Time-Changed Levy Processes and Option Pricing

Peter Carr
a,
, Liuren Wu
b,
a
2 Washington Square Village, Apt. 13-S, New York, NY 10012
b
Fordham University, GBA, 113 West 60th Street, New York, NY 10023
September 20, 2001; rst draft: July 17, 2000
Abstract
We apply stochastic time change to Levy processes to generate a wide variety of
tractable option pricing models. In particular, we prove a fundamental theorem that
transforms the characteristic function of the time-changed Levy process into the Laplace
transform of the stochastic time under appropriate measure change. We extend the tradi-
tional measure theory into the complex domain and dene the measure change by a class
of complex valued exponential martingales. We provide extensive examples to illustrate its
applications and its link to existing models in the literature.
JEL Classication: G10, G12, G13.
Keywords: Stochastic time change; Levy processes; subordination; characteristic functions;
option pricing; exponential martingales; measure change.

We thank Yuri Kabanov, Dilip Madan, Marek Musiela, and Albert Shiryaev for comments. Any remaining
errors are ours. We welcome comments, including references to related papers we inadvertently overlooked. The
latest version of the paper can be downloaded from http://www.bnet.fordham.edu/lwu.

Correspondence Information: Tel.: (212) 260-3765; pcarr@nyc.rr.com.

Correspondence Information: Tel.: + 212-636-6117; fax: + 212-765-5573; wu@fordham.edu.

1. Introduction
In conformity with the increasingly important role played by nancial derivatives in the econ-
omy, a large stream of literature has been devoted to derivative pricing. Recently, in an im-
portant paper, Bakshi and Madan (2000) provide economic foundations for valuing derivative
securities and establish how the characteristic function of future uncertainty is basis augment-
ing and spans the payo universe of most derivative assets. This paper is inspired by their
work. The objective is to derive the characteristic function of a plethora of stochastic pro-
cesses which can be applied to describe the uncertainty of the economy. We generate the
candidate stochastic processes by applying stochastic time change to Levy processes. More
importantly, we prove a fundamental theorem that transforms the characteristic function of
the time-changed Levy process into the Laplace transform of the stochastic time under appro-
priate measure change. We extend the traditional measure theory into the complex domain
and dene the measure change by a class of complex valued exponential martingales. The
transformation signicantly simplies the derivation of the characteristic function. We provide
extensive examples to illustrate its applications and its link to existing models in the literature.
Stochastic time change has historically been proven to be a powerful tool in generating
various stochastic processes. In particular, for asset prices to be consistent with no-arbitrage,
the price process must be semimartingales;
1
yet, every semimartingale can be written as a
time-changed Brownian motion (Monroe, 1978). Instead of starting with a Brownian motion,
however, we begin with a general Levy process because the characteristic function of all Levy
processes are readily available from the well-known Levy-Khintchine formula. We then proceed
to explore stochastic time processes with analytically tractable Laplace transforms.
A key result of this paper is that the generalized Fourier transform of the time-changed Levy
processes can be written as, after some appropriate measure change, the Laplace transform of
the stochastic time evaluated at the characteristic exponent of the Levy process. The measure
change is dened by a family of complex valued exponential martingales, a straightforward
1
See, for example, Delbaen and Schachermayer (1994).
extension of the time-changed exponential family. Measure change under such a family takes
extremely simple forms and is often supported by utility optimization problems.
2
Constructing complex valued measures and applying them to measure changes are new
to the literature. While the probabilistic or economic interpretations of a complex measure
are yet to be dened, the mathematical extension from the real space to the complex space is
relatively straightforward. We leave potential economic interpretations of a complex measure to
future research; instead, we focus on how such a complex valued measure change dramatically
streamlines the operations under the frequency domain.
We provide extensive examples to illustrate the applications of the theorem. We categorize
the examples in terms of the properties of the stochastic time. The rst category is independent
Levy subordinators. It is known that a Levy process subordinated by an independent Levy
subordinator is still a Levy process.
3
The models of Clark (1973) and Madan and Seneta
(1990) belong to this category. Since the subordinated process remains Levy, the characteristic
function can also be obtained from the Levy-Khintchine formula by directly specifying the Levy
measure, which controls the arrival rate of jumps in the Levy process. A recent endeavor in
this category is by Carr, Geman, Madan, and Yor (2000).
The second category focuses on the continuous and dierentiable part of the stochastic
time process. We label the derivative of the stochastic time with respect to the calendar time
as the instantaneous rate of activity. It can be interpreted as a measure of the rate of business
and economic activities in terms of their impact on the uncertainty of the economy. When
the Levy process is a standard Brownian motion, the instantaneous activity rate is equivalent
to the concept of instantaneous variance. Therefore, all stochastic or GARCH-type volatility
models can be obtained by stochastic time change of the second category.
2
Refer to K uchler and Srensen (1997) for details on the exponential families of stochastic processes. Kallsen
and Shiryaev (2000) provide an excellent analysis on measure changes dened by exponential martingales and
their economic underpinnings.
3
See, for example. Bertoin (1996) and Sato (1999) for standard reference.
2
Within the second category, by transforming the characteristic function of the time-changed
process to the Laplace transform of the stochastic time, we also make transparent a fundamen-
tal link between option pricing and bond pricing: the Laplace transform of the stochastic time
as a function of the instantaneous activity rate has exactly the same form as the zero-coupon
bond pricing formula as a function of the instantaneous interest rate. Therefore, the large lit-
erature on term structure of interest rates can be directly adopted to model the stochastic time
or volatility. In particular, we illustrate how the ane term structure models of Due and Kan
(1996) and the quadratic term structure models of Leippold and Wu (2001) can be adopted
to model the stochastic time with extreme analytical tractability. In light of the increasing
evidence of long memories in both return volatilities and interest rates, we also propose a new
class of analytically tractable long-memory models which are equally capable in modeling both
the stochastic time change and the term structure of interest rates.
While the rst category focuses on the discontinuous feature of asset price movements,
or arguably, the non-normal feature of asset return distributions, the second category focuses
on the time-varying and clustering feature of return volatilities. Both are robust and well-
known features of the nancial markets. In a market that is decisively incomplete, there may
exist potentially many models or probability measures that can describe the observed asset
prices. However, as argued in Carr, Geman, and Madan (2001), a large number of model
candidates help tremendously in completing the market in a weak sense and in pricing and
hedging nancial assets. They also play important roles in dening coherent measures of risk
in Artzner, Delbaen, Eber, and Heath (1998). Our paper provides a powerful tool in generating
empirically reasonable and analytically tractable model candidates.
Application of stochastic time change to asset pricing goes back to Clark (1973), who
models the asset price as a geometric Brownian motion subordinated by an independent Levy
subordinator. Most recently, Ane and Geman (2000) show that stochastic time changes are
mathematically much less constraining than subordinators. Based on the general idea that
every semimartingale can be represented as time-changed Brownian motion, Ane and Geman
(2000) show that normality of asset returns can be recovered through a stochastic time change.
In particular, they nd that the cumulative number of trades is a better stochastic clock than
3
the volume for generating virtually perfect normality in returns. Following the same idea,
Geman, Madan, and Yor (2000) identify the stochastic time change of various pure jump Levy
processes that can transform these Levy processes back into Brownian motions. We follow the
same idea of stochastic time change but have dierent perspectives. Instead of decomposing
existing models in the literature into time-changed Brownian motions, we apply stochastic time
change to generate a plethora of new tractable option pricing models and consolidate existing
ones in the literature.
However, the most important and innovative contribution of our paper is the complex
valued measure change. Such a measure change is not necessary when the stochastic time
process is independent of the original Brownian motion, as is assumed in the above-listed
stochastic time change literature. When one incorporates dependence between the two, as in
traditional jump-diusion/stochastic volatility models, e.g., Bakshi, Cao, and Chen (1997),
Bates (1996), and Bates (2000), one often discards the powerful tool of stochastic time change
and derives the characteristic function of the asset return directly from the fundamental partial
dierential equation. Our proposed theorem on complex valued measure change combines and
consolidates these two streams of literature and enables us to apply stochastic time change
under the most general set up.
The structure of the paper is as follows. The next section states the fundamental theo-
rem that relates the characteristic function of the time-changed Levy process to the Laplace
transform of the stochastic time under an appropriate measure change. Section 3 proposes two
transform methods which price many European style state-contingent claims from the charac-
teristic function. Section 4 provide extensive examples generated by stochastic time change of
a Levy process. Section 5 concludes.
2. Time-changed Levy processes
Consider a d-dimensional real-valued stochastic process X {X
t
|t 0} with X
0
= 0 dened
on an underlying probability space (, F, P) endowed with a standard complete ltration
4
F = {F
t
|t 0}. We assume that X is a Levy process with respect to the ltration F, that is,
X
t
is adapted to F
t
, the sample paths of X are right-continuous with left limits, and X
u
X
t
is independent of F
t
and distributed as X
ut
for 0 t < u. Then, by the Levy-Khintchine
Theorem, the characteristic function of X
t
has the form,

