Applications of Lévy processes

Similar documents
Lecture 1: Lévy processes

Pricing of some exotic options with N IG-Lévy input

Stochastic Dynamical Systems and SDE s. An Informal Introduction

Time change. TimeChange8.tex LaTeX2e. Abstract. The mathematical concept of time changing continuous time stochastic processes

SADDLEPOINT APPROXIMATIONS TO OPTION PRICES 1. By L. C. G. Rogers and O. Zane University of Bath and First Chicago NBD

A Continuity Correction under Jump-Diffusion Models with Applications in Finance

Chapter 1. Introduction and Preliminaries. 1.1 Motivation. The American put option problem

Basic Concepts in Mathematical Finance

Brownian Motion. Richard Lockhart. Simon Fraser University. STAT 870 Summer 2011

Large Deviations and Stochastic Volatility with Jumps: Asymptotic Implied Volatility for Affine Models

Drunken Birds, Brownian Motion, and Other Random Fun

1 Mathematics in a Pill 1.1 PROBABILITY SPACE AND RANDOM VARIABLES. A probability triple P consists of the following components:

A GENERAL FORMULA FOR OPTION PRICES IN A STOCHASTIC VOLATILITY MODEL. Stephen Chin and Daniel Dufresne. Centre for Actuarial Studies

On modelling of electricity spot price

Optimal Option Pricing via Esscher Transforms with the Meixner Process

Option pricing in the stochastic volatility model of Barndorff-Nielsen and Shephard

Modeling via Stochastic Processes in Finance

An Introduction to Stochastic Calculus

Mgr. Jakub Petrásek 1. May 4, 2009

BROWNIAN MOTION Antonella Basso, Martina Nardon

M5MF6. Advanced Methods in Derivatives Pricing

An Introduction to Stochastic Calculus

Introduction to Stochastic Calculus With Applications

MASSACHUSETTS INSTITUTE OF TECHNOLOGY 6.265/15.070J Fall 2013 Lecture 19 11/20/2013. Applications of Ito calculus to finance

MASM006 UNIVERSITY OF EXETER SCHOOL OF ENGINEERING, COMPUTER SCIENCE AND MATHEMATICS MATHEMATICAL SCIENCES FINANCIAL MATHEMATICS.

A note on the existence of unique equivalent martingale measures in a Markovian setting

Unified Credit-Equity Modeling

Beyond the Black-Scholes-Merton model

Pricing in markets modeled by general processes with independent increments

Financial Engineering. Craig Pirrong Spring, 2006

Valuing volatility and variance swaps for a non-gaussian Ornstein-Uhlenbeck stochastic volatility model

Rough volatility models: When population processes become a new tool for trading and risk management

Stochastic Processes and Stochastic Calculus - 9 Complete and Incomplete Market Models

Credit Risk using Time Changed Brownian Motions

Limit Theorems for the Empirical Distribution Function of Scaled Increments of Itô Semimartingales at high frequencies

Near-expiration behavior of implied volatility for exponential Lévy models

Sato Processes in Finance

Applications of short-time asymptotics to the statistical estimation and option pricing of Lévy-driven models

Normal Inverse Gaussian (NIG) Process

AMH4 - ADVANCED OPTION PRICING. Contents

Control. Econometric Day Mgr. Jakub Petrásek 1. Supervisor: RSJ Invest a.s.,

CRRAO Advanced Institute of Mathematics, Statistics and Computer Science (AIMSCS) Research Report. B. L. S. Prakasa Rao

MATH3075/3975 FINANCIAL MATHEMATICS TUTORIAL PROBLEMS

arxiv: v1 [q-fin.pm] 13 Mar 2014

The value of foresight

Enlargement of filtration

Continuous Time Finance. Tomas Björk

Control Improvement for Jump-Diffusion Processes with Applications to Finance

The ruin probabilities of a multidimensional perturbed risk model

Time-changed Brownian motion and option pricing

Path Dependent British Options

RMSC 4005 Stochastic Calculus for Finance and Risk. 1 Exercises. (c) Let X = {X n } n=0 be a {F n }-supermartingale. Show that.

