Uniwersytet Jagiello nski

Wydzial Matematyki i Informatyki

Instytut Matematyki
Fractional Brownian Motion
and applications to nancial
modelling
Ulamkowy proces Wienera i jego zastosowania
do modelowania nansowego
Marcin Krzywda
Numer indeksu: 1018034
Praca magisterska na kierunku matematyka (studia dzienne)
Opiekun: dr hab. Piotr Kobak
Krakow 2011
Contents
Introduction iii
1 Fractional Brownian Motion 1
1.1 Denition and existence . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Long range dependence . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3 Sample path properties . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.4 p-variation and quadratic variation . . . . . . . . . . . . . . . . . . . 6
1.5 fBM is not a semimartingale . . . . . . . . . . . . . . . . . . . . . . . 8
2 Integration with respect to fBM 11
2.1 Pathwise integration . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2 Wick-Ito integration . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.2.1 Spaces L
2

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.2.2 Wick exponential . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.2.3 Analogue of Malliavin derivative . . . . . . . . . . . . . . . . 16
2.2.4 Wick product . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.2.5 Wick-Ito integral . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.2.6 Wick-Ito formula . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.3 Conditional distribution of fBM . . . . . . . . . . . . . . . . . . . . . 22
2.3.1 Conditional Wick-Ito formula . . . . . . . . . . . . . . . . . . 24
3 fBM as a model in nance 25
3.1 Basics of nancial markets modelling . . . . . . . . . . . . . . . . . . 25
3.2 Pathwise fractional Black-Scholes model . . . . . . . . . . . . . . . . 27
3.3 Wick-fractional Black-Scholes model . . . . . . . . . . . . . . . . . . 28
3.4 Other approaches to exclude arbitrage . . . . . . . . . . . . . . . . . 29
3.4.1 Mixed fBM . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3.4.2 Market with transaction costs . . . . . . . . . . . . . . . . . . 30
3.4.3 Non-continuous trading . . . . . . . . . . . . . . . . . . . . . 31
3.5 Pricing by risk preferences . . . . . . . . . . . . . . . . . . . . . . . . 32
3.5.1 Price of an European option . . . . . . . . . . . . . . . . . . . 32
3.5.2 Role of the Hurst parameter . . . . . . . . . . . . . . . . . . . 35
4 Application to real market data 39
4.1 Estimating the Hurst parameter . . . . . . . . . . . . . . . . . . . . 39
4.2 Estimating volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
4.3 Market data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Bibliography 45
i
ii
Introduction
Since the introduction of the classical Black-Scholes model for pricing nancial
derivatives its assumptions have been commonly criticised. During the study of
statistical properties of the nancial data, several stylised factshave been recog-
nised to be common to a wide variety of markets, i.a.: long-range dependence, heavy
tails, skewness (gain/loss asymmetry), jumps, volatility clustering.
All of the above is in conict with the BlackScholes model. To overcome the
rst point, it has been proposed to replace the Brownian motion by the fractional
Brownian motion. We shall focus on this area of research in our thesis.
Fractional Brownian Motion (fBM) is a stochastic process introduced by Kol-
mogorov [Kol] in 1940 for the turbulence modelling. In 1968 Mandelbrot and van
Ness [MvN] gave a representation theorem for Kolmogorovs process, and introduced
the name of fractional Brownian Moon.
Fractional Brownian motion is a continuous, zero-mean process with stationary
increments and variance
E(B
H
t
) = t
2H
The Hurst parameter H > 0.5 determines the statistical long-range dependence.
For H = 0.5 we obtain the standard Brownian Motion. It has been shown that for
nancial data H (
1
2
, 1).
After some initial enthusiasm, the idea of involving fBM into quantitative nance
was abandoned for many years because, as the process had occurred not to be a
semimartingale, and no integration theory was known. Then Hu and Oksendal [HO]
developed new methods of stochastic calculus and the hope arised again.
Because of the non-semimartingale-property fBM pricing models admit arbitrage
possibilities with continuous trading. Therefore in order to exclude arbitrage several
classes of admissible portfolios have been suggested. Such a class must be: small
enough to eliminate arbitrage possibilities, large enough to contain hedging strategies
for relevant options, economically meaningful.
Recently Rostek and Schobel [RS] gave explicit formulae for the price of an Euro-
pean option in the model in which arbitrage is excluded by imposing some minimal
amount of time between two consecutive transactions. Preference based approach is
used to derive formulae.
The goals of this thesis are:
Introduce the fractional Brownian Motion and study its basic properties im-
portant from the modelling point of view (Chapter 1)
Study the pathwise (Chaper 1, 1) and Wick-Ito (Chaper 1, 2) integration
theories with respect to fBM
iii
iv
Study conditional distribution of fBM (Chapter 2, 3)
Give a survey on the history of fBM application to nancial modelling (Chapter
3, 1-4)
Present the Rostek-Schobel model (Chapter 3, 5)
Discuss the issue of parameter estimation for the model and perform empirical
studies of the formulae derived (Chapter 4)
Podzi

ekowania
Dzi

ekuj

e Panu doktorowi hab. Piotrowi Kobakowi za wskazanie tematu zastosowa n

ulamkowego procesu Wienera do modelowania rynkow nansowych oraz inspiracj

e
do napisania niniejszej pracy, jak rownie z za opiek

e nad prac

a, czas poswi

econy na
dyskusje prezentowanych rezultatow oraz liczne uwagi i poprawki.
Sluchaczom Seminarium Zakladu Matematyki Finansowej UJ, w szczegolnosci
Panu prof. Armenowi Edigarianowi, za wysluchanie moich referatow oraz wskazanie
niedocigni.
Rodzicom dzi

ekuj

e za wsparcie, ktore otrzymalem w calym okresie studiow.

Prac

e magistersk

a dedykuj

e Madzi.
Chapter 1
Fractional Brownian Motion
In this chapter we shall introduce the self-similarity property and dene the frac-
tional Brownian Motion (fBM). Next we shall study other basic properties of the
fBM such as: long-range dependence, Holder continuity, path dierentiability, etc.
The fractional Brownian Motion was rst introduced by Kolmogorov in 1940
[Kol], and then Maldelbrot and Van Ness [MvN] discovered many of its properties.
1.1 Denition and existence
Denition 1.1.1. A stochastic process X : T R is Gaussian if for any
positive integer n, and any collection t
1
, . . . , t
n
T the distribution of the random
vector (X
t
1
, . . . , X
t
n
) is normal.
Denition 1.1.2. A stochastic process X : [0, +) R is called H-self-similar
with H (0, 1) if
a > 0, t 0 X
at
a
H
X
t
(1.1)
where denotes the equality of the nite-dimensional distributions.
Denition 1.1.3. We say that a process X : [0, +) R has stationary
increments if
s, t 0 X
t+s
X
t
X
s
X
0
(1.2)
Directly from the above denitions one can easily obtain:
Lemma 1.1.1. [EM, Prop. 2.2.] A stochastic process X : [0, +) R which
is H-self-similar, with stationary increments and nite variance has the following
properties:
1. X
0
= 0 a.s.
2. t 0 E(X
t
) = 0
3. t 0 E(X
2
t
) = t
2H

2
, where
2
= E(X
2
1
)
4. s, t 0 Cov(X
t
, X
s
) =

2
2
(t
2H
+s
2H
|t s|
2H
)
Proof. 1. X
0
= X
a0
a
H
X
0
for each a > 0.
2. By self-similarity we have E(X
2t
) = 2
H
E(X
t
), on the other hand by stationar-
ity E(X
2t
) = E(X
2t
X
t
) +E(X
t
) = 2E(X
t
).
1
2 CHAPTER 1. FRACTIONAL BROWNIAN MOTION
3. E(X
2
t
) = E(t
H
X
1
)
2
= t
2H
E(X
1
)
4.
Cov(X
t
, X
s
) = E(X
t
X
s
) =
1
2
(EX
2
t
+EX
2
s
E(X
t
X
s
)
2
)
=

2
2
(t
2H
+s
2H
|t s|
2H
)
Our next goal is to show that H-self-similar processes with stationary increments
in fact exist. To achieve this we shall need the following proposition:
Proposition 1.1.2. [Taq, Prop. 2.2] Let H (0, 1). The function
R
H
(s, t) = t
2H
+s
2H
|t s|
2H
(1.3)
is nonnegative-denite.
Proof. Let t
1
, . . . , t
n
0,
1
, . . . ,
n
R. We ask if
n

i,j=1
R
H
(t
i
, t
j
)
i

j
0
Set t
0
= 0 and
0
=

n
i=1

i
. Because

n
i=0

i
= 0 we get
n

i,j=1
R
H
(t
i
, t
j
)
i

j
=
n

i,j=1
(t
2H
i
+t
2H
j
|t
i
t
j
|
2H
)
i

j
=
n

i,j=0
|t
i
t
j
|
2H

j
For any > 0 we have
n

i,j=0
e
|t
i
t
j
|
2H

j
=
n

i,j=0
(e
|t
i
t
j
|
2H
1)
i

j
=
n

i,j=0
|t
i
t
j
|
2H

j
+o()
Now, as 0, it is enough to show that
n

i,j=0
e
|t
i
t
j
|
2H

j
0
but this follows from the fact that the function e
|t|
2H
is a characteristic function
(cf. [JS, Chapter 9.2]).
Theorem 1.1.3. [Shi2, Theorem II.9.1] (Kolmogorovs consistency theorem)
For all k N, t
1
, . . . , t
k
T let Q
t
1
,...,t
k
be probability measures on R
nk
such that
for all Borel sets F
i
and all permutations on {1, . . . , k}
Q
(t
1
),...,(t
k
)
(F
1
F
k
) = Q
t
1
,...,t
k
(F

1
(1)
F

1
(k)
) (1.4)
and
Q
t
1
,...,t
k
(F
1
F
k
) = Q
t
1
,...,t
k
,t
k+1
(F
1
F
k
R) (1.5)
Then there exists a probability space (, F, P) and a stochastic process X : R
n
such that
Q
t
1
,...,t
k
(F
1
F
k
) = P(X
t
1
F
1
, . . . , X
t
k
F
k
) (1.6)
for all t
i
T, k N and all Borel sets F
i
.
1.1. DEFINITION AND EXISTENCE 3
Now for each collection t
1
, . . . , t
k
0 by proposition 1.1.2 we know that there ex-
ists a Gaussian vector (Z
1
, . . . , Z
k
) with the covariance matrix [
2
R
H
(t
i
, t
j
)]
i,j=1,...,k
which induces a probability measure Q
t
1
,...,t
k
. One can easily verify that a fam-
ily {Q
t
1
,...,t
k
: t
1
, . . . , t
k
0} is consistent. Consequently by theorem 1.1.3 there
exists a probability distribution and a stochastic process that Q
t
1
,...,t
k
are its nite-
dimensional distributions.
Denition 1.1.4. Let H (0, 1). A stochastic process B
H
: [0, +) R
which is Gaussian, H-self-similar, has stationary increments and
2
= 1 is called the
fractional Brownian Motion.
Figure 1.1: Sample path of the fBM for H = 0.3
Figure 1.2: Sample path of the fBM for H = 0.5
Figure 1.3: Sample path of the fBM for H = 0.7
4 CHAPTER 1. FRACTIONAL BROWNIAN MOTION
The index H is called Hurst exponent after the British hydrologist H. E. Hurst.
Note that for H =
1
2
we get the standard Brownian Motion, which we shall further
denote by W
t
.
1.2 Long range dependence
Long-range dependence is a phenomenon that may arise in the analysis of time series
data. It relates to the rate of decay of statistical dependence. More formally:
Denition 1.2.1. A stationary random sequence {X
n
}
nN
exhibits long-range de-
pendence if the autocovariance function (n) = EX
0
X
n
fulls

n=1
(n) = . (1.7)
Denition 1.2.2. The sequence
X
n
= B
H
n+1
B
H
n
(1.8)
is called the fractional Gaussian noise (fGn) with Hurst index H.
Figure 1.4: Autocovariance function of fBM for the case of persistence.
For H =
1
2
we know that the increments of the Brownian Motion are independent,
therefore uncorrelated. On the other hand, when H ,=
1
2
the increments are not
independent, more precisely we have
(n) =
1
2
((n + 1)
2H
+ (n 1)
2H
2n
2H
) H(2H 1)n
2H2
(1.9)
1.3. SAMPLE PATH PROPERTIES 5
as n . In particular, when H >
1
2
the increments of the fractional Brownian
Motion are positively correlated and exhibit the long-range dependence. In the
case when H <
1
2
increments are negatively correlated and have the short-range
dependence property (i.e.

