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Abstract
Discrete time innite horizon growth optimal investment in stock
markets with transactions costs is considered. The stock processes
are modelled by homogeneous Markov processes. Assuming that the
distribution of the market process is known, we show two recursive
investment strategies such that, in the long run, the growth rate on
trajectories (in "liminf" sense) is greater than or equal to the growth
rate of any other investment strategy with probability 1.
The rst author acknowledges the support of the Computer and Automation Research
Institute of the Hungarian Academy of Sciences.
1
1 Introduction
by a Wiener process and using long run expected reward criteria. Akien,
Sulem and Taksar [1] extend these results to the case of several risky assets.
Papers dealing with growth optimal investment with transaction costs
in discrete time setting are seldom. Cover and Iyengar [18] formulated the
problem of horse race markets, where in every market period one of the
assets has positive pay o and all the others pay nothing. Their model
included proportional transaction costs and they used a long run expected
average reward criterion. There are results for more general markets as
well. Iyengar [16] investigated growth optimal investment with several
returns were assumed. In the case of discrete time, the most far reaching
study was Schäfer [26] who considered the maximization of the long run
expected growth rate with several assets and proportional transaction costs,
when the asset returns follow a stationary Markov process.
Other authors considered transaction costs with a xed and a propor-
tional part: Morton and Pliska [23], Easthem and Hastings [9], (cf. [5], [24],
[25], [21] and see also the references therein). The optimality criteria was
either long run expected average reward or long run expected discounted
reward. These articles assumed continuous time parameter and geometric
2
from Nk 1 to Nk .
Most of the above mentioned papers use some kind of method from
stochastic optimal control theory. Without exception all the papers con-
sider optimality in expected reward. None of these papers give result on
factor by which capital invested in the j -th asset grows during the trading
period.
The investor is allowed to diversify his capital at the beginning of each
trading period according to a portfolio vector b = (b (1)
; : : : b(d) ) T
. The j -th
(j )
component bb denotes the proportion of the investor's capital invested
of
in asset j . Throughout the paper we assume that the portfolio vector b has
nonnegative components with
Pd
j =1 b(j ) = 1. The fact that
Pd
j =1 b(j ) =1
means that the investment strategy is self nancing and consumption of
capital is excluded. The non-negativity of the components of b means that
short selling and buying stocks on margin are not permitted. To make the
analysis feasible, some simplifying assumptions are used that need to be
taken into account. We assume that assets are arbitrarily divisible and all
assets are available in unbounded quantities at the current price at any
3
given trading period. We also assume that the behavior of the market
is not aected by the actions of the investor using the strategies under
investigation.
Let S0 denote the investor's initial capital. Then at the end of the
d
=S = S hb ; x i ;
X
S1 0 b(j ) x(j ) 0
j =1
: R ! d ; = 1; 2; : : :
i 1
d
bi + i
so that (
bi xi1 1
) denotes the portfolio vector chosen by the investor on the
i-th trading period, upon observing the past behavior of the market. We
write (
b xi1 1
) = b (x ) to ease the notation.
i
i 1
1
the investor sets up his new portfolio, i.e. buys/sells stocks according to
the actual portfolio vector bn+1 . During this rearrangement, he has to pay
transaction cost, therefore at the beginning of a new market day n +1
the net wealth Nn in the portfolio bn+1 is less than Sn . Using the above
notations the (gross) wealth Sn at the end of market day n is
Sn = N hb n 1 n ; xn : i
The rate of proportional transaction costs (commission factors) levied on
one asset are denoted by 0<c s < 1 and 0 < c p < 1, i.e., the sale of 1 dollar
4
worth of asset i nets only 1 cs dollars, and similarly we take into account
the purchase of an asset such that the purchase of 1 dollar's worth of asset
i costs an extra cp dollars. We consider the special case when the rate of
costs are constant over the assets.
