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Me, myself and I: a general theory of non-Markovian time-inconsistent stochastic control for sophisticated agents

Camilo Hern\'andez and Dylan Possama\"i

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Abstract: We develop a theory for continuous-time non-Markovian stochastic control problems which are inherently time-inconsistent. Their distinguishing feature is that the classical Bellman optimality principle no longer holds. Our formulation is cast within the framework of a controlled non-Markovian forward stochastic differential equation, and a general objective functional setting. We adopt a game-theoretic approach to study such problems, meaning that we seek for \emph{sub-game perfect Nash equilibrium} points. As a first novelty of this work, we introduce and motivate a new definition of equilibrium that allows us to establish rigorously an \emph{extended dynamic programming principle}, in the same spirit as in the classical theory. This in turn allows us to introduce a system of backward stochastic differential equations analogous to the classical HJB equation. We prove that this system is fundamental, in the sense that its well-posedness is both necessary and sufficient to characterise the value function and equilibria. As a final step we provide an existence and uniqueness result. Some examples and extensions of our results are also presented.

Date: 2020-02
New Economics Papers: this item is included in nep-gth
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Handle: RePEc:arx:papers:2002.12572