O UTLINE OF THE WHOLE LECTURES .

PART 1 : JUMP - DIFFUSION PROCESSES .

I Theory and simulation.

I Stochastic calculus with jump-diffusion processes.

I Applications in finance.

PART 2 : GENERAL L ÉVY PROCESSES .

I Theory.

I Simulation.

I Stochastic calculus with semimartingales.

I Applications in finance.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 1 / 34

I NTRODUCTION .

C ONTINUOUS TIME MODELS WITH CONTINUOUS TRAJECTORIES .

Black-Scholes model. Scale invariance of the Brownian motion.
Local volatility models. Possible perfect hedging.
Stochastic volatility models. Difficulty to obtain heavy tails, no
large sudden moves.

C ONTINUOUS TIME MODELS WITH DISCONTINUOUS TRAJECTORIES .

I Market crash.
I Credit risk.
I High-frequency trading. Aït-Sahalia & Jacod, High-frequency
Financial Econometrics.
I Insurance and ruin theory.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 2 / 34

I NTRODUCTION .

C ONTINUOUS TIME MODELS WITH CONTINUOUS TRAJECTORIES .

Black-Scholes model. Scale invariance of the Brownian motion.
Local volatility models. Possible perfect hedging.
Stochastic volatility models. Difficulty to obtain heavy tails, no
large sudden moves.

C ONTINUOUS TIME MODELS WITH DISCONTINUOUS TRAJECTORIES .

I Market crash.
I Credit risk.
I High-frequency trading. Aït-Sahalia & Jacod, High-frequency
Financial Econometrics.
I Insurance and ruin theory.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 2 / 34

T WO DIFFERENT CLASSES .

1 J UMP - DIFFUSION MODELS .

Prices : diffusion process, with jumps at randon times.
Jumps : rare events −→ cracks or large losses.

1 Advantages :
I price structure : easy to understand, to describe and to simulate ;
I then efficient Monte Carlo methods to compute path-depend prices.
I Very performant to interpolate the implicit volatility smiles.
2 Inconvenients :
I unknown closed formula for the densities,
I statistical estimation or moments/quantiles computations : difficult to
realize.
2 I NFINITE ACTIVITY MODELS (general Lévy processes).

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T WO DIFFERENT CLASSES .

1 J UMP - DIFFUSION MODELS .

2 I NFINITE ACTIVITY MODELS (general Lévy processes).
Models with a infinite number of jumps during any time period.
Unnecessary Brownian component.

1 Advantages :
I give a more realistic description of the prices at different time scales.
I often obtained as subordinator of a Brownian motion (time change),
I hence closed formulas or more tractable than for the jump-diffusion
models.
2 Inconvenients :
I often more complicated to simulate.
I Price structure less intuitive.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 3 / 34

D EFINITIONS .

D EFINITION
A stochastic process (Xt )t≥0 defined on (Ω, F, P), with values in Rd , is
a Lévy process if
1 X0 = 0 a.s.
2 its increments are independent : for every increasing sequence
t0 , . . . , tn , the r.v. Xt0 , Xt1 − Xt0 , . . . , Xtn − Xtn−1 are independent ;
3 its increments are stationnary : the law of Xt+h − Xt does not
depend on t ;
4 X satisfies the property called stochastic continuity : for any ε > 0,
lim P(|Xt+h − Xt | ≥ ε) = 0
h→0
5 there exists a subset Ω0 s.t. P(Ω0 ) = 1 and for every ω ∈ Ω0 ,
t 7→ Xt (ω) is RCLL.

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D EFINITIONS .

If a filtration (Ft )t≥0 is already given on (Ω, F, P)

D EFINITION
A stochastic process (Xt )t≥0 defined on (Ω, F, P), with values in Rd , is
a Lévy process if
1 X0 = 0 a.s.
2 its increments are independent : for any s ≤ t, the r.v. Xt − Xs is
independent of Fs ;
3 its increments are stationnary ;
4 X satisfies the property called stochastic continuity ;
5 a.s. t 7→ Xt (ω) is RCLL .

