Documente Academic
Documente Profesional
Documente Cultură
Allanus Tsoi
University of Missouri, Columbia, USA
David Nualart
University of Kansas, USA
George Yin
Wayne State University, Michigan, USA
World Scientific
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Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii
vi Contents
vii
Preface
viii Preface
Allanus Tsoi
Columbia, Missouri
David Nualart
Lawrence, Kansas
George Yin
Detroit, Michigan
April 21, 2011 16:30 WSPC - Proceedings Trim Size: 9in x 6in names
ix
D. Nualart∗
Department of Mathematics, University of Kansas
Lawrence, KS 66045, USA
E-mail: nualart@math.ku.edu
S. Ortiz-Latorre
Departament de Probabilitat, Lògica i Estadı́stica, Universitat de Barcelona
Gran Via 585, 08007 Barcelona, Spain
Email: sortiz@ub.edu
An Itô formula for multidimensional Gaussian processes using the Wick inte-
gral is obtained. The conditions allow us to consider processes with infinite
quadratic variation. As an example we consider a correlated heterogenous frac-
tional Brownian motion. We also use this Itô formula to compute the price of
an exchange option in a Wick-fractional Black-Scholes model.
1. Introduction
The classical stochastic calculus and Itô’s formula can be extended to semi-
martingales. There has been a recent interest in developing a stochastic
calculus for Gaussian processes which are not semimartingales such as the
fractional Brownian motion (fBm for short). These developments are mo-
tivated by the fact that fBm and other related processes are suitable input
noises in practical problems arising in a variety of fields including finance,
telecommunications and hydrology (see, for instance, Mandelbrot and Van
Ness7 and Sottinen13 ).
A possible definition of the stochastic integral with respect to the fBm
is based on the divergence operator appearing in the stochastic calculus
of variations. This approach to define stochastic integrals started from the
work by Decreusefond and Üstünel3 and was further developed by Carmona
and Coutin2 and Duncan, Hu and Pasik-Duncan4 (see also Hu5 and Nu-
alart9 for a general survey papers on the stochastic calculus for the fBm).
The divergence integral can be approximated by Riemman sums defined
using the Wick product, and it has the important property of having zero
expectation.
Nualart and Taqqu11,12 have proved a Wick-Itô formula for general
Gaussian processes. In 11 they have considered Gaussian processes with
finite quadratic variation, which includes the fBm with Hurst parameter
H > 1/2. The paper 12 deals with the change-of-variable formula for Gaus-
sian processes with infinite quadratic variation, in particular the fBm with
Hurst parameter H ∈ (1/4, 1/2). The lower bound for H is a natural one,
see Alòs, Mazet and Nualart.1
The aim of this paper is to generalize the results of Nualart and Taqqu12
to the multidimensional case. We introduce the multidimensional Wick-Itô
integral as a limit of forward Riemann sums and prove a Wick-Itô formula
under conditions similar to those in Nualart and Taqqu,12 allowing infinite
quadratic variation processes.
The paper is organized as follows. In Section 2, we introduce the con-
ditions that the multidimensional Gaussian process must satify and state
the Itô formula. Section 3 contains some definitions in order to introduce
the Wick integral. In Section 4 we prove some technical lemmas using ex-
tensively the integration by parts formula for the derivative operator. The
convergence results used in the proof of the main theorem are proved in
Section 5. Section 6 is devoted to study two examples related to the multi-
dimensional fBm with parameter H > 1/4. Finally, in section 7 we use our
Itô formula to compute the price of an exchange option on a Wick-fractional
Black-Scholes market.
2. Preliminaries
Let X = {Xt , t ∈ [0, T ]} be a d-dimensional centered Gaussian process with
continuous covariance function matrix R(s, t), that is,
where
The mapping 1i[0,t] 7→ Xti can be extended to a linear isometry between the
space H and the Gaussian Hilbert space generated by the process X. We
denote by let I1 : h 7→ X (h) , h ∈ H this isometry.
Let H⊗m denote the mth tensor power of H, equipped with the following
scalar product
m
Y
hh1 ⊗ · · · ⊗ hm , g1 ⊗ · · · ⊗ gm iH⊗m = hhi , gi iH ,
i=1
i=1
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Definition 2.2. Let F ∈ D1,2 and h ∈ H. Then the Wick product F X (h)
is defined by
Actually, the Wick product coincides with the divergence (or the Sko-
rohod integral) of F h, and by the properties of the divergence operator we
can write
such that
|π|
≤ D,
|π|inf
j=1 i=0
as |π| tends to zero, where π runs over all the partitions of the interval [0, T ]
in the class D.
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3. Main Result
We will make use of the following assumptions.
Assumptions.
(A1) For all j, k ∈ {1, . . . , d} the function t 7→ Vtj,k has bounded varia-
tion on [0, T ].
(A2) For all k, l ∈ {1, . . . , d}
n−1
E[∆i X k ∆j X l ]2 → 0,
X
as |π| → 0.
i,j=0
Condition (3) holds if det Vt > 0 for all t ∈ (0, T ], and the partial
derivatives ∂ α f satisfy the exponential growth condition
2
|∂ α f (x)| ≤ CT ecT |x| , (4)
Besides the multi-index notation for the derivatives, we will also use the
following notation for iterated derivatives. Let f (x1 , . . . , xd ) be a sufficiently
smooth function, then
∂f
∂i f = , i ∈ {1, . . . , d}
∂xi
∂im1 ,...,im f = ∂im ∂im−1 (· · · ∂i2 (∂i1 f ) ,
ik ∈ {1, . . . , d} , k = 1, . . . , m.
The next theorem is the main result of the paper.
Theorem 3.1. Suppose that the Gaussian process X and the function f
satisfy the preceding assumptions (A1) to (A4). Then the forward integrals
(see Definition 2.3)
Z t
∂j f (Xs ) dXsj , 0 ≤ t ≤ T, j = 1, . . . , d
0
and
X i = λXti + (1 − λ) Xti+1 , 0 ≤ λ ≤ 1.
By the definition of the Wick product, see Definition 2.2, one has
∂j f (Xti ) ∆i X j = ∂j f (Xti ) ∆i X j + hD (∂j f (Xti )) , 1jδi iH ,
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d
X
2
D (∂j f (Xti )) = ∂j,k f (Xti ) 1k[0,ti ] ,
k=1
one gets
d d d
f (Xti ) h1k[0,ti ] , 1jδi iH .
X X X
∂j f (Xti ) ∆i X j = ∂j f (Xti ) ∆i X j + 2
∂j,k
j=1 j=1 j,k=1
we have
1 j,k 1
h1k[0,ti ] , 1jδi iH = E[Xtki (Xtji+1 − Xtji )] = ϕi − E ∆i X j ∆i X k ,
2 2
where
h i
ϕj,k
i =E Xtji+1 − Xtji Xtki+1 + Xtki .
This gives
d
X
∂j f (Xti ) ∆i X j
f Xti+1 = f (Xti ) +
j=1
d
1 X
2
f (Xti ) ∆i X j ∆i X k − E ∆i X j ∆i X k
+ ∂j,k
2
j,k=1
d
1 X 2
+ ∂j,k f (Xti ) ϕj,k π π
i + T3 (i) + T4 (i) .
2
j,k=1
Hence,
n−1
X
f (Xt ) = f (X0 ) + f Xti+1 − f (Xti )
i=0
n−1
XX d
= f (X0 ) + ∂j f (Xti ) ∆i X j
i=0 j=1
n−1 d
1X X 2 1 π 1 π 1
+ ∂j,k f (Xti ) ϕj,k
i + R2 + R + Rπ ,
2 i=0 2 3! 3 4! 4
j,k=1
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where
n−1
X d
X
R2π = 2
f (Xti ) ∆i X j ∆i X k − E ∆i X j ∆i X k
∂j,k
i=0 j,k=1
n−1
X n−1
X d
X
R3π = T3π (i) = 3
∂j,k,l f (Xti ) ∆i X j ∆i X k ∆i X l ,
i=0 i=0 j,k,l=1
n−1
X n−1
X d
X
R4π = T4π (i) = 4
∂j,k,l,m f (X i )∆i X j ∆i X k ∆i X l ∆i X m .
i=0 i=0 j,k,l,m=1
Note that
d d
1 X 2 1X 2
∂j,k f (Xti ) ϕj,k = ∂ f (Xti ) ϕj,j
2 i
2 j=1 j,j i
j,k=1
d
1 X 2
+ ∂j,k f (Xti ) (ϕj,k k,j
i + ϕi )
2
k>j=1
d
1X 2
= ∂ f (Xti ) (Vtj,j − Vtj,j )
2 j=1 j,j i+1 i
d
f (Xti ) (Vtj,k − Vtj,k
X
2
+ ∂j,k i+1 i
)
k>j=1
d
1 X 2
= ∂j,k f (Xti ) (Vtj,k − Vtj,k ).
2 i+1 i
j,k=1
as |π| → 0. The convergences of R2π and R3π to zero in L2 (Ω) as |π| → 0 are
proved in Propositions 5.1 and 5.2. The convergence of R4π to zero in L1 (Ω)
as |π| → 0 is proved in Proposition 5.3. This clearly implies the convergence
in probability
n−1
XX d d Z
X t
j
lim ∂j f (Xti ) ∆i X = ∂j f (Xs ) dXsj ,
|π|→0 0
i=0 j=1 j=1
4. Technical Lemmas
In this section we establish some preliminary lemmas. The first one is trivial.
where
and thus
Then,
= E[ D4 F, h2 g2 h1 g1 H⊗4 ],
where we have applied Lemmas 4.3 and 4.1 in the second and third equalities
respectively. For the term B, we have
E [hA2 , h2 g2 iH⊗2 ]
= E [X (g1 ) hDF h1 , h2 g2 iH⊗2 ]
1 1
= [X (g1 ) hDF, h2 iH ] hh1 , g2 iH + [X (g1 ) hDF, g2 iH ] hh1 , h2 iH
2 2
1
2 1
E [hA3 , h2 g2 iH⊗2 ]
1
1
5. Convergence Results
From now on, C will denote a finite positive constant that may change from
line to line.
Then
lim E[(R2π )2 ] = 0.
|π|→0
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Then
n−1 d
E[(R2π )2 ] = E[Fij11 ,k1 Fij22 ,k2 ϕji11 ,k1 ϕji22 ,k2 ],
X X
where
B1 = hE[D4 (Fij11 ,k1 Fij22 ,k2 )], 1jδ1i 1jδ2i 1kδi1 1kδi2 iH⊗4 ,
1 2 1 2
B2 = hE[D2 (Fij11 ,k1 Fij22 ,k2 )], 1jδ2i 1kδi1 iH⊗2 h1jδ1i , 1kδi2 iH ,
2 1 1 2
B3 = hE[D 2
(Fij11 ,k1 Fij22 ,k2 )], 1kδi1 1kδi2 iH⊗2 h1jδ1i , 1δj2i iH ,
1 2 1 2
B4 = hE[D2 (Fij11 ,k1 Fij22 ,k2 )], 1jδ1i 1jδ2i iH⊗2 h1kδi1 , 1kδi2 iH ,
1 2 1 2
B5 = hE[D2 (Fij11 ,k1 Fij22 ,k2 )], 1jδ1i 1kδi2 iH⊗2 h1jδ2i , 1kδi1 iH ,
1 2 2 1
P6
so E[(R2π )2 ] = h=1 Bh . We have that
4
4
hE[Dp (Fij11 ,k1 ) D4−p (Fij22 ,k2 )], 1jδ1i 1jδ2i 1kδi1 1kδi2 iH⊗4 .
X
B1 =
p=0
p 1 2 1 2
Hence,
4 p 4−p
X 4 X X p! (4 − p)!
B1 =
p=0
p u1 ,...,ud =0 v1 ,...,vd =0
u1 ! · · · ud ! v1 ! · · · vd !
u1 +···+ud =p v1 +···+vd =4−p
Notice that
= 1w w2 w3 w4
[0,s1 ] 1[0,s2 ] 1[0,s3 ] 1[0,s4 ] ,
1
1 X wσ(1) w w w
≤ |h1 0,s , 1j1 i h1 σ(2) , 1j2 i h1 σ(3) , 1k1 i h1 σ(4) , 1k2 i |
4! [ σ(1) ] δi1 H [0,sσ(2) ] δi2 H [0,sσ(3) ] δi1 H [0,sσ(4) ] δi2 H
σ∈Σ4
j1 j2 k1 k2
≤ sup |h1w w w w
[0,s] , 1δi iH ||h1[0,s] , 1δi iH ||h1[0,s] , 1δi iH ||h1[0,s] , 1δi iH |
1 2 1 2
0≤s≤t
1≤w≤d
which tends to zero as |π| → 0 by Assumptions (A2) and (A3). The proof
for the terms B3 , B4 and B5 is almost the same as for the term B2 . Finally,
B6 = E[Fij11 ,k1 Fij22 ,k2 ]h1jδ1i , 1jδ2i iH h1kδi1 , 1kδi2 iH
1 2 1 2
Hence,
2
n−1
X d
X
B6 ≤ CaT E[∆i1 X j ∆i2 X k ]
i1 ,i2 =0 j,k=1
d n−1
E[∆i1 X j ∆i2 X k ]2 ,
X X
≤ CaT
j,k=1 i1 ,i2 =0
Proposition 5.2. If
n−1
X d
X
R3π = 3
∂j,k,l f (Xti ) ∆i X j ∆i X k ∆i X l ,
i=0 j,k,l=1
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then
lim E[(R3π )2 ] = 0.
|π|→0
Proof. Setting
∆i X j ∆i X k ∆i X l = ∆i X j ∆i X k − E ∆i X j ∆i X k ∆i X l
+E ∆i X j ∆i X k ∆i X l ,
one gets
2
E[(R3π ) ]
2
n−1 d
X X 3
∂j,k,l f (Xti ) ∆i X l ∆i X j ∆i X k − E ∆i X j ∆i X k
≤ 2E
i=0 j,k,l=1
2
n−1
X d
X
3
f (Xti ) ∆i X l E ∆i X j ∆i X k
+2E ∂j,k,l
i=0 j,k,l=1
= 2C1 + 2C2 .
To prove the convergence of C1 to zero, observe that
2
d
X n−1
X d
X n h io
3 l j k j k
C1 ≤ C E ∂j,k,l f (Xti ) ∆i X ∆i X ∆i X − E ∆i X ∆i X .
l=1 i=0 j,k=1
2
So it suffices to fix l and apply Proposition 5.1 with the term ∂j,k f (Xti )
3 l
replaced by ∂j,k,l f (Xti ) ∆i X =: g Xti , Xti+1 whose exact form does not
matter because it satisfies the exponential condition (4). Using Lemma 4.2,
we obtain that
n−1
X d
X
C2 = E[∂j31 ,k1 ,l1 f (Xti1 )∂j32 ,k2 ,l2 f (Xti2 )∆i1 X l1 ∆i2 X l2 ]
i1 ,i2 =0 j1 ,k1 ,l1 ,j2 ,k2 ,l2 =1
= E1 + E2 ,
where Eh = in−1
P Pd
1 ,i2 =0 j1 ,k1 ,l1 ,j2 ,k2 ,l2 =1 Eh , for h = 1, 2, and
E1 = E[hD2 (∂j31 ,k1 ,l1 f (Xti1 )∂j32 ,k2 ,l2 f (Xti2 )), 1lδ1i 1lδi2 iH2 ]
1 2
j1 k1 j2 k2
×E ∆i1 X ∆i1 X E ∆i2 X ∆i2 X ,
E2 = E[∂j31 ,k1 ,l1 f (Xti1 )∂j32 ,k2 ,l2 f (Xti2 )]h1lδ1i , 1lδ2i iH
1 2
As a consequence, we obtain
n−1 d n−1 d
2
E ∆i X j ∆i X k 2 ,
X X X X
sup E[Xsw ∆i X j ]
E1 ≤ CaT
i=0 j=1 0≤s≤t i=0 j,k=1
1≤w≤d
Proposition 5.3. Let X i be a point in the straight line that joins Xti and
Xti+1 and
n−1
X d
X
R4π = 4
∂j,k,l,m f (X i )∆i X j ∆i X k ∆i X l ∆i X m ,
i=0 j,k,l,m=1
then
lim E[ |R4π | ] =0.
|π|→0
Proof. We have
kR4π kL1 (Ω)
n−1
X d
X
4
∂j,k,l,m f (X i )∆i X j ∆i X k ∆i X l ∆i X m
≤ L1 (Ω)
i=0 j,k,l,m=1
n−1 d 1/2
2
X X
4
≤ E[(∂j,k,l,m f (X i )) ]
i=0 j,k,l,m=1
2 2 2 1/2
2
× E[ ∆i X j ∆i X k ∆i X l (∆i X m ) ] .
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where we have used that for all p > 0 if ξ is a centered Gaussian variable
one has
kξkLp (Ω) = κ (p) kξkL2 (Ω) ,
where
p+1
!1/p
√ Γ 2
κ (p) = 2 √ , p > 0.
π
And the last term in equation (7) converges to zero as |π| → 0 by Assump-
tion (A2).
6. Examples
6.1. Correlated Heterogeneous Fractional Brownian Motion
In this section we give an example where the theory previously developed
applies. Let B H = {(Bt1,H1 , . . . , Btd,Hd ), t ∈ [0, T ]} be a d-dimensional
heterogeneous fractional Brownian motion with Hurst parameter H =
d
(H1 , . . . , Hd ) ∈ (0, 1) and H1 ≤ · · · ≤ Hd . That is, B H is a d-dimensional
centered Gaussian process with covariance function matrix RH (s, t) given
by
i,j δij 2Hi 2H
RH (s, t) = δij RHi (s, t) = {s + t2Hi − |s − t| i },
2
for i, j = 1, . . . , d. Set Xt = ABtH , where A = (ai,j )i,j=1,...,d is a d×d matrix.
We call X a correlated heterogeneous fractional Brownian motion. X is
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d d
" ! !#
E[Xsi Xtj ] aj,l Btl,Hl
X X
i,j
R (s, t) = =E ai,k Bsk,Hk
k=1 l=1
d
X
= ai,k aj,k RHk (s, t) .
k=1
Proposition 6.1. The process X = ABtH with 1/4 < min Hi < 1 satisfies
i
Assumptions (A1) to (A3). Therefore, the Wick-Itô formula applies to X.
d
Vtj,k = Rj,k (t, t) =
X
aj,m ak,m t2Hm ,
m=1
E ∆i X k ∆j X l
= Rk,l (ti+1 , tj+1 ) − Rk,l (ti+1 , tj ) − Rk,l (ti , tj+1 ) + Rk,l (ti , tj )
d
X
= ak,m al,m
m=1
k,l k,l k,l k,l
× RH m
(t , t
i+1 j+1 ) − R (t
Hm i+1 j, t ) − R (t
Hm i j+1, t ) + R (t
Hm i j , t )
d
1 X
= ak,m al,m
2 m=1
2H 2H 2H 2H
× |tj+1 − ti | m + |tj − ti+1 | m − |tj − ti | m − |tj+1 − ti+1 | m .
Therefore
n−1
E ∆i X k ∆j X l 2 = Bn + Cn + Dn ,
X
An =
i,j=0
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where
n−1 d
!2
X X
Bn = ak,m al,m |ti+1 − ti |2Hm ,
i=0 m=1
n−2 d 2
!
1 X X
Cn = ak,m al,m |ti+2 − ti |2Hm − |ti+1 − ti |2Hm − |ti+2 − ti+1 |2Hm ,
2 i=0 m=1
n−3 n−1 d
1 X X X
Dn = ak,m al,m
2 i=0 j=i+2 m=1
!2
× |tj+1 − ti |2Hm + |tj − ti+1 |2Hm − |tj − ti |2Hm − |tj+1 − ti+1 |2Hm .
We have
n−1 d d
4Hm 4Hm −1
X X X
Bn ≤ C |ti+1 − ti | ≤ CT |π| ,
i=0 m=1 m=1
Then,
d n X
h
4Hm
X X
Dn ≤ C |π| k 4Hm −4 .
m=1 h=1 k=1
−1
Since our partitions are in the class D we have n ≤ C |π| . Therefore,
2
C |π|
if H1 > 3/4
2 −1
Dn ≤ C |π| ln(|π| ) if H1 = 3/4 ,
C |π|4H1 −1
if H1 < 3/4
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d
!2
1 X 2Hm 2Hm 2Hm 2Hm
= ak,m al,m (ti+1 − ti + |t − ti | − |t − ti+1 | )
4 m=1
d 2 2
2H 2H
X
≤C t2H 2Hm
i+1 − ti
m
+ |t − ti | m − |t − ti+1 | m .
m=1
2
As before, the convergence to zero of E Xtk ∆j X l
as |π| → 0 is con-
trolled by the term with H1 . If 1/4 < H1 ≤ 1/2, one has that t2H i+1 − ti
1 2H1
2H1 2H1 2H1
and |t − ti | − |t − ti+1 | are both bounded by (ti+1 − ti ) , and the
4H −1
sum of their squares is bounded by C |π| 1 , which converges to zero
as |π| → 0. If H1 > 1/2, either term is bounded by C (ti+1 − ti ) . Hence,
the sum of their squares is bounded by C |π| , which converges to zero as
|π| → 0. So the proof is concluded.
Proposition 6.2. The process B H with 1/4 < H < 1 satisfies Assump-
tions (A1) to (A3). Therefore, the Wick-Itô formula applies to B H .
Brownian
Xt1 = Bt1,H1 ,
Xt2 = ρBt1,H1 + 1 − ρ2 Bt2,H2 ,
p
C 1,2,2 and satisfies the exponential growth condition (4). Then the Wick-Itô
formula yields
Z t
∂C
C t, St1 , St2 = C 0, S01 , S02 + u, Su1 , Su2 du
0 ∂u
Z t Z t
∂C ∂C
+ µ1 u, Su1 , Su2 Su1 du + σ1 u, Su1 , Su2 Su1 dXu1
0 ∂x 0 ∂x
Z t Z t
∂C 1 2
2 ∂C
+ µ2 u, Su , Su Su du + σ2 u, Su1 , Su2 Su2 dXu2
0 ∂y 0 ∂y
Z t 2 2 0
1 2 ∂ C
+ σ1 2
u, Su1 , Su2 Su1 Vu1,1 du
2 0 ∂x
1 2 t ∂2C 2
2,2 0
Z
1 2 2
+ σ2 2
u, S u , S u S u V u du
2 0 ∂y
Z t 2 0
∂ C
+ σ1 σ2 u, Su1 , Su2 Su1 Su2 Vu1,2 du. (8)
0 ∂x∂y
The price C t, St1 , St2 should coincide with the value at time t of a port-
+
folio which replicates the contingent claim ST1 − ST2 . Let Πt denote the
amuount of this portfolio invested in the risk free asset Bt an h1t , h2t the
amount of stocks S 1 and S 2 , respectively. Then,
C t, St1 , St2 = Πt + h1t St1 + h2t St2 .
May 11, 2011 10:49 WSPC - Proceedings Trim Size: 9in x 6in 01-nu
where d1 and d2 are obtained from d1 and d2 making z = St1 /St2 and
Z T
θ (s) ds = σ12 + σ22 − 2ρσ1 σ2 T 2H1 − t2H1
t
+ σ22 1 − ρ2 T 2H2 − t2H2 .
References
1. E. Alòs, O. Mazet and D. Nualart, Stochastic calculus with respect to Gaus-
sian processes, Ann. Probab. 29, 766–801 (2001).
2. P. Carmona and L.Coutin, Stochastic integration with respect to fractional
Brownian motion, Ann. Inst. H. Poincaré 39, 27–68 (2003).
3. L. Decreusefond and A. S. Üstünel, Stochastic analysis of the fractional Brow-
nian motion, Potential Analysis 10, 177–214 (1998).
4. T. E. Duncan, Y. Hu and B. Pasik-Duncan, Stochastic calculus for fractional
Brownian motion I. Theory, SIAM J. Control Optim. 38, 582–612 (2000).
5. Y. Hu, Integral transformations and anticipative calculus for fractional Brow-
nian motions, Memoirs of the AMS 175 (2005).
6. S. Janson, Gaussian Hilbert Spaces (Cambridge University Press, Cambridge,
1997).
7. B. B. Mandelbrot and J. W.Van Ness, Fractional Brownian motions, frac-
tional noises and applications, SIAM Review 10, 422–437 (1968).
May 11, 2011 10:49 WSPC - Proceedings Trim Size: 9in x 6in 01-nu
8. W. Margrabe, The value of an option to exchange one asset for another, The
Journal of Finance 33, 177-186 (1978).
9. D. Nualart, Stochastic integration with respect to fractional Brownian motion
and applications, Contemporary Mathematics 336, 3–39 (2003).
10. D. Nualart, The Malliavin Calculus and Related Topics, (Springer-Verlag,
Berlin, 2006).
11. D. Nualart and M.S. Taqqu, Wick-Itô formula for regular processes and appli-
cations to the Black and Scholes formula, Stochastics and Stochastics Reports,
to appear.
12. D. Nualart and M.S. Taqqu, Wick-Itô formula for Gaussian processes, J.
Stoch. Anal. Appl. 24, 599–614 (2006).
13. T, Sottinen, Fractional Brownian motion in finance and queueing, Ph.D.
Thesis, University of Helsinki (2003).
May 11, 2011 10:58 WSPC - Proceedings Trim Size: 9in x 6in 02-tsoi
27
Allanus H. Tsoi
Department of Mathematics, University of Missouri
Columbia, MO 65211, USA
Email: tsoia@missouri.edu
1. Introduction
White noise multiplication has been discussed in the book by H.-H. Kuo.12
One of its advantage over the Ito differential is that it generalizes the dif-
fusion coefficient term b(t, Xt ) in the classical Ito differential equation:
in the sense that the b(t, Xt )dBt is replaced by the white noise term Ḃt ·
b(t, Xt )dt in such a way that the term b comes from a comparatively much
wider class of functions.
The application of white noise calculus to solve a class of Cauchy prob-
lems were presented in the work by Chung, Ji and Saitô.3 On the other
hand, the classical investment and consumption problem can be formu-
lated and solved in terms of solving a Cauchy problem, as can be seen in
the book by I. Karatzas and S.E. Shreve.11 As a consequence, our fractional
white noise multiplication results can be used to: (1) generate and solve a
wide class of fractional Cauchy problems, which, in turn, (2) can be applied
May 11, 2011 10:58 WSPC - Proceedings Trim Size: 9in x 6in 02-tsoi
28 A. H. Tsoi
30 A. H. Tsoi
In this paper we study the fractional Brownian motion with Hurst param-
eter 21 < H < 1 in terms of the standard Gaussian white noise. We express
the FBM as a fractional integral of Gaussian white noise in the sense of
generalized functionals. We construct a fractional differential operator in
Sec. 3 and study some of its properties. In Sec. 4 we formulate the no-
tion of fractional white noise multiplication, while in Sec. 5 we present an
application of the above concept on a Binomial type finance model.
Now suppose that both the generalized functions f (x) and g(y) have
support on the same interval (−∞, T ] for some constant T > 0. Consider
(f (x), φ(x + y)) where φ has bounded support, which is an infinitely differ-
entiable function of y. For sufficiently large negative values of y, the support
of φ(x + y) does not intersect with that of f (x). Thus for such y the func-
tion (f (x), φ(x + y)) vanishes, and its support is therefore bounded on the
left. But the support of g(y) is bounded on the right by assumption. Hence
for large enough a > 0, the strip |x + y| ≤ a that contains the support of
φ(x + y) has a bounded intersection with the support of the product f × g.
Thus in |x + y| ≤ a we can replace φ(x + y) by a function φ(x, y) with
bounded support having the same values in the intersection of the strip
and the support of f × g. Now we can define the convolution f ∗ g of two
such generalized functions f and g by:
< f ∗g, φ >=< f (x)×g(y), φ(x+y) >=< g(y), < f (x), φ(x+y) >> . (18)
Similarly, if the supports of both f and g are bounded on the left side (i.e.,
f = 0 for x < a and g = 0 for y < b), then the product f × g and the
convolution f ∗ g can be defined. See page 103, Gel’fand and Shilov.5
Now we consider generalized functions g concentrated on the interval
(−∞, T ], for fixed constant T > 0. Define, for λ > 0,
γTλ = xλ
if x ∈ (−∞, T ], and
γTλ (x) = 0
otherwise.
Next we define the fractional integral of g of order λ > 0 as the convo-
lution:
γTλ−1
Iλ (g)(x) = gλ (x) = (g ∗ )(x). (19)
Γ(λ)
Note that in the above definition, the function γTλ−1 is locally summable.
