Non-concave stochastic optimal control in finite discrete time under model uncertainty

TL;DR

This paper develops a general framework for non-concave robust stochastic control in finite discrete time under model uncertainty, with applications to financial derivative hedging during crises, demonstrating improved performance over classical strategies.

Contribution

It introduces a dynamic programming approach for non-concave robust control problems with path-dependent ambiguity sets, including Wasserstein-balls, and applies it to financial hedging under model uncertainty.

Findings

Robust control outperforms classical hedging during financial crises.

Wasserstein-balls effectively model ambiguity in financial data.

The framework provides bounds on the value difference between robust and non-robust problems.

Abstract

In this article we present a general framework for non-concave robust stochastic control problems under model uncertainty in a discrete time finite horizon setting. Our framework allows to consider a variety of different path-dependent ambiguity sets of probability measures comprising, as a natural example, the ambiguity set defined via Wasserstein-balls around path-dependent reference measures with path-dependent radii, as well as parametric classes of probability distributions. We establish a dynamic programming principle which allows to derive both optimal control and worst-case measure by solving recursively a sequence of one-step optimization problems. Moreover, we derive upper bounds for the difference of the values of the robust and non-robust stochastic control problem in the Wasserstein uncertainty and parameter uncertainty case. As a concrete application, we study the robust hedging problem of financial derivatives under an asymmetric (and non-convex) loss function accounting for different preferences of sell- and buy side when it comes to the hedging of financial derivatives. As our entirely data-driven ambiguity set of probability measures, we consider Wasserstein-balls around the empirical measure derived from real financial data. We demonstrate that during adverse scenarios such as a financial crisis, our robust approach outperforms typical model-based hedging strategies such as the classical Delta-hedging strategy as well as the hedging strategy obtained in the non-robust setting with respect to the empirical measure and therefore overcomes the problem of model misspecification in such critical periods.