A. Popier (ENSTA) Jump-diffusion processes. January 2020 4 / 34

R EMARKS .
R EMARKS ON THE DEFINITIONS :
If Ft = FtX , the two definitions are equivalent.
If {Ft } is a larger filtration than (FtX ⊂ Ft ) and if Xt − Xs is
independent of Fs , then {Xt ; 0 ≤ t < +∞} is a Lévy process
under the large filtration.

R EMARKS ON THE HYPOTHESES :

If we remove Assumption 5, we speak about Lévy process in law.
If we remove Assumption 3, we obtain an additive process.
Dropping Assumptions 3 and 5, we have an additive process in
law.

T HEOREM
A Lévy process (or an additive process) in law has a RCLL
modification.
We can also prove that 2, 3 and 5 imply 4.
A. Popier (ENSTA) Jump-diffusion processes. January 2020 5 / 34
R EMARKS .
R EMARKS ON THE DEFINITIONS :
If Ft = FtX , the two definitions are equivalent.
If {Ft } is a larger filtration than (FtX ⊂ Ft ) and if Xt − Xs is
independent of Fs , then {Xt ; 0 ≤ t < +∞} is a Lévy process
under the large filtration.

R EMARKS ON THE HYPOTHESES :

If we remove Assumption 5, we speak about Lévy process in law.
If we remove Assumption 3, we obtain an additive process.
Dropping Assumptions 3 and 5, we have an additive process in
law.

T HEOREM
A Lévy process (or an additive process) in law has a RCLL
modification.
We can also prove that 2, 3 and 5 imply 4.
A. Popier (ENSTA) Jump-diffusion processes. January 2020 5 / 34
E NLARGED FILTRATION .

For a process X = {Xt ; t ≥ 0}, we define

N∞ = N the set of P-negligible events.
For any 0 ≤ t ≤ ∞, augmented filtration : Ft = σ(FtX ∪ N ).

T HEOREM
Let X = {Xt ; t ≥ 0} be a Lévy process. Then
the augmented filtration {Ft } is right-continuous.
With respect to the enlarged filtration, {Xt , t ≥ 0} is still a Lévy
process.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 6 / 34

C HARACTERISTIC FUNCTIONS .

P ROPOSITION
Let (Xt )t≥0 be a Lévy process in Rd . Then there exists a function
ψ : Rd → R called characteristic exponent of X s.t. :
 
∀z ∈ Rd , E eihz,Xt i = etψ(z) .

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 T HEORY OF THE JUMP - DIFFUSION PROCESSES .

Alexandre Popier

ENSTA, Palaiseau

January 2020

A. Popier (ENSTA) Jump-diffusion processes. January 2020 8 / 34

O UTLINE

1 J UMP - DIFFUSION PROCESSES

Compound Poisson process
Jump-diffusion processes

2 P ROPERTIES OF JUMP - DIFFUSION PROCESSES

Densities of the jump-diffusion processes.
Moments
Jump-diffusion processes and martingales.
Poisson and Lévy measures

A. Popier (ENSTA) Jump-diffusion processes. January 2020 9 / 34

B ROWNIAN MOTION .
A Brownian motion is a Lévy process satisfying
1 for every t > 0, X is Gaussian with mean vector zero and
t
covariance matrix t Id ;
2 the process X has continuous sample paths a.s.

Characteristic function :
E(eihz,Bt i ) = exp(−t|z|2 /2).

A. Popier (ENSTA) Jump-diffusion processes. January 2020 10 / 34

O UTLINE

1 J UMP - DIFFUSION PROCESSES

Compound Poisson process
Jump-diffusion processes

2 P ROPERTIES OF JUMP - DIFFUSION PROCESSES

Densities of the jump-diffusion processes.
Moments
Jump-diffusion processes and martingales.
Poisson and Lévy measures

A. Popier (ENSTA) Jump-diffusion processes. January 2020 11 / 34

P OISSON PROCESS .

D EFINITION
A stochastic process (Xt )t≥0 , with values in R, is a Poisson process
with intensity λ > 0 if it is a Lévy process s.t. for every t > 0, Xt has a
Poisson law with parameter λt.

