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Albert N. SHIRYAEV Steklov Mathematical Institute, Lomonosov Moscow State University LECTURES on Financial Statistics, Stochastics, and Optimization e-mail: [email protected] 1

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Page 1: Shiryaev

Albert N. SHIRYAEV

Steklov Mathematical Institute,

Lomonosov Moscow State University

LECTURES on

FinancialStatistics, Stochastics, and Optimization

e-mail: [email protected]

1

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TOPIC I. Financial models and innovations in stochastic

economics

1. The classical and neoclassical models of the dynamics ofthe prices driven by Brownian motion and Levy processes

2. Stylized facts3. Constructions based on the change of time, stochastic

volatility

TOPIC II. Technical Analysis. I

1. Kagi and Renko charts2. Prediction of time of maximum value of prices observable

on time interval [0, T ]3. Quickest detection of time of appearing of arbitrage4. Drawdowns as the characteristics of risk

TOPIC III. Technical Analysis. II

1. Buy and Hold2. Stochastic Buy an Hold (rebalancing of the portfolio)

TOPIC IV. General Theory of Optimal Stopping 2

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TOPIC I. Financial models and innovationsin stochastic economics

1. The classical and neoclassical models of the

dynamics of the prices driven by Brownian

motion and Levy processes

2. Stylized facts

3. Constructions based on the change of time,

stochastic volatility

I-1

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The construction of the right probability-statistical models of the

dynamics of prices of the basic financial instruments (bank account,

bonds, stocks, etc.) is undoubtedly one of important steps for successful

application of the results of mathematical finance and financial

engineering.

Without adequate models for prices there is no successful risk management,

portfolio optimization, allocation of funds, derivative pricing, etc.

The main accent in this lecture is made on the construction of the

HYPERBOLIC LEVY PROCESSES,

which are widely used in econometric models of the dynamics of the

financial indexes.

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THE FIRST CLASSICAL MODELS FOR

PRICE DYNAMICS

In the sequel,

S = (St)t!0 is the price of (for simplicity) one asset

L. Bachelier (1900). Theorie de la speculation:

St = S0 + µt + !Bt ,

where B = (Bt)t!0 is a standard Brownian motion, i.e.,

a Gaussian process with independent

increments and continuous trajectories,

B0 = 0, EBt = 0, E(Bt " Bs)2 = t " s.

I-3

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M. Kendall (1953). The analysis of economic time series.Part 1. Prices (J. Roy. Statist. Soc., 96, 11–25):

The empirical analysis of prices S = (Sn)n!0 for

– wheat (monthly average prices on the Chicago market, 1883–1934),– cotton (the New York Mercantile Exchange, 1816–1951)

did not reveal (contrary to common expectations) neither rhythms,nor cycles. The observed data look as if

“...the Demon of Chance drew a random number... andadded it to the current price to determine the next... price”:

Sn = S0eHn , where Hn = h1 + · · · + hn is the sum of

independent random variables

(“random walk hypothesis”)

I-4

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M. F.M. Osborne (1959). Brownian motion in the stock market.

Operation Research, 7, 145–153: St = S0 + µt + !Bt .

P. A. Samuelson (1965). Proof that properly anticipated prices

fluctuate randomly. Industrial Management Rev., 6, 41–49:

St = S0eHt, Ht =!µ "

!2

2

"t + !Bt,

S = (St)t!0 is an economic (geometric) Brownian motion;

dSt = St(µ dt + ! dBt)

#This model underlies the Black–Scholes theory of option pricing.$

I-5

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MARTINGALE APPROACH TO STUDYING THE MODELS

S = (Sn)n!0, Sn = S0eHn, Hn = h1 + · · · + hn

(hn = log(Sn/Sn"1) is a “return”, “logarithmic return”)

Doob’s decomposition. Assume that “stochastics” of the marketis described by a filtered probability space (!,F , (Fn)n!0, P) andE|Hn| < %, n ! 0.

Hn =n#

k=1

E(hk | Fk"1) +n#

k=1

!hk " E(hk | Fk"1)

", or

hn = E(hn | Fn"1)$ %& 'µn

are Fn"1-measurable

+ (hn " E(hn | Fn"1))$ %& '"n

are Fn-measurable,E("n | Fn"1) = 0,

("n) is a martingale di!erence

I-6

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1970s#large time intervals –year, quarter, month$

: linear models like AR, MA, ARMA with

hn = µn + !n#n (i.e., "n = !n#n),

"#$ µn and !n are Fn"1-measurable,

#n & N (0,1) are independent, n ! 1.

AR(p) model:

µn = a0 + a1hn"1 + · · · + aphn"p, !n = const

MA(q) model:

µn = b0 + b1#n"1 + · · · + bq#n"q, !n = const

ARMA(p, q) model:

µn =(a0 + a1hn"1 + · · · + aphn"p

)

+(b0 + b1#n"1 + · · · + bq#n"q

), !n = const

I-7

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1980s#analysis of day data$

: nonlinear models ARCH, GARCH, CRR

Sn = S0 exp{h1 + · · · + hn}

ARCH(p) model – AutoRegressive Conditional Heteroskedastic

model; P. Engle (1982):

hn = !n#n, !n =

*++,$0 +p#

i=1

$ih2n"i is random (!).

GARCH(p, q) model – Generalized ARCH model; T. Bollerslev

(1986):

hn = !n#n, !n =

*+++,

-

$0 +p#

i=1

$ih2n"i

.

+

- q#

j=1

%j!2n"j

.

.

Binary CRR-model – Cox, Ross, Rubinstein (1979):

hn = log(1 + &n), &n takes two values, &n > "1.

I-8

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1990s#intraday data analysis$

: (a) Stochastic processes with discrete

intervention of chance (piecewise

constant trajectories with jumps at

“close” times '1, '2, . . .):

Ht =#

hkI('k ' t)

(b) Data come almost continuously.

I-9

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WEAKNESS of the MODEL St = S0eHt, Ht = (µ"!2/2)t+!Bt,

based on a Brownian motion, i.e., dSt = St(µ dt + ! dBt) with a

constant volatility !.

Really observable smile e!ect says that the volatility ! is NOT a

constant.

Consider a call (buyer) option with pay-o! function (ST " K)+:

C(t, x) = EP

((ST " K)+ |St = x

).

By the Black–Scholes formula we find C(t, x) = CBS(t, x;T, K, !).

On option market there exist real prices

/C(t, x;T, K).

From CBS(t, x;T, K, !) ( /C(t, x;T, K) we calculate the implied volatility

! = !(t, x;T, K). Fix t, x, T . It turns out that !(K) has a U-form

(with Kmin ( x) – smile e!ect.

I-10

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1st CORRECTION

(R. Merton, 1973)

! ") !(t)

!(t) ") !(t, St)

2nd CORRECTION

(B. Dupire, 1994)

Pricing with a smile,

RISK, 7, 18–20

I-11

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One- and two-dimensional distributions of H = (Ht)t!0.

The observable properties of h(")t = log(St/St"")

A. The behavior of empirical densities p(")(x), constructed upon

h(")" , h(")

2" , . . ., is di!erent from that of normal distribution. In

a neighborhood of the central value, the densities p(")(x) are

peak-like, and “heavy tails” are observed as x ) ±%.

B. The empirical estimator of autocorrelation (t = k")

&(n") =0Eh(")

t h(")t+n" " Eh(")

t Eh(")t+n"

1203Dh(")

t Dh(")t+n"

1

shows that for small n" the value &(n") is negative, while most

of the values of &(n") are close to zero (noncorrelatedness).

C. Analogous estimators for autocorrelation of absolute values

|h(")t | and |h(")

t+n"| show that for small n" the autocorrelation

is positive (clustering e!ect).

I-12

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HERE THE PICTURE

I-13

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Searching for adequate statistical models which describe

dynamics of the prices S = (St)t!0 led to

LEVY PROCESSES.

Now these processes take the central place in modelling the

prices of financial indexes, the latter displaying the jump

character of changes.

I-14

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MAIN MODELSbased on a Brownian motion

Exponential

Brownian model

St = S0 exp{µt + !Bt}

* *Exponential

INTEGRAL

Brownian model:

St = S0 exp45 t

0µs ds +

5 t

0!s dBs

6

Exponential

TIME-CHANGED

Brownian model:

St = S0 exp7µT(t) + BT(t)

8

I-15

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Assuming that µ = 0, one can rewrite these models in a brief form:

S = S0e!B

* *S = S0e!·B S = S0eB+T

where • ! · B is the stochastic integral (5 ·

0!s dBs),

• B + T is a time change in Brownian motion (BT(t)).

I-16

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A generalization of these “Brownian” models, which have being

predominating in financial modelling for a long time, is based on

the idea to replace

BROWNIAN MOTION

B = (Bt)t!0

by LEVY PROCESSES

L = (Lt)t!0

:

S = S0e!L

* *S = S0e!·L S = S0eL+T

I-17

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LEVY PROCESS L = (Lt)t!0 is a process with stationary

increments, L0 = 0, which is continuous in probability.

Such processes have modifications whose trajectories

• are right-continuous (for t ! 0) and

• have limits from the left (for t > 0).

Kolmogorov-Levy-Khinchin’s formula for characteristic functions:

Eei(Lt = exp

9

t0i(b "

(2

2c +

5 !ei(x " 1 " i(h(x)

"F(dx)

1:

,

where: h(x) = xI(|x| ' 1) (classical “truncation” function),

F(dx) is a !-finite measure on R \ {0}such that

;min(1, x2)F(dx) < %,

b , R and c ! 0;

(b, c, F) =: T is a triplet of local characteristics of L.

I-18

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The Levy–Ito representation for trajectories of L = (Lt)t!0:

Lt = Bt + Lct +

5 t

0

5h(x) d(µ " )) +

5 t

0

5(x " h(x)) dµ ,

• Bt = bt; • Lct is a continuous component of L

(Lct =

-c Wt, where Wt is a Wiener process);

• µ is the measure of jumps: for A , B(R \ {0})

µ(*; (0, t] . A) =#

0<s'tIA("Ls) ("Ls = Ls " Ls");

• ) is the compensator of the measure of jumps µ:

)((0, t] . A) = tF(A), F(A) =;A F(dx).

The measure µ is a Poissonian measure with

E exp4i#

k'n(kµ(Gk)

6= exp

4#k'n

(ei(k " 1))(Gk)6, n ! 1,

where Gk are sets from R+ . R and )(dt, dx) = dt F(dx).

I-19

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EXAMPLES of LEVY PROCESSES :

• Brownian motion,

• Poisson process,

• compound Poisson process Lt =Nt#

k=1

+k, where

(Nt)t!0 is a Poisson process,

(+k)k!1 is a sequence of independent and identicallydistributed random variables

I-20

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In connection with financial econometrics, these are

HYPERBOLIC Levy processes,

that are of a great interest, because they model well the really

observable processes H = (Ht)t!0 for many underlying financial

instruments (rate of exchange, stocks, etc.).

The credit of developing the theory of such processes and their

applications is due to E. Halphen, O. Barndor!-Nielsen, E. Eberlein.

We will construct these processes, following mostly Chapters 9

and 12 of the monograph: O. Barndor!-Nielsen, A. N. Shiryaev,

Change of Time and Change of Measures, World Scientific (in

print).

I-21

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For a Levy process (Ht)t!0 we have

Eei(Ht = (Eei(H1)t.

The properties of Levy’s processes imply that the random variable

h = H1 is infinitely divisible, i.e., for any n one can find i.i.d. r.v.’s

+1, . . . , +n such that

Law(h) = Law(+1 + · · · + +n).

We will look for the infinitely divisible r.v.’s h having the form

h = µ + %!2 + !#,

where # is a standard Gaussian random variable, # & N (0,1),

! = !(*) is the “volatility” (which does not depend on #), for

whose square, !2, we will construct the special distribution

GIG – Generalized Inverse Gaussian distribution.

I-22

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Strikingly, this distribution (on R+) is infinitely divisible and the

distribution of h = µ + %!2 + !# (on R) is infinitely divisible as well.

Hence there exist Levy processes T = (T(t))t!0 and H/ = (H/t )t!0

such that

Law(T(1)) = Law(!2) and Law(H/1) = Law(h).

As a realization of H/ = (H/t )t!0 one can take

Ht = µt + %T(t) + BT(t),

where the “time change” T = (T(t))t!0 and the Brownian motion

B = (Bt)t!0 are independent.

In the sequel, we do not distinguish between the processes H and H/.

This process H, remarkable in many respect, bears the name

L(GH) – Generalized Hyperbolic Levy process.

I-23

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Let discuss the details of construction of GIG-distributions for !2.

Let W = (Wt)t!0 be a Wiener process (standard Brownian motion).

For A ! 0, B > 0 introduce

TA(B) = inf{s ! 0: As + Ws ! B}.

HERE MUST BE A PICTURE

I-24

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The formula for the density pTA(B)(s) = dP(TA(B) ' s)/ds is well

known:

pTA(B)(s) =B

s,s(B " As), "#$ ,s(x) =

1-2-s

e"x2/(2s). (1)

Herefrom we find the Laplace transform:

Ee"(TA(B) = exp7AB(1 "

<1 + 2(/A2)

8.

Letting b = B2 > 0 and a = A2 ! 0, we find from (1) the following

formula for p(s; a, b) = pT-

a(-

b)(s):

p(s; a, b) = c1(a, b)s"3/2e"(as+b/s)/2 , "#$ c1(a, b) =

=b

2-e-

ab.

The distribution with density p(s; a, b) is named

IG = IG(a, b) – Inverse Gaussian distribution.

I-25

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Next important step: one define ad hoc the function

p(s; a, b, )) = c2(a, b, )) s)"1e"(as+b/s)/2, (2)

where parameters a, b, ) , R are chosen in such a way that p(s; a, b, ))

be probability density on R+:

a ! 0, b > 0, ) < 0

a > 0, b > 0, ) = 0

a > 0, b ! 0, ) > 0

>

05 %

0s)"1e"(as+b/s)/2 ds < %

?

.

It is well known that K)(y) 1 12

5 %

0s)"1e"y(s+1/s)/2 ds is the modified

third-kind Bessel function of order ), which for y > 0 solves

y2f 22(y) + yf 2(y) " (y2 + )2)f(y) = 0.

The constant in (2) has the form c2(a, b, )) =(a/b))/2

2K)(-

ab).

I-26

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The distribution on R+ with density

p(s; a, b, )) =(a/b))/2

2K)(-

ab)s)"1e"(as+b/s)/2

bears the name

GIG = GIG(a, b) – Generalized Inverse Gaussian distribution.

I-27

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IMPORTANT PROPERTIES of GIG-DISTRIBUTION (for !2):

A. This distribution is infinitely divisible.

B. The density p(s; a, b, )) is unimodal with the mode

m =

@AB

AC

b /(2(1 " ))

), if a = 0,

(() " 1) +

<ab + () " 1)2

)/a, if a > 0.

C. Laplace’s transform L(() =;%0 e"(sp(s; a, b, )) ds is given by

L(() =D1 +

2(

a

E")/2K)(<

ab(1 + 2(/a))

K)(-

ab).

As a by-product, one deduces the representation for the density f(y)

of Levy measure F(dy). (Note: L(() = exp{;%0 (e"(y " 1)f(y) dy}.)

I-28

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Particularly important SPECIAL CASES of GIG-distributions:

I. a ! 0, b > 0, ) = "1/2: in this case GIG(a, b,"1/2) = IG(a, b)

– Inverse Gaussian distribution.

Density: p(s; a, b) = c1(a, b)s"3/2e"(as+b/s)/2, c1(a, b) =<

b2- e

-ab.

Density of Levy’s measure: f(y) =<

b2-

e"ay/2

y3/2 .

II. a > 0, b = 0, ) > 0: in this case GIG(a,0, ))=Gamma(a/2, ))

– Gamma distribution. Density: p(s; a,0, )) = (a/2))

#()) s)"1e"as/2.

Density of Levy’s measure: f(y) = y"1)e"ay/2.

III. a > 0, b > 0, ) = 1: p(s; a, b,1) =

<a/b

2K1(-

ab)e"(as+b/s)/2

– PH – Positive Hyperbolic distribution, or H+-distribution.

I-29

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Since GIG-distribution is infinitely divisible, if one take it as the

distribution of squared volatility !2,

Law(!2) = GIG,

then one can construct a nonnegative nonincreasing Levy process

T = (T(t))t!0 (a subordinator) such that

Law(T(1)) = Law(!2) = GIG.

In the subsequent constructions, this process plays the role of

change of time, operational time,

business time.

As was explained above, the next step in construction of the return

process H = (Ht)t!0, consists in the following.

