1. MERTON SET-UP Let xt be the amount invested in the bond and yt be the amount invested in the stock.

The equations governing the evolution of xt and yt are given by dxt = (rxt ct )dt, dyt = yt dt + yt dBt , where ct is the investors consumption and Bt is a standard one-dimensional Brownian motion. Denote Wt = xt + yt the investors total wealth. Then, dWt = [rWt + ( r)t Wt ct ]dt + t Wt dBt , where t = yt /Wt is the fraction of total wealth held in stock. Let W0 = w. Then, the value function of the investor is given by c1 et t dt]. V (w) = max E[ ct ,t 1 0 This problem is known as the innite-horizon setting. Then, HJB(Hamilton-Jacobi-Bellman) equation is derived as c1 1 . 0 = [rw + ( r)w c]V (w) + 2 2 w2 V (w) V (w) + 2 1 From the rst-order conditions, the optimal consumption c and the optimal portfolio can be determined: c = V (w)
1/

(1)

, =

r 1 V (w) . 2 W V (w)

Substituting these optimal controls into HJB (1) yields 0 = rwV (w) 1 ( r)2 V (w) + V (w) 2 2 V (w) 1
2 11/

V (w).

(2)

This non-linear partial differential equation (PDE) can be completely solved by the following solution form: V (w) = K w1 . 1

K is completely determined by substituting the guessed solution form into (2): K=[ 1 ( r)2 1 r+ + ] . 2 2 2 r

2. DAVIS-NORMAN SET-UP This section deals with the proportional transaction costs. The set-up is the following: dxt = (rxt ct )dt (1 + )dLt + (1 )dUt , dyt = yt dt + yt dBt + dLt dUt , where Lt and Ut is the cumulative purchase and sale of stock on the time interval [0, t]. Let x0 = x and y0 = y. Then, the investors value function is given by c1 dt]. V (x, y) = max E[ et t ct ,Lt ,Ut 1 0 This problem is also innite-horizon setting. Assume that Lt and Ut is absolutely continuous with bounded derivative. Then,
t t

Lt =
0

ls ds, Ut =
0

us ds, 0 ls , us k.

Then, HJB equation is derived as 1 c1 0 = (rx c)Vx + yVy + 2 y 2 Vyy V + + [(1 + )Vx + Vy ]l + [(1 )Vx Vy ]u. 2 1 From the rst-order conditions, the optimal consumption c and the optimal purchase and sale, l and u are determined: c = (Vx )1/ , l= u= k if Vy (1 + )Vx , 0 otherwise, k if Vy (1 )Vx , 0 otherwise.

Notice that V has the homothetic property: for > 0, V (x, y) = 1 V (x, y). Then, > 0, Vx (x, y) = Vx (x, y), Vy (x, y) = Vy (x, y). This implies that for some (x, y), if Vy = (1 + )Vx then Vy (x, y) = (1 + )Vx (x, y). In other words, the same is true at all points along the ray through (x, y). This strongly suggests that the boundaries between the transaction and no-transaction (NT) regions are straight lines through the origin. In the transaction regions, transactions take place at maximum, i.e., innite speed, which implies that the investor will make an instantaneous nite transaction to the boundary of NT. In NT region, HJB is given by 0= 1 2 2 y Vyy + rxVx + yVy + (Vx )11/ V. 2 1 (3)

Dene (x) := V (x, 1). Then, by the homothetic property V (x, y) = y 1 (x/y). Hence, HJB (3) is transformed into the following: 11/ 0 = 3 x2 (x) + 2 x (x) + 1 (x) + (x) , x0 x xT , (4) 1
1 where 1 = 1 2 (1 ) + , 2 = 2 (1 ) + r , 3 = 2 2 . Moreover, in the transaction regions 2 1 (x) = A(x + 1 ) , x x0 , 1 (x) = B(x + 1 + ) , x xT ,

(5)

for some constants A, B. The key to solving this problem is thus to nd constants x0 , xT , A, B and a globally C 2 function such that (4) and (5) hold. 3. LIU-LOEWENSTEIN SET-UP Liu and Loewenstein (2002) examine the optimal trading strategy for a CRRA investor who maximizes the expected utility A of wealth on a nite date and faces transaction costs. The investor can buy the stock at the ask price, St = St , and sell the B stock at the bid price, St = (1 )St , 0 1. The equations governing the evolution of xt and yt are given by dxt = rxt dt dIt + (1 )dDt , dyt = yt dt + yt dwt + dIt dDt , where the processed D and I represent the cumulative dollar amount of sales and purchases of the stock, respectively. Notice A that the ask price St instead of midpoint is chosen as the numeraire for notational simplicity without any loss of generality. Then, the investors value function is given by V (x, y, t) = max E[
D,I

