Graduation Year

2017

Document Type

Dissertation

Degree

Ph.D.

Degree Name

Doctor of Philosophy (Ph.D.)

Degree Granting Department

Mathematics and Statistics

Major Professor

Gangaram S. Ladde, Ph.D.

Committee Member

Chris Tsokos, Ph.D.

Committee Member

Kandethody Ramachandran, Ph.D.

Committee Member

Gabriel Picone, Ph.D.

Keywords

LLGMM Method, Non Linear Hybrid, Option Pricing, Regime Switching, Semi Markov

Abstract

Mathematical and statistical modeling have been at the forefront of many significant advances in many disciplines in both the academic and industry sectors. From behavioral sciences to hard core quantum mechanics in physics, mathematical modeling has made a compelling argument for its usefulness and its necessity in advancing the current state of knowledge in the 21rst century. In Finance and Insurance in particular, stochastic modeling has proven to be an effective approach in accomplishing a vast array of tasks: risk management, leveraging of investments, prediction, hedging, pricing, insurance, and so on.

However, the magnitude of the damage incurred in recent market crisis of 1929 (the great depression), 1937 (recession triggered by lingering fears emanating from the great depression), 1990 (one year recession following a decade of steady expansion) and 2007 (the great recession triggered by the sub-prime mortgage crisis) has suggested that there are certain aspects of financial markets not accounted for in existing modeling. Explanations have abounded as to why the market underwent such deep crisis and how to account for regime change risk. One such explanation brought forth was the existence of regimes in the financial markets. The basic idea of market regimes underscored the principle that the market was intrinsically subjected to many different states and can switch from one state to another under unknown and uncertain internal and external perturbations. Implementation of such a theory has been done in the simplifying case of Markov regimes. The mathematical simplicity of the Markovian regime model allows for semi-closed or closed form solutions in most financial applications while it also allows for economically interpretable parameters. However, there is a hefty price to be paid for such practical conveniences as many assumptions made on the market behavior are quite unreasonable and restrictive. One assumes for instance that each market regime has a constant propensity of switching to any other state irrespective of the age of the current state. One also assumes that there are no intermediate states as regime changes occur in a discrete manner from one of the finite states to another. There is therefore no telling how meaningful or reliable interpretation of parameters in Markov regime models are.

In this thesis, we introduced a sound theoretical and analytic framework for Levy driven linear stochastic models under a semi Markov market regime switching process and derived It\'o formula for a general linear semi Markov switching model generated by a class of Levy It'o processes (1). It'o formula results in two important byproducts, namely semi closed form formulas for the characteristic function of log prices and a linear combination of duration times (2).

Unlike Markov markets, the introduction of semi Markov markets allows a time varying propensity of regime change through the conditional intensity matrix. This is more in line with the notion that the market's chances of recovery (respectively, of crisis) are affected by the recession's age (respectively, recovery's age). Such a change is consistent with the notion that for instance, the longer the market is mired into a recession, the more improbable a fast recovery as the the market is more likely to either worsens or undergo a slow recovery. Another interesting consequence of the time dependence of the conditional intensity matrix is the interpretation of semi Markov regimes as a pseudo-infinite market regimes models. Although semi Markov regime assume a finite number of states, we note that while in any give regime, the market does not stay the same but goes through an infinite number of changes through its propensity of switching to other regimes. Each of those separate intermediate states endows the market with a structure of pseudo-infinite regimes which is an answer to the long standing problem of modeling market regime with infinitely many regimes.

We developed a version of Girsanov theorem specific to semi Markov regime switching stochastic models, and this is a crucial contribution in relating the risk neutral parameters to the historical parameters (3). Given that Levy driven markets and regime switching markets are incomplete, there are more than one risk neutral measures that one can use for pricing derivative contracts. Although much work has been done about optimal choice of the pricing measure, two of them jump out of the current literature: the minimal martingale measure and the minimum entropy martingale measure. We first presented a general version of Girsanov theorem explicitly accounting for semi Markov regime. Then we presented Siu and Yang pricing kernel. In addition, we developed the conditional and unconditional minimum entropy martingale measure which minimized the dissimilarity between the historical and risk neutral probability measures through a version of Kulbach Leibler distance (4).

Estimation of a European option price in a semi Markov market has been attempted before in the restricted case of the Black Scholes model. The problems encountered then were twofold: First, the author employed a Markov chain Monte Carlo methods which relied much on the tractability of the likelihood function of the normal random sequences. This tractability is unavailable for most Levy processes, hence the necessity of alternative pricing methods is essential. Second, the accuracy of the parameter estimates required tens of thousands of simulations as it is often the case with Metropolis Hasting algorithms with considerable CPU time demand. Both above outlined issues are resolved by the development of a semi-closed form expression of the characteristic function of log asset prices, and it opened the door to a Fourier transform method which is derived on the heels of Carr and Madan algorithm and the Fourier time stepping algorithm (5).

A round of simulations and calibrations is performed to better capture the performance of the semi Markov model as opposed to Markov regime models. We establish through simulations that semi Markov parameters and the backward recurrence time have a substantial effect on option prices ( 6). Differences between Markov and Semi Markov market calibrations are quantified and the CPU times are reported. More importantly, interpretation of risk neutral semi Markov parameters offer more insight into the dynamic of market regimes than Markov market regime models ( 7). This has been systematically exhibited in this work as calibration results obtained from a set of European vanilla call options led to estimates of the shape and scale parameters of the Weibull distribution considered, offering a deeper view of the current market state as they determine the in-regime dynamic crucial to determining where the market is headed.

After introducing semi Markov models through linear Levy driven models, we consider semi Markov markets with nonlinear multidimensional coupled asset price processes (8). We establish that the tractability of linear semi Markov market models carries over to multidimensional nonlinear asset price models. Estimating equations and pricing formula are derived for historical parameters and risk neutral parameters respectively (9). The particular case of basket of commodities is explored and we provide calibration formula of the model parameters to observed historical commodity prices through the LLGMM method. We also study the case of Heston model in a semi Markov switching market where only one parameter is subjected to semi Markov regime changes. Heston model is one the most popular model in option pricing as it reproduces many more stylized facts than Black Scholes model while retaining tractability. However, in addition to having a faster deceasing smiles than observed, one of the most damning shortcomings of most diffusion models such as Heston model, is their inability to accurately reproduce short term options prices. An avenue for solving these issues consists in generalizing Heston to account for semi Markov market regimes. Such a solution is implemented and a semi analytic formula for options is obtained.

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