I-30

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Form the variable h = µ+%!2+!#, where Law(!2) = GIG, Law(#) =

N (0,1), !2 and # are independent. It is clear that

Law(h) = E!2N (µ + %!2, !2)

is a mixture of normal distributions, i.e., the density ph(x) of h is of

the form

ph(x) =5 %

0

1-

2-yexp

9

"(x " (µ + %y))2

2y

:

pGIG(y) dy.

Integrating and denoting ph(x) by p/(x; a, b, µ, %, )), we find that

p/(x; a, b, µ, %, )) = c3(a, b, %, ))K)"1/2

!$<

b + (x " µ)2"

!<b + (x " µ)2

"1/2")e%(x"µ) ,

where $ =<

a + %2 and c3(a, b, %, )) =(a/b))/2 $

12")

-2- K)(

-ab)

.

I-31

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The obtained distribution Law(h) with density p/(x; a, b, µ, %, )) bears

the name

Generalized Hyperbolic distribution, GH = GH(a, b, µ, %, ))).

In the case ) = 1 the graph of the function

log p/(x; a, b, µ, %,1) = log c/(a, b, %) " $<

b + (x " µ)2 + %(x " µ)

is a hyperbola with asymptotes $|x " µ| + %(x " µ).

This is why the distribution for h in the case ) = 1 is called

hyperbolic, which explains the name “generalized hyperbolic distribution”

in the case of arbitrary ).

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SOME PROPERTIES of GH-distribution (for h):

A*. This distribution is infinitely divisible.

B*. If % = 0, then the distribution is unimodal with mode m = µ.

(In the general case m is determined as a root

of a certain transcendental equation.)

C*. Laplace’s transform L/(() =5 %

0e(xp(x; a, b, µ, %, )) dx

(for complex ( such that |% + (| < $, $ =<

a + %2)

is given by

L/(() = e(µ0

a

$2 " (% + ()2

1)/2 K)(<

b[$2 " (% + ()2])

K)(-

ab).

I-33

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THREE important SPECIAL CASES of GH-distributions:

I*. a ! 0, b > 0, ) = "1/2: in this case

GIG(a, b,"1/2) = IG(a, b) is Inverse Gaussian distribution.

The corresponding GH-distribution is commonly named

Normal Inverse Gaussian

and denoted by N + IG. The density has the form

p/(x; a, b, µ, %,"12) =

$b

-e-

ab K1($<

b + (x"µ)2)<

b + (x"µ)2e%(x"µ) , x , R.

Laplace’s transform:

L/(() = exp7(µ +

-b(-

a "<

a " 2%( " (2)8.

I-34

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II*. a > 0, b = 0, ) > 0: in this case

GIG(a,0, )) = Gamma(a/2, )) – Gamma distribution.

The corresponding GH-distribution is named

Normal Gamma distribution

(notation: N + Gamma) or

VG-distribution

(notation: VG [Variance Gamma]). Density:

p/(x; a,0, µ, %, )) =a)

--#())(2$))"1/2

|x " µ|)"1/2

. K)"1/2($|x " µ|) e%(x"µ).

Laplace’s transform: L/(() = eµ((a/[a " 2%( " (2])).

I-35

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III*. a > 0, b > 0, ) = 1: in this case

GIG(a, b,1) = H+(a, b) – Positive hyperbolic distribution.

The corresponding GH-distribution for h is the hyperbolic distribution

H called also

“NORMAL positive hyperbolic distribution”

(notation: H or N + H+). Density:

p/(x; a, b, µ, %,1) =a

2b$K1(-

ab)exp

4"$

<b + (x " µ)2 + %(x " µ)

6,

where $ =<

a + %2.

I-36

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Having GIG-distributions for !2 and GH-distributions for h, we turnto construction of the Levy process H = (Ht)t!0 used in representationof the prices St = S0eHt, t ! 0.

TWO POSSIBILITIES! !

the fact that h has infinitely

divisible distribution allows

one to construct, using the

general theory, the Levy

process H/ = (H/t )t!0 such

that

Law(H/1) = Law(h)

using the already constructed

process T = (Tt)t!0, one forms the

process H = (Ht)t!0:

Ht = µt + %T(t) + BT(t),

where Brownian motion B and

process T are taken to be

independent.

The process H = (Ht)t!0 bears the name

L(GH) – “GENERALIZED hyperbolic Levy distribution”.

I-37

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In the cases I*, II*, and III* mentioned above the corresponding

Levy processes have the special names:

L(N + IG)-process,

L(N + H+)- or L(H)-process,

L(N + Gamma)- or L(VG)-process.

It is interesting to note that L(N+ IG)- and L(N+Gamma)-processes

have an important property:

Law(Ht) belongs to the same type of distributions as Law(H1)

(this follows immediately from the formulae for Laplace’s transforms).

I-38

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CONCLUDING NOTES.

Densities of distributions of h (= H1) are determined by FIVE

parameters (a, b, µ, %, )), that gives a great freedom in determining

parameters which would fit well the empirical data.

In this connection it is appropriate to recall that in statistics, there

exists a well-known method of “Pearson’s curves”, which is widely

used to construct (one-dimensional) densities of distributions upon

independent observations over a random variable +. K. Pearson itself

(1894) constructed such densities as solutions f(x) of the system

of nonlinear equations

f 2(x) =(x " a)f(x)

b0 + b1x + b2x2.

I-39

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These densities are determined by FOUR parameters (a, b0, b1, b2).

The density p/(x; a, b, µ, %, )) of GH-distributions of (constructively

built) variables h = µ+%!2+!# is determined by FIVE parameters.

(It is known that these densities lie between Pearson’s curves of

type III and type V.)

The essential advantage of GH-distributions consists in their

infinite divisibility

(this is not the case for distributions from the Pearson system),

which enables us to construct processes H = (Ht)t!0 which describe

adequately the time dynamics of logarithmic return of the prices

S = (St)t!0.

I-40

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TOPIC II. Technical Analysis. I

1. Kagi and Renko charts

2. Prediction of time of maximum value of prices

observable on time interval [0, T ]

3. Quickest detection of time of appearing of

arbitrage

4. Drawdowns as the characteristics of risk

II-1

Page 44: Shiryaev

The main motivation of this lecture is based on idea to obtain a

mathematical explanation of some practical methods (“when to buy,

when to sell”, etc.) of the Technical Analysis which have as usual

only a descriptive character.

As is well known, the “fundamentalists” are trying to explain

WHY the stock price moves;

they make their decisions by looking at the state of the “economy

at large”; they define a stock value and calculate proper stock prices

in view of its estimated future values; they build their analysis upon

the assumption that the actions of market operators are “rational”.

II-2

Page 45: Shiryaev

As to the “technicians” they concentrate on the local peculiarities

of the markets, they emphasize “mass behavior”, “market moods”;

they start their analysis from an idea that stock price movement

is “the product of supply and demand”; their basic concept is the

following: the analysis of past stock prices helps us to see future

prices because past prices take future prices into account; they try

to explain

HOW the stock prices move.

II-3

Page 46: Shiryaev

1. Kagi and Renko charts

Let X = (Xt)t!0 be a stock price.

The Japanese “Kagi chart” and “Renko chart” (also called the price

ranges) give methods to forecast price trends from price changes

which exceed either a certain range H or a certain rate H. The price

range or rate H is determined in advance. (In Japan, popular price

ranges are "5, 10, 20, 50, 100, 200.) Greater price ranges are used

for stocks with higher prices because their upward and downward

movements are larger.

II-4

Page 47: Shiryaev

R ) |X|, K ) maxX " X

RENKO construction: Step I: We construct (/&i):

/&0 = 0,

/&n+1 = inf7t > /&n : |Xt " X/&n

| = H8, n ! 1.

!

"

X

t

H

2H

3H

4H

!

/&0#

#$

!

/&1%%&

!

/&2 ##'

!

/&3((()

!

/&4*

*+

!

/&5##$

!

/&6 ,,-

!/&7,,-

!

/&8

!

/&9

II-5

Page 48: Shiryaev

Step II: Construction (/&n) ") (&m, &/m).

We look at all /&n such that!X/&n

" X/&n"1

"!X/&n"1

" X/&n"2

"< 0.

&/m"1

&m"1

&m

&/m t

X&m is a Markov time

&/m is a non-Markov time

II-6

Page 49: Shiryaev

KAGI construction: !0 = inf4u > 0 : max

[0,u]X " min

[0,u]X = H

6

!/0 =

@AAAB

AAAC

inf4u , [0, !0] : Xu = min

[0,!0]X6

if X!0 = max[0,!0]

X

inf4u , [0, !0] : Xu = max

[0,!0]X6

if X!0 = min[0,!0]

X

H H

!/0 !/

0!0 !0

tt

XX

II-7

Page 50: Shiryaev

Next step: we define by induction

!n+1 =

@AAAAB

AAAAC

inf4u > !n : max

[xn,u]X " Xu = H

6if X!n " X!/

n= H

inf4u > !n : max

[xn,u]X " Xu = H

6if X!n " X!/

n= "H

!/n+1 =

@AAAAB

AAAAC

inf4u , [!n, !n+1] : Xu = max

[!n,!n+1]X6

if X!n " X!/n= H

inf4u , [!n, !n+1] : Xu = min

[!n,!n+1]X6

if X!n " X!/n= "H

II-8

Page 51: Shiryaev

Kagi and Renko variation (on [0, T ]):

KT (X;H) =N#

n=1

|X!/n"X!/

n"1|, N =NT(X;H),

RT (X;H) =M#

n=1

|X&/n"X&/n"1|, M =MT(X;H).

Kagi and Renko volatilities (on [0, T ]):

kT (X;H) =KT (X;H)

MT(X;H),

rT (X;H) =RT (X;H)

MT(X;H).

II-9

Page 52: Shiryaev

THEOREM. If X = !B, then

1) kT (!B;H) & 2H,

NT &T!2

H2(P-a.s.),

KT = kTNTP&

2T!2

H2;

2) rT (!B;H)P& 2H,

MT &T!2

2H2(P-a.s.),

RT = rTMTP&

T!2

H.

II-10

Page 53: Shiryaev

Results of the statistical analysis

of some stock prices

X = (Xt)t!0 % Future on Index SP500 (Emini-SP500 Futures)

1 point = $ 50

2002-2003 (471 trading days)

" = 1 sec, Xt is the value of the last transaction at time t.

H 1 1.25 1.5 2 2.25 2.5 3 4rT(X;H)

H1.83 1.84 1.86 1.88 1.86 1.88 1.80 1.69

RENKO

H 1 1.25 1.5 2 2.25 2.5 3 4kT(X;H)

H1.83 1.85 1.85 1.89 1.91 1.93 1.92 1.87

KAGI

Almost the same results are valid for Futures on Index Nasdaq 100

(Emini-Nasdag100 Futures), 1 point = $ 20

II-11

Page 54: Shiryaev

0.5

1

1.5

2

2.5

3

0.75 1.25 1.75 2.25 2.75 3.25 3.75 4.251 1.5 2 2.5 3 3.5 4 4.5

Kagi

Renko

For EESR (United Energy System of

Russia)

rT (X;H)

H& 1.99 &

kT (X;H)

H.

II-12

Page 55: Shiryaev

Let us say that X-market has

r(H)-property if E rT (X;H) & r(H) · Hk(H)-property if E kT (X;H) & k(H) · H

(For a Brownian motion r(H) = k(H) = 2.)

II-13

Page 56: Shiryaev

Define Renko strategy .R = (.Rt )t!0 with

.Rt =

#

n!1

sgn!X&n"1 " X&/n"1

"I[&n"1,&/n"1)

(t)

.!I(k(H)!2) " I(k(H)<2)

", t ! 0,

and the corresponding capital

C.R

t =5 t

0.Ru dXu " (

5 t

0|d.R

u |.

Then

limt)%

EC.R

t

Mt= |r(H) " 2| · H " 2(.

The similar result is valid for the Kagi strategy .K = (.Kt )t!0.

II-14

Page 57: Shiryaev

&/m"1

&m"1

&m

&/m t

X

If R(H)>2, then

we buy at &m"2, &m, . . .

we sell at &m"1, &m+1, . . .

(33) (**)

If R(H)<2, then

we buy at &m"1, &m+1, . . .

we sell at &m"2, &m, . . .

(3*) (*3)

II-15

Page 58: Shiryaev

2. Prediction of time of maximum value of prices observable

on time interval [0, T ]

We would like to present now several our probability and statistical

approaches to solving some other problems of the technical analysis.

Problem. When to sell stock optimally?

We shall describe prices

by a Brownian motion

B = (Bt)0't'1; / is a

point of maximum of B:

B/ = max0't'1

Bt.

!

"..

...##/

/////0001

1111111110000**#

##*

*%%%%!

"

!

t

1'

/'

B/

II-16

Page 59: Shiryaev

Suppose that we begin to observe this process at time t = 0

(“morning time”), and, using only past observations, we stop at

time ' declaring “alarm” about selling. It is very natural to try to

solve the following problem: to find “optimal” times '/ and '// such

that either

inf0'''1

E |B/ " B' |2 = E |B/ " B'/|2

orinf

0'''1E |/ " ' | = E |/ " '//|.

For us it was a little bit surprising that here the optimal stopping

times coincide: '// = '/. The solution shows that

'/ = inf4t ' 1 : max

s'tBs " Bt ! z/

-1 " t

6,

where z/ is a certain (known) constant (z/ = 1.12 . . .).

II-17

Page 60: Shiryaev

This problem belongs to the theory of optimal stopping and methodof its solution is based on reducing to the special free-boundaryproblem.

1

1

τ

t z*√1- t

t*

It is interesting to note that

E '/ = 0.55 . . . , D'/ = 0.05 . . . .II-18

Page 61: Shiryaev

The cases Bµt = µt + Bt instead of Bt are more complicated.

If µ > 0 and µ is away from 0, then

'/ = inf{t ' 1 : b1(t) ' Sµt " Bµ

t ' b2(t)}

where • Bµt = µt + Bt, Sµ

t = maxu't Bµu,

• b1(t) and b2(t) have the following form:

b1

D

γ1

T0

b2

γ2

C

t*u*

C

#Here C is

the area of

continuation of

observations, D

is the stopping

area.$

II-19

Page 62: Shiryaev

If µ > 0 and µ is close to 0, then the corresponding picture has the

following form:

γ1

b2

γ2

C

u*

C

b1

D

T0

C

s*

C

II-20

Page 63: Shiryaev

For µ < 0 and if µ is far from 0, the picture is as follows:

T

b1C

D

γ1

0

C

II-21

Page 64: Shiryaev

In the considered problem, the time / is a “change point” of the

changing of the directions of trend

t1/

Bt

Solution of the problem

“ inf'

E |B' " B/|2 ”

or the problem “ inf' E |'"/|”depends, of course, on the

construction at any time t

a “good” prediction of the

change point /. The natural

estimate of / should be

based on the a posteriori

probability -t = P(/ ' t | FBt ), where FB

t = !(Bs, s ' t).

II-22

Page 65: Shiryaev

Stochastic analysis shows that

-t = 2,

>St " Bt-

1 " t

?

" 1, St = maxu't

Bu,

that explains appearing of the expression

St " Bt-1 " t

which is involved above in the definition of optimal stopping time

'/ = inf

9

t ' 1 :St " Bt-

1 " t! z/

:

.

Statistics St " Bt is appearing in many problems of the financial

mathematics and financial engineering (and, generally, in the mathematical

statistics under name CUSUM statistics).

Now we are going to tackle the following problem, which is interesting,

e.g., from the point of view of the quickest detection of arbitrage.

II-23

Page 66: Shiryaev

3. Quickest detection of time of appearing of arbitrage

Problem. Suppose we observe the prices

Xt = r(t"/)++!Bt

or

dXt =

@B

C! dBt, t ' /,

r dt + ! dBt, t > /./

Here a “change point” / is considered as a time of appearing of

arbitrage. (Brownian motion’s prices correspond to the non-arbitrage

situation. Brownian motion with drift corresponds to a case of

arbitrage.)

One very di&cult question here is “what is /?”. There are two

approaches. In the first one we assume that / is a random variable.

II-24

Page 67: Shiryaev

Suppose that ' is time of “alarm” /. Consider two events

{' < /} and {' ! /}.The set {' < /} is the event of a false alarm with a (false alarm)probability P(' < /).

# # #

'

/

'

{'</}& '$ %

$ %& '{'!/}

From a financial point of view

an interesting characteristic of

the event {' ! /} is a delay

time E('"/ | ' ! /) or E('"/)+.

