# Lévy Process as Combination of a Brownian Motion with Drift and Infinite Sum of Independent Compound Poisson Processes: Introduction to Martingales. Part 4.

Every piecewise constant Lévy process Xt0 can be represented in the form for some Poisson random measure with intensity measure of the form ν(dx)dt where ν is a finite measure, defined by

ν(A) = E[#{t ∈ [0,1] : ∆Xt0 ≠ 0, ∆Xt0 ∈ A}], A ∈ B(Rd) —– (1)

Given a Brownian motion with drift γt + Wt, independent from X0, the sum Xt = Xt0 + γt + Wt defines another Lévy process, which can be decomposed as:

Xt = γt + Wt + ∑s∈[0,t] ΔXs = γt + Wt + ∫[0,t]xRd xJX (ds x dx) —– (2)

where JX is a Poisson random measure on [0,∞[×Rd with intensity ν(dx)dt.

Can every Lévy process be represented in this form? Given a Lévy process Xt, we can still define its Lévy measure ν as above. ν(A) is still finite for any compact set A such that 0 ∉ A: if this were not true, the process would have an infinite number of jumps of finite size on [0, T], which contradicts the cadlag property. So ν defines a Radon measure on Rd \ {0}. But ν is not necessarily a finite measure: the above restriction still allows it to blow up at zero and X may have an infinite number of small jumps on [0, T]. In this case the sum of the jumps becomes an infinite series and its convergence imposes some conditions on the measure ν, under which we obtain a decomposition of X.

Let (Xt)t≥0 be a Lévy process on Rd and ν its Lévy measure.

ν is a Radon measure on Rd \ {0} and verifies:

|x|≤1 |x|2 v(dx) < ∞

The jump measure of X, denoted by JX, is a Poisson random measure on [0,∞[×Rd with intensity measure ν(dx)dt.

∃ a vector γ and a d-dimensional Brownian motion (Bt)t≥0 with covariance matrix A such that

Xt = γt + Bt + Xtl + limε↓0 X’εt —– (3)

where

Xtl = ∫|x|≥1,s∈[0,t] xJX (ds x dx)

X’εt = ∫ε≤|x|<1,s∈[0,t] x{JX (ds x dx) – ν(dx)ds}

≡ ∫ε≤|x|<1,s∈[0,t] xJ’X (ds x dx)

The terms in (3) are independent and the convergence in the last term is almost sure and uniform in t on [0,T].

The Lévy-Itô decomposition entails that for every Lévy process ∃ a vector γ, a positive definite matrix A and a positive measure ν that uniquely determine its distribution. The triplet (A,ν,γ) is called characteristic tripletor Lévy triplet of the process Xt. γt + Bt is a continuous Gaussian Lévy process and every Gaussian Lévy process is continuous and can be written in this form and can be described by two parameters: the drift γ and the covariance matrix of Brownian motion, denoted by A. The other two terms are discontinuous processes incorporating the jumps of Xt and are described by the Lévy measure ν. The condition ∫|y|≥1 ν(dy) < ∞ means that X has a finite number of jumps with absolute value larger than 1. So the sum

Xtl = ∑|∆Xs|≥10≤s≤t ∆Xs

contains almost surely a finite number of terms and Xtl is a compound Poisson process. There is nothing special about the threshold ∆X = 1: for any ε > 0, the sum of jumps with amplitude between ε and 1:

Xεt = ∑1>|∆Xs|≥ε0≤s≤t ∆Xs = ∫ε≤|x|≤1,s∈[0,t] xJX(ds x dx) —– (4)

is again a well-defined compound Poisson process. However, contrarily to the compound Poisson case, ν can have a singularity at zero: there can be infinitely many small jumps and their sum does not necessarily converge. This prevents us from making ε go to 0 directly in (4). In order to obtain convergence we have to center the remainder term, i.e., replace the jump integral by its compensated version,

X’εt = ∫ε≤|x|≤1,s∈[0,t] xJ’X (ds x dx) —– (5)

which, is a martingale. While Xε can be interpreted as an infinite superposition of independent Poisson processes, X’εshould be seen as an infinite superposition of independent compensated, i.e., centered Poisson processes to which a central-limit type argument can be applied to show convergence. An important implication of the Lévy-Itô decomposition is that every Lévy process is a combination of a Brownian motion with drift and a possibly infinite sum of independent compound Poisson processes. This also means that every Lévy process can be approximated with arbitrary precision by a jump-diffusion process, that is by the sum of Brownian motion with drift and a compound Poisson process.

# Derivative Pricing Theory: Call, Put Options and “Black, Scholes'” Hedged Portfolio.Thought of the Day 152.0

Fischer Black and Myron Scholes revolutionized the pricing theory of options by showing how to hedge continuously the exposure on the short position of an option. Consider the writer of a call option on a risky asset. S/he is exposed to the risk of unlimited liability if the asset price rises above the strike price. To protect the writer’s short position in the call option, s/he should consider purchasing a certain amount of the underlying asset so that the loss in the short position in the call option is offset by the long position in the asset. In this way, the writer is adopting the hedging procedure. A hedged position combines an option with its underlying asset so as to achieve the goal that either the asset compensates the option against loss or otherwise. By adjusting the proportion of the underlying asset and option continuously in a portfolio, Black and Scholes demonstrated that investors can create a riskless hedging portfolio where the risk exposure associated with the stochastic asset price is eliminated. In an efficient market with no riskless arbitrage opportunity, a riskless portfolio must earn an expected rate of return equal to the riskless interest rate.

Black and Scholes made the following assumptions on the financial market.