n=1
(n) < ).
For us the interesting case is when H (
1
2
, 1) because, as some research showed,
for nancial data H 0.6.
1.3 Sample path properties
Let us begin with recalling the Kolmogorovs criterion
Denition 1.3.1. Let X, Y : T R be stochastic processes on (, F, P). We
say that X is a version of Y if for all t T
P(X
t
= Y
t
) = 1 a.s.
Theorem 1.3.1. [Pro][Cor. VII.1](Kolmogorovs criterion) Suppose the process
X : [0, +) R satises the following condition: For all T > 0 there exist
, , C > 0 such that
0 t, s T E[|X
t
X
s
|

] C|t s|
1+
(1.10)
Then there exists a version of X which is Holder continuous of order [0,

) a.s.
Proposition 1.3.2. [S, Prop. 3.2] The fractional Brownian Motion admits a ver-
sion with almost all sample paths Holder continuous of order strictly less than H.
Proof. For B
H
we have:
E|B
H
t
B
H
s
|

= E|B
H
1
|

|t s|
H
It is enough now to apply the Kolmogorovs criterion 1.3.1.
Proposition 1.3.3. [MvN, Prop. 4.2.] The sample paths of the fractional Brownian
Motion are nowhere dierentiable a.s.
Proof. By self-similarity:
B
H
t
B
H
t
0
t t
0
(t t
0
)
H1
B
H
1
Let us consider the event
A(t) =
_
sup
t
0
st

B
H
s
B
H
t
0
s t
0

> d
_
.
For any sequence t
n
decreasing to t
0
, we have
A(t
n
) A(t
n+1
)
and
A(t
n
)
_

B
H
t
n
B
H
t
0
t
n
t
0

> d
_
Finally
P
__

B
H
t
n
B
H
t
0
t
n
t
0

> d
__
= P({|B
H
1
| > (t
n
t
0
)
1H
d}) 1, as n
6 CHAPTER 1. FRACTIONAL BROWNIAN MOTION
1.4 p-variation and quadratic variation
Another criterion of the regularity of trajectories is the p-variation. We follow mostly
[S]. Consider partitions = {0 = t
0
< t
1
< . . . < t
n
= T} of the interval [0, T]. For
p 1 and f : [0, T] R we denote:
v
p
(f; ) =
n

k=1
|f(t
k
) f(t
k1
)|
p
(1.11)
Denition 1.4.1. We say that f has nite p-variation if the limit
v
0
p
(f) = lim
||0
v
p
(f; ) (1.12)
exists and is nite.
1
We say that f has bounded p-variation if
v
p
(f) = sup

v
p
(f; ) < (1.13)
By W
p
([0, T]) we denote the Banach space of all functions with bounded p-
variation equipped with the norm
||f||
[p]
= ||f||
(p)
+||f||

where
||f||
(p)
= v
p
(f)
1
p
and ||f||

= sup
t[0,T]
|f(t)|
For more details on the notion of p-variation see [DN].
Denition 1.4.2. Let {
n
} be a sequence of partitions of [0, T] such that |
n
| 0.
For a stochastic process X
t
by the quadratic variation along the sequence {
n
} we
mean
[X, X]
T
= lim
n
n

k=1
(X
t
k
X
t
k1
)
2
if the limit exists (in probability).
Further we shall use the following notions and theorems from ergodic theory:
Denition 1.4.3. [Shi, Def. V.3.1] A set A F is invariant with respect to the
sequence {
n
} of random variables if there is a Borel set set B B(R

) such that
for n 1
A = { : (
n
,
n+1
, . . .) B}
Denition 1.4.4. [Shi, Def. V.3.2] A stationary sequence {
n
} is ergodic if the
measure of every invariant set is either 0 or 1.
Theorem 1.4.1. [Shi, Theorem V.3.3](Birkhof s Ergodic Theorem) Let {
n
}
be a stationary (strict sense), ergodic random sequence with E|
1
| < . Then
lim
n
1
n
n

k=1

k
() = E(
1
)
P-a.s. and in L
1
.
1
Hee lim
||0
means the common limit for all sequences of partitions.
1.4. P-VARIATION AND QUADRATIC VARIATION 7
Lemma 1.4.2. (cf. [Shi, Theorem V.3]) Let {
n
} be a Gaussian stationary sequence
with E
n
= 0, and autocovariance function (n) 0. Then {
n
} is ergodic.
Basing on the ergodic theory Rogers [Rog] obtained the following:
Lemma 1.4.3. [Rog] Let
n
= {
j
2
n
: j = 0, . . . , 2
n
} be a partition of [0, 1]. Then
lim
n
v
p
(B
H
;
n
) =
_
_
_
, if pH < 1
E|B
H
1
|
p
, if pH = 1
0, if pH > 1
(1.14)
in probability.
Proof. Set Y
n
:= (2
n
)
pH1

2
n
k=1
|B
H
t
k
B
H
t
k1
|
p
. By self similarity:
Y
n
(2
n
)
pH1
2
n

k=1
|t
k
t
k1
|
pH
|B
H
k
B
H
k1
|
p
= 2
n
2
n

k=1
|B
H
k
B
H
k1
|
p
The sequence of one step increments of B
H
k
B
H
k1
is stationary, centred Gaussian
and with covariance function (n) which tends to 0. Therefore it is ergodic.
By Birkhofs Ergodic Theorem:
2
n
2
n

k=1
|B
H
k
B
H
k1
|
p
E|B
H
1
|
p
=: C
p
a.s. and in L
1
.
Therefore Y
n
P
C
p
. Because v
p
(B
H
;
n
) = (2
n
)
pH1
Y
n
the proof is nished.
Proposition 1.4.4. [S, Prop. 3.8]
1. For pH > 1 v
0
p
(B
H
) = 0 a.s.
2. For pH < 1 v
p
(B
H
) = + and v
0
p
(B
H
) does not exists.
Proof. 1. Let be a partition of [0, 1]. By proposition 1.3.2:
n

k=1
|B
H
t
k
B
H
t
k1
|
p
C
p
n

k=1
|t
k
t
k1
|
p
C
p
||
p1
n

k=1
|t
k
t
k1
| a.s.
for < H and p > 1. Now it is enough to let || 0.
2. Let
n
be a sequence of partitions like in lemma 1.4.3. By Riesz theorem we
can take its subsequence

n
such that v 1
H
(B
H
,

n
) E|B
H
1
|
1
H
a.s. There-
fore v
p
(B
H
,

n
) + a.s., so v
0
p
(B
H
) cannot exist. This also proves that
v
p
(B
H
) = + a.s.
Corollary 1.4.5. [Azm2, Theorem 2.3] For the fBM we have [B
H
, B
H
]
T
= 0 if
H >
1
2
and [B
H
, B
H
]
T
does not exist if H <
1
2
. Moreover B
H
is of unbounded
variation P-a.s.
Proof. v
1
(B
H
) v
p
(B
H
) = + for all p <
1
H
.
8 CHAPTER 1. FRACTIONAL BROWNIAN MOTION
1.5 fBM is not a semimartingale
Denition 1.5.1. By a martingale with respect to the ltration {F
t
} we mean a
stochastic process X such that:
1. X is adapted to {F
t
}
2. E|X
t
| <
3. s t E(X
t
|F
s
) = X
s
Denition 1.5.2. By a local martingale with respect to the ltration {F
t
} we mean
an {F
t
}-adapted stochastic process X for which there exists an increasing sequence
of {F
t
}-stopping times
k
such that
1.
k
a.s. as k
2. X
t
k
is an {F
t
}-martingale for all k
Denition 1.5.3. Let E R be any interval. A function f : E R is called a
c`adl`ag function if, for every t E
1. the left limit f(t) = lim
st

f(s) exists;
2. the right limit f(t+) = lim
st
+
f(s) exists and equals f(t).
That is, f is right-continuous with left limits.
Denition 1.5.4. By a semimartingale with respect to the ltration {F
t
} we mean
a stochastic process X : [0, ) R that can be decomposed as
X
t
= X
0
+M
t
+A
t
where M is a local martingale and A is a c`adl`ag adapted process of locally
2
bounded
variation. For the case of a continuous semimartingale processes M and A are
continuous, moreover the representation is unique (cf. [RY, Theorem IV.1.8]).
Proposition 1.5.1. [RY, Prop. IV.1.18] The quadratic variation exists for every
semimartingale.
Proposition 1.5.2. [Rog] The fractional Brownian Motion is not a semimartingale
for H ,=
1
2
.
Proof.
Case H <
1
2
: B
H
cannot be a semimartingale, because its quadratic variation does
not exist.
Case H >
1
2
: Suppose B
H
is a semimartingale. Therefore we have a decomposition
B
H
= B
H
0
+M +A. By [RY, Prop. IV.1.18]:
[M, M]
t
= [B
H
, B
H
]
t
= 0
Therefore M
t
= M
0
= 0 a.s. since a continuous local martingale with zero
quadratic variation is constant (cf. [RY, Prop. IV.1.12]). This implies that
B
H
= A has nite variation, but this is a contradiction.
2
Here locally means that there exists a sequence of stopping times
k
a.s. such that the
property holds for each A
t
k
1.5. FBM IS NOT A SEMIMARTINGALE 9
Why is not-being-a-semimartingale an important property of the fBM? Because,
as the theorem which we are going to quote below states, semimartingales form the
largest class of processes for which one can dene a stochastic integral in a way that
it has reasonable properties.
Here we quote only the simplest denitions and the main result. For more details
the reader is referred to [Pro].
Denition 1.5.5. A simple integrand is a stochastic process H with the represen-
tation
H
t
=
n

k=1
H
k (
k1
,
k
]
(t)
where H
k
L

(, F

k1
, P) and {
k
} is a sequence of stopping time such that
0
0
. . .
n
T.
Following [Pro] by S
u
we denote the class of all simple integrands on (, F, {F
t
}
t[0,T]
, P)
equipped with the topology of uniform convergence, and by L
0
the space L
0
(, F, P)
with the topology of convergence in probability.
For a given process X we dene a linear mapping I
X
: S
u
L
0
by putting:
I
X
(H) =
n

