Past exam of the mathematics course of the University of Cambridge / 2012 / iii / Paper 43 / 5 / With transaction costs

Under a proportional transaction cost, the sample gain $h_x(\theta )=\theta x-\epsilon |\theta |$ is concave when $\epsilon \ge 0$. The utility function is increasing and concave, soTake finite expectations. Thus $\boxed{G\text{ is concave}}$. The monotonicity of $U$ is essential to composing it with the concave transaction-cost payoff.

On each open half-line the sample objective is a utility of a linear gain: $U(\theta (X-\epsilon ))$ on the positive half-line, and $U(\theta (X+\epsilon ))$ on the negative half-line. On a compact subinterval wholly inside either half-line, the secant domination argument from the frictionless part ii applies verbatim, using finiteness of $G$ at four surrounding points. The dominated convergence theorem therefore gives the derivativesThey are continuous on their respective half-lines. Near zero, the same outer secants of the globally concave sample objective bound its one-sided slopes. Dominated convergence consequently givesHere $\mathbb{E}|X|<\infty$: the frictionless derivative at zero already proves it, since $U^{\prime }(0)>0$. Thus zero generally has a transaction-cost kink; when $\epsilon =0$ the two formulas agree.

For marginal utility pricing with proportional transaction costs, if $X-\epsilon \ge 0$ almost surely or $-X-\epsilon \ge 0$ almost surely, the source's second alternative holds. Otherwise $\mathbb{P}(X<\epsilon )>0$ and $\mathbb{P}(X>-\epsilon )>0$. The Fatou lemma argument now gives $G(\theta )\to -\infty$ at both ends, since a large positive holding loses on the first event and a large negative holding loses on the second. Let ${\theta }_{\ast }$ be a finite maximizer.

If ${\theta }_{\ast }>0$, set $Z_0=U^{\prime }({\theta }_{\ast }(X-\epsilon ))$. The derivative condition gives $\mathbb{E}[X{Z}_0]=\epsilon \mathbb{E}{Z}_0$. As before, split according to $|X-\epsilon |\ge 1$ to obtain integrability of $Z_0$ from the absolutely integrable derivative, with a compact-set bound on the complement. If ${\theta }_{\ast }<0$, use $Z_0=U^{\prime }({\theta }_{\ast }(X+\epsilon ))$ and obtain $\mathbb{E}[X{Z}_0]=-\epsilon \mathbb{E}{Z}_0$. In either case normalize $Z=Z_0/\mathbb{E}{Z}_0$; then $Z>0$, $\mathbb{E}Z=1$, and $XZ$ is absolutely integrable.

If ${\theta }_{\ast }=0$, a concave maximum has $G_{-}^{\prime }(0)\ge 0\ge G_{+}^{\prime }(0)$, so $\mathbb{E}X\in [-\epsilon ,\epsilon ]$. Choose $Z=1$. In every case of this first alternative, $\boxed{\mathbb{E}[XZ]\in [-\epsilon ,\epsilon ]}$. The normalization establishes a stronger, economically meaningful statement than the literal unnormalized condition: the expected gain under the resulting density lies inside the transaction-cost spread.