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based on Brownian motions, suffers from several defects. First, the path continuity assumption does not seem reasonable in view of the possibility of

sudden price variations (jumps) resulting of market crashes. Secondly, the

modeling of risky asset prices by Brownian motion relies on the use of the

Gaussian distribution which tends to underestimate the probabilities of extreme events.

A solution is to use stochastic processes with jumps, that will account for

sudden variations of the asset prices. On the other hand, such jump models

are generally based on the Poisson distribution which has a slower tail decay

than the Gaussian distribution. This allows one to assign higher probabilities

to extreme events, resulting in a more realistic modeling of asset prices.

The most elementary and useful jump process is the standard Poisson process

which is a stochastic process (Nt )tR+ with jumps of size +1 only, and whose

paths are constant in between two jumps, i.e. at time t, the value Nt of the

process is given by

Nt =

1[Tk ,) (t),

t R+ ,

(14.1)

k=1

where

The notation Nt is not to be confused with the same notation used for num

eraire

processes in Chapter 10.

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N. Privault

1[Tk ,) (t) =

1 if t Tk ,

0 if 0 t < Tk ,

k 1, and (Tk )k1 is the increasing family of jump times of (Nt )tR+ such

that

lim Tk = +.

k

1. Independence of increments: for all 0 t0 < t1 < < tn and n 1 the

random variables

Nt1 Nt0 , . . . , Ntn Ntn1 ,

are independent.

2. Stationarity of increments: Nt+h Ns+h has the same distribution as

Nt Ns for all h > 0 and 0 s t.

The meaning of the above stationarity condition is that for all fixed k N

we have

P(Nt+h Ns+h = k) = P(Nt Ns = k),

for all h > 0, i.e. the value of the probability

P(Nt+h Ns+h = k)

does not depend on h > 0, for all fixed 0 s t and k N.

The next figure represents a sample path of a Poisson process.

7

Nt

0

0

10

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Based on the above assumption, given a time value T > 0 a natural question

arises:

what is the probability distribution of the random variable NT ?

We already know that Nt takes values in N and therefore it has a discrete

distribution for all t R+ .

It is a remarkable fact that the distribution of the increments of (Nt )tR+ ,

can be completely determined from the above conditions, as shown in the

following theorem.

As seen in the next result, cf. [6], Nt Ns has the Poisson distribution

with parameter (t s).

Theorem 14.1. Assume that the counting process (Nt )tR+ satisfies the

above Conditions 1 and 2. Then for all fixed 0 s t we have

P(Nt Ns = k) = e(ts)

((t s))k

,

k!

k N,

(14.2)

The parameter > 0 is called the intensity of the Poisson process (Nt )tR+

and it is given by

1

:= lim P(Nh = 1).

(14.3)

h0 h

The proof of the above Theorem 14.1 is technical and not included here,

cf. e.g. [6] for details, and we could in fact take this distribution property

(14.2) as one of the hypotheses that define the Poisson process.

Precisely, we could restate the definition of the standard Poisson process

(Nt )tR+ with intensity > 0 as being a process defined by (14.1), which is

assumed to have independent increments distributed according to the Poisson

distribution, in the sense that for all 0 t0 t1 < < tn ,

(Nt1 Nt0 , . . . , Ntn Ntn1 )

is a vector of independent Poisson random variables with respective parameters

((t1 t0 ), . . . , (tn tn1 )).

In particular, Nt has the Poisson distribution with parameter t, i.e.

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P(Nt = k) =

(t)k t

e ,

k!

t > 0.

IE[Nt ] = t,

(14.4)

P(Nh = 1) = heh ' h,

h 0,

P(Nh = 0) = eh ' 1 h,

h 0.

and

By stationarity of the Poisson process we find more generally that

P(Nt+h Nt = 1) = heh ' h,

h 0,

P(Nt+h Nt = 0) = eh ' 1 h,

h 0,

and

for all t > 0.

