Advanced numerical probabilistic methods for finance

Term 3 2019

This exam consists of two problems. The total number of points is 35 and the
number of points for each question is indicated. The rigour and clarity of your answers
will be taken into account in the final grade. Within a problem, you are allowed to use
the results of the previous questions.
This is a 3 hour exam.

1
1 Problem I (22 pts)
Let pΩ, A, Pq be a probability space supporting a one-dimensional standard Brownian
motion pWt qtě0 and let T be a positive real number. We denote by pFt qtě0 the natural
filtration generated by the Brownian motion.
For x P R, let pY x , Z x , X x q be the solution of the following Forward-Backward
Stochastic Differential Equation, for t ď T ,
żt
Xt “ x ` bpXsx qds ` Wt
x
(1.1)
0
żT żT
x x x
Yt “ gpXT q ` f pYs qds ´ Zsx dWs (1.2)
t t

where g, b and f are twice differentiable with bounded first and second derivatives. We
thus know that there exists a unique solution to the above system.
Let u : r0, T s ˆ R Ñ R be a classical solution to the following semi-linear PDE
#
Bt u ` bpxqBx u ` 21 Bxx
2 u ` f puq “ 0 on r0, T q ˆ R
(1.3)
upT, ¨q “ gp¨q

We have moreover that u is twice differentiable with bounded first and second derivatives
on r0, T s ˆ R.

1. (3 pts) (Preliminary question) Let ξ P L2 pFT q, α and β be two continuous adapted

processes and consider the following BSDE pY, Zq:
żT żT
Yt “ ξ ` pαs Ys ` βs qds ´ Zs dWs , t ď T (1.4)
t t

and the process Γ:

żt
Γt “ 1 ` αs Γs ds , t ě 0.
0

(a) (1 pt) Compute the dynamics of the process pΓt Yt q0ďtďT .

(b) (2 pts) Deduce that, for t ď T ,
„ ş żT ş 
T s
Yt “ E e t αu du ξ ` e t αu du βs ds | Ft . (1.5)
t

2. (5 pts) The goal of this question is to obtain a probabilistic representation of Z0x .

(a) (1 pt) Show that Ytx “ upt, Xtx q and Ztx “ Bx upt, Xtx q, for t P r0, T s.
(b) (4 pts) For  P R, we define, for t ď T ,

∆ Xt “ Xtx` ´ Xtx , ∆ Yt “ Ytx` ´ Ytx and ∆ Zt “ Ztx` ´ Ztx .

2
 i. (2 pts) Show that there exists a bounded continuous adapted process a
and a bounded random variable γT (give their expression) such that
żT żT
 
∆ Yt “ γT ∆ XT ` as ∆ Ys ds ´ ∆ Zs dWs .
t t

ii. (2 pts) Deduce that

« ff
2
E sup |∆ Yt | ď C2 .
tPr0,T s

(c) (6 pts) Let p∇Xtx q0ďtďT be the tangent process associated to x. For latter
use, we recall that
« ff
∆ X
 t 2
lim E sup |∇Xtx ´ | “0.
Ñ0 tPr0,T s 

Let p∇Y x , ∇Z x q be the solution of the following affine BSDE:

żT żT
∇Ytx “ g 1 pXTx q∇XTx ` f 1 pYsx q∇Ysx ds ´ ∇Zsx dWs
t t

i. (2 pts) Recall the dynamics of ∇X x

and show that it is bounded on
r0, T s.
ii. (1 pt) Let Ut “ ∆Yt ´ ∇Ytx . Show that
żT żT
  ∆ XT x x   
Ut “ γ T 1
´ g pXT q∇XT ` pas Us ` θs qds ´ Vs dWs , t ď T ,
 t t

for a continuous and adapted process θ to precise.

iii. (3 pts) Prove that
” şT 1 x ı
Z0x “ E e 0 f pYs qds g 1 pXTx q∇XTx .

3. (8 pts) Discrete-time approximation. (In this question x is fixed and we omit it

in the notation.)
For n ě 1, let π “ t0 “: t0 ă ¨ ¨ ¨ ă ti ă ¨ ¨ ¨ ă tn “ T u be a time grid of r0, T s
with constant stepsize ti`1 ´ ti “ h “ T {n, i ă n.
We assume that no error is made on X nor on ∇X (no discrete-time scheme
needed).
Let pYtπi q0ďiďn be the implicit Euler scheme for the BSDE (1.2), we will use the
following result:

max E |Yti ´ Ytπi |2 ď Ch.

