Obloj 2012 Paris Lecture

From Classical to Robust framework for valuation and hedging
Lectures on Skorokhod embedding problem and its applications Jan Oblj o

University of Oxford
These slides touch on some issues raised in the lecture, please see the lecture notes for further details. Parts of these lectures are based on joint works with
Alexander Cox (University of Bath), Mark Davis (Imperial College London), Vimal Raval and Frdrik Ulmer. e e
5th European Summer School in Financial Mathematics Paris, August 2012
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Modelling in Mathematical Finance Classical modelling framework Toward a Robust modelling framework Theory of robust valuation and hedging Discrete time models Continuous time models with discrete trading Continuous time models with continuous trading Skorokhod embedding problem: a short tour SEP introduction One-touch: case study Double-barriers: pricing, hedging and numerics Robust hedging in practice Comparison of performance of hedging methods
Robust approach to Mathematical Finance Paris, August 2012 Jan Oblj o
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Modelling: Key Ingredients

Inputs:
Beliefs (about the future dynamics of the stock price process) Information (market prices) Rules (self-nancing trading strategies, frictions)
Reasoning principles:
Markets are ecient there are no arbitrages.
Outputs:
Prices and hedges Risk management Portofolio optimisation
Robust approach to Mathematical Finance
Paris, August 2012
Jan Oblj o
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Modelling: Classical approach

Inputs:
Beliefs (about the future dynamics of the stock price process):
Prices of risky assets (Sti ) have given dynamics and are semimartingales on a xed (, F, (Ft ), P). i Information (market prices): S0 Market quotes used to calibrate the above by choosing free parameters via reverse engineering. Rules (self-nancing trading strategies, frictions): s-f trading strategy = stochastic integral; no frictions
Markets are ecient there are no arbitrages:
Reasoning principles: Fundamental theorem of asset pricing (FTAP) asserts that no-arbitrage is equivalent to existence of Q equivalent to P under which (discounted) Sti are all martingales.
Outputs:
Prices and hedges via cost of replication; computing
expectations of functionals of solutions to SDEs
Portofolio optimisation stochastic control theory Risk management duality, convex and functional analysis
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Inputs: Prices of risky assets (Sti ) have given dynamics and are semimartingales on a xed (, F, (Ft ), P). i Information (market prices): S0 Market quotes used to calibrate the above by choosing free parameters via reverse engineering. Rules (self-nancing trading strategies, frictions): s-f trading strategy = stochastic integral; no frictions Reasoning principles:
Markets are ecient there are no arbitrages: Beliefs (about the future dynamics of the stock price process):
Fundamental theorem of asset pricing (FTAP) asserts that no-arbitrage is equivalent to existence of Q equivalent to P under which (discounted) Sti are all martingales.
Outputs:
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Outputs:
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Outputs:
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Outputs:
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Recently, its critique has been vocal ...

the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth (Paul Krugman 09) Misplaced reliance on sophisticated maths [...] inherent Knightian uncertainty. (The Turner Review 09) we need insights into the omnipresent model risk. [...] the program of introducing a Robust framework is one the greatest challenges also from the mathematical perspective (Hans Fllmer 09) o For banks, the only way to avoid a repetition of the current crisis is to measure and control all their risks, including the risk that their models give incorrect results (Steven Shreve 08) the problem is that we dont have enough math. [...] Frictions are just bloody hard with the mathematical tools we have now (John Cochrane 09)
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The prevailing approach in math nance proceeds as follows:
Write down a plausible and well behaved stochastic model. Compute prices of (liquid) nancial instruments as function of
model parameters.
Calibrate the model: chose the parameters to match the
prices already observed in the market.
Use it: sell and hedge derivatives.
This approach has important drawbacks:

It is exposed to model risk which may be hard to quantify. Inevitably, it ignores information present in the market.
Models are re-calibrated daily: theoretically inconsistent.
A robust approach aims to address these weaknesses. It does not replace the classical framework but oers an alternative allowing for a comprehensive understanding and control of risk.
Robust approach to Mathematical Finance Paris, August 2012
It is a rst order approximation which ignores market frictions.
Jan Oblj o
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The prevailing approach in math nance proceeds as follows:
Write down a plausible and well behaved stochastic model. Compute prices of (liquid) nancial instruments as function of
model parameters.
Calibrate the model: chose the parameters to match the
prices already observed in the market.
Use it: sell and hedge derivatives.
This approach has important drawbacks:

It is exposed to model risk which may be hard to quantify. Inevitably, it ignores information present in the market.
Models are re-calibrated daily: theoretically inconsistent.
A robust approach aims to address these weaknesses. It does not replace the classical framework but oers an alternative allowing for a comprehensive understanding and control of risk.
It is a rst order approximation which ignores market frictions.
Jan Oblj o
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Relaxing Beliefs: Model uncertainty