This means that within a short interval [t, t + h] of length h, the increment Nt+h Nt behaves like a Bernoulli random variable with parameter

h. This fact can be used for the random simulation of Poisson process paths.

We also find that

P(Nt+h Nt = 2) ' h2

2

,

2

h 0,

t > 0,

k

,

k!

h 0,

t > 0.

P(Nt+h Nt = k) ' hk

The intensity of the Poisson process can in fact be made time-dependent (e.g.

by a time change), in which case we have

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k

w

r t (u)du

t

s

P(Nt Ns = k) = exp (u)du

,

s

k!

k 0.

In particular,

(t)dt

' 1 (t)dt,

o(dt),

k = 0,

k = 1,

k 2,

and (13.3) above. The intensity process ((t))tR+ can also be made random

in the case of Cox processes.

In order to prove the next proposition we note that we have the equivalence

{T1 > t} {Nt = 0},

and more generally

{Tn > t} {Nt n 1},

for all n 1.

In the next proposition we compute the distribution of Tn with its density.

It coincides with the gamma distribution with integer parameter n 1, also

known as the Erlang distribution in queueing theory.

Proposition 14.1. For all n 1 the probability distribution of Tn has the

density function

tn1

t 7 n et

(n 1)!

on R+ , i.e. for all t > 0 the probability P(Tn t) is given by

P(Tn t) = n

w

t

es

sn1

ds.

(n 1)!

Proof. We have

P(T1 > t) = P(Nt = 0) = et ,

t R+ ,

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P(Tn1 > t) =

w

t

es

(s)n2

ds,

(n 2)!

n 2,

we obtain

P(Tn > t) = P(Tn > t Tn1 ) + P(Tn1 > t)

= P(Nt = n 1) + P(Tn1 > t)

w

(s)n2

(t)n1

es

+

ds

= et

t

(n 1)!

(n 2)!

w

(s)n1

ds,

t R+ ,

=

es

t

(n 1)!

where we applied an integration by parts to derive the last line.

P(Nt = n) = pn (t) = et

(t)n

,

n!

Similarly we could show, using the strong Markov property (see e.g. Theorem 6.5.4 of [81]) that the times

k := Tk+1 Tk

spent in state k N, with T0 = 0, form a sequence of independent identically distributed random variables having the exponential distribution with

parameter > 0, i.e.

P(0 > t0 , . . . , n > tn ) = e(t0 +t1 ++tn ) ,

t0 , . . . , tn R+ .

with parameter > 0 is given by

IE[k ] =

1

,

we can check that the higher the intensity (i.e. the higher the probability

of having a jump within a small interval), the smaller is the time spent in

each state k N on average.

In addition, conditionally to {NT = n}, the n jump times on [0, T ] of

the Poisson process (Nt )tR+ are independent uniformly distributed random

variables on [0, T ]n , cf. e.g. 12.1 of [91]. This fact can be useful for the

random simulation of the Poisson process.

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Compensated Poisson Martingale

From (14.4) above we deduce that

IE[Nt t] = 0,

(14.5)

i.e. the compensated Poisson process (Nt t)tR+ has centered increments.

Since in addition (Nt t)tR+ also has independent increments we get

the following proposition.

Proposition 14.2. The compensated Poisson process

(Nt t)tR+

is a martingale with respect to its own filtration (Ft )tR+ .

Extensions of the Poisson process include Poisson processes with timedependent intensity, and with random time-dependent intensity (Cox processes). Renewal processes are counting processes

X

Nt =

1[Tn ,) (t),

t R+ ,

n1

distributed random variables. In particular, Poisson processes are renewal

processes.

The Poisson process itself appears to be too limited to develop realistic price

models as its jumps are of constant size. Therefore there is some interest in

considering jump processes that can have random jump sizes.

Let (Zk )k1 denote an i.i.d. sequence of square-integrable random variables with probability distribution (dy) on R, independent of the Poisson

process (Nt )tR+ . We have

P(Zk [a, b]) = ([a, b]) =

wb

a

(dy),

< a b < .

