Topics in

Financial Mathematics
IVAN G. AVRAMIDI
New Mexico Tech
Financial terminology, options
Random Variables, stochastic processes, ran-
dom walks, stochastic calculus, SDE
Hedging, no arbitrage principle, Black-Scholes
equation
Stochastic volatility, jump diusion,
Heat kernel method
Methods for calculation of the heat kernel
1
Financial Instruments
Real assets are necessary for producing goods
and services for the survival of society
Financial assets (also called securities) are
pieces of paper that entitle its holder to a claim
on a fraction of the real assets and to the in-
come generated by these real assets
Financial instrument is a specic form of a
nancial asset
equities (stocks, shares) represent a share
in the ownership of a company
xed income securities (bonds) promise ei-
ther a single xed payment or a stream of
xed payents
derivative securities are nancial assests
that are derived from other nancial assets
2
Ecient Market Hypothesis
Ecient market concept is the hypothesis
that the market is in equilibrium:
the securities have their fair prices
the market prices have only small and tem-
porary deviations from their fair prices
changes in prices of securities are, up to a
drift, random
The random time evolution of the price of a
security is a stochastic process
3
Options
A call option is a contract that gives the right
(but not the obligation!) to buy a particular as-
set (called the underlying asset) for an agreed
amount (called the strike price E) at a speci-
ed time T in the future (called the expiration
date)
The payo function of the call option is its
value at expiry
(S E)
+
= max (S E, 0)
A put option is a contract that gives the right
to sell a particular asset for an agreed amount
at a specied time in the future
The payo function of the put option is
(E S)
+
Other option types: American, Bermudan, bi-
nary, spreads, straddles, strangles buttery spreads,
condors, calendar spreads, LEAPS
4
Random Variables
Random variable X
Probability density function f
X
Expectation value
E(X) =

R
dxf
X
(x)x
Variance
Var(X) = E(X
2
) [E(X)]
2
Covariance of random variables
Cov(X
i
, X
j
) = E(X
i
X
j
) E(X
i
)E(X
j
)
Correlation matrix
(X
i
, X
j
) =
Cov(X
i
, X
j
)

Var(X
i
)Var(X
j
)
5
Stochastic Processes
A stochastic process X(t) is a one-parameter
family of random variables, 0 t T
A Wiener process X(t) (Brownian motion, or
Gaussian randow walk) is a stochastic pro-
cess characterized by the conditions:
X(0) = 0
X(t) is continuous (almost surely)
the increments dX(t) = X(t + dt) X(t)
are independent random variables with the
normal distribution N(0, dt) centered at 0
with variance dt
6
Properties of Wiener Processes
The Wiener process has the properties
E(dX) = 0, E(dX
2
) = dt .
For several Wiener processes one denes the
correlation matrix
ij
E(dX
i
) = 0 E(dX
i
dX
j
) =
ij
dt
7
Itos Lemma
Idea
dt dX
2

For a function F of a stochastic process X
t
dF(X) =
dF
dX
dX +
1
2
d
2
F
dX
2
dt
Rule: replace in Taylor series
dX
2
dt
Itos Lemma for a function F(t, X
i
) of several
variables
dF =
F
t
dt +
n

i=1
F
X
i
dX
i
+
1
2
n

i,j=1

ij

2
F
X
i
X
j
dt
Rule: replace in Taylor series
dX
i
dX
j

ij
dt
8
Stochastic Dierential Equations
Brownian motion with drift
dS = dt +dX
Solution
S(t) = S(0) +t +[X(t) X(0)]
Lognormal random walk
dS = Sdt +SdX
Solution
S(t) = S(0) = exp

1
2

t +[X(t) X(0)]

Mean-reverting random walk

dS = ( S)dt +dX
Solution
S(t) = +[S(0) ]e
t
+

X(t)

t
0
ds e
(st)
X(s)

9
Hedging
Stock (log-normal random walk)
dS = ( D)Sdt +SdX
where is the drift, D is the dividend yield,
is the volatility
Let V be a (European call) option
Risk-free portfolio
= V
V
S
S
Portfolio change (Itos lemma)
d =
V
t
dt+
V
S
dS+
1
2