γ λ−1
If λ ≤ 0, we have to view Γ(λ) T
as a generalized function, and regulariza-
tion and normalization are involved. See Chapters 3 and 5 in Gel’fand and
Shilov.5
Since Eq. (19) can also be expressed as:
Z t
1
Iλ (g)(t) = (t − v)λ−1 g(v)dv, (20)
Γ(λ) −∞
May 11, 2011 10:58 WSPC - Proceedings Trim Size: 9in x 6in 02-tsoi
32 A. H. Tsoi
Proposition 2.1. For α > 0 and λ > 0 and generalized function g with
support (−∞, T ], we have:
Iα Iλ (g)) = Iα+λ (g). (22)
Proof.
Z t Z z
1 1
Iα (Iλ (g))(t) = (t − z)α−1 (z − v)λ−1 g(v)dvdz
Γ(α) −∞ Γ(λ) −∞
Z t Z t
1
= g(v) (t − z)α−1 (z − v)λ−1 dzdv.
Γ(α)Γ(λ) −∞ v
since
Z 1
Γ(α)Γ(λ)
(1 − u)α−1 uλ−1 du = .
0 Γ(α + λ)
May 11, 2011 10:58 WSPC - Proceedings Trim Size: 9in x 6in 02-tsoi
For the rest of this paper we shall concentrate on the Hurst parameter
H, with 12 < H < 1. Recall that the fractional Brownian motion(FBM)
with Hurst parameter H, 12 < H < 1, can be expressed in the form given
on the right hand side of Eq. (14).
Now we consider the white noise space (S 0 (R), µB ), where µB is the
standard white noise measure and B is the standard Brownian motion
given in Sec. 1.
Denote Ḃ(t)(x) = dB(t)(x)
dt = x(t) as the sample path of the Brownian
noise (time derivative of the Brownian motion) evaluated at the sample
path x ∈ S 0 (R).
We would like to express B H as
Z t
B H (t) = Ḃ H (τ )dτ (23)
0
Z t
1 3
Ḃ H (t) = |t − τ |H− 2 Ḃ(τ )dτ
Γ(H − 12 ) −∞ (24)
= IH− 12 (Ḃ)(t).
If we substitute this into Eq. (23), then, upon changing the order of
integration, Eq. (23) becomes
1
Z t Z τ 3
B H (t) = |τ − s|H− 2 Ḃ(s)dsdτ
Γ(H − 12 ) 0 −∞
1
Z 0 Z t 3
Z t Z t 3
= |τ − s|H− 2 dτ Ḃ(s)ds + |τ − s|H− 2 dτ Ḃ(s)ds
Γ(H − 12 ) −∞ 0 0 s
1
Z 0 1 1
Z t 1
= |t − s|H− 2 − |s|H− 2 Ḃ(s)ds + |t − s|H− 2 Ḃ(s)ds
Γ(H + 12 ) −∞ 0
34 A. H. Tsoi
We also have
Z tZ τ
1 3
B H (t) = 1 |τ − s|H− 2 Ḃ(s)dsdτ
Γ(H − 2 ) 0 −∞
Z t
= Ḃ H (τ )dτ
0
Z t
= IH− 12 (Ḃ)(τ )dτ
0
= hχ[0,t] , IH− 12 (Ḃ)i
Z
= χ[0,t] (τ )IH− 12 (Ḃ)(τ )dτ.
R
Remark 2.1.
xH (t) = hxH , δt i
= Ḃ H (t)(x) (25)
= IH− 12 (x)(t).
Rt
Note that in the above Eq. (25) the integral 0
IH− 12 (s) is understood to be
hIH− 12 (Ḃ), I[0,t] i, which is the generalized function IH− 21 (Ḃ) ∈ S ∗ acting
the L( R) function I[0,t] , which is interpreted as the L2 (S ∗ , µ) limit of a
sequence hIH− 21 (Ḃ), ξn i, where the sequence {ξn } ⊂ S(R) converging in
L2 (R) to I[0,t] .
DH
y Φn (x) := nh: x
⊗(n−1)
:, hyH , f n ii, (26)
where
Z
n
hyH , f i(·) = f (·, t)yH (t)dt ∈ L2C (Rn−1 ), (27)
R
and
Consequently,
∞
X 1
DH
y (: e
h·,ξi
:) = n h: x⊗(n−1) :, hyH , ξiξ ⊗(n−1) i
n=1
n! (29)
h·,ξi
= hξ, yH i : e :,
and
By definition,
∗ ∗
S(DH H
y Φ)(ξ) = hhDy Φ, : e
h·,ξi
:ii
= hhΦ, DyH (: eh·,ξi :)ii (30)
= hξ, yH iSΦ(ξ).
That is,
∗
DH
y Φ(x) = hx, yH iΦ(x). (31)
Thus
∗
DH
y (h: x
⊗n
:, f n i) = hx, yH ih: x⊗n :, f n i
(32)
= h: x⊗(n+1) :, f n ⊗y
ˆ H i.
Remark 3.1.
∗
∂tH Φ(x) = hx, δtH iΦ(x). (33)
In particular,
∗
∂tH (h: x⊗n :, f n i) = hx, δtH ih: x⊗n :, f n i
(34)
= h: x⊗(n+1) :, f n ⊗δ
ˆ tH i.
Proposition 3.1.
In particular,
36 A. H. Tsoi
where
n (n)
fH (t1 , . . . , tn ) = IH− 1 (t1 , . . . , tn )
2
Z t1 Z tn
3 3
= ... (t1 − v1 )H− 2 . . . (tn − vn )H− 2 f n (v1 , . . . , vn )dvn . . . dv1 .
−∞ −∞
(40)
Definition 4.2. For Φ ∈ (S)0 , φ, ψ ∈ (S), define the fractional multiplica-
tion φ ◦H Φ of order H by:
hhφ ◦H Φ, ψii := hhφ(KH Φ), ψii
(41)
= hhKH Φ, φψii.
Remark 4.1. From Definition 4.1, for Φ = h·, νi and ν ∈ S(R) with
compact support, we obtain KH Φ(x) = h·, νH i.
Next, for φ =: eh·,ξi :, ψ =: eh·,ηi :, where ξ, η ∈ S(R), we have
hhh·, νi ◦H φ, ψii = hhh·, νH i, φψii
Z
1 2 2
= e− 2 (|ξ|0 +|η|0 ) h·, νH ieh·,ξ+ηi dµ(x) (42)
= hνH , ξ + ηiehη,ξi ,
where the last equality is a consequence of Lemma 9.16 on page 113 from
Kuo.12
Theorem 4.1. The fractional white noise multiplication is given by:
∗
Ḃ H (t) ◦H φ = (∂tH + ∂tH )φ, φ ∈ (S). (43)
38 A. H. Tsoi
Hence
hhh·, νi ◦H φ, h: ·⊗n : f n iii = hhh·, νH ih: ·⊗n :, f n i, φii
∗
= hhDνH h: ·⊗n :, f n i + DνH h: ·⊗n :, f n i, φii
∗
= hh(DνH + DνH )φ, h: ·⊗n :, f n iii
(47)
which implies
∗
h·, νi ◦H φ = (DνH + DνH )φ. (48)
In particular, for
Ḃ H (t)(x) = hxH , δt i,
we have
Ḃ H (t)(x) = hx, δtH i
∗
= DδHt + DδHt (49)
∗
= ∂tH + ∂tH .
That is,
∗
Ḃ H (t) ◦H φ = (∂tH + ∂tH )φ. (50)
2
ḂH,u
p= 2 2
(51)
ḂH,u + ḂH,d
and the probability operator of the downstate is:
2
ḂH,d
p= 2 2
, (52)
ḂH,u + ḂH,d
where ḂH,u and ḂH,d are interpreted as fractional white noise operater
with parameter H as discussed in the previous sections, and we define the
2 2
squares ḂH,u and ḂH,d as:
May 11, 2011 10:58 WSPC - Proceedings Trim Size: 9in x 6in 02-tsoi
2 ∗
ḂH,u ξ = ((∂H,u,· + ∂H,u,· )ξ)2 ; (53)
and
2 ∗
ḂH,d ξ = ((∂H,d,· + ∂H,d,· )ξ)2 . (54)
There are two securities: one risk-free bond with interest rate R and one
stock with initial price S(0) and time t = 1 price S(1) with u and d being
the returns of the stock at the upstate and at the downstate at time t = 1.
The price system of the bond and the stock admits arbitrage if and only if
there is a trading strategy (B0 ), ∆0 ) with V (0) = B0 + ∆0 S(0) = 0 such
that V (1) ≥ 0 and P (V (1) > 0) > 0. It can be shown that the price system
does not admit arbitrage if and only if d < 1 + R < u. Suppose that the
condition d < 1 + R < u is violated, say, 1 + R ≤ d. It is easy to verify
that ∆0 = 1 and B0 = −S(0) is an arbitrage trading strategy. The case
u ≤ 1 + R is argued similarly. Conversely, if d < 1 + R < u, then for any
strategy (B0 , ∆0 ) with V (0) = B0 + ∆0 S(0),
40 A. H. Tsoi
Consider a European option which gives its holder the right (not obliga-
tion) to receive or pay a pre-specified amount that is contingent on the
state of the economy on a specific date. For example, a Euorpean call op-
tion written on a risky security gives its holder the right (not obligation)
to buy the underlying security at a pre-specified price on a specific date;
while a European put option written on a security gives its holder the right
(not obligation) to sell the underlying security at a pre-specified prie on
a specific date. The pre-specified price is called the strike price and the
specific date is called the expiration or maturity time. The payoff functions
for a European call option and a European put option are maxS(T ) − K, 0
and maxK − S(T ), 0, respectively, where K is the strike price and T is the
expiration time.
Consider now that there is an option which pays Cu at the upstate and Cd
at the downstate at time t = 1. To determine the price of this option, we
construct a portfolio hoping that the payoff of this portfolio is the same as
that of the option. If we can do so, then the price of the option must be
equal to the initial value of the portfolio in order to avoid arbitrage. For
the option with payoff Cu or Cd , the corresponding portfolio is constructed
as follows. The trading strategy (B0 , ∆0 ) should be such that the following
payoff equations are satisfied:
B0 (1 + R) + ∆0 S(0)u = Cu (58)
and
B0 (1 + R) + ∆0 S(0)d = Cd . (59)
Solving these equations yields
Cu − Cd
∆0 S(0) = , (60)
u−d
and
uCd − dCu
B0 = . (61)
(1 + R)(u − d)
Therefore the price of the option is given by
where
2
ḂH,u 1+R−d
p= 2 2
= . (63)
ḂH,u + ḂH,d u−d
Therefore we have
2 1+R−d 2
ḂH,u = Ḃ . (64)
u − 1 − R H,d
Note that the right hand side of the above equation is intepreted as an
operator defined on a suitable domain of generalized functions.
References
1. E. Alos, O. Mazet and D. Nualart: Stochastic calculus with respect to Gaus-
sian Processes, Ann. of Probability, Vol. 29, No. 2 (2001), p. 766-801.
2. R.J. Barton: Signal Detection in Fractional Gaussian Noise, IEEE Transac-
tions on Information Theory, Vol. 34, No. 5, (1988), p. 943-959.
3. D.M. Chung, U.C. Ji and K. Saitô: Cauchy problems associated with the Lévy
Laplacian in white noise analysis. Infinite dimensional Analysis, Quantum
Probability and Related Topics, Vol. 2, No.1 (1999). 131-153.
4. T.E. Duncan, Y. Hu and B. Pasik-Duncan: Stochastic calculus for fractional
Brownian motion. I. Theory. SIAM Journal of Control and Optimization 38,
no.2 (2000), 582- 612.
5. I.M. Gel’fand and G.E. Shilov: Generalized Functions. Vol. I. Academic Press
1964.
6. T. Hida: Canonical representations of Gaussian processes and their applica-
tions. Memoirs Coll. Sci., Univ. Kyoto A33 (1960), 109-155.
7. T. Hida and M. Hitsuda: Gaussian Processes. American Math. Soc. Trans-
lation of Math. Monographs Vol. 12, 1993.
8. T. Hida, H.-H. Kuo, J. Potthoff and L. Streit: White Noise Analysis. Kluwer,
1993.
9. H. Holden, B. Oksendal, J. Uboe and T. Zhang: Stochastic Partial Differential
Equations. Birkhauser 1996.
10. Y. Hu: Ito-Wiener chaos expansion with exact residual and correlation, vari-
ance inequalities. Journal of Theoretical Probability, 10 (1997), 835- 848.
11. I. Karatzas and S.E. Shreve: Brownian Motion and Stochastic Calculus. Sec-
ond Edition. Springer-Verlag, New York 1991.
12. H.-H. Kuo: White Noise Distribution Theory. CRC Press 1996.
13. S.J. Lin: Stochastic analysis of fractional Brownian motion. Stochastics and
Stochastic Reports 55 (1995), 121- 140.
14. B.B. Mandelbrot and J.W. Van Ness: Fractional Brownian motion, fractional
noises and applications. SIAM Rev. 10 (1968), 422- 437.
May 27, 2011 13:34 WSPC - Proceedings Trim Size: 9in x 6in 02-tsoi
42 A. H. Tsoi
15. K. Nishi, K. Saitô and A.H. Tsoi: Fractional Brownian motion and the Lévy
Laplacian. Quantum Information V. World Scientific (2006), p. 181-191.
16. I. Podlubny: Fractional Differential Equations. Academic Press, 1999.
17. P. Protter: Stochastic Integration and Differential Equations. Springer- Ver-
lag, 1990.
18. L.C.G. Rogers: Arbitrage with fractional Brownian motion. Math. Finance
7 (1997), 95-105.
19. K. Saitô and A.H. Tsoi: The Levy Laplacian as a self- adjoint operator.
Quantum Information. Ed. T. Hida and K. Saitô, World Scientific (1999),
159- 171.
May 11, 2011 11:3 WSPC - Proceedings Trim Size: 9in x 6in 03-chao
43
C. Zhu
Department of Mathematical Sciences
University of Wisconsin-Milwaukee
Milwaukee, WI 53201, USA
Email: zhu@uwm.edu
G. Yin
Department of Mathematics
Wayne State University
Detroit, MI 48202, USA
Email: gyin@math.wayne.edu
1. Introduction
1.1. Introduction
This work is concerned with large-time behavior of switching diffusion pro-
cesses, which are two-component Markov processes. In such processes, be-
cause of the two components, continuous dynamics and discrete events co-
exist and are intertwined. The models are versatile and much enlarge the
domain of applicability of diffusion-type processes. Our motivation of the
study stems from a wide variety of applications in financial engineering,
production planning, wireless communications, and other related fields, in
which the traditional stochastic differential equation formulation is not ad-
equate. In addition to the usual dynamic systems modeled by differential
equations, there is another factor in the model that could be used to cap-
ture the environmental changes and other random factors. In lieu of one
May 11, 2011 11:3 WSPC - Proceedings Trim Size: 9in x 6in 03-chao
1.4. Outline
The rest of the paper is arranged as follows. Section 2 begins with the for-
mulation of the problem. Section 3 is devoted to the invariance principles.
Liapunov function type criteria are obtained first. Then linear (in x) sys-
tems are treated. Finally, a few more remarks are made in Section 4 to
conclude the paper.
2. Formulation
Throughout the paper, we use z 0 to denote the transpose of z ∈ R`1 ×`2
with `i ≥ 1, whereas R`×1 is simply written as R` ; 11 = (1, 1, . . . , 1)0 ∈ Rm0
May 11, 2011 11:3 WSPC - Proceedings Trim Size: 9in x 6in 03-chao
is a column vector with all entries being 1; the Euclidean norm for a row
or a column vector x is denoted by |x|. As usual, I denotespthe identity
matrix. For a matrix A, its trace norm is denoted by |A| = tr(A0 A). If
a matrix A is real and symmetric, we use λmax (A) and λmin (A) to denote
the maximal and minimal eigenvalues of A, respectively, and set ρ(A) :=
max {|λmax (A)| , |λmin (A)|}. When B is a set, IB (·) denotes the indicator
function of B.
Let (Ω, F , P) be a complete probability space. Suppose that (X(t), α(t))
is a two-component Markov process such that X(·) is a continuous compo-
nent taking values in Rr and α(·) is a jump component taking values in a
finite set M = {1, 2, . . . , m0 }. The process (X(t), α(t)) has a generator L
given as follows. For each i ∈ M and any twice continuously differentiable
function g(·, i),
r r
1 X ∂ 2 g(x, i) X ∂g(x, i)
Lg(x, i) = ajk (x, i) + bj (x, i) + Q(x)g(x, ·)(i),
2 ∂xj ∂xk j=1
∂xj
j,k=1
1
= tr(a(x, i)∇2 g(x, i)) + b0 (x, i)∇g(x, i) + Q(x)g(x, ·)(i),
2
(1)
where x ∈ Rr , and Q(x) = (qij (x)) is an m0 × m0 matrix depending on x
P
satisfying qij (x) ≥ 0 for i 6= j and j∈M qij (x) = 0,
X X
Q(x)g(x, ·)(i) = qij (x)g(x, j) = qij (x)(g(x, j)−g(x, i)), i ∈ M,
j∈M j∈M,j6=i
and ∇g(·, i) and ∇2 g(·, i) denote the gradient and Hessian of g(·, i), respec-
tively.
The process (X(t), α(t)) can be described by
and for i 6= j
3. Main Results
This section is the core of the paper. We begin with the definition of in-
variant sets. Inspired by the study in Ref. 4, we define the invariant set as
follows.
(i) stable in probability if for any ε > 0 and ρ > 0, there is a δ > 0
such that
Px,i sup d((X(t), α(t)), K) < ρ ≥ 1 − ε, if d((x, i), K) < δ;
t≥0
Proof. Let (x0 , i0 ) ∈ Ker(V ). By virtue of the generalized Itô Lemma (Ref.
19), we have for any t ≥ 0,
Z t
V (X(t), α(t)) = V (x0 , i0 ) + LV (X(s), α(s))ds + M (t), (2)
0
That is
Px0 ,i0 {(X(t), α(t)) ∈ Ker(V ), for all t ≥ 0} = 1.
This proves the first assertion of the theorem.
We proceed to prove the second assertion. For any δ > 0, let Uδ be a
neighborhood of Ker(V ) such that
Uδ := {(x, i) ∈ Rr × M : d((x, i), Ker(V )) < δ} . (3)
Let the initial condition (x, i) ∈ Uδ − Ker(V ) and τ be the first exit time
of the process from Uδ . That is,
τ = inf{t : (X(t), α(t)) 6∈ Uδ }.
Then for any t ≥ 0, we have by virtue of generalized Itô’s lemma that
Z t∧τ
V (X(t ∧ τ ), α(t ∧ τ )) = V (x, i) + LV (X(s), α(s))ds + M (t ∧ τ ),
0
where
Z t∧τ
M (t ∧ τ ) = ∇V (X(s), α(s)), σ(X(s), α(s))dw(s)
0Z
t∧τ Z
+ V (X(s), i + h(X(s), α(s−), z))
0 R
−V (X(s), α(s)) µ(ds, dz).
As argued in the previous paragraph, by virtue of (1), we can use a sequence
of stopping times and Fatou’s Lemma, if necessary, to obtain
Z t∧τ
Ex,i [V (X(t∧τ ), α(t∧τ ))] ≤ V (x, i)+Ex,i LV (X(s), α(s))ds ≤ V (x, i).
0
Proof. Fix any (x, i) ∈ Uε,r . By virtue of generalized Itô’s Lemma, we have
that for any t ≥ 0,
Z t∧τε,r
V (X(t∧τε,r ), α(t∧τε,r )) = V (x, i)+ LV (X(s), α(s))ds+M (t∧τε,r ),
0
Theorem 3.5. Assume that there exists a function V satisfying the con-
ditions of Lemma 3.4. Then Ker(V ) is an invariant set for the process
(X(t), α(t)) and Ker(V ) is asymptotically stable in probability.
Proof. Our proof is motivated by Ref. 17, Theorem 5.36; we use similar
ideas. By virtue of Theorem 3.3, we know that Ker(V ) is an invariant set
for the process (X(t), α(t)) and that Ker(V ) is stable in probability. Hence
it remains to show that
n o
Px,i lim d((X(t), α(t)), Ker(V )) = 0 → 1 as d((x, i), Ker(V )) → 0.
t→∞
Since Ker(V ) is stable in probability, for any ε > 0 and any θ > 0, there
exists some δ > 0 (without loss of generality, we may assume that δ < θ)
such that
ε
Px,i sup d((X(t), α(t)), Ker(V )) < θ ≥ 1 − , (8)
t≥0 2
for any (x, i) ∈ Uδ , where Uδ is defined in (3). Now fix any (x, α) ∈ Uδ −
Ker(V ) and r > d((x, i), Ker(V )). let ρ > 0 be arbitrary satisfying 0 < ρ <
d((x, i), Ker(V )) and choose some % ∈ (0, ρ). Define
(We use the convention that inf {∅} = ∞.) For any t ≥ 0, we apply gener-
alized Itô’s lemma and (7) to obtain
Ex,α V (X(τρ ∧ t), α(τρ ∧ t))
Z τρ ∧t
≤ Ex,α V (X(τ% ∧ t), α(τ% ∧ t)) + Ex,α LV (X(s), α(s))ds (11)
τ% ∧t
LV (x, i) ≤ −W
c (x, i), for any (x, i) ∈ U, (19)
Proof. This theorem can be proved using the arguments in Ref. 16, Theo-
rem 2.1. Some modifications are needed, though. 2
May 11, 2011 11:3 WSPC - Proceedings Trim Size: 9in x 6in 03-chao
We end this section with the following results on linear systems. More
specifically, we assume that the evolution (2) is replaced by
d
X
dX(t) = b(α(t))X(t)dt + σj (α(t))X(t)dwj (t), (21)
j=1
where b(i), σj (i) are r × r constant matrices and wj (t) are independent
1-dimensional standard Brownian motions for i = 1, 2, . . . , m0 and j =
1, 2, . . . , d.
Note that 0 is an equilibrium point for the system given by (21) and
(3). As we indicated earlier, it was shown in Refs. 12 and 15 that the set
Rr × M is invariant with respect to the process (X(t), α(t)).
Theorem 3.8. Assume that the discrete component α(·) is ergodic with
constant generator Q = (qij ) and invariant distribution π = (π1 , . . . , πm0 ) ∈
R1×m0 . Then the equilibrium point x = 0 of system given by (21) and (3)
(i) is asymptotically stable with probability 1 if
m0
X X d
0 0
πi λmax b(i) + b (i) + σj (i)σj (i) < 0, (22)
i=1 j=1
Proof. We need only prove assertion (i), since assertion (ii) was proved
in Ref. 12. For notational simplicity, define the column vector µ =
(µ1 , µ2 , . . . , µm0 )0 ∈ Rm0 with
d
1 0
X
0
µi = λmax b(i) + b (i) + σj (i)σj (i) .
2 j=1
Also let β := −πµ. Note that β > 0 by (22). It follows from the result in
Ref. 12 that the equation
Qc = µ + β11
has a solution c = (c1 , c2 , . . . , cm0 )0 ∈ Rm0 . Thus we have
m0
X
µi − qij cj = −β, i ∈ M. (24)
j=1
May 11, 2011 11:3 WSPC - Proceedings Trim Size: 9in x 6in 03-chao
Note that
d
x0 b(i)x 1 X x0 σj0 (i)σj (i)x
+
|x|2 2 j=1 |x|2
d
x0 (b0 (i) + b(i))x 1 X x0 σj0 (i)σj (i)x
= + (26)
2|x|2 2 j=1 |x|2
d
1 0
X
0
≤ λmax b(i) + b(i) + σj (i)σj (i) = µi .
2 j=1
Hence it follows from (24)–(27) that when 0 < γ < 1 sufficiently small, we
have
m0
X
LV (x, i) ≤ γ(1 − γci )|x|γ µi − qbij cj + O(γ)
j=1
γ
= γ(1 − γci )|x| (−β + O(γ))
β
≤ − γ(1 − γci ) |x|γ := −W
c (x, i).
2
Note that Ker(W c ) = {0} × M. Therefore we conclude from Theorem 3.7
point x = 0 is asymptotically stable with probability 1. 2
4. Further Remarks
This paper has focused on invariance principles of regime-switching diffu-
sion processes. The results obtained accommodate the stability results and
May 11, 2011 11:3 WSPC - Proceedings Trim Size: 9in x 6in 03-chao
provide further insight. For subsequent study, we may consider such prob-
lems as the ω-limit sets in the deterministic setup. In lieu of memoryless
setup, if delays are considered in the system, one gets switching diffusions
with delay. Studying invariance for such systems is a worthwhile effort.
Another direction is the investigation of associated problems with Poisson
type of jumps, in which the sample paths are no longer continuous. It will
be interesting to see if any invariance principle can be obtained in that
regards.
Acknowledgments
This research was supported in part by the National Science Foundation
under grant DMS-0907753 and in part by the Air Force Office of Scientific
Research under grant FA9550-10-1-0210.
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63
Alain Bensoussan
School of Management
University of Texas at Dallas
The Hong Kong Polytechnic University
Richardson, TX 75083-0688, Hong Kong
Email: alain.bensoussan@utdallas.edu
J. David Diltz
Department of Finance and Real Estate
The University of Texas at Arlington
Arlington, TX 76019, USA
Email: diltz@uta.edu
This paper provides a review of our research, Bensoussan et al. Refs. 3,4, which
explore optimal investment policies for irreversible capital investment projects
under uncertainty in monopoly and Stackelberg leader-follower frameworks.
Optimal policies derived for the Stackelberg duopoly case in an incomplete
market are, to our knowledge, heretofore undocumented. We show that com-
petition and market incompleteness have vital impacts on investment decisions.
In our survey, we present models in the case of complete markets and in the case
of incomplete markets with different types of investment payoffs and market
competition frameworks. We discuss model setup, explaining solution tech-
nique and procedure. We provide major results and theorem, and refer proofs
and details to our original papers Refs. 3,4.
1. Introduction
This paper provides a review of our research, Bensoussan et al. Refs. 3,4,
which explore optimal investment policies for irreversible capital investment
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
64 A. Bensoussan et al.
66 A. Bensoussan et al.
where r is a risk free interest rate, σ is the volatility and λ is the Sharpe
ratio; they are all constants. The market is complete and there exists a
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
W
c (t) = W (t) + λt
dQ
b
|F = Z(t)
dQ t
68 A. Bensoussan et al.
a In the context of the leader-follower model, we assume a > 12 . Otherwise, the leader
will surrender a majority interest in the project, providing a strong disincentive to enter
at all.
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
where
s
1 r + η(ξ − λ) 1 r + η(ξ − λ) 2 2r
β= − + − + 2 > 1, (6)
2 η2 2 η2 η
βK
v̂ = (7)
(1 − a)(β − 1)
and we assume ξ < λ.
The optimal stopping rule τ̂ (v) which achieves the supremum in (4) is:
τ̂ (v) = inf{t|Vv (t) ≥ v̂} (8)
70 A. Bensoussan et al.
From (10), the manager’s expected discounted payoff from the capital
investment project taken at time τ is:
b e−rτ
δYy (τ )
Jy (τ ) = E − K 1τ <∞ . (11)
r − (α − λς)
The manager’s value function is:
F (y) = sup Jy (τ ). (12)
τ ≥0
βK r − (α − λς)
ŷ = (15)
β−1 δ
and we assume r − (α − λς) > 0.
The optimal stopping rule τ̂ (y) that achieves the supremum in (12) is:
τ̂ (y) = inf{t|Yy (t) ≥ ŷ} (16)
with ŷ defined in (15).
From (18), the manager’s expected discounted payoff from the capital
investment project taken at time τ is:
−rτ Yy (τ ) α − λς
Jy (τ ) = E e
b δ( + 2
) − K 1τ <∞ . (19)
r r
The manager’s value function is:
F (y) = sup Jy (τ ). (20)
τ ≥0
where
r
α − λς α − λς 2 2r
β=− + + 2 > 0, (22)
ς2 ς2 ς
and
1 r α − λς
ŷ = + K− > 0. (23)
β δ r
The optimal stopping rule τ̂ (y) that achieves the supremum in (20) is:
τ̂ (y) = inf{t|Yy (t) ≥ ŷ} (24)
with ŷ defined in (23).
72 A. Bensoussan et al.
A. Follower
B. Leader
When the leader enters at time θ < ∞, by paying cost K, he/she receives:
aVv (θ)1Vv (θ)≥v̂ + (Vv (θ) − βF (Vv (θ))1Vv (θ)<v̂ − K,
where F (v), β and v̂ are defined in (5), (6) and (7) respectively. The leader’s
value function is:
b e−rθ Ψ(Vv (θ))1θ<∞ ,
L(v) = sup E (25)
θ≥0
b We refer the formulation and proof to the original work Bensoussan et al. (2009) Ref. 3.
