8.levy Processes - Option Pricing PDF

8.
Option pricing
Lévy processes in Finance and Insurance
Celine Azizieh
ULB
2016-2017
1/46
Merton approach
Pricing and Hedging in incomplete markets
Esscher transform
8. Option pricing
Mean correcting martingale measure/Risk neutral modelling
European option pricing in exponential Lévy models
Carr-Madan formula
Merton approach
The stock price is modelled under P as:
Nt
X
St = S0 exp(µt + σWt + Yi )
i=1
where
Wt : standard BM
Nt : Poisson process of intensity λ, independent of Wt
Yi ∼ N(m, δ 2 ) i.i.d. , independent of Wt , Nt
One can see that there exists an infinity of risk neutral measures, i.e. such that
Ŝt = e −rt St is a martingale under this measure.
Merton proposes a choice of martingale measure (following the general result
on equivalent measure changes) consisting only to change the drift (like in
Black-Scholes model) and not the jump part.
2/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton approach
We have seen that if there is a diffusion part, it is possible to find (an infinity
of) equivalent measure changes in which only the drift is changing, other
elements of the triplet being kept identical. Indeed, under a new equivalent
measure:
1 σ = σ0
dν 0
2 ν ∼ ν 0 with e φ(x ) = dν
R1
3 γ0 − γ = −1
x (ν 0 − ν)(dx ) + σ 2 η
And in particular if φ(x ) = 0, this leads to:
1 σ = σ0
2 ν = ν0
3 γ 0 = γ + σ2 η
For any choice of η, we have a measure change in which only the drift changes.
3/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton approach
Here, we would like that the new drift, after measure change, is such that
e −rt+Xt becomes a martingale (under the new measure). We have seen the
following result:
Proposition: Let (Xt ) be a Levy process on R with triplet (σ, ν, γ). Then
1 (Xt ) is a martingale iff
Z Z
|x |ν(dx ) < ∞ and γ+ x (dx ) = 0
|x |≥1 |x |≥1
2 exp(Xt ) is a martingale iff
σ2
Z Z
e x ν(dx ) < ∞ and +γ+ (e x −1−x I|x |≤1 )ν(dx ) = ψ(−i) = 0
|x |≥1
2 R
4/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton approach
If the jump part is of finite variation (which is here the case), the last condition
becomes :
σ2
Z
+ b + (e x − 1)ν(dx ) = 0
2 R
where b is the absolute
PNt drift. In the jump diffusion case,
Xt = bt + σWt + i=1 Yi , where Yi ∼ F and Nt ∼ P(λt), ν(dx ) = λdF (x ),
so that the martingale condition becomes:
σ2 σ2
Z
+b+λ (e x − 1)dF (x ) = + b + λE[e Yi − 1] = 0
2 R
2
We will apply a measure change only acting on the drift, such that the
parameters of −rt + Xt under the new measure satisfy this last condition.
5/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton approach
If µ is the drift of Xt , and µM is the new drift after measure change, we

have µM = µ + σ 2 η (where η defines the measure change).
Hence, under the corresponding new equivalent measure QM , the
dynamics of the process St can be written:
Nt
X
St = S0 exp(µM t + σWtM + Yi )
i=1
where W M is a standard BM under QM , Yi and Nt are defined as above

(with identical distributions under this new measure), and µM = µ + σ 2 η.
6/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton approach
The condition that e −rt+Xt is a martingale under this measure QM

becomes:
σ2
+ µM − r + λE[e Yi − 1] = 0
2
i.e.:
σ2
µM = r− − λEP [e Yi − 1]
2
σ2 δ2
= r− − λ(exp(m + ) − 1)
2 2
δ2
as exp(Yi ) ∼ LN(m, δ 2 ) so that E [exp(Yi )] = exp(m + 2 ).
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton approach
We hence only change the drift and leave the jump part unchanged (we
only compensate this jump part with part of the new drift).
Merton justifies this choice by saying that the jump part is diversifiable,
so that no risk premium is needed. In other terms, statistical properties
of the jump part (jump sizes and instants) under QM or P are identical.
8/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton approach - price of a European call

