Faculty Publications

An Optimal Investment Model With Markov-Driven Volatilities

Document Type

Article

Keywords

Dynamic programming, Portfolio optimization, Stochastic control, Utility functions

Journal/Book/Conference Title

Quantitative Finance

Volume

14

Issue

9

First Page

1651

Last Page

1661

Abstract

We consider a multi-stock market model. The processes of stock prices are governed by stochastic differential equations with stock return rates and volatilities driven by a finite-state Markov process. Each volatility is also disturbed by a Brownian motion; more exactly, it follows a Markov-driven Ornstein-Uhlenbeck process. Investors can observe the stock prices only. Both the underlying Brownian motion and the Markov process are unobservable. We study a discretized version, which is a discrete-time hidden Markov process. The objective is to control trading at each time step to maximize an expected utility function of terminal wealth. Exploiting dynamic programming techniques, we derive an approximate optimal trading strategy that results in an expected utility function close to the optimal value function. Necessary filtering and forecasting techniques are developed to compute the near-optimal trading strategy. © 2014 Copyright Taylor & Francis Group, LLC.

Department

Department of Mathematics

Original Publication Date

1-1-2014

DOI of published version

10.1080/14697688.2011.596487

Link to Full Text

Comments?

Share

COinS