2
V
S
2
dS
2

V
S
(dS+DSdS)
=

V
t
+
1
2

2
S
2

2
V
S
2
DS
V
S

dt
10
Black-Scholes Equation
No-arbitrage principle: A completely risk-free
change in the portfolio value must be the same
as the growth one would get if one puts the
equivalent amount of cash in a risk-free interest-
bearing account (bond)
d = rdt
Black-Scholes equation (linear parabolic PDE)

t
+L

V = 0
where (elliptic PDO)
L =
1
2

2
S
2

2
S
2
+(r D)S

S
r
Remark: is eliminated!
Homogeneous in S. Can be solved by Mellin
transform in S (or Fourier transform in x =
logS)
11
Domain: [0, T] R
+
Terminal condition
V (T, S) = f(S)
Boundary conditions
V (t, 0) = 0,
lim
S
[V (t, S) S] = 0
12
Payo Function
f(S) is usually a piecewise linear function
Call : f(S) = (S E)
+
Put : f(S) = (E S)
+
Binary call : f(S) = (S E)
Binary put : f(S) = (E S)
Call spread:
f(S) =
1
E
2
E
1

(S E
1
)
+
(S E
2
)
+

13
Basket (Rainbow) Options
Multiple assets S
i
dS
i
= (
i
D
i
)S
i
dt +
i
S
i
dX
i
Multiple correlated Winer processes X
i
E(dX
i
) = 0 E(dX
i
dX
j
) =
ij
Multi-dimensional Black-Scholes operator
L =
1
2
n

i,j=1
C
ij
S
i
S
j

2
S
i
S
j
+
n

i=1
(r D
i
)S
i

S
i
r
where
C
ij
=
i

ij
Homogeneous in S
i
. Can be solved by multi-
dimensional Fourier transform in x
i
= logS
i
.
14
Assumptions of Black-Scholes
Hedging is done continuously
There are no transaction costs
Volatility is a known constant
Interest rates and dividends are known con-
stants
Underlying asset path is continuous
Underlying asset is unaected by trade in
the option
Hedging eliminates all risk
15
Stochastic Volatility
Assume that the volatility of an asset S is a
function of n stochastic factors v
i
, i = 1, 2, . . . , n.
dS = rS dt +(t, S, v)S dX
dv
i
= a
i
(t, v) dt +
n

j=1
b
ij
(t, v) dW
j
where E(dXdW
i
) =
0i
, E(dW
i
dW
j
) =
ij
Then the valuation operator is
L =
1
2

2
S
2

2
S
2
+
n

i=1
A
i
S

2
Sv
i
+
1
2
n

i,j=1
B
ij

2
v
i
v
j
+rS

S
+
n

i=1
a
i

v
i
r
where
A
k
(t, v) =
n

j=1
b
kj
(t, v)
j0
B
kl
(t, v) =
n

i,j=1
b
ki
(t, v)
ij
b
jl
(t, v)
16
Two-dimensional Models
SDE
dS = rS dt +(v, S)S dX ,
dv = a(v) dt +b(v) dW
Valuation operator
L =
1
2

2
(S, v)S
2

2
S
+b(v)(S, v)S
S

v
+
1
2
b
2
(v)
2
v
+rS
S
+a(v)
v
r
Domain: [0, T] R
+
R
+
Terminal condition at t = T and boundary con-
ditions at S, v 0 and S, v .
Non-constant coecients. Cannot be solved
exactly. Can be studied by using the meth-
ods of asymptotic analysis (theory of singular
perturbations)
17
Jump Process
Poisson process with intensity is a stochas-
tic process such that there is a probability dt
of a jump 1 in Q in the time step dt, that is,
dQ =

0 with probability (1 dt)

1 with probability dt
so that,
E(dQ) = dt
Dene the jump process by
dN = mdt +

e
J
1

dQ
where J is a random variable with the proba-
bility density function (J) and
m =

dJ (J)

e
J
1

such that
E(dN) = 0
18
Jump Diusion with
Stochastic Volatility
SDE
dS = rS dt +(v, S)S dX +SdN
dv = a(v) dt +b(v) dW
Assume that there is no correlation between
the Wiener processes X and W and the Poisson
process Q, that is,
E(dXdQ) = E(dWdQ) = 0
19
Hedging
No arbitrage principle
E(d) = rE() dt
Valuation operator
L =

