On the Snell envelope approach to optimal switching and pricing Bermudan options



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On the Snell envelope approach to optimal switching and pricing Bermudan options Ali Hamdi September 22, 2011

Abstract This thesis consists of two papers related to systems of Snell envelopes. The rst paper uses a system of Snell envelopes to formulate the problem of two-modes optimal switching for the full balance sheet in nite horizon. This means that the switching problem is formulated in terms of trade-o strategies between expected prot and cost yields, which act as obstacles to each other. Existence of a minimal solution of this system is obtained by using an approximation scheme. Furthermore, the optimal switching strategies are fully characterized. The second paper uses the Snell envelope to formulate the fair price of Bermudan options. To evaluate this formulation of the price, the optimal stopping strategy for such a contract must be estimated. This may be done recursively if some method of estimating conditional expectations is available. The paper focuses on nonparametric estimation of such expectations, by using regularization of a least-squares minimization, with a Tikhonov-type smoothing put on the partial diferential equation which characterizes the underlying price processes. This approach can hence be viewed as a combination of the Monte Carlo method and the PDE method for the estimation of conditional expectations. The estimation method turns out to be robust with regard to the size of the smoothing parameter.

Acknowledgements I wish to thank my supervisor Professor Boualem Djehiche and my cosupervisor Associate Professor Henrik Hult for their support and encouragement. Furthermore, I want to thank Associate Professor Filip Lindskog for helpful discussions and comments regarding the second paper. The nancial support from The Swedish Export Credit Corporation (SEK) is gratefully acknowledged. In particular, I want to thank Per Åkerlind and Richard Anund for making this possible.

Introduction and summary of the papers In this section we give a short introduction to the notions of the Snell envelope and its connection to obstacle problems, optimal switching and arbitrage-free pricing of Bermudan derivatives, which constitute the building blocks for the main results in the thesis, and provide a summary of the content of the two papers. Snell envelope Consider a nite time horizon [0, T ], where T > 0, and a probability space (Ω, F, P) on which is dened a standard d-dimensional Brownian motion W = { W t, 0 t T }. Let F 0 = { F 0 t := σ{w s, s t}, 0 t T } be the natural ltration of W and let F = {F t, 0 t T } be its completion with the P-null sets of F. Let θ be an F-stopping time, and let T θ denote the set of F-stopping times τ such that τ θ. Given an F-adapted R-valued càdlàg process U = {U t, 0 t T } such that {U τ, τ T 0 } is uniformly integrable, there exists an F-adapted R-valued càdlàg process Z = {Z t : 0 t T } such that Z is the smallest supermartingale which dominates U. The process Z is known as the Snell envelope of U, and is of the form Z θ = ess sup τ T θ E[U τ F θ ], for any F-stopping time θ. Furthermore, if U has only positive jumps, then Z is a continuous process and is optimal after θ, i.e., it holds that τ θ = inf { s θ : Z s = U s } T Z θ = ess sup τ T θ E[U τ F θ ] = E [ Z τ θ F θ ] = E [ Uτ θ F θ ]. Reected backward SDEs El Karoui et al. [4] show that the Snell envelop is connected to the solution of an obstacle problem in the continuous case. This is extended to the càdlàg case by Hamadène [6] and by Lepeltier and Xu [8]. To be specic, consider the reected solution of a backward SDE with generator f, end time condition ξ and obstacle process S = {S t R, 0 t T }. Omitting the regularity conditions which can be found in the rst paper, the solution is a i

