Portfolio Optimization & Stochastic Volatility Asymptotics

Download or read book Portfolio Optimization & Stochastic Volatility Asymptotics written by Jean-Pierre Fouque and published by . This book was released on 2015 with total page 37 pages. Available in PDF, EPUB and Kindle. Book excerpt: We study the Merton portfolio optimization problem in the presence of stochastic volatility using asymptotic approximations when the volatility process is characterized by its time scales of fluctuation. This approach is tractable because it treats the incomplete markets problem as a perturbation around the complete market constant volatility problem for the value function, which is well-understood. When volatility is fast mean-reverting, this is a singular perturbation problem for a nonlinear Hamilton-Jacobi-Bellman PDE, while when volatility is slowly varying, it is a regular perturbation. These analyses can be combined for multifactor multiscale stochastic volatility models. The asymptotics shares remarkable similarities with the linear option pricing problem, which follows from some new properties of the Merton risk-tolerance function. We give examples in the family of mixture of power utilities and also we use our asymptotic analysis to suggest a "practical" strategy which does not require tracking the fast-moving volatility. In this paper, we present formal derivations of asymptotic approximations, and we provide a convergence proof in the case of power utility and single factor stochastic volatility. We assess our approximation in a particular case where there is an explicit solution.