Inputs:
Prices of the assets (Sti ) are adapted to (, F, (Ft )) and we have a set of possible measures (P ). i Information (market prices): only S0 . Rules (self-nancing trading strategies, frictions): no frictions; trading strategy = stochastic integral: classical and its extensions (quasi-sure analysis, G-expectation...)
Markets are ecient there are no arbitrages:
Reasoning principles: Essentially link back to the classical FTAP.
Outputs:
Robust Portofolio optimisation and Risk management Price bounds and super/sub-hedges of liabilities
see e.g. Rogers (01), Maccheroni et al. (06), Schied (07); Lyons (95), Avellaneda et al. (95), Denis and Martini (06), Peng (07), Soner et al. (11); Bick and Willinger (94), Cassese (08), Vovk (12)
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Including Information: Market Models

Inputs: A probability space (, F, (Ft ), Q) is xed and we specify the joint dynamics of the asset St and the option prices PtK ,T . Information (market prices): full use market prices simply specify the initial values of K S0 , P0 ,T . Rules (self-nancing trading strategies, frictions): no frictions; trading strategies are stochastic integrals. Reasoning principles:
The classical FTAP.
Outputs:
In principle all prices/hedges are specied clearly if one can
compute them.
see Schonbucher (99), Bergomi (05), Schweizer and Wissel (08), Jacod and Protter (10), Carmona and Natochiy (09,11),
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B & I: the Robust Approach

Inputs:
(Cox & O. (11))
Prices of risky assets (Sti )tT belong to some path space P. X X : P R, with given prices P : X R
Information (market prices): set of payos X ,
Rules (self-nancing trading strategies, frictions): no frictions,
trading
simple trading; pathwise stochastic integrals
New FTAP needed:
Outputs: Consider an option OT : P R and investigate P admits no arbitrage on X {OT } LB POT UB & derive robust hedging strategies which enforce LB and UB.
no-arbitrage exists a (P, X , P)market model i.e. a classical setup (, F, (Ft ), Q, (St )) with (St ) P a.s., St a Qmartingale and with PX = EQ X , X X . no-arbitrage restrictions on P and on P.
there exists a (P, P, X {OT })market model

Jan Oblj o
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Inputs:
(Cox & O. (11))
trading
New FTAP needed:

Jan Oblj o
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Inputs:
(Cox & O. (11))
trading
New FTAP needed:

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Outline
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One period model a rst pass

Inputs: Beliefs: (S0 , S1 ) P = {S0 } P, P R. Information: set of payos X = {1 , . . . , n }, i : P R,
Rules: no frictions, self-nancing trading given by (S1 S0 )
with given prices P : X R. i.e. P(S1 ) = S0 .
(Strong arbitrage)
We say that (P, X , P) admits strong arbitrage (SA) if there exists a X , i.e. X = n i (i Pi ) + (S1 S0 ), with X (S1 ) > 0 for i=1 all S1 P. A (P, P, X )market model simply corresponds to a probability on R, (P) = 1, s(ds) = S0 , Xi (s)(ds) = P(Xi ).
Outputs: Assume the Inputs are consistent with no-arbitrage and consider an option with a payo O(S1 )...
Paris, August 2012 Jan Oblj o
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(Strong arbitrage)
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(Strong arbitrage)
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Outputs:
Then no SA = LB PO(S1 ) UB with sup

MP
Let M(P,P,X ) = MP be the set of market models and assume MP = . Consider an option with a payo O(S1 ).
n
O(s)(ds) UB inf
P(X ) : X =
i=1 n
i i (S1 ) + S1 O(S1 ) i i (S1 ) + S1 O(S1 )
MP
inf
O(s)(ds) LB sup P(X ) : X =
i=1
Davis, O. and Raval (12): for O 0, Xi = (S1 Ki )+ the above boils down to a semi-innite linear programming. UB is trivial, for LB the RHS always has a maximiser but dual minimiser mail fail to exist. Absence of SA is to weak to grant existence of the dual minimiser In fact, it is too weak to grant MP = in the rst place!
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Outputs:

MP
n
O(s)(ds) UB inf
P(X ) : X =
i=1 n
i i (S1 ) + S1 O(S1 ) i i (S1 ) + S1 O(S1 )
MP
inf
i=1
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Outputs:

MP
n
O(s)(ds) UB inf
P(X ) : X =
i=1 n
i i (S1 ) + S1 O(S1 ) i i (S1 ) + S1 O(S1 )
MP
inf
i=1
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Outputs:

MP
n
O(s)(ds) UB inf
P(X ) : X =
i=1 n
i i (S1 ) + S1 O(S1 ) i i (S1 ) + S1 O(S1 )
MP
inf
i=1
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An Instructive Example
The following example by Davis and Hobson (07) shows that the arbitrage may require further specication of beliefs... Consider three call options with prices:
5
1 0
10
ATM
15
16
Then the arbitrage is

If we believe that S1 16 a.s. then sell Call(16). If we believe that S1 > 16 with a positive p-ty then sell
Call(16) and buy Call(15).
Paris, August 2012
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One period model a third pass

