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On optimal tracking portfolio in incomplete markets: The reinforcement learning approach

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Listed:
  • Lijun Bo
  • Yijie Huang
  • Xiang Yu

Abstract

This paper studies an infinite horizon optimal tracking portfolio problem using capital injection in incomplete market models. The benchmark process is modelled by a geometric Brownian motion with zero drift driven by some unhedgeable risk. The relaxed tracking formulation is adopted where the fund account compensated by the injected capital needs to outperform the benchmark process at any time, and the goal is to minimize the cost of the discounted total capital injection. When model parameters are known, we formulate the equivalent auxiliary control problem with reflected state dynamics, for which the classical solution of the HJB equation with Neumann boundary condition is obtained explicitly. When model parameters are unknown, we introduce the exploratory formulation for the auxiliary control problem with entropy regularization and develop the continuous-time q-learning algorithm in models of reflected diffusion processes. In some illustrative numerical example, we show the satisfactory performance of the q-learning algorithm.

Suggested Citation

  • Lijun Bo & Yijie Huang & Xiang Yu, 2023. "On optimal tracking portfolio in incomplete markets: The reinforcement learning approach," Papers 2311.14318, arXiv.org, revised Oct 2024.
  • Handle: RePEc:arx:papers:2311.14318
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    References listed on IDEAS

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    1. Sun, Yeneng, 2006. "The exact law of large numbers via Fubini extension and characterization of insurable risks," Journal of Economic Theory, Elsevier, vol. 126(1), pages 31-69, January.
    2. Strub, O. & Baumann, P., 2018. "Optimal construction and rebalancing of index-tracking portfolios," European Journal of Operational Research, Elsevier, vol. 264(1), pages 370-387.
    3. Lijun Bo & Huafu Liao & Xiang Yu, 2020. "Optimal Tracking Portfolio with A Ratcheting Capital Benchmark," Papers 2006.13661, arXiv.org, revised Apr 2021.
    4. Chendi Ni & Yuying Li & Peter Forsyth & Ray Carroll, 2022. "Optimal asset allocation for outperforming a stochastic benchmark target," Quantitative Finance, Taylor & Francis Journals, vol. 22(9), pages 1595-1626, September.
    5. Yanwei Jia & Xun Yu Zhou, 2022. "q-Learning in Continuous Time," Papers 2207.00713, arXiv.org, revised Apr 2023.
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