## Doctoral Thesis

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This thesis deals with 3 important aspects of optimal investment in real-world financial markets: taxes, crashes, and illiquidity. An introductory chapter reviews the portfolio problem in its historical context and motivates the theme of this work: We extend the standard modelling framework to include specific real-world features and evaluate their significance. In the first chapter, we analyze the optimal portfolio problem with capital gains taxes, assuming that taxes are deferred until the end of the investment horizon. The problem is solved with the help of a modification of the classical martingale method. The second chapter is concerned with optimal asset allocation under the threat of a financial market crash. The investor takes a worst-case attitude towards the crash, so her investment objective is to be best off in the most adverse crash scenario. We first survey the existing literature on the worst-case approach to optimal investment and then present in detail the novel martingale approach to worst-case portfolio optimization. The first part of this chapter is based on joint work with Ralf Korn. In the last chapter, we investigate optimal portfolio decisions in the presence of illiquidity. Illiquidity is understood as a period in which it is impossible to trade on financial markets. We use dynamic programming techniques in combination with abstract convergence results to solve the corresponding optimal investment problem. This chapter is based on joint work with Holger Kraft and Peter Diesinger.

One crucial assumption of continuous financial mathematics is that the portfolio can be rebalanced continuously and that there are no transaction costs. In reality, this of course does not work. On the one hand, continuous rebalancing is impossible, on the other hand, each transaction causes costs which have to be subtracted from the wealth. Therefore, we focus on trading strategies which are based on discrete rebalancing - in random or equidistant times - and where transaction costs are considered. These strategies are considered for various utility functions and are compared with the optimal ones of continuous trading.

The main two problems of continuous-time financial mathematics are option pricing and portfolio optimization. In this thesis, various new aspects of these major topics of financial mathematics will be discussed. In all our considerations we will assume the standard diffusion type setting for securitiy prices which is today well-know under the term "Black-Scholes model". This setting and the basic results of option pricing and portfolio optimization are surveyed in the first chapter. The next three chapters deal with generalizations of the standard portfolio problem, also know as "Merton's problem". Here, we will always use the stochastic control approach as introduced in the seminal papers by Merton (1969, 1971, 1990). One such problem is the very realistic setting of an investor who is faced with fixed monetary streams. More precisely, in addition to maximizing the utility from final wealth via choosing an investment strategy, the investor also has to fulfill certain consumption needs. Also the opposite situation, an additional income stream can now be taken into account in our portfolio optimization problem. We consider various examples and solve them on one hand via classical stochastic control methods and on the other hand by our new separation theorem. This together with some numerical examples forms Chapter 2. Chapter 3 is mainly concerned with the portfolio problem if the investor has different lending and borrowing rates. We give explicit solutions (where possible) and numerical methods to calculate the optimal strategy in the cases of log utility and HARA utility for three different modelling approaches of the dependence of the borrowing rate on the fraction of wealth financed by a credit. The further generalization of the standard Merton problem in Chapter 4 consists in considering simultaneously the possibilities for continuous and discrete consumption. In our general approach there is a possibility for assigning the different consumption times different weights which is a generalization of the usual way of making them comparable via discounting. Chapter 5 deals with the special case of pricing basket options. Here, the main problem is not path-dependence but the multi-dimensionality which makes it impossible to give usuefull analytical representations of the option price. We review the literature and compare six different numerical methods in a systematic way. Thereby we also look at the influence of various parameters such as strike, correlation, forwards or volatilities on the erformance of the different numerical methods. The problem of pricing Asian options on average spot with average strike is the topic of Chapter 6. We here apply the bivariate normal distribution to obtain an approximate option price. This method proves to be very reliable and e±cient for the valuation of different variants of Asian options on average spot with average strike.

In the classical Merton investment problem of maximizing the expected utility from terminal wealth and intermediate consumption stock prices are independent of the investor who is optimizing his investment strategy. This is reasonable as long as the considered investor is small and thus does not influence the asset prices. However for an investor whose actions may affect the financial market the framework of the classical investment problem turns out to be inappropriate. In this thesis we provide a new approach to the field of large investor models. We study the optimal investment problem of a large investor in a jump-diffusion market which is in one of two states or regimes. The investor’s portfolio proportions as well as his consumption rate affect the intensity of transitions between the different regimes. Thus the investor is ’large’ in the sense that his investment decisions are interpreted by the market as signals: If, for instance, the large investor holds 25% of his wealth in a certain asset then the market may regard this as evidence for the corresponding asset to be priced incorrectly, and a regime shift becomes likely. More specifically, the large investor as modeled here may be the manager of a big mutual fund, a big insurance company or a sovereign wealth fund, or the executive of a company whose stocks are in his own portfolio. Typically, such investors have to disclose their portfolio allocations which impacts on market prices. But even if a large investor does not disclose his portfolio composition as it is the case of several hedge funds then the other market participants may speculate about the investor’s strategy which finally could influence the asset prices. Since the investor’s strategy only impacts on the regime shift intensities the asset prices do not necessarily react instantaneously. Our model is a generalization of the two-states version of the Bäuerle-Rieder model. Hence as the Bäuerle-Rieder model it is suitable for long investment periods during which market conditions could change. The fact that the investor’s influence enters the intensities of the transitions between the two states enables us to solve the investment problem of maximizing the expected utility from terminal wealth and intermediate consumption explicitly. We present the optimal investment strategy for a large investor with CRRA utility for three different kinds of strategy-dependent regime shift intensities – constant, step and affine intensity functions. In each case we derive the large investor’s optimal strategy in explicit form only dependent on the solution of a system of coupled ODEs of which we show that it admits a unique global solution. The thesis is organized as follows. In Section 2 we repeat the classical Merton investment problem of a small investor who does not influence the market. Further the Bäuerle-Rieder investment problem in which the market states follow a Markov chain with constant transition intensities is discussed. Section 3 introduces the aforementioned investment problem of a large investor. Besides the mathematical framework and the HJB-system we present a verification theorem that is necessary to verify the optimality of the solutions to the investment problem that we derive later on. The explicit derivation of the optimal investment strategy for a large investor with power utility is given in Section 4. For three kinds of intensity functions – constant, step and affine – we give the optimal solution and verify that the corresponding ODE-system admits a unique global solution. In case of the strategy-dependent intensity functions we distinguish three particular kinds of this dependency – portfolio-dependency, consumption-dependency and combined portfolio- and consumption-dependency. The corresponding results for an investor having logarithmic utility are shown in Section 5. In the subsequent Section 6 we consider the special case of a market consisting of only two correlated stocks besides the money market account. We analyze the investor’s optimal strategy when only the position in one of those two assets affects the market state whereas the position in the other asset is irrelevant for the regime switches. Various comparisons of the derived investment problems are presented in Section 7. Besides the comparisons of the particular problems with each other we also dwell on the sensitivity of the solution concerning the parameters of the intensity functions. Finally we consider the loss the large investor had to face if he neglected his influence on the market. In Section 8 we conclude the thesis.