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# Stochastic Volatility and

Epsilon-Martingale Decomposition
Jean-Pierre Fouque, George Papanicolaou and Ronnie Sircar
Abstract. We address the problems of pricing and hedging derivative securi-
ties in an environment of uncertain and changing market volatility. We show
that when volatility is stochastic but fast mean reverting Black-Scholes pricing
theory can be corrected. The correction accounts for the eect of stochastic
volatility and the associated market price of risk. For European derivatives it
is given by explicit formulas which involve parsimonous parameters directly
calibrated from the implied volatility surface. The method presented here is
based on a martingale decomposition result which enables us to treat non-
Markovian models as well.
1. Stochastic Volatility Models
We consider stochastic volatility models where the asset price (X
t
)
t0
satises the
stochastic dierential equation
dX
t
= X
t
dt +
t
X
t
dW
t
,
and (
t
)
t0
is called the volatility process. It must satisfy some regularity condi-
tions for the model to be well-dened, but it does not have to be an Ito process:
it can be a jump process, a Markov chain, etc. In order for it to be a volatility,
it should be positive. Unlike the implied deterministic volatility models for which
the volatility is a deterministic function (t, X
t
) of time and price, the volatil-
ity process is not perfectly correlated with the Brownian motion (W
t
). Therefore,
volatility is modeled to have an independent random component and since
t
is
not the price of a traded asset, the market is incomplete and there is no longer a
unique equivalent martingale measure. We refer to [6], [5] or [3](Ch.2) for reviews
of stochastic volatility models.
1.1. Mean-Reverting Stochastic Volatility Models
We consider rst volatility processes which are It o processes satisfying stochastic
dierential equations driven by a second Brownian motion. This is a convenient
way to incorporate correlation with stock price changes.
One feature that most volatility models seem to like is mean-reversion. The
term mean-reverting refers to the characteristic (typical) time it takes for a process
2 J.-P. Fouque, G. Papanicolaou and R. Sircar
to get back to the mean-level of its invariant distribution (the long-run distribution
of the process). In other words we assume that
t
properties. From a nancial modeling perspective, mean-reverting refers to a linear
pull-back term in the drift of the volatility process itself, or in the drift of some
(underlying) process of which volatility is a function. Let us denote
t
= f(Y
t
)
where f is some positive function. Then mean-reverting stochastic volatility means
that the stochastic dierential equation for (Y
t
) looks like
dY
t
= (mY
t
)dt +d

Z
t
,
where (

Z
t
)
t0
is a Brownian motion correlated with (W
t
). Here is called the rate
of mean-reversion and m is the long-run mean-level of Y . The drift term pulls Y
towards m and consequently we would expect that
t
is pulled towards the mean
value of f(Y ), with respect to the long-run distribution of Y .
Choosing > 0 constant corresponds to the Ornstein-Uhlenbeck process
which is a Gaussian process with the normal invariant distribution N(m,
2
/2).
This choice, though not necessary, is particularly convenient to explain the concept
of fast mean-reversion and to show through relatively explicit computations how
to exploit this property in pricing and hedging problems. It is still very exible
since the function f is unspecied.
The second Brownian motion (

Z
t
) is correlated with the Brownian motion
(W
t
) driving the asset price equation. We denote by [1, 1] the instantaneous
correlation coecient dened by
dW,

Z
t
= dt.
It is also convenient to write

Z
t
= W
t
+
_
1
2
Z
t
,
where (Z
t
) is a standard Brownian motion independent of (W
t
). It is often found
from nancial data that < 0, and there are economic arguments for a negative
correlation or leverage eect between stock price and volatility shocks. From com-
mon experience and empirical studies, when volatility goes up, asset prices tend
to go down. In general, the correlation may depend on time (t) [1, 1], but we
shall assume it a constant for notational simplicity and because, in most practical
situations, it is taken to be such.
1.2. Pricing with Equivalent Martingale Measures
Because of the additional source of randomness in the volatility process, contingent
claims cannot, in general, be replicated by self-nancing portfolios made of stocks
and riskfree bonds for which we assume a constant interest rate r for simplicity.
There is no uniqueness of no-arbitrage prices. We take the point of view that
the market is choosing one equivalent martingale measure to determine prices of
derivatives. This translates into the introduction of a market price of volatility risk
Stochastic Volatility and Martingale Decomposition 3

