Optimal investment and consumption when regime transitions cause price shocks

This paper concerns optimal investment and consumption with CRRA utility when there is event risk. Events are modeled by transitions in a finite state Markov chain, but unlike traditional regime switching models, transitions not only change the instantaneous return statistics but are accompanied by jumps in the price at the instant of transition. Optimal investment and consumption policies are characterized using stochastic control methods and computed by solving a system of ordinary differential equations and a convex optimization problem. We show that optimal policies are significantly different from those of traditional regime switching or jump-diffusion problems and that the cost of ignoring transition price shocks can be substantial. ► We solve investment and consumption problems when there is event risk. ► Unlike traditional regime switching, prices jump at the instant of transition. ► Optimal solutions significantly differ from those of traditional regime switching. ► The cost of ignoring transition price shocks can be substantial.