By definition of QM , the associated price at time t < T of a European call of
maturity T and strike K is equal to:
CtM = e −r (T −t) EQM [(ST − K )+ |St = S]

 !+ 
NT −Nt
!
X
= e −r (T −t) EQM  S exp µM (T − t) + σWTM−t + Yi −K 
i=1
" n
! !+ #
−r τ
X
−λτ (λτ )n M
X
= e e EQM S exp µ τ+ σWτM + Yi −K
n!
n∈N i=1
+
(λτ )n nm
X
−r τ −λτ M
= e e EQM S exp (µ + )τ + σn W̃τM −K
n! τ
n∈N
by conditioning with respect to NT −t , by using the fact that q

Pn nδ 2
Y ∼ N(nm, nδ 2 ), and by denoting τ = T − t and σn = σ 2 +
i=1 i T −t
.
9/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton approach - price of a European call

By replacing µM by its value (see slide 7), we obtain:
2
X (λτ )n nδ 2 δ2 σn M
e −r τ e −λτ EQM [(Se nm+ 2 −λτ exp(m+ 2 )+λτ e (r − 2 )τ +σn W̃τ − K )+ ]
n!
n∈N
This looks like the price at t of a European call of maturity T and strike K , in
a Black-Scholes model with volatility σn , and on an underlying whose (known)
value at t is:
nδ 2 δ2
S̃n = Se nm+ 2 −λτ exp(m+ 2 )+λτ
i.e.: X (λτ )n BS
CtM = e −λτ C (τ, Sn ; σn )
n!
n∈N
ln(S/K )+(r +σ 2 /2)τ

where C (τ, S; σ) = SΦ(d1 ) − Ke −r τ Φ(d2 ), d1 =
BS √
σ τ
,
√
d2 = d1 − σ τ .
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton approach – price of a European call – Comments
Merton formula:
X (λτ )n BS
CtM = e −λτ C (τ, Sn ; σn )
n!
n∈N
This appears as a weighted sum of European calls in Black-Scholes

model.
One can see that this series converges very fast (exponentially...),
especially if λ is small (which means that the frequency of jump
occurrence is small). In practice, it can be calculated numerically,
from only a limited number of terms.
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Merton shows that it is possible to construct a hedging portfolio,

where the hedging error represents the average effect of jumps, and
which leaves the investor completely exposed to the risk linked to
these jumps.
This could be justified in practice if one supposes that the investor
has a diversified portfolio, i.e. many assets with correlated diffusions
(e.g. present some common component, representing systemic risk,
or in other words a common market index, the “market portfolio”)
but whose jumps are independent, and hence diversifiable across
the different assets.
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Problem: when looking at index prices, like S&P500 or NIKKEI,

they clearly show jumps as well, generally large downward jumps,
resulting from large downward movements of their different
components that appear to be positively correlated with each other
(this is what happens in particular in case of crash in the market).
Concretely this means that Merton argument behind his measure
change does not hold.
Changing measure by means of only the drift means that we
consider that there is no price of risk linked to the jumps.
Some other approaches linked to measure changes are summarized below.
13/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Pricing and hedging in incomplete markets

If the market is incomplete, there is not a unique risk neutral measure, hence
not a unique price of options.
Different hedging and pricing methods can be proposed, in which the price of
the contingent claim is equal to the price of some “optimal” hedge to put in
place, where the “optimality” criteria can take different forms:
Superhedging: Cost of the cheapest superhedging strategy, where a
superhedging strategy corresponds to a hedge “eliminating” all risks
associated with the option (i.e. Payoff of the hedge ≥ Payoff of the
option)
Utility maximization: one defines a utility function (concave increasing
function), and one searches for the utility indifference price
Quadratic hedging, in particular mean-variance hedging: minimization of
the terminal hedging error in the mean-square sense
(inf φ EQ [(VT (φ) − HT )2 ])
Optimal martingale measure, in particular minimal entropy martingale
measure (inf Q EP [ dQ
dP
ln dQ
dP
]) - link with the Esscher transform 14/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

