Carole Bernard (University of Waterloo, Canada)

“Optimal Payoffs under State-dependent Constraints”

abstract

Most decision theories including expected utility theory, rank dependent utility theory and the cumulative prospect theory assume that investors are only interested in the distribution of returns and not about the states of the economy in which income is received. Optimal payoffs have their
lowest outcomes when the economy is in a downturn, and this is often at odds with the needs of many investors. We introduce a framework for portfolio selection that permits to deal with state-dependent preferences. We are able to characterize optimal payoffs in explicit form. Some applications in security design are discussed in detail. For example, we extend the classical expected utility optimization problem of Merton to the
state-dependent situation and also give some stochastic extensions of the target probability optimization problem.