Course structure

1. Motivation for jump processes in finance

2. Basic notions
● Definitions, properties and first examples

3. Lévy-Itô decomposition and path properties

● Lévy-Khinchin formula, Lévy triplet, infinite activity, finite variation

4. Financial modelling with Lévy processes

● Building Levy processes

5. Monte Carlo simulations for Lévy processes

6. Stochastic calculus with Lévy processes (optional)
● Stochastic integral, Ito lemma

7. Measure transformations for Lévy processes

● Generalization of Girsanov theorem

8. Option pricing within exponential Lévy models

● Risk-neutral modelling and arbitrage free pricing
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1. Motivation for jump processes in finance

 Financial modelling has extensively used geometric Brownian motion

and its extensions
 Brownian motion: random process (Wt) with independent, stationary
and Gaussian increments
● It is the most widely studied stochastic process
● It led to modern stochastic finance

 Louis Bachelier [Théorie de la Speculation, 1900] models the price of a

stock as an (additive) Brownian motion:
𝑆𝑡 = 𝑆0 + 𝜎𝑊𝑡
 70 years later: Samuelson -Black-Scholes-Merton: multiplicative
version of Brownian motion (geometric BM)
𝜎2
𝑆𝑡 = 𝑆0 exp 𝛿− 𝑡 + 𝜎𝑊𝑡
2

⟺ 𝑑𝑆𝑡 = 𝛿𝑆𝑡 𝑑𝑡 + 𝜎𝑆𝑡 𝑑𝑊𝑡 3

1. Motivation for jump processes in finance

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1. Motivation for jump processes in finance

 Important properties of Brownian motion:

● Gaussian increments, no heavy tails

● Continuity of all sample paths

 No jumps, even at very small scales

● Scale invariance
 Statistical properties are identical at all time scales (fractal property)
 If (W(t)) is a standard BM, it is self-similar with Hurst index 0.5:
{W(at)}~{a1/2 W(t)}

 If Xt is a BM with drift 0 and volatility 𝜎 ∶ Δ𝑋𝑡 ~𝑁(0, 𝜎 2 Δ𝑡) and

𝑋 𝑎𝑡 ∼ 𝑎0.5 𝑋(𝑡)
 See illustration next slide

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 1. Motivation for jump processes in finance

 Illustration of the scale invariance of Brownian motion

Brownian motion with drift 0 volatility 0.2 Brownian motion with drift 0 volatility 0.2
0.5
1.5

0.4

0.3 1

0.2
0.5
0.1
X(t)

X(t)
0 0

-0.1
-0.5
-0.2

-0.3 -1

-0.4

-1.5
-0.5
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 0 5 10 15 20 25 30 35 40 45 50
Time t Time t

● Brownian motion with 𝜇 = 0% , 𝜎 = 20%

● Left: simulation over a 5 years period
● Right: simulation over a 50 years period
 Y axis has been rescaled by a factor 10 in the right hand graph 6
1. Motivation for jump processes in finance

 Observed prices however show:

● Jumps (or large sudden moves)
at intraday scale
● Heavy tails, volatility clustering
● Scale invariance still holds, except
when passing to intraday scales (where prices move essentially by jumps)

1800 1600

1500
1600

1400
1400

1300
1200
1200

1000
1100

800
1000

600 900
0 500 1000 1500 2000 2500 3000 3500 0 100 200 300 400 500

S&P500 data from 2000 to 2013 (left) and from 2000 to 2002 (right) 7
1. Motivation for jump processes in finance

 Clearly Black-Scholes model is not sufficient in many situations,

but diffusion models can go much far beyond…
 Diffusion models are handy for option pricing
● Uniqueness of risk-neutral probability measure (market completeness)
● Good model calibration on volatility surfaces possible if passing to local
or stochastic volatility models
● Leads to dynamic hedging strategies

 What do we ask to a financial model?

● Actually it depends a lot for which purpose the model is developed… !