Yt =

Nt

X

Zk ,

t R+ ,

(14.6)

k=1

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is called a compound Poisson process.

The next figure represents a sample path of a compound Poisson process,

with here Z1 = 0.9, Z2 = 0.7, Z3 = 1.4, Z4 = 0.6, Z5 = 2.5, Z6 = 1.5,

Z7 = 1.2.

2.5

Yt

1.5

0.5

-0.5

0

10

Given that {NT = n}, the n jump sizes of (Yt )tR+ on [0, T ] are independent

random variables which are distributed on R according to (dx). Based on

this fact, the next proposition allows us to compute the moment generating

function of the increment YT Yt .

Proposition 14.3. For any t [0, T ] we have

w

IE [exp ((YT Yt ))] = exp (T t)

(ey 1)(dy) ,

R.

Proof. Since Nt has a Poisson distribution with parameter t > 0 and is

independent of (Zk )k1 , for all R we have by conditioning:

"

IE [exp ((YT Yt ))] = IE exp

!#

NT

X

Zk

k=Nt +1

"

= IE exp

NT

Nt

X

!#

Zk

k=1

"

IE exp

n=0

= e(T t)

n

X

!#

Zk

P(NT Nt = n)

k=1

"

!#

n

X

X

n

(T t)n IE exp

Zk

n!

n=0

k=1

Pn

k=1

Zk = 0 if n = 0.

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"

= e(T t)

X

n

n

(T t)n (IE [exp (Z1 )])

n!

n=0

w

= exp (T t)

(ey 1)(dy) ,

(dy) = 1.

From the characteristic function we can compute the expectation and variance of Yt for fixed t, as

IE[Yt ] = t IE[Z1 ]

and

IE[Yt ] = i

w

d

IE[eiYt ]|=0 = t

y(dy) = t IE[Z1 ].

##

" "N

t

X

Zk Nt

IE[Yt ] = IE IE

k=1

" n

#

X

X

n tn

=e

IE

Zk Nt = n

n!

n=1

k=1

" n

#

X

X

n tn

t

=e

IE

Zk

n!

n=1

t

k=1

X

(t)n1

= tet IE[Z1 ]

(n 1)!

n=1

= t IE[Z1 ].

More generally one can show that for all 0 t0 t1 tn and 1 , . . . , n

R we have

" n

#

!

n

w

Y i (Y Y

X

IE

e k tk tk1 ) = exp

(tk tk1 )

(eik y 1)(dy)

k=1

k=1

=

=

n

Y

k=1

n

Y

(eik y 1)(dy)

h

i

IE ei(Ytk Ytk1 ) .

k=1

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This shows in particular that the compound Poisson process (Yt )tR+ has

independent increments, as the standard Poisson process (Nt )tR+ .

Since the compensated Poisson process also has centered increments by

(14.5), we have the following proposition.

Proposition 14.4. The compensated compound Poisson process

Mt := Yt t IE[Z1 ],

t R+ ,

is a martingale.

By construction, compound Poisson processes only have a finite number

of jumps on any interval. They belong to the family of Levy processes which

may have an infinite number of jumps on any finite time interval, cf. [15].

Given (t )tR+ a stochastic process we let the stochastic integral of (t )tR+

with respect to (Yt )tR+ be defined by

wT

0

t dYt :=

NT

X

Tk Zk .

k=1

wT

Note that this expression

t dYt has a natural financial interpretation as

0

the value at time T of a portfolio containing a (possibly fractional) quantity

t of a risky asset at time t, whose price evolves according to random returns

Zk at random times Tk .

In particular the compound Poisson process (Yt )tR+ in (14.1) admits the

stochastic integral representation

wt

ZNs dNs .