“ ‰
iďn

We consider an approximation of Z0 given by the following quantity

” řn´1 1 π ı
Z0π “ E eh i“0 f pYti q g 1 pXT q∇XT

3
(a) (1 pt) Recall the definition of pYtπi q0ďiďn .
(b) (2 pts) Show that, for all i ă n,
ˆ „ż ti`1 ˙
2 2
“ ‰
sup E |Yt ´ Yti | ď C h ` E |Zt | dt .
tPrti ,ti`1 s ti

(c) (2 pts) Prove that

« ff
n´1
ÿ ż ti`1
E 1
|f pYt q ´ f 1
pYtπi q|2 dt ď Ch.
i“0 ti

(d) (3 pts) Deduce that

?
|Z0 ´ Z0π | ď C h .

4
2 Problem II (13 pts)
For this problem, we work on a complete probability space supporting a one dimensional
Brownian motion W . Let T ą 0 be a prescribed terminal time.
Let u : r0, T s ˆ R Ñ R be the classical solution to the following semi-linear PDE
#
Bt u ` bpxqBx u ` 21 Bxx
2 u“0 on r0, T q ˆ R
(2.1)
upT, ¨q “ gp¨q

where g, b are in Cb8 pRq functions (i.e. bounded function with all derivatives bounded).
We then have also that u is in Cb8 pr0, T s ˆ Rq.
For t P r0, T s, X is solution to
żt
Xt “ X0 ` bpXs qds ` Wt , X0 P R .
0

We introduce a discrete-time grid π “ t0 “: t0 ă ¨ ¨ ¨ ă ti ă ¨ ¨ ¨ ă tn :“ T u of r0, T s

with ti “ ih where h “ T {n. We consider the following Euler scheme for X:

X0π “ X0 and Xtπi`1 “ Xtπi ` bpXtπi qh ` Wti`1 ´ Wti . (2.2)

The goal of this exercise is to show the following error expansion:

ErgpXTπ qs ´ up0, X0 q “ Kh ` Oph2 q , (2.3)

where K is a constant to determine, independent of π.

To this end, we introduce the following operator, parametrised by y P R:
1 2
Ly ϕpt, xq “ Bt ϕpt, xq ` bpyqBx ϕpt, xq ` Bxx ϕpt, xq, pt, xq P r0, T s ˆ R,
2
for ϕ : r0, T s ˆ R Ñ R a smooth function.
We also consider the following process:

X̂st,x,y “ x ` bpyqs ` Wt`s ´ Wt , @px, y, t, sq P R2 ˆ R2` .

1. (2 pts) Show that, for all i ă n,

” ı h2
E upti`1 , X̂hti ,x,y q “ upti , xq ` hLy upti , xq ` Ly ˝ Ly upti , xq ` Oph3 q .
2

2. (2 pts) Prove that

” ı
E upti`1 , Xtπi`1 q “ E upti , Xtπi q ` h2 ψpti , Xtπi q ` Oph3 q
“ ‰

where ψ is a smooth function.

3. (7 pts)

5
 (a) (2 pts) Show that, for all i ă n

E ψpti , Xti q ´ ψpti , Xtπi q “ Ophq

“ ‰

(b) (2 pts) Prove that, for all t P rti , ti`1 s, i ă n,

Erψpti , Xti q ´ ψpt, Xt qs “ Ophq

(c) (3 pts) Using the results of the previous questions, prove (2.3) and give the
expression of the constant K in terms of T , ψ and X.

4. (2 pts) Suggest an order two method to approximate up0, X0 q based on the ex-
pansion (2.3).

6
PROBLEM I

1. (a)

dpΓt Yt q “ Γt p´αt Yt ´ βt qdt ` Γt Zt dWt ` αt Yt ΓT dt “ ´Γt βt dt ` Γt Zt dWt

şT şT
(b) Γt Yt “ ΓT YT ` t Γs βs ds ´ t şΓs Zs dWs Take conditional expectation and
t
divide by Γt , noting that Γt “ e 0 αs ds

2. (a) Apply Ito’s formula to pupt, Xtx qqt and by uniqueness to the BSDE the result
follows.
(b) i. We observe that
żT żT
∆  Yt “ γT ∆ XT ` as ∆ Ys ds ´ ∆ Zs dWs .
t t
ş1 şλ
where γT “ 0 g 1 pXTx ` λ∆ XT qdλ, as “ 0 f 1 pYsx ` λ∆ Ys q, boundedness
and continuity follows from the assumptions on the coefficient functions.
ii. We then have, using the first question,
” şT  ı
∆ Yt “ E e t as ds γT ∆ XT |Ft

