Abstract

We are concerned with an optimal investment-consumption problem with stochastic affine interest rate and stochastic volatility, in which interest rate dynamics are described by the affine interest rate model including the Cox-Ingersoll-Ross model and the Vasicek model as special cases, while stock price is driven by Heston’s stochastic volatility (SV) model. Assume that the financial market consists of a risk-free asset, a zero-coupon bond (or a convertible bond), and a risky asset. By using stochastic dynamic programming principle and the technique of separation of variables, we get the HJB equation of the corresponding value function and the explicit expressions of the optimal investment-consumption strategies under power utility and logarithmic utility. Finally, we analyze the impact of market parameters on the optimal investment-consumption strategies by giving a numerical example.

1. Introduction

As a hot topic, investment-consumption problem has abstracted increasing attention of many investment institutions which include insurance companies, pension management institutions, and commercial banks. As a milestone of investment-consumption field, Merton [1, 2] studied a continuous-time consumption and portfolio selection problem and obtained optimal investment strategies under power utility and logarithmic utility by using dynamic programming principle. Subsequently, more and more scholars paid their attentions to the investment-consumption problems. Vila and Zariphopoulou [3] researched an investment-consumption problem with borrowing constraints. On this basis, Yao and Zhang [4] studied the investment-consumption problem with housing risky. Duffie et al. [5] investigated the investment-consumption problem with HARA utility in incomplete markets. Dai et al. [6] investigated the investment-consumption problem with transaction costs in finite time horizon. Peng et al. [7] studied the optimal investment-consumption-proportional reinsurance problem with option type payoff. By complicated deliberation and calculation, Zhao et al. [8] got the optimal investment-consumption policies with nonexponential discounting and logarithmic utility. In order to further investigate investment-consumption problems, Palacios-Huertay and Prez-Kakabadsez [9] and de-Paz et al. [10] introduced discounting function into stochastic hyperbolic discounting function and heterogeneous discounting function, respectively. Kronborg and Steffensen [11] devoted themselves to an inconsistent investment-consumption problem and received some instructive results.

It is clear to show that the above-mentioned literatures have been achieved on the preconditions of constant interest rate and constant volatility. However, a fact has been established that some typical market parameters (such as interest rate, volatility, and inflation rate) are not invariable for a long time horizon and can be influenced by a variety of uncertain factors (e.g., disaster, war, exchange rate, and monetary policy). Hence, the introducing of stochastic interest rate or stochastic volatility makes the optimal investment strategy greatly instructive. Korn and Kraft [12] studied the portfolio selection problem with stochastic interest rate by applying stochastic control approach. Deelstra et al. [13] researched the optimal investment problem with minimum guarantee. Fleming and Pang [14] introduced stochastic control theory to investigate the consumption-investment problem with stochastic interest rate. H. Chang and K. Chang [15] used Legendre transform-dual method to study the investment-consumption problem with Vasicek model. Fleming and Hernandez-Hernandez [16] investigated the optimal consumption model with stochastic volatility. As an innovation to [16], Chacko and Viceira [17] concerned the dynamic consumption and portfolio selection problem with stochastic volatility in incomplete markets. On the latest advance of reinsurance-investment problems with the Heston model, the interested readers can refer to the works of Li et al. [18], Yi et al. [19], Zhao et al. [20], and A and Li [21].

Obviously, most literatures of the previous paragraph have been finished under the assumption of single uncertain factor, while real investment environment is very complicated and its interest rate and volatility should be stochastic. It is very clear that the portfolio decisions with stochastic interest rate and stochastic volatility are more practical. In recent years, some results have been obtained under the different market assumptions. For example, Liu [22] and Noh and Kim [23] investigated the optimal consumption-investment problems with stochastic interest rate and stochastic volatility, but they did not obtain the explicit solutions to the optimal consumption-investment strategies. Chang and Rong [24] studied a special optimal investment-consumption problem with CIR interest rate and stochastic volatility under the assumption that interest rate dynamics are independent of stock price dynamics. However, stock market environment in practical is greatly affected by interest rate. Guan and Liang [25] introduced stochastic interest rate and stochastic volatility into a pension management problem and received good results. Inspired by previous works, this paper considers the impact of interest rate on stock price and extends the model of Chang and Rong [24] and further studies a general investment-consumption problem with stochastic interest rate and stochastic volatility. The financial market is supposed to be composed of a risk-free asset, a zero-coupon bond, and a risky asset. In addition, short-term interest rate is assumed to be driven by affine interest rate model, and stock price is affected by interest rate dynamics and volatility dynamics simultaneously. The zero-coupon bond can be reproduced by a kind of convertible bond when there is no zero-coupon bond in the financial market. We use dynamic programming principle and the method of separation of variable to obtain the explicit solutions to the optimal investment-consumption strategies. Finally, we give a numerical example to illustrate our results.