EFFICIENT MONTE CARLO ALGORITHM FOR PRICING BARRIER OPTIONS

Stochastic Modelling Unit 3: Brownian Motion and Diffusions

Quadratic hedging in affine stochastic volatility models

Citation: Dokuchaev, Nikolai Optimal gradual liquidation of equity from a risky asset. Applied Economic Letters. 17 (13): pp

STOCHASTIC VOLATILITY AND OPTION PRICING

IEOR E4703: Monte-Carlo Simulation

Small-time asymptotics of stopped Lévy bridges and simulation schemes with controlled bias

Risk Neutral Valuation

Advanced Stochastic Processes.

Analytical formulas for local volatility model with stochastic. Mohammed Miri

We discussed last time how the Girsanov theorem allows us to reweight probability measures to change the drift in an SDE.

Introduction to Probability Theory and Stochastic Processes for Finance Lecture Notes

1 Rare event simulation and importance sampling

American Option Pricing Formula for Uncertain Financial Market

Hedging with Life and General Insurance Products

مجلة الكوت للعلوم االقتصادية واالدارية تصدرعن كلية اإلدارة واالقتصاد/جامعة واسط العدد) 23 ( 2016

Lecture Note 8 of Bus 41202, Spring 2017: Stochastic Diffusion Equation & Option Pricing

Optimal stopping problems for a Brownian motion with a disorder on a finite interval

Weierstrass Institute for Applied Analysis and Stochastics Maximum likelihood estimation for jump diffusions

Monte Carlo Methods in Financial Engineering

The Black-Scholes Model

Martingale Approach to Pricing and Hedging

MASSACHUSETTS INSTITUTE OF TECHNOLOGY 6.265/15.070J Fall 2013 Lecture 11 10/9/2013. Martingales and stopping times II

INSTITUTE OF ACTUARIES OF INDIA

Stochastic modeling of electricity prices

PAPER 27 STOCHASTIC CALCULUS AND APPLICATIONS

Lecture 4. Finite difference and finite element methods

Introduction Credit risk

based on two joint papers with Sara Biagini Scuola Normale Superiore di Pisa, Università degli Studi di Perugia

Lecture 17. The model is parametrized by the time period, δt, and three fixed constant parameters, v, σ and the riskless rate r.

Drawdowns, Drawups, their joint distributions, detection and financial risk management

THE MARTINGALE METHOD DEMYSTIFIED

From Discrete Time to Continuous Time Modeling

Credit-Equity Modeling under a Latent Lévy Firm Process

A Simulation Study of Bipower and Thresholded Realized Variations for High-Frequency Data

Conditional Density Method in the Computation of the Delta with Application to Power Market

The discounted portfolio value of a selffinancing strategy in discrete time was given by. δ tj 1 (s tj s tj 1 ) (9.1) j=1

Chapter 15: Jump Processes and Incomplete Markets. 1 Jumps as One Explanation of Incomplete Markets

The stochastic calculus

Advanced. of Time. of Measure. Aarhus University, Denmark. Albert Shiryaev. Stek/ov Mathematical Institute and Moscow State University, Russia

Sparse Wavelet Methods for Option Pricing under Lévy Stochastic Volatility models

Pricing Dynamic Solvency Insurance and Investment Fund Protection

Using Lévy Processes to Model Return Innovations

Lévy models in finance

The British Russian Option

Hedging of Contingent Claims under Incomplete Information

S t d with probability (1 p), where

Economathematics. Problem Sheet 1. Zbigniew Palmowski. Ws 2 dw s = 1 t

Transcription:

Applications of Lévy processes Graduate lecture 29 January 2004 Matthias Winkel Departmental lecturer (Institute of Actuaries and Aon lecturer in Statistics) 6. Poisson point processes in fluctuation theory 7. Lévy processes and population models 8. Lévy processes in mathematical finance 1

Summary of Introduction to Lévy processes We ve defined Lévy processes via stationary independent increments. We ve seen how Brownian motion, stable processes and Poisson processes arise as limits of random walks, indicated more general results. We ve analysed the structure of general Lévy processes and given representations in terms of compound Poisson processes and Brownian motion with drift. We ve simulated Lévy processes from their marginal distributions and from their Lévy measure. 2

6. Poisson point proc. in fluctuation theory Fluctuation theory studies the extremes of the sample paths: S t = sup s t X s and I t = inf s t X s, t 0. This also includes level passages and overshoots T x = inf{t 0 : X t > x}, K x = X Tx x, and the set of times that X spends at its supremum R = {t 0 : X t = S t } cl = {T x : x 0} cl 3

