Hedging using reinforcement learning: Contextual $k$-Armed Bandit versus $Q$-learning

TL;DR

This paper compares reinforcement learning approaches for hedging in financial markets, showing that a contextual $k$-armed bandit model offers more realistic, sample-efficient, and adaptable strategies than traditional $Q$-learning, especially in real-world data scenarios.

Contribution

It introduces a risk-averse contextual $k$-armed bandit framework for hedging, demonstrating its advantages over $Q$-learning and traditional models in practical financial settings.

Findings

The $k$-armed bandit model outperforms $Q$-learning in sample efficiency.

The approach aligns with the Profit and Loss hedging framework.

It reduces to Black-Scholes in idealized conditions.

Abstract

The construction of replication strategies for contingent claims in the presence of risk and market friction is a key problem of financial engineering. In real markets, continuous replication, such as in the model of Black, Scholes and Merton (BSM), is not only unrealistic but it is also undesirable due to high transaction costs. A variety of methods have been proposed to balance between effective replication and losses in the incomplete market setting. With the rise of Artificial Intelligence (AI), AI-based hedgers have attracted considerable interest, where particular attention was given to Recurrent Neural Network systems and variations of the $Q$-learning algorithm. From a practical point of view, sufficient samples for training such an AI can only be obtained from a simulator of the market environment. Yet if an agent was trained solely on simulated data, the run-time performance will primarily reflect the accuracy of the simulation, which leads to the classical problem of model choice and calibration. In this article, the hedging problem is viewed as an instance of a risk-averse contextual $k$-armed bandit problem, which is motivated by the simplicity and sample-efficiency of the architecture. This allows for realistic online model updates from real-world data. We find that the $k$-armed bandit model naturally fits to the Profit and Loss formulation of hedging, providing for a more accurate and sample efficient approach than $Q$-learning and reducing to the Black-Scholes model in the absence of transaction costs and risks.