International Journal of Scientific and Innovative Mathematical Research (IJSIMR) - 3

I nternational J ournal of Scientific and I nnovative Mathematical Research (I J SI MR)
Volume I , I ssue I, August- 2013, PP 1-16

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ARC Page | 1

Margrabe Formulas for a Simple Bivariate Exponential
Variance-Gamma Price Process (I) Theory

Werner Hrlimann
Wolters Kluwer Financial Services,
Seefeldstrasse 69,
CH-8008 Zrich, Switzerland.
werner.huerlimann@wolterskluwer.com

Received: 20-06-2013 Revised: 21-07-2013 Accepted: 24-07-2013

Abstract: For the purpose of simultaneous market consistent valuation of insurance liabilities and/or
asset prices from financial markets, an alternative to the Black-Scholes-Vasicek deflator is derived. It is
based on a simple multivariate exponential variance-gamma process associated to a multivariate Lvy
process, whose components are drifted Brownian motions time changed by a common independent gamma
subordinator. The logarithm of the multivariate variance-gamma deflator is linear in the variance-gamma
components. The practicability of the state-price deflator approach is demonstrated by determining the
price of the Margrabe exchange option with a bivariate exponential variance-gamma real-world or
deflated price process. Applications to both Insurance and Finance are mentioned. In a specialized
bivariate exponential variance-Erlang model, the formulas simplify to analytical closed-form expressions.
Keywords: Black-Scholes model, variance-gamma process, state-price deflator, market price of risk.

1. INTRODUCTION
It has long been observed that insurance liability data and financial returns exhibit non-zero
skewness, kurtosis and heavy tails, which cannot be captured by a Gaussian process. A typical
example is the Black-Scholes-Merton lognormal model used in option pricing. Modern Actuarial
Science and Finance is more and more focusing on alternative stochastic processes that enable the
modeling of non-Gaussian characteristics. However, the construction of multivariate non-
Gaussian processes for the simultaneous modeling of real-world insurance liabilities and/or asset
prices from financial markets is a complex topic, which seldom leads to simple analytical
formulas. Moreover, for market consistent valuation one needs to deflate these processes with so-
called state price deflators or use an equivalent martingale measure for deflated price processes as
argued in the Remarks 4.1. Though general frameworks for deriving state-price deflators exist
(e.g. [1], [2]), there are not many papers, which propose explicit expressions for them and their
corresponding distribution functions.
The goal of our contribution is two-fold. First, we propose an alternative to the multivariate
Black-Scholes-Vasicek (BSV) deflator introduced in [3] (see also [4]). For the interested reader
we remark that the article [5] contains an extension of the Black-Scholes deflator to a more
general version with interest rates as additional source of randomness. From a mathematical
viewpoint, it is natural to investigate other generalizations, namely the consideration of alternative
asset price processes for use in incomplete financial markets. Indeed, let us assume that asset
prices admit no arbitrage. Then, there exists a unique state-price deflator if, and only if, the
market is complete. Otherwise, if the market is incomplete, several state-price deflators exist and
pricing is not uniquely defined. Therefore, the study of state-price deflators is motivated by one of
Margrabe Formulas for a Simple Bivariate Exponential Variance-Gamma Price Process (I) Theory
International J ournal of Scientific and Innovative Mathematical Research (IJ SIMR) Page | 2

the main problems of Modern Finance, which consists to understand the pricing of arbitrary
portfolios in incomplete markets.
A valuable and popular competitor to the ubiquitous multivariate exponential Gaussian process is
the multivariate exponential variance-gamma process presented in Section 2. It is obtained from a
multivariate Lvy process, whose components are drifted Brownian motions time changed by a
common independent gamma subordinator. This process has been previously considered in [6]
and [7]. For a better understanding of the state-price deflator approach, we recall briefly in
Section 3 the construction of the BSV deflator. Proceeding similarly, the logarithm of the
multivariate variance-gamma deflator is assumed to be linear in the variance-gamma components
and its coefficients are explicitly determined in Theorem 4.2.
As second goal, the practicability of the present state-price deflator approach is demonstrated by
pricing the Margrabe exchange option with a bivariate exponential variance-gamma real-world or
deflated price process. Theorem 5.1 displays Margrabe formulas for the bivariate exponential
variance-gamma real-world price process. Analytical closed-form expressions are obtained for the
bivariate exponential variance-Erlang special case. Based on the VG deflator, we derive in
Theorem 6.1 Margrabe formulas for the corresponding deflated price processes. Example 6.1
illustrates by comparing Margrabe option prices in the bivariate Black-Scholes model and the
bivariate variance-Erlang model. Section 7 is devoted to further discussion and conclusions.
Remaining technicalities are proved in Appendix 1 and 2. Statistical estimation of the multivariate
variance-gamma model and an application to stock market indices are presented in [8].
2. A SIMPLE MULTIVARIATE VARIANCE-GAMMA PROCESS
In its original representation, the univariate VG process is defined as a drifted Brownian motion
time changed by an independent gamma process. Viewed from the initial time 0 it is defined by
, 0 , > + = t W G X
t
G t t
t u (2.1)
where
t
W is a standard Wiener process and the independent subordinator (i.e. an increasing,
positive Lvy process) ) , ( ~
1 1
I v v t G
t
is a gamma process with unit mean rate and variance
rate v . Since
t
X is a Lvy process, the dynamics of the VG process is determined by its
distribution at unit time. In fact, the random variable ) , , ( ~ :
1
v t u VG X X
t=
= follows a three
parameter distribution with cumulant generating function (cgf)
< < > = =

u v t vt vu v , 0 , ), 1 ln( ] ) exp( [ ln ) (
2 2
2
1
1
u u uX E u C
X
. (2.2)
One notes that the cgf is only defined over the open interval
1 2 2 1 2 2
) 2 ) ( ( 2 ) 2 ) ( ( 2