X
t
() E
_
e
i

X
t
_
= e
t
x
()
, t 0, (1)
where the characteristic exponent
x
(), R
d
, is given by (Bertoin (1996), page 12):

x
() i

+
1
2

+
_
R
d
_
1 e
i

x
+i

x1
|x|<1
_
(dx).
The Levy process X is specied by the vector R
d
, the positive semi-denite quadratic form
on R
dd
, and the Levy measure on R
d
{0}. The triplet (, , ) is referred to as the Levy
characteristics of X. For the purpose of option pricing, we extend the characteristic function
parameter to the complex plane, D C
d
, where D is the set of values for for which
the expectation in (1) is well dened.
X
t
() dened on the complex plane is often referred
to as the generalized or complex Fourier transform. A comprehensive reference is Titchmarsh
(1975).
Next, let t T
t
(t 0) be an increasing right-continuous process with left limits such
that for each xed t, the random variable T
t
is a stopping time with respect to F. Suppose,
furthermore, that T
t
is nite P-a.s. for all t 0 and that T
t
as t . Then the family
of stopping times {T
t
} denes a stochastic time change.
Finally, consider the d-dimensional process Y obtained by evaluating X at T, i.e.:
Y
t
X
T
t
, t 0.
We propose that this process be the underlying uncertainty of the economy. Obviously, by
specifying dierent Levy characteristics for X
t
and dierent stochastic processes for T
t
, we can
generate a plethora of stochastic processes from this setup. Our primary objective is to derive
5
the generalized characteristic function of such processes, with which we can price contingent
claims via transform methods (Section 3).
The following theorem represents the key result of this paper. It states that, after an
appropriate measure change, the generalized Fourier transform of Y
t
can be written as the
Laplace transform of T
t
.
Theorem 1 The generalized Fourier transform of the time-changed Levy process Y
t
X
Tt
under measure P can be represented as the Laplace transform of T
t
under a new complex-
valued measure Q(), evaluated at the characteristic exponent
x
() of X
t
,

Y
t
() E
_
e
i

Y
t
_
= E

_
e
T
t

x
()
_
L

T
t
(
x
()) , (2)
where E[] and E

[] denote expectations under measures P and Q(), respectively. The new

class of complex-valued measures Q() are absolutely continuous with respect to P and are
dened by
dQ()
t
dP
t
M
t
(),
with
M
t
() exp
_
i

Y
t
+T
t

x
()
_
, D. (3)
To prove the theorem, we rst need to prove that M
t
(), D, dened in (3) is a P-
martingale with respect to the ltration {F
Tt
|t 0}.
Lemma 1 For every D, M
t
() in (3) is a complex-valued P-martingale with respect to
{F
Tt
|t 0}.
Proof. First, dene
Z
t
() exp
_
i

X
t
+t
x
()
_
. (4)
6
Suppose that
x
() = 0. Then, the niteness of E [|Z
t
()|] is a direct consequence of the
niteness of
x
() since
E [|Z
t
()|] exp(t
x
()) .
Now for 0 s < t,
E
_
e
i

(X
t
X
s
)+
x
()(ts)
|F
s
_
= e

x
()(ts)+
x
()(ts)
= 1.
Hence, Z
t
() is a complex-valued P-martingale with respect to {F
t
|t 0}.
Next, for every xed t 0, T
t
is a stopping time which is nite P-a.s. By the optional
stopping theorem, M
t
() Z
T
t
() is also a complex-valued martingale with respect to the
ltration generated by the process {(Y
t
, T
t
) : t 0}, i.e., {F
T
t
|t 0}.
Z
t
() is the familiar Wald martingale. See, for example, Harrison (1985), page 7, Karlin and
Taylor (1975), page 243, and Bertoin (1996), page 40. We extend the real-valued exponential
family of martingales dened on Levy processes in (K uchler and Srensen 1997, page 8) to
the complex plane. Similarly, M
t
() = Z
Tt
() can be regarded as a complex extension of the
time-changed exponential martingale in (K uchler and Srensen 1997, page 230).
Given that M
t
() = dQ()
t
/dP
t
is a well-dened complex-valued P-martingale, the proof
of Theorem 1 follows straightforwardly.
Proof. (Theorem 1)
E
_
e
i

