The importance of dynamic risk constraints for limited liability operators

Abstract Previous literature shows that prevalent risk measures such as value at or expected shortfall are ineffective to curb excessive risk-taking by a tail-risk-seeking trader with S-shaped utility function in the context of portfolio optimisation. However, these conclusions hold only when constraints static sense measure is just applied terminal value. In this paper, we consider optimisation problem featuring and dynamic constraint which imposed throughout entire trading horizon. Provided control policy sufficiently strict relative Sharpe ratio asset, trader’s strategies resulting maximal can be effectively constrained measure. Finally, argue might still if has access derivatives market.