1 Department of Management Engineering, Technical University of Denmark 2 Management Science, Department of Management Engineering, Technical University of Denmark 3 Vienna University of Economics and Business 4 University of Liechtenstein
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.
Operations Research Letters, 2013, Vol 41, Issue 5, p. 494-498
Scenario trees; No-arbitrage; Financial optimization; Moment matching; Scenario reduction
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