A Framework of State-dependent Utility Optimization with General Benchmarks

Abstract: Benchmarks in the utility function have various interpretations, including performance guarantees and risk constraints in fund contracts and reference levels in cumulative prospect theory. In most literature, benchmarks are a deterministic constant or a fraction of the underlying wealth variable; thus, the utility is also a function of the wealth. In this paper, we propose a general framework of state-dependent utility optimization with stochastic benchmark variables, which includes stochastic reference levels as typical examples. We provide the optimal solution(s) and investigate the issues of well-definedness, feasibility, finiteness, and attainability. The major difficulties include: (i) various reasons for the non-existence of the Lagrange multiplier and corresponding results on the optimal solution; (ii) measurability issues of the concavification of a state-dependent utility and the selection of the optimal solutions. Finally, we show how to apply the framework to solve some constrained utility optimization problems with state-dependent performance and risk benchmarks as some nontrivial examples.