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Dynamic asset allocation for a bank under CRRA and HARA framework

Author

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  • Ryle S. Perera

    (Department of Applied Finance and Actuarial Studies, Faculty of Business and Economics, Macquarie University, Sydney, NSW 2109, Australia;
    Department of Applied Mathematics and Statistics, Whiting School of Engineering, The Johns Hopkins University, Baltimore, MD 21218, USA)

Abstract

This paper analyzes an optimal investment and management strategy for a bank under constant relative risk aversion (CRRA) and hyperbolic absolute risk aversion (HARA) utility functions. We assume that the bank can invest in treasuries, stock index fund and loans, in an environment subject to stochastic interest rate and inflation uncertainty. The interest rate and the expected rate of inflation follow a correlated Ornstein–Uhlenbeck processes and the risk premia are constants. Then we consider the portfolio choice under a power utility that the bank's shareholders can maximize expected utility of wealth at a given investment horizon. Closed form solutions are obtained in a dynamic portfolio optimization model. The results indicate that the optimal proportion invested in treasuries increases while the optimal proportion invested in the loans progressively decreases with respect to time.

Suggested Citation

  • Ryle S. Perera, 2015. "Dynamic asset allocation for a bank under CRRA and HARA framework," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 2(03), pages 1-19.
    • Handle: RePEc:wsi:ijfexx:v:02:y:2015:i:03:n:s2424786315500310
    DOI: 10.1142/S2424786315500310
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    References listed on IDEAS

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    1. Philip Lowe, 2002. "Credit risk measurement and procyclicality," BIS Working Papers 116, Bank for International Settlements.
    2. Claudio Borio & Craig Furfine & Philip Lowe, 2001. "Procyclicality of the financial system and financial stability: issues and policy options," BIS Papers chapters, in: Bank for International Settlements (ed.), Marrying the macro- and micro-prudential dimensions of financial stability, volume 1, pages 1-57, Bank for International Settlements.
    3. Bank for International Settlements, 2001. "Marrying the macro- and micro-prudential dimensions of financial stability," BIS Papers, Bank for International Settlements, number 01.
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    Cited by:

    1. Ryle S. Perera & Kimitoshi Sato, 2018. "Optimal asset allocation for a bank under risk control," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 5(03), pages 1-27, September.
    2. Ryle S. Perera, 2020. "Provisions for bank deposit withdrawals and portfolio selection," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 7(01), pages 1-32, March.

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    More about this item

    Keywords

    Bank asset allocation; Basel II CAR; CRRA utility; HARA utility; stochastic interest rate; C02; C61; GE50; G23;
    All these keywords.

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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