POLYNOMIAL UTILITY

Abstract

We approximate the utility function by polynomial series and solve the related dynamic portfolio optimization problems. We study the quality of the Taylor and Bernstein series approximation in response to the points and degrees of the expansions and generalize from earlier expansions applied to portfolio optimization. The issue of time inconsistency, arising from a dynamically adapted center of the expansion, is approached by equilibrium theory. We present new ways of constructing polynomial utility functions and study their pitfalls and potentials. In the numerical study, we focus on two specific utility functions: For power utility, access to the optimal portfolio allows for a complete illustration of the approximations; for the S-shaped utility function of prospect theory, the use of equilibrium theory allows for approximating the solution to the (obviously interesting but yet unsolved) case of current wealth as a dynamic reference point.