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
Theorem 3.1. There exist three points 0 < v1 < v2 < v̂ < v3 such that:
− 21 U 00 (v)η 2 v 2 − (r + η(ξ − λ))vU 0 (v) + rU (v) = aη(ξ − λ)v + rK
for 0 < v < v and v < v < v
1 2 3
U (v) = χ(v) for v1 ≤ v ≤ v2
U (v) = 0 for v > v3
(29)
0 0 0 0 0
with matching conditions: U (v1) = χ (v1 ); U (v2 ) = χ (v2 ); U (v3 ) = 0,
where χ(v) = (1 − a)v − βF (v) 1v<v̂ satisfying
1 00 2 2 0
− 2 χ (v)η v − (r + η(ξ − λ))vχ (v) + rχ(v) = −(1 − a)η(ξ − λ)v
if v < v̂
χ(0) = χ(v̂) = (1 − a)v̂ − βK = 0
β−1
(30)
with F (v), β and v̂ defined in (5), (6), and (7) respectively.
A. Follower
The follower’s solution is the same as that defined in (16) but replacing δ
by δ2 . Since the follower enters after the leader (who starts at θ < ∞), the
follower will enter at time: τ̂θ = θ + τ̂ (Yy (θ)).
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
74 A. Bensoussan et al.
B. Leader
When the leader enters at time θ < ∞, by paying cost K, he/she receives:
δ2 Yy (θ) Yy (θ) β
−K + + (δ1 − δ2 ) − F (Yy (θ)) 1Yy (θ)<ŷ
r − α + λς r − α + λς δ2
where F (y), β and ŷ are is defined in (13), (14), and (15) respectively. The
leader’s value function is:
L(y) = sup E{exp(−rθ)Ψ
b Yy (θ) 1θ<∞ } (32)
θ≥0
δ2 y y β
where Ψ(y) = −K + r−α+λς + (δ1 − δ2 ) r−α+λς − δ2 F (y) 1y<ŷ . L(y) must
satisfy:
δ1 − δ2
0 ≤ U (y) ≤ K max(1, ),
δ2
δ1 − δ2 δ1 − δ2
and 0 ≤ χ(y) ≤ K ≤ K max(1, ). (35)
δ2 δ2
Theorem 3.2. There exist three points 0 < y1 < y2 < ŷ < y3 = ȳ such
c We refer the formulation and proofs to the original work Bensoussan et al. (2009) Ref. 4.
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
that:
− 21 U 00 (y)ς 2 y 2 − (α − ςλ)yU 0 (y) + rU = −δ2 y + rk
for 0 < y < y and y < y < y
1 2 3
U (y) = χ(y) for y1 ≤ y ≤ y2
U (y) = 0 for y ≤ y3
with F (y), β and ŷ defined in (13), (14), and (15) respectively. The function
U vanishes for y sufficiently large.
The leader’s optimal stopping rule is defined in the the same way as the
lump-sum payoff case (cf.(31)).
A. Follower
The follower’s solution is the same as that defined in (24) but replacing δ
by δ2 . Since the follower enters after the leader (who starts at θ < ∞), the
follower will enter at time: τ̂θ = θ + τ̂ (Yy (θ)).
B. Leader
When the leader enters at time θ < ∞, by paying cost K, he/she receives:
Yy (θ) α − λς Yy (θ) α − λς
−K + δ2 + 2
+ (δ1 − δ2 )1Yy (θ)<ŷ +
r r r r2
ŷ α − λς −β(ŷ−Yy (θ))
− + e ,
r r2
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
76 A. Bensoussan et al.
where β and ŷ are defined in (22) and (23) respectively. The leader’s value
function is:
b e−rθ Ψ(Yy (θ))1θ<∞
L(y) = sup E (37)
θ≥0
δ2 yr
+ α−λς + (δ1 − δ2 )1y<ŷ yr + α−λς 1
where Ψ(y) = −K + r 2 r2 − rβ +
K
−β(ŷ−y)
δ2 e . L(y) must satisfy:
d We refer the formulation and proofs to the original work Bensoussan et al. (2009) Ref. 3.
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
The leader’s optimal stopping rule is defined in the the same way as the
lump-sum payoff case (cf.(31)).
and the cash flow investment payoffs by arithmetic Brownian motion pro-
cess evolve as:
p
dY (t) = αdt + ς ρdW (t) + 1 − ρ2 dW 0 (t) , Y (0) = y
(43)
where W (t) and W 0 (t) are independent Wiener processes. The parameter
|ρ| < 1 is the correlation coefficient between market uncertainty and in-
vestment payoff uncertainty. The market asset S can only span a portion
of the investment payoff risk driven by the Wiener process W (t), leaving
the remaining risk driven by W 0 (t) unhedgeable. The unique equivalent
martingale measure is undefined, so the risk-neutral pricing is no longer
appropriate, and an alternative must be developed in this framework.
We adopt the utility-based pricing approach where the risk averse in-
vestor’s preferences are characterized by an exponential utility function
given by:
1
U (x) = − e−γx (44)
γ
where γ is his/her risk aversion parameter, γ > 0.
The valuation formulation is: given initial wealth, the investor consid-
ers utility maximization by choosing an optimal stopping time to invest
the project together with a portfolio investment-consumption strategy. We
will formulate the investor’s specific utility maximization problem in each
corresponding scenarios.
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
78 A. Bensoussan et al.
where π(t) is the portion of wealth invested in asset S. We use the dis-
counted value Ve (t) = V (t)e−rt and X(t)
e = X(t)e−rt where:
p
dVe (t) = Ve (t)η ξdt + ρdW (t) + 1 − ρ2 dW 0 (t) , Ve (0) = v
(46)
dX(t) = X(t)π(t)σ λdt + dW (t) , X(0) = x.
e e e (47)
Let Ft = σ(W (s), W 0 (s); s ≤ t). We consider stopping times τ with respect
to Ft . At τ , the individual invests and receives X ex (τ ) + (Vev (τ ) − K)+e . To
a pair (π(·), τ ), we associate with the objective function:
λ2
Jx,v (π(·), τ ) = E e 2 τ U Xex (τ ) + Vev (τ ) − K + .
(48)
We assume τ is finite a.s.. The function (48) is well defined but the value
−∞ is possible.
We define the associated value function as:
2(ξ − ρλ)
β =1− > 1, (52)
η
e This formulation is similar to the specification that the investment cost grows at the
risk-free rate.
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v̂ solves
$
(1 − a)v̂ = K + (53)
γ(1 − ρ2 )
with $ the unique positive solution of
$ Kγ(1 − ρ2 )
e$ − =1+ , (54)
β β
and we assume ξ − ρλ < 0.
We next define the optimal stopping rule which achieves supremum in
(49):
ex (t) + (1 − a)Vev (t) − K +
τ̂ (x, v) = inf t ≥ 0|F X
ex (t), Vev (t) = U X
80 A. Bensoussan et al.
and
dX 1 (t) = π(t)X 1 (t)σ(λdt + dW (t)) + rX 1 (t)dt − C(t)dt + δY (t)dt, (58)
where X 0 is the wealth process X before the stopping time τ and X 1 is the
wealth process X after the stopping time τ .
is the unique function in C 2 (0, ∞), solution of (68), (67) in the interval
[0, y + M ]g , such that f (y) ↑ ∞ as y ↑ ∞. Moreover, the function f 0 (y) is
bounded.
Note that the function f (y) defined in (69) is the function entering into the
transversality condition in (61).
Theorem 4.1. The function F 1 (x, y) given by (66) coincides with the value
function given by (63).
We now turn to the problem of optimal stopping with the obstacle defined
by F 1 (x, y). Before the stopping time τ , the wealth process X is governed
by X 0 (t) (57) and the cash flow process evolves as (42).
0
Introduce the set of admissible controls, Ux,y = {π(.), C(.), τ }, satisfy-
ing:
( RT 2
E[ 0 π(t)X 0 (t) dt] < ∞, ∀ T
RT , (70)
E[ 0 C(t)2 dt] < ∞, ∀ T
δ
2
gM
− r + α − λςρ
is defined as: M = . Note that can be arbitrarily small.
2ς 2 r 2 γ(1 − ρ2 )
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82 A. Bensoussan et al.
If θ0 ≤ τ, the investment never takes place and the investor receives
F X 0 (θ0 ) (cf.(64)). If τ < θ0 , the investor will receive F 1 (X 0 (τ ) −
K, Y (τ ))(cf.(66)) at the stopping time τ . Therefore, the objective function
is:
Z τ ∧θ0
e−µt U C(t) dt + F 1 X 0 (τ ) − K, Y (τ )
Jx,y C(·), π(·), τ = E
0
−µτ 0 0
−µθ0
×e 1τ <θ0 + F X (θ ) e 1θ0 ≤τ
(73)
=0
g(0) = 0.
(76)
In (76), the nonlinear operator is connected to a minimization problem and
the inequalities are connected to a maximization problem for a stopping
time. g(y) can be interpreted as the value function of a differential game.
Define: u(y) = g(y) − f (y) + K, yielding:
− 12 y 2 ς 2 u00 − yu0 α − λςρ − yf 0 ς 2 rγ(1 − ρ2 ) + 12 y 2 ς 2 rγ(1 − ρ2 )u02 + ru
≥ −δy + rK
u≥ 0
u − 12 y 2 ς 2 u00 − yu0 α − λςρ − yf 0 ς 2 rγ(1 − ρ2 ) + 12 y 2 ς 2 rγ(1 − ρ2 )u 02
+ ru + δy − rK = 0
u(0) = K.
(77)
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We study (77) by the threshold approach. For fixed ŷ, we solve the Dirichlet
problem:
1 2 2 00 0 0 2 2
1 2 2 2 02
− 2 y ς u − yu α − λςρ − yf ς rγ(1 − ρ ) + 2 y ς rγ(1 − ρ )u + ru
= −δy + rK, 0 < y < ŷ
u(0) = K, u(ŷ) = 0.
(78)
Equation (78) is a Bellman equation of the following control problem with
the controlled diffusion:
p
dY = Y α − λςρ − Y f 0 (Y )ς 2 rγ(1 − ρ2 ) + ς rγ(1 − ρ2 )v dt + Y ςdW
(80)
where θy v(·) = inf{t|Y (t) is outside (0, ŷ)}, and it is a.s. finite.
Theorem 4.2. There exists a unique value ŷ such that
Kr
u0 (ŷ) = 0, ŷ ≥ . (81)
δ
The value function u(y)(cf.80) extended by 0 beyond ŷ is the unique solution
of the V.I. (77). It is C 1 and piecewise C 2 .
Hence, there exists a unique ŷ such that:
− 21 y 2 ς 2 g 00 − g 0 y(α − λςρ) + 21 y 2 ς 2 rγ(1 − ρ2 )g 02 + rg = 0, y < ŷ
g(y) = f (y) − K, y ≥ ŷ
.
g 0 (ŷ) = f 0 (ŷ)
g(0) = 0
(82)
Note that g(y) ≥ 0 since u(y) ≥ −f (y) + K.
Theorem 4.3. The function F (x, y) defined by (75) coincides with the
value function given by (74).
We next define the optimal stopping rule as: τ̂ (y) = inf{t|Yy (t) ≥ ŷ}, where
ŷ is the unique value defined by the V.I. (77) and (81)(the smooth matching
point).
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
84 A. Bensoussan et al.
Theorem 4.4.
2
1 δ µ + λ2
F 1 (x, y) = −
exp − rγ(x + y) + 1 −
rγ r r
δγ 1
α − λςρ − ς 2 δγ(1 − ρ2 )
−
r 2
(88)
is the solution of the value function (87).
p
h The cash flow process now evolves as: dY (t) = αdt + ς(ρdW (t) + 1 − ρ2 dW 0 (t)).
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
We now solve the optimal stopping problem with the obstacle defined by
the value function F 1 (x, y). Before the stopping time τ , the wealth pro-
cess X 0 (t) evolves as (57) and the cash flow process Y (t) evolves as (43).
0
Introduce the set of admissible controls Ux,y = {π(·), C(·), τ } satisfying:
2
( RT
E[ 0 π(t)X 0 (t) dt] < ∞, ∀ T
RT , (89)
E[ 0 C(t)2 dt] < ∞, ∀ T
δy δ
i f (y) α − λςρ − 21 ς 2 ργ(1 − ρ2 ) .
= r
+ r2
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
86 A. Bensoussan et al.
We study (95) by the threshold approach. For ŷ fixed, we solve the Dirichlet
problem:
1 2 00 0 2 2
1 2 2 02
− 2 ς u − u α − λςρ − ς δγ(1 − ρ ) + 2 ς rγ(1 − ρ )u + ru
= −δy + rK, y < ŷ
u(ŷ) = 0
(96)
and we require a linear growth for y → −∞.
Theorem 4.5. For each ŷ, there exists a unique solution of (96) with the
estimate:
(−δ ŷ + rK)−
δ 1
− ≤ u(y) ≤ − (y − ŷ)+ − δ ŷ + rK
r r r
+
δ
− α − λςρ − γδς 2 (1 − ρ2 ) ,
r
for y < ŷ. (97)
The solution is C 2 in (−∞, ŷ). There exists a unique ŷ such that:
rK
u0 (ŷ) = 0, ŷ ≥ . (98)
δ
The corresponding solution of (96) extended by 0 beyond ŷ is the unique
solution of the V.I. (95). It is C 1 and piecewise C 2 .
Theorem 4.6. The function F (x, y) given by (93) coincides with the value
function (92).
where v̂ is defined in (53). The stopping time τ̂ (v) is the optimal entry if
the follower can enter in the market at time zero. Since the follower enters
after the leader (who
starts at θ), for finite θ, the follower will enter at time:
τ̂θ = θ + τ̂ Vev (θ) .
B. Leader
(1) If Ve (θ) > v̂, the follower enters immediately and the leader gets X(θ)
e +
aVe (θ) − K.
(2) If Ve (θ) < v̂, then τ̂ Ve (θ) > 0, the leader gets immediately X(θ)e +
(Ve (θ) − K), but he/she surrenders at time θ + τ̂ Ve (θ) , a percentage
(1 − a) of project value to the follower.
A difficulty occurs in the latter scenario. At time θ, the leader must deter-
mine the value surrendered to the follower, taking into account the follower’s
optimal entry at τ̂θ . However, we work with investor’s utility and there is
no identity relationship for values at different times. We will circumvent
this problem converting the surrender value by employing equivalence (in-
difference) considerations.
Let X(t),
e Ve (t) be the wealth of the follower and the value process
governed by (47) and (46). Suppose θ = 0 and v > v̂, then the follower
receives (1 − a)v at time 0 and he/she values this operation by U x + (1 −
a)v). If θ = 0 and 0 < v < v̂, then the follower receives (1 − a)Ve τ̂ (v) at
λ2
time τ̂ (v); the corresponding value is: e 2 τ̂ (v) U X
ex τ̂ (v) +(1−a)Vev τ̂ (v) .
Since the follower can dynamically optimize his/her portfolio between time
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
88 A. Bensoussan et al.
and we have the boundary conditions: H(x, v̂) = U x + (1 − a)v̂ and
H(x, 0) = U (x).
then:
−γH e (v)
e = Λ(v), 0 < v < v̂
H e (v) ≤ (1 − a)v, if v ≤ v̂ . (103)
e
H (v) = (1 − a)v, v ≥ v̂
H e (v) is the value that makes the follower indifferent between receiving it
at time 0 and losing the right to undertake investment at time τ̂ (v), or to
exert the right to undertake the investment. The leader must deduct this
amount in addition to K at time 0 if he/she decides to invest at time 0.
We now formulate completely the leader’s problem. For each pair of
(π(·), θ), the leader’s objective function is :
λ2 +
Jx,v (π(·), θ) = E e 2 θ U X(θ)
e + Ve (θ) − K − H e (Ve (θ)) (104)
+
2 e
The obstacle, ψ(v) = e−γ(1−ρ ) v−K−H (v) is continuous but not C 1 ,
and its derivative is discontinuous at v o (K < v o < v̂) and v̂. Therefore, we
must consider (107) in a weak sense. Nevertheless, (107) is the V.I. of the
following optimal stopping problem with the state equation:
dV (t) = V (t)η (ξ − λρ)dt + dW (t) , V (0) = v (108)
∞
1 − v 2 (% − 1) φ̃(v)
Z
φ0 (v) − η(ξ − λρ) + η 2
b(φ, φ̃) = dv
0 1 − v2 (1 + v 2 )%
1 ∞ φ0 (v)φ̃0 (v)v 2 η 2
Z
+ dv.
2 0 (1 + v 2 )%
b(Σ, Σ
e − Σ) ≥ 0, ∀Σ
e ∈ K, Σ ∈ K (110)
Theorem 4.7. Assume ξ − λρ < 0. Then there exists one and only one
solution of (110). It coincides with the value function (109).
90 A. Bensoussan et al.
We have the follower’s value function as defined by (75) with g(y) satisfying
(76) and δ replaced by δ2 . The optimal stopping strategy for the follower
is:
B. Leader
If θ = 0 and y > ŷ, the follower enters immediately, and the leader’s
problem is identical to the follower’s, i.e., (63) with δ = δ2 . So, we consider
the function:
2
µ+ λ
1
2
L2 (x, y) = − e−rγ x+f (y) +1− r , (112)
rγ
where f is the solution of (68), (67) in the interval [0, y + M]j with δ being
replaced by δ2 .
If θ = 0 and y < ŷ, the leader’s problem is described as follows. The
wealth process is described by X 1 in (111) and the cash flow process follows
1
(42). Introduce the set of admissible controls, Ux,y = {C(·), π(·)}, satisfying:
( RT 2
E 0 π(t)X 1 (t) dt < ∞, ∀ T < ∞
RT , (113)
E 0 C(t)2 dt < ∞, ∀ T < ∞
and
Recall θ0 = inf{t|Yy (t) = 0}. If θ0 < τ̂ (y), the follower never in-
vests, and the leader’s value function at time θ0 corresponds to
F (X 1 (θ0 ))(cf.(64)). Ifτ̂ (y) < θ0 , the leader’s value function corresponds to
L2 (X 1 τ̂ (y)), Y (τ̂ (y)) , at the follower’s entry time, τ̂ (y). Thus, to a pair
of (C(·), π(·)), we associate the objective function:
0
τ̂ (y)∧θ −µt
Z
0
e U (C(t))dt + F X 1 (θ0 ) e−µθ 1θ0 ≤τ̂ (y)
J C(·), π(·) = E
0
+ L2 X 1 τ̂ (y) , Y τ̂ (y) e−µτ̂ (y) 1τ̂ (y)<θ0 .
(115)
We consider the value function:
L1 (x, y) =
sup J C(·), π(·) . (116)
1
{π(·),C(·)}∈Ux,y
We study the Bellman equation associated with (116) for 0 < y < ŷ. We
look for a solution of the form:
2
µ+ λ
1
2
L1 (x, y) = − e−rγ x+g(y) +1− r , (117)
rγ
92 A. Bensoussan et al.
and we define:
L1 (x, y) = L2 (x, y), if y > ŷ,
2
where L (x, y) is defined in (112). The Bellman equation that the value
function L1 (x, y) (116) must satisfy reduces to:
(
1 2 2 00 0 1 2 2 2 2 2 02
2 y ς g + (α − λςρ)yg − 2 r γ y ς (1 − ρ )g − rg + δ1 y = 0, 0 < y < ŷ
g(0) = 0, g(ŷ) = f (ŷ).
(118)
k
Where f (y) is the solution of (68), (67) in the interval [0, y + M ] with δ
being replaced by δ2 . We extend g(y) by f (y) for y > ŷ.
Similar to the study of (68), g(y) may be interpreted as a function of a
control problem, and there exists a unique solution which is C 2 (0, ŷ).
Theorem 4.8. The function L1 (x, y) defined by (117) coincides with the
value function given in (116).
B.2 Pre-Investment Utility Maximization
(122)
(126)
where m = g(y) − f (y) is the solution of:
− 21 y 2 ς 2 m00 − y α − λςρ − yς 2 rγ(1 − ρ2 )f 0 m0 + 21 ς 2 rγy 2 (1 − ρ2 )m02
+ ry = (δ − δ )y, 0 < y < ŷ
1 2
m(0) = m(ŷ) = 0
m(y) = 0, y > ŷ.
(127)
We next show that u(y) is more appropriately the value function of a
stochastic differential game.
r−α+λςρ
Theorem 4.9. We assume γς 2 (1−ρ2 ) > δ1 ŷ. There exists a unique u(y) ∈
1 2
C (0, ∞), piecewise C , solution of (126). This function vanishes for y
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
94 A. Bensoussan et al.
with
p
2 2 0
dY (t) = Y (t) α − λςρ − ς rγ(1 − ρ )Y (t)f (Y (t)) + v(t)ς rγ(1 − ρ 2 ) dt
+ ςY (t)dW (t)
Y (0) = y
R θ0 ∧θ 1 2
−rt 0
e dt + Ke−rθ 1θ0 <θ
J y v(·), θ = E 0 − δ 2 Yy (t) + rK + 2 v (t)
+ m Yy (θ) e−rθ 1θ<θ0
m(y) = g(y) − f (y), solution of (127) and extended by 0 for y > ŷ.
Theorem 4.10. There exists a unique triple y1 , y2 , y3 with 0 < y1 < y2 <
ŷ < y3 such that
1 1 2
− y 2 ς 2 u00 − y α − λςρ − yς 2 rγ(1 − ρ2 )f 0 u0 + ς rγy 2 (1 − ρ2 )u02 + ru
2 2
= −δ2 y + rK,
0 < y < y1 and y2 < y < y3
(129)
with the smooth pasting conditions:
0 0
u(y1 ) = m(y1 ), u (y1 ) = m (y1 )
u(y2 ) = m(y2 ), u0 (y2 ) = m0 (y2 ) , (130)
u(y3 ) = 0, u0 (y3 ) = 0
where m(y) = g(y)−f (y), the solution of (127) and extended by 0 for y > ŷ.
Theorem 4.11. The function L(x, y) defined by (124) coincides with the
value function (122).
The leader’s optimal stopping rule is defined in the the same way as the
lump-sum payoff case in case of complete markets (cf.(31)).
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
The follower’s value function as defined by (93) with g(y) satisfying (94),
where ŷ is the unique value defined by the V.I. (95) and (98). We take
δ = δ2 . The optimal stopping stopping strategy for the follower is:
where ŷ is the unique value defined by the V.I. (95) and (98). Note again
that we must take δ = δ2 and thus ŷ ≥ rK δ2 . Since the follower enters
after the leader (who starts at θ < ∞), the follower will enter at time:
τ̂θ = θ + τ̂ Yy (θ) .
B. Leader
Suppose θ = 0, his/her wealth is x, and the cash flow y > 0. The wealth
becomes immediately x − K since he/she has to pay the fixed cost of entry.
The follower will enter at τ̂ (y). The leader’s wealth evolves as (111).
If θ = 0, and y ≥ ŷ, the follower enters immediately and the leader’s
problem is exactly the same as the follower’s, i.e., (87) with δ = δ2 . So we
consider the function:
2
µ+ λ
1
2
L (x, y) = − e−rγ
2 x+f (y) +1− r (131)
rγ
δ2 y δ2 1
+ 2 α − λςρ − ς 2 δ2 γ(1 − ρ2 ) .
with: f (y) = (132)
r r 2
96 A. Bensoussan et al.
1
Ux,y = {C(·), π(·)} satisfying:
( RT 2
E 0 π(t)X 1 (t) dt < ∞, ∀ T < ∞
RT , (133)
E 0 C(t)2 dt < ∞, ∀ T < ∞
Theorem 4.12. The function L1 (x, y) defined by (137) coincides with the
value function given in (136).
We now turn to the leader’s optimal stopping problem (i.e., choice of θ).
Before the stopping time θ, the leader’s wealth evolves according to (57)
0
and cash flow evolve as (43). Introduce the set of admissible controls, Ux,y =
{C(·), π(·), θ}, satisfying:
( RT 2
E 0 π(t)X 0 (t) dt < ∞, ∀ T < ∞
RT , (141)
E 0 C(t)2 dt < ∞, ∀ T < ∞
The V.I. that the value function L(x, y) (144) must satisfy reduces to:
1 2 00 0 1 2 2 02
2 ς h + (α − λςρ)h − 2 ς rγ(1 − ρ )h − rh ≤ 0
h(y) ≥ g(y) − K .
h(y) − g(y) + K 1 ς 2 h00 + (α − λςρ)h0 − 1 ς 2 rγ(1 − ρ2 )h02 − rh = 0
2 2
(146)
98 A. Bensoussan et al.
The function m(y) = g(y) − f (y) is defined by (139). To exclude the case
that the leader and the follower have the same strategy, we will consider:
As in the geometric Brownain motion cash flow case, we next show that
u(y) is more appropriately the value function of a stochastic differential
game.
where
Rθ 1 2
−rt
Jy v(·), θ = E 0 − δ2 Yy (t) + rK + 2 v (t) e dt + m Yy (θ)
× e−rθ 1θ<∞ .
−rT
v(·) ∈ U = {lim sup
T →∞ − EYy (T )e
y = 0}
(150)
δ2
Moreover, u(y) + r y is bounded for y → −∞, and u ≥ 0.
(151)
We can take y3 = ȳ = kŷ with k sufficiently large.
Theorem 4.15. Assume (148). Then the function L(x, y) defined by (145)
is the value function (144).
The leader’s optimal stopping rule can be defined in the same way as
the lump-sum payoff case in case of complete markets (cf.(31)).
5. Conclusion
From our research results, we caution that, for managers, naively assum-
ing market completeness and ignoring the potential strategic interactions
from competitors will likely lead to non-optimal investment decisions. The
leader’s three threshold solution, which is understandable but non-intuitive,
cannot be predicted without the mathematical theory.
References
1. Bensoussan, A. and J.L. Lions, Applications of Variational Inequalities in
Stochastic Control, Elsevier North-Holland, 1978.
2. Bensoussan, A., 2008, ”Real Options”, Handbook of Mathematical Modelling
and Numerical Methods in Finance, A. Bensoussan and Q. Zhang(Eds.),
15(1), Elsevier(December), 531-572.
3. Bensoussan, A., J. D. Diltz and S. Hoe, 2009, ”Real Options Games in Com-
plete and Incomplete Markets with Several Decision Makers,” forthcoming,
SIAM Journal of Financial Mathematics.
4. Bensoussan, A., J. D. Diltz and S. Hoe, 2009, ”Real Options in a Stackelberg
Game with a Stochaastic Demand Process,” to be published.
5. Brennan, M. and E. Schwartz, 1982, Regulation and Corporate Investment
Policy, Journal of Finance, 37(2), 289-300.
6. Brennan, M. and E. Schwartz, 1982, Consistent Regulatory Policy Under
Uncertainty, Bell Journal of Economics, 13(2), 506-524.
7. Brennan, M. and E. Schwartz, 1985, Evaluating Natural Resource Invest-
ments, Journal of Business, 58(2), 135-157.
May 11, 2011 11:18 WSPC - Proceedings Trim Size: 9in x 6in 04-bens
101
Mark Brown
Department of Mathematics
City College, CUNY, New York, NY, USA
Email: cybergarf@aol.com
Erol A. Peköz
School of Management
Boston University
595 Commonwealth Avenue
Boston, MA 02215, USA
Email: pekoz@bu.edu
Sheldon M. Ross
Department of Industrial and Systems Engineering
University of Southern California
Los Angeles, CA 90089, USA
Email: smross@usc.edu
1. Introduction
Let X , . . . , Xn be independent Bernoulli random variables, and let T =
Pn 1
i=1 Xi be their sum. Also, suppose that φ is a nondecreasing function
of the vector X = (X1 , . . . , Xn ). In Section 2 we show how we can effi-
ciently estimate E[φ(X)] by a simulation approach that stratifies on T.
In Section 3, we note that E[φ(X)|T ] is a nondecreasing function of T ,
and show how this result can sometimes be used to modify our simulation
May 11, 2011 11:25 WSPC - Proceedings Trim Size: 9in x 6in 05-ross
Pj (i) = P (Xj + . . . + Xn = i)
Starting with the preceding expression for Pn (i), the equations (1) are easily
solved by a recursion that first solves for Pn−1, then Pn−2 , and so on.
