On the optimal stopping of a one-dimensional diffusion

Lamberton, Damien and Zervos, Mihail ORCID: 0000-0001-5194-6881 (2013) On the optimal stopping of a one-dimensional diffusion. Electronic Journal of Probability, 18. p. 34. ISSN 1083-6489

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Abstract

We consider the one-dimensional diffusion X that satisfies the stochastic differential equation dXt=b(Xt)dt+σ(Xt)dWt in the interior int(I)=]α,β[ of a given interval I⊆[-∞,∞], where b,σ:int(I)→R are Borel-measurable functions and W is a standard one-dimensional Brownian motion. We allow for the endpoints α and β to be inaccessibl or absorbing. Given a Borel-measurable function r:I→R+ that is uniformly bounded away from 0, we establish a new analytic representation of the r({dot operator}) potential of a continuous additive functional of X. Furthermore, we derive a complete characterisation of differences of two convex functions in terms of appropriate r({dot operator})-potentials, and we show that a function F:I→R+ is r({dot operator})-excessive if and only if it is the difference of two convex functions and -(1/2σ2F″′+bF′-rF) is a positive measure. We use these results to study the optimal stopping problem that aims at maximising the performance index over all stopping times τ, where f:I→R+ is a Borel-measurable function that may be unbounded. We derive a simple necessary and sufficient condition for the value function v of this problem to be real valued. In the presence of this condition, we show that v is the difference of two convex functions, and we prove that it satisfies the variational inequality max{1/2σ2v″′+bv′-rv, f--v}=0 in the sense of distributions, where f- identifies wit the upper semicontinuous envelope of f in the interior int(I) of I. Conversely, we derive a simple necessary and sufficient condition for a solution to the equation above to identify with the value function v. Furthermore, we establish several other characterisations of the solution to the optimal stopping problem, including a generalisation of the so-called "principle of smooth fit". In our analysis, we also make a construction that is concerned with pasting weak solutions to the SDE at appropriate hitting times, which is an issue of fundamental importance to dynamic programming.

Item Type:	Article
Official URL:	http://ejp.ejpecp.org
Additional Information:	© 2013 The Authors
Divisions:	Mathematics
Subjects:	Q Science > QA Mathematics
Date Deposited:	05 Apr 2013 15:26
Last Modified:	12 Dec 2024 00:22
Projects:	GR/S22998/01
Funders:	Engineering and Physical Sciences Research Council
URI:	http://eprints.lse.ac.uk/id/eprint/49625

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