Chapter 5

Models Based on Compound Poisson

Processes
5.1 Jump-diffusion Models
In Cont and Tankov (2003), it was argued that the real mechanismof volatility smile/skews
is the fear for crashes or downward jumps. In fact, incorporating jumps into asset dynam-
ics easily allows us to produce smiles as well as the leptokurtic feature in asset-price den-
sities. Hence, it is rather intuitive to develop asset-pricing model with jump and diffusion
processes.
Denition 5.1.1 A Poisson process is an adaptive counting process N(t) with the following prop-
erties:
1. For 0 t
1
t
2
t
n
< , N(t
1
), N(t
2
) N(t
1
), , N(t
n
) N(t
n1
) are
stochastically independent.
2. For every t > s 0, N(t) N(s) is Poisson distributed with parameter , i.e.,
P (N(t) N(s) = n) = e
(ts)
((t s))
n
n!
.
3. For each xed , N(, t) is right continuous in t.
4. N(0) = 0 almost surely.
5. The rst two moments of N(t) are identical
E[N(t)] = V ar[N(t)] = t.
1
2 CHAPTER 5. MODELS BASED ON COMPOUND POISSON PROCESSES
A jump-diffusion process is a stochastic process driven by both diffusion and com-
pound Poisson process. It take the following form:
X
t
= X
0
+
_
t
0
b
s
ds +
s
dZ
s
+
Nt

i=1
X
i
,
where Z
s
is a P-Brownian motion, b
t
and
t
are continuous F
t
-adaptive functions with
E
__
T
0

2
t
dt
_
< ,
and the jump size X
i
is also stochastic and obeys certain distribution. For later uses, we
will need the Itos lemma for jump-diffusion processes
Lemma 5.1.2 (Itos Lemma) Let X
t
follow
X
t
= X
0
+
_
t
0
b
s
ds +
s
dZ
s
+
Nt

i=1
X
i
,
where b
t
and
t
are continuous F
t
-adaptive functions with
E
__
T
0

2
t
dt
_
< .
Then, for any C
1,2
function f : [0, T] R R, the process Y
t
= f(t, X
t
) satises
f(t, X
t
) f(0, X
0
) =
_
t
0
_
f
s
+
f
x
b
s
+
1
2

2
s

2
f
x
2
_
ds
+
_
t
0

s
f
x
dZ
s
+

i1,T
i
t
[f(X
T
i

+ X
i
) f(X
T
i

)]
The proof is straightforward is is left as an exercise.
5.2 Merton Model
It was rst proposed by Merton (1976) that, under the physical measure, P, the asset price
dynamics under diffusion and jump risks follows the following dynamics:
dS
t
/S
t
=
t
dt +
t
dZ
t
+Y dN
t
.
Let V (S
t
, t) be the option price. By the Itos lemma,
dV
t
=
_
V
t
t
+S
t
V
t
S
+
1
2

2
t
S
2
t

2
V
t
S
2
_
dt +
t
S
t
V
t
S
dZ
t
+
_
V (S
t
, t) V (S
t

, t

dN
t
.
5.2. MERTON MODEL 3
Let = V
t
/S and consider the -hedged portfolio

t
= V
t
S
t
.
The change in
t
is
d
t
=
_
V
t
t
+S
V
t
S
+
1
2

2
t
S
2
t

2
V
t
S
2
_
dt +
t
S
t
V
t
S
dZ
t
S
t
(
t
dt +
t
dZ
t
) + (V
t
S
t
) dN
t
=
_
V
t
t
+
1
2

2
t
S
2
t

2
V
t
S
2
_
dt + (V
t
S
t
) dN
t
,
there is no diffusion risk. Mertons argued that the jump risk is diversiable, so the
market does not charge any risk premium (called idiosyncratic risk). Consequently, the
expected return of the hedged portfolio is equal to risk-free rate, yielding
V
t
t
+
1
2

2
t
S
2
t

2
V
t
S
2
+E [V
t
S
t
] = r(V
t
S
t
),
or,
V
t
t
+
1
2

2
t
S
2
t

2
V
t
S
2
+ (r E[Y ]) S
V
t
S
+E[V
t
] rV
t
= 0.
Note that
E[SdN
t
] = SE[Y ]dt.
The implied risk-neutral process is
dS
t
/S
t
= (r E[Y ]) dt +
t
dZ
t
+Y dN
t
.
When it comes to hedging, people may consider minimal variance hedging using the
underlying (This is the best one can do), which is
=
< dV
t
, dS
t
>
< dS
t
, dS
t
>
=