+ + < < + vu vt vu vu vt vu u . (2.3)
The formula (2.2) is obtained from the cgf of the gamma random variable ) / 1 , / 1 ( ~ :
1
v v I =
= t
G G
by conditioning using that ) , ( ~
2
G G N G X t u is normally distributed. Since the distribution
of ) , , ( v t u VG is infinitely divisible, the VG process has independent and stationary increments,
which also follow a VG distribution, namely
. 0 ), / , , ( ~ t s t t t VG X X
s s t
< s
+
v t u (2.4)
The symmetric case 0 = u is used in the original model by [9] and [10]. The VG process has
been studied at many places (e.g. [11]-[14]). It is a special case of the bilateral gamma process
and other tempered stable processes considered in many recent papers (e.g. [15]-[19]).
Several multivariate versions of the VG process have been considered so far. Madan and Seneta
[9] first introduced a multivariate symmetric VG process by subordinating a multivariate
Brownian motion without drift by a common gamma process. The asymmetric version of this
Werner Hrlimann

model has been developed in Cont and Tankov [6] and Luciano and Schoutens [7]. Generalizing
(2.1) these authors consider multivariate Lvy processes with VG components of the type
, ,..., 2 , 1 ,
) ( ) (
n k W G X
k
G k t k
k
t
t
= + = t u (2.5)
where the
) (k
t
W s are correlated standard Wiener processes such that dt dW dW E
ij
j
t
i
t
= ] [
) ( ) (
.
More complex multivariate VG models have also been considered (e.g. [20]-[24]). Despite all its
shortcomings, the use of the model (2.5) is justified theoretically by looking at the variance of its
VG margins ) , , ( ~ :
) (
1
) (
v t u
k k
k
t
k
VG X X
=
= at unit time, namely
2 2 ) (
] [
k k
k
X Var u v t + = . (2.6)
Each variance decomposes into an idiosyncratic component
2
k
t , that is attributed to the Brownian
motion, and an exogenous component
2
k
v u , that is due to the gamma distributed time change of
the Brownian motion. The parameters
k
u govern the exposures of the margins to the global
market uncertainty measured by the common parameter v . Similarly, one notes that the skewness
and kurtosis are also affected by the single marginal settings and the common parameter v . On
the other hand, the statistical moment method developed in [8] and its successful application to
real-world data justifies its use in practical work. To fix ideas, and for the sake of simplicity, the
first focus is therefore on the model (2.5). The joint cgf of this multivariate process can be
expressed in closed-form.
Proposition 2.1 (cgf of the multivariate VG process) The joint cgf of the multivariate VG process
) / , , ( ~ ) ..., , (
) ( ) 2 ( ) 1 (
t t t VG X X X X
n
t t t t
v u E = with parameters ( )
n
u u u u ,..., ,
2 1
= , ( )
j i ij
t t = E , is
determined by
) ,..., , ( )}, ( 1 ln{ ) (
2 1 2
1
1
n
T T
X
u u u u u u u t u C
t
= E + =

u v v . (2.7)
Proof Since the conditional margins are normally distributed as ), , ( ~
2 ) (
t k t k t
k
t
G G N G X t u one
obtains the representation (2.7) from the following calculation
)]. ( [exp E ln ]] ) exp( [E[ E ln ] ) exp( [ ln ) (
2
1
G G
t t
t
T
t
T
t t
T
t
T
X
uG u uG G X u X u E u C
t
E + = = = u
Remarks 2.1 The random vector at unit time ) ,..., , (
) ( ) 2 ( ) 1 ( n
X X X X = of the special case 1 = v
has a so-called multivariate asymmetric Laplace distribution, denoted ) , ( ~ E u AL X , that has
been extensively studied in the monograph [26] (see also [27]). The parameter estimation of the
shifted version ) ,..., ( ), , , ( ~
1 n
AL X u = E + , has been discussed in [28] and [25]. The
method is extended in [8] to the statistical estimation of the shifted variance-gamma
model ) , , ( v u E +VG .
3. THE BLACK-SCHOLES-VASICEK DEFLATOR
Recall the Black-Scholes-Vasicek (BSV) deflator introduced in [3]. Consider a multiple risk
economy with 1 > n risky assets, whose real-world prices follow lognormal distributions. Given
the current prices of these risky assets at initial time 0 we assume that the future prices at time
0 > t are described by exponential Brownian motions of the type
n k W v t m S S
k
t
k
t k
k
t
k k
t
,..., 2 , 1 ), ) exp((
) ( ) ( 2
2
1
) ( ) (
0
) (
= + = o , (3.1)
where the
) (k
t
W s are correlated standard Wiener processes such that dt dW dW E
ij
j
t
i
t
= ] [
) ( ) (
.
We assume that the correlation matrix ) (
ij
= E is positive semi-definite with non-vanishing
determinant. The quantities
) (k
t
m and
) (k
t
v are interpreted as mean and standard deviation per

time unit of the k -th asset logarithmic return
) (k
t
r over the interval | | t , 0 , and
k
o is a constant
volatility parameter. The representation (3.1) includes two popular asset pricing models:
Black-Scholes model:
) ( ) ( k
t k k
k
t
dW dt dr o + = with
k
k
t
m =
) (
, .
) (
k
k
t
v o =

Vasicek (Ornstein-Uhlenbeck) model:
) ( ) ( ) (
) (
k
t k
k
t k k
k
t
dW dt r b a dr o + = with
t
e b
m
t a
k k
t
k
) 1 (
) (

= , .
2
1
2
) (
t a
e
v
k
t a
k
k
t
k
= o
The economic model contains also a risk-free asset, which is assumed (for simplicity) to
accumulate at a constant rate r per time unit. The BSV deflator of dimension n has the same
form as the price processes in (3.1), i.e.
, 0 ), exp( > = t W t D
t
T
t t t
| o (3.2)
for some time dependent parametric function
t
o and vectors , ) ..., , (
, 2 , 1 ,
T
n t t t t
| | | | =
) ..., , (
) ( ) 2 ( ) 1 ( n
t t t t
W W W W = . To define a state-price deflator the stochastic processes (3.1) and (3.2)
must satisfy the martingale conditions
, ,..., 2 , 1 , 0 , ] [ , ] [
) (
0
) (
n k t S S D E e D E
k k
t t
rt
t
= > = =

(3.3)
where ] [ E denotes conditional expectation with respect to the information at initial time 0.
Theorem 3.1 (BSV deflator of dimension n ) Given is a financial market with a risk-free asset
with constant rate of return r and 1 > n risky assets that have log-normal real-world prices
(3.1). Assume a non-singular positive semi-definite correlation matrix ) (
ij
= E . Then, the BSV
deflator (3.2) is determined by
, 0 ), exp( > = t W t D
t
T
t t t
| o with (3.4)
. ,..., 2 , 1 ), ] [ (
, ) ..., , ( , , ) (
2 ) ( 2
2
1
) ( ) (
,
, 2 , 1 ,
1
2
1
1
n k v r m v
r C r
k
t k
k
t
k
t k t
T
n t t t t t t t
T
t t W t
t
= =
= E = E + = + =

