# Contents

Articles

Mathematical finance Asymptotic analysis Calculus Copula (statistics) Differential equation Expected value Ergodic theory Feynman–Kac formula Fourier transform Girsanov's theorem Itô's lemma Martingale representation theorem Mathematical model Monte Carlo method Numerical analysis Real analysis Partial differential equation Probability Probability distribution Binomial distribution Log-normal distribution Heat equation Radon–Nikodym derivative Risk-neutral measure Stochastic calculus Wiener process Lévy process Stochastic differential equations Stochastic volatility Numerical partial differential equations Crank–Nicolson method Finite difference Value at risk Volatility (finance) 1 4 7 20 25 31 38 44 46 66 68 72 73 79 90 100 102 114 120 125 132 137 149 153 155 157 164 167 171 174 175 180 186 194

Autoregressive conditional heteroskedasticity Brownian Model of Financial Markets Rational pricing Arbitrage Futures contract Put–call parity Intrinsic value (finance) Option time value Moneyness Black–Scholes Black model Binomial options pricing model Monte Carlo option model Volatility smile Implied volatility SABR Volatility Model Markov Switching Multifractal Greeks (finance) Finite difference methods for option pricing Trinomial tree Optimal stopping Interest rate derivative Short rate model Hull–White model Cox–Ingersoll–Ross model Chen model LIBOR Market Model Heath–Jarrow–Morton framework

198 202 207 214 223 235 237 239 240 242 254 255 260 263 267 270 272 275 284 285 287 288 291 293 296 297 299 300

References

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Mathematical finance

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Mathematical finance

Mathematical finance is applied mathematics concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by financial economics. Thus, for example, while a financial economist might study the structural reasons why a company may have a certain share price, a financial mathematician may take the share price as a given, and attempt to use stochastic calculus to obtain the fair value of derivatives of the stock (see: Valuation of options). In terms of practice, mathematical finance also overlaps heavily with the field of computational finance (also known as financial engineering). Arguably, these are largely synonymous, although the latter focuses on application, while the former focuses on modeling and derivation (see: Quantitative analyst). The fundamental theorem of arbitrage-free pricing is one of the key theorems in mathematical finance. Many universities around the world now offer degree and research programs in mathematical finance; see Master of Mathematical Finance.

History

The history of mathematical finance starts with The Theory of Speculation (published 1900) by Louis Bachelier, which discussed the use of Brownian motion to evaluate stock options. However, it hardly caught any attention outside academia. The first influential work of mathematical finance is the theory of portfolio optimization by Harry Markowitz on using mean-variance estimates of portfolios to judge investment strategies, causing a shift away from the concept of trying to identify the best individual stock for investment. Using a linear regression strategy to understand and quantify the risk (i.e. variance) and return (i.e. mean) of an entire portfolio of stocks and bonds, an optimization strategy was used to choose a portfolio with largest mean return subject to acceptable levels of variance in the return. Simultaneously, William Sharpe developed the mathematics of determining the correlation between each stock and the market. For their pioneering work, Markowitz and Sharpe, along with Merton Miller, shared the 1990 Nobel Memorial Prize in Economic Sciences, for the first time ever awarded for a work in finance. The portfolio-selection work of Markowitz and Sharpe introduced mathematics to the “black art” of investment management. With time, the mathematics has become more sophisticated. Thanks to Robert Merton and Paul Samuelson, one-period models were replaced by continuous time, Brownian-motion models, and the quadratic utility function implicit in mean–variance optimization was replaced by more general increasing, concave utility functions [1] . The next major revolution in mathematical finance came with the work of Fischer Black and Myron Scholes along with fundamental contributions by Robert C. Merton, by modeling financial markets with stochastic models. For this M. Scholes and R. Merton were awarded the 1997 Nobel Memorial Prize in Economic Sciences. Black was ineligible for the prize because of his death in 1995. More sophisticated mathematical models and derivative pricing strategies were then developed but their credibility was damaged by the financial crisis of 2007–2010. Bodies such as the Institute for New Economic Thinking are now attempting to establish more effective theories and methods.[2]

Mathematical finance

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**Mathematical finance articles
**

Mathematical tools

• • • • • • • • • • • • • • • • • • • Asymptotic analysis Calculus Copulas Differential equations Expected value Ergodic theory Feynman–Kac formula Fourier transform Gaussian copulas Girsanov's theorem Itô's lemma Martingale representation theorem Mathematical models Monte Carlo method Numerical analysis Real analysis Partial differential equations Probability Probability distributions

• Binomial distribution • Log-normal distribution • Quantile functions • Heat equation • Radon–Nikodym derivative • Risk-neutral measure • Stochastic calculus • Brownian motion • Lévy process • Stochastic differential equations • Stochastic volatility • Numerical partial differential equations • Crank–Nicolson method • Finite difference method • Value at risk • Volatility • ARCH model • GARCH model

Mathematical finance

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Derivatives pricing

• The Brownian Motion Model of Financial Markets • Rational pricing assumptions • Risk neutral valuation • Arbitrage-free pricing • Futures contract pricing • Options • • • • Put–call parity (Arbitrage relationships for options) Intrinsic value, Time value Moneyness Pricing models • • • • • Black–Scholes model Black model Binomial options model Monte Carlo option model Implied volatility, Volatility smile

• SABR Volatility Model • Markov Switching Multifractal • The Greeks • Finite difference methods for option pricing • Trinomial tree • Optimal stopping (Pricing of American options) • Interest rate derivatives • Short rate model • Hull–White model • Cox–Ingersoll–Ross model • Chen model • LIBOR Market Model • Heath–Jarrow–Morton framework

See also

• • • • • • • • • • • • Computational finance Quantitative Behavioral Finance Derivative (finance), list of derivatives topics Modeling and analysis of financial markets International Swaps and Derivatives Association Fundamental financial concepts - topics Model (economics) List of finance topics List of economics topics, List of economists List of accounting topics Statistical Finance Brownian model of financial markets

• Master of Mathematical Finance

Mathematical finance

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Notes

[1] Karatzas, I., Methods of Mathematical Finance, Secaucus, NJ, USA: Springer-Verlag New York, Incorporated, 1998 [2] Gillian Tett (April 15 2010), Mathematicians must get out of their ivory towers (http:/ / www. ft. com/ cms/ s/ 0/ cfb9c43a-48b7-11df-8af4-00144feab49a. html), Financial Times,

References

• Harold Markowitz, Portfolio Selection, Journal of Finance, 7, 1952, pp. 77–91 • William Sharpe, Investments, Prentice-Hall, 1985

Asymptotic analysis

In mathematical analysis, asymptotic analysis is a method of describing limiting behavior. The methodology has applications across science. Examples are • in computer science in the analysis of algorithms, considering the performance of algorithms when applied to very large input datasets • the behavior of physical systems when they are very large. The simplest example is, when considering a function f(n), there is a need to describe its properties when n becomes very large. Thus, if f(n) = n2+3n, the term 3n becomes insignificant compared to n2 when n is very large. The function "f(n) is said to be asymptotically equivalent to n2 as n → ∞", and this is written symbolically as f(n) ~ n2.

Definition

Formally, given complex-valued functions f and g of a natural number variable n, one writes

to express the fact that

and f and g are called asymptotically equivalent as n → ∞. This defines an equivalence relation on the set of functions being nonzero for all n large enough. Alternatively, a more general definition is that

using little O notation, which defines an equivalence relation on all functions. In each case, the equivalence class of f informally consists of all functions g which "behave like" f, in the limit. Here, o(1) stands for some function of n whose value tends to 0 as n → ∞; in general o(h(n)) stands for some function k(n) such that k(n)/h(n) tends to 0 as n → ∞. Big O notation (also known as Landau notation or asymptotic notation) has been developed to provide a convenient language for the handling of statements about order of growth and is now ubiquitous in the analysis of algorithms. The asymptotic point of view is basic in computer science, where the question is typically how to describe the resource implication of scaling-up the size of a computational problem.

we need to try dropping different terms in step 2. to obtain as many terms in the asymptotic expansion as desired. the asymptotic expansion is in power of a small parameter. 2. saddle-point method. Otherwise. Assume that the asymptotic behavior has the form . In symbols. while some limit is taken. However. Check that the solution is consistent with step 2. : in the boundary layer case. An example is Stirling's approximation. 4. the partial sums of which do not necessarily converge. The idea is that successive terms provide a more and more accurate description of the order of growth of f. Indeed. which means the (gk) form an asymptotic scale. but such that taking any initial partial sum provides an asymptotic formula for f. An illustrative example is the derivation of the boundary layer equations from the full Navier-Stokes equations governing fluid flow. Asymptotic expansions typically arise in the approximation of certain integrals (Laplace's method. this optimal partial sum will usually have more terms as the argument approaches the limit value. Make a clever guess as to which terms in the ODE may be negligible in the limit we are interested in. In many cases.
. or assumed. applications of asymptotic analysis in mathematical modelling often[1] centre around a nondimensional parameter which has been shown.Asymptotic analysis
5
Asymptotic expansion
An asymptotic expansion of a function f(x) is in practice an expression of that function in terms of a series. The requirement that the successive sums improve the approximation may then be expressed as In case the asymptotic expansion does not converge. method of steepest descent) or in the approximation of probability distributions (Edgeworth series). this is the nondimensional ratio of the boundary layer thickness to a typical lengthscale of the problem. The process is as follows: 1. usually with the requirement that gk+1 = o(gk). 3.
Method of dominant balance
The method of dominant balance is used to determine the asymptotic behavior of solutions to an ODE without solving it. then we have the controlling factor of the asymptotic behavior. The famous Feynman graphs in quantum field theory are another example of asymptotic expansions which often do not converge. Drop those terms and solve the resulting ODE. The process is iterative in that the result obtained by performing the method once can be used as input when the method is repeated. it means we have
but also
and
for each fixed k. for any particular value of the argument there will be a particular partial sum which provides the best approximation and adding additional terms will decrease the accuracy. If this is the case. to be small through a consideration of the scales of the problem at hand.
Use in applied mathematics
Asymptotic analysis is a key tool for exploring the ordinary and partial differential equations which arise in the mathematical modelling of real-world phenomena[1] .

. Thus we find the dominant asymptotic behaviour of a solution to our ODE:
By convention. Repeat the process using our result as the first term of the solution. we set y equal to
where we have used the product rule and chain rule to find the derivatives of y. or as . it may be useful to know how the solutions behave for large x. but it represents the is
have been negligible with respect to the ones we kept. consistent:
dominant asymptotic behaviour. Now let us suppose that a solution to this new ODE satisfies as as We get the dominant asymptotic behaviour by setting
If
satisfies the above asymptotic conditions. This differential equation cannot be solved exactly. and re-express the ODE in
Since we only care about the behavior of y in the large x limit. The terms we dropped will indeed is not a solution to the ODE for S.Asymptotic analysis 5. However. Let us check that this choice for
Everything is indeed consistent. then everything is consistent. to make things quicker. the asymptotic series is written as:
so to get at least the first term of this series we have to do another step to see if there is a power of x out the front. We do this with the benefit of hindsight. We start by assuming terms of S(x): . Substituting into the ODE for S(x) we find
. which is what we are interested in. We proceed by making an ansatz that we can write
and then attempt to find asymptotic solutions for C(x).
6
Example
Consider this second order ODE:
where c and a are arbitrary constants.

Cambridge. functions.
.umich. 2005. calculus was called "the calculus of infinitesimals". A course in calculus is a gateway to other. New York: Dover. P. or "infinitesimal calculus". Cambridge University Press.edu/~jpboyd/boydactaapplicreview. More generally. we keep C' and (c-a)/x and find that
7
The leading asymptotic behaviour is therefore
See also
• Asymptotic computational complexity • Asymptotic theory
References
[1] S. 1987. a small stone used for counting) is a branch of mathematics focused on limits. calculus. Practical Applied Mathematics. Erdélyi. Preprint (http://www-personal. 56: 1-98 (1999). and join calculus. pi calculus. Historically. differential calculus and integral calculus. Howison. superasymptotic and hyperasymptotic series". Acta Applicandae Mathematicae. and infinite series. "The Devil's Invention: asymptotic. calculus (plural calculi) may refer to any method or system of calculation guided by the symbolic manipulation of expressions.Asymptotic analysis Repeating the same process as before. variational calculus. Some examples of other well-known calculi are propositional calculus. which are related by the fundamental theorem of calculus.[1] in the same way that geometry is the study of shape and algebra is the study of operations and their application to solving equations. Asymptotic Expansions. derivatives. pdf). broadly called mathematical analysis.
Calculus
Calculus (Latin. This subject constitutes a major part of modern mathematics education. lambda calculus. ISBN 0-521-60369-2
• J. Calculus is the study of change. economics. Calculus has widespread applications in science. integrals. more advanced courses in mathematics devoted to the study of functions and limits. It has two major branches. Boyd. • A. and engineering and can solve many problems for which algebra alone is insufficient.

one goal of integral calculus. but does not seem to have developed these ideas in a rigorous or systematic way. Bhāskara II. using a method that is readily generalizable to finding the formula for the sum of any higher integer powers. inventing heuristics which resemble the methods of integral calculus. 408−355 BC) used the method of exhaustion. with no indication as to method. but this treatise was lost until the early part of the twentieth century. In his publications. The formal study of calculus combined Cavalieri's infinitesimals with the calculus of finite differences developed in Europe at around the same time. the foundational work was a treatise due to Bonaventura Cavalieri.[7] Also in the 12th century.[3] The method of exhaustion was later reinvented in China by Liu Hui in the 3rd century AD in order to find the area of a circle. and James Gregory. Indian mathematician Madhava of Sangamagrama. Taylor series. replacing calculations
.
Medieval
Around AD 1000. 1820 BC). with. which prefigures the concept of the limit. a precursor of the derivative. and the infinitesimal quantities he introduced were disreputable at first.[10] [11] [12]
Modern
In Europe. developed an early method using infinitesimal change.[4] In the 5th century AD. the Indian mathematician. while Archimedes (c. the latter two proving the second fundamental theorem of calculus around 1675. In the 12th century. suggest trial and error.[5]
Isaac Newton is one of the most famous contributors to the development of calculus. Some. Eudoxus (c. Isaac Barrow.[8] In the 14th century. and analytical functions were introduced by Isaac Newton in an idiosyncratic notation which he used to solve problems of mathematical physics. who argued that volumes and areas should be computed as the sums of the volumes and areas of infinitesimal thin cross-sections. and some of them are wrong. along with other mathematician-astronomers of the Kerala school of astronomy and mathematics. Cavalieri's work was not well respected since his methods can lead to erroneous results. the Chinese polymath Shen Kuo developed 'packing' equations that prefigure integration.Calculus
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History
Ancient
The ancient period introduced some of the ideas that led to integral calculus. Newton rephrased his ideas to suit the mathematical idiom of the time. the use of calculus in his laws of motion and gravitation. described special cases of Taylor series. the mathematician Ibn al-Haytham (Alhacen) was the first to derive the formula for the sum of the fourth powers of an arithmetic progression. The combination was achieved by John Wallis. The ideas were similar to Archimedes' in The Method. the notion of higher derivatives. among other things.[2] From the age of Greek mathematics. 287−212 BC) developed this idea further. to calculate areas and volumes.[9] which are treated in the text Yuktibhasa. Calculations of volumes and areas. including Morris Kline in Mathematical thought from ancient to modern times. The product rule and chain rule. can be found in the Egyptian Moscow papyrus (c. Zu Chongzhi established a method which would later be called Cavalieri's principle to find the volume of a sphere. but the formulas are mere instructions. the Persian mathematician Sharaf al-Dīn al-Tūsī used a method similar to taking the derivative of cubic polynomials. I. and he stated a form of Rolle's theorem. Vol.[6] In the 11th century.