2
t
S
2
t
Vt
S
(1 dt) +E[V
t
]E[S
t
]dt

2
t
S
2
t
(1 t) + (E[S
t
])
2
dt
=

2
t
S
2
t
Vt
S
(1 dt) +E[V
t
]E[S
t
]dt

2
t
S
2
t
(1 t) + (E[Y ])
2
S
2
t
dt
.
Note that the arguments of Merton breaks down for index option. As a matter of fact,
stocks jumps with the market, so idiosyncratic risk is not necessarily non-systematic risk
and may not be diversiable.
4 CHAPTER 5. MODELS BASED ON COMPOUND POISSON PROCESSES
5.3 EquilibriumOption Pricing under Jump-Diffusion Pro-
cesses
Consider a generic asset with real-world dynamics
dS
t
S
t
= (
S
E[Y ])dt +dZ
t
+Y dN
t
,
where
S
is the expected return of the asset. For equilibrium pricing, we need the wealth
process
dW
t
W
t
=
W
dt +
W
dZ
t
+Y
W
dN
t
,
and the expected utility function
J(W
t
, t) = max
{xt,ct}
E
t
__
T
t
U(c
s
)ds +B(W
T
, T)
_
.
Note that
W
has accounted for the assumption. Our theory is based on the following
result of nance.
Proposition 5.3.1 The function J
W
(W
T
, T)/J
W
(W
t
, t) is the pricing kernel, meaning that, for
price of any cum-dividend security, S
t
satises
E
t
_
J
W
(W
T
, T)
J
W
(W
t
, t)
S(T)
_
= S(t).
Proof: According to the denition of the expected utility function, there is
J(W
t
, t) = max
{xt,ct}
E
t
[U(c
t
)dt +J(W
t+dt
, t +dt)] . (5.3.1)
Let e
t
be the original consumption
t
be the optimal allocation to the share, so that
c
t
= e
t

t
S
t
.
Differentiate (5.3.1) w.r.t.
t
and set the derivative to zero we obtain
0 = E
t
_
U

(c
t
)S
t
+J
W
(W
t+dt
, t +dt)
dW
t+dt
d
t
_
= E
t
[J
W
(W
t
, t)S
t
+J
W
(W
t+dt
, t +dt)S
t+dt
]
= E
t
[d (J
W
(W
t
, t)S
t
)] .
The implication is that J
W
(W
t
, t)S
t
is a martingale, so that
J
W
(W
t
, t)S
t
= E
t
[J
W
(W
T
, T)S(T)] ,
5.3. EQUILIBRIUM OPTION PRICING UNDER JUMP-DIFFUSION PROCESSES 5
and the conclusion follows
The result of the proposition can be recast to
E
t
_
J
W
(W
T
, T)
J
W
(W
t
, t)
S(T)
S(t)
_
= 1, (5.3.2)
which applies to any cum-dividend assets, including money market account, B
t
= e
rt
,
which satises
E
t
_
J
W
(W
T
, T)
J
W
(W
t
, t)
B(T)
B(t)
_
= E
t
_
J
W
(W
T
, T)
J
W
(W
t
, t)
e
r(Tt)
_
= 1. (5.3.3)
Combining the last two equations we obtain the rst variational condition
E
t
_
J
W
(W
t+dt
, t +dt)(S
t+dt
S
t
e
rdt
)

= 0. (5.3.4)
An alternative derivation of (5.3.6) can proceed as follows. We keep the original con-
sumption and nance the purchase of the share by money market account. Then, by
differentiating (5.3.1) we obtain
0 = E
t
_
J
W
(W
t+dt
, t +dt)
dW
t+dt
d
t
_
,
= E
t
_
J
W
(W
t+dt
, t +dt)
_
S
t+dt
S
t
e
rdt
_
.
It then follows that
E
t
_
dS
t
S
t
_
rdt = E
t
_
dJ
W
J
W

dS
t
S
t
_
+o(dt).
By the Itos lemma
dJ
W
= J
W
dt +J
WW
dW
t
+
1
2
J
WWW

2
W
W
2
dt + J
W
dN
t
,
where
J
W
= J
W
(W(1 +Y
W
), t) J
W
(W, t)
dW
t
W
t

dN=0
=
W
dt +
W
dZ
t
.
Plug in into the last equation, we obtain
Proposition 5.3.2 The equilibrium excess return is

