SDE Week13

An Introduction to Stochastic Calculus
Haijun Li
lih@math.wsu.edu Department of Mathematics Washington State University
Week 13
Haijun Li
Week 13
1 / 15
Outline
Numerical Solutions The Euler Approximation The Milstein Approximation Monte Carlo Methods in Financial Engineering References
Haijun Li
Week 13
2 / 15
Numerical Solution of Stochastic Differential Equations

SDEs which admit an explicit solution are few exceptions. Therefore numerical techniques for the approximation of the solution to a SDE are often called for.
Haijun Li
Week 13
3 / 15

SDEs which admit an explicit solution are few exceptions. Therefore numerical techniques for the approximation of the solution to a SDE are often called for. One purpose is to visualize a variety of sample paths of the solution. A collection of such paths is called a scenario, which can be used for some kind of prediction of the stochastic process at future instants of time.
Haijun Li
Week 13
3 / 15

SDEs which admit an explicit solution are few exceptions. Therefore numerical techniques for the approximation of the solution to a SDE are often called for. One purpose is to visualize a variety of sample paths of the solution. A collection of such paths is called a scenario, which can be used for some kind of prediction of the stochastic process at future instants of time. A second objective is to achieve reasonable approximations to the distributional quantities (expectations, variances, covariance and higher-order moments) of the solution to a SDE.
Haijun Li
Week 13
3 / 15

SDEs which admit an explicit solution are few exceptions. Therefore numerical techniques for the approximation of the solution to a SDE are often called for. One purpose is to visualize a variety of sample paths of the solution. A collection of such paths is called a scenario, which can be used for some kind of prediction of the stochastic process at future instants of time. A second objective is to achieve reasonable approximations to the distributional quantities (expectations, variances, covariance and higher-order moments) of the solution to a SDE. Only in a few cases one is able to give explicit formulas for these quantities, and even then they frequently involve special functions which have to be approximated numerically.
Haijun Li
Week 13
3 / 15

SDEs which admit an explicit solution are few exceptions. Therefore numerical techniques for the approximation of the solution to a SDE are often called for. One purpose is to visualize a variety of sample paths of the solution. A collection of such paths is called a scenario, which can be used for some kind of prediction of the stochastic process at future instants of time. A second objective is to achieve reasonable approximations to the distributional quantities (expectations, variances, covariance and higher-order moments) of the solution to a SDE. Only in a few cases one is able to give explicit formulas for these quantities, and even then they frequently involve special functions which have to be approximated numerically. Numerical solutions allow us to simulate as many sample paths as we want; they constitute the basis for Monte-Carlo techniques to obtain the distributional characteristics and option pricing.
Haijun Li An Introduction to Stochastic Calculus Week 13 3 / 15
The Euler Approximation Scheme

For illustration, consider the SDE dXt = (Xt )dt + (Xt )dBt , t [0, T ]. We assume that the coefcient functions (x) and (x) are Lipschitz 2 continuous, and EX0 < , which guarantee the existence and uniqueness of a strong solution.
Haijun Li
Week 13
4 / 15

1
To approximate the solution, partition [0, T ] as follows, n : 0 = t0 < t1 < < tn1 < tn = T , with i = ti ti1 , 1 i n, and mesh(n ) = max1in i . Let i B = Bti Bti1 , 1 i n.
Haijun Li
Week 13
4 / 15

1
To approximate the solution, partition [0, T ] as follows, n : 0 = t0 < t1 < < tn1 < tn = T , with i = ti ti1 , 1 i n, and mesh(n ) = max1in i . Let i B = Bti Bti1 , 1 i n. Dene recursively, 1 i n, Xti with X0
(n) (n)
= Xti1 + (Xti1 )i + (Xti1 )i B,
(n)
(n)
(n)
= X0
An Introduction to Stochastic Calculus Week 13 4 / 15
Haijun Li
Idea: The First-Order Approximation