k=1
H
k
(X

k
X

k1
) (1.15)
Since this denition is a path-by-path denition for the step functions, it does
not depend on the choice of representation of H in S
u
.
Denition 1.5.6. A process X is a good integrator if it is c`adl`ag , adapted and
I
X
is continuous.
The following theorem gives a complete characterisation of good integrators:
Theorem 1.5.3 (Bichteler-Dellacherie). [Pro, Theorem III.43] An adapted, c`adl`ag stochas-
tic process is a good integrator if and only if it is a semimartingale.
10 CHAPTER 1. FRACTIONAL BROWNIAN MOTION
Chapter 2
Integration with respect to fBM
2.1 Pathwise integration
As we have just proved fBM is not a semimartingale, hence one cannot use standard
Ito integration theory. A natural way to introduce a stochastic integral with respect
to the fBM is to consider the Riemann-style sums:
n

i=1
f(t
i
)[B
H
(t
i+1
) B
H
(t
i
)]
where 0 = t
1
< . . . < t
n
= T is a partition of [0, T] and then to investigate if the
convergence holds at least in probability. For a more thorough study of dierent
types of integration see e.g. [BHOZ].
Denition 2.1.1. By the forward integral of a process f : [0, T] R with
respect to B
H
we mean:
_
T
0
f(s)dB
H
s
= lim
||0
n

i=1
f(t
i
)[B
H
(t
i+1
) B
H
(t
i
)] (2.1)
The fundamental question is when (upon what conditions) this integral exists.
Young proved that the Riemann-Stieltjes integral can be extended to functions that
are together smooth in the p-variation sense:
Theorem 2.1.1. [DN, Theorem 2.1] Suppose f W
p
, g W
q
for some p and q such
that
1
p
+
1
q
> 1 and have no common discontinuities. Then the Riemann-Stieltjes
integral exists.
We may apply this theorem to the fBM and obtain:
Proposition 2.1.2. [S, Theorem 6.2] Let f : [0, T] R be a stochastic process
with sample paths in W
q
a.s. with q <
1
1H
. Then the integral
_
T
0
f(s)dB
H
s
exists a.s.
Since we dened pathwise integrals in the Riemann-Stieltjes style, we have the
classical change of variables formula:
11
12 CHAPTER 2. INTEGRATION WITH RESPECT TO FBM
Proposition 2.1.3. [S, Theorem 6.4] Let F C
1,1
([0, T]R) such that the mapping
[0, T] t
F
x
(t, B
H
t
) R is in W
q
for some q <
1
1H
. Then the equation
F(t, B
H
t
) F(s, B
H
s
) =
_
t
s
F
x
(u, B
H
u
)dB
H
u
+
_
t
s
F
t
(u, B
H
u
)du (2.2)
holds a.s. for all s, t [0, T].
The above can be regarded as an analogue of Itos formula.
2.2 Wick-Ito integration
Here we briey summarise a new approach towards stochastic integration with re-
spect to the fBM based on a renormalisation operator called the Wick product
introduced by Duncan, Hu and Pasik-Duncan [DHPD] and Hu and Oksendal [HO].
For more aspects on these matters the reader should consult original papers or
monography [BHOZ].
Let (, F, P) be the probability space on which a fBM with Hurst parameter H
was dened.
1
The probability measure P depends on H. In this section we assume
H (
1
2
, 1).
2.2.1 Spaces L
2

Let H (
1
2
, 1). We dene : R R R
+
by putting
(s, t) = H(2H 1)|t s|
2H2
(2.3)
Denition 2.2.1. For Borel measurable functions f, g : [0, T] R we dene:
||f||
2

=
_
T
0
_
T
0
f(s)f(t)(s, t)dsdt (2.4)
f, g

=
_
T
0
_
T
0
f(s)g(t)(s, t)dsdt (2.5)
L
2

([0, T]) = {f : [0, T] R : f is Borel measurable, and ||f||

2

< +} (2.6)
(L
2

([0, T]), < , >

) is a Hilbert space.
Denition 2.2.2. For a deterministic function f L
2

([0, T]) we dene its Wick

integral in an ordinary way. Let
n
= {0 = t
0
< . . . < t
n
= T} be a sequence of
partitions of [0, T] such that |
n
| 0, and f
n
be the step functions approximating
f:
f
n
(t) =

i
a
n
i
1l
[t
i
,t
i+1
)
(t)
(L
2

)
f(t)
Then we put
_
T
0
f
n
(t)d

B
H
t
:=

i
a
n
i
(B
H
t
i+1
B
H
t
i
) (2.7)
and
_
T
0
f(t)d

B
H
t
(L
2
)
:= lim
n
_
T
0
f
n
(t)d

B
H
t
(2.8)
1
Note that = C
0
(R
+
, R), a space of continuous functions such that (0) = 0.
2.2. WICK-ITO INTEGRATION 13
Lemma 2.2.1. [DHPD, Lemma 2.1] If f, g L
2

([0, T]) then

_
T
0
fd

B
H
,
_
T
0
gd

B
H
are well dened Gaussian random variables. Moreover:
1. E(
_
T
0
fd

B
H
) = 0
2. E(
_
T
0
fd

B
H
_
T
0
gd

B
H
) = f, g

3. E(
_
T
0
fd

B
H
)
2
= ||f||
2

(Wick-Ito isometry)
Proof. Step 1. Let f, g be simple functions, that is: f =

n
i=1
a
i
1l
[t
i
,t
i+1
)
, g =

n
i=1
b
i
1l
[t
i
,t
i+1
)
.
E(
_
T
0
fd

B
H
) =

n
i=1
a
i
E(B
H
t
i+1
B
H
t
i
) =

n
i=1
a
i
[E(B
H
t
i+1
) E(B
H
t
i
)] = 0
E
__
T
0
fd

B
H
_
T
0
gd

B
H
_
=
n

k,j=1
a
k
b
j
E[(B
H
t
k+1
B
H
t
k
)(B
H
t
j+1
B
H
t
j
)]
=
n

k,j=1
a
k
b
j
[E(B
H
t
k+1
B
H
t
j+1
) +E(B
H
t
k
B
H
t
j
) E(B
H
t
k+1
B
H
t
j
) E(B
H
t
k
B
H
t
j+1
)]
=
1
2
n

k,j=1
a
k
b
j
[|t
k
t
j+1
|
2H
+|t
k+1
t
j
|
2H
|t
k
t
j
|
2H
|t
k+1
t
j+1
|
2H
]
=
n

k,j=1
a
k
b
j
_
t
k+1
t
k
_
t
j+1
t
j
|s t|
2H2
dsdt
=
_
T
0
_
T
0
f(s)g(t)(s, t)dsdt = f, g

Step 2. Let {f
n
}
nN
be a sequence of step functions such that f
n
f in L
2

. By
Step 1. we have:
E(
_
T
0
(f
n
f
m
)d

B
H
)
2
= ||f
n
f
m
||
2

0
so we can proceed with a passage to the limit.
Step 3. Let {f
n
}
nN
,{g
n
}
nN
be sequences of step functions such that f
n
f,
g
n
f in L
2

. Using again Step 2.:

E(
_
T
0
(f
n
g
n
)d

B
H
)
2
= ||f
n
g
n
||

||f
n
f||

+||g
n
f||

0
so the limit does not depend on the choice of the approximating sequence.
14 CHAPTER 2. INTEGRATION WITH RESPECT TO FBM
2.2.2 Wick exponential
Our goal is to generalise the concept of integration to random variables of L
p
(, F, P).
In the following we shall show how such variables can be approximated by the linear
combinations of the, so called, Wick exponentials:
Denition 2.2.3. By the Wick exponential we mean : L
2

([0, T]) L
2
(, F, P)
dened by:
(f) = exp
__
T
0
f(t)d

B
H
t

1
2
||f||
2

_
(2.9)
Note that such an exponential is a random variable. By E we denote the linear span
of the exponentials, that is:
E = span{(f) : f L
2

([0, T])} (2.10)

Lemma 2.2.2. (f)(g) = (f +g)e
f,g

Proof. We compute:
(f)(g) = exp
__
T
0
f(t)d

B
H
t
)
1
2
_
T
0
_
T
0
f(s)f(t)(s, t)dsdt
_

exp
__
T
0
gf(t)d

B
H
t
)
1
2
_
T
0
_
T
0
g(s)g(t)(s, t)dsdt
_
= (f +g) exp
__
T
0
_
T
0
f(s)g(t)(s, t)dsdt
_
= (f +g)e
f,g

The next two propositions reduce many verications for variables in L

2
(, F, P)
to verications of exponentials in E:
Proposition 2.2.3. [DHPD, Theorem 3.1] E is dense in L
p
(, F, P) for p 1.
Proof. Step 1. F : R is a polynomial of the fBM if
F = p(B
H
t
1
, . . . , B
H
t
n
)
where p is a polynomial, and 0 t
1
. . . t
n
. By the Stone-Weierstrass
theorem the set of all polynomials of the fBM is dense in L
p
.
Step 2. By lemma 2.2.2 the product of elements of E is still in E, therefore it is
enough to show that B
H
t
can be approximated by elements of E.
Indeed, for > 0 we dene a function f

= 1l
[0,t]
, f

L
2

. The Wick
exponential (f

) = C

e
B
H
t
for some C

> 0. We also put

F

=
(f

) C

=
e
B
H
t
1

E and F

B
H
t
in L
p
if 0.
Lemma 2.2.4. Wick exponential moments share the following properties:
2.2. WICK-ITO INTEGRATION 15
1. E((f)) = 1
2. E((f)(g)) = e
f,g

3. E((f)
2
) = e
||f||
2

Proof. 1. By lemma 2.2.1

_
T
0
f(t)d

B
H
t
is normally distributed with zero mean
and variance ||f||
2

. Therefore exp
_
_
T
0
f(t)d

B
H
t
_
) is log-normally distributed
with mean exp(
1
2
||f||
2

).
E((f)) = E
_
exp(
_
T
0
f(t)d

B
H
t
)
_
exp
_

1
2
||f||
2

_
= exp
_
1
2
||f||
2

_
exp
_

1
2
||f||
2

_
= 1
2. By lemma 2.2.2:
E((f)(g)) = e
f,g

Proposition 2.2.5. [DHPD, Theorem 3.2] If f

1
, . . . , f
n
L
2

([0, T]) such that

||f
i
f
j
||

,= 0 for i ,= j then (f
1
), . . . , (f
n
) are linearly independent in L
2
(, F, P).
Proof. Let
1
, . . . ,
n
R be such that
||
1
(f
1
) + +
n
(f
n
)||
L
2 = 0
For every g L
2

we have

1
(f
1
) + +
n
(f
n
), (g)
L
2 = E[(
1
(f
1
) + +
n
(f
n
))(g)] = 0
By lemma 2.2.4 this means that

1
e
f
1
,g

+ +
n
e
f
n
,g

= 0
Replacing g by g we obtain

1
e
f
1
,g

+ +
n
e
f
n
,g

= 0
Expanding in the powers of and comparing coecients we obtain a system of linear
equations
_