Inputs:
Beliefs: P = R+ Information: set of payos X = {(S1 K )+ : K 0} with
Outputs: Any option O(S1 ) can be replicated by an innite portfolio of calls and puts has a unique price. Perfect hedge may fail to exist.
Reasoning principles: no SA = C (0) = S0 , C (0+) 1 and C (K ) is convex and non-increasing. FTAP (Cox & O. (11)): no WFLVR MP = C (K ) as above and C (K ) 0 as K .
given prices P(S1 K )+ = C (K ). Rules: no frictions, self-nancing trading given by (S1 S0 ) i.e. P(S1 ) = S0 .
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One period model a third pass

Inputs:
Beliefs: P = R+ Information: set of payos X = {(S1 K )+ : K 0} with
Reasoning principles: no SA = C (0) = S0 , C (0+) 1 and C (K ) is convex and non-increasing. FTAP (Cox & O. (11)): no WFLVR MP = C (K ) as above and C (K ) 0 as K .
given prices P(S1 K )+ = C (K ). Rules: no frictions, self-nancing trading given by (S1 S0 ) i.e. P(S1 ) = S0 .
Outputs: Any option O(S1 ) can be replicated by an innite portfolio of calls and puts has a unique price. Perfect hedge may fail to exist.
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Discrete time models

Inputs:
Beliefs: P = Rn + Information: set of payos
Outputs: Using Moge-Kantorovich (martingale) mass transport approach Beiglbck, Henry-Labord`re and Penkner (12) show that o e duality holds: sup (payo expectation) = inf{P(superhedge)}
MP
Reasoning principles: Assume MP = .
X = {(St K )+ : K 0, t = 1, . . . , n} with given prices. Rules: no frictions, discrete time trading in S, static in calls.
and existence holds on the LHS.
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Discrete time models

Inputs:
Beliefs: P = Rn + Information: set of payos
Outputs: Using Moge-Kantorovich (martingale) mass transport approach Beiglbck, Henry-Labord`re and Penkner (12) show that o e duality holds: sup (payo expectation) = inf{P(superhedge)}
MP
Reasoning principles: Assume MP = .
X = {(St K )+ : K 0, t = 1, . . . , n} with given prices. Rules: no frictions, discrete time trading in S, static in calls.
and existence holds on the LHS.
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Up-and-out put example
(Brown, Hobson, Rogers (01))
Consider an up-and-out put option with strike K and barrier B > K . Assume prices of vanilla put options are known with strikes Ki . For L = Ki < K we have, with S t := suput Su ,
(K ST )+ 1S T <B K L K L B K (L ST )+ (ST B)+ (ST B)1S T B B L B K B K
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(K ST )+ 1S T <B
0.5 0.4 0.3 0.2 0.1 0 0.1 0.2 0.3 0.4 0.5 0 0.5 1 1.5 2 2.5 L=0.3 K=0.6 B=1.2
K L K L B K (L ST )+ (ST B)+ (ST B)1S T B B L B K B K

Initial Position Put Payoff
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(K ST )+ 1S T <B
0.5 0.4 0.3 0.2 0.1 0 0.1 0.2 0.3 0.4 0.5 0 0.5 1 1.5 2 2.5 L=0.3 K=0.6 B=1.2
K L K L B K (L ST )+ (ST B)+ (ST B)1S T B B L B K B K

Put Payoff After B hit
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No-arbitrage pricing & the Skorokhod Embeddings

The methodology used in: Hobson (98); Brown, Hobson and Rogers (01), Dupire (05), Lee (07), Cox, Hobson and O. (08), Cox and Wang (12); cf. O. (10), Hobson (10).
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P = C ([0, T ]), we are given call prices and want to price OT . Suppose we have a market model: a classical framework with (St ) is a continuous martingale under P = Q, we see market prices C (K ) = E(ST K )+ , K 0.
Equivalently (St : t T ) is a UI martingale, ST , (dx) = C (dx). Via Dubins-Schwarz St = Bt is a time-changed Brownian
motion. Say we have OT = O(S)T = O(B)T . We are led then to investigate the bounds LB = inf EO(B) ,

and UB = sup EO(B) ,
i.e. for all solutions to the Skorokhod Embedding problem. The bounds are tight: the process St := B t denes an
for all stopping times : B and (Bt ) a UI martingale,

T t
asset model which matches the market data.

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T t

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T t

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T t

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From BM to MI superhedging
Consider UB. The idea is to devise inequalities of the form
O(B)u Nu + F (Bu ),
u 0,
and where Nu is a is a martingale , with equality for with B : then E[O(B) ] = UB = E[F (B )]. If can make sense of Ht = N 1 as a self-nancing trading t strategy then we have the cheapest superhedge and PO(S)T UB = PF (ST ). Case 1: Ht = k i (ST Si )1i t , for some rst hitting i=1 times i i.e. we simply buy/sell forwards when the price reaches predened levels. Makes sense pathwise.
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Consider UB. The idea is to devise super-hedges of the form
O(S)T N 1 + F (ST )
T
If can make sense of Ht = N 1 as a self-nancing trading t
and where N 1 is a ?
t
strategy then we have the cheapest superhedge and PO(S)T UB = PF (ST ). Case 1: Ht = k i (ST Si )1i t , for some rst hitting i=1 times i i.e. we simply buy/sell forwards when the price reaches predened levels. Makes sense pathwise.
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O(S)T N 1 + F (ST )
T
t
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O(S)T N 1 + F (ST )
T
t
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Example: double barriers options