These considerations lead to the following problem: in the classM$ = {' : P(' < /) ' $}, i.e., in the class of stopping times withthe probability of false alarm P(' < /) which less or equal the fixedlevel $, one need to find optimal stopping '/$ , M$ such that

inf',M$

E(' " /)+ = E('/$ " /)+.

II-25

Page 68: Shiryaev

It turned out that it is not a simple problem if we consider anarbitrary distribution for /. However, there exists one case when wemay solve this problem in implicit form. This case is the following.

Assume that / has the exponential distribution:

P(/ = 0) = - and P(/ > t | / > 0) = e"(t,

where ( is a given positive constant and - , [0,1). This assumptionis very reasonable. Indeed, for A < a < b < B

lim()0

P

!/ , (a, b) | / , (A, B)

"=

|b " a||B " A|

.

It means that in limit (( ) 0) the conditional distribution of / isuniform, that is, in some sense the worst possible case from pointof view of uncertainty of time of appearing of a change point /.

We describe now the results about structure of the optimal stoppingtime '/$.

II-26

Page 69: Shiryaev

Denote -t = P(/ ' t | FXt ), where FX

t = !(Xs, s ' t). This process

satisfies the following nonlinear stochastic di!erential equation:

d-t =D( "

r2

!2-2

t

E(1 " -t) dt +

r

!2-t(1 " -t) dX'

with -0 = -.

Then it turns out that an optimal stopping time '/$ is given by

'/$ = inf{t : -t ! B/$},

where (for case - = 0, for simplicity)

B/$ = 1 " $.

Second formulation of the quickest detection of arbitrage assumes

that / is simply a parameter from [0,%). In this case we denote by

P/ the distribution of the process X under the assumption that a

change point is occurred at time /.

II-27

Page 70: Shiryaev

By P% we denote the distribution of X under assumption that thereis no change point at all. Denote for given T > 0

MT = {' : E% ' ' T}the class of stopping time for which the mean time E% ' before(false) alarm is less or equal to T .

Put also

C(T) = inf',MT

sup/

ess sup*

E/

((' " /)+ | F/

)(*).

We proved that for each T > 0 in the class MT there exists anoptimal strategy with the following structure: declare alarm at time

'/T = inf4t : max

u'tXu " Xt ! a/(T)

6,

where a/(T) is a certain constant. It is interesting to note that (ifr2/(2!2) = 1)

C(T) & logT, T ) %.

II-28

Page 71: Shiryaev

The given method, based on the

“CUSUM statistics maxX " X”,

also is asymptotically optimal for more tractable criteria

D(T) = inf',MT

sup/

E/(' " / | ' ! /)

(We don’t know what is an optimal method for D(T)-criterion.)

Asymptotically, again

D(T) & logT, T ) %.

II-29

Page 72: Shiryaev

4. Drawdowns as the characteristics of risk

From given above exposition we observe importance of the “maxX"X”-characteristics for taking optimal decisions. Now we would like to

discuss that statistics and related ones in the problems of measure

of risk. There is a special terminology for such an object which

related to words “drawdown”, or “downfall”.

In practice a “drawdown” on time interval [0, t] is defined as the

percent change in a manager’s net asset value

– from any newly established peak to

a subsequent through,

– from a high “water mark” to the next

low “water mark”.

II-30

Page 73: Shiryaev

From the theoretical point of view,

Drawdown is a statistical measure of risk for investments; a

competitor to the standard measure of risk such

as return probability, VaR, Sharpe ration, etc.

There are various definitions of drawdown’s characteristics, whichmeasure the decline in net asset value from the historic high point.

In one financial paper we read that

. . . Measuring risk through extreme losses is a very

appealing idea. This is indeed how financial companies

perceive risks. This explains the popularity of loss

statistics as the maximum drawdown and maximum

loss. . .

and

. . . it does not seem possible to derive exact results for

the expected maximum drawdown.

II-31

Page 74: Shiryaev

Looking forward:

• What kinds of drawdowns should we expect over any given investment

horizon?

• How many drawdowns should be experienced?

• How big?

Under the

Commodity Futures Trading Commission’s

(CFTC)

mandatory disclosure regime managed futures advisors are obliged

to disclose, as part of their capsule performance records, their

“worst peak-to-valley drawdown”.

We shall demonstrate here some our theoretical calculations related

to drawdowns.II-32

Page 75: Shiryaev

Let Bµt = µt + !Wt be a Brownian motion with drift, W0 = 0.

There are several interesting characteristics related to

!

"

!

2

maxs't

Bµs

TµH

H

Range:

Rµt = max

s'tBµ

s " mins't

Bµs

Statistics T µH for Bµ:

TµH = inf

4t ! 0 : max

s'tBµ

s " Bµt ! H

6

Range,

Drawdowns,

Downfalls,. . .

II-33

Page 76: Shiryaev

If µ = 0:

E T0H =

>H

!

?2

, E maxt'T0

H

B0t = H,

DT0H =

2

3

>H

!

?4

, E e"(T0H =

1

cosh

>H

!

-2(

?

.

If µ 4= 0:

E TµH =

!2

2µ2

-

exp42µ

!2H6" 1 "

!2H

.

,

E maxt'Tµ

H

Bµt =

!2

-

exp42µ

!2H6" 1

.

.

II-34

Page 77: Shiryaev

Towards a problem from Kolmogorov’s diary (1944):

...For free (or not) random walk: How Xt drops when Xt falls for

the first time (on (t " ", t)) from above to some level +? To all

appearance, certainly very steeply!..

!

"

'(H)

H

0T

!

B(H)t = H + Bt, B(H)

0 = H, Bt = B0t

'(H) = inf{u : B(H)u = 0}

F(t) = P

!'(H) ' t | mins'T Bs ' 0

"

f(t) =dF(t)

dt

=H-

T

2G(H/-

T )t"3/2e"H2/2t, t ' T,

G(x) =5 %

xe"u2/2 du

II-35

Page 78: Shiryaev

The following three characteristics of drawdowns are the most important:

1 Maximumdrawdown

") Dt = max0's's2't

(Bs " Bs2)

(cf. Rt = max0's,s2't(Bs " Bs2); so Dt ' Rt).

"

!

t

B

Dt

II-36

Page 79: Shiryaev

2

Drawdown fromhigh “watermark” to thenext low “watermark”

")Dt = B!t " min

!t's2'tBs2

= max0's't

Bs " min!t's2't

Bs2

(where !t = inf{s ' t : Bs = maxu't

Bu}.

II-37

Page 80: Shiryaev

3

Drawdown fromprevious high“water mark”to the lowest“water mark”

") Dt = max0's'!2

t

Bs " B!2t

(where !2t = inf{s ' t : Bs = minu't Bu}.

"

!

!2t t

B

Dt

II-38

Page 81: Shiryaev

General results on D, D, D for B:

(1) Dt = Dt

(2) Dt = max(Dt, Dt)

(3) Dtlaw= max

s't|Bs|

(4) Dtlaw= max

gt's't|Bs|

where gt = sup{s ' t : Bs = 0}.

II-39

Page 82: Shiryaev

Distributional results on D1, D1 for a standard Brownian motion

B = B":

(5) P(D1'x) = P

Dmaxs'1

|Bs|'xE

=4

-

%#

n=0

("1)n

2n+1exp

4"

-2(2n+1)2

8x2

6

E D1 = Emaxs'1

|Bs| =<

-2 = 1.2533 . . .

E Dt = !-

t<

-2 (for !B+ on [0, t])

(6) P(D1 ' x) = P

Dmax

g1's'1|Bs| ' x

E= FD1

(x)

fD1(x) =

dFD1(x)

dx=<

8-

%#

k=1

("1)k"1ke"12k2x2

E D1 =<

8- log 2 = 1.1061

II-40

Page 83: Shiryaev

Note that

fR1(x) =

8-2-

%#

k=1

("1)k"1k2e"k2x2/2, x > 0,

FK1(x) = P

Dmaxs'1

|bs| ' xE,

fK1(x) =

dFK1(x)

dx= 8x

%#

k=1

("1)k"1k2e"k2x2,

where b = (bs)s'1 is a Brownian bridge (bs = Bs " sB1).

Since fR1(x) =

<2-

1x fK1

(x), we have E R1 =<

8- = 1.5957 . . . and

E D1 ' E D1 ' E R1=8

-log 2 '

3-

2'

=8

-1.1061 . . . ' 1.2533 . . . ' 1.5957 . . .

II-41

Page 84: Shiryaev

LEMMA.

(1) Dtlaw= Dt

(2) Dt =

@B

CDt = Dt on {!t ' !2

t}

max(Dt, Dt) on {!t > !2t}

(3) max(Dt, Dt) = Dt ' Rt

Known results about Rt and Td

R = R1: t = 1, µ = 0, ! = 1

W. Feller (1951) got for fR(x) =dP(R ' x)

dx, x > 0, the following

formula:

fR(x) =8-2-

%#

k=1

("1)k"1k2e"k2x2

2 .

II-42

Page 85: Shiryaev

REMARK. If b(t) = Bt " tB1, t ' 1, is a Brownian bridge, then forKolmogorov’s distribution FK(x) = P

!supt'1

|b(t)| ' x"

we have

FK(x) = 1 " 2%#

k=1

("1)k"1e"2k2x2=

-2-

x

%#

k=1

e"(2k"1)2-2/x2

5 (/-function)

fK(x) = 8x%#

k=1

("1)k"1k2e"2k2x2.

Since fR(x) =8-2-

%#

k=1

("1)k"1k2e"k2x2

2 , we get

fR(x) =

=2

-

1

xfK(x),

so

E R =

=8

-(= 1.5957691216 . . .)

II-43

Page 86: Shiryaev

THEOREM. (t = 1, µ = 0, ! = 1)

(a) D1law= max

0't'1|Bt|

(b) If FD1(x) = P(D1 ' x) then (it is well known)

FD1(x) = 1 "

1-2-

%#

k="%

5 x

"x

0e"

(y+4kx)2

2 " e"(y+2x+4kx)2

2

1dy

=4

-

%#

n=0

("1)n

2n + 1e"-2(2n+1)2

8x2

(c) E D1 = E max0't'1

|Bt| =<

-2

(E DT = !-

T<

-2)

II-44

Page 87: Shiryaev

Proof. (a): Denote

Mt = maxs't

Bs, Lt = lim#*0

1

2#

t5

0

I(|Bs| ' #) ds.

By Levy’s theorem

(Mt " Bt, Mt; t ' 1)law= (|Bt|, Lt; t ' 1).

Hence

D1 = max0's's2'1

(Bs"Bs2) = max0's2'1

!max

0's's2Bs " Bs2

"

= max0's2'1

(Ms2 " Bs2)law= max

0't'1|Bt|.

II-45

Page 88: Shiryaev

Proof. (c): We give two proofs. Let % = (%t)t!0 be a Brownian

motion. From self-similarity

(%at; t ! 0)law= (a1/2%t; t ! 0).

So if s1 = inf{t ! 0 : |%t| = 1}, then

P!

sup0't'1

|%t| ' x"= P

!supt'1

|%t/x2| ' 1"= P

!sup

t'1/x2|%t| ' 1

"

= P

Ds1 !

1

x2

E= P

D1

-s1

' xE,

i.e.,

supt'1

|%t|law=

1-

s1.

II-46

Page 89: Shiryaev

The normal distribution property=

2

-

%5

0

e" x2

2!2 dx = !

5

E D = E sup0't'1

|%t| = E1

-s1

=

=2

-

%5

0

E e"x2s12 dx

II-47

Page 90: Shiryaev

We have E e"(s1 =1

cosh-

2(. Hence

E D =

=2

-

5 %

0

dx

coshx= 2

=2

-

%5

0

ex dx

e2x + 1

= 2

=2

-

%5

1

dy

1 + y2= 2

=2

-arctan(x)

FFFFF

%

1

= 2

=2

-

-

4=3

-

20 E D =

3-

2

II-48

Page 91: Shiryaev

Second proof of the equality E D =3

-

2is based on the fact that

supt'1

|%t|law=

1

2

5 1

0

du

R(2)u

,

where R(2)s is a Bessel-2:

R(2)s = G%s +

1

2

5 s

0

du

R(2)u

.

Thus,

E D = E sup |%t| = E R(2)1 = E

<+21 + +22 =

3-

2,

+166 +2, +i & N (0,1).

II-49

Page 92: Shiryaev

THEOREM. (t = 1, µ = 0, ! = 1, D1 = B!1 " min!1's2'1 Bs2)

(a) D1law= sup

g1's'1|Bs|, where g1 = sup{t ' 1 : Bt = 0}.

(b) fD1

(x) =

=8

-

%#

k=1

("1)k"1ke"k2x2

2 , x > 0.

(c) E D1 =

=8

-log 2 (= 1.1061 . . .),

E D1 ' E D1 ' E R

<8- log 2 '

<-2 '

<8-

1.1061... ' 1.2533... ' 1.5957...

II-50

Page 93: Shiryaev

Proof: By Levy’s theorem

>Mt " Bt, Mt, Bt;

t ' 1

?law=

>|Bt|, Lt, Lt " |Bt|;t ' 1

?

5>

Mt " Bt, Mt, Bt;

!1 ' t ' 1

?law=

>|Bt|, Lt, Lt " |Bt|;

g1 ' t ' 1

?

where !1 = min7s ' 1 : Bs = max

u'1Bu

8.

II-51

Page 94: Shiryaev

Therefore!B!1, max

!1't'1(Mt " Bt " Mt)

"

law=

!Lg1 " |Bg1|, max

g1't'1(|Bt|" Lt)

"

=!Lg1, max

g1't'1|Bt|" Lg1

"

(since Bg1 = 0 and Lt = Lg1 for g1 ' t ' 1).

Finally,

D1 = B!1 " min!1't'1

Bt = B!1 + max!1't'1

("Bt)

= B!1 + max!1't'1

(Mt " Bt " Mt)

law= Lg1 + max

g1't'1|Bt|" Lg1 = max

g1't'1|Bt|.

II-52

Page 95: Shiryaev

TOPIC III. Technical Analysis. II

1. Buy and Hold

2. Stochastic Buy an Hold

(rebalancing of the portfolio)

III-1-1

Page 96: Shiryaev

TOPIC III. 1: BUY & HOLD

Consider (B, S)-market. For example: dB = rB dt

dS = S(µ dt + ! dWt)

Pt =St

Bt, MT = max

t'TPt, mT = min

t'TPt.

PROBLEMS:

Buying: (1) inf''T

E UD

S'

MT

E

(2) inf''T

E UD

S'

mT

E

Selling: (1) sup''T

E UD

S'

MT

E

(2) sup''T

E UD

S'

mT

E

where U = U(x) is a “utility function”.

III-1-2

Page 97: Shiryaev

Interesting cases: U(x) = x, U(x) = log x

For U(x) = x :

(1): inf''T

EUD

S'

MT

E& sup

''TEU

DMT " S'

MT

E

3Maximization of the expected relative

error between the buying price and the

highest possible stock price by choosing

a proper time to buy

(2): Maximization of the expected relative error between

the buying price and the lowest possible stock price

III-1-3

Page 98: Shiryaev

For U(x) = log x :

E logP'

MT= E logP' " E logMT, E log

P'/TMT

= E logP'/T" E logMT.

Take Pt = exp4D

µ " r "!2

2

Et + !Wt

6. Then

E logP' = E

0Dµ " r "

!2

2

E' + !W'

1,

sup''T

E logP' = sup''T

E

0Dµ " r "

!2

2

E' + !W'

1

= sup''T

E

0Dµ " r "

!2

2

E'1.

Thus, '/T =

@B

C0, µ " r " !2/2 ' 0,

T, µ " r " !2/2 > 0.(#)

III-1-4

Page 99: Shiryaev

Problem (1) for U(x) = x is more di&cult.

However, it is remarkable that answer is the same:

sup''T

EP'

MT= E

P'/TMT

, where '/T is given by (#).

The first step of solving the nonstandard problem sup''T

EP'

MTis its

reduction to the standard problem of the type

V = sup''T

EG(X')

for some Markov process X and Markov time ' (with respect to

(FXt )t!0, FX

t = !(Xs, s ' t)).

III-1-5

Page 100: Shiryaev

Taking E( · | F'), F' = FS' , where FS

t = !(Su, u ' t), we find

EP'

MT= E E

DP'

MT

FFFF F'

E= EG(', M)

' " W )' ),

where

) = µ " r " !2/2, W )t = )t + !Wt, M)

t = max0'u't

Wu,

G(t, x) = E(e"x 7 e"M)

T"t), t , [0, T ], x , [0,%).

For a given ), the process Xt = M)t " W )

t is a Markov process.

III-1-6

Page 101: Shiryaev

So the problem sup!$T

E(P!/MT ) is reduced to sup!$T

EG(!, X! ).

