Continuous time mean-variance optimal portfolio allocation under jump diffusion: An numerical impulse control approach

• Published in: Numerical methods for partial differential equations 2014-03, Vol.30 (2), p.664-698
• Main Authors: Dang, Duy-Minh, Forsyth, Peter A.
• Format: Article
• Language: English
• Subjects: Allocations; finite difference; Hamilton-Jacobi-Bellman equation; impulse control; mean-variance; viscosity solution
• ISSN: 0749-159X; 1098-2426
• DOI: 10.1002/num.21836

We present efficient partial differential equation methods for continuous time mean‐variance portfolio allocation problems when the underlying risky asset follows a jump‐diffusion. The standard formulation of mean‐variance optimal portfolio allocation problems, where the total wealth is the underlying stochastic process, gives rise to a one‐dimensional (1D) nonlinear Hamilton–Jacobi–Bellman (HJB) partial integrodifferential equation (PIDE) with the control present in the integrand of the jump term, and thus is difficult to solve efficiently. To preserve the efficient handling of the jump term, we formulate the asset allocation problem as a 2D impulse control problem, 1D for each asset in the portfolio, namely the bond and the stock. We then develop a numerical scheme based on a semi‐Lagrangian timestepping method, which we show to be monotone, consistent, and stable. Hence, assuming a strong comparison property holds, the numerical solution is guaranteed to converge to the unique viscosity solution of the corresponding HJB PIDE. The correctness of the proposed numerical framework is verified by numerical examples. We also discuss the effects on the efficient frontier of realistic financial modeling, such as different borrowing and lending interest rates, transaction costs, and constraints on the portfolio, such as maximum limits on borrowing and solvency. © 2013 Wiley Periodicals, Inc. Numer Methods Partial Differential Eq 30: 664–698, 2014