Perturbative Expansion of FBSDE in an Incomplete Market with Stochastic Volatility
AbstractIn this work, we apply our newly proposed perturbative expansion technique to a quadratic growth FBSDE appearing in an incomplete market with stochastic volatility that is not perfectly hedgeable. By combining standard asymptotic expansion technique for the underlying volatility process, we derive explicit expression for the solution of the FBSDE up to the third order of volatility-of-volatility, which can be directly translated into the optimal investment strategy. We compare our approximation with the exact solution, which is known to be derived by the Cole-Hopf transformation in this popular setup. The result is very encouraging and shows good accuracy of the approximation up to quite long maturities. Since our new methodology can be extended straightforwardly to multi-dimensional setups, we expect it will open real possibilities to obtain explicit optimal portfolios or hedging strategies under realistic assumptions.
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Bibliographic InfoPaper provided by Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo in its series CARF F-Series with number CARF-F-270.
Length: 23 pages
Date of creation: Feb 2012
Date of revision: Jun 2012
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-09-09 (All new papers)
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- Ying Hu & Peter Imkeller & Matthias Muller, 2005. "Utility maximization in incomplete markets," Papers math/0508448, arXiv.org.
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