Simulating Portfolio Decisions under Uncertainty When the Risky Asset and Short Rate Are Modulated by an Inhomogeneous and Asset-Dependent Markov Chain

Abstract

This paper aims to simulate portfolio decisions under uncertainty when the diffusion parameters of the risky asset and short rate paid for a bond are both modulated by a time-inhomogeneous Markov chain, with transition probabilities dependent on states, time, and asset prices. To do this, we first found closed-form solutions of the corresponding utility-maximization problem, which solves a rational consumer that makes portfolio and consumption decisions by using the corresponding infinitesimal generator associated with the Markov chain. Subsequently, as an illustration of the theoretical results obtained, several scenarios were simulated for the Mexican case. The expected economic policy was inferred from announced monetary policy decisions regarding the reference rate and possible changes in trend due to the lack of fiscal stimuli. Under this framework, states were defined from the current and expected economic policies, and transition probabilities were expressed in terms of the ratio between the prices of the risky asset and the bond. It should be noted, as far as the authors know, that no analytical solutions are known in the literature for the case of Markov-modulated time-inhomogeneous chains with transition probabilities that, themselves, are stochastic processes.

Keywords

• diffusion process
• short rate
• Markov regime switching
• portfolio simulation