(xT + (1 )yT )1 |Ft ], 1

where Ft is the ltration generated by a standard one-dimensional Brownian motion wt . This problem is nite-time setting. Similar steps in Davis and Norman (1990) give the following:
1 2 2 2 y Vyy + rxVx Vx = Vy , in Buy,

+ yVy + Vt = 0, in NT,

(1 )Vx = Vy , in Sell. By the homothetic property of V , V (x, y, t) = y 1 ( x , t). Let z = x . Then, y y r1 (t) < z < r2 (t) : 1 2 z 2 zz + ( 2 ( r))zz (1 )( 2 /2 ) + t = 0, 2 z r2 (t) : (z + 1)z = (1 ), z r1 (t) : (z + 1 )z = (1 ). This system of equations involves nding a pair of moving boundaries r1 (t) and r2 (t) and is difcult to solve. To solve the problem, consider exponentially distributed horizon. In particular, the investors problem is to choose admissible trading strategies D and I so as to maximize E[u(x + (1 )y )] for an event which occurs at the rst jump time of a standard, independent Poisson process with intensity . is thus exponentially distributed with parameter , that is, P { dt} = et dt. Then, the investors value function is written as V (x, y) = max E[
D,I

x + + (1 )y 1

] = max E[
D,I 0

et

xt + (1 )yt 1

dt].

The homothetic property of V yields that V (x, y) = y 1 ( x ). Let z = x . Then, y y

1

r1 < z < r2 : z 2 zz + 2 zz + 1 + 0 z r2 : (z + 1)z = (1 ), z r1 : (z + 1 )z = (1 ),

z+(1) 1

= 0,

where 2 = 2 2 ( r) , 1 = 2 + (1 )( 2 /2 ) / 2 , 0 = 2/ 2 . The ordinary differential equation in NT has the following closed form solution: C1 1 (z) + C2 2 (z) + p (z), where C1 and C2 are constants and 1 (z) = |z|n1 , 2 (z) = |z|n2 , n1,2 = The particular solution p (z) is given by p (z) = 0 1 ()2 (z) 1 (z)2 () ( + 1 )1 d. 1 ()2 () 1 ()2 () (1 ) 2 (1 2 ) (1 2 )2 41 . 2

Hence, we need to nd for some constants A,B,C1 ,C2 ,C 1 ,C 2 ,r1 ,r2 such that 1 A (z+1) , if z r2 , 1 C1 1 (z) + C2 2 (z) + p (z), if r1 0 < z < r2 0, (z) = C 1 1 (z) + C 2 2 (z) + p (z), if r1 0 < z < r2 0, 1 B z+1 , if 1 < z r .
1 1

So far, we considered exponentially distributed horizon. Now, we generalize the model in the sense that the investors horizon occurs after the nth i.i.d. Poisson jump, which means that will be Erlang distributed. Let P { i dt} = i ti1 et dt, (i 1)!

and = n . This method comes from Carr (1998). We set the intensity = n/T . Then, the expected horizon is n/ = T and the variance of is T 2 /n. If n is large enough, then is almost surely T . Denote V i(x, y) the value function when there are i jumps left until the horizon. Then, V i (x, y) = max E[
D,I
1

x( i ) + (1 )y( i ) 1

].

Notice that V 0 (x, y) =

x+(1)y 1

. To compute V i (x, y), we can solve the following recursive structure:

V i (x, y) = E[
0

et V i1 (xt , yt )], i = 1, 2, ..., n.

From the homothetic property of V i (x, y), V i (x, y) = y 1 i ( x ). Let z = x . Then, we can obtain y y
i i i i r1 < z < r2 : z 2 zz + 2 zz + 1 i + 0 i1 = 0, i = 1, 2, ..., n. i i z r2 : (z + 1)z (z) = (1 ) i (z), i i z r1 : (z + 1 )z (z) = (1 ) i (z).

4. DAI-YI SET-UP The equations governing the evolution of xy and yt are given by dxt = rxt dt (1 + )dLt + (1 )dMt , dyt = yt dt + yt dBt + dLt dMt , where Lt and Mt are representing cumulative dollar values for the purpose of buying and selling stock respectively. The value function of the investor is given as (x, y, t) = max
L,M

xT + (1 )yT

, < 1, = 0.

