fixed time-to-maturity bonds BT and LT can be replicated by a portfolio
strategy involving the two fixed maturity bonds B and L.
Let us call R the wealth of an agent and (wG , wB , wL ) the self-financing
strategy involving the riskless assets, the bond BT and the bond LT , such that

R = wG G + wB BT + wL LT ,

8
whose dynamic value is
¡ ¡ ¢¢
dR = Rr + wB BT CT σ r ξ r + wL LT CT σ r ξ r + σ p ξ p dt (16)
+ (wB BT + wL LT ) CT σ r dWr + wL LT σ p dWp .

Instead, a self-financing strategy (θG , θB , θL ) involving the riskless asset, the

bond B, and the bond L can replicate the same wealth
R = θG G + θB B + θL L,

if and only if the dynamic equation

¡ ¡ ¢¢
dR = Rr + θB BCσ r ξ r + θL L Cσ r ξ r + σ p ξ p dt (17)
+ (θB B + θL L) Cσ r dWr + θL Lσ p dWp ,

has the same drift and diffusion terms as (16). It can be immediately checked
that such equalities hold only for the following portfolio strategy
µ ¶
BT CT LT CT
θB = wB + wL −1 ,
B C B C
LT
θL = wL .
L
Thus, for the sake of consistency with the infinite horizon of the optimization
problem we will show in the following section, we will always use the fixed
time-to-maturity bonds BT and LT by knowing that there exists a one to one
relationship with a portfolio composed only by the fixed maturity bonds B and
L.

3 The optimal portfolio

In our model we take into account the case of an agent whose preferences are
described by a CRRA (Constant Relative Risk Aversion) utility function. Fur-
thermore, the agent is assumed to intertemporally maximize the expected util-
ity function of his wealth weighted by his survival probability. For the sake on
simplicity let us now assume that the agent we are describing is part of the
population which the longevity bond is based on. Accordingly, the frequency
(t px ) can be also viewed as the survival probability for t periods for an agent
aged of x. Accordingly, the problem can be written as
·Z ∞ ¸
−ρt 1 1−δ
max E0 −e R (t) d (t px )
w 1−δ
·Z0 ∞ ¸
−ρt 1 1−δ
= max E0 λ (x, t) (t px ) e R (t) dt , (18)
w 0 1−δ
£ ¤
where the control variable w = wB wL wS is a self-financing portfolio
strategy (based on the fixed time-to-maturity bonds). The parameters ρ and

9
δ (both strictly positive) measure the subjective discount rate and the relative
risk aversion, respectively. In particular, the parameter δ is assumed not to be
lower than 1 (i.e. 1 − δ < 0) so that the lower risk aversion is that of the log-
investor (in fact when δ = 1 the Problem (18) coincides with the maximization
of the log of the investor’s wealth).
The state variables r (t), (t px ), and R (t) follow Equations (1) and (6), re-
spectively. Given the matrices already defined in (10)-(13) the investor’s wealth
(the third state variable) for a self-financing portfolio can be written as

dR = (Rr + w0 (µ − rA)) dt + w0 Σ0 dW, (19)

£ ¤
where W = Wr Wp WS .

Proposition 1 Given the state variables described in Equations (1), (6), and
(19), the optimal portfolio solving Problem (18) is
µ ¶
wB BT 1 ξr σrS ξ S 1 δ − 1 1 − φ (t)
= − +
R δ CT σ r CT σ r σ S CT δ α
1 ξp 1
− − ,
δ σp δ
wL LT 1 ξp 1
= + ,
R δ σp δ
wS S 1 ξS
= ,
R δ σS
where
 ³R Us ´ 1 −1 
∞
λ (x, s) (s p̂x ) e−ρs e−(δ−1) t (r̂(u)+ 12 δ1 ξ0 ξ)du ds δ
Et  R∞
t
Us