3 2 1 0-1 S_t X_t -2 0 3 6 I_t 4

6 3 T_x excursions 0-2 -1 0 1 2 3 of X-S 5

6 5 4 3 2 T_-x 1 excursions 0-3 -2-1 0 1 2 of I-X 6

Markov property Theorem 10 (Bingham) Lévy proc. are strong Markov processes, i.e. (X T +s X T ) s 0 X and is indep. of (X r ) r T. The independence of (X T +s X T ) s 0 and X T is called spatial homogeneity (in addition to temporal homogeneity). Proof of simple Markov property: T = t Choose s > 0, 0 r t, then X t+s X t and X r (and X t X r ) are independent, and similarly for 0 = s 0 <... < s m, 0 = r 0 <... < r k t finite-dimensional subfamilies are independent. Their distributions determine the distribution of (X t+s X t ) s 0 and (X r ) r t. 7

T x, x 0, for spectrally negative processes, E(X 1 ) 0 Theorem 11 (Zolotarev) T x, x 0, is a Lévy process. Proof: X has no positive jumps. Therefore X Tx = x a.s. By the strong Markov property X = (X Tx +s x) s 0 X is independent of (X r ) r Tx, in particular of T x. Also, T y T y and T x + T y = T x+y, i.e. T y = T x+y T x. In particular T x, x 0, is a Poisson point process. In fact, also (X Tx +t X Tx ) 0 t Tx, x 0, is a Poisson point process, a so-called excursion process. Example: X Brownian motion T 1/2-stable. 8

Results from fluctuation theory for general X Theorem 12 For fixed t > 0, (S t, X t S t ) (X t I t, I t ). Theorem 13 (Rogozin) For τ Exp(q) and all β > 0 E(e βsτ ) = exp ( 0 [0, ) (e βx 1)t 1 e qt P(X t dx) ). Theorem 14 R = {T x : x 0} cl = {U s : s 0} cl is the range of an increasing Lévy process U, and also (U s, X Us ) s 0 is a bivariate Lévy process, the so-called ladder process. Theorem 15 (Wiener-Hopf factorisation) If E(e iλx 1) = e ψ(λ), E(e αu 1 βs U1 ) = e κ(α,β), E(e αv 1+βI V1 ) = e ˆκ(α,β), q q + ψ(λ) κ(q, 0) ˆκ(q, 0) = κ(q, iλ) ˆκ(q, iλ). 9

Subordination and time change The operation Z t = X At with a subordinator (increasing Lévy process) is called subordination, or time change. Example in fluctuation theory: ladder height process X Ut. Bochner s subordination, Bochner(57), A independent. Conditional distributions L(A Z), also more gen. A in W(02b) Subordination in the wide sense, Huff(59), Monroe(78), Bertoin (97), Simon(99), W(WIP), A suitably dependent on X. Right inverses, Evans(00), W(02a), X At = t. 10

7. Lévy processes and population models Galton-Watson branching processes: each individual either doubles or dies at the end of each time unit, independently. Centered case: populations die out Note higher fluctuations at higher pop. sizes. Population size population size Generation or time Generation or time 11

Continuous limits of Galton-Watson processes Scaling limits give so-called Feller s diffusion, which is not Brownian motion: σ(x) = cx, x population size. 6 5 4 population size population size 3 2 1 0 Generation or time time As for random walk limits, there are generalisations to stable and infinitely divisible branching mechanisms. 12

6 5 4 population size 3 2 1 0 time 13

Genealogy of populations 30 30 Population size 20 10 0 cumulative population size 20 10 0 time time Split population into n parts and look at the evolution of their descendants (here n = 20). Let n to get full genealogy. 14

30 cumulative population size 20 10 0 time 15

Links to subordination and random trees At t = 0 infinitely many unrelated ancestors, at large t > 0, most individuals descendants of a single ancestor. Study evolution of families, can be expressed by a family of subordinators S (s,t) with subordination S (r,s) = S x (r,t), 0 S x (s,t) r s t, expressing that the descendants of a time-rindividual at time t are the time-t-descendants of all his time-s-descendants. Cf. Bertoin-LeGall-LeJan (1997) Describe continually branching family trees as stochastic objects. Literature: Aldous, Le Gall, Evans-Winter, Pitman- W(03), Duquesne-W(WIP). 16