Y
t
_
= E
_
e
i

Y
t
+T
t

x
()T
t

x
()
_
= E
_
M
t
()e
T
t

x
()
_
= E

_
e
T
t

x
()
_
= L

T
t
(
x
()) .
The following corollaries present special cases of the stochastic time change.
7
Corollary 1 If the stochastic time change T
t
is independent of X
t
, then the time-changed
process Y
t
X
Tt
can also be represented as the Laplace transform of T
t
evaluated at
x
()
under the original measure P:

Y
t
() = L
T
t
(
x
()) . (5)
When T
t
is independent of X
t
, T
t
follows the same process under the two measures P and
Q(). Hence, the proposed measure change is not necessary. The result can also be derived
directly via the principle of conditional expectation. Traditional application of stochastic time
change is mostly under such an independence assumption so that the complex valued measure
change is not required.
Corollary 2 If the stochastic time change T
t
is also a Levy subordinator independent of X
t
,
then the subordinated process Y
t
X
Tt
remains a Levy process under P with respect to the
ltration {F
t
}. In particular, the Laplace transform of T
t
is
L
Tt
() E
_
e
Tt
_
= e
t
T
()
, (6)
with

T
() = +
_
(0,)
_
1 e
x
_
(dx).
The Levy characteristics of Y
t
are given by

Y
=
X
+
_
(0,)
(ds)
_
|x|1
xF
s
(dx);

Y
=
X
;

Y
(dx) =
X
(dx) +
_
(0,)
F
s
(dx)(ds),
where F(dx) is the distribution function of X
1
.
Refer to Sato (1999), pages 197198, for a proof. This corollary forms the basis for the classic
work of Clark (1973).
8
In essence, we have transformed the problem of nding the generalized Fourier transform
into a problem of nding the Laplace transform of the stochastic time process under the
new complex valued measure Q(). Since the new measure change is dened by a family
of time-changed exponential martingales, measure change takes extremely simple forms and
is often supported by utility optimization problems. Refer to K uchler and Srensen (1997)
for an excellent book treatment on the exponential families of stochastic processes. Kallsen
and Shiryaev (2000) provide an excellent analysis on measure changes dened by exponential
martingales and their economic underpinnings. Our result on measure change extends that of
Kallsen and Shiryaev (2000) to the complex plane.
3. Option Pricing
Given the generalized Fourier transforms of the state vector Y
t
, many state contingent claims
can be priced eciently via inversion of the transforms. Formally, consider a European-style
state-contingent claim with the general payo structure at maturity,

Y
(k; a, b, , c) =
_
a +be

Yt
_
1
c

Y
t
k
, (7)
where Y X
T
t
is the d-dimensional time-changed Levy process. For example, if we assume
that the forward price of an asset is given by F
t
= F
0
exp(

Y
t
), the payo of a European call
option with strike price K is given by (lnK/F
0
; K, F
0
, , ), the payo of a European
put option with strike price K is given by (lnK/F
0
; K, F
0
, , ), that of a covered call is
max[S
t
, K] = (lnK/F
0
; 0, F
0
, , ) + (lnK/F
0
; K, 0, 0, ), and nally, the payo of a
binary call is given by (lnK/F
0
; 1, 0, 0, ). We can therefore write the payos of many
European-type contingent claims in the form of (7) or a linear combination of it.
Let G(k; a, b, , c) denote the time-0 price of such a contingent claim. Note that we drop
the argument in maturity t as no confusion shall occur. In what follows, we show that the price
G of such a general contingent claim can be obtained by two transform methods. The rst
transform method is analogous to Bakshi and Madan (2000) and is applied by Due, Pan,
9
and Singleton (2000) and Leippold and Wu (2001) to interest rate derivatives. The second
transform method is an extension of Carr and Madan (1999) and is applied to quadratic term
structure models by Leippold and Wu (2001).
3.1. Fourier Transform I
Let G
I
(z; a, b, , c) denote a Fourier transform of G(k; a, b, , c) dened as
G
I
(z; a, b, , c)
_
+

e
izk
dG(k; a, b, , c), z R. (8)
The following proposition derives a closed-form solution for this transform.
Proposition 1 The Fourier transform, dened in (8), of the price of the state-contingent
claim G(k; a, b, , c), when it exits, can be written as an ane function of the generalized
Fourier transform of Y
t
:
G
I
(z; a, b, , c) = a
Y
(zc) +b
Y
(zc i).
Proof. The result is obtained by applying Fubinis theorem and applying the result on the
Fourier transform of a Dirac function.
Given the Fourier transform G
I
(z; a, b, , c), the price G(k; a, b, , c) can be obtained by an
extended version of the Levy inversion formula.
Proposition 2 The price G(k; a, b, , c) of the state-contingent claim is given by the following
inversion formula:
G(k; a, b, , c) =
G
I
0
2
+
1
2
_

0
e
izk
G
I
(z; a, b, , c) e
izk
G
I
(z; a, b, , c)
iz
dz,
where G
I
0
= G
I
(0; a, b, , c) = a +b
Y
(i).
10
To prove the inversion formula, one can follow the proof of the inversion formula for cumulative
density functions. See, for example, Chapter 4 of Alan and Ord (1987). The only dierence
is that the limit of the claim price is given by: lim
k+
G(k; a, b, , c) = a + b
Y
(i) while
the limit of a cumulative density goes to unity. Also see Due, Pan, and Singleton (2000) and
Leippold and Wu (2001) for similar proofs under dierent circumstances.
3.2. Fourier Transform II
Traditional numerical integration methods for the inversion in Proposition 2, such as the
quadrature method used in Singleton (1999) and Due, Pan, and Singleton (2000), can be
inecient due to the oscillating nature of the Fourier transform. Instead of working with the
inversion formula in Proposition 2, we can also cast the problem in a way such that we can
apply the fast Fourier transform (FFT) and thus take full advantage of its considerable increase
in computational eciency.
For this purpose, let G
II
(z; a, b, , c) denote a second Fourier transform of G(k; a, b, , c)
dened as,
G
II
(z; a, b, , c)
_