× t e −α(s−t) −ρs −(δ−1)
λ (x, s) (s p̂x ) e e (r̂(u)+ 12 δ1 ξ0 ξ)du ds
t
φ (t) = ·³ ´ δ1 ¸ < 1,
R∞ Us
−ρs e−(δ−1) t (r̂(u)+ 2 δ ξ ξ)du ds
1 1 0
Et t
λ (x, s) ( s p̂x ) e
µ ¶
d (s p̂x ) δ−1
= −λ (x, s) − σ p (x, s) ξ p ds + σ p (x, s) dWp ,
(s p̂x ) δ
(t p̂x ) = (t px ) ,
µ ¶
1 − δ σr ξ r
dr̂ (s) = α β+ − r̂ ds − σ r dWr ,
δ α
r̂ (t) = r (t) .

Proof. See Appendix A.

10
3.1 The case without longevity risk: a comparison
When there is no longevity risk then the variable (t px ) follows a deterministic
path (i.e. σ p = 0). In this case the longevity bond cannot be distinguished from
the ordinary bond and so on the financial market there are only two risky assets
(the stock and the bond).
In order to carry out a comparison between the portfolio management with
the mortality risk (and the longevity bond) and the portfolio management with-
out the longevity bond, we show in the following proposition the optimal port-
folio solving the problem with a deterministic function (t px ).

Proposition 2 Given the state variables described in Equations (1), (6), and
(19), the optimal portfolio solving Problem (18) when the function (t px ) is de-
terministic (i.e. σ p = 0) is
µ ¶
wB,0 BT 1 ξr σ rS ξ S 1 δ − 1 1 − φ (t)|σp =0
= − + ,
R δ CT σr CT σ r σ S CT δ α
wS,0 S 1 ξS
= ,
R δ σS
where
 ³R Us ´ 1 −1 
∞
λ (x, s) (s px ) e−ρs e−(δ−1) t (r̂(u)+ 12 δ1 ξ0 ξ)du ds δ
Et  R∞
t
Us

× t e −α(s−t)
λ (x, s) (s px ) e e −ρs −(δ−1) (r̂(u)+ 12 δ1 ξ0 ξ)du ds
t
φ (t)|σp =0 = ·³ ´ 1δ ¸ < 1,
R∞ U
−(δ−1) ts (r̂(u)+ 12 δ1 ξ0 ξ)du
Et −ρs
λ (x, s) (s px ) e e ds
t
µ ¶
1 − δ σr ξ r
dr̂ (s) = α β + − r̂ ds − σr dWr ,
δ α
r̂ (t) = r (t) .
Proof. See Appendix A.

The comparison between the results shown in Propositions ?? and 2 allows

us to state what follows:
1. the stock does not have any hedging role: in fact the percentage of wealth
invested in stock is the same with and without the longevity risk;
2. the percentage of wealth invested in the longevity bond just reduces the
percentage of wealth invested in the bond.
Now, our purpose is to understand whether the percentage of wealth which
is invested in the longevity bond is entirely deducted from the bond or if it also
affect the weight of the riskless asset. A first result can be easily obtained in
the case where the investor has a log utility function (i.e. δ = 1 in the previous
proposition).

11
Corollary 1 Given the state variables described in Equations (1), (6), and
(19), and for a log-utility function (i.e. δ = 1), the optimal portfolio solving
Problem (18) is
wB BT ξr σ rS ξ S ξp
= − − − 1,
R CT σ r CT σ r σS σp
wL LT ξp
= + 1,
R σp
wS S ξS
=
R σS
while the optimal portfolio when the function (t px ) is deterministic (i.e. σ p = 0)
is
wB,0 BT ξr σ rS ξ S
= − ,
R CT σ r CT σ r σS
wS,0 S ξS
= ,
R σS
Proof. It is sufficient to put δ = 1 in the results of Propositions 1 and 2. In
particular, when δ = 1 the function F (z, t) in Proposition 1 does not depend
any longer on r (t) and so its derivative vanishes.