● Capturing the empirical properties of asset returns

● Representing the main features of option prices
● Flexible and handy tool for options hedging and realistic risk
management

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1. Motivation – Empirical properties of assets returns

 Ability to reproduce empirical properties of asset returns: important for

predictive or risk analyses
 Geometric Brownian motion (BS model) generates log-returns with
constant average volatility and continuous movements in prices (no
large movement)
 Now, in the market, we observe:
● Large peaks, that can be seen as “jumps”
 Jump ~ large sudden move in price

 Heavy tails in the empirical distribution of log-returns

 Slow decay of the distribution of returns at infinity, i.e. large moves have
significant probability of occurrence
● Volatility is not constant, and presents clustering

 See illustrations below on S&P500 data

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1. Motivation – Empirical properties of assets returns
Illustration on S&P 500 data

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 1. Motivation – Empirical properties of assets returns
Illustration on S&P 500 data

Rem: realized volatilities are computed from daily log-returns, and are not annualized here
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1. Motivation – Empirical properties of assets returns
Comparison with Black-Scholes model

(GBM calibrated
on the historical
data shown
above)

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1. Motivation – Empirical properties of assets returns
Comparison with Black-Scholes model

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1. Motivation – Empirical properties of assets returns

 Now, it is possible to introduce heavy tails within diffusion

models : stochastic volatility models
● Simple example: Heston model
● These are non-Gaussian models, although the driving noises are Gaussian
● Heavy tails can be obtained in such models, but at the price of high values
of volatility of volatility

 Diffusion models can generate heavy tails BUT cannot generate

sudden discontinuous moves in price
● Unless fine-tuning the parameters to extreme values, while it is a generic
property of models with jumps

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1. Motivation – Evidence from option markets

 Main motivation for continuous-time models in finance: the

development of option pricing models
● Completely different approaches and purpose than the traditional time
series models used in econometrics
● Some models may be good for reproducing characteristics of times series of
returns, but poor for (derivative) pricing and hedging

 A derivative pricing model aims at:

● Capturing the features of option prices quoted in the market

● Relating prices of market instruments in an arbitrage free manner (pricing

vanilla options consistently with the market)
● Extrapolating the value of instruments not priced in the market

“Pricing model ~ arbitrage free interpolation and

extrapolation tool”
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1. Motivation – Evidence from option markets

 Hence, a pricing model must capture the state of the options

market at a given instant
 model calibration: parameters are chosen to fit as best as
possible the market prices of options

 Volatility smile / skew

● Price at t in Black-Scholes model of a European call on the underlying
asset St , with strike K and maturity date T:

𝐶 𝐵𝑆 𝑆𝑡 , 𝐾, 𝜏 = 𝑇 − 𝑡, 𝜎 = 𝑆𝑡 𝑁 𝑑1 − 𝐾𝑒 −𝑟𝜏 𝑁 𝑑2

𝑆𝑡 𝜎2
ln + 𝑟+ 𝜏
𝐾 2
𝑑1 = , 𝑑2 = 𝑑1 − 𝜎 𝜏
𝜎 𝜏
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1. Motivation – Evidence from option markets
Volatility Smile and Skew

 In the market, the hypotheses of Black-Scholes model do not

necessarily hold
 In fact, most of market participants do not believe in the
hypotheses of BS model
 Actually, market prices of vanilla options can be quoted or
expressed in terms of their implied Black-Scholes volatility :
● Let us denote the observed market price by 𝐶𝑡∗ (𝑇, 𝐾)

● The function 𝜎 ↦ 𝐶 𝐵𝑆 𝑆𝑡 , 𝐾, 𝜏, 𝜎 is strictly increasing from 0, +∞ to

𝑆𝑡 − 𝐾𝑒 −𝑟𝜏 +
, 𝑆𝑡
 Cf. [Modeles financiers en temps continu:] the vega is strictly positive

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 1. Motivation – Evidence from option markets
Volatility Smile and Skew

 Example: S(0)=1, K=1.1, t=0, T=2, r=0%

● The BS price is then contained in the interval [0,1]
Black-Scholes price in function of the volatility Black-Scholes price in function of the volatility
0.5 1