By Newton's time. Lebesgue generalized the notion of the integral so that virtually any function has an integral. and it was clear that he understood the principles of the Taylor series. who was originally accused of plagiarism by Newton.[14]
Gottfried Wilhelm Leibniz was originally accused of plagiarizing Sir Isaac Newton's unpublished work (only in Britain. A careful examination of the papers of Leibniz and Newton shows that they arrived at their results independently. there was great controversy over which mathematician (and therefore which country) deserved credit. and the notion of an approximating polynomial series. and at this time infinitesimal methods were still considered disreputable. the oblateness of the earth. δ)-definition of limit). Today. Unlike Newton. but is now regarded as an independent inventor of and contributor to calculus. to the detriment of English mathematics. many mathematicians have contributed to the continuing development of calculus. His contribution was to provide a clear set of rules for manipulating infinitesimal quantities. and providing the product rule and chain rule. He used the methods of calculus to solve the problem of planetary motion. the shape of the surface of a rotating fluid. calculus was put on a much more rigorous footing by mathematicians such as Cauchy. Since the time of Leibniz and Newton. Newton called his calculus "the science of fluxions". which Newton had shared with a few members of the Royal Society. Leibniz and Newton are usually both credited with the invention of calculus. Leibniz paid a lot of attention to the formalism—he often spent days determining appropriate symbols for concepts.Calculus with infinitesimals by equivalent geometrical arguments which were considered beyond reproach. It is Leibniz. not in continental Europe). while Laurent Schwartz extended differentiation in much the same way. he developed series expansions for functions. with Leibniz starting first with integration and Newton with differentiation. Newton claimed Leibniz stole ideas from his unpublished notes. Calculus is a ubiquitous topic in most modern high schools and universities around the world. who gave the new discipline its name. It was also during this period that the ideas of calculus were generalized to Euclidean space and the complex plane.
9
When Newton and Leibniz first published their results. In the 19th century.
. second and higher derivatives. in their differential and integral forms. The basic insights that both Newton and Leibniz provided were the laws of differentiation and integration. This controversy divided English-speaking mathematicians from continental mathematicians for many years. and many other problems discussed in his Principia Mathematica. These ideas were systematized into a true calculus of infinitesimals by Gottfried Wilhelm Leibniz. the fundamental theorem of calculus was known. Newton was the first to apply calculus to general physics and Leibniz developed much of the notation used in calculus today. Newton derived his results first.[13] He is now regarded as an independent inventor of and contributor to calculus. the motion of a weight sliding on a cycloid. Riemann. both Newton and Leibniz are given credit for developing calculus independently. He did not publish all these discoveries. and Weierstrass (see (ε. In other work. however. allowing the computation of second and higher derivatives. including fractional and irrational powers. but Leibniz published first.

India. and the infinitely small behavior of the function is found by taking the limiting behavior for smaller and smaller numbers. Iraq.
. Applications of integral calculus include computations involving area. Any integer multiple of an infinitesimal is still infinitely small. An infinitesimal number dx could be greater than 0.
Foundations
In mathematics. The foundations of calculus are included in the field of real analysis. i. and for this reason they are the standard approach. For centuries. the slope of a curve. More advanced applications include power series and Fourier series. 1/2. The ancient Greek philosopher Zeno gave several famous examples of such paradoxes. Historically. which contains full definitions and proofs of the theorems of calculus as well as generalizations such as measure theory and distribution theory. and optimization.e. Working out a rigorous foundation for calculus occupied mathematicians for much of the century following Newton and Leibniz and is still to some extent an active area of research today. Infinitesimals get replaced by very small numbers. 1/3. In the 19th century. and motion. China.. but less than any number in the sequence 1. This approach fell out of favor in the 19th century because it was difficult to make the notion of an infinitesimal precise. and Japan. and less than any positive real number. the modern use of calculus began in Europe.Calculus
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Significance
While some of the ideas of calculus were developed earlier in Egypt. time. which provided solid foundations for the manipulation of infinitesimals. during the 17th century. They capture small-scale behavior. as in the original Newton-Leibniz conception. An alternative is nonstandard analysis. calculus is a collection of techniques for manipulating infinitesimals. center of mass. volume. Calculus provides tools. However. Calculus is also used to gain a more precise understanding of the nature of space. Calculus can be used to compute the trajectory of a shuttle docking at a space station or the amount of snow in a driveway. but use the ordinary real number system. the concept was revived in the 20th century with the introduction of non-standard analysis and smooth infinitesimal analysis. The usual one today is via the concept of limits defined on the continuum of real numbers. foundations refers to the rigorous development of a subject from precise axioms and definitions. In this treatment.
Principles
Limits and infinitesimals
Calculus is usually developed by manipulating very small quantities. just like infinitesimals. arc length. infinitesimals do not satisfy the Archimedean property. "infinitely small". Persia. work. There is more than one rigorous approach to the foundation of calculus. infinitesimals were replaced by limits. The development of calculus was built on earlier concepts of instantaneous motion and area underneath curves. . in which the real number system is augmented with infinitesimal and infinite numbers. when Isaac Newton and Gottfried Wilhelm Leibniz built on the work of earlier mathematicians to introduce its basic principles. especially the limit and the infinite series. These are objects which can be treated like numbers but which are. mathematicians and philosophers wrestled with paradoxes involving division by zero or sums of infinitely many numbers. Limits describe the value of a function at a certain input in terms of its values at nearby input. which resolve the paradoxes. Applications of differential calculus include computations involving velocity and acceleration. the first method of doing so was by infinitesimals. These questions arise in the study of motion and area.. From this point of view.. in some sense. Greece. and pressure. Limits are the easiest way to provide rigorous foundations for calculus. calculus is a collection of techniques for manipulating certain limits.

" For instance. if the doubling function is given the input three. and if the squaring function is given the input three. if f(x) = x2 is the squaring function. Thus. the derivative at that point is a way of encoding the small-scale behavior of the function near that point. (a. If the input of the function represents time. and fix a point a in the domain of f.) The most common symbol for a derivative is an apostrophe-like mark called prime.Calculus
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Differential calculus
Differential calculus is the study of the definition. If the graph of the function is not a straight line. the derivative is a Tangent line at (x. properties. where functions usually input a number and output another number. four is sent to sixteen. The derivative is defined by taking the limit as h tends to zero. f(a + h)) is close to (a. f(x)). To be concrete. In mathematical jargon. pronounced "f prime. if the graph of the function is a straight line). For example. and applications of the derivative of a function. A line through two points on a curve is called a secant line. if f is a function that takes a time as input and gives the position of a ball at that time as output. the doubling function. f(a)). For example. so m is the slope of the secant line between (a. If h is a number close to zero. (The function it produces turns out to be the doubling function. then it outputs six. then it outputs nine. and so on—and uses this information to produce another function. The process of finding the derivative is called differentiation. then the derivative represents change with respect to time. Given a function and a point in the domain. where:
This gives an exact value for the slope of a straight line. The derivative. The slope between these two points is
This expression is called a difference quotient. it is the velocity of the ball. Therefore (a + h. then the derivative of f is how the position is changing in time. The secant line is only an approximation to the behavior of the function at the point a because it does not account for what happens between a and a + h. Derivatives give an exact meaning to the notion of change in output with respect to change in input. however. By finding the derivative of a function at every point in its domain. then the change in y divided by the change in x varies. that is. outputs a second function. called the derivative function or just the derivative of the original function. This means that the derivative takes all the information of the squaring function—such as that two is sent to four. This is more abstract than many of the processes studied in elementary algebra. f(a)) and (a + h. then f′(x) = 2x is its derivative. The derivative f′(x) of a curve at a point is the slope (rise linear operator which inputs a function and over run) of the line tangent to that curve at that point. three is sent to nine. the derivative of the function of f is f′. meaning that it considers the behavior of f
. however. which is impossible. then the function can be written y = mx + b. It is not possible to discover the behavior at a by setting h to zero because this would require dividing by zero. f(a + h)). then a + h is a number close to a. can take the squaring function as an input. If a function is linear (that is. it is possible to produce a new function. f(a)) is a point on the graph of the function. let f be a function.

A similar computation to the one above shows that the derivative of the squaring function is the doubling function. For this reason.Calculus for all small values of h and extracts a consistent value for the case when h equals zero:
12
Geometrically. the derivative is the slope of the tangent line to the graph of f at a. Note that the vertical and horizontal scales in this image are different. or just the derivative of the squaring function for short.
The slope of tangent line to the squaring function at the point (3. the derivative is sometimes called the slope of the function f. The limit process just described can be performed for any point in the domain of the squaring function. This slope is determined by considering the limiting value of the slopes of secant lines. −15/8) has a slope of 23/4. Here the function involved (drawn in red) is f(x) = x3 − x. This defines the derivative function of the squaring function.
The derivative f′(x) of a curve at a point is the slope of the line tangent to that curve at that point. that is to say. The tangent line is a limit of secant lines just as the derivative is a limit of difference quotients. The tangent line (in green) which passes through the point (−3/2.
. the derivative of the squaring function at the input 3. it is going up six times as fast as it is going to the right.9) is 6. Let f(x) = x2 be the squaring function. Here is a particular example.

The process of finding the value of an integral is called integration. In technical language. however. Leibniz. which gives the area between the graph of the input and the x-axis. for the derivative in the example above is
In an approach based on limits.
. a Riemann sum only gives an approximation of the distance traveled. then we need a more powerful method of finding the distance. but if the speed changes. introduced by Leibniz. The indefinite integral is the antiderivative. the derivative. then multiplying the time elapsed in each interval by one of the speeds in that interval. as the output. The technical definition of the definite integral is the limit of a sum of areas of rectangles.and lower-case letters for a function and its indefinite integral is common in calculus. We can also think of d/dx as a differentiation operator. dy being the infinitesimally small change in y caused by an infinitesimally small change dx applied to x. did intend it to represent the quotient of two infinitesimally small numbers. then the speed will stay more or less the same. properties. (This use of upper. the indefinite integral and the definite integral.Calculus
13
Leibniz notation
A common notation.
Integral calculus
Integral calculus is the study of the definitions. although it is possible to avoid such manipulations. For example:
In this usage. called a Riemann sum. the symbol dy/dx is to be interpreted not as the quotient of two numbers but as a shorthand for the limit computed above. and applications of two related concepts. However. Even when calculus is developed using limits rather than infinitesimals. the inverse operation to the derivative. We must take the limit of all such Riemann sums to find the exact distance traveled. A motivating example is the distances traveled in a given time. only multiplication is needed. it is common to manipulate symbols like dx and dy as if they were real numbers. F is an indefinite integral of f when f is a derivative of F. The basic idea is that if only a short time elapses.
If the speed is constant.) The definite integral inputs a function and outputs a number. integral calculus studies two related linear operators. which takes a function as an input and gives another function. they are sometimes notationally convenient in expressing operations such as the total derivative. and then taking the sum (a Riemann sum) of the approximate distance traveled in each interval. One such method is to approximate the distance traveled by breaking up the time into many short intervals of time. the dx in the denominator is read as "with respect to x".

the distance traveled (between the times represented by a and b) is the area of the shaded region s. the notation
is to be understood as an operator that takes a function as an input and gives a number. the antiderivative of the latter is given by:
An undetermined constant like C in the antiderivative is known as a constant of integration. The sum Integration can be thought of as measuring the area under a curve. or antiderivative. which is an approximation of the total distance traveled. Associated with each segment is the average value of the function above it. the area between the axis and the curve. is y′ = 2x. Then the area of the rectangle with base Δx and height h gives the distance (time Δx multiplied by speed h) traveled in that segment. we can choose one value of the function f(x). so that their width Δx becomes the infinitesimally small dx.
To approximate that area. The symbol of integration is . the length of each segment represented by the symbol Δx. an elongated S (the S stands for "sum").Calculus
14 If f(x) in the diagram on the left represents speed as it varies over time. the area. and is not being multiplied by f(x). In a formulation of the calculus based on limits. where C is any constant. The indefinite integral. defined by of all such rectangles gives an approximation of f(x).
." The Leibniz notation dx is intended to suggest dividing the area under the curve into an infinite number of rectangles. Since the derivative of the function y = x² + C. as an output. f(x)=h. Call that value h. but for an exact answer we need to take a limit as Δx approaches zero. is written:
Functions differing by only a constant have the same derivative. The definite integral is written as:
and is read "the integral from a to b of f-of-x with respect to x. and therefore the antiderivative of a given function is actually a family of functions differing only by a constant. dx is not a number. an intuitive method would be to divide up the distance between a and b into a number of equal segments. between two points (here a and b). A smaller value for Δx will give more rectangles and in most cases a better approximation. For each small segment.

it can be used with linear algebra to find the "best fit" linear approximation for a set of points in a domain. the Fundamental Theorem of Calculus provides a practical way of computing definite integrals.Calculus
15
Fundamental theorem
The fundamental theorem of calculus states that differentiation and integration are inverse operations. Maxwell's theory of electromagnetism and Einstein's theory of general relativity are also expressed in the language of differential calculus. made by both Newton and Leibniz. population dynamics starts with reproduction and death rates to model population changes. and many times in studying a problem we know one and are trying to find the other. It is also a prototype solution of a differential equation. concavity and inflection points. statistics. b). all concepts in classical mechanics and electromagnetism are interrelated through calculus. who based their results on earlier work by Isaac Barrow. In analytic geometry. An example of the use of calculus in mechanics is Newton's second law of motion: historically stated it expressly uses the term "rate of change" which refers to the derivative saying The rate of change of momentum of a body is equal to the resultant force acting on the body and is in the same direction. computer science. Calculus can be used in conjunction with other mathematical disciplines. b). The fundamental theorem provides an algebraic method of computing many definite integrals—without performing limit processes—by finding formulas for antiderivatives.
Applications
Calculus is used in every branch of the physical sciences. b] and if F is a function whose derivative is f on the interval (a.
. actuarial science. Differential equations relate an unknown function to its derivatives. it involves differential calculus because acceleration is the time derivative of velocity or second time derivative of trajectory or spatial position. It can also be interpreted as a precise statement of the fact that differentiation is the inverse of integration. for every x in the interval (a. and are ubiquitous in the sciences.
This realization. In biology. demography. the moment of inertia of objects. we use calculus to derive its path. engineering. The The logarithmic spiral of the Nautilus shell is a mass of an object of known density. classical image used to depict the growth and change related to calculus as well as the total energy of an object within a conservative field can be found by the use of calculus. For example. It allows one to go from (non-constant) rates of change to the total change or vice versa. slope. economics. Starting from knowing how an object is accelerating. and in other fields wherever a problem can be mathematically modeled and an optimal solution is desired. Commonly expressed today as Force = Mass × acceleration. The Fundamental Theorem of Calculus states: If a function f is continuous on the interval [a. business. calculus is used to find high points and low points (maxima and minima). medicine. was key to the massive proliferation of analytic results after their work became known. Physics makes particular use of calculus. Or it can be used in probability theory to determine the probability of a continuous random variable from an assumed density function. Chemistry also uses calculus in determining reaction rates and radioactive decay. then
Furthermore. it relates the values of antiderivatives to definite integrals. Because it is usually easier to compute an antiderivative than to apply the definition of a definite integral. the study of graphs of functions. More precisely.

For instance.
16
See also
Lists
• • • • List of differentiation identities List of calculus topics Publications in calculus Table of integrals
Related topics
• • • • • • • • • • • • • • • • • • Calculus of finite differences Calculus with polynomials Complex analysis Differential equation Differential geometry Elementary calculus Fourier series Integral equation Mathematical analysis Mathematics Multivariable calculus Non-classical analysis Non-standard analysis Non-standard calculus Precalculus (mathematical education) Product integral Stochastic calculus Taylor series
. and linear approximation. spacecraft use a variation of the Euler method to approximate curved courses within zero gravity environments. is applied in an instrument known as a planimeter which is used to calculate the area of a flat surface on a drawing. For example. Examples are methods such as Newton's method.Calculus Green's Theorem. which gives the relationship between a line integral around a simple closed curve C and a double integral over the plane region D bounded by C. fixed point iteration. it's used to derive dosing laws. it's used to build models of radiation transport in targeted tumor therapies. In the realm of medicine. In nuclear medicine. calculus can be used to find the optimal branching angle of a blood vessel so as to maximize flow. it can be used to calculate the amount of area taken up by an irregularly shaped flower bed or swimming pool when designing the layout of a piece of property. calculus allows for the determination of maximal profit by providing a way to easily calculate both marginal cost and marginal revenue. in practice it's the standard way to solve differential equations and do root finding in most applications. In economics. From the decay laws for a particular drug's elimination from the body. Calculus is also used to find approximate solutions to equations.

