Risk Aware Minimum Principle for Optimal Control of Stochastic Differential Equations

Abstract

We present a probabilistic formulation of risk aware optimal control problems for stochastic differential equations. Risk awareness is in our framework captured by objective functions in which the risk neutral expectation is replaced by a risk function, a nonlinear functional of random variables that accounts for the controller's risk preferences. We state and prove a risk aware minimum principle that gives necessary and sufficient conditions for optimality of generalized control processes taking values on probability measures defined on a given action space. We show that going from the risk neutral to the risk aware case, the minimum principle is modified by the introduction of one additional real-valued stochastic process that acts as a risk adjustment factor. This adjustment process is explicitly given as the expectation, conditional on the filtration at the given time, of an appropriately defined functional derivative of the risk function evaluated at the random total cost. The control model we employ differs from standard relaxed controls, and we elaborate on the differences, and benefits and drawbacks, of the control types; we further give conditions under which the generalized control can be realized using a strict control process. We present an application of the results for a portfolio allocation problem and show that the risk awareness of the objective function gives rise to a risk premium term that is characterized by the risk adjustment process described above. This suggests uses of our results in e.g. pricing of risk modeled by generic risk functions in financial applications.