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1[Tk ,) (t),
t R+ ,
(14.1)
k=1
where
The notation Nt is not to be confused with the same notation used for num
eraire
processes in Chapter 10.
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N. Privault
1[Tk ,) (t) =
1 if t Tk ,
0 if 0 t < Tk ,
k 1, and (Tk )k1 is the increasing family of jump times of (Nt )tR+ such
that
lim Tk = +.
k
Nt
0
0
10
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P(Nt Ns = k) = e(ts)
((t s))k
,
k!
k N,
(14.2)
The proof of the above Theorem 14.1 is technical and not included here,
cf. e.g. [6] for details, and we could in fact take this distribution property
(14.2) as one of the hypotheses that define the Poisson process.
Precisely, we could restate the definition of the standard Poisson process
(Nt )tR+ with intensity > 0 as being a process defined by (14.1), which is
assumed to have independent increments distributed according to the Poisson
distribution, in the sense that for all 0 t0 t1 < < tn ,
(Nt1 Nt0 , . . . , Ntn Ntn1 )
is a vector of independent Poisson random variables with respective parameters
((t1 t0 ), . . . , (tn tn1 )).
In particular, Nt has the Poisson distribution with parameter t, i.e.
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P(Nt = k) =
(t)k t
e ,
k!
t > 0.
(14.4)
h 0,
P(Nh = 0) = eh ' 1 h,
h 0.
and
By stationarity of the Poisson process we find more generally that
P(Nt+h Nt = 1) = heh ' h,
h 0,
P(Nt+h Nt = 0) = eh ' 1 h,
h 0,
and
for all t > 0.
This means that within a short interval [t, t + h] of length h, the increment Nt+h Nt behaves like a Bernoulli random variable with parameter
h. This fact can be used for the random simulation of Poisson process paths.
We also find that
P(Nt+h Nt = 2) ' h2
2
,
2
h 0,
t > 0,
k
,
k!
h 0,
t > 0.
The intensity of the Poisson process can in fact be made time-dependent (e.g.
by a time change), in which case we have
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k 0.
In particular,
(t)dt
' 1 (t)dt,
o(dt),
k = 0,
k = 1,
k 2,
w
t
es
sn1
ds.
(n 1)!
Proof. We have
P(T1 > t) = P(Nt = 0) = et ,
t R+ ,
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P(Tn1 > t) =
w
t
es
(s)n2
ds,
(n 2)!
n 2,
we obtain
P(Tn > t) = P(Tn > t Tn1 ) + P(Tn1 > t)
= P(Nt = n 1) + P(Tn1 > t)
w
(s)n2
(t)n1
es
+
ds
= et
t
(n 1)!
(n 2)!
w
(s)n1
ds,
t R+ ,
=
es
t
(n 1)!
where we applied an integration by parts to derive the last line.
(t)n
,
n!
t0 , . . . , tn R+ .
1
,
we can check that the higher the intensity (i.e. the higher the probability
of having a jump within a small interval), the smaller is the time spent in
each state k N on average.
In addition, conditionally to {NT = n}, the n jump times on [0, T ] of
the Poisson process (Nt )tR+ are independent uniformly distributed random
variables on [0, T ]n , cf. e.g. 12.1 of [91]. This fact can be useful for the
random simulation of the Poisson process.
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(14.5)
i.e. the compensated Poisson process (Nt t)tR+ has centered increments.
Since in addition (Nt t)tR+ also has independent increments we get
the following proposition.
Proposition 14.2. The compensated Poisson process
(Nt t)tR+
is a martingale with respect to its own filtration (Ft )tR+ .
Extensions of the Poisson process include Poisson processes with timedependent intensity, and with random time-dependent intensity (Cox processes). Renewal processes are counting processes
X
Nt =
1[Tn ,) (t),
t R+ ,
n1
wb
a
(dy),
< a b < .
Nt
X
Zk ,
t R+ ,
(14.6)
k=1
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is called a compound Poisson process.
The next figure represents a sample path of a compound Poisson process,
with here Z1 = 0.9, Z2 = 0.7, Z3 = 1.4, Z4 = 0.6, Z5 = 2.5, Z6 = 1.5,
Z7 = 1.2.
2.5
Yt
1.5
0.5
-0.5
0
10
R.
Proof. Since Nt has a Poisson distribution with parameter t > 0 and is
independent of (Zk )k1 , for all R we have by conditioning:
"
IE [exp ((YT Yt ))] = IE exp
!#
NT
X
Zk
k=Nt +1
"
= IE exp
NT
Nt
X
!#
Zk
k=1
"
IE exp
n=0
= e(T t)
n
X
!#
Zk
P(NT Nt = n)
k=1
"
!#
n
X
X
n
(T t)n IE exp
Zk
n!
n=0
k=1
Pn
k=1
Zk = 0 if n = 0.
