Applied Diffusion Processes from Engineering to Finance

Introduction xiii Chapter 1 Diffusion Phenomena and Models 1 1.1 General presentation of diffusion process 1 1.2 General balance equations 6 1.3 Heat conduction equation 10 1.4 Initial and boundary conditions 12 Chapter 2 Probabilistic Models of Diffusion Processes 17 2.1 Stochastic differentiation 17 2.2 Itô's formula 19 2.3 Stochastic differential equations (SDE) 24 2.4 Itô and diffusion processes 28 2.5 Some particular cases of diffusion processes 32 2.6 Multidimensional diffusion processes 36 2.7 The Stroock-Varadhan martingale characterization of diffusions (Karlin and Taylor) 41 2.8 The Feynman-Kac formula (Platen and Heath) 42 Chapter 3 Solving Partial Differential Equations of Second Order 47 3.1 Basic definitions on PDE of second order 47 3.2 Solving the heat equation 51 3.3 Solution by the method of Laplace transform 65 3.4 Green's functions 75 Chapter 4 Problems in Finance 85 4.1 Basic stochastic models for stock prices 85 4.2 The bond investments 90 4.3 Dynamic deterministic continuous time model for instantaneous interest rate 93 4.4 Stochastic continuous time dynamic model for instantaneous interest rate 98 4.5 Multidimensional Black and Scholes model 110 Chapter 5 Basic PDE in Finance 111 5.1 Introduction to option theory 111 5.2 Pricing the plain vanilla call with the Black-Scholes-Samuelson model 115 5.3 Pricing no plain vanilla calls with the Black-Scholes-Samuelson model 120 5.4 Zero-coupon pricing under the assumption of no arbitrage 127 Chapter 6 Exotic and American Options Pricing Theory 145 6.1 Introduction 145 6.2 The Garman-Kohlhagen formula 146 6.3 Binary or digital options 149 6.4 "Asset or nothing" options 150 6.5 Numerical examples 152 6.6 Path-dependent options 153 6.7 Multi-asset options 157 6.8 American options 165 Chapter 7 Hitting Times for Diffusion Processes and Stochastic Models in Insurance 177 7.1 Hitting or first passage times for some diffusion processes 177 7.2 Merton's model for default risk 193 7.3 Risk diffusion models for insurance 201 Chapter 8 Numerical Methods 219 8.1 Introduction 219 8.2 Discretization and numerical differentiation 220 8.3 Finite difference methods 222 9.1 Nonlinear model in heat conduction 232 Chapter 9 Advanced Topics in Engineering: Nonlinear Models 231 9.2 Integral method applied to diffusive problems 233 9.3 Integral method applied to nonlinear problems 239 9.4 Use of transformations in nonlinear problems 243 Chapter 10 Lévy Processes 255 10.1 Motivation 255 10.2 Notion of characteristic functions 257 10.3 Lévy processes 257 10.4 Lévy-Khintchine formula 259 10.5 Examples of Lévy processes 261 10.6 Variance gamma (VG) process 264 10.7 The Brownian-Poisson model with jumps 266 10.8 Risk neutral measures for Lévy models in finance 275 10.9 Conclusion 276 Chapter 11 Advanced Topics in Insurance: Copula Models and VaR Techniques 277 11.1 Introduction 277 11.2 Sklar theorem (1959) 279 11.3 Particular cases and Fréchet bounds 280 11.4 Dependence 288 11.5 Applications in finance: pricing of the bivariate digital put option 293 11.6 VaR application in insurance 296 Chapter 12 Advanced Topics in Finance: Semi-Markov Models 307 12.1 Introduction 307 12.2 Homogeneous semi-Markov process 308 12.3 Semi-Markov option model 328 12.4 Semi-Markov VaR models 332 12.5 Conclusion 339 Chapter 13 Monte Carlo Semi-Markov Simulation Methods 341 13.1 Presentation of our simulation model 341 13.2 The semi-Markov Monte Carlo model in a homogeneous environment 345 13.3 A credit risk example 350 13.4 Semi-Markov Monte Carlo with initial recurrence backward time in homogeneous case 362 13.5 The SMMC applied to claim reserving problem 363 13.6 An example of claim reserving calculation 366 Conclusion 379 Bibliography 381 Index 393