S
r =
WJ
WW
J
W
E
dN=0
_
dW
W
dS
S
_
E
dN=1
_
J
W
J
W
S
S
_
=RCov
dN=0
_
dW
W
,
dS
S
_
E
dN=1
_
J
W
J
W
S
S
_
,
(5.3.5)
6 CHAPTER 5. MODELS BASED ON COMPOUND POISSON PROCESSES
where
R =
WJ
WW
J
W
is the coefcient of relative risk aversion.
For later use we denote

W,S
= Cov
dN=0
_
dW
W
,
dS
S
_
instantaneous covariance conditional on no jump,
so we can write

S
r =R
W,S
E
dN=1
_
J
W
J
W
S
S
_
. (5.3.6)
If we use CPRA utility function, then the solution of J takes form
J(W, t) = e
kt
W

,
then
1. R =
WJ
WW
J
W
= 1 = constant
2.
J
W
J
W
= (1 +Y
W
)
1
1.
It follows that

S
r = ( 1)Cov
dN=0
_
dW
W
,
dS
S
_
E
dN=1
__
(1 +Y
W
)
1
1

Y
_
(5.3.7)
Let us consider option pricing. Similar to the the last proposition, we can derive the
equilibrium expected return for an option as

V
r = RS
V
S
V

W,S
E
dN=1
_
J
W
J
W
V
V
_
, (5.3.8)
where
V = V (S(1 +Y ), t) V (S, t).
Denote
J

W
= J
W
(W(1 +Y
W
), t)
5.3. EQUILIBRIUM OPTION PRICING UNDER JUMP-DIFFUSION PROCESSES 7
By Itos lemma,

V
V = V
t
+SV
S
(
S
E[Y ]) +
1
2

2
S
2
V
SS
+E[V ]. (5.3.9)
Multiply (5.3.8) by V and make use of (5.3.9), we obtain
V
t
+SV
S
(
S
E[Y ]) +
1
2

2
S
2
V
SS
+E[V ] rV
=R
W,S
SV
S
E
_
J
W
J
W
V
_
=SV
S
_

S
r +E
_
J
W
J
W
S
S
__
E
_
J
W
J
W
V
_
=SV
S
_

S
r +E
__
J

W
J
W
1
_
Y
__
E
__
J

W
J
W
1
_
V
_
,
(5.3.10)
Here, the subindex
dN=1
is omitted for simplicity. Due to cancelations, we arrive at
V
t
+
_
r E
_
J

W
J
W
Y
__
SV
S
+
1
2

2
S
2
V
SS
+E
_
J

W
J
W
V
_
= rV, (5.3.11)
Introducing

= E
_
J

W
J
W
_
E

[X] = E
_
J

W
/J
W
E[J

W
/J
W
]
X
_
Then, (5.3.11) is rewritten into
V
t
+ (r

[Y ])SV
S
+
1
2

2
S
2
V
SS
+

[V ] = rV.
The risk-neutralized process is thus
dS
t
S
t
= (r

[Y ])dt +
t
dZ
t
+Y dN

.
So, the jump intensity is changed to

, and the jump distribution is changed by

J

W
/J
W
E[J

W
/J
W
]
.
Under the CPRA utility function, there is
J

W
J
W
= (1 +Y
W
)
1
.
8 CHAPTER 5. MODELS BASED ON COMPOUND POISSON PROCESSES
We now understand that for the risk-neutralized process, both jump intensity and
jump distribution have changed. With this understanding, we drop the super-script *
for simplicity, and have write the risk-neutral process as
dS
t
S
t
= (r
t
E[Y ])dt +
t
dZ
t
+Y dN
t
.
Let V
t
= V (S
t
, t) be the value of a derivative. If the jump size is deterministic, then V
satises
V
t
t
+
1
2