130. 279 (http:/ / books. nfo& softpage=PL_frame)
Books
• Larson.. ISBN 0-321-48987-X
. ISBN 9781891389245 • Stewart. Scotland. google. Yucti Bhasha.C. Mathematical Methods for Scientists and Engineers. (http:/ / turnbull. School of Mathematics and Statistics University of St Andrews. [10] "An overview of Indian mathematics" (http:/ / www-history. com/ books?id=jaQH6_8Ju-MC& pg=PA279) [5] Zill. Cengage Learning. "Calculus". Springer. Mathematical thought from ancient to modern times. Chapter . . com/ books?hl=en& lr=& id=7d8_4WPc9SMC& oi=fnd& pg=PA3& dq=Gottfried+ Wilhelm+ Leibniz+ accused+ of+ plagiarism+ by+ Newton& ots=09h9BdTlbE& sig=hu5tNKpBJxHcpj8U3kR_T2bZqrY#v=onepage& q=plagairism& f=false|Online) [14] UNESCO-World Data on Education (http:/ / nt5. Calculus: Early Transcendentals (http:/ / books. L. [11] "Science and technology in free India" (http:/ / www. Bhaskaracharya II. uk/ ~history/ Projects/ Pearce/ Chapters/ Ch8_5. google. in The Works of Archimedes ISBN 978-0-521-66160-7 [4] Dun. p. James (2008). ISBN 9780547167022 • McQuarrie.Calculus
17
References
Notes
[1] Latorre. p. . google. Robert Sonné (1966). . the Tantra Sahgraham. Inc. Copy (http:/ / books. ac. 6th ed.G. doi:10. George B.. School of Mathematics and Statistics University of St Andrews. mcs. 2. Donald A. Bruce H. com/ cgi-bin/ om_isapi. A comparison of Archimdes' and Liu Hui's studies of circles (http:/ / books. Brooks Cole Cengage Learning. st-and.. I [3] Archimedes. Brooks Cole Cengage Learning. pp. scbbs. Wright. html). Addison-Wesley. Journal of the American Oriental Society 110 (2). Joel Hass. st-andrews. xxvii. The Early Mathematical Manuscripts of Leibniz. google. Retrieved 2006-07-07. .). uk/ HistTopics/ Indian_mathematics. Indian Maths. Scott. 9th ed. University Science Books. 163-174. JSTOR 25581775 [13] Leibniz. pp. "Innovation and Tradition in Sharaf al-Din al-Tusi's Muadalat". p. [9] "Madhava" (http:/ / www-gap. ISBN 0-792-33463-9. Dennis G. 279. 11th ed. Sherry (2007). Maurice D. Dainian. . "Ideas of Calculus in Islam and India". html). Weir. [12] Charles Whish (1834). com/ books?id=jaQH6_8Ju-MC). Vol.Ramachandran Nair. Calculus Concepts: An Applied Approach to the Mathematics of Change (http:/ / books. st-and... Iris B. (2009). Calculus: Early Transcendentals. com/ books?id=bQhX-3k0LS8C). Donald R. Frank R. ISBN 0-763-75995-3. dcs. . p. Chapter 1. Chinese studies in the history and philosophy of science and technology. Pearce. Ron. google. com/ books?id=R3Hk4Uhb1Z0C& pg=PR27) [6] Victor J. Biggers. Berggren (1990). Transactions of the Royal Asiatic Society of Great Britain and Ireland (Royal Asiatic Society of Great Britain and Ireland) 3 (3): 509–523.. September 2004. com/ books?id=bQhX-3k0LS8C& pg=PA2) [2] Morris Kline. "Calculus". Giordano (2008). Carana Padhati and Sadratnamala". Liu. Kenelly. Cohen. gov. Cosimo. in/ keralcallsep04/ p22-24. Katz (1995). Retrieved 2006-09-13. com/ books?id=R3Hk4Uhb1Z0C) (3 ed. Edwards (2010). ac. [7] Ian G. Reed. Biography of Madhava. mcs.. Prof. pdf) (PDF). ISBN 9780495011668 • Thomas. Wright. 304-309. Fan. Warren S... (2003).. ISBN 0-618-78981-2. Extract of page 27 (http:/ / books. Page 228. Gottfried Wilhelm. Government of Kerala — Kerala Call. kerala.1017/S0950473700001221. ac. dll?clientID=137079235& infobase=iwde. Jones & Bartlett Learning. p 2 (http:/ / books. uk/ ~history/ Biographies/ Madhava. Retrieved 2006-07-09. Method. John W. "On the Hindu Quadrature of the circle and the infinite series of the proportion of the circumference to the diameter exhibited in the four Sastras. Mathematics Magazine 68 (3). Scotland. html) [8] J.. google. google. 2008.

Leonid P. Ch. ED 300 252. J. (1991).caltech. 1–46. (2000). Loftsgaarden.htm)
.edu/~sean/applied_math. No.com/calc/calc.edu/~stroyan/InfsmlCalculus/InfsmlCalc.D.html (http://www. • Silvanus P. Retrieved 6 May 2007 from http://ocw.pdf (http://www. Multi-Variable Calculus and Linear Algebra with Applications. ISBN 978-0-312-18548-0 Calculus Made Easy.edu/~garrett/calculus/ first_year/notes. Anderson and Don O. (2004). ISBN 978-0-471-26987-8 Calculus and Pizza: A Math Cookbook for the Hungry Mind. • Weisstein.uiowa.
• Tom M. (2003). (1969). Albers. One-Variable Calculus with an Introduction to Linear Algebra. Mathematical Association of America No. 7.edu/ans7870/resources/Strang/ strangtext.htm (http://www. Lebedev and Michael J. Not a Filter. American Mathematical Society." (http://mathworld. ISBN 978-0-914098-89-8 Calculus.org/drupal/de2de/ (http://synechism.edu/~garrett/calculus/first_year/notes. Calculus for a New Century.math. Dan (2000). Retrieved 6 May 2007 from http://www. 25. "Notes on first year calculus" University of Minnesota.lightandmatter.Calculus
18
Other resources
Further reading
• • • • • • • • • Courant.edu/~keisler/calc.math.math. "A brief introduction to infinitesimal calculus" University of Iowa.pdf) • Faraz.wisc. Addison Wesley. "Sean's Applied Math Book" California Institute of Technology. ISBN 978-0-201-39607-2 Calculus: A complete course. Thompson and Martin Gardner. Florian Cajori. Michael Spivak.com/) (HTML only) • Keisler.wolfram.pdf) • Sloughter. Retrieved 17 March 2009 from http://synechism.uiowa. Retrieved 6 May 2007 from http://www. (1996).com/ (http://www. "Understanding Calculus" Retrieved 6 May 2007 from Understanding Calculus. 1 (Sep. Vol. A Pump. 2nd Ser. P. ISBN 978-0-521-62401-5. (2006). Princeton Univ.
Online books
• Crowell. (2003).com/ SecondFundamentalTheoremofCalculus. Edmund Landau. (1986) Undergraduate Programs in the Mathematics and Computer Sciences: The 1985-1986 Survey. ISBN 9780471000075 Calculus.cacr. ISBN 978-0-201-53174-9 Calculus and Analytic geometry 9th. • Tom M.edu/~sean/applied_math. Richard ISBN 978-3540650584 Introduction to calculus and analysis 1. (2004). Retrieved 6 May 2007 from http://www. Cloud: "Approximating Perfection: a Mathematician's Journey into the World of Mechanics. • Mathematical Association of America. 1998..pdf (http://www. • Thomas/Finney.edu/ans7870/resources/Strang/strangtext. "Difference Equations to Differential Equations: An introduction to calculus".umn. (September 1994).pdf) • Garrett. The Association. mit. Cliff Pickover. Wiley. Retrieved 6 May 2007 from http://www.org/drupal/de2de/) • Stroyan. Apostol. Fullerton. Volume 1. Publish or Perish publishing.. (1998). "The History of Notations of the Calculus.math. 1: The Tools of Calculus". NY.math. Press. 1923). Cambridge University Press. Wiley. lightandmatter. (1999).html) From MathWorld—A Wolfram Web Resource. "Calculus" Massachusetts Institute of Technology.. "Elementary Calculus: An Approach Using Infinitesimals" Retrieved 29 August 2010 from http://www. S.pdf (http://www.understandingcalculus. K. Adams. Donald J. Uses synthetic differential geometry and nilpotent infinitesimals. (2006). Robert A. (1967). John Lane Bell: A Primer of Infinitesimal Analysis.edu/~keisler/calc. Apostol. H. G. Stony Brook.htm) (HTML only) • Strang. B. ISBN 0-8218-2830-4 Differential and Integral Calculus.html) • Mauch. H.edu/ ~stroyan/InfsmlCalculus/InfsmlCalc.understandingcalculus.com/calc/calc. ed. Eric W. Richard D. (1988).umn." Annals of Mathematics.caltech. "Second Fundamental Theorem of Calculus. ISBN 9780471000051 Calculus.math. 2004.cacr.mit.wisc. "Calculus" Light and Matter. pp.htm (http://ocw. Volume 2. URL http:// www.

co.calculus.bbc.springer.nd. MIT • Calculus Problems and Solutions (http://www.uk/iplayer/console/b00mrfwq/In_Our_Time_Calculus)) • Calculus.htm) – an article on its historical development. • Topics on Calculus (http://planetmath. William V.math.uk/programmes/b00mrfwq) on In Our Time at the BBC.com/) from Wolfram Research • The Role of Calculus in College Mathematics (http://www.solved-problems.. OpenCourseWare from the University of Notre Dame with activities.htm) • Online Integrator (WebMathematica) (http://integrals. Kouba • Solved problems in calculus (http://calculus.bbc. in Encyclopaedia of Mathematics.uk/staff/aldrich/Calculus and Analysis Earliest Uses. " Calculus (http://mathworld. • Calculus for Beginners and Artists (http://math.economics.mit.org/encyclopedia/TopicsOnCalculus. "The Calculus" Retrieved 4 July 2008 (http://www. Eric W.
19
External links
• Weisstein.edu/mathematics/elements-of-calculus-i) and Calculus II for Business (http://ocw.org: The Calculus page (http://www. ( listen now (http:// www.edu/~smithw/ Calculus/) (HTML only).com/)
. Thompson (http://djm.html) by D.org • OpenCourseWare Calculus (http://ocw. • Calculus Made Easy (1914) by Silvanus P. (2001). pdf) Full text in PDF • Calculus (http://www.Calculus • Smith.math. Davis – contains resources and links to other sites • COW: Calculus on the Web (http://cow.co.org/pre-9217/calculus.cc/library/Calculus_Made_Easy_Thompson.de/I/i050950.htm) from the Massachusetts Institute of Technology • Infinitesimal Calculus (http://eom.edu/mathematics/calculus-ii-for-business). A.ucdavis.edu/~kouba/ProblemsList.ericdigests.mit. .html) at PlanetMath.nd.edu/OcwWeb/Mathematics/index.wolfram.edu/) at Temple University – contains resources ranging from pre-calculus and associated algebra • Earliest Known Uses of Some of the Words of Mathematics: Calculus & Analysis (http://www. soton.wolfram. exams and interactive applets.html)" from MathWorld.ac.edu/~djk/calculus_beginners/) by Daniel Kleitman.com/Calculus. Michiel Hazewinkel ed.temple.math.htm) from ERICDigests. • Elements of Calculus I (http://ocw.org) at University of California.byu.

It follows that X’ and Y’ both have uniform distributions but are. X’ and Y’ remain independent). n-copula) if: C(u)=0 whenever u∈[0. it is possible to derive the copula corresponding to any given multivariate distribution. the dependence structure can be expressed as a multivariate distribution on the obtained uniforms. With X’ and Y’ being uniform random variables. the above transformations might be fitted as an initial step for each marginal distribution. a copula..
is the so called C-volume of
. or the parameters of the transformations might be fitted jointly with those of the copula. in a way. C is n-increasing. which is equal to ui. A typical use for copulas is to choose one such family and use it to define the multivariate distribution to be used. So the idea is to simplify the problem by removing consideration of many different marginal distributions by transforming the marginal variates to uniforms. Some families of copulas are outlined below. with continuous cumulative distribution functions FX and FY.1]n has at least one component equal to 0. i. A family will typically have several parameters which relate to the strength and form of the dependence. for each hyperrectangle
where the
. However. The probability integral transform can be applied separately to the two random variables to define X’ = FX(X) and Y’ = FY(Y).1]n→[0. When applied in a practical context.
The basic idea
Consider two random variables X and Y.Copula (statistics)
20
Copula (statistics)
In statistics. C:[0. if X and Y were independent. C(u) = ui whenever u∈[0. 1]. the problem reduces to specifying a bivariate distribution between two uniforms. Since the transforms are invertible.
.[1] The approach to formulating a multivariate distribution using a copula is based on the idea that a simple transformation can be made of each marginal variable in such a way that each transformed marginal variable has a uniform distribution. Specifically. There are many families of copulas which differ in the detail of the dependence they represent. in general.e. typically in fitting a distribution to a sample of data.1]n has all the components equal to 1 except the ith one. specifying the dependence between X and Y is. a copula is used as a general way of formulating a multivariate distribution in such a way that various general types of dependence can be represented. 1]n such that every marginal distribution is uniform on the interval [0. the same as specifying dependence between X’ and Y’.1] is an n-dimensional copula (briefly.
Definition
A copula is a multivariate joint distribution defined on the n-dimensional unit cube [0. Once this is done. dependent if X and Y were already dependent (of course. that is. and a copula is precisely a multivariate distribution on marginally uniform random variables. and then specifying dependence as a multivariate distribution on the uniforms.

It represents perfect positive dependence between variates:
For n-variate copulas. Sklar's theorem states that given a joint distribution function for variables. Then
the marginal distributions
is unique on the range of values of the marginal distributions. the upper bound is given by
Conclusion: For all copulas C(u. Otherwise. For any bivariate distribution function and there exists a copula (where the symbol such that for the copula has also been used for with its cumulative distribution function). and respective marginal distribution functions. the corresponding inequality is
. For the bivariate case. Moreover. To understand the density function of the coupled random variable The expectation of a function g can be written in the following ways: it should be noticed that
Fréchet–Hoeffding copula boundaries
Minimum (antimonotone) copula: This is the lower bound for all copulas. the copula . there exists a copula such that the copula binds the margins to give the joint distribution. the copula function is unique.Copula (statistics)
21
Sklar's theorem
The theorem proposed by Sklar[2] underlies most applications of the copula. if and are continuous. Sklar's theorem can be stated as follows.
Graphs of the Fréchet–Hoeffding copula limits and of the independence copula (in the middle). it represents perfect negative dependence between variates.
For n-variate copulas. In the bivariate case only. let
be the univariate marginal probability distribution functions. the lower bound is given by
Maximum (comonotone ) copula: This is the upper bound for all copulas. v).
In the multivariate case.

which have a simple form with properties such as associativity and have a variety of dependence structures. this copula has no dependence between variates. For example: Clayton copula: For θ = 0 in the Clayton copula.g.
Where the generator function is indexed by a parameter. Li in 2000—is the Gaussian copula. most of the Archimedean copulas have closed-form solutions and are not derived from the multivariate distribution functions using Sklar’s Theorem. Gaussian). Any generator function which
satisfies the properties below is the basis for a valid copula: Product copula: Also called the independent copula.4
where
and
denotes the standard normal cumulative distribution function.[3] which is constructed from the bivariate normal distribution via Sklar's theorem. a whole family of copulas may be Archimedean. the Gaussian copula function is
Cumulative distribution and probability density functions of Gaussian copula with ρ = 0. by simply including more additive terms. Unlike elliptical copulas (e. Its density function is unity everywhere. Gumbel copula:
Frank copula:
. Such copulas are known as Archimedean.
Archimedean copulas
Archimedean copulas are an important family of copulas. the random variables are statistically independent. One particularly simple form of a n-dimensional copula is
where
is known as a generator function. With being the standard bivariate normal cumulative distribution function with correlation ρ.
Differentiating C yields the copula density function:
where is the density function for the standard bivariate Gaussian with Pearson's product moment correlation coefficient ρ and is the standard normal density. The generator function approach can be extended to create multivariate copulas.Copula (statistics)
22
Families of copula
Gaussian copula
One example of a copula often used for modelling in finance—as introduced by David X.