1
Consider, 1 i n,
ti ti
Xti = Xti1 +
(Xs )ds +
ti1 ti1
(Xs )dBs .
Haijun Li
Week 13
5 / 15

1
Consider, 1 i n,
ti ti
Xti = Xti1 +
2
(Xs )ds +
ti1 ti1
(Xs )dBs .
The Euler approximation is based on a discretization of the integrals

ti ti1 ti
(Xs )ds (Xti1 )i ,
ti1
(Xs )dBs (Xti1 )i B.
Haijun Li
Week 13
5 / 15

1
Consider, 1 i n,
ti ti
Xti = Xti1 +
2
(Xs )ds +
ti1 ti1
(Xs )dBs .

ti ti1 ti
(Xs )ds (Xti1 )i ,
ti1
That is, for 1 i n, Xti Xti1 + (Xti1 )i + (Xti1 )i B.
Haijun Li
Week 13
5 / 15

1
Consider, 1 i n,
ti ti
Xti = Xti1 +
2
(Xs )ds +
ti1 ti1
(Xs )dBs .

ti ti1 ti
(Xs )ds (Xti1 )i ,
ti1
That is, for 1 i n, Xti Xti1 + (Xti1 )i + (Xti1 )i B.
In practice one usually chooses equi-distant points ti such that mesh(n ) = T /n, and XiT /n = X(i1)T /n + (X(i1)T /n )i + (X(i1)T /n )i B, 1 i n.
(n)
(n)
(n)
(n)
Strong Numerical Solution
Haijun Li
Week 13
6 / 15

Strong Marginal Convergence
1
The numerical solution X (n) converges strongly to X with order > 0 if there exists a constant c > 0 such that (n) E|XT XT | c mesh(n ) , n 1. X (n) is a strong numerical solution of the SDE if (n) E|XT XT | 0, as mesh(n ) 0.
Haijun Li
Week 13
6 / 15

1
(n)
One could use E sup0tT |Xt Xt | as a more appropriate criteria to describe the pathwise closeness of X and X (n) . But this quantity is more difcult to deal with theoretically.
Haijun Li
Week 13
6 / 15

1
(n)
One could use E sup0tT |Xt Xt | as a more appropriate criteria to describe the pathwise closeness of X and X (n) . But this quantity is more difcult to deal with theoretically.
The Euler Approximation

The equidistant Euler approximation converges strongly with order 0.5.
Haijun Li
Week 13
6 / 15
Weak Numerical Solution

In contrast to a strong numerical solution, a weak numerical solution aims at the approximation of the moments of the solution X . Let f be chosen from a class of smooth functions, e.g., certain polynomials or functions with a specic polynomial growth.
Haijun Li
Week 13
7 / 15

Weak Marginal Convergence

1
The numerical solution X (n) converges weakly to X with order > 0 if there exists a constant c > 0 such that (n) |Ef (XT ) Ef (XT )| c mesh(n ) , n 1. X (n) is a weak numerical solution of the SDE if (n) |Ef (XT ) Ef (XT )| 0, as mesh(n ) 0.
Haijun Li
Week 13
7 / 15

Weak Marginal Convergence

1
The numerical solution X (n) converges weakly to X with order > 0 if there exists a constant c > 0 such that (n) |Ef (XT ) Ef (XT )| c mesh(n ) , n 1. X (n) is a weak numerical solution of the SDE if (n) |Ef (XT ) Ef (XT )| 0, as mesh(n ) 0.
The Euler Approximation

The equidistant Euler approximation converges weakly with order 1.0 for a class of functions f with appropriate polynomial growth.
The Milstein Approximation Scheme

In contrast to the rst order approximation, the Milstein approximation exploits a so-called Taylor-It expansion that incorporates high order approximation.
Haijun Li
Week 13
8 / 15