P ROPOSITION (C ONSTRUCTION )
If (Tn )n∈N is a random walk on R s.t. for every n ≥ 1, Tn − Tn−1 is
exponentially distributed with parameter λ (with T0 = 0), then the
process (Xt )t≥0 defined by

Xt = n ⇐⇒ Tn ≤ t < Tn+1

is a Poisson process with intensity λ.

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P OISSON PROCESS .

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J UMP DISTRIBUTION .

For any interval I, we denote by N(I) the number of jumps of Xt , t ∈ I.

P ROPOSITION
For 0 < s < t and n ≥ 1, the conditional law of Xs knowing Xt = n is
binomial with parameters n and s/t.
For 0 = t0 < t1 < . . . < tk = t and Ij =]tj−1 , tj ], the conditional law of
(N(I1 ), . . . , N(Ik )) knowing Xt = n is multinomial with parameters n,
(t1 − t0 )/t, . . . , (tk − tk −1 )/t.

Ti : jump times of the process.

P ROPOSITION
Let n ≥ 1 and t > 0. The conditional law of T1 , . . . , Tn knowing Xt = n
coincides with the law of the order statistics U(1) , . . . , u(n) of n
independent variables, uniformly distributed on [0, t].

A. Popier (ENSTA) Jump-diffusion processes. January 2020 14 / 34

C OMPOUND P OISSON PROCESSES .

We consider a Poisson process (Pt )t≥0 with intensity λ and jump times
Tn , and a sequence (Yn )n∈N∗ of Rd -valued r.v. s.t.
1 Yn are i.i.d. with distribution measure π ;
2 (Pt )t≥0 and (Yn )n∈N∗ are independent.
Define
Pt
X +∞
X
Xt = Yn = Yn 1[0,t] (Tn ).
n=1 n=1

D EFINITION
The process (Xt )t≥0 is a compound Poisson processes with intensity λ
and jump distribution π.

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M ERTON MODEL .

Compound Poisson processes with Gaussian jumps.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 16 / 34

C OMPOUND P OISSON PROCESSES .

P ROPOSITION
The process (Xt )t≥0 is a Lévy process, with piecewise constant
trajectories and characteristic function :
   Z 
d ihz,Xt i ihz,xi
∀z ∈ R , E e = exp tλ (e − 1)π(dx)
Rd
 Z 
ihz,xi
= exp t (e − 1)ν(dx) ;
Rd

D EFINITION
ν is a finite measure defined on Rd by : ν(A) = λπ(A), A ∈ B(Rd ). ν is
called the Lévy measure of the compound Poisson process. Moreover

ν(A) = E [#{t ∈ [0, 1], ∆Xt 6= 0, ∆Xt ∈ A}] .

A. Popier (ENSTA) Jump-diffusion processes. January 2020 17 / 34

C OMPOUND P OISSON PROCESSES .

D EFINITION
The law µ of X1 is called compound Poissondistribution
Z and has a 
ihz,xi
characteristic function given by : µ̂(z) = exp λ (e − 1)π(dx) .
Rd

P ROPOSITION
Let X be a compound Poisson process and A and B two disjointed
subsets of Rd . Then :
X X
Yt = ∆Xs 1∆Xs ∈A and Zt = ∆Xs 1∆Xs ∈B
s≤t s≤t

are two independent compound Poisson processes.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 17 / 34

O UTLINE

1 J UMP - DIFFUSION PROCESSES

Compound Poisson process
Jump-diffusion processes

2 P ROPERTIES OF JUMP - DIFFUSION PROCESSES

Densities of the jump-diffusion processes.
Moments
Jump-diffusion processes and martingales.
Poisson and Lévy measures

A. Popier (ENSTA) Jump-diffusion processes. January 2020 18 / 34

D EFINITION .

D EFINITION
A jump-diffusion process X is the sum of a Brownian motion and of a
independent compound Poisson process. Therefore a jump-diffusion
process is a Lévy process.