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= e(T t)
X
n
n
(T t)n (IE [exp (Z1 )])
n!
n=0
(dy) = 1.
From the characteristic function we can compute the expectation and variance of Yt for fixed t, as
IE[Yt ] = t IE[Z1 ]
and
w
d
IE[eiYt ]|=0 = t
y(dy) = t IE[Z1 ].
" n
#
X
X
n tn
=e
IE
Zk Nt = n
n!
n=1
k=1
" n
#
X
X
n tn
t
=e
IE
Zk
n!
n=1
t
k=1
X
(t)n1
= tet IE[Z1 ]
(n 1)!
n=1
= t IE[Z1 ].
More generally one can show that for all 0 t0 t1 tn and 1 , . . . , n
R we have
" n
#
!
n
w
Y i (Y Y
X
IE
e k tk tk1 ) = exp
(tk tk1 )
(eik y 1)(dy)
k=1
k=1
=
=
n
Y
k=1
n
Y
(eik y 1)(dy)
h
i
IE ei(Ytk Ytk1 ) .
k=1
"
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This shows in particular that the compound Poisson process (Yt )tR+ has
independent increments, as the standard Poisson process (Nt )tR+ .
Since the compensated Poisson process also has centered increments by
(14.5), we have the following proposition.
Proposition 14.4. The compensated compound Poisson process
Mt := Yt t IE[Z1 ],
t R+ ,
is a martingale.
By construction, compound Poisson processes only have a finite number
of jumps on any interval. They belong to the family of Levy processes which
may have an infinite number of jumps on any finite time interval, cf. [15].
wT
0
t dYt :=
NT
X
Tk Zk .
k=1
wT
Note that this expression
t dYt has a natural financial interpretation as
0
the value at time T of a portfolio containing a (possibly fractional) quantity
t of a risky asset at time t, whose price evolves according to random returns
Zk at random times Tk .
In particular the compound Poisson process (Yt )tR+ in (14.1) admits the
stochastic integral representation
wt
ZNs dNs .
Yt = Y0 +
0
Next, given (Wt )tR+ a standard Brownian motion independent of (Yt )tR+
and (Xt )tR+ a jump-diffusion process of the form
Xt =
wt
0
us dWs +
wt
0
vs ds + Yt ,
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t R+ ,
"
we let the stochastic integral of (s )sR+ with respect to (Xs )sR+ be defined
by
wT
0
s dXs :=
wT
0
s us dWs +
wT
0
s vs ds +
NT
X
Tk Z k ,
T > 0.
k=1
IE
"
w
2 #
t (dYt IE[Z1 ]dt)
= IE[|Z1 |2 ] IE
w
T
0
||2t dt ,
(14.7)
=2
2
t (dYt IE[Z1 ]dt)
wT
0
w t
0
w
T
0
2
||2t ZN
dN
,
t
t
in which the diagonal has been excluded in the double integral, and using the
fact that the expectation of the double stochastic integral vanishes.
For the mixed continuous-jump martingale
wt
Xt =
us dWs + Yt t IE[Z1 ],
0
t R+ ,
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IE
"
wT
0
2 #
s dXs
= IE
w
T
0
w
T
|s |2 |us |2 ds + IE[|Z1 |2 ] IE
|s |2 ds .
0
(14.8)
provided (s )sR+ is adapted to the filtration (Ft )tR+ generated by (Wt )tR+
and (Yt )tR+ .
This isometry formula will be used in Section 15.5 for the computation of
hedging strategies in jump models.
When (Xt )tR+ takes the form
Xt = X0 +
wt
0
us dWs +
wt
0
vs ds +
wt
0
s dYs ,
t R+ ,
s dXs :=
wT
wT
s us dWs +
wT
s vs ds +
s us dWs +
wT
s vs ds +
wT
0
NT
X
s s dYs
Tk Tk Zk ,
T > 0.
k=1
14.4 It
o Formula with Jumps
Let us first consider the case of a standard Poisson process (Nt )tR+ with
intensity . We have the telescoping sum
f (Nt ) = f (0) +
Nt
X
(f (k) f (k 1))
k=1
= f (0) +
= f (0) +
= f (0) +
wt
0
wt
0
wt
0
(f (1 + Ns ) f (Ns ))dNs
(f (Ns ) f (Ns 1))dNs
(f (Ns ) f (Ns ))dNs .
Here, Ns denotes the left limit of the Poisson process at time s, i.e.
