Mean–variance optimal trading problem subject to stochastic dominance constraints with second order autoregressive price dynamics

• Published in: Mathematical methods of operations research (Heidelberg, Germany) Vol. 86; no. 1; pp. 29 - 69
• Main Authors: Singh, Arti, Selvamuthu, Dharmaraja
• Format: Journal Article
• Language: English
• Published: Berlin/Heidelberg Springer Berlin Heidelberg 01.08.2017; Springer Nature B.V
• Subjects: Autoregressive processes; Business and Management; Calculus of Variations and Optimal Control; Optimization; Computer simulation; Cost engineering; Dynamic programming; Economic models; Exact solutions; Marketing; Markets; Mathematical analysis; Mathematical models; Mathematics; Mathematics and Statistics; Mutual funds; Operations research; Operations Research/Decision Theory; Original Article; Quadratic programming; Randomness; Risk; Stochastic models; Variance; Optimal trading; Stochastic dominance; Autoregressive behavior; Quadratic programming problem; Risk averse; Execution cost
• ISSN: 1432-2994; 1432-5217
• DOI: 10.1007/s00186-017-0582-4

The efficient modeling of execution price path of an asset to be traded is an important aspect of the optimal trading problem. In this paper an execution price path based on the second order autoregressive process is proposed. The proposed price path is a generalization of the existing first order autoregressive price path in literature. Using dynamic programming method the analytical closed form solution of unconstrained optimal trading problem under the second order autoregressive process is derived. However in order to incorporate non-negativity constraints in the problem formulation, the optimal static trading problems under second order autoregressive price process are formulated. For a risk neutral investor, the optimal static trading problem of minimizing expected execution cost subject to non-negativity constraints is formulated as a quadratic programming problem. Whereas, for a risk averse investor the variance of execution cost is considered as a measure for the timing risk, and the mean–variance problem is formulated. Moreover, the optimal static trading problem subject to stochastic dominance constraints with mean–variance static trading strategy as the reference strategy is studied. Using Static approximation method the algorithm to solve proposed optimal static trading problems is presented. With numerical illustrations conducted on simulated data and the real market data, the significance of second order autoregressive price path, and the optimal static trading problems is presented.