Optimal Portfolio under Fast Mean-Reverting Fractional Stochastic Environment

Source abstract

Empirical studies indicate the existence of long-range dependence in the volatility of the underlying asset. This feature can be captured by modeling its return and volatility using functions of a stationary fractional Ornstein--Uhlenbeck (fOU) process with Hurst index $H \in (\frac{1}{2}, 1)$. In this paper, we analyze the nonlinear optimal portfolio allocation problem under this model and in the regime where the fOU process is fast mean-reverting. We first consider the case of power utility, and rigorously give first order approximations of the value and the optimal strategy by a martingale distortion transformation. We also establish the asymptotic optimality in all admissible controls of a zeroth order trading strategy. Then, we consider the case with general utility functions using the epsilon-martingale decomposition technique, and we obtain similar asymptotic optimality results within a specific family of admissible strategies.