=
o
| | | | o
(3.5)
The quantity
k t ,
is called market price of the k -th risky asset at time t .
Proof The martingale conditions (3.3) are equivalent with the system of linear equations
0
2
1
= E + +
t
T
t t
r | | o and
t t
| = E (see [3], proof of Proposition 2).
4. A STATE-PRICE DEFLATOR FOR THE MULTIVARIATE EXPONENTIAL VG PROCESS
We begin with the construction of the univariate VG deflator. Consider the following asset
pricing model. Given the current price of a risky asset at time 0, its future price at time 0 > t is
described by an exponential VG process
, ), ) exp((
0
t
G t t t t
W G X X t S S t u e + = + = (4.1)
where represents the mean logarithmic rate of return of the risky asset per time unit and
0 )) ( 1 ln( ) 1 (
2
2
1
1
> + = =

t u v v e
X
C . (4.2)
To obtain (4.2) one uses the defining relationship ) exp( ] [
0
t S S E
t
= and the expression (2.7) for
the univariate cgf. The VG deflator has the same form as the price process in (4.1). For some
parameters | o, (to be determined) one sets
Werner Hrlimann

. 0 ), exp( > = t X t D
t t
| o (4.3)
Now, a simple cgf calculation shows that the state-price deflator martingale conditions
, 0 , ] [ , ] [
0
> = =

t S S D E e D E
t t
rt
t
(4.4)
are equivalent with the system of two non-linear equations in the three unknowns e | o , , :
. 0 ) ) 1 ( ) 1 ( 1 ln(
, 0 ) 1 ln(
2 2
2
1
1
2 2
2
1
1
= +
= + +
| vt | vu v e o
| vt vu| v o r
(4.5)
Inserting the first equation into the second one yields the necessary relationship
. 0 )} ) 1 ( ) 1 ( 1 ln( ) 1 {ln(
2 2
2
1
2 2
2
1
1
= + +

| vt | vu | vt vu| v e r (4.6)
As the system (4.5) has one degree of freedom, the unknown e can be chosen arbitrarily, say
r = e , (4.7)
which is interpreted as the (time-independent) VG market price of the risky asset. With the
restriction (4.2) on the VG parameters this value is always positive. Inserted into (4.6) and using
(4.2) shows that the parameter | is determined by the two alternate expressions
)). exp( 1 (
1 2
2
1
2
ve v t u |t = + =

(4.8)
In particular, comparing the first and third term in (4.8) shows that the parameter | is a simple
exponential transform of the market price, which is equivalent to the logarithmic relationship
). 1 ln(
2 1
v|t v e = =

r (4.9)
With the Mercator series for the logarithm, one sees that the VG market price of risk is given by
, ... ) ( ) (
2
2
1
2 2 2
2
1
2
1
2
1
1
t u |t |t v |t v|t v e + = ~ + + = = =

=
j
j
j
r (4.10)
where the last equality in the first order approximation follows from (4.8). Summarizing and
rearranging the above one obtains the following VG deflator representation.
Theorem 4.1 (univariate VG deflator) Given is a risk-free asset with constant return r and a
risky asset with real-world price (4.1). Then, the VG deflator (4.3) is determined by
, 0 ), , ( ~ ), ) ( exp(
1 1 2
2
1
> I =

t t G W G t D
t G t t
t
v v |t t | | o with (4.11)
. ), ) 1 ( 1 ln( ) (
2
2
1
2 2
2
1
1
t u |t t | v| v | o + = = + =

r C r
X
(4.12)
Next, consider 2 > n risky assets. Given the current prices of these risky assets at initial time 0
their future prices at time 0 > t are described by exponential VG processes of the type
n k X t S S
k
t k k
k k
t
,..., 2 , 1 ), ) exp((
) ( ) (
0
) (
= + = e , (4.13)
where
k
represents the mean logarithmic rate of return of the k -th risky asset per time unit,
the random vector process ) ,.., ,. (
) ( ) 2 ( ) 1 ( n
t t t t
X X X X = follows a simple multivariate VG process
with cgf (2.7), and similarly to (4.2) one has
. 0 )) ( 1 ln(
2
2
1
1
> + =

k k k
t u v v e (4.14)
The VG deflator of dimension n has the same form as the price processes in (4.13). For some
parameter o and vector ) ,..., , (
2 1 n
| | | | = (both to be determined) one sets

. 0 ), exp( > = t X t D
t
T
t
| o (4.15)
In this situation, the martingale conditions, which define the state-price deflator, are equivalent
with the non-linear system of 1 + n equations in the 1 2 + n unknowns
k k
e | o , , (use the
explicit form of the cgf (2.7)):
, ,..., 2 , 1 , 0 )} ( 1 ln{
, 0 )} ( 1 ln{
) ( ) (
2
1
) ( 1
2
1
1
n k
r
k
T
k k T
k k
T T
= = E + +
= E + +
| | | u v v e o
| | | u v v o
(4.16)
with the vector notation n k j
j
k
j
k
j
k
n
k k k
,..., 2 , 1 , , ), ,..., , (
) ( ) ( ) (
2
) (
1
) (
= = = | o | | | | | . As the system
(4.16) has n degrees of freedom, the unknowns
k
e can be chosen arbitrarily. A convenient
appropriate choice, which leads to a simple solution of the system (4.16), consists to set
, r
k k
= e (4.17)
which is interpreted as the (time-independent) VG market price of the k -th risky asset. Now,
inserting the first equation of (4.16) into the second ones taking into account (4.17) yields
. ,..., 2 , 1 ), ( 1 ) ( 1
) ( ) (
2
1
) (
2
1
n k
k
T
k k T T T
= E + = E + | | | u v | | | u v (4.18)
A straightforward calculation shows that the components of the parameter vector | are
determined by the two alternate expressions (use (4.14) for the second one)
, ,..., 2 , 1 , , )) exp( 1 (
2 1 2 2
2
1
2
n k
k j
k
j
kj k k k k k k k k k k
= = + = + + =
=
t
t
t ve v t t u t | (4.19)
which generalize the relation (4.8). In particular, comparing the first and third term in (4.19)
shows that the parameters
k
| are simple exponential transforms of the market prices of risk,
which are equivalent to the logarithmic relationships
. ,..., 2 , 1 ), ) ( 1 ln(
2 1
n k
k k k k
= =

t | v v e (4.20)
Similarly to (4.10) one obtains the series expansions and the first order approximations for the VG
market prices of the risky assets
, ) (
... ] ) ( [ ) ( ] ) ( [
2
2
1
2
2 2
2
1
2
1
2
1
1
k k k k k
k k k k k k
j
j
k k k j k
t u t |
t | v t | t | v v e
+ = ~
+ + = =