e
izk
G(k; a, b, , c) dk, z C C. (9)
Compare the two Fourier transforms dened in (8) and (9), we see that G(k; a, b, , c) is treated
as an analogue of a cumulative density function in G
I
(z; a, b, , c) while it is treated as a
probability density in G
II
(z; a, b, , c). Also note that the transform parameter z in (9) is
extended to the complex plane with C being the complex domain of z where G
II
(z; a, b, , c) is
well-dened. Hence, we are dealing with an extended Fourier transform in G
II
(z; a, b, , c).
Proposition 3 The generalized Fourier transform of the price G(k; a, b, , c) dened in (9),
when well-dened, is given by:
G
II
(z; a, b, , c) =
i
z
(a
Y
(zc) +b
Y
(zc i)) .
11
The result is obtained via integration by parts and Proposition 1:
G
II
(z; a, b, , c) = G(k; a, b, , c)
e
izk
iz

1
iz
_

e
izy
dG(k; a, b, , c)
=
i
z
(a
Y
(zc) +b
Y
(zc i)) .
Since lim
k
G(k; a, b, , c) = G
I
0
= 0, the limit term is well-dened and vanishes only when
Im z > 0. Therefore, the extension of the Fourier transform to the complex domain is neces-
sary for it to be well-dened. In general, the admissible domain C of z depends on the exact
payo structure of the contingent claim. Table 1 present the generalized Fourier transforms
of various contingent claims and their respective admissible domains on z. Similarly, they are
derived via integration by parts and by checking the boundary conditions as y .
Table 1
Fourier Transforms of Various Contingent Claims
(, , a, b are real constants with < .)
Contingent Generalized transform Restrictions
Claim iz(z) on Im z
G(k; a, b, , c) a
Y
(zc) +b
Y
(zc i) (0, )
G(k; a, b, , c) a
Y
(zc) +b
Y
(zc i) (, 0)
e
k
G(k; a, b, , c) a
Y
((z i)c) +b
Y
((z i)c i) (, )
e
k
G(k; a, b, , c) a
Y
((z i)c) +b
Y
((z i)c i) (, )
e
k
G(k; a
1
, b
1
,
1
, c
1
) a
1

Y
((z i)c
1
) +b
1

Y
((z i)c
1
i
1
)
+e
k
G(k; a
2
, b
2
,
2
, c
2
) +a
2

Y
((z i)c
2
) +b
2

Y
((z i)c
2
i
2
) (, )
Let z = z
r
+ iz
i
, where z
r
and z
i
denote, respectively the real and imaginary part of
z. Let G
II
(z; a, b, , c) denote the generalized Fourier transform of some contingent claim
price function G(k), which can be in any of the forms presented in Table 1. Then, given
that G
II
(z; a, b, , c) is well-dened, the corresponding contingent claim price function G(k) is
obtained via the inversion formula:
G(k) =
1
2
_
iz
i
+
iz
i

e
izk
G
II
(z; a, b, , c)dz.
12
The integral is along a straight line in the complex z-plane parallel to the real axis. z
i
can be
chosen to be any real number satisfying the restriction in Table 1 for the corresponding state
price function. The integral can also be written as
G(k) =
e
z
i
k

_

0
e
iz
r
k
(z
r
+iz
i
) dz
r
,
which can be approximated on a nite interval by
G(y) G

(y) =
e
z
i
k

N1

k=0
e
iz
r
(j)k
(z
r
(j) +iz
i
) z
r
, (10)
where z
r
(j) are the nodes of z
r
and z
r
the grid of the nodes. Recall that the FFT is an ecient
algorithm for computing the discrete Fourier coecients. The discrete Fourier transform is a
mapping of f = (f
0
, ..., f
N1
)

on the vector of Fourier coecients d = (d

0
, ..., d
N1
)

, such
that
d
j
=
1
N
N1

k=0
f
k
e
jk
2
N
i
, j = 0, 1, ..., N 1. (11)
FFT allows the ecient calculation of d if N is an even number, say N = 2
m
, m N. The
algorithm reduces the number of multiplication in the required N summations from an order
of 2
2m
to that of m2
m1
, a very considerable reduction. By a suitable choice of z
r
and a
discretization scheme for k, we can cast the approximation in the form of (11) to take advantage
of the computing eciency of FFT. For more details on the discretization schemes, see Carr
and Madan (1999), who implement the FFT algorithm on the pricing of a European call option.
4. Examples of Stochastic Time Change
This section provides extensive examples on how the stochastic time change and, if necessary,
measure change work in practice and how they relate to existing models in the literature.
13
4.1. Independent Levy subordinator
When the stochastic time change is an independent Levy subordinator, the subordinated Levy
process remains a Levy process. Many existing jump models can be obtained by such subor-
dination.
4.1.1. VG model: Gamma-subordinated arithmetic Brownian motion
The variance gamma (VG) model of Madan and Seneta (1990), Madan and Milne (1991), and
Madan, Carr, and Chang (1998) can be obtained by subordinating an arithmetic Brownian
motion by an independent gamma process. In particular, let X be a one dimensional arithmetic
Brownian motion with drift coecient R and diusion coecient R
+
. Then the
generalized characteristic exponent of X,
x
(), C, is given by:

x
() = i +

2

2
2
.
Let T be an independent gamma process with scale parameter a and shape parameter b. The
Laplace Transform of T
t
is:
L
Tt
() Ee
Tt
=
_
1 +

b
_
at
, C, Re () 0. (12)
Thus, from (5), the characteristic function of Y
t
is:

Y
t
() =
_
1
i
b
+

2

2
2b
_
at
. (13)
The process Y is the variance gamma process.
4.1.2. A 2-stable process: -Stable-subordinated standard Brownian motion
Let X
t
be a standard Brownian motion with characteristic exponent
x
() =
2
/2. Consider
an -stable process T
t
with zero drift, dispersion , skewness parameter and tail index . It
14
can be a subordinator if and only if (0, 1) and = 1. The Laplace transform of such an
-stable subordinator T
t
is:
L
Tt
() Ee
Tt
= e
tc

, C, Re () 0, (14)
with c =

sec

2
. The characteristic function of such an -stable subordinated standard
Brownian motion, Y
t
X
Tt
, is therefore given by

