Affine Process Minicourse CompFin

Ane Processes
Martin Keller-Ressel
TU Berlin
mkeller@math.tu-berlin.de
Workshop on Interest Rates and Credit Risk 2011

TU Chemnitz
23. November 2011
Ane Processes
Outline
Introduction to Ane Processes

Ane Jump-Diusions
The Moment Formula
Bond & Option Pricing in Ane Models
Extensions & Further Topics
Ane Processes
Part I
Introduction to Ane Processes
Ane Processes
Ane Processes
Ane Processes are a class of stochastic processes. . .
with good analytic tractability
(= explicit calculations and/or ecient numerical methods
often available)
that can be found in every corner of finance (stock price
modeling, interest rates, commodities, credit risk, . . . )
ecient methods for pricing bonds, options,. . .
dynamics and (some) distributional properties are
well-understood
They include models with
mean-reversion (important e.g. for interest rates)
jumps in asset prices (may represent shocks, crashes)
correlation and more sophisticated dependency eects
(stochastic volatility, simultaneous jumps, self-excitement . . . )
Ane Processes
The mathematical tools used are

characteristic functions (Fourier transforms)
stochastic calculus (with jumps)
ordinary dierential equations
Markov processes
Ane Processes
Recommended Literature
Transform Analysis and Asset Pricing for Ane Jump-Diusions,
Darrell Due, Jun Pan, and Kenneth Singleton, Econometrica,
Vol. 68, No. 6, 2000
Ane Processes and Applications in Finance, Darrell Due, Damir
Filipovic and Walter Schachermayer, The Annals of Applied
Probability, Vol. 13, No. 3, 2003
A didactic note on ane stochastic volatility models, Jan Kallsen,
In: From Stochastic Calculus to Mathematical Finance,
pages 343-368. Springer, Berlin, 2006.
Ane Diusion Processes: Theory and Applications, Damir
Filipovic and Eberhard Mayerhofer, Radon Series Comp. Appl.
Math 8, 1-40, 2009.
Ane Processes
We start by looking at the Ornstein-Uhlenbeck process and the

Feller Diusion.
The simplest (continuous-time) stochastic models for
mean-reverting processes
Used for modeling of interest rates, stochastic volatility,
default intensity, commodity (spot) prices, etc.
Also the simplest examples of ane processes!
Ane Processes
Ornstein-Uhlenbeck process and Feller Diusion

Ornstein-Uhlenbeck (OU)-process
dXt = (Xt ) dt + dWt ,
X0 R
Feller Diusion
dXt = (Xt ) dt +
Xt dWt ,
X0 R0
. . . long-term mean
> 0. . . rate of mean-reversion
0. . . volatility parameter
for the OU-process

We define (Xt ) :=
Xt for the Feller diusion

Ane Processes
An important dierence: The OU-process has support R, while

the Feller diusion stays non-negative
What can be said about the distribution of Xt ?
We will try to understand the distribution of Xt through its
characteristic function
Xt (y ) = E e iyXt
Ane Processes
Characteristic Function
Characteristic Function
For y R, the characteristic function X (y ) of a random variable
X is defined as

iyX
X (y ) := E e
=
e iyx dF (x) .
Properties:
X (0) = 1, X (y ) = X (y ), and |X (y )| 1 for all y R.
d
X (y ) = Y (y ) for all y R, if and only if X = Y .
Let X and Y be independent random variables. Then

X +Y (y ) = X (y ) Y (y ) .
Ane Processes
Let k N. If E[|X |k ] < , then

k
E[X ] = i
(y
)
.
X
y k
y =0
If the characteristic function X (y ) of a random variable X

with density f (x) is known, then f (x) can be recovered by an
inverse Fourier transform:

1
f (x) =
e iyx X (y ) dy .
2
Ane Processes
Back to the OU and CIR processes: We write u = iy and make the

ansatz that the characteristic function of Xt is of
exponentially-ane form:
Exponentially-Ane characteristic function
E e iyXt = E e uXt = exp ((t, u) + (t, u)X0 )
More precisely, if we can find functions (t, u), (t, u) with