In contrast to the rst order approximation, the Milstein approximation exploits a so-called Taylor-It expansion that incorporates high order approximation. Heuristics: Apply the It lemma to the integrands (Xs ) and (Xs ) at each point ti1 of discretization, and then estimate the higher order terms using the fact that (dBs )2 = ds.
Haijun Li
Week 13
8 / 15

In contrast to the rst order approximation, the Milstein approximation exploits a so-called Taylor-It expansion that incorporates high order approximation. Heuristics: Apply the It lemma to the integrands (Xs ) and (Xs ) at each point ti1 of discretization, and then estimate the higher order terms using the fact that (dBs )2 = ds. Taylor-It expansions involve multiple stochastic integrals. Their rigorous treatment requires a more advanced theory of the stochastic calculus.
Haijun Li
Week 13
8 / 15

The Milstein Approximation

Dene recursively for 1 i n, (n) (n) (n) (n) (n) (n) Xti = Xti1 + (Xti1 )i + (Xti1 )i B + 1 (Xti1 ) (Xti1 )[(i B)2 i ], 2 with X0
(n)
= X0 .
Haijun Li
Week 13
8 / 15

The Milstein Approximation

Dene recursively for 1 i n, (n) (n) (n) (n) (n) (n) Xti = Xti1 + (Xti1 )i + (Xti1 )i B + 1 (Xti1 ) (Xti1 )[(i B)2 i ], 2 with X0
(n)
= X0 .
The equidistant Milstein approximation converges strongly with order 1.0.

Monte Carlo vs Numerical Methods

Once sample paths (or scenarios) of the solution of an It SDE are obtained, they can be used to estimate the distributional quantities (expectations, variances, covariance and higher-order moments) of the solution.
Haijun Li
Week 13
9 / 15

Once sample paths (or scenarios) of the solution of an It SDE are obtained, they can be used to estimate the distributional quantities (expectations, variances, covariance and higher-order moments) of the solution. Since derivative prices are often written as expectations of underlying asset values, which are the solutions of SDEs, Monte Carlo method becomes an essential tool in the pricing of derivative securities and in risk management.
Haijun Li
Week 13
9 / 15

Once sample paths (or scenarios) of the solution of an It SDE are obtained, they can be used to estimate the distributional quantities (expectations, variances, covariance and higher-order moments) of the solution. Since derivative prices are often written as expectations of underlying asset values, which are the solutions of SDEs, Monte Carlo method becomes an essential tool in the pricing of derivative securities and in risk management. Monte Carlo is generally not a competitive method for calculating univariate expectation. For example, the error in a trapezoidal rule for the integral of a d-dimensional twice continuously differentiable function is O(n2/d ), which is in contrast to the standard error O(n1/2 ) of the Monte Carlo method for the same problem.
Haijun Li
Week 13
9 / 15

Once sample paths (or scenarios) of the solution of an It SDE are obtained, they can be used to estimate the distributional quantities (expectations, variances, covariance and higher-order moments) of the solution. Since derivative prices are often written as expectations of underlying asset values, which are the solutions of SDEs, Monte Carlo method becomes an essential tool in the pricing of derivative securities and in risk management. Monte Carlo is generally not a competitive method for calculating univariate expectation. For example, the error in a trapezoidal rule for the integral of a d-dimensional twice continuously differentiable function is O(n2/d ), which is in contrast to the standard error O(n1/2 ) of the Monte Carlo method for the same problem. The performance degradation with increasing dimension is a characteristic of all deterministic integration methods, and thus Monte Carlo methods are attractive in evaluating integrals in high dimension.
Illustrative Example: European Call Option

The price of one share of a risky asset (stock) is described by dXt = cXt dt + Xt dBt , t [0, T ].
Haijun Li
Week 13
10 / 15

The price of one share of a risky asset (stock) is described by dXt = cXt dt + Xt dBt , t [0, T ]. The price of a riskless asset (bond) is described by dt = r dt , t [0, T ].
Haijun Li
Week 13
10 / 15

