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Purely Discontinuous Asset Price Processes
Dilip B. Madan
University of Maryland
April 19, 1999
Abstract
This paper presents the case for modeling asset price processes as
purely discontinuous processes of ¯nite variation with an in¯nite arrival
rate of jumps that have arrival rates completely monotone in the jump size.
The arguments address both the empirical realities of asset returns and
the implications of the economic principle of no arbitrage. Two classes
of economic models meeting these conditions are presented and linked.
An important example given by the variance gamma process is studied
in detail and used to design optimal derivative investment portfolios that
are calibrated to actual portfolios to reverse engineer trader preferences
and beliefs and infer personalized risk neutral measures termed position
measures. Illustrative comparisons of statistical, risk neutral and position
measures are also provided