Interpretable Optimal Stopping

63 Pages Posted: 3 Oct 2018 Last revised: 19 Oct 2018

See all articles by Dragos Ciocan

Dragos Ciocan

INSEAD

Velibor Mišić

University of California, Los Angeles (UCLA) - Anderson School of Management

Date Written: October 10, 2018

Abstract

Optimal stopping is the problem of deciding when to stop a stochastic system to obtain the greatest reward, arising in numerous application areas such as finance, healthcare and marketing. State-of-the-art methods for high-dimensional optimal stopping involve approximating the value function or the continuation value, and then using that approximation within a greedy policy. Although such policies can perform very well, they are generally not guaranteed to be interpretable; that is, a decision maker may not be able to easily see the link between the current system state and the policy’s action. In this paper, we propose a new approach to optimal stopping, wherein the policy is represented as a binary tree, in the spirit of naturally interpretable tree models commonly used in machine learning. We formulate the problem of learning such policies from observed trajectories of the stochastic system as a sample average approximation (SAA) problem. We prove that the SAA problem converges under mild conditions as the sample size increases, but that computationally even immediate simplifications of the SAA problem are theoretically intractable. We thus propose a tractable heuristic for approximately solving the SAA problem, by greedily constructing the tree from the top down. We demonstrate the value of our approach by applying it to the canonical problem of option pricing, using both synthetic instances and instances calibrated with real S&P500 data. Our method obtains policies that (1) outperform state-of-the-art non-interpretable methods, based on simulation-regression and martingale duality, and (2) possess a remarkably simple and intuitive structure.

Keywords: Optimal Stopping, Approximate Dynamic Programming, Interpretability, Decision Trees, Option Pricing

JEL Classification: C60

Suggested Citation

Ciocan, Dragos and Misic, Velibor, Interpretable Optimal Stopping (October 10, 2018). INSEAD Working Paper No. 2018/48/TOM. Available at SSRN: https://ssrn.com/abstract=3247318 or http://dx.doi.org/10.2139/ssrn.3247318

Dragos Ciocan (Contact Author)

INSEAD ( email )

Boulevard de Constance
77305 Fontainebleau Cedex
France

Velibor Misic

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

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