WORST-CASE PORTFOLIO OPTIMIZATION IN A MARKET WITH BUBBLES

Abstract

We investigate a utility maximization problem in the presence of asset price bubbles. At random times, the investor receives warnings that a bubble has formed in the market which may lead to a crash in the risky asset. We propose a regime-switching model for the warnings and we make no assumptions about the distribution of the timing and the size of the crashes. Instead, we assume that the investor takes a worst-case perspective towards their impacts, i.e. the investor maximizes her expected utility under the worst-case crash scenario. We characterize the value function by a system of Hamilton–Jacobi–Bellman equations and derive a coupled system of ordinary differential equations for the optimal strategies. Numerical examples are provided.