In other words
I a k -dimensional Brownian motion (Wt )t≥0 , a d × k matrix A,
I a d-dimensional vector γ,
I a Poisson process (Pt )t≥0 with intensity λ and jump times Tn , and
a sequence (Yn )n∈N∗ of Rd -valued r.v.
such that
1 Yn are i.i.d. with distribution measure π ;
2 (Wt )t≥0 , (Pt )t≥0 and (Yn )n∈N∗ are independent.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 19 / 34

D EFINITION .

In other words
I a k -dimensional Brownian motion (Wt )t≥0 , a d × k matrix A,
I a d-dimensional vector γ,
I a Poisson process (Pt )t≥0 with intensity λ and jump times Tn , and
a sequence (Yn )n∈N∗ of Rd -valued r.v.
such that
1 Yn are i.i.d. with distribution measure π ;
2 (Wt )t≥0 , (Pt )t≥0 and (Yn )n∈N∗ are independent.

Pt
X +∞
X
Xt = AWt + γt + Yn = AWt + γt + Yn 1[0,t] (Tn ).
n=1 n=1

A. Popier (ENSTA) Jump-diffusion processes. January 2020 19 / 34

D EFINITION .

X
Xt = AWt + γt + ∆Xs .
0<s≤t

C HARACTERISTIC EXPONENT : for any z ∈ Rd :

Z
1 ∗
ψX (z) = − hz, AA zi + ihz, γi + λ (eihz,xi − 1)π(dx)
2 Rd
Z
1 ∗
= − hz, AA zi + ihz, γi + (eihz,xi − 1)ν(dx).
2 R d

A∗ is the transpose matrix of A.

C HARACTERISTIC TRIPLE : (A, ν, γ).

A. Popier (ENSTA) Jump-diffusion processes. January 2020 19 / 34

T WO EXAMPLES .
Jump-diffusion process with Gaussian jumps (used in the Merton
model).

A. Popier (ENSTA) Jump-diffusion processes. January 2020 20 / 34

T WO EXAMPLES .
Kou model where the jump sizes are given by a non symmetric
Laplace distribution.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 20 / 34

S IMULATION .

For the Brownian part Xt = σWt + γt :

1 split the interval [0, t] by a grid t0 = 0 < t1 < . . . < tn = t,
2 simulate n standard Gaussian r.v. Zi ,
p
3 define ∆Xi = σ ti − ti−1 Zi + b(ti − ti−1 ),
i
X
4 put Xi = ∆Xi .
k =1
The simulation is exact on the grid in the sense that Xi has the same
law as Xti . Between Xi and Xi+1 , one can used a linear interpolation.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 21 / 34

S IMULATION .
For the Brownian part Xt = σWt + γt :
1 split the interval [0, t] by a grid t = 0 < t < . . . < t = t,
0 1 n
2 simulate n standard Gaussian r.v. Z ,
p i
3 define ∆X = σ
i ti − t Z
i−1 i + b(ti − ti−1 ),
Xi
4 put X = ∆Xi .
i
k =1
To simulate the compound Poisson part on the interval [0, T ], the
algorithm is :
1 simulate a Poisson r.v. N with parameter λT ,

2 simulate N independent r.v. U with uniform law on [0, T ],

i
3 simulate the jumps : N independent r.v. Y with distribution
i
ν(dx)/λ,
N
X
4 put X =
t 1Ui <t Yi .
i=1
Xt , t ∈ [0, T ], has the asked law without any error.
A. Popier (ENSTA) Jump-diffusion processes. January 2020 21 / 34
O UTLINE

1 J UMP - DIFFUSION PROCESSES

Compound Poisson process
Jump-diffusion processes

2 P ROPERTIES OF JUMP - DIFFUSION PROCESSES

Densities of the jump-diffusion processes.
Moments
Jump-diffusion processes and martingales.
Poisson and Lévy measures

A. Popier (ENSTA) Jump-diffusion processes. January 2020 22 / 34

D EFINITION .

X
Xt = AWt + γt + ∆Xs .
0<s≤t

W : Brownian motion and A matrix.