8. Lévy processes in mathematical finance The Black-Scholes model Two assets: Risk-free bank account A t = exp{rt} and a risky stock at prices Z t = Z 0 exp {(µ 12 ) } σ2 t + σb t, t 0, where r interest rate, B Brownian motion, σ volatility and µ drift parameter. Data: non-normality, semi-heavy tails, non-constant σ Therefore: need more flexible models: Lévy-based models 17

A trading strategy is a (bounded predictable) process U t to signify the number of stock units that we hold at time t 0. All money invested is taken from or borrowed on the bank account. Given an initial wealth W 0, this determines the (random) terminal wealth W T at time T. Theorem 16 (Predictable representation property) For every square-integrable T -measurable random variable H, there is a trading strategy U and a unique 0-measurable initial wealth W 0 s.th. W T = H. As a consequence, we have a unique price W 0 for all contingent claims H, e.g. H = (Z T q) + European call option. 18

Example: The Predictable representation property is easier to believe in discrete time, say in a 2-step model A 0 = 10 A 1 = 12 A 2 = 16 Z 0 = 10 W 0 = 10 U 0 = 2 (20, 10) Z 1 = 15 Z 1 = 6 W 1 = 18, U 1 = 3 W 1 = 0, U 1 = 0 (30, 12) (45, 27) (12, 12) (0, 0) Z 2 = 22 Z 2 = 12 Z 2 = 8 Z 2 = 5 W 2 = 30 W 2 = 0 W 2 = 0 W 2 = 0 (66, 36) (36, 36) (0, 0) (0, 0) 19

Given W 2, W 0 (and W 1 ) are independent of the transition probabilities. Calculations are quite heavy, in many-step or continuous models. However, there is a unique probability measure Q, s.th. the wealth can be calculated as conditional expectations of H = W T = g(z), for all H. Q is called a martingale measure since (A 1 t W t ) 0 t T is a martingale under Q. In particular A 1 0 W 0 = A 1 T E Q(W T ). 20

Exponential Lévy processes as stock prices The Predictable representation property fails, hence no uniqueness of arbitrage free prices, different ways to choose a martingale measure. Once martingale measure chosen (changes parameters of the Lévy process), options can be priced by simulation: Option described by contingent claim H = g(z). Price 1 n n k=1 g(z (k) ) E Q (g(z)). g may depend on the path of Z, not just Z T (barriers etc.). 21

Exmpl: Black-Scholes, r = 0, σ = 1, t = 1, H = (Z 1 2) +. option price estimate 1.2 1.0.8.6.4.2 0.0 n=0 n=500 n=1000 22

Popular models Z t = B Xt, X inverse Gaussian (X t = T B t where B is NIG process 1.5 1.0.5 0.0 -.5-1.0 1.5 exponential NIG process 3.0 2.0 1.0 0.0 3.0 a Brownian motion with drift), or Gamma subord. VG process 1.0.5 0.0 -.5-1.0 exponential VG process 2.0 1.0 0.0 23

1.5 3.0 NIG process 1.0.5 0.0 -.5-1.0 exponential NIG process 2.0 1.0 0.0.1.1 VG minus NIG 0.0 -.1 -.2 exp VG minus exp NIG 0.0 -.1 -.2 24

Parametric families are useful to facilitate model fitting Stochastic volatility Stochastic volatility: Time-change by an integrated stationary volatility process, e.g. OU processes driven by subordinators X t : Y t = exp{ λt}y 0 + t I t = 0 Y sds = B It Z t t 0 exp{ λ(t s)}dx λs This model is by Barndorff-Nielsen and Shephard. This and others can be simulated and used for option pricing. 25

Summary We ve studied the extremes of Lévy processes. Ladder processes are two-dimensional Lévy processes. We ve studied subordination to construct and relate Lévy processes. Limits of branching processes can be studied like limits of random walks, giving continuous processes. We ve indicated how their genealogy can be expressed by subordination. In some sense, the genealogy of branching processes is an infinite-dimensional Lévy process. In mathematical finance, stock prices can be modelled using specific Lévy processes, often constructed by subordination. This can be used, e.g., for option pricing. 26