Optimal stopping of Markov processes: Hilbert space theory, approximation algorithms, and an application to pricing high-dimensional financial derivatives

The authors develop a theory characterizing optimal stopping times for discrete-time ergodic Markov processes with discounted rewards. The theory differs from prior work by its view of per-stage and terminal reward functions as elements of a certain Hilbert space. In addition to a streamlined analysis establishing existence and uniqueness of a solution to Bellman´s equation, this approach provides an elegant framework for the study of approximate solutions. In particular, the authors propose a stochastic approximation algorithm that tunes weights of a linear combination of basis functions in order to approximate a value function. They prove that this algorithm converges (almost surely) and that the limit of convergence has some desirable properties. The utility of the approximation method is illustrated via a computational case study involving the pricing of a path dependent financial derivative security that gives rise to an optimal stopping problem with a 100-dimensional state space