1
+ +
n
= 0

1
f
1
, g

+ +
n
f
n
, g

= 0

1
f
1
, g
n1

+ +
n
f
n
, g
n1

= 0
By the Vandermonde formula the determinant of the above system is

i<j
f
i
f
j
, g

16 CHAPTER 2. INTEGRATION WITH RESPECT TO FBM

This determinant is not equal to 0. Therefore the only solution to our system of
equations is
1
= =
n
= 0.
Indeed, for every i, j such that i ,= j the set {g L
2

: f
i
f
j
, g

,= 0}
is the complement of a hyperplane in L
2

. Since the intersection of nitely many

complements of hyperplanes is not empty there exists g L
2

such that f
i
f
j
, g

,=
0 for all i, j such that i ,= j.
2.2.3 Analogue of Malliavin derivative
Following [DHPD, Section 3] in this subsection we introduce an analogue of the
Malliavin derivative. We give extended proofs of the derivation formulae.
Let be the following functional
(g)(t) =
_
T
0
(t, u)g(u)du for g L
2

([0.T]) (2.11)
Denition 2.2.4. We say that L
p
(, F, P) has a -derivative in the direction
g if the following limit exists in L
p
(, F, P)
D
g
()(t) = lim
0
( +
_
t
0
(g)(v)dv) ()

(2.12)
Denition 2.2.5. We say that L
p
(, F, P) is -dierentiable if there exists a
process {D

s
}
s0
such that
D
g
=
_
T
0
D

s
g(s)ds a.s. (2.13)
for all g L
2

([0.T]).
Denition 2.2.6. We say that z stochastic process X : [0, T] R is -
dierentiable if for each t X
t
is -dierentiable and D

s
X
t
is jointly measurable.
The higher derivatives can be dened in a similar way.
Proposition 2.2.6. [DHPD, Section 3] The -dierentiation fulls the following
chain rules:
D
g
f() = f

()D
g
(2.14)
D

s
f() = f

()D

s
(2.15)
D
g
1
D
g
2
f() = f

()D
g
1
D
g
2
+f

()D
g
1
D
g
2
(2.16)
where is -dierentiable and f is smooth.
Proof. The same as for standard dierentiation in normed spaces.
Proposition 2.2.7. [DHPD, Section 3] For the -derivative we have the following
rules of dierentiation:
D
g
_
T
0
f(s)d

B
H
s
=
_
T
0
_
T
0
f(s)g(t)(s, t)dsdt = f, g

(2.17)
2.2. WICK-ITO INTEGRATION 17
D

s
_
T
0
f(u)d

B
H
u
=
_
T
0
f(u)g(s)(u, s)du = (f)(s) (2.18)
D
g
(f) = (f)
_
T
0
_
T
0
f(s)g(t)(s, t)dsdt = (f)f, g

(2.19)
D

s
(f) = (f)
_
T
0
f(u)g(s)(u, s)du = (f)(f)(s) (2.20)
where f, g L
2

([0, T]).
Proof. Let
F() =
_
T
0
f(s)d

B
H
s
() =
_
T
0
f(s)d(s)
We have
F( + g) =
_
T
0
f(s)(d(s) + dg(s))
=
_
T
0
f(s)d

B
H
s
() +
_
T
0
_
T
0
f(s)f(t)(s, t)dsdt
=
_
T
0
f(s)d

B
H
s
() + f, g

Finally
D
g
f() = lim
0
F() F( + g)

= f, g

2.2.4 Wick product

In this subsection we dene the Wick product . We shall need it to extend the
theory of stochastic calculus to the fractional Brownian Motion case.
Denition 2.2.7. By the Wick product for Wick exponentials we mean:
(f) (g) = (f +g) (2.21)
Because for distinct f
1
, . . . , f
n
their exponentials are linearly independent, the
above denition can be extended to dene the Wick product of two random
variables , E and further to any random variables of L
p
(, F, P).
Note that the Wick product of two random variables cannot be interpreted in a
pathwise sense. This means that when one knows only the values (), () he will
be not able to compute ( )().
Lemma 2.2.8. Let f, g L
2

([0, T]), then:

1. E((f) (g)) = E((f))E((g))
2. E((f) (g))
2
= e
||f+g||
2

18 CHAPTER 2. INTEGRATION WITH RESPECT TO FBM

Proof.
E((f) (g)) = E((f +g)) = 1 = E((f))E((g))
E((f) (g))
2
= E((f +g))
2
= e
||f+g||
2

Proposition 2.2.9. [DHPD, Proposition 3.4] Let g L

2

([0, T]), , D
g
L
2
(, F, P)
then

_
T
0
g(s)d

B
H
s
=
_
T
0
g(s)d

B
H
s
D
g
(2.22)
Proof. By the denition of a Wick product we have
(f) (g) = (f + g) R
Dierentiating with respect to and evaluating at = 0 we obtain
(f)
_
T
0
g(s)d

B
H
s
= (f)
__
T
0
g(s)d

B
H
s

_
T
0
_
T
0
f(s)g(t)(s, t)dsdt
_
= (f)
_
T
0
g(s)d

B
H
s
(f)f, g

= (f)
_
T
0
g(s)d

B
H
s
D
g
(f)
By linearity and proposition 2.2.3 the proof is nished.
Proposition 2.2.10. [DHPD, Proposition 3.5] Let f, g L
2

([0, T]), E then:

1. E
_
(f)
_
T
0
g(t)d

B
H
t
_
2
= exp(||f||
2

)
_
(f, g

)
2
+||g||
2

_
2. E
_

_
T
0
g(t)d

B
H
t
_
2
= E
_
(D
g
)
2
+
2
||g||
2

_
Proof. By lemmas 2.2.4, 2.2.8 for , R we have
E[((f) (g))((h) (g))] = e
f+g,h+g

Taking partial derivatives

2

to both sides and evaluating at (, ) = (0, 0) we

get
E
__
(f)
_
T
0
g(s)d

B
H
s
__
(h)
_
T
0
g(s)d

B
H
s
__
= e
f,h

(f, g

h, g

+g, g

)
= E(D
g
(f)D
g
(h) + (f)(h)g, g

)
By bilinearity we nish the proof.
Corollary 2.2.11. [DHPD, Corollary 3.6] Let g, h L
2

([0, T]), , E then:

E
__

_
T
0
g(t)d

B
H
t
__

_
T
0
h(t)d

B
H
t
__
= E[D
h
D
g
+ g, h

] (2.23)
Proof. The formula may be obtained by applying the polarisation technique.
2.2. WICK-ITO INTEGRATION 19
2.2.5 Wick-Ito integral
We are now ready to dene the fractional Wick-Ito integral for random integrands.
Let for all t [0, T] X
t
L
2
(, F, P), and = {0 = t
0
, . . . , t
n
= T} be a partition of
[0, T]. We consider a Riemann-Stieltjes sum, but we replace the ordinary products
in the denition of the forward integral with Wick products.
S

=
n1

i=0
X
t
i
[B
H
t
i+1
B
H
t
i
] (2.24)
Denition 2.2.8. By the fractional Wick-Ito integral we mean:
_
T
0
X
s
d

B
H
s
= lim
||0
S

(2.25)
if the Wick products and the limit exist in L
2
(, F, P).
Denition 2.2.9. We say that a stochastic process X : [0, T] R belongs to
the family L

(0, T) if:
W1 E(||X||
2

) < +
W2 X is -dierentiable
W3 the trace of {D

s
X
t
: s, t [0, T]} exists
W4 E(
_
T
0
_
T
0
|D

s
X
t
|
2
dsdt) < +
W5 for each sequence of partitions such that |
n
| 0
n1

i=0
E
_
_
t
i+1
t
i
_
t
j+1
t
j
|D

s
X
t
i
D

t
X
t
j
D

s
X
t
D

t
X
s
|dsdt
_
0
and
E||X

X||
2

0
where X

t
= X
t
i
for t
i
t < t
i+1
.
Theorem 2.2.12. [DHPD, Theorem 3.7] If X : [0, T] R is a stochastic
process such that X L

(0, T) then the fractional Wick-Ito integral

_
T
0
X
s
d

B
H
s
exists.
Proof. The rst equality from lemma 2.2.8 extends to more general , such that
is well-dened. Therefore:
E(S

) =
n1

i=0
E
_
X
t
i
(B
H
t
i+1
B
H
t
i
)
_
=
n1

i=0
E(X
t
i
)E(B
H
t
i+1
B
H
t
i
) = 0
Now we compute the L
2
norm of S

. To do this, we denote:

i,j
= E[(X
t
i
(B
H
t
i+1
B
H
t
j
))(X
t
j
(B
H
t
j+1
B
H
t
j
))]
20 CHAPTER 2. INTEGRATION WITH RESPECT TO FBM
By corollary 2.2.11:

i,j
= E
_
_
t
j+1
t
j
D

s
X
t
i
ds
_
t
i+1
t
i
D

t
X
t
j
dt +X
t
i
X
t
j
_
t
i+1
t
i
_
t
j+1
t
j
(u, v)dudv
_
therefore
E(S
2

) =
n1

i,j=0
E
_
_
t
j+1
t
j
D

s
X
t
i
ds
_
t
i+1
t
i
D

t
X
t
j
dt +X
t
i
X
t
j
_
t
i+1
t
i
_
t
j+1
t
j
(u, v)dudv
_
Condition W5 guarantees that S

n
is a Cauchy sequence in L
2
(, F, P) when
|
n
| 0.
Corollary 2.2.13. [DHPD, Theorem 3.7] For any X L

(0, T) :
1. E(
_
T
0
X
s
d

B
H
s
) = 0
2. E(
_
T
0
X
s
d

B
H
s
)
2
= E
_
(
_
T
0
D

s
X
s
ds)
2
+||X||
2

_
(Wick-Ito isometry)
Proposition 2.2.14. [DHPD, Theorem 3.7] Let X, Y L

(0, T).
1.
_
T
0
(aX
s
+bY
s
)d

B
H
s
= a
_
T
0
X
s
d

B
H
s
+b
_
T
0
Y
s
d

B
H
s
a.s.
2. If E[ sup
s[0,T]
|X
s
|]
2
< +, sup
s,t[0,T]
E[|D

s
X
t
|
2
] < + then
_
t
0
X
s
d

B
H
s
has a
continuous version.
Proof. We denote Z
t
=
_
t
0
X
s
d

B
H
s
. Applying Wick-Ito isometry we have:
E(|Z
t
Z
s
|
2
) E
_
|
_
t
s
X
u
d

B
H
u
|
2
_
E
__
t
s
_
t
s
|D

u
X
v
|
2
dudv +
_
t
s
_
t
s
X
u
X
v
(u, v)dudv
_
C(t s)
2
+D(t s)
2H
By the Kolmogorovs criterion 1.3.1 the proof is nished.
2.2.6 Wick-Ito formula
Further we get Ito formula for the new type of integration:
Proposition 2.2.15. [DHPD, Theorem 4.1] Let F C
2
(R) with bounded second
derivative, then
F(B
H
t
) F(B
H
s
) =
_
t
s
F