1. Trading takes place continuously in time.
2. The riskless interest rate r is known and constant over time.
3. The asset pays no dividend.
4. There are no transaction costs in buying or selling the asset or the option, and no taxes.
5. The assets are perfectly divisible.
6. There are no penalties to short selling and the full use of proceeds is permitted.
7. There are no riskless arbitrage opportunities.

The stochastic process of the asset price St is assumed to follow the geometric Brownian motion

dSt/St = μ dt + σ dZt —– (1)

where μ is the expected rate of return, σ is the volatility and Zt is the standard Brownian process. Both μ and σ are assumed to be constant. Consider a portfolio that involves short selling of one unit of a call option and long holding of Δt units of the underlying asset. The portfolio value Π (St, t) at time t is given by

Π = −c + Δt St —– (2)

where c = c(St, t) denotes the call price. Note that Δt changes with time t, reflecting the dynamic nature of hedging. Since c is a stochastic function of St, we apply the Ito lemma to compute its differential as follows:

dc = ∂c/∂t dt + ∂c/∂St dSt + σ2/2 St2 ∂2c/∂St2 dt

such that

-dc + Δt dS= (-∂c/∂t – σ2/2 St2 ∂2c/∂St2)dt + (Δ– ∂c/∂St)dSt

= [-∂c/∂t – σ2/2 St2 ∂2c/∂St+ (Δ– ∂c/∂St)μSt]dt + (Δ– ∂c/∂St)σSdZt

The cumulative financial gain on the portfolio at time t is given by

G(Π (St, t )) = ∫0t -dc + ∫0t Δu dSu

= ∫0t [-∂c/∂u – σ2/2 Su22c/∂Su2 + (Δ– ∂c/∂Su)μSu]du + ∫0t (Δ– ∂c/∂Su)σSdZ—– (3)

The stochastic component of the portfolio gain stems from the last term, ∫0t (Δ– ∂c/∂Su)σSdZu. Suppose we adopt the dynamic hedging strategy by choosing Δu = ∂c/∂Su at all times u < t, then the financial gain becomes deterministic at all times. By virtue of no arbitrage, the financial gain should be the same as the gain from investing on the risk free asset with dynamic position whose value equals -c + Su∂c/∂Su. The deterministic gain from this dynamic position of riskless asset is given by

Mt = ∫0tr(-c + Su∂c/∂Su)du —– (4)

By equating these two deterministic gains, G(Π (St, t)) and Mt, we have

-∂c/∂u – σ2/2 Su22c/∂Su2 = r(-c + Su∂c/∂Su), 0 < u < t

which is satisfied for any asset price S if c(S, t) satisfies the equation

∂c/∂t + σ2/2 S22c/∂S+ rS∂c/∂S – rc = 0 —– (5)

This parabolic partial differential equation is called the Black–Scholes equation. Strangely, the parameter μ, which is the expected rate of return of the asset, does not appear in the equation.

To complete the formulation of the option pricing model, let’s prescribe the auxiliary condition. The terminal payoff at time T of the call with strike price X is translated into the following terminal condition:

c(S, T ) = max(S − X, 0) —– (6)

for the differential equation.

Since both the equation and the auxiliary condition do not contain ρ, one concludes that the call price does not depend on the actual expected rate of return of the asset price. The option pricing model involves five parameters: S, T, X, r and σ. Except for the volatility σ, all others are directly observable parameters. The independence of the pricing model on μ is related to the concept of risk neutrality. In a risk neutral world, investors do not demand extra returns above the riskless interest rate for bearing risks. This is in contrast to usual risk averse investors who would demand extra returns above r for risks borne in their investment portfolios. Apparently, the option is priced as if the rates of return on the underlying asset and the option are both equal to the riskless interest rate. This risk neutral valuation approach is viable if the risks from holding the underlying asset and option are hedgeable.

The governing equation for a put option can be derived similarly and the same Black–Scholes equation is obtained. Let V (S, t) denote the price of a derivative security with dependence on S and t, it can be shown that V is governed by

∂V/∂t + σ2/2 S22V/∂S+ rS∂V/∂S – rV = 0 —– (7)

The price of a particular derivative security is obtained by solving the Black–Scholes equation subject to an appropriate set of auxiliary conditions that model the corresponding contractual specifications in the derivative security.

The original derivation of the governing partial differential equation by Black and Scholes focuses on the financial notion of riskless hedging but misses the precise analysis of the dynamic change in the value of the hedged portfolio. The inconsistencies in their derivation stem from the assumption of keeping the number of units of the underlying asset in the hedged portfolio to be instantaneously constant. They take the differential change of portfolio value Π to be

dΠ =−dc + Δt dSt,

which misses the effect arising from the differential change in Δt. The ability to construct a perfectly hedged portfolio relies on the assumption of continuous trading and continuous asset price path. It has been commonly agreed that the assumed Geometric Brownian process of the asset price may not truly reflect the actual behavior of the asset price process. The asset price may exhibit jumps upon the arrival of a sudden news in the financial market. The interest rate is widely recognized to be fluctuating over time in an irregular manner rather than being constant. For an option on a risky asset, the interest rate appears only in the discount factor so that the assumption of constant/deterministic interest rate is quite acceptable for a short-lived option. The Black–Scholes pricing approach assumes continuous hedging at all times. In the real world of trading with transaction costs, this would lead to infinite transaction costs in the hedging procedure.