The price of one share of a risky asset (stock) is described by dXt = cXt dt + Xt dBt , t [0, T ]. The price of a riskless asset (bond) is described by dt = r dt , t [0, T ]. At time of maturity T , VT = (XT K )+ .
Haijun Li
Week 13
10 / 15

The price of one share of a risky asset (stock) is described by dXt = cXt dt + Xt dBt , t [0, T ]. The price of a riskless asset (bond) is described by dt = r dt , t [0, T ]. At time of maturity T , VT = (XT K )+ . Using the Fundamental Theorem of Arbitrage-Free Pricing, we have C := V0 = E(erT (XT K )+ ). with XT = X0 e(r 2
1 2 )T +B T
Haijun Li
Week 13
10 / 15

The price of one share of a risky asset (stock) is described by dXt = cXt dt + Xt dBt , t [0, T ]. The price of a riskless asset (bond) is described by dt = r dt , t [0, T ]. At time of maturity T , VT = (XT K )+ . Using the Fundamental Theorem of Arbitrage-Free Pricing, we have C := V0 = E(erT (XT K )+ ). with XT = X0 e(r 2
1 2 )T +B T
Although this formula can be written explicitly in terms of the normal distribution (the Black-Scholes formula), we can also estimate C using Monte Carlo method.
MC Estimate of European Call Options

Algorithm
for i = 1, . . . , n generate the standard normal Zi set Xi (T ) = X0 e(r 2
1 2 )T +
T Zi
set Ci = erT (Xi (T ) K )+ set Cn = (C1 + + Cn )/n.
Haijun Li
Week 13
11 / 15

Algorithm
1 2 )T +
T Zi
set Ci = erT (Xi (T ) K )+ set Cn = (C1 + + Cn )/n. The estimator Cn is unbiased and strongly consistent.
Haijun Li
Week 13
11 / 15

Algorithm
1 2 )T +
T Zi
set Ci = erT (Xi (T ) K )+ set Cn = (C1 + + Cn )/n. The estimator Cn is unbiased and strongly consistent. For nite but at least moderately large n, we can supplement the point estimate Cn with a (1 )100% condence interval s Cn + t/2,n1 C , where sC is the sample standard deviation, and n t/2,n1 is the upper 100(/2)th percentage point of a t distribution with n 1 degrees of freedom.
Another Illustrative Example: Asian Options

Consider the payoff VT = (X K )+ , where X = ( a xed set of dates 0 = t0 < t1 < < tm = T .
m j=1 Xtj )/m
for
Haijun Li
Week 13
12 / 15

m j=1 Xtj )/m
for
Again, the Fundamental Theorem of Arbitrage-Free Pricing implies that C := V0 = E(erT (X K )+ ) where 1 (r 2 2 )(tj+1 tj )+ tj+1 tj Zj+1 Xtj+1 = Xtj e .
Haijun Li
Week 13
12 / 15

m j=1 Xtj )/m
for
Again, the Fundamental Theorem of Arbitrage-Free Pricing implies that C := V0 = E(erT (X K )+ ) where 1 (r 2 2 )(tj+1 tj )+ tj+1 tj Zj+1 Xtj+1 = Xtj e .
Algorithm
for i = 1, . . . , n for j = 1, . . . , m generate the standard normal Zij set Xi (j) = Xi (j 1)e(r 2 )(tj tj1 )+ set Xi = (Xi (1) + + Xi (m))/m set Ci = erT (Xi K )+ set Cn = (C1 + + Cn )/n.
Haijun Li 1 2
tj tj1 Zij
Week 13
12 / 15
Efciency of Simulation Estimators

Cn from above two examples is unbiased and asymptotically normal.
Haijun Li
Week 13
13 / 15

Cn from above two examples is unbiased and asymptotically normal. More precisely, let s denote our computational budget, and denote the computational time needed for Ci , then s[C s/ C] d N(0, 2 ),
C
as s . In comparing unbiased estimators, we should prefer 2 the one for which C is smallest.
Haijun Li
Week 13
13 / 15

