Cone-constrained continuous-time Markowitz problems

DOI10.1214/12-AAP855MaRDI QIDQ1948703zbMATH OpenOpenAlexFDO

Authors Christoph Czichowsky, Martin Schweizer

Publication date 24 April 2013

Published in The Annals of Applied Probability (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1206.0243, https://projecteuclid.org/euclid.aoap/1360682029

zbMATH Keywords

\(\varepsilon\)-martingalesbackward stochastic differential equationscone constraintslinear-quadratic controlMarkowitz problemmartingale optimality principlemean-variance hedgingopportunity processportfolio selectionsemimartingalesstochastic control

Mathematics Subject Classification ID

Linear-quadratic optimal control problems (49N10) Generalizations of martingales (60G48) Portfolio theory (91G10) Financial applications of other theories (91G80) Optimal stochastic control (93E20)

Abstract: The Markowitz problem consists of finding in a financial market a self-financing trading strategy whose final wealth has maximal mean and minimal variance. We study this in continuous time in a general semimartingale model and under cone constraints: Trading strategies must take values in a (possibly random and time-dependent) closed cone. We first prove existence of a solution for convex constraints by showing that the space of constrained terminal gains, which is a space of stochastic integrals, is closed in L^2. Then we use stochastic control methods to describe the local structure of the optimal strategy, as follows. The value process of a naturally associated constrained linear-quadratic optimal control problem is decomposed into a sum with two opportunity processes L^{pm} appearing as coefficients. The martingale optimality principle translates into a drift condition for the semimartingale characteristics of L^{pm} or equivalently into a coupled system of backward stochastic differential equations for L^{pm}. We show how this can be used to both characterise and construct optimal strategies. Our results explain and generalise all the results available in the literature so far. Moreover, we even obtain new sharp results in the unconstrained case.

Review text

The mean-variance portfolio selection problem (Markowitz problem) consists in finding in a financial market a self-financing strategy whose final wealth has maximal mean and minimal variance. In the present paper this problem is studied in continuous time in a general semimartingale model and under some constraints, meaning that each allowed trading strategy is restricted to always lie in a closed cone which might depend on the state and time in a predictable way. As in the unconstrained case, the solution to the Markowitz problem can be obtained by solving the particular mean-variance hedging problem of approximating in \(L^2\) a constant payoff by the terminal gains of a self-financing trading strategy. To get existence of a solution to the latter problem, it is shown first that the space of constrained terminal gains is closed in \(L^2\); this is sufficient if the constraints are in addition convex. The main focus and achievement of the paper is the subsequent structural description of the optimal strategy by its local properties. This is made possible by treating the approximation in \(L^2\) as a problem in stochastic optimal control. By exploiting the quadratic and conic structure of the problem, the authors obtain a decomposition of its value process into a sum with two opportunity processes \(L^\pm\) appearing as coefficients. Using the martingale optimality principle allows them to describe the drift of \(L^\pm\) and from there the optimal strategy locally in feedback form via the pointwise minimizers of two predictable functions. So, the martingale optimality principle translates into a drift condition for the semimartingale characteristics of \(L^\pm\) or equivalently into a coupled system of backward stochastic differential equations for \(L^\pm\). Verification results are proved as well. This explains and generalizes all results so far in the literature on the Markowitz problem under cone constraints. The generality of the framework allows us to capture a new behavior of the optimal strategy.

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Cited in

(23)

• Continuous-time Markowitz's model with constraints on wealth and portfolio
• Optimal dynamic mean-variance portfolio subject to proportional transaction costs and no-shorting constraint
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