(t, u) = 0 and (t, u) = u, such that
Mt = f (t, Xt ) = exp((T t, u) + (T t, u)Xt )
is a martingale then we have
E e uXT = E [MT ] = M0 = exp ((T , u) + (T , u)X0 ) ,

and (1) indeed gives the characteristic function.
Ane Processes
(1)
Assume , are suciently dierentiable and apply the

Ito-formula to
f (t, Xt ) = exp ((T t, u) + Xt (T t, u)) .
The relevant derivatives are
f (t, Xt ) = (T
t, u) + Xt (T
t, u) f (t, Xt )
t
f (t, Xt ) = (T t, u)f (t, Xt )

x
2
f (t, Xt ) = (T t, u)2 f (t, Xt )
x 2
Ane Processes
We get:
df (t, Xt )
1
= T t + Xt T t dt + T t dXt + T2 t 2 Xt dt =
f (t, Xt )
2
= T t + Xt T t dt + T t (Xt ) dt+
1
+ T t (Xt ) dWt + T2 t (Xt )2 dt
2
f (t, Xt ) is local martingale, if

1
( T t + Xt T t ) = T t (Xt ) + T2 t (Xt )2
2
for all possible states Xt .
Note that both sides are ane in Xt , since
2 for the OU-process

2
(Xt ) =
2 Xt for the CIR process
Ane Processes
We can collect coecients:

For the OU-process this yields
2
u) = (s, u) + (s, u)
(s,
2
u) = (s, u)
(s,
For the CIR process we get

u) = (s, u)
(s,
2
u) = (s, u) + (s, u)
(s,
2
These are ordinary dierential equations. We also know the

initial conditions
(0, u) = 0,
(0, u) = u .
Ane Processes
If (t, u) and (t, u) solve the ODEs on the preceding slide,

then Mt is a local martingale.
It is easy to check that in both cases M is also bounded,
hence a true martingale.
If Mt is a martingale, then
E e iyXt = exp ((t, iy ) + Xo (t, iy ))

is the characteristic function of Xt .
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The OU process
For the OU-process we solve
2
u) = (s, u) + (s, u)2 , (0, u) = 0
(s,
2
u) = (s, u), (0, u) = u
(s,
and get
(t, u) = e t u
(t, u) = u(1 e t ) +
2 2
u (1 e 2t )
4
Ane Processes
Thus the characteristic function of the OU-process is given by

y 2 2
iyXt
t
t
2t
E e
= exp iy e
X0 + (1 e
)
(1 e
)
2 2
and we get the following:
Distributional Properties of OU-process
Let X be an Ornstein-Uhlenbeck process. Then Xt is normally
distributed, with
EXt = + e t (X0 ),
Var Xt =
2
1 e 2t ,
2
Q: Can you think of a simpler way to obtain the above result?
Ane Processes
The CIR process

For the CIR-process we solve
u) = (s, u),
(s,
(0, u) = 0
2
u) = (s, u) + (s, u)2 ,
(s,
2
(0, u) = u .
and get
(t, u) =
ue t
2
2 u(1
e t )
2
2
t
(t, u) = 2 log 1
u(1 e
)
2
1
The dierential equation for is called a Riccati equation.

Q: How was the solution of the Riccati equation determined?
Ane Processes
(2)
(3)
Thus the characteristic function of the CIR-process is given by
22
2
e t iy
iyXt
t
E e
= 1
(1 e
)iy
exp
2
2
1 (1 e t )iy
2
and we get the following:

Distributional Properties of the Feller Diusion
2
Let X be an Feller-diusion, and define b(t) = 4

(1 e t ). Then
Xt
2
b(t) has non-central -distribution, with parameters
k=
4
,
2
e t
,
b(t)
Q: Does there exist a limiting distribution? What is it?
Ane Processes
Summary
The key assumption was that the characteristic function of Xt
is of exponentially-ane form
E e iyXt = exp ((t, iy ) + X0 (t, iy ))