In the preceding methods, the trick is that hedging is performed only
with the underlying asset(s). Now, these notions of market completeness
and replication must be completely revised when (some) options are also
available in the market and can be used as hedging instruments.
In practice, plain vanilla options have become liquid traded assets
(especially calls and puts on equity indices), traded similarly to their
underlying.
In that case, you don’t need a model to determine the price of the
European calls and puts... ! The market price is directly given by the
market. Models remain however useful for pricing exotic options.
Moreover, plain vanilla options are commonly used for static hedging of
more complex options (cf. Dupire result on the possibility to hedge
statically any European option with a portfolio of vanilla options).
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

A concrete modelling approach consists to depart from the model
already specified under “some” risk neutral measure (i.e. the
discounted stock price is a martingale) without emphasizing the
measure change, and we will calibrate directly the parameters of
this risk-neutral dynamics by imposing:
Market prices of traded options ∼

= model prices of these options
This constitute a choice of risk neutral measure Q, but within a

limited set of measures (as we depart already from a given
analytical expression for the underlying ...)
Actually, by following that approach, we do not make any measure
change... and the real world dynamics of the stock is not even
considered 16/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Suppose that H is a (European) contingent claim and suppose
that, in addition to the numeraire and the underlying, we have at
our disposal for hedging a basket of options whose market prices
are given by Ci∗ , i = 1, ..., n, with terminal payoff Hi .
A static hedge of H is a portfolio constituted of the traded options,
the numeraire and the underlying, such that the payoff of H can be
replicated in all states of the world:
n
X Z T
H = V0 + xi Hi + φdS +
i=1 0
where represents the non-hedgeable part (that will remain, as one

cannot find all the Dupire options in the market...).
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Let Q be a pricing rule / martingale measure. Then we can suppose that
EQ [] = 0 (otherwise we can put it in V0 ). H can be valued as:
n
X
e −rT EQ [H] = V0 + xi e −rT EQ [Hi ].
i=1
On the other hand, the cost of the hedge, i.e. the cost of the investment
in options, underlying and risk free asset necessary for setting this hedge
is: X
V0 + xi Ci∗ .
i
The price of H corresponds to the cost of hedging whatever the
contingent claim H, if these 2 quantities are equal for all xi , i.e. if:
e −rT EQ [Hi ] = Ci∗ ∀i = 1, ..., n
| {z } |{z}
ModelPrices MarketPrices
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
So even if the market is incomplete, the presence of vanilla options

(European calls and put) allowing the hedging of European options
imposes de facto the calibrating condition above.
Concretely, we will have to impose these conditions to Q, more
precisely to the parameters of the model giving the dynamics of
the underlying under Q.
In other words: With such calibrated parameters, the price of the
European option calculated under the resulting model allows to put
in place static hedging with vanilla options
19/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Concretely, we can address the problem by 2 approaches:
A) Departing from a model specified under the RW measure P and
finding explicitly a “relevant” measure change leading to an equivalent
martingale measure Q, i.e. under which e −rt+Xt becomes a martingale.
Two commonly used approaches are:
θ θX
1 Esscher Transform: dQ dP
e T
= E [exp(θXT )]
2 Mean correcting martingale measure: changing measure by only
modifying the drift of Xt (like in Black-Scholes and Merton
approaches) - (rem: this requires the presence of a diffusion in the
process used to change measure !)
B) Specifying directly the model under “some” risk neutral measure Q,
i.e. under which e −rt+Xt is already a martingale, and calibrating the
parameters on the available option prices
Remark that A.2 is essentially equivalent with B, as in practice, imposing the
martingale condition in B will lead to adjust the drift, and calibration of parameters in
A.2. is generally made with option prices... see below 20/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Option pricing by explicit measure change - Esscher

Transform
We suppose that St = S0 e Xt for some Lévy process Xt , whose distribution
under P is:
Xt ∼ ft (x ) under P,
and we change measure such that under the new measure Qθ ,
e θx ft (x )
Xt ∼ ftθ (x ) = .
EP [exp(θXt )]

dQθ
In other words, the Radon-Nikodym derivative process is equal to

dP
Ft
e θXt
EP [exp(θXt )]
.
Imposing that (e −rt St ) = S0 e −rt+Xt is a martingale under Qθ directly leads to:
ψ(−i(θ + 1))
r=
ψ(−iθ)
where ψ is he characteristic exponent of process Xt under the historic measure 21/46
P. This imposes the value of θ in functionLévy
of processes
r and the distribution
in Finance of X1
and Insurance
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Option pricing by explicit measure change – Esscher

