AFFINE PROCESSES AND

APPLICATIONS IN FINANCE

(with D. Duffie and W. Schachermayer)

Damir Filipović
Department of Operations Research and Financial Engineering
Princeton University

Fields Institute
April 24, 2002
1
 Overview

- Pricing Problem

- Classical Examples (CIR, Lando, Heston)

- Definition of an Affine Process

- Main Results and Applications

2
 The Pricing Problem

• State vector process X in Rd.

• Financial asset paying f (Xt) at time t (ex: f ≡ 1).

Rt
• State price density (deflator) e− 0 L(Xs ) ds .

• Price today
· Rt ¸
π(t, x) = E e− 0 L(Xs ) ds f (Xt ) | X0 = x .

3
 Markovian Framework

Markov process X in D ⊂ Rd

= transition law pt(x, dξ)

Z
Ex[f (Xt)] = f (ξ) pt(x, dξ)
D

= semigroup Pt on bD
Z
Ptf (x) = f (ξ) pt(x, dξ)
D

à infinitesimal generator
Ptf (x) − f (x)
Af (x) = lim .
t→0 t
4
General theory:
· Rt ¸ Z
π(t, x) = Ex e− 0 L(Xs ) ds f (Xt ) = f (ξ) qt(x, dξ) = Qtf (x),
D

where
· Rt ¸
Qt1A(x) = qt(x, A) := Ex e− 0 L(Xs ) ds 1A (Xt )

is a (Markov) semigroup on bD (if L ≥ 0),

the “pricing semigroup”.

5
 Computational Methods

1.) Solve Kolmogorov backward equation (Feynman–Kac)

∂tπ(t, x) = Aπ(t, x) − L(x)π(t, x)
(1)
π(0, x) = f (x).
In general (extensive) numerically, for d ≥ 3.

2.) Integrate w.r.t. qt(x, dξ).

Easy if qt(x, dξ) is known explicitly.

In general: Fourier-inversion.

6
 Decomposition

R ihλ,ξi
• (Inverse) Fourier transform f (ξ) = e f˜(λ) dλ,

implies
Z Z µZ ¶
π(t, x) = f (ξ) qt(x, dξ) = eihλ,ξi qt(x, dξ) f˜(λ) dλ
D | D {z }
=:πλ (t,x)

• πλ(t, x): “basis price functions”

à Spanning (Bakshi–Madan (2000))

• π0(t, x) = P (0, t): zero-coupon bond prices

7
Separation ansatz

πλ(t, x) = eφ(t,λ)+hψ(t,λ),xi. (2)

à PDE (1) splits into ODEs for φ(·, λ), ψ(·, λ).

à Computational tractability.

à Extensive use in many financial applications.

Q: Theory of Markov processes qt(x, dξ) that satisfy (2).

R
− 0t L(Xs) ds
Q: What about X (pt(x, dξ)) and e ?

8
 Interest Rates: Cox–Ingersoll–Ross (85)

• Nonnegative short rates X (D = R+, L(x) = x)

p
dXt = (b + β Xt) dt + 2α Xt dWt.

• The bond price is

P (t, T ) = QT −t1(Xt) = π0(T − t, Xt) = e−A(T −t)−B(T −t)Xt .

• In general (v ∈ C−)
Z
evξ qt(x, dξ) = eφ(t,v)+ψ(t,v)x.
R+

9
• φ, ψ solve Riccati equations
Z t
φ(t, v) = b ψ(s, v) ds
0
∂tψ(t, v) = αψ(t, v)2 + βψ(t, v) − 1
ψ(0, v) = v.

à qt(x, ·) ∼ non-central χ2.

à closed form bond option prices π(t, x).

• Generator of X

Af (x) = αxf 00(x) + (b + βx) f 0(x).

10
 Default Risk

• State process X = (Y, N ) in D = R2

+
√
− CIR short rates dYt = (b + β Yt) dt + 2α Yt dWt.

Rt
− Point process Nt with compensator 0 Ys ds.

• τ = first jump time of Nt = default time.

• Lando (98): price of a defaultable bond is

· Rt ¸ · Rt ¸
Ex e− 0 Ys ds 1
{τ >t} = Ex e− 0 2Ys ds .