0.45 0.9

0.4 0.8

0.35 0.7

0.3 0.6
BS call price

BS call price
0.25 0.5

0.2 0.4

0.15 0.3

0.1 0.2

0.05 0.1

0 0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0 1 2 3 4 5 6 7 8 9 10
sigma sigma

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1. Motivation – Evidence from option markets
Volatility Smile and Skew

 Implied Black-Scholes volatility

● The function 𝜎 ↦ 𝐶 𝐵𝑆 𝑆𝑡 , 𝐾, 𝜏, 𝜎 is strictly increasing from
0, +∞ to 𝑆𝑡 − 𝐾𝑒 −𝑟𝜏 +
, 𝑆𝑡
● Hence, we can invert BS formula w.r.t. σ:
∃! Σ𝑡 𝑇, 𝐾 > 0 ∶ 𝐶 𝐵𝑆 𝑆𝑡 , 𝐾, 𝜏, Σ𝑡 𝑇, 𝐾 = 𝐶𝑡∗ 𝑇, 𝐾
● Σ𝑡 𝑇, 𝐾 is called the (market) Black-Scholes implied
volatility surface

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1. Motivation – Evidence from option markets
Volatility Smile and Skew

 BS model is not used as pricing model for plain vanilla options

but as a tool for translating market prices into a representation
in terms of implied volatility
 The implied volatility is the « wrong number which, plugged into
the wrong formula, gives the right answer » (Renobato)

 Implied volatility surface at date t:

● Generally directly obtained from
market quotes

 t : (T , K )   t (T , K )

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1. Motivation – Evidence from option markets
Volatility Smile and Skew

 In Black-Scholes model, the implied volatility is flat:

Σ𝑡 𝑇, 𝐾 = 𝜎 ∀ 𝑇, 𝐾
 From observation of market prices, implied volatility is not
flat
● Equity and FX: strong dependence with respect to strike K.
Decreasing with strike (skew) or U-shaped (smile)
● The smile/skew flattens out as maturity increases (flattening of
smile)
● Smile is mostly a function of the moneyness m=K/St

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1. Motivation – Evidence from option markets
Volatility Smile and Skew

 A lot of generalizations of BS aim at dealing with this market

property (the « smile problem »)
● Local volatility models, based on Dupire formula: for any arbitrage free
profile of observed call option prices (or implied volatilities) :
𝐶0 𝑇, 𝐾 , 𝑇 ∈ 0, 𝑇 ∗ , 𝐾 > 0
there exists a unique deterministic function 𝜎 𝑡, 𝑆 , given by a
tractable formula, s.t. in the corresponding local volatility model:
𝑑𝑆𝑡 = 𝑟𝑆𝑡 𝑑𝑡 + 𝜎 𝑡, 𝑆𝑡 𝑆𝑡 𝑑𝑊𝑡 ,
we have:
model prices = market prices (𝐶0 𝑇, 𝐾 )
● More precisely:

𝜕𝐶 𝜕𝐶
𝑇, 𝐾 + 𝑟𝐾 (𝑇, 𝐾)
𝜎 𝑇, 𝐾 = 2 𝜕𝑇 𝜕𝐾 (Dupire formula)
2 𝜕2𝐶
𝐾 𝑇, 𝐾
𝜕𝐾 2 22
1. Motivation – Evidence from option markets
Volatility Smile and Skew

 A lot of generalizations of BS aim at dealing with this market

property (the « smile problem »)

● Dupire volatility is a solution to the calibration problem, but does

not explain the smile phenomenon in terms of market dynamics,
and future smiles are systematically flatter than at t=0

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1. Motivation – Evidence from option markets
Volatility Smile and Skew