Let's calculate the transaction cost to be paid when select the portfolio
bn+1 . j -th asset there is b(nj ) x(nj ) Nn
Before rearranging the capitals, at the 1
otherwise we have to buy and the transaction cost at the j -th asset is
(j )
cp bn+1 Nn b(nj ) x(nj ) Nn 1 :
Let x+ denote the positive part of x. Thus, the gross wealth Sn decom-
poses to the sum of the net wealth and cost the following - self-nancing -
way
d d
=S
X + X +
(j ) (j )
Nn n cs b(nj ) x(nj ) Nn 1 bn+1 Nn cp bn+1 Nn b(nj ) x(nj ) Nn 1 ;
j =1 j =1
or equivalently
d d
= N +c +c
X + X +
(j ) (j )
Sn n s b(nj ) x(nj ) Nn 1 bn+1 Nn p bn+1 Nn b(nj ) x(nj ) Nn 1 :
j =1 j =1
wn = NS n
;
n
hbn ; xni
(j )
b
n+1 wn +c p
X
b
(j )
n+1 wn
hbn ; xni :
j =1 j =1
5
Remark 2.1. Equation (2.1) is used in the sequel. Examining this cost
equation, it turns out, that for arbitrary portfolio vectors bn , bn+1 , and
return vector xn there exists a unique cost factors wn 2 [0; 1), i.e. the
portfolio is self nancing. The value of cost factor wn at day n is determined
by portfolio vectors bn and bn+1 as well as by return vector xn , i.e.
wn = w (b ; b n n+1 ; xn );
for some function w. If we want to rearrange our portfolio substantially,
then our net wealth decreases more considerably, however, it remains pos-
itive. Note also, that the cost does not restrict the set of new portfolio
vectors, i.e., the optimization algorithm searches for optimal vector bn+1
within the whole simplex . The value of the cost factor ranges between
d
1 c w 1: s
1+c p
n
n
= N hb i = wn hbn ; xni = [w(bi ) hb ; x i]:
Y
Sn n 1 n ; xn 1 Sn 1 1 ; bi ; xi 1 i i
i=1
(
g bi 1 ; bi ; xi 1 ; xi ) = log(w(b i 1 ; bi ; xi 1 ) hb ; x i);
i i
1 log S = 1 log(w(b ; b ; x ) hb ; x i)
n
n
X
i 1 i i 1 i i
n n i=1
= n1 g(b ; b ; x ; x ): Xn
(2.2) i 1 i i 1 i
i=1
Remark 2.2. In modelling the behavior of the evolution of the market, two
6
arbitrary values and no stochastic model is imposed on the mechanism gen-
erating the price relatives. In this approach the achieved wealth is compared
with that of the best in a class of reference strategies. For example, Cover
[7] considers the class of all constantly rebalanced portfolios ( crp) dened
by strategies B for which bi (x ) equals a xed portfolio vector indepen-
i 1
1
i 1
dently of i and the past x1 . Without transaction cost, Cover showed that
there exist investment strategies B (so-called universal portfolios) which
perform almost as well as the best constantly rebalanced portfolio. The
advantage of this worst-case approach is that it avoids imposing statis-
tical models on the stock market and the results hold for all possible se-
quences xn1 . In this sense this approach is extremely robust. Taking into
account the transaction cost Iyengar [17], Iyengar and Cover [18], Kalai
and Blum [20], and Merhav et al [22] introduced universal portfolio selec-
(2.3)
1 log S = I + J ;
n n n
n
where
= n1 (g(b
n
In
X
i 1 ; bi ; Xi 1 ; Xi ) Efg(b i 1 ; bi ; Xi 1 ; Xi )jX g)
i 1
1
i=1
= n1 Efg(b
and
n
)jX g:
X
i 1
Jn i 1 ; bi ; Xi 1 ; Xi 1
i=1
i=1
i2
implies that
In !0
almost surely. Thus, the asymptotic maximization of the average growth
rate
1
n
log S n is equivalent to the maximization of Jn .
