English

Time-consistent conditional expectation under probability distortion

Mathematical Finance 2020-06-29 v5

Abstract

We introduce a new notion of conditional nonlinear expectation under probability distortion. Such a distorted nonlinear expectation is not sub-additive in general, so it is beyond the scope of Peng's framework of nonlinear expectations. A more fundamental problem when extending the distorted expectation to a dynamic setting is time-inconsistency, that is, the usual "tower property" fails. By localizing the probability distortion and restricting to a smaller class of random variables, we introduce a so-called distorted probability and construct a conditional expectation in such a way that it coincides with the original nonlinear expectation at time zero, but has a time-consistent dynamics in the sense that the tower property remains valid. Furthermore, we show that in the continuous time model this conditional expectation corresponds to a parabolic differential equation whose coefficient involves the law of the underlying diffusion. This work is the first step towards a new understanding of nonlinear expectations under probability distortion, and will potentially be a helpful tool for solving time-inconsistent stochastic optimization problems.

Cite

@article{arxiv.1809.08262,
  title  = {Time-consistent conditional expectation under probability distortion},
  author = {Jin Ma and Ting-Kam Leonard Wong and Jianfeng Zhang},
  journal= {arXiv preprint arXiv:1809.08262},
  year   = {2020}
}

Comments

38 pages, 4 figures. To appear in Mathematics of Operations Research