Transform
Indeed, the martingale condition for exp Lévy models can be expressed as
e −rt Eθ [St ] = S0 for all t > 0. In our case, this leads to:
e θXt (θ+1)Xt

−rt θ −rt −rt EP [S0 e ]
e E [St ] = e EP St = e = S0
EP [e θXt ] EP [e θXt ]
Now φt (u) = EP [e iuXt ], hence φt (−iθ) = E [e θXt ], and the martingale

condition becomes:
φt (−i(θ + 1)) ψ(−i(θ + 1))
S0 = e −rt S0 ⇔ e ψ(−i(θ+1))t = e rt e ψ(−iθ)t ∀t ⇔ =r
φt (−iθ) ψ(−iθ)
which directly leads to the announced condition

22/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Transform
One can see that after Esscher transform, the distribution of Xt under Qθ
is characterised by the triplet:
Z
γθ = γ + σ 2 θ + (e θx − 1)ν(dx )
|x |≤1
σθ = σ
νθ (dx ) = e θx ν(dx )
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Transform – Example
Example – Black-Scholes model: dSt = µSt dt + σSt dWt under P.

σ2 2
In particular, ln S1 ∼ N(µ − 2 , σ ). This implies
σ2 σ2 u2
ψ(u) = iu(µ − )− .
2 2
The condition on θ (guaranteeing e −rt+Xt is a martingale under Qθ )
becomes:
σ2 σ2 r −µ
r =µ− + (2θ + 1) ⇒ θ(r ) = .
2 2 σ2
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Transform – Example
Process (Xt ) under the new measure is characterised by:

σ2 σ2 σ2
γθ = γ + σ2 θ = µ − + σ2 θ = µ − +r −µ=r −
2 2 2
σθ = σ
νθ (dx ) = e θx ν(dx ) = 0
so that under Qθ , the dynamics of St becomes:
dSt = rSt dt + σSt dWt
⇒ we recover the usual risk neutral measure. Is this surprising?
25/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Option pricing by explicit measure change – Mean

correcting martingale measure
The second methodology consists to apply a measure change that will only
modify the drift of Xt .
We leave unchanged the diffusion part (governed by σ) and the Lévy measure
ν within the measure change.
We suppose St = S0 e Xt and we make a change of measure only acting on the
drift, such that e −rt e Xt is a martingale under the new measure Q. This is
equivalent to asking that the new drift γQ satisfies:
σ2
Z
+γQ −r + (e x −1−x I|x |<1 )ν(dx ) = ψQ (−i)−r = ψP (−i)−r +(γQ −γ) = 0
2 R
i.e. that the new drift of Xt under Q equals:
γQ = γ + r − ψP (−i)
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Option pricing by explicit measure change – Mean

correcting martingale measure
This is a consequence of the general result on equivalent measure changes if there is a
diffusion part (like in Merton model1 )
we can change the drift within a measure change if there is a diffusion part
(σ 6= 0)
Now, this is not possible if there is no diffusion part... (!)
Actually changing only the drift by an equivalent measure change in the case of pure
jump processes (without diffusion, e.g. VG or NIG) is not possible... i.e. we cannot
depart from the model specified under the historical measure and make a measure
change that changes only the drift.
Now, we can directly specify the model under “some” risk-neutral measure, and
impose that e −rt St is a martingale under Q.
We hence actually choose methodology B): directly specifying the model under a
risk-neutral framework, without any change of measure
1
This is actually the Merton approach 27/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Directly specifying the model under a risk-neutral measure
This can be reformulated in: we directly specify the model under a measure Q:
St = S0 e Xt +mt
such that m verifies
m = r − ln(Φ1 (−i)) = r − ψ(−i),
where ψ is the characteristic exponent of (Xt ).

