Introduction to Importance Sampling

dung cheng

2017. 08

dung cheng Introduction to Importance Sampling 2017. 08 1 / 32

Table of Contents

1 Basic knowledge

2 Variance Reduction

3 Change of Measure

4 Remarks for Option Pricing

5 Importance Sampling

6 Efficient Importance Sampling

7 Large Deviation Principle and Cramer’s Theorem

8 Reference

dung cheng Introduction to Importance Sampling 2017. 08 2 / 32

Rare Event

We consider the events that occur with low frequency as rare event.
Financial example:
I Default rate: joint default probability
I Risk management: portfolio credit risk, systemic risk

dung cheng Introduction to Importance Sampling 2017. 08 3 / 32

Monte Carlo Simulation

(Law of Large Number)

n
1X
Xi → E[X ]
n
i=1

(Central limit theorem)

1 Pn
n i=1 Xi− E[X ]
√ → N(0, 1)
σ/ n
Application: integration, probability estimation.

dung cheng Introduction to Importance Sampling 2017. 08 4 / 32

Simulation
Now, we want to estimate the probability P(X < −5) for X ∼ N(0, 1)

function estimate(N, C)
for i=1:length(C)
%Crude Monte Carlo
A = randn(1,N);
CMC_sm = sum(A<C(i))/N;
CMC_se = std(A<C(i))/sqrt(N);
%Exact answer
mu = 0;
sigma = 1;
pd = makedist(’Normal’,mu,sigma);
cdf_ans = cdf(pd,C(i));
fprintf(’%1.1f & %e & %e & %e \\\\\n’, C(i), cdf_ans,
end
end

dung cheng Introduction to Importance Sampling 2017. 08 5 / 32

Simulation

c cdf CMC s.e.

-1 0.158655253931457 0.162900000000000 0.003692928752667
-1.5 0.066807201268858 0.064900000000000 0.002463616435364
-2 0.022750131948179 0.021000000000000 0.001433912692796
-2.5 0.006209665325776 0.005400000000000 7.328967961256935e-04
-3 0.001349898031630 0.001100000000000 3.314965897243874e-04
-3.5 2.326290790355250e-04 2.000000000000000e-04 1.414142842854940e-04
-4 3.167124183311996e-05 0 0
-4.5 3.397673124730062e-06 0 0
-5 2.866515718791946e-07 0 0

Table: Results of CMC for N = 10000

dung cheng Introduction to Importance Sampling 2017. 08 6 / 32

Variance Reduction

Additivity:
Estimate E[X ] by E[X + C λ]
where λ: control parameter with E[C ] = 0
I Asian option !
1 T
Z  1 RT 
X =h St dt , Y = h e T 0 ln St dt
T 0
Let C = Y − E[Y ], then E[C ] = 0.
I American option pricing by Monte Carlo Simulation
(ref. Longstaff-Schwartz, 2000)

dung cheng Introduction to Importance Sampling 2017. 08 7 / 32

Variance Reduction

Multiplicity:
Estimate E[X ] by Ẽ[X · Q(X )] where Q(X ): importance function.
In option pricing, the importance sampling plays the role of change of
probability measure.
I X ∼ N(0, 1), evaluate p = P(X < c) = E[I(X < c)]

dung cheng Introduction to Importance Sampling 2017. 08 8 / 32

Exponential Twisting

Z
E[I(X < c)] = I(X < c)f (x)dx
Z
f (x) ˜
= I(X < c) · f (x)dx
f˜(x)
h f (x) i
=E
e I(X < c)
f˜(x)
| {z }
likelyhood ratio

e µx f (x)
where f˜(x) = , MX (µ) = E[e µX ]: moment generating function
MX (µ)

dung cheng Introduction to Importance Sampling 2017. 08 9 / 32

Remark: Option Pricing by Esscher Transforms

In rare event simulation, µ is determined by threshold.

In option pricing, µ is determined by martingale condition.
I (Risk-neutral Esscher transform)
I S(t): the price of a non-divident-paying stock (security) at time t with
S(t) = S(0)e X (t)
I (Xt )t≥0 : stochastic process with stationary and independent
increments and X (0) = 0
I M(z, t) := E[e zX (t) ], M(z, t) = [M(z, 1)]t provided M(z, t):
continuous at t = 0

dung cheng Introduction to Importance Sampling 2017. 08 10 / 32

Remark: Option Pricing by Esscher Transforms

Z ∞
M(z, t) = e zx f (x, t)dx
−∞
e hx f (x, t)
f (x, t; h) :=
M(h, t)
M(z + h, t)
M(z, t; h) := , and note that M(z, t; h) = [M(z, 1; h)]t
M(h, t)