triplet of càdlàg processes (Y t, Z t, K t ) 0 t T which satises the conditions T Y t = ξ + f ( ) T s, ω, Y s, Z s ds + KT K t Z s db s t t Y t S t T 0 ( St Y t ) dkt = 0, for 0 t T, where K = {K t, 0 t T } is a nondecreasing process such that K 0 = 0. Intuitively, the process K pushes the solution upwards when needed, to make sure that the solution stays above the obstacle process S. The last condition above states that this eect of K is minimal in the sense that K only pushes when Y hits the obstacle S. Given sucient regularity on f, ξ and S it can be shown (see [6] or [8]) that the solution has the representation of a Snell envelope on the form [ τ Y t = ess sup τ T t E t f ( s, Y s, Z s ) ds + Sτ 1 {τ<t } + ξ1 {τ=t } F t ]. Hence, the obstacle problem is equivalent to the Snell envelope on the particular form shown above. Optimal switching Optimal switching refers to the problem of switching between a set of nodes, or stations, with the objective of maximizing some functional J. The functional J is usually some expectation of a running prot as well as some cost incurred when a switch between the nodes is made. A simple example of an application would be maximizing the prot from production of electricity. Assuming that there is only one production unit then the problem reduces to nding an optimal strategy of starting and stopping the production in the facility. The price of the electricity is a random entity, and so the prot from the production varies with time. Hence, one would like to nd an optimal strategy of starting and stopping as to maximize the expected prot over some xed time period. This is an example of the special case of optimal switching known as the starting and stopping problem. A strategy may be dened, for this two-modes switching example, as a sequence of stopping times δ = {τ n } n 0, where τ n τ n+1 and τ n T P-a.s. as n. At τ n, the manager switches from the current mode to the other, which incurs some switching cost. Let the random cost incurred at time τ n be denoted by l n, and let the state at time t be denoted by u t, where u t = 1 if the production is active, and u t = 0 if it is not. Furthermore, let X t be the price of electricity at time t, and let the prot per unit time be f(t, X t, u t ), ii

at any time 0 t T. Then the functional J which is to be maximized over all strategies δ may be loosely dened as [ T J(δ) = E f ( ] ) s, X s, u s ds l n 1 {τn<t }. 0 Then, the problem of maximizing the expected prot over all strategies may be written as sup J(δ). δ By using the Dynamic Programming Principle, it can be shown that the problem formulation above is equivalent to the existence of a pair of adapted processes (Y 1, Y 2 ) which satises a system of Snell envelopes on the form Y 1 t Y 2 t = ess sup τ T t = ess sup τ T t n 0 E [ Prot over [t, τ] given mode 1 at time t and switch to mode 2 at time τ ] E [ Prot over [t, τ] given mode 2 at time t and switch to mode 1 at time τ ]. Hence, Yt 1 can be interpreted as the maximal expected prot given that at time t mode 1 is activated, and Yt 2 can be interpreted as the same given ( that at time t mode 2 is activated. Furthermore, the existence of the pair Y 1, Y 2) gives the optimal strategy of the problem as a sequence of stopping ( times where a switch between the two modes is made. The existence of Y 1, Y 2) uses the connection between the Snell envelope and RBSDE mentioned above, as is the case for many of the papers found in the literature regarding the optimal switching problem. Arbitrage-free pricing Consider a standard European put option with maturity T and strike K. The contingent claim of the contract at time T is φ(s T ) = max { K S T, 0 }, where S t is the value of the underlying asset at time t. To derive a price for this claim, a model of the underlying asset S is needed. If arbitrage-free pricing theory is to be used, then this model needs to be free of arbitrage. That is, given the model, there should not be possible to make money by buying or selling assets within the model without taking risk. The rst fundamental theorem of arbitrage-free pricing states that the model is free of arbitrage if and only if there exists a martingale measure Q. By the second fundamental theorem of arbitrage-free pricing, the measure iii