t
, an adapted process such that
dIP
()
dIP
= exp
_

1
2
_
T
0
(
2
s
+
2
s
)ds
_
T
0

s
dW
s

_
T
0

s
dZ
s
_
,
denes an equivalent probability IP
()
with
t
= ( r)/f(Y
t
) . By Girsanovs
theorem
W

t
= W
t
+
_
t
0
( r)
f (Y
s
)
ds , Z

t
= Z
t
+
_
t
0

s
ds,
are two independent Brownian motions under IP
()
. We assume that
t
= (Y
t
)
is a function of Y
t
only and our model under the equivalent martingale measure
IP
()
becomes
dX
t
= rX
t
dt +f(Y
t
)X
t
dW

t
,
dY
t
= [(mY
t
) (Y
t
)] dt +d

t
,
where

Z

t
= W

t
+
_
1
2
Z

t
and (y) =
(r)
f(y)
+ (y)
_
1
2
is a combined
market price of risk.
Denoting by IE
()
the expectation with respect to IP
()
, derivatives with
time T payo H are then priced by using the formula
V
t
= IE
()
{e
r(Tt)
H|F
t
},
for all t T, excluding arbitrage opportunities. The ltration (F
t
) is generated by
(W, Z) or (W

, Z

## ). Even though, in these Markovian models, derivatives prices

can be obtained as solutions of PDEs through the Feynman-Kac formula, we
will not use this point of view. The martingale approach developed here has the
advantage to generalize naturally to non-Markovian models.
1.3. Fast Mean-Reversion
We consider the regime where the rate of mean-reversion is large while the
variance of the invariant distribution of Y
t
remains of order one (
2
=
2
/2 in
the OU case). In other words the volatility clock is running faster than typical
maturities of order one unit of time (the year for instance). Empirical evidence for
this regime in the S&P500 are given in [3](Ch.4) and in the forthcoming detailed
analysis [4]. It is mathematically convenient to introduce the small parameter
= 1/,
and to rescale accordingly to =

2 /

## where does not vary with . With

this notation our model under the pricing equivalent martingale measure becomes
dX

t
= rX

t
dt +f(Y

t
)X

t
dW

t
,
dY

t
=
_
1

(mY

t
)

(Y

t
)
_
dt +

t
,
where we write (X

, Y

## ) to indicate explicitly the dependence upon .

4 J.-P. Fouque, G. Papanicolaou and R. Sircar
2. Asymptotic Pricing
We consider a European derivative given by its nonnegative payo function h(x)
and its maturity time T. We assume that h is a smooth function in order to avoid
technicalities in explaining the principle of our asymptotic method rst introduced
in [3](Ch.10). The nonsmooth case is more technical and not presented here. The
price P

## (t) of this derivative at time t < T is given by

P

(t) = IE
()
{e
r(Tt)
h(X

T
)|F
t
} ,
where the conditional expectation is with respect to the ltration (F
t
) of the two
Brownian motions. Instead of characterizing this price as a function of the current
values (x, y) of (X

t
, Y

t
) satisfying a two-dimensional PDE, we characterize P

(t)
by the fact that the process M

dened by
M

t
= e
rt
P

(t) = IE
()
{e
rT
h(X

T
)|F
t
} ,
is a martingale with a terminal value given by
M

T
= e
rT
h(X

T
) .
Our goal is to show that P

Q

(t, X

t
) where Q

## (t, x) is a function, independent of y, to be determined.

2.1. The Epsilon-Martingale Decomposition Argument
For a function Q

## (t, x) to be determined which may depend on but not on y, we

consider the process N

dened by
N

t
= e
rt
Q

(t, X

t
) .
Requiring that the function Q

satises Q

## (T, x) = h(x) at the nal time T, we

have
M

T
= N

T
.
The method consists in nding Q

## (t, x) such that N

can be decomposed as
N

t
=

M

t
+R

t
,
where

M

is a martingale and R

t
is of order . Observe that in this decomposition
the terms of order

are absorbed in the martingale part.
Supposing that this has been established, by taking a conditional expectation
with respect to F
t
on both sides of the equality
N