dung cheng Introduction to Importance Sampling 2017. 08 11 / 32

Remark: Option Pricing by Esscher Transforms

Goal: seek h∗ such that the discounted price e −δt S(t) is a martingale
under the new probability measure given by Esscher transform
I S(0) = E∗ [e −δt S(t)] ⇒ S(0) = e −δt S(0)E∗ [e X (t) ]
I e δt = E∗ [e X (t) ] = M(1, t; h∗ ) = [M(1, 1; h∗ )]t ⇒ δ = log M(1, 1; h∗ )
To evaluate a European call option on the stock with strike K and
exercise date τ at time t = 0: V0 := E∗ [e −δt (S(t) − K )+ |F0 ]
K
I Define κ := log
ZS(0)
∞
−δt
I V0 = e S(0) e x f (x, τ ; h∗ )dx − e −δt K [1 − F (κ, τ ; h∗ )]
κ
where e x f (x, τ ; h∗ ) = e δt f (x, τ ; h∗ + 1)
I V0 = S(0)[1 − F (κ, τ, h∗ + 1)] − e −δt K [1 − F (κ, τ ; h∗ )]

dung cheng Introduction to Importance Sampling 2017. 08 12 / 32

Remark: Option Pricing by Esscher Transforms

{X (t)}: Wiener process with mean µ and variance σ 2 (per unit time)
I F (x, t) := P(X (t) ≤ x) = N(x; µt, σ 2 t)
1 2 2
I M(z, t) = e (µz+ 2 σ z )t
2 1 2 2
I M(z, t; h) = e ((µ+hσ )z+ 2 σ z )t
I F (x, t; h) = N(x; (µ + hσ 2 )t, σ 2 t)
Risk-neutral Esscher transform
δ = (µ + h ∗ σ 2 ) + σ 2 /2
µ∗ = µ + h∗ σ 2 = δ − σ 2 /2
V0Wie =
−κ + (δ + σ 2 /2)τ −κ + (δ − σ 2 /2)τ
  
−δτ
S(0)Φ √ −e KΦ √
σ τ σ τ

dung cheng Introduction to Importance Sampling 2017. 08 13 / 32

Remark: Option Pricing by Esscher Transforms

{X (t) = kN(t) − ct}: shifted Poisson process

I N(t): Poisson process with parameter λ, k, c > 0
X e −θ θj
I CDF: Λ(x; θ) =
j!
 0≤j≤x 
x + ct
I F (x, t) = Λ , λt
k
zk
I M(z, t) = e tλ(e −1)−cz]t
hk zk
I M(z, t; h) = e tλe (e −1)−cz]t
Risk-neutral Esscher transform
∗
δ = λe h k (e k − 1) − c
∗ δ+c
λ∗ = λe h k = k
e −1
V0Poi =     
κ + cτ ∗ k −δτ κ + cτ ∗
S(0) 1 − Λ ;λ e τ − Ke 1−Λ ;λ τ
k k

dung cheng Introduction to Importance Sampling 2017. 08 14 / 32

Remark: Option Pricing by Esscher Transforms

{S(t) = S(0)e X (t) }: discrete-time multiplicative binomial process

with X (t) = X1 + · · · + Xt
I Ω = {a, b} with P(b) = p, P(a) = 1 − p
X n
I CDF: B(x; n, θ) = θj (1 − θ)n−j
j
0≤j≤x
 
x − at
I F (x, t) = B ; t, p
b−a
I M(z, t) = [(1 − p)e az + pe bz ]t
I M(z, t; h) = [(1 − π(h))e az + π(h)e bz ]t
pe bh
where π(h) =
(1 − p)e ah + pe bh

dung cheng Introduction to Importance Sampling 2017. 08 15 / 32

Remark: Option Pricing by Esscher Transforms

Risk-neutral Esscher transform

e δ = [1 − π(h∗ )]e a + π(h∗ )e b
eδ − ea
π(h∗ ) = b
e − e a  
Bin κ − aτ ∗
V0 = S(0) 1 − B ; τ, π(h + 1) −
  b − a 
κ − aτ
Ke −δt 1 − B ; τ, π(h∗ ) where π(h∗ + 1) = π(h∗ )e b−δ
b−a
Note that it is not necessary to know P(b) = p to price the option.
(Only need to know π(h∗ ))

dung cheng Introduction to Importance Sampling 2017. 08 16 / 32

Remark: Option Pricing by Esscher Transforms

{X (t) = Y (t) − ct}: shifted gamma process

I Y (t): gamma processZ x with parameter α, β, c > 0
βα
I G (x; α, β) = y α−1 e −βy dy , x ≥ 0
Γ(α) 0
I F (x, t) = G (x + ct; αt, β)
 αt
β
I M(z, t) = e −ctz , z < β
β−z
 αt
β−h
I M(z, t; h) = e −ctz , z < β − h
β−h−z
Risk-neutral Esscher
αtransform
β − h∗