fXig is a homogeneous and rst order Markov
If the market process
process then, for appropriate portfolio selection fbi g, we have that
Efg(bi ; bi ; Xi ; Xi )jXi g1 1 1
1
= v (b
def
i 1 ; bi ; Xi 1 );
therefore the maximization of the average growth rate
1
n
log S n is asymp-
totically equivalent to the maximization of
= n1
n
( ):
X
(2.4) Jn v bi 1 ; bi ; Xi 1
i=1
8
B with capital Sn = S (B) and for any stationary and ergodic return
n
process fXng11,
lim!1inf n1 log SS 0
n
almost surely
n
n
and
lim 1
n!1 n log S = W n almost surely,
where ( )
Györ and Schäfer [12] and Györ, Lugosi and Udina [11] constructed em-
pirical (data dependent) log-optimum strategies in case of unknown distri-
butions. Note that for rst order Markovian return process
(
bn X1n 1
) = b (X ) = argbmax
n n 1
E f log hb(X ) ; X ij X g :
()
n 1 n n 1
includes daily prices of 36 assets along a 22-year period (5651 trading days)
ending in 1985. = 36. However, for a usual value of
This means that d
transaction coecient c = c = c = 0:0015 the portfolio b (X ) has poor
b s
n 1
n
performance, i.e., the resulting average growth rate is typically negative.
a Borel space, called the state space, the action space A is Borel, too, the
space of admissible actions U s ( ) is a Borel subset of A. Let the set K be
9
f(s; a) : s 2 S; a 2 U (s)g. The transition law is a stochastic kernel Q(:js; a)
on S given K, and ( ) is the reward function.
r s; a
The evolution of the process is the following. Let St denote the the state
at time t, action At is chosen at that time. Let St s and At a , then = =
( )
the reward is r s; a , and the process moves to St+1 according to the kernel
(j )
Q : s; a . A control policy is a sequence =f g
n of stochastic kernels on
(j
A given the past states and actions, i.e., n s0 ; a0 ; : : : ; sn 1 ,an 1 ; sn is a )
randomized policy, it is the conditional probability distribution of the the
randomization.
Two reward criteria is considered. The expected long run average re-
ward for is dened by
(3.1) ( ) = liminf
J
1 n
X1
E r(St ; At ):
!1 n
n
t=0
(3.2) ( ) := liminf
J
1 n
X1
(
r St ; At : )
!1 nn
t=0
In the theory of MCP most of the results correspond to (3.1), while just
a few present result for the sample-path criterion (3.2). Such sample-path
results can be found in [3] for bounded rewards and in [14], [15], [31], [19]
for unbounded rewards.
For Markov control processes, the main aim is to approach the maximum
asymptotic reward:
J = sup J ();
10
2: The action space is
A := :
d
This special form of admissible set of actions makes the optimization prob-
lem much easier.
4: The stochastic kernel is the transition probability distribution of the
Markov market process, describing the asset returns:
((
Q d b0 ; x0 )j(b; x); b0) := P (dx0jx) := PfdX = dx0jX = xg:
2 1
Note, that this corresponds to the assumption, that the market behaviour is
not aected by the investor. In general, the optimal strategy is randomized.
However, if the market is not inuenced by the trading then the optimal
strategy can be non-randomized, as it will be shown in the next section.
!1 n v (b ; b ; x )
X X
t 1 t 1 t t 1 t t 1
n n
t=1 t=1
= lim!1inf J : n
n
Remark 3.1. It should be noted that the methods of MCP literature, more
precisely the theorems in [3], [14], [15], [31], [19] can't be applied in our
case. However, we do use the formalism, the results on the existence of the
solution of discounted Bellman equations, and the basic idea of vanishing
discount approach. The diculties arise from the fact, that we do not as-
sume weakly continuous transition kernel. (cf. [3]). But even if we assumed
weak or even strong continuity (continuity for bounded Borel measurable
functions) of ( j ), an additional ergodicity assumption would be nec-
Q dy :; :
essary. The usual uniform ergodicity assumption on f(b ; x )g is equivalent
t t
to aperiodicity and Doeblin's condition (cf. [14]). However, the aperiodic-
ity of f(bt; xt)g is not necessarily true, one can easily give counterexamples
for it.
