ISSN 2456-1312

Volume 1, Number 2
Universal Journal of Mathematics

On an Investors Optimal Portfolio under Constant Elasticity of Variance

Model and Logarithmic Utility Preference
Silas A. Ihedioha
Dept. of Mathematics, Plateau State University, Bokkos
P.M. B. 2012, Jos, Plateau State, Nigeria
silasihedioha@yahoo.com
ABSTRACT
In this study, optimal portfolio of an investor is studied when there are taxes, dividends, transaction costs and
a risk-free asset with time varying rate of returns under constant elasticity of variance model. The Hamilton-
JacobBellman (HJB) equation associated with the optimization problem is obtained using the Itos lemma.
Explicit solution of the logarithmic utility maximization is obtained.
It is found that the optimal investment of the investor is dependent on horizon and wealth. Also found is that
the investment in the risky asset increased by a fraction of the wealth when transaction costs and taxes are
charged on the total investment of the investor. The investor should take the horizon and wealth dependency
of his investment into consideration when making investment policy decisions.
Keywords: Constant elasticity of variance; optimal portfolio; transaction costs; taxes; dividends; Itos
lemma.
MSC 2010: 91G10, 91G80
1. INTRODUCTION
Markowitzs [1] work of 1952 provided a theoretical foundation for modern portfolio selection theory and analysis. After his,
many research works in this area have evolved. Li and Ng [2] considered the mean-variance formulation in multi-period
framework and first presented an embedding technique to obtain the analytical solution of the efficient strategy and
efficient frontier. Vigna and Haberman [3] analyzed the financial risk in a DC pension scheme and found an optimal
investment strategy. Gao [4] studied the portfolio optimization of DC pension fund under a CEV model and obtain the
closed-form solution of the optimal investment strategy in power and exponential
utility case. Li et al. [5] studied the optimal investment problem for utility maximization with taxes, dividends and
transaction costs under the CEV model and obtained explicit solutions for the logarithmic, exponential and quadratic utility
functions.
The articles above are all derived in the case that the interest rate is constant but in real life cases, interest rates may
always be changing with time, which can reflect the change of interest rates of the market. Some term structure models to
describe such situations include the Vasicek model [6] and the CIR model [7].
Korn and Kraft [8] used a stochastic control approach to deal with portfolio selection problems with stochastic interest rate
and proved a verification theorem.
Deelstra et al.[9] studied the optimal investment problems for DC pension fund in a continuous-time framework and
assumed that the interest rates follow the affine dynamics, including the CIR model and the Vasicek model. Chang et
al.[10] studied an asset and liability management problem with stochastic interest rate in which the interest rate was
assumed to be an affine interest rate model. Chang et al. [11] investigated an investment and consumption problem with
stochastic interest rate, in which interest rate was assumed to follow the Ho-Lee model and be correlated with stock price
and derived optimal strategies for power and logarithm utility function. Gao [12] investigated the portfolio problem of a
pension fund management in a complete financial market with stochastic interest rate. Chang and Lu [13] studied an asset
and liability management problem with CIR interest rate dynamics and obtained the closed form solutions to the optimal
investment strategies by applying dynamic programming principle and variable change technique. Boulier et al. [14]
obtained the optimal strategy for DC pension management with stochastic interest rate.
Kraft [15] solved the portfolio problem under Heston model and presented a verification result.
Li et .al. [16] considered the optimal time-consistent investment and reinsurance for an insurer under Heston model and
presented economic implications and numerical sensitivity analysis.
Under stochastic interest rate and stochastic volatility Liu [17] explicitly solved dynamic portfolio choice problem with
stochastic interest rate and stochastic volatility and presented three special applications. In this paper, the interest rate,
the stock returns and volatility are all a function of the Markov diffusion factor. Li and Wu [18] studied an optimal
investment problem where the stochastic interest rate was a CIR model and the volatility was a Heston model. However,
in this article above, there is no correlation between interest rate dynamic and stock price dynamic. Chang and Rong [19]
studied an investment and consumption problem with stochastic interest rate and stochastic volatility and obtained the
optimal investment and consumption strategies. Guan and Liang [20] studied the optimal management of a DC pension

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Universal Journal of Mathematics
plan in a stochastic interest rate and stochastic volatility framework and maximized the expectation of the CRRA utility
over a guarantee, then derived the optimal strategies of the problem.
This paper intends to find the optimal investment strategy of the optimal portfolio for the financial market, in which interest
rate of the risk-free asset is a linear function of time and the risky asset assumed to follow constant elasticity of variance
(CVE) model and look into the variation that may occur when transaction costs and taxes are charged on the risky asset
only and total investment.
The rest of the paper is organized as followed. In section 2, the introduction of the financial market done and the wealth
process established. Section 3 presents the optimization criterion and the derivation of the HJB equation. Also the
introduction of the utility function and explicit solution of the optimal portfolio optimization problem obtained.