δ
e = e −c
β − h∗ − 1
1
β ∗ = β − h∗ =
1 − e −(c+δ)/α
V0Gam = S(0)[1 − G (κ + cτ ; ατ, β ∗ − 1)] − Ke −δt [1 − G (κ + cτ ; ατ.β ∗ )]

dung cheng Introduction to Importance Sampling 2017. 08 17 / 32

Remark: Option Pricing by Esscher Transforms

{X (t) = Y (t) − ct}: shifted inverse Gaussian process

I {Y (t)}: inverse
 Gaussian process
 with√ parameter a, b
√ √
 
−a 2a b −a
I J(x; a, b) = Φ √ + 2bx + e Φ √ − 2bx , x > 0
2x 2x
I F (x, t) = J(x√+ ct;
√
at, b)
I M(z, t) = e a( b−√
b−z)−ctz
√
,z <b
a( b−h− b−h−z)−ctz
I M(z, t; h) = e , z <b−h
Risk-neutral
√ Esscher
√ transform
δ = a( b − h∗ − b − h∗ − 1) − c
2
√ √

∗ ∗ ∗ ∗
c +δ ∗ 1 c +δ a
b = b −h ⇒ b − b − 1 = ⇒b = +
a 4 a c +δ
V0InG = S(0)[1 − J(κ + cτ ; aτ, b ∗ − 1)] − e −δt [1 − J(κ + cτ ; aτ, b ∗ )]

dung cheng Introduction to Importance Sampling 2017. 08 18 / 32

Example: Ruin Probability

Consider an insurance firm earing premiums at a constant rate p per

unit of time, and paying claims that arrive at the jump of a Poisson
process with rate λ.
N(t): number of claims arriving in [0, t]
Yi : size of i-th claim
ξi : interarrival time of Poisson process ∼ exp(λ)
Set x: reserve, λE[Yi ] < p
N(t)
X
Net payout over [0, t]: Yi − pt
i=1
Net payout up to n-th claim: Sn = X1 + · · · + Xn where Xi = Yi − pξi

dung cheng Introduction to Importance Sampling 2017. 08 19 / 32

Example: Ruin Probability

dung cheng Introduction to Importance Sampling 2017. 08 20 / 32

Example: Ruin Probability

Define τx := inf n
Sn >x
Estimate the eventual ruin P(τx < ∞):
(For general setting, we assume {Xi }: i.i.d. with 0 < P(Xi > 0) < 1,
E[Xi ] < 0 and drop the special form Yi − pξi )

P(τx < ∞) = E[I(τx < ∞)]

h i
= Eθ e −θSτx +ψX (θ)τx · I(τx < ∞)

If 0 < ψX0 (θ) < ∞, then Eθ [Xn ] = ψX0 (θ) < ∞.

h i
Then P(τx < ∞) = 1 =⇒ P(τx < ∞) = Eθ e −θSτx +ψX (θ)τx

dung cheng Introduction to Importance Sampling 2017. 08 21 / 32

Example: First Hitting Time

dung cheng Introduction to Importance Sampling 2017. 08 22 / 32

Optimal Measure

 
dP
p = EP [X ] = EQ X
dQ
"  #
dP 2 dP 2
   
dP
VarQ X = EQ X − EQ X
dQ dQ dQ
 
dP
= EP X 2 − p2
dQ
dQ∗
 
∗ dP X
∃Q such that VarQ∗ X ∗
= 0 by taking =
dQ dP EP [X ]

dung cheng Introduction to Importance Sampling 2017. 08 23 / 32

Asymptotically Optimal Importance Sampling

P1Q , P2Q : first, and second moment, respectively.

VarQ [X ] = P2Q − (P1Q )2
We call the importance sampling efficient (or asymptotically optimal)
1 1
if lim log P2Q = 2 lim log P1Q
n→∞ n n→∞ n

dung cheng Introduction to Importance Sampling 2017. 08 24 / 32

Toy Model

E[I(X < c)] for X ∼ N(0, 1)

1 x2 µ2 1 1 2
f (x) = √ e − 2 , MX (µ) = e 2 , f˜(x) = √ e − 2 (x−µ)
2π 2π
Second moment:

h f (x) 2 i
 h i
−µx+ 12 µ2
P2Q = EQ I(X < c) = E I(X < c)e
f˜(x)
1 2 1 2
≤ E[e −cµ+ 2 µ ] = e −cµ+ 2 µ

d  1 2

By taking log e −cµ+ 2 µ = 0, we have µ = c
dµ

dung cheng Introduction to Importance Sampling 2017. 08 25 / 32

Simulation

for i=1:length(C)
%Crude Monte Carlo
A = randn(1,N);
CMC_sm = sum(A<C(i))/N;
CMC_se = std(A<C(i))/sqrt(N);
%Efficient I.S.
B=A+C;
EIS_sm=
sum((B<C(i)).*(exp(1).^(-C(i).*B+0.5.*C(i).^2)))/N
EIS_se=
(std((B<C(i)).*(exp(1).^(-C(i).*B+0.5.*C(i).^2))))/sqrt(N)
end

dung cheng Introduction to Importance Sampling 2017. 08 26 / 32

Simulation

c cdf CMC s.e. EIS s.e.

