Optimal Stopping and Utility in a Simple Modelof Unemployment Insurance
Abstract
:1. Introduction
2. Optimal Stopping Problem
2.1. The Model of Unemployment Insurance
2.2. Setting the Optimal Stopping Problem
2.3. Allowing for Mortality
2.4. A Priori Properties of the Value Function
- (i)
- and, moreover, for all ;
- (ii)
- for all .
2.5. The Optimal Stopping Rule
2.6. Deterministic Case
3. Solving the Optimal Stopping Problem
3.1. Guessing the Solution
3.2. Free-Boundary Problem
3.3. Verification of the Found Solution
- (i)
- Let us first show that ). If the map was a -function (i.e., with continuous second derivative), then the classical Itô formula (Øksendal 2003, Theorem 4.1.2, p. 44) applied to would yield, on account of (1) and (36),However, for the function given by (43), its -smoothness breaks down at the point , where it is only . However, is strictly convex on (i.e., ) and linear on , and we can define the action at by using the one-sided second derivative, say,In this situation, a generalization of the Itô formula holds, known as the Itô–Meyer formula (see (Shiryaev 1999, chp. VIII, §2a, p. 757)), which ensures that the representation (45) is still valid.Recall that by construction (see the differential equation in (38)), we haveMoreover, it is easy to check using (47) that the equality (48) also extends to . On the other hand, on account of the condition (11) and the definition of b in (42), for we getAccording to formula (46), is a continuous local martingale (Shiryaev 1999, chp. II, §1c, p. 101). Let be a localizing sequence of bounded stopping times, so that (-a.s.) and the stopped process is a martingale, for each .Now, let be an arbitrary stopping time of (. From (51) we getFinally, taking in (54) the supremum over all stopping times , we obtain
- (ii)
- Let us now prove the opposite inequality, (). According to (30) and (44), we readily have for . Next, fix and consider the representation (45) with t replaced by , where is the localizing sequence of stopping times for () as before. Then, by virtue of the identity (48) (which, as has been explained, is also true for ), it follows thatSimilarly as above, taking expectation on both sides of the equality (55) and again applying Doob’s optional sampling theorem to the martingale , we obtainNote that, for , we have and (-a.s.), henceUsing that , observe that, -a.s.,
4. Elementary Solution of the Reduced Problem
4.1. Distribution of the Hitting Time
4.2. Alternative Derivation
4.3. Direct Maximization
5. Statistical Issues and Numerical Illustration
5.1. Specifying the Model Parameters
- The loss of job rate can be extracted from the publicly available data about the mean length at work, which is theoretically given by .
- Likewise, the inflation rate r is also in the public domain.
- To specify the wage growth rate , a simple approach is just to set as a crude version of a “tracking” rule. However, it may be possible that the individual’s wage growth rate is, to some extent, stipulated by the job contract—for example, that it must not exceed the inflation rate r by more than 1% per annum (applicable, e.g., to civil servants) or, by contrast, that it must be no less than r minus 0.5% per annum (more realistic in the private sector). In practical terms, this would often mean that the actual growth rate is kept on the lowest predefined level.
- More generally, the wage growth rate can be estimated by observing the wage process . This can be implemented by first using regression analysis on and estimating the regression line slope (see (2)). In addition, the volatility can be estimated by using a suitable quadratic functional of the sample path .
- Finally, knowing the benefit schedule (which should be available through the insurance policy’s terms and conditions), it is in principle possible to calculate, or at least estimate the value .
5.2. Estimating the Drift and Volatility
5.3. Hypothesis Testing
5.4. Numerical Examples
6. Parametric Dependencies
6.1. Monotonicity
6.2. Limiting Values
6.3. Comparative Statics and Sensitivity Analysis
6.4. Economic Interpretation
7. Including Utility Considerations
7.1. Perpetual American Call Option
7.2. Heuristic Optimal Stopping Models with Utility
7.3. Suboptimal Solutions
7.4. Connections to Expected Utility Theory
8. Concluding Remarks
Author Contributions
Funding
Acknowledgments
Conflicts of Interest
References
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1 | For technical convenience, we choose to work with continuous-time models, but our ideas can also be adapted to discrete time (which may be somewhat more natural, since the wage process is observed by the individual on a weekly time scale). |
2 | Impact of individualistic (not always rational) perception in economics and financial markets is the subject of the modern behavioral economics (see, e.g., a recent monograph by Dhami 2016). |
3 | More specifically, according to the French UI system back in the 1990s (Kerr 1996, p. 8), a worker aged 50 or more, with eight months of insurable employment in the last twelve months, was entitled to full benefits equal to 57.4% of the final wage payable for the first eight months, thereafter declining by 15% every four months; however, the payments continued for no longer than 21 months overall. This leads to choosing the following numerical values in (6): , (weeks) and (per week). The restriction of the benefit term by weeks can be taken into account in our model by adjusting the parameter from the condition , giving . A more conservative choice is to use a tail probability condition, for example, , yielding (with ). |
4 | This conclusion is in accord with the general optimal stopping theory (Peskir and Shiryaev 2006, §2.2). |
5 | The equivalence of the problems (105) and (106), which we have established directly, is not a coincidence: it is known (Villeneuve 2007, Proposition 3.1, p.185) that, under mild assumptions, the solution of the general optimal stopping problem does not change with the positive truncation of . |
(a) Derivatives | ||
Derivative | Example 2 | Example 3 |
(b) Increments (euro) | ||
Increment | Example 2 | Example 3 |
() | ||
() | ||
() | ||
() |
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Anquandah, J.S.; Bogachev, L.V. Optimal Stopping and Utility in a Simple Modelof Unemployment Insurance. Risks 2019, 7, 94. https://doi.org/10.3390/risks7030094
Anquandah JS, Bogachev LV. Optimal Stopping and Utility in a Simple Modelof Unemployment Insurance. Risks. 2019; 7(3):94. https://doi.org/10.3390/risks7030094
Chicago/Turabian StyleAnquandah, Jason S., and Leonid V. Bogachev. 2019. "Optimal Stopping and Utility in a Simple Modelof Unemployment Insurance" Risks 7, no. 3: 94. https://doi.org/10.3390/risks7030094
APA StyleAnquandah, J. S., & Bogachev, L. V. (2019). Optimal Stopping and Utility in a Simple Modelof Unemployment Insurance. Risks, 7(3), 94. https://doi.org/10.3390/risks7030094