11
4 Optimal portfolio selection algorithms
Remark 4.1. One may consider long run expected average reward crite-
ria (3.1), to maximize the expected average growth rate of wealth of the
lim!1inf n1 Eflog S g:
investor:
n
n
g + V (b; x) = max
b
fv0(b; b0; x) + EfV (b0; X )gg ;
0
1
Iyengar [16] proves that if the solution (V; g) exists then this portfolio
selection has optimal expected growth rate g. In order to avoid imposing
12
some regularity conditions on the optimal policy for the convergence of
the value iteration algorithm, it is shown that for all > 0 there exists
a continuous portfolio selection function with expected growth rate not
smaller than g .
(4.2) ( ) = max
F b; x
b
fv(b; b0; x) + (1
0
)EfF (b0; X ) j X = xgg :
2 1
way we give only the sketch of it. Let H be the following operator
H : h(b; x) ! max
b
fv(b; b0; x) + (1
0
)Efh(b0; X ) j X = xgg 2 1
F;m+1 b; x( ) = max
b
fv(b; b0; x) + (1
0
)EfF (b0; X ) j X = xgg ;
;m 2 1
Schäfer [26]).
13
Remark 4.2. A strategy similar to (4.3) was dened by Schäfer [26].
He introduces an additional asset to settle the transaction costs when the
portfolio is restructured.
(i i )=i ! 0 +1
2
+1
as i ! 1, and 1
X 1 < 1:
n=1 n2 n2
Then, for Strategy 1, the portfolio fbi g with capital Sn is optimal in
the sense that for any portfolio strategy fbi g with capital Sn ,
n n
n
a.s.
14
Remark 4.4. According to Theorem 4.2.1 in Schäfer [26],
n n
n
i =i
;
1 log S = 1 n
X
(
g bi ; bi+1 ; Xi ; Xi+1 )
n
n n i=1
is convergent for ergodic market process, and the limit W is not random.
A further problem is how to calculate W .
1
~ =
Sn
X
qk Sn B(k) : ( )
k=1
15
Theorem 4.2 Assume (i) and (ii) of Theorem 4.1. Choose the dis-
count factor i # 0 as i ! 1. Then, for Strategy 2,
lim 1 log S 1 log S~ = 0
n!1 n n n n
a.s.
The importance of the Theorem 4.2 is that we can approach the optimal
average growth rate asymptotically with ~
Sn . An important direction of our
future work is to construct an empirical version of this stationary rule, i.e.,
to get a data driven portfolio selection when the distribution of the market
process is unknown.
5 Proofs
( ) = F (b; x):
Fi b; x i
lim!1inf n1 1 !
n n
g (bi ; bi+1 ; Xi ; Xi+1 ) ( ) 0
X X
g bi ; bi+1 ; Xi ; Xi+1
n
i=1
n i=1
lim!1inf n1 ) n1
!
n n
(
g bi ; bi+1 ; Xi ; Xi+1 ( )
X X
g bi ; bi+1 ; Xi ; Xi+1
n
i=1 i=1
= lim!1inf n1 1 !
n n
v (bi ; bi+1 ; Xi ) ( )
X X
v bi ; bi+1 ; Xi
n
i=1
n i=1
lim!1inf n1 1 !