(B
H
u
)d

B
H
u
+H
_
t
s
F

(B
H
u
)u
2H1
du (2.26)
2.2. WICK-ITO INTEGRATION 21
Proof. Let = {0 = t
0
, . . . , t
n
= T} be a partition of [0, T]. By Taylors formula
F(B
H
T
) F(B
H
0
) =
n1

i=0
[F(B
H
t
i+1
) F(B
H
t
i
)]
=
n1

i=0
F

(B
H
t
i
)[B
H
t
i+1
B
H
t
i
] +
1
2
n1

i=0
F

(
i
)[B
H
t
i+1
B
H
t
i
]
2
=
n1

i=0
F

(B
H
t
i
) [B
H
t
i+1
B
H
t
i
] +
n1

i=0
_
t
i+1
t
i
D

s
F

(B
H
t
i
)ds
+
1
2
n1

i=0
F

(
i
)[B
H
t
i+1
B
H
t
i
]
2
= I
1
+I
2
+I
3
where
i
(B
H
t
i
, B
H
t
i+1
).
I
1

_
T
0
F

(B
H
u
)d

B
H
u
in L
2
.
By the chain rule, for s [t
i
, t
i+1
)
D

s
F

(B
H
t
i
) = F

(B
H
t
i
)D

s
B
H
t
i
= F

(B
H
t
i
)
_
t
i
0
(u, s)du
= HF

(B
H
t
i
)(s
2H1
(s t
i
)
2H1
)
Therefore I
2
H
_
T
0
u
2H1
F

(B
H
u
)d

B
H
u
.
Finally I
3
0 because H >
1
2
and F

is bounded.
The following proposition shows how the -derivative of a stochastic Wick-Ito
integral is computed.
Proposition 2.2.16. [DHPD, Theorem 4.2] Let X L

(0, T) and sup

s[0,T]
E[|D

s
X
s
|
2
] < + ,
and let
Y
t
=
_
t
0
X
u
d

B
H
u
then for s, t [0, T]
D

s
Y
t
=
_
t
0
D

s
X
u
d

B
H
u
+
_
t
0
X
u
(s, u)du a.s. (2.27)
Finally we have he general Wick-Ito formula:
Theorem 2.2.17. [DHPD, Theorem 4.3] Let X L

(0, T) and let Y

t
=
_
t
0
X
u
d

B
H
u
.
Assume that there exists > 1 H such that
E|X
u
X
v
|
2
C|u v|
2
where |u v| for some > 0 and
lim
0u,vt;|uv|0
E|D

u
(X
u
X
v
)|
2
= 0
Let F C
1,2
([0, T] R; R) be a function with bounded derivatives. Moreover let
E[
_
T
0
|X
s
D

s
Y
s
|] < + and F

(s, Y
s
)X
s
L

(0, T). Then

F(t, Y
t
) = F(0, 0) +
_
t
0
F
s
(s, Y
s
)ds +
_
t
0
F
x
(s, Y
s
)X
s
d

B
H
s
+
_
t
0

2
F
x
2
(s, Y
s
)X
s
D

s
Y
s
ds a.s. (2.28)
22 CHAPTER 2. INTEGRATION WITH RESPECT TO FBM
The following is a version of the Wick-Ito formula useful in applications.
Theorem 2.2.18. [DHPD, Theorem 4.5] Let X L

(0, T) satisfy the conditions

of the Wick-Ito theorem, Y be such that E[sup
s[0,T]
|Y
s
|] < + and let
Z
t
= a +
_
t
0
Y
u
du +
_
t
0
X
u
d

B
H
u
, a R
Let F C
1,2
([0, T] R; R) be a function with bounded derivatives and F

(s, Y
s
)X
s

L

(0, T). Then

F(t, Z
t
) = F(0, a) +
_
t
0
F
s
(s, Z
s
)ds +
_
t
0
F
x
(s, Z
s
)Y
s
ds
+
_
t
0
F
x
(s, Z
s
)X
s
d

B
H
s
+
_
t
0

2
F
x
2
(s, Y
s
)X
s
D

s
Z
s
ds a.s.(2.29)
We omit the proofs as they are rather long and technical.
2.3 Conditional distribution of fBM
In this section we consider a two-sided fractional Brownian Motion, that is a stochas-
tic process B
H
: R R sharing the same properties as in the previous case. We
are interested in the conditional distribution of

B
H
T,t
:= E[B
H
T
|F
H
t
]
where T > t and F
H
t
= (B
H
s
: s t). We follow [RS].
Gripenberg and Norros [GN] gave the following prediction formula:
Proposition 2.3.1. [GN][Theorem 3.1] Let H (
1
2
, 1). For each T > t > 0, the
conditional expectation of B
H
T
can be represented by:

B
H
T,t
= B
H
t
+
_
t

g(T t, s t)d

B
H
s
(2.30)
where
g(v, w) =
sin((H
1
2
))

(w)
H+
1
2
_
v
0
x
H
1
2
x w
dx
=
sin((H
1
2
))

_
1
H
1
2
_
w
v
_
H+
1
2

v
vw
_
H
1
2
,
3
2
H
_
_
and denotes the incomplete Beta function.
They also proved a technical lemma:
Lemma 2.3.2. [GN][Corollary 3.2]
_

0
_

0
g(T t, x)g(T t, y)(x, y)dxdy = (T t)
2H
(1
H
) (2.31)
where

H
=
sin((H
1
2
))(
3
2
H)
2
(H
1
2
)(2 2H)
2.3. CONDITIONAL DISTRIBUTION OF FBM 23
We omit the proofs of the above results as they are rather technical and rely
mostly on computations of integrals.
Let [
1
]
t
denotes the equivalence class
[
1
]
t
= { : B
H
s
() = B
H
s
(
1
), s (, t]}
The following theorem characterises the conditional distribution of B
H
T
within
its equivalence class:
Proposition 2.3.3. [RS][Theorem 3.2] Let
1
be a representative of an equivalence
class [
1
]
t
. The conditional distribution of B
H
T
based on the observation [
1
]
t
is
N(B
H
t
+
T,t
,
2
T,t
), where:

T,t
:= E[B
H
T
|F
H
t
](
1
) =
_
t

g(T t, s t)d

B
H
s
(
1
) (2.32)

2
T,t
:= V ar[B
H
T
|F
H
t
](
1
) = E[(B
H
T


B
H
T,t
)
2
|F
H
t
](
1
) =
H
(T t)
2H
(2.33)
Proof. The normality of the conditional distribution follows from the Gaussian char-
acter of the fBM. By the denition of the conditional expectation:
_
[
1
]
t
B
H
T
dP =
_
[
1
]
t

B
H
T
dP =

B
H
T
(
1
)P([
1
]
t
)
because

B
H
T
is constant on [
1
]
t
. Therefore

B
H
T
(
1
) =
_
[
1
]
t
B
H
T
d
P
P([
1
]
t
)
=
_
[
1
]
t
B
H
T
d

P
Respectively for the conditional variance:

2
T,t
=
_
[
1
]
t
(B
H
T


B
H
T
)
2
d

P = E
_
(B
H
T


B
H
T,t
)
2
|F
H
t
_
(
1
)

B
H
T
is the orthogonal projection of B
H
T
on span{B
H
s
: s t}, so B
H
T


B
H
T,t
is or-
thogonal to span{B
H
s
: s t}, therefore independent. As a conclusion E
_
(B
H
T


B
H
T,t
)
2
|F
H
t
_
is deterministic.

2
T,t
= E
_
(B
H
T


B
H
t
)
2
|F
H
t
_
= E
_
E
_
((B
H
T


B
H
t
)
T,t
)
2
|F
H
t
__
= E
_
E
_
(B
H
T


B
H
t
)
2
|F
H
t
_
2E
_
(B
H
T


B
H
t
)
T,t
|F
H
t
_
+E
_
(
T,t
)
2
|F
H
t

_
= E(B
H
T


B
H
t
)
2
2E(
T,t
)
2
+E(
T,t
)
2
= E(B
H
T


B
H
t
)
2
E(
T,t
)
2
= (T t)
2H
E(
T,t
)
2
E(
T,t
)
2
= E
__
t

g(T t, s t)d

B
H
s
_
2
=
_
t

_
t

tg(T t, v t)tg(T t, w t)(v, w)dvdw

=
_

0
_

0
g(T t, x)g(T t, y)(x, y)dxdy = (T t)
2H
(1
H
)
24 CHAPTER 2. INTEGRATION WITH RESPECT TO FBM
Finally:

2
T,t
= (T t)
2H
(1 (1
H
)) =
H
(T t)
2H
Gripenberg and Norros [GN] considered also prediction based on a partial knowl-
edge about the past, that is focused on the distribution of B
H
T
conditional on
(B
H
s
: s [t a, t]. In this setting they obtained coecients
H,a
, and
2
T,t,a
and showed that if the observation interval becomes as large as the interval to be
predicted, that is a (T t) then
H,a

H
and
2
T,t,a

2
T,t
. So concerning the
variance, a limited historical observation is justied.
Rostek [Ros] concludes that it is more comfortable to consider the theoretical
case of unlimited history.
2.3.1 Conditional Wick-Ito formula
Following the proof of the Wick-Ito formula one can obtain its conditional version
for the process

B
H
T
:
Proposition 2.3.4. [RS][Theorem 4.1] Let F C
1,2
([0, T] R; R) be a function
with bounded derivatives, then under some regularity conditions:
F(t,

B
H
t
) = F(0, 0) +
_
t
0
F
s
(s,

B
H
s
)ds +
_
t
0
F
x
(s,

B
H
s
)

B
H
s
d

B
H
s
+
H
H
_
t
0
s
2H1

2
F
x
2
(s,

B
H
s
)(

B
H
s
)
2
ds a.s. (2.34)
Chapter 3
fBM as a model in nance
3.1 Basics of nancial markets modelling
In recent years many authors have suggested to replace the classical Brownian motion
as driving process in the modelling of stock prices with the fractional one. Let us
start with recalling some basic notions from the theory of arbitrage pricing. A good
monography on this subject is [DS].
Denition 3.1.1. By a market model we mean a 7-tuple:
M = (, F, {F
t
}
t[0,T]
, P, B, S, A)
where
(, F, {F
t
}
t[0,T]
, P) is a probability space with ltration
B = (B
t
)
t[0,T]
is a deterministic R-valued function modelling the risk free
bank account
S = (S
t
)
t[0,T]
is an {F
t
}-adapted R-valued stochastic process modelling dis-
counted stock prices
A is a set of admissible trading strategies.
The interpretation is the following. Our market consists of two tradable assets:
a discounted bank account B (usually B
t
= e
rt
, r > 0) and the stock S which prices
are measured in the same units as B. (Therefore B is sometimes called a numeraire.)
Denition 3.1.2. By a portfolio (or strategy) we mean a pair of {F
t
}-adapted
processes = (
t
,
t
)
t[0,T]
.
Again we look at
t
as the amount of money stored (or borrowed) on the bank
account at time t, and at
t
as the number of stock shares possessed at time t.
With a portfolio we associate the wealth process given by:
V
t
() =
t
B
t
+
t
S
t
(3.1)
Following [BSV2] we introduce several denitions of arbitrage:
Denition 3.1.3. A portfolio is an arbitrage opportunity if
1. V
0
() = 0
25
26 CHAPTER 3. FBM AS A MODEL IN FINANCE
2. V
T
() 0 P-a.s., and
3. P(V
T
() > 0) > 0.
Denition 3.1.4. A portfolio is a strong arbitrage if
1. V
0
() = 0
2. c > 0 such that V
T
() c P-a.s.
Denition 3.1.5. A sequence of portfolios {
n
}
nN
is an approximate arbitrage if
1. V
0
(
n
) = 0 for all n
2. V