one can transform the empirical data distribution into an "empirical copula" by warping such that the marginal distributions become uniform[1] . then both
are copula functions. See also the article by Donnelly and Embrechts [9] and the book by Brigo. which is effectively a basket: C = S1/S2 or C = S1*S2. Less arguably. in particular in fixed income constant maturity swap (CMS) spread options.[4] They noticed that if ƒ is a 1-periodic non-negative function that integrates to 1 over [0. specifically the lack of dependence dynamics and the poor representation of extreme events[8] . copula functions have been successfully applied to the database formulation for the reliability analysis of highway bridges.[5] Some believe the methodology of applying the Gaussian copula to credit derivatives to be one of the reasons behind the global financial crisis of 2008–2009. Recently. The volume "Credit Correlation: Life After Copulas". copulas have also been applied to other asset classes as a flexible tool in analyzing multi-asset derivative products. This may be a tool to introduce asymmetric dependence.
Empirical copulas
When analysing data with an unknown underlying distribution. Whilst the application of copulas in credit has gone through popularity as well as misfortune during the global financial crisis of 2008-2009. simply replace the data along each dimension with the data ranks divided by n. Mathematically the empirical copula frequency function is calculated by where x(i) represents the ith order statistic of x. the second one not necessarily exchangeable. published in 2007 by World Scientific. • Analyzing and pricing spread options. which is absent in most known copula functions. • Analyzing and pricing volatility smile/skew of less liquid FX cross. Copulas have since gained popularity in pricing and risk management [13] of options on multi-assets in the presence of volatility smile/skew. to the analysis of spike counts in neuroscience [14] and to various multivariate simulation studies in civil. foreign exchange and fixed income derivative business. The first such application outside credit was to use a copula to construct an implied basket volatility surface.g.[3] [11] it is arguably an industry standard model for pricing CDOs. occurring before the crisis. Less formally.
. best/worst of. Some typical examples of application of copulas are listed below: • Analyzing and pricing volatility smile/skew of exotic baskets. mechanical and offshore engineering. e.for example in the pricing of collateralized debt obligations (CDOs). to address the limitations of the Gaussian copula and of Copula functions more generally.Copula (statistics)
23
Periodic copula
In 2005 Aurélien Alfonsi and Damiano Brigo introduced new families of copulas based on periodic functions. summarizes a 2006 conference held by Merrill Lynch in London where several practitioners attempted to propose models rectifying some of the copula limitations. in equity. 1] and F is a double primitive of ƒ. there are documented attempts of the financial industry.
Applications
Dependence modelling with copula functions is widely used in applications of financial risk assessment and actuarial analysis .[12] taking into account the volatility smile of basket components.[6] [7] Despite this perception. Pallavicini and Torresetti [10] .

"Copula sensitivity in collateralized debt obligations and basket default swaps". ploscompbiol. Wilmott Magazine. 15. 2009). E. Communications in Statistics . 141–151. • C. (1999). Walter Vecchiato (Nov 2003). 2/23/2009 [7] MacKenzie. (1998).. (2010). 2008-05-08. • A. D. S. "Copula Methods vs Canonical Multivariate Distributions: The Multivariate Student T Distibution with General Degrees of Freedom". 229-231. "Multivariate Simulation and Multimodal Dependence Modeling of Vehicle Axle Weights with Copulas". Friederichs (2008). Biometrika 65. Financial Times. (2010). Rachev.1371/journal. "Fonctions de répartition à n dimensions et leurs marges". doi:10. Fabozzi (2005). "Understanding Relationships Using Copulas". R. doi:10. Obermayer. 1-33 [10] Brigo. html). Publ. 1371/ journal.2-Y) • Frees. "New families of Copulas based on periodic functions". Dong. PMID 19956759.org/sici?sici=0006-3444(197804)65:1<141:AMFAIB>2. co. Schölzel. MH. Copulas. (2005). htm). Pallavicini. "Analyzing Short-Term Noise Dependencies of Spike-Counts in Macaque Prefrontal Cortex Using Copulas and the Flashlight Transformation" (http:/ / www.soa. Statist. K. Correlations and dynamic Models. • S. Roger B. July. org/ article/ info:doi/ 10. Derivatives Week. defaultrisk. (Editors) (2007). A. Link to NAAJ copy (http://www.A. 1–25. An Introduction to Copulas. A. worldscibooks.0. C. Paris 8: 229–231 [3] Li. Pricing Basket Options With Skew. P. C. 4 June. ISBN 0-471-71886-6.A. F. 761-772 Copernicus (open access) (http://www. lrb. Journal of Futures Markets 24 (1): 37–70. html). "A model for association in bivariate life tables and its application in epidemiological studies of familial tendency in chronic disease incidence". The devil is in the tails: actuarial mathematics and the subprime mortgage crisis.net/15/761/2008/npg-15-761-2008. PLoS Computational Biology 5 (11): e1000577. Nonlinear Processes in Geophysics. Shaw. "Multivariate non-normally distributed random variables in climate research – introduction to the copula approach". A. Grünewälder. html). Dong.org/library/journals/north-american-actuarial-journal/ 1998/january/naaj9801_1. David X. Lee (2006).kcl. (2005). Inst.jstor. wired. Basket Implied Volatility Surface. [13] Qu. "The formula that felled Wall St" (http:/ / www. Nelsen (1999). "End-of-the-World Trade" (http:/ / www. com/ pp_corr_05. and A.nonlin-processes-geophys. (2000). Valdez. World Scientific. [12] Qu. E. PDF (http://www. Menn. A. & Brigo. ASTIN Bulletin 40(1). David.pcbi. com/ techbiz/ it/ magazine/ 17-03/ wp_quant?currentPage=all) Wired. A. and Torresetti. doi:10. Credit Models and the Crisis: A Journey into CDOs. An Introduction to Copulas. Sam (April 24.CO. K (2009). Munk. retrieved 2009-07-27 [8] Lipton.1000577. Journal of Fixed Income 9: 43–54. North American Actuarial Journal 2. London Review of Books. Credit Correlation: Life after Copulas (http:/ / www.T. JSTOR (subscription) (http:// links.W. Clayton (1978).uk/~shaww/ web_page/papers/MultiStudentc.ac. PMC 2776173. Devdas Menon and A. Embrechts. ft. D. Donald (2008). (2001). P. . "On Default Correlation: A Copula Function Approach" (http:/ / www.
General
• David G.1002/fut. Rennie. Wiley and Sons [11] Jones.Theory and Methods 34 (7): 1437–1447.pdf) • Roger B.pdf) • Srinivas Sriramula. [14] Onken. Publications de l'Institut de Statistique de L'Université de Paris 8. [4] Alfonsi..html) • W. (1959). pcbi. [2] Sklar. 1000577). ASCE Journal of Transportation Engineering 132
. Fat-Tailed and Skewed Asset Return Distributions.10110 [6] Recipe for Disaster: The Formula That Killed Wall Street (http:/ / www. com/ cms/ s/ 2/ 912d85e8-2d75-11de-9eba-00144feabdc0. ISBN 0-387-98623-5. Meher Prasad (2006). ISBN 0387986235. com/ economics/ 6559. Univ. uk/ v30/ n09/ mack01_.T. "Fonctions de répartition à n dimensions et leurs marges".1081/STA-200063351 [5] Meneguzzo. Sklar (1959).Copula (statistics)
24
See also
• Joint probability distribution
References
Notes
[1] Nelsen.mth. [9] Donnelly. New York: Springer.

vosesoftware.htm) Public Media • Copula Functions and their Application in Pricing and Risk Managing Multiame Credit Derivative Products (http://www. "Sklar's Theorem. by solving the heat equation. (1986). providing a steady state temperature distribution.mathfinance. economics. Heat is being generated internally in the casing and being cooled at the boundary. C.defaultrisk.com/ ModelRiskHelp/Modeling_correlation/Copulas." From MathWorld—A Wolfram Web Resource (http:// mathworld.com/site/ copulawiki/) • A collection of Copula simulation and estimation codes (http://www.
.com/SklarsTheorem. and other disciplines.aghakouchak.Copula (statistics) (12).asce.google. MacKay. This is illustrated in classical mechanics. Marketplace.htm)
Differential equation
A differential equation is a mathematical equation for an unknown function of one or several variables that relates the values of the function itself and its derivatives of various orders.org/stable/2684602).html) • Copula Wiki: community portal for researchers with interest in copulas (http://sites.. The American Statistician (American Statistical Association) 40 (4): 280–283.publicradio.wired.org/ cgi/WWWdisplay. Wired News • Did math formula cause financial crisis? (http://marketplace. (doi 10.2307/2684602
25
External links
• MathWorld Eric W. physics. 945–955. doi:10. Differential equations play a prominent role in engineering.cn/tags/copula) • Recipe for Disaster: The Formula That Killed Wall Street (http://www.cgi?0613154) • Genest.com/techbiz/it/magazine/17-03/ wp_quant) By Felix Salmon. Weisstein. R.1061/(ASCE)0733-947X(2006)132:12(945)) ASCE(subscription) (http://cedb.J. "The Joy of Copulas: Bivariate Distributions with Uniform Marginals" (http:// jstor.com/pp_crdrv_41.org/display/web/2009/02/24/ pm_stock_formula_q/) By Felix Salmon and Kai Ryssdal. specifically whenever a deterministic relation involving some continuously varying quantities (modeled by functions) and their rates of change in space and/or time (expressed as derivatives) is known or postulated.wolfram. Differential equations arise in many areas of science and technology. American • Several short articles on copulas (http://www. where the motion of a body
Visualization of heat transfer in a pump casing.com/resources/copulas) • An introduction and some examples to modeling with copulas in Excel (http://www.

considering only gravity and air resistance. such as possible presence of shocks for equations of hyperbolic type.e. Pure mathematics focuses on the existence and uniqueness of solutions. This means the ball's acceleration. do not have closed form solutions. In the simplest form. Newton's laws allow one to relate the position. while applied mathematics emphasizes the rigorous justification of the methods for approximating solutions. some properties of solutions of a given differential equation may be determined without finding their exact form. Differential equations play an important role in modelling virtually every physical. the unknown function is a real or complex valued function. Instead. i.
Nomenclature
The theory of differential equations is quite developed and the methods used to study them vary significantly with the type of the equation. Differential equations are mathematically studied from several different perspectives. The most important cases for applications are first-order and second-order differential equations. In some cases. to interactions between neurons.Differential equation is described by its position and velocity as the time varies. to bridge design. An example of modelling a real world problem using differential equations is determination of the velocity of a ball falling through the air. The study of the stability of solutions of differential equations is known as stability theory. All of these disciplines are concerned with the properties of differential equations of various types. Gravity is constant but air resistance may be modelled as proportional to the ball's velocity. Finding the velocity as a function of time involves solving a differential equation. technical. mostly concerned with their solutions—the set of functions that satisfy the equation. this differential equation (called an equation of motion) may be solved explicitly. which are types of solutions that do not have to be differentiable everywhere. and it also results in more physically reasonable properties of solutions. The ball's acceleration towards the ground is the acceleration due to gravity minus the deceleration due to air resistance. solutions can be approximated using numerical methods. If a self-contained formula for the solution is not available. which is the derivative of its velocity. In the classical literature also distinction is made between differential equations explicitly solved with respect to the highest derivative and differential equations in an implicit form. and engineering. from celestial motion. Ordinary differential equations are further classified according to the order of the highest derivative of the dependent variable with respect to the independent variable appearing in the equation. velocity.
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Directions of study
The study of differential equations is a wide field in pure and applied mathematics. however. • An ordinary differential equation (ODE) is a differential equation in which the unknown function (also known as the dependent variable) is a function of a single independent variable. the solution may be numerically approximated using computers. or biological process. Differential equations such as those used to solve real-life problems may not necessarily be directly solvable. Only the simplest differential equations admit solutions given by explicit formulas. while many numerical methods have been developed to determine solutions with a given degree of accuracy. acceleration and various forces acting on the body and state this relation as a differential equation for the unknown position of the body as a function of time. but more generally. physics. meteorology. Mathematicians also study weak solutions (relying on weak derivatives). The theory of dynamical systems puts emphasis on qualitative analysis of systems described by differential equations. it may be vector-valued or matrix-valued: this corresponds to considering a system of ordinary differential equations for a single function.
. This extension is often necessary for solutions to exist. depends on the velocity.

hyperbolic. and parabolic equations.
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Examples
In the first group of examples. The characteristic property of linear equations is that their solutions form an affine subspace of an appropriate function space. if these coefficients are constants then one speaks of a constant coefficient linear differential equation. • Inhomogeneous first-order linear constant coefficient ordinary differential equation:
• Homogeneous second-order linear ordinary differential equation:
• Homogeneous second-order linear constant coefficient ordinary differential equation describing the harmonic oscillator:
• First-order nonlinear ordinary differential equation:
• Second-order nonlinear ordinary differential equation describing the motion of a pendulum of length L:
In the next group of examples. and well-posedness of initial and boundary value problems for nonlinear PDEs are hard problems and their resolution in special cases is considered to be a significant advance in the mathematical theory (cf. the unknown function u depends on two variables x and t or x and y. A differential equation is linear if the unknown function and its derivatives appear to the power 1 (products are not allowed) and nonlinear otherwise. the harmonic oscillator equation is an approximation to the nonlinear pendulum equation that is valid for small amplitude oscillations (see below). Both ordinary and partial differential equations are broadly classified as linear and nonlinear. Even the fundamental questions of existence. and extendability of solutions for nonlinear differential equations. those that are known typically depend on the equation having particular symmetries. uniqueness. Navier–Stokes existence and smoothness). Linear differential equations frequently appear as approximations to nonlinear equations. especially for second-order linear equations. let u be an unknown function of x. but further classification into elliptic.e. These approximations are only valid under restricted conditions. The coefficients of the unknown function and its derivatives in a linear differential equation are allowed to be (known) functions of the independent variable or variables. the sum of any set of solutions or multiples of solutions is also a solution. For example. characteristic of chaos. • Homogeneous first-order linear partial differential equation:
. The order is defined similarly to the case of ordinary differential equations.Differential equation • A partial differential equation (PDE) is a differential equation in which the unknown function is a function of multiple independent variables and the equation involves its partial derivatives. Nonlinear differential equations can exhibit very complicated behavior over extended time intervals. which results in much more developed theory of linear differential equations. Homogeneous linear differential equations are a further subclass for which the space of solutions is a linear subspace i. is of utmost importance. and c and ω are known constants. There are very few methods of explicitly solving nonlinear differential equations. Some partial differential equations do not fall into any of these categories over the whole domain of the independent variables and they are said to be of mixed type.

for example. may give rise to identical differential equations. All of them may be described by the same second-order partial differential equation. mathematical theory behind the equations can be viewed as a unifying principle behind diverse phenomena. Conduction of heat. the Korteweg–de Vries equation:
Related concepts
• A delay differential equation (DDE) is an equation for a function of a single variable. much like familiar waves in the water. The mathematical theory of differential equations first developed. where the equations had originated and where the results found application. is governed by another second-order partial differential equation. As an example. • A differential algebraic equation (DAE) is a differential equation comprising differential and algebraic terms. and of waves on the surface of a pond. the heat equation. sometimes originating in quite distinct scientific fields. together with the sciences. in which the derivative of the function at a certain time is given in terms of the values of the function at earlier times. Whenever this happens. diverse problems.Differential equation
28
• Homogeneous second-order linear constant coefficient partial differential equation of elliptic type.
. in which the coordinates assume only discrete values. and the relationship involves values of the unknown function or functions and values at nearby coordinates. the theory of which was developed by Joseph Fourier. usually called time. the Wiener process in the case of diffusion equations. In biology and economics differential equations are used to model the behavior of complex systems. which allows us to think of light and sound as forms of waves. given in implicit form. It turned out that many diffusion processes. • A stochastic differential equation (SDE) is an equation in which the unknown quantity is a stochastic process and the equation involves some known stochastic processes. However. the Laplace equation:
• Third-order nonlinear partial differential equation. consider propagation of light and sound in the atmosphere.
Universality of mathematical description
Many fundamental laws of physics and chemistry can be formulated as differential equations. the wave equation. related to the heat equation. Many methods to compute numerical solutions of differential equations or study the properties of differential equations involve approximation of the solution of a differential equation by the solution of a corresponding difference equation. are described by the same equation. while seemingly different.
Connection to difference equations
The theory of differential equations is closely related to the theory of difference equations. Black-Scholes equation in finance is for instance.

which defines harmonic functions Poisson's equation Einstein's field equation in general relativity The Schrödinger equation in quantum mechanics The geodesic equation The Navier–Stokes equations in fluid dynamics The Cauchy–Riemann equations in complex analysis The Poisson–Boltzmann equation in molecular dynamics The shallow water equations
• Universal differential equation • The Lorenz equations whose solutions exhibit chaotic flow.Differential equation
29
Notable differential equations
• • • • • • • • • • • • • • • • Newton's Second Law in dynamics (mechanics) Hamilton's equations in classical mechanics Radioactive decay in nuclear physics Newton's law of cooling in thermodynamics The wave equation Maxwell's equations in electromagnetism The heat equation in thermodynamics Laplace's equation.
Biology
• • • • Verhulst equation – biological population growth von Bertalanffy model – biological individual growth Lotka–Volterra equations – biological population dynamics Replicator dynamics – may be found in theoretical biology
Economics
• • • • The Black–Scholes PDE Exogenous growth model Malthusian growth model The Vidale-Wolfe advertising model
See also
• • • • • Complex differential equation Exact differential equation Integral equations Linear differential equation Picard–Lindelöf theorem on existence and uniqueness of solutions
.