For G(t, x) we can find explicit expressions:

G(t, x) =2() " 1)

2) " 1e"()"1/2)(T"t)$

D"x + () " 1)(T " t)-T " t

E

+1

2) " 1e"(1"2))x$

D"x " )(T " t)-T " t

E

+ e"x$D

x " )(T " t)-T " t

E, if " %=

1

2,

G(t, x) =D1 + x +

T " t

2

E$D"x " (T " t)/2-

T " t

E

"=

T " t

2-exp

4"

(x + (T " t)/2)2

2(T " t)

6

+ e"x$D

x " (T " t)/2-T " t

E, if " =

1

2.

III-1-7

Page 102: Shiryaev

Solution of the problem “supt$T EG(!, X! )”:

By dynamic programming methods we must find for 0 ' t ' T

and x , [0,%)

V (t, x) = sup''T"t

ExG(t + ', Xxt+'), where Xx

t = x 7 M)t " W )

t .

It is clear that V (0,0) = sup''T E(P'/MT).

Introduce the sets

D =7(t, x) , [0, T ] . [0,%): V (t, x) = G(t, x)

8,

C =7(t, x) , [0, T) . [0,%): V (t, x) > G(t, x)

8;

the set D is a set of stopping observation and

the set C is a continuation area.

III-1-8

Page 103: Shiryaev

To find V = V (t, x) and sets C and D we usually consider the Stefan

(free-boundary) problem: to find GV = GV (t, x), GC, and HD such that

Lx GV (t, x) = 0, (t, x) , GC, GV (t, x) = G(t, x), (t, x) , HD,

where Lx is the infinitesimal operator of the process Xx = (Xxt )t!0,

x ! 0. We know that

Law(Xxt , t ' T) = Law(|Y x

t |, t ' T),

where Y x is a “bang-bang” process:

dY xt = ") sgnY x

t dt + dIWt, Y x0 = x.

III-1-9

Page 104: Shiryaev

By the Tanaka formula

|Y xt | = |x|+

5 t

0sgnY x

s dY xs +Lt(Y

x) = |x|")t+5 t

0sgnY x

s dIWs+Lt(Yx),

where Lt(Y x) is the local time of Y x at zero over time interval [0, t].

Since Law(Xu) = Law(|Y x|), from the previous formula we find that

Lxf(t, x) =0f

0t" )

0f

0x+

1

2

02f

0x2, t , (0, T), x , (0,%),

for f , C1,2 with reflection condition0f

0x(t,0+) = 0.

Free-boundary method can be applied here. However, it is more

convenient to use the following “direct” method.

III-1-10

Page 105: Shiryaev

If G(t, x) , C1,2, then, by the Ito formula,

G(t + s, |Y xs |) = G(t, s) +

5 s

0LxG(t + u, |Y x

u |) du

+5 s

0

0G

0x(t + u, |Y x

u |) dIWu

$ %& 'is a martingale,

where "1 ' 0G0x ' 0

+5 s

0

0G

0x(t + u, |Y x

u |) dLu(Yx)

$ %& '= 0,

since 0f0x(t,0+) = 0

.

So, V (t, x) = sup''T"t

ExG(t + ', Xx' ) = sup

''T"tExG(t + ', |Y x

' |)

= G(t, x) + sup''T"t

Ex

5 '

0H(t + u, |Y x

u |) du

= G(t, x) + sup''T"t

Ex

5 '

0H(t + u, Xx

u) du,

where H(t, x) 1 LxG(t, x) =0G

0t" )

0G

0x+

1

2

02G

0x2.

III-1-11

Page 106: Shiryaev

From explicit formulae for G = G(t, x) we find that

H(t, x) =D) "

1

2

EG(t, x) "

0G

0x(t, x).

If ) ! 1/2, then 0G/0x ' 0 and H(t, x) ! 0.

From V (t, x) = G(t, x)+ sup''T"t

Ex

5 '

0H(t+u, Xx

u) du we conclude that

if ) ! 1/2, then V (t, x) ! G(t, x)

if ) > 1/2, then V (t, x) > G(t, x).

III-1-12

Page 107: Shiryaev

As a result we see that

if " > 1/2, then the optimal !#T equals T ;

if " = 1/2, then any time !#T = t is optimal.

For " < &1/2 we find that

H(t, x) =D) +

1

2

EG(t, x) "

DG(t, x) +

0G

0x(t, x)

$ %& '> 0

E.

So, in this case V (t, x) ' G(t, x). From here we conclude that

if " < &1/2, then the optimal !#T equals zero

The case &1/2 < " < 1/2 is more complicated and can be investigatedby the “free-boundary methods”.

III-1-13

Page 108: Shiryaev

So, we have the following result:

the optimal stopping time !#T is DETERMINISTIC:

!#T =

@B

C0, if ) 1 µ " r " !2/2 ' 0,

T, if ) 1 µ " r " !2/2 > 0.

III-1-14

Page 109: Shiryaev

POPULAR STOCK MODELS IN FINANCE:

St = S0eµ(t)+!(t)Bt (exponential Brownian model);

St = S0eµ(t)+; t0 !(s)dBs (stochastic volatility model);

St = S0eµ(t)+BT (t) (change-of-time model).

Instead of bT we can take a Levy process Lt.

The similar model can be considered for case of discrete time.

III-1-15

Page 110: Shiryaev

For example, let’s take Gaussian-Inverse Gaussian process

Ht = µt + %T(t) + BT(t) ,

where T(t) = inf{s > 0: /Bs +-

as !-

bt},( /Bs) and (Bs) are independent Brownian motions.

For case

sup''T

ESt

MT, St = eHt, MT = exp

4supt'T

Ht

6

we find that

if µ ' 0, # ' 0, then the optimal stopping time is !#T = T

III-1-16

Page 111: Shiryaev

TOPIC III. 2: STOCHASTIC “BUY & HOLD”

(PORTFOLIO REBALANCING)

III-2-1

Page 112: Shiryaev

TOPIC IV. General Theory of Optimal Stopping

Lecture 1. Introduction, pp. 2–46.

Lectures 2-3. Theory of optimal stopping for discrete time

(finite and infinite horizons)

A) Martingale approach B) Markovian approach

(pp. 47–85) (pp. 86–104)

Lectures 4-5. Theory of optimal stopping for continuous time

(finite and infinite horizons)

A) Martingale approach B) Markovian approach

(pp. 105–119) (pp. 120–146)

Essential references p. 147.

IV-1-1

Page 113: Shiryaev

Lecture 1. INTRODUCTION.

1. Connections of the Optimal stopping theory and the Mathematical

analysis (especially PDE-theory) are as well illustrated by the

Dirichlet problem for the Laplace equation:

to find a harmonic function u = u(x) in the class C2 in the

bounded open domain C 8 Rd, i.e., to find a function u , C2

that satisfies the equation

"u = 0, x , C, (/)

and the boundary condition

u(x) = G(x), x , 0D, where D = Rd \ C. (//)

IV-1-2

Page 114: Shiryaev

Let

'D = inf{t : Bxt , D},

where

Bxt = x + Bt

and B = (Bt)t!0 is a d-dimensional standard Brownian motion.

Then the probabilistic solution of the Dirichlet problem

"u = 0, x , C,

u(x) = G(x), x , 0D,

is given by the formula

u(x) = EG(Bx'D

), x , C 9 0DDu(x) = ExG(B'D)

E.

IV-1-3

Page 115: Shiryaev

The optimal stopping theory operates with the optimization

problems, where

• we have a set of domains C =7C : C 8 Rd

8and

• we want to find the function

U(x) = sup'D

ExG(B'D) , where G = G(x) is given for all x , Rd,

D , D =JD = C : C , C

K

or, generally, to find the function

V (x) = sup'

ExG(B') , where ' is an arbitrary finite

stopping time defined by the

process B.

IV-1-4

Page 116: Shiryaev

2. The following scheme illustrates the kind of concrete problems

of general interest that will be studied in the courses of lectures:

A. Theory of probability

sharp inequalities

B. Mathematical statistics

sequential analysis

C. Financial mathematics

stochastic equilibria

The solution method for problems A, B, C consists in reformulation

to an optimal stopping problem and reduction to a free-boundary

problem as stated in the diagram:

IV-1-5

Page 117: Shiryaev

A, B, C

!#

"$

!"#$1 !"

#$4

Optimal stopping problems

!#

"$

!"#$2 !"

#$3

Free-boundary problems

IV-1-6

Page 118: Shiryaev

3. To get some idea of the character of problems A, B, C that will

be studied, let us begin with the following remarks.

(A) Let B = (Bt)t!0 be a standard Brownian motion. Then

Wald identities:EBT = 0 and EB' = 0 if E

-' < %

EB2T = T and EB2

' = E' if E' < %

From Jensen’s inequality and E|B' |2 = E' we get

E|B' |p ' (E')p/2 for 0 < p ' 2

E|B' |p ! (E')p/2 for 2 ' p < %

B. Davis (1976): E|B' | ' z/1E-

' , z/1 = 1.30693 . . .

IV-1-7

Page 119: Shiryaev

Now our main interest relates with the estimation of the expectations

Emaxt''

Bt and Emaxt''

|Bt|.

We have

maxBlaw= |B|.

So,

Emaxt'T

Bt = E|BT | =

=2

-T

and

Emaxt''

Bt = E|B' | '

@B

C

-E' ,

z/1E-

' , z/1 = 1.30993 . . .

IV-1-8

Page 120: Shiryaev

The case of max |B| is more di&cult. We know that

P

>

maxt'T

|Bt| ' x

?

=4

-

%#

n=0

("1)n

2n + 1exp

>

"-2(2n + 1)2

8x2

?

.

From here it is possible to obtain (but it is not easy!) that

Emaxt'T

|Bt| =3

-

2T

!= 1.25331 . . .

".

(Recall that E|BT | =<

2-T (= 0.79788 . . .).)

IV-1-9

Page 121: Shiryaev

SIMPLE PROOF:

(Bat; t ! 0)law= (

-aBt; t ! 0).

Take ! = inf {t > 0 : |Bt| = 1}. Then

P

Dsup

0't'1|Bt| ' x

E= P

Dsup

0't'1|Bt/x2| ' 1

E

= P

Dsup

0't'1/x2|Bt| ' 1

E= P

D! !

1

x2

E= P

>1-

!' x

?

,

that is,

sup0't'1

|Bt|law=

1-

!

IV-1-10

Page 122: Shiryaev

The normal distribution property:

=2

-

5 %

0Ee

" x2

2a2 dx = a , a > 0. (#)

So,

E sup0't'1

|Bt| = E1-

!

(#)=

=2

-

5 %

0Ee

"x2!2 dx.

Since Ee"(! = 1cosh

-2(

, we get

E sup0't'1

|Bt| =

=2

-

5 %

0

dx

coshx= 2

=2

-

5 %

0

ex dx

e2x + 1=

=2

-

5 %

1

dy

1 + y2

= 2

=2

-arctan(x)

FFFFF

%

1

= 2

=2

-·-

4=

3-

2.

IV-1-11

Page 123: Shiryaev

E sup0't'1

|Bt| =3

-

2E sup

0't'T|Bt| =

3-

2T

In connection with MAX the following can be interesting. In his

speech delivered in 1856 before a grand meeting at the St.-Petersburg

University the great mathematician

P. L. Chebyshev (1821–1894)

has formulated some statements about the “unity of theory and

practice”. In particular he emphasized that

“a large portion of the practical questions can be stated in the

form of problems of MAXIMUM and MINIMUM... Only the

solution of these problems can satisfy the requests of practice

which is always in search of the best and the most e&cient.”

IV-1-12

Page 124: Shiryaev

4. Suppose that instead of maxt'T |Bt|, where, as already known,

E max0' t'T

|Bt| =3

-

2T ,

we have some random time ' and we want to find

E max0' t' !

|Bt| = ?

It is clear that it is virtually impossible

• to compute this expectation for every stopping time ' of B.

Thus, as the second best thing, one can try

• to bound it with a quantity which is easier computed.

A natural candidate for the latter is E' at least when finite.

In this way a PROBLEM A has appeared.

IV-1-13

Page 125: Shiryaev

Problem A leads to the following maximal inequality:

E

Dmax0't''

|Bt|E' C

-E' (3)

which is valid for all stopping times ' of B with the best constant

C equal to-

2.

We will see that the problem A can be solved in the form (3) by

REFORMULATION to the following optimal stopping problem:

V/ = sup'

E

Dmax0't''

|Bt|" c'E

, (4)

where

• the supremum is taken over all stopping times ' of B

satisfying E' < %, and

• the constant c > 0 is given and fixed.

It constitutes Step 1 in the diagram above.

IV-1-14

Page 126: Shiryaev

If V/ = V/(c) can be computed, then from (4) we get

E

Dmax0't''

|Bt|E' V/(c) + c E' (5)

for all stopping times ' of B and all c > 0. Hence we find

E

Dmax0't''

|Bt|E' inf

c>0

!V/(c) + c E'

". (6)

for all stopping times ' of B. The RHS in (6) defines a function of

E' that, in view of (4), provides a sharp bound of the LHS.

Our lectures demonstrate that the

optimal stopping

problem (4)can be reduced to a

free-boundary

problem

This constitutes Step 2 in the diagram above.

IV-1-15

Page 127: Shiryaev

Solving the free-boundary problem one finds that V/(c) = 1/2c.

Inserting this into (6) yields

infc>0

E

!V/(c) + c E'

"=

-2 E' (7)

so that the inequality (6) reads as follows:

E

Dmax0't''

|Bt|E'

-2 E' (8)

for all stopping times ' of B.

This is exactly the inequality (3) above with C =-

2.

The constant-

2 is the best possible in (8).

IV-1-16

Page 128: Shiryaev

In the lectures we consider similar sharp inequalities for other stochastic

processes using ramifications of the method just exposed.

Apart from being able to

• derive sharp versions of known inequalities

the method can also be used to

• derive some new inequalities.

IV-1-17

Page 129: Shiryaev

(B) Classic examples of problems in SEQUENTIAL ANALYSIS:

• WALD’s problem (“Sequential analysis”, 1947) of sequential

testing of two statistical hypotheses

H0 : µ = µ0 and H1 : µ = µ1 (9)

about the drift parameter µ , R of the observed process

Xt = µt + Bt , t ! 0, where B = (Bt)t!0 is

a standard Brownian

motion.

(10)

• The problem of sequential testing of two statistical hypotheses

H0 : ( = (0 and H1 : ( = (1 (11)

IV-1-18

Page 130: Shiryaev

about the intensity parameter ( > 0 of the observed process

Xt = N(t , t ! 0, where N = (Nt)t!0 is a

standard Poisson process.

(12)

Page 131: Shiryaev

The basic problem in both cases seeks to find the

optimal decision rule ('/, d/)

in the class "($, %) consisting of decision rules

(d, '), where ' is the time of stopping and

accepting H1 if d = d1 or

accepting H0 if d = d0,

such that the probability errors of the first and second kind satisfy:

P(accept H1 | true H0) ' $ (13)

P(accept H0 | true H1) ' % (14)

and the mean times of observation E0' and E1' are as small as

possible.

It is assumed that $ > 0 and % > 0 with $ + % < 1.

IV-1-19

Page 132: Shiryaev

It turns out that with this (variational) problem

one may associate an optimal stopping (Bayesian) problem

which in turn can be reduced to a free-boundary problem .

This constitutes Steps 1 and 2 in the diagram above.

Solving the free-boundary problem leads to an optimal decision rule

('/, d/) in the class "($, %) satisfying (13) and (14) as well as the

following two identities:

E0' = inf(',d)

E0' (15)

E1' = inf(',d)

E1' (16)

where the infimum is taken over all decision rules (', d) in "($, %).

This constitutes Steps 3 and 4 in the diagram above.

IV-1-20

Page 133: Shiryaev

In our lectures we study these as well as closely related problems of

QUICKEST DETECTION.

(The story of creating of the quickest detection problem of randomly

appearing signal, its mathematical formulation, and the route of

solving the problem (1961) are also interesting.)

Two of the prime findings, which also reflect the historical development

of these ideas, are the

principles of SMOOTH and CONTINUOUS FIT

respectively.

IV-1-21

Page 134: Shiryaev

C) One of the best-known specific problems of

MATHEMATICAL FINANCE,

that has a direct connection with optimal stopping problems, is the

problem of determining the

arbitrage-free price of the American put option.