T
= lim
n
V
T
(
n
) exists in probability
3. V

T
0 P-a.s., and
4. P(V

T
> 0) > 0.
Denition 3.1.6. A sequence of portfolios {
n
}
nN
is a strong approximate arbi-
trage if it is approximate arbitrage and c > 0 such that V

T
c P-a.s.
Denition 3.1.7. A sequence of portfolios {
n
}
nN
is free lunch with vanishing risk
if it is approximate arbitrage and
lim
n
esssup

|V
T
(
n
)()1l
{V
T
(
n
)<0}
| = 0
We say that a market M is free of arbitrage if no portfolio A is an arbitrage.
Informally - arbitrage opportunity is the possibility that arises on the nancial
market to make a prot without risk and investing your own capital. Absence
of arbitrage is a basic equilibrium condition in economics. It is rather obvious that
when there were an arbitrage opportunity in the market all agents would start to buy
this portfolio, and by the law of supply and demand the price of this strategy would
increase immediately, proving that the market prices were not in an equilibrium.
However, in a mathematical theory, the absence of arbitrage depends on the set of
admissible strategies A. Now we shall discuss typical restrictions put on admissible
portfolios.
The main restriction is that only self-nancing portfolios should be admissible.
We assume no transaction costs. Suppose that the investors portfolio is constant
between times t
1
and t
2
, and he changes his portfolio at time t
2
. Self-nancing
means that at time t
2
the value of the old and new portfolio is the same, that is no
money is added or withdrawn. Algebraically it means:

t
1
B
t
1
+
t
1
S
t
2
=
t
2
B
t
2
+
t
2
S
t
2
or equivalently:
V
t
2
() = V
t
1
() +
t
1
(B
t
2
B
t
1
) +
t
1
(S
t
2
S
t
1
)
A natural extension of the above condition is the following:
Denition 3.1.8. We say that the portfolio = (
t
,
t
) is self-nancing if for all
t [0, T]
V
t
() = V
0
() +
_
t
0

s
dB
s
+
_
t
0

s
dS
s
(3.2)
3.2. PATHWISE FRACTIONAL BLACK-SCHOLES MODEL 27
Note that the meaning of the above denitions depends on the integration theory
used.
[BSV2] introduce the following:
Denition 3.1.9. We call a self-nancing portfolio nds-admissible (no doubling
strategies) when there exists a constant M 0 such that V
t
() M P-a.s. for
all t [0, T] This class of portfolios we denote by A
nds
.
Denition 3.1.10. We call a portfolio simple when there exists a nite number
of stopping times 0
0
. . .
n
T such that is constant on (
k
,
k+1
]. In
other words

t
=
n1

k=0

k (
k
,
k+1
]
(t)
where

k
s are F

k
-measurable. The class of simple and self-nancing portfolios we
denote by A
si
.
Denition 3.1.11. We call a portfolio -simple when it is simple, and
k+1

k
>
for all k. The class of -simple and self-nancing portfolios we denote by A
,si
.
Denition 3.1.12. We call a portfolio almost simple when there exists a sequence
{
k
}
kN
of stopping times 0
0
. . .
n
T for all n, such that P({k N
k
=
T}) = 1 and is constant on (
k
,
k+1
]. In other words

t
=
N1

k=0

k (
k
,
k+1
]
(t)
where

k
s are F

k
-measurable and N is an a.s. N-valued random variable. The
class of almost simple and self-nancing portfolios we denote by A
as
.
In this chapter we are interested in modelling the stock dynamics with fBM. We
assume H (
1
2
, 1).
3.2 Pathwise fractional Black-Scholes model
The classical Black-Scholes model of the stock market is described by the stochastic
dierential equations:
dB
t
= rB
t
dt (3.3)
dS
t
= S
t
dt + S
t
dW
t
(3.4)
The rst try to involve the fractional Brownian motion in the modelling of the
market was simply to replace the process W with B
H
in the above equations, and to
interpret the integrals in the pathwise way, which is natural from a modelling point
of view. In this case our equations become:
dB
t
= rB
t
dt (3.5)
dS
t
= S
t
dt + S
t
dB
H
t
(3.6)
By the proposition 2.1.3 we get the solution to the above equation:
S(t) = s
0
e
t+B
H
t
(3.7)
28 CHAPTER 3. FBM AS A MODEL IN FINANCE
Unfortunately this model admits arbitrage opportunities. Probably the rst to
prove it was Rogers [Rog]. Here we show a simple example by Shiryaev [Shi]:
Let
t
= 1 e
2B
H
t
,
t
= 2(e
B
H
t
1). For simplicity we assume = r and
= s
0
= 1. For this portfolio we have:
V
t
() =
t
B
t
+
t
S
t
= (1 e
2B
H
t
)e
rt
+ 2(e
B
H
t
1)(e
B
H
t
+rt
)
= e
rt
(e
B
H
t
1)
2
> 0
Now using proposition 2.1.3 we obtain:
dV
t
() = re
rt
(e
B
H
t
1)
2
dt + 2e
rt
(e
B
H
t
1)e
B
H
t
dB
H
t
= (1 e
2B
H
t
)re
rt
dt + 2(e
B
H
t
1)e
B
H
t
re
rt
dt + 2e
rt
(e
B
H
t
1)e
B
H
t
dB
H
t
=
t
dB
t
+
t
S
t
(rdt +dB
H
t
) =
t
dB
t
+
t
dS
t
hence the portfolio is self-nancing.
Note that the existence of arbitrage in this pathwise model is a direct consequence
of the following theorem by Delbaen and Schachermeyer:
Theorem 3.2.1. [DS][Theorem 9.7.2] Let S be an adapted c`adl`ag process. If S is
locally bounded and satises no free lunch with vanishing risk in the class A
si
A
nds
,
then S is a semimartingale.
The theorem says that if there is no arbitrage using simple portfolios (with
pathwise products) then the price process is a semimartingale. However, since our
process is not a semimartingale, an arbitrage must exist. In view of this result the
pathwise fBS model is not suitable in nance.
3.3 Wick-fractional Black-Scholes model
Under Wick-Ito integrals our stock market model becomes:
dB
t
= rB
t
dt (3.8)
dS
t
= S
t
dt + S
t
d

B
H
t
(3.9)
Thanks to the proposition 2.2.15 we get the solution to the above stochastic
equation:
S
t
= s
0
e
B
H
t
+t

2
2
t
2H
(3.10)
Unfortunately, in this model also arbitrage strategies can be constructed. Cherid-
ito proved the following:
Proposition 3.3.1. [Che2, Theorems 3.1, 3.2 and 4.3] In the model given by 3.9
there is:
1. free lunch with vanishing risk in the class A
si
A
nds
2. strong arbitrage in the class A
as
A
nds
3. no arbitrage in the class A
,si
for every > 0.
To exclude arbitrage, but still keeping to continuous trading, Hu and Oksendal
[HO] suggested to adjust the denition of a self-nancing portfolio:
3.4. OTHER APPROACHES TO EXCLUDE ARBITRAGE 29
Denition 3.3.1. We say that the portfolio = (
t
,
t
) is Wick-self-nancing if
for all t [0, T]
V
t
() = V
0
() +
_
t
0

s
dB
s
+
_
t
0

s
d

S
s
and similarly for the wealth process:
V
t
() =
t
B
t
+
t
S
t
Hu and Oksendal [HO] showed that the Wick-fractional Black-Scholes model is
free of arbitrage with the class of Wick-self-nancing portfolios and complete.
Finally, using their results Necula [Nec] proved the following version of a Black-
Scholes formula:
Theorem 3.3.2. [Nec][Theorem 4.2] The price of an European call option with
strike K and maturity T at time t [0, T] is given by:
C(t, S
t
) = S
t
N(d
+
) Ke
r(Tt)
N(d

) (3.11)
where
d

=
ln
S
t
K
+r(T t)

2
2
(T
2H
t
2H
)

T
2H
t
2H
(3.12)
There is a lot of controversy about this model. Although the result by Hu,
Oksendal and Necula is mathematically a good analogue of the no-arbitrage result
for classical Black-Scholes model, the usage of the Wick products does not admit any
economic interpretation. In particular, the proof of the no-arbitrage result for Wick-
self-nancing portfolios does not assume that the portfolio is adapted to the ltration
generated by the stock price process. So, even if the investor has full information
about the future stock prices, he cannot generate arbitrage in this model, which
would be obviously possible in the real world economy.
The second surprising feature appears when one takes a deeper look a the Wick-
fBS formula itself. If we have t
1
t
2
t T and two options with the same
maturity T written in date t
1
and t
2
respectively the Wick-fractional Black-Scholes
prices (at time t) for these two options will be dierent. Suppose one option is
cheaper than the other. Now we can buy a (C
2
C
1
)e
r(Tt)
).
This means one can do arbitrage in a non-arbitrage market!
Oksendal [Oks] introduced the concept of a market observer to justify the de-
nition of the Wick self-nancing portfolios. All formulae containing Wick products
are interpreted as abstract quantities that become real prices by an observation.
A good summary was given by C. Necula: Nowadays the Wick-fractional BS
market based on Wick integrals is considered a beautiful mathematical construct
but with limited applicability in nance.
1
3.4 Other approaches to exclude arbitrage
3.4.1 Mixed fBM
Cheridito [Che1] proposed to modify the stochastic process of the stock price in
order to get a semimartingale. The so called mixed fractional Brownian Motion is
a linear combination of fBM and a classical Brownian Motion. We take
Z
t
= B
H
t
+ W
t
(3.13)
1
Ciprian Necula, May 2010, private communication
30 CHAPTER 3. FBM AS A MODEL IN FINANCE
where B
H
and W are independent. For H (
3
4
, 1) and > 0 by [Che1, Theorem
1.7]
B
H
t
+ W
t
W
t
We observe that
Cov(W
t
+ B
H
t
, W
s
+ B
H
s
) =
2
min(s, t) + Cov(B
H
t
, B
H
s
)
In the mixed model the stock price process is
S
t
= s
0
e
t+(B
H
t
+W
t
)
1
2

2
t
(3.14)
The model is arbitrage-free in the class A
nds
and complete. For each > 0 one
can price assets with respect to the unique martingale measure Q

, and get (at time

t = 0):
C() = E
Q
[max(s
0
e
T+(B
H
t
+W
t
)
e
rT
K, 0)] = BS(0, s
0
, ) (3.15)
where BS(0, s
0
, ) denotes the classical Black-Scholes price with initial price s
0
,
and volatility .
3.4.2 Market with transaction costs
Guasoni et. al. [GRS2] introduced transaction costs into the fBS model and showed
that in this context arbitrage disappears.
By C
+
s
0
([0, T]) we denote the space of continuous processes with positive trajec-
tories starting from s
0
.
For the markets with transaction costs the following notion of consistent price
systems corresponds to equivalent martingale measures in the frictionless case:
Denition 3.4.1. Let S C
+
s
0
([0, T]). By an -consistent price system we mean a
pair (

