Optimal stopping of Markov processes: Hilbert space theory, approximation algorithms, and an application to pricing high-dimensional financial derivatives

John N. Tsitsiklis, Benjamin Van Roy

IEEE Transactions on Automatic Control · 1999 · 340 citations · 15 references

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TL;DR

The theory treats per‑stage and terminal rewards as Hilbert‑space elements, distinguishing it from prior work. The study develops a theory for optimal stopping times of discrete‑time ergodic Markov processes with discounted rewards. They present a streamlined analysis proving existence and uniqueness of Bellman’s equation, introduce a stochastic approximation algorithm that tunes linear‑combination basis weights to approximate the value function, and demonstrate its use in a 100‑dimensional pricing case study. The algorithm is shown to converge almost surely, yielding a limit with desirable properties, and its effectiveness is demonstrated in a 100‑dimensional derivative pricing case study.

Abstract

The authors develop a theory characterizing optimal stopping times for discrete-time ergodic Markov processes with discounted rewards. The theory differs from prior work by its view of per-stage and terminal reward functions as elements of a certain Hilbert space. In addition to a streamlined analysis establishing existence and uniqueness of a solution to Bellman's equation, this approach provides an elegant framework for the study of approximate solutions. In particular, the authors propose a stochastic approximation algorithm that tunes weights of a linear combination of basis functions in order to approximate a value function. They prove that this algorithm converges (almost surely) and that the limit of convergence has some desirable properties. The utility of the approximation method is illustrated via a computational case study involving the pricing of a path dependent financial derivative security that gives rise to an optimal stopping problem with a 100-dimensional state space.

References

15