=
(4.21)
where the last equality follows from (4.19). Summarizing and rearranging the above one obtains
the following multivariate VG deflator representation.
Theorem 4.2 (VG deflator of dimension n ) Given are 2 > n risky assets with real-world prices
(4.13), where the random vector process ) ,..., , (
) ( ) 2 ( ) 1 ( n
t t t t
X X X X = follows a multivariate VG
process. Then, the VG deflator (4.15) is determined by
, 0 ), exp(
) (
1
> =
=
t X t D
k
t
n
k
k t
| o with (4.22)
. ,..., 2 , 1 , , ) ( ), (
2
2
1
2
1
n k C r
k j
k
j
kj k k k k k k X
t
= = + + = + =
=
=
t
t
t u t | | o (4.23)
Remarks 4.1 It is instructive to note that (3.2) and (4.15) correspond to an Esscher transformed
measure that has long been used in option pricing (e.g. [29]). Moreover, an important connection
with the standard no-arbitrage framework of Mathematical Finance must be mentioned (e.g. [30],
Section 2.5, and [31], Chap. 2). By the Fundamental Theorem of Asset Pricing, the assumption of
no-arbitrage (weak form of the efficient market hypothesis) is equivalent with the existence of an
Werner Hrlimann

equivalent martingale measure for deflated price processes. In complete markets, the equivalent
martingale measure is unique, perfect replication of contingent claims holds, and straightforward
pricing applies. In incomplete markets, an economic model is required to decide upon which
equivalent martingale measure is appropriate. Now, let P denotes the real-world measure and
*
P an equivalent martingale measure. Then, one can either work under P , where the price
processes are deflated with a state-price deflator. Alternatively, one can work under
*
P by
discounting the price processes with the bank account numeraire. Working with financial
instruments only, one often works under
*
P . But, if additionally insurance liabilities are
considered, one works under P (see [30], Remark 2.13). A non-trivial example is pricing of the
guaranteed maximum inflation death benefit (GMIDB) option (equation (5.4) in [4]). In the
present paper, we demonstrate the practicability of the state-price deflator approach for
exponential variance-gamma price processes of Margrabe type used in insurance and financial
markets. In insurance, the Margrabe option has been discussed by [32], [33], [34], Sections V.4 to
V.6, [30], Section 4. On the other hand, [8] offers an alternative approach to calibration based on
a novel multivariate statistical moment method that uses besides means and covariances also the
coskewness and cokurtosis tensors. A real-world comparison of the exponential variance-gamma
model with the ubiquitous Black-Scholes model for pricing the Margrabe option is also made.
5. MARGRABE FORMULA FOR THE REAL-WORLD PRICE PROCESS
Given is the shifted version ) ,..., , ( ,
2 1 n t
X t = + , of the Lvy process induced by the unit
time shifted multivariate VG random vector ) , , , ( ~ v u E + VG X . We assume that future
values of financial entities at time 0 > t are described by exponential VG processes of the form
n k X t S
k
t k
k
t
,.., 2 ,. 1 ), exp(
) ( ) (
= + = . (5.1)
This general framework enables simultaneous modelling of real-world insurance liabilities and/or
asset prices from financial markets. For market consistent valuation one needs to deflate them
with so-called state price deflators, as explained in the Remarks 4.1, which will be done in the
next Sections. In both settings we derive integral and closed-form formulas for the two-
dimensional Margrabe exchange option, here of the real-world type
0 ], ) [(
) 2 ( ) 1 (
> =
+
t S S E M
t t
R
t
. (5.2)
Therefore, the bivariate case 2 = n in (5.1) is of interest and for this we set
12
= . For
simplicity and without loss of generality, it suffices to discuss the unit time case 1 = t . By abuse
of notation, the time index is removed from any stochastic process in the following. Conditioning
on the common gamma subordinator, one can write
. ), ( / ) ( ) ( ], ) [( ) (
, ) ( ) ( ] ) [(
1 1 ) 2 ( ) 1 (
0
) 2 ( ) 1 (

+
+
= I = = =
}
= =
v
w R
R R
e w w f w G S S E w M
dw w f w M S S E M
(5.3)
As usual ) (x u denotes the standard normal distribution, ) ( 1 ) ( x x u = u is the survival
function, and ) ( ' ) ( x x u = is the density. The bivariate standard normal density is denoted by
( ) { }
2 2
) 1 ( 2
1
) 1 ( 2
1
2
2 exp ) ; , (
2
2
y xy x y x + =

t
.
By definition (2.5) one obtains
} }
=

+
+ + + +
dxdy y x e e w M
y w w x w w R
) ; , ( ) ( ) (
2
2 2 2 1 1 1

t u t u
. (5.4)

The expression in the bracket of (5.4) is non-negative provided ) ( y x x >
with y w
w
y x
1
2
1
1 2
1
1 2
) (
) (
t
t
t
u u
t

+
= . Now, it is possible to separate the double integral as

}
=

dy y w y J w M
R R
) ( ) , ( ) ( , because
2 2
2
1 / ) 1 / ) (( ) ( ) ; , ( = y x y y x . With this
the inner integral reads
}
=

+ + + +
) (
2 2
) 1 / ) (( } { ) 1 / 1 ( ) , (
2 2 2 1 1 1
y x
y w w x w w R
dx y x e e w y J
t u t u
. (5.5)
A straightforward application of Lemma A1.1 in the Appendix 1 yields
) ( ) 1 ( ) , (
2
2 2 2
2
2
1
2
2
1
1 1 1
1
) (
1
2
1
) (
) 1 (
t u
t t u
t