S, Q) such that Q P,

S is a Q-martingale such that

S
0
= S
0
and for t [0, T]
(1 )S
t


S
t
(1 + )S
t
, a.s. (3.16)
In this subsection a trading portfolio = (, ) is a predictable, nite-variation
R
2
-valued process such that
0
=
T
= 0 (a strategy must begin and end with a
cash position only). By the total variation of we mean the process:
V
t
() = sup
0t
0
...t
n
=t
n

i=1
|
t
i

t
i1
| (3.17)
The wealth process is:
V

() =
_
T
0

s
dB
s
+
_
T
0

s
dS
s

_
T
0
S
s
dV()
s
V

t
() = V

(1l
(0,t)
)
Note that the integrals are a.s. well-dened pathwise, in the Riemann-Stieltjes sense,
since V() is a.s. nite.
Proportional transaction exclude the possibility of continuous trading. During
the interval [t, t +t] the value of the position in stock (without considering trans-
action costs) changes by
t
dSt, while the transaction cost S
t
V()
t
is charged to the
cash account. The term 1l
(0,t)
in the denition of V

t
() accounts for the liquidation
cost.
3.4. OTHER APPROACHES TO EXCLUDE ARBITRAGE 31
Denition 3.4.2. We say that is admissible for -transaction costs if there exists
M 0 such that for all t [0, T] V

t
() M a.s.. We denote this class of
portfolios by A
,nds
.
Theorem 3.4.1. [GRS2, Theorem 1.11](The fundamental theorem of asset
pricing with -transaction costs) Let S C
+
s
0
([0, T]). The following conditions
are equivalent:
1. For each > 0 there exists an -consistent price system.
2. For each > 0 there is no arbitrage in the class A
,nds
.
Denition 3.4.3. A continuous process S : [0, T] R
+
satises the conditional
full support (CFS) condition if for all t [0, T)
supp P(S|
[t,T]
|F
t
) = C
+
S
t
([t, T])
The following shows that the Wick-fractional BS model does not have arbitrage
under transaction costs in the class A
,nds
.
Proposition 3.4.2. [GRS, Theorem 1.2] Conditional full support implies the exis-
tence of an -consistent price system for every > 0
Lemma 3.4.3. [C] Fractional Brownian Motion has CFS.
The problem of option price remains unsolved in this setting.
3.4.3 Non-continuous trading
Cheridito [Che2] arguments that in reality the seller of an option can only carry
out nitely many transactions to hedge the option. Moreover he cannot buy and
sell within nanoseconds. To nd a reasonable option price, one should postulate the
existence of an arbitrary small minimal amount of time > 0 that must lie between
two consecutive transactions, that restricts trading strategies to the class
>0
A
,si
.
As we mentioned before (cf. Prop. 3.3.1) there is no arbitrage in this class.
Having given up on continuous trading dynamical hedging and replication meth-
ods are no longer available. In a complete market no arbitrage ensures the existence
of unique equivalent martingale measure. In this setting the measure is not unique.
However, we may impose another economic equilibrium condition to nd the best
pricing measure. We shall discuss this approach in the next section.
Bender, Sottinen adn Valkeila [BSV2] noticed that the class
>0
A
,si
is some-
what to much restrictive. To remedy this problem they proposed the following more
general class of admissible portfolios.
Denition 3.4.4. A sequence of stopping times 0
0
. . .
n
= T satises the
delay property if for all k there exist:
1. an F

k
-measurable open set U
k
C
+
S

k
([
k
, T]) and
2. an F

k
-measurable a.s. positive random variable
k
such that
k+1

k

k
in the set U
k
{
k+1
>
k
}.
32 CHAPTER 3. FBM AS A MODEL IN FINANCE
We call a portfolio delay-simple if it is of the form

t
=
n1

k=0

k (
k
,
k+1
]
(t)
where

k
s are F

k
-measurable. The class of delay-simple and self-nancing port-
folios we denote by A
desi
.
Note that
>0
A
,si
A
desi
.
Basing on the CFS property the authors obtained the following:
Proposition 3.4.4. [BSV2, Theorem 4.2] In the Wick-fractional BS model there is
no arbitrage in the class A
desi
.
3.5 Pricing by risk preferences
In this section our market model is the Wick-fractional market model with the class
of delay-simple portfolios. We keep the notation from section 2.3.
3.5.1 Price of an European option
Here we study pricing approach suggested by Rostek and Schobel [RS], which they
call preference based equilibrium pricing. Their idea is to focus on a two-time
approach. They postulate some equilibrium condition, namely that investor should
be indierent between buying the stock and holding the amount S
t
of the riskless
asset. Formally we demand:
E[e
r(Tt)
S
T
|F
H
t
] = S
t
(3.18)
This is less than being a martingale.
2
However, this condition is not achieved by
changing the measure like in the standard Black-Scholes model, but by adjusting the
drift rate of the stock process. Economic argumentation given by the authors is that
in a world where all investors are risk-neutral (but possessing and using information
about the past), the basic asset cannot be of an arbitrary shape, but has to be in
equilibrium itself.
The price of an European call option in this model is dened to be:
C(T, t, S
t
, K, r, , H) = e
r(Tt)
E[max(S
T
K, 0)|F
H
t
] (3.19)
Lemma 3.5.1. [RS, Section 4] Let

S
t
= s
0
e

B
H
t
+t

2
2
t
2H
be the conditional stock process. ln(

S
T
) is normally distributed with moments
m = ln S
t
+r(T t)
1
2

2
(T t)
2H
(3.20)
v =
H

2
(T t)
2H
(3.21)
2
Recently, the same authors have shown that this condition may be obtained by maximising
investors expected utility, cf. [RS2].
3.5. PRICING BY RISK PREFERENCES 33
Proof. Applying the fractional Wick-Ito formula to F(t,

B
H
t
) = ln

S
t
we have
ln(

S
T
) = ln(

S
t
) +(T t)
1
2

2
(T t)
2H
+ (

B
H
T


B
H
t
)
Therefore ln(

S
T
) N(m, v) (on the space ([
1
]
t
, ([
1
]
t
),

P)) where
m = ln S
t
+(T t)
1
2

2
(T t)
2H
+
T,t
v =
H

2
(T t)
2H
and

S
T
logN(M, V ) with
M = exp(m+
1
2
v) = S
t
e
(Tt)+
T,t
V = exp(2m+ 2v) exp(2m+v) = S
2
t
e
2(Tt)
(e

2
(Tt)
2H
1)
The mean of the conditional process

S
t
must equal the conditional mean of the
process S
t
, that is:
E(

S
T
) = E(S
T
|F
H
t
)
therefore
S
t
e
(Tt)+
T,t
= S
t
e
r(Tt)
where is the adjusted drift rate. Finally we get:
(T t) = r(T t)
T,t
(3.22)
Combining the last equality with previous results we obtain the conditional mo-
ments of ln(

S
T
) to be
m = ln S
t
+r(T t)
1
2

2
(T t)
2H
v =
H

2
(T t)
2H
Lemma 3.5.2. Let X N(m, v), K > 0. Then
E(e
X
1l
{XK}
) = e
m+
v
2
N
_

K mv

v
_
(3.23)
Proof. Let Q be a measure such that X N(m + v, v) under Q. The following
functions
f(x) =
1

2v
exp
_

(x m)
2
2v
_
g(x) =
1

2v
exp
_

(x mv)
2
2v
_
are densities of X under measures P and Q respectively. Put
(x) = f(x)g
1
(x) = exp
_
(x m
v
2
)
_
34 CHAPTER 3. FBM AS A MODEL IN FINANCE
For each h measurable and such that E|h(X)| < + we have:
E
P
(h(X)) =
_

h(X)dP =
_
R
h(x)f(x)dx =
_
R
h(x)(x)g(x)dx
=
_

h(X)(X)dQ = E
Q
(h(X)(X))
Therefore
E(e
X
1l
{XK}
) = E
Q
((X)e
X
1l
{XK}
) = E
Q
(e
X+m+
v
2
e
X
1l
{XK}
)
= E
Q
(e
m+
v
2
1l
{XK}
) = e
m+
v
2
Q(1l
{XK}
)
But
Q(1l
{XK}
) = Q
__
X mv

v

K mv

v
__
= N
_

K mv

v
_
Combining above equalities we nish the proof.
Proposition 3.5.3. [RS, Theorem 4.2] The price of an European call option with
strike K and maturity T at time t [0, T] valued by a risk-neutral investor is given
by the following formula:
C(T, t, S
t
, K, r, , H) = S
t
N(d
H
+
) Ke
r(Tt)
N(d
H

) (3.24)
where
d
H

=
ln(
S
t
K
) +r(T t)
1
2

2
(T t)
2H

H
(T t)
H
(3.25)
Proof. We start with exploiting the denition:
C(T, t, S
t
, K, r, , H) = E
_
e
r(Tt)
(S
T
K)1l
{S
T
K}
|F
H
t
_
= E
_
e
r(Tt)

S
T
1l
{

S
T
K}
_
+E
_
e
r(Tt)
K1l
{

S
T
K}
_
= I
1
+I
2
Using previous lemmas:
I
1
= e
r(Tt)
E
_

S
T
1l
{

S
T
K}
_
= e
r(Tt)
E
_
e
ln

S
T
1l
{ln

S
T
ln K}
_
= e
r(Tt)
e
ln S
t
+r(Tt)
N
_

ln K ln S
t
r(T t)
1
2

2
(T t)
2H

H
(T t)
H
_
= S
t
N(d
H
+
)
Finally
I
2
= e
r(Tt)
KE
_
1l
{

S
T
K}
_
= e
r(Tt)
KP
_
1l
{ln

S
T
ln K}
_
= e
r(Tt)
KN
_

ln K ln S
t
r(T t) +
1
2

2
(T t)
2H

H
(T t)
H
_
= Ke
r(Tt)
N(d
H

)
3.5. PRICING BY RISK PREFERENCES 35
Note that for the case H =
1
2
one obtains standard Black-Scholes pricing formula.
Corollary 3.5.4. The price of a fractional European put option is
P(T, t, S
t
, K, r, , H) = Ke
r(Tt)
(d
H

) S
t
(d
H
+
) (3.26)
Corollary 3.5.5. (Put-Call parity)
C(T, t, S
t
, K, r, , H) P(T, t, S
t
, K, r, , H) = S
t
Ke
r(Tt)
(3.27)
3.5.2 Role of the Hurst parameter
The conditional variance of the fBM consists of two factors. The rst
H
depends
only on the Hurst parameter. The following gure shows the shape of this factor:
Figure 3.1: Shape of the factor
H
for H [0.5, 1].
We see that for H =
1
2

H
reaches its maximum and as H 1,
H
0, which
means that in case of total persistence the uncertainty vanishes.
The second factor is (T t)
2H
and for H (
1
2
, 1) the relation between time to
maturity and the variance has convex shape.
Now let us take a look at the values of option for dierent Hurst parameters.
From the following diagram we see that when increasing H the price is decreasing.
To examine this eect in details we have to calculate a partial derivative with
respect to H.
Proposition 3.5.6. [RS, Theorem 4.3] The partial derivative of the call price C
with respect to the Hurst parameter H is given by
C
H
= S
t
f(d
H
+
)

H
(T t)
H
_
(1 H) (H +
1
2
) + 2 ln 2 + 2 ln(T t)
_
2
(3.28)
where f is a density of standard normal distribution, and is the digamma function.
3
3
The digamma function is dened as the logarithmic derivative of the gamma function:
(x) =
d
dx
ln (x) =