Theorem (Cox and O. (11))
Let P = C ([0, T ]). Suppose P admits no WFLVR on X = {1, 1ST >b , 1ST b , (ST K )+ : K 0}. Then the following are equivalent
P admits no WFLVR on X {1{S b, S b} }, T T there exists a (P, P, X {1{S b, S b} }) market model, T
T
P(1{S P(1{S
T b, S T b} T b, S T b}
) inf P(H ), P(H (K2 )), P(H (K3 )) , ) sup P(H I ), P(H II (K1 , K2 )) .
II
III
where H , H are explicit super- and subhedging strategies.

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Robust hedging and pathwise stochastic integrals

Case 2: Nu =
u 0
hs dBs
t
Ht =
t 0
hu dSu . 1
If hs = h(Bs , As ) for a nice A, e.g. Au = supsu Bs then we
have Ht = 0 h(Su , A(S)u )dSu . (Extensions of) Fllmers o pathwise stochastic calculus allows to make sense of such trading strategies. Gives pathwise It or Tanaka. Applies to o e.g. options on variance or on local time, see Cox, Hobson and
O. (08), Davis, O. and Raval (12), Cox and Wang (12).
Requires pathspace P with well dened quadratic variation or pathwise local time. We can either assume (believe) it or try to rule out other paths by arbitrage, see Vovk (12). Admissibility is an interesting question (again)!
Otherwise, if OT is arbitrary, we look at generic
hu dSu dened on (, F, (Ft )) simultaneously for a large class of measures P , see e.g. Denis and Martini (06), Peng (07), Soner,
Touzi and Zhang (11), Nutz (12), Galichon, Henry-Labord`re and e Touzi (12).
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Case 2: Nu =
u 0
hs dBs
t
Ht =
t 0
hu dSu . 1
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Case 2: Nu =
u 0
hs dBs
t
Ht =
t 0
hu dSu . 1
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Case 2: Nu =
u 0
hs dBs
t
Ht =
t 0
hu dSu . 1
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Case 2: Nu =
u 0
hs dBs
t
Ht =
t 0
hu dSu . 1
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Outline
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The Skorokhod Embedding Problem (SEP)
Given B = (Bt : t 0) a Brownian motion, and a probability measure , nd a stopping time , such that B
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Given B = (Bt : t 0) a Brownian motion, and a probability measure , nd a stopping time , such that B
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Given B = (Bt : t 0) a Brownian motion, and a probability measure , nd a stopping time , small, such that B
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Given B = (Bt : t 0) a Brownian motion, and a probability measure , nd a stopping time , such that B and (Bt ) is UI.
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Given B = (Bt : t 0) a Brownian motion, and a probability measure , nd a stopping time , such that B and (Bt ) is UI.
Theorem (Skorokhod 61)

For an arbitrary centered probability measure , there exists a stopping time , such that B and (Bt )t0 is a uniformly integrable martingale.
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Given B = (Bt : t 0) a Brownian motion, some process (Xt ) and a probability measure , nd a stopping time , optimal: min or max EO such that B and (Bt ) is UI.
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Short biased guided tour of SEP

Skorokhod 61 Root 69 Rost 71 Monroe 72 Chacon Walsh 74 Azma Yor 79 Vallois 83 Perkins 85 Jacka 88 Bertoin Le Jan 92 Cox Hobson 02 & 04 O. Yor 04
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Skorokhod 61 Root 69 Rost 71 Monroe 72 Chacon Walsh 74 Azma Yor 79 Vallois 83 Perkins 85 Jacka 88 Bertoin Le Jan 92 Cox Hobson 02 & 04 O. Yor 04 Discrete vs Continuous approach
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Skorokhod 61 Root 69 Rost 71 Monroe 72 Chacon Walsh 74 Azma Yor 79 Vallois 83 Perkins 85 Jacka 88 Bertoin Le Jan 92 Cox Hobson 02 & 04 O. Yor 04 Use of first hitting times & Aplications in finance
Cox Hobson - O. 07
O. 06
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Pb: Given (Bt : t 0) a BM and a centered prob. measure we look for a process Yt and a region D such that = inf{t : Yt D} s.t. B
Skorokhod: Yt = Bt Root: Yt = (Bt , t) Vallois: Yt = (Bt , Lt )
Azma and Yor: Yt = (Bt , maxut Bu ) e
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Pb: Given (Bt : t 0) a BM and a centered prob. measure we look for a process Yt and a region D such that = inf{t : Yt D} s.t. B
Skorokhod: Yt = Bt Root: Yt = (Bt , t)
= a,b = inf{t : Bt [a, b]} and / b a B ba a + ba b . S R Write = SR R + SR S and enlarge ltration with indep (R, S). Then BR,S .
Vallois: Yt = (Bt , Lt )
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Pb: Given (Bt : t 0) a BM and a centered prob. measure we look for a process Yt and a region D such that
Theory
= inf{t : Yt D} s.t.
We have Ef ( ) Ef () for any convex f and any other , B .
There exists a barrier D s.t. B .
Root: Yt = (Bt , t)
Skorokhod: Yt = Bt
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There exist unique increasing +/ such that D = {(x, l) : x [ (l), + (l)]}. /
EF (L ) EF (L ) for any other , B .
Root: Yt = (Bt , t)
Skorokhod: Yt = Bt
Practice
Jan Oblj o
E
$%#" !
$B 5 7 5 3 1 0 ( & B 7 CA3 @898642')'