Thus, |∆ Yt | ď CEr|∆ XT ||Ft s. and by Doob’s Inequality

« ff
E sup |∆ Yt | ď CE |∆ XT |2 ď C2
2
“ ‰
tPr0,T s

şt şt 1 x
(c) i. ∇Xt “ 1 ` 0 b1 pXsx q∇Xs ds “ e 0 b pXs qds ď CT as b1 is bounded.
ii. bs “ tas ´ f 1 pYsx qu∇Ysx
iii. One has, using the first question,
” şT 1 x ı
∇Y0 “ E e 0 f pYs qds g 1 pXTx q∇XTx

moreover
up0, x ` q ´ up0, xq
∇Y0 “ lim (2.4)
Ñ0 
“ Bx up0, xq “ Z0 .

Equation (2.4) comes from the fact that limÑ0 |U0 | “ 0. Indeed, from
the first question, one obtain
ˇ „ ş żT ş ˇ
ˇ T  ∆ XT t  ˇ
|U0 | ď “ ˇˇE e 0 as ds tγT ´ g 1 pXT q∇XT u ` e 0 as ds bt dt ˇˇ
 0
„ żT 
 ∆ XT 1 
ď CE |γT ´ g pXT q∇XT | ` |bt |dt
 0

7
3. (a) see lecture notes
(b) One computes, for t P rti , ti`1 s
„ żt żt 
2 2 2
“ ‰ 1
E |Yt ´ Yti | ď 2E | f pYs qds| ` | Zs dWs |
t ti
ˆ i „ż ti`1 ˙
2 2
ďC h `E |Zs | ds
ti

(c) One has

« ff « ff
n´1
ÿ ż ti`1 n´1
ÿ ż ti`1
1 1 π 2 2 π 2
E |f pYt q ´ f pYti q| dt ď CE p|Yt ´ Yti | ` |Yti ´ Yti q| qdt
i“0 ti i“0 ti
˜ ¸
n´1
ÿ ż ti`1 ż ti`1
2
“ ‰
ďC h` dt E |Zs | ds ď Ch
i“0 ti ti

şT řn´1 1 π
(d) Denote ζT “ 0 f 1 pYs qds and ζTπ “ h i“0 f pYti q. We compute that
” π
ı
|Z0 ´ Z0π | ď C|E eζT ´ eζT | ď CEr|ζT ´ ζTπ |s

Using Cauchy schwartz inequality, we get

˜ « ff¸ 1
n´1
ÿ ż ti`1 2

|Z0 ´ Z0π | ď C E |f 1 pYt q ´ f 1 pYtπi q|2 dt

i“0 ti

and the proof is concluded using the previous question.

PROBLEM II

1. Apply Ito’s Formula to get (x and y are omitted in the computation below)
ż ti`1
upti`1 , X̂h q “ upti , xq ` Ly ups, X̂s qds ` Mt0i`1
ti

and similarly
ż ti`1
Ly upt, X̂t q “ Ly upti , X̂ti q ` L ˝ Ly ups, X̂s qds ` Mt1
ti
żt
Ly ˝ Ly upt, X̂t q “ Ly ˝ Ly upti , X̂ti q ` Ly ˝ Ly ˝ Ly ups, X̂s qds ` Mt2
ti

where M 0 , M 1 , M 2 are martingales with null expectation.

We thus obtain:
„ż ti`1 
”
x,y
ı h
E upti`1 , X̂h q “ upti , xq ` hLy upti , xq ` Ly ˝ Ly upti , xq ` E Ly ˝ Ly ˝ Ly ups, X̂s qds
2 ti

8
 From the property of b and u, one easily deduces
„ż ti`1 
E Ly ˝ Ly ˝ Ly ups, X̂s qds “ Ophq
ti

2. apply the previous results with X̂ “ Xtπi and observe that LXtπ upti , Xtπi q “ 0.
i

3. (a) classical weak error estimate for the euler scheme

(b) apply Ito’s formula
(c) We have
ÿ ” ı
ErgpXTπ q ´ up0, xqs “ E upti`1 , Xtπi`1 q ´ upti , Xtπi q
ÿ “
E h2 ψpti , Xtπi q ` Oph2 q
‰
“
żT ÿ “
Erψpt, Xt qs dt ` h2 E ψpti , Xtπi q ´ ψpti , Xti q
‰
“h
0
ÿ ż ti`1
`h Erψpt, Xt q ´ ψpti , Xti qs dt ` Oph2 q
ti

4. Romberg-Richardson extrapolation method.