+ +
+ + +
u + u =
y x y y w w y x y
w y w w
R
e w e w y J .
Taking into account the above definition of the auxiliary function ) ( y x , one rewrites the
arguments inside the normal distribution functions as
, , 1
2 2
1
) (
1
2
1
) (
cy b cy a w
y x y y x y
+ = + = +

t with
2
1
2 1
2
1
2 1 2 1
2
1
2 1
2
1
2
2 1
1 1
) (
1
) ) 1 ( (
, ,
t
t t
t
u u
t
t u u
+ +
= = = c b a
w
w
w
w
.
Furthermore, one notes that
) ( ) ( ), ( ) (
2 1
2
2
2
1
2
2
1
2
2
1
1
w y e y e w y e y e
w
y w
w
y w
t t
t
t
t
t
= = .
Now, using twice the Lemma A1.2 of the Appendix 1 one obtains
) ( ) ( ) (
2
2
2
2
2
1
2 2
2
1
2
1
2
1
1 1
1
) (
1
) (
c
w c b w
c
w c a w
R
e e w M
+
+ + +
+
+ + +
u u =
t t u t t u
.
An algebraic calculation based on the expressions for the coefficients c b a , , yields further
. , 2 , 1 ,
), ( ) ( ) (
2
2
2
1 2 1
2 2
) ( ) (
2 1
2
2 2 1
2
2
2
1
2 2 2 1
2
1 2 1
2
1
2
1
1 1
e e e t t t e
e

e
e u u t u
e

e
e u u t u
+ = = =
+ u + u =
+ + + + +
k
w e w e w M
k k
w
w
w
w
R
(5.6)
We are ready for the following result.
Theorem 5.1 (Margrabe formula for the real-world exponential shifted bivariate VG process)
Given is the bivariate process at unit time 2 , 1 ), exp(
) ( ) (
= + = k X S
k
k
k
, with
) , , , ( ~ v u E + VG X . With
1
12
,

= = v , , , 2 , 1 ,
2
2
2
1 2 1
2 2
e e e t t t e + = = = k
k k
one has
.
) (
, 2 , 1 ,
) 1 (
), (
, ) / ( ) ( / 1 ) , , , (
), , , , ( ) , , , ( ] ) [(
2 1
2 1
2 1 2
2
1
1
0
1
2 2 1 1
) 2 ( ) 1 (
2 1
e

e
e u u
t u

= =
+
= + =
}
+ u I = +
+ + = =

+
c k b a
dz z c z b e e z c b a
c b a e c b a e S S E M
k
k
k k k k
az z
R
(5.7)
Proof It remains to insert (5.6) into (5.3) and make the change of variables w z = .
Remark 5.1 One observes that the +-function in (5.7) is related to the one stated in [26], p.296
(European risk-neutral call-option price for an exponential VG price process).
A particular instance, for which the formula (5.7) simplifies considerably, is the special
case 0 = c , that is
2 1
= , which is analyzed into more details. In this situation, the +-function
Werner Hrlimann

simplifies to the calculation of the expression (make the change of variables ) 1 ( 2 /
2
a x z =
under the assumption 1 < a )
,
) 1 ( 2
) (
] ) 1 ( 2 [ 2
) , 0 , , (
-
|
|
.
|
\
|
I

= +
a
b
L
a
b a

(5.8)
with the integral function of normal type
dx x z x x z L
}
u =

0
1 2
) ( ) ( 2 ) ( t

. (5.9)
The assumption 1 < a in (5.8) means that (5.7) will be finite for 0 = c
provided 2 , 1 , 1 ) (
2
2
1
1
= < + =

k a
k k k
t u , a condition, which is equivalent with the existence of
the cgf ) 1 ln( ) (
k k SG
a a C = of a standard gamma random variable with shape parameter
and scale parameter 1. In case the gamma distributed subordinator ) , ( ~ t G
t
I reduces to an
Erlang distributed subordinator ) , ( ~ m t m Erlang G
t
with integer parameter ,... 2 , 1 = m , the
integral function (5.9) can be evaluated according to the following closed-form formula (proof in
Appendix 2):
,... 2 , 1 , )
) 1 ( ! 2
! )! 1 2 (
1 ( 1 )! 1 ( 2 ) (
1
1
2
1
2
2
=
|
|
.
|
\
|
+ + =

=
+
m
d k
k
m d L
m
k
k k
d
d
m
m
. (5.10)
6. MARGRABE FORMULA FOR THE DEFLATED PRICE PROCESS
Consider the Margrabe exchange option for the deflated price process in (5.1) such that
0 ], ) ( [
) 2 ( ) 1 (
> =
+
t S S D E M
t t t
D
t
. (6.1)
The state-price deflator is of the form (4.22) with 2 = n . As in Section 5, we set
12
= and
discuss the unit time case 1 = t . Conditioning on the common gamma subordinator, one writes
. ), ( / ) ( ) ( ], ) ( [ ) (
, ) ( ) ( ] ) ( [
1 1 ) 2 ( ) 1 (
0
) 2 ( ) 1 (

+
+
= I = = =
}
= =
v
w D
D D
e w w f w G S S D E w M
dw w f w M S S D E M
(6.2)
Similarly to (5.5) it is possible to separate the double integral as
}
=

dy y w y J w M
D D
) ( ) , ( ) (
with the inner integral
.
) (
) (
, ) 1 / ) (( 1 / 1 ) , (
1
2
1
1 2
1
1 2
) (
2
) )( 1 ( ) (
) ( ) )( 1 (
2
2 2 2 1 1 1 2
2 2 2 1 1 1 1
y w
w
y x
dx y x
e
e
w y J
y x
y w w x w w
y w w x w w
D
t
t
t
u u
t

t u | t u | o
t u | t u | o
+
=
}

=

+ + +
+ + +
(6.3)
A straightforward application of Lemma A1.1 in the Appendix 1 yields
). 1 (
) ) 1 ( 1 ( ) , (
1 1
2
1
) (
) 1 ( ) )( 1 (
1 1
2
1
) (
) 1 )( 1 ( ) 1 ( ) ( ) 1 (
2
2
1
2
1
2
2
1
1 1 2 2 2 1 1 2
2
2
1
2
1
2
2
1
1 1 2 2 2 1 1 1
w e
w e w y J
y x y
w y w y w w w
y x y
w y w y w w w
D
t |
t |
t | t | t u | u | o
t | t | t u | u | o
u
+ u =
+ + +
+ + + +

