Density Analysis for coupled forward-backward SDEs with non-Lipschitz drifts and Applications

TL;DR

This paper establishes the existence of densities for solutions to coupled quadratic forward-backward SDEs with non-Lipschitz drifts, extending density analysis and applications to regime switching models and derivative pricing.

Contribution

It introduces a novel framework combining weak decoupling fields, local time integration, and Kolmogorov equations to analyze densities beyond existing methods.

Findings

Proves existence of densities for solutions with non-Lipschitz drifts.

Extends density and differentiability results to regime switching interest rate models.

Provides a representation of hedging strategies via weak derivatives of pricing functions.

Abstract

We explore the existence of a continuous marginal law with respect to the Lebesgue measure for each component $(X,Y,Z)$ of the solution to coupled quadratic forward-backward stochastic differential equations (QFBSDEs) {for which the drift coefficient of the forward component is either bounded and measurable or H\"older continuous. Our approach relies on a combination of the existence of a weak {\it decoupling field} (see \cite{Delarue2}), the integration with respect to space time local time (see \cite{Ein2006}), the analysis of the backward Kolmogorov equation associated to the forward component along with an It\^o-Tanaka trick (see \cite{FlanGubiPrio10})}. The framework of this paper is beyond all existing papers on density analysis for Markovian BSDEs and constitutes a major refinement of the existing results. We also derive a comonotonicity theorem for the control variable in this frame and thus extending the works \cite{ChenKulWei05}, \cite{DosDos13}. As applications of our results, we first analyse the regularity of densities of solution to coupled FBSDEs. In the second example, we consider a regime switching term structure interest rate models (see for e.g., \cite{ChenMaYin17}) for which the corresponding FBSDE has discontinuous drift. Our results enables us to: firstly study classical and Malliavin differentiability of the solutions for such models, secondly the existence of density of such solutions. Lastly we consider a pricing and hedging problem of contingent claims on non-tradable underlying, when the dynamic of the latter is given by a regime switching SDE (i.e., the drift coefficient is allowed to be discontinuous). We obtain a representation of the derivative hedge as the weak derivative of the indifference price function, thus extending the result in \cite{ArImDR10}.