2003. htm [7] http:/ / publicliterature. aspx [5] http:/ / www. 1913. D. net/ research/ models. 001 [2] http:/ / hti. • W. 2006
External links
• • • • • • • • • Lectures on Differential Equations [3] MIT Open CourseWare Video Online Notes / Differential Equations [4] Paul Dawkins. Ordinary Differential Equations. edu/ OcwWeb/ Mathematics/ 18-03Spring-2006/ VideoLectures/ index. org/ tools/ differential_equation_solver/ [8] http:/ / user. math. John Wiley and Sons. Handbook of Exact Solutions for Ordinary Differential Equations (2nd edition). hedengren.O. with critical remarks. Blanchard. Differential Equations. org/ diffyqs/
. it/ patrone/ differential_equations_intro.L. Zwillinger. Polyanin and V. Zaitsev. F. lamar. Dover Publications. Coddington and N. Thompson. htm [10] http:/ / www. com/ diffeq/ diffeq. Handbook of Differential Equations (3rd edition).L. 1997. mit. umich. Mathematics Introduction to modeling via differential equations [6] Introduction to modeling by means of differential equations. edu/ cgi/ b/ bib/ bibperm?q1=abv5010. umich. 1955 • P. cz/ marik/ maw/ index. Differential Equation Solver [7] Java applet tool used to solve differential equations. • A. G. Mathematical Assistant on Web [8] Symbolic ODE tool. A Treatise on Ordinary and Partial Differential Equations [1].A. mendelu. 1956 • E. Levinson. Boston. ISBN 1-58488-297-2. php?lang=en& form=ode [9] http:/ / eqworld. sosmath. Boca Raton. Ince. in University of Michigan Historical Math Collection [2] • E. edu/ u/ umhistmath/ [3] http:/ / ocw. htm [4] http:/ / tutorial. Devaney. htm [11] http:/ / www. Theory of Ordinary Differential Equations. Academic Press. jirka. ipmnet.Differential equation
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References
• D. html [6] http:/ / www.S. McGraw-Hill. Hall.R. S. diptem. unige. Chapman & Hall/CRC Press. hti. Lamar University Differential Equations [5]. R. 0001. using Maxima Exact Solutions of Ordinary Differential Equations [9] Collection of ODE and DAE models of physical systems [10] MATLAB models Notes on Diffy Qs: Differential Equations for Engineers [11] An introductory textbook on differential equations by Jiri Lebl of UIUC
References
[1] http:/ / www. ru/ en/ solutions/ ode. Johnson. edu/ classes/ de/ de.

which not only lay down the foundations of the theory of probability. The term "expected value" can be misleading. because an equal degree of probability gives an equal right for the sum hoped for. such as the Cauchy distribution. and for French “Espérance mathématique”." The expected value is in general not a typical value that the random variable can take on. is almost surely the limit of the sample mean as sample size grows to infinity. expectation is the long-run average: if a test could be repeated many times. as wou’d procure me in the same Chance and Expectation at a fair Lay. when it exists. This problem was solved in 1654 by Blaise Pascal in his private correspondence with Pierre de Fermat. This division is the only equitable one when all strange circumstances are eliminated. a Dutch mathematician Christiaan Huygens published a treatise (see Huygens (1657)) “De ratiociniis in ludo aleæ” on probability theory. Whitworth (1901) “Choice and chance”. Pierre-Simon Laplace published his tract “Théorie analytique des probabilités”. or first moment) of a random variable is the integral of the random variable with respect to its probability measure. or mean.” More than a hundred years later. … If I expect a or b. in 1657.A.g. The symbol has become popular since for English writers it meant “Expectation”. but also considered the problem of points. Huygens writes: “That my Chance or Expectation to win any thing is worth just such a Sum. The value may not be expected in the general sense — the "expected value" itself may be unlikely or even impossible (such as having 2. For continuous random variables with a density function it is the probability density-weighted integral of the possible values.[3] It is possible to construct an expected value equal to the probability of an event by taking the expectation of an indicator function that is one if the event has occurred and zero otherwise. e. or mathematical expectation. the expected value (or expectation value. For discrete random variables this is equivalent to the probability-weighted sum of the possible values. based on the chance each has of winning the game from that point. just like the sample mean. [4] Neither Pascal nor Huygens used the term “expectation” in its modern sense. It must not be confused with the "most probable value. This relationship can be used to translate properties of expected values into properties of probabilities. given the current circumstances of the game.5 children). In particular. Three years later. expectation is the mean of all the results. It is often helpful to interpret the expected value of a random variable as the long-run average value of the variable over many independent repetitions of an experiment. it is the partial sum which ought to result when we do not wish to run the risks of the event in supposing that the division is made proportional to the probabilities. want to divide the stakes fairly. posed by a French nobleman chevalier de Méré.[1] [2] Intuitively. where the concept of expected value was defined explicitly:
“
… This advantage in the theory of chance is the product of the sum hoped for by the probability of obtaining it. and have an equal Chance of gaining them. The expected value does not exist for some distributions with large "tails". using the law of large numbers to justify estimating probabilities by frequencies. The expected value may be intuitively understood by the law of large numbers: The expected value. We will call this advantage mathematical hope. however the idea was not communicated to the broad scientific community. The problem was that of two players who want to finish a game early and.Expected value
31
Expected value
In probability theory and statistics. presenting a solution essentially the same as Pascal’s.
”
The use of letter E to denote expected value goes back to W.
History
The idea of the expected value originated in the middle of the 17th century from the study of the so-called problem of points. for Germans “Erwartungswert”. my Expectation is worth .[5]
. in 1814.

then the expected value of is also .The absolute convergence is necessary because conditional convergence means that different order of addition gives different result. g(X).
is a constant random variable.947368421. and the expected value of a one-dollar bet is $0. then the expected value can be
It follows directly from the discrete case definition that if fixed real number . The net change in your financial holdings is −$1 when you lose. on average. which is against the nature of expected value.Expected value
32
Examples
The expected outcome from one roll of an ordinary (that is. A winning bet on a single number pays 35-to-1. Two variables with the same probability distribution will have the same expected value. and $35 when you win. is defined as .
When this integral converges absolutely. is zero) is called a “fair game”. meaning that the original stake is not lost. Here the Lebesgue integral is employed. and 35 times that amount is won. the expected value of the profit resulting from a dollar bet on a single number is the sum of potential net loss times the probability of losing and potential net gain times the probability of winning. In gambling.e. an event of which the expected value equals the stake (i. Note that not all random variables have an expected value.g. i. to lose about five cents for every dollar bet. or net gain. fair) six-sided die is which is not among the possible outcomes. if it is defined. denote a positive real number. then the expected value of .. then the expected value becomes
as in the gambling example mentioned above. Cauchy distribution).
for some
The expected value of an arbitrary function of X. the bettor's expected profit. If the probability distribution of computed as admits a probability density function . it is called the expectation of X.
Mathematical definition
In general. . since the integral may not converge absolutely (e. then
.e. that is. Considering all 38 possible outcomes. with respect to the probability density function f(x) is given by the inner product of f and g:
This is sometimes called the law of the unconscious statistician. if denoted by is a random variable defined on a probability space . an American roulette wheel has 38 places where the ball may land. Using representations as Riemann–Stieltjes integral and integration by parts the formula can be restated as • if • if As a special case let . Thus one may expect. all equally likely.[6] A common application of expected value is gambling. or . so you receive 36 times what you've bet. If is a discrete random variable with probability mass function . For example. .

for
. etc.
Monotonicity
If X and Y are random variables so that almost surely. then .Expected value
33
In particular.
Properties
Constants
The expected value of a constant is equal to the constant itself. • When one speaks of the "expected number of attempts needed to get one successful attempt.
Linearity
The expected value operator (or expectation operator) is linear in the sense that
Note that the second result is valid even if X is not statistically independent of Y. "expected height". Cf. Combining the results from previous three equations. this reduces to:
if
.. then .
Conventional terminology
• When one speaks of the "expected price"." one might conservatively approximate it as the reciprocal of the probability of success for such an attempt. i.e. etc.
and
(which need to be defined on the same probability space) and any real
. we can see that
for any two random variables numbers and . one means the expected value of a random variable that is a price. where F is the cumulative distribution function of X. if c is a constant. a height. expected value of the geometric distribution.

and integrals to replace equalities. the absolute value of expectation of a random variable is less
In particular.Expected value
34
Iterated expectation
Iterated expectation for discrete random variables For any two discrete random variables one may define the conditional expectation:[7]
which means that Then the expectation of
is a function on satisfies
. the results are completely analogous. . Iterated expectation for continuous random variables In the continuous case. the following equation holds:[8]
The right hand side of this equation is referred to as the iterated expectation and is also sometimes called the tower rule. density functions. This proposition is treated in law of total expectation. since
than or equal to the expectation of its absolute value:
. and summations. the main result still holds:
Inequality
If a random variable X is always less than or equal to another random variable Y. mass functions. respectively.
Hence. The definition of conditional expectation would use inequalities. the expectation of X is less than or equal to that of Y: If . However. then and .

. is a . via their moment generating functions. The point at In classical mechanics. Now consider a weightless rod on (whose sum is one). this procedure estimates the true expected value in an unbiased manner and has the property of minimizing the sum of the squares of the residuals (the sum of the squared differences between the observations and the estimate). and corresponding probabilities along the rod and having masses . say j(x. involving expected values of convex (or concave) functions.Expected value
35
Non-multiplicativity
If one considers the joint PDF of X and Y.e. since most quantities of interest can be written in terms of expectation. Then and .y)=f(x)g(y).
Observe that independence of X and Y is required only to write j(x. including general problems of statistical estimation and machine learning. the amount by which multiplicativity fails is called the covariance: Thus multiplicativity holds precisely when
is not necessarily equal to
.e.g. i.
Uses and applications
The expected values of the powers of expected values of powers of are called the moments of . the center of mass is an analogous concept to expectation. This property is often exploited in a wide variety of applications. i. by means of the computational formula for the variance
. in which case
and
are said to be uncorrelated
(independent variables are a notable case of uncorrelated variables).
Functional non-invariance
In general. the expectation operator and functions of random variables do not commute. e. Now if X and Y are independent. as the size of the sample gets larger. For example. The moments of some random variables can be used to specify their
distributions. at locations which the rod balances is . If the expected value exists. The third equality follows from a basic application of the Fubini-Tonelli theorem. the moments about the mean of are . The law of large numbers demonstrates (under fairly mild conditions) that.
Expected values can also be used to compute the variance.y). one repeatedly measures observations of the variable and computes the arithmetic mean of the results. the variance of this estimate gets smaller. then by definition j(x. the expected value operator is not multiplicative. that is
A notable inequality concerning this topic is Jensen's inequality.y)=f(x)g(y) where f and g are the marginal PDFs for X and Y. where is the indicator function for set . To empirically estimate the expected value of a random variable. and this is required to establish the second equality above. then the expectation of XY is
In general. In fact. suppose discrete random variable with values which are placed weights. to estimate (probabilistic) quantities of interest via Monte Carlo methods.

The can be calculated using the formula
36
Expectation of matrices
If is an matrix. This is because
exactly when the first
tosses yielded tails. The expectation of may be computed by . we can have the number of tosses is at least . in particular.Expected value A very important application of the expectation value is in the field of quantum mechanics.
Formulas for special cases
Discrete distribution taking only non-negative integer values
When a random variable takes only values in expectation: we can use the following formula for computing its
Proof:
interchanging the order of summation. Note that we are counting only the tails and not the heads which ends the experiment. How many tosses can we expect until the first heads (not including the heads itself)? Let be this number. . suppose we toss a coin where the probability of heads is . This result can be a useful computational shortcut. we have
as claimed. We used the formula for Geometric progression:
. The expectation value of a quantum mechanical operator uncertainty in operating on a quantum state vector is written as . then the expected value of the matrix is defined as the matrix of expected values: This is utilized in covariance matrices. This matches the expectation of a
random variable with an Exponential distribution. For example.

). Academic Press. "Sampling from the Cauchy distribution and averaging gets you nowhere – one sample has the same distribution as the average of 1000 samples!" [4] In the foreword to his book. . finance. google. [2] Richard W Hamming (1991). that for some time some of the best mathematicians of France have occupied themselves with this kind of calculus so that no one should attribute to me the honour of the first invention. ISBN 0125980620. mean and the expected value" (http:/ / books. when a continuous random variable X takes only non-negative values. "Example 2.
interchanging the order of integration. com/ books?id=jX_F-77TA3gC& pg=PA64).Expected value
37
Continuous distribution taking non-negative values
Analogously with the discrete case above. .7–1 The Cauchy distribution" (http:/ / books. p. google. com/ books?id=jX_F-77TA3gC& printsec=frontcover& dq=isbn:0201406861& cd=1#v=onepage& q=Cauchy& f=false). ISBN 0125980620. Huygens writes: “It should be said. html). com/ stat. .15" (http:/ / books. p. tripod. and it is impossible for me for this reason to affirm that I have even started from the same principle. [6] Sheldon M Ross.5 Random variables. also. we can use the following formula for computing its expectation:
Proof: It is first assumed that X has a density
. google. . ISBN 0125980620. cited work. cited work. "§2. I have had therefore to examine and go deeply for myself into this matter by beginning with the elements. [8] Sheldon M Ross. so that before his book went to press in 1657 he knew about Pascal’s priority in this subject. com/ books?id=12Pk5zZFirEC& pg=PA38). Thus. 97 ff. "§3. com/ books?id=12Pk5zZFirEC& pg=PA39).4: Computing expectations by conditioning" (http:/ / books. com/ books?id=12Pk5zZFirEC& pg=PA97). we have
as claimed. p. 105 ff.
. Addison-Wesley. google. ISBN 0201406861. p. . The art of probability for scientists and engineers. 64 ff. Huygens learned about de Méré’s problem in 1655 during his visit to France. 38 ff. . [7] Sheldon M Ross. "Chapter 3: Conditional probability and conditional expectation" (http:/ / books. have hidden their methods. cited work. In case no density exists. and many other subjects The general term expectation Moment (mathematics) Expectation value (quantum mechanics) Wald's equation for calculating the expected value of a random number of random variables
Notes
[1] Sheldon M Ross (2007). "§2. com/ books?id=12Pk5zZFirEC& pg=PA105). p. "Example 8.4 Expectation of a random variable" (http:/ / books. But finally I have found that my answers in many cases do not differ from theirs. Addison-Wesley. it is seen that
See also
• • • • • • • Conditional expectation An inequality on location and scale parameters Expected value is also a key concept in economics. The art of probability for scientists and engineers. 39. ISBN 0201406861.” (cited in Edwards (2002)). although they put each other to the test by proposing to each other many questions difficult to solve. Introduction to probability models (9th ed. p. google. see Richard W Hamming (1991). 290 ff. [5] "Earliest uses of symbols in probability and statistics" (http:/ / jeff560. This does not belong to me. But these savants. google. [3] For a discussion of the Cauchy distribution. ISBN 0125980620. later on in 1656 from his correspondence with Carcavi he learned that his method was essentially the same as Pascal’s. .