# Optimal Hedging…..

Risk management is important in the practices of financial institutions and other corporations. Derivatives are popular instruments to hedge exposures due to currency, interest rate and other market risks. An important step of risk management is to use these derivatives in an optimal way. The most popular derivatives are forwards, options and swaps. They are basic blocks for all sorts of other more complicated derivatives, and should be used prudently. Several parameters need to be determined in the processes of risk management, and it is necessary to investigate the influence of these parameters on the aims of the hedging policies and the possibility of achieving these goals.

The problem of determining the optimal strike price and optimal hedging ratio is considered, where a put option is used to hedge market risk under a constraint of budget. The chosen option is supposed to finish in-the-money at maturity in the, such that the predicted loss of the hedged portfolio is different from the realized loss. The aim of hedging is to minimize the potential loss of investment under a specified level of confidence. In other words, the optimal hedging strategy is to minimize the Value-at-Risk (VaR) under a specified level of risk.

A stock is supposed to be bought at time zero with price S0, and to be sold at time T with uncertain price ST. In order to hedge the market risk of the stock, the company decides to choose one of the available put options written on the same stock with maturity at time τ, where τ is prior and close to T, and the n available put options are specified by their strike prices Ki (i = 1, 2,··· , n). As the prices of different put options are also different, the company needs to determine an optimal hedge ratio h (0 ≤ h ≤ 1) with respect to the chosen strike price. The cost of hedging should be less than or equal to the predetermined hedging budget C. In other words, the company needs to determine the optimal strike price and hedging ratio under the constraint of hedging budget.

Suppose the market price of the stock is S0 at time zero, the hedge ratio is h, the price of the put option is P0, and the riskless interest rate is r. At time T, the time value of the hedging portfolio is

S0erT + hP0erT —– (1)

and the market price of the portfolio is

ST + h(K − Sτ)+ er(T−τ) —– (2)

therefore the loss of the portfolio is

L = (S0erT + hP0erT) − (ST +h(K−Sτ)+ er(T−τ)) —– (3)

where x+ = max(x, 0), which is the payoff function of put option at maturity.

For a given threshold v, the probability that the amount of loss exceeds v is denoted as

α = Prob{L ≥ v} —– (4)

in other words, v is the Value-at-Risk (VaR) at α percentage level. There are several alternative measures of risk, such as CVaR (Conditional Value-at-Risk), ESF (Expected Shortfall), CTE (Conditional Tail Expectation), and other coherent risk measures. The criterion of optimality is to minimize the VaR of the hedging strategy.

The mathematical model of stock price is chosen to be a geometric Brownian motion, i.e.

dSt/St = μdt + σdBt —– (5)

where St is the stock price at time t (0 < t ≤ T), μ and σ are the drift and the volatility of stock price, and Bt is a standard Brownian motion. The solution of the stochastic differential equation is

St = S0 eσBt + (μ−1/2σ2)t —– (6)

where B0 = 0, and St is lognormally distributed.

Proposition:

For a given threshold of loss v, the probability that the loss exceeds v is

Prob {L ≥ v} = E [I{X ≤ c1} FY (g(X) − X)] + E [I{X ≥ c1} FY (c2 − X)] —– (7)

where E[X] is the expectation of random variable X. I{X < c} is the index function of X such that I{X < c} = 1 when {X < c} is true, otherwise I{X < c} = 0. FY (y) is the cumulative distribution function of random variable Y , and

c1 = 1/σ [ln(K/S0) − (μ−1/2σ2)τ] ,

g(X) = 1/σ [(ln (S0 + hP0)erT − h (K − f(X)) er(T−τ) −v)/S0 − (μ − 1/2σ2) T],

f(X) = S0 eσX + (μ−1/2σ2)τ,

c2 = 1/σ [(ln (S0 + hP0) erT − v)/S0 − (μ− 1/2σ2) T

X and Y are both normally distributed, where X ∼ N(0,√τ), Y ∼ N(0,√(T−τ).

For a specified hedging strategy, Q(v) = Prob {L ≥ v} is a decreasing function of v. The VaR under α level can be obtained from equation

Q(v) = α —– (8)

The expectations in Proposition can be calculated with Monte Carlo simulation methods, and the optimal hedging strategy which has the smallest VaR can be obtained from equation (8) by numerical searching methods….

# High Frequency Markets and Leverage

Leverage effect is a well-known stylized fact of financial data. It refers to the negative correlation between price returns and volatility increments: when the price of an asset is increasing, its volatility drops, while when it decreases, the volatility tends to become larger. The name “leverage” comes from the following interpretation of this phenomenon: When an asset price declines, the associated company becomes automatically more leveraged since the ratio of its debt with respect to the equity value becomes larger. Hence the risk of the asset, namely its volatility, should become more important. Another economic interpretation of the leverage effect, inverting causality, is that the forecast of an increase of the volatility should be compensated by a higher rate of return, which can only be obtained through a decrease in the asset value.

Some statistical methods enabling us to use high frequency data have been built to measure volatility. In financial engineering, it has become clear in the late eighties that it is necessary to introduce leverage effect in derivatives pricing frameworks in order to accurately reproduce the behavior of the implied volatility surface. This led to the rise of famous stochastic volatility models, where the Brownian motion driving the volatility is (negatively) correlated with that driving the price for stochastic volatility models.

Traditional explanations for leverage effect are based on “macroscopic” arguments from financial economics. Could microscopic interactions between agents naturally lead to leverage effect at larger time scales? We would like to know whether part of the foundations for leverage effect could be microstructural. To do so, our idea is to consider a very simple agent-based model, encoding well-documented and understood behaviors of market participants at the microscopic scale. Then we aim at showing that in the long run, this model leads to a price dynamic exhibiting leverage effect. This would demonstrate that typical strategies of market participants at the high frequency level naturally induce leverage effect.

