Portfolio Optimization with Ambiguous Correlation and Stochastic Volatilities
SIAM J. Control Optim., 54(5), 2309-2338, 2016
30 Pages Posted: 14 Aug 2014 Last revised: 17 Mar 2017
Date Written: August 13, 2014
In a continuous-time economy, we investigate the asset allocation problem among a risk-free asset and two risky assets with an ambiguous correlation between the two risky assets. The portfolio selection that is robust to the uncertain correlation is formulated as the utility maximization problem over the worst-case scenario with respect to the possible choice of correlation. Thus, it becomes a maximin problem. We solve the problem under the Black-Scholes model for risky assets with an ambiguous correlation using the theory of G-Brownian motions. We then extend the problem to stochastic volatility models for risky assets with an ambiguous correlation between risky asset returns. An asymptotic closed-form solution is derived for a general class of utility functions, including CRRA and CARA utilities, when stochastic volatilities are fast mean-reverting. We propose a practical trading strategy that combines information from the option implied volatility surfaces of risky assets through the ambiguous correlation.
Keywords: Ambiguous correlation, G-Brownian motion, Hamilton-Jacobi-Bellman-Isaacs equation, Stochastic volatility
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