Modelling
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P(supt Bt b) P(supt Bt b) for any other UI , B . D = {(x, m) : m (x)} with 1 (x) = ([x,)) x u(du).
Azma and Yor: Yt = (Bt , maxut Bu ) e Vallois: Yt = (Bt , Lt ) Root: Yt = (Bt , t) Skorokhod: Yt = Bt
SEP
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Modelling
One touch option pays 1suptT St b .

Note that suptT St b 1 (b). ST
for any UI martingale (St ), S0 = S0 , E(ST K )+ = E(ST K )+ .
With St = BAY
P(sup St b) P(sup St b),
tT
Theory
t T t
One-touch option: pricing
we have
tT
AY = inf{t 0 : (Bt ) sup Bu }
maximises P(sup Bu b), b > B0 Azma-Yor (1979) e

Practice
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Modelling

With St = BAY
tT
Theory
t T t
we have
tT

Practice
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With St = BAY
tT
Theory
t T t
we have
tT

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One-touch option: hedging

Consider pathwise inequality (with S T = supuT Su ):
1{S T b}
(ST K )+ (b ST ) + 1 bK b K {S T >b}
where b > S0 , and K < b. When S T < b , we get: 0 (ST K )+ bK
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1{S T b}
(ST K )+ (b ST ) + 1 bK b K {S T >b}
where b > S0 , and K < b. When S T b, we get: 1 (K ST )+ b K + bK bK
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1{S T b}
(ST K )+ (b ST ) + 1 bK b K {S T b}
a call a forward transaction
where b > S0 , and K < b. Hence, we have a superhedging strategy for any K < b and, letting P be the pricing operator, we deduce P1S T b inf P(ST K )+ P(ST K )+ = , bK b K K <b
for K = 1 (b), bound attained in the Azma-Yor model. e
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

1{S T b}
(ST K )+ (b ST ) + 1 bK b K {S T b}
a call a forward transaction
where b > S0 , and K < b. Hence, we have a superhedging strategy for any K < b and, letting P be the pricing operator, we deduce P1S T b inf P(ST K )+ P(ST K )+ = , bK b K K <b
for K = 1 (b), bound attained in the Azma-Yor model. e
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Robust pricing and hedging of double barrier options, e.g. Payo = 1 if suptT St b and inf tT St b 0 otherwise
Mathematical Finance Robust hedging strategies preferred by a risk averse agent facing
model uncertainty transaction costs operational costs
Probability Theory
New solutions to the SEP
maximising/minimising double exit probabilities Studies of admissible laws of (B , supu Bu , inf u Bu ) Studies of harmonic functions of (Bt , suput Bu , inf ut Bu )
Based on
A. Cox and J.O. Robust hedging of double touch barrier
options. SIAM Journal on Financial Mathematics. 2: 141182, 2011. A. Cox and J.O. Robust hedging of double no-touch barrier options. Finance and Stochastics. 2011. in press.
Modelling
Theory
SEP
Practice
Robust pricing and hedging of double barrier options, e.g. Payo = 1 if suptT St b and inf tT St b 0 otherwise
Mathematical Finance Robust hedging strategies preferred by a risk averse agent facing
model uncertainty transaction costs operational costs
Probability Theory
New solutions to the SEP
maximising/minimising double exit probabilities Studies of admissible laws of (B , supu Bu , inf u Bu ) Studies of harmonic functions of (Bt , suput Bu , inf ut Bu )
Based on
A. Cox and J.O. Robust hedging of double touch barrier
options. SIAM Journal on Financial Mathematics. 2: 141182, 2011. A. Cox and J.O. Robust hedging of double no-touch barrier options. Finance and Stochastics. 2011. in press.
Modelling
Theory
SEP
Practice
We will consider the problem of maximising
P sup Bt b and inf Bt b

t t
Construct pathwise inequalities of the form:
over UI stopping times , B , where b < S0 < b. 1supt Bt b, F (Bt ) + Nt , ()
inf t Bt b
where Nt is a martingale (combination of forward purchases at hitting times).

Construct stopping time with B which achieves
equality in (). This gives a tight upper bound and the associated super-hedge.
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

t t
inf t Bt b

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

t t
inf t Bt b

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
We construct with B maximising P M b and I b . What is thethe best way of getting as as much mass as possible to go best way of getting much mass as possible to go What is from from b b and vice-versa? b to b and vice-versa? to
b S0 b We construct with B maximizing P M b and I b .
Run paths to b and b might need to stop some in the Runmiddle to b and b might need to stop some in the paths
middle From b, want to run as much as possible to b needs to balance out, so run rest to tails (biggest push in other direction)
Similarly from b. . .
Jan Oblj o Mathematical Finance and Probability
Run to remaining gaps.
In each step we keep uniform integrability, i.e. embedding
measure on [, ] we stop before (or when) hitting or .