Taking into account the definition of the auxiliary function ) ( y x , one rewrites the arguments
inside the normal distribution functions as

, 1 , ) 1 ( 1
1 1
2
1
) (
1 1
2
1
) (
2 2
cy b w cy a w
y x y y x y
+ = + = +

t | t |

with
. , ,
2
1
2 1
2
1
2 1
2
1 1
2
2 1
2
1
2 1
2
1 1
2
2 1
1 1
) ) 1 ( (
1
) ) 1 )( 1 ( (
t
t t
t
t | u u
t
t | u u
+ +
= = = c b a
w
w
w
w

Furthermore, one notes that
{ }
{ }
{ }
{ }
{ }
{ } ). ) 1 ( ( ) (
), ) 1 ( ( ) (
1 1 2 2
) 1 (
) 1 (
2 2 1 1
) 1 (
) 1 (
2
1 1 2 2
2
1
1 1 2 2
2
2 2 1 1
2
1
2 2 1 1
w y e y e
w y e y e
w
y w
w
y w
t | t |
t | t |
t | t |
t | t |
t | t |
t | t |
=
=

Now, using twice the Lemma A1.2 of the Appendix 1 one obtains
{ } { }
{ } { }
). (
) ( ) (
2
1 1 2 2
2
1
2
1
2
1
2 1 2 1 1
2
2
2
2
2
1
2 2 2
2
2 2 1 1
2
2
2
2
2
1
2 1 1 2 2
2
1
2
1
2
1
1 1 1
1
) 1 ( ) ) 1 ( ( ) 1 ( ) 1 (
1
) 1 ( ) ) 1 ( ( ) 1 ( ) 1 (
c
w c b w
c
w c a w
D
e
e w M
+
+ + + + +
+
+ + + + +
u
u =
t | t | t | t t | u | t | t | o
t | t | t | t t | u | t | t | o
(6.4)
Repeated use of the following relationships for
2 1
, | | in (3.23) is made:
. 2 , 1 ,
2 1
2
2
1
2
= + + = k
k k k k
t t t u t | (6.5)
An algebraic calculation based on the expressions for the coefficients c b a , , yields
{ }
{ }
. , 2 , 1 ,
, ) ( ,
, ) ( ,
2
2
2
1 2 1
2 2
2 1 2
1
2 2
1
) 1 (
2 1 2
1
1 1
1
) 1 (
2 1 2 1
2
1 1 2 2
2 1 2 1
2
2 2 1 1
e e e t t t e
| | e
| | e
e
t t
e
t | t |
e
t t
e
t | t |
+ = = =
+ = + =
+ = + =
+
+
+
+
k
b w b
b w b
k k
w
c
w c b
w
c
w c a
(6.6)
Furthermore, the coefficients of w in the curly brackets of (6.4) are respectively equal to
. ) 1 ( , ) 1 (
2
1
2 1 1 2 2
1
2 1 2 1
| | | u t t | | | | u t t | E + = E + =
T T T T
a a (6.7)
We are ready for the following result.
Theorem 6.1 (Margrabe formula for the deflated exponential shifted bivariate VG process)
Given is the bivariate process at unit time 2 , 1 ), exp(
) ( ) (
= + = k X S
k
k
k
, with
) , , , ( ~ v u E + VG X , the bivariate deflator ) exp(
) 2 (
2
) 1 (
1
X X D | | o = of Theorem 4.2,
and set
1
12
,

= = v , . , 2 , 1 ,
2
2
2
1 2 1
2 2
e e e t t t e + = = = k
k k
Then one has
.
) (
, 2 , 1 ), ) ( ) 1 ( (
), ) 1 (( ), ) 1 ((
, ) / ( ) ( / 1 ) , , , (
), , , , ( ) , , , ( ] ) ( [
2 1 2 1
2 1
1
2
1
1
2
1
2 1 1
1
2 2
1
2 1 2
1
1
0
1
2 2 1 1
) 2 ( ) 1 (
2 1
e

e
t t
| | e
| | | u t t | | | | u t t |

o o
= = + =
E + = E + =
}
+ u I = +
+ + = =

+
c k b
a a
dz z c z b e e z c b a
c b a e c b a e S S D E M
k
k
T T T T
az z
D
(6.8)
Proof It remains to insert (6.4) into (6.2), make the necessary identifications based on (6.6) and
(6.7), and perform the change of variables w z = .
In the special case 0 = c , that is
2 1
= , and if 2 , 1 , 1 = < k a
k
, the expression (6.8) can be
evaluated using the formula (5.8) for the +-function. Specializing further to a shifted simple
bivariate variance-Erlang price process with integer parameter ,... 2 , 1 = = m , one obtains via
(5.10) closed-form Margrabe formulas.
Example 6.1 Bivariate Black-Scholes versus bivariate variance-Erlang models
Werner Hrlimann

It is interesting to compare the classical closed-form formula by Margrabe [35] with closed-form
variants obtained from (6.8). In the bivariate Black-Scholes model the future prices at unit time
1 = t are described by the equations (3.1), that is
, 2 , 1 ), exp(
2
2
1
) (
0
) (
1
= + = k Z S S
k k k k
k k
o o (6.9)
where the
k
Z s are correlated standard normal with correlation coefficient
BS
. The means and
variance-covariance characteristics of (6.9) are given by
. 2 , 1 , }, 1 ) {exp( ] , [
), exp( ] [
) (
1
) (
1
) (
0
) (
1
= = =
= =
j i E E S S Cov V
S S E E
j i
BS
ij
BS
j
BS
i
j i BS
ij
i
i i BS
i
o o
(6.10)
For illustration set 2 , 1 , 0 , 1
) (
0
= = = k S
k
k
. Applying the Black-Scholes deflator from Theorem
3.1 one obtains Margrabes classical exchange option price at initial time 0 = t (e.g. [3],
Theorem 2)
2 1
2
2
2
1 2
1
) 2 (
1
) 1 (
1 1
2 , 1 ) ( 2 ] ) ( [ o o o o o o
BS BS
S S D E M + = u = =
+
. (6.11)
In the bivariate variance-Erlang model (with closed-form exchange option price) the future prices
at unit time 1 = t are described by equations of the form (5.1) such that
2 , 1 , ), exp(
) (
1
= + = + = k Z W W X X S
k k k k k
k
t u , (6.12)
with ) ( ~ m Erlang W , and the
k
Z s are correlated standard normal with correlation coefficient
VE
. The corresponding means and variance-covariance characteristics are
. 2 , 1 , , } 2 1 ln( 2 exp{ ] , [
, )}, 1 ln( exp{ ] [
) (
1
) (
1
2
2
1
) (
1
= = =
+ = = =
j i E E m S S Cov V
m S E E
BS
j
BS
i j i
Ve
ij j i
j i VE
ij
i i i i
i VE
i
t t o o
t u o o
(6.13)
It is natural to compare both models under equal first and second order moments. In case
2 , 1 , 0 , 1
) (
0
= = = k S
k
k
, the equations of equal mean and variance-covariance, which consists to
equate (6.10) and (6.13), result into the following parameter constraints
.
2 1
) 1 (
ln ,
2 1
) 1 (
ln
), ( , ), 1 ln(
2 1 1
2
1
2 1
2
1
2
1 2
2
2
2
1
2
1
1 2
2
1
2
1
1 1 2 1
|
|
.
|
\
|