Cn from above two examples is unbiased and asymptotically normal. More precisely, let s denote our computational budget, and denote the computational time needed for Ci , then s[C s/ C] d N(0, 2 ),
C
as s . In comparing unbiased estimators, we should prefer 2 the one for which C is smallest. Bias frequently occurs in estimation via MC methods. For example, the bias can arise due to the following errors.
1
Model discretization error: For many models, exact sampling of the continuous-time dynamics is infeasible, some discretization approximation has to be used, resulting a bias. Payoff discretization error: Discretization has to be used for the payoffs that are functionals of the underlying asset processes. Nonlinear functions of means: In a compound option, the price of the rst option depends on the price of the second option ..., but these prices can only be estimated, resulting a bias.
An Introduction to Stochastic Calculus Week 13 13 / 15
Haijun Li
Some References and Further Reading

This lecture notes are written using the books Elementary Stochastic Calculus (World Scientic, 2002) by Thomas Mikosch, and Introductory Stochastic Analysis for Finance and Insurance (Wiley, 2006) by Sheldon Lin.
Haijun Li
Week 13
14 / 15

This lecture notes are written using the books Elementary Stochastic Calculus (World Scientic, 2002) by Thomas Mikosch, and Introductory Stochastic Analysis for Finance and Insurance (Wiley, 2006) by Sheldon Lin. A Standard Advanced Textbook on It Integrals: Brownian Motion and Stochastic Calculus (Springer 1991) by I. Karatzas and S. E. Shreve.
Haijun Li
Week 13
14 / 15

This lecture notes are written using the books Elementary Stochastic Calculus (World Scientic, 2002) by Thomas Mikosch, and Introductory Stochastic Analysis for Finance and Insurance (Wiley, 2006) by Sheldon Lin. A Standard Advanced Textbook on It Integrals: Brownian Motion and Stochastic Calculus (Springer 1991) by I. Karatzas and S. E. Shreve. Stochastic Integrals and SDEs Driven by Lvy Processes: Lvy Processes and Stochastic Calculus (Cambridge 2009) by D. Applebaum.
Haijun Li
Week 13
14 / 15

This lecture notes are written using the books Elementary Stochastic Calculus (World Scientic, 2002) by Thomas Mikosch, and Introductory Stochastic Analysis for Finance and Insurance (Wiley, 2006) by Sheldon Lin. A Standard Advanced Textbook on It Integrals: Brownian Motion and Stochastic Calculus (Springer 1991) by I. Karatzas and S. E. Shreve. Stochastic Integrals and SDEs Driven by Lvy Processes: Lvy Processes and Stochastic Calculus (Cambridge 2009) by D. Applebaum. Stochastic Finance: Stochastic Calculus for Finance I, II (Springer 2004) by S. E. Shreve.
Haijun Li
Week 13
14 / 15