Yt = Y0 +

0

Next, given (Wt )tR+ a standard Brownian motion independent of (Yt )tR+

and (Xt )tR+ a jump-diffusion process of the form

Xt =

wt

0

us dWs +

wt

0

vs ds + Yt ,

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t R+ ,

"

where (t )tR+ is a process which is adapted to the filtration (Ft )tR+ generated by (Wt )tR+ and (Yt )tR+ , and such that

w

w

T

T

IE

2s |us |2 ds < and IE

|s vs |ds < ,

T > 0,

0

we let the stochastic integral of (s )sR+ with respect to (Xs )sR+ be defined

by

wT

0

s dXs :=

wT

0

s us dWs +

wT

0

s vs ds +

NT

X

Tk Z k ,

T > 0.

k=1

satisfy the Ito isometry

IE

"

w

2 #

t (dYt IE[Z1 ]dt)

= IE[|Z1 |2 ] IE

w

T

0

||2t dt ,

(14.7)

(Yt )tR+ , which makes the left limit process (s )sR+ predictable. The proof

of (14.7) can be written using simple predictable processes, similarly to the

proof of Proposition 4.3. It also follows by taking expectations on both sides

of the stochastic Fubini type theorem

w

=2

2

t (dYt IE[Z1 ]dt)

wT

0

w t

0

w

T

0

2

||2t ZN

dN

,

t

t

in which the diagonal has been excluded in the double integral, and using the

fact that the expectation of the double stochastic integral vanishes.

For the mixed continuous-jump martingale

wt

Xt =

us dWs + Yt t IE[Z1 ],

0

t R+ ,

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IE

"

wT

0

2 #

s dXs

= IE

w

T

0

w

T

|s |2 |us |2 ds + IE[|Z1 |2 ] IE

|s |2 ds .

0

(14.8)

provided (s )sR+ is adapted to the filtration (Ft )tR+ generated by (Wt )tR+

and (Yt )tR+ .

This isometry formula will be used in Section 15.5 for the computation of

hedging strategies in jump models.

When (Xt )tR+ takes the form

Xt = X0 +

wt

0

us dWs +

wt

0

vs ds +

wt

0

s dYs ,

t R+ ,

wT

0

s dXs :=

wT

wT

s us dWs +

wT

s vs ds +

s us dWs +

wT

s vs ds +

wT

0

NT

X

s s dYs

Tk Tk Zk ,

T > 0.

k=1

14.4 It

o Formula with Jumps

Let us first consider the case of a standard Poisson process (Nt )tR+ with

intensity . We have the telescoping sum

f (Nt ) = f (0) +

Nt

X

(f (k) f (k 1))

k=1

= f (0) +

= f (0) +

= f (0) +

wt

0

wt

0

wt

0

(f (1 + Ns ) f (Ns ))dNs

(f (Ns ) f (Ns 1))dNs

(f (Ns ) f (Ns ))dNs .

Here, Ns denotes the left limit of the Poisson process at time s, i.e.

Ns = lim Nsh .

h&0

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In particular we have

k 1.

k = NTk = 1 + NT ,

k

By the same argument we find, in the case of the compound Poisson process

(Yt )tR+ ,

f (Yt ) = f (0) +

= f (0) +

= f (0) +

Nt

X

(f (YT + Zk ) f (YT ))

k

k=1

wt

0

wt

0

as

wt

wt

f (Yt ) = f (0) + (f (Ys ) f (Ys ))(dNs ds) + (f (Ys ) f (Ys ))ds.

