Risk Sensitive Icapm, with Application to Fixed Income Management

IEEE Transactions on Automatic Control, Vol. 49, No. 3, pp. 420-432, March 2004

Posted: 2 May 2005

See all articles by Tomasz R. Bielecki

Tomasz R. Bielecki

Illinois Institute of Technology

Stanley R. Pliska

University of Illinois at Chicago - Department of Finance

Abstract

This paper presents an application of risk sensitive control theory in financial decision making. A variation of Merton's continuous-time intertemporal capital asset pricing model is developed where the infinite horizon objective is to maximize the portfolio's risk adjusted growth rate. The resulting model is tractable and thus provides economic insight about optimal trading strategies as well as the fact that the strategy of 100% cash is not necessarily the least risky one. For fixed income applications we utilize the concept of rolling-horizon bonds, which are stochastic process models of certain mutual funds of zero coupon bonds. We show by numerical example that the optimal proportion of one's wealth to hold in an asset is given by a simple affine function of economic factors such as interest rates of various maturities.

Keywords: risk sensitive control, optimal portfolios, fixed income management,

JEL Classification: C61, G11

Suggested Citation

Bielecki, Tomasz R. and Pliska, Stanley R., Risk Sensitive Icapm, with Application to Fixed Income Management. IEEE Transactions on Automatic Control, Vol. 49, No. 3, pp. 420-432, March 2004, Available at SSRN: https://ssrn.com/abstract=710822

Tomasz R. Bielecki (Contact Author)

Illinois Institute of Technology ( email )

Department of Applied Mathematics
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Chicago, IL 60616
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312 567 3185 (Phone)
312 567 3135 (Fax)

Stanley R. Pliska

University of Illinois at Chicago - Department of Finance ( email )

2431 University Hall (UH)
601 S. Morgan Street
Chicago, IL 60607-7124
United States
312-996 7170 (Phone)

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