We derived that (t, u) and (t, u) satisfy ordinary
dierential equations of the form
u) = F ((t, u)),
(t,
u) = R((t, u)),
(t,
(0, u) = 0
(0, u) = u
Solving the dierential equation gave (t, u) and (t, u) in

explicit form.
The same approach works if the coecients of the SDEs are
time-dependent; ODEs become time-dependent too.
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Part II
Ane Jump-Diusions
Ane Processes
Jump Diusions
n
We consider a jump-diusion on D = Rm
0 R
Jump-Diusion
dXt = (Xt ) dt + (Xt ) dWt + dZt
diusion part
where
jump part
Wt is a Brownian motion in Rd ;
: D Rd , : D Rdd , and
Z is a right-continuous pure jump process, whose jump

heights have a fixed distribution (dx) and arrive with
intensity (Xt ), for some : D [0, ).
The Brownian motion W , the jump heights of Z , and the

jump times of Z are assumed to be independent.
Ane Processes
(4)
Jump Diusions (2)
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Some elementary properties and notation for the jump process Zt :

Zt is RCLL (right continuous with left limits)
Zt := limst,st Zs and Zt := Zt Zt .
Zt = Zt if and only Zt = 0 if and only a jump occurs at

time t.
Let (i) be the time of the i-th jump of Zt . Let f be a
function such that f (0) = 0. Then
f (Zs ) :=
f (Zs )
0st
0 (i)t
is a well-defined sum, that runs only over finitely many values

(a.s.)
Ane Processes
Ito formula for jump-diusions

Ito formula for jump diusions
Let X be a jump-diusion with diusion part Dt and jump part Zt .
Assume that f : Rd R is a C 1,2 -function and that Zt is a pure
jump process of finite variation. Then
t
t
f
f
f (t, Xt ) = f (0, X0 ) +
(s, Xs ) ds +
(s, Xs ) dDs +
t
x
0
0
2
1 t
f
+
tr
(s, Xs )(Xs )(Xs )
ds+
2 0
x 2
+
f (s, Xs ) .
0st
Here
2f
x 2
f
x
f
f
x1 , . . . , xd
2f
xi xj
denotes the gradient of f , and
is the Hessian matrix of the second derivatives of f .

Ane Processes
Ane Jump-Diusion
Ane Jump-Diusion
We call the jump diusion X (defined in (4)) ane, if the drift
(Xt ), the diusion matrix (Xt )(Xt ) and the jump intensity
(Xt ) are ane functions of Xt .
More precisely, assume that
(x) = b + 1 x1 + + d xd
(x)(x) = a + 1 x1 + + d xd
(x) = m + 1 x1 + d xd
where b, i Rd ; a, i Rdd and m, i [0, ).

Note: (d + 1) 3 parameters for a d-dimensional process.
Ane Processes
We want to show that an ane jump-diusion has a (conditional)

characteristic function of exponentially-ane form:
Characteristic function of Ane Jump Diusion
n
Let X be an ane jump-diusion on D = Rm
0 R . Then

E e uXT Ft = exp ((T t, u) + Xt (T t, u))
for all u = iz iRd and 0 t T , where and solve the

system of dierential equations
u) = F ((t, u)),
(t,
u) = R((t, u)),
(t,
(0, u) = 0
(5)
(0, u) = u
(6)
with. . .
Ane Processes
(continued)
(u) = Rd (e ux 1) (dx), and
1
F (u) = b u + u au + m(u)
2
1
R1 (u) = 1 u + u 1 u + 1 (u),
2
..
.
1
Rd (u) = d u + u d u + d (u).
2
The dierential equations satisfied by (t, u) and (t, u) are called
generalized Riccati equations.
The functions F (u), R1 (u), . . . , Rd (u) are of Levy-Khintchine form.
Ane Processes
Proof (sketch:)
Show that the generalized Riccati equations have unique
global solutions , (This is the hard part, and here the
n
assumption that D = Rm
0 R enters!)
Fix T 0, define
Mt = f (t, Xt ) = exp((T t, u) + (T t, u) Xt )
and show that Mt remains bounded.
Apply Itos formula to Mt :
Ane Processes
The relevant quantities for Itos formula are
f (t, Xt ) = (T
t, u) + Xt (T
t, u) f (t, Xt )
t
f (t, Xt ) = (T t, u)f (t, Xt )