0

wt

wt

wt

Xt = X0 +

us dWs +

vs ds +

s dYs ,

0

t R+ ,

we find, by combining the Ito formula for Brownian motion with the above

argument we get

f (Xt ) = f (X0 ) +

+

wt

0

wt

0

us f 0 (Xs )dWs +

vs f 0 (Xs )ds +

wt

NT

X

1 w t 00

f (Xs )|us |2 ds

2 0

(f (XT + Tk Zk ) f (XT ))

k

wt

1 w t 00

vs f 0 (Xs )ds

f (Xs )|us |2 ds +

us f 0 (Xs )dWs +

0

2 0

= f (X0 ) +

0

wt

+ (f (Xs + s ZNs ) f (Xs ))dNs

0

k=1

t R+ .

i.e.

wt

wt

1 w t 00

f (Xs )|us |2 ds +

vs f 0 (Xs )ds

f (Xt ) = f (X0 ) +

us f 0 (Xs )dWs +

0

0

2 0

wt

+ (f (Xs ) f (Xs ))dNs ,

t R+ .

(14.9)

0

"

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wt

wt

wt

Xt =

us dWs +

vs ds +

s dNs ,

0

t R+ ,

we get

wt

1wt

f (Xt ) = f (0) +

us f 0 (Xs )dWs +

|us |2 f 00 (Xs )dWs

0

2 0

wt

wt

+ vs f 0 (Xs )ds + (f (Xs + s ) f (Xs ))dNs

0

0

wt

1wt

0

|us |2 f 00 (Xs )dWs

(14.10)

= f (0) +

us f (Xs )dWs +

0

2 0

wt

wt

0

+ vs f (Xs )ds + (f (Xs ) f (Xs ))dNs .

0

Xt =

wt

us dWs +

wt

vs ds +

wt

s dNs ,

t R+ ,

Yt =

wt

as dWs +

wt

bs ds +

wt

cs dNs ,

t R+ ,

and

d(Xt Yt ) = Xt dYt + Yt dXt + dXt dYt

where the product dXt dYt is computed according to the extension

dt

dBt

dNt

dt

0

0

0

dBt

0

dt

0

dNt

0

0

dNt

dXt dYt = (vt dt + ut dBt + t dNt )(bt dt + at dBt + ct dNt )

= bt vt (dt)2 + bt ut dt dBt + bt t dt dNt

+at vt dtdBt + at ut (dBt )2 + at t dBt dNt

+ct vt dNt dBt + ct ut (dBt )2 + ct t dNt dNt

= at ut dt + ct t dNt ,

and in particular

(dXt )2 = (vt dt + ut dBt + t dNt )2 = u2t dt + t2 dNt .

For a process of the form

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Xt = X0 +

wt

0

us dWs +

wt

0

s dYt ,

t R+ ,

wt

wt

f (Xt ) = f (X0 ) +

vs f 0 (Xs )ds +

us f 0 (Xs )dWs

0

0

wt

1 w t 00

+

f (Xs )|us |2 ds +

s f 0 (Xs )dYs

0

2 0

wt

+ (f (Xs ) f (Xs ) Xs f 0 (Xs )) d(Ns s)

0

wt

+ (f (Xs ) f (Xs ) Xs f 0 (Xs )) ds,

t R+ ,

0

wt

0

s f 0 (Xs )dYs =

wt

0

Xs f 0 (Xs )dNs ,

t 0.

os formula to

Levy processes with an infinite number of jumps on any interval, using the

bound

|f (x + y) f (x) yf 0 (x)| Cy 2 ,

for f a Cb2 (R) function. Such processes, also called infinite activity Levy

processes [15] are also useful in financial modeling and include the gamma

process, stable processes, variance gamma processes, inverse Gaussian processes, etc, as in the following illustrations.

1. Gamma process.

0

t

"

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2. Stable process.

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4. Inverse Gaussian process.

0

t

Let us start with the simplest example

dSt = St dNt ,

(14.11)

of a stochastic differential equation with respect to the standard Poisson process, with constant coefficient R.

When

Nt = Nt Nt = 1,

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i.e. when the Poisson process has a jump at time t, the equation (14.11) reads

dSt = St St = St ,

t > 0.

St = (1 + )St ,

t > 0.

By induction, applying this procedure for each jump time gives us the solution

St = S0 (1 + )Nt ,

t R+ .

dSt = t St dNt .