Y
t
() = exp
_
t
c
2

2
_
, C, (15)
which is, obviously, the transform of a 2-stable process.
As a special case, consider the rst time that a standard Brownian motion X
1
hits a barrier
t 0. As t varies, the sequence of hitting times generates the inverse Gaussian process T
t
,
which is the special case of the stable process with =
1
2
, = 1, and = 1. The Laplace
transform of the inverse Gaussian process T
t
is:
L
Tt
() = e
t

2
, C, Re () 0. (16)
We have X
1
T
t
= t. Now, consider another standard Brownian motion X
2
and let it be subor-
dinated by T
t
. Then, by (15), the characteristic function of Y
t
X
2
T
t
is given by:

Y
t
() = e
t
1

2
||
, R, (17)
so that X
2
T
t
is a Cauchy process on R.
4.1.3. Linnik distribution: Gamma-subordinated -stable process
Consider a one dimensional symmetric -stable process X with characteristic exponent,
x
(),
R, given by:

x
() = ||

,
15
for (0, 2]. Let T be an independent gamma process with scale parameter a and shape
parameter b. Recall from (12) that the Laplace transform of T
t
is:
L
Tt
() Ee
Tt
=
_
1 +

b
_
at
, C, Re () 0. (18)
The characteristic function of Y
t
is therefore,

Y
t
() =
_
1 +
||

b
_
at
, R. (19)
For at = 1, this is the characteristic function of a Linnik distribution or a geometric stable
distribution, see Sato (1999) page 203.
4.1.4. Subordinating a subordinator
As a special case of Corollary 2, a Levy subordinator subordinated by a Levy subordinator
remains a Levy subordinator. Let T
1
t
and T
2
t
denote two independent Levy subordinators with
Laplace exponents
1
() and
2
(), then T
3
t
T
1
T
2
t
is also a Levy subordinator with Laplace
exponent given by

3
() =
2
(
1
()). (20)

1
-Stable subordinated
2
-stable is an
1

2
-stable process: Let T
1
be an
1
-stable
subordinator and T
2
an independent
2
-stable subordinator, both with zero drift. The Laplace
exponents are, respectively, c
1

1
and c
2

2
. Thus, from (20), the Laplace exponent of T
3
t

T
1
T
2
t
is:

3
() =
2
(
1
()) = c
2
(c
1

1
)

2
= c
2
c

2
1

2
,
so that T
3
is an
1

2
-stable process.
Gamma-subordinated Poisson is a negative binomial distribution: Let T
1
be a Pois-
son process with parameter c > 0. Its Laplace exponent is c(1e

). Let T
2
be an independent
16
gamma process with scale parameter a and shape parameter b. From (12), we see that the
Laplace exponent of T
2
t
is:

2
() = a ln(1 +/b) , C, Re () 0.
Thus, the Laplace transform of T
3
t
T
1
T
2
t
is:
L
T
3
t
() = exp(t
3
()) =
_
1 +
c(1 e

)
b
_
at
.
Setting a = 1 and letting p
b
b+c
, we have
L
T
3
t
() =
_
p
1 (1 p)e

_
t
.
which is the Laplace transform for a negative binomial distribution with parameters t and p.
4.1.5. Levy measures and the ne structure of jumps
The discontinuous component of a Levy process is determined by the Levy measure, which
governs the arrival rate of jumps of dierent sizes. As a Levy process repeatedly subordinated
by Levy subordinators remains a Levy process, an alternative to the repeated subordination
is to directly specify the ne structure of the Levy measure.
-Stable process: The Levy measure for an -stable process, (0, 2), is
(dx) = c

|x|
1
dx
on R

for some c

0. The arrival rate of jumps decreases monotonically with the jump

magnitude. The arrival rate approaches innity as the jump size approaches zero. The arrival
rate decays at a power rate proportional to the tail index . The bigger the , the faster the
decay. Furthermore, the arrival rate is also controlled by the scaling of c

. When c
+
= c

, the
stable distribution is symmetric since the arrival rates of both negative and positive jumps of
17
the same magnitude are the same. When c

= 0, we achieve maximum positive skewness since

all jumps occur in the positive direction almost surely. The opposite is true when c
+
= 0. The
driver underlying the Finite Moment Log Stable Process (FMLS) of Carr and Wu (2000) is an
-stable process with c
+
= 0. For an -stable subordinator, (0, 1), the Levy measure is
(dx) = cx
1
dx on (0, ) for some c > 0. Obviously, all jumps are positive jumps for an
-stable subordinator.
Compound Poisson process: The compound Poisson-jump process of Press (1967) has been
widely adopted for continuous time nancial modeling, especially after the inuential work of
Merton (1976). Under such a process, the jump rate is controlled by a Poisson distribution with
intensity . Conditional on one jump happening, the jump magnitude, g, is drawn from an
i.i.d. normal distribution N(
g
,
2
g
). Such a jump process can be regarded as a g-randomized
Poisson process with constant intensity . The Levy measure can be written as
(dx) = dF(x) =
1

2
g
exp
_

(x
g
)
2
2
2
g
_
dx.
Note that the arrival rate of jumps of size x decays with |x
g
|, hence the center is not
around zero but around
g
. In addition, the arrival rate decays exponentially with |x
g
|,
and therefore much faster than the power decay of the -stable case.
Kou (1999) also applies a compound Poisson process but with a dierent jump size dis-
tribution: conditional on one jump occurring, the jump magnitude is drawn from an i.i.d.
double-exponential distribution. The Levy measure is therefore given by
(dx) = dF(x) =
1
2
exp
_

|x k|

_
dx.
Note that the arrival rate decays slower than the normal jump case but is still faster than the
stable case.
18
Along the lines, we can choose any distribution, F(x), for the jump size under the compound
Poisson framework and we would obtain a new Levy measure of the form
(dx) = dF(x).
For example, if we choose a gamma distribution with scale parameter b > 0 and shape param-
eter c > 0 for the jump size, the Levy measure becomes
(dx) =

b(c)
_
x
b
_
c1
exp
_

x
b
_
dx, x > 0, b > 0, c > 0. (21)
Under such a measure, all jumps are positive. When c < 1, the arrival rate decreases mono-
tonically with the size of the jump. When c 1, jumps of the size b(c 1) have the maximum
arrival rate as b(c 1) is the mode of the gamma distribution.
The variance-gamma model: The Levy measure for the variance gamma model of Madan
and Seneta (1990), Madan and Milne (1991), and Madan, Carr, and Chang (1998) is a combi-
nation of the exponential and power law:
(dx) =
_