x
2
f (t, Xt ) = (T t, u) (T t, u) f (t, Xt )
x 2
f (t, Xt ) = e (T t,u)Xt 1 f (t, Xt )
Also define the cumulant generating function of the jump measure:
(u) =
(e ux 1)(dx).
Rd
Ane Processes
We can write f (t, Xt ) as...

f (t, Xt ) = local martingale
t
(T
s, u) + Xs (T
s, u) f (s, Xs ) ds+
0 t
+
(T s, u) (Xs )f (s, Xs ) ds+
0
t
1
+
(T s, u) (Xs )(Xs ) (T s, u)f (s, Xs ) ds+
2 0
t
+
(T s, u) (Xs )f (s, Xs ) ds
0
Inserting the definitions of (Xs ), (Xs )(Xs ) and (Xs )

and using the generalized Riccati equations we obtain the local
martingale property of M.
Ane Processes
Since M is bounded it is a true martingale and it holds that
E e

Ft = E [ MT | Ft ] =
uXT
= Mt = exp ((T t, u) + (T t, u) Xt ) ,
showing desired form of the conditional characteristic function.
Ane Processes
Example: The Heston model

Heston proposes the following model for a stock St and its
(mean-reverting) stochastic variance Vt (under the risk-neutral
measure Q)1 :
Heston model
dSt =
Vt St dWt1
dVt = (Vt ) dt +

Vt dWt1 + 1 2 dWt2
where Wt = (Wt1 , Wt2 ) is two-dimensional Brownian motion.
We assume here that the interest rate r = 0

Ane Processes
The Heston model (2)
The parameters have the following interpretation:

. . . mean-reversion rate of the variance process
. . . long-term average of Vt
. . . vol-of-var: the volatility of the variance process
. . . leverage: correlation bet. moves in stock price and in
variance.
Ane Processes

Transforming to the log-price Lt = log(St ) we get
Vt
dt + Vt dWt1
2

dVt = (Xt ) dt + Vt dWt1 + 1 2 dWt2
dLt =
which is a two dimensional ane diusion!

Writing Xt = (Lt , Vt ) we find

0
1/2
(Xt ) =
+
0 Lt +
Vt
1

b
1
(Xt )(Xt ) =
0 +
0 Lt +
Vt
2
a
1

Ane Processes
Thus, the characteristic function of log-price Lt and stochastic

variance Vt of the Heston model can be calculated from
u) = 2 (t, u)
(t,
1 2
2
2 (t, u) =
u1 u1 2 (t, u) + 22 (t, u) + u1 2 (t, u)
2
2
with initial conditions (0, u) = 0, 2 (t, u) = u2 .

Note that 1 (t, u) = 0 and thus 1 (t, u) = u1 for all t 0.
Ane Processes
Due-Garleanu default intensity process

Due and Garleanu propose to use the following process (taking
values in D = R0 ) as a model for default intensities:
Due-Garleanu model
dXt = (Xt ) dt +
Xt dWt + dZt
where Zt is a pure jump process with constant intensity c, whose

jumps are exponentially distributed with parameter .
The above process is an ane jump diusion, whose characteristic
function can be calculated from the generalized Riccati equations
u) = F ((t, u)),
(t,
where
F (u) = u +
cu
,
u
u) = R((t, u))
(t,
R(u) = u +
Ane Processes
u2 2
Parameter Restrictions
Revisit the Feller Diusion
Feller Diusion
dXt = (Xt ) dt +
Can we allow < 0?
Xt dWt ,
When Xt = 0, then Xt+t < 0 and