 A lot of generalizations of BS aim at dealing with this market

property (the « smile problem »)
● Stochastic volatility diffusion models : good for smile calibration at a
given fixed maturity, but often fail across different maturities
 At-the-money skew (slope of implied volatility expressed as a function of
moneyness) decays faster than market skews
● Moreover, to get a skew, these models require a negative correlation
between price and instantaneous volatility movements
 This negative correlation is interpreted as a kind of leverage effect
 Now, this does not explain why the skew becomes a smile in the FX market,
nor why the skew effect increased after the 1987 crash (different leverage
effect since then?)
● So, diffusion stochastic volatility models do not really propose any
straightforward explanation for the smile/skew phenomenon
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1. Motivation – Evidence from option markets
Volatility Smile and Skew

 Like diffusion models, jump models can reproduce variety of

smile/skew patterns
 But they also propose explanation in terms of market
anticipations:
● A skew is attributed to the fear of large negative jumps by market
participants
 This explains the increasing skew effect observed after the 1987 crisis
● Jump processes also allow to explain the distinction between smile
and skew : in terms of asymmetry of jumps anticipated/feared by
market participants
 FX market: jumps expected to be symmetric  smile (U shaped)

 Equity market: fear jumps are negative  skew

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1. Motivation – Evidence from option markets
Volatility Smile and Skew

 The existence of short-term options also provide evidence

that jumps (or large movements) in the price are recognized
by market participants
● These options are traded at a significant price, and form a very active
market. They would have no value if the market did not recognize the
possibility of sudden large movements
● These options present a significant skew, which is unreachable in diffusion
models unless using very high values of volatility of volatility
● This can be somehow solved by using Levy models

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1. Motivation – Hedging and risk management

 A pricing model should also allow:

● Computing and applying realistic hedging strategies
● Quantifying the (remaining) risk associated to a given position

 One-dimensional diffusion models (local volatility models) result

in complete markets:
● Perfect replication of any option by a self-financing strategy involving
underlying and cash only
● In such market, options are redundant  Why is there an option market??
 In practice, perfect hedging is not possible, so that options are used, in
addition to the underlying and cash, to better transfer risks
 Purpose for the creation of derivative markets initially
 In practice, one complements delta-hedging by gamma and vega hedging
● Common practice of quasi-static hedging of exotic options with vanilla
options, while it is not natural in a diffusion model
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1. Motivation – Hedging and risk management

 Financial models involving jumps are not complete anymore

● Any hedging strategy will keep a residual risk which cannot be eliminated
 more realistic picture of risk management of option portfolios

 Stochastic volatility models also lead to incomplete markets, unless

adding a single option to the set of available hedging instruments
● Perfect hedge is then possible BUT in a dynamic approach
● In practice, dynamic hedging is not (always) possible for liquidity reasons…
and hedging applied in practice is generally static
 Dynamic hedging remains a challenge
● On the contrary to what is suggested by these diffusion models, option
trading is not riskless
 Models with jumps explicitly recognize the riskiness of option trading,
and offer a more natural framework for hedging and quantifying the
remaining risks
● The hedging problem is seen as an optimisation problem: approximation of a
future payoff by a trading strategy, but keeping some risk to be quantified
and minimised
● Other vision of hedging, more in line with market practice and reality
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 1. Motivation – Summary

Empirical facts Diffusion models Models with jumps

large and sudden
need very large volatilities generic property
moves in prices
possible by choosing nonlinear volatility
heavy tails generic property
structures
options are risky options can be hedged in a risk-free perfect hedges do not exist: they are risky
investments manner investments

market are incomplete; markets are complete (possibly

some risks cannot be requiring the addition of a single option markets are incomplete
hedged in the set of traded assets)

exotic options are options are redundant: any payoff can

options are not redundant: using plain
hedged by using plain be replicated by dynamic hedging with
vanilla can allow to reduce hedging error
vanilla options only the underlying
explanation with anticipations of market
smile and skew can be calibrated, but not explained participants for negative of symmetric large
moves in market prices
losses are
concentrated in a few price moves are conditionnally
jumps can give rise to large losses
large downwards Gaussian, no large sudden move
moves
Reference: Financial modelling with jump processes, R. Cont and P. Tankov, Chapman and Hall, 2004
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