Abstract
We compare two popular scenario tree generation methods in the context of financial optimization: moment matching and scenario reduction. Using a simple problem with a known analytic solution, moment matching-when ensuring absence of arbitrage-replicates this solution precisely. On the other hand, even if the scenario trees generated by scenario reduction are arbitrage-free, the solutions are biased and highly variable. These results hold for correlated and uncorrelated asset returns, as well as for normal and non-normal returns. © 2013 Elsevier B.V. All rights reserved.
Original language | English |
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Journal | Operations Research Letters |
Volume | 41 |
Issue number | 5 |
Pages (from-to) | 494-498 |
ISSN | 0167-6377 |
DOIs | |
Publication status | Published - 2013 |
Keywords
- Scenario trees
- No-arbitrage
- Financial optimization
- Moment matching
- Scenario reduction