Q is unique if the model is complete, and vice versa. The model is said to be complete if all contingent claims can be replicated within the model. For a comprehensive review of arbitrage-free pricing theory see [1]. The measure is called martingale measure because every price process denominated with the numeraire will be a martingale. The numeraire of the martingale measure, also called the risk-neutral measure, is what is known as the bank account process. Let the bank process be denoted by B = {B t, t 0}. With this notation, the process Z t = V t B t, t 0, is a Q-martingale for any price process {V t : t 0}. In particular, if V t denotes the value of the T-claim φ(s T ) at time t, then it may be written as [ ] V t = B t E Q φ(s T ) B T F t, since it must hold that V T = φ(s T ). This is known as the risk-neutral valuation formula. Hence, if no analytic formula is available, the price of the contingent claim may be calculated by using standard Monte Carlo algorithms. It is also possible to use the martingale property of the discounted value process, i.e. Z, to derive a PDE formulation of the price so that PDE methods provide another alternative for evaluating the price numerically. In fact, these methods can be quite eective for low-dimensional derivatives. However, as the number of dimensions increases, this method is no longer viable due to what is known as the curse of dimensionality, and so Monte Carlo methods must be used. Bermudan derivatives A Bermudan derivative is one that may be exercised at any of a set of predetermined times. Taking the put option from previous section, then this would be a Bermudan put if the buyer of the contract had the right to decide to recieve the claim φ(s tk ) at any time t k {t i } N i=1, where, 0 < t 1 <... < t N = T are the possible times of exercise. The pricing problem of such a derivative is equivalent to an obstacle problem formulation. This is intuitively understood by the fact that at any of the possible exercise times, the value of the contract must be greater than or equal to what would be paid if the contract was exercised. In other words, the claim of the contract acts as the obstacle to the value process for the iv

claim. Hence, it can be shown that the value process of such a contract admits the representation of a Snell envelope of the form [ ] φ(s τ ) V t = B t ess sup E τ T t B τ F t. Letting U t = φ(s t), t 0, B t then it holds that the discounted value process Z is the Snell envelope of the discounted payo process U = {U t R : 0 t T }. It follows that the optimal stopping time for the contract at time t is τt = inf { } s t : Z s = U s = inf { s t : V s = φ(s s ) }. It follows that, at any of the times t k, it holds that V tk = max { φ (X tk ), E [ ]} V tk+1 Xtk { [ [ ) ] ]} = max φ (X tk ), E E φ (X τ Xtk+1 Xtk k+1 { [ ) ]} = max φ (X tk ), E φ (X τ Xtk, k+1 so that it holds that τn = T, { [ ) ] τk = tk, if φ (X tk ) E φ (X τ Xtk k+1 τk+1, otherwise. This means that the optimal stopping time for the contract may be recursively estimated, if some method of estimating the conditional expectations was given. Summary of paper 1: A Full Balance Sheet Two-modes Optimal Switching problem This paper deals with a two-modes optimal switching problem for the full balance sheet. This means that the formulation takes into account the trade-o strategies between expected prot and expected cost yields. It is a combination of ideas and techniques for the two-modes starting and stopping problem developed in [7] and [2], and optimal stopping involving the full balance sheet introduced in [3]. This problem is a natural extension of previous work since it incorporates both the action of switching between modes and the action of terminating a project, if it is found to be unprotable. For v

example, being in mode 1, one may want to switch to mode 2 at time t, if the expected prot, Y +,1, in this mode falls below the maximum of the expected prot yield in mode 2, Y +,2, minus a switching cost l 1 from mode 1 to mode 2, and the expected cost yield in mode 1, Y,1 minus the cost a 1 incurred when exiting/terminating the production while in mode 1, i.e. Y +,1 t (Y +,2 t l 1 (t)) (Y,1 t a 1 (t)), or, if the expected cost yield in mode 1, Y,1, rises above the minimum of the expected cost yield in mode 2, Y,2, plus the switching cost l 1 from mode 1 to mode 2, and the expected prot yield in mode 1, Y +,1 plus the benet b 1 incurred when exiting/terminating the production while in mode 1, i.e. Y,1 t (Y,2 t + l 1 (t)) (Y +,1 t + b 1 (t)). A similar switching criterion holds from mode 2 to mode 1. Hence, the problem formulation in this paper allows for two possible actions given the current mode, a switch to the other mode or the termination of the project. If F t denotes the history of the production up to time t, and ψ i + and ψi denote respectively the running prot and cost per unit time dt and ξ i + and ξi are the prot and cost yields at the horizon T, while in mode i = 1, 2, the expected prot yield, while in mode 1, can be expressed in terms of a Snell envelope as follows: [ τ ] Y +,1 t = ess sup E ψ 1 + (s)ds + S+,1 τ 1 {τ<t } + ξ 1 + 1 {τ=t } F t τ t t S τ +,1 = ( (Y τ +,2 l 1 (τ)) (Yτ,1 a 1 (τ)) ), where, the supremum is taken over exit times from the production in mode 1. Furthermore, the Snell envelope expression of the expected cost yield, while in mode 1, reads [ σ ] Y,1 t = ess inf E ψ1 (s)ds + S,1 σ 1 {σ<t } + ξ1 1 {σ=t } σ t F t t S,1 σ = ( (Y,2 σ + l 1 (σ)) (Y +,1 σ + b 1 (σ)) ), where, the inmum is taken over exit times from the production in mode 1. The expected prot and cost yields Y +,2 and Y,2, when the production is in mode 2, satistfy a similar set of Snell envelopes. The existence of a minimal solution to the system of Snell envelopes is proven with the help of an approximation scheme, and the optimal switching strategies are fully characterized. Summary of paper 2: Pricing Bermudan Options - A nonparametric estimation approach In this paper the problem of nding an estimator for conditional expectations, for use in the method of estimating optimal stopping times for Bermuvi