2
S
2

2
V
t
S
2
+rS
V
t
S
rV
t
+
_
V ((Y + 1)S, t) V (S, t) Y S
V
t
S
_
= 0.
For random jump size, the equation becomes
V
t
t
+
1
2

2
S
2

2
V
t
S
2
+rS
V
t
S
rV
t
+
_
E[V ((Y + 1)S, t) V (S, t)] E[Y ]S
V
t
S
_
= 0.
Let (x) be the distribution of jump size, then the last equation is a so-called partial
integro-differential equation (PIDE):
V
t
t
+
1
2

2
S
2

2
V
t
S
2
+rS
V
t
S
rV
t
+
_
(dy)[V ((y + 1)S, t) V (S, t) yS
V
t
S
] = 0,
which is usually solved by numerical methods.
5.4 Popular Jump Models
5.4.1 Lognormal or Merton Jumps
Merton (1976) assumed that, in case of a jump, the jump size follows
S
t
S
t

= (1 +
J
)e

1
2

2
J
+
J

, N(0, 1).
It is equivalent to say that the percentage jump-size distribution is
ln(1 +J) N
_
ln(1 +
J
)
1
2

2
J
,
2
J
_
.
5.4. POPULAR JUMP MODELS 9
Let X
t
= ln S
t
. Then X
t
has the following risk-neutral dynamics:
dX
t
=
_
r
J

1
2

2
_
dt +dZ
t
+ ln (1 +J) dN(t).
Conditional to jumps, we have the following expression for the log price:
X
T
= X
0
+
_
r
J

1
2

2
_
T +
N
T

i=1
ln(1 +J
i
) +Z
T
.
Conditional to n jumps by the time T, we have
S
T
=S
0
exp
_
(r
J

1
2

2
)T +Z
T
+n[ln(1 +
J
)
1
2

2
J
+
J
]
_
=S
0
exp
__
r
J
+
n
T
ln(1 +
J
)
1
2
_

2
+
n
T

2
J
_
_
T +
_
_

2
+
n
T

2
J
_
T )
_
,
where N(0, 1) under the risk-neutral measure.
The pricing of European options is conditional to 0, 1, , n, , jumps, respectively,
so we have
C =

n=0
e
T
(T)
n
n!
C
BS
(S
0
, K, T, r, q
n
,
n
),
where
C
BS
(S, K, T, r, q, ) = Se
qT
N(d
1
) e
rT
KN(d
2
)
d
1,2
=
ln(S/K) + (r q
1
2

2
)T

T
q
n
=
J

n
T
ln(1 +
J
)

2
n
=
2
+
n
T

2
J
.
and r is the spot rate. Alternatively, we can write
C =

n=0
e
T
(T)
n
n!
e
[
J
+
n
T
ln(1+
J
)]T
C
BS
(S
0
, K, T, r
n
,
n
)
=

n=0
e
(1+
J
)T
(T(1 +
J
))
n
n!
C
BS
(S
0
, K, T, r
n
,
n
),
where
C
BS
(S, K, T, r, ) = SN(d
1
) e
rT
KN(d
2
),
d
1,2
=
ln(S/K) + (r
1
2

2
)T

T
,
r
n
= r
J
+
n
T
ln(1 +
J
),

2
n
=
2
+
n
T

2
J
.
10 CHAPTER 5. MODELS BASED ON COMPOUND POISSON PROCESSES
Through conditioning arguments, we can deduce that the price formula for a general
European option is
C =

n=0
exp[T(1 +
J
)] (T(1 +
J
))
n
n!
C
n
,
where C
n
is the European option price with an instantaneous variance
2
+
n
T

2
J
and risk-
free rate r
J
+
n
T
ln(1 +
J
).
Option pricing can also be done through transformation method. The moment-generating
function of X
T
can be calculated as
(u) = E [exp{uX
T
}]
= E
_
exp
_
u
_
X
0
+
_
r
J

1
2

2
_
T +
N
T

i=1
ln(1 +J
i
) +Z
T
___
= e
u(X
0
+rT)
E
_
exp
_
u
_

1
2

2
T +Z
T
___
E
_
exp
_
u
_

J
+
N
T

i=1
ln(1 +J
i
)
___
.
The two expectations can be evaluated analytically. In fact,

BS
(u)