Consider the Black–Scholes model, where the stock price X =

(Xt)t!0 is assumed to follow a geometric Brownian motion:

Xt = x expD!Bt + (r " !2/2) t

E, (17)

where x > 0, ! > 0, r > 0 and B = (Bt)t!0 is a standard Brownian

motion. By Ito’s formula one finds that the process X solves

dXt = rXt dt + !Xt dBt with X0 = x. (18)

IV-1-22

Page 135: Shiryaev

General theory of financial mathematics makes it clear that the

initial problem of determining the arbitrage-free price of the American

put option can be reformulated as the following optimal stopping

problem:

V/ = sup'

Ee"r'(K " X')+ (19)

where the supremum is taken over all stopping times ' of X.

This constitutes Step 1 in the diagram above.

The constant K > 0 is called the strike price. It has a certain

financial meaning which we set aside for now.

IV-1-23

Page 136: Shiryaev

It turns out that the optimal stopping problem (19):

V/ = sup'

Ee"r'(K " X')+

can be reduced again to a free-boundary problem which can be

solved explicitly. It yields the existence of a constant b/ such that

the stopping time

'/ = inf { t ! 0 | Xt ' b/ } (20)

is optimal in (19).

This constitutes Steps 2 and 3 in the diagram above.

Both the optimal stopping point b/ and the arbitrage-free price V/can be expressed explicitly in terms of the other parameters in the

problem. A financial interpretation of these expressions constitutes

Step 4 in the diagram above.

IV-1-24

Page 137: Shiryaev

In the formulation of the problem (19) above:

V/ = sup'

Ee"r'(K " X')+

no restriction was imposed on the class of admissible stopping

times, i.e. for certain reasons of simplicity it was assumed there

that

' belongs to the class of stopping times

M = { ' | 0 ' ' < % } (21)

without any restriction on their size.

IV-1-25

Page 138: Shiryaev

A more realistic requirement on a stopping time in search for the

arbitrage-free price leads to the following optimal stopping problem:

V T/ = sup

',MTEe"r'(K " X')

+ (22)

where the supremum is taken over all ' belonging to the class of

stopping times

MT = { ' | 0 ' ' ' T } (23)

with the horizon T being finite.

The optimal stopping problem (22) can be also reduced to a free-

boundary problem that apparently cannot be solved explicitly.

IV-1-26

Page 139: Shiryaev

Its study yields that the stopping time

'/ = inf { 0 ' t ' T | Xt ' b/(t) } (24)

is optimal in (22), where b/ : [0, T ] ) R is an increasing continuous

function.

A nonlinear Volterra integral equation can be derived which characterizes

the optimal stopping boundary t :) b/(t) and can be used to compute

its values numerically as accurate as desired.

The comments on Steps 1–4 in the diagram above made in the

infinite horizon case carry over to the finite horizon case without

any change.

In our lectures we study these and other similar problems that arise

from various financial interpretations of options.

IV-1-27

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5. So far we have only discussed problems A, B, C and their reformulations

as optimal stopping problems. Now we want to address the methods

of solution of optimal stopping problems and their reduction to free-

boundary problems.

There are essentially two equivalent approaches to finding a solution

of the optimal stopping problem. The first one deals with the problem

V/ = sup',M

EG' in the case of infinite horizon, (25)

or the problem

V T/ = sup

',MTEG' in the case of finite horizon, (26)

where M = { ' | 0 ' ' ' %}, and MT = { ' | 0 ' ' ' T }.

IV-1-28

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In this formulation it is important to realize that

G = (Gt)t!0 is an arbitrary stochastic process defined on

a filtered probability space (!,F , (Ft)t!0, P), where it is

assumed that G is adapted to the filtration (Ft)t!0 which

in turn makes each ' from M or MT a stopping time.

Since the method of solution to the problems (25) and (26) is based

on results from the theory of martingales (Snell’s envelope, 1952),

the method itself is often referred to as the

MARTINGALE METHOD.

IV-1-29

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On the other hand, if we are to take a state space (E,B) large

enough, then one obtains the

“Markov representation” Gt = G(Xt)

for some measurable function G, where X = (Xt)t!0 is a Markov

process with values in E. Moreover, following the contemporary

theory of Markov processes it is convenient to adopt the definition

of a Markov process X as the family of Markov processes

((Xt)t!0, (Ft)t!0, (Px)x,E) (27)

where Px(X0 = x) = 1, which means that the process X starts at

x under Px. Such a point of view is convenient, for example, when

dealing with the Kolmogorov forward or backward equations, which

presuppose that the process can start at any point in the state

space.

IV-1-30

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Likewise, it is a profound attempt, developed in stages, to study

optimal stopping problems through functions of initial points in the

state space.

In this way we have arrived to the second approach which deals with

the problem

V (x) = sup'

ExG(X') (28)

where the supremum is taken over M or MT as above (Dynkin’s

formulation, 1963).

Thus, if the Markov representation of the initial problem is valid, we

will refer to the

MARKOVIAN METHOD of solution.

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6. To make the exposed facts more transparent, let us consider the

optimal stopping problem

V/ = sup'

E

Dmax0't''

|Bt|" c'E

in more detail.

Denote

Xt = |x + Bt| (29)

for x ! 0, and enable the maximum process to start at any point by

setting for s ! x

St = s 7D

max0'r't

Xr

E. (30)

IV-1-32

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St = s 7D

max0'r't

Xr

E

The process S = (St)t!0 is not Markov, but

the pair (X, S) = (Xt, St)t!0 forms a Markov process

with the state space

E = { (x, s) , R2 |0 ' x ' s }.

The value V/ from (4) above: V/ = sup'

E

Dmax0't''

|Bt|" c'E

coincides

with the value function

V/(x, s) = sup'

Ex,s

!S'" c'

"(31)

when x = s = 0. The problem thus needs to be solved in this more

general form.

IV-1-33

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The general theory of optimal stopping for Markov processes makes

it clear that the optimal stopping time in (31) can be written in the

form

'/ = inf { t ! 0 | (Xt, St) , D/} (32)

where D/ is a stopping set, and

C/ = E \ D/ is the continuation set.

In other words,

• if the observation of X was not stopped before time t

since Xs , C/ for all 0 ' s < t, and we have that Xt , D/,then it is optimal to stop the observation at time t,

• if it happens that Xt , C/ as well, then the observation

of X should be continued.

IV-1-34

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"

#$$

$$

$$

$$

$$

$$

$$

$$

$$

$$

$$

$

x

ss = x

% #%(xt, st)

D/ C/Heuristic considerations about the

shape of the sets C/ and D/makes it plausible to guess that

there exist a point s/ ! 0 and

a continuous increasing function

s :) g/(s) with g/(s/) = 0 such

thatD/ = { (x, s) , R

2 | 0 ' x ' g/(s) , s ! s/ } (33)

Note that such a guess about the shape of the set D/ can be made

using the following intuitive arguments. If the process (X, S) starts

from a point (x, s) with small x and large s, then it is reasonable to

stop immediately because to increase the value s one needs a large

time ' which in the formula (31) appears with a minus sign.

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At the same time it is easy to see that

if x is close or equal to s then it is reasonable to continue

the observation, at least for small time ", because s will

increase for the value-

" while the cost for using this

time will be c", and thus-

" " c" > 0 if " is small

enough.

Such an a priori analysis of the shape of the boundary between the

stopping set C/ and the continuation set D/ is typical to the act of

finding a solution to the optimal stopping problem. The

art of GUESSING

in this context very often plays a crucial role in solving the problem.

IV-1-36

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Having guessed that the stopping set D/ in the optimal stopping

problem V/(x, s) = sup' Ex,s(S'" c') takes the form

D/ = { (x, s) , R2 | 0 ' x ' g/(s) , s ! s/ },

it follows that '/ attains the supremum, i.e.,

V/(x, s) = Ex,s

!S'/" c'/

"for all (x, s) , E. (34)

Consider V/(x, s) for (x, s) in the continuation set

C/ = C1/ 9 C2

/ (35)

where the two subsets are defined as follows:

C1/ = { (x, s) , R

2 | 0 ' x ' s < s/ } (36)

C2/ = { (x, s) , R

2 | g/(s) < x ' s , s ! s/ }. (37)

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Denote by

LX =1

2

02

0x2

the infinitesimal operator of the process X. By the strong Markov

property one finds that V/ solves

LXV/(x, s) = c for (x, s) in C/. (38)

If the process (X, S) starts at a point (x, s) with x < s, then during

a positive time interval the second component S of the process

remains equal to s.

This explains why the infinitesimal operator of the process (X, S)

reduces to the infinitesimal operator of the process X in the interior

of C/.

IV-1-38

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On the other hand, from the structure of the process (X, S) it followsthat at the diagonal in R2

+

• the condition of normal reflection holds:

0V/0s

(x, s)

FFFFFx=s"

= 0. (39)

Moreover, it is clear that for (x, s) , D/• the condition of instantaneous stopping holds:

V/(x, s) = s. (40)

Finally, either by guessing or providing rigorous arguments, it isfound that at the optimal boundary g/

• the condition of smooth fit holds:

0V/0x

(x, s)

FFFFFx=g/(s)+

= 0. (41)

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This analysis indicates that the value function V/ and the optimal

stopping boundary g/ can be obtained by searching for the pair of

functions (V, g) solving the following free-boundary problem:

LXV (x, s) = c for (x, s) in Cg (42)0V

0s(x, s)

FFFFx=s"

= 0 (normal reflection) (43)

V (x, s) = s for (x, s) in Dg (instantaneous stopping) (44)0V

0x(x, s)

FFFFx=g(s)+

= 0 (smooth fit) (45)

where the two sets are defined as follows (g(s0) = 0):

Cg = { (x, s) , R2 | 0 ' x ' s < s0 or g(s) < x ' s, s ! s0 } (46)

Dg = { (x, s) , R2 | 0 ' x ' g(s) , s ! s0 } (47)

It turns out that this system does not have a unique solution so

that an additional criterion is needed to make it unique in general.

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Let us show how to solve the free-boundary problem (42)–(45) bypicking the right solution (more details will be given in the lectures).

From (42) one finds that for (x, s) in Cg we have

V (x, s) = cx2 + A(s) x + B(s) (48)

where A and B are some functions of s. To determine A and B aswell as g we can use the three conditions

0V

0s(x, s)

FFFFx=s"

= 0 (normal reflection)

V (x, s) = s for (x, s) in Dg (instantaneous stopping)0V

0x(x, s)

FFFFx=g(s)+

= 0 (smooth fit)

which yield

g2(s) =1

2(s " g(s)), for s ! s0. (49)

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It is easily verified that the linear function

g(s) = s "1

2c(50)

solves (49). In this way a candidate for the optimal stopping boundary

g/ is obtained.

For (x, s) , E with s ! 12c one can determine V (x, s) explicitly using

V (x, s) = cx2 + A(s) x + B(s)

and

g(s) = s "1

2c.

This in particular gives that V (1/2c,1/2c) = 3/4c.

IV-1-42

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For other points (x, s) , E when s < 1/2c one can determine V (x, s)

using that the observation must be continued. In particular for x =

s = 0 this yields that

V (0,0) = V (1/2c,1/2c) " c E0,0(!) (51)

where ! is the first hitting time of the process (X, S) to the point

(1/2c,1/2c).

Because E0,0(!) = E0,0(X2!) = (1/2c)2 and V (1/2c,1/2c) = 3/4c,

we find that

V (0,0) =1

2c(52)

as already indicated prior to (7) above. In this way a candidate for

the value function V/ is obtained.

IV-1-43

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The key role in the proof of the fact that

V = V/ and g = g/

is played by

Ito’s formula (stochastic calculus) and the

optional sampling theorem (martingale theory).

This step forms a VERIFICATION THEOREM that makes it

clear that

the solution of the free-boundary problem coincides

with the solution of the optimal stopping problem

IV-1-44

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7. The important point to be made in this context is that the

verification theorem is usually not di&cult to prove in the cases

when a candidate solution to the free-boundary problem is obtained

explicitly.

This is quite typical for one-dimensional problems with infinite

horizon, or some simpler two-dimensional problems, as the one just

discussed.

In the case of problems with finite horizon, however, or other

multidimensional problems, the situation can be radically di!erent.

In these cases, in a manner quite opposite to the previous ones,

the general results of optimal stopping can be used to prove the

existence of a solution to the free-boundary problem, thus providing

an alternative to analytic methods.

IV-1-45

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8. From the material exposed above it is clear that our basic interest

concerns the case of continuous time.

The theory of optimal stopping in the case of continuous time is

considerably more complicated than in the case of discrete time.

However, since the former theory uses many basic ideas from the

latter, we have chosen to present the case of discrete time first, both

in the martingale and Markovian setting, which is then likewise

followed by the case of continuous time. The two theories form

several my lectures.

IV-1-46

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LECTURE 2–3:Theory of optimal stopping for discrete time.

A. Martingale approach.

1. Definitions

(!,F , (Fn)n!0, P), F0 8 F1 8 · · · 8 Fn 8 · · · 8 F , G = (Gn)n!0.

Gain Gn is Fn-measurable

Stopping (Markov) time ' = '(*):

' : ! ) {0,1, . . . ,%}, {' ' n} , Fn for all n ! 0.

M is the family of all finite stopping times

M is the family of all stopping times

MNn = {' , M |n ' ' ' N}

For simplicity we will set MN = M

N0 and Mn = M

%n .

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The optimal stopping problem to be studied seeks to solve

V/ = sup'

E G' . (53)

For the existence of E G' suppose (for simplicity) that

E sup0'k<%

|Gk| < % (54)

(then E G' is well defined for all ' , MNn , n ' N < %).

In the class MNn we consider

V Nn = sup

',MNn

E G' , 0 ' n ' N. (55)

Sometimes we admit that ' in (53) takes the value % (P(' = %) >0), so that ' , M. We put G' = 0 on {' = %}.

Sometimes it is useful to set G% = limsupn)%

Gn.

IV-2/3-2

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2. The method of backward induction.

V Nn = sup

n'''NE G'

To solve this problem we introduce (by backward induction) a special

stochastic sequence SNN , SN

N"1, . . . , SN0 :

SNN = GN, SN

n = max{Gn, E(SNn+1 | Fn)},

n = N " 1, . . . ,0.

If n = N we have to stop and our stochastic gain SNN , equals GN .

#&&&&&&&&&' (

((

((

((

(() *********+,,,,,,- *********+ ,,,,,,,,,-

0 1 2 N " 2 N " 1 N

&

Stop at time N

!

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For n = N " 1 we can either stop or continue. If we stop, our gain

SNN"1, equals GN"1, and if we continue our gain SN

N"1 will be equal

to E(SNN | FN"1).

#&&&&&&&&&' ,,,,,,,,,- *********+

&&&&&&' ,,,,,,,,,- ..

..

..

../

0 1 2 N " 2 N " 1 N

!

either stop at time N " 1

or continue and stop at time N

&

&"

So,SN

N"1 = max{GN"1, E(SNN | FN"1)}

and optimal stopping time is

'NN"1 = min{N " 1 ' k ' N : SN

k = Gk}.

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Define now a sequence (SNn )0'n'N recursively as follows:

SNn = GN, n = N,

SNn = max{Gn, E(SN

n+1 | Fn)}, n = N"1, . . . ,0.

The described method suggests to consider the following stopping

time:

'Nn = inf{n ' k ' N : SN

k = Gk} for 0 ' n ' N .

The first part of the following theorem shows that SNn and 'N

n solve

the problem in a stochastic sense.

The second part of the theorem shows that this leads also to a

solution of the initial problem

V Nn = sup

n'''NE G' for each n = 0,1, . . . , N.

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Theorem 1. (Finite horizon)

I. For all 0 ' n ' N we have:

(a) SNn ! E(G' | Fn), ;' , M

Nn ;

(b) SNn = E(G'N

n| Fn).

II. Moreover, if 0 ' n ' N is given and fixed, then we have:

(c) 'Nn is optimal in V N

n = supn'''N

E G' ;

(d) if '/ is also optimal then 'Nn ' '/;

(e) the sequence (SNk )n'k'N is the smallest

supermartingale which dominates (Gk)n'k'N

(Snell’s envelope)

(f) the stopped sequence (SNk<'N

n)n'k'N is a

martingale.

IV-2/3-6

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Proof of Theorem 1.

I. Induction over n = N, N"1, . . . ,0.

Conditions

(a) SNn ! E(G' | Fn), ;' , M

Nn ,

and

(b) SNn = E(G'N

n| Fn)

are trivially satisfied for n = N .

Suppose that (a) and (b) are satisfied for n = N, N"1, . . . , k, where

k ! 1, and let us show that they must then also hold for n = k"1.

