ECSE 506: Stochastic Control and Decision Theory

Aditya Mahajan
Winter 2022

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Example: Call options

An investor has a call option to buy one share of a stock at a fixed price \(p\) dollars and has \(T\) days to exercise this option. For simplicity, we assume that the investor makes a decision at the beginning of each day.

The investory may decide not to exercise the option but if he does exercise the option when the stock price is \(x\), he effectively gets \((x-p)\).

Assume that the price of the stoch varies with independent increments, i.e., the price on day \(t+1\) is \[X_{t+1} = X_t + W_t\] where \(\{W_t\}_{t \ge 1}\) is an i.i.d. process with mean \(\mu\).

Let \(\tau\) denote the stopping time when the investor exercises his option. Then the optimization problem is to maximize \[ \EXP\big[ (X_{\tau} - p )\cdot \IND\{\tau \le T \} \big].\]

Since this is an optimal stopping problem with perfect state observation, the optimal strategy is given by the solution of the following dynamic program

Dynamic program \[\begin{align*} V_{T}(x) &= \max\{ x-p, 0 \} \\ V_{t}(x) &= \max\{ x-p, \EXP[ V_{t+1}(x + W) \}. \end{align*}\]

1 Qualitative properties of the value function

Lemma
  1. For all \(t\), \(V_t(x)\) is increasing in \(x\).
  2. For all \(t\), \(V_t(x) - x\) is decreasing in \(x\).
  3. For all \(x\), \(V_t(x) \ge V_{t+1}(x)\).

Proof

The first property follows immediately from monotonicity of terminal reward and the monotonicity of the dynamics. From Assignment 2, to show the third property, we need to show that \(V_{T-1}(x) \ge V_T(x)\). Observe that \[ V_{T-1}(x) = \max\{x - p, \EXP[V_{T}(x + W) \} \ge \max\{ x - p, 0 \} = V_T(x). \]

Now we prove the second property using backward induction. At \(t=T\), \[ V_T(x) - x = \max\{ -p, -x \}\] which is decreasing in \(x\). This forms the basis of induction. Now assume that \(V_{t+1}(x) - x\) is decreasing in \(x\). Then, \[ \begin{align*} V_t(x) - x &= \max\{ -p, \EXP[ V_{t+1}(x+W) ] - x \} \\ &= \max\{ -p, \EXP[ V_{t+1}(x+W) - (x + W) ] + \EXP[W] \}. \end{align*} \] By the induction hypothesis the second term is decreasing in \(x\). The minimum of a constant and a decreasing function is decreasing in \(x\). Thus, \(V_t(x) - x\) is decreasing in \(x\). This completes the induction step.

Lemma

At any time \(t\), if it is optimal to sell when the stock price is \(x^\circ\), then it is optimal to sell at all \(x \ge x^\circ\).

Proof

Since it is optimal to sell at \(x^\circ\), we must have \[\begin{equation} \label{eq:p1} x^\circ - p \ge \EXP[V_{t+1}(x^\circ + W) ] \end{equation}\] Since \(V_{t}(x) - x\) is decreasing in \(x\), we have that for any \(x \ge x^\circ\), \[\begin{equation} \label{eq:p2} \EXP[ V_{t+1}(x + W) - x ] \le \EXP[ V_{t+1}(x^\circ + W) - x^\circ ] \le -p \end{equation}\] where the last inequality follows from \eqref{eq:p1}. Eq \eqref{eq:p2} implies that \[ \EXP[ V_{t+1}(x+W) ] \le x - p. \] Thus, the stopping action is also optimal at \(x\).

Theorem

The optimal strategy is of the threshold type. In particular, there exist numbers \(s_1 \ge s_2 \ge \cdots \ge s_T\) such that it is optimal to exercise the option at time \(t\) if and only if \(x_t \ge s_t\).

Proof

Let \(S_t = \{x : g_t(x) = 1\}\). The previous Lemma shows that \(S_t\) is of the form \([s_t, \infty)\), where \(s_t = \min \{ x : g_t(x) = 1\}\), where we assume that \(s_t = \infty\) is it is not optimal to stop in any state. Thus proves the threshold property.

To show that the thresholds are decreasing with time, it suffices to show that \(S_t \subseteq S_{t+1}\). Suppose \(x \in S_t\). Then, \[\begin{equation} \label{eq:p3} x - p \ge \EXP[ V_{t+1}(x + W) ] \ge \EXP[ V_{t+2}(x + W) ], \end{equation}\] where the first inequality follows because \(x \in S_t\) and the second inequality follows because \(V_{t+1}(x) \ge V_{t+2}(x)\). Eq \eqref{eq:p3} implies that \(x \in S_{t+1}\). Hence, \(S_t \subseteq S_{t+1}\) and, therefore, the optimal thresholds are decreasing.


References

The above model for pricing options was introduced by Taylor (1967).

Taylor, H.M. 1967. Evaluating a call option and optimal timing strategy in the stock market. Management Science 14, 1, 111–120. Available at: http://www.jstor.org/stable/2628546.

This entry was last updated on 31 Mar 2020 and posted in MDP and tagged optimal stopping, structural results, threshold strategy, finance.