(14.12)

dSTk = STk ST = Tk ST ,

k

i.e.

STk = (1 + Tk )ST ,

k

and repeating this argument for all k = 1, . . . , Nt yields the product solution

St = S0

Nt

Y

(1 + Tk ) = S0

(1 + s ),

t R+ .

Ns =1

0st

k=1

The equation

dSt = t St dt + t St (dNt dt),

(14.13)

is then solved as

St = S0 exp

w

s ds

wt

0

Y

Nt

s ds

(1 + Tk ),

t R+ .

k=1

is given in Figure 14.8 for constant = t , t R+ .

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2

St

1.5

0.5

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

2.0

The above simulation can be compared to the real sales ranking data of

Figure 14.9.

A random simulation of the geometric compound Poisson process

St = S0 exp

w

s ds IE[Z1 ]

wt

0

Y

Nt

s ds

(1 + Tk Zk )

t R+ ,

k=1

solution of

dSt = t St dt + t St (dYt IE[Z1 ]dt),

is given in Figure 14.10.

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2

St

1.5

0.5

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

2.0

dSt = t St dt + t St (dYt IE[Z1 ]dt) + t St dWt ,

we get

St = S0 exp

Nt

Y

w

s ds IE[Z1 ]

wt

0

s ds +

wt

0

s dWs

1wt

|s |2 ds

2 0

(1 + Tk Zk ),

k=1

t R+ . A random simulation of the geometric Brownian motion with compound Poisson jumps is given in Figure 14.11.

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"

3

2.5

St

1.5

1

0.5

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

2.0

By rewriting St as

w

wt

wt

t

1wt

St = S0 exp

s ds +

s (dYs IE[Z1 ]ds) +

s dWs

|s |2 ds

0

0

0

2 0

Nt

Y

(eTk (1 + Tk Zk )),

k=1

t R+ , one can extend this jump model to processes with an infinite number

of jumps on any finite time interval, cf. [15]. The next Figure 14.12 shows

a number of downward and upward jumps occuring in the historical price

of the SMRT stock, with a typical geometric Brownian behavior in between

jumps.

"

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N. Privault

Recall that in its simplest form, the Girsanov theorem for Brownian motion

follows from the calculation

2

1 w

IE[f (WT T )] =

f (x T )ex /(2T ) dx

2T

2

1 w

f (x)e(x+T ) /(2T ) dx

=

2T

2

2

1 w

=

f (x)ex T /2 ex /(2T ) dx

2T

2

(WT )],

= IE[f

T /2

]

(14.14)

defined by

= eWT 2 T /2 dP,

dP

cf. Section 6.2. Equivalently we have

(WT + T )],

IE[f (WT )] = IE[f

(14.15)

hence

under the probability measure

2

:= eWT

dP

T /2

dP,

N (0, T ).

More generally, the Girsanov theorem states that (Wt + t)t[0,T ] is a stan

dard Brownian motion under P.

When Brownian motion is replaced with a standard Poisson process

(Nt )tR+ , the above space shift

Wt 7 Wt + t

may not be used because Nt + t cannot be a Poisson process, whatever the

change of probability applied, since by construction, the paths of the standard Poisson process has jumps of unit size and remain constant between

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"

jump times.

The correct way to proceed in order to extend (14.15) to the Poisson case

is to replace the space shift with a time contraction (or dilation) by a certain

factor 1 + c with c > 1, i.e.

Nt 7 Nt/(1+c)

or Nt 7 N(1+c)t .

Assume that (Nt )tR+ is a standard Poisson process with intensity under

P. By analogy with (14.14) we can write

((1 + c)T )k

= ecT (1 + c)k P(NT = k),

k!

P(N(1+c)T = k) = e(1+c)T

IE[f (N(1+c)T )] =

f (k)P(N(1+c)T = k)

(14.16)

k=0

= ecT

k=0

w

= ecT

(1 + c)NT f (NT )dP

=

f (NT )dP

[f (NT )],

= IE

is defined by

where the probability measure P

dP

Consequently,

under the probability measure

:= ecT (1 + c)NT dP,

dP

with intensity (1 + c)T , i.e. the law of N(1+c)T under P.

