Explicit Option Pricing Formula

for a Mean-Reverting Asset in

Energy Markets
Anatoliy Swishchuk
Mathematical & Computational
Finance Lab
Dept of Math & Stat, University
of Calgary, Calgary, AB, Canada
QMF 2007 Conference
Sydney, Australia
December 12-15, 2007

This research is supported by MITACS and NSERC

 Outline
• Mean-Reverting Models (MRM): Deterministic
vs. Stochastic
• MRM in Finance Markets: Variances or
Volatilities (Not Asset Prices)
• MRM in Energy Markets: Asset Prices
• Change of Time Method (CTM)
• Mean-Reverting Model (MRM)
• Option Pricing Formula
• Drawback of One-Factor Models
• Future Work
 Motivations for the Work
• Paper: Javaheri, Wilmott and Haug (2002)
”GARCH and Volatility Swaps”, Wilmott
Magazine, Jan Issue (they applied PDE
approach to find a volatility swap for MRM and
asked about the possible option pricing formula
• Paper: Bos, Ware and Pavlov (2002) “On a
Semi-Spectral Method for Pricing an Option on a
Mean-Reverting Asset”, Quantit. Finance J.
(PDE approach, semi-spectral method to
calculate numerically the solution)
 Wilmott, Javaheri & Haug (2002)
Model
• Wilmott, Javaheri & Haug (GARCH and
Volatility Swaps, Wilmott Magazine, 2002)-
volatility swap for

-continuous-time GARCH(1,1) model

 M. Yor’s Results
• M. Yor On some exponential functions of
Brownian motion, Adv. In Applied Probab., v. 24,
No. 3, (1992), 509-531-started the research for
the integral of an exponential Brownian motion
• H. Matsumoto, M. Yor Exponential Functionals
of Brownian motion, I: Probability laws at fixed
time, Probability Surveys, v. 2 (2005), 312-347-
there is still no closed form probability density
function, while the best result is a function with a
double integral.
 Mean-Reversion Effect
• Guitar String Analogy: if we pluck the guitar
string, the string will revert to its place of
equilibrium
• To measure how quickly this reversion back to
the equilibrium location would happen we had to
pluck the string
• Similarly, the only way to measure mean
reversion is when the variances of asset prices
in financial markets and asset prices in energy
markets get plucked away from their non-event
levels and we observe them go back to more or
less the levels they started from
The Mean-Reverting Deterministic
Process
Mean-Reverting Plot (a=4.6,L=2.5)
 Meaning of Mean-Reverting Parameter
• The greater the mean-reverting parameter
value, a, the greater is the pull back to the
equilibrium level
• For a daily variable change, the change in time,
dt, in annualized terms is given by 1/365
• If a=365, the mean reversion would act so
quickly as to bring the variable back to its
equilibrium within a single day
• The value of 365/a gives us an idea of how
quickly the variable takes to get back to the
equilibrium-in days
Mean-Reverting Stochastic Process
Mean-Reverting Models in Financial
Markets
• Stock (asset) Prices follow
geometric Brownian motion
• The Variance of Stock Price
follows Mean-Reverting Models
• Example: Heston Model
 Mean-Reverting Models in
Energy Markets

• Asset Prices follow Mean-Reverting

Stochastic Processes
• Example: Continuous-Time GARCH
Model (or Pilipovic One-Factor Model)
Mean-Reverting Models in Energy
Markets
Change of Time: Definition and Examples
• Change of Time-change time from t to a non-
negative process T(t) with non-decreasing sample
paths
• Example1 (Subordinator): X(t) and T(t)>0 are
some processes, then X(T(t)) is subordinated to
X(t); T(t) is change of time
• Example 2 (Time-Changed Brownian Motion):
M(t)=B(T(t)), B(t)-Brownian motion
• Example 3 (Product Process):
 Time-Changed Brownian Motion by
Bochner
• Bochner (1949) (‘Diffusion Equation and
Stochastic Process’, Proc. N.A.S. USA, v.
35)-introduced the notion of change of
time (CT) (time-changed Brownian motion)
• Bochner (1955) (‘Harmonic Analysis and
the Theory of Probability’, UCLA Press,
176)-further development of CT
Change of Time: First Intro into Financial
Economics
• Clark (1973) (‘A • He wrote down a model
‘Subordinated Stochastic for the log-price M as
Process Model with Fixed
Variance for Speculative M(t)=B(T(t)),
Prices’, Econometrica,
41, 135-156)-introduced
Bochner’s (1949) time- • where B(t) is Brownian
changed Brownian motion, T(t) is time-
motion into financial change (B and T are
economics: independent)
 Change of Time: Short History. I.