= E
_
exp
_
u
_

1
2

2
T +Z
T
___
= exp
_

1
2
u
2
T +
1
2
u
2

2
T
_
= exp
_
1
2

2
Tu(u 1)
_
,
and

J
(u)

= E
_
exp
_
u
_

J
T +
N
T

i=1
ln(1 +J
i
)
___
= e
u
J
T
E
_
exp
_
u
N
T

i=1
ln(1 +J
i
)
__
= e
u
J
T
E
_
(E [exp (uln(1 +J))])
N
T

.
Let
g(u) =E [exp (uln(1 +J))]
=E
_
(1 +
j
)
u
e
u(
1
2

2
J
+
J

_
=(1 +
J
)
u
e
1
2
u(u1)
2
J
,
5.4. POPULAR JUMP MODELS 11
then

J
(u) = e
u
J
T
E
_
(g(u))
N
T

= e
u
J
T

n=0
e
T
(T)
n
n!
g
n
(u)
= e
u
J
T
e
T
e
Tg(u)
= exp
_
T
_
u
J
1 + (1 +
J
)
u
e
1
2
u(u1)
2
J
__
.
So it follows that
(u) = e
u(X
0
+rT)+
1
2

2
Tu(u1)+T

u
J
1+(1+
J
)
u
e
1
2
u(u1)
2
J

.
5.4.2 Pareto Jumps
Dufe, Pan and Singleton (1999) model jump by exponential distribution with a mean
as follows
ln(1 +J) E
x
(),
where the probability density function (PDF) of an exponential distribution takes the form
pdf
exp
(x; ) =
1

exp
_

_
, 0 < x < .
Note that the mean and standard deviation of an exponentially distributed random vari-
able are
E[X] =
_
V AR(X) = .
The density function for J follows from the chain rule:
pdf
J
(x) =
1
(1 +x)
exp
_

ln(1 +x)

_
=
1

(1 +x)

1
, 0 < x < .
We say that J is Pareto distributed, and call the the jump process Pareto jump. Note that
there are
J > 0, ln(1 +J) > 0,
and
E[J] =

1
,
which imposes a constraint of (0, 1).
12 CHAPTER 5. MODELS BASED ON COMPOUND POISSON PROCESSES
To incorporate possible negative jumps, we introduce two Pareto jumps,
dS
t
S
t
= (r )dt +dZ
t
+J
1
dN
1
(t) J
2
dN
2
(t),
with
=
1
+
2
,
=

1

1
+
2
E[J
1
]

2

1
+
2
E[J
2
] =

1

1
+
2

1
1
1

1
+
2

2
1
2
,
or
dX(t) =
_
r
1
2

2
_
dt +dZ
t
+ ln (1 +J
1
) dN
1
(t) ln (1 +J
2
) dN
2
(t),
with
ln(1 +J
1
)
1

1
exp
_

ln(1 +J
1
)

1
_
, 0 < J
1
< ,
ln(1 +J
2
)
1

2
exp
_

ln(1 +J
2
)

2
_
, 0 < J
2
< .
We can also calculate the MGF explicitly, and perform inverse Laplace transform for
option evaluation.
5.4.3 Kou Model
Kou model (2002) takes the form
dS
t
S
t
= (r E[J]) dt +dZ
t
+JdN(t), (5.4.12)
where U = ln(1 + J) has an asymmetric double-exponential distribution with a density
function
Pdf
U
(x) = p
1
e

1
x
1
x0
+q
2
e

2
x
1
x<0
,
with
1
> 0,
2
> 0, p > 0, q > 0 and p +q = 1.
To show that the Kou model can be treated as a special case of the Pareto jump model,
we denote

1
=
1

1
and
2
=
1

2
,
Then,
Pdf
U
(x) = p
1

1
exp
_

1
_
1
x0
+q
1

2
exp
_
x

2
_
1
x<0
.
5.4. POPULAR JUMP MODELS 13
The Kou model can be cast into
dS
t
S
t
= (r E[J])dt +dZ
t
+J
+
dN
1
(t) J

dN
2
(t),
with
E[J] = p

1
1
1
q

2
1
2
,
J
+
= e
U
+
1, J

= e
U

1,
dN
1
(t) = pdN(t), dN
2
(t) = qdN(t).
where U
+
= max(U, 0) and U

= min(U, 0).