_
exp
_

|x|

+
_
v
+
|x|
dx for x > 0
exp
_

|x|

_
v

|x|
dx for x < 0
, (22)
Comparing (22) with (21), we see that the variance-gamma model can be regarded, in the limit,
as the compound Poisson jump model where the jump size has a double-gamma distribution
with shape parameter c 0.
The CGMY model: Most recently, Carr, Geman, Madan, and Yor (2000) recognizes the
importance of the Levy measure in controlling the jump process. They therefore start the
specication of their CGMY process directly from the Levy measure, which is given by

CGMY
(x) =
_

_
C
exp(G|x|)
|x|
1+Y
for x < 0
C
exp(M|x|)
|x|
1+Y
for x < 0
,
19
with the four parameter C, G, M, Y denoting the four authors of the paper. The variance-
gamma process is a special case with Y = 0. On the other hand, by setting G = M = 0, the
CGMY Levy measure reduces to that for a symmetric -stable Levy process,

CY
(x) = C|x|
Y 1
.
4.2. Stochastic instantaneous rate of activity
The stochastic time does not need to be a Levy process. For example, the stochastic time pro-
cess can have autocorrelated increments. Indeed, a large class of stochastic volatility models
can be regarded as models for the stochastic time process and almost none of them are Levy
processes. This is mainly because of the empirical observation that while asset returns deter-
mined in speculative markets are approximately uncorrelated, they are not independent, as
most return processes tend to exhibit temporal bursts of volatility (Mandelbrot (1963)). Many
empirical studies such as Ding, Engle, and Granger (1993) and Ding and Granger (1996)
have noticed that measures of volatility such as powers or logarithms of absolute returns have
strong dependence (volatility clustering). Prominent examples of volatility models include
(1) (G)ARCH-type models of Engle (1982) and Bollerslev (1986) and extensions, (2) stochastic
volatility models of Heston (1993), Hull and White (1987) and Romano and Touzi (1997), and
(3) long memory models of Breidt, Crato, and de Lima (1998), Comte and Renault (1998),
and Li, Deo, and Hurvich (2000).
While the previous subsection focuses on the independent Levy subordinators, this subsec-
tion focuses on the continuous and dierentiable part of the stochastic time change. Assume
that the time change T
t
is continuous and dierentiable P-a.s., we start the modeling of T
t
with its derivative with respect to the calendar time, v(t) T

(t). We label this derivative

v(t) as the instantaneous rate of activity. It can be interpreted as a measure of the rate of the
economic and business activities in terms of their impact on the uncertainty of the economy,
X
t
. When the Levy process X is a Brownian motion, one can think of v(t) as the instantaneous
variance rate. Note, however, that even with T
t
continuous, the instantaneous rate of activity
20
process v(t) does not need to be continuous. It only needs to be nonnegative for T
t
to be
nondecreasing.
Given a process for v(t), the stochastic time is given by the integral: T
t
=
_
t
0
v(s)ds. The
Laplace transform of T
t
is then given by:
L
Tt
() E
_
exp
_

_
t
0
v(s)ds
__
.
But this formulation is analogous to the one encountered in the bond pricing literature if we
regard v(t) as the instantaneous interest rate. In particular, both the instantaneous interest
rate and the instantaneous rate of activity are required to be positive and hence share similar
properties. We therefore can adopt existing interest rate models to model the instantaneous
activity rate v(t). In particular, we illustrate how to apply two of the most tractable classes
of term structure models to the Laplace transform of the stochastic time. We then proceed to
introduce a new class of tractable models which incorporate the long memory property.
4.2.1. Ane activity rate models
Let a k-dimensional Markov process, Z, starting at z
0
, satises the following stochastic dier-
ential equation:
dZ
t
= (Z
t
)dt +(Z
t
)dW
t
+qdJ((Z
t
)), (23)
where W is a k-dimensional Wiener process, J is a Poisson jump component with intensity
(Z
t
) and random jump magnitude q, characterized by its two-sided Laplace transform L
q
().
Furthermore, we assume that the k 1 vector (Z
t
) and k k matrix (Z
t
) satisfy some
technical conditions such that the stochastic dierential equation has a strong solution. The
instantaneous rate of activity v(t) is represented as a function of the Markov process Z
t
.
21
Denition 1 In ane activity rate models, the Laplace transform of the stochastic time,
T
t
=
_
t
0
v(s)ds, is an exponential-ane function of the Markov process Z
t
:
L
Tt
() E
_
e
Tt
_
= exp
_
b(t)

z
0
c(t)
_
, (24)
where b(t) R
k
and c(t) is a scaler.
The following proposition presents the sucient conditions for equation (24) to hold.
Proposition 4 If instantaneous rate of activity v(t), the drift (Z), the diusion variance
(Z)(Z)

, and the arrival rate (Z) of the Markov process are all ane in Z, then the
Laplace transform L
T
t
() is exponential-ane in z
0
.
The process and proposition are adopted from Due and Kan (1996) for the ane term
structure models of interest rates. The extension to jumps is due to Due, Pan, and Singleton
(2000). In particular, let
v(t) = b

v
Z
t
+c
v
, b
v
R
k
, c
v
R,
(Z
t
) = a Z
t
, R
kk
, a R
k
,
_
(Z
t
)(Z
t
)

_
ii
=
i
+

i
Z
t
,
i
R,
i
R
k
,
_
(Z
t
)(Z
t
)

_
ij
= 0, i = j,
(Z
t
) = a

+b

Z
t
, a

R, b

R
k
.
Then the coecients {b(t), c(t)} for the Laplace transform in (24) are determined by the
following ordinary dierential equations:
b(t)
t
= b
v

b(t) b(t)
2
/2 b

(L
q
(b(t)) 1) ; (25)
c(t)
t
= c
v
+b(t)

a b(t)

b(t)/2 a

(L
q
(b(t)) 1) ,
with the boundary conditions: b(0) = 0, and c(0) = 0. Closed-form solutions for the coef-
cients exist only under special cases, though they can readily be computed numerically. A
22
one-factor special case, where an analytical solution is available, is the square-root model of
Cox, Ingersoll, and Ross (1985) for interest rates and Heston (1993) for stochastic volatility.
4.2.2. Quadratic activity rate models
We adopt the quadratic term structure model of Leippold and Wu (2001) and apply it to the
instantaneous activity rate modeling.
Denition 2 In quadratic activity rate models, the Laplace transform of the stochastic
time is an exponential-quadratic function of the Markov process Z:
L
Tt
() = E
_
exp(
_
t
0
v(s)ds
_
= exp
_
z

