Portfolio optimization in the case of an exponential utility function and in the presence of an illiquid asset

Abstract

We study an optimization problem for a portfolio with a risk-free, a liquid, and an illiquid risky asset. The illiquid risky asset is sold in an exogenous random moment with a prescribed liquidation time distribution. The investor prefers a negative or a positive exponential utility function. We prove that both cases are connected by a one-to-one analytical substitution and are identical from the economic, analytical, or Lie algebraic points of view. It is well known that the exponential utility function is connected with the HARA utility function through a limiting procedure if the parameter of the HARA utility function is going to infinity. We show that the optimization problem with the exponential utility function is not connected to the HARA case by the limiting procedure and we obtain essentially different results. For the main three dimensional PDE with the exponential utility function we obtain the complete set of the nonequivalent Lie group invariant reductions to two dimensional PDEs according to an optimal system of subalgebras of the admitted Lie algebra. We prove that in just one case the invariant reduction is consistent with the boundary condition. This reduction represents a significant simplification of the original problem.

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