well-defined.
= Parameter restrictions are necessary.
X0 R0
Xt+t is not
Ideally, we can find necessary & sucient parameter

restrictions.
Ane Processes
Characterization of ane jump-di. on D = Rn Rm

0
Due, Filipovic & Schachermayer (2003) derive the necessary &
sucient parameter restrictions (admissibility conditions) for all
d
ane jump-diusions on the state space D = Rn Rm
0 R . We
write
J := {1, . . . , n} , I := {n + 1, . . . , n + m}
for indices of the real-valued and the non-negative components.
The following holds:
Characterization of an ane jump-diusion on Rn Rm
0
Let X be an ane jump-diusion with state space D = Rn Rm

0 .
Then the parameters a, k , b, k , m, k , (dx) satisfy the following
conditions:
Ane Processes
(continued)
a, k are positive semi-definite matrices and j = 0 for all
j J.
aek = 0 for all k I
i ek = 0 for all k I and i I \ {k}

j = 0 for all j J
bD
i ek 0 for all k I and i I \ {k}

j ek = 0 for all k I and j J
j = 0 for all j J
supp D .
Conversely, if the parameters a, k , b, k , m, k , (dx) satisfy the

above conditions, then an ane jump-diusion X with state space
D = Rn Rm
0 exists.
Ane Processes
Illustration of the parameter conditions
a=
0
0 0
b=
..
.
...
j
=
(j J)
(j J)
i
=
(i I )
..
.
...
..
.
0
..
.
0
0
0 iii
0
..
.
(i I )
..
.
..
.
where ii R

i
i
...
where iii 0
Stars denote arbitrary real numbers; the small -signs denote non-negative real numbers and the big -sign a
positive semi-definite matrix.
Ane Processes
We sketch a proof of the conditions necessity:

(x)(x) = a + 1 x1 + d xd has to be positive
semidefinite for all x D
= a, ai are positive semidefinite for i I and j = 0 for

j J.
(x) = m + 1 x1 + d xd has to be non-negative for all
x D
= j = 0 for j J.
The process must not move outside D by jumping

= supp D.
Ane Processes
Assume that Xt has reached the boundary of D, that is Xt = x

with xk = 0 for some k I . The following conditions have to hold,
such that Xt does not cross the boundary:
inward pointing drift: 0 ek (x) = ek b + i=k i xi
= b D, i ek 0 for all i I \ {i}, and j ek = 0

for all j J.
diusion parallel to the boundary:
0 = ek (x) = ek a + i=k i xi
= aek = 0 and i ek = 0 for all i I \ {k}.
(ek denotes the k-th unit vector.)
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Part III
The Moment Formula
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The Moment formula
n
0 R . We have
shown that

E e uXT Ft = exp ((T t, u) + Xt (T t, u))
for all u iRd where and solve the generalized Riccati

equations.
What can be said about general u Cd and in particular about

the moment generating function E e XT with Rd ?
Ane Processes
In general we should expect that
The exponential moment E e uXT may be finite or infinite

depending on the value of u Cd and on the distribution of
XT
The generalized Riccati equations no longer have global
solutions for arbitrary starting values u Cd (blow-up of
solutions may appear)
Ane Processes
Moment formula
n

0 R with X0 D
d
and assume that dom R is open. Let
(t, u) = F ((t, u)),

t
(t, u) = R((t, u)),

t
(0, u) = 0
(7)
(0, u) = u
(8)
be the associated generalized Riccati equations, with F and R

analytically extended to
S(dom ) := u Cd : Re u dom .
Then the following holds. . . ,
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Moment formula (contd.)
(a) Let u Cd and suppose that E e uXT < . Then

u S(dom ) and there exists unique solutions , of the
gen. Riccati equations such that