This lecture notes are written using the books Elementary Stochastic Calculus (World Scientic, 2002) by Thomas Mikosch, and Introductory Stochastic Analysis for Finance and Insurance (Wiley, 2006) by Sheldon Lin. A Standard Advanced Textbook on It Integrals: Brownian Motion and Stochastic Calculus (Springer 1991) by I. Karatzas and S. E. Shreve. Stochastic Integrals and SDEs Driven by Lvy Processes: Lvy Processes and Stochastic Calculus (Cambridge 2009) by D. Applebaum. Stochastic Finance: Stochastic Calculus for Finance I, II (Springer 2004) by S. E. Shreve. SDE Application in Actuarial Science: Introductory Stochastic Analysis for Finance and Insurance (Wiley, 2006) by Sheldon Lin, and Stochastic Control in Insurance (Springer 2008) by H. Schmidli.
More References
Numerical Analysis on SDEs: Numerical Solution of Stochastic Deferential Equations (Springer 1995) by P. Kloeden and E. Platen.
Haijun Li
Week 13
15 / 15
More References
Numerical Analysis on SDEs: Numerical Solution of Stochastic Deferential Equations (Springer 1995) by P. Kloeden and E. Platen. Monte Carlo Simulation: Monte Carlo Methods in Financial Engineering (Springer 2004) by Paul Glasserman.
Haijun Li
Week 13
15 / 15
More References
Numerical Analysis on SDEs: Numerical Solution of Stochastic Deferential Equations (Springer 1995) by P. Kloeden and E. Platen. Monte Carlo Simulation: Monte Carlo Methods in Financial Engineering (Springer 2004) by Paul Glasserman. Lvy Matters: Financial Modelling with Jump Processes (Chapman & Hall 2004) by Rama Cont and Peter Tankov.
Haijun Li
Week 13
15 / 15
More References
Numerical Analysis on SDEs: Numerical Solution of Stochastic Deferential Equations (Springer 1995) by P. Kloeden and E. Platen. Monte Carlo Simulation: Monte Carlo Methods in Financial Engineering (Springer 2004) by Paul Glasserman. Lvy Matters: Financial Modelling with Jump Processes (Chapman & Hall 2004) by Rama Cont and Peter Tankov. Financial Times Series (GARCH, univariate and multivariate): Statistics of Financial Markets (Springer 2008) by J. Franke, C. M. Hafner and W. K. Hardle.
Haijun Li
Week 13
15 / 15

SDE Week13

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An Introduction to Stochastic Calculus

An Introduction to Stochastic Calculus

An Introduction to Stochastic Calculus

Numerical Solution of Stochastic Differential Equations

An Introduction to Stochastic Calculus

Numerical Solution of Stochastic Differential Equations

An Introduction to Stochastic Calculus

Numerical Solution of Stochastic Differential Equations

An Introduction to Stochastic Calculus

Numerical Solution of Stochastic Differential Equations

An Introduction to Stochastic Calculus

Numerical Solution of Stochastic Differential Equations

The Euler Approximation Scheme

An Introduction to Stochastic Calculus

The Euler Approximation Scheme

An Introduction to Stochastic Calculus

The Euler Approximation Scheme

= Xti1 + (Xti1 )i + (Xti1 )i B,

Idea: The First-Order Approximation

An Introduction to Stochastic Calculus

Idea: The First-Order Approximation

The Euler approximation is based on a discretization of the integrals

(Xs )ds (Xti1 )i ,

(Xs )dBs (Xti1 )i B.

An Introduction to Stochastic Calculus

Idea: The First-Order Approximation

The Euler approximation is based on a discretization of the integrals

(Xs )ds (Xti1 )i ,

(Xs )dBs (Xti1 )i B.

That is, for 1 i n, Xti Xti1 + (Xti1 )i + (Xti1 )i B.

An Introduction to Stochastic Calculus

Idea: The First-Order Approximation

The Euler approximation is based on a discretization of the integrals

(Xs )ds (Xti1 )i ,

(Xs )dBs (Xti1 )i B.

That is, for 1 i n, Xti Xti1 + (Xti1 )i + (Xti1 )i B.

Strong Numerical Solution

An Introduction to Stochastic Calculus

Strong Numerical Solution

An Introduction to Stochastic Calculus

Strong Numerical Solution

An Introduction to Stochastic Calculus

Strong Numerical Solution

The Euler Approximation

An Introduction to Stochastic Calculus

Weak Numerical Solution

An Introduction to Stochastic Calculus

Weak Numerical Solution

Weak Marginal Convergence

An Introduction to Stochastic Calculus

Weak Numerical Solution

Weak Marginal Convergence

The Euler Approximation

The Milstein Approximation Scheme

An Introduction to Stochastic Calculus

The Milstein Approximation Scheme

An Introduction to Stochastic Calculus

The Milstein Approximation Scheme

An Introduction to Stochastic Calculus

The Milstein Approximation Scheme

The Milstein Approximation

An Introduction to Stochastic Calculus