Heat kernel models for asset pricing

DOI10.1142/S0219024914500484MaRDI QIDQ2941066zbMATH OpenFDO

Authors Andrea Macrina

Publication date 21 January 2015

Published in International Journal of Theoretical and Applied Finance (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1211.0856

zbMATH Keywords

Markov processescontagionequityinterest ratesasset pricingdebtpricing kernelspread dynamicsLévy random bridges

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) PDEs in connection with game theory, economics, social and behavioral sciences (35Q91) Continuous-time Markov processes on general state spaces (60J25) Heat kernel (35K08) PDEs with randomness, stochastic partial differential equations (35R60) Applications of stochastic analysis (to PDEs, etc.) (60H30) Interest rates, asset pricing, etc. (stochastic models) (91G30) Financial applications of other theories (91G80)

Abstract: A heat kernel approach is proposed for the development of a general, flexible, and mathematically tractable asset pricing framework in finite time. The pricing kernel, giving rise to the price system in an incomplete market, is modelled by weighted heat kernels which are driven by multivariate Markov processes and which provide enough degrees of freedom in order to calibrate to relevant data, e.g. to the term structure of bond prices. It is shown how, for a class of models, the prices of bonds, caplets, and swaptions can be computed in closed form. The dynamical equations for the price processes are derived, and explicit formulae are obtained for the short rate of interest, the risk premium, and for the stochastic volatility of prices. Several of the closed-form asset price models presented in this paper are driven by combinations of Markovian jump processes with different probability laws. Such models provide a rich basis for consistent applications in several sectors of a financial market including equity, fixed-income, commodities, and insurance. The flexible, multidimensional and multivariate structure, on which the asset price models are constructed, lends itself well to the transparent modelling of dependence across asset classes. As an illustration, the impact on prices by spiralling debt, a typical feature of a financial crisis, is modelled explicitly, and contagion effects are readily observed in the dynamics of asset returns.

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Cites work

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Cited in

(10)

• Stochastic modelling with randomized Markov bridges
• A recursive method for fractional Hawkes intensities and the potential approach of credit risk
• Rational multi-curve models with counterparty-risk valuation adjustments
• Rational models for inflation-linked derivatives
• Heat kernel models for asset pricing
• Randomised mixture models for pricing kernels
• Algorithmic trading with learning
• IMPLIED KERNEL MODELS
• Polynomial term structure models
• Randomised mixture models for pricing kernels

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