T
=

M

T
+R

T
,
and using the martingale property of

M

, one obtains
IE

{N

T
|F
t
} =

M

t
+IE

{R

T
|F
t
} .
Stochastic Volatility and Martingale Decomposition 5
From the terminal condition M

T
= N

T
and the martingale property of M

we
deduce that the left hand side is also equal to M

t
. From the decomposition of N

t
we have

M

t
= N

t
R

t
and therefore
M

t
= N

t
+IE

{R

T
|F
t
} R

t
.
Multiplying by e
rt
and using the denitions of M

t
and N

t
one deduces
P

(t) = Q

(t, X

t
) +O() ,
which is the desired approximation result. Indeed it remains to determine Q

## leading to the epsilon-decomposition of N

.
2.2. Decomposition Result
Assuming a priori sucient smoothness of the function Q

we write
dN

t
= d
_
e
rt
Q

(t, X

t
)
_
= e
rt
_

t
+
1
2
f(Y

t
)
2
(X

t
)
2

2
x
2
+rX

x
r
_
Q

(t, X

t
)dt
+ e
rt
_
Q

x
(t, X

t
)
_
f(Y

t
)X

t
dW

t
.
The method consists in cancelling the bounded variation terms as much as possible.
The rst obvious step in that direction is to replace the volatility f(Y

t
) by a
constant volatility and to consider Q

## (t, x) as a perturbation of the corresponding

Black-Scholes pricing function. A natural choice of a constant volatility is given
by averaging f
2
with respect to the invariant distribution of Y

. Denoting this
averaging by

we dene

2

= f
2

.
In our example, Y

## is a perturbed Ornstein-Uhlenbeck process and its invariant

J

exp
_

(y m)
2
2
2

(y)
_
,
where

is an antiderivative of the market price of risk and J

is the appropriate
normalizing constant. Introducing the usual Black-Scholes operator
L
BS
() =

t
+
1
2

2
x
2

2
x
2
+r
_
x

x

_
,
we have
dN

t
= e
rt
_
L
BS
(

) +
1
2
_
f(Y

t
)
2

2

_
(X

t
)
2

2
x
2
_
Q

(t, X

t
)dt
+ e
rt
_
Q

x
(t, X

t
)
_
f(Y

t
)X

t
dW

t
.
6 J.-P. Fouque, G. Papanicolaou and R. Sircar
Setting Q

= P

0
+

Q

1
where P

0
is the the solution of the Black-Scholes equation
L
BS
(

)P

0
= 0 with the terminal condition P

0
(T, x) = h(x), we deduce
dN

t
= e
rt
_
L
BS
(

1
(t, X

t
) +
1
2
_
f(Y

t
)
2

2

_
(X

t
)
2

2
Q

x
2
(t, X

t
)
_
dt
+ e
rt
_
Q

x
(t, X

t
)
_
f(Y

t
)X

t
dW

t
.
The second term will be small of order O(

## ) by a central limit type argument and

1
will be chosen to combine with it into a term of order O() and a martingale
term. For clarity we do that rst by using the Markov property of Y

.
2.2.1. Markovian Case. We denote by
1
L
0
(resp.
1
L

0
) the innitesimal
generator of the unperturbed (resp. perturbed) Markov process Y

. In the partic-
ular case of an OU process one has:
L
0
= (my)

y
+
2

2
y
2
,
L

0
= L
0

2 (y)

y
= (my

2 (y))

y
+
2

2
y
2
.
We then consider a solution

## of the Poisson equation

L

(y) = f(y)
2

2

,
which we assume to be well dened (up to an additive constant) and to have a
bounded derivative as in the OU case with a bounded function f.
We then deduce from Itos formula that
_
f(Y

t
)
2

2

_
dt =
_
d(

(Y

t
))