0
A(t) z
0
b(t)

z
0
c (t)
_
, (26)
with A(t) R
kk
, b(t) R
k
, and c(t) R.
The following proposition presents the sucient conditions for the quadratic activity rate
models in terms of the Markov processes and the instantaneous activity rate function v(t).
Proposition 5 If the instantaneous rate of activity v(t) is quadratic in Z, (Z) is ane in Z,
and (Z) = is a constant matrix, then the Laplace transform of the stochastic time L
T
t
()
is exponential-quadratic in X.
The proof follows closely to that in Leippold and Wu (2001) for the quadratic term structure
models. Formally, under non-degeneracy conditions and a possible re-scaling and rotation of
indices, we let
(Z) = Z, (Z) = I, , I R
kk
,
v(t) = Z

t
A
v
Z
t
+b

v
Z
t
+c
v
, A
v
R
kk
, b
v
R
k
, c
v
R.
For the Markov process to be stationary, we need all eigenvalues of to be positive. Fur-
thermore, a sucient condition for v(t) to be positive is to let A
v
be positive denite and
23
c
v
>
1
4
b

v
A
v
b
v
. Given the above parameterization, the ordinary dierential equations that
solve the coecients in the Laplace transform are given by
A(t)
t
= A
v
A(t)

A() 2A(t)
2
;
b(t)
t
= b
v
b(t) 2A(t)

b(t) ; (27)
c(t)
t
= c
v
+ trA(t) b(t)

b(t)/2,
subject to the boundary conditions: A(0) = 0, b(0) = 0, and c(0) = 0.
4.2.3. Long-memory ane activity rate models
Following the important work on unit roots and cointegration which started in the mid 1980s,
econometricians have become increasingly aware of the subtleties and varieties of near nonsta-
tionarity and persistence that characterize so many economic and nancial time series data.
Recently, there has been renewed interest in fractional Brownian motion, fractionally integrated
processes, and long memory processes. Refer to Baillie (1996) for an excellent review on their
applications in economics and nance. In particular, long memory has found in exchange rates,
interest rates, and volatilities of asset returns.
In this section, we propose a class of activity rate models with long memory. In conformity
with the original specication of long memory processes in economics
4
, we derive the class of
models in a discrete-time setting.
5
Formally, we assume that the state vector, Z
t
R
k
, follows
a fractionally integrated process of the following form:
(I L)
d
(Z
t

Z
) =
_
V (Z
t1
)
t
(28)
where
t
is iid N (0, I) and d (0, 1). The process is stationary when d < 0.5.
4
See, for example, Granger (1980) and Granger and Joyeux (1980).
5
Comte and Renault (1996) and Comte and Renault (1998) map the discrete-time set up of long-memory
into continuous time and consider the option pricing problem under long-memory stochastic volatility.
24
We can write Z
t
in the form of a moving average
Z
t
=
Z
+ (I L)
d
_
V (Z
t1
)
t
=
Z
+

j=0

Z
(j)
_
V (Z
tj1
)
tj
,
with

Z
(j) =
(d +j)
(d) (j + 1)
.
The Laplace transform of the stochastic time is now dened as
L
t
(n, ) E [exp(T
n
)] E
_
exp
_

i=0
v(Z
t+i
)
__
,
where n denotes the number of discrete periods.
Denition 3 The class of long memory ane activity rate models is dened by (i) a
k-dimensional state vector with long memory as in (28) and (ii) an instantaneous activity rate
as a function of the state vector, v(Z
t
), such that the Laplace transform of the stochastic time,
L
t
(n, ), is an exponential-ane function of the state vector innovations:
log L
t
(n, ) = A(n) +

j=0
(n, j)

_
V (Z
tj1
)
tj
, (29)
with (n, j) R
k
for all n, j.
Proposition 6 Under the current set-up and some technical regularity conditions, the neces-
sary and sucient conditions for the Laplace transform to be of the form in (29) are:
(i) v (Z
t
) be ane in Z
t
;
(ii) Each element of V (Z
t
) is ane in Z
t
.
Proof. The proof relies heavily on the pricing relation
L
t
(n, ) = E
_
e
v(Z
t
)
L
t+1
(n 1, )
_
. (30)
25
Assume that equation (29) indeed holds, the right hand side of (30) becomes
log e
v(Zt)
L
t+1
(n 1, ) = v(Z
t
) +A(n 1) +

j=0
(n 1, j + 1)

_
V (Z
tj1
)
tj
+ (n 1, 0)

_
V (Z
t
)
t+1
.
Taking the expectation and matching to the left hand side of (30), we have
A(n) +

j=0
(n, j)

_
V (Z
tj1
)
tj
= v(Z
t
) +A(n 1) +

j=0
(n 1, j + 1)

_
V (Z
tj1
)
tj

1
2
(n 1, 0)

V (Z
t
) (n 1, 0)

. (31)
For (31) to hold for all Z
t
, we need: (i) v (Z
t
) be ane in Z
t
and (ii) each element of V (Z
t
) is
ane in Z
t
. These conditions are both necessary and sucient.
Formally, let
v (Z
t
) = A
v
+B

v
Z
t
, A
v
R, B
v
R
k
,
V
ij
(Z
t
) =
ij
+

ij
Z
t
,
ij
R,
ij
R
k
.
Regularity conditions are needed to guarantee that V (Z
t
) is positive denite for all Z
t
.
Principle of matching yields the following nite dierence equations for the coecients:
A(n) = A(n 1) +A
v
+B

v

Z

1
2

ij

i
(n 1, 0)
2
_

ij
+

ij

Z
_
;
(n, j) = (n 1, j + 1) +B
v

Z
(j)
Z
(j)

