Optimal Portfolio Choice with Absorbing Markov Chains: Application to Markets that May Potentially Decouple
Vol. 22, No. 2, 2024
by Andrew Ang, Henry Shen, Jeff Shen and Rui Zhao
We develop a model of optimal asset allocation with a market that has the potential to decouple. There are three Markov regimes: a regime where the market remains fully investable, a second regime where the market may become potentially decouple, and a third regime where the market becomes decoupled and investors lose all capital. The investor wishes to hold the potentially decoupled market as it can provide a source of returns that can be partially liquidated to provide intermediate consumption. With the framework, we compute certainty equivalents of foregoing investment in the potentially decoupling market and investigate a range of comparative statics including varying the probability of decoupling