One could argue that transactions take place at the finest frequencies and prices are revealed through order book type mechanisms. Therefore, it is an obvious fact that leverage effect arises from high frequency properties. However, under certain market conditions, typical high frequency behaviors, having probably no connection with the financial economics concepts, may give rise to some leverage effect at the low frequency scales. It is important to emphasize that leverage effect should be fully explained by high frequency features.

Another important stylized fact of financial data is the rough nature of the volatility process. Indeed, for a very wide range of assets, historical volatility time-series exhibit a behavior which is much rougher than that of a Brownian motion. More precisely, the dynamics of the log-volatility are typically very well modeled by a fractional Brownian motion with Hurst parameter around 0.1, that is a process with Hölder regularity of order 0.1. Furthermore, using a fractional Brownian motion with small Hurst index also enables to reproduce very accurately the features of the volatility surface.

The fact that for basically all reasonably liquid assets, volatility is rough, with the same order of magnitude for the roughness parameter, is of course very intriguing. Tick-by-tick price model is based on a bi-dimensional Hawkes process, which is a bivariate point process (Nt+, Nt)t≥0 taking values in (R+)2 and with intensity (λ+t, λt) of the form

Here μ+ and μ are positive constants and the functions (φi)i=1,…4 are non-negative with associated matrix called kernel matrix. Hawkes processes are said to be self-exciting, in the sense that the instantaneous jump probability depends on the location of the past events. Hawkes processes are nowadays of standard use in finance, not only in the field of microstructure but also in risk management or contagion modeling. The Hawkes process generates behavior that mimics financial data in a pretty impressive way. And back-fitting, yields coorespndingly good results.  Some key problems remain the same whether you use a simple Brownian motion model or this marvelous technical apparatus.

In short, back-fitting only goes so far.

• The essentially random nature of living systems can lead to entirely different outcomes if said randomness had occurred at some other point in time or magnitude. Due to randomness, entirely different groups would likely succeed and fail every time the “clock” was turned back to time zero, and the system allowed to unfold all over again. Goldman Sachs would not be the “vampire squid”. The London whale would never have been. This will boggle the mind if you let it.

• Extraction of unvarying physical laws governing a living system from data is in many cases is NP-hard. There are far many varieties of actors and variety of interactions for the exercise to be tractable.

• Given the possibility of their extraction, the nature of the components of a living system are not fixed and subject to unvarying physical laws – not even probability laws.

• The conscious behavior of some actors in a financial market can change the rules of the game, some of those rules some of the time, or complete rewire the system form the bottom-up. This is really just an extension of the former point.

• Natural mutations over time lead to markets reworking their laws over time through an evolutionary process, with never a thought of doing so.

Thus, in this approach, Nt+ corresponds to the number of upward jumps of the asset in the time interval [0,t] and Nt to the number of downward jumps. Hence, the instantaneous probability to get an upward (downward) jump depends on the arrival times of the past upward and downward jumps. Furthermore, by construction, the price process lives on a discrete grid, which is obviously a crucial feature of high frequency prices in practice.

This simple tick-by-tick price model enables to encode very easily the following important stylized facts of modern electronic markets in the context of high frequency trading:

1. Markets are highly endogenous, meaning that most of the orders have no real economic motivation but are rather sent by algorithms in reaction to other orders.
2. Mechanisms preventing statistical arbitrages take place on high frequency markets. Indeed, at the high frequency scale, building strategies which are on average profitable is hardly possible.
3. There is some asymmetry in the liquidity on the bid and ask sides of the order book. This simply means that buying and selling are not symmetric actions. Indeed, consider for example a market maker, with an inventory which is typically positive. She is likely to raise the price by less following a buy order than to lower the price following the same size sell order. This is because its inventory becomes smaller after a buy order, which is a good thing for her, whereas it increases after a sell order.
4. A significant proportion of transactions is due to large orders, called metaorders, which are not executed at once but split in time by trading algorithms.

In a Hawkes process framework, the first of these properties corresponds to the case of so-called nearly unstable Hawkes processes, that is Hawkes processes for which the stability condition is almost saturated. This means the spectral radius of the kernel matrix integral is smaller than but close to unity. The second and third ones impose a specific structure on the kernel matrix and the fourth one leads to functions φi with heavy tails.

# Financial Forward Rate “Strings” (Didactic 1)

Imagine that Julie wants to invest \$1 for two years. She can devise two possible strategies. The first one is to put the money in a one-year bond at an interest rate r1. At the end of the year, she must take her money and find another one-year bond, with interest rate r1/2 which is the interest rate in one year on a loan maturing in two years. The final payoff of this strategy is simply (1 + r1)(1 + r1/2). The problem is that Julie cannot know for sure what will be the one-period interest rate r1/2 of next year. Thus, she can only estimate a return by guessing the expectation of r1/2.

Instead of making two separate investments of one year each, Julie could invest her money today in a bond that pays off in two years with interest rate r2. The final payoff is then (1 + r2)2. This second strategy is riskless as she knows for sure her return. Now, this strategy can be reinterpreted along the line of the first strategy as follows. It consists in investing for one year at the rate r1 and for the second year at a forward rate f2. The forward rate is like the r1/2 rate, with the essential difference that it is guaranteed : by buying the two-year bond, Julie can “lock in” an interest rate f2 for the second year.