=
|
|
.
|
\
|

=
= + = = =
t t o
o
o o
t o
o
o
t t u u t u o o o
VE
BS
k
k
m m
m
(6.14)
Calculation of the deflated exchange option price (6.8) requires the parameters of the VG deflator
in (4.23), which are herewith determined by
2 , 1 , ), (
2 1
2
2
1
2
) , (
2 1
= + + = + = k C r
VE
k k k k X X
t t t u t | | o . (6.15)
For the bivariate symmetric Laplace special case 1 = m with the simple parameter choice
t t t u u = = = = =
1 2 1 2
, 0 , 0
VE
, one obtains (6.16)
2
1
2 1
2
4
1
) , (
), 1 ln( ) (
2 1
= = = + = | | t | o r C r
X X
. (6.17)
The remaining parameters in (6.8) take the values
t t t
2
2
2 2
2
1
2
4
1
1 2
, , = = = = b b a a . (6.18)
A straightforward calculation of (6.8) using (5.8) and (5.10) for 1 = m yields the symmetric
Laplace Margrabe option price
2
) 1 ( ] ) ( [
2
2
1
) 2 (
1
) 1 (
1 1
t
t = =

+
r SL
e S S D E M . (6.19)

Numerically, if 1 . 0 , 0 = = t r , then 0.14249 = o , and 5.67991% =
BS
M compares with
4.975% =
SL
M . The follow-up [8] provides some comparisons based on stock market indices.
7. RESULTS, FURTHER DISCUSSION AND CONCLUSIONS
First, it is useful to summarize what has been accomplished. The starting point is the wish to
enrich multidimensional option pricing with some multivariate non-Gaussian models able to
capture skewness, kurtosis and other stylized facts from observed insurance liability and financial
market data. It turns out that not much is known in this respect, especially when it comes to
market consistent valuation for use in the Basel III and Solvency II projects. To achieve this, one
can either work with an equivalent martingale measure for deflated price processes or use a state-
price deflator to discount insurance liabilities and asset prices under the real-world probability
measure. The second possible path has been followed. Since a multivariate exponential variance-
gamma process is one of the popular alternative choices to the multivariate exponential Gaussian
process, the construction of an explicit state-price deflator for it is a main first goal, which has
been achieved in Theorem 4.1. An application to bivariate option pricing has been undertaken.
Theorem 6.1, which displays a Margrabe formula for the deflated exponential shifted bivariate
variance-gamma process, is a main new contribution. Moreover, analytical closed-form
expressions for the bivariate exponential variance-Erlang special case are also obtained.
Second, it is important to remark that our simple model is easy to work with but has some serious
drawbacks. For example, linear correlation cannot be fitted once the margins are fixed. Moreover,
the choice of a single parameter v causes great difficulty in the joint calibration to option prices
on the margins, as observed in [21]. To overcome these difficulties there are at least two
possibilities at disposal. One can either apply an alternative estimation method, which does not
share some of the inconveniences (main purpose of the follow-up [8]), or consider more complex
multivariate variance-gamma models. Results on the latter proposal will be presented elsewhere.
APPENDIX 1: Integral identities of normal type
The crucial identities used in the derivation of Theorem 5.1 are stated and proved separately.
Lemma A1.1 For any real numbers , , c b and 0 > o one has the identity
( ) o o o
o
o
b e dx x e
c
b b
c
bx
+ u =
}

+
2 2
2
1
) / ) ((
1
. (A1.1)
Proof Consider first the case 1 , 0 = = o . From the relation ) ( ) (
2
2
1
b x e x e
b
bx
= one gets
( ) c b e dt t e dx x e
b
b c
b
c
bx
u =
}
=
}

2
2
1 2
2
1
) ( ) ( .
Using this one obtains by a change of variables
( ) o o o
o
o
o
o
b e dt t e dx x e
c
b b
c
t b b
c
bx
+ u =
}
=
}

+
2 2
2
1
/ ) (
1
) ( ) / ) (( .
Lemma A1.2 For any real numbers , , b a and 0 > o one has the identity
|
.
|
\
|
u =
}
+ u
+
+
2 2
1
1
) / ) (( ) (
o
o o
b
b a
dx x bx a . (A1.2)
Proof Consider the functions
}
+ u =
}
+ u =

dx x zx a z G dx x x z z F
a
) ( ) ( ) ( , ) ( ) ( ) ( . One notes
that
2
1
) ( ) ( ) 0 ( =
}
u =

dx x x F and ) ( ) ( ) ( ) ( '
2
2
2 z
dx x x z z F =
}
+ =

, from which one gets
) ( ) ( ' ) 0 ( ) (
2
0
a
a
dz z F F a F u =
}
+ = . On the other hand, one has ) ( ) ( ) 1 (
2
a
a
a F G u = = and
Werner Hrlimann

) ( ) ( ) ( ) (
2
2 / 3 2
1
) 1 (
'
z
a
z
z
a
dx x zx a z z G
+
+

=
}
+ = , hence ) ( ) ( ' ) 1 ( ) (
2
1
1
b
a
b
a a
dz z G G b G
+
u =
}
+ = . It
follows that |
.
|
\
|
u = =
}
+ u
+
+
+
2 2
1
1
) ( ) / ) (( ) (
o
o o o
b
b a
b a
b G dx x bx a .
APPENDIX 2: Closed-form evaluation of an integral function of normal type
In case ,... 2 , 1 = = m , is an integer parameter, the evaluation of the integral (5.9) is done through
partial integration by finding first a primitive integral for ) (
1 2
x x
m
of the form
) ( ) ( ) (
1 2
x x P dx x x
m
m
=
}