E e uXT Ft = exp ((T t, u) + (T t, u) Xt ) (9)

for all t [0, T ].
(b) Let u S(dom ) and suppose that the gen. Riccati equations
have
, that start at u and exist up to T . Then
solutions
E e uXT < and (9) holds for all t [0, T ].
Essentially: Solution to gen. Riccati equation exists
Exponential Moment exists.
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Sketch of the proof of (a) (for real arguments Rd ):
Show by analytic extension that there exist functions (t, )

and (t, ) such that

Mt := E e XT Ft = exp ((T t, ) + (T t, ) Xt ) .
By the assumption of (a) M is a martingale.
Show that and are dierentiable in t (This is the hard

part!)
Use the Ito-formula to show that the martingale property of M
implies that and solve the generalized Riccati equations
Ane Processes
Sketch of the proof of (b):

Let dom . Define
Mt = exp ((T t, ) + (T t, ) Xt )
Use the Ito-formula and the generalized Riccati equations to
show that M is a local martingale
Since M is positive, it is a supermartingale and
E e ,XT = E [MT ] M0 < .
Apply part (a) of the theorem and use that the solutions of
the gen. Riccati equations are unique.
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Some consequences (we still assume that dom is open)

Exponential Martingales: t e Xt is a martingale if and only if
dom and F () = R() = 0.
Exponential Measure Change: Let X be an ane jump diusion

and dom . Then there exists a measure P P
such that X is an ane jump-diusion under P with
F (u) = F (u + ) F ()
R (u) = R(u + ) R().

Exponential Family: The measures (P )dom form a curved
exponential family with likelihood process
t
dP
Lt =
= exp Xt F ()t R()
Xs ds .
dP
0
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Proof: Extension of state-space approach

t
Consider the process (Xt , Yt = 0 Xs ). The process (X , Y ) is
again an ane jump-diusion (note: dYt = Xt dt)
Define
Lt = exp ( Xt F ()t R() Yt )
Applying the moment formula to find the exponential moment
of order (, R()) of the extended process (X , Y ) we get

E LT Ft =
= exp (p(T t) + q(T t) Xt )exp (F ()T R() Yt )
where
p(t) = F (q(t)),
p(0) = 0
t
q(t) = R(q(t)) R(),

q(0) = .
t
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is a stationary point of the second Riccati equation. Hence,

the (global) solutions are q(t) = and p(t) = tF () for all
t0
Inserting the solution yields

E LT Ft = exp ( Xt F ()t R() Yt ) = Lt ,

and hence t Lt is a martingale.
Define the measure P by
dP
= Lt .
dP Ft
A similar calculation yields F (u) and R (u) for the process X

under P .
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Part IV
Bond and Option Pricing in Ane Models
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Pricing of Derivatives
We consider the following setup:
The goal is to price a European claim on some underlying
asset St , which has payo f (ST ) at time T . We denote the
value of the claim at time t by Vt .
As numeraire
asset, we use the money market account
t
Mt = exp 0 R(Xs ) ds determined by the short rate process
R(Xs ).
Under the assumption of no-arbitrage, there exists a
martingale measure Q for the discounted asset price process
Mt1 St , such that

Vt = Mt EQ MT1 f (ST ) Ft .
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To allow for analytical calculations we make the following

assumption:
Both the short rate process R(Xt ) and the asset St are modelled
under the risk-neutral measure Q through an ane jump-diusion
process Xt in the following way:
R(Xt ) = r + Xt ,
St = e
for some fixed parameters r , 0 and dom .
This setup includes the combination of many important short rate

and stock price models: Vasicek, Cox-Ingersoll-Ross,
Black-Scholes, Heston, Heston with jumps,. . .
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Extension-of-state-space-approach and moment formula yield the

following:
Discounted moment generating function

Let u S(dom ) and (t, u) = Mt EQ MT1 e uXT Ft . Suppose

the dierential equations
(t, u) = F ( (t, u)),
(t, u) = R ( (t, u)),
(0, u) = 0
(0, u) = u
with
F (u) = F (u) r ,
or more precisely . . .
and R (u) = R(u) ,
Ane Processes
(10)
(11)
(continued)
1
F (u) = b u + u au + m(u) r
2
1
R1 (u) = 1 u + u 1 u + 1 (u) 1 ,
2
..
.
1
Rd (u) = d u + u d u + d (u) d .
2
have solutions t (t, u) and t (t, u) up to time T , then
(t, u) = exp ( (T t, u) + (T t, u) Xt )
for all t T .
Ane Processes
Bond Pricing in Ane Jump Diusion models