org/?op=getobj&.ifa.id=505) on PlanetMath
Ergodic theory
Ergodic theory is a branch of mathematics that studies dynamical systems with an invariant measure and related problems.uk/depts/maths/histstat/huygens. methods of ergodic theory have been used to study the geodesic flow on Riemannian manifolds. Ergodic theory has fruitful connections with harmonic analysis. lattices in algebraic groups). An outstanding role in ergodic theory and its applications to stochastic processes is played by the various notions of entropy for dynamical systems. Two of the most important examples are ergodic theorems of Birkhoff and von Neumann. (http://www. ISBN 0-8018-6946-3. The first result in this direction is the Poincaré recurrence theorem. • Huygens.pdf)). have also been extensively studied.youtube.com (http://www. Pascal’s arithmetical triangle: the story of a mathematical idea (2nd ed.W. In geometry. L-functions).
.F (2002).com). Lie theory (representation theory. More precise information is provided by various ergodic theorems which assert that. Christiaan (1657). york. the time average is the same for almost all initial points: statistically speaking. youtube.com • Expectation (http://planetmath.
External links
• An 8-foot-tall (2. under certain conditions. and number theory (the theory of diophantine approximations. which claims that almost all points in any subset of the phase space eventually revisit the set. De ratiociniis in ludo aleæ (English translation.).ac. JHU Press. For the special class of ergodic systems. The problem of metric classification of systems is another important part of the abstract ergodic theory. such as mixing and equidistribution.from=objects&.Expected value
38
Historical background
• Edwards. published in 1714: (http://www. the system that evolves for a long time "forgets" its initial state. Stronger properties. A central aspect of ergodic theory is the behavior of a dynamical system when it is allowed to run for a long time. A. Its initial development was motivated by problems of statistical physics. starting with the results of Eberhard Hopf for Riemann surfaces of negative curvature.4 m) Probability Machine (named Sir Francis) comparing stock market returns to the randomness of the beans dropping through the quincunx pattern.com/ watch?v=AUSKTk9ENzg) from Index Funds Advisors IFA. the time average of a function along the trajectories exists almost everywhere and is related to the space average. Markov chains form a common context for applications in probability theory. Applications of ergodic theory to other parts of mathematics usually involve establishing ergodicity properties for systems of special kind.

and thus cannot be ergodic: for any interval I of length a.q)=E} of constant energy. This transformation has even stronger properties of unique ergodicity. A measure-preserving transformation T as above is ergodic if for every with either or . consisting of the continuous characters of G. Let G* be the Pontryagin dual group. By contrast. in an abstract form due to George David Birkhoff. Let T: X → X be a measure-preserving transformation on a measure space (X.) The equidistribution theorem is a special case of the ergodic theorem. More generally. the pointwise or strong ergodic theorem states that the limit in the definition of the time average of f exists for almost every x and that the (almost everywhere defined) limit function is integrable:
. • Ergodicity of a continuous dynamical system means that its trajectories "spread around" the phase space.
Examples
• An irrational rotation of the circle R/Z. In particular. Birkhoff's paper considers not the abstract general case but only the case of dynamical systems arising from differential equations on a smooth manifold. The "time average" is defined as the average (if
it exists) over iterations of T starting from some initial point x. i. ergodicity of the shift transformation associated with a sequence of i.q): H(p. hence the system possesses invariant sets of positive but less than full measure. T: x → x+θ.e.d. if θ = p/q is rational (in lowest terms) then T is periodic. hence it has measure qa strictly between 0 and 1. with period q. in particular.
If
is finite and nonzero. . if G is the n-dimensional torus and the automorphism T is represented by an integral matrix A then T is ergodic if and only if no eigenvalue of A is a root of unity. One may then consider the "time average" of a . Σ. A property of continuous dynamical systems that is the opposite of ergodicity is complete integrability. This applies. More precisely. • A Bernoulli shift is ergodic. but the dynamics of the system is constrained to the level sets of I on X. Liouville's theorem implies the existence of a finite invariant measure on X. is ergodic. A system with a compact phase space which has a non-constant first integral cannot be ergodic.i. random variables and some more general stationary processes follows from Kolmogorov's zero-one law. dealing specifically with the distribution of probabilities on the unit interval. and equidistribution. The automorphism T is ergodic if and only if the equality (T*)n(χ)=χ is possible only when n = 0 or χ is the trivial character of G. and T a group automorphism of G. and T* be the corresponding adjoint automorphism of G*. then the time average is equal to the space average almost everywhere. defined as
In general the time average and space average may be different.
Ergodic theorems
Let be a measure-preserving transformation on a measure space -integrable function f. usually assumed to have finite measure. This is the celebrated ergodic theorem. to Hamiltonian systems with a first integral I functionally independent from the Hamilton function H and a compact level set X = {(p. But if the transformation is ergodic. minimality. • Let G be a compact abelian group. μ). and the measure is invariant. 0 < a < 1/q. we can consider the "space average" or "phase average" of f. where θ is irrational. μ the normalized Haar measure. (Actually.Ergodic theory
39
Ergodic transformations
Ergodic theory is often concerned with ergodic transformations. its orbit under T is a T-invariant mod 0 set that is a union of q intervals of length a.

Probabilistic formulation: Birkhoff–Khinchin theorem
Birkhoff–Khinchin theorem. -algebra. or equivalently. for all x except for a set of measure zero. the time average equals the space average almost surely. if
is also ergodic. one has that
for almost all x. This theorem specializes to the case in which the Hilbert space H consists of L2 functions on a measure space and U is an operator of the form
. Let be the . i. holds in Hilbert spaces.[1] Let be a unitary operator on a Hilbert space but Then. and thus
Corollary (Pointwise ergodic theorem) In particular. then
is the trivial
Mean ergodic theorem
Another form of the ergodic theorem. As an example. then
must be a constant (almost everywhere). Then the pointwise ergodic theorems says that the average velocity of all particles at some given time is equal to the average velocity of one particle over time. assume that the measure space models the particles of a gas as above. Then
where
is the conditional expectation given the
-algebra
of invariant sets of
. more generally.. For an ergodic transformation. if T is ergodic. and if
is finite. the sequence of averages
converges to P in the strong operator topology. Joining the first to the last claim and assuming that
is finite and nonzero.e. von Neumann's mean ergodic theorem. satisfying orthogonal projection onto necessarily surjective linear operator satisfying
where the limit is with respect to the norm on H. and let f(x)
denotes the velocity of the particle at position x. and be a measure-preserving map.
is T-invariant. . for any not necessarily . then the normalization is the same:
In particular.Ergodic theory
40
Furthermore. Let be measurable. and so one has that
almost everywhere. a not for all ). In other words. we have: . . that is to say
holds almost everywhere. an isometric linear operator (that is.

Also. as a simple consequence of the Birkhoff–Khinchin theorem. k2. let Ut be a strongly continuous one-parameter group of unitary operators on H. it is intuitive that its powers will fill up the circle.
. that is
convergence theorem states that the ergodic means of ergodic means may fail to be equidominated in
is integrable. of of the T-invariant sets is a linear projector
be as above a probability space with a measure preserving transformation T. In fact.
Let the occurrence times of a measurable set A be defined as the set k1. Then the operator
converges in the strong operator topology as T → ∞. assuming that the initial point x is in A. Since the circle is symmetric around 0. the longer it takes to return to it. and so the projection onto the space of fixed points must be the zero
Convergence of the ergodic means in the
Let The conditional expectation with respect to the sub-σ-algebra norm 1 of the Banach space characterized as the space of all T-invariant converge to the projector topology if
norms
. however. in an ergodic system. it makes sense that the averages of the powers of 0.
(See almost surely.[2] The ergodic theorem then asserts that the average behavior of a function f over sufficiently large time-scales is approximated by the orthogonal component of f which is time-invariant. . sorted in increasing order. 0 is the only fixed point of operator (which agrees with the limit just described). In another form of the mean ergodic theorem. Remark: Some intuition for the mean ergodic theorem can be developed by considering the case where complex numbers of unit length are regarded as unitary transformations on the complex plane (by left multiplication).. The time spent in a measurable set A is called the sojourn time. If we pick a single complex number of unit length (which we think of as ). thought of in applications as representing a time-step of a discrete dynamical system.. of times k such that Tk(x) is in A..) That is.Ergodic theory
41
where T is a measure-preserving endomorphism of X. so that k0 = 0. Another consequence of the ergodic theorem is that the average recurrence time of A is inversely proportional to the measure of A. Finally. this result also extends to the case of strongly continuous one-parameter semigroup of contractive operators on a reflexive space. the
also have unit operator norm. will converge to . . The ergodic means. as linear operators on if and in the weak operator . and let onto its closed subspace
The latter may also be
-functions on X. in the strong operator topology of . the relative measure of A is equal to the mean sojourn time:
for all x except for a set of measure zero. and. The differences between consecutive occurrence times Ri = ki − ki−1 are called the recurrence times of A. if f is assumed to be in the Zygmund class. k3. then the ergodic means are even dominated in
Sojourn time
Let be a measure space such that is finite and nonzero. if . where
is the indicator function of A. the smaller A is. An immediate consequence of the ergodic theorem is that. More is true if then the Wiener–Yoshida–Kakutani ergodic dominated are dominated in .

.jstor. Ratner's theorems provide a major generalization of ergodicity for unipotent flows on the homogeneous spaces of the form Γ\G.org/cgi/reprint/17/12/656). I.12.jstor. Much of the development described there generalizes to hyperbolic manifolds. 4) 49 (4): 222–226. where G is a Lie group and Γ is a lattice in G. Proc Natl Acad Sci USA 18 (1): 70–82. In the 1930s G.18.R) was described in 1952 by S.17. PMC 1076138. since they can be viewed as quotients of the hyperbolic space by the action of a lattice in the semisimple Lie group SO(n. • von Neumann.org/stable/ 86260). doi:10.pubmedcentral. Ergodicity of the geodesic flow on Riemannian symmetric spaces was demonstrated by F. Proc Natl Acad Sci USA 18 (3): 263–266. PMC 1076204. PMC 1076162. and he was awarded the Fields medal in 2010 for this result. M. there have been many works trying to find a measure-classification theorem similar to Ratner's theorems but for diagonalizable actions. American Mathematical Monthly (The American Mathematical Monthly. Barry Simon.fcgi?tool=pmcentrez&artid=1076162). Mautner in 1957. doi:10. V.pnas. "What is the ergodic theorem?" (http://www.18. "Physical Applications of the Ergodic Hypothesis" (http://www.R) and on Riemann surfaces of negative curvature. 49. "Proof of the Quasi-ergodic Hypothesis" (http://www. Sinai proved ergodicity of the geodesic flow on compact manifolds of variable negative sectional curvature. Fomin and I. Unique ergodicity of the flow was established by Hillel Furstenberg in 1972. In the last 20 years. The article on Anosov flows provides an example of ergodic flows on SL(2. John (1932).nih. • Birkhoff.1073/pnas. doi:10. Vol. • von Neumann.2307/2303229. Anosov and Ya. PMID 16587674. George David (1942).
See also
• • • • • Chaos theory Ergodic hypothesis Ergodic process Maximal ergodic theorem Statistical mechanics
References
[1] I: Functional Analysis : Volume 1 by Michael Reed.Ergodic theory
42
Ergodic flows on manifolds
The ergodicity of the geodesic flow on compact Riemann surfaces of variable negative curvature and on compact manifolds of constant negative curvature of any dimension was proved by Eberhard Hopf in 1939. John (1932).1.656.1073/pnas.gov/ articlerender. motivated by conjectures of Furstenberg and Marguils. although special cases had been studied earlier: see for example. The relation between geodesic flows on Riemann surfaces and one-parameter subgroups on SL(2.1073/pnas. REV edition (1980) [2] (Walters 1982)
Historical references
• Birkhoff.Academic Press. Moore in 1966. C. V. PMID 16577406.org/stable/2303229). A. doi:10. In 1967 D. Hedlund proved that the horocycle flow on a compact hyperbolic surface is minimal and ergodic. No. G. Gelfand.3. Hadamard's billiards (1898) and Artin billiard (1924).1).263. George David (1931). A simple criterion for the ergodicity of a homogeneous flow on a homogeneous space of a semisimple Lie group was given by C.70. PMID 16577432. An important partial result (solving those conjectures with an extra assumption of positive entropy) was proved by Elon Lindenstrauss. Proc Natl Acad Sci USA 17 (12): 656–660. "Proof of the ergodic theorem" (http://www. Many of the theorems and results from this area of study are typical of rigidity theory.

org/stable/1970054). Encyclopaedia of Mathematics. Uspehi Mat. ISBN 0-387-95152-0. • Joseph M.
43
Modern references
• D. I. (1952).) • A. Vol. • Leo Breiman.
External links
• Ergodic Theory (29 October 2007) (http://www. "Geodesic flows on manifolds of constant negative curvature". V. eds. F.2307/1970054.2307/2373052. symbolic dynamics and hyperbolic spaces.html) Notes by Cosma Rohilla Shalizi
. • Moore. Gelfand.) • Peter Walters. "Ergodic theory" (http://eom. An introduction to ergodic theory. Of Math. • Tim Bedford. Focuses on methods developed by Bourgain. Probability. Verhandl. ISBN 978-1556080104 • This article incorporates material from ergodic theorem on PlanetMath. with exercises. Sec. Sergei V. Akad.. Cambridge University Press. 88. 1992. Petersen and Ibrahim A. Math. in Hazewinkel. 2nd ed.. Michiel. No. Springer. (1957). Ergodic theory. • Vladimir Igorevich Arnol'd and André Avez. (American Journal of Mathematics. which is licensed under the Creative Commons Attribution/Share-Alike License. No. Cambridge: Cambridge University Press. Oxford University Press. (1966). Cambridge. 1990. eds. J. Springer 1996. Sächs. (1993) appearing in Ergodic Theory and its Connections with Harmonic Analysis. Amer. reprinted by Society for Industrial and Applied Mathematics. 1968. I. Michael Keane and Caroline Series. Ergodic Problems of Classical Mechanics. Nauk 7 (1): 118–137. 1968.org/stable/2373052). Proceedings of the 1993 Alexandria Conference. 3) 65 (3): 416–431.cscs. "Statistik der geodätischen Linien in Mannigfaltigkeiten negativer Krümmung". ISBN 0-19-853390-X (A survey of topics in ergodic theory. "Geodesic flows on symmetric Riemann spaces" (http://jstor. (1995) Karl E. (An extensive survey of the ergodic properties of generalizations of the equidistribution theorem of shift maps on the unit interval. Rosenblatt and Máté Weirdl. Vol.de/e/e036150. C. 1982.springer. ISBN 0-89871-296-3. (1991). (The Annals of Mathematics. ISBN 0-387-94549-0.umich. Anosov (2001). Ann. • Mautner. Ergodic Theory (Cambridge Studies in Advanced Mathematics). doi:10.edu/~crshalizi/notebooks/ergodic-theory. Springer. Leipzig Ber.3. Shiryaev. Pointwise ergodic theorems via harmonic analysis. M. (See Chapter 6.htm). Eberhard (1939).A.) • Karl Petersen. New York: W. C. ISBN 0-521-45999-0.V. Original edition published by Addison–Wesley. Benjamin. • Fomin. Salama. "Ergodicity of flows on homogeneous spaces" (http://jstor. Wiss. Probability. doi:10. 1) 88 (1): 154–178. New York.N. 91: 261–304. 65..Ergodic theory • Hopf.