IV-2/3-7

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(a)!SN

n ! E(G' | Fn), ;' , MNn

": Take ' , MN

k"1 and set ' = ' 7 k;

then ' , MNk , and since {' !k} , Fk"1 it follows that

E(G' | Fk"1) = E[I(' =k"1)Gk"1 | Fk"1] + E[I(' !k)G' | Fk"1]

= I(' =k"1)Gk"1 + I(' !k) E[E(G' | Fk) | Fk"1].

By the induction hypothesis, (a) holds for n = k. Since ' , MNk this

implies that

E(G' | Fk) ' SNk . (56)

From SNn = max(Gn, E(SN

n+1 | Fn)) for n = k " 1 we have

Gk"1 ' SNk"1, (57)

E(SNk | Fk"1) ' SN

k"1. (58)

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Using (56)–(58) in (??) we get

E(G' | Fk"1) ' I(' =k"1)SNk"1 + I(' !k) E(SN

k | Fk"1)

' I(' =k"1) SNk"1 + I(' !k) SN

k"1 = SNk"1. (59)

This shows that

SNn ! E(G' | Fn), ;' , M

Nn

holds for n = k " 1 as claimed.

(b)!SN

n = E(G'Nn| Fn)

": To prove (b) for n = k " 1 it is enough to

check that all inequalities in (??) and (59) remain equalities when

' = 'Nk"1. For this, note that

'Nk"1 = 'N

k on {'Nk"1 ! k};

Gk"1 = SNk"1 on {'N

k"1 = k " 1};E(SN

k | Fk"1) = SNk"1 on {'N

k"1 ! k}.

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Then we get

E(G'N

k"1| Fk"1

)= I('N

k"1 = k " 1)Gk"1

+ I('Nk"1!k) E

(E(G'N

k| Fk) | Fk"1

)

= I('Nk"1 = k " 1)Gk"1 + I('N

k"1!k) E(SNk | Fk"1)

= I('Nk"1 = k " 1)SN

k"1 + I('Nk"1!k)SN

k"1 = SNk"1.

Thus

SNn = E

!G'N

n| Fn

"

holds for n = k " 1. (We supposed by induction that (b) holds for

n = N, . . . , k.)

IV-2/3-10

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(c)!'Nn is optimal in V N

n = supn'''N

E G'

":

Take expectation E in SNn ! E(G' | Fn), ' , Mn

n. Then

E SNn ! E G' for all ' , M

Nn

and by taking the supremum over all ' , MNn we see that

E SNn ! V N

n

D= sup

',MNn

E G'

E.

On the other hand, taking the expectation in SNn = E(G'N

n| Fn) we

get

E SNn = E G'N

n

which shows that

E SNn ' V N

n

D= sup

',MNn

E G'

E.

IV-2/3-11

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So,

E SNn = V N

n

and since E SNn = E G'N

n, we see that

V Nn = E G'N

n

implying the claim (c): “The stopping time 'Nn is optimal”.

(d)!

if '/ is also optimal then 'Nn ' '/

":

If we suppose that '/ is also optimal then 'Nn ' '/. We claim that

the optimality of '/ implies that SN'/ = G'/ (P-a.s.). Indeed,

for all n ' k ' N SNk ! Gk, thus SN

'/ ! G'/.

If SN'/ 4= G'/ (P-a.s.) then

P(SN'/ > G'/) > 0.

IV-2/3-12

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It thus follows that

E G'/ < E SN'/

($)' E SN

n(#)= V N

n ,

where

($) follows by the supermartingale property of

(SNk )n'k'N (see (e)) and the optional sampling

theorem, and

(#) was obtained in (c).

The strict inequality E G'/ < V Nn , however, contradicts the fact that

'/ is optimal.

Hence SN'/ = G'/ (P-a.s.) and the fact that 'N

n ' '/ (P-a.s.) follows

from the definition

'Nn = inf{n ' k ' N : SN

k = Gk}.

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(e)!the sequence (SN

k )n'k'N is the smallest supermartingale

which dominates (Gk)n'k'N

":

From

SNk = max{Gk, E(SN

k+1 | Fk)}, k = N " 1, . . . , n,

we see that (SNk )n'k'N is a supermartingale:

SNk ! E(SN

k+1 | Fk).

Also we have SNk ! Gk. It means that (SN

k )n'k'N is a supermartingale

which dominates (Gk)n'k'N .

Suppose that ( /Sk)n'k'N is another supermartingale which dominates

(Gk)n'k'N , then the claim that /Sk ! SNk (P-a.s.) can be verified by

induction over k = N, N " 1, . . . , l.

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Indeed, if k = N then the claim follows by SNn = GN for n = N .

Assuming that /Sk ! SNk for k = N, N " 1, . . . , l with l ! n + 1 it

follows that

SNl"1 = max(Gl"1, E(SN

l | Fl"1))

' max(Gl"1, E( /Sl | Fl"1)) ' /Sl"1 (P-a.s.)

using the supermartingale property of (Sk)n'k'N . So, (SNk )n'k'N is

the smallest supermartingale which dominates (Gk)n'k'N

(Snell’s envelop).

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(f)!

the stopped sequence (SNk<'N

n)n'k'N is a martingale

":

To verify the martingale property

E

(SN(k+1)<'N

n| Fk

)= SN

k<'Nn

with n ' k ' N " 1 given and fixed, note that

E(SN(k+1)<'N

n| Fk

)= E

(I('N

n ' k)SNk<'N

n| Fk

)

+ E

(I('N

n ! k + 1)SNk+1 | Fk

)

= I('Nn ' k)SN

k<'Nn

+ I('Nn ! k + 1) E(SN

k+1 | Fk)

= I('Nn ' k)SN

k<'Nn

+ I('Nn ! k + 1)SN

k = SNk<'N

n

where we used that

SNk = E(SN

k+1 | Fk) on { 'Nn ! k + 1 }

and { 'Nn ! k + 1 } , Fk since 'N

n is a stopping time.

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Summary

1) The optimal stopping problem

V N0 = sup

',MN0

E G'

is solved inductively by solving the problems

V Nn = sup

',MNn

E G' for n = N, N " 1, . . . ,0.

2) The optimal stopping rule 'Nn for V N

n satisfies

'Nn = 'N

k on {'Nn ! k}

for 0 ' n ' k ' N when 'Nk is the optimal stopping rule for V N

k . In

other words, this means that if it was not optimal to stop within

the time set {n, n + 1, . . . , k " 1} then the same optimality rule for

V Nn applies in the time set {k, k + 1, . . . , N}.

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3) In particular, when specialized to the problem V N0 , the following

general principle (of dynamic programming) is obtained:

if the stopping rule 'N0 is optimal for V N

0 and it was notoptimal to stop within the time set {0,1, . . . , n " 1}, thenstarting the observation at time n and being based on theinformation Fn, the same stopping rule is still optimal forthe problem V N

n .

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IV-2/3-18

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3. The method of ESSENTIAL SUPREMUM

The method of backward induction by its nature requires that the

horizon N be FINITE so that the case of infinite horizon remains

uncovered.

It turns out, however, that the random variables SNn defined by the

recurrent relations

SNn = GN, n = N,

SNn = max{Gn, E(SN

n+1 | Fn)}, n = N"1, . . . ,0,

admit a di!erent characterization which can be directly extended to

the case of infinite horizon N .

This characterization forms the base of the SECOND method that

will now be presented.

IV-2/3-19

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Note that the relations

(a) SNn ! E(G' | Fn) ;' , M

Nn ;

(b) SNn = E(G'N

n| Fn)

from Theorem 1 suggest that the following identity should hold:

SNn = sup

',MNn

E(G' | Fn) .

(!) Di"culty: sup',MNn

E(G' | Fn) need not define a

measurable function.

To overcome this di&culty it turns out that the concept of

ESSENTIAL SUPREMUM

proves useful.

IV-2/3-20

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Lemma (about Essential Supremum).

Let {Z$, $ , A} be a family of random variables defined on (!,F , P)

where the index set A can be arbitrary.

I. Then there exists a countable subset J of A such that the random

variable Z/ : ! ) R defined by

Z/ = sup$,J

Z$

satisfies the following two properties:

(a) P(Z$'Z/) = 1, ;$ , A;

(b) If Z : ! ) R is another random variable

satisfying P(Z$ ' Z/) = 1, ;$ , A, then

P(Z/ ' Z) = 1.

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II. Moreover, if the family {Z$, $ , A} is upwards directed in thesense that

for any $ and % in A there exists . in A

such that max(Z$, Z%) ' Z. (P-a.s.),

then the countable set J = {$n, n ! 1} can be chosen so that

Z/ = limn)%Z$n (P-a.s.)

where Z$1 ' Z$2 ' · · · (P-a.s.).

Proof. (1) Since x :) 2- arctan(x) is a strictly increasing function

from R to ["1,1], it is no restriction to assume that |Z$| ' 1.

(2) Let C denote the family of all countable subsets C of A. Choosean increasing sequence {Cn, n ! 1} in C such that

adef= sup

C,CE

Dsup$,C

Z$

E= sup

n!1E

Dsup$,Cn

Z$

E.

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Then Jdef=

L%n=1 Cn is a countable subset of A and we claim that

Z/ def= sup

$,JZ$

satisfies the properties (a) and (b).

(3) To verify these claims take $ , A arbitrarily.

(a): If $ , J then Z$ ' Z/ so that (a) holds. If $ /, J and we assume

that P(Z$ > Z/) > 0, then

a < E(Z/ 7 Z$) ' a

since a = E Z/ , ["1,1] (by the monotone convergence

theorem) and J 9 {$} belongs to C. As the strict inequality

is impossible, we see that P(Z$ ' Z/) = 1, ;$ , A as claimed.

(b): follows from Z/ = sup$,J Z$ and (a): P(Z$'Z/) = 1, ;$ , A,

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Finally, assume that the condition in II is satisfied. Then the initial

countable set

J = {$1, $2, . . .}

can be replaced by a new countable set J+ = {$+1, $+

2, . . .} if we

initially set $+1 = $1, and then inductively choose $+

n+1 ! $+n 7 $n+1

for n ! 1, where . ! $ 7 % corresponds to Z$, Z% and Z. such that

Z. ! Z$ 7 Z% (P-a.s.). The concluding claim Z/ = limn)% Z$n in II

is then obvious, and the proof of the lemma is complete.

With the concept of essential supremum we may now rewrite

SNn ! E(G' | Fn) ;' , M

Nn ; SN

n = E(G'Nn| Fn)

in Theorem 53 above as follows:

SNn = ess sup

n'''NE(G' | Fn) for all 0 ' n ' N .

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This ess sup identity provides an additional characterization of the

sequence of r.v.’s (SNn )0'n'N introduced initially by means of the

recurrent relations

SNn = GN, n = N,

SNn = max{Gn, E(SN

n+1 | Fn)}, n = N"1, . . . ,0.

Its advantage in comparison with these recurrent relations lies in

the fact that the identity

SNn = ess sup

n'''NE(G' | Fn)

can naturally be extended to the case of INFINITE horizon N . This

programme will now be described.

Consider (instead of V Nn = sup',MN

nE G')

Vn = sup',M%

n

E G' .

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To solve this problem we will consider the sequence of r.v.’s (Sn)n!0defined as follows:

Sn = ess sup'!n

E(G' | Fn)

as well as the following stopping time:

'n = inf{k ! n |Sk = Gk} for n ! 0,

where inf " = % by definition.

The first part (I) of the next theorem shows that (Sn)n!0 satisfiesthe same recurrent relations as (SN

n )0'n'N .

The second part (II) of the theorem shows that Sn and 'n solve theproblem in a stochastic sense.

The third part (III) shows that this leads to a solution of the initialproblem Vn = sup'!n E G' .

The fourth part (IV) provides a supermartingale characterization ofthe solution.

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Theorem 2 (Infinite horizon).

Consider the optimal stopping problems

Vn = sup'!n

E G' , ' , M%n , n ! 0

assuming that the condition E sup0'k<%

|Gk| < % holds.

I. The following recurrent relations hold:

Sn = max{Gn, E(Sn+1 | Fn)}, ;n ! 0.

II. Assume moreover if required below that

P('n<%) = 1.

Then for all n ! 0 we have:

Sn ! E(G' | Fn) ;' , Mn, Sn = E(G'n | Fn).

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III. Moreover, if n ! 0 is given and fixed, then we have:

The stopping time 'n = inf{k ! n : Sk = Gk} is

optimal in Vn = sup'!n E G' .

If '/ is an optimal stopping time for Vn = sup'!n E G'then 'n ' '/ (P-a.s.).

IV. The sequence (Sk)k!n is the smallest supermartingale

which dominates (Gk)k!n (Snell’s envelope).

The stopped sequence (Sk<'n)k!n is a martingale.

Finally, if the condition P('n < %) = 1 fails so that

P('n = %) > 0, then there is NO optimal stopping time

in Vn = sup'!n E G' .

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Proof. I. We need prove the recurrent relations

Sn = max{Gn, E(Sn+1 | Fk)}, n ! 0.

Let us first show that

Sn ' max{Gn, E(Sn+1 | Fk)}.

For this, take ' , Mn and set ' = ' 7 (n + 1).

Then ' , Mn+1, and since {' ! n + 1} , Fn we have

E(G' | Fn) = E[I(' = n)Gn | Fn] + E[I(' ! n + 1)G' | Fn]

= I(' = n)Gn + I(' ! n + 1) E(G' | Fn)

= I(' = n)Gn + I(' ! n + 1) E[E(G' | Fn+1) | Fn]

' I(' = n)Gn + I(' ! n + 1) E Sn+1 | Fn)

' max{Gn, E(Sn+1 | Fn)}.

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From this inequality it follows that

Sn = ess sup'!n

E(G' | Fn) ' max{Gn, E(Sn+1 | Fn)}

which is the desired inequality.

For the reverse inequality, let us first note that Sn ! Gn (P-a.s.)

by the definition of Sn, so that it is enough to show (and it is the

most di"cult part of the proof) that

Sn ! E(Sn+1 | Fn)

which is the supermartingale property of (Sn)n!0. To verify this

inequality, let us first show that the family {E(G' | Fn+1); ' , Mn+1}is upwards directed in the sense that

for any $ and % in A there exists . in A

such that Z$ 7 Z% ' Z..(#)

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For this, note that if !1 and !2 are from Mn+1 and we set !3 =

!1IA + !2IA where

A = {E(G!1 | Fn+1) ! E(G!2 | Fn+1)},

then !3 , Mn+1 and we have

E(G!3 | Fn+1) = E(G!1IA+ G!2IA | Fn+1)

= IA E(G!1 | Fn+1) + IA E(G!2 | Fn+1)

= E(G!1 | Fn+1) 7 E(G!2 | Fn+1)

implying (#) as claimed. Hence by Lemma there exists a sequence

{!k, k ! 1} in Mn+1 such that

ess sup'!n+1

E(G' | Fn+1) = limk)%

E(G!k | Fn+1)

where

E(G!1 | Fn+1) ' E(G!2 | Fn+1) ' · · · (P-a.s.).

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Since

Sn+1 = ess sup'!n+1

E(G' | Fn+1),

by the conditional monotone convergence theorem we get

E(Sn+1 | Fn) = E

(lim

k)%E(G!k | Fn+1) | Fn

)

= limk)%

E(E(G!k | Fn+1) | Fn

)

= limk)%

E(G!k | Fn) ' Sn.

So, Sn = max{Gn, E(Sn+1 | Fn)} and the proof if I is complete.

II. The inequality Sn ! E(G' | Fn), ;' , Mn, follows from the definition

Sn = ess sup'!n E(G' | Fn).

For the proof of the equality Sn = E(G'n | Fn) we use the fact stated

below in IV that the stopped sequence (Sk<'n)k!n is a martingale.

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Setting G/n = supk!n |Gk| we have

|Sk| ' ess sup'!k

E

!|G' | | Fk

"' E(G/

n | Fk) (/)

for all k ! n. Since G/n is integrable due to E supk!n |Gk| < %, it

follows from (/) that (Sk)k!n is uniformly integrable.

Thus the optional sampling theorem can be applied to the martingale

(Mk)k!n = (Sk<'n)k!n and we get

Mn = E(M'n | Fn). (//)

Since Mn = Sn and M'n = S'n we see that (//) is the same as Sn =

E(G'n | Fn).

III: “The stopping time 'n is optimal in Vn = sup'!n E G' .”

The proof uses II and is similar to the corresponding proof in Theorem

1 (N < %).

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IV. “The sequence (Sk)k!n is the smallest supermartingale which

dominates (Gk)k!n” (Snell’s envelop).