, (A2.1)
where ) (x P
m
is a polynomial of degree ) 1 ( 2 m with integer coefficients. The following
recursive relationship determines this polynomial completely.
Lemma A2.1 The polynomial ) (x P
m
defined by (A2.1) satisfies the following recursion
1 ) ( ,..., 3 , 2 ), ( ) 1 ( 2 ) (
1 1
) 1 ( 2
= = + =

x P m x P m x x P
m
m
m
. (A2.2)
Proof First of all, since ) ( ) ( ' x x x = it is immediate that ) (x is a primitive integral of
) (x x , hence 1 ) (
1
= x P . For 2 > m the recursion is shown by induction. For 2 = m one
proceeds as follows. Let ) (x H
k
be the (probabilistic) Hermite polynomial of order k ,
,... 2 , 1 , 0 = k , which satisfies the property ) ( ) ( ) 1 ( ) (
) (
x x H x
k
k k
= . In particular, one has
) ( ) 3 ( ) (
3 ) 3 (
x x x x = , hence ) ( ) ( ' 3 ) ( ) ( 3 ) (
) 3 ( ) 3 ( 3
x x x x x x x = = .
This leads to the primitive integral
) ( ) 2 ( ) ( )) ( 3 ( ) ( ' ' ) ( 3 ) (
2
2
3
x x x x H x x dx x x + = + = =
}
, hence
) ( 2 2 ) (
1
2 2
2
x P x x x P + = + = ,
which shows (A2.2) for 2 = m . The induction step from m to 1 + m is shown by performing
two successive partial integrations as follows:
( )
, ) ( 2 ) (
) ( ) 1 ( 2 ) ( ) 1 ( 2 ) ( 2
) ( ) 1 ( 2 ) (
] ) ( ) 1 ( 2 ) ( [ 2 ) ( ) 1 ( 2 ) (
] ) ( [ 2 ) ( ] ) ( [ ) (
1 2 2
1 2 3 2 2 1 2
3 2 2 2
3 2 1 2 3 2 ) 1 ( 2 2
1 2 1 2 2 2 1 2 1 2
}
+ =
}
+
}

}
+
}
+ =
} }
+
}
+ =
} }

}
=
}
=
}

+
dx x x m x x
dx x x m dx x x x m dx x x
dx x x x m x x
dx dx x x x m x x dx x x m x x x
dx dx x x x dx x x x dx x x x dx x x
m m
m m m
m m
m m m m
m m m m

which shows the recursion for the index 1 + m , namely ). ( 2 ) (
) 2
1
x mP x x P
m
m
m
+ =
+

A successive application of the recursion (A2.2) yields the following explicit formula.
Lemma A2.2 The polynomial ) (x P
m
satisfies the explicit representation
,... 3 , 2 , 1 ,
2 !
1
)! 1 ( 2 ) (
2
1
0
1
=
|
|
.
|
\
|
=

=
m
x
k
m x P
k
m
k
m
m
. (A2.3)
Proof From Lemma A2.1 one knows that ) (x P
m
is a polynomial in even powers of x , say
=

=
1
0
2
,
) (
m
k
k
k m m
x a x P . With (A2.2) one obtains the recursive relationship
,... 4 , 3 , 2 , 1 , 2 ,..., 1 , 0 , ) 1 ( 2
1 , , 1 ,
= = = =

m a m k a m a
m m k m k m
,

which implies that ,... 3 , 2 , 1 , 1 ,..., 1 , 0 ,
! 2
1
)! 1 ( 2
1
,
= = =

m m k
k
m a
k
m
k m
.
Now, let us derive the formula (5.10). A partial integration of (5.9) using (A2.1) yields
. ) ( 2 ) 1 / (
1
) 0 (
2
1
) 1 ( ) ( ) 0 (
) ( ) ( ) ( ) ( ) ( ) ( 2 ) ( ) ( 2 ) (
0
2
2
0
2
2
1
0
0
0
1 2
|
|
.
|
\
|
}
+
+
+ =
}
+ + =
|
.
|
\
|
}
+ u =
}
u =

dt t d t P
d
d
P dx x d x P d P
dx dx x x P d dx x x P dx dx x x d L
m m m m
m m
m
m

t t

Using (A2.3) it follows that
,... 2 , 1 , ) ) ( 2
) 1 ( ! 2
1
1 (
1
1 )! 1 ( 2 ) (
1
1 0
2
2
2
2
=
|
|
.
|
\
|
}
+
+
+
+ =

=
m dt t t
d k
d
d
m d L
m
k
k
k k
m
m
.
Next, one observes that the function < s x x 0 ), ( 2 , is the probability density of the half-
normal distribution with moment generating function (e.g. [36], equation (9))
) ( ) exp( 2 ) (
2
2
1
t t t m u = .
Through induction one shows the recursive relation
,... 3 , 2 ), ( ) ( ) 1 ( ) (
) 1 ( ) 2 ( ) (
= + =

k t m t t m k t m
k k k
,
which shows that the moments
k
m of the half-normal distribution satisfy the recursion
,... 3 , 2 , ) 1 (
2
= =

k m k m
k k
. Since 1
0
= m one sees that
,... 3 , 2 , 1 , ) 1 2 ( ! )! 1 2 ( ) ( 2
1
2
0
2
= = = =
}
=
k j k m dt t t
k
j
k
k
,
The formula (5.10) is shown.
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AUTHORS BIOGRAPHY

Werner Hrlimann has studied mathematics and physics at ETHZ, where
he obtained his PhD in 1980 with a thesis in higher algebra. After
postdoctoral fellowships at Yale University and at the Max Planck
Institute in Bonn, he became 1984 an actuary at Winterthur Life and
Pensions, a senior actuary at Aon Re and IRMG Switzerland 2003-06, a
senior consultant at IRIS in Zrich 2006-2008, and is currently employed
at FRSGlobal Switzerland (a Wolters Kluwer Company). He has been
visiting associate professor in actuarial science at the University of
Toronto during the academic year 1988-89. More information is found at
his homepage https://sites.google.com/site/whurlimann/.

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= . Now, it is possible to separate the double integral as

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