Portfolio selection in stochastic markets with HARA utility functions

In this paper, we consider the optimal portfolio selection problem where the investor maximizes the expected utility of the terminal wealth. The utility function belongs to the HARA family which includes exponential, logarithmic, and power utility functions. The main feature of the model is that returns of the risky assets and the utility function all depend on an external process that represents the stochastic market. The states of the market describe the prevailing economic, financial, social, political and other conditions that affect the deterministic and probabilistic parameters of the model. We suppose that the random changes in the market states are depicted by a Markov chain. Dynamic programming is used to obtain an explicit characterization of the optimal policy. In particular, it is shown that optimal portfolios satisfy the separation property and the composition of the risky portfolio does not depend on the wealth of the investor. We also provide an explicit construction of the optimal wealth process and use it to determine various quantities of interest. The return-risk frontiers of the terminal wealth are shown to have linear forms. Special cases are discussed together with numerical illustrations.

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