The case shown in Corollary 1 allows us to conclude that for a log-investor

the presence of the longevity bond affects neither the investment in the stock
nor the investment in the riskless asset. Accordingly, when the longevity risk
is taken into account, a log-investor who optimally invest x% of his wealth in
this longevity bond must reduce the investment in the bond by x% without
modifying the allocation of wealth on stock and riskless asset.
Nevertheless, in the general case, when the risk aversion is grater than 1
the comparison between the two portfolios is tricky since it is based on the
comparison between the derivatives of the functions F ((t px ) , r, t) and F (r, t)
with respect to the interest rate (r).
The comparison can be made in an implicit form by comparing the total
amount of wealth invested in assets other than the stock and the riskless asset
for the two cases with and without the longevity risk:
wB BT wL LT wB,0 BT
+ R ,
R R R
which can be written as
φ (t) Q φ (t)|σp =0 .
Accordingly we can conclude what follows.

Proposition 3 The amount of wealth invested in the longevity bond is deducted

from the ordinary bond and the riskless asset if and only if
φ (t) < φ (t)|σp =0 .

12
A The optimal portfolio
The general problem can be written as
·Z ∞ ¸
1
max E0 f (z, t) R (t)1−δ dt
w 0 1−δ
0
dz = µz (z, t)dt + Ω (z, t) dW ,
2×1 2×1 2×2 2×1
µ ¶
dR = Rr + w0 M dt + w0 Σ0 dW ,
1×2 2×1 1×2 2×2 2×1

where
· ¸ · ¸ · ¸
r α (β − r) −σr 0 0
z≡ , µz ≡ , Ω0 ≡ ,
(t p x ) −λ (x, t) (t px ) 0 (t p x ) σ p 0
   
¡ BT CT σr ξ r ¢ BT CT σr 0 0
M ≡  LT CT σ r ξ r + σ p ξ p  , Σ0 ≡  LT CT σ r LT σ p 0 ,
S (σ rS ξ r + σ S ξ S ) Sσ Sr 0 Sσ S
f (z, t) ≡ λ (x, t) (t px ) e−ρt .

We underline that here we are able to deal with both cases of a deterministic
and a stochastic function (t px ). In particular, in the deterministic case f (z, t)
does not depend on the state variables z.
The Hamiltonian of this problem is
1
H = f (z, t) R (t)1−δ + JR (Rr + w0 M ) + µ0z Jz
1−δ
1 1
+ JRR w0 Σ0 Σw + tr (Ω0 ΩJzz ) + w0 Σ0 ΩJzR ,
2 2
from which we can write the first order condition for the optimal portfolio as
∂H
= JR M + JRR Σ0 Σw + Σ0 ΩJzR = 0,
∂w
JR −1 1 −1
w∗ = − (Σ0 Σ) M − (Σ0 Σ) Σ0 ΩJzR .
JRR JRR
After substituting the value w∗ in the Hamiltonian we obtain the so-called
Hamilton-Jacobi-Bellman partial differential equation (HJB):
2
1 1 JR
0 = Jt + f (z, t) R (t)1−δ + JR Rr − ξ 0 ξ + µ0z Jz
1−δ 2 JRR
1 1 0 0 1 JR 0
− J Ω ΩJzR + tr (Ω0 ΩJzz ) − ξ ΩJzR ,
2 JRR zR 2 JRR
with the boundary condition

