Max-plus decomposition of supermartingales and convex order. Application to American options and portfolio insurance

DOI10.1214/009117907000000222MaRDI QIDQ2482283zbMATH OpenOpenAlexFDO

Publication date 16 April 2008

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

Full work available at URL https://arxiv.org/abs/0804.2561

American options Azéma-Yor martingales convex order Lévy processes martingale optimization with constraints Max-Plus algebra optimal stopping portfolio insurance running supremum process supermartingale decompositions

Mathematics Subject Classification ID

General theory of stochastic processes (60G07) Stopping times; optimal stopping problems; gambling theory (60G40) Martingales with continuous parameter (60G44) Processes with independent increments; Lévy processes (60G51)

Abstract: We are concerned with a new type of supermartingale decomposition in the Max-Plus algebra, which essentially consists in expressing any supermartingale of class

(m a t h c a l D)

as a conditional expectation of some running supremum process. As an application, we show how the Max-Plus supermartingale decomposition allows, in particular, to solve the American optimal stopping problem without having to compute the option price. Some illustrative examples based on one-dimensional diffusion processes are then provided. Another interesting application concerns the portfolio insurance. Hence, based on the ``Max-Plus martingale, we solve in the paper an optimization problem whose aim is to find the best martingale dominating a given floor process (on every intermediate date), w.r.t. the convex order on terminal values.

Review text

The authors establish the existence of the new type of supermartingale decomposition where the operations \((+,x)\) are changed for \((\max,+)\). It means that for supermartingale \(Z\) they find a martingale \(M\) and adapted increasing process \(\Lambda\) with max-plus density \(L\) such that \(M=\max(Z,\Lambda)\) and \(\Lambda_t=\sup_{s\leq t}L_s\). So, the result consists in expressing any supermartingale of class \((\mathcal D)\) as a conditional expectation of some running supremum process. The existence is proved via convex analysis argument. The martingale \(M\) is also characterized as the optimal solution of some martingale problem. An optimization problem consists in finding of the best martingale dominating a given floor process (on every intermediate date), w.r.t. the convex order on terminal values. As an application, it is demonstrated how the Max-Plus supermartingale decomposition allows, in particular, to solve the American optimal stopping problem without having to compute the option price.

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