L +L
J
,
where

L is the PDO dened above and L
J
is
an integral operator dened by
(L
J
V )(t; S, v) = E

V (t; e
J
S, v) V (t, S, v)

E(e
J
1)S
S
V (t, S, v)
=

dJ (J)

V (t; e
J
S, v) V (t; S, v)

mS
S
V (t; S, v)
Notice that
L
J
= (iS
S
) mS
S
1
where is the characteristic function
(z) =

dJ (J)e
izJ
20
Double-exponential Distribution
Double-exponential distribution
(J) = (J)
p
+

+
exp

+(J)
p

exp

where p

0 are the probabilities of positive

and negative jumps, and

> 0 are the means

of positive and negative jumps
Characteristic function
(z) =
p
+
1 iz
+
+
p

1 iz

Average jump amplitude

m =
p
+
1
+
+
p

1 +

1.
As
+
,

0 the probability density degener-

ates and the average jump amplitude vanishes,
that is,
(J) (J) , m 0.
21
Heston Model
SDE
dS = Sdt +

v S dX ,
dv = ( v) +

v dW
where is the mean reverting rate, is the
long-term volatility, and is the volatility of
volatility
Valuation operator
L =
1
2
v

S
2

2
S
+2S
S

v
+

2
2

2
v

+rS
S
+( v)
v
r
Homogeneous in S and linear in v
Can be solved by Mellin transform in S (or
Fourier transform in x = logS) and Laplace
transform in v
22
SABR Model
SDE
dS = vS
1
dX ,
dv = v dW
where 0 1
Valuation operator
L =
1
2
v
2

S
22

2
S
+2S
1

v
+
2

2
v

Denes a Riemannian metric on the hyper-

bolic plane H
2
with constant negative curva-
ture
2
/2.
Can be solved by the tools of geometric anal-
ysis
23
SABR Model with
Mean-Reverting Volatility
SDE
dS = vS
1
dX ,
dv = ( v)dt +v dW
Valuation operator
L =
1
2
v
2

S
22

2
S
+2S
1

v
+
2

2
v

+( v)
v
Can be solved in perturbation theory in param-
eter
24
Change of Variables
Change of variables
= T t, x = logS,
Valuation equation
(

L)V = 0
where
L =

L +L
J
,

L =
1
2

2
(x, v)
2
x
+2b(v)(x, v)
x

v
+b
2
(v)
2
v

r
1
2

2
(x, v)

x
+a(v)
v
r
L
J
= (i
x
) m
x
1
The operator L
J
acts as follows
(L
J
V )(; x, v) =

dJ (J)V (; x +J, v)
V (; x, v) m
x
V (; x, v)
25
Heat Kernel
Heat equation
(

L)U(; x, v, x
t
, v
t
) = 0
Initial condition (and boundary conditions at
v = 0 and at innity)
U(0; x, v, x
t
, v
t
) = (x x
t
)(v v
t
)
Heat semigroup representation
U(; x, v, x
t
, v
t
) = exp(L)(x x
t
)(v v
t
)
Option price
V (; x, v) =

dx
t

0
dv
t
U(; x, v, x
t
, v
t
)f(x
t
)
where f(x) is the payo function; for call op-
tion
f(x) = (e
x
E)
+
Thus, the knowledge of the heat kernel gives
the value of all options with any payo func-
tion.
26
Solution Methods
Analytic: integral transforms (Fourier, Laplace,
Mellin)
Geometric: Riemannian geometry, nega-
tive curvature, diusion on hyperbolic plane
Singularly perturbed pde: asymptotic ex-
pansion of the heat kernel as 0
Perturbative: semi-groups, Volterra series,
perturbation theory
Numeric: nite dierences, Monte-Carlo,
binomial trees
Functional: path integrals, Feynman-Kac
formula
27
Example: Black-Scholes Heat Kernel
Heat Kernel
U(; x, x
t
) = exp(L)(x x
t
)
Valuation operator
L = a
2
x
+b
x
r
where a =