à tractable as CIR
11
• Generator of X = (Y, N )

Af (x) = αy∂yy f (x) + (b + βy ) ∂y f (x) + y(f (x + e2) − f (x)).

• Extensions to multi-default models with recovery rate: Duffie–

Singleton (99), Lando (98), Madan–Unal (98),. . .

12
 Option Pricing: Heston (93)

• State process X = (Y, Z) in D = R+ × R,

p
dYt = (b + β Yt) dt + 2α Yt dWt1
µ ¶ p
1
dZt = r − Yt dt + Yt dWt2,
2
• (W 1, W 2) Wiener process in R2, r ≥ 0 interest rates.

• Asset price St = exp(Zt).

√
• Y : stochastic volatility (extension of Black–Scholes (73)).

• Generator of X
µ ¶
y y
Af (x) = αy∂yy f (x) + ∂zz f (x) + (b + βy ) ∂y f (x) + r − ∂z f (x).
2 2
13
European call option price (strike K, expiration date t)
h i
π(t, y, z) = E(y,z) (St − K )+
h i
= E(y,z) St 1{Zt≥log K} − K P(y,z) [Zt ≥ log K ] .
Need to know distribution of Zt under St P(y,z) and P(y,z).

Characteristic functions
h i
E(y,z) St eiwZt = e−Φ(t,(w 2 −iw)/2)−Ψ(t,(w 2 −iw)/2) y+(1+iw) z

h i
e−Φ(t,(w +iw)/2)−Ψ(t,(w +iw)/2) y+iw z
iwZ 2 2
E(y,z) e t =
where
Z t
Φ(t, v) = bΨ(s, v) ds
0
∂tΨ(t, v) = −αΨ(t, v)2 + βΨ(t, v) + v (v ∈ C+)
Ψ(0, v) = 0.

14
 Jump-Diffusion Models

Jump-diffusion (with killing) X in D ⊂ Rd

X
Af (x) = Aij (x)∂xi ∂xj f (x) + hB(x), ∇f (x)i − C(x)f (x)
i,j
Z
+ (f (x + ξ) − f (x) − h∇f (x), χ(ξ)i) M (x, dξ).

Duffie, Pan, Singleton (2000): If A(x), B(x), C(x), M (x, dξ)

and L(x) have affine dependence on x and are well-behaved, then
Z · Rt ¸
eihλ,ξi qt(x, dξ) = Ex e− 0 L(Xs ) ds eihλ,Xt i = eφ(t,λ)+hψ(t,λ),xi,
D
where φ and ψ solve some generalized Riccati equations.

15
 Issues

• Maximal domain of admissible parameters.

• Existence and uniqueness results (”well-behaved”).

• Good definition = “minimal definition” of an affine process.

• Explore affine structure (leads to new examples).

16
 Canonical Setup

State space D = Rm
+ × R n (d = m + n ∈ N).

Stochastically continuous Markov process X = (Y, Z) in D.

Definition: X is affine if the characteristic function of Xt has

exponential-affine dependence on X0 = x,
h i Z
Ex ehu,Xti = ehu,ξi pt(x, dξ) = eφ(t,u)+hψ(t,u),xi, (3)
D
for all u ∈ iRd, (t, x) ∈ R+ × D.

Remark: (3) holds a fortiori for all u ∈ U := Cm − × iR (Schwarz

n

reflexion principle). Necessarily, φ(t, u) ∈ C− and ψ(t, u) ∈ U .

17
Chapman–Kolmogorov equations

φ(t + s, u) = φ(t, u) + φ(s, ψ(t, u))

ψ(t + s, u) = ψ(s, ψ(t, u)).

Assumption:

F (u) := ∂tφ(t, u)|t=0

R(u) := ∂tψ(t, u)|t=0
exist for all u ∈ U and are continuous at u = 0.

à ODEs

∂tφ(t, u) = F (ψ(t, u)), φ(0, u) = 0,

∂tψ(t, u) = R(ψ(t, u)), ψ(0, u) = u.