[f (NT /(1+c) )],

IE[f (NT )] = IE

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N. Privault

the law of NT /(1+c) is that of a standard Poisson random varii.e. under P

, and since (Nt/(1+c) t)tR has

Poisson process with intensity under P

+

Nt/(1+c) t,

t R+ ,

is a martingale under P

Nt/(1+c) =

n1

t R+ ,

1[(1+c)Tn ,) (t),

n1

which shows that under P

and we know that they are distributed as the jump times of a Poisson process

.

with intensity under P

Next, taking

c := 1 +

i.e.

)k

(T

(NT = k),

=P

k!

k N, and

under the probability measure

dP

!NT

dP,

= (1 + c)T.

T

Consequently, since

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"

tR

(Nt (1 + c)t)tR+ = (Nt t)

+

has independent increments, the compensated Poisson process

Nt (1 + c)t = Nt t

by (6.2), although when c 6= 0 it is not a martingale

is a martingale under P

under P.

In the case of compound Poisson processes the Girsanov theorem can be

extended to variations in jump sizes in addition to time variations, and we

have the following more general result.

Theorem 14.2. Let (Yt )t0 be a compound Poisson process with intensity > 0 and jump distribution (dx). Consider another jump distribution

(dx), and let

d

(x) :=

(x) 1,

x R.

d

Then,

under the probability measure

NT

Y

:= e()T

dP

,

, ,

(1 + (Zk ))dP

k=1

the process

Yt =

Nt

X

Zk ,

t R+ ,

k=1

> 0, and

- modified intensity

- modified jump distribution (dx).

Proof. For any bounded measurable function f on R, we extend (14.16) to

the following change of variable

"

#

NT

Y

()T

IE,

IE, f (YT ) (1 + (Zi ))

[f (YT )] = e

i=1

=e

()T

X

k=0

"

"

IE, f

k

X

i=1

!

Zi

k

Y

#

(1 + (Zi ))NT = k P(NT = k)

i=1

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N. Privault

= eT

X

(T )k

k=0

=e

= eT

k!

X

(T )k w

k=0

X

k=0

k

X

!

Zi

i=1

X

(T )k w

k=0

= eT

k!

"

IE, f

k!

k

Y

#

(1 + (Zi ))

i=1

f (z1 + + zk )

k

Y

i=1

f (z1 + + zk )

k

Y

d

i=1

!

(zi ) (dz1 ) (dzk )

w

) w

(T

f (z1 + + zk )

(dz1 ) (dzk ).

k!

k

, YT has the distribution of a compound Poisson

and jump distribution . We refer to Proposition 9.6

process with intensity

.

of [15] for the independence of increments of (Yt )tR+ under P

,

Note that the compound Poisson process with intensity

distribution can be built as

Nt/

Xt :=

h(Zk ),

k=1

P(h(Zk ) A) = P(Zk h1 (A)) = (h1 (A)) = (A),

for all measurable subset A of R.

As a consequence of Theorem 14.2, the compensated process

IE [Z1 ]

Yt t

defined by

becomes a martingale under the probability measure P

,

= e()T

dP

,

NT

Y

, .

(1 + (Zk ))dP

k=1

of a standard Brownian motion (Wt )tR+ and an independent compound

Poisson process (Yt )tR+ , as in the following result which is a particular case

of Theorem 33.2 of [105].