This problem is also nite-time setting. Liu and Loewenstein (2002) used Carr (1998) method to solve the problem. Carr (1998) is praised to given a new method to the deterministic horizon problem but we have to solve recursive structure for applying Carr (1998) method and it is impossible to characterize various properties of buying and selling boundary analytically. This paper uses an elegant transformation and shows that the original problem, whose value function is governed by a time-dependent HJB equation with gradient constraints, is equivalent to a parabolic double obstacle problem involving two free boundaries which correspond to the optimal buying and selling boundaries, respectively. This help us to make use of the well-developed theory of obstacle problem to solve the problem. The value function is shown to be the viscosity solution to the following HJB equation (Shreve and Soner 1994): min{t L, (1 )x + y , (1 + )x y } = 0, with the terminal condition x + (1 )y (x, y, T ) = where L =

1 2 2 y yy + yy + rxx . 2

Dene V (x, t) = (x, 1, t). By the homothetic property of , (x, y, t) = y V ( x , t). Then, y min{Vt L1 V, (x + 1 )Vx + V, (x + 1 + )Vx V } = 0, 1 V (x, T ) = (x + 1 ) ,

where

1 2 2 1 x Vxx + 2 xVx + 1 V, 1 = 2 (1 ) , 2 = r 2 (1 ) . 2 2 HJB (6) can be written as Vx 1 1 Vt L1 V = 0, if x+1+ < V < x+1 , Vx Vx 1 1 Vt L1 V 0, if V = x+1+ , V = x+1 , V (x, T ) = 1 (x + 1 ) . L1 V = w(x, t) = 1 log(V ).

(6)

Consider the transformation

Then, 1 1 wt L2 w = 0, if x+1+ < wx < x+1 , 1 1 wt L2 w 0, if wx = x+1+ , wx = x+1 , w(x, T ) = log(x + 1 ), where L2 w = Set v(x, t) = wx (x, t). Then, 1 vt Lv = 0, if x+1+ < v < v Lv 0, if v = 1 , t x+1+ 1 vt Lv 0, if v = x+1 , 1 v(x, T ) = x+1 , where Lv =
1 x+1 ,

1 2 2 2 x (wxx + wx ) r 2 (1 ) 2

(7)

1 2 2 x vxx r (2 ) 2 xvx r (1 ) 2 v + 2 (x2 vvx + xv 2 ). 2 and upper obstacles, respectively. Notice that vt Lv 0 on the lower obstacle

1 1 x+1+ and x+1 correspond to lower and vt Lv 0 on the upper obstacle.

Now, we can characterize various properties of free boundaries. A double obstacle problem usually gives rise to two free boundaries. Lemma 1 Let v(x,t) be the solution to the double obstacle problem (7). Then, vx + v 2 0. Theorem 1 There are two monotonically increasing functions xs (t) and xb (t) such that SR = {(x, t) : x xs (t), t [0, T )} and BR = {(x, t) : x xb (t), t [0, T )}. Moreover, xs (t) < xb (t) f or all t [0, T ). The monotonicity of xs (t) and xb (t) indicates that the shorter the maturity, the less the chance of buying risky asset and the more the chance of selling risky asset. This is consistent with the investment criterion that younger investors should allocate a greater share of wealth to stocks than older investors. In nance, xs (t) and xb (t) stand for the optimal selling and buying boundaries, respectively. Theorem 2 Let xs (t) be the optimal selling boundary in Theorem 1. Then, (i) xs (t) (1 )xM ,

where xM = r(1) , and r (ii)

xs (T ) := lim = (1 )xM ,
t>T

xs (t) 0 when r (1 ) 2 = 0, xs (t) > 0 when r (1 ) 2 < 0, xs (t) < 0 when r (1 ) 2 > 0, (iii) xs (t) is continuous. Moreover, xs (t) C [0, T ). We deduce xs (t) 0 (i.e. NT {x > 0}) if and only if r (1 ) 2 0, which indicates that the leverage is always suboptimal when r (1 ) 2 0. Theorem 3 Let xb (t) be the optimal buying boundary in Theorem 1. Then, (i) xb (t) (1 + )xM , and there exists a t0 such that xb (t) = f or t0 t < T, (ii) xb (t) > 0 when r (1 ) 2 0, and there exists a t1 such that xb (t) > 0 f or t (t1 , T ), xb (t1 ) = 0, xb (t) < 0 f or t (0, t1 ) when r (1 ) 2 > 0. (iii) xb (t) is continuous.

References
Merton, R.C. 1971. Optimal Consumption and Portfolio Rules in a Continuous Time Model. Journal of Economic Theory. 3. 373-413. Davis, M.H.A., and Norman, A.R. 1990. Portfolio Selection with Transaction Costs. Mathematics of Operations Research. 15. 676-713. Liu, H., and Loewenstein, M. 2002. Optimal Portfolio Selection with Transaction Costs and Finite Horizons. The Review of Financial Studies. 14. 805-835. Dai, M., and Yi, F.H. 2009. Finite-Horizon Optimal Investment with Transaction Costs: A Parabolic Double Obstacle Problem. Journal of Differential Equations. 246. 1445-1469.