Asymptotic Impulse Control of Mean-Reverting Interest Rates with a Slowly Varying Stochastic Volatility

27 Pages Posted: 18 Feb 2021 Last revised: 13 Sep 2021

See all articles by Chi Seng Pun

Chi Seng Pun

Nanyang Technological University (NTU) - School of Physical and Mathematical Sciences

Rachana Gupta

affiliation not provided to SSRN

Date Written: December 27, 2020

Abstract

This paper studies the optimal central bank intervention of interest rate problem, where the interest rate process is modelled by an Ornstein—Uhlenbeck (mean-reverting) process with a slowly varying stochastic volatility. The objective of the central bank is to maintain the interest rate close to a target level, subject to fixed and proportional costs of interventions. The problem is formulated as an impulse control problem, which is being converted to a free boundary problem by adopting an ansatz of a band policy. Due to the complexity introduced by the stochastic volatility, there is no analytical solution to the free boundary value problem in the literature. This paper applies a regular perturbation approach to derive an asymptotic solution to the free boundary problem and the associated band policy. We establish a rigorous error analysis for a smooth asymptotic solution. We also numerically illustrate the asymptotic solutions with a fully solvable model.

Keywords: Impulse control, Central bank intervention, Interest rate, Stochastic volatility asymptotics, Accuracy of approximations, Asymptotic optimality

Suggested Citation

Pun, Chi Seng and Gupta, Rachana, Asymptotic Impulse Control of Mean-Reverting Interest Rates with a Slowly Varying Stochastic Volatility (December 27, 2020). Available at SSRN: https://ssrn.com/abstract=3756104 or http://dx.doi.org/10.2139/ssrn.3756104

Chi Seng Pun (Contact Author)

Nanyang Technological University (NTU) - School of Physical and Mathematical Sciences ( email )

SPMS-MAS-05-22
21 Nanyang Link
Singapore, 637371
Singapore
(+65) 6513 7468 (Phone)

HOME PAGE: http://personal.ntu.edu.sg/cspun/

Rachana Gupta

affiliation not provided to SSRN

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