We proved in I that (Sk)k!n is a supermartingale. Moreover, from

the definition

Sn = ess sup'!n

E(G' | Fn)

it follows that Sk ! Gk, k ! n, which means that (Sk)k!n dominates

(Gk)k!n. Finally, if (Sk)k!n is another supermartingale which dominates

(Gk)k!n, then from Sn = E(G'n | Fn) (Part II) we find

Sk = E(G'k | Fk) ' E(S'k | Fk) ' Sk, ;k ! n.

(The last inequality follows by the optional sampling theorem being

applicable since S"k ' G"

k ' G/n (= supk!n |Gk|) with G/

n integrable.)

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The statement

“The stopped sequence (Sk<'n)k!n is a martingale”

is proved in exactly the same way as for case N < %.

Finally, note that the final claim

“If the condition P('n < %) = 1 fails so that P('n = %) >

0, then there is NO optimal stopping time in the problem

Vn = sup'!n E G'”

follows directly from III (“If 'n is optimal stopping tome then 'n ' '/(P-a.s.) for the problem Vn = sup'!n E G'”).

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Remark. From the definition

Sn = ess supn'''N

E(G' | Fn)

it follows that

N :) SNn and N :) 'N

n

are increasing. So,

S%n = lim

N)%SN

n and '%n = limN)%

'Nn

exist P-a.s. for each n ! 0.

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Note also that from

V Nn = sup

n'''NE G'

it follows that N :) V Nn is increasing, so that V %

n = limN)% V Nn

exists for each n ! 0.

From SNn = ess supn'''N E(G' | Fn) and Sn = ess sup'!n E(G' | Fn)

we see that

S%n ' Sn and '%n ' 'n. (/)

Similarly,

V %n ' Vn

!= sup

'!nE G'

". (//)

If condition E supn'k<% |Gk| < % does not hold then the inequalities

in (/) and (//) can be strict.

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Theorem 3 (From finite to infinite horizon).

If E sup0'k<% |Gk| < % then in S%n ' Sn, '%n ' 'n and V %

n ' Vn we

have equalities for all n ! 0.

Proof. From

SNn = max{Gn, E(SN

n+1 | Fn)}, n ! 0,

we get

S%n = max{Gn, E(S%

n+1 | Fn)}, n ! 0.

So, (S%n )n!0 is a supermartingale.

Since S%n ! Gn we see that

(S%n )" ' G"

n ' supn!0

G"n , n ! 0.

So, ((S%n )")n!0 is uniformly integrable.

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Then by the optional sampling theorem we get

S%n ! E(S%

' | Fn) for all ' , Mn. (/)

Moreover, since S%k ! Gk, k ! n, it follows that S%

' ! G' for all

' , Mn, and hence

E(S%' | Fn) ! E(G' | Fn) (//)

for all ' , Mn. From (/), (//) and

Sn = ess sup'!n

E(G' | Fn)

we see that S%n ! Sn.

Since the reverse inequality holds in general as shown above, this

establishes that S%n = Sn (P-a.s.) for all n ! 0. From this it also

follows that '%n = 'n (P-a.s.), n ! 0. Finally, the third identity

V %n = Vn follows by the monotone convergence theorem.

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B. Markovian approach.

We will present basic results of optimal stopping when

the time is discrete and the process is Markovian.

1. We consider a time-homogeneous Markov chain X = (Xn)n!0

• defined on a filtered probability space (!,F , (Fn)n!0, Px)

• taking values in a measurable space (E,B)

where for simplicity we will assume that

(a) E = Rd for some d ! 1

(b) B = B(Rd) is the Borel !-algebra on Rd.

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It is assumed that the chain X starts at x under Px for x , E.

It is also assumed that the mapping x :) Px(F) is measurable for

each F , F.

It follows that the mapping x :) Ex(Z) is measurable for each random

variable Z.

Finally, without loss of generality we will assume that (!,F) equals

the canonical space (EN0,BN0) so that the shift operator /n : ! ) !

is well defined by

/n(*)(k) = *(n+k) for * = (*(k))k!0 , ! and n, k ! 0.

(Recall that N0 stands for N 9 {0}.)

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Given a measurable function G : E ) R satisfying the following

condition (with G(XN) = 0 if N = %):

Ex

Dsup

0'n'N|G(Xn)|

E< %

for all x , E, we consider the optimal stopping problem

V N(x) = sup0'''N

Ex G(X')

where x , E and the supremum is taken over all stopping times '

of X. The latter means that ' is a stopping time w.r.t. the natural

filtration of X given by

FXn = !(Xk; 0 ' k ' n) for n ! 0.

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Since the same results remain valid if we take the supremum in

V N(x) = sup0'''N

Ex G(X') (/)

over stopping times ' w.r.t. (Fn)n!0, and this assumption makes

final conclusions more powerful (at least formally), we will assume

in the sequel that the supremum in (/) is taken over this larger class

of stopping times.

Note also that in (/) we admit that N can be +% as well.

In this case, however, we still assume that the supremum is taken

over stopping times ' , i.e. over Markov times ' satisfying 0 ' ' < %.

In this way any specification of G(X%) becomes irrelevant for the

problem (/).

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To solve

V N(x) = sup0'''N

Ex G(X') (/)

when N < %, we may note that by setting Gn = G(Xn) for n ! 0

the problem reduces to the problem

V Nn = sup

n'''NEx G' . (//)

Having identified (/) as (//), we can apply the method of back-

ward induction which leads to a sequence of r.v.’s (SNn )0'n'N and

a stopping time 'Nn = inf{n ' k ' N : SN

k = Gk}.

The key identity is

SNn = V N"n(Xn) for 0 ' n ' N , Px-a.s.; x , E (///)

Once (///) is known to hold, the results of the Theorem 1 (finite

horizon) from the Martingale theory translate immediately into the

present Markovian setting and get a more transparent form.

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To get formulation, let us define

CNn = {x , E : V N"n(x) > G(x) }

DNn = {x , E : V N"n(x) = G(x) }

for 0 ' n ' N . We also define stopping time

'D = inf {0 ' n ' N : Xn , DNn }.

and the transition operator T of X

TF(x) = Ex F(X1)

for x , E whenever F : E ) R is a measurable function so that

F(X1) is integrable w.r.t. Px for all x , E.

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Theorem 4 (Finite horizon: The time-homogeneous case)

Consider the optimal stopping problems

V n(x) = sup0'''n

Ex G(X') (/)

assuming that Ex sup0'k'N

|G(Xk)| < %. Then

I. Value functions V n satisfy the “Wald–Bellman equation”

V n(x) = max(G(x), TV n"1(x)) (x , E)

for n = 1, . . . , N where V 0 = G.

II. The stopping time 'D = inf {0 ' n ' N : Xn , DNn } is

optimal in (/) for n = N .

III. If '/ is an optimal stopping time in (/) then 'D ' '/ (Px-a.s.)

for every x , E.

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IV. The sequence (V N"n(Xn))0'n'N is the smallest

supermartingale which dominates (G(Xn))0'n'N under Px

for x , E given and fixed.

V. The stopped sequence (V N"n(Xn<'D))0'n'N is a

martingale under Px for every x , E.

Proof. To verify the equality SNn = V N"n(Xn) recall that

SNn = Ex(G(X'N

n) | Fn) (i)

for 0 ' n ' N . Since SN"nk + /n = SN

n+k we get that 'Nn satisfies

'Nn = inf{n ' k ' N : SN

k = G(Xk)} = n + 'N"n0 + /n (ii)

for 0 ' n ' N (/n*(k) = *(k + n)).

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Inserting (ii) into (i) and using the Markov property we obtain

SNn = Ex

(G(X

n+'N"n0 +/n

) | Fn

)= Ex

(G(X

'N"n0

) + /n | Fn

)

= EXn G(X'N"n0

)($)= V N"n(Xn)

(iii)

where ($) follows by (i): SNn = Ex(G(X'N

n) | Fn), which imply

Ex SN"n0 = Ex G(X

'N"n0

) = sup0'''N"n

Ex G(X') = V N"n(x) (iv)

for 0 ' n ' N and x , E.

Thus SNn = V N"n(Xn) holds as claimed.

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To verify the “Wald–Bellman equation”, note that the equality

SNn = max{Gn, E(SN

n+1 | Fn)},

using the Markov property, reads as follows:

V N"n(Xn) = max7G(Xn), Ex

(V N"n"1(Xn+1) | Fn

)8

= max7G(Xn), Ex

(V N"n"1(X1) + /n | Fn

)8

= max7G(Xn), EXn V N"n"1(X1)

8

= max7G(Xn), TV N"n"1(Xn)

8

(/)

for all 0 ' n ' N . Letting n = 0 and using that X0 = x under Px we

see that (/) yields V n(x) = max{G(x), TV n"1(x)}.

The remaining statements of the theorem follow directly from the

Martingale Theorem (1). The proof is complete.

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The “Wald–Bellman equation” can be written in a more compact

form as follows. Introduce the operator Q by setting

QF(x) = max(G(x), TF(x))

for x , E where F : E ) R is a measurable function for which

F(X1) , L1(Px) for x , E. Then the “Wald–Bellman equation” reads

as follows:

V n(x) = QnG(x)

for 1 ' n ' N where Qn denotes the n-th power of Q. These

recursive relations form a constructive method for finding V N when

Law(X1 |Px) is known for x , E.

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TIME-INHOMOGENEOUS MARKOV CHAINS X = (Xn)n!0

Put Zn = (n, Xn).

Z = (Zn)n!0 is a time-homogeneous Markov chain.

Optimal stopping problem:

(/) V N(n, x) = sup0'''N"n

En,x G(n+', Xn+') , 0 ' n ' N.

We assume

(//) En,x

Dsup

0'k'N"n|G(n + k, Xn+k)|

E< %, 0 ' n ' N.

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Theorem 5 (Finite horizon: The time-inhomogeneous case)

Consider the optimal stopping problem (/) upon assuming that the

condition (//) holds. Then:

I. The function V n satisfies the “Wald–Bellman equation”

V N(n, x) = max(G(n, x), TV N(n, x))

for n = N"1, . . . ,0 where

TV N(n, x) = En,x V N(n + 1, Xn+1), n = N " 1, . . . ,0,

and

TV N(N"1, x) = EN"1,x G(N, XN);

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II. The stopping time

'ND = inf{n ' k ' N : (n + k, Xn+k) , D}

with

D =7(n, x) , {0,1, . . . , N}.E : V (n, x) = G(n, x)

8

is optimal in the problem (/):

V N(n, x) = sup0'''N"n

En,x G(n+', Xn+');

III. If 'N/ is an optimal stopping time in (/) then 'N

D ' 'N/

(Pn,x-a.s.) for every (n, x) , {0,1, . . . , N}.E;

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IV. The value function V N is the smallest superharmonic

function which dominates the gain function G on

{0, . . . , N}.E,

TV N(n, x) ' V N(n, x), V N(n, x) ! G(n, x);

V. The stopped sequence!V N((n+k) < 'N

D , X(n+k)<'ND)"

0'k'N"n

is a martingale under Pn,x for every (n, x) , {0,1, . . . , N}.E;

The proof is carried out in exactly the same way as the proof of

Theorem 4.

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Optimal stopping for infinite horizon (N = %):

V (x) = sup'

Ex G(X')

Theorem 6

Assume Ex supn!0 |G(Xn)| < %, x , E.

I. The value function V satisfies the “Wald–Bellman equation”

V (x) = max(G(x), TV (x)), x , E.

II. Assume moreover when required below that Px('D < %) = 1

for all x , E, where

'D = inf{t ! 0 : Xt , D}

with D = {x , E : V (x) = G(x)}. Then the stopping time 'D

is optimal.

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III. If '/ is an optimal stopping time then 'D ' '/ (Px-a.s. for

every x , E).

IV. The value function V is the smallest superharmonic function

(Dynkin’s characterization) (TV ' V ) which dominates the

gain function G on E, or, equivalently, (V (Xn))n!0 is the

smallest supermartingale (under Px, x , E) which dominates

(G(Xn))n!0.

V. The stopped sequence (V (Xn<'D))n!0 is a martingale under

Px for every x , E.

VI. If the condition Px('D < %) = 1 fails so that Px('D = %) >

0 for some x , E, then there is no optimal stopping time in

the problem V (x) = sup' Ex G(X') for all x , E.

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Corollary (Iterative method). We have

V (x) = limn)%QnG(x)

(a constructive method for finding the value function V ).

Uniqueness in the Wald–Bellman equation

F(x) = max(G(x), TF(x))

Suppose E supn!0 F(Xn) < %.

Then F equals the value function V if and only if the following

“boundary condition at infinity ” holds:

lim supn)%

F(Xn) = limsupn)%

G(Xn) Px-a.s. ;x , E.

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2. Given $ , (0,1] and bounded g : E ) R and c : E ) R+, consider

the optimal stopping problem

V (x) = sup'

Ex

D$'g(X') "

'#

k=1

$k"1c(Xk"1)E.

Let IX = (IXn)n!0 denote the Markov chain X killed at rate $. It

means that

/TF(x) = $ TF(x).

Then

V (x) = sup'

Ex

Dg(IX') "

'#

k=1

c(IXk"1)E.

The “Wald–Bellman equation” takes the following form:

V (x) = max7g(x), $TV (x) " c(x)

8.

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LECTURES 4–5.

Theory of optimal stopping for continuous time

A. Martingale approach

Let (!,F , (Ft)t!0, P) be a stochastic basis (a filtered probability

space with right-continuous family (Ft)t!0 where each Ft contains

all P-null sets from F.

Let G = (Gt)t!0 be a gain process. (We interpret Gt as the gain if

the observation of G is stopped at time t.)

DEFINITION.

A random variable ' : ! ) [0,%] is called a Markov time

if {' ' t} , Ft for all t ! 0.

A Markov time is called a stopping time if ' < % P-a.s.

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We assume that G = (Gt)t!0 is right-continuous and left-continuous

over stopping times (if 'n 3 ' then G'n ) G' P-a.s.).

We also assume that

E!

sup0't'T

|Gt|"

< % (GT = 0 if T = %).

BASIC OPTIMAL STOPPING PROBLEM:

V Tt = sup

t'''TE G' .

We shall admit that T = %. In this case the supremum is still taken

over stopping times ' , i.e. over Markov times ' satisfying t ' ' < %.

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Two ways to tackle the problem V Tt = supt'''T E G' :

(1) Discrete time approximation

[0, T ] ") T(n) =7t(n)0 , t(n)

1 , . . . , t(n)n

83 T is a dense

subset of [0, T ]

G ") G(n) = (Gt(n)i

)

with applying previous discrete-time results and then

passing to the limit n ) %;

(2) Straightforward extension of the method of essential

supremum. This programme will now be addressed.

We denote for simplicity of the notation

Vt = V Tt (T < % or T = %).

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Consider the process S = (St)t!0 defined as follows:

St = ess sup'!t

E(G' |Ft).

The process S is the Snell’s envelope of G.

Introduce

't = inf {u ! t |Su = Gu} where inf " = % by definition.

We shall see below that

St ! max{Gt, E(Su | Ft)} for u ! t.

The reverse inequality is not true generally.

However,

St = max{Gt, E(S!<'t | Ft)}

for every stopping time ! ! t and 't given above.

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Theorem 1. Consider the optimal stopping problem

Vt = sup'!t

E G' , t ! 0,

upon assuming E supt!0 |Gt| < %. Assume moreover when required

below that

P('t < %) = 1, t ! 0.

(Note that this condition is automatically satisfied when the horizon

T is finite.) Then:

I. For all t ! 0 we have

St ! E(G' | Ft) for each ' , Mt

St = E(G't| Ft)

where Mt = {' : ' ' T} if T < %,

Mt = {' : ' < %} if T = %.

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II. The stopping time 't = inf{u ! t : Su = Gu} is

optimal (for the problem Vt = sup'!t E G').

III. If '/t is an optimal stopping time as well then

't ' '/t P-a.s.

IV. The process (Su)u!t is the smallest right-

continuous supermartingale which dominates

(Gs)s!t.

V. The stopped process (Su<'t)u!t is a right-

continuous martingale.

VI. If the condition P('t < %) = 1 fails so that

P('t = %) > 0, then there is no optimal stopping

time.

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Proof. 1+. Let us first prove that S = (St)t!0 defined by

St = ess sup'!t

E(G' | Ft)

is a supermartingale.

Show that the family {E(G' | Ft) : ' , Mt} is upwards directed in the

sense that if !1 and !2 are from Mt then there exists !3 , Mt such

that

E(G!1| Ft) 7 E(G!2| Ft) ' E(G!3| Ft).

Put !3 = !1IA + !2IA where

A = {E(G!1|Ft) ! E(G!2| Ft)}.

Then !3 , Mt and

E(G!3| Ft) = E(G!1IA + G!2IA | Ft) = IA E(G!1| Ft) + IA E(G!2| Ft)

= E(G!1| Ft) 7 E(G!2| Ft).