This paper is organized as follows. In Section 2, we characterize the consumption-investment model in a stochastic affine interest rate and stochastic volatility framework. In Section 3, we use dynamic programming principle to derive the HJB equation and apply the method of separation of variable to obtain the optimal investment-consumption strategies. Numerical analysis is given in Section 4. Section 5 concludes the paper.

2. Problem Formulation

Let be a filtered complete probability space; represents information available at time in the market. We assume that all processes introduced below are well defined and adapted to .

2.1. Financial Market

The financial market consists of a cash, a bond, and a stock. The interest rate is supposed to be a stochastic process and to be governed bywhere , , , and are positive real constants and is a standard Brownian motion on . Notice that (1) consists of the Vasicek model () and CIR model () as special cases. In the case of (), the condition is required to ensure that .

The risk-free asset (i.e., cash) satisfies the following equation:

The second asset is one zero-coupon bond with maturity , whose price process is given by the following stochastic differential equation (SDE):where the boundary condition and is the market price of risk resulting from . In addition,

The maturity of the bond is , which varies continuously over time. Since there does not exist zero-coupon bond with any maturity in the market, it is unrealistic to invest in . So we introduced a convertible bond with a constant maturity . We can invest in the convertible bond to hedge the risk of interest rate.

Assume that price process of the convertible bond is denoted by and follows the following stochastic differential equations (SDE):

In fact, since the convertible bond is only correlated with interest rate, it can be reproduced by the zero-coupon bond and cash:The price process of risky asset (i.e., stock) is denoted by ; then satisfies the following SDE:where , , , and are positive constants. Moreover, and are standard Brownian motion with , and is independent of and ; the price of risk of Brownian motion is given by .

2.2. Wealth Process

During the time horizon , we assume that the initial wealth of an investor is given by and the wealth value is at time . We denote the consumption amount, the proportion of the wealth invested in the convertible bond, and the stock at time by , , and , respectively. In addition, is the proportion of wealth invested in the cash, so . Therefore, wealth process evolves according to the following equation:Substituting (2), (5), and (7) into (9), we can get

Definition 1. The investment-consumption strategy is said to be admissible if the following conditions are satisfied:(i) is -progressively measurable on .(ii).(iii)Equation (10) has a unique strong solution for any .

2.3. Objective Function

Assume that the set of all admissible strategies could be denoted by . Investors wish to maximize the expected discounted utility of the intermediate consumption and terminal wealth; namely, our optimization problem can be formulated as follows:where and are utility functions which are strictly concave. is the subject discount rate and determines the relative importance of the intermediate consumption and the bequest. When , the expected utility only depends on the terminal wealth and problem (11) is reduced to an asset allocation problem.

3. Optimal Consumption and Portfolio Decision

In this section, we obtain the HJB equation of the value function by using dynamic programming principle. We define the value function aswith the boundary condition

Using dynamic programming principle, we can get the corresponding HJB equation:where , , , , , , , , and are the first-order, second-order, and mixed partial derivatives of the value function with respect to the variables , , , and . We use similar symbol to represent partial derivatives of the other functions in latter part of this paper.

Using first-order maximizing conditions for the optimal investment and consumption strategies, we get

Putting (14) into (13), we obtain the HJB equation as follows:

In this paper, we assume that the risk aversion degree of investors can be described by power utility and logarithmic utility, respectively. We use variable change technique to investigate the optimal investment-consumption strategies under power utility and logarithmic utility.

3.1. Power Utility

Power utility is given by , and , where is the risk aversion factor. We conjecture the solution to problem (15) with the following form:The partial derivatives of (16) are as follows:Therefore, we get the optimal consumption policy as follows:

Substituting (17) and (18) back into (15), we deriveEliminating the dependence on , we obtainAssume that the solution to (20) is given byThe partial derivatives of the above function are as follows:

Putting (22) into (20), we can get

Due to , we can get the partial differential equation as follows:

For (24), we find that this equation is similar to (22) in the paper of Chang and Rong [24]. Inspired by the method of Chang and Rong [24], we give Lemma 2.

Lemma 2. Suppose thatis the solution to (24); then satisfies

Proof. For any function , we define the following variational operator:Then we can rewrite (24) asIn addition, we getPutting (29) in (28), we deriveSo we haveNamely, (26) holds. It is obvious that we can verify (26).