To generate (X1 , . . . , Xn ) conditional on T = i, generate in sequence
• X1 given T = i
• X2 given T = i, X1
• X3 given T = i, X1 , X2
n
X j−1
X
P (Xj = 1|T = i, X1 , . . . , Xj−1 ) = P (Xj = 1| Xk = i − Xk )
k=j k=1
Pj−1
pj Pj+1 (i − 1 − k=1 Xk )
= Pj−1 . (2)
Pj (i − k=1 Xk )
s2i ≡ Var(φ(X)|T = i) , i = 0, . . . , n.
Remark. Whether using the standard or the more efficient procedure, fur-
ther variance reduction can be obtained by using antithetic variables. That
is, in generating (X1 , . . . , Xn ) conditional on T = i, first generate random
numbers U1 , . . . , Un , and then generate the value of Xj , given both that
T = i and the values of X1 , . . . , Xj−1 , by letting it equal 1 if Uj is less than
the right side of (2) In the next generation of (X1 , . . . , Xn ) conditional on
T = i, we can utilize the same set of random numbers, but this time sub-
tracting each from 1. (That is, we use the random numbers 1−U1, . . . , 1−Un
in the next run.) Because φ is a monotone function the reuse of the random
number set will lead to a variance reduction when compared with using a
new independent set of random numbers (see7 for a proof).
X20
φ(x1 , . . . , x20 ) = ( ixi )2 .
i=1
Theorem 3.1 is a special case of a general result of 3 which states that the
preceding is true whenever the Xi are independent and have logconcave
densities or mass functions. As the proof of 3 is rather involved, we now
present a proof that is not only elementary but also in the spirit of this
paper. We being with a lemma.
Proof. The proof makes use of the log concavity result that P (T =
k)/P (T = k − 1) is nonincreasing in k. (For a proof, see.5 ) Let pn =
May 11, 2011 11:25 WSPC - Proceedings Trim Size: 9in x 6in 05-ross
Pn−1
P (Xn = 1) = 1 − qn . Also, let br = P ( i=1 Xi = r). Then, we have
pn bk−1
P (Xn = 1|T = k) =
P (T = k)
pn bk−1
=
pn bk−1 + qn bk
pn
=
pn + qn bk /bk−1
and the result follows since bk /bk−1 is nonincreasing by log concavity.
Case 1: Zn = Yn = 1
Given the scenario of this case, Y1 , ..., Yn−1 is distributed as X1 , .., , Xn−1
conditional on Sn−1 = k − 1; and Z1 , ..., Zn−1 is distributed as X1 , .., , Xn−1
conditional on Sn−1 = k − 2. Consequently, by Lemma 3.1
P (Yn−1 = 1|Yn = 1) ≥ P (Zn−1 = 1|Zn = 1).
Thus, we can repeat KEY STEP to generate Yn−1 and Zn−1 so that
Yn−1 ≥ Zn−1 .
Case 2: Zn = Yn = 0
Given the scenario of this case, Y1 , ..., Yn−1 is distributed as X1 , .., , Xn−1
May 11, 2011 11:25 WSPC - Proceedings Trim Size: 9in x 6in 05-ross
Case 3. Zn = 0, Yn = 1
Given the scenario of this case, the random vectors Y1 , ..., Yn−1 and
Z1 , ..., Zn−1 have the same joint distribution. Thus, we can generate them
so that Yi = Zi , i = 1, . . . , n − 1.
m2 be the size of the largest minimal path set. Because the system works
whenever T > m2 and does not work when T < m1 , we have that
m2
X
E[φ(X1 , . . . , Xn )] = E[φ(X1 , . . . , Xn )|T = i]P (T = i) + P (T > m2 ).
i=m1
L = max min Wj
i=1,...,s j∈Mi
where M1 , . . . , Ms are the minimal path sets for the structure function φ.
Suppose that a cost C(t) is incurred if the lifetime of the system is t,
where, for some specified time t∗ ,
Now, it can be shown (see Section 11.3 of 7 for a proof) that for any random
variable R
(
0 if Z = 0
R= C(L) .
Z if Z > 0
Because Z = 0 if and only if C(L) = 0, the identity (3 ) yields that
C(L)
E[C(L)] = λ E[ |ZI = 1]. (4)
Z
Using that
P (Zj = 1) aj
P (I = j|ZI = 1) = Pr = Pr
i=1 P (Zi = 1) i=1 ai
where
Y
ai = (1 − pj )
j∈Ci
As can be seen our estimator is far superior to the raw simulation esti-
mator, and thus to the estimator of.2
P (Ti = j), j = 1, . . . , n, i = 1, . . . , n + 1
where Ti is the number of matches that player i wins. Now perform a fixed
number of raw simulations of the tournament. Based on the results, let
N (i, j) be the number of simulation runs in which player i wins exactly j
matches, and let W (i, j) denote the number of simulation runs in which
player i both wins exactly j matches and, in addition, is the sole winner of
May 11, 2011 11:25 WSPC - Proceedings Trim Size: 9in x 6in 05-ross
the tournament. Now, take W (i, j)/N (i, j) as an estimate of P (Wi |Ti = j).
Since
n
X
P (Wi ) = P (Wi |Ti = j)P (Ti = j)
j=1
Acknowledgments
The research of Mark Brown was supported by the National Security
Agency, under Grant H98230-06-01-0149.
References
1. Barlow, R. E., Bartholomew, D. J., Bremner, J. M., and Brunk, H. D., (1972),
Statistical Inference under Order Restrictions: Isotonic Regression, Wiley,
New York.
2. Chen, Z. and Glasserman, P., (2008), Fast Pricing of Basket Default Swaps,
Operations Research, 56, 2, 286-303.
3. Efron, B., (1965) Increasing Properties of Polya Frequency Functions. Annals
of Mathematical Statistics, 36, 272-279.
4. Joshi, M. and Kainth, D., (2004), Rapid and Accurate development of Prices
and Greeks for nth to Default Credit Swaps in the Li Model, Quantitative
Finance, Vol. 4, Institute of Physics Publishing, London, UK, 266-275.
5. Keilson, J., and Gerber, H., (1971), Some Results for Discrete Unimodality,
Jour. Amer. Statist. Assc. 66, 386-389.
6. Ross, S. M., (2007), Introduction to Probability Models, Nineth ed., Aca-
demic Press, Burlington, MA.
7. Ross, S. M., (2006), Simulation, fourth ed., Academic Press, Burlington, MA.
May 11, 2011 15:18 WSPC - Proceedings Trim Size: 9in x 6in 06-zeng
115
Xing Hu
Department of Economics
Princeton University
Princeton, 08544, USA
Email: xinghu@princeton.edu
David R. Kuipers
Department of Finance
Henry W. Bloch School of Business and Public Administration
University of Missouri at Kansas City
Kansas City, MO 64110, USA
Email: kuipersd@umkc.edu
Yong Zeng
Department of Mathematics and Statistics
University of Missouri at Kansas City
Kansas City, MO 64110, USA
Email: zengy@umkc.edu
Keywords: Ultra high frequency data; filtering; counting process; Markov chain
approximation method; Bayes parameter estimation; price discreteness; and
price clustering.
May 11, 2011 15:18 WSPC - Proceedings Trim Size: 9in x 6in 06-zeng
1. Introduction
Asset pricing models in financial markets can broadly be classified into two
types based on the observed data frequency: macromovement and micro-
movement models. Macromovement models generally refer to data observed
at daily or less frequent horizons. For example, Figure 1 depicts a time series
plot of daily closing prices for trading in a particular 5-year U.S. Treasury
note in the bond market during the six-week period November 15, 2000
through December 29, 2000. The macromovement for this security consists
of 31 data points for the 31 business days during this time period. Despite
the brevity, the stochastic nature of the time series is evident in the fig-
ure, and is often modelled in the econometrics and mathematical finance
literature by continuous-time diffusion models such as geometric Brownian
motion (GBM), stochastic volatility (SV), jump diffusion, or more elaborate
Markov-class stochastic price processes.
Alternatively, transactional price data on an intraday basis is the do-
main for micromovement asset pricing models. Engle5 refers to data of this
type as ultra high frequency (UHF), because it contains the trading times
and prices for all market activity at the maximum level of disaggregation.
Because traders choose to transact at random times during the trading
day, due to both information-based and liquidity-based motives (O’Hara21 ),
econometricians model the duration between trades as a stochastic phenom-
ena resulting in irregularly-spaced time series. Engle5 develops a general
framework for modelling such time series with many recent developments.
Figure 2 depicts the micromovement data for the same 5-year U.S. Trea-
sury note graphed in Figure 1, during the same time period. There are over
2,200 transactions shown in the figure. The general movement in Figure 2
can be seen as its subsample macromovement from Figure 1, with an overlay
of an additional noise process that results from the UHF data. The source
of this noise process can fundamentally be related to the asynchronicity of
trading in security markets; actual price processes are not continuous-time
realizations, but are observed with discrete sampling, at the irregular inter-
vals where trades take place. Further, markets set minimum price variation
conventions for trading–the so-called “tick size” in the market–which re-
sults in price discreteness noise. In the 5-year Treasury note market, the
minimum tick size is 1/128th percent of par value, so that realized price
processes exhibit some level of noise as prices move from discrete tick to
tick, or level by level.
Finally, even after consideration of asynchronous trading and price dis-
creteness, additional noise is observed in actual security market price pro-
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Fig. 1.
Daily closing prices of 5−year Treasury Notes from Nov15 2000 to Dec29 2000
104
103.5
103
102.5
price(% of par value)
102
101.5
101
100.5
100
5 10 15 20 25 30
day (31 business days)
cesses due to the tendency for trades and price changes to cluster on certain
ticks and in particular increments compared to others. This price clustering
noise, extensively modelled in the finance literature by Harris15 and others,
can be seen for the 5-year U.S. Treasury note in Figure 3.
Given this background, we reach the simple intuition, prevalent in the
finance and econometrics modelling literature, that micromovement mod-
els should be built upon fundamental intrinsic value price processes, with
an overlay of market microstructure noise derived from any of the several
sources noted above. Zeng25 proposes one such model for asset prices in
a trading market, a filtering micromovement (hereafter, FM) model, that
incorporates UHF data. Corresponding to the macromovement, an unob-
servable intrinsic value process for an asset is assumed and it is the per-
manent component and has a long-term impact on price. Trading times
are assumed to be driven by a conditional Poisson process. Prices are cor-
rupted observations of the intrinsic value process at the trading times by
market microstructure noise, which is explicitly and flexibly modeled by a
random transformation. Comparing with intrinsic value, noise is the tran-
sient component and only has a short-term impact (when a trade happens)
on price. The FM model can be framed as a filtering problem with counting
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Fig. 2.
Transaction data of 5−year Treasury Notes from Nov15 2000 to Dec29 2000
104
103.5
103
102.5
price(% of par value)
102
101.5
101
100.5
100
5 10 15 20 25 30
day (31 business days)
Fig. 3.
5−Year Treasury Note,Nov15−Dec20 2002 5−Year Treasury Note,Nov15−Dec20 2002
800 1200
700
1000
600
800
500
frequency
frequency
400 600
300
400
200
200
100
0 0
−40 −20 0 20 40 1/32 1/128 1/64
price changes (1/128th) fractional parts
fit the bond market. Moreover, the trading times are assumed to follow
an Exponential Autoregressive Duration (EACD) model proposed by Engle
and Russel6 instead an inhomogeneous Poisson process. The EACD model
is estimated and tested. We find that the EACD model fits the trading
times pretty well.
To the best of our knowledge, Frey11 and Frey and Runggaldier12 are
the first papers that employ the non-linear filtering technique to model
UHF data. Their viewpoint is to model the unobserved volatility process,
which is crucial for option pricing. Their model is able to capture the Pois-
son random arrival times in UHF data. Cvitnic, Lipster and Rozovskii4
extends the previous model to a more general framework. However, market
microstructure noise is missing in these models and they did not consider
the impact of other observable variable on volatility.
In Section 2, we present the extended FM model with an observable
variable in two equivalent fashions. In Section 3, we present the continuous-
time Bayes estimation via filtering for the extended FM model including
the filtering equations, a robustness theorem, a recursive algorithm, and a
theorem on the consistency of the Bayes estimates. In Section 4, we present
a Monte Carlo example. In Section 5, we provide empirical results for the 5
May 11, 2011 15:18 WSPC - Proceedings Trim Size: 9in x 6in 06-zeng
the possibility that price moves in the market exhibit asymmetric volatil-
ity as a function of transacting dealers’ inventory position (Fleming and
Rosenberg,10 ).
In the general case considered in Hu, Kuipers and Zeng,16 a mild as-
sumption on (θ, X), stated below, is invoked so that all relevant stochastic
processes are included.
∂ 1 ∂2
Av f (θ, x) = µx f (θ, x) + (σ + κv)2 x2 2 f (θ, x). (2)
∂x 2 ∂x
However, in UHF data, the price can not be observed continuously in
time, neither can it moves continuously. Therefore, we need two more steps.
Step 2 takes care of the trading times and Step 3 takes care of the trading
noise.
In Step 2: We assume trading times t1 , t2 , . . . , ti , . . ., are driven by an
Exponential Autoregressive Conditional Duration (EACD) model proposed
by Engle and Russell.6
We use a couple ways to describe EACD model. The first way is from
the viewpoint of point process. We view trading times t1 , t2 , . . . , ti , . . . as a
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where
In brief,
1
Y (ti ) = bi (R[X(ti ) + Vi , ]) = F (X(ti )).
M
The detail of bi (·), and the explicit p(y|x) for F can be found in Appendix
A. A simulation example in Section 4 demonstrates that the constructed
F (x) are able to capture the tick-level sample characteristics of bond price
data.
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Y1 (t)
Y2 (t)
~ (t) =
Y . ,
(8)
..
Yn (t)
Assumption 4. The intensities are of the form: λj (t) = λ̄(t)p(yj |x), where
P −1
λ̄(t) = i I{ti < t ≤ ti+1 }(t)ψi+1 is the total trading intensity at time t
and p(yj |x) is the transition probability from x to yj , the jth price level.
RT
Assumption 5. 0
E P [λ̄(s)]ds < ∞, for t > 0.
The proof is exactly the same as that of the proposition in,26 where
the main idea is to show both representations have the same stochastic
intensity kernel.
Since the observed prices can be equivalently represented by Y or Y ~
~
in Representations I or II, respectively, we use Y or Y in exchange of one
another in the rest of the paper.
~
3.1.2. The Continuous-time Likelihoods of Y
Note that X are not observable. To do parameter estimation, we would like
to have the likelihood of Y ~ alone. Namely, we would like to integrate out
X. The probability way to achieve this is to use conditional expectation.
Let FtY,V = σ{(Y ~ (s), V (s))|0 ≤ s ≤ t} be all the available information up
to time t. We use E Q [X] and E P [X] to indicate that the expectation is
taken with respect to the measures Q and P , respectively.
Definition 1. Let
Z
ρ(f, t) = E Q [f (θ(t), X(t))L(t)|FtY,V ] = f (θ, x)ρt (dθ, dx).
Remark 5. Note that λ̄(t) disappears in Equation (12). This not only
greatly reduces the computation in of Bayes estimates, but also implies
that the joint posterior and the Bayes estimates are independent or ”model
free” of the assumptions of trading times as long as λ̄(t) is FtY,V -predictable.
Remark 6. For the FM model studied in this paper, the trading intensity
is given by Equation (3), which is, indeed, FtY,V -predictable. Therefore,
we only use the simplified filtering equation (12) to construct a recursive
algorithm to compute Bayes estimates.
Another nice property of the filtering equations for πt is that they sat-
isfy a separation principle in the following sense. Let the trading times be
t1 , t2 , . . . , then Equation (12) can be written in two parts. The first de-
scribes the evolution without trades and is called the propagation equation.
The second describes the update when a trade occurs and is called the
updating equation. The propagation equation is written as
Z ti+1 −
π(f, ti+1 −) = π(f, ti ) + π(Af, s)ds. (13)
ti
It has no random component and this implies that the posterior evolves
deterministically between trades.
When the price at time ti+1 happens at the jth price level, the updating
equation is written as
π(f pj , ti+1 −)
π(f, ti+1 ) = . (14)
π(pj , ti+1 −)
Note that the price level j, the observation, is random. Therefore, the up-
dating equation is random.
Definition 3. Let
h ~
i
ρ (f, t) = E Q f θ (t), Xx (t) L (t)|FtY ,
and
h ~ i
π (f, t) = E P f θ (t), Xx (t) |FtY .
and the updating equation (assuming that a trade at jth price level occurs
at time ti+1 ):
π (f p,j , ti+1 −)
π (f, ti+1 ) = . (17)
π (p,j , ti+1 −)
In Step 3, we turn Equations (16) and (17) to the recursive algorithm in
discrete state space and in discrete times by two substeps: (a) expresses
π (·, t) as a finite array using the components π (f, t) with lattice-point
indicator f and (b) use Euler scheme to approximate the time integral in
(16). Details of the construction of the algorithm are given in the sub-section
below.
Russell.6 The other parameters, µ, σ, κ and ρ, are Group III and they are
estimated by Bayes estimation via filtering through the recursive algorithm
to be constructed.
We follow the three-step blueprint for the Markov chain approximation
method summarized in the end of Section 3.3 to construct the recursive al-
gorithms. Finally, we show the consistency of the algorithms. For notational
simplicity, let ~θ~ = (µµ , σσ , κκ , ρρ ) to denote an approximate discretized
parameter signal, which is random in Bayesian framework.
where
(σ + κv)2 x2w
1 µk xw
β(~θ~v , xw ) = 2
+ ,
2 x x
and
(σ + κv)2 x2w
1 µk xw
δ(~θ~v , xw ) = 2
− .
2 x x
β(~θ~v , xw ) and δ(~θ~v , xw ) are the birth and death rates, respectively, and
should be nonnegative. If necessary x can be made small to ensure the
nonnegativity.
Clearly, Aε,v → Av . So, (~θ~, Xx ) ⇒ (~θ, X) as ε → 0 where ε =
max(µ , σ , κ , ρ , x ). With the approximate model (~θ~, Xx (t)), we have
the approximate Y ~ε which is defined by Equation (15).
The counting process observations can be treated as Y ~ (t) defined by
~
Equation (8) or Yε (t) defined by Equation (15) conditioning on whether the
driving process is (~θ, X(t)) or (~θ , Xx (t)). In the true model, the parame-
ters and the bond value are (~ θ, X(t)), and the counting process observations
of bond price are regarded as Y ~ (t). In the approximate model where we in-
tend to compute the posterior and Bayes estimates, we use (~θ~, Xx (t)) to
approach (~θ, X(t)) and the counting process observations of bond price
are regarded as Y ~ε (t). The recursive algorithm is to calculate the joint
posterior and Bayes estimates of the approximate model (~θ~ , Xx , Y ~ε , V ),
which is close to the joint posterior and Bayes estimates of the true model
(~θ, X, Y
~ , V ), by Theorem 2, when ε is small.
~~
θ v ,xw
where the summation goes over all lattices in the discretized state spaces.
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pε (~
θ~v , xw ; t) = πε,t {~θ~ = ~θ~v , X (t) = xw }.
There are two substeps. The key of the first substep is to specify f as
the following lattice-point indicator function:
We observe:
πε β(θ~~ , X (t))I{θ~ ~ (θ~~ , X (t) + x ), t = β(θ~~v , xw−1 )pε (θ~~v , xw−1 ; t).
=θ~
~ v ,X (t)+x =xw }
Suppose that a trade at jth price level happens at time ti+1 , the updat-
ing Equation (17) becomes,
where the summation goes over the total discretized space, and p(yj |xw , ρn ),
which is the transition probability from xw to yj , is given by Equation (A.2)
in Appendix A.
In the second substep, we use Euler scheme to approximate the time
integral in Equation (20) in order to obtain a recursive algorithm discrete
in time. Since the probability of the event that two or more jumps occur at
the same time is zero, there are two possible cases for the length of duration.
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Case 1, when ti+1 − ti ≤ LL, the length controller in the Euler scheme, we
approach p(~θ~v , xw ; ti+1 −) as
h
p(~θ~v , xw ; ti+1 −) ≈ p(~θ~v , xw ; ti ) + β(~θ~v , xw−1 )p(~θ~v , xw−1 ; ti )
Fig. 4.
Simulated Data Simulated Data
600 1200
500 1000
400 800
frequency
frequency
300 600
200 400
100 200
0 0
−40 −20 0 20 40 1/32 1/128 1/64
price changes (1/128th) fractional parts
~ X(t)), their
to calculate, at each trading time ti , the joint posterior of (θ,
marginal posteriors, their Bayes estimates and their standard errors (SE),
respectively. The recursive algorithm and the software are fast enough to
generate real-time Bayes estimates. We test the software extensively and
verify it on Monte Carlo data, where we know the true parameters.
Figure 5 has four plots to display how the trade-by-trade Bayes esti-
mates and the two standard errors (SE) bounds evolve in comparison with
the true values for µ, σ, κ and ρ, respectively. The figure clearly shows that
the estimates of µ, σ, κ and ρ converge to their true values, the two-SE
bounds shrink, and the true values are within the two-SE bounds. Simi-
larly, the Bayes estimates of X(t) are close to their true values, which are
always within two-SE bounds.Their final Bayes estimates, SEs, and true
values are presented in Table 1. The true values are close to the Bayes
estimates and all within two SE bounds.
Fig. 5.
−7 mu
x 10
1.5
0.5
0
0 500 1000 1500 2000
−5 sigma
x 10
1.5
1.4
1.3
1.2
0 500 1000 1500 2000
rho
0.03
0.025
0.02
0.015
0 500 1000 1500 2000
−6 kapa
x 10
−1
−2
−3
−4
−5
0 500 1000 1500 2000
Bayesian Estimates Upper 2−SE Bound Lower 2−SE Bound True value
all trades of Treasury Securities by the three major interdealer brokers ex-
cept one major interdealer broker, Cantor Fitzgerald. Thus its data count
for a significant portion of the primary-dealer activity. We exam trades
of the active, “on-the-run”, 5-year U.S. Treasury notes issued on Novem-
ber 15, 2000 and for the period 11/15-12/29, 2000. During this time period,
GovPx-brokered trades in Treasury notes count for roughly half of the trad-
ing volume in notes on a global basis. A big bulk of trading activity in the
treasury market is in the active instruments, so-called “on-the run” instru-
ment which is the most-recently auctioned security of that type. Secondary
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Table 2. Summary Statistics for 5-year Treasury Note 11/15 - 12/29, 2000
The relative frequencies for odd 1/128, odd 1/64 and odd 1/32 or coarser
are 18.24%, 37.52%, and 44.23%. Method of relative frequencies produces
the estimates for the clustering parameters: α = .2505 and β = .3847.
The daily pattern of treasury trading has been studied in details Flem-
ing.9 To model the daily duration pattern for the transactions of U.S. trea-
sury, we follow the same approach as in Engle and Russell.6 Figure 5 shows
the nonparametric kernel estimation (run by supsmu function in Matlab) of
the expected duration conditional on the time of the day. Consistent with
previous studies, trading is most active between 8:30 a.m and 9:30 which
is partly a result of the important macroeconomic news release time and
the opening of U.S. Treasury futures market. The slight shorter durations
around 2:30 p.m. and 3:00 p.m. coincides with the closing time of U.S.
Treasury futures market. To capture this diurnal pattern, we use a cubic
spline (run by spfit function in Matlab) to approximate the daily factor.
Nodes are set on 7:30 a.m., 8:30 a.m., 9:00 a.m. and each hour after 9:00
a.m. until 5:00 p.m. when the trading activity falls.
After the diurnal adjustment for duration (namely, each ∆ti divided by
a positive number produced by the cubic spline fit according to the time
of day), we fit an EACD(1, 1) model using maximum likelihood approach.
The parameter estimates are given in Table 3. All parameters are signif-
icant. The sum of α1 and β1 is 0.9377, indicating strong persistence in
duration. We do diagnostic check on EACD(1,1) model. If the model is ap-
propriate, the residues, or the standardized durations, are i.i.d. exponential
distributed with mean one. Higher order moments should be independent
also. The Ljung-Box Q-Statistics for residue and residue-squared suggest
that the model does a very good job of accounting for the intertemporal
dependence in durations. Next, we consider the exponential specification of
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Fig. 6.
Nonparametric estimate of daily pattern for transaction durations(5Year2ndInstrument)
600
550
500
Duration(seconds)
450
400
350
300
250
7:30AM 8:30AM9AM 10AM 11AM 12PM 1PM 2PM 3PM 4PM 5PM
Time
residue. For the null hypothesis that the residue is exponential, Engle and
Russell6 (page 1144) provided a simple test, whose limiting distribution is
standard normal and the test statistic is reported in the last line of Table
3. Even though the exponential assumption is rejected, the test value is
much smaller than those in Engle and Russell.6 This also suggests other
distributions such as Weibull or generalized Gamma distributions may be
considered in the future research. Even for other ACD models, since they
are FtY,V -predictable, the Bayes estimates of (µ, σ, κ, ρ) presented in Table
4 are not changed and these estimates are “model-free” of the assumptions
of duration.
With the estimates of the non-clustering parameters, we apply the tested
Fortran program to the transaction data of 5-year bond and obtain Bayes
estimates for the extended FM model for two cases. One is GBM case and
the other is GBM with initiation dummy in volatility. The Bayes estimates
of both cases are presented in Table 4. All the estimates are statistically
significant. Note that the estimates of µ and ρ changes quite significantly,
suggesting the significant impact of including the initiation dummy. More-
over, the sign κ is negative, implying inventory theory is the main impact
in the bond trading.
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Model µ σ κ ρ
GBM only 25.10% 3.41% 0 0.128
(κ ≡ 0) (10.01%) (0.06 %) (0) (0.0147)
Extended GBM 54.50% 3.90% -0.80% 0.0228
(κ 6= 0) (10.63%) (0.11%) (0.14%) (0.0085)
Standard errors are in parentheses.
6. Conclusion
This paper reviews recent development of a rich class of filtering models
with counting process observations for the micromovement of asset price
with observable factors and the related Bayes estimation via filtering. A
specific extended FM model built upon GBM and with a buyer-seller initi-
ation dummy in volatility is constructed for the 5-year Treasury note trans-
action price data. Employing the developed filtering techniques, we perform
Bayes estimation via filtering for the model. We find that the buyer-seller
initiation dummy is statistically significantly negative. This supports the
inventory theory for the bond trading.
This model can be further extended in different directions. For example,
we can study whether other observable factors have impacts on volatility.
Especially, in Hu, Kuipers and Zeng,16 we add another macro-economic
news dummy in the volatility and we find that macro-economic news has
even higher impacts on the bond price volatility than the buyer-seller initi-
ation dummy. With these two examples, we believe the method developed
May 11, 2011 15:18 WSPC - Proceedings Trim Size: 9in x 6in 06-zeng
Acknowledgments
Part of the work was done when Yong Zeng was on sabbatical, visited and
taught a special course on Statistical Analysis of Ultra-high Frequency Fi-
nancial Data - An Overview and A New Filtering Approach in Department
of Operations Research and Financial Engineering (ORFE) in Princeton
University in Spring semester of 2007. He would like to thank Savas Dayanik
for the invitation and thank ORFE Department of Princeton for the hospi-
tality. He also gratefully acknowledge the support of the National Science
Foundation under grant DMS-0604722.
References
1. Ait-Sahalia, Y., P. A. Mykland and L. Zhang, How Often to Sample a
Continuous-Time Process in the Presence of Market Microstructure Noise,
Review of Financial Studies, 18 (2005), 351–416.
2. Bandi, F. M. and J. R. Russell, Separating microstructure noise from volatil-
ity, Journal of Financial Economics, 79 (2006), 655-692.
3. Bremaud, P., 1981. Point Processes and Queues:Martingale Dynamics.
Springer-Verlag, New York.
4. Cvitanic, J., R. Liptser and B. Rozovskii, A filtering approach to tracking
volatility from prices observed at random times. Annals of Applied Probabil-
ity, 16 (2006), 1633–1652.
May 11, 2011 15:18 WSPC - Proceedings Trim Size: 9in x 6in 06-zeng
145
Michael Kohlmann
Department of Mathematics and Statistics
University of Konstanz
D-78457, Konstanz, Germany
Email: michael.kohlmann@uni-konstanz.de
Dewen Xiong
Department of Mathematics
Shanghai Jiaotong University
Shanghai 200240, P.R.China
Email: xiongdewen@sjtu.edu.cn
In finance, a bond is a debt security in which the authorized issuer owes the
holder a debt and, depending on the terms of the bond, is obliged to pay interest
(the coupon) and/or to repay the principal a a later date, termed maturity.
A bond is a formal contract to repay borrowed money with interest at fixed
intervals.