Ns = lim Nsh .
h&0
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k = NTk = 1 + NT ,
k
By the same argument we find, in the case of the compound Poisson process
(Yt )tR+ ,
f (Yt ) = f (0) +
= f (0) +
= f (0) +
Nt
X
(f (YT + Zk ) f (YT ))
k
k=1
wt
0
wt
0
t R+ ,
we find, by combining the Ito formula for Brownian motion with the above
argument we get
f (Xt ) = f (X0 ) +
+
wt
0
wt
0
us f 0 (Xs )dWs +
vs f 0 (Xs )ds +
wt
NT
X
1 w t 00
f (Xs )|us |2 ds
2 0
(f (XT + Tk Zk ) f (XT ))
k
wt
1 w t 00
vs f 0 (Xs )ds
f (Xs )|us |2 ds +
us f 0 (Xs )dWs +
0
2 0
= f (X0 ) +
0
wt
+ (f (Xs + s ZNs ) f (Xs ))dNs
0
k=1
t R+ .
i.e.
wt
wt
1 w t 00
f (Xs )|us |2 ds +
vs f 0 (Xs )ds
f (Xt ) = f (X0 ) +
us f 0 (Xs )dWs +
0
0
2 0
wt
+ (f (Xs ) f (Xs ))dNs ,
t R+ .
(14.9)
0
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t R+ ,
we get
wt
1wt
f (Xt ) = f (0) +
us f 0 (Xs )dWs +
|us |2 f 00 (Xs )dWs
0
2 0
wt
wt
+ vs f 0 (Xs )ds + (f (Xs + s ) f (Xs ))dNs
0
0
wt
1wt
0
|us |2 f 00 (Xs )dWs
(14.10)
= f (0) +
us f (Xs )dWs +
0
2 0
wt
wt
0
+ vs f (Xs )ds + (f (Xs ) f (Xs ))dNs .
0
wt
us dWs +
wt
vs ds +
wt
s dNs ,
t R+ ,
Yt =
wt
as dWs +
wt
bs ds +
wt
cs dNs ,
t R+ ,
and
dt
dBt
dNt
dt
0
0
0
dBt
0
dt
0
dNt
0
0
dNt
"
wt
0
us dWs +
wt
0
s dYt ,
t R+ ,
s f 0 (Xs )dYs =
wt
0
Xs f 0 (Xs )dNs ,
t 0.
0
t
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2. Stable process.
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"
0
t
(14.11)
of a stochastic differential equation with respect to the standard Poisson process, with constant coefficient R.
When
Nt = Nt Nt = 1,
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i.e. when the Poisson process has a jump at time t, the equation (14.11) reads
dSt = St St = St ,
t > 0.
t > 0.
By induction, applying this procedure for each jump time gives us the solution
St = S0 (1 + )Nt ,
t R+ .
(14.12)
i.e.
STk = (1 + Tk )ST ,
k
and repeating this argument for all k = 1, . . . , Nt yields the product solution
St = S0
Nt
Y
(1 + Tk ) = S0
(1 + s ),
t R+ .
Ns =1
0st
k=1
The equation
dSt = t St dt + t St (dNt dt),
(14.13)
is then solved as
St = S0 exp
w
s ds
wt
0
Y
Nt
s ds
(1 + Tk ),
t R+ .
k=1
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St
1.5
0.5
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2.0
The above simulation can be compared to the real sales ranking data of
Figure 14.9.
w
s ds IE[Z1 ]
wt
0
Y
Nt
s ds
(1 + Tk Zk )
t R+ ,
k=1
solution of
dSt = t St dt + t St (dYt IE[Z1 ]dt),
is given in Figure 14.10.
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2
St
1.5
0.5
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2.0
Nt
Y
w
s ds IE[Z1 ]
wt
0
s ds +
wt
0
s dWs
1wt
|s |2 ds
2 0
(1 + Tk Zk ),
k=1
t R+ . A random simulation of the geometric Brownian motion with compound Poisson jumps is given in Figure 14.11.
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2.5
St
1.5
1
0.5
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2.0
By rewriting St as
w
wt
wt
t
1wt
St = S0 exp
s ds +
s (dYs IE[Z1 ]ds) +
s dWs
|s |2 ds
0
0
0
2 0
Nt
Y
(eTk (1 + Tk Zk )),
k=1
t R+ , one can extend this jump model to processes with an infinite number
of jumps on any finite time interval, cf. [15]. The next Figure 14.12 shows
a number of downward and upward jumps occuring in the historical price
of the SMRT stock, with a typical geometric Brownian behavior in between
jumps.
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T /2
]
(14.14)
(14.15)
hence
under the probability measure
2
:= eWT
dP
T /2
dP,
More generally, the Girsanov theorem states that (Wt + t)t[0,T ] is a stan
dard Brownian motion under P.
When Brownian motion is replaced with a standard Poisson process
(Nt )tR+ , the above space shift
Wt 7 Wt + t
may not be used because Nt + t cannot be a Poisson process, whatever the
change of probability applied, since by construction, the paths of the standard Poisson process has jumps of unit size and remain constant between
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"
or Nt 7 N(1+c)t .