2
2
, b = r D

2
2
We have
exp(L) = e
r
exp(b
x
) exp

a
2
x

By using
exp

a
2
x

(x x
t
) = (4a)
1/2
exp

x x
t

2
4a

exp(b
x
) f(x) = f(x +b)
we get
U(; x, x
t
) = (4a)
1/2
exp

x x
t
+b

2
4a

28
Elliptic Operators
Second-order PDO
L =
n

i,j=1
g
ij
(x)

2
x
i
x
j
+
n

i=1
A
i
(x)

x
i
+P(x)
Symbol
(x, p) =
n

j,k=1
g
jk
(x)p
j
p
k
i
n

j=1
A
j
(x)p
j
P(x) .
Leading symbol

L
(x, p) =
n

j,k=1
g
jk
(x)p
j
p
k
.
Operator L is elliptic if for any point x in M and
for any real p ,= 0 the leading symbol
L
(x, p)
is positive
The matrix (g
ij
) = (g
ij
)
1
is positive denite
and plays the role of a Riemannian metric
29
Heat Kernel of Operators
with Constant Coecients
Fourier transform
U(; x, x
t
) =

R
n
dp
(2)
n
exp

(p) +i

j
p
j
(x x
t
)
j

For a dierential operator (Gaussian integral)

U(; x, x
t
) = (4)
n/2
g
1/2
exp

P
1
4

i,j
g
ij
A
i
A
j

exp

1
2

i,j
g
ij
(x x
t
)
i
A
j

exp

1
4

i,j
g
ij
(x x
t
)
i
(x x
t
)
j

where g = det g
ij
30
Indegro-Dierential Operators
Pseudo-dierential operator
L =

L +(i)
where (p) ,= 0 for any p ,= 0 and (p) [p[
m
as p
Heat kernel
U(; x, x
t
) =

R
n
dp
(2)
n
exp|[(p) +(p)]
exp

j
p
j
(x x
t
)
j

31
Heat Kernel Asymptotic Expansion
Asymptotic ansatz as 0
U(; x, x
t
) = (4)
n/2
exp

d
2
(x, x
t
)
4

k=0

k
a
k
(x, x
t
)
where d(x, x
t
) is the geodesic distance
Recursion dierential equations (transport equa-
tions along geodesics) for coecients a
k
Can be solved in form of a covariant Taylor
series in x close to x
t
32
Perturbation Theory
for Heat Semigroup
Let L = L
0
+L
1
be a negative operator
The heat semigroup is a one-parameter fam-
ily of operators (for 0)
U() = exp(L)
Volterra series
U() = U
0
() +

k=1

0
d
k

0
d
k1

0
d
1
U
0
(
k
)L
1
U
0
(
k

k1
)
U
0
(
2

1
)L
1
U
0
(
1
)
Thus the heat kernel
U(, x, x
t
) =

1 +L
1
+

2
2

2
L
2
1
+[L
0
, L
1
]

+O(
3
)

U
0
(; x, x
t
)
33
Discretization
Let
k
= k/N, k = 0, 1, . . . , N. Then
U() = lim
N
U(
N

N1
)U(
N1

N2
)
U(
2

1
)U(
1
)
Then the heat kernel is
U(; x, x
t
) = lim
N

R
Nn
dx
1
. . . dx
N
U(
N

N1
, x, x
N1
)
U(
N1

N2
, x
N1
, x
N2
)
U(
2

1
, x
2
, x
1
)U(
1
, x
1
, x
t
)
34
Path Integrals
As 0
U(; x, x
t
) = (4)
n/2
g
1/2
exp

S(, x, x
t
)

where
S(, x, x
t
) =

0
ds

1
4

i,j
g
ij
dx
i
ds
dx
j
ds
+
1
2

i,j
g
ij
dx
i
ds
A
j
+
1
4

i,j
g
ij
A
i
A
j
P

is the action functional

Let / be the space of all all continuous paths
x(s) starting at x
t
at = 0 and ending at x at
s = , that is,
x(0) = x
t
, x() = x,
Then the heat kernel is represented as a path
integral
U(, x, x
t
) =

/
Tx(s) exp[S(, x, x
t
)]
35