n n
v (bi ; bi+1 ; Xi ) ( ) 0
X X
(5.1) v bi ; bi+1 ; Xi
n
i=1
n i=1
(5.2) (
Fi bi ; Xi ) = v(b; b i i+1 ; Xi ) + (1 i )EfF (b i i+1 ; Xi+1 )jb i+1 ; Xi g;
16
while for any portfolio fbig,
(5.3) (
Fi bi ; Xi ) v (b ; b i i+1 ; Xi ) + (1 i )EfF (b i i+1 ; Xi+1 )jb i+1 ; Xi g:
Because of (5.2) and (5.3), we get that
1 n
X
(
v bi ; bi+1 ; Xi )
n i=1
= n1
n
( ) (1 )EfF (b )j
Fi bi ; Xi g
X
i i i+1 ; Xi+1 bi+1 ; Xi
i=1
= 1
n
( ) (1 )EfF (b )j g
Fi bi ; Xi
X
i
i i i+1 ; Xi+1 X1
n i=1
and
1 n
X
(
v bi ; bi+1 ; Xi )
n i=1
n1
n
(F (b ; X ) (1 )EfF (b )jb g)
X
i i i i i i+1 ; Xi+1 i+1 ; Xi
i=1
= n1
n
( ) (1 )EfF (b )jX g
X
i
Fi bi ; Xi i i i+1 ; Xi+1 1 ;
i=1
therefore
1 n
X
(
v bi ; bi+1 ; Xi ) n1
n
X
(
v bi ; bi+1 ; Xi )
n i=1 i=1
n1
n
( ) (1 )EfF (b )j g
Fi bi ; Xi
X
i
i i i+1 ; Xi+1 X1
i=1
1 Xn
(
Fi bi ; Xi ) (1 i )EfF (b i i+1 ; Xi+1 )jX g i
:
1
n i=1
(1 )jX g
i )EfF (b i i+1 ; Xi+1
i
1 (
Fi bi ; Xi )
= EfF (b ; X )jX g F (b
i i+1 i+1
i
1 i i+1 ; Xi+1 )
+ F (b ; X ) F (b ; X )
i i+1 i+1 i i i
EfF (b ; X )jX g
i i i+1 i+1
i
1
= a +b +c :i i i
17
Because of
( ) = max
Fi b; x
b
fv(b; b0; x) + (1
0
i )E(F (b0; X )jX = x); g
i i+1 i
we have that
kFik1 kvk1
therefore
therefore, because of
P 1
2
n n2 n < 1, the Chow Theorem implies that
(5.4)
1 n
X
ai !0
n i=1
( ) = max
Fi b; x
b
fv(b; b0; x) + (1
0
i )E(F (b0; X )jX = x))g
i i+1 i
( ) = max
Fi+1 b; x
b
fv(b; b00; x) + (1 )E(F (b00; X )jX = x)g
00
i+1 i+1 i+2 i+1
( ) F (b; x)
Fi b; x i+1
max
b
f(1 )E(F (b0; X jX = x)) (1 )E(F (b0; X )jX = x))g
0
i i i+1 i i+1 i+1 i+1 i
(1 )kF F k1 + (
i i ) max E(F (b0 ; X )jX = x)
b
i+1 i+1 i 0
i+1 i+1 i
(1 )kF F k1 + (
i i )kF k1 :
i+1 i+1 i i+1
18
So we have
kFi Fi+1 k 1 i i
i+1
kFi k1:
+1
1 (F (b
n
) ( ))
X
i i+1 ; Xi+1 Fi+1 bi+1 ; Xi+1
n
i=1
+ 1 (F (b ; X ) F (b ; X ))
Xn
i+1 i+1 i+1 i i i
n
i=1
n1 kF F k1
n
X
i i+1
i=1
+ 1 (F (b ; X ) F (b ; X ))
n+1 n+1 n+1 1 1 1
n
n1 k1 + kFn k1n+ kF k1
n
kFi
X
+1 1
Fi+1
i=1
kvk1 n1 ji i j
+ kvk 1=n + 1=
n X
+1 +1 1
2 1 n
i i =1 +1
(5.5) ! 0
by conditions. Concerning the proof of (5.1) what is left to show that
sup n1
n
lim!1 f ( )j g f ( )j g 0
i E Fi bi+1 ; Xi+1 Xi1