2. MODEL FORMULATION AND THE MODEL

Assuming an investor trades two assets in a financial market: a risky asset (stock) and a risk free asset (bond) that has a
rate of returns that is a linear function of time. The dynamics of the price of the risk free asset denoted by is given by
= + ; 0 = 1, (1)
(Osu and Ihedioha, [20]), and that of the risky asset described by the Constant elasticity variance (CEV) model ( Damping
et al. Xiao et al. [21]; Gao, [5]).
dS(t) = S(t)[ + ()] , (2)
where S(t) denotes the price of the risky asset, , , , and are constants. is the appreciation rate of the risky asset
as : > 0 is a standard Brownian motion in a complete probability space (, , ()>0 , ). >0 is the augmented
filtration generated by the Brownian motion (). is the instantaneous volatility and the elasticity, , a parameter
that satisfies the general condition 0, (Damping et al; [21]). If the elasticity parameter = 0, then equation (2), the
constant elasticity of variance (CEV), reduces to a geometric Brownian motion .
Let () be the amount of money the investor puts in the risky asset at time , then [ ()] is the money amount he
invested in the risk free asset, where is his total money investment in both assets.
Suppose that in the financial market, taxes are charged at the rate , dividends at the rate and transaction costs of the
rate .
Assumption:
Dividends are paid only on the risky investment.
This study considers two cases;
(a). when transaction cost, and taxes are charged on the risky investment only.
(b). when transaction costs and taxes are charged on the total investment of the investor.
Corresponding to the trading strategy (), the dynamics of the wealth process of the investor is given by the stochastic
differential equation (SDE)
()S(t)
=
+
+ [ + ] , (3)

when taxes and transaction costs are charged only on the risky investment, and
()S(t)
+ + + (4)

when taxes and transaction costs are charged on the investors total investment.
Substituting (1) and (2) into (3) and respectively obtains,
= + + + + [ + ] ,
(5)
which simplifies to
= { + + + + + + () .
(6)
Also, Substituting (1) and (2) into (4) and respectively obtains,
= + + + + +
(7)
which simplifies to
= ( + + + + + ()} + ()()) .
(8)

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Universal Journal of Mathematics
The quadratic variation equation of (6) and (8) is,
< >= 2 2 2 . (9a)
. = . = 0
where, (9b)
. = 1
Suppose the investor has a utility function (. ), then the investors problem can be written as
,
, ; = | 0 = (10)
subject to:
= + + + + + [ + ] +
when the taxes and transaction costs are charged only on risky investment of the investor and
,
, ; = | 0 =
subject to:
= + + + + ( + ) +
when the taxes and transaction costs are charged on total investment of the investor.

3. THE OPTIMIZATION
The program for the investors optimization problem is presented in this section. The study assumes that the investor has
logarithmic utility preference.
That is,
= , (11)
with relative risk aversion,
()
= , (12)

where is the wealth level of the investor. The aim of this study is to give an explicit solution to the investors problem
where his utility preference is the logarithmic function.
CASE 1: When the taxes and transaction costs are charged only on risky investment, the theorem below follows:

Theorem 1:
The policy that maximizes the expected logarithmic utility of the investor when transaction costs and taxes are charged on
risky investment only is to invest in the risky asset at each time, ;
+ + + +
= ()
2 2
and the optimal value function;

, ; =
.