Thus a bond is like a loan: The issuer is the borrower, the holder is the
lender, and the coupon is the interest. Bonds provide the borrower with external
funds to finance long-term investments, or, in the case of government bonds,
to finance current expenditure. Bonds must be repaid a fixed intervals over a
period of time.
Bonds and stocks are both securities, but the major difference between
the two is that stockholders ave an equity stake in the company (i.e. they are
owners), whereas bondholders have a creditor stake in the company (i.e. they
are lenders). Another difference is that bonds have a defined term or maturity
after which the bond is redeemed, whereas may be outstanding indefinitely.
The simplest case of a bond is a bank account with fixed interest rate rt :
dP (t, T ) = rt P (t, T )dt, P (T, T ) = 1.
A short look at the chart of a banks interest rates over some years however
shows that the interest rate is by no means fixed so that we should assume that
it is a random variable. This leads to the well known classical bond models (in
alphabetical order of the authors) by Black-Derman, Chen, Cox-Ingersoll-Ross
(CIR), Heath-Jarrow-Morton (HJM), Ho-Lee, Hull-White, Vasicek (V), among
many others, where those with an abbreviation after the names are the best
known to my observation.
However, while models for stock markets are meanwhile quite satisfactory,
the models for bonds/interest rates have diverse deficiencies, so that reality
May 27, 2011 13:45 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
is not really well described. Also the models appear mathematically more dif-
ficult and technical than the classical stock market models: While researchers
and practitioners are concerned with the fine-tuning in stock models, the basics
on a general model for bond markets are still discussed without a commonly
agreed result.
The first attempt to describe a general model is found in the seminal paper
by Björk et al(1997)7 and we are often referring to this article.
Here we will discuss two mainstreams of problems, namely mean variance hedg-
ing and utility optimization (exponential utility indifference) in a general jump
bond market. The purpose of this paper then is to introduce some new tech-
niques, especially techniques from the theory of backward stochastic differential
equations (BSDEs) in mean variance hedging, and to contribute to a general
model.
In the first part we will consider a model based on n maturities to apply
recent results from MVH in jump stock markets. Carmona et al(2004)10 im-
pressively describe the shortcomings of the models based on a finite number of
maturities. To make things short: In the corresponding continuous HJM model
the market is infinite dimensional with only a finite number of random sources
so that this market always is complete which is contrary to the observations.
Further shortcomings caused by the infiniteness of the market are described in
Cont (2004)17 .
There are several attempts to overcome these difficulties. Carmona et
al(2004)10 introduce an infinite dimensional Brownian motion and so use Malli-
avin calculus methods to treat hedging problems with hedging strategies de-
rived from a Clark-Ocone formula. Baran et al.2 consider generalized strate-
gies in an infinite dimensional HJM-model. A similar approach is taken by
DeDonno18 . However these generalized strategies are not very useful to solve
hedging problems more explicitly. In the second part of this paper we will here
propose and extend an infinitely dimensional market where we consider mea-
sure valued strategies. Of course also these strategies have certain drawbacks
when we come to the economical interpretation. And the main drawback is the
fact that we always have to work in martingale markets to consider (M, Q0 )-
normalized martingales as approximate wealth processes. For many problems
this is sufficient but e.g. to describe superhedging we needed the notion of
semimartingale. This, however, still is a long-standing open problem already de-
scribed by Schwartz(1994)43 : Il n’est pas facile de savoir exactement de qu’on
doit appeler une semimartingale valeurs dans un espace vectoriel topologique.
So, the contents of this paper should be seen as one perhaps promising looking
step towards a general model for which we then consider exponential hedging
problems.
The paper is organized as follows: In the first part we construct a market of
bonds with jumps driven by a general marked point process as well as by an Rn -
valued Wiener process based on Björk et al(1997)7 , in which there exists at least
one equivalent martingale measure Q0 . Then we consider the mean-variance
hedging of a contingent claim H ∈ L2 (FT0 ) w.r.t. self-financing portfolios
based on the given maturities T1 , · · · , Tn with T0 < T1 < · · · < Tn ≤ T ∗ .
We introduce the concept of variance-optimal martingale (VOM) and describe
the VOM by a backward semimartingale equation (BSE). By making use of
the concept of E ∗ -martingales introduced by Choulli et al.(1998)13 , we obtain
another BSE which has a unique solution. We derive an explicit solution of
the optimal strategy and the optimal cost of the mean-variance hedging by the
solutions of these two BSEs.
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
For example from remark 3.2 of Björk et al (1997)7 the stochastic basis
has the following predictable representation property: any local martingale
M is of the form
Z t Z tZ
Mt = M0 + fu0 dW (u) + ψ(u, y)(µ(du, dy) − ν(du, dy))
0 0 R
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
Since
Z T
A(u, T ) := − Ψ(u, l; σ, δ, φ, ϕ)dl
Z uT
l
Z Z T
σ(u, l)0 σ(u, l)0 φ(u)dl
=− σ(u, s)ds dl +
u u u
T
Z Z
δ(u, y, l)eD(u,y,l) dl ϕ(u, y)λ(u, dy)
+
E u Z
1 D(u,y,T )
= − kS(u, T )k2 − S(u, T )0 φ(u) −
e − 1 ϕ(u, y)λ(u, dy),
2 E
dQ0
:= ZT0 ∗ .
dP F
is the compensator of µ(du, dy) under Q0 , thus the dynamics of the bond
price under Q0 are given by
Z · Z ·
p(t, T ) = p(0, T )E ru du + S(u, T )0 dW̃ (u)
0 Z Z 0
· D(u,y,T )
+ e − 1 (µ(du, dy) − ν̃(du, dy)) .
0 E t
Rt
− ru du
The discounted bond price p̄(t, T ) = e p(t, T ) is then given by
0
Z ·
p̄(t, T ) = p̄(0, T )E S(u, T )0 dW̃ (u)
0 Z Z
· D(u,y,T )
+ e − 1 (µ(du, dy) − ν̃(du, dy)) ,
0 E t
(3)
which is a uniformly integrable Q0 -martingale, by the boundedness of S
and D.
We have:
Corollary 1.1. When σ(u, T ) is independent on the maturity T , i.e.,
σ(u, T ) ≡ σ(u), where {σ(u); u ∈ [0, T ∗]} is a bounded Rn -valued predictable
process, and δ(u, y, T ) is of the following form
δ̃(u, y)
δ(u, y, T ) = −
1 + δ̃(u, y)(T1 − u)
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
1
for a bounded P-measurable
e function δ̃(u, y) with δ̃(u, y) > − ∗ , then
T
(z1 , z2 ) in the density process must satisfy
Z
−z1 (u)0 σ(u) + δ̃(u, y)z2 (u, y)ϕ(u, y)λ(u, dy) = 0. (6)
E
Obviously the market is incomplete.
Z2exp (T1 , · · · , Tn ) := Z; Z ∈ Z2s (T1 , · · · , Tn ), Z is a stochastic exponential ,
Z2e (T1 , · · · , Tn ) := Z; Z ∈ Z2s (T1 , · · · , Tn ), Z is strictly positive ,
0
Υ(u, y) := eD(u,y,T1 ) − 1, · · · , eD(u,y,Tn ) − 1 ,
0
P̄ (t) := (p̄(t, T1 ), · · · , p̄(t, Tn )) ,
and, similar to Assumption (H2) in Biagini(2001)4, we assume in this sec-
tion that
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
0
0 τ
(i) E −ã I]]τ,T0 ]] · P̄ s Zτ,s E (z1 , z2 )s ; s ∈ [τ, T0 ] is a uni-
formly integrable martingale for any τ ∈ TT0 and (z1 , z2 ) ∈
2,τ
Zexp ;
h i
(ii) E E −ã0 I]]τ,T0 ]] · P̄ T Fσ
0
0
2
= E E −ã I]]τ,T0 ]] · P̄ T Fσ ∈ (0, 1], a.s., for any
0
stopping times σ ≤ τ ;
(iii) for any π ∈ A(T1 , · · · , Tn )
E VTx,π − Vτx,π E −ã0 I]]τ,T0 ]] · P̄ T0 = 0.
0
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
(τ )
Under Assumption 2.1, {Mt (p̄(t, Ti ) − p(τ, Ti )); t ∈ [τ,
T0 ]} is a local
(τ )
martingale, thus Z10 Mt (p̄(t, Ti ) − p(τ, Ti )); t ∈ [τ, T0 ] is a local Q0 -
t
(τ ) (τ )
martingale, therefore there exists a pair (z1 , z2 ) depending on τ satisfy-
ing (2) such that
(τ ) 0 (τ ) (τ )
Mt = Zτ,t E τ z1 , z2 , a.s., for t ∈ [τ, T0 ], (4)
t
and
" #
2
0 (τ ) (τ )
Ψ(τ ) = E Zτ,T Eτ z1 , z2
0
Fτ
T0
(τ ) 2
= E MT0 Fτ
1
= h i.
E E −ã0 I]]τ,T0 ]] · P̄ T0
Fτ
Lemma 2.3. Under Assumption 2.1, there exists a pair (z1∗ , z2∗ ) satisfying
(2) such that for all τ ∈ TT0 , (z1∗ , z2∗ ) ∈ Zexp2,τ
and
h
0
2 i
Ψ(τ ) = EQ0 Zτ,T 0
E τ(z1∗ , z2∗ )T0 Fτ , Q0 -a.s.
(τ ) (τ )
Proof. We only need to show that z1 , z2 in (4) is independent of τ ,
i.e., for any τ1 , τ2 ∈ TT0 with τ1 < τ2 , we need to show that z1τ1 I]]τ2 ,T0 ]] =
z1τ2 I]]τ2 ,T0 ]] and z2τ1 I]]τ2 ,T0 ]] = z2τ2 I]]τ2 ,T0 ]] , which follows from the definition of
M (τ ) and the fact that for any t ≥ τ2
E −ã0 I]]τ1 ,τ2 ]] · P̄ τ2 × E E −ã0 I]]τ2 ,T0 ]] · P̄ T0 Ft
(τ1 )
Mt =
E E −ã0 I]]τ1 ,T0 ]] · P̄ T Fτ1
0
E −ã0 I]]τ1 ,τ2 ]] · P̄ τ × E E −ã0 I]]τ2 ,T0 ]] · P̄ T Fτ2
(τ ) .
= 2
0
Mt 2
E E −ã0 I]]τ1 ,T0 ]] · P̄ T0 Fτ1
(τ ) (τ2 )
= Mτ2 1 Mt ,
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
(τ )
Note here that Mτ2 2 = 1.
1 ≤ Ψ(t) ≤ C < ∞
Corollary 2.2. Let Assumption 2.1 be satisfied and let (z1∗ , z2∗ ) be given as
in Lemma 2.3, then for any τ ∈ TT0 and for any t ≥ τ
0
E τ(z1∗ , z2∗ )t Ψ(t) = Ψ(τ )E −ã0 I]]τ,T0 ]] · P̄ t , Q0 -a.s.
Zτ,t
∗
For simplicity, we introduce Zτ∗n∗ ,t := E τn(z1∗ , z2∗ )t and Z̃τn∗ ,t :=
∗ 0
Ψ(τn )E −ã I]]τ,T0 ]] · P̄ t , so that
Z t Z t Z
Zτ∗∗ ,t = 1 + Zτ∗∗ ,u− z1∗ (u)0 dW̃ (u) + Zτ∗∗ ,u− z2∗ (u, y)(µ(du, dy) − ν̃(du, dy))
n ∗ n ∗ n
τn τn E
Z t
Z̃τn∗ ,t = Ψ(τn∗ ) − Z̃τn∗ ,u− â(u)0 S(u)dW̃ (u)
∗
τn
Z t Z
− Z̃τn∗ ,u− â(u)0 Υ(u, y)(µ(du, dy) − ν̃(du, dy)),
∗
τn E
where â = (â1 , · · · , ân )0 and âi (u) = p̄(u−, Ti )ãi (u) for each i = 1, · · · , n.
A lengthy, though not very difficult computation shows that the follow-
ing representations hold: Let
1 − â(u)0 Υ(u, y)
%(u, y) := .
z2∗ (u, y) + 1
1 − â(u)0 Υ(u, y)
z2∗ (u, y) = −1
%(u, y)
and
Z
z1∗ (u) =− S(u)−1 Υ(u, y)z2∗(u, y)ϕ(u, y)λ(u, dy)
ZE
1 − â(u)0 Υ(u, y)
−1
=− S(u) Υ(u, y) − 1 ϕ(u, y)λ(u, dy)
E %(u, y)
:= −Iu (â, %),
A bounded solution of the BSE (5) is a triple (Y, a, ρ) satisfying (5) such
that
(1) a is an Rn -valued predictable process such that for any stopping time
τ ∈ TT0 ,
n Z 2
ai (u)I]]τ,T0 ]] (u)
X
E E − dp̄(u, Ti ) < ∞;
i=1
p̄(u−, Ti ) T0
1 − a(u)0 Υ(u, y)
where z1∗ (u) := −Iu (a, ρ) and z2∗ (u, y) := − 1;
ρ(u, y)
(3) Y is a bounded RCLL semimartingale with 0 < c1 ≤ Y ≤ c2 < ∞ for
some constants c1 and c2 .
Remark. Although ρ(u, y) is strictly positive, z2∗ may be less than −1,
thus E τ(z1∗ , z2∗ ) may be negative. From (5), we have the following lemma:
Lemma 2.4. Under Assumptions 2.1 and (H), (Ψ, â, %) is a bounded so-
lution of the BSE (6).
Theorem 2.1. Assume Assumptions (H) and 2.1 be satisfied and (Y, a, ρ)
be a bounded solution of the BSE (5), then for any τ ∈ TT0 , (z1∗ , z2∗ ) is the
solution to the minimization problem (3), i.e.,
Z t Z tZ
Mt∗ := z1∗ (u)0 dW̃ (u) + z2∗ (u, y)(µ(du, dy) − ν̃(du, dy))
0 0 E
is the variance-optimal martingale.
2,τ 0 ∗ 0
E τ(z1 , z2 )t ;
Proof. It is shown that for any (z1 , z2 ) ∈ Zexp , Yt Zτ,t Zτ,t Zτ,t
t ∈ [τ,
T0 ] 0 is ∗a local martingale. As Y is bounded, one can easily derive
0
that Yt Zτ,t Zτ,t Zτ,t E τ(z1 , z2 )t ; t ∈ [τ, T0 ] is uniformly integrable, thus
0 ∗ 0
E τ(z1 , z2 )T Fτ = E YT Zτ,T 0 ∗ 0
E τ(z1 , z2 )T Fτ = Yτ .
E Zτ,T Zτ,T Zτ,T Zτ,T Zτ,T
Similar to the proof of Theorem 3.4 of Kohlmann-Xiong-Ye(2007)31,35, one
derives that (z1∗ , z2∗ ) is the solution of the minimization problem (3) for any
τ ∈ TT0 and Yτ is the optimal cost, i.e.,
2
0 2
Yτ = E Zτ,T0
Eτ z1∗ , z2∗ T Fτ = ess inf E 0 τ
Zτ,T0 E (z1 , z2 )T0 Fτ ,
0 2,τ
(z1 ,z2 )∈Zexp
Corollary 2.3. Under Assumptions (H) and 2.1, there exists a unique
solution of the BSE (6).
1 − a(u)0 Υ(u, y)
z2∗ (u, y) = − 1,
ρ(u, y)
where
1 − a(u)0 Υ(u, y)
Z
−1
Iu (a, ρ) = S(u) Υ(u, y) − 1 ϕ(u, y)λ(u, dy).
E ρ(u, y)
From Theorem 2.1
Z t Z tZ
Mt∗ := z1∗ (u)0 dW̃ (u) + z2∗ (u, y)(µ(du, dy) − ν̃(du, dy))
0 0 E
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
Definition.
(i) X is an E ∗ -martingale, if for any n
∗
0 ∗ ∗ τn
E Zτn∗ ,T0 E M − (M )
Xτn < ∞
∗
T0
n ∗
o
and (Xt − Xt∧τn∗ )Zτ0n∗ ,t E M ∗ − (M ∗ )τn t ; t ∈ [0, T0 ] is a martin-
gale. The class of E ∗ -martingales is denoted by M(E ).
∗
[0, T0 ] is a Q -local martingale for each n. The rest is completely the same
as in the proof of Proposition 3.15 of 13.
Corollary 2.4. Let Assumption (BS) be satisfied and let H be any contin-
gent claim belonging to L2 (FT0 , P ), then the BSE
Z t Z tZ
0
h t = h 0 + ξ1 (u) dW (u) + ξ2 (u, y)µ(du, dy)
0 0 E
Z t Z t Z
− ξ1 (u)0 {z1∗ (u) + φ(u)}du − ξ2 (u, y) z2∗ (u, y) + 1 ϕ(u, y)λ(u, dy)du,
0 0 E
hT = H
(7)
has a solution (h, ξ1 , ξ2 ).
With these results mainly adopted from recent results on mean variance
hedging we now turn to the already above stated mean-variance hedging
problem in the bond market and derive an analytical solution. Given a
contingent claim H ∈ L2 (FT0 , P ), which might not be fully replicated by
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
Theorem 2.2. Let Assumptions (H) and 2.1 be satisfied and let (Y, a, ρ)
be the bounded solution of the BSE (6). For a given contingent claim H ∈
L2 (FT0 , P ), let (h, ξ1 , ξ2 ) be a solution of the BSE (7), let
∗
x,π
π ∗ (u) := <−1
u ζu + (hu− − Vu− )a(u), (8)
then π ∗ is the optimal strategy of Problem (MHV-n). The optimal cost is
given by
J = Y0−1 (h0 − x)2
Z T0
ϕ(u, y)
Z
−1
+E Yu− kξ1 (u)k2 + ξ2 (u, y)2 λ(u, dy) − ζu0 <−1
u u du .
ζ
0 E ρ(u, y)
∗
Remark. We let Vt∗ := Vtx,π be the wealth process corresponding to
(x, π ∗ ), one can see that h − V ∗ is the solution of the following stochastic
differential equation (SDE)
Z t
∗
ht − Vt∗ = h0 − x + Rt − (hu− − Vu− )dM̃u , (9)
0
where
Z t
ξ1 (u)0 − ζu0 <−1 ∗
Rt := u S(u) dW (u)
0 Z Z
t
+ {ξ2 (u, y) − ζu0 <−1 ∗
u Υ(u, y)}(µ(du, dy) − ν (du, dy)),
Z t0 E Z t
M̃t := − a(u)0 S(u)dW ∗ (u) − a(u)0 Υ(u, y)(µ(du, dy) − ν ∗ (du, dy))
0 0
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
and where
Z t
W ∗ (t) = W (t) − {z1∗ (u) + φ(u)}du
0
ν ∗ (du, dy) = z2∗ (u, y) + 1 ϕ(u, y)λ(u, dy)du.
To solve the SDE (9), we let Z̃t := E(M̃ )t , one can see that Z̃τn∗ = 0 and
26
Z̃− I[[τn∗,τn+1
∗
[[ 6= 0 for each n. It follows from Theorem 6.8 of Jacod(1979)
that the solution of the SDE (9) can be written as
X
h−V∗ = (h − V ∗ )(n) I[[τn∗ ,τn+1
∗ [[ ,
n≥0
where
n 1 ∗ ∗
(h − V ∗ )(n) = Z̃ ∆Rτn∗ + n · (Rτn+1 − Rτn )
Z̃−
1 h ∗ ∗
i
τn+1 τn
+ n I[[0,τn+1 ∗ [[ · R, M̃ − M̃
Z̃−
n ∗ ∗ ∗
and where Z̃ = E(M̃ − M̃ τn ) = E(M̃ τn+1 − M̃ τn ).
x,π 2
Yt−1 (ht − Vt ) = Y0−1 (h0 − x)2 + mt
Z t
2
−1
0 x,π 0
+ Yu−
ξ1 (u) − S(u) π(u) + (hu− − Vu− )S(u) a(u)
du
Z0t Z n
−1 0 o2 ϕ(u, y) x,π
+ Yu− ξ2 (u, y) − π(u) Υ(u, y) + hu− − Vu− λ(u, dy)du
Z0t ZE ρ(u, y)
−1 x,π 0 0 ϕ(u, y)
+ 2Yu− hu− − Vu− π(u) Υ(u, y) − ξ2 (u, y) {1 − a(u) Υ(u, y)} λ(u, dy)du
Z0t ZE ρ(u, y)
n 2 o ϕ(u, y)
−1 x,π 2 0
− Yu− hu− − Vu− 1 − a(u) Υ(u, y) λ(u, dy)du,
0 E ρ(u, y)
where
Z t
x,π 0
mπ
t =
−1
Yu− 2 hu− − Vu− ξ1 (u) − S(u)0 π(u)
0
x,π 2 0
+ hu− − Vu− φ(u) − Iu (a, ρ) + S(u)0 a(u) dW (u)
Z t Z
−1
+ Yu− ξ2 (u, y) − π(u)0 Υ(u, y)
0 E
x,π 2 ϕ(u, y) x,π 2
+ hu− − Vu− − hu− − Vu− {µ(du, dy) − ν(du, dy)}
ρ(u, y)
x,π
Yt−1 (ht − Vt )2 = Y0−1 (h0 − x)2 + mπ t
Z t
2
−1
0 x,π 0
+ Yu−
ξ1 (u) − S(u) π(u) + (hu− − Vu− )S(u) a(u)
du
Z0t Z 2
−1 0 x,π 0 ϕ(u, y)
+ Yu− ξ2 (u, y) − Υ(u, y) π(u) + hu− − Vu− Υ(u, y) a(u) λ(u, dy)du
0 E ρ(u, y)
x,π 2 −1 x,π 2
E(hT − V ) = EY (hT − V )
0 T0 T0 0 T0
−1
=Y (h0 − x)2
0
Z T 0
0 −1 −1 x,π −1 x,π
+E Y π(u) − <u ζu − (hu− − V )a(u) <u π(u) − <u ζu − (hu− − V )a(u)
u− u− u−
0 Z
2 ϕ(u, y) 0 −1
+kξ1 (u)k2 + ξ2 (u, y) λ(u, dy) − ζu <u ζu du.
E ρ(u, y)
Z t
2 ϕ(u, y)
Z
−1 2 0 −1
+ Yu− kξ1 (u)k + ξ2 (u, y) λ(u, dy) − ζu <u ζu du.
0 E ρ(u, y)
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
∗
Since mπ is only a local martingale, there exists a sequence of stopping
∗
times (τn ) with ↑ limn→∞ τn = T0 such that {mπt∧τn ; t ∈ [0, T0 ]} is a uni-
∗ 2
formly integrable martingale for each n. Since Y h − V x,π is left con-
tinuous at T0 , one can see from Fatou’s lemma that
2 2 2
x,π ∗ x,π ∗ x,π ∗
E hT0 − VT = E YT0 hT0 − VT =E lim inf Yτn hτn − Vτ
0 0 n
n→∞
x,π ∗ 2
≤ lim inf E Yτn hτn − Vτn
n→∞
Z τn
Z
−1 2 2 ϕ(u, y) 0 −1
= Y0−1 (h0 − x)2 + lim inf E Yu− kξ1 (u)k + ξ2 (u, y) λ(u, dy) − ζu <u ζu du
n→∞ ρ(u, y)
Z T 0 Z E
0 −1 2 2 ϕ(u, y) 0 −1
≤ Y0−1 (h0 − x)2 + E Yu− kξ1 (u)k + ξ2 (u, y) λ(u, dy) − ζu <u ζu du
2 0 E ρ(u, y)
x,π
≤E hT0 − VT ,
0
δ̃(u, y)
δ(u, y, T ) = −
1 + δ̃(u, y)(T − u)
1
for a bounded P-measurable
e function δ̃(u, y) with δ̃(u, y) > − ∗ . One can
T
see that S(u, T ) = −σ(u)(T − u) and eD(u,y,T ) − 1 = δ̃(u, y)(T − u), thus
the discounted bond price maturing at T is given by
Z ·
p̄(t, T ) = p̄(0, T )E − σ(u)0 (T − u)dW̃ (u)
0
Z ·Z
+ δ̃(u, y)(T − u)(µ(du, dy) − ν̃(du, dy)) .
0 E t
(10)
Fix a T0 ∈ (0, T ∗ ) and given any integer n0 , let T1 , · · · , Tn0 be n0
maturities with T0 < Ti < T ∗ for each i and T1 < T2 < · · · < Tn0 . Given
a contingent claim H ∈ L2 (FT0 ), we consider the mean-variance hedging
problem of H by a self-financing portfolio based on p̄(t, T1 ), . . . , p̄(t, Tn0 ).
From the following Lemma, one can see that to hedge H, we only need to
trade the bond maturing at T1 :
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
Lemma 2.6. Assume that the discounted bond price p̄(t, T ) is given by
(10), then for any
2,τ
We now denote Zd exp for the family of (z1 , z2 ) satisfying (6) with
0 τ
2
E Zτ,T0 E (z1 , z2 )T0 < ∞, and consider the following kind of mini-
mization problem
h
0
2 i
Ψ(τ ) := ess inf E Zτ,T 0
E τ(z1 , z2 )T0 Fτ . (11)
d2,τ
(z1 ,z2 )∈Zexp
Assumption 2.2. There exists a pair (z1∗ , z2∗ ) satisfying (2) such that for
2,τ
all τ ∈ T , (z ∗ , z ∗ ) ∈ Zd
T0 1 and
2 exp
h
0 τ ∗ ∗
2 i
Ψ(τ ) = EQ0 Zτ,T0
E (z , z )
1 2 T0 Fτ , Q0 -a.s.,
and
Z t Z tZ
Mt∗ = z1∗ (u)0 dW̃ (u) + z2∗ (u, y)(µ(du, dy) − ν̃(du, dy))
0 0 E
(1) a is an Rn -valued predictable process such that for all stopping times
τ ∈ TT0 ,
2
a(u)I]]τ,T0 ]] (u)
Z
E E − dp̄(u, T1 ) < ∞;
p̄(u−, T1 )(T1 − u) T0
1 − a(u)δ̃(u, y)
where ẑ2 (u, y) := − 1;
ρ(u, y)
(3) Y is a bounded RCLL semimartingale with 0 < c1 ≤ Y ≤ c2 < ∞ for
some constants c1 and c2 .
Similar to Lemma 2.4 and Theorem 2.1, we can show the following
theorem
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
Theorem 2.3. 1) Under Assumption 2.2, the BSE (12) has a bounded
solution;
2) If the BSE (12) has a bounded solution denoted by (Y, a, ẑ1 , ρ), then
Yt = Ψ(t), a.s., for all t ∈ [0, T0 ] and
Z t Z tZ
Mt∗ := ẑ1 (u)0 dW̃ (u) + ẑ2 (u, y)(µ(du, dy) − ν̃(du, dy))
0 0 E
is the variance-optimal martingale.
then π ∗ is the optimal strategy for Problem (MHV-1). The optimal cost is
then given by
Z T0
J = Y0−1 (h0 − x)2 + E −1
Yu− kξ1 (u)k2
0
ζ̂u2
2 ϕ(u, y)
Z
+ ξ2 (u, y) λ(u, dy) − du .
E ρ(u, y) ˆu
<
Remark. The reader should note that in Lemma (2.6) T1 can be replaced
by any Ti , i ∈ {1, · · · , n0 }. So the agent is free to choose the bond with any
admissible time of maturity. As a consequence, it is not surprising that the
optimal cost is independent of the chosen maturity time what is directly
seen from Theorem 2.4. A similar observation in a simpler market setting is
already made in Proposition 4.5 in Björk (1997)5 . We should however note
that this is somewhat contradictory to observations in reality: There seems
to be an extra risk in hedging a claim with exercise time one month with a
bond expiring in ten years (see (17).
Again, let
Z t
f (t, T ) = f (0, T ) + Ψ(u, T ; σ, δ, φ, ϕ)du
Z t 0 Z tZ (15)
0
+ σ(u, T ) dW (u) + δ(u, y, T )µ(du, dy),
0 0 E
where
Z T
Ψ(u, T ; σ, δ, φ, ϕ) := σ(u, T ) 0
σ(u, s)ds − σ(u, T )0 φ(u)
u Z
− δ(u, y, T )eD(u,y,T )ϕ(u, y)λu (dy).
E
(16)
dQ0
The bond market is arbitrage-free, since Q0 defined by dP F := ZT0 ∗ is a
equivalent martingale measure, where
Z t Z tZ
0
Zt0 = 1 + φ(u)0 dW (u) + 0
Zu− Zu− ϕ(u, y) − 1 µ(du, dy) − ν(du, dy) ,
0 0 E
38
(see Mania and Schweizer(2005) ). Similar problems have been considered
in Becher(2006)3, Mania and Schweizer(2005)38, or Morlais(2008)40. The
main difference between this paper and those papers is that we have a
continuum of traded securities and the wealth process is described by an
(M, Q0 )-normalized martingale.
