Dynamic Portfolio Allocation under Market Incompleteness and Wealth Effects - new publication by Olivier Scaillet
A new paper by GFRI's Director Olivier Scaillet has been accepted for publication in Operations Research, one of the 50 Journals used in FT Research Rank.
The paper develops a novel decomposition of optimal dynamic portfolio choice under flexible incomplete market models and the wealth-dependent HARA utility.
The decomposition reveals the fundamental impacts of market incompleteness and wealth effect in portfolio allocation. With hedgeable interest rate risk, the authors show that the optimal portfolio under HARA
utility can be decomposed into a pure CRRA optimal portfolio and a financing bond portfolio that matches the investor future subsistence requirements. In this case, the wealth growth rate is always higher for HARA investors with more initial wealth, leading to increased wealth inequality regardless of the market scenario.
As an application of their decomposition, the authors solve the HARA optimal policy in closed-form under an incomplete market model with both stochastic interest rate and volatility. Using parameters calibrated from U.S. market data, they find that the wealth effect generates a procyclical pattern in investor stock positions and time-varying risk aversion levels. Moreover, the wealth effect in investor utility and the increased risk premium in stressed market combined lead to a novel “buy-high-sell-low” channel that may hurt HARA investors with low initial wealth.
The paper is co-authored with Yiwen Shen from the School of Business and Management, HKUST, Chenxu Li from Guanghua School of Management, Peking University, and Yueting Jiang CUHK Business School, CUHK.
Aug 15, 2025