(Y

t
)d

t
_
,
dN

t
= e
rt
_
L
BS
(

1
(t, X

t
)dt +
1
2
(X

t
)
2

2
Q

x
2
(t, X

t
)d(

(Y

t
))
_
+ e
rt
_
Q

x
(t, X

t
)
_
f(Y

t
)X

t
dW

2
e
rt
_
(X

t
)
2

2
Q

x
2
(t, X

t
)
_

(Y

t
)d

t
.
The second term is computed by using the integration by parts formula:
(X

t
)
2

2
Q

x
2
d (

(Y

t
)) = d
_
(X

t
)
2

2
Q

x
2

(Y

t
)
_

(Y

t
)d
_
(X

t
)
2

2
Q

x
2
_
d
_
(X

)
2

2
Q

x
2
,

(Y

)
_
t
,
Stochastic Volatility and Martingale Decomposition 7
where the covariation term is given by
d
_
(X

)
2

2
Q

x
2
,

(Y

)
_
t
=

(Y

t
)

x
_
x
2

2
Q

x
2
_
(t, X

t
)f(Y

t
)X

t
dt .
Collecting the martingale terms and the bounded variation terms of order O(),
we get
N

t
= N

0
+ Martingale
+
_
t
0
e
rs
_
L
BS
(

1
(s, X

s
)

(Y

s
)f(Y

s
)X

x
_
x
2

2
P

0
x
2
_
(t, X

s
)
_
ds
+ O() .
We choose now

Q

1
such that the quantity to be integrated in time is centered with
respect to the invariant distribution of Y

## . Repeating the argument above, one can

show that this integral can be replaced by the sum of a martingale and a term of
order O(). The centering involves the third derivative of the Black-Scholes price
P

0
. Introducing the small constant
V

3
=

2
f

,
and dening the source function
H

(t, x) = V

3
x

x
_
x
2

2
P

0
x
2
_
= V

3
_
2x
2

2
P

0
x
2
+x
3

3
P

0
x
3
_
,
we choose

Q

1
(t, x) to be the solution of the Black-Scholes equation
L
BS
(

1
= H

,
with the zero terminal condition

Q

1
(T, x) = 0. The desired decomposition follows
N

t
=

M

t
+R

t
,
where

is a martingale and R

## is small of order O(). Note that Q

= P

0
+

1
do
not depend on y and satises Q

Q

1
is of order O(

)
and P

(t) = Q

## (t, x) + O(). Note also that in the less interesting uncorrelated

case = 0, the correction

Q

1
is simply zero and the approximated price is the
Black-Scholes price P

0
with the modied volatility

.
2.2.2. Non-Markovian Case. We briey indicate how to obtain the decom-
position of N

that Y

## has an invariant distribution and is strongly mixing with a fast exponen-

tial rate of mixing denoted by . We again set = 1/ and we assume that the
variance of the invariant distribution of the unperturbed process Y denoted by

2
is independent of . We also suppose that Y has a diusion part driven by a
8 J.-P. Fouque, G. Papanicolaou and R. Sircar
Brownian motion correlated to W through the constant as in the Markovian
case.
The decomposition result is then obtained as in the Markovian case except
that we cannot dene the corrector

## by using the Poisson equation involving

(Y

t
) is replaced by the random quantity

(t)
dened by the conditional shift

(t) =
1

IE

_
_
T
t
_
f(Y

s
)
2

2

_
ds|F

t
_
.
It is very similar to the way the solutions of the Poisson equations are constructed
in the Markovian case since the simple change of variable u = s/ shows that it is
comparable to

(y) =
_
+
0
IE

__
f(Y
t
)
2

2

_
|Y
0
= y
_
dt ,
used in the Markovian case. The method of conditional shift (or pseudo-generator)
is treated in [7] for instance. The rest of the proof is very similar to the Markovian
case once we observe that
M

t
=

(t)
1

_
t
0
_
f(Y

s
)
2

2

_
ds ,
is a martingale. Dening

(t) by

2
d W

, M

t
=

(t)dt ,
so that it plays the role of

(Y

t
) in the Markovian case, the small constant
V

3
is given by the averaging
V

3
= f

.
The source function H

## (t, x) and the correction

Q

1
(t, x) are then dened exactly
as in the Markovian case and the same conlusion follows:

Q

1
is of order O(

)
and P

(t) = P

0
(t, x) +

Q

1
(t, x) +O().
3. Practical Form of the Approximated Price
The computation of the approximated price P

