A stochastic control problem arising from relaxed wealth tracking with a monotone benchmark process

Abstract

This paper studies a nonstandard stochastic control problem motivated by the optimal consumption in an incomplete market with wealth tracking of a non-decreasing benchmark process. In particular, the monotone benchmark is modelled by the running maximum of a drifted Brownian motion. We consider a relaxed tracking formulation using capital injection such that the wealth compensated by the injected capital dominates the benchmark process at all times. The stochastic control problem is to maximize the expected utility on consumption deducted by the cost of the capital injection under the dynamic floor constraint. By introducing two auxiliary state processes with reflections, an equivalent auxiliary control problem is formulated and studied such that the singular control of capital injection and the floor constraint can be hidden. To tackle the HJB equation with two Neumann boundary conditions, we establish the existence of a unique classical solution to the dual PDE in a separation form using some novel probabilistic representations involving the dual reflected processes and the local time. The proof of the verification theorem on the optimal feedback control can be carried out by some technical stochastic flow analysis of the dual reflected processes and estimations of the optimal control.Comment: Keywords: Non-decreasing benchmark, capital injection, optimal consumption, Neumann boundary conditions, probabilistic representation, reflected diffusion processe