X
i E Fi bi+1 ; Xi+1 Xi1
n
i=1
19
a.s. The denition of Fi implies that
( ) F (b ; X )
Fi bi+1 ; Xi+1 i i+1 i+1
0
i+1 i+1 i i i+2 i+1
b
00
i+1 i+1 i i i+2 i+1
b
i+2 i+1
max v (b ; b0 ; X ) v (b ; b0 ; X )
n o
b 0
i+1 i+1 i+1 i+1
2kvk1;
therefore
(5.6)
1 n
X
f (
i E Fi bi+1 ; Xi+1 ) (
Fi bi+1 ; Xi+1 Xi1 )j g 2kvnk1
n
X
i ! 0:
n i=1 i=1
n n
n
(5.7) n n
n
1 log S~ = 1 log 1 q S (B )
n
X
k n
(k )
n n k=1
1 log sup q S (B ) n
k n
(k)
20
a.s. which is equivalent to
(5.8)
(5.9) ( (k)
Fk bi ; Xi ) = v (b (k)
i
(k)
; bi+1 ; Xi ) + (1 k )EfF (bk
(k)
i+1 )j (k)
; Xi+1 bi+1 ; Xi ; g
while for any portfolio fbig,
(
Fk bi ; Xi ) v (b ; b i i+1 ; Xi ) + (1 k )EfF (b k i+1 ; Xi+1 )jbi+1 ; Xi g;
thus for the portfolio fbi g
(5.10) (
Fk bi ; Xi ) v(b; b i i+1 ; Xi ) + (1 k )EfF (bk i+1 ; Xi+1 )jb i+1 ; Xi g:
Because of (5.9) and (5.10), we get that
1 n
X
(
v bi ; bi+1 ; Xi )
n i=1
n1
n
( ) (1 )EfF (b )j
Fk bi ; Xi g
X
k k i+1 ; Xi+1 bi+1 ; Xi
i=1
= n1
n
( ) (1 )EfF (b )j g
Fk bi ; Xi
X
i
k k i+1 ; Xi+1 X1
i=1
and
1 n
X
( (k)
v bi ; bi+1 ; Xi
(k)
)
n i=1
= n1
n
( ) (1 )EfF (b )j
g
X
(k ) (k) (k)
Fk bi ; Xi k k i+1 ; Xi+1 bi+1 ; Xi
i=1
= 1
n
( ) (1 )EfF (b )j g
X
(k ) (k)
Fk bi ; Xi k k i+1 ; Xi+1 Xi1 ;
n i=1
21
therefore
1 n
X
(
v bi ; b
(k) (k)
;X )
1
i
n
X
(
v bi ; bi+1 ; Xi )
i+1
n i=1
n i=1
n1
n
( ) (1 )EfF (b )j g
X
(k) (k)
Fk bi ; Xi k k i+1 ; Xi+1 Xi1
i=1
1 Xn
Fk bi ; Xi( ) (1 k )EfF (b i
)j g
k i+1 ; Xi+1 X1 :
n i=1
(1 )jX g
k )EfF (b k i+1 ; Xi+1
i
1 (
Fk bi ; Xi )
= EfF (b ; X )jX g F (b
k i+1 i+1
i
1 k i+1 ; Xi+1 )
+ F (b ; X ) F (b ; X )
k i+1 i+1 k i i
EfF (b ; X )jX g
k k i+1 i+1
i
1
= a +b +c :
i i i
Similarly to the proof of Theorem 4.1, the averages of ai 's and bi 's tend to
k !1
n n i=1
i i+1 i
n i=1
i i+1 i
!
n n
= sup lim!1inf
k n
k
n
X
EfFk (b (k )
i+1 ; Xi+1 X1 )j g i k
n
X
EfFk (bi+1 ; Xi+1 )jXi1 g :
i=1 i=1
The problem left is to show that the last term is non negative a.s. Using
22
the denition of Fk
( (k )
Fk bi+1 ; Xi+1 ) F (b ; X ) k i+1 i+1
0
i+1 i+1 k k i+2 i+1
b
00
i+1 i+1 k k i+2 i+1
b
0 00
i+1 i+1 k k i+2 i+1
b b
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