(x)
(x)
36 CHAPTER 3. FBM AS A MODEL IN FINANCE
Figure 3.2: Shape of the factor (T t)
2H
.
The following are immediate consequences of the properties of natural logarithm:
Proposition 3.5.7. [RS, Theorem 4.3] The partial derivative of the call price C
with respect to the Hurst parameter H has the following properties:
1. For := T t 1 it holds
C
H
(H) < 0, H (
1
2
, 1)
2. For := T t > 1 there exists

H (
1
2
, 1) such that
C
H
(

H) = 0
C
H
(H) > 0, H (
1
2
,

H)
C
H
(H) < 0, H (

H, 1)
We omit the technical proofs.
The next gure shows these relations between the Hurst parameter and the call
price in a graphical way:
3.5. PRICING BY RISK PREFERENCES 37
Figure 3.3: Price of the fractional European call option with varying Hurst parameter
H (chosen parameters: r = 0, 02, K = 100, = 0, 2, T t = 0, 25).
38 CHAPTER 3. FBM AS A MODEL IN FINANCE
Figure 3.4: Maturity eect on the relation between the price of the fractional Eu-
ropean call and Hurst parameter H for maturity = 0, 25, = 0, 75 and = 2
(chosen parameters: r = 0, 02, S = 100, K = 100, = 0, 2)
Chapter 4
Application to real market data
In this chapter we perform empirical analysis of the formula derived in section 3.4
for the intraday data from Warsaw Stock Exchange in Poland with comparison to
the standard Black-Scholes one.
4.1 Estimating the Hurst parameter
The scaling character of H-self-similarity suggests that the self-ane random func-
tion B
H
(t) is proportional to |t|
H
. Several methods of estimating H make use
of this property.
The simplest, the oldest and the most popular is R/S analysis. This method was
introduced by Hurst. Given a physical time series of length n ({X
i
: i {1, . . . , n}}
we divide it into k non-overlapping blocks. Next we compute two numbers
R(t
i
, d) = max{0, W(t
i
, 1), . . . , W(t
i
, d)} min{0, W(t
i
, 1), . . . , W(t
i
, d)} (4.1)
where t
i
= n/k|(i 1) + 1 are the starting points of the blocks which satisfy
(t
i
1) +d n and
W(t
i
, j) =
j

l=1
X
t
i
+l1

j
d
d

l=1
X
t
i
+l1
, j = 1, . . . , d
and S
2
((t
i
, d)) is the sample variance of X
t
i
, . . . , X
t
i
+d1
. For each value of d we
obtain a number of R/S samples. We compute these samples for logarithmically
spaced values of d. For the fractional Gaussian noise the ratio R/S follows
E[R(d)/S(d)] Cd
H
Hence a plot of log R(d)/S(d) versus log d should have a constant slope. Finally
the slope of the regression line for the R/S samples is an estimate for the Hurst
parameter. More on the methods of estimation the Hurst parameter can be found
in [Rose] or [Cle].
4.2 Estimating volatility
Here we present the procedure of volatility estimation introduced by Cajueiro and
Barbachan [CB]. Let
X
t
= ln(
S
t
S
0
) = t
1
2

2
t
2H
+ B
H
t
39
40 CHAPTER 4. APPLICATION TO REAL MARKET DATA
Let us assume that in order to estimate volatility () we make observations of the
realisation of this process at times t
k
=
kT
n
for k = 0, 1, . . . , n. We denote
Z
k
= Xk+1
n
T
Xk
n
T
Therefore
Z
k
= (B
H
k+1
n
T
B
H
k
n
T
) +

n

1
2

2
(t
2H
k+1
t
2H
k
)
Dividing both sides by T
H
we obtain:
Z
k
T
H
=

n
H

k
+

T
H
n

1
2T
H

2
(t
2H
k+1
t
2H
k
)
where
k
=
n
H
T
H
(B
H
k+1
n
T
B
H
k
n
T
). By self-similarity
(
0
, . . . ,
n1
)
_
B
H
1
B
H
0
, . . . , B
H
n
B
H
n1
_
We see that E(
k
) = 0 and E(
2
k
) = 1. We refer to [KMV] for the proof that one can
use sample variance to estimate :

2
n
=
n
n 1
(y
2
n
y
n
2
)
where y
k
=
n
H
Z
k
T
H
and y
n
=
y
0
++y
n1
n
.
The above procedure gives dierent values of estimated volatility. Let s

be the
sample variance of observed Z
k
s. By
2
H
we shall denote the estimated variance with
assumed Hurst parameter H. Therefore, when we use daily data for the purpose of
estimating annual volatility we have for the classical Black-Scholes model:

2
1
2
=

250s

and for the fractional one

2
H
= 250
H
s

As we shall see in the next section for the stock market H 0.63 which means
2
H
is
two times bigger than
2
1
2
. This property aects the option price obtained from the
proper formulae. The next gure shows the relation between FBS prices for several
values of H, but for volatility estimated basing on the same sample data.
4.3 Market data
All the calculations presented here are based on the WIG20
1
option intraday prices
from the period 01/01/2005 - 31/12/2009.
2
We eliminated all transactions made
before 120 days to maturity, because of small liquidity. As a result, taking in our
opinion the most reliable data we obtained the set of 152 000 transactions.
First we observed that by performing R/S analysis for dierent subperiods we
obtain very similar values of the estimated Hurst parameter, therefore since the
1
The WIG20 is the index of the twenty largest companies on the Warsaw Stock Exchange.
2
To be precise, because of the data availability, we took all the options series with the follow-
ing maturity dates: 18/03/2005, 17/06/2005, 16/09/2005, 16/12/2005, 17/03/2006, 16/06/2006,
15/09/2006, 15/12/2006, 16/03/2007, 21/03/2008, 20/06/2008, 19/09/2008, 19/12/2008,
20/03/2009, 19/06/2009, 18/09/2009, 18/12/2009.
4.3. MARKET DATA 41
Figure 4.1: Price of the fractional European call option with varying Hurst parameter
H (chosen parameters: r = 0, 02, K = 100,
2
1
2
= 0, 2, T t = 0, 25).
impact of the slight dierence in that parameter on the option price is negligible
we decided to use the value estimated for the whole sample period which is H =
0.6378215. For this value of the Hurst parameter we calculated the
H
coecient
to be
H
= 0.9316925.
We estimated historical volatility for the two-months periods. For the riskless
rate we took the yield of 52-week Polish Treasury notes.
To be able to price index options in both standard BS and Rosteks fractional
BS models one needs to be able to estimate the dividend yield. Because performing
this task would be very time consuming or even impossible we instead used formulae
for the price of the option on futures (Blacks formula). Futures contract follow the
behaviour of the index itself and at the same time are sensible to the payment of
dividends. The price of an option on the stock index is equivalent to the price of
the option on futures.
In the standard Black-Scholes model the Black formula is:
C(T, t, F
t
, K, r, ) = e
r(Tt)
(F
t
N(d
+
) KN(d

)) (4.2)
where
d

=
ln(
F
t
K
)
1
2

2
(T t)
_
(T t)
(4.3)
and in Rosteks fractional model:
42 CHAPTER 4. APPLICATION TO REAL MARKET DATA
C(T, t, F
t
, K, r, , H) = e
r(Tt)
(F
t
N(d
H
+
) KN(d
H

)) (4.4)
where
d
H

=
ln(
F
t
K
)
1
2

2
(T t)
2H

H
(T t)
H
(4.5)
Here F
t
denotes the price of the futures contract (written on the same asset as
the option) with maturity T at time t.
For our calculations we also took intraday data for respective futures contract
listen on the WSE.
To estimate the forecasting power of the formulae obtained we perform similar
analysis to the one that can be found in [MW]. For each transaction we compute
BS, and FBS price and then compare them in the means of average mean square
error.
AMSE =
1
n
n

i=1
_
C
market
i
C
calc
i
C
market
i
_
2
(4.6)
where C
market
i
denotes the market option price for i-th sample, and C
calc
i
is the price
from BS or FBS formula. Obviously the smaller the AMSE is, the better the pricing
formula is.
The following table shows the AMSEs of BS and FBS calculated for the full
sample set.
BS FBS
AMSE 0.6596 10.44
Table 4.1: AMSEs of BS and FBS
Judging only by the numbers above we nd that BS gives better approximation
of the market price in average. Performing further investigation, we shall see how
volatility, time to maturity and moneyness can inuence the comparison result.
For an option we dene the moneyness in the following way:
m =
S
t
K
1 (4.7)
where as usual S
t
stands for the stock price at time t and K is the strike price.
We divided our sample set into separable groups to check for which values of
m which formula performs better. Therefore we call an option deep out-of-the-
money if m < 10%, out-of-the-money for m [10%, 2%), at-the-money for
m [2%, 2%), in-the-money for m [2%, 10%) and deep in-the-money when
m 10%. The following table shows the AMSEs for the introduced option classes:
deep OTM OTM ATM ITM deep ITM
BS 0.0027 0.0076 3.0124 0.1482 0.3400
FBS 0.0119 0.0483 2.2930 1.2915 26.2758
Table 4.2: AMSEs of BS and FBS depending on the moneyness
4.3. MARKET DATA 43
From the above we see that for most classes of options BS approximates their
prices better, but FBS is much better then BS for at-the-money options (most liquid,
and most traded). We may also notice that the average error is very high for deep-
OTM option.
Next we divided our sample set according to the time to maturity. We say an
option is short-term if T t < 45 days, middle-term for T t [45 days, 90 days)
and long-term when T t 90 days. The following table shows the AMSEs for the
introduced time-to-maturity classes:
short middle long
BS 1.0604 0.1681 0.1990
FBS 24.4137 8.2451 9.4993
Table 4.3: AMSEs of BS and FBS depending on the time to maturity
From the above we see that BS formula outperforms FBS in all time-to-maturity
classes.
Finally we examine how the two pricing formulae behave in dependence on the
volatility. We introduce three volatility intervals: low volatility when 1
2
< 20%,
medium volatility for 1
2
[20%, 35%) and high volatility if 1
2
35%. The following
table shows the AMSEs for the introduced volatility classes:
small medium high
BS 0.1534 0.1911 2.0724
FBS 2.4060 12.8238 10.4624
Table 4.4: AMSEs of BS and FBS depending on volatility
In conclusion, we see that although the average error of the whole sample set is
lower for the BS formula, examination in more details showed that FBS may outper-
form the standard model under certain circumstances. This is not as astonishing,
because Meng and Wang [MW] earlier obtained similar results (yet for the dier-
ent formula) and concluded that because most investors and market makers trade
according to the prices obtained from the classical Black-Scholes formula the other
models can outperform BS only when the market mechanism is given a full scope.
The result shown here proves that the fractional Black-Scholes formula for option
price, more accurate from the theoretical point of view, may be more consistent
with the market price then the classical Black-Scholes formula, even though most
market participants trade according to the standard model, but only in certain
circumstances. However, we accentuate that in order to investigate this phenomenon
in more details data from more liquid stock or FX market should be taken into
consideration.
Also further modications to the model presented here may be considered, for
instance introducing stochastic volatility process, stochastic interest rates or random
jumps, that would increase the exactness of option pricing. In our opinion Rosteks
model opened a new, probably more fecund than the previous ones, way of involving
the fractional Brownian Motion into stochastic nance.
44 CHAPTER 4. APPLICATION TO REAL MARKET DATA
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