Modelling
Theory
SEP
Practice
We construct with B maximising P M b and I b . What is thethe best way of getting as as much mass as possible to go What is best way of getting much mass as possible to go from from b b and vice-versa? b to b and vice-versa? to
Runmiddle to b and b might need to stop some in the paths
Run paths to b and b might need to stop some in the
Run to remaining gaps. Similarly from b. . .


Jan Oblj o
Modelling
Theory
SEP
Practice

Modelling
Theory
SEP
Practice

Modelling
Theory
SEP
Practice
We now want to construct an inequality which attains equality at exactly these sites.
lb
ub
Initially, we stop in the centre, or run to b, b. the inequality needs to be 1.
If we hit b, we run to the upper tail or b if we hit b now,

After hitting b, we embed near b.
Modelling
Theory
SEP
Practice
lb
ub

Modelling
Theory
SEP
Practice
lb
ub

Modelling
Theory
SEP
Practice
lb
ub
Initially, we stop in the centre, or run to b, b. the inequality needs to be 1. After hitting b, we embed near b.
If we hit b, we run to the lower tail or b if we hit b now,
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
lb
ub
If we hit b, we run to the lower tail or b if we hit b now, the inequality needs to be 1. After hitting b, we embed near b.
Initially, we stop in the centre, or run to b, b.
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
lb
ub
the inequality needs to be 1. After hitting b, we embed near b.

If we hit b, we run to the lower tail or b if we hit b now,
Initially, we stop in the centre, or run to b, b.
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Writing Hz = inf{t : Bt = z}, the inequality can then be written as follows: 1{S T b, S
T b}
+ 3 (K3 B )+ + 4 (K4 B )+ 1 (B b)1Hb <Hb + 2 (B b)1Hb <Hb + 3 (B b)1H <H 4 (B b)1H <H
b b b b
1 (B K1 )+ + 2 (B K2 )+
=: G (K1 , K2 , K3 , K4 ),
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
T b}
b b b b
1 (B K1 )+ + 2 (B K2 )+
=: G (K1 , K2 , K3 , K4 ),
Function of B (i.e. portfolio of calls and puts)
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
T b}
b b b b
1 (B K1 )+ + 2 (B K2 )+
=: G (K1 , K2 , K3 , K4 ), Martingale terms
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
T b}
b b b b
1 (B K1 )+ + 2 (B K2 )+
=: G (K1 , K2 , K3 , K4 ),
(K1 K2 )(b K4 )(b b) (K1 b)(b K2 )(b K4 ) 3 = b)2 (K3 b)(K1 b)(b K2 )(b K4 ) (K1 K2 )(K3 K4 )(b K3 K4 1 (1) 1 = 1 3 bK4 (b b) (K1 b) 1 = 1 + 2 2 = 1 3 K3 K4 (b b) (b K2 )1 . bK4 2 = 3 + 4 = K2 b 4 bK4 3
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
If we can construct an embedding which attains equality at its
stopping then we are done. In fact, the above construction does not always work there are another three cases we need to consider:
If both b and b are close to zero, we might not need to stop before hitting b or b. The strategies is G II (K1 , K2 ). is large, and b is close to zero, constraint becomes If both b how much mass can we embed at b. Construction becomes same as in Azma-Yor case. The case where b is large, and b e III is close to zero is similar. The strategies are G (K2 ) and G IV (K3 ).
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Both small construction
K2 lb
ub
K1
No stopping initially
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
K2 lb
ub
K1
Hit b: Stop in tails or run to b
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
K2 lb
ub
K1
Stop in middle
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

Again, get inequality of the form: 1{S T b, S
T b}
1 (B K1 )+ + 2 (K2 B )+ + 3 B + 4
b b b b
1 (B b)1Hb <Hb + 2 (B b)1Hb <Hb + 3 (B b)1H <H 4 (B b)1H <H =: G (K1 , K2 ),

II
Simpler expressions can be given for the nal two cases: write these as G III (K2 ) and G IV (K3 ). Note that optimal choices of K2 , K3 are given by barycentre functions from earlier.
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

T b}
1 (B K1 )+ + 2 (K2 B )+ + 3 B + 4
b b b b

II
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

T b}
1 (B K1 )+ + 2 (K2 B )+ + 3 B + 4
b b b b

II
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
This gives us a rened upper bound: P sup Bt b, inf Bt b

t t
(2)
II III IV
inf EG (K1 , K2 , K3 , K4 ), EG (K1 , K4 ), EG (K2 ), EG (K3 )