• Feller (1966) (‘An Introduction to Probability

Theory’, vol. II, NY: Wiley)-introduced subordinated
processes X(T(t)) with Markov process X(t) and T(t) as a
process with independent increments (i.e., Poisson
process); T(t) was called randomized operational time
• Johnson (1979) (‘Option Pricing When the
Variance Rate is Changing’, working paper, UCLA)-
introduced time-changed SVM in continuous time
• Johnson & Shanno (1987) (‘Option Pricing
When the Variance is Changing’, J. of Finan. & Quantit.
Analysis, 22, 143-151)-studied the pricing of options
using time-changing SVM
 Change of Time: Short History. II.

• Ikeda & Watanabe (1981) (‘SDEs and Diffusion

Processes’, North-Holland Publ. Co)-introduced and
studied CTM for the solution of SDEs
• Barndorff-Nielsen, Nicolato & Shephard (2003)
(‘Some recent development in stochastic volatility
modelling’)-review and put in context some of their
recent work on stochastic volatility (SV) modelling,
including the relationship between subordination and SV
(random time-chronometer)
• Carr, Geman, Madan & Yor (2003) (‘SV for Levy
Processes’, mathematical Finance, vol.13)-used
subordinated processes to construct SV for Levy
Processes (T(t)-business time)
 CT and Embedding Problem
• Embedding Problem was first terated by Skorokhod
(1965)-sum of any sequence of i.r.v. with mean zero and
finite variation could be embedded in Brownian motion
(BM) using stopping time
• Dambis (1965) and Dubis and Schwartz (1965)-every
continuous martingale could be time-changed BM
• Huff (1969)-every processes of pathwise bounded
variation could be embedded in BM
• Monroe (1972)-every right continuous martingale could
be embedded in a BM
• Monroe (1978)-local martingale can be embedded in BM
 Change of Time:
Simplest (Martingale) Case
 Change of Time:
Ito Integral’s Case
Change of Time: SDE’s Case
Geometric Brownian Motion SVM
Change of Time Method
Connection between phi_t and phi_t^(-1)
Solution for GBM Equation
Using Change of Time
Explicit Expression for
Mean-Reverting SV Model
Solution of MRM by CTM
Explicit Expression for
Explicit Expression for
Comparison: Solution of GBM & MRM

-GBM

-MRM
Explicit Expression for S(t)

where
Properties of
Properties of
Properties of eta(t)
Properties of Eta(t). II.
Mean Value of MRM S(t)
Dependence of ES(t) on T
Dependence of ES(t) on S_0 and T
Variance for S(t)
Dependence of Variance of S(t) on S_0 and T
Dependence of Volatility of S(t) on S_0 and T
European Call Option for MRM.I.
European Call Option. II.
Expression for C_T in the case of
MRM

C_T=BS(T)+A(T)
Expression for C_T=BS(T)+A(T).II.
Expression for BS(T)
Expression for y_0 for MRM
Expression for A(T).I.
Moment generating) function of
Eta(T)
Expression for A(T)
European Call Option for MRM
(Explicit Formula)
European Call Option for MRM in Risk-Neutral
World
Dependence of C_T on T
 Comparison of Three
Solutions
• Heston Model
• Mean-Reverting Model
• Black-Scholes Model
Comparison: Heston Model
(1993)
Explicit Solution for CIR Process: CTM
Comparison: Solutions to the Three
Models

-GBM

-MRM

-Heston model
 Summary
GBM Model
1.
-martingale

Mean-Reverting Model
2.

-sum of two martingales

Heston Model
3.

-martingale
 Problem

-explicit expression ?
To calculate an option price for Heston model, for example

We know all the moments at this moment,

though
 Drawback of One-Factor Mean-
Reverting Models
• The long-term mean L remains fixed over time:
needs to be recalibrated on a continuous basis
in order to ensure that the resulting curves are
marked to market
• The biggest drawback is in option pricing: results
in a model-implied volatility term structure that
has the volatilities going to zero as expiration
time increases (spot volatilities have to be
increased to non-intuitive levels so that the long
term options do not lose all the volatility value-as
in the marketplace they certainly do not)
 Future Work
• Change of Time
Method for Two-
Factor
Continuous-Time
GARCH Model
 The End

Thank You for Your

Attention and Time!

aswish@ucalgary.ca
http://wwww.math.ucalgary.ca/~aswish/