Game-theoretic derivation of upper hedging prices of multivariate contingent claims and submodularity

DOI10.1007/S13160-019-00394-YMaRDI QIDQ2300963zbMATH OpenOpenAlexWikidataFDO

Publication date 28 February 2020

Published in Japan Journal of Industrial and Applied Mathematics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1806.07626

Black-Scholes-Barenblatt equation game-theoretic probability Lovász extension multivariate contingent claim submodular upper hedging price

Mathematics Subject Classification ID

Applications of game theory (91A80) Derivative securities (option pricing, hedging, etc.) (91G20)

Abstract: We investigate upper and lower hedging prices of multivariate contingent claims from the viewpoint of game-theoretic probability and submodularity. By considering a game between "Market" and "Investor" in discrete time, the pricing problem is reduced to a backward induction of an optimization over simplexes. For European options with payoff functions satisfying a combinatorial property called submodularity or supermodularity, this optimization is solved in closed form by using the Lov'asz extension and the upper and lower hedging prices can be calculated efficiently. This class includes the options on the maximum or the minimum of several assets. We also study the asymptotic behavior as the number of game rounds goes to infinity. The upper and lower hedging prices of European options converge to the solutions of the Black-Scholes-Barenblatt equations. For European options with submodular or supermodular payoff functions, the Black-Scholes-Barenblatt equation is reduced to the linear Black-Scholes equation and it is solved in closed form. Numerical results show the validity of the theoretical results.

Review text

The authors investigate upper and lower hedging prices of multivariate contingent claims from the viewpoint of game-theoretic probability and submodularity. For each period \(n=1,\ldots, N\), an investors invests amounts \(M_n\in R^d\) on \(d\) asset in a market, and \(x_n\in R^d\) is the vector of price changes for period \(n\). Then the capital of the investor changes according to the rules: \(K_0=\alpha\), \(K_n=K_{n-1}+x_nM_n\) where \(\alpha\) is the initial capital. By considering a game in discrete time, the pricing problem is reduced to a backward induction of an optimization over simplexes. The authors consider this problems for payoff functions possessing the property submodularity or supermodularity, i. e. functions \(f:2^X\rightarrow R\) for which \(f(U\cap V)+f(U\cup V)\leq f(U)+F(V)\) or \(f(U\cap V)+f(U\cup V)\geq f(U)+F(V)\) correspondingly. For European options with payoff functions satisfying submodularity or supermodularity, this optimization is solved in closed form by using the Lovász extension and the upper and lower hedging prices can be calculated efficiently. The asymptotic behavior as \(n\rightarrow \infty\) is also studied. The upper and lower hedging prices of European options converge to the solutions of the Black-Scholes-Barenblatt equations. For European options with submodular or supermodular payoff functions, the Black-Scholes-Barenblatt equation is reduced to the linear Black-Scholes equation and it is solved in closed form.

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