This is exactly the condition to impose in order that e −rt+Xt +mt is a martingale
under Q:
e −rt+mt+Xt martingale ⇔ ψ(−i) − r + m = 0
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
One can see that in many models,m has an analytic form:

Model m
VG r +Cp ln (M−1)(G+1)
MG p
NIG r + δ( α2 − (β + 1)2 − α2 − β 2 )
(be careful that here this does not correspond to the parameterization seen up
to now for the NIG but to another one, see next slide)
29/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Remark that in this table m is not expressed in the same parameterization as

the one seen before for the NIG process,
√ i.e.: √
Xt = θSt + σW (St ) where St ∼ IG(t/ K , 1/ K ).
p
Here, Xt = βδ 2 St + δW (St ) where St ∼ IG(at, b) with a = 1, b = δ α2 − β 2 !.
We can pass from one parameterization to the other e.g. by considering
moments (...), which leads to:
p
θ2 + σ 2 /K
α =
σ2
θ
β =
σ2
σ
δ = √
K
30/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Another way is just specifying the model under a measure Q by:
St = S0 exp(rt + Xt )
and imposing the martingale condition for e Xt on the triplet (σ 2 , ν, γ) of Xt :

Z
e x ν(dx ) < ∞
|x |≥1
2
Z
σ
γ+ + (e y − 1 − y I|y |≤1 )ν(dy ) = 0 ⇔ ψ(−i) = 0
2 R
by Lévy-Khinchin representation. This imposes the drift γ (or b) in function of
the other parameters and r .
Model calibration (of the remaining parameters) is then performed on a set of
prices of plain vanilla options quoted in the market, by minimizing some
distance between model and market prices.
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
European options in exponential Lévy models

Price of a European call on (St ), maturity T, strike K, payoff (ST − K )+ paid
in T :
Ct (T , K ) = e −r (T −t) EQ [(ST − K )+ |F t ] = C (t, St , T , K )
A.O.A. assumptions leads to the put-call parity relationship (this is model
independent), so that we get put prices from call prices.
One shows that C (t, St , T , K ) = C (x , τ, K ), where τ = T − t and
x = ln SKt + r τ is the log-forward moneiness, like in Black-Scholes model.
We can then pass to the relative variables:
e rt C (x , τ, K )
u(τ, x ) = = EQ [(e x +Xτ − 1)+ ].
K
The structure of option prices in this family of models has a priori 4 degrees of
freedom (time, underlying price, maturity date, strike), but it can be
parameterized by only two variables: time to maturity and log-forward
moneyness.
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Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Smile in exponential Lévy models

The implied volatility surface can also be expressed in terms of some other
relative variables (m = K /St , τ = T − t): It (τ, m) = Σt (t + τ, mSt ).
Illustration of the model implied volatility surface:
33/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Smile in exponential Lévy models
In general this surface depends on t: it has a dynamics, it is not static).

In exponential Lévy models , we have the following result:
Proposition
If the risk-neutral dynamics is given by St = S0 e rt+Xt (+ conditions on
Xt seen on slide 22), then the implied volatility surface It (τ, m) for a level
of moneyness m = SKt , and time to maturity τ = T − t, does not depend
on time t:
It (τ, m) = I0 (τ, m) ∀ t ≥ 0.
Proof: ...
On say that exponential Lévy models are “sticky moneyness”.
34/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Smile in exponential Lévy models – Remarks

1 Remark that the volatility surface Σt (T , K ) at K fixed depends on
time t:
K
Σt (T , K ) = I0 ( , T − t))
St
(depends on time through T − t and St ).
2 Smile vs skew: if the jump distribution has a negative skewness,
then the implied volatility surface has a skew (decreases with
moneyness)
3 Short term skew: the skew is very pronounced for very short
maturities in exponential Lévy models : at T fixed, with T − t
small, the skew becomes very pronounced
4 If maturities increase, then the skew flattens (in models with finite
variance). This means that the volatility structure tends to
Black-Scholes one (flat volatility in function of moneyness).
35/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Source: R.Cont-P.Tankov, Financial modelling by jump processes
36/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Source: R.Cont-P.Tankov, Financial modelling by jump processes
37/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
Option pricing using characteristic functions

Model calibration requires the revaluation for many values of the
parameters of a set of call options (within an optimisation scheme). This
requires an efficient way to compute numerically these prices.
If we have an explicit formula for the density function (e.g. VG or
NIG case) we can calculate (numerically) the integral:
Z
−rT
C (K , T ) = e fXT (x )(S0 e rT +x − K )+ dx .
R
This is typically time-consuming