γ : vector.
ν : finite measure on Rd .
C HARACTERISTIC EXPONENT : for any z ∈ Rd :
Z
1
ψX (z) = − hz, AA∗ zi + ihz, γi + (eihz,xi − 1)ν(dx).
2 Rd

C HARACTERISTIC TRIPLE : (A, ν, γ).

A. Popier (ENSTA) Jump-diffusion processes. January 2020 23 / 34

O UTLINE

1 J UMP - DIFFUSION PROCESSES

Compound Poisson process
Jump-diffusion processes

2 P ROPERTIES OF JUMP - DIFFUSION PROCESSES

Densities of the jump-diffusion processes.
Moments
Jump-diffusion processes and martingales.
Poisson and Lévy measures

A. Popier (ENSTA) Jump-diffusion processes. January 2020 24 / 34

C ONTINUITY OF THE LAW.
L EMMA
If X is a compound Poisson process, then P(Xt = 0) = e−λt .

T HEOREM
Let X be a jump-diffusion process with triple (A, ν, γ). Equivalence :
1 P(Xt ) is continuous for every t > 0,
2 P(Xt ) is continuous for one t > 0,
3 A 6= 0.

C OROLLARY
Equivalence between :
1 P(Xt ) is discrete for every t > 0,
2 P(Xt ) is discrete for one t > 0,
3 A = 0 and ν discrete.
A. Popier (ENSTA) Jump-diffusion processes. January 2020 25 / 34
E XISTENCE OF A DENSITY.

P ROPOSITION
Let X be a d-dimensional jump-diffusion process with triple (A, ν, γ)
with A of rank d. Then the law of Xt , t > 0 is absolutely continuous.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 26 / 34

O UTLINE

1 J UMP - DIFFUSION PROCESSES

Compound Poisson process
Jump-diffusion processes

2 P ROPERTIES OF JUMP - DIFFUSION PROCESSES

Densities of the jump-diffusion processes.
Moments
Jump-diffusion processes and martingales.
Poisson and Lévy measures

A. Popier (ENSTA) Jump-diffusion processes. January 2020 27 / 34

S UBMULTIPLICATIVE FUNCTIONS .
D EFINITION
A function on Rd is under-multiplicative if it is non-negative and if there
exists a constant a > 0 s.t.

∀(x, y ) ∈ (Rd )2 , g(x + y ) ≤ ag(x)g(y ).

L EMMA
1 The product of two submultiplicative functions is submultiplicative.
2 If g is submultiplicative on Rd , then so is g(cx + γ)α with c ∈ R,
γ ∈ Rd and α > 0.
3 Let 0 < β ≤ 1. Then the following functions are submultiplicative.

|x| ∨ 1 = max(|x|, 1), exp(|x|β ), ln(|x| ∨ e), ln ln(|x| ∨ ee ).

4 If g is submultiplicative and locally bounded, then g(x) ≤ bec|x| .

A. Popier (ENSTA) Jump-diffusion processes. January 2020 28 / 34
M OMENTS OF A JUMP - DIFFUSION PROCESS .

T HEOREME
Let g be a under-multiplicative function, locally bounded on Rd . Then
equivalence between
there exists t > 0 s.t. E(g(Xt )) < +∞
for any t > 0, E(g(Xt )) < +∞.
Moreover E(g(Xt )) < +∞ if and only if E(g(Y1 )) < +∞.

Hence E(|Xt |n ) < ∞ if and only if E(|Y1 |n ) < ∞. In particular

E(Xt ) = t (γ + λE(Y1 )) ,

and
Var Xt = t (A∗ A + λVar (Y1 )) .

A. Popier (ENSTA) Jump-diffusion processes. January 2020 29 / 34

E XPONENTIAL MOMENTS .

T HEOREM
Let X be a jump-diffusion process with triple (A, ν, γ). Let
 Z 
d hc,xi hc,Y1 i
C= c∈R , e ν(dx) < +∞ ⇔ Ee < +∞ .
Rd

1 C is convex and contains 0.

2 c ∈ C if and only if E(ehc,Xt i ) < +∞ for some t > 0 or equivalently
for any t > 0.
3 If w ∈ Cd is s.t. Rew ∈ C, then
Z
1
ψ(w) = hw, Awi + hγ, wi + (ehw,xi − 1)ν(dx)
2 Rd

has a sense, E(ehw,Xt i ) < +∞ and E(ehc,Xt i ) = etψ(w) .

