Perturbative Expansion of FBSDE in an Incomplete Market with Stochastic Volatility

Abstract:     
In this work, we apply our newly proposed perturbative expansion technique to a quadratic growth FBSDE appearing in an incomplete market with stochastic volatility that is not perfectly hedgeable. By combining standard asymptotic expansion technique for the underlying volatility process, we derive explicit expression for the solution of the FBSDE up to the third order of volatility-of-volatility, which can be directly translated into the optimal investment strategy. We compare our approximation with the exact solution, which is known to be derived by the Cole-Hopf transformation in this popular setup. The result is very encouraging and shows good accuracy of the approximation up to quite long maturities. Since our new methodology can be extended straightforwardly to multi-dimensional setups, we expect it will open real possibilities to obtain explicit optimal portfolios or hedging strategies under realistic assumptions.

Number of Pages in PDF File: 21

Keywords: FBSDE, optimal portfolio, incomplete market, quadratic growth, perturbative expnasion, asymptotic expansion

JEL Classification: C61, G11,G12,G13

working papers series