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"

Theorem 14.3. Let (Yt )t0 be a compound Poisson process with intensity

> 0 and jump distribution (dx). Consider another jump distribution (dx)

> 0, and let

and intensity parameter

(x) :=

(x) 1,

d

x R,

and let (ut )tR+ be a bounded adapted process. Then the process

wt

IE [Z1 ]t

Wt +

us ds + Yt

0

tR+

Y

NT

wT

1wT

)T

= exp (

, .

dP

us dWs

|us |2 ds

(1+(Zk ))dP

u,,

0

2 0

k=1

(14.17)

As a consequence of Theorem 14.3, if

wt

Wt +

vs ds + Yt

0

is not a martingale under P

u,,

provided u,

IE [Z1 ],

vs = us

s R,

(14.18)

IE [Z1 ]dt,

dWt + ut dt + dYt

wt

IE [Z1 ]

in which both Wt +

us ds

and Yt t

0

tR+

tingales under P

u,,

When

for Brownian motion, in which case (14.18) admits only one solution given

u,0,0 . Note that uniqueness occurs also

by u = v and there is uniqueness of P

when u = 0 in the absence of Brownian motion with Poisson jumps of fixed

size a (i.e. (dx) = (dx) = a (dx)) since in this case (14.18) also admits

= v and there is uniqueness of P

. These remarks will

only one solution

0,,a

be of importance for arbitrage pricing in jump models in Chapter 15.

"

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N. Privault

Exercises

Exercise 14.1 Let (Nt )tR+ be a standard Poisson process with intensity

> 0, started at N0 = 0.

a) Solve the stochastic differential equation

dSt = St dNt St dt = St (dNt dt).

b) Using the first Poisson jump time T1 , solve the stochastic differential equation

dSt = St dt + dNt ,

t (0, T2 ).

Exercise 14.2 Consider a standard Poisson process (Nt )tR+ with intensity

> 0.

a) Solve the stochastic differential equation dXt = Xt dNt for (Xt )tR+ ,

where > 0 and X0 = 1.

b) Show that the solution (St )tR+ of the stochastic differential equation

dSt = rdt + St dNt ,

wt

is given by St = S0 Xt + rXt

Xs1 ds.

0

c) Compute IE[Xt ] and IE[Xt /Xs ], 0 s t.

d) Compute IE[St ], t R+ .

Nt

X

Zk , where

k=1

(Nt )tR+ is a standard Poisson process with intensity > 0, (Zk )k1 is an

i.i.d. sequence of N (0, 1) Gaussian random variables. Solve the stochastic

differential equation

dSt = rSt dt + St dYt ,

where , r R.

Exercise 14.4 Show, by direct computation or using the characteristic function, that the variance of the compound Poisson process Yt with intensity

> 0 satisfies

w

Var [Yt ] = t IE[|Z1 |2 ] = t

x2 (dx).

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"

St = S0 et+Wt +Yt ,

t R+ ,

a) Derive the stochastic differential equation with jumps satisfied by (St )tR+ .

) of probability measures under which the

b) Let r > 0. Find a family (P

u,,

Exercise 14.6 Consider (Nt )tR+ a standard Poisson process with intensity

> 0, independent of (Wt )tR+ , under a probability measure P. Let (St )tR+

be defined by the stochastic differential equation

dSt = St dt + YNt St dNt ,

(14.19)

Yk = eXk 1,

where

Xk ' N (0, 2 ),

k 1.

b) We assume that and the risk-free rate r > 0 are chosen such that the

discounted process (ert St )tR+ is a martingale under P. What relation

does this impose on and r?

c) Under the relation of Question (b), compute the price at time t of a European call option on ST with strike and maturity T , using a series

expansion of Black-Scholes functions.

Exercise 14.7 Consider a standard Poisson process (Nt )tR+ with intensity

> 0 under a probability measure P. Let (St )tR+ be the mean reverting

process defined by the stochastic differential equation

dSt = St dt + (dNt dt),

(14.20)

a) Solve the equation (14.20) for St .

b) Compute f (t) := IE[St ] for all t R+ .

c) Under which condition on , , and does the process St become a

submartingale ?

d) Propose a method for the calculation of expectations of the form IE[(ST )]

where is a payoff function.

"

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