This course aims at introducing the fundamental concepts of Reinforcement Learning (RL), and develop use cases for applications of RL for option valuation, trading, and asset management. Prerequisites are the courses "Guided Tour of Machine Learning in Finance" and "Fundamentals of Machine Learning in Finance". Students are expected to know the lognormal process and how it can be simulated. Knowledge of option pricing is not assumed but desirable.
Stochastic Approximations
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From the course by New York University Tandon School of Engineering
Reinforcement Learning in Finance
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New York University Tandon School of Engineering
34 ratings
Course 3 of 4 in the Specialization Machine Learning and Reinforcement Learning in Finance
From the lesson
MDP model for option pricing - Reinforcement Learning approach
Meet the Instructors
Igor Halperin
So, in the last video we talked about the setting of
bench reinforcement learning and what sort of data it works with.
Now, let's talk about how reinforcement learning works.
When the model is unknown,
we still deal with the same Bellman optimality equation that we had before.
To remind you of this equation, it says that,
"The time T optimal Q function is equal to the expected optimal rewards,
plus the discounted expected value of the next step optimal Q function."
Now, let's pay attention to
these expectations sign entering the right-hand side of this equation.
This is a one-step expectation,
involving the next step quantities which is conditional on
the information Ft available at time T. If we know the model,
this conditional one-step expectation can be calculated exactly in least in theory.
For example, for a discrete state model and given
a current state to compute the right-hand side of the Bellman optimality equation,
we would simply sum up over
all possible next states with
the corresponding transition probabilities as weights in this sum.
On the other hand,
if we deal with a continuous state model,
then the calculation of expectations should involve integrals instead of sums.
But again, if the model is known,
such integrals can be computed in a straightforward way at least in theory.
But what about the case when we do not know the model?
Well, in this case we can rely on
the most common trick of statistics and machine learning,
which amounts to replacing theoretical expectations with empirical means.
So, if we have samples that can be expressed as values from centre in the sum here,
then an estimate of the optimal Q function can be
obtained as an empirical mean of such values.
Please, note that this is in fact what Monte Carlo simulation does.
In our previous approach based on dynamic programming,
we first simulated four parts of
the underlying stock St from known dynamics and after that,
treated this generated sample size data to numerically
compute or estimate the option price and hedge.
Now, instead of generated data for the history
of stock prices in the setting of reinforcement learning,
we have actual price histories as a part of our information set
Ft for reinforcement learning that we discussed in the previous video.
So, if you observe stock prices in the rewards,
you might be able to rely on empirical means to estimate
the right-hand side of the Bellman optimality equation and hence to estimate
the optimal Q function at time T. But now what about
situations where we do not have a fixed historical data set to compute empirical means?
For example, for online reinforcement learning,
an agent interacts with the environment in real time
so that amount of available data increases with time.
Now, the question is,
can we adjust a sample-based estimation of expectations to handle such settings?
And the answer to this question is yes,
this is indeed possible and this is achieved
using the so-called stochastic approximations.
The most well-known stochastic approximation is called, The Robbins-Monro algorithm.
The Robbins-Monro algorithm estimates the mean without directly suming the samples,
but instead adding data points one by one.
Each time where the data point,
the algorithm iterates to the next step.
So, we can introduce the index k as
both the iteration number and the number of data point in a data set.
If we have the total of k points in the data set,
the algorithm can continue for all values of k between one and capital K. In each step,
it iteratively update the running estimation of the mean.
You know it here as hat X of k as shown in this equation.
Now, let's see what is what in this equation.
K here stands for the k-th data point,
and Xk with a hat is the estimation of the mean at the k step.
Now parameter alpha k which should be between zero and one is called learning rate and it
describes how much this estimation of the mean should be
updated after absorbing the single additional point Xk.
Please note that the superscript K in alpha k,
this means that the learning rate depends on the iteration number.
So, if the learning rate is small,
the running estimate of the mean changes only a bit with each new observation,
while the change is larger if we take a larger learning rate.
Now, the most interesting and useful fact about such simple updates rule for
the running mean is that it converges to
a true mean with probability one under certain conditions.
These conditions were found by Robbins and Monro and are shown here.
What they mean is that,
parameters alpha k should decrease sufficiently fast with
the iteration number K so that the infinite sum of alpha k squared, would be finite.
So, one can take some simple parameterization also sometimes called scheduling,
for the learning rate alpha k For example,
we can make it fall as a fractional function of k parameterized by some hyper parameters.
The original choice of Monro and Robbins is shown here.
It's given by a constant alpha between zero and one and divided by
k. In other situations depending on the actual data generating algorithm,
other scheduling schemes for alphak can work better.
In general, this means that learning rate alpha k is not integral but specific to
a problem and it may require
some experimentation when you want to apply it for your particular domain.
Finally, I want to emphasize that the Robbins-Monro algorithm is
an on-line algorithm that is best suitable for
reinforcement learning agent that interacts with its environment in real time.
However, upon a proper generalization,
we can extend it to an offline setting as well.
If we work offline instead of a single data point,
we could pick a chunk of data to update model parameters.
We discussed advantages of using such chunks of data also called
mini benches in our previous course when we discussed stochastic gradient descent.
If you remember that we said that adding mini benches instead of single points,
makes updates less volatile.
While back there we discussed a stability or gradients in optimization.
Here we discuss running average updates,
but the effect of adding mini benches instead of single point is the same.
It smoothes our variability of updates and hence,
it's a good thing if applied in variation.
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