Trading strategies generated by Lyapunov functions

DOI10.1007/S00780-017-0332-8MaRDI QIDQ2364535zbMATH OpenOpenAlexDBLPWikidataFDO

Authors Johannes Ruf, Ioannis Karatzas

Publication date 21 July 2017

Published in Finance and Stochastics (Search for Journal in Brave)

Copyright license Creative Commons Attribution 4.0 International

Full work available at URL https://arxiv.org/abs/1603.08245

zbMATH Keywords

concavitydeflatorsfunctional generationregular and Lyapunov functionsrelative arbitragesemimartingale propertystochastic portfolio theorytime horizons

Mathematics Subject Classification ID

Martingales with continuous parameter (60G44) Stochastic integrals (60H05) Applications of stochastic analysis (to PDEs, etc.) (60H30) Portfolio theory (91G10) Lyapunov and storage functions (93D30)

Abstract: Functional portfolio generation, initiated by E.R. Fernholz almost twenty years ago, is a methodology for constructing trading strategies with controlled behavior. It is based on very weak and descriptive assumptions on the covariation structure of the underlying market model, and needs no estimation of model parameters. In this paper, the corresponding generating functions $G$ are interpreted as Lyapunov functions for the vector process $mu(cdot)$ of market weights; that is, via the property that $G(mu(cdot))$ is a supermartingale under an appropriate change of measure. This point of view unifies, generalizes, and simplifies several existing results, and allows the formulation of conditions under which it is possible to outperform the market portfolio over appropriate time-horizons. From a probabilistic point of view, the present paper yields results concerning the interplay of stochastic discount factors and concave transformations of semimartingales on compact domains.

Review text

The authors revise the well-known Fernholz's portfolio construction via an interpretation of portfolio-generating functions as Lyapunov functions for the vector process of relative market weights. This functional generation is generalized from portfolios to trading strategies which may involve short-selling, as well as to situations where some, but not all, of the market weights can vanish. Along the way, the authors introduce the new notion of ``additive functional generation of strategies, and compare it to the ``multiplicative generation. Such point of view allows the formulation of conditions under which it is possible to outperform the market portfolio over appropriate time horizons. Conditions guaranteeing the existence of relative arbitrage with respect to the market over sufficiently long time horizons are formulated. It is proved that concave functions satisfying certain additional assumptions are indeed Lyapunov, and counterexamples in which those additional assumptions are not satisfied, are provided. From a probabilistic point of view, this approach yields results concerning the interplay of stochastic discount factors and concave transformations of semimartingales on compact domains. Many previous results in this area are unified, simplified and generalized using the above approach.

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Cited in

(28)

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