lim J (z, R, t) = 0.
t→∞

13
 Now, we use a guess function in the log form:
δ 1 1−δ
J (z, R, t) = F (z, t) R (t) ,
1−δ
and so the HJB equation can be simplified as follows:
1 1
0 = δF δ−1 Ft R1−δ + f (z, t) R1−δ + F δ R1−δ r
1−δ 1−δ
1 F δ R1−δ 0 1 1
+ ξ ξ + δF δ−1 R1−δ µ0z Fz + R1−δ δF δ−2 Fz0 Ω0 ΩFz
2 δ 1−δ 2
1 1 ¡ ¡ ¢¢
+ R1−δ tr Ω0 Ω δ (δ − 1) F δ−2 Fz Fz0 + δF δ−1 Fzz + R1−δ F δ−1 ξ 0 ΩFz ,
21−δ
and
µ ¶
δ−1 0 1
0 = Ft + µ0z − ξ Ω Fz + tr (Ω0 ΩFzz ) (20)
δ 2
µ ¶
δ−1 11 0 1
− r+ ξ ξ F + F 1−δ f (z, t) ,
δ 2δ δ
with the following boundary condition
lim F (z, t) = 0. (21)
t→∞

Given the boundary condition (21) the solution to Equation (20) has the
following representation
"µZ ¶ 1δ #
∞ U
−(δ−1) ts (r(Z,u)+ 12 δ1 ξ 0 ξ)du
F (z, t) = Et f (Z (s) , s) e ds , (22)
t

where
µ ¶
δ−1 0
dZ (s) = µz − Ω ξ ds + Ω0 dW,
δ
Z (t) = z.
In our case the vector z contains two state variables (the survival probability
(t px ) and the interest rate r). Thus the solution for the function F (z, t) can be
written as
"µZ ¶ 1δ #
∞ U
−ρs −(δ−1) ts (r̂(u)+ 12 δ1 ξ 0 ξ )du
F ((t px ) , r, t) = Et λ (x, s) (s p̂x ) e e ds ,
t
µ ¶
d (s p̂x ) δ−1
= −λ (x, s) − σ p (x, s) ξ p ds + σp (x, s) dWp ,
(s p̂x ) δ
(t p̂x ) = (t px ) ,
µ ¶
δ − 1 σr ξ r
dr̂ (s) = α β − − r̂ (s) ds − σ r dWr ,
δ α
r̂ (t) = r (t) .

14
 The solutions to the differential equations are
U s 1−δ 2
Us
(s p̂x ) = (t px ) e t (−λ(x,u)+ δ σp (x,u)ξp − 2 σp (x,u) )du+
1
σ p (x,u)dWp
t , (23)
and
µ ¶ Z s
−α(s−t) δ − 1 σ r ξ r 1 − e−α(s−t)
r̂ (s) = r (t) e +α β − − e−α(s−u) σr dWr (u) ,
δ α α t
(24)
respectively.
Now, after substituting the guess function into the optimal portfolio we
obtain
R −1 R −1
w∗ = (Σ0 Σ) M + (Σ0 Σ) Σ0 ΩFz ,
δ F
and, after substituting for the matrices Σ, M , and Ω we finally have
 ³ ´ 
  1 ξr
− σ rS ξ S
−
ξp
wB  BT CT σr CT σ r σ S σp 
 wL  = R  1 ξp 
δ  L T σ p

wS 1 ξS
S σS
 
− BT1CT − B1T (t px ) " ∂F ((t px ),r,t)
#
R  1  ∂r
+ 0 LT (t px ) ∂F ((t px ),r,t) ,
F ((t px ) , r, t) ∂(t px )
0 0
and so
 
  ξr σ rS ξS ξp
wB BT
CT σ r − CT σ r σ S − σp

R
wL LT  = 1
 ξp


R
wS S δ σp
ξS

R
σS
 ∂F ((t px ),r,t)

− C1T ∂r − (t px ) ∂F ((t px ),r,t)
∂(t px )
1  
+  (t px ) ∂F ((t px ),r,t)
.
F ((t px ) , r, t) ∂(t px )
0
We still have to compute the derivatives of function F (z, t) with respect to
(t px ) and r . Let us start with
 ³R Us ´ 1δ −1 
0
1 ∞ −ρs −(δ−1) t (r̂(u)+ 12 δ1 ξ ξ )du
∂F ((t px ) , r, t) λ (x, s) ( p̂
s x ) e e ds
= Et  δ ³tR Us ´ ,
∂ (t px ) ×
∞ 1 1 0
λ (x, s) ∂(s p̂x ) e−ρs e−(δ−1) t (r̂(u)+ 2 δ ξ ξ)du ds
t ∂(t px )

and, since
∂ (s p̂x ) (s p̂x )
= ,
∂ (t px ) (t p x )
as it is easy to check from Equation (23), then we have
∂F ((t px ) , r, t) 1 F ((t px ) , r, t)
= . (25)
∂ (t p x ) δ (t px )