As an immediate application we derive the following formula for
pricing of zero-coupon bonds:
Bond Pricing
Suppose the gen. Riccati equations for the discounted mgf have
solutions up to time T for the initial value u = 0. Then the price
at time t of a (unit-notional) zero-coupon bond Pt (T ) maturing at
time T is given by
Pt (T ) = exp ( (T t, 0) + Xt (T t, 0)) .
Yields the well-known pricing formulas for the Vasicek and the
CIR-Model as special cases.
Ane Processes
No-arbitrage constraints on F and R :
The martingale assumption

EQ MT1 ST Ft = Mt1 St
leads to the following no-arbitrage constraints on F and R :

No-arbitrage constraints
F () = F () r = 0
R () = R() = 0 .
Ane Processes
Pricing of European Options
A European call option with strike K and time-to-maturity T

pays (ST K )+ at time T . We will parameterize the option
by the log-strike y = log K and denote its value at time t by
Ct (y , T ).
The goal is to derive a pricing formula based on our
knowledge of the discounted moment generating function

(t, u) = Mt EQ MT1 e uXT Ft
Ane Processes
Idea: Calculate the Fourier transform of Ct (y , T ) (regarded

as a function of y ), and hope that it is a nice
expression involving (T t, u).
Problem: Ct (y , T ) may not be integrable, and thus may have

no Fourier transform.
Solution 1: Use the exponentially dampened call price
t (y , T ) = e y Ct (y , T ) where > 0.
C
Solution 2: Replace the call option by a covered call with payo

ST (ST K )+ = min(ST , K ).
Several other (related) solutions can be found in the literature. . .
Ane Processes
Fourier pricing formula for European call options:

Let Ct (y , T ) be the price of a European call option with log-strike
y and maturity T . Then Ct (y , T ) is given by the inverse Fourier
transform
e y iy (T t, ( + 1 + i))
Ct (y , T ) =
e
d (12)
2
( + i)( + 1 + i)
where is chosen such that > 0 and the generalized Riccati
equations starting at ( + 1) have solutions up to time T .
(This formula is obtained by exponential dampening)
Note: the required can always be found, since dom is open and
contains 0 and .
Ane Processes
Fourier pricing formula for European put options:

Let Pt (y , T ) be the price of a European put option with log-strike
y and maturity T . Then Pt (y , T ) is given by the inverse Fourier
transform
e y iy (T t, ( + 1 + i))
Pt (y , T ) =
e
d (13)
2
( + i)( + 1 + i)
where is chosen such that > 1 and the generalized Riccati
equations starting at ( + 1) have solutions up to time T .
(This formula is obtained by exponential dampening)
Note: the required can always be found, since dom is open and
contains 0 and .
Ane Processes
Part V
Extensions and further topics
Ane Processes
Extensions
Allow jumps with infinite activity, superpositions of d + 1

dierent jump measures and killing.
These are the ane processes in the sense of Due, Filipovic
and Schachermayer (2003))
This definition includes all Levy process and all so-called
continuous-state branching processes with immigration.
Consider other state spaces:

Positive semidefinite matrices: Wishart process, etc.
Polyhedral and symmetric cones
Quadratic state spaces (level sets of quadratic polynomials)
Time-inhomogeneous processes
Ane Processes
Further Topics/Current Research

