Optimal Selling of Defaultable Assets using the Distribution Builder

Abstract

We consider the problem of when it is best to sell a risky asset in the framework of the \textit{distribution builder} approach under the consideration of potential ruin. This approach allows investors to express their preferences directly as a desired target distribution without first specifying a risk aversion or utility function. Mathematically, the problem is closely related to the Skorokhod embedding problem, where the goal is to attain a given distribution by stopping a diffusion process. We work in a general framework of one-dimensional diffusion processes and extend existing results to include the possibility of ruin. We first provide a full characterization of the set of distributions that can be attained before ruin occurs. Then, we formulate two optimization problems that tackle the issue of what to do if the originally specified distribution is either not attainable or not optimal: finding the attainable distribution closest to an unattainable distribution and selecting an optimal attainable distribution under first-order stochastic dominance constraints if the originally specified distribution is attainable, but not optimal. We show existence and uniqueness of solutions to these constrained convex optimization problems in an extended $f$-divergence framework, provide an analytic characterization of solutions and give numerical examples.

33 pages, 2 figures