This simple example illustrates that the set of all possible bonds traded on the market is equivalent to the so-called forward rate curve. The forward rate f(t,x) is thus the interest rate that can be contracted at time t for instantaneously riskless borrowing 1 or lending at time t + x. It is thus a function or curve of the time-to-maturity x2, where x plays the role of a “length” variable, that deforms with time t. Its knowledge is completely equivalent to the set of bond prices P(t,x) at time t that expire at time t + x. The shape of the forward rate curve f(t,x) incessantly fluctuates as a function of time t. These fluctuations are due to a combination of factors, including future expectation of the short-term interest rates, liquidity preferences, market segmentation and trading. It is obvious that the forward rate f (t, x+δx) for δx small can not be very different from f (t,x). It is thus tempting to see f(t,x) as a “string” characterized by a kind of tension which prevents too large local deformations that would not be financially acceptable. This superficial analogy is in the follow up of the repetitious intersections between finance and physics, starting with Bachelier who solved the diffusion equation of Brownian motion as a model of stock market price fluctuations five years before Einstein, continuing with the discovery of the relevance of Lévy laws for cotton price fluctuations by Mandelbrot that can be compared with the present interest of such power laws for the description of physical and natural phenomena. The present investigation delves into how to formalize mathematically this analogy between the forward rate curve and a string. We formulate the term structure of interest rates as the solution of a stochastic partial differential equation (SPDE), following the physical analogy of a continuous curve (string) whose shape moves stochastically through time.

The equation of motion of macroscopic physical strings is derived from conservation laws. The fundamental equations of motion of microscopic strings formulated to describe the fundamental particles derive from global symmetry principles and dualities between long-range and short-range descriptions. Are there similar principles that can guide the determination of the equations of motion of the more down-to-earth financial forward rate “strings”?

Suppose that in the middle ages, before Copernicus and Galileo, the Earth really was stationary at the centre of the universe, and only began moving later on. Imagine that during the nineteenth century, when everyone believed classical physics to be true, that it really was true, and quantum phenomena were non-existent. These are not philosophical musings, but an attempt to portray how physics might look if it actually behaved like the financial markets. Indeed, the financial world is such that any insight is almost immediately used to trade for a profit. As the insight spreads among traders, the “universe” changes accordingly. As G. Soros has pointed out, market players are “actors observing their own deeds”. As E. Derman, head of quantitative strategies at Goldman Sachs, puts it, in physics you are playing against God, who does not change his mind very often. In finance, you are playing against Gods creatures, whose feelings are ephemeral, at best unstable, and the news on which they are based keep streaming in. Value clearly derives from human beings, while mass, charge and electromagnetism apparently do not. This has led to suggestions that a fruitful framework to study finance and economy is to use evolutionary models inspired from biology and genetics.

This does not however guide us much for the determination of “fundamental” equa- tions, if any. Here, we propose to use the condition of absence of arbitrage opportunity and show that this leads to strong constraints on the structure of the governing equations. The basic idea is that, if there are arbitrage opportunities (free lunches), they cannot live long or must be quite subtle, otherwise traders would act on them and arbitrage them away. The no-arbitrage condition is an idealization of a self-consistent dynamical state of the market resulting from the incessant actions of the traders (ar- bitragers). It is not the out-of-fashion equilibrium approximation sometimes described but rather embodies a very subtle cooperative organization of the market.

We consider this condition as the fundamental backbone for the theory. The idea to impose this requirement is not new and is in fact the prerequisite of most models developed in the academic finance community. Modigliani and Miller [here and here] have indeed emphasized the critical role played by arbitrage in determining the value of securities. It is sometimes suggested that transaction costs and other market imperfections make irrelevant the no-arbitrage condition. Let us address briefly this question.

Transaction costs in option replication and other hedging activities have been extensively investigated since they (or other market “imperfections”) clearly disturb the risk-neutral argument and set option theory back a few decades. Transaction costs induce, for obvious reasons, dynamic incompleteness, thus preventing valuation as we know it since Black and Scholes. However, the most efficient dynamic hedgers (market makers) incur essentially no transaction costs when owning options. These specialized market makers compete with each other to provide liquidity in option instruments, and maintain inventories in them. They rationally limit their dynamic replication to their residual exposure, not their global exposure. In addition, the fact that they do not hold options until maturity greatly reduces their costs of dynamic hedging. They have an incentive in the acceleration of financial intermediation. Furthermore, as options are rarely replicated until maturity, the expected transaction costs of the short options depend mostly on the dynamics of the order flow in the option markets – not on the direct costs of transacting. For the efficient operators (and those operators only), markets are more dynamically complete than anticipated. This is not true for a second category of traders, those who merely purchase or sell financial instruments that are subjected to dynamic hedging. They, accordingly, neither are equipped for dynamic hedging, nor have the need for it, thanks to the existence of specialized and more efficient market makers. The examination of their transaction costs in the event of their decision to dynamically replicate their options is of no true theoretical contribution. A second important point is that the existence of transaction costs should not be invoked as an excuse for disregarding the no-arbitrage condition, but, rather should be constructively invoked to study its impacts on the models…..

# Portfolio Optimization, When the Underlying Asset is Subject to a Multiplicative Continuous Brownian Motion With Gaussian Price Fluctuations

Imagine that you are an investor with some starting capital, which you can invest in just one risky asset. You decided to use the following simple strategy: you always maintain a given fraction 0 < r < 1 of your total current capital invested in this asset, while the rest (given by the fraction 1 − r) you wisely keep in cash. You select a unit of time (say a week, a month, a quarter, or a year, depending on how closely you follow your investment, and what transaction costs are involved) at which you check the asset’s current price, and sell or buy some shares of this asset. By this transaction you adjust the current money equivalent of your investment to the above pre-selected fraction of your total capital.