Another methodology consists to use Fourier transform and the
characteristic function
38/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Carr-Madan2 proposed a formula easy to implement and much more faster in
general, based on the application of the Fourier transform with respect to the
log-strike.
Let k denote the log-strike: k = ln K and CT (k) the price of a T maturity call
option with strike exp k.
The problem is that the option price CT (k), seen as a function of k, is not
squared integrable (tends to a positive constant S0 if k tends to −∞), so that
Fourier theory is not applicable as such.
The idea of Carr-Madan was to consider the Fourier transform of a modified
function of the log-strike:
cT (k) = exp(αk)CT (k)
for some fixed α > 0, for which we suppose that the new function becomes
squared integrable.
2
P.Carr, D. Madan, Option Valuation Using the Fast Fourier Transform, J. Computational Finance, 2, 1998 39/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Carr-Madan formula:
Z ∞
exp(−α ln K )
C (K , T ) = exp(−iv ln K )ρ(v )dv
π 0
where
exp(−rT )EQ [exp(i(v − (α + 1)i) ln ST )]
ρ(v ) =
α2 + α − v 2 + i(2α + 1)v
exp(−rT )φT (v − (α + 1)i))]
=
α2 + α − v 2 + i(2α + 1)v
where φT is the characteristic function of ln ST .
Proof:...
Remark that the initial price S0 is implicitly contained in φT . 40/46

Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
A way to calculate this expression for a given maturity T and a set of strikes
efficiently is to apply a FFT methodology.
Suppose that we want to approximate numerically the inverse Fourier transform
of a function f (x ). This can be done by considering the discrete Fourier
transform:
Z +∞ Z A/2 N−1
AX
e −iux f (x )dx ≈ e −iux f (x )dx ≈ wk f (xk )e −iuxk
−∞ −A/2
N
k=0
where xk = − A2 + k N−1
A
and wk are the weights associated to the discretization
method used to calculate numerically the integral (e.g. w0 = wN−1 = 0.5 and
wk = 1 for all k 6= 0 and N − 1 in the case of the trapezoidal method).
41/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
An efficient algorithm has been proposed by Cooley and Tukey in 1965

for calculating faster this discretized integral when N is a power of 2: the
Fast Fourier Transform.
It allows to calculate the discrete Fourier inverse on a grid for u such that
the product of both discretization steps (in the Fourier space and in the
original space) is equal to 2π/N.
42/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

Concretely, we need here to calculate:
N
exp(−αk) X
C (T , k) ≈ exp(−ivj k)ρ(vj )∆, where vj = ∆(j − 1)
π
j=1
If we want to calculate this expression for a given maturity T , and for a range
of log-strikes k going from −b to b with a discretization step of λ, i.e. for:
kn = −b + λ(n − 1), n = 1, ..., N, b = Nλ/2,
this becomes:
N
exp(−αkn ) X
C (T , kn ) ≈ exp(−i∆λ(j−1)(n−1)) exp(ivj b)ρ(vj )∆, vj = ∆(j−1)
π
j=1
The FFT is applicable if we suppose that: λ∆ = 2π/N, which leads:

N
exp(−αkn ) −i2π(j − 1)(n − 1)
X
C (T , kn ) ≈ exp exp(ivj b)ρ(vj )∆, vj = ∆(j−1).
π N
j=1
43/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

This correspond exactly to apply the FFT on the vector
(exp(ivj b)ρ(vj )∆)j=1,...,N .
Carr-Madan apply the methodology in the VG model with
∆ = 0.25,
N = 4096
α = 1.5
leading to λ = 0.0061 (= interstrike range) and b = 12.57.
They also use the Simpson discretization method for the integral and
obtain a more accurate approximation.
One can see that the methodology can also be applied to obtain
analytical formulae for other payoffs: binary options, power-calls
(((ST − K )+ )d ), self-quanto (ST (ST − K )+ ),... 44/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula

In practice, implementation of this formula requires to provide as inputs to a
pricing program:
the characteristic function φ of the underlying log-price at maturity (i.e.
of ln(ST ))
the model parameters (taken as inputs of the characteristic function φ
concretely)
the maturities of the options to be priced (also taken as input of φ)
The pricing program generates as output:
for a range of strikes (chosen by the FFT algorithm) and all the given
maturities: the European call option prices
If one needs to get the price for a particular strike, it is then obtained by
interpolation. In practice, FFT application implies a sufficiently thin grid for
the strikes, so that accuracy is guaranteed.
45/46
Merton approach
Esscher transform
8. Option pricing
Carr-Madan formula
The methodology is model independent. It is very flexible as we can easily

introduce a new model by just changing the characteristic function.
The algorithm is very fast and generates in one run option prices for a fine grid
of strikes and all given maturities.
It can be applied on very advanced models, and leads to efficient calibration, in
a reasonable time.
Now, the FFT methodology is justified when we need to calculate repeatedly
an important amount of options with the same maturity (typically for
calibration needs or within Monte Carlo simulations of an option portfolio for
VaR or TailVar purpose).
For pricing a single option, the speed is not really an issue especially on modern
computers, for which all methods can do this computation quickly...
46/46

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8.

Lévy processes in Finance and Insurance

2 exp(Xt ) is a martingale iff

If µ is the drift of Xt , and µM is the new drift after measure change, we

where W M is a standard BM under QM , Yi and Nt are defined as above

The condition that e −rt+Xt is a martingale under this measure QM

Merton approach - price of a European call

CtM = e −r (T −t) EQM [(ST − K )+ |St = S]

by conditioning with respect to NT −t , by using the fact that q

Merton approach - price of a European call

ln(S/K )+(r +σ 2 /2)τ

Merton approach – price of a European call – Comments

This appears as a weighted sum of European calls in Black-Scholes

Merton approach – price of a European call – Comments

Merton shows that it is possible to construct a hedging portfolio,

Merton approach – price of a European call – Comments

Problem: when looking at index prices, like S&P500 or NIKKEI,

Some other approaches linked to measure changes are summarized below.

Pricing and hedging in incomplete markets

Pricing and hedging in incomplete markets

Pricing and hedging in incomplete markets

Market prices of traded options ∼

This constitute a choice of risk neutral measure Q, but within a

Pricing and hedging in incomplete markets

where  represents the non-hedgeable part (that will remain, as one

Pricing and hedging in incomplete markets

Pricing and hedging in incomplete markets

So even if the market is incomplete, the presence of vanilla options

Pricing and hedging in incomplete markets

Option pricing by explicit measure change - Esscher

Imposing that (e −rt St ) = S0 e −rt+Xt is a martingale under Qθ directly leads to:

Option pricing by explicit measure change – Esscher

Now φt (u) = EP [e iuXt ], hence φt (−iθ) = E [e θXt ], and the martingale

which directly leads to the announced condition

Option pricing by explicit measure change – Esscher

Option pricing by explicit measure change – Esscher

Example – Black-Scholes model: dSt = µSt dt + σSt dWt under P.

Option pricing by explicit measure change – Esscher

Process (Xt ) under the new measure is characterised by:

so that under Qθ , the dynamics of St becomes:

dSt = rSt dt + σSt dWt

⇒ we recover the usual risk neutral measure. Is this surprising?

Option pricing by explicit measure change – Mean

i.e. that the new drift of Xt under Q equals:

Option pricing by explicit measure change – Mean

Directly specifying the model under a risk-neutral measure

such that m verifies

m = r − ln(Φ1 (−i)) = r − ψ(−i),

where ψ is the characteristic exponent of (Xt ).

Directly specifying the model under a risk-neutral measure

One can see that in many models,m has an analytic form:

Directly specifying the model under a risk-neutral measure

Remark that in this table m is not expressed in the same parameterization as

Directly specifying the model under a risk-neutral measure

and imposing the martingale condition for e Xt on the triplet (σ 2 , ν, γ) of Xt :

European options in exponential Lévy models

Smile in exponential Lévy models

Smile in exponential Lévy models

In general this surface depends on t: it has a dynamics, it is not static).

Smile in exponential Lévy models – Remarks

Smile in exponential Lévy models – Remarks

Smile in exponential Lévy models – Remarks

Option pricing using characteristic functions

where represents the non-hedgeable part (that will remain, as one