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
We are aware of the fact that from a practical point of view our results
are not very satisfying. However, in our minds, the results might bring for-
ward the general theory of bond markets which still needs a lot of research.
For a given maturity T0 , let Z be the set of strictly positive martingales
on [0, T0 ] with Z0 = 1 such that for any maturity T ∈ [T0 , T ∗ ], Zt p̄(t, T )
is a local martingale on [0, T0 ]. Then we know that for any Z ∈ Z, there
exists a pair (z1 , z2 ) satisfying (5) for all T ∈ [T0 , T ∗ ] and
z1 ,z2 0 ez1 ,z2
Zt = Z
t Z := Zt Zt
·
=E (φ(u) + z1 (u))0 dW (u)
0 Z ·Z
+ ϕ(u, y) 1 + z2 (u, y) − 1 (µ(du, dy) − ν(du, dy)) .
0 E t
In other words,
ez1∗ ,z2∗ = E M z1∗ ,z2∗ ,
Z
Z t Z tZ
z ∗ ,z2∗
where Mt 1 := z1∗ (u)0 dW
f (u) + z2∗ (u, y)(µ(du, dy) − ν̃(du, dy)) is
0 0 E
a locally square integrable martingale under Q0 .
It is natural to introduce
z1 ,z2
Z ∈ Z with Z0 = 1 and E ZT0 ln ZT0 < ∞ and
ZEnt := Z z1 ,z2 .
Z T Z T Z
0 0
kz1 (u)k2 du + ϕ(u, y)z2 (u, y)2 λu (dy)du < ∞, Q0 -a.s.
0 0 E
0
ZT00
for all stopping times τ with τ ≤ T0 , where Zτ,T = and k is a positive
0
Zτ0
constant.
∗ ∗
Remark. Obviously, under Assumption 3.1 the MEM Ẑ = Z z1 ,z2 is also
the solution of the following optimization problem:
Note that now we can trade all bonds with maturities in [T0 , T ∗ ]!
Since there exists a continuum of basic traded securities, we introduce the
cylindrical martingale and the normalized martingale which is related to
the normalized integral in De Donno and Pratelli(2004)19, which was first
introduced in Mikulevicius-Rozovskii(1998)39 as a mathematical tool with-
out relation to financial problems.
where
Z
0
eD(u,y,T1 ) −1 eD(u,y,T2 ) −1 ϕ(u, y)λu (dy).
Qu (T1 , T2 ) = S(u, T1 ) S(u, T2 )+
E
then its topological dual R is the space of all Radon measures on [T0 , T ∗ ].
Note that (C, R) is a Schwartz pair. We have the following lemma:
where
T∗ T∗ T∗
Z Z Z 0
`(S(u, ·)) := S(u, T )`(dT ) = S1 (u, T )`(dT ), · · · , Sn (u, T )`(dT ) ,
ZTT0 ∗ n o
T0 T0
L2loc (M, R) is not complete. To overcome this we need to introduce the nor-
malized martingale.
and
Z Z 2
T0
n 2 n D(u,y,·)
lim EQ0 `u (S(u, ·))−l1 (u) + `u e − 1 − l2 (u, y) ϕ(u, y)λu (dy) du = 0.
n→∞ 0 E
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
Proof. For any Z z1 ,z2 ∈ ZEnt , one can see that Z z1 ,z2 can be rewritten as
Ztz1 ,z2 = Zt0 E M z1 ,z2 t ,
where
Z t Z tZ
Mtz1 ,z2 := z1 (u)0 dW
f (u) + z2 (u, y)(µ(du, dy) − ν̃(du, dy)).
0 0 E
Since (z1 , z2 ) satisfies
Z T0 Z T0 Z
2
kz1 (u)k du + ϕ(u, y)z2 (u, y)2 λu (dy)du < ∞, Q0 -a.s.,
0 0 E
z1 ,z2
one can see that M is a locally square integrable martingale under
Q0 , thus there exists a sequence of stopping n o with τn % T0
times (τn )n∈N
l1 ,l2
as n → ∞ such that for each n, Mt∧τn ; t ∈ [0, T0 ] is a (M, Q0 )-
z1 ,z2
normalized martingale and Mt∧τ n
; t ∈ [0, T0 ] is a square integrable mar-
tingale
n under Q0 . Similar o
to the proof of Proposition 3.2, one can show that
l1 ,l2 z1 ,z2
Mt∧τn Mt∧τn ; t ∈ [0, T0 ] is a uniformly integrable martingale under Q0
n o
for each n, thus Mtl1 ,l2 Mtz1 ,z2 ; t ∈ [0, T0 ] is a local martingale under Q0
and
Z
l1 ,l2 Q0
M , M z1 ,z2 t = z1 (u)0 l1 (u) + ϕ(u, y)z2 (u, y)l2 (u, y)λu (dy) = 0.
E
From Theorem 4.2 of De Donno and Pratelli19 , we may adapt the fol-
lowing corollary
Corollary 3.2. If the martingale measure is unique, i.e. there is no
nonzero pair (z1 , z2 ) satisfying (5) for each T ∈ [T0 , T ∗ ], then the mar-
ket is approximately complete, i.e., for every ξ ∈ L2 (Q0 , FT0 ), there is
an (M, Q0 )-normalized martingale M such that MT0 = ξ.
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
which is the largest RCLL process with V (T0 ) = 0 such that Zt {V (t) +
ln(Zt )}; t ∈ [0, T0 ] is a submartingale for each Z ∈ ZEnt .
Z t
∗ 0 0
a(t) = a(0) + l1 (u) − (φ(u) + θ1 (u)) dW (u)
0
Z t
1 2 ∗ 0
+ kφ(u) + θ1 (u)k − l1 (u) φ(u) du
Z0 Z 2
t
l2∗ (u, y) − ln ϕ(u, y) 1 + θ2 (u, y)
+ µ(du, dy)
Z0 t ZE
ϕ(u, y) 1 + θ2 (u, y) − l2∗ (u, y) − 1 ν(du, dy).
+
0 E
a(T0 ) = 0 .
(17)
A solution of the BSE (17) is a 5-tuple (a; l1∗ , l2∗ ; θ1 , θ2 ) satisfying (17) such
that
Z t Z tZ
l∗ ,l∗
Mt 1 2
:= l1∗ (u)0 dW
f (u) + l2∗ (u, y){µ(du, dy) − ν̃(du, dy)}
0 0 E
Theorem 3.1. Let Assumption 3.1 be satisfied, and assume that the BSE
(17) has a solution denoted by (a; l1∗ , l2∗ ; θ1 , θ2 ), then V (t) = a(t), a.s. for
every t ∈ [0, T0 ] and the MEM based on [T0 , T ∗ ] is given by Z θ1 ,θ2 .
Proof. The idea is the same as the proof of Theorem 3.3 of Kohlmann and
Xiong(2008)33 , but the computation is different. For any pair (z1 , z2 ) such
that
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
Z t 0
a(t) + ln Ztz1 ,z2 = a(0) + l1∗ (u) + z1 (u) − θ1 (u) dW (u)
Z t 0
1 1
2
+ kφ(u) + θ1 (u)k2 − l1∗ (u)0 φ(u) −
φ(u) + z1 (u)
du
Z0 t Z 2 2
∗
+ l2 (u, y) − ln 1 + θ2 (u, y) + ln 1 + z2 (u, y) µ(du, dy)
Z0 t ZE
∗
+ ϕ(u, y) θ2 (u, y) − l2 (u, y) − z2 (u, y) ν(du, dy),
0 E
thus
Z t 0
z1 ,z2
+ Zu− l1∗ (u) + z1 (u) − θ1 (u) dW (u)
Z0 t
z1 ,z2 1 1
2
+ Zu− kφ(u) + θ1 (u)k2 − l1∗ (u)0 φ(u) −
φ(u) + z1 (u)
du
Z0 t Z 2 2
z1 ,z2
+ Zu− l2∗ (u, y) − ln 1 + θ2 (u, y) + ln 1 + z2 (u, y) µ(du, dy)
Z0t ZE
z1 ,z2
+ Zu− ϕ(u, y) θ2 (u, y) − l2∗ (u, y) − z2 (u, y) ν(du, dy)
0 E
Z t
z1 ,z2
+ Zu− (φ(u) + z1 (u))0 l1∗ (u) + z1 (u) − θ1 (u) du
Z0 t Z
z1 ,z2
+ Zu− ϕ(u, y) 1 + z2 (u, y) − 1
0 E
× l2∗ (u, y) − ln 1 + θ2 (u, y) + ln 1 + z2 (u, y) µ(du, dy)
Z t
z1 ,z2 1
= a(0) + mt + Zu− kθ1 (u) − z1 (u)k2 + z1 (u)0 l1∗ (u) du
0Z 2
Z t
z1 ,z2
+ Zu− ϕ(u, y) z2 (u, y)l2∗ (u, y) + θ2 (u, y) − z2 (u, y)
0 E
+ 1 + z2 (u, y) ln 1 + z2 (u, y) − ln 1 + θ2 (u, y) ν(du, dy)
May 27, 2011 13:50 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
where
Z t
z1 ,z2 z1 ,z2
mt := Zu− a(u−) + ln Zu− (φ(u) + z1 (u))0
0
0
+ l1∗ (u) + z1 (u) − θ1 (u) dW (u)
Z t Z
z1 ,z2 z1 ,z2
+ Zu− a(u−) + ln Zu− ϕ(u, y) 1 + z2 (u, y) − 1
0 E ∗
+ ϕ(u, y) 1 + z2 (u, y)
l2 (u, y) − ln 1 + θ2 (u, y)
+ ln 1 + z2 (u, y) (µ(du, dy) − ν(du, dy))
∗ ∗
is a martingale under P . Since M l1 ,l2 is a local (M, Q0 )-normalized mar-
tingale, according to Corollary 3.1, one can see that
Z
0 ∗
z1 (u) l1 (u) + ϕ(u, y)z2 (u, y)l2∗ (u, y)λu (dy) = 0,
E
thus
Z t
1
Ztz1 ,z2 {a(t) Ztz1 ,z2 } z1 ,z2
kθ1 (u) − z1 (u)k2 du
+ ln = a(0) + mt + Zu−
Z tZ 2 0
z1 ,z2
+ Zu− ϕ(u, y) θ2 (u, y) − z2 (u, y)
0 E
+ 1 + z2 (u, y) ln 1 + z2 (u, y) − ln 1 + θ2 (u, y) ν(du, dy)
= E Z θ1 ,θ2 ln Z θ1 ,θ2 )Ft ,
T T
thus
h i
θ1 ,θ2 θ1 ,θ2
a(t) = E Zt,T ln Zt,T Ft
≥ ess inf Z∈ZEnt E Zt,T0 ln(Zt,T0 )Ft = V (t),
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
thus a(t) = V (t), a.s., and Z θ1 ,θ2 is the MEM based on [T0 , T ∗ ].
Theorem 3.2. Let Assumption 3.1 be satisfied, then the BSE (17) has a
solution if and only if there exists a Z z1 ,z2 ∈ ZEnt satisfying the reverse
Hölder inequality REnt (P ), which is of the following form
Corollary 3.3. Let Assumption 3.1 be satisfied, and assume that the BSE
(17) has a solution denoted by (a; l1∗ , l2∗ ; θ1 , θ2 ), then for any Z z1 ,z2 ∈ ZEnt ,
∗ ∗
Z z1 ,z2 M l1 ,l2
Z0z1 ,z2 = 1 such that for any maturity Ti ∈ [T0 , T ∗ ], Ztz1 ,z2 p̄(t, Ti ) is a local
martingale on [0, T0 ]. Similarly, we let
h i
z1 ,z2 z ,z z ,z
Z ∈ ZT1 ,··· ,Tn satisfies E ZT1 2 ln ZT1 2 < ∞ and
Z Z T Z 0 0
ZT1 ,··· ,Tn := Z z1 ,z2 T0 0 ,
Ent
2
kz1 (u)k du + ϕ(u, y)z2 (u, y) λu (dy)du < ∞, Q -a.s.
2 0
0 0 E
In general, the MEM based on [T0 , T ∗ ] may not be the MEM based on
T1 , · · · , Tn , however, we have the following corollary
Corollary 3.5. Let Assumption 3.1 be satisfied. Assume that the BSE (17)
has a solution denoted by (a; l1∗ , l2∗ ; θ1 , θ2 ). If the local (M, Q0 )-normalized
∗ ∗
martingale M l1 ,l2 satisfies
Z t
l∗ ∗
1 ,l2
Mt = `∗u dM(u),
0
Pn
where `∗u (dT )
= j
and where lj is a predictable process and
j=1 lu δTj (dT ),
δTj (dT ) is the Dirac measure at the point Tj for each j, then Z θ1 ,θ2 is the
minimal entropy martingale based on T1 , · · · , Tn .
This corollary allows to compare the results on bond markets with a finite
number of maturities and the more general situation here.
3.4. An Example
In a situation which should be compared to (2.3), it is possible to give an
example in which we can solve the BSE (17) explicitly. Assume that S(u, T )
is given by
S(u, T ) = s1 (T − u) + s2 (T − u)2
where s1 and s2 are two deterministic Rd -valued vector with s01 s2 = 0, and
eD(u,y,T ) − 1 is given by
eD(u,y,T ) − 1 = d(y)(T − u)
for some deterministic continuous function (y). To simplify the presentation,
we again assume that φ is a deterministic Rd -valued vector and ϕ(y) is
a deterministic bounded strictly positive continuous function on R, while
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
2∗ (u, y) := γ1 d(y),
l
θ1 (u) := γ1 s1 + γ2 s2 − φ,
eγ1 d(y)
θ2 (u, y) :=
−1
ϕ(y)
Z n
eγ1 d(y) (γ1 d(y) − 1) + 1 λ(dy)
1
kγ1 s1 + γ2 s2 k2 +
o
and a(0) := T0 ×
2 R
and assume that a is given by
Z t
a(t) = a(0) + l1∗ (u)0 − (φ(u) + θ1 (u))0 dW (u)
Z t 0
1
+ kφ(u) + θ1 (u)k2 − l1∗ (u)0 φ(u) du
Z0 t Z 2
∗
+ l2 (u, y) − ln ϕ(u, y) 1 + θ2 (u, y) µ(du, dy)
Z0 t ZE
+ ϕ(u, y) 1 + θ2 (u, y) − l2∗ (u, y) − 1 ν(du, dy),
0 E
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
then (a; l1∗ , l2∗ ; θ1 , θ2 ) is the solution of the BSE (17) and the minimal entropy
martingale is given by Z θ1 ,θ2 .
Proof. From Itô’s formula applied to ln Ztθ1 ,θ2 and the equations (18), we
have
Z tZ
θ1 ,θ2
ln Zt = (γ1 s1 + γ2 s2 ) W (t) +
0f
γ1 d(y){µ(du, dy) − ν̃(du, dy)}
0 R n
Z
1 γ1 d(y)
ks1 γ1 + γ2 s2 k + (γ1 d(y) − 1)e
o
2
+ + 1 λ(dy) t
2 R
and hence
Z T0 Z
= c + (γ1 s1 + γ2 s2 )0 W γ1 d(y){µ(du, dy) − ν̃(du, dy)},
θ ,θ2
ln ZT10 f (T0 ) +
0 R
where
Z n
1 γ1 d(y)
ks1 γ1 + γ2 s2 k2 + (γ1 d(y) − 1)e
o
c= + 1 λ(dy) × T0 .
2 R
Furthermore, trivially there exists an R-valued function `∗u (dT ) such that
Z T∗
(T − u)`∗u (dT ),
γ1 =
T0 ∗ (19)
Z T
2 ∗
γ2 = (T − u) `u (dT ),
T0
Z Z
thus (γ1 s1 +γ2 s2 )0 W
f+ γ1 d(y){µ(du, dy)−ν̃(du, dy)} is a local (M, Q0 )-
R
normalized martingale, and from Theorem 3.2 we get that Theorem 3.3
holds.
Theorem 3.4. Assume that the BSE (17) has a solution denoted by
(a; l1∗ , l2∗ ; θ1 , θ2 ), then the optimal exp-approximate wealth process (i.e., the
solution of Problem (exp-utility opt)) is given by
1 l∗1 ,l∗2
Xt∗ = x − M .
k0 t
Proof. From Theorem 3.2 we get X ∗ ∈ M(x) and from the proof of The-
orem 3.2, we derive that
l∗ ,l∗
ln ZTθ10 ,θ2 = a(0) + MT10 2
.
From the discussion in the papers on this subject and from the short sum-
mary of this in the introduction it makes no sense to look for an admissible
self-financing portfolio replicating X ∗ . Also the direct valuation problem
of a contingent claim in this setting leads to problems with the intuitive
economic interpretation. Thus we turn to the indifference valuation which
really does make sense.
Definition. The dynamic exp utility indifference value process for a given
H ∈ L∞ (FT0 ) is a bounded RCLL semimartingale, denoted by C(H) =
{Ct (H); t ∈ [0, T0 ]}, satisfying
ess sup E U (XT0 − Xt )Ft = ess sup E U Ct (H) + XT0 − Xt − H Ft ,
X∈W X∈W
(20)
where U (x) = − exp{−k0 x}.
Let Assumption 3.1 be satisfied and assume that the BSE (17) has a
solution denoted by (a; l1 , l2 ; θ1 , θ2 ), one can define the minimal entropy
martingale measure Q∗ by
dQ∗
= ZTθ10 ,θ2 .
dP FT0
Similar to 38, we have the following lemma from (3.2) and (20)
Lemma 3.4. Let Assumption 3.1 be satisfied and assume that the BSE (17)
has a solution denoted by (a; l1∗ , l2∗ ; θ1 , θ2 ), then the exp utility indifference
value process C(H) can be determined by
ek0 Ct (H) = ess inf EQ∗ e−k0 (XT0 −Xt −H) Ft
X∈W
= ess inf EQ∗ e−k0 (XT0 −Xt −H) Ft .
X∈W b
May 11, 2011 15:39 WSPC - Proceedings Trim Size: 9in x 6in 07-koh
Lemma 3.5. Let Assumption 3.1 be satisfied and assume that the BSE
(17) has a solution denoted by (a; l1∗ , l2∗ ; θ1 , θ2 ). Then
Z t Z t
W ∗ (t) := W
f (t) − θ1 (u)du = W (t) − {φ(u) + θ1 (u)}du
0 0
d ∗
is a R -valued Brownian motion under Q and
ν ∗ (du, dy) := (1 + θ2 (u, y))ν̃(du, dy) = (1 + θ2 (u, y))ϕ(u, y)λu (dy)du
is the compensator of µ under Q∗ .
Then we get from the standard martingale optimality principle (see e.g.
Proposition 12 of Mania and Schweizer(2005)38):
Theorem 3.5. Let Assumption 3.1 be satisfied, assume that the BSE (17)
has a solution denoted by (a; l1∗ , l2∗ ; θ1 , θ2 ) and the BSE (21) has a bounded
solution (h; l̂1 , l̂2 ; ξ, ζ) for given H ∈ L∞ (FT0 ), then for any t ∈ [0, T0 ],
Ct (H) = ht , a.s.
4. Outlook
It is seen that by leaving the basic somewhat unrealistic model of the first
sections towards more realistic ones many technical and interpretational
difficulties arise. One way out of these deficiencies might be to consider more
structured models like affine term structures. To this end it will be necessary
to study Wishart processes (see Bru(1991)9). There is a lot of research going
on in this field, and some results look rather promising. A different approach
might be to consider markets consisting of a stock and many tradable bonds.
However, for such markets arbitrage and possibly completeness has to be
reconsidered in the sense that the new objects have to be compatible with
the standard market objects to be able to redefine risk-neutral markets.
Some attempts to develop such concepts of “compatitibility” in different
situations are found e.g. in Jacod and Protter(2006)28 and in a manuscript
on the compatible bond-stock market with jumps which we are working on
right now.
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erateurs. Seminaire de Probabilites XXVIII (Lect. Notes Math., vol. 1583)
BerlinHeidelbergNew York: Springer 1994.
44. Schweizer, M. (1996). Approximation Pricing and the Variance-Optimal Mar-
tingale Measure.Annals of Probability 24, 206-236(1996).
45. Xiong D. and Kohlmann M. (2010). The mean-variance hedging in a bond
market with jumps. Preprint University of Konstanz, Germany, to appear in
Stochastic Analysis and Applications.
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193
R. H. Liu
Department of Mathematics
University of Dayton
300 College Park, Dayton, OH 45469-2316, USA
Email: ruihua.liu@notes.udayton.edu
This paper is concerned with a multinomial tree method for option pricing
when the underlying asset price follows a regime-switching model. A direct ex-
tension of the well-known CRR tree to the regime-switching model is examined
first. Then an efficient recombining tree is presented that grows linearly as the
number of time steps increases. The weak convergence of the discrete multino-
mial approximations to the continuous regime-switching process is proved via
the method of martingale problem formulation.
1. Introduction
Lattice methods have been broadly adapted in computational finance ever
since the innovative work by Cox, Ross and Rubinstein (Ref. 7) for the
Black-Scholes-Merton option pricing model (the CRR binomial tree). See
Refs. 2,6,8,10,14–16,21–23 and the references therein. From the computa-
tional perspective, a crucial feature for a successful tree design is that the
number of nodes can not grow too fast as the number of time steps increases.
According to Nelson and Ramaswamy (Ref. 21), a binomial approximation
to a diffusion is “computationally simple” if the number of nodes grows at
most linearly in the number of time intervals. One of the main reasons for
the CRR method being practically popular is because it grows linearly and
is therefore computationally simple.
Pricing derivative securities in regime-switching model has drawn con-
siderable attention in recent decade. See Refs. 1,3–5,9,11–13,17,20,24,
among others. In this setting, asset prices are dictated by a number of
May 11, 2011 13:45 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
194 R. H. Liu
196 R. H. Liu
pα
ij = P {αk+1 = j αk = i}, 1 ≤ i, j ≤ m0 . (2)
It then follows that at the (k + 1)th step, there are totally 2m0 possible
states for (Sk+1 , αk+1 ), given by
It can be seen that the state space for the two-dimensional Markov chain
{(Sk , αk )}k≥0 is the set
n
2l 0 −km0
(S0 u2l 1 −k1 2l2 −k2
u2 · · · umm , i)0 ≤ li ≤ ki , 1 ≤ i ≤ m0 ,
1 0
m0
X o (4)
ki = k, 0 ≤ k ≤ N ,
i=1
where S0 is the initial stock price. It was shown in Aingworth et al. [1,
Proposition
the number of distinct asset prices at the kth period
1] that
k + 2m0 − 1
is = O(k 2m0 −1 ). Thus the tree does not grow linearly and
2m0 − 1
therefore is not computationally simple according to Ref. 21. Consequently,
it works well for small number of regimes and for moderate number of tree
steps. However, if m0 and N are large, such an implementation will become
computationally formidable due to node explosion. For example, consider a
model with 20 regimes.
If 100 time steps were used, then the last step of the
139
tree would have ≈ 4.7 × 10192 nodes. Apparently. most computers
39
can not handle such a heavy computation requirement.
198 R. H. Liu
at the kth step is m0 (2bk + 1), linear in k. Hence, our design does yield
a computationally simple tree. If we consider again the previous example,
namely, m0 = 20 and N = 100, then the last step of the new tree will have
20(200b + 1) = 80020 if b = 20 is chosen, a much smaller number comparing
to 4.7 × 10192 .
Fig. 2 displays a recombining tree with 7 branches (b = 3) emanating
from each node (a heptanomial tree structure).
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Note that if li and h are not chosen properly, it is possible that (8) results
in negative branch probabilities. The following proposition gives conditions
under which the branch probabilities are guaranteed to be non-negative.
200 R. H. Liu
Using the recombining tree we have constructed for the underlying asset
process Xt , both European and American options can be priced following
a similar procedure that is used in the CRR tree for valuing options in the
Black-Scholes model, i.e., by starting at the last step of the tree (n = N )
and working backward iteratively. At each step and for each node, we first
calculate the probability weighted average of all option prices at the nodes
in the next step that are directly emanated from the current node. We then
discount the averaged future price using the interest rate of the current
node. This gives us the discounted expectation of the future option value,
where the expectation is taken with respect to the risk-neutral probability
Pe . For American options, in addition we need to check the early exer-
cise possibility by comparing this value with the immediate exercise value.
Because of the presence of regime-switching, those computations become
more involved and special care needs to take. Note that the option values
are functions of the underlying asset price and also depend on the regime.
Consider a put option, let P n (x, i) denote the option value at step n for
the node associated with the state (Xn , αn ) = (x, i). Then, for the terminal
step n = N ,
P N (x, i) = max{K − S0 ex , 0}, i = 1, . . . , m0 , (10)
where K is the strike price of the option. At step n < N , for European put,
m0
X h √
P n (x, i) = e−ri h pα
ij P
n+1
(x + li σ̄ h, j)pi,u
j=1 (11)
n+1
√ n+1
i
+P (x − li σ̄ h, j)pi,d + P (x, j)pi,m ,
May 11, 2011 13:45 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
202 R. H. Liu
where functions X ε,l (·, ·) : R × M → R satisfy −∞ < X ε,l (x, i) < ∞ for all
x ∈ R and each i ∈ M, and pε,l (·, ·) : R × M → R satisfy
n0
X
0 ≤ pε,l (x, i) ≤ 1, pε,l (x, i) = 1, for all x ∈ R, i ∈ M. (23)
l=1
and
n0
h i X 2
E (Xn+1 − x)2 Xn = x, αn = i = pε,l (x, i) X ε,l (x, i) − x
l=1
(25)
2 2 2
= σ (x, i)ε + µ (x, i)ε .
May 11, 2011 13:45 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
Note that these conditions are all satisfied by the regime-switching recom-
bining tree design presented in Section 2 with n0 = 3.
The following lemma presents an upper bound of the second moments
of Xn , 0 ≤ n ≤ b Tε c which will be used in the weak convergence proof.
Lemma 1. Under Assumptions (14), (15), (24) and (25), for any fixed
T > 0 and any ε > 0, we have
2
sup E [Xn ] ≤ (X02 + KT )eKT < ∞. (26)
0≤n≤bT /εc
It follows that
h i
2
Xn , αn ≤ Xn2 + Kε 1 + Xn2 .
E Xn+1 (27)
204 R. H. Liu
where the random functions ξ(·, ·) are defined as following: For each x ∈ R
and each i ∈ M, ξ(x, i) takes values from the set of n0 values {X ε,l (x, i) −
x − µ(x, i)ε, l = 1, . . . , n0 } with probabilities pε,l (x, i), l = 1, 2, . . . n0 , as
defined in (22) and (23). It follows from (24) and (25) that
h i
E ξ (Xn , αn ) Xn = x, αn = i = 0,
h i (32)
E ξ 2 (Xn , αn ) Xn = x, αn = i = σ 2 (x, i)ε.
Lemma 2. Under Assumptions (14), (15), (24) and (25), the interpolation
process {X ε (t) : 0 ≤ t ≤ T } is tight in D[0, T ], the space of functions
that are right continuous and have left limits, endowed with the Skorohod
topology.
Note that for simplicity, in the above we have used t/ε and (t + s)/ε for the
integer parts of t/ε and (t+s)/ε, respectively. We will adapt this convention
for the rest of the paper.
Note that
2
(t+s)/ε−1 (t+s)/ε−1
X X
2
E µ2 (Xk , αk )
ε E µ (Xk , αk ) ≤ εδ
k=t/ε k=t/ε
(t+s)/ε−1
X
1 + E[Xk2 ] ≤ Kδ 2 ,
≤ εδK
k=t/ε
May 11, 2011 13:45 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
and
2
(t+s)/ε−1
X
E ξ (Xk , αk )
k=t/ε
(t+s)/ε−1
X X
E ξ 2 (Xk , αk ) + 2
= E [ξ (Xk , αk ) ξ (Xl , αl )]
k=t/ε k<l
(t+s)/ε−1
X X
E Ek ξ 2 (Xk , αk ) + 2
= E [ξ (Xk , αk ) El [ξ (Xl , αl )]]
k=t/ε k<l
(t+s)/ε−1 (t+s)/ε−1
X X
E σ 2 (Xk , αk ) ≤ Kε 1 + E[Xk2 ] ≤ Kδ,
=ε
k=t/ε k=t/ε
Then the tightness criterion (see Ref. 18, P47) implies that {X ε (·)} is tight
in D[0, T ].