The question that is interesting is: which investment fraction provides the optimal typical long-term growth rate of investor’s capital? By typical, it is meant that this growth rate occurs at large-time horizon in majority of realizations of the multiplicative process. By extending time-horizons, one can make this rate to occur with probability arbitrary close to one. Contrary to the traditional economics approach, where the expectation value of an artificial “utility function” of an investor is optimized, the optimization of a typical growth rate does not contain any ambiguity.

Let us assume that during the timescale, at which the investor checks and readjusts his asset’s capital to the selected investment fraction, the asset’s price changes by a random factor, drawn from some probability distribution, and uncorrelated from price dynamics at earlier intervals. In other words, the price of an asset experiences a multiplicative random walk with some known probability distribution of steps. This assumption is known to hold in real financial markets beyond a certain time scale. Contrary to continuum theories popular among economists our approach is not limited to Gaussian distributed returns: indeed, we were able to formulate our strategy for a general probability distribution of returns per capital (elementary steps of the multiplicative random walk).

Thus risk-free interest rate, asset’s dividends, and transaction costs are ignored (when volatility is large they are indeed negligible). However, the task of including these effects in our formalism is rather straightforward. The quest of finding a strategy, which optimizes the long-term growth rate of the capital is by no means new: indeed it was first discussed by Daniel Bernoulli in about 1730 in connection with the St. Petersburg game. In the early days of information sciences, C. F. Shannon has considered the application of the concept of information entropy in designing optimal strategies in such games as gambling. Working from the foundations of Shannon, J. L. Kelly Jr. has specifically designed an optimal gambling strategy in placing bets, when a gambler has some incomplete information about the winning outcome (a “noisy information channel”). In modern day finance, especially the investment in very risky assets is no different from gambling. The point Shannon and Kelly wanted to make is that, given that the odds are slightly in your favor albeit with large uncertainty, the gambler should not bet his whole capital at every time step. On the other hand, he would achieve the biggest long-term capital growth by betting some specially optimized fraction of his whole capital in every game. This cautious approach to investment is recommended in situations when the volatility is very large. For instance, in many emergent markets the volatility is huge, but they are still swarming with investors, since the long-term return rate in some cautious investment strategy is favorable.

Later on Kelly’s approach was expanded and generalized in the works of Breiman. Our results for multi-asset optimal investment are in agreement with his exact but non-constructive equations. In some special cases, Merton has considered the problem of portfolio optimization, when the underlying asset is subject to a multiplicative continuous Brownian motion with Gaussian price fluctuations.

# Black-Scholes (BS) Analysis and Arbitrage-Free Financial Economics

The Black-Scholes (BS) analysis of derivative pricing is one of the most beautiful results in financial economics. There are several assumptions in the basis of BS analysis such as the quasi-Brownian character of the underlying price process, constant volatility and, the absence of arbitrage.

let us denote V (t, S) as the price of a derivative at time t condition to the underlying asset price equal to S. We assume that the underlying asset price follows the geometrical Brownian motion,

dS/S = μdt + σdW —– (1)

with some average return μ and the volatility σ. They can be kept constant or be arbitrary functions of S and t. The symbol dW stands for the standard Wiener process. To price the derivative one forms a portfolio which consists of the derivative and ∆ units of the underlying asset so that the price of the portfolio is equal to Π:

Π = V − ∆S —– (2)

The change in the portfolio price during a time step dt can be written as

dΠ = dV − ∆dS = (∂V/∂t + σ2S22V/2∂S2) dt + (∂V/∂S – ∆) dS —– (3)

from of Ito’s lemma. We can now chose the number of the underlying asset units ∆ to be equal to ∂V/∂S to cancel the second term on the right hand side of the last equation. Since, after cancellation, there are no risky contributions (i.e. there is no term proportional to dS) the portfolio is risk-free and hence, in the absence of the arbitrage, its price will grow with the risk-free interest rate r:

dΠ = rΠdt —– (4)

or, in other words, the price of the derivative V(t,S) shall obey the Black-Scholes equation:

(∂V/∂t + σ2S22V/2∂S2) dt + rS∂V/∂S – rV = 0 —– (5)

In what follows we use this equation in the following operator form:

LBSV = 0, LBS = ∂/∂t + σ2S22V/2∂S2 + rS∂/∂S – r —– (6)

To formulate the model we return back to Eqn(1). Let us imagine that at some moment of time τ < t a fluctuation of the return (an arbitrage opportunity) appeared in the market. It happened when the price of the underlying stock was S′ ≡ S(τ). We then denote this instantaneous arbitrage return as ν(τ, S′). Arbitragers would react to this circumstance and act in such a way that the arbitrage gradually disappears and the market returns to its equilibrium state, i.e. the absence of the arbitrage. For small enough fluctuations it is natural to assume that the arbitrage return R (in absence of other fluctuations) evolves according to the following equation:

dR/dt = −λR,   R(τ) = ν(τ,S′) —– (7)

with some parameter λ which is characteristic for the market. This parameter can be either estimated from a microscopic theory or can be found from the market using an analogue of the fluctuation-dissipation theorem. The fluctuation-dissipation theorem states that the linear response of a given system to an external perturbation is expressed in terms of fluctuation properties of the system in thermal equilibrium. This theorem may be represented by a stochastic equation describing the fluctuation, which is a generalization of the familiar Langevin equation in the classical theory of Brownian motion. In the last case the parameter λ can be estimated from the market data as

λ = -1/(t -t’) log [〈LBSV/(V – S∂V/∂S) (t) LBSV/(V – S∂V/∂S) (t’)〉market / 〈(LBSV/(V – S∂V/∂S)2 (t)〉market] —– (8)

and may well be a function of time and the price of the underlying asset. We consider λ as a constant to get simple analytical formulas for derivative prices. The generalization to the case of time-dependent parameters is straightforward.