18
 Admissible Parameters (for D = R2
+ × R)

(a, α, b, β, c, γ, m, µ) are admissible if, for all x = (y, z) ∈ D,

i) A(x) := a + α1y1 + α2y2 ∈ Sem3,

     
0 0 0 + 0 ∗ 0 0 0
     
where a =  0 0 0 , α1 =  0 0 0 , and α2 =  0 + ∗ .
0 0 + ∗ 0 + 0 ∗ +

ii) B(x) := b + βx ∈ TD (x) (tangent cone)

 
∗ + 0
 
hence b ∈ D and β =  + ∗ 0 .
∗ ∗ ∗

19
iii) C(x) := c + hγ, yi ≥ 0, hence c ≥ 0 and γ ∈ R2
+.

iv) M (x, dξ) := m(dξ) + y1µ1(dξ) + y2µ2(dξ) is a measure on D

with

M (x, {0}) = 0
Z ³ ´
χ(y1) + χ(y2) + χ(z)2 m(dy, dz) < ∞
ZD ³ ´
χ(y1)2 + χ(y2) + χ(z)2 µ1(dy, dz) < ∞
ZD ³ ´
χ(y1) + χ(y2)2 + χ(z)2 µ2(dy, dz) < ∞
D
where
1 ∧ |t|
χ(t) := t (truncation function).
|t|

20
 Main Theorem

X is affine iff it is a Feller semimartingale with generator

X
Af (x) = Aij (x)∂xi ∂xj f (x) + hB̃(x), ∇f (x)i − C(x)f (x)
i,j
Z
+ (f (x + ξ) − f (x) − h∇f (x), χ(ξ)i) M (x, dξ).
D
for some admissible parameters (a, α, b, β, c, γ, m, µ).

Moreover
Z ³ ´
F (u) = hau, ui + hb̃, ui − c + ehu,ξi − 1 − hu, χ(ξ)i m(dξ),
DZ
³ ´
Y Y hu,ξi
Ri (u) = hαiu, ui + hβi , ui − γ + e − 1 − hu, χ(ξ)i µi(dξ),
D
RZ (u) = β Z w,
where R(u) = (RY (u), RZ (u)), u = (v, w) ∈ Cm × Cn.
21
Ã Generalized Riccati equations
Z t µ ¶
φ(t, v, w) = F ψ Y (s, v, w), e βZ s w ds
0 µ ¶
Z
∂tψ Y (t, v, w) = RY ψ Y (t, v, w), eβ tw

ψ Y (0, v, w) = v
Z
ψ Z (t, v, w) = eβ tw

Corollary. Set u = (v, 0):

h i Y
E(y,z) ehv,Y t i = eφ(t,(v,0))+hψ (t,(v,0)),yi = function of y only,
hence Y is an (affine!) Markov process.

Corollary. Y is a CBI-process. If m = 0 then X is an Ornstein–

Uhlenbeck type process. Conversely, every CBI- or Ornstein–
Uhlenbeck type process is affine.
22
 Structure Preserving Transformations

The affine structure is invariant with respect to:

- affine transformations X 7→ λ + ΛX

Rt
- discounting with exp − 0(` + hλ, Xsi) ds

- change to the forward measure

- Esscher measure transformations

à flexible and robust

23
 Default Risk

• X = (Y, Z) affine in Rm
+×R
n

• Y 1=short rate

• Y 2=point process with compensator (` + hλ, Yti)δ1 dt

n o
• τ = inf t | Yt2 > 0

• Distribution of Xt conditioned on {τ > t} with discounting

· Rt ¸
− 1 0 (t,u)+hψ 0 (t,u),xi
Ex e 0 Ys ds ehu,Xt i 1 φ
{τ >t} = e 1{y2=0}.
à price of a defaultable security
· Rt ¸
Ex e−
1
0 Ys ds h(X
t)1{τ >t} .

24
 Option Pricing with Stochastic Intensity

• X = (Y, Z) affine in Rm
+×R

• Stock price St = eZt

• Dynamics of Z pure jump

Z
dZt = (b + hβ, Xti) dt + ζN (dt, dζ),
D
where N (dt, dζ) is a Poisson random measure with compensator

(m(dζ) + hYt, µ(dζ)i) dt

(“stochastic Lévy density”)

eθ2 ζ−θ3 |ζ|

• Example: VG with Lévy density µ(dζ) = θ1 |ζ|
(θ3 ≥ θ2).
25