Feynman–Kac formula
44
Feynman–Kac formula
The Feynman–Kac formula. establishes a link between parabolic partial differential equations (PDEs) and stochastic processes.
defined for all real
and
in the interval
. Conversely. the third term is
[1]
. Consider the PDE. Specifically. Applying Itō's
lemma once again to . Suppose we wish to find the expected value of the function
in the case where under the conditions that
is some realization of a diffusion process starting at . named after Richard Feynman and Mark Kac.
. and observing that the right side is an Itō integral. the above PDE and is therefore zero. The desired result is
Remarks
When originally published by Kac in 1949. Let one gets
be the solution to
and can be dropped. What remains is
Integrating this equation from
to
.
Proof
NOTE: The proof presented below is essentially that of above PDE. which has . an important class of expectations of random processes can be computed by deterministic methods.
This expectation can then be approximated using Monte Carlo or quasi-Monte Carlo methods. albeit with more detail. one concludes that
Upon taking expectations. it follows that The first term contains. It offers a method of solving certain PDEs by simulating random paths of a stochastic process. Then the Feynman–Kac
formula tells us that the solution can be written as an expectation:
where
is an Itō process driven by the equation
with
is a Wiener process (also called Brownian motion) and the initial condition for
is
.
is a parameter and
is the unknown. Applying Itō's lemma to the process Since . in parentheses. subject to the terminal condition
where
are known functions. it follows that obtained by observing that
. The Feynman–Kac
formula says that this expectation is equivalent to the integral of a solution to a diffusion equation.
.[2] the Feynman–Kac formula was presented as a formula for determining the distribution of certain Wiener functionals. conditioned on expectation zero.

See also
• • • • Itō's lemma Kunita–Watanabe theorem Girsanov theorem Kolmogorov forward equation (also known as Fokker–Planck equation)
References
• Simon. Academic Press. Mark (1949). edu/ faculty/ kohn/ pde_finance. Functional Integration and Quantum Physics. org/ stable/ 1990512).
[1] http:/ / www. then
where
is a solution to the parabolic partial differential equation
with initial condition
. . jstor.2307/1990512. Retrieved 2008-05-30.Feynman–Kac formula where and
45
The Feynman–Kac formula can also be interpreted as a method for evaluating functional integrals of a certain form.
. Barry (1979). If
where the integral is taken over all random walks. doi:10. math. Transactions of the American Mathematical Society 65 (1): 1–13. "On Distributions of Certain Wiener Functionals" (http:/ / www. html [2] Kac. nyu.

Fourier transform

46

Fourier transform

In mathematics, the Fourier transform (often abbreviated FT) is an operation that transforms one complex-valued function of a real variable into another. In such applications as signal processing, the domain of the original function is typically time and is accordingly called the time domain. The domain of the new function is typically called the frequency domain, and the new function itself is called the frequency domain representation of the original function. It describes which frequencies are present in the original function. This is analogous to describing a musical chord in terms of the individual notes being played. In effect, the Fourier transform decomposes a function into oscillatory functions. The term Fourier transform refers both to the frequency domain representation of a function, and to the process or formula that "transforms" one function into the other. The Fourier transform and its generalizations are the subject of Fourier analysis. In this specific case, both the time and frequency domains are unbounded linear continua. It is possible to define the Fourier transform of a function of several variables, which is important for instance in the physical study of wave motion and optics. It is also possible to generalize the Fourier transform on discrete structures such as finite groups. The efficient computation of such structures, by fast Fourier transform, is essential for high-speed computing.

Fourier transforms Continuous Fourier transform Fourier series Discrete Fourier transform Discrete-time Fourier transform Related transforms

Definition

There are several common conventions for defining the Fourier transform of an integrable function ƒ : R → C (Kaiser 1994). This article will use the definition: for every real number ξ. When the independent variable x represents time (with SI unit of seconds), the transform variable ξ represents frequency (in hertz). Under suitable conditions, ƒ can be reconstructed from for every real number x. For other common conventions and notations, including using the angular frequency ω instead of the frequency ξ, see Other conventions and Other notations below. The Fourier transform on Euclidean space is treated separately, in which the variable x often represents position and ξ momentum. by the inverse transform:

Introduction

The motivation for the Fourier transform comes from the study of Fourier series. In the study of Fourier series, complicated periodic functions are written as the sum of simple waves mathematically represented by sines and cosines. Due to the properties of sine and cosine it is possible to recover the amount of each wave in the sum by an integral. In many cases it is desirable to use Euler's formula, which states that e2πiθ = cos 2πθ + i sin 2πθ, to write Fourier series in terms of the basic waves e2πiθ. This has the advantage of simplifying many of the formulas involved and providing a formulation for Fourier series that more closely resembles the definition followed in this article. This passage from sines and cosines to complex exponentials makes it necessary for the Fourier coefficients to be

Fourier transform complex valued. The usual interpretation of this complex number is that it gives both the amplitude (or size) of the wave present in the function and the phase (or the initial angle) of the wave. This passage also introduces the need for negative "frequencies". If θ were measured in seconds then the waves e2πiθ and e−2πiθ would both complete one cycle per second, but they represent different frequencies in the Fourier transform. Hence, frequency no longer measures the number of cycles per unit time, but is closely related. We may use Fourier series to motivate the Fourier transform as follows. Suppose that ƒ is a function which is zero outside of some interval [−L/2, L/2]. Then for any T ≥ L we may expand ƒ in a Fourier series on the interval [−T/2,T/2], where the "amount" (denoted by cn) of the wave e2πinx/T in the Fourier series of ƒ is given by

47

and ƒ should be given by the formula

If we let ξn = n/T, and we let Δξ = (n + 1)/T − n/T = 1/T, then this last sum becomes the Riemann sum

By letting T → ∞ this Riemann sum converges to the integral for the inverse Fourier transform given in the Definition section. Under suitable conditions this argument may be made precise (Stein & Shakarchi 2003). Hence, as in the case of Fourier series, the Fourier transform can be thought of as a function that measures how much of each individual frequency is present in our function, and we can recombine these waves by using an integral (or "continuous sum") to reproduce the original function. The following images provide a visual illustration of how the Fourier transform measures whether a frequency is present in a particular function. The function depicted oscillates at 3 hertz (if t measures seconds) and tends quickly to 0. This function was specially chosen to have a real Fourier transform which can easily be plotted. The first image contains its graph. In order to calculate we must integrate e−2πi(3t)ƒ(t). The second image shows the plot of the real and imaginary parts of this function. The real part of the integrand is almost always positive, this is because when ƒ(t) is negative, then the real part of e−2πi(3t) is negative as well. Because they oscillate at the same rate, when ƒ(t) is positive, so is the real part of e−2πi(3t). The result is that when you integrate the real part of the integrand you get a relatively large number (in this case 0.5). On the other hand, when you try to measure a frequency that is not present, as in the case when we look at , the integrand oscillates enough so that the integral is very small. The general situation may be a bit more complicated than this, but this in spirit is how the Fourier transform measures how much of an individual frequency is present in a function ƒ(t).

Original function showing oscillation 3 hertz.

Real and imaginary parts of integrand for Fourier transform at 3 hertz

Real and imaginary parts of integrand for Fourier transform at 5 hertz

Fourier transform with 3 and 5 hertz labeled.

Fourier transform

48

**Properties of the Fourier transform
**

An integrable function is a function ƒ on the real line that is Lebesgue-measurable and satisfies

Basic properties

Given integrable functions f(x), g(x), and h(x) denote their Fourier transforms by respectively. The Fourier transform has the following basic properties (Pinsky 2002). Linearity For any complex numbers a and b, if h(x) = aƒ(x) + bg(x), then Translation For any real number x0, if h(x) = ƒ(x − x0), then Modulation For any real number ξ0, if h(x) = e2πixξ0ƒ(x), then Scaling For a non-zero real number a, if h(x) = ƒ(ax), then time-reversal property, which states: if h(x) = ƒ(−x), then Conjugation If , then . . The case a = −1 leads to the . , , and

In particular, if ƒ is real, then one has the reality condition And if ƒ is purely imaginary, then Convolution If , then

Uniform continuity and the Riemann–Lebesgue lemma

The rectangular function is Lebesgue integrable.

The sinc function, the Fourier transform of the rectangular function, is bounded and continuous, but not Lebesgue integrable.

The Fourier transform

of an integrable function ƒ is bounded and continuous, but need not be integrable – for

example, the Fourier transform of the rectangular function, which is a step function (and hence integrable) is the sinc

Fourier transform function, which is not Lebesgue integrable, though it does have an improper integral: one has an analog to the alternating harmonic series, which is a convergent sum but not absolutely convergent. It is not possible in general to write the inverse transform as a Lebesgue integral. However, when both ƒ and integrable, the following inverse equality holds true for almost every x: are

49

Almost everywhere, ƒ is equal to the continuous function given by the right-hand side. If ƒ is given as continuous function on the line, then equality holds for every x. A consequence of the preceding result is that the Fourier transform is injective on L1(R).

**The Plancherel theorem and Parseval's theorem
**

Let f(x) and g(x) be integrable, and let and be their Fourier transforms. If f(x) and g(x) are also square-integrable, then we have Parseval's theorem (Rudin 1987, p. 187):

where the bar denotes complex conjugation. The Plancherel theorem, which is equivalent to Parseval's theorem, states (Rudin 1987, p. 186):

The Plancherel theorem makes it possible to define the Fourier transform for functions in L2(R), as described in Generalizations below. The Plancherel theorem has the interpretation in the sciences that the Fourier transform preserves the energy of the original quantity. It should be noted that depending on the author either of these theorems might be referred to as the Plancherel theorem or as Parseval's theorem. See Pontryagin duality for a general formulation of this concept in the context of locally compact abelian groups.

**Poisson summation formula
**

The Poisson summation formula provides a link between the study of Fourier transforms and Fourier Series. Given an integrable function ƒ we can consider the periodic summation of ƒ given by:

where the summation is taken over the set of all integers k. The Poisson summation formula relates the Fourier series of to the Fourier transform of ƒ. Specifically it states that the Fourier series of is given by:

Fourier transform

50

Convolution theorem

The Fourier transform translates between convolution and multiplication of functions. If ƒ(x) and g(x) are integrable functions with Fourier transforms and respectively, then the Fourier transform of the convolution is given by the product of the Fourier transforms Fourier transform a constant factor may appear). This means that if: and (under other conventions for the definition of the

where ∗ denotes the convolution operation, then:

In linear time invariant (LTI) system theory, it is common to interpret g(x) as the impulse response of an LTI system with input ƒ(x) and output h(x), since substituting the unit impulse for ƒ(x) yields h(x) = g(x). In this case, represents the frequency response of the system. Conversely, if ƒ(x) can be decomposed as the product of two square integrable functions p(x) and q(x), then the Fourier transform of ƒ(x) is given by the convolution of the respective Fourier transforms and .

**Cross-correlation theorem
**

In an analogous manner, it can be shown that if h(x) is the cross-correlation of ƒ(x) and g(x):

then the Fourier transform of h(x) is:

As a special case, the autocorrelation of function ƒ(x) is:

for which

Eigenfunctions

One important choice of an orthonormal basis for L2(R) is given by the Hermite functions

where

are the "probabilist's" Hermite polynomials, defined by Hn(x) = (−1)nexp(x2/2) Dn exp(−x2/2). Under

this convention for the Fourier transform, we have that In other words, the Hermite functions form a complete orthonormal system of eigenfunctions for the Fourier transform on L2(R) (Pinsky 2002). However, this choice of eigenfunctions is not unique. There are only four different eigenvalues of the Fourier transform (±1 and ±i) and any linear combination of eigenfunctions with the same eigenvalue gives another eigenfunction. As a consequence of this, it is possible to decompose L2(R) as a direct sum of four spaces H0, H1, H2, and H3 where the Fourier transform acts on Hk simply by multiplication by ik. This approach to define the Fourier transform is due to N. Wiener (Duoandikoetxea 2001). The choice of Hermite functions is convenient because they are exponentially localized in both frequency and time domains, and thus give rise to the fractional Fourier transform used in time-frequency analysis (Boashash 2003).

Fourier transform

51

**Fourier transform on Euclidean space
**

The Fourier transform can be in any arbitrary number of dimensions n. As with the one-dimensional case there are many conventions, for an integrable function ƒ(x) this article takes the definition:

where x and ξ are n-dimensional vectors, and x · ξ is the dot product of the vectors. The dot product is sometimes written as . All of the basic properties listed above hold for the n-dimensional Fourier transform, as do Plancherel's and Parseval's theorem. When the function is integrable, the Fourier transform is still uniformly continuous and the Riemann–Lebesgue lemma holds. (Stein & Weiss 1971)

Uncertainty principle

Generally speaking, the more concentrated f(x) is, the more spread out its Fourier transform must be. In particular, the scaling property of the Fourier transform may be seen as saying: if we "squeeze" a function in x, its Fourier transform "stretches out" in ξ. It is not possible to arbitrarily concentrate both a function and its Fourier transform. The trade-off between the compaction of a function and its Fourier transform can be formalized in the form of an Uncertainty Principle by viewing a function and its Fourier transform as conjugate variables with respect to the symplectic form on the time–frequency domain: from the point of view of the linear canonical transformation, the Fourier transform is rotation by 90° in the time–frequency domain, and preserves the symplectic form. Suppose ƒ(x) is an integrable and square-integrable function. Without loss of generality, assume that ƒ(x) is normalized:

It follows from the Plancherel theorem that

is also normalized.

The spread around x = 0 may be measured by the dispersion about zero (Pinsky 2002) defined by

In probability terms, this is the second moment of

about zero.

The Uncertainty principle states that, if ƒ(x) is absolutely continuous and the functions x·ƒ(x) and ƒ′(x) are square integrable, then (Pinsky 2002). The equality is attained only in the case (hence ) where σ > 0

is arbitrary and C1 is such that ƒ is L2–normalized (Pinsky 2002). In other words, where ƒ is a (normalized) Gaussian function, centered at zero. In fact, this inequality implies that: for any in R (Stein & Shakarchi 2003).

In quantum mechanics, the momentum and position wave functions are Fourier transform pairs, to within a factor of Planck's constant. With this constant properly taken into account, the inequality above becomes the statement of the Heisenberg uncertainty principle (Stein & Shakarchi 2003).

It is still an active area of study to understand restriction problems in Lp for 1 < p < 2. For n = 1 and 1 < p < ∞. The set Ak consists of the solid spherical harmonics of degree k. then convergence still holds. Unfortunately. if one takes ER = (−R. For a given integrable function ƒ. the restriction of the Fourier transform of an L2(Rn) function cannot be defined on sets of measure 0. In the case that ER is taken to be a cube with side length R. In fact. For n ≥ 2 it is a celebrated theorem of Charles Fefferman that the multiplier for the unit ball is never bounded unless p = 2 (Duoandikoetxea 2001). by the boundedness of the Hilbert transform. it is necessary that the multiplier for the unit ball be bounded in Lp(Rn). The case when S is the unit sphere in Rn is of particular interest. Further : L2(R) → L2(R) is a unitary operator (Stein & Weiss 1971. When k = 0 this gives a useful formula for the Fourier transform of a radial function (Grafakos 2004). then . Let the set Hk be the closure in L2(Rn) of linear combinations of functions of the form f(|x|)P(x) where P(x) is in Ak. As such. But for a square-integrable function the Fourier transform could be a general class of square integrable functions. the Plancherel theorem allows us to extend the definition of the Fourier transform to general functions in L2(R) by continuity arguments. then where Here J(n + 2k − 2)/2 denotes the Bessel function of the first kind with order (n + 2k − 2)/2. In fact. Another natural candidate is the Euclidean ball ER = {ξ : |ξ| < R}. or cubes of side 2R. Many of the properties remain the same for the Fourier transform.Fourier transform
52
Spherical harmonics
Let the set of homogeneous harmonic polynomials of degree k on Rn be denoted by Ak. further extensions become more technical. but for some functions ƒ ∈ Lp(Rn). Specifically. The Fourier transform of an integrable function is continuous and the restriction of this function to any set is defined. Since compactly supported smooth functions are integrable and dense in L2(R).3). The Hausdorff–Young inequality can be used to extend the definition of the Fourier transform to include functions in Lp(R) for 1 ≤ p ≤ 2. R). Surprisingly. it can be shown that there are functions in Lp with p>2 so that the Fourier transform is not defined as a function (Stein & Weiss
. In order for this partial sum operator to converge.∞): such as balls of radius R centered at the origin. consider the function ƒR defined by:
Suppose in addition that ƒ is in Lp(Rn). then ƒR converges to ƒ in Lp as R tends to infinity. Thm. Consider an increasing collection of measurable sets ER indexed by R ∈ (0. In this case the Tomas-Stein restriction theorem states that the restriction of the Fourier transform to the unit sphere in Rn is a bounded operator on Lp provided 1 ≤ p ≤ (2n + 2) / (n + 3). it is possible in some cases to define the restriction of a Fourier transform to a set S.
Restriction problems
In higher dimensions it becomes interesting to study restriction problems for the Fourier transform. when p ≠ 2. One notable difference between the Fourier transform in 1 dimension versus higher dimensions concerns the partial sum operator.
Generalizations
Fourier transform on other function spaces
It is possible to extend the definition of the Fourier transform to other spaces of functions. if f(x) = e−π|x|2P(x) for some P(x) in Ak. ƒR is not even an element of Lp. Let ƒ(x) = ƒ0(|x|)P(x) (with P(x) in Ak). The Fourier transform of functions in Lp for the range 2 < p < ∞ requires the study of distributions (Katznelson 1976). Naively one may hope the same holds true for n > 1. 2. The solid spherical harmonics play a similar role in higher dimensions to the Hermite polynomials in dimension one. The space L2(Rn) is then a direct sum of the spaces Hk and the Fourier transform maps each space Hk to itself and is possible to characterize the action of the Fourier transform on each space Hk (Stein & Weiss 1971). this shows that not only may ƒR fail to converge to ƒ in Lp. provided S has non-zero curvature.

