10/10/2006

Controlling the risky fraction process with an ergodic criterion

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This article examines a tracking problem, similar to the one presented in Pliska and Suzuki (Quantitative Finance, 2004): an investor would keep constant proportions of her wealth in different assets if markets were frictionless; however, in the presence of fixed and proportional transaction costs her implementation problem is to keep asset proportions close to the target levels whilst avoiding too much intervention costs. Instead of minimizing discounted tracking error plus transaction costs over an infinite horizon, the optimization objective here is minimization of long run tracking error plus intervention costs per unit time. This ergodic problem is treated via combining basic tools from diffusion theory and nonlinear optimization techniques. A comparative sensitivity analysis of the ergodic and discounted problems is undertaken.
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