Mind the cap!—constrained portfolio optimisation in Heston's stochastic volatility model

M. Escobar-Anel, M. Kschonnek, R. Zagst

Research output: Contribution to journalArticlepeer-review


We consider a portfolio optimisation problem for a utility-maximising investor who faces convex constraints on his portfolio allocation in Heston's stochastic volatility model. We apply existing duality methods to obtain a closed-form expression for the optimal portfolio allocation. In doing so, we observe that allocation constraints impact the optimal constrained portfolio allocation in a fundamentally different way in Heston's stochastic volatility model than in the Black Scholes model. In particular, the optimal constrained portfolio may be different from the naive ‘capped’ portfolio, which caps off the optimal unconstrained portfolio at the boundaries of the constraints. Despite this difference, we illustrate by way of a numerical analysis that in most realistic scenarios the capped portfolio leads to slim annual wealth equivalent losses compared to the optimal constrained portfolio. During a financial crisis, however, a capped solution might lead to compelling annual wealth equivalent losses.

Original languageEnglish
Pages (from-to)1793-1813
Number of pages21
JournalQuantitative Finance
Issue number12
StatePublished - 2023


  • Allocation constraints
  • Dynamic programming
  • Heston's stochastic volatility model
  • Incomplete markets
  • Portfolio optimisation


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