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Perturbative Expansion of FBSDE in an Incomplete Market with Stochastic Volatility

Author

Listed:
  • Masaaki Fujii

    (Faculty of Economics, The University of Tokyo)

  • Akihiko Takahashi

    (Faculty of Economics, The University of Tokyo)

Abstract

In 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.

Suggested Citation

  • Masaaki Fujii & Akihiko Takahashi, 2012. "Perturbative Expansion of FBSDE in an Incomplete Market with Stochastic Volatility," CARF F-Series CARF-F-270, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo, revised Jun 2012.
    • Handle: RePEc:cfi:fseres:cf270
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    References listed on IDEAS

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    1. Masaaki Fujii & Akihiko Takahashi, 2011. "Analytical Approximation for Non-linear FBSDEs with Perturbation Scheme," CIRJE F-Series CIRJE-F-802, CIRJE, Faculty of Economics, University of Tokyo.
    2. Masaaki Fujii & Akihiko Takahashi, 2011. "Analytical Approximation for Non-linear FBSDEs with Perturbation Scheme," CARF F-Series CARF-F-248, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
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    4. Akihiko Takahashi & Kohta Takehara & Masashi Toda, 2011. "A General Computation Scheme for a High-Order Asymptotic Expansion Method," CIRJE F-Series CIRJE-F-787, CIRJE, Faculty of Economics, University of Tokyo.
    5. Masaaki Fujii & Akihiko Takahashi, 2010. "Asymmetric and Imperfect Collateralization, Derivative Pricing, and CVA," CIRJE F-Series CIRJE-F-781, CIRJE, Faculty of Economics, University of Tokyo.
    6. Ying Hu & Peter Imkeller & Matthias Muller, 2005. "Utility maximization in incomplete markets," Papers math/0508448, arXiv.org.
    7. Christian Kahl & Peter Jackel, 2006. "Fast strong approximation Monte Carlo schemes for stochastic volatility models," Quantitative Finance, Taylor & Francis Journals, vol. 6(6), pages 513-536.
    8. Thaleia Zariphopoulou, 2001. "A solution approach to valuation with unhedgeable risks," Finance and Stochastics, Springer, vol. 5(1), pages 61-82.
    9. Horst, Ulrich & Hu, Ying & Imkeller, Peter & Réveillac, Anthony & Zhang, Jianing, 2014. "Forward–backward systems for expected utility maximization," Stochastic Processes and their Applications, Elsevier, vol. 124(5), pages 1813-1848.
    10. Kenichiro Shiraya & Akihiko Takahashi & Masashi Toda, 2009. "Pricing Barrier and Average Options under Stochastic Volatility Environment," CIRJE F-Series CIRJE-F-682, CIRJE, Faculty of Economics, University of Tokyo.
    11. Akihiko Takahashi & Kohta Takehara & Masashi Toda, 2011. "A General Computation Scheme for a High-Order Asymptotic Expansion Method," CARF F-Series CARF-F-242, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo, revised Jul 2011.
    12. Kenichiro Shiraya & Akihiko Takahashi & Masashi Toda, 2009. "Pricing Average Options under Stochastic Volatility Models," CARF J-Series CARF-J-059, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
    13. Masaaki Fujii & Akihiko Takahashi, 2012. "Perturbative Expansion Technique for Non-linear FBSDEs with Interacting Particle Method," Papers 1204.2638, arXiv.org, revised Apr 2012.
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    Cited by:

    1. Masaaki Fujii & Akihiko Takahashi & Masayuki Takahashi, 2017. "Asymptotic Expansion as Prior Knowledge in Deep Learning Method for high dimensional BSDEs," Papers 1710.07030, arXiv.org, revised Mar 2019.
    2. Akihiko Takahashi & Toshihiro Yamada, 2015. "An Asymptotic Expansion of Forward-Backward SDEs with a Perturbed Driver," CARF F-Series CARF-F-363, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
    3. Akihiko Takahashi & Yukihiro Tsuzuki, 2013. "A New Improvement Scheme for Approximation Methods of Probability Density Functions," CIRJE F-Series CIRJE-F-874, CIRJE, Faculty of Economics, University of Tokyo.
    4. Kenichiro Shiraya & Akihiko Takahashi, 2015. "An Approximation Formula for Basket Option Prices under Local Stochastic Volatility with Jumps: an Application to Commodity Markets," CIRJE F-Series CIRJE-F-973, CIRJE, Faculty of Economics, University of Tokyo.
    5. Masaaki Fujii, 2015. "Optimal Position Management for a Market Maker with Stochastic Price Impacts," CIRJE F-Series CIRJE-F-963, CIRJE, Faculty of Economics, University of Tokyo.
    6. Akihiko Takahashi & Masashi Toda, 2012. "Note on an Extension of an Asymptotic Expansion Scheme," CARF F-Series CARF-F-286, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo, revised Dec 2012.
    7. Akihiko Takahashi & Yukihiro Tsuzuki, 2013. "A New Improvement Scheme for Approximation Methods of Probability Density Functions," CARF F-Series CARF-F-305, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
    8. Akihiko Takahashi & Masashi Toda, 2013. "Note on an Extension of an Asymptotic Expansion Scheme," CARF F-Series CARF-F-312, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
    9. Kenichiro Shiraya & Akihiko Takahashi, 2014. "Pricing Basket Options under Local Stochastic Volatility with Jumps," CIRJE F-Series CIRJE-F-913, CIRJE, Faculty of Economics, University of Tokyo.
    10. Masaaki Fujii, 2015. "Optimal Position Management for a Market Maker with Stochastic Price Impacts," Papers 1503.07007, arXiv.org, revised Sep 2015.
    11. Masaaki Fujii & Seisho Sato & Akihiko Takahashi, 2012. "An FBSDE Approach to American Option Pricing with an Interacting Particle Method," CIRJE F-Series CIRJE-F-871, CIRJE, Faculty of Economics, University of Tokyo.
    12. Masaaki Fujii & Akihiko Takahashi, 2012. "Perturbative Expansion Technique for Non-linear FBSDEs with Interacting Particle Method," CARF F-Series CARF-F-278, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo, revised Jan 2015.
    13. Kenichiro Shiraya & Akihiko Takahashi, 2013. "Pricing Basket Options under Local Stochastic Volatility with Jumps," CARF F-Series CARF-F-336, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo, revised May 2014.
    14. Masaaki Fujii & Akihiko Takahashi, 2015. "Perturbative Expansion Technique for Non-linear FBSDEs with Interacting Particle Method," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 22(3), pages 283-304, September.
    15. Masaaki Fujii, 2015. "Optimal Position Management for a Market Maker with Stochastic Price Impacts," CARF F-Series CARF-F-360, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo, revised Sep 2015.
    16. Akihiko Takahashi & Toshihiro Yamada, 2016. "An Asymptotic Expansion for Forward–Backward SDEs: A Malliavin Calculus Approach," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 23(4), pages 337-373, December.
    17. Masaaki Fujii & Akihiko Takahshi, 2015. "Perturbative Expansion Technique for Non-linear FBSDEs with Interacting Particle Method," CIRJE F-Series CIRJE-F-954, CIRJE, Faculty of Economics, University of Tokyo.
    18. Masaaki Fujii & Akihiko Takahashi, 2012. "Perturbative Expansion Technique for Non-linear FBSDEs with Interacting Particle Method," Papers 1204.2638, arXiv.org, revised Apr 2012.
    19. Masaaki Fujii & Akihiko Takahashi & Masayuki Takahashi, 2017. "Asymptotic Expansion as Prior Knowledge in Deep Learning Method for high dimensional BSDEs," CIRJE F-Series CIRJE-F-1069, CIRJE, Faculty of Economics, University of Tokyo.
    20. Akihiko Takahashi & Masashi Toda, 2012. "Note on an Extension of an Asymptotic Expansion Scheme," CIRJE F-Series CIRJE-F-860, CIRJE, Faculty of Economics, University of Tokyo.
    21. Kenichiro Shiraya & Akihiko Takahashi, 2015. "An approximation formula for basket option prices under local stochastic volatility with jumps: an application to commodity markets," CARF F-Series CARF-F-361, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo, revised Aug 2015.
    22. Akihiko Takahashi & Toshiaki Watanabe, 2015. "An Asymptotic Expansion of Forward-Backward SDEs with a Perturbed Driver ," CIRJE F-Series CIRJE-F-976, CIRJE, Faculty of Economics, University of Tokyo.
    23. Masaaki Fujii & Seisho Sato & Akihiko Takahashi, 2015. "An FBSDE Approach to American Option Pricing with an Interacting Particle Method," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 22(3), pages 239-260, September.
    24. Masaaki Fujii & Akihiko Takahashi & Masayuki Takahashi, 2017. "Asymptotic Expansion as Prior Knowledge in Deep Learning Method for high dimensional BSDEs," CARF F-Series CARF-F-423, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.

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