I
where the inmum is taken over values of K1 , . . . , K4 with K1 < b < K2 K3 < b < K4 .
Theorem
For any (centered in S0 ) target distribution B , and any b < S0 < b we attain equality in (2).
Theorem (Rephrased)
For any (arbitrage-free) curve of call prices, and any b < S0 < b, there exists a stock price process for which (2) is the price of a double touch option.
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
This gives us a rened upper bound: P sup Bt b, inf Bt b

t t
(2)
II III IV
inf EG (K1 , K2 , K3 , K4 ), EG (K1 , K4 ), EG (K2 ), EG (K3 )

I
where the inmum is taken over values of K1 , . . . , K4 with K1 < b < K2 K3 < b < K4 .
Theorem
Theorem (Rephrased)
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
This gives us a rened upper bound: P 1supt Bt b,

inf t Bt b
inf PG I (K1 , K2 , K3 , K4 ), PG II (K1 , K4 ), PG III (K2 ), PG IV (K3 ) where the inmum is taken over values of K1 , . . . , K4 with K1 < b < K2 K3 < b < K4 .
(2)
Theorem
Theorem (Rephrased)
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
The tricky part of the proof is to show that these are all the
possibilities. measures.
Approach is to use various properties of barycentres of
In fact, we give explicit criteria to decide, given , b, b, which of the four strategies is optimal and with what choice of strikes Ki ( robust super-hedging).
Unlike with Azma-Yor or Perkins results (type of inequality e
and the formula for the upper bound) depend on , b, b.
We have analogous story for the lower bound and subhedging and we can also treat other double barrier options...
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Outline
Modelling
Theory
SEP
Practice
Performance of robust hedges

1{S
T b, S T b}
(with F. Ulmer (11))
Traders A & B sell a digital double barrier option, e.g.
Underlying dynamics are unknown but calibrated to the initial
, 1{S T b, S
T b}
, for an initial price p.
surface. We will use BS, Heston, Bates and VGSV models. ATM IV. Rebalancing is done
Trader A will use BS delta or delta/vega hedging with the

daily or every six hours optimally: based on a bandwith around his delta and vega
positions (Whalley and Wilmott (97)) Trader B will use the robust hedges. More precisely, for a
price p1 > p Trader B buys the superhedge H. His nal payo is given as p p1 1{S b, S T b} + H
T
which is bounded below by p p1 if the path is in P = C ([0, T ]). The hitting times of barrier are observed exactly or monitored every six hours or daily.
Modelling
Theory
SEP
Practice

1{S
T b, S T b}
, 1{S T b, S
T b}
surface. We will use BS, Heston, Bates and VGSV models.
ATM IV. Rebalancing is done
T
Modelling
Theory
SEP
Practice

1{S
T b, S T b}
, 1{S T b, S
T b}
surface. We will use BS, Heston, Bates and VGSV models.
ATM IV. Rebalancing is done
T
Modelling
Theory
(b) Heston; AUDUSD

SEP
Practice
Initial data corresponds to 176 quotes on AUD/USD on 14 Jan 2010: from 5 put to 35 put, ATM and from 35 call to 5 call for 16 maturities. We assume trading in S carries a 4bps transaction costs and in options a 100bps costs. Spot S0 = 0.9308.
(d) Bates; AUDUSD

Modelling
Theory
SEP
Practice

We consider 24 scenarios:
4 positions (long/short in DNT, DT) each under 6 market scenarios. no hedging Traders A using 8 hedges Traders B using 3 hedges.
For each scenario we run MC and generate hedging errors for
For each out of 288 combinations, we report Mean, SD, Skew, Kurtosis Minimum, Maximum VaR, CVaR both at 99% EUM, EUH expected exponential utility with = 1, 2 CDF plot
We say that hedge H1 outperforms H2 if

H1 achieves lower VaR, CVaR and max loss than H2 and expected return (H1) expected return (H2).
Modelling
Theory
SEP
Practice

4 positions (long/short in DNT, DT) each under 6 market scenarios.

no hedging Traders A using 8 hedges Traders B using 3 hedges.

Modelling
Theory
SEP
Practice



Modelling
Theory
SEP
Practice



Modelling
Theory
SEP
Practice
Hedge errors CDF, long position in a DNT option, barriers (0.85, 1.01), BS model:
1 No hedging Delta 250 Delta/vega 250 Opt. delta 1000 Opt. delta/vega 1000 Robust Hedge 250 Robust Hedge 1000 Robust Hedge Exact
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.8
0.6
0.4
0.2
0.2
0.4
0.6
0.8
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Hedge errors CDF, short position in a DT option, barriers (0.85, 1.01), BATES:
1 No hedging Delta 250 Delta/vega 250 Opt. delta 1000 Opt. delta/vega 1000 Robust Hedge 250 Robust Hedge 1000 Robust Hedge Exact
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.8
0.6
0.4
0.2
0.2
0.4
0.6
0.8
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Hedge errors CDF, long position in a DT option, barriers (0.875, 0.985), VGSV:
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
No hedging Delta 250 Delta/vega 250 Opt. delta 1000 Opt. delta/vega 1000 Robust Hedge 250 Robust Hedge 1000 Robust Hedge Exact 1 0.8 0.6 0.4 0.2 0 0.2 0.4 0.6 0.8 1
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Comparative performance of hedging methods