15
 Furthermore, from Equation (24), we compute that
∂r̂ (u)
= e−α(u−t) ,
∂r (t)
and we can write
 ³R Us ´ 1δ −1 
0
∂F ((t px ) , r, t) δ−1 ∞ −ρs −(δ−1) t (r̂(u)+ 12 δ1 ξ ξ)du
− λ (x, s) (s p̂x ) e e ds
= Et  Rδ t
Us
,
∂r (t) ∞ 0
−ρs −(δ−1) t (r̂(u)+ 12 δ1 ξ ξ)du 1−e−α(s−t)
× t λ (x, s) (s p̂x ) e e α ds
which cannot be simplified further. Now this equation can be divided into the
sum of the expected values
 ³R Us ´ 1δ −1 
0
∂F ((t px ) , r, t) δ−1 1 ∞ −ρs −(δ−1) t (r̂(u)+ 12 δ1 ξ ξ)du
− λ (x, s) ( p̂ ) e e ds
= Et  δ α
R∞
t s x
Us

∂r (t) 1 1 0
× t λ (x, s) (s p̂x ) e−ρs e−(δ−1) t (r̂(u)+ 2 δ ξ ξ)du ds
 ³R Us ´ 1δ −1 
0
δ−1 1 ∞ −ρs −(δ−1) t (r̂(u)+ 12 δ1 ξ ξ)du
λ (x, s) ( p̂ ) e e ds
+Et  δ Rα t s x
Us 1 1 0
.
λ (x, s) ( p̂ ) e−α(s−t) e−ρs e−(δ−1) t (r̂(u)+ 2 δ ξ ξ)du ds
∞
× t s x

The first term can be easily simplified while for the second term we have to
rewrite it in the following way
 
Z ∞ Us 1 1 0
t ( )
−(δ−1) r̂(u)+ ξ ξ du
δ−1 1  λ (x, s) (s p̂x ) e−ρs e 2 δ

e−α(s−t) Et  ³ ´1− 1δ  ds,
δ α t R∞ U s
λ (x, s) (s p̂x ) e−ρs e−(δ−1) t (r̂(u)+ 2 δ ξ ξ)du ds
1 1 0

which has the following form

Z ∞
δ−1 1
e−α(s−t) g (t, s) ds,
δ α t
where g (t, s) is a function of time. The mean value theorem for integrals tells
us that there exists a constant φ (t) < 1 such that
Z ∞ Z ∞
φ (t) g (t, s) ds = e−α(s−t) g (t, s) ds.
t t
Accordingly, we can write
∂F ((t px ) , r, t) δ − 1 1 − φ (t)
=− F ((t px ) , r, t) , (26)
∂r (t) δ α
where the function φ (t) solves
 ³ ´ 1δ −1 
R∞ Us 0
−ρs −(δ−1) t (r̂(u)+ 12 δ1 ξ ξ)du
λ (x, s) (s p̂x ) e e ds
Et  R t Us 0

∞ −α(s−t) −ρs −(δ−1) t (r̂(u)+ 12 δ1 ξ ξ)du
× t e λ (x, s) (s p̂x ) e e ds
φ (t) = ·³ ´ 1δ ¸ .
R∞ Us
−ρs e−(δ−1) t (r̂(u)+ 2 δ ξ ξ)du ds
1 1 0
Et t
λ (x, s) ( p̂
s x ) e

Once the simplifications obtained in (25) and (26) are substituted in the
optimal portfolio equation, the result stated in Proposition 1 in obtained.

16
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