dan contracts, as described earlier. Specically, when some random sample of two random variables D = { X, Y } M i=1 is given, the aim of the paper is to try to formulate an estimator ˆf D of the L 2 function f(x) = E [ Y X ]. Here, the random variable Y refers to the stopped payo in the pricing formula for a Bermudan contract, and the random variable X refers to the underlying at some point in time. The focus is to nd such an estimator which is nonparametric and which requires no handcrafting. Due to the illposed nature of the introduced approach (c.f. [5]), a smoothing operator is used, which uses known dynamics of the conditional expectation to project the solution onto a reduced space where the true solution is included. The necessary proof of convergence is presented, independently of the particular choice of regularization function, as well as regularization parameter. This estimator is illustrated in some examples, where the partial dierential operator, which characterizes the underlying model, is used as regularization operator. The intuition behind this is that the partial dierential equation should equal zero, for any solution to the pricing problem. Thus, given that the discretization gives some error, it is reasonable to demand that the norm of this discretized equation should at least be small. A drawback of the method is presented in the way the smoothing operator is calculated. Since the smoothing operator takes the form of a PDE the calculations means, as it is now, introducing the use of a grid. As such, the curse of dimensionality is likely to still pose a problem in higher dimensions. Hence, the problem of pricing Bermudans in higher dimensions is not fully solved by the method. But nevertheless, the method is a rst take on a novel approach towards solving that problem, and it does seem like further development can be done. In fact, as of the time of this writing, some success has been made in relaxing the use of the grid. But the results are still too preliminary to be able to draw any conclusions on extending the method to higher dimensions. References [1] T. Björk. Arbitrage Theory in Continuous Time, Second Edition. Oxford University Press Inc., New York, 2005. [2] B. Djehiche and S. Hamadène. On a nite horizon starting and stopping problem with risk of abandonment. International Journal of Theoretical and Applied Finance, 12(4):523543, 2009. vii

[3] B. Djehiche, S. Hamadène, and M-A Morlais. Optimal stopping of expected prot and cost yields in an investment under uncertainty. Stochastics: An International Journal Of Probability And Stochastic Processes, to appear, 201. [4] N. El Karoui, C. Kapoudjan, E. Pardoux, S. Peng, and M-C Quenez. Re- ected solutions of backward sdes and related problems for pde's. Annals of Probability, 25(2):702737, 1997. [5] H. W. Engl, M. Hanke, and A. Neubauer. Regularization of Inverse Problems. Kluwer Academic Publishers, Dordrecht, 1996. [6] S. Hamadène. Reected bsdes with discontinuous barriers. Stochastics and Stocastics Reports, 74(3-4):571596, 2002. [7] S. Hamadène and M. Jeanblanc. On the starting and stopping problem: Application in reversible investments. Mathematics of Operations Research, 32(1):182192, February 2007. [8] J.-P. Lepeltier and M. Xu. Penalization method for reected backward stochastic dierential equations with one r.c.l.l. barrier. Statistics and Probability Letters, 75:5866, November 2005. viii