Overwhelmingly, we nd that the robust hedges outperform
traditional hedging methods. Often lead to a dramatic reduction of risk while achieving similar or higher returns. This remains true even in the models with jumps (Bates, VGSV). Robust hedging errors are typically positively skewed: frequent small losses compared with some large gains. Traditional hedging errors are typically negatively skewed. SD of robust hedging errors typically 23 larger than of the traditional hedges. We assumed no interest rates: applies for currency pairs with similar domestic interest rates. Makes sense for singularly large position in a barrier option in uncertain market conditions. Robust hedges akin to the methods used by old-school traders
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Conclusions and further research

I advocate a new robust framework for pricing and hedging. It
is a pathwise approach which combines beliefs about possible paths together with market information. New notions of no-arbitrage are introduced and examples of FTAP obtained. Estimates on e.g. realised total volatility or IVol surface obtained from past data can be incorporated. The outputs are: no-arbitrage price bounds and the superand subhedging strategies which enforce them. Robust hedging methods may greatly outperform delta/vega hedging in presence of transaction costs and/or model uncertainty.
So far one-step models are worked out, many examples for
continuous time but a general theory is missing. further development.
Pathwise stochastic calculus and its link to no-arbitrage need Incorporating econometrics to reduce P has only been started,
no exotics treated so far.
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice

Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
Thank You!
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
This talk was based on

A.M.G. Cox and J. Oblj. Robust hedging of double no-touch o
barrier options. Finance and Stochastics, 15(3): 573605, 2011. A.M.G. Cox and J. Oblj. Robust hedging of double touch o barrier options. SIAM Journal on Financial Mathematics, 2: 141182, 2011. M. Davis, J. Oblj and V. Raval. Arbitrage bounds for o weighted variance swap prices. 20092011. arXiv: 1001.2678 F. Ulmer and J. Oblj. Performance of robust hedging of o double barrier options. International Journal of Theoretical and Applied Finance, to appear, 2011. (DOI: 10.1142/S0219024911006516) work in progress with Sergey Nadtochiy, 2012. my own ideas and not-yet-nished preprints.
Paris, August 2012
Jan Oblj o
Modelling
Theory
SEP
Practice
(Weak free lunch with vanishing risk (Cox & O. 11))

We say that (P, X P) admits a weak free lunch with vanishing risk if there exists Xn , Z Lin(X ) such that Xn X (pointwise on P), Xn Z , X 0 and lim PXn < 0.
Paris, August 2012
Jan Oblj o

Obloj 2012 Paris Lecture

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From Classical to Robust framework for valuation and hedging

Lectures on Skorokhod embedding problem and its applications Jan Oblj o

5th European Summer School in Financial Mathematics Paris, August 2012

Modelling: Key Ingredients

Robust approach to Mathematical Finance

Paris, August 2012

Modelling: Classical approach

expectations of functionals of solutions to SDEs

Modelling: Classical approach

expectations of functionals of solutions to SDEs

Modelling: Classical approach

expectations of functionals of solutions to SDEs

Modelling: Classical approach

expectations of functionals of solutions to SDEs

Modelling: Classical approach

expectations of functionals of solutions to SDEs

Recently, its critique has been vocal ...

Modelling: Classical approach

Calibrate the model: chose the parameters to match the

prices already observed in the market.

Use it: sell and hedge derivatives.

This approach has important drawbacks:

Models are re-calibrated daily: theoretically inconsistent.

It is a rst order approximation which ignores market frictions.

Modelling: Classical approach

Calibrate the model: chose the parameters to match the

prices already observed in the market.

Use it: sell and hedge derivatives.

This approach has important drawbacks:

Models are re-calibrated daily: theoretically inconsistent.

It is a rst order approximation which ignores market frictions.

Relaxing Beliefs: Model uncertainty

Reasoning principles: Essentially link back to the classical FTAP.

Including Information: Market Models

The classical FTAP.

B & I: the Robust Approach

(Cox & O. (11))

Beliefs (about the future dynamics of the stock price process):

Information (market prices): set of payos X ,

Rules (self-nancing trading strategies, frictions): no frictions,

simple trading; pathwise stochastic integrals

there exists a (P, P, X {OT })market model

B & I: the Robust Approach

(Cox & O. (11))

Beliefs (about the future dynamics of the stock price process):

Information (market prices): set of payos X ,

Rules (self-nancing trading strategies, frictions): no frictions,

simple trading; pathwise stochastic integrals

there exists a (P, P, X {OT })market model

B & I: the Robust Approach

(Cox & O. (11))

Beliefs (about the future dynamics of the stock price process):

Information (market prices): set of payos X ,

Rules (self-nancing trading strategies, frictions): no frictions,

simple trading; pathwise stochastic integrals

there exists a (P, P, X {OT })market model

One period model a rst pass

with given prices P : X R. i.e. P(S1 ) = S0 .

Robust approach to Mathematical Finance

One period model a rst pass

with given prices P : X R. i.e. P(S1 ) = S0 .

One period model a rst pass

with given prices P : X R. i.e. P(S1 ) = S0 .