The solution of Equation 7 gives us R(t,S) = ν(τ,S)e−λ(t−τ) which, after summing over all possible fluctuations with the corresponding frequencies, leads us to the following expression for the arbitrage return at time t:

R (t, S) = ∫0t dτ ∫0 dS’ P(t, S|τ, S’) e−λ(t−τ) ν (τ, S’), t < T —– (9)

where T is the expiration date for the derivative contract started at time t = 0 and the function P (t, S|τ, S′) is the conditional probability for the underlying price. To specify the stochastic process ν(t,S) we assume that the fluctuations at different times and underlying prices are independent and form the white noise with a variance Σ2 · f (t):

⟨ν(t, S)⟩ = 0 , ⟨ν(t, S) ν (t′, S′)⟩ = Σ2 · θ(T − t) f(t) δ(t − t′) δ(S − S′) —– (10)

The function f(t) is introduced here to smooth out the transition to the zero virtual arbitrage at the expiration date. The quantity Σ2 · f (t) can be estimated from the market data as:

∑2/2λ· f (t) = 〈(LBSV/(V – S∂V/∂S)) 2 (t)⟩ market —– (11)

and has to vanish as time tends to the expiration date. Since we introduced the stochastic arbitrage return R(t, S), equation 4 has to be substituted with the following equation:

dΠ = [r + R(t, S)]Πdt, which can be rewritten as

LBSV = R (t, S) V – (S∂V/∂S) —– (12)

using the operator LBS.

It is worth noting that the model reduces to the pure BS analysis in the case of infinitely fast market reaction, i.e. λ → ∞. It also returns to the BS model when there are no arbitrage opportunities at all, i.e. when Σ = 0. In the presence of the random arbitrage fluctuations R(t, S), the only objects which can be calculated are the average value and other higher moments of the derivative price.

# Yield Curve Dynamics or Fluctuating Multi-Factor Rate Curves

The actual dynamics (as opposed to the risk-neutral dynamics) of the forward rate curve cannot be reduced to that of the short rate: the statistical evidence points out to the necessity of taking into account more degrees of freedom in order to represent in an adequate fashion the complicated deformations of the term structure. In particular, the imperfect correlation between maturities and the rich variety of term structure deformations shows that a one factor model is too rigid to describe yield curve dynamics.

Furthermore, in practice the value of the short rate is either fixed or at least strongly influenced by an authority exterior to the market (the central banks), through a mechanism different in nature from that which determines rates of higher maturities which are negotiated on the market. The short rate can therefore be viewed as an exogenous stochastic input which then gives rise to a deformation of the term structure as the market adjusts to its variations.

Traditional term structure models define – implicitly or explicitly – the random motion of an infinite number of forward rates as diffusions driven by a finite number of independent Brownian motions. This choice may appear surprising, since it introduces a lot of constraints on the type of evolution one can ascribe to each point of the forward rate curve and greatly reduces the dimensionality i.e. the number of degrees of freedom of the model, such that the resulting model is not able to reproduce any more the complex dynamics of the term structure. Multifactor models are usually justified by refering to the results of principal component analysis of term structure fluctuations. However, one should note that the quantities of interest when dealing with the term structure of interest rates are not the first two moments of the forward rates but typically involve expectations of non-linear functions of the forward rate curve: caps and floors are typical examples from this point of view. Hence, although a multifactor model might explain the variance of the forward rate itself, the same model may not be able to explain correctly the variability of portfolio positions involving non-linear combinations of the same forward rates. In other words, a principal component whose associated eigenvalue is small may have a non-negligible effect on the fluctuations of a non-linear function of forward rates. This question is especially relevant when calculating quantiles and Value-at-Risk measures.

In a multifactor model with k sources of randomness, one can use any k + 1 instruments to hedge a given risky payoff. However, this is not what traders do in real markets: a given interest-rate contingent payoff is hedged with bonds of the same maturity. These practices reflect the existence of a risk specific to instruments of a given maturity. The representation of a maturity-specific risk means that, in a continuous-maturity limit, one must also allow the number of sources of randomness to grow with the number of maturities; otherwise one loses the localization in maturity of the source of randomness in the model.

An important ingredient for the tractability of a model is its Markovian character. Non-Markov processes are difficult to simulate and even harder to manipulate analytically. Of course, any process can be transformed into a Markov process if it is imbedded into a space of sufficiently high dimension; this amounts to injecting a sufficient number of “state variables” into the model. These state variables may or may not be observable quantities; for example one such state variable may be the short rate itself but another one could be an economic variable whose value is not deducible from knowledge of the forward rate curve. If the state variables are not directly observed, they are obtainable in principle from the observed interest rates by a filtering process. Nevertheless the presence of unobserved state variables makes the model more difficult to handle both in terms of interpretation and statistical estimation. This drawback has motivated the development of so-called affine curve models models where one imposes that the state variables be affine functions of the observed yield curve. While the affine hypothesis is not necessarily realistic from an empirical point of view, it has the property of directly relating state variables to the observed term structure.

