TY - JOUR

T1 - Discretionary stopping of stochastic differential equations with generalised drift

AU - Zervos, Mihail

AU - Rodosthenous, Neofytos

AU - Chan Lon, Pui

AU - Bernhardt, Thomas

PY - 2019/12/5

Y1 - 2019/12/5

N2 - We consider the problem of optimally stopping a general one-dimensional stochastic differential equation (SDE) with generalised drift over an infinite time horizon. First, we derive a complete characterisation of the solution to this problem in terms of variational inequalities. In particular, we prove that the problem’s value function is the difference of two convex functions and satisfies an appropriate variational inequality in the sense of distributions. We also establish a verification theorem that is the strongest one possible because it involves only the optimal stopping problem’s data. Next, we derive the complete explicit solution to the problem that arises when the state process is a skew geometric Brownian motion and the reward function is the one of a financial call option. In this case, we show that the optimal stopping strategy can take several qualitatively different forms, depending on parameter values. Furthermore, the explicit solution to this special case shows that the so-called “principle of smooth fit” does not hold in general for optimal stopping problems involving solutions to SDEs with generalised drift.

AB - We consider the problem of optimally stopping a general one-dimensional stochastic differential equation (SDE) with generalised drift over an infinite time horizon. First, we derive a complete characterisation of the solution to this problem in terms of variational inequalities. In particular, we prove that the problem’s value function is the difference of two convex functions and satisfies an appropriate variational inequality in the sense of distributions. We also establish a verification theorem that is the strongest one possible because it involves only the optimal stopping problem’s data. Next, we derive the complete explicit solution to the problem that arises when the state process is a skew geometric Brownian motion and the reward function is the one of a financial call option. In this case, we show that the optimal stopping strategy can take several qualitatively different forms, depending on parameter values. Furthermore, the explicit solution to this special case shows that the so-called “principle of smooth fit” does not hold in general for optimal stopping problems involving solutions to SDEs with generalised drift.

UR - http://dx.doi.org/10.1214/19-ejp377

U2 - 10.1214/19-ejp377

DO - 10.1214/19-ejp377

M3 - Article

SN - 1083-6489

VL - 24

SP - 1

EP - 39

JO - Electronic Journal of Probability

JF - Electronic Journal of Probability

ER -