Risk-sensitive ICAPM with application to fixed-income management

This paper presents an application of risk-sensitive control theory in financial decision making. A variation of Merton´s continuous-time intertemporal capital asset pricing model is developed where the infinite horizon objective is to maximize the portfolio´s risk adjusted growth rate. The resulting model is tractable and thus provides economic insight about optimal trading strategies as well as the fact that the strategy of 100% cash is not necessarily the least risky one. For fixed-income applications we utilize the concept of rolling-horizon bonds, which are stochastic process models of certain mutual funds of zero coupon bonds. We show by numerical example that the optimal proportion of one´s wealth to hold in an asset is given by a simple affine function of economic factors such as interest rates of various maturities.