Assume that (Nt )tR+ is a standard Poisson process with intensity under
P. By analogy with (14.14) we can write
((1 + c)T )k
= ecT (1 + c)k P(NT = k),
k!
P(N(1+c)T = k) = e(1+c)T
f (k)P(N(1+c)T = k)
(14.16)
k=0
= ecT
k=0
=
f (NT )dP
[f (NT )],
= IE
is defined by
where the probability measure P
Consequently,
under the probability measure
:= ecT (1 + c)NT dP,
dP
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the law of NT /(1+c) is that of a standard Poisson random varii.e. under P
t R+ ,
Nt/(1+c) =
n1
t R+ ,
1[(1+c)Tn ,) (t),
n1
)k
(T
(NT = k),
=P
k!
k N, and
under the probability measure
!NT
dP,
Consequently, since
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Nt (1 + c)t = Nt t
by (6.2), although when c 6= 0 it is not a martingale
is a martingale under P
under P.
In the case of compound Poisson processes the Girsanov theorem can be
extended to variations in jump sizes in addition to time variations, and we
have the following more general result.
Theorem 14.2. Let (Yt )t0 be a compound Poisson process with intensity > 0 and jump distribution (dx). Consider another jump distribution
(dx), and let
d
(x) :=
(x) 1,
x R.
d
Then,
under the probability measure
NT
Y
:= e()T
dP
,
, ,
(1 + (Zk ))dP
k=1
the process
Yt =
Nt
X
Zk ,
t R+ ,
k=1
()T
IE,
IE, f (YT ) (1 + (Zi ))
[f (YT )] = e
i=1
=e
()T
X
k=0
"
"
IE, f
k
X
i=1
!
Zi
k
Y
#
(1 + (Zi ))NT = k P(NT = k)
i=1
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N. Privault
= eT
X
(T )k
k=0
=e
= eT
k!
X
(T )k w
k=0
X
k=0
k
X
!
Zi
i=1
X
(T )k w
k=0
= eT
k!
"
IE, f
k!
k
Y
#
(1 + (Zi ))
i=1
f (z1 + + zk )
k
Y
i=1
f (z1 + + zk )
k
Y
d
i=1
!
(zi ) (dz1 ) (dzk )
w
) w
(T
f (z1 + + zk )
(dz1 ) (dzk ).
k!
k
Xt :=
h(Zk ),
k=1
= e()T
dP
,
NT
Y
, .
(1 + (Zk ))dP
k=1
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(x) 1,
d
x R,
and let (ut )tR+ be a bounded adapted process. Then the process
wt
IE [Z1 ]t
Wt +
us ds + Yt
0
tR+
0
2 0
k=1
(14.17)
As a consequence of Theorem 14.3, if
wt
Wt +
vs ds + Yt
0
s R,
(14.18)
tR+
tingales under P
u,,
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Exercises
Exercise 14.1 Let (Nt )tR+ be a standard Poisson process with intensity
> 0, started at N0 = 0.
a) Solve the stochastic differential equation
dSt = St dNt St dt = St (dNt dt).
b) Using the first Poisson jump time T1 , solve the stochastic differential equation
dSt = St dt + dNt ,
t (0, T2 ).
Exercise 14.2 Consider a standard Poisson process (Nt )tR+ with intensity
> 0.
a) Solve the stochastic differential equation dXt = Xt dNt for (Xt )tR+ ,
where > 0 and X0 = 1.
b) Show that the solution (St )tR+ of the stochastic differential equation
dSt = rdt + St dNt ,
wt
is given by St = S0 Xt + rXt
Xs1 ds.
0
c) Compute IE[Xt ] and IE[Xt /Xs ], 0 s t.
d) Compute IE[St ], t R+ .
Nt
X
Zk , where
k=1
(Nt )tR+ is a standard Poisson process with intensity > 0, (Zk )k1 is an
i.i.d. sequence of N (0, 1) Gaussian random variables. Solve the stochastic
differential equation
dSt = rSt dt + St dYt ,
where , r R.
Exercise 14.4 Show, by direct computation or using the characteristic function, that the variance of the compound Poisson process Yt with intensity
> 0 satisfies
w
Var [Yt ] = t IE[|Z1 |2 ] = t
x2 (dx).
"
t R+ ,
(14.19)
where
Xk ' N (0, 2 ),
k 1.
Exercise 14.7 Consider a standard Poisson process (Nt )tR+ with intensity
> 0 under a probability measure P. Let (St )tR+ be the mean reverting
process defined by the stochastic differential equation
dSt = St dt + (dNt dt),
(14.20)
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