Another feature of term structure movements is that, as a curve, the forward rate curve displays a continuous deformation: configurations of the forward rate curve at dates not too far from each other tend to be similar. Most applications require the yield curve to have some degree of smoothness e.g. differentiability with respect to the maturity. This is not only a purely mathematical requirement but is reflected in market practices of hedging and arbitrage on fixed income instruments. Market practitioners tend to hedge an interest rate risk of a given maturity with instruments of the same maturity or close to it. This important observation means that the maturity is not simply a way of indexing the family of forward rates: market operators expect forward rates whose maturities are close to behave similarly. Moreover, the model should account for the observation that the volatility term structure displays a hump but that multiple humps are never observed.

# Forward Pricing in Commodity Markets. Note Quote.

We use the Hilbert space

Hα := {f ∈ AC(R+,C) : ∫0 |f′(x)|2 eαx dx < ∞}

where AC(R+,C) denotes the space of complex-valued absolutely continuous functions on R+. We endow Hα with the scalar product ⟨f,g⟩α := f(0) g(0) + ∫0 f′(x) g(x) eαx dx, and denote the associated norm by ∥ · ∥αFilipović shows that (Hα, ∥ · ∥α) is a separable Hilbert space. This space has been used in Filipović for term structure modelling of bonds and many mathematical properties have been derived therein. We will frequently refer to Hα as the Filipović space.

We next introduce our dynamics for the term structure of forward prices in a commodity market. Denote by f (t, x) the price at time t of a forward contract where time to delivery of the underlying commodity is x ≥ 0. We treat f as a stochastic process in time with values in the Filipović space Hα. More specifically, we assume that the process {f(t)}t≥0 follows the HJM-Musiela model which we formalize next. The Heath–Jarrow–Morton (HJM) framework is a general framework to model the evolution of interest rate curve – instantaneous forward rate curve in particular (as opposed to simple forward rates). When the volatility and drift of the instantaneous forward rate are assumed to be deterministic, this is known as the Gaussian Heath–Jarrow–Morton (HJM) model of forward rates. For direct modeling of simple forward rates the Brace–Gatarek–Musiela model represents an example.

On a complete filtered probability space (Ω,{Ft}t≥0,F,P), where the filtration is assumed to be complete and right continuous, we work with an Hα-valued Lévy process {L(t)}t≥0 for the construction of Hα-valued Lévy processes). In mathematical finance, Lévy processes are becoming extremely fashionable because they can describe the observed reality of financial markets in a more accurate way than models based on Brownian motion. In the ‘real’ world, we observe that asset price processes have jumps or spikes, and risk managers have to take them into consideration. Moreover, the empirical distribution of asset returns exhibits fat tails and skewness, behavior that deviates from normality. Hence, models that accurately fit return distributions are essential for the estimation of profit and loss (P&L) distributions. Similarly, in the ‘risk-neutral’ world, we observe that implied volatilities are constant neither across strike nor across maturities as stipulated by the Black and Scholes. Therefore, traders need models that can capture the behavior of the implied volatility smiles more accurately, in order to handle the risk of trades. Lévy processes provide us with the appropriate tools to adequately and consistently describe all these observations, both in the ‘real’ and in the ‘risk-neutral’ world. We assume that L has finite variance and mean equal to zero, and denote its covariance operator by Q. Let f0 ∈ Hα and f be the solution of the stochastic partial differential equation (SPDE)

df(t) = ∂xf(t)dt + β(t)dt + Ψ(t)dL(t), t≥0,f(0)=f

where β ∈ L ((Ω × R+, P, P ⊗ λ), Hα), P being the predictable σ-field, and

Ψ ∈ L2L(Hα) := ∪T>0 L2L,T (Hα)

where the latter space is defined as in Peszat and Zabczyk. For t ≥ 0, denote by Ut the shift semigroup on Hα defined by Utf = f(t + ·) for f ∈ Hα. It is shown in Filipović that {Ut}t≥0 is a C0-semigroup on Hα, with generator ∂x. Recall, that any C0-semigroup admits the bound ∥Utop ≤ Mewt for some w, M > 0 and any t ≥ 0. Here, ∥ · ∥op denotes the operator norm. Thus s → Ut−s β(s) is Bochner-integrable (The Bochner integral, named for Salomon Bochner, extends the definition of Lebesgue integral to functions that take values in a Banach space, as the limit of integrals of simple functions). and s → Ut−s Ψ(s) is integrable with respect to L. The unique mild solution of SPDE is

f(t) = Utf0 + ∫t0 Ut−s β(s)ds+ ∫t0 Ut−s Ψ(s)dL(s)

If we model the forward price dynamics f in a risk-neutral setting, the drift coefficient β(t) will naturally be zero in order to ensure the (local) martingale property (In probability theory, a martingale is a model of a fair game where knowledge of past events never helps predict the mean of the future winnings and only the current event matters. In particular, a martingale is a sequence of random variables (i.e., a stochastic process) for which, at a particular time in the realized sequence, the expectation of the next value in the sequence is equal to the present observed value even given knowledge of all prior observed values.) of the process t → f(t, τ − t), where τ ≥ t is the time of delivery of the forward. In this case, the probability P is to be interpreted as the equivalent martingale measure (also called the pricing measure). However, with a non-zero drift, the forward model is stated under the market probability and β can be related to the risk premium in the market. In energy markets like power and gas, the forward contracts deliver over a period, and forward prices can be expressed by integral operators on the Filipović space applied on f. The dynamics of f can also be considered as a model for the forward rate in fixed-income theory. This is indeed the traditional application area and point of analysis of the SPDE. Note, however, that the original no-arbitrage condition in the HJM approach for interest rate markets is different from the no-arbitrage condition. If f is understood as the forward rate modelled in the risk-neutral setting, there is a no-arbitrage relationship between the drift β, the volatility σ and the covariance of the driving noise L.