Utility maximization and variance-optimal hedging in ane
models (Jan Kallsen, Johannes Muhle-Karbe et al.)
Distributional Properties of ane processes: (non-central)
Wishart distributions, infinite divisibility of marginal laws
(Eberhard Mayerhofer et al.)
Feller property, path regularity, regularity of the characteristic
function (Christa Cuchiero, Josef Teichmann et al.)
Relation to branching processes and superprocesses,
infinite-dimensional generalizations
Large-deviations and stationary distributions of ane
processes
Interaction between state-space geometry and distributionalor path-properties
Ane Processes
Further Topics/Current Research
Statistical estimation, density approximations, spectral

approximations
State-space-independent classification and/or characterization
results
Ane processes as finite-dimensional realizations of HJM-type
models
Applications, applications, applications:
Ane term structure models (ATSMs)
Ane stochastic volatility models (ASVMs)
Credit risk models, . . .
Ane Processes
Thank you for your attention!
Ane Processes

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Ane Processes

Workshop on Interest Rates and Credit Risk 2011

Introduction to Ane Processes

The mathematical tools used are

We start by looking at the Ornstein-Uhlenbeck process and the

Ornstein-Uhlenbeck process and Feller Diusion

for the OU-process

Xt for the Feller diusion

An important dierence: The OU-process has support R, while

X (y ) = Y (y ) for all y R, if and only if X = Y .

Let X and Y be independent random variables. Then

Let k N. If E[|X |k ] < , then

If the characteristic function X (y ) of a random variable X

Back to the OU and CIR processes: We write u = iy and make the

E e iyXt = E e uXt = exp ((t, u) + (t, u)X0 )

More precisely, if we can find functions (t, u), (t, u) with

E e uXT = E [MT ] = M0 = exp ((T , u) + (T , u)X0 ) ,

Assume , are suciently dierentiable and apply the

f (t, Xt ) = (T t, u)f (t, Xt )

f (t, Xt ) is local martingale, if

2 for the OU-process

We can collect coecients:

For the CIR process we get

These are ordinary dierential equations. We also know the

If (t, u) and (t, u) solve the ODEs on the preceding slide,

E e iyXt = exp ((t, iy ) + Xo (t, iy ))

Thus the characteristic function of the OU-process is given by

Q: Can you think of a simpler way to obtain the above result?

The CIR process

The dierential equation for is called a Riccati equation.

Thus the characteristic function of the CIR-process is given by

and we get the following:

Let X be an Feller-diusion, and define b(t) = 4

Q: Does there exist a limiting distribution? What is it?

E e iyXt = exp ((t, iy ) + X0 (t, iy ))

Solving the dierential equation gave (t, u) and (t, u) in

Z is a right-continuous pure jump process, whose jump

The Brownian motion W , the jump heights of Z , and the

Jump Diusions (2)

Some elementary properties and notation for the jump process Zt :

Zt = Zt if and only Zt = 0 if and only a jump occurs at

is a well-defined sum, that runs only over finitely many values

Ito formula for jump-diusions

denotes the gradient of f , and

is the Hessian matrix of the second derivatives of f .

where b, i Rd ; a, i Rdd and m, i [0, ).

We want to show that an ane jump-diusion has a (conditional)

E e uXT Ft = exp ((T t, u) + Xt (T t, u))

for all u = iz iRd and 0 t T , where and solve the

(u) = Rd (e ux 1) (dx), and

The relevant quantities for Itos formula are

f (t, Xt ) = (T t, u)f (t, Xt )

f (t, Xt ) = e (T t,u)Xt 1 f (t, Xt )

Also define the cumulant generating function of the jump measure:

We can write f (t, Xt ) as...

Inserting the definitions of (Xs ), (Xs )(Xs ) and (Xs )

Since M is bounded it is a true martingale and it holds that

showing desired form of the conditional characteristic function.

Example: The Heston model

where Wt = (Wt1 , Wt2 ) is two-dimensional Brownian motion.

We assume here that the interest rate r = 0

The Heston model (2)

The parameters have the following interpretation: