Constrained Quadratic Risk Minimization via Forward and Backward Stochastic Differential Equations

TL;DR

This paper develops a framework for solving constrained quadratic risk minimization problems in finance using forward-backward stochastic differential equations, providing explicit solutions and characterizations.

Contribution

It introduces a duality-based approach to characterize optimal portfolios and wealth processes via FBSDEs in a constrained stochastic control setting.

Findings

Explicit solutions for quadratic risk minimization with cone constraints.

Dynamic characterization of optimal wealth and portfolio processes.

Derivation of solutions to extended stochastic Riccati equations.

Abstract

In this paper we study a continuous-time stochastic linear quadratic control problem arising from mathematical finance. We model the asset dynamics with random market coefficients and portfolio strategies with convex constraints. Following the convex duality approach, we show that the necessary and sufficient optimality conditions for both the primal and dual problems can be written in terms of processes satisfying a system of FBSDEs together with other conditions. We characterise explicitly the optimal wealth and portfolio processes as functions of adjoint processes from the dual FBSDEs in a dynamic fashion and vice versa. We apply the results to solve quadratic risk minimization problems with cone-constraints and derive the explicit representations of solutions to the extended stochastic Riccati equations for such problems.