-1 0.158655253931457 0.162900000000000 0.003692928752667 0.156958196898354 0.001895435259949
-1.5 0.066807201268858 0.064900000000000 0.002463616435364 0.065160610408277 9.033103757300151e-04
-2 0.022750131948179 0.021000000000000 0.001433912692796 0.023020966481626 3.494388612908102e-04
-2.5 0.006209665325776 0.005400000000000 7.328967961256935e-04 0.006138267097036 1.043373591892651e-04
-3 0.001349898031630 0.001100000000000 3.314965897243874e-04 0.001321438853177 2.459045897978202e-05
-3.5 2.326290790355250e-04 2.000000000000000e-04 1.414142842854940e-04 2.370773935282700e-04 4.671138444317568e-06
-4 3.167124183311996e-05 0 0 3.148668008326063e-05 6.698453759226119e-07
-4.5 3.397673124730062e-06 0 0 3.383089349109682e-06 7.653502125235220e-08
-5 2.866515718791946e-07 0 0 2.857501664657509e-07 6.762587035351070e-09

Table: Results of EIS for N = 10000

dung cheng Introduction to Importance Sampling 2017. 08 27 / 32

Useful Tools

Large deviation principle(LDP):

A sequence {Yi } obeys the LDP with rate function ! I (·) if
n
1 1 X
For any closed set F , lim sup log P Yi ∈ F ≤ − inf I (a)
n→∞ n n a∈F
i=1
n
!
1 1X
For any open set G , lim sup log P Yi ∈ G ≥ − inf I (a)
n→∞ n n a∈G
i=1

dung cheng Introduction to Importance Sampling 2017. 08 28 / 32

Useful Tools

ψ(θ) := log E[e θX ] and ψ ∗ (x) := sup[θx − ψ(θ)]

θ∈R
(Cramer’s theorem)  
1 Sn
∀x ≥ E[X1 ], we have lim log P ≥ x = −ψ ∗ (x)
n→∞ n n
Example:
Multivariate normal distribution X ∼ N(µ, Σ),
1
the rate function is given by I (a) = (a − µ)t Σ−1 (a − µ)
2

dung cheng Introduction to Importance Sampling 2017. 08 29 / 32

Importance Sampling for Diffusions via Girsanov’s Theorem

X : d-dimensional diffusion process dXs = µ(Xs )ds + σ(Xs )dWs

(Wt )t≥0 : n-dimensional Brownian motion on a filter probability space
(Ω, F, F = (Ft )t≥0 , P)
Xst,x : the solution from time x to t
v (x, t) := E g (Xst,x , t ≤ s ≤ T ) , (t, x) ∈ [0, T ] × Rd
 

Let φ = (φ ) : Rd -valued adapted such that

R t t 00≤t≤T 1 R t 2
Mt = e − 0 φu dWu − 2 0 |φu | du is a martingale. i.e., E[MT ] = 1
dQ
Let Q be a probability measure such that = MT
dP

dung cheng Introduction to Importance Sampling 2017. 08 30 / 32

Importance Sampling for Diffusions via Girsanov’s Theorem

Z t
W
ft = Wt + φu du: Brownian motion under Q
0
dXs = (µ(Xs ) − σ(Xs )φs ) ds + σ(Xs )dW
fs
t,x
 
Then v (t, x) = EQ g (Xs , t ≤ s ≤ T )LT
Rt Rt
fu − 1
φ0u dW |φu |2 du
where LT = e 0 2 0

N
1 X
Importance sampling: IgN,φ (t, x) = g (X i,t,x )LiT
N
i=1

dung cheng Introduction to Importance Sampling 2017. 08 31 / 32

Reference

C.H.Han, Efficient Importance Sampling Estimation for Joint Default

Probability: the First Passage Time Problem.
J.Bucklew, Introduction to rare event simulation.
P.Glasserman, Monte Carlo methods in financial engineering.
Pham, Large deviations in mathematical finance.
Hans U. Gerber, Elias S.W. Shiu, Option Pricing by Esscher
Transforms.

dung cheng Introduction to Importance Sampling 2017. 08 32 / 32