Note that it can be shown by applying Theorem 3.1 in Ref. 27 that the
interpolated process {αε (·)} is tight. It then follows that {X ε (·), αε (·)} is
tight in D([0, T ]; R × M), the space of functions that are defined on D[0, T ]
taking values in R × M, and that are right continuous and have left limits,
endowed with the Skorohod topology.
Since {X ε (·), αε (·)} is tight, by the Prohorov’s Theorem, it has con-
vergent subsequences. We select such a subsequence and still denote it by
{X ε (·), αε (·)} for notational simplicity. Denote the limit by {X(·), α(·)}.
By Skorohod representation, we may assume without loss of generality that
the subsequence {X ε (·), αε (·)} converges to {X(·), α(·)} w.p.1, and that the
convergence is uniform on any bounded interval. Next we apply the Mar-
tingale problem formulation method (Refs. 25,28) to characterize the limit
process {X(·), α(·)}.
Theorem 1. Under Assumptions (14), (15), (24) and (25), the interpo-
lation process (X ε (·), αε (·)) converges weakly to (X(·), α(·)) as ε → 0 such
that (X(·), α(·)) is the solution of the martingale problem associated with
operator L defined by (16).
May 11, 2011 13:45 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
206 R. H. Liu
Proof. We are to show that for each i ∈ M and for any function ϕ(·, i) ∈
C02 ,
Z t
Mϕ (t) := ϕ(X(t), α(t)) − ϕ(X0 , α0 ) − Lϕ(X(s), α(s)) ds (33)
0
is a martingale. This is done via a series of approximations that average
out the unwanted terms.
Following Refs. 25,28, the claim (33) will be verified if we can show that
for each i ∈ M, any bounded and continuous function hj (·, i), any positive
integer κ, any 0 < tj ≤ t with j ≤ κ, s > 0, and t + s ≤ T ,
( κ
Y h
E hj (X(tj ), α(tj )) ϕ(X(t + s), α(t + s)) − ϕ(X(t), α(t))
j=1
Z t+s i
) (34)
− Lϕ(X(u), α(u)) du = 0.
t
In what follows we show that (34) holds for the pair (X ε (·), αε (·)) and hence
for the pair (X(·), α(·)). The proof is divided into four steps.
Step 1. We begin by choosing a sequence of positive integers {mε } satisfying
mε → ∞ as ε → 0 but ∆ε := εmε → 0. Again, we use t/∆ε and (t + s)/∆ε
for their integer parts (to avoid the use of the floor function notation).
Introduce the index set
χεl = {k : lmε ≤ k ≤ (l + 1)mε − 1}. (35)
Then we can rewrite ϕ(X ε (t + s), αε (t + s)) − ϕ(X ε (t), αε (t)) as
ϕ(X ε (t + s), αε (t + s)) − ϕ(X ε (t), αε (t))
(t+s)/∆ε −1
X
= ϕ(X(l+1)mε , α(l+1)mε ) − ϕ(X(l+1)mε , αlmε )
l=t/∆ε (36)
(t+s)/∆ε −1
X
+ ϕ(X(l+1)mε , αlmε ) − ϕ(Xlmε , αlmε ) .
l=t/∆ε
Step 2. We work on the second summation (the third line) of (36) in this
step. Noting that
(t+s)/∆ε −1
X
ϕ(X(l+1)mε , αlmε ) − ϕ(Xlmε , αlmε )
l=t/∆ε
(t+s)/∆ε −1
X X
= [ϕ(Xk+1 , αlmε ) − ϕ(Xk , αlmε )] ,
l=t/∆ε k:k∈χεl
May 27, 2011 13:55 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
we have ,
Yκ (t+s)/∆ε −1
ε ε
X
lim E hj (X (tj ), α (tj )) ϕ(X(l+1)mε , αlmε ) − ϕ(Xlmε , αlmε )
ε→0
j=1 l=t/∆ε
Yκ (t+s)/∆ε −1
X X
ε ε
= lim E hj (X (tj ), α (tj )) ϕ0x (Xk , αlmε )µ(Xk , αk )ε
ε→0
k:k∈χε
j=1 l=t/∆ε l
(t+s)/∆ε −1
X X
+ ϕ0x (Xk , αlmε )ξ(Xk , αk )
l=t/∆ε k:k∈χε
l
(t+s)/∆ε −1
1 X X
2 2
+ ϕ00
xx (Xk , αlmε )µ (Xk , αk )ε
2
l=t/∆ε k:k∈χε
l
(t+s)/∆ε −1
1 X X
2
+ ϕ00
xx (Xk , αlmε )ξ (Xk , αk )
2
l=t/∆ε k:k∈χε
l
(t+s)/∆ε −1
X X
+ ϕ00
xx (Xk , αlmε )µ(Xk , αk )ξ(Xk , αk )ε
l=t/∆ε k:k∈χε
l
(t+s)/∆ε −1 1
X X Z h i 2
+ ϕ00 g 00
xx (Xk + u∆xk , αlmε ) − ϕxx (Xk , αlmε ) ∆xk du
g ,
l=t/∆ε k:k∈χε 0
l
(37)
κ (t+s)/∆ε −1
(
Y X X Z 1 h
ε ε
lim E hj (X (tj ), α (tj )) ϕ00xx (Xk + u∆x
gk , αlmε )
ε→0 0
j=1 l=t/∆ε k:k∈χεl
)
i 2
− ϕ00xx (Xk , αlmε ) gk du
∆x = 0.
(38)
May 11, 2011 13:45 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
208 R. H. Liu
Since ϕ0x (·, i) and µ(·, i) are continuous for each i ∈ M, we have
(t+s)/∆ε −1
( κ
)
Y ε ε
X X
lim E hj (X (tj ), α (tj )) ϕ0x (Xk , αlmε )µ(Xk , αk )ε
ε→0
j=1 l=t/∆ε k:k∈χε
l
(t+s)/∆ε −1
( κ
)
Y ε ε
X X
= lim E hj (X (tj ), α (tj )) ε ϕ0x (Xlmε , αlmε )µ(Xlmε , αk )
ε→0
j=1 l=t/∆ε k:k∈χε
l
(t+s)/∆ε −1
( κ
Y X X
= lim E hj (X ε (tj ), αε (tj )) ε Elmε
ε→0
j=1 k:k∈χl ε
" ml=t/∆ε #)
X 0
0
× ϕx (Xlmε , αlmε )µ(Xlmε , i)I{αk =i} .
i=1
κ (t+s)/∆ε −1
(
Y X X
ε ε
lim E hj (X (tj ), α (tj )) ε Elmε
ε→0
j=1 l=t/∆ε k:k∈χεl
"m #)
X 0
κ (t+s)/∆ε −1
(
Y X X
ε ε
E hj (X (tj ), α (tj )) ϕ00xx (Xk , αlmε )
j=1 l=t/∆ε k:k∈χεl (41)
)
× µ(Xk , αk )ξ(Xk , αk )ε = 0.
Using the boundedness of ϕ00xx (·, i), hj (·, i), the linear growth condition (15)
for µ(·, i), and the estimate (26), we have,
(t+s)/∆ε −1
κ
Y
hj (X ε (tj ), αε (tj )) ϕ00 2 2
X X
E xx (Xk , αlmε )µ (Xk , αk )ε
j=1 l=t/∆ε k:k∈χε l
(t+s)/∆ε −1 h i (t+s)/∆ε −1
X h i
ε2 E µ2 (Xk , αk ) ≤ Kε2 1 + E Xk2
X X X
≤K
l=t/∆ε k:k∈χεl l=t/∆ε k:k∈χεl
T 2
≤ Kε · = O(ε) → 0 as ε → 0.
ε
(42)
In view of (32), we have
Yκ (t+s)/∆ε −1
ε ε
ϕ00 2
X X
E hj (X (tj ), α (tj )) xx (Xk , αlmε )ξ (Xk , αk )
j=1
l=t/∆ε k:k∈χεl
Yκ (t+s)/∆ε −1 h i
hj (X ε (tj ), αε (tj )) ϕ00 2
X X
=E xx (Xk , αlmε )Ek ξ (Xk , αk )
ε
j=1 l=t/∆ε k:k∈χl
Yκ (t+s)/∆ε −1
hj (X ε (tj ), αε (tj )) ϕ00 2
X X
=E xx (Xk , αlmε )σ (Xk , αk )ε .
ε
j=1 l=t/∆ε k:k∈χl
May 27, 2011 14:35 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
210 R. H. Liu
By using a similar argument to the one leading to (39), we can show that
Yκ (t+s)/∆ε −1
X X
lim E hj (X ε (tj ), αε (tj )) ϕ00 2
xx (Xk , αlmε )ξ (Xk , αk )
ε→0 ε
j=1 l=t/∆ε k:k∈χl
(43)
Yκ Z t+s
2
=E hj (X(tj ), α(tj )) ϕ00
xx (X(u), α(u))σ (X(u), α(u)) du .
j=1 t
( κ
Y Z t+s h
=E hj (X(tj ), α(tj )) ϕ0x (X(u), α(u))µ(X(u), α(u))
j=1 t
)
i
2
+ ϕ00
xx (X(u), α(u))σ (X(u), α(u)) du .
(44)
Step 3. Now we work on the first summation (the second line) of (36). Using
the continuity of ϕ(·, i) for each i ∈ M, we can argue along the same line
as in Step 2 that the limit of
(t+s)/∆ε −1
X
ϕ(X(l+1)mε , α(l+1)mε ) − ϕ(X(l+1)mε , αlmε )
l=t/∆ε
Yκ (t+s)/∆ε −1
X X
=E hj (X ε (tj ), αε (tj )) [ϕ(Xlmε , αk+1 ) − ϕ(Xlmε , αk )]
j=1 l=t/∆ε k:k∈χεl
May 27, 2011 14:25 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
κ (t+s)/∆ε −1 m0
(
Y X X X
hj (X ε (tj ), αε (tj ))
=E Ek [ϕ(Xlmε , αk+1 )
j=1 l=t/∆ε k:k∈χεl i=1
)
− ϕ(Xlmε , αi )]I{αk =i}
(t+s)/∆ε −1 m0
( κ
"m
Y X X X X 0
# )
× P {αk+1 = j|αk = i} − ϕ(Xlmε , i) I{αk =i}
(t+s)/∆ε −1 m0
( κ
"m
Y X X X X 0
ε ε
=E hj (X (tj ), α (tj )) ϕ(Xlmε , j)(δij + εqij )
j=1 l=t/∆ε k:k∈χεl i=1 j=1
# )
− ϕ(Xlmε , i) I{αk =i}
Yκ (t+s)/∆ε −1 m0 X
m0
X X X
=E hj (X ε (tj ), αε (tj )) εqij ϕ(Xlmε , j)I{αk =i}
j=1 l=t/∆ε k:k∈χεl i=1 j=1
κ
(
Y Z t+s
→E hj (X(tj ), α(tj )) Qϕ (X(u), ·) (α(u)) du as ε → 0,
j=1 t
(45)
in which (21) is used for the one-step transition probability of {αn , n ≥ 0}.
Yκ Z t+s
→E hj (X(tj ), α(tj )) Lϕ(X(u), α(u)) du as ε → 0.
j=1 t
May 11, 2011 13:45 WSPC - Proceedings Trim Size: 9in x 6in 08-liu
212 R. H. Liu
On the other hand, by virtue of the weak convergence of (X ε (·), αε (·)), the
Skorohod representation, and the continuity of hj (·, i) and ϕ(·, i), we have,
Yκ
hj (X ε (tj ), αε (tj )) ϕ(X ε (t + s), αε (t + s)) − ϕ(X ε (t), αε (t))
E
j=1
Y κ
→E hj (X(tj ), α(tj )) [ϕ(X(t + s), α(t + s)) − ϕ(X(t), α(t))] as ε → 0.
j=1
Hence Equation (34) is verified, and the desired result follows and the proof
of Theorem 1 is completed.
4. Concluding Remarks
In this paper we present a multinomial tree method for option pricing
when the underlying asset price follows a regime-switching model. The new
tree grows linearly as the number of time steps increases. We prove the
weak convergence of the discrete tree approximations to the continuous
regime-switching process by applying the method of martingale problem
formulation.
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Applied Finance, 8 (2005), 223-238.
3. N.P.B. Bollen, Valuing options in regime-switching models, Journal of Deriva-
tives, Vol. 6 (1998), 38-49.
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214 R. H. Liu
215
Shangzhen Luo
Department of Mathematics,
University of Northern Iowa,
Cedar Falls, Iowa, 50614-0506, USA
Email: luos@uni.edu
1. Introduction
During last few decades, various applications of stochastic control theory
in actuarial science have been appearing. See, e.g., Asmussen and Tak-
sar,1 Browne,2 Browne,3 Emanuel et. al,5 Höjgaard and Taksar,7 Höjgaard
and Taksar,8 Liang,9 Luo et. al,10 Schmidli,11 Schmidli,12 Taksar and
Markussen13 etc. Specifically, Browne2 studied a diffusion model with in-
vestment under exponential utility maximization and ruin minimization
criteria; Yang and Zhang15 studied the same problem under more general
jump diffusion settings. Noticing that in many recent actuarial models, e.g.,
Höjgaard and Taksar,7 Höjgaard and Taksar,8 and Luo et. al,10 control of
reinsurance purchase is incorporated as a part of the management of the
insurance company. In this paper, we apply stochastic control theory to
solve an optimization problem on reinsurance. We consider an exponential
utility maximization as the optimization scenario; more exactly the objec-
tive is to seek an optimal proportional reinsurance policy to maximize the
expected utility of the terminal wealth; here we assume that the surplus
of the insurance company is modeled by a perturbed compound Poisson
process, which is a jump diffusion process. Note that this class of risk pro-
May 11, 2011 13:54 WSPC - Proceedings Trim Size: 9in x 6in 09-luo
216 S. Luo
cesses has been studied extensively in the literature (see, e.g., Dufresne and
Gerber,4 Gerber and Yang,6 and Wang and Wu14 ). A similar study to this
paper has been conducted in Liang,9 where the utility maximization prob-
lem was studied under both diffusion approximation and jump diffusion
models. There investment was not considered. However in this paper (as in
Taksar and Markussen13 ) we assume that there is a risk free asset in the
market, and we then solve the optimization problem in the case with all
surplus invested in the riskless asset. More explicit results are given when
the claim size distribution is exponential or gamma. Economic analysis on
relations between optimal reinsurance strategy and exogenous parameters
is also provided.
We start with a perturbed Cramer-Lundberg risk process in differential
form
where µ is the premium rate, x is the initial surplus level, σ is the volatility
of the perturbing process wt which is a standard Brownian motion inde-
pendent of process Lt , and Lt is a compound Poisson process given by
Nt
X
Lt = Yi , (2)
i=1
and an optimal control policy π ∗ such that V (t, x) = Vπ∗ (t, x).
For any admissible control policy π, applying Ito’s lemma to a func-
tion g(t, x) of the jump diffusion process governed by (3), we obtain the
following:
g(t, Rtπ ) − g(0, x)
Z t
1
= {gs (s, Rsπ ) + [µ − β(1 − us ) + rRsπ ]gx (s, Rsπ ) + σ 2 gxx (s, Rsπ )}ds
0 2
Z t
+ gx (s, Rsπ )σdws + Σ [g(s, Rsπ ) − g(s, Rs− π
)],
0 s∈JL ;s≤t
(7)
May 11, 2011 13:54 WSPC - Proceedings Trim Size: 9in x 6in 09-luo
218 S. Luo
where gs , gx , and gxx are partial derivatives, and JL is the set of jump-
ing times of the claim process L := {Ls }s≥0 . Thus the generator of the
controlled process under a fixed policy ut ≡ u is given by
1
Au g(t, x) =gt (t, x) + [µ − β(1 − u) + rx]gx (t, x) + σ 2 gxx (t, x)
2 (8)
+ λE[g(t, x − uY ) − g(t, x)].
Suppose the function V has continuous partial derivatives Vt , Vx and
Vxx , and all limits and expectations can be interchanged, then one can show
that the function V solves an HJB equation given as follows
sup Au V (t, x) = 0, (9)
0≤u≤1
We note that u∗ (t) and ũ(t) are both continuous and increasing functions
in t.
Theorem 3.1. The optimal value function V in (6) admits form (12), its
associated optimal investment feedback function u∗ (t) is given by (16), and
function h in (12) solves the following equation
h0 (T − t) = − γ(µ − β(1 − u∗ (t)))er(T −t)
1 (17)
+ γ 2 σ 2 e2r(T −t) + λMY (γer(T −t) u∗ (t)) − λ,
2
with boundary condition h(0) = 0.
Lemma 3.1. Under the optimal reinsurance policy π ∗ = {u∗ (t)}, the pro-
∗
cess {V (t, Rtπ )}0≤t≥T is a martingale.
Proof. Apply Ito’s formula to V (s, Rsπ∗ ) and take expectation, then we
have
Z t Z t
π∗ u∗ (s) π∗ ∗
E[V (t, Rt ) − V (0, x)] = A V (s, Rs )ds + E[ σVx (s, Rsπ )dws ],
0 0
= 0,
∗ ∗ ∗
since Au (s)
V (s, Rsπ ) = 0 and Vx (s, Rsπ ) is squarely integrable.
One can also show that {V (t, Rtπ )}0≤t≥T is a super-martingale for any ad-
missible control π, and the theorem follows immediately.
Remark 3.1. In the case of cheap reinsurance, i.e., β ≤ λα, it always holds
that ũ(t) ≤ 0. Thus the optimal reinsurance strategy is
u∗ (t) ≡ 0;
May 11, 2011 13:54 WSPC - Proceedings Trim Size: 9in x 6in 09-luo
220 S. Luo
it implies that the optimal control policy for the insurance company is
to buy 100% of reinsurance, and hence the risk on claims is eliminated.
Consequently, the optimal value function is given as follows
δ σ 2 γ 2 2r(T −t)
exp{−γxer(T −t) +
V (t, x) = c − e
γ 4r
γ σ2 γ 2 γ
− (µ − β)er(T −t) − + (µ − β)},
r 4r r
which does not depend on the claim size distribution.
q
1 λ
α− αβ
(2) 0 < γ < 1, and
q q
1 λ 1 λ
α− αβ α− αβ
(3) γ ≥1> γerT .
h0 (T − t) = g1 (T − t),
where
1 λ
g1 (T − t) = −γµer(T −t) + σ 2 γ 2 e2r(T −t) + − λ. (19)
2 α( α1 − γer(T −t) )
Thus we obtain:
q
1 λ
α− αβ
Theorem 4.1. If γerT ≥ 1, then the optimal reinsurance retention level
is
u∗ (t) ≡ 1,
δ 1 − αγ σ 2 γ 2 2r(T −t)
V (t, x) = c − ( r(T −t)
)λ/r exp{−γxer(T −t) + e
γ 1 − αγe 4r
γ σ2 γ 2 γ
− µer(T −t) + λ(T − t) − + µ}.
r 4r r
q
1 λ
α− αβ
Remark 4.1. In Theorem 4.1, the assumption γerT ≥ 1 is equivalent
λ 1 rT
to β ≥ α( 1 −γerT )2 and α − γe > 0. Noticing
α
λ λ
β≥ > = λα,
α( α1 rT
− γe ) 2 α( α1 )2
222 S. Luo
Notice that
s
r(T −t) 1 λ
MY (γe ũ(t)) = MY ( − )
α αβ
1
= q
α[ α1 − ( α1 − λ
αβ )]
r
β
= ,
λα
thus when u∗ (t) ≡ ũ(t), the function h in (12) solves
h0 (T − t) = g2 (T − t),
where
r
r(T −t) 1 β λβ
g2 (T − t) = −γ(µ − β)e + σ 2 γ 2 e2r(T −t) − + 2 − λ. (20)
2 α α
q
1 λ
α− αβ
We note here that under constraint 0 < γ < 1, it always holds that
0 < ũ(t) < 1. These discussions lead to the following theorem:
q
1 λ
α− αβ
Theorem 4.2. If 0 < γ < 1, then the optimal reinsurance retention
level is
q
1 λ
α − αβ
∗
u (t) = ũ(t) = ,
γer(T −t)
and the optimal value function is given by
δ σ 2 γ 2 2r(T −t) γ
V (t, x) = c − exp{−γxer(T −t) + e − (µ − β)er(T −t)
γ 4r r
r
2 2
β λβ σ γ γ
+( − 2 + λ)(T − t) − + (µ − β)}.
α α 4r r
q
1 λ
α− αβ
Remark 4.2. Notice that the condition 0 < γ < 1 is equivalent to
the union of the following two cases:
Under these conditions (high claim size expectation, or low claim size ex-
pectation with not too expensive reinsurance), the optimal policy always
involves certain levels of reinsurance purchase, and it is never 0% or 100%.
Now
q
we consider the qlast case of expensive reinsurance on parameters:
1 λ 1 λ
α− αβ α− αβ
γ ≥ 1 > γerT
; under this constraint, we compute t0 , with
0 ≤ t0 < T , given as the following,
q
1 λ
1 α − αβ
t0 = ln , (21)
r γ
so that
ũ(T − t0 ) = 1.
Hence ũ(t) ≤ 1 and u∗ (t) = ũ(t) when 0 < t ≤ T − t0 ; ũ(t) > 1 and
u∗ (t) = 1 when T − t0 < t ≤ T . Now we conclude that the function h in
(12) solves the following equation:
(
g1 (T − t) if 0 ≤ T − t ≤ t0
h0 (T − t) = ,
g2 (T − t) if t0 < T − t ≤ T
where g1 and g2 are defined by (19) and (20) respectively. One checks
g1 (t0 ) = g2 (t0 ); thus the piece-wisely defined function above is continuous
in t. The discussions above lead to the following theorem:
q q
1 λ 1 λ
α− αβ α− αβ
Theorem 4.3. If γ ≥ 1 > γerT , then the optimal reinsurance
retention level is
(
1 if 0 ≤ T − t ≤ t0
u∗ (t) = , (22)
ũ(t) if t0 < T − t ≤ T
224 S. Luo
δ σ 2 γ 2 2r(T −t) γ
V (t, x) = c − exp{−γxer(T −t) + e − (µ − β)er(T −t)
γ 4r r
r r
2 2
β λβ σ γ β λβ βγ rt0
+( − 2 + λ)(T − t) − −( −2 )t0 − e
α α 4r α α r
1
λ −γ γ
− ln αq + µ},
r λ r
αβ
for t0 < T − t ≤ T .
Remark 4.3. Under the condition in Theorem 4.3, the retention level
increases to 100% as time evolves; the optimal strategy is to buy less rein-
surance gradually down to 0% near the terminal time.
To this end, we have considered all the possible cases of the parameters.
1
λaba a+1
b− β
(1) γerT ≥ 1,
1
a+1
λaba
b− β
(2) 0 < γ < 1, and
1
a+1 1
λaba λaba a+1
b− β b− β
(3) γ ≥1> γerT .
1
λaba a+1
b− β
Theorem 4.4. If γerT ≥ 1, then the optimal reinsurance retention
level is
u∗ (t) ≡ 1,
and the optimal value function is given by (12) where h solves the following
equation
h0 (T − t) = f1 (T − t),
where
1 b a
f1 (T − t) = −γµer(T −t) + σ 2 γ 2 e2r(T −t) + λ r(T −t)
− λ, (24)
2 b − γe
with boundary condition h(0) = 0.
Now we compute
λaba a+1
1
MY (γer(T −t) ũ(t)) = MY (b − )
β
b a
= a
1 .
λab
a+1
β
1
a+1
λaba
b− β
Further we notice that under the condition 0 < γ < 1, it always
holds that 0 < ũ(t) < 1, and this leads to the following theorem:
May 27, 2011 14:37 WSPC - Proceedings Trim Size: 9in x 6in 09-luo
226 S. Luo
1
a+1
λaba
b− β
Theorem 4.5. If 0 < γ < 1, then the optimal reinsurance
retention level is
1
λaba a+1
b− β
u∗ (t) = ũ(t) = ,
γer(T −t)
and the optimal value function is given by (12) and function h solves
h0 (T − t) = f2 (T − t),
where
1 λaba a+1
1
f2 (T − t) = − γ(µ − β)er(T −t) + σ 2 γ 2 e2r(T −t) − β(b − )
2 β
ba (25)
+λ a
a − λ,
λab
a+1
β
Under these conditions, the optimal policy always involves certain positive
level of reinsurance purchase that is never 0% or 100%.
ũ(T − t1 ) = 1.
Consequently, ũ(t) ≤ 1 and u∗ (t) = ũ(t) when 0 < t ≤ T − t1 ; ũ(t) > 1 and
u∗ (t) = 1 when T − t1 < t ≤ T . Now we come to the following theorem:
May 11, 2011 13:54 WSPC - Proceedings Trim Size: 9in x 6in 09-luo
1
a+1 1
λaba λaba a+1
b− β b− β
Theorem 4.6. If γ ≥1> γerT , then the optimal rein-
surance retention level is
(
1 if 0 ≤ T − t ≤ t1
u∗ (t) = , (27)
ũ(t) if t1 < T − t ≤ T
and the optimal value function is given by (12), where the function h solves
the following equation:
(
0 f1 (T − t) if 0 ≤ T − t ≤ t1
h (T − t) = ,
f2 (T − t) if t1 < T − t ≤ T
here f1 and f2 are defined by (24) and (25) respectively, and the function
above is continuous.
Under the paramerter condition in Theorem 4.6, the optimal strategy sug-
gests to buy less reinsurance gradually down to 0% to the final time.
The solution of the case with gamma claims is now complete.
228 S. Luo
1.1
Optimal Value Function
0.9
0.8
0.6
Value Function Without Reinsurance
0.5
0.4
T−t0
Acknowledgments
This research is supported by a UNI summer research fellowship.
References
1. Asmussen, S. and Taksar, M.: Controlled Diffusion Models for Optimal Div-
idend Payout, Insurance: Math. Econ. 20, 1–15 (1997)
May 11, 2011 13:54 WSPC - Proceedings Trim Size: 9in x 6in 09-luo
1.1
1.05
0.95
0.9
0.85
0.8
Optimal Value Function
0.75
Optimal Risk Exposure
0.7
0.65
T−t1
2. Browne, S.: Optimal Investment Policies for a Firm with a Random Risk
Process: Exponential Utility and Minimizing the Probaiblity of Ruin, Math.
Ope. Res 20(4), 937–958 (1995)
3. Browne, S.: Survival and Growth with Liability: Optimal Portfolio Strategies
in Continuous Time, Math. Ope. Res 22, 468–492 (1997)
4. Dufresne, F. and Gerber, H. U. Risk theory for a compound Poisson process
that is perturbed by diffusion. Insurance Math. Econom. 10 51–59 (1991)
5. Emanuel, D.C., Harrison J.M. and Taylor, A.J.: A Diffusion Approximation
for the Ruin Probability with Compounding Assets, Scan. Actuarial J. 37–45
(1975)
6. Gerber, H.U. and Yang, H.L.: Absolute Ruin Probabilities in a Jump Diffu-
sion Risk Model with Investment, North American Actuarial Journal 11(3),
159–169 (2007)
7. Höjgaard., B. and Taksar, M.: Optimal Proportional Reinsurance Policies
for Diffusion Models with Transaction Costs, Insurance Math. Econom. 22,
41–51 (1998)
8. Höjgaard., B. and Taksar, M.: Optimal Proportional Reinsurance Policies for
Diffusion Models, Scan. Actuarial J. 166–180 (1998)
May 11, 2011 13:54 WSPC - Proceedings Trim Size: 9in x 6in 09-luo
230 S. Luo
231
Jianguo Sun
Department of Statistics
University of Missouri, USA
Email: sunj@missouri.edu
The counting process and martingale have been the research topic in probabil-
ity for a long time and there exists a great deal of literature for both their stud-
ies and their applications. This article discusses their applications in survival
analysis, a field that plays an essential and fundamental role in biostatistics
and deals with experiments concerning times to events. In addition to being a
key component in most of medical and public health studies, survival analysis
is applied to many other fields including demographical studies, economics, re-
liability studies and social studies. Although survival analysis has existed for a
long time, the modern survival analysis really started about 30 years ago when
the counting process and martingale tools were applied for the advance of the
field (Aalen, 1975, 1980; Andersen et al., 1993).
1. Introduction
Survival analysis refers to the statistical field that deals with data con-
cerning positive random variables representing times to certain events
(Kalbfleisch and Prentice, 2002). Examples of the event, often referred to
as the failure or survival event, include death, the onset of a disease or
certain milestone, the failure of a mechanical component of a machine, or
learning something. The occurrence of the event is usually referred to as a
failure and often we also use the terminology failure time data analysis and
refer to the variable of interest as failure or survival time or variable. Fail-
ure time or survival data arise extensively in medical studies, but there are
many other investigations that also produce survival data. These include
biological studies, demographical studies, economic and financial studies,
epidemiological studies, psychological experiments, reliability experiments,
and sociological studies.
