Control Systems Methods in Finance:

Modeling and Optimal Trading

James A. Primbs
Management Science and Engineering
Stanford University
ACC 2010
Baltimore, MD
June 30, 2010
Introduction
Outline
Future Outlook
Modeling Market Dynamics
Optimal Trading in Financial Market
Important Early Developments in Quantitative Finance
1964: William Sharpe publishes the Capital Asset Pricing Model. (Lintner,
Mossin, and Treynor independently discover the same theory).
1955: Harry Markowitz develops mean-variance portfolio optimization in a
single period framework in his PhD thesis from University of Chicago.
Quantitative finance is born.
1969+: Samuelson (69) and especially Merton (69,71,73) publish dynamic
portfolio optimization work using control theory and dynamic programming.
1973: Black and Scholes (with input from Merton) publish the seminal paper
on option pricing theory that shows that dynamic strategies can be used to
create options. Option pricing theory takes off and quantitative finance is
here to stay.
Where is Control Engineering for Finance Now?
It has been nearly 40 years since dynamic methods were
prominently introduced into finance.
However, despite having control underpinnings, control
systems theory, methods, and tools are not widely taught as
part of quantitative finance or financial engineering
curriculums.
There is a huge opportunity for that to change if the control
systems community is willing to educate itself regarding
financial engineering.
In this talk, we will take a high level look at two
opportunities for the control systems community
Introduction
Outline
Future Outlook
Modeling Market Dynamics
Optimal Trading in Financial Markets
Control Problems in Finance
Most of the standard financial engineering problems can
be cast in a stochastic optimal control framework.
What is the dynamics?
Stochastic
differential/difference equation
models of stock price
movement.
SdZ Sdt dS o + =
rBdt dB =
Example:
Control Problems in Finance
What can we control?
We control what we hold in
our portfolio and this
determines our wealth
dynamics.
Most of the standard financial engineering problems can
be cast in a stochastic optimal control framework.
) ( rSdt dS u rWdt dW + =
How many shares do you want?
SdZ Sdt dS o + =
rBdt dB =
Example:
Control Problems in Finance
Most of the standard financial engineering problems can
be cast in a stochastic optimal control framework.
) ( rSdt dS u rWdt dW + =
SdZ Sdt dS o + =
rBdt dB =
Example:
Stochastic
System
Dynamics
Things can quickly get more complicated:
Transaction Costs
Margin Constraints
Liquidity Constraints
Market Impact
Control Problems in Finance
What is the objective?
Portfolio Optimization: Maximize the utility of wealth.
))] ( ( [ max T W U E
u
Who uses this: Assets Management Firms, Hedge Funds, Investment
Advisors. All of us! (Think about your retirement account!)
Most of the standard financial engineering problems can
be cast in a stochastic optimal control framework.
1. Grow Wealth
Control Problems in Finance
What is the objective?
Dynamic Hedging: Minimize the difference between wealth and a
payoff at a specified time T.
| |
2
) ) ( ( min payoff T W E
u

Who uses this: Investment Banks (Option Pricing, Risk Management),

Hedge Funds (Statistical Arbitrage).
Most of the standard financial engineering problems can
be cast in a stochastic optimal control framework.
2. Replicate a payoff
Control Problems in Finance
What is the objective?
Index Tracking: Minimize the tracking error between your wealth and
a pre-specified index such as the S&P 500.
(

0
2
)) ( ) ( ( min dt t I t W e E
t
u

Who uses this: Asset Management Firms (variations such as beat a

benchmark index), ETFs.
Most of the standard financial engineering problems can
be cast in a stochastic optimal control framework.
3. Track an index
What are the challenges and
opportunities for control engineers?
Bottom line: Do what we already do, just tailor it to
financial engineering applications.
Create practical, engineering oriented solutions to real
financial engineering problems.
Handle transaction costs and constraints
Efficient algorithms for large problems sizes.
Examples:
Introduction
Outline
Future Outlook
Modeling Market Dynamics
Optimal Trading in Financial Market
Financial Market Dynamics
Price dynamics results from the interaction of many
traders using a variety of strategies and objectives.
Lots of feedback loops! To understand such a system, one
must understand feedback. That is what we know best
Market
Financial
Institutions
Funds
Individuals
Government
Regulation
Motivating Example 1
87 Stock Market Crash
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Returns
Returns
0
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Stock Prices
DJI
The Dow Jones Industrial Average Drops over 500 points (more than 22%) in
a single day!
There is no apparent fundamental reason for the crash. What happened?
The finger is pointed at feedback effects from so called portfolio insurance
ideas. (See the Brady Commission Presidential Report.)
Crash!
Motivating Example 2
Stock Pinning
Stocks on options with high open interest can become pinned to the strike
price at expiration. Why does this happen?
One explanation: Feedback effects from Black-Scholes option pricing theory
based dynamic hedging strategies are responsible.
See Avellaneda and Lipkin (03), Primbs and Rathinam (09).
Strike Price
Stock Path
Motivating Example 3
August 2007 Hedge Fund Unwinding
See What Happened to the Quants in August 2007? by Khandani and Lo (07).
The price impact of the unwind causes other hedge funds to de-leverage
which exacerbates losses.
Top quant hedge funds lose big: Renaissance loses 8.7% in first 10 days of
August. Highbridge drops 18%. Tykhe is down 20%.
Note: Nothing unusual in overall market during that time. Losses were narrowly
confined to model driven long/short market neutral strategies. Could a control
systems/feedbacks analysis explain and even have predicted this?
What happened: The rapid unwinding of one or more quantitative market
neutral portfolios ripples through the entire quant hedge fund industry.
Long Short
Feedback Phenomena
Lots of interesting feedback phenomena occurring in the
market!
Control and systems perspective can help to understand,
explain, and perhaps even predict and mitigate
phenomena.
1. Volatility Clustering
2. Heavy Tail Distributions
3. Volatility Smile and Smirks
4. 1000 point drop in 2010.
5. Etc
Theres more!
Introduction
Outline
Future Outlook
Modeling Market Dynamics
Optimal Trading in Financial Market
Looking to the Future
Control and systems engineering can become a major tool
for the design, optimal management, and understanding of
financial systems.
Lots of interesting problems that have not been explored
from the control perspective.
We have the tools to address real problems whose impact
is felt on a global scale. An exciting opportunity!