Proof:
The derivation of the Hamilton- Jacobi-Bellman (HJB) partial differential equation starts with the bellman equation
, : = ,
, ; (13)

where denotes the amount of the investors wealth at time, + t. Hence,

,
, ; , ; =0 (14)

The division of both sides of (14) by t and taking limit to zero gives the Bellman equation
1
= 0. (15)

By Itos lemma (Nie, [22]) that states;

2
= + + ()2 (16)
2 2

Re-writing (16) by substituting (6) and (9) into gives,

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Universal Journal of Mathematics
=
2
+ ( + + + + + ()} + ()()) + 2 2 2
2 2
(17)
Applying (17) to (15) obtains,
1 ,

+
( + + + + + ()} + ()()) +
222222=0. (18)

Equation (18) simplifies to the Hamilton-Jacob-Bellman, partial differential equation (P.D.E)

+ ( + + + + ) + + + 2
2 2 2 (19a)

where
=0 (19b)
Differentiating (19a) with respect to () gives

+ + + + + 22 2 = 0, (20)
2

which simplifies to the optimal investment in the risky asset as:

+ + ++
= . (21)
2 2

Let
, ; = ; (22)
be a solution to (19a) above, then
; ;
= , ; =
; = 2
. (23)

Using (23) in (21), obtains:

+ + ++
= (t). (24)
2 2

The investor holds the risky asset which is dependent on horizon and wealth, as long as + + + + > 0.
Now, applying (23) to (19) gives;
1 + + + + ; +
; + , 1 = 0. (25)
+ 2 2 2
2 2

Further simplification of (25) gives:

; + ; = 0, (26a)
where

1
+ + + + + +
= { 1 . (26b)
2 2 2 2 2

The solution of (26a) is;

(,)
(,)
=
, (27)

from which obtains ;

, =

, (28)
and at the terminal time
, = 1.
Therefore the optimal value function of the investor is

, ; = ln ()

. (29)

CASE 2:

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Universal Journal of Mathematics

The theorem below follows;

Theorem 2:
The policy that maximizes the expected logarithmic utility of the investor when transaction costs and taxes are charged on
the investors total investment is to invest in the risky asset at each time at;
+ +
= ()
2 2
and the optimal value function;

, ; = .
.

Proof :
Applying (8) and (9) and going through the procedures of (13) to (18b), obtains the Hamillon- Jacobi- Bellman (H.J.B)
equation;

+ + + + + ( + ) + 2
2 2 2 =0 .
(30)
Differentiating (29) with respect to obtains,

+ + + 2 2 = 0. (31)
Equation (31) simplifies to the optimal investment in the risky asset to be,
+ +
= (32)
2 2

Applying (23, B & C) to (32) above gives,

+ +
= () (33)
2 2

which is dependent on both wealth and horizon, and the investor holds the risky asset as long as ,
+ + > 0. (34)
Rewriting (30) using (23, B & C) obtains,
, ,
, + + + + + + = ,
()
(35)
which reduces to,
, +

, ()
+ + + + ( + ) ()
= ,
(36)
and further simplifies to,
, + () , = (37a)
where

= ()
+ + + + ( + ) ()
.
(37b)
Therefore,
,
,
=
(), (38)

Giving,

, =
()
, (39)
which satisfies the boundary condition,
, = .
So the optimal value function for the investors problem is given by,

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Universal Journal of Mathematics

, ; = ()
()
(40)

Comparison:
The investments in the risky asset under the stated conditions are;
+ +++
=
()

when transaction cost, and taxes are charged on the risky investment only, and,
+ +
=
()

when transaction costs and taxes are charged on the total investment of the investor. Therefore
+ +++
=

+ +) (+)
=

(+)
= (41)

Equation (41) shows that charging transaction costs and taxes on the investors total investment warrants an
increment in the in the investment in the risky asset.
Alternatively;
[ + + ]
=[
+ +++ ]

[ + + ]
= . (42)
+ + (+)

Let
+ = [ + + ], (43)
where, 0 < < 1, then obtains,
[ + + ]

= (1) + +
1
= ; < 1. (44a)
(1)

That is,
: = 1: (1 ). (44b)
This clearly shows that the amount invested in the risky asset when transaction costs and taxes are charged on the total
investment needs to be increased for the investors smooth operations.

CONCLUSION
In this study, the optimal investment problem of logarithmic utility maximization with taxes, dividends and transaction costs
is studied adopting the constant elasticity of variance (CEV) model to describe the dynamic movements of the risky assets
price.
Applying stochastic optimal control the corresponding Hamilton-Jacobi-Bellman (HJB) equation obtained, using Itos
lemma for which an explicit solution is obtained considering when transaction costs and taxes are charged on the risky
investment only and the total investment of the investor.
It is found that charging transaction costs and taxes on the total investment warranted an increase on the investment in
the risky asset as compared to when these charges are on the risky investment only.
It is found that the investments are both horizon and wealth dependent which the investor must put into consideration
when making investments policy decisions.

REFERENCES
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Universal Journal of Mathematics
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