Numerical Methods for Continuous Time Mean Variance Type Asset Allocation

Abstract

Many optimal stochastic control problems in finance can be formulated in the form of Hamilton-Jacobi-Bellman (HJB) partial differential equations (PDEs). In this thesis, a general framework for solutions of HJB PDEs in finance is developed, with application to asset allocation. The numerical scheme has the following properties: it is unconditionally stable; convergence to the viscosity solution is guaranteed; there are no restrictions on the underlying stochastic process; it can be easily extended to include features as needed such as uncertain volatility and transaction costs; and central differencing is used as much as possible so that use of a locally second order method is maximized. In this thesis, continuous time mean variance type strategies for dynamic asset allocation problems are studied. Three mean variance type strategies: pre-commitment mean variance, time-consistent mean variance, and mean quadratic variation, are investigated. The numerical method can handle various constraints on the control policy. The following cases are studied: allowing bankruptcy (unconstrained case), no bankruptcy, and bounded control. In some special cases where analytic solutions are available, the numerical results agree with the analytic solutions. These three mean variance type strategies are compared. For the allowing bankruptcy case, analytic solutions exist for all strategies. However, when additional constraints are applied to the control policy, analytic solutions do not exist for all strategies. After realistic constraints are applied, the efficient frontiers for all three strategies are very similar. However, the investment policies are quite different. These results show that, in deciding which objective function is appropriate for a given economic problem, it is not sufficient to simply examine the efficient frontiers. Instead, the actual investment policies need to be studied in order to determine if a particular strategy is applicable to specific investment problem.