A. Popier (ENSTA) Jump-diffusion processes. January 2020 30 / 34

O UTLINE

1 J UMP - DIFFUSION PROCESSES

Compound Poisson process
Jump-diffusion processes

2 P ROPERTIES OF JUMP - DIFFUSION PROCESSES

Densities of the jump-diffusion processes.
Moments
Jump-diffusion processes and martingales.
Poisson and Lévy measures

A. Popier (ENSTA) Jump-diffusion processes. January 2020 31 / 34

P ROCESSES WITH INDEPENDENT INCREMENTS .

P ROPOSITION
Let X be a process with independent increments. Then
!
e ihu,Xt i
1 for every u ∈ Rd , is a martingale.
E(eihu,Xt i )
t≥0
!
e hu,Xt i
2 If E(e hu,X i
t ) < ∞, ∀t ≥ 0, then is a martingale.
E(ehu,Xt i )
t≥0
3 If E(|Xt |) < ∞, ∀t ≥ 0, then Mt = Xt − E(Xt ) is a martingale (with
independent increments).
4 In dimension 1, if Var (Xt ) < +∞, ∀t ≥ 0, then (Mt )2 − E((Mt )2 ) is
a martingale.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 32 / 34

O UTLINE

1 J UMP - DIFFUSION PROCESSES

Compound Poisson process
Jump-diffusion processes

2 P ROPERTIES OF JUMP - DIFFUSION PROCESSES

Densities of the jump-diffusion processes.
Moments
Jump-diffusion processes and martingales.
Poisson and Lévy measures

A. Popier (ENSTA) Jump-diffusion processes. January 2020 33 / 34

P OISSON MEASURES .

D EFINITION
Let (Ω, F, P) by a probability space, E ⊂ Rk , and ρ a measure on
(E, E). A Poisson random measure on E with intensity ρ is a function
with values in N :
M : Ω×E → N s.t.
(ω, A) 7→ M(ω, A),

1 ∀ω ∈ Ω, M(ω, .) Radon measure on E : ∀A ∈ E measurable and

bounded, M(A) < +∞ r.v. with values in N ;
2 ∀A ∈ E, M(., A) = M(A) Poisson r.v. with parameter ρ(A) ;
3 for any A1 , . . . , An disjointed sets, the r.v. M(A1 ), . . . , M(An ) are
independents.

A. Popier (ENSTA) Jump-diffusion processes. January 2020 34 / 34

P OISSON MEASURES .

For a compound Poisson process X with intensity λ and jump

distribution π, (random) measure on [0, +∞[×Rd \ {0} :

∀B ⊂ E = [0, +∞[×Rd \ {0}, JX (ω, B) = #{(t, Xt (ω) − Xt − (ω)) ∈ B}.

P ROPOSITION (P OISSON MEASURE )

JX : Ω × E → N is a Poisson measure on E = [0, +∞[×Rd \ {0} with
intensity
ρ(dt × dx) = dtν(dx) = λdtπ(dx).
We obtain

ν(A) = E(JX ([0, 1] × A)) = E [#{t ∈ [0, 1], ∆Xt 6= 0, ∆Xt ∈ A}] .

Remember that ν is the Lévy measure of X .

A. Popier (ENSTA) Jump-diffusion processes. January 2020 34 / 34

P OISSON MEASURES .

For a compound Poisson process X with intensity λ and jump

distribution π, (random) measure on [0, +∞[×Rd \ {0} :

∀B ⊂ E = [0, +∞[×Rd \ {0}, JX (ω, B) = #{(t, Xt (ω) − Xt − (ω)) ∈ B}.

Moreover we have
Z
E(JX ([0, t] × A)) = tν(A) = tλ π(dx)
A

and Z
X
Xt = ∆Xs = xJX (ds × dx).
0<s≤t [0,t]×Rd

A. Popier (ENSTA) Jump-diffusion processes. January 2020 34 / 34