ij
1
2

i
(n 1, 0)
2

ij
. (32)
The initial conditions are: A(0) = 0 and (0, j) = 0 for all j. Such a general class of long-
memory model are applicable to the modeling of both the stochastic activity rate and the term
structure of interest rates. A one-factor example is used by Backus and Zin (1993) to model
26
the term structure of interest rates. Our identication of this long memory ane class is new
to the literature.
4.2.4. Measure change
When the activity rate process v
t
is correlated with the Levy process X
t
, the Laplace transform
of T
t
needs to be evaluated at a new complex valued measure Q(). Hence, as long as the
specications in the previous section hold under measure Q(), the results on the Laplace
transform are applicable to the characteristic function of Y
t
. In this section, we use the ane
framework as an example to illustrate how measure changes can be performed in both diusions
and jumps.
Hestons Model: The square-root stochastic volatility model of Heston (1993) can be re-
garded as a standard Brownian motion time-changed by a square-root activity rate process:
dY
t
= dW
1
Tt
=
_
v (t)dW
1
t
;
dv (t) = (a v (t)) dt +
_
v (t)dW
2
t
;
dt = E
_
dW
1
dW
2
_
.
The instantaneous correlation between X
t
and v
t
is captured by .
By Theorem 1, the characteristic function of Y
t
can be represented as the Laplace transform
of T
t
under measure Q():
F
Y
t
() E
_
e
iY
t
_
= L

T
t
_
1
2

2
_
,
where the new measure Q() is dened as
dQ()
t
dP
t
M()
t
= exp
_
iY
t
+
1
2

2
_
t
0
v (s) ds
_
.
27
By Girsanovs theorem, under measure Q(), the diusion
_
v(t) of v(t) remains unchanged
while the drift of v (t) is adjusted as

v
(t)
Q
= a v (t) +iv (t) .
Hence, under measure Q(), v(t) satises the conditions of the ane class with
b
v
= 1, c
v
= 0;

Q
= i, a
Q
= a; (33)
= 0, =
2
, = 0;
=
x
() =
2
/2.
Based on Proposition 4, the characteristic function of Y
t
is exponential-ane in v
0
,

Y
t
() = exp(b(t)v
0
c(t)) ,
where the parameters [a(t), b(t)] are given by the ordinary dierential equations in (25) with
the substitutions given in (33). For this particular one-factor case, the ordinary dierential
equations can be solved analytically:
b (t) =

2
_
1 e
t
_
( +
Q
) + (
Q
) e
t
;
c (t) =
a

2
_
_
2 ln
_
2
_

Q
_ _
1 e
t
__
2
+
_

Q
_
t
_
_
,
where
2
= (
Q
)
2
+
2

2
.
Ane jump-diusions: We assume that X
t
follows superposition of a standard Brownian
motion and a compound Poisson process
dX
t
= dW
1
t
+q
1
dJ
1
t
,
28
where W
1
t
is the standard Brownian motion and J
1
t
is a compound Poisson jump process,
J
1
t

Nt

j=1
q
1
j
,
where N
t
is the number of jumps within the time interval [0, t] and is governed by a Poisson
distribution with a constant arrival rate of . q
1
j
is the jump size, which is i.i.d. for all j. Given
a stochastic time T
t
with instantaneous activity rate v(t), the subordinated process Y
t
X
T
t
becomes,
dY
t
=
_
v(t)dW
1
t
+
N
T
t

j=1
Z
1
j
,
where the arrival rate of the Poisson jump is now v(t).
We further assume that the instantaneous activity rate is governed by the following jump-
diusion process
dv (t) = (a v(t)) dt +
_
v(t)dW
2
t
+q
2
dJ
2
t
,
where J
2
t
is another compound jump process controlled by the same Poisson process N
T
t
with
arrival rate v(t), i.e., jumps in the two processes Y
t
and v
t
arrive at the same time. The
jump size for J
2
t
is q
2
j
. Conditional on a jump occurring, the jump sizes of the two processes
Q
_
q
1
, q
2

are assumed to have a correlated joint distribution F(dq). Let (u) denotes the
joint Laplace transform of Q. The two Brownian motions are also assumed to be correlated
with dt = E[dW
1
, dW
2
].
Then, by Theorem 1, we have
F (t, y, v; ) = L

T
t
(
x
()) ,
where the characteristic exponent for X is

x
() =
1
2

2
(
1
(i) 1) ,
29
where
1
(i) E
_
e
iq
1
_
denotes the marginal Laplace transform of q
1
. The new measure
Q() is hence dened by
dQ()
t
dP
t
exp(iY
t
+
x
()T
t
) .
Straightforward application of the Girsanov theorem implies that

Q
= i; a
Q
= a;
Q
= ; F
Q
(dq) = e
iq
1
F(dq).
Hence, both the drift and instantaneous variance of v(t) remain ane in v(t) under Q().
Furthermore, the compound Poisson jump has the same intensity v(t) and the marginal
Laplace transform of q
2
under Q() is
Q
2
(b) = ([i; b]). The structure of v(t) under Q()
ts the specication of the ane activity rate model with Poisson jumps. The characteristic
function of Y
t
therefore remains exponential-ane in v
0
and the coecients are given by the
solutions to the ordinary dierential equations:
b(t)
t
=
x
()
Q
b(t)
2
b(t)
2
/2 (([i; b(t)]) 1) ;
c(t)
t
= ab(t),
with b(0) = c(0) = 0. The above ordinary dierential equations are directly adopted from (25)
with =
x
(), c
v
= = a

= 0, b
v
= 1, b

= .
5. Concluding Remarks
By time changing a d-dimensional Levy process, we arrive at a wide variety of stochastic pro-
cesses suitable for option pricing. Indeed, most existing option pricing models can be generated
by such an approach. More importantly, we relate the generalized characteristic function of
the stochastic process to the Laplace transform of the stochastic time under some appropriate
measure change. This transformation greatly facilitates the derivation of the characteristic
function and deepens our understanding of the processes. Given the characteristic function,
we show how many contingent claims can be priced by two transform methods.
30
The empirical works of Bakshi, Cao, and Chen (1997), Bates (1996), and Bates (2000)
have identied the need to incorporate both a jump component and a stochastic volatility
component in the asset return process to capture the behavior of option prices. More recently,
a series of papers, e.g., Chernov, Gallant, Ghysels, and Tauchen (1999) and Perron (1999),
have also identied jumps in the stochastic volatility process. Stochastic time change provides
a powerful tool in unifying these components into one framework. In particular, one can apply
stochastic time change to rene the structure of jumps and the dynamics of stochastic volatility.
On top of our research agenda is to investigate the empirical performance of a large variety of
new option pricing models generated by such a framework.
31
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