Paper 4, Section II, K

Stochastic Financial Models
Part II, 2016

Let UU be concave and strictly increasing, and let A\mathcal{A} be a vector space of random variables. For every random variable ZZ let

F(Z)=supXAE[U(X+Z)]F(Z)=\sup _{X \in \mathcal{A}} \mathbb{E}[U(X+Z)]

and suppose there exists a random variable XZAX_{Z} \in \mathcal{A} such that

F(Z)=E[U(XZ+Z)]F(Z)=\mathbb{E}\left[U\left(X_{Z}+Z\right)\right]

For a random variable YY, let π(Y)\pi(Y) be such that F(Yπ(Y))=F(0)F(Y-\pi(Y))=F(0).

(a) Show that for every constant aa we have π(Y+a)=π(Y)+a\pi(Y+a)=\pi(Y)+a, and that if P(Y1Y2)=1\mathbb{P}\left(Y_{1} \leqslant Y_{2}\right)=1, then π(Y1)π(Y2)\pi\left(Y_{1}\right) \leqslant \pi\left(Y_{2}\right). Hence show that if P(aYb)=1\mathbb{P}(a \leqslant Y \leqslant b)=1 for constants aba \leqslant b, then aπ(Y)b.a \leqslant \pi(Y) \leqslant b .

(b) Show that Yπ(Y)Y \mapsto \pi(Y) is concave, and hence show tπ(tY)/tt \mapsto \pi(t Y) / t is decreasing for t>0t>0.

(c) Assuming UU is continuously differentiable, show that π(tY)/t\pi(t Y) / t converges as t0t \rightarrow 0, and that there exists a random variable X0X_{0} such that

limt0π(tY)t=E[U(X0)Y]E[U(X0)]\lim _{t \rightarrow 0} \frac{\pi(t Y)}{t}=\frac{\mathbb{E}\left[U^{\prime}\left(X_{0}\right) Y\right]}{\mathbb{E}\left[U^{\prime}\left(X_{0}\right)\right]}