0
+

Q

1
requires the two parameters

and V

3
in order to compute rst the Black-Scholes price P

0
and then deduce
the correction

Q

1
. In fact it is easily shown, [3](Ch.5), that

1
= (T t)H

= (T t)V

3
x

x
_
x
2

2
P

0
x
2
_
.
The mean square volatility
2

## would be easy to estimate except for the fact that

we do not observe stock returns under the risk neutral probability IP
()
but
rather under the subjective probability IP which does not involve the market price
Stochastic Volatility and Martingale Decomposition 9
of volatility risk . For practical purpose we need to rewrite our approximation
formula with a dierent set of parameters.
3.1. Perturbed Invariant Distribution
Denoting by the average with respect to the invariant distribution of the un-
perturbed Y process, we have the following expansion of the invariant distribution
of the perturbed Y

process

( )
_
+O() ,
where

is an antiderivative of the combined market price of risk . Dening

2
= f
2
, it follows that
L
BS
(

) = L
BS
( ) +
1
2
_
f
2

f
2

_
x
2

2
x
2
= L
BS
( )

(f
2
f
2
)x
2

2
x
2
+O() .
Introducing P
0
(t, x), the Black-Scholes solution with constant voaltility , one can
easily write

P
1
= (T t)
_
V
2
x
2

2
P
0
x
2
+V
3
x
3

3
P
0
x
3
_
,
for two parameters V
2
and V
3
, small of order O(

## ), and such that the approx-

imation P

(t) = P
0
(t, x) +

P
1
(t, x) + O() holds. This is the form which arises
naturally when performing the asymptotics on the pricing PDE in the Markovian
case as described rst in [1] and detailed in [3](Ch.5).
3.2. Calibration
Without going into details we see that, in order to use this formula, we need the
three parameters ( , V
2
, V
3
). The rst one is easily estimated on historical returns
data. The two others, the V s, can be obtained by using observed call option prices
or equivalently by tting the term structure of implied volatility. Explicit formulas
are given in [2] and, in [3](Ch.6) with a stability analysis.
4. Hedging
To stay within a reasonable length we simply recall that, in presence of stochastic
volatility, a perfect self-nancing hedge of a derivative, with stocks and bonds
only, is not possible in general. When volatility is fast mean-reverting as described
in this paper, it is possible to correct a pure Black-Scholes hedge ratio in order
to reduce the bias introduced in the cost of the hedging strategy. This hedging
correction gives a mean self-nancing strategy up to order O(). It is obtained by
the method described in Section 2.2 but performed under the objective probability
IP. We refer to [3](Ch.7) for details and formulas.
10 J.-P. Fouque, G. Papanicolaou and R. Sircar
References
[1] J.P. Fouque, G. Papanicolaou and R. Sircar, Asymptotics of a Two-Scale Stochastic
Volatility Model, Equations aux derivees partielles et applications, Articles dedies `a
Jacques-Louis Lions, Gauthier-Villars, Paris (1998) 517526.
[2] J.P. Fouque, G. Papanicolaou and R. Sircar, Mean-Reverting Stochastic Volatility,
International Journal of Theoretical and Applied Finance, 3(1) (2000), 101142.
[3] J.P. Fouque, G. Papanicolaou and R. Sircar, Derivatives in Financial Markets with
Stochastic Volatility, Cambridge University Press, 2000.
[4] J.P. Fouque, G. Papanicolaou, R. Sircar and K. Solna, Mean Reversion of S&P 500
Volatility, preprint (2000).
[5] R. Frey, Derivative Asset Analysis in Models with Level-Dependent and Stochastic
Volatility, CWI Quarterly, 10(1) (1996), 134.
[6] E. Ghysels, A. Harvey and E. Renault, Stochastic Volatility, Statistical Methods in
Finance. Handbook of Statistics, 14(Ch.5) (1996) 119191.
[7] A. Kushner, Approximation and Weak Convergence Methods for random Processes,
MIT Press, 1984.
Jean-Pierre Fouque,
Department of Mathematics,
North Carolina State University,
Raleigh NC 27695-8205, USA
Partially supported by NSF/DMS-0071744