The right time to sell a stock whose price is driven by Markovian noise

DOI10.1214/105051604000000747MaRDI QIDQ1769428zbMATH OpenOpenAlexFDO

Authors Robert C. Dalang, Max-Olivier Hongler

Publication date 21 March 2005

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

Full work available at URL https://arxiv.org/abs/math/0503580, https://projecteuclid.org/euclid.aoap/1099674093

optimal stopping piecewise deterministic Markov process principle of smooth fit telegrapher's noise

Stopping times; optimal stopping problems; gambling theory (60G40) Continuous-time Markov processes on discrete state spaces (60J27)

Abstract: We consider the problem of finding the optimal time to sell a stock, subject to a fixed sales cost and an exponential discounting rate ho. We assume that the price of the stock fluctuates according to the equation dY_t=Y_t(mu dt+sigmaxi(t) dt), where (xi(t)) is an alternating Markov renewal process with values in {pm1}, with an exponential renewal time. We determine the critical value of ho under which the value function is finite. We examine the validity of the ``principle of smooth fit and use this to give a complete and essentially explicit solution to the problem, which exhibits a surprisingly rich structure. The corresponding result when the stock price evolves according to the Black and Scholes model is obtained as a limit case.

Review text

This paper deals with the problem of finding the optimal time to sell a stock. The stock price \(Y_t\) fluctuates according to the random ordinary differential equation \(dY_t= Y_t(\mu dt+ \sigma\xi(t)dt)\), where \(\mu\) and \(\nu\) are constants and \((\xi(t))\) is an alternating Markov renewal process with value in \(\{\pm 1\}\), with an exponential renewal time with mean \(1/\alpha\). The problem is to find a stopping time \(\tau\), which maximizes the expected reward with fixed transaction cost \(a\) and discount rate \(\rho\), \(E[\exp^{-\rho\tau}(Y_\tau- a)]\), and the value function. Considering the couple \((Y(t),\xi(t))\), the authors show how the structure of solution depends on the relationship between four parameters \(\rho\), \(\mu\), \(\sigma\) and \(\lambda\). 1. The critical value of \(\rho\), under which the value function is finite, is given by \(\rho= \mu-\lambda+ \sqrt{\sigma^2+\lambda^2}\). 2. According to the possible relationship between four parameters, the authors investigate the validity of the principle of smooth fit and, using this, obtain a complete and essentially explicit solution to the problem, which exhibits a surprisingly rich structure. 3. The corresponding result for Black and Scholes model is obtained as an appropriate limit case, since \(\sqrt{\lambda}\int^t\xi(s)\,ds\) converges to a Brownian motion, as \(\lambda\to\infty\).

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