April 26, 2011 17:27 WSPC - Proceedings Trim Size: 9in x 6in 10-sun
232 J. Sun
6-MP 6, 6, 6, 6∗ , 7, 9∗ , 10, 10∗ , 11∗ , 13, 16, 17∗ , 19∗ , 20∗ , 22, 23, 25∗
32∗ , 32∗ , 34∗ , 35∗
Placebo 1, 1, 2, 2, 3, 4, 4, 5, 5, 8, 8, 8, 8, 11, 11, 12, 12, 15, 17, 22, 23
Survival analysis differs from other statistical fields due to many rea-
sons. One major reason, also the feature that distinguishes the analysis of
failure time data from other statistical problems, is the existence of cen-
soring such as right censoring that will be introduced below. Censoring
mechanisms can be quite complicated and thus necessitate special methods
of treatment. The methods available for other types of data are usually
simply not appropriate for censored data. Truncation is another feature of
some failure time data that requires special treatments. Because of censor-
ing and/or truncation, failure time data are always incomplete and the goal
of survival analysis is to develop statistical approaches that can handle such
incompleteness.
To give an example, Table 1 presents a typical set of failure time data,
which arose from a clinical trial on acute leukemia patients. The table
gives remission times in weeks for 42 patients in two treatment groups.
One treatment is the drug 6-mercaptopurine (6-MP) and the other is the
placebo treatment. The study was performed over a one-year period and
the patients were enrolled into the study at different times. In the table, the
starred numbers are right-censored remission times, meaning that the true
remission times were known only to be greater than these censored times.
This happened because these patients were still in the state of remission
at the end of the trial and the times observed are the amount of time
from when the patient entered the study to the end of the study. For other
patients, their remission times were observed exactly.
In survival analysis, it is common to use T to denote the nonnegative
random variable under study or the failure time of interest. For inference
about T , unlike other statistical fields, it is more common and convenient
to consider or model the so-called survival and hazard functions defined as
Z t
f (t) d log S(t)
λ(t) = =− , S(t) = exp − λ(s) ds = exp [ − Λ(t) ] ,
S(t) dt 0
Rt
where f (t) denotes the density function of T and Λ(t) = 0 λ(s) ds, usually
referred to as the cumulative hazard function.
A counting process, usually denoted by N (t), is a stochastic process
that can be thought of as registering the occurrences in time of certain
recurrent events. That is, N (t) is a step function jumping by one each
time when the event occurs. In survival analysis, more often one will face a
multivariate counting process, a vector of counting processes all being zero
at time zero with paths which are piecewise constant and nondecreasing,
having jumps of size one only with no two processes jumping simultaneously.
A martingale is also a stochastic process often regarded as a kind of pure
random noise process. Many stochastic processes can be written as the sum
of a martingale and a finite variation predictable stochastic process with
the latter called the compensator of the process. In the following, we will
show that many inference problems in survival analysis can be conveniently
formulated using the counting process and martingale and thus one can
apply the existing, rich theory about them to solve the problems much
easily.
The remainder of the paper is organized as follows. In Section 2, we will
consider regression analysis of right-censored failure time data using the
Cox or proportional hazards model. Section 3 discusses regression analysis
of current status failure time data using the additive hazards model. Current
status failure time data mean that the failure time of interest is observed
only to be either smaller or larger than a number, usually the observation
time. In this case, each study subject is observed only once and one area that
often produces such data is cross-sectional studies. In Section 4, regression
analysis of bivariate current status failure time data will be described under
the proportional hazards model. For all situations, the focus will be on
estimation of regression parameters. Section 5 contains some concluding
remarks.
April 26, 2011 17:27 WSPC - Proceedings Trim Size: 9in x 6in 10-sun
234 J. Sun
or to solve the partial score function U (β) = ∂ log L(β)/∂β = 0. This ap-
proach was originally proposed by Cox (1975) and has been studied by many
authors (Andersen et al., 1993; Kalbfleisch and Prentice, 2002) using the
formulation and theory of the counting process and martingale described
below. A key advantage of this partial likelihood approach is that L(β) is
independent of the baseline hazard function λ0 (t). In other words, one does
not have to deal with or estimate λ0 (t).
To express L(β) or U (β) using the counting process and martingale,
define
Nri (t) = I(Xi ≤ t, δi = 1)
and Yri (t) = I(Xi ≥ t), i = 1, ..., n. It is easy to see that Nri (t) is a counting
process jumping from 0 to 1 at t = Ti if the survival time Ti is observed
April 26, 2011 17:27 WSPC - Proceedings Trim Size: 9in x 6in 10-sun
instead of the censoring time Ci . Yri (t) is usually referred to as the indicator
process indicating if subject i is under study at time t. Also define
Z t
Mri (t) = Nri (t) − Yri (u) exp(Zi0 β)λ0 (u)du , i = 1, ..., n ,
0
n
Zij Yri (t) exp(Zj0 β) , j = 0, 1,
X
Sr(j) (β, t) =n −1
i=1
(1) (0)
and Er (β, t) = Sr (β, t)/Sr (β, t). Then {Mri (t)} are martingales and the
partial likelihood function can be rewritten as L(β) = L(β, ∞) with
n
" #∆Nri (u)
Y (u) exp(Zi0 β)
Pn ri
Y Y
L(β, t) = 0 .
i=1 0≤u≤t j=1 Yrj (u) exp(Zj β)
n Z
X t
= [Zi − Er (β, u)] dMri (u) . (2)
i=1 0
Let β̂r denote the solution to U (β, ∞) = 0. It is clear that the integrand
with respect to each Mri (t) is a predictable process and thus Ur (β, t) is the
sum of martingales. By applying the martingale theory and using expression
(2), one can show that β̂r is a consistent estimate of β in the proportional
hazards model (1). Furthermore, Ur (β, t) converges to a Gaussian process
and β̂r converges in distribution to a normal random vector. The details
can be found in Andersen and Gill (1982).
236 J. Sun
Table 2. Death times in days for 144 male RFM mice with lung tumors
CE With tumor 381, 477, 485, 515, 539, 563, 565, 582, 603, 616, 624, 650
651, 656, 659, 672, 679, 698, 702, 709, 723, 731, 775, 779
795, 811, 839
No tumor 45, 198, 215, 217, 257, 262, 266, 371, 431, 447, 454, 459
475, 479, 484, 500, 502, 503, 505, 508, 516, 531, 541, 553
556, 570, 572, 575, 577, 585, 588, 594, 600, 601, 608, 614
616, 632, 632, 638, 642, 642, 642, 644, 644, 647, 647, 653
659, 660, 662, 663, 667, 667, 673, 673, 677, 689, 693, 718
720, 721, 728, 760, 762, 773, 777, 815, 886
GE With tumor 546, 609, 692, 692, 710, 752, 773, 781, 782, 789, 808, 810
814, 842, 846, 851, 871, 873, 876, 888, 888, 890, 894, 896
911, 913, 914, 914, 916, 921, 921, 926, 936, 945, 1008
No tumor 412, 524, 647, 648, 695, 785, 814, 817, 851, 880, 913, 942
986
{ Ci , δi = I(Ti ≤ Ci ), Zi ; i = 1, ..., n } .
(Lin and Ying, 1994, 1995), where λ0 (t) and β are defined as in model (1).
It can be easily seen that in model (1), β represents the multiplicative effect
of covariates on the hazard function, while β in model (3) gives the additive
effect of covariates, which are often more interesting in fields such as social
studies.
To estimate β in model (3), define Yci (t) = I(Ci ≤ t) and the counting
process
for subject i, i = 1, ..., n. Then one can show that Nci (t) has the intensity
238 J. Sun
Then motivated by Ur (β, t) given in Section 2, one can construct the fol-
lowing estimating function
n Z t
" #
(1)
X Sc (β, u)
Uc (β, t) = tZi − (0) dNci (u)
i=1 0 Sc (β, u)
n Z
" #
t (1)
X Sc (β, u)
= tZi − (0)
dMci (u)
i=1 0 Sc (β, u)
and estimate β by the solution to Uc (β, ∞) = 0. Let β̂c denote the such
defined estimate. Then as β̂r , by applying the counting and martingale
theory, one can prove that β̂c is consistent and converges in distribution to
a normal random vector. The detailed derivation and proofs of the results
given above can be found in Lin et al. (1998).
δ1 = I(T1 ≤ C) , δ2 = I(T2 ≤ C) ,
(C, δ1 , δ2 , Z)
the full likelihood approach here. For this, we will assume that T1 and T2
follow the copula model specified by
Cα (u, v) = φα {φ−1 −1
α (u) + φα (v)} , 0 ≤ u , v ≤ 1 ,
S10 (θ, t) = P (T1 ≤ t, T2 > t), S00 (θ, t) = P (T1 > t, T2 > t) .
April 26, 2011 17:27 WSPC - Proceedings Trim Size: 9in x 6in 10-sun
240 J. Sun
(2)
ajm = −(−1)m exp(Z 0 β) Λ2 S2 [j + (−1)j Dv ] ,
(1) (2)
and Bjm = (ajm + ajm )−1 (−1)m+j Dα . Also for j, m = 0, 1, let ajm =
(1) (2)
(ajm , ajm )0 and define the matrix
Z Z
Zjm =
Bjm Bjm
and b∗ = H ∗ G−1 , where,
1 X
X 1
E a⊗2
G = jm Y λc /Sjm
j=0 m=0
and
1 X
X 1
E Zjm a⊗2
H = jm Y λc /Sjm .
j=0 m=0
Then one can show that the efficient score function for θ has the form
1 X 1 Z ∞
˙lθ∗ =
X (Zjm − b∗ ) ajm
dNjm (t) (5)
j=0 m=0 0
Sjm
April 26, 2011 17:27 WSPC - Proceedings Trim Size: 9in x 6in 10-sun
where Λ̂1 and Λ̂2 denote some consistent estimates of Λ1 (t) and Λ2 (t). As
in Sections 2 and 3, one can apply the counting process and martingale
theory to establish the asymptotic properties of the such defined estimate.
Wang et al. (2008) provided more details about the discussion above.
5. Concluding Remarks
In the preceding sections, we discussed regression analysis of failure time
data under three different censoring mechanisms and presented the counting
process and martingale connection to these problems. As it can be seen, for
all three situations, the estimation problems can be expressed using count-
ing processes and martingales and thus one could conveniently employ the
existing theory about them, especially various types of central limit results,
to investigate or establish the asymptotic properties of the resulting esti-
mates commonly expected and needed for inference. It is worth noting that
without the use of the connection to the counting process and martingale
and their theory, many of the asymptotic results could still be obtained
by different approaches but would be much more difficult and complicated.
In contrast, the application of the counting process and martingale makes
these results much easy and straightforward and more importantly, some
of the other results possible and available.
There are many other types of problems in survival analysis in addition
to regression analysis or the assessment of covariate effects and most of
these can be formulated and investigated using the counting process and
martingale. For example, consider the right-censored failure time data dis-
cussed in Section 2 and suppose that one is interested in estimation of the
overall survival function S(t), which is usually the first thing that one does
in analyzing failure time data. Suppose that there do not exist covariates
April 26, 2011 17:27 WSPC - Proceedings Trim Size: 9in x 6in 10-sun
242 J. Sun
As with estimation of regression parameters, one can easily apply the count-
ing process and martingale theory to investigate the statistical properties
of Ŝ(t) such as deriving the variance estimate. If there is no right censoring
or all δi = 1, then the Kaplan-Meier estimator reduces to one minus the
empirical distribution function.
As discussed above, the Cox or proportional hazards model (1) is the
most commonly used regression model in survival analysis and the additive
hazards model (3) is also a popular choice. There exist many other models
in survival analysis and the selection of an appropriate model for a given
problem usually depends on the nature and prior knowledge of the problem
but could be very difficult sometimes. Note that in both models (1) and
(3), we assumed that covariates are time-independent and actually one can
apply them even if the covariates are time-dependent. Furthermore, both
models assume the linear effects of covariates and one can easily generalize
them to include nonlinear covariate effects. In addition to these two models,
another popular semiparametric model, motivated by the common linear
regression model, is the accelerated failure time model given by
log T = Z 0 β +
(Jin et al., 2003), where denotes a random error with unknown distribution
function. Note that this model directly models the effects of covariates on
the failure time of interest instead of the hazard function as in models
(1) and (3). Sometimes one may be more interested in the direct effects
of covariates on survival function and in this case, one could apply the
proportional odds model given by
SZ (t) S0 (t)
= exp(Z 0 β)
1 − SZ (t) 1 − S0 (t)
(Yang and Prentice, 1999), where SZ (t) denotes the survival function for
a subject with covariates Z and S0 (t) is an unknown baseline survival
function.
April 26, 2011 17:27 WSPC - Proceedings Trim Size: 9in x 6in 10-sun
References
Aalen, O. O. (1975). Statistical inference for a family of counting processes.
Ph.D Thesis, University of California, Berkeley.
Aalen, O. O. (1980). A model for nonparametric regression analysis of
counting processes. Spring Lect. Notes Statist. 2, 1-25. Mathemat-
ical Statistics and Probability Theory. W. Klonecki, A. Kozek, and
J. Rosiński, editors.
Andersen, P. K., Borgan, O., Gill, R. D. and Keiding, N. (1993). Statistical
models based on counting processes. Springer-Verlag: New York.
Andersen, P. K. and Gill, R. D. (1982). Cox regression model for count-
ing processes: a large sample study. The Annals of Statistics, 10,
1100-1120.
Clayton, D. G. (1978). A model for association in bivariate life tables and
its application in epidemiological studies of familial tendency in
chronic disease incidence. Biometrika, 65, 141-151.
Cox, D. R. (1972). Regression analysis and life tables (with discussion). J.
R. Statist. Soc. B, 34, 187-220.
Cox, D. R. (1975). Partial likelihood. Biometrika, 62, 269-276.
Hoel, D. G. and Walburg, H. E. (1972). Statistical analysis of survival
experiments. Journal of National Cancer Institute, 49, 361-372.
Hougaard, P. (2000). Analysis of multivariate survival data. Springer-
Verlag: New York.
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244 J. Sun
Jin, Z., Lin, D. Y., Wei, L. J. and Ying, Z. (2003). Rank-based inference
for the accelerated failure time model. Biometrika, 90, 341-353.
Kalbfleisch, J. D., and Prentice, R. L. (2002). The statistical analysis of
failure time data. Second edition. Wiley: New York
Kaplan, E. L. and Meier, P. (1958). Nonparametric estimation from incom-
plete observations. Journal of the American Statistical Association,
53, 457-481.
Klein, J. P. and Moeschberger, M. L. (2003). Survival analysis, Springer-
Verlag: New York.
Lawless, J. F. (2003). Statistical models and methods for lifetime data.
John Wiley: New York.
Lin, D. Y., Oakes, D. and Ying, Z. (1998). Additive hazards regression
with current status data. Biometrika, 85, 289-298.
Lin, D. Y. and Ying, Z. (1994). Semiparametric analysis of the additive
risk model. Biometrika, 81, 61-71.
Lin, D. Y. and Ying, Z. (1995). Semiparametric analysis of general
additive-multiplicative hazard models for counting processes. The
Annals of Statistics, 23, 1712-1734.
Sun, J. (2006). The statistical analysis of interval-censored failure time
data. Springer.
Wang, L., Sun, J. and Tong, X. (2008). Efficient estimation for the propor-
tional hazards model with bivariate current status data. Lifetime
Data Analysis, accepted.
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portional odds regression model. Journal of the American Statisti-
cal Association, 94, 125-136.
April 27, 2011 14:8 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
245
Q. Zhang
Department of Mathematics
University of Georgia
Athens, GA 30602, USA
Email: qingz@math.uga.edu
C. Zhuang
Marshall School of Business
University of Southern California
Los Angeles, CA 90089, USA
Email: czhuang@usc.edu
G. Yin
Department of Mathematics
Wayne State University
Detroit, MI 48202, USA
Email: gyin@math.wayne.edu
1. Introduction
This work is concerned with developing a systematic numerical procedure
for trading a mean-reverting asset. The trading strategy consists of two
ingredients, buy and sell. One wishes to buy low and sell high. Nevertheless,
it is challenging to be able to correctly identify these low and high prices
April 27, 2011 9:40 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
tive. For example, contrarian and momentum strategies were studied in Ref.
4, Ref. 8, and Ref. 18–20. Not until recently was a rigorous mathematical
analysis on the buying side provided in Ref. 30, in which they considered
buying and selling for assets governed by mean-reverting processes. The ob-
jective is to buy and sell the underlying asset sequentially to maximize the
discounted reward function when the slippage cost is taken into account.
[Slippage cost usually refers to the difference between the estimated price
and the actual price paid.] In Ref. 30, the optimal buying and selling prices
were obtained using dynamic programming approach and the associated
HJB equations for the value functions. One makes a buy decision when the
market price hits the buying price and makes a sell decision when the mar-
ket price exceeds the selling price. In order to implement the strategy in
Ref. 30, one needs to know the values of parameters in the mean-reverting
processes in order to compute the optimal threshold values. In practice, it
is difficulty to determine those values. Taking this point into consideration,
in Ref. 26, a stochastic approximation algorithm was proposed to solve the
problem for buying and selling the asset once. Instead of solving two quasi-
algebraic equations, the problem is formulated as a stochastic optimization
procedure. The algorithm is model free and uses observed stock prices only.
In this paper, we further develop the algorithm that allows buying and
selling to take place a multiple number of times.
The essential feature of our approach is the use of stochastic approx-
imation methods (see Ref. 22 and Ref. 6 for up-to-date development of
stochastic approximation algorithms). The proposed stochastic approxima-
tion algorithm allows us to deal with general model free case and use only
observed stock prices to determine the optimal buying and selling prices.
Therefore the proposed method can be easily implemented in practice.
The rest of the paper is arranged as follows. Section 2 offers a precise
formulation of the problem and the description of algorithm. Section 3
proceeds with the convergence and rates of convergence of the proposed
algorithm. To demonstrate the feasibility and efficiency of the algorithm,
numerical experiments using simulations and real market data are given
in Section 4. We demonstrate that the proposed algorithms provide sound
estimated optimal threshold values; they can be easily implemented in real
time and provide guidelines for stock trading. Finally we conclude this paper
with some further remarks in Section 5. Since the main concerns in this
paper are to develop sound numerical algorithms, and since the theoretical
development has been setup in Ref. 26, the paper is concentrated on the
numerical aspects. The detailed proofs are omitted for brevity.
May 12, 2011 11:9 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
2. Problem Formulation
In Ref. 30, they assume that X(t) ∈ R is a mean-reverting process governed
by
dX(t) = a(b − X(t))dt + σdW (t), X(0) = x, (1)
where a > 0 is the rate of reversion, b is the equilibrium level, σ > 0 is the
volatility, and W (t) is a standard Brownian motion. Then the asset price
is given by
S(t) = exp(X(t)). (2)
In our formulation, we do not require asset price S(t) to be any specific
stochastic process or follow any specific distribution. We only assume that
asset price can be observed. Based on the observed stock price, two se-
quences of stopping times τ {bi } and τ {si } with
0 ≤ τ {b1 } ≤ τ {s1 } ≤ τ {b2 } ≤ τ {s2 } ≤ · · ·
are considered. One makes a buying decision at time τ {bi } and makes a
selling decision at time τ {si } , with i = 1, 2, .... Suppose that 0 < K < 1 is
the percentage of slippage per transaction and ρ > 0 is the discount factor.
We aim to find the optimal buying price and selling price that maximize a
suitable reward function. Thus the formulation is
Find argmax Φ(θ) = E[J(θ)],
1 2 0
θ = (θ , θ ) ∈ (0, ∞) × (0, ∞),
∞
Problem P : X (3)
J(θ) = [exp(−ρτ {si } )S(τ {si } )(1 − K)
i=1
− exp(−ρτ {bi } )S(τ {bi } )(1 + K)],
where
τ {b1 } = inf{t > 0, S(t) ≤ exp(θ1 )},
τ {bi } = inf{t > τ {si−1 } , S(t) ≤ exp(θ1 )}, for i ≥ 2,
τ {si } = inf{t > τ {bi } , S(t) ≥ exp(θ2 )}, for i ≥ 1.
Note that τ {bi } and τ {si } denote the stopping times for buying and sell-
ing respectively, θ1 and θ2 denote the buying and selling threshold values
respectively, and S(t) is the stock price at time t.
The analytic solution is obtained in Ref. 30 when S(t) is governed by
(2). However, the solution depends on the values of a and b in (1), which
are difficult to be determined in practice. Our contribution is to devise a
optimization procedure that estimates the optimal threshold value θ and
April 27, 2011 9:40 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
where eι is the standard unit vectors with e1 = (1, 0)0 and e2 = (0, 1)0 ,
ξn± are two different collective noises taken at threshold values θ ± δn eι ,
respectively, and δn is the finite difference sequence satisfying δn → 0 as
n → ∞. We write Yn± = Yn± (θ, ξn± ). For simplicity, henceforth, we often use
ξn to represent ξn+ and ξn− if there is no confusion. The gradient estimate
at iteration n is given by
def
b n , ξn ) = (Yn+ − Yn− )/(2δn ).
DΦ(θ (9)
θn+1 = θn + εn DΦ(θ
b n , ξn ), (10)
Note that θ0 (·) is a piecewise constant process and θn (·) is its shift. With
the above definition, the interpolated process hn (·) becomes
m(tn +t)−1 m(tn +t)−1
n
X X λj
θ (t) = θn + εj Φθ (θj ) + εj
j=n j=n
2δj
m(tn +t)−1 m(tn +t)−1
(2)
X X εj
+ ε j βj + ηj (θj , ξj ).
j=n j=n
2δj
where
n+N n −1
1 X εj
ein =
γ En+i [ηj (θn+i+1 , ξj ) − ηj (θn+i , ξj )], i ≤
εn+i j=n+i
2δj
Nn − 1.
Remark 3.1. Our default choice of step size and finite difference sequences
is εn = O(1/n) and δn = O(1/n1/6 ), it follows that the sequences {εn } and
{δn } satisfy 0 < εn → 0, n εn = ∞, 0 < δn → 0, and εn /δn2 → 0 as
P
n → ∞. Moreover,
εn+i δn+i
lim sup sup < ∞, lim sup < ∞,
n 0≤i≤Nn −1 εn n δn
2
(εn+i /δn+i
)
lim sup < ∞.
n (εn /δn2 )
For simplicity, we use a mixing condition. Assume that ξn± = g0 (ζn± )
±
where g0 (·) is a real-valued function, {ζn,` } are homogeneous finite-state
April 27, 2011 9:40 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
Theorem 3.2. Assume that (A1)–(A2) and that {θn } is tight in R2 . Then
θn (·) converges weakly to θ(·), the solution to the differential equation
θ̇ = Φθ (θ), (4)
Corollary 3.3. Suppose that (4) has a unique stationary point θ∗ that is
globally asymptotically stable in the sense of Liapunov, and that {sn } is a
sequence of real numbers such that sn → ∞. Then θn (sn + ·) converges
weakly to θ∗ as n → ∞.
Theorem 3.6. Assume that (A3) holds. Then un (·) converges weakly to a
diffusion process u(·) that is a solution of the stochastic differential equation
Remark 3.7. To easily handle real market data, we do not take a sample
b ξ ± ) = Φ(θ,
average as in (6). Instead of that, we set n0 = 1 and use Φ(θ, e ξ± )
n n
without using sample averages. The resulting estimate is not expected to
be a smooth and the bias will be larger. Nevertheless, it does provide us a
reasonable estimate.
Define Yn± as in (8) and use algorithm (10). Since conditions concerning
b ξn ), we
the noise given in Sections 3 and 4 all refer to the function Φ(θ,
obtain the convergence and rate of convergence of the algorithm just as in
the previous sections. We summarize the above as the following proposition.
4. Numerical Demonstration
In this section, we report our simulation results and numerical experiments.
We first use Monte Carlo simulation and compare our algorithm with the
analytic solution obtained in Ref. 30. Then we test our algorithm using real
market data.
and the stock price is given by S(t) = exp(X(t)). First, we take a = 0.8,
b = 2, σ = 0.5, x = 0, let the slippage rate K = 0.01, and the discount
rate ρ = 0.5. In this case, the analytic solution in Ref. 30 gives (θ∗1 , θ∗2 ) =
(1.331, 1.631).
We let n0 = 5000, where n0 is the number of random samples used in
each iteration; see (6). Then we use (1) to simulate the stock prices and
the recursive algorithm (10) is applied for 200 iterations. The sequence
of ξn and δn are chosen to be ξn = 1/(n + k0 ) and δn = 1/(n1/6 + k1 ),
respectively, where k0 and k1 are some positive constants. The proposed
algorithm yields the optimal
p estimation of (θ1 , θ2 ) = (1.3225, 1.6292). The
1 1 2 2 2 2
p = (θ − θ∗ ) + (θ − θ∗ ) = 0.0087, and the relative
(absoulate) error
1 2 2 2
error = error/ (θ∗ ) + (θ∗ ) = 0.0041.
April 27, 2011 9:40 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
In Table 3, we vary the volatility σ. The larger the σ, the greater the
range for the stock price St = exp(Xt ). To avoid closing positions due
to normal price fluctuations, one needs to increase the values of (θ1 , θ2 ).
Consistent with this, Table 3 shows the values (θ1 , θ2 ) increase in σ.
In Table 4, we vary the discount rate ρ. A larger discount rate ρ implies
smaller return and smaller threshold values (θ1 , θ2 ). These are confirmed in
Table 4.
April 27, 2011 9:40 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
It is clear to see from the above tables that the stochastic approxima-
tion constructed in this paper indeed provide sound estimates of optimal
threshold values (θ1 , θ2 )0 . The average error is 0.0440 and the average rel-
ative error is only 0.0220, or 2.20%.
April 27, 2011 9:40 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
In the above procedure, if a stock is bought in any period but the stock
price doesn’t exceed the selling price after buying, we will sell stock at
the end of the period regardless of selling price. Now we choose different
stocks to conduct above experiment. For example, Figure 1 is the graph of
historical prices of Wal-Mart Stores Inc. during the period January 2, 2002
to December 31, 2007.
Fig. 1. The Prices of Wal-Mart from Jan 2, 2002 to Dec 31, 2007
We apply the same procedure to Home Depot’s stock, see Figure 2 for
the daily stock price during the period January 2, 2002 to December 31,
2007.
Based on the prices of Home Depot in Period 1, after 600 iteration of
(10), the calculated buying price is $34.0484 and selling price is $38.9126.
Using the threshold values above, we trade Home Depot in Period 2. We
first buy it at $33.29 on Sep 2, 2004 and sell it at $39.45 on Nov 10, 2004.
We buy it again at $33.96 on May 10, 2005. However, before the ending
of Period 2, the price doesn’t raise above the selling price $38.9126 again.
Thus we have to sell it at the end of Period 2 for $32.77. The total dollar
return in Period 2 is $3.5753. Using the prices in Period 2, the computed
selling price is $32.7166 and $38.7353. Therefore, in Period 3, we buy it at
$32.61 on Dec 27, 2005 and sell it at $39.87 on Aug 9, 2007, resulting a
total profit of $6.5352.
The same procedure are also applied to other stocks. The detail trading
results are shown in Table 6. As can be seen, using the threshold values
computed by the proposed algorithm does not necessarily trigger transac-
tions in every period. However, overall speaking, the proposed algorithm in
this paper may provide trading guidelines in practice.
April 27, 2011 9:40 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
Fig. 2. The Prices of Home Depot from Jan 2, 2002 to Dec 31, 2007
5. Further Remarks
A stochastic approximation algorithm has been developed for buying low
and selling high strategy in stock trading. Compared with the analytic so-
lution, the simulation results indicate that this algorithm provides sound
estimates for optimal buying and selling prices. One advantage of the pro-
posed method is its simple recursive form. In addition, this method only
April 27, 2011 9:40 WSPC - Proceedings Trim Size: 9in x 6in 11-zhang
requires the observed stock prices. Thus this method can be easily im-
plemented in practice. As demonstrated by using real market data, the
proposed algorithm can provide useful guidelines for stock tradings.
A note of caution is in order. The approximation only works for stocks
under mean reversion. If the stock prices do not revert to an equilibrium
level, then the threshold values provided by the proposed algorithm may
make no sense in practice. Thus, before using the stochastic approxima-
tion methods, one needs to check if the mean reversion occurs in stock
prices. Finally, we note that developing a rigorous procedure to identify
mean-reverting assets is a challenge problem and maybe added to current
literatures.
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