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Hence there exists a sequence {!k; k ! 1} in Mt such that

(/) ess sup',Mt

E(G' | Ft) = limk)%

E(G!k | Ft)

where

E(G!1| Ft) ' E(G!2| Ft) ' · · · P-a.s.

From (/) and the conditional monotone convergence theorem (using

E supt!0 |Gt| < %) we find that for 0 ' s < t

E(St | Fs) = E

!lim

k)%E(G!k| Ft) | Fs

"

= limk)%

E[E(G!k| Ft) | Fs]

= limk)%

E(G!k| Fs) ' Ss

!= ess sup

'!sE(G' | Fs)

".

Thus (St)t!0 is a supermartingale as claimed.

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Note that from E supt!0 |Gt| < % and

St = ess sup'!t

E(G' | Ft),

ess sup'!t

E(G' | Ft) = limk)%

E(G!k| Ft)

it follows that

E St = sup'!t

E G' .

2+. Let us next show that the supermartingale S admits a right-

continuous modification /S = ( /St)t!0.

From the general martingale theory it follows that it su&ces to

check that

t% E St is right-continuous on R+.

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By the supermartingale property of S

E St ! · · · ! E St2 ! E St1, tn 3 t.

So, L := limn)% E Stn exists and

E St ! L.

To prove the reverse inequality, fix # > 0 and by means of E St =

sup'!t E G' choose ! , Mt such that

E G! ! E St " #.

Fix " > 0 and note that there is no restriction to assume that

tn , [t, t + "] for all n ! 1. Define

!n =

@B

C! if ! > tn,

t + ! if ! ' tn.

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Then for all n ! 1 we have

(/) E G!n = E G!I(! > tn) + E Gt+"I(! ' tn) ' E Stn

since !n , Mtn and E St = sup'!t E G' . Letting n ) % in (/) and

assuming that E sup0't'T |Gt| < % we get

E G!I(! > t) + E Gt+"I(! = t) ' L (= limn

E Stn).

Letting now " * 0 and using that G is right-continuous we obtain

E G!I(! > t) + E GtI(! = t) = E G! ' L.

From here and E G! ! E St " # we see that L ! E St " # for all # > 0.

Hence L ! E St and thus

limn)%E Stn = L = E St, tn 3 t,

showing that S admits a right-continuous modification /S = ( /St)t!0

which we also denote by S throughout.

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Let us prove property IV:

The process (Su)u!t is the smallest right-continuous

supermartingale which dominates (Gs)s!t.

For this, let GS = ( GSu)u!t be another right-continuous supermartingale

which dominates G = (Gu)u!t. Then by the optional sampling theorem

(using E supt!0 |Gt| < %) we have

GSu ! E( GS' | Fu) ! E(G' | Fu)

for all ' , Mu when u ! t. Hence by the definition Su = ess sup'!u

E(G' | Fu)

we find that Su ' GSu (P-a.s.) for all u ! t. By the right-continuity of

S and GS this further implies that

P(Su ' GSu for all u ! t) = 1

as claimed.

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Property I: for all t ! 0

(/) St ! E(G' | Ft) for each ' , Mt,

(//) St = E(G't| Ft).

The inequality (/) follows from the definition St = ess sup'!t E(G' | Ft).

The proof of (//) is the most di&cult part of the proof of the

Theorem.

The sketch of the proof is as follows.

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Assume that Gt ! 0 for all t ! 0.

($) Introduce, for ( , (0,1), the stopping time

'(t = inf{s ! t : (Ss ' Gs}

(Then (S'(t' G'(

t, '(

t+ = 't.)

(%) We show that

St = E(S'(t| Ft) for all ( , (0,1).

So St ' (1/() E(G'(t| Ft) and letting ( 3 1 we get

St ' E(G'1t| Ft)

where '1t = lim(31 '(

t ('(t 3 when ( 3).

(.) Verify that '1t = 't. Then St ' E(G't| Ft) and evidently

St ! E(G't| Ft). Thus St = E(G't| Ft).

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For the proof of property V:

The stopped process (Su<'t)u!t is a right-

continuous martingale

it is enough to prove that

E S!<'t = E St

for all bounded stopping times ! ! t.

The optional sampling theorem implies

E S!<'t ' E St. (60)

On the other hand, from St = E(G't | Ft) and S't = G't we see that

E St = E G't = E S't ' E S!<'t.

Thus, E S!<'t = E St and (Su<'t)u!t is a martingale.

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B. Markovian approach

Let X = (Xt)t!0 be a strong Markov process defined on a filtered

probability space

(!,F , (Ft)t!0, Px)

where x , E (= Rd), Px(X0 = x) = 1,

x ) Px(A) is measurable for each A , F.

Without loss of generality we will assume that

(!,F) = (E[0,%),B[0,%)) (canonical space)

Shift operator /t = /t(*): ! ) ! is well defined by

/t(*)(s) = *(t + s) for * = (*(s))s!0 , ! and t, s ! 0.

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We consider the optimal stopping problem

V (x) = sup0'''T

Ex G(X')

G(XT ) = 0 if T < %; Ex sup0't'T

|G(Xt)| < %.

Here ' = '(*) is a stopping time w.r.t.

(Ft)t!0 (FXt 8 Ft, FX

t = !(Xs; 0 ' s ' t)).

G is called the gain function,

V is called the value function.

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CASE T = %:V (x) = sup

'Ex G(X')

Px(X0 = x) = 1

Introduce

the continuation set C = {x , E : V (x) > G(x)} and

the stopping set D = {x , E : V (x) = G(x)}

NOTICE! If

V is lsc (lower semicontinuous)

$

%

&

G is usc (upper semicontinuous)

%

&

&

then

C is open and D is closed

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The first entry time

'D = inf{t ! 0 : Xt , D}

for closed D is a stopping time since both X and (Ft)t!0 are right-

continuous.

DEFINITION. A measurable function F = F(x) is said to be

superharmonic (for X) if

Ex F(X!) ' F(x)

for all stopping times ! and all x , E. (It is assumed that F(X!) ,L1(Px) for all x , E whenever ! is a stopping time.)

We have:

F is superharmonic i!(F(Xt))t!0 is a supermartingale

under Px for every x , E.

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The following theorem presents

NECESSARY CONDITIONS

for the existence of an optimal stopping time.

Theorem. Let us assume that there exists an optimal stopping time

'/ in the problem

V (x) = sup'

Ex G(X')

i.e. V (x) = Ex F(X'/). Then

(I) The value function V is the smallest superharmonic

function (Dynkin’s characterization) which dominates

the gain function G on E.

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Let us in addition to “V (x) = Ex F(X'/)” assume that

V is lsc and G is usc.

Then

(II) The stopping time 'D = inf{t ! 0 : Xt , D} satisfies

'D ' '/ (Px-a.s., x , E)

and is optimal;

(III) The stopped process (V (Xt<'D))t!0 is a right-continuous

martingale under Px for every x , E.

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Now we formulate

SUFFICIENT CONDITIONS

for the existence of an optimal stopping time.

Theorem. Consider the optimal stopping problem

V (x) = sup'

Ex G(X')

upon assuming that the condition

Ex supt!0

|G(Xt)| < %, x , E,

is satisfied.

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Let us assume that there exists the smallest superharmonic functionGV which dominates the gain function G on E.

Let us in addition assume that

GV is lsc and G is usc.

Set D = {x , E : GV (x) = G(x)} and let 'D = inf{t : Xt , D}.

We then have:

(a) If Px('D < %) = 1 for all x , E, then GV = V and 'D is

optimal in V (x) = sup' Ex G(X');

(b) If Px('D < %) < 1 for some x , E, then there is no

optimal stopping time in V (x) = sup' Ex G(X').

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Corollary (The existence of an optimal stopping time).

Infinite horizon (T = %). Suppose that V is lsc and G is usc. If

Px('D < %) = 1 for all x , E, then 'D is optimal. If Px('D < %) < 1

for some x , E, then there is no optimal stopping time.

Finite horizon (T < %). Suppose that V is lsc and G is usc. Then

'D is optimal.

Proof for T = %. (The case T < % can be proved in exactly the

same way as the case T = % if the process (Xt) is replaced by the

process (t, Xt).)

The key is to show that V is SUPERHARMONIC.

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If so, then evidently V is the smallest superharmonic function

which dominates G on E. Then the claims of the corollary follow

directly from the Theorem (on su&cient conditions) above.

For this, note that V is measurable (since it is lsc) and thus so is

the mapping

(/) V (X!) = sup'

EX! G(X')

for any stopping time ! which is given and fixed.

On the other hand, by the strong Markov property we have

(//) EX! G(X') = Ex [G(X!+'+/!) | F!]

for every stopping time ' and x , E. From (/) and (//) we see that

V (x!) = ess sup'

Ex [G(X!+'+/!) | F!]

under Px where x , E is given and fixed.

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We can show that the family7

E[X!+'+/! | F!] : ' is a stopping time8

is upwards directed: if &1 = !+'1 +/! and &2 = !+'2+/! then there

is & = ! + ' + /! such that

E[G(X&) | F!] = E[G(X&1) | F!] 7 E[G(X&2) | F!].

From here we can conclude that there exists a sequence of stopping

times {'n;n ! 1} such that

V (X!) = limn

Ex [G(X!+'n+/!) | Fn]

where the sequence {Ex [G(X!+'n+/!) | Fn]} is increasing Px-a.s.

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By the monotone convergence theorem using E supt!0 |Gt| < % we

can conclude

Ex V (X!) = limn

Ex G(X!+'n+/!) ' V (x)

for all stopping times ! and all x , E. This proves that V is

superharmonic.

REMARK 1. If the function

x :) Ex G(X')

is continuous (or lsc) for every stopping time ' , then x :) V (x) is lsc

and the results of the Corollary are applicable. This yields a powerful

existence result by simple means.

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REMARK 2. The above results have shown that the optimal stopping

problem

V (x) = sup'

Ex G(X')

is equivalent to the problem of finding the smallest superharmonic

function GV which dominates G on E. Once GV is found it follows

that V = GV and 'D = inf{t : G(Xt) = GV (Xt)} is optimal.

There are two traditional ways for finding GV :

(i) Iterative procedure (constructive but non-explicit)

(ii) Free-boundary problem (explicit or non-explicit).

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For (i), e.g., it is known that if G is lsc and

Ex inft!0

G(Xt) > "% for all x , E,

then GV can be computed as follows:

GV (x) = limn)% lim

N)%QN

n G(x)

where

QnG(x) := G(x) 7 Ex G(X1/2n)

and QNn is the N-th power of Qn.

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The basic idea (ii) is that

GV and C (or D)

should solve the free-boundary problem:

(/) LXGV ' 0

(//) GV ! G ( GV > G on C & GV = G on D)

where LX is the characteristic (infinitesimal) operator of X.

Assuming that G is smooth in a neighborhood of 0C the following

“rule of thumb” is valid.

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If X after starting at 0C enters immediately into int(D) (e.g. when X

is a di!usion process and 0C is su&ciently nice) then the condition

LXGV ' 0 under (//) splits into the two conditions:

LXGV = 0 in C

0 GV

0x

FFFF0C

=0G

0x

FFFF0C

(smooth fit).

On the other hand, if X after starting at 0C does not enter immediately

into int(D) (e.g. when X has jumps and no di!usion component

while 0C may still be su&ciently nice) then the condition LXGV ' 0

(i.e. (/)) under (//) splits into the two conditions:

LXGV = 0 in C

GVFFF0C

= GFFF0C

(continuous fit).

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Proof of the Theorem on NECESSARY conditions

Basic lines

(I) The value function V is the smallest superharmonic

function which dominated the gain function G on E.

We have by the strong Markov property:

Ex V (X!) = Ex EX! G(X'/) = Ex Ex[G(X'/) + /! | F!]

= Ex G(X!+'/+/!) ' sup'

Ex G(X') = V (x)

for each stopping time ! and all x , E.

Thus V is superharmonic.

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Let F be a superharmonic function which dominates G on E. Then

Ex G(X') ' Ex F(X') ' F(x)

for each stopping time ' and all x , E. Taking the supremum over all

' we find that V (x) ' F(x) for all x , E. Since V is superharmonic

itself, this proves that V is the smallest superharmonic function

which dominated G.

(II) Let us show that the stopping time

'D = inf{t : V (Xt) = G(Xt)}

is optimal (if V is lsc and G is usc).

We assume that there exists an optimal stopping time '/:

V (x) = Ex G(X'/), x , E.

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We claim that V (X'/) = G(X'/) Px-a.s. for all x , E.

Indeed, if Px{V (X'/) > G(X'/)} > 0 for some x , E, then

Ex G(X'/) < Ex V (X'/) ' V (x)

since V is superharmonic, leading to a contradiction with the fact

that '/ is optimal. From the identity just verified it follows that

'D ' '/ Px-a.s. for all x , E.

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By (I) the value function V is the superharmonic (Ex V (X!) ' V (X)

for all stopping time ! and x , E). Setting ! 1 s and using the

Markov property we get for all t, s ! 0 and all x , E

V (Xt) ! EXt V (Xs) = Ex [V (Xt+s) | Ft].

This shows that

The process (V (Xt))t!0 is a supermartingale

under Px for each x , E.

Suppose for the moment that V is continuous. Then obviously it

follows that (V (Xt))t!0 is right-continuous. Thus, by the optional

sampling theorem (using E supt!0 |G(Xt)| < %), we see that

Ex V (X') ' Ex V (X!) for ! ' ' .

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In particular, since 'D ' '/ we get

V (x) = Ex G(X'/) = Ex V (X'/)

' Ex V (X'D) = Ex G(X'D) ' V (x),

where we used that

V (X'D) = G(X'D)

Now it is easy to show that 'D is optimal if V is continuous.

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If V is only lsc, then again (see the lemma below) the process

(V (Xt))t!0 is right-continuous (Px-a.s. for each x , E), and the

proof can be completed as above.

This shows that 'D is optimal if V is lsc as claimed.

Lemma. If a superharmonic function F : E ) R is lsc, then

the supermartingale (F(Xt))t!0 is right-continuous

(Px-a.s. for each x , E).

We omit the proof.

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(III) The stopped process (V (Xt<'D))t!0 is a right-continuous

martingale under Px for every x , E.

PROOF. By the strong Markov property we have

Ex [V (Xt<'D) | Fs<'D] = Ex

(EXt<'D

G(X'D) | Fs<'D

)

= Ex

!Ex [G(X'D) + /t<'D | Ft<'D] | Fs<'D

"

= Ex

!Ex [G(X'D) | Ft<'D] | Fs<'D

"= Ex [G(X'D) | Fs<'D]

= EXs<'DG(X'D) = V (Xs<'D)

for all 0 ' s ' t and all x , E proving the martingale property. The

right-continuity of!V (Xt<'D)

"

t!0follows from the right-continuity

of (V (Xt))t!0 that we proved above.

The proof of the theorem on necessary conditions is complete.

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REMARK. The result and proof of the Theorem extend in exactly

the same form (by slightly changing the notation only) to the finite

horizon problem

VT(X) = sup0'''T

Ex G(X').

Now we formulate the theorem which provides

su"cient condition

for the existence of an optimal stopping time.

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THEOREM. Consider the optimal stopping problem

V (x) = sup'

Ex G(X')

upon assuming that Ex supt!0 |G(Xt)| < %, x , E. Let us assume

that

(a) there exists the smallest superharmonic function GV which

dominates the gain function G on E;

(b) GV is lsc and G is usc.

Set D = {x , E : GV (x) = G(x)} and 'D = inf{t : Xt , D}.

We then have:

(I) If Px('D < %) = 1 for all x , E, then GV = V and 'D is

optimal;(II) If Px('D < %) < 1 for some x , E, then there is no

optimal stopping time.

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SKETCH OF THE PROOF.

(I) Since GV is superharmonic majorant for G, we have

Ex G(X') ' Ex GV (X') ' V (x)

for all stopping times ' and all x , E. So

G(x) ' V (x) = sup'

Ex G(X') ' GV (x)

for all x , E.

Next step (di"cult!): assuming that Px('D < %) = 1 for all x , E,

we prove the inequality

GV (x) ' V (x)

and optimality of time 'D.

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(II) If Px('D < %) < 1 for some x , E then there is no optimal

stopping time.

Indeed, by “necessary-condition theorem” if there exists optimal

optimal '/ then 'D ' '/.

But 'D takes value % with positive probability for some x , E.

So, for this state x we have Px('/ = %) > 0 and '/ cannot be

optimal (in the class M = {' : ' < %}).

IV-4/5-42