First let ƒ and g be integrable functions. and gives a homeomorphism of the space to itself (Stein & Weiss 1971). A locally compact abelian group is an abelian group which is at the same time a locally compact Hausdorff topological space so that the group operations are continuous. Because of this it is possible to define the Fourier transform of tempered distributions. For a locally compact abelian group G it is possible to place a topology on the set of characters so that is also a locally compact abelian group. The Fourier transform may be used to give a characterization of continuous measures. In the case when the distribution has a probability density function this definition reduces to the Fourier transform applied to the probability density function. For a function ƒ in L1(G) it is possible to define the Fourier
. and let and be their Fourier transforms respectively. again with a different choice of constants. These include all the integrable functions mentioned above and have the added advantage that the Fourier transform of any tempered distribution is again a tempered distribution. Then the Fourier transform obeys the following multiplication formula (Stein & Weiss 1971). It follows that
Distributions can be differentiated and the above mentioned compatibility of the Fourier transform with differentiation and convolution remains true for tempered distributions. we define the Fourier transform by the relation for all Schwartz functions φ. then the formula above reduces to the usual definition for the Fourier transform of ƒ.
53
Fourier–Stieltjes transform
The Fourier transform of a finite Borel measure μ on Rn is given by (Pinsky 2002):
This transform continues to enjoy many of the properties of the Fourier transform of integrable functions. In the case that dμ = ƒ(x) dx. the Dirac delta function is not a function but it is a finite Borel measure.
Tempered distributions
The Fourier transform maps the space of Schwartz functions to itself. In the case that μ is the probability distribution associated to a random variable X.
Secondly. One notable difference is that the Riemann–Lebesgue lemma fails for measures (Katznelson 1976).
Locally compact abelian groups
The Fourier transform may be generalized to any locally compact abelian group. called Haar measure. the Fourier-Stieltjes transform is closely related to the characteristic function. given a distribution T. Furthermore. The following two facts provide some motivation for the definition of the Fourier transform of a distribution. every integrable function ƒ defines a distribution Tƒ by the relation for all Schwartz functions φ. Bochner's theorem characterizes which functions may arise as the Fourier–Stieltjes transform of a measure (Katznelson 1976). but the typical conventions in probability theory take eix·ξ instead of e−2πix·ξ (Pinsky 2002). If G is a locally compact abelian group. Its Fourier transform is a constant function (whose specific value depends upon the form of the Fourier transform used). In fact. it has a translation invariant measure μ.Fourier transform 1971).

this isomorphism of Banach spaces is in fact an isomorphism of C* algebras into a subspace of C∞(Σ). Given a locally compact Hausdorff topological space X.
Non-abelian groups
The Fourier transform can also be defined for functions on a non-abelian group. The Peter-Weyl theorem holds.
. and can be identified with evaluation at a point of x. The generalization of the Fourier transform to the noncommutative situation has also in part contributed to the development of noncommutative geometry. if μ is absolutely
continuous with respect to the left-invariant probability measure λ on G. this loses the connection with harmonic functions. The mapping defines an isomorphism between the Banach space M(G) of finite Borel measures (see rca
space) and a closed subspace of the Banach space C∞(Σ) consisting of all sequences E = (Eσ) indexed by Σ of (bounded) linear operators Eσ : Hσ → Hσ for which the norm
is finite. complex conjugation. and a version of the Fourier inversion formula (Plancherel's theorem) follows: if ƒ ∈ L2(G). a categorical generalization of the Fourier transform to noncommutative groups is Tannaka-Krein duality. In this context. denoted are naturally a topological space. and one has an isometric isomorphism In the case where X=R is the real line. in which M(G) is equipped with the product given by convolution of measures and C∞(Σ) the product given by multiplication of operators in each index σ. Let Σ denote the collection of all isomorphism classes of finite-dimensional irreducible unitary representations. provided that the group is compact. which is scalar-valued. and with norm as the uniform norm. Chapter 8). along with a definite choice of representation U(σ) on the Hilbert space Hσ of finite dimension dσ for each σ ∈ Σ. then
where the summation is understood as convergent in the L2 sense. then it is represented as for some ƒ ∈ L1(λ). In this case. The "convolution theorem" asserts that. multiplication. the space A=C0(X) of continuous complex-valued functions on X which vanish at infinity is in a natural way a commutative C*-algebra. The Fourier transform on compact groups is a major tool in representation theory (Knapp 2001) and non-commutative harmonic analysis. the characters of this algebra A. Let G be a compact Hausdorff topological group. which replaces the group of characters with the category of representations.Fourier transform transform by (Katznelson 1976):
54
Locally compact Hausdorff space
The Fourier transform may be generalized to any locally compact Hausdorff space. via pointwise addition. the Fourier transform on a non-abelian group is operator-valued (Hewitt & Ross 1971. this is exactly the Fourier transform. furthermore. one identifies the Fourier transform of ƒ with the Fourier–Stieltjes transform of μ. Conversely. Unlike the Fourier transform on an abelian group. If μ is a finite Borel measure on G. As in the abelian case. which recovers the topology but loses the group structure. However. then the Fourier–Stieltjes transform of μ is the operator on Hσ defined by
where
is the complex-conjugate representation of U(σ) acting on Hσ.

g. such as the short-time Fourier transform or fractional Fourier transform. there is a trade-off between these.Fourier transform
55
Alternatives
In signal processing terms. where 1/p + 1/q = 1 and 1 ≤ p ≤ 2 (Hausdorff–Young inequality).
Applications
Analysis of differential equations
Fourier transforms and the closely related Laplace transforms are widely used in solving differential equations. (Boashash 2003). a function (of time) is a representation of a signal with perfect time resolution. More details may be found in (Stein & Weiss 1971). but no frequency information. the De Groot Fourier Transform can be considered.
. while the Fourier transform has perfect frequency resolution. with the wavelet analog of the (continuous) Fourier transform being the continuous wavelet transform. one uses time-frequency transforms or time-frequency distributions to represent signals in a form that has some time information and some frequency information – by the uncertainty principle. as in wavelet transforms and chirplet transforms. e. Unfortunately. For a variable time and frequency resolution. • In particular. It is possible to extend the domain of the Fourier transform in various ways. and standing waves are not localized in time – a sine wave continues out to infinity. as discussed in generalizations above. then the Fourier transform of its derivative is given by . The definition of Fourier transform as an integral naturally restricts the domain to the space of integrable functions. This can be used to transform differential equations into algebraic equations. Schwartz functions are rapidly decaying functions and do not include all functions which are relevant for the Fourier transform. there is no simple characterizations of which functions are Fourier transforms of integrable functions (Stein & Weiss 1971).
Fourier transform spectroscopy
The Fourier transform is also used in nuclear magnetic resonance (NMR) and in other kinds of spectroscopy. This limits the usefulness of the Fourier transform for analyzing signals that are localized in time. in time-frequency analysis. The following list details some of the more common domains and ranges on which the Fourier transform is defined. notably transients. • The space L1 of Lebesgue integrable functions maps into C0. These can be generalizations of the Fourier transform. • The space of Schwartz functions is closed under the Fourier transform. Note that this technique only applies to problems whose domain is the whole set of real numbers. but location is only given by phase (argument of the Fourier transform at a point). the space L2 is closed under the Fourier transform. infrared (FTIR). but no time information: the magnitude of the Fourier transform at a point is how much frequency content there is.
Domain and range of the Fourier transform
It is often desirable to have the most general domain for the Fourier transform as possible. the space of continuous functions that tend to zero at infinity – not just into the space of bounded functions (the Riemann–Lebesgue lemma). • The space Lp maps into the space Lq. or any signal of finite extent. but here the Fourier transform is no longer defined by integration. As alternatives to the Fourier transform. In NMR an exponentially-shaped free induction decay (FID) signal is acquired in the time domain and Fourier-transformed to a Lorentzian line-shape in the frequency domain. without decaying. By extending the Fourier transform to functions of several variables partial differential equations with domain Rn can also be translated into algebraic equations. The Fourier transform is compatible with differentiation in the following sense: if f(x) is a differentiable function with Fourier transform . The Fourier transform is also used in magnetic resonance imaging (MRI) and mass spectrometry. or can use different functions to represent signals.

the previous notation appears frequently. The interpretation of the complex function may be aided by expressing it in polar coordinate form:
in terms of the two real functions A(ξ) and φ(ξ) where: is the amplitude and
is the phase (see arg function). This mapping is linear. Tempered distributions are also a form of generalization of functions. Notice that is applied first to f and then the resulting function is evaluated
at ξ. often when a particular function or a function of a particular variable is to be transformed. In mathematics and various applied sciences it is often necessary to distinguish between a function f and the value of f when its variable equals x. is sometimes used to express that the Fourier transform of a rectangular function is a sinc function. it is implicitly understood that or as . Despite this flaw. not the other way around. and this is denoted either as in the former case.
. Since the result of applying the Fourier transform is again a function. This mapping is here denoted is used to denote the Fourier transform of the function f. which means that and can
also be seen as a linear transformation on the function space and implies that the standard notation in linear algebra of applying a linear transformation to a vector (here the function f) can be used to write instead of . For example.
56
Other notations
Other common notations for are these: Though less commonly other notations are used. Then the inverse transform can be written:
which is a recombination of all the frequency components of ƒ(x). and sometimes it is written informally as F(2πf) in order to use ordinary frequency. the omega (ω) is often used instead of ξ due to its interpretation as angular frequency. Denoting the Fourier transform by a capital letter corresponding to the letter of function being transformed (such as f(x) and F(ξ)) is especially common in the sciences and engineering. denoted f(x). or is used to express the shift property of the Fourier transform. sometimes it is written as F(jω). that the last example is only correct under the assumption that the transformed function is a function of x. Each component is a complex sinusoid of the form e2πixξ whose amplitude is A(ξ) and whose initial phase angle (at x = 0) is φ(ξ). to indicate its relationship with the Laplace transform. In electronics. we can be interested in the value of this function evaluated at the value ξ for its variable. Notice. It is in this generality that one can define the Fourier transform of objects like the Dirac comb. where j is the imaginary unit. The Fourier transform may be thought of as a mapping on function spaces. This means that a notation like formally can be interpreted as the Fourier transform of the values of f at x. not of x0.Fourier transform • The set of tempered distributions is closed under the Fourier transform.

As in the case of the "non-unitary angular
frequency" convention above. In the physics literature. the inverse transform becomes:
Unlike the convention followed in this article. but in this context it is typical to take a different convention for the constants. It also restores the symmetry between the Fourier transform and its inverse.
. the Fourier transform is again a unitary transformation on L2(Rn). or in the exponential. Variations of all three conventions can be created by conjugating the complex-exponential kernel of both the forward and the reverse transform.
Summary of popular forms of the Fourier transform
ordinary frequency ξ (hertz) unitary
angular frequency ω (rad/s)
non-unitary
unitary
The ordinary-frequency convention (which is used in this article) is the one most often found in the mathematics literature. this convention takes the opposite sign in the exponential. Another convention is to split the factor of (2π)n evenly between the Fourier transform and its inverse. there is no factor of 2π appearing in either of the integral. the two angular-frequency conventions are more commonly used. The signs must be opposites. There is also less symmetry between the formulas for the Fourier transform and its inverse.Fourier transform
57
Other conventions
The Fourier transform can aslo be written in terms of angular frequency: ω = 2πξ whose units are radians per second. Typically characteristic function is defined . the characteristic function of a random variable is the same as the Fourier–Stieltjes transform of its distribution measure. when the Fourier transform is defined this way. Unlike any of the conventions appearing above. which leads to definitions:
Under this convention. Other than that. it is no longer a unitary transformation on L2(Rn). the choice is (again) a matter of convention. The substitution ξ = ω/(2π) into the formulas above produces this convention:
Under this convention. As discussed above.

angular frequency Remarks
Definition
101 102
Linearity Shift in time domain Shift in frequency domain. and respectively. .
.
Functional relationships
The Fourier transforms in this table may be found in (Erdélyi 1954) or the appendix of (Kammler 2000). angular frequency Fourier transform non-unitary. Only the three most common conventions are included. then is concentrated around 0 and
103
104
spreads out and flattens. dual of 102 Scaling in the time domain. It is sometimes useful to notice that entry 105 gives a relationship between the Fourier transform of a function and the original function. ordinary frequency Fourier transform unitary. If is large. which can be seen as relating the Fourier transform and its inverse.
Function Fourier transform unitary. g(x) and h(x) denote their Fourier transforms by . For functions ƒ(x) .Fourier transform
58
Tables of important Fourier transforms
The following tables record some closed form Fourier transforms.

Results from swapping "dummy" variables of and or or . and are purely imaginary odd functions.
105
106 107 This is the dual of 106 The notation denotes the convolution of and — this rule is the convolution theorem 109 This is the dual of 108 a purely Hermitian symmetry. and are purely real even functions.Fourier transform
59
Duality. 111 For a purely . indicates the complex conjugate.
108
110 For real
real even function 112 For a purely . Here needs to be calculated using the same method as Fourier transform column.
real odd function
.

(Erdélyi 1954). the Gaussian function exp(−αx2) is its own Fourier transform for some choice of α.Fourier transform
60
Square-integrable functions
The Fourier transforms in this table may be found in (Campbell & Foster 1948). The function u(x) is the Heaviside unit step function and a>0. angular frequency Fourier transform non-unitary. The function tri(x) is the triangular function Dual of rule 203. here defined as sinc(x) = sin(πx)/(πx) Dual of rule 201. For this to be integrable we must have Re(α)>0. ordinary frequency Fourier transform unitary. or the appendix of (Kammler 2000).
Function Fourier transform unitary. angular frequency Remarks
201
The rectangular pulse and the normalized sinc function. The rectangular function is an ideal low-pass filter. for the unitary Fourier transforms.
202
203
204
205
206
. This shows that. and the sinc function is the non-causal impulse response of such a filter.

ordinary frequency Fourier transform unitary.Fourier transform
61
For a>0. The functions Un (x) are the Chebyshev polynomial of the second kind. The functions Jn (x) are the n-th order Bessel functions of the first kind. That is. Hyperbolic secant is its own Fourier transform
207
208
209
Distributions
The Fourier transforms in this table may be found in (Erdélyi 1954) or the appendix of (Kammler 2000). angular frequency Remarks
The distribution δ(ξ) denotes the Dirac delta function.
2
This follows from 103 and 301. See 315 and 316 below.
1
Dual of rule 301.
Function Fourier transform unitary. the Fourier transform of a decaying exponential function is a Lorentzian function.
3
This follows from rules 101 and 303 using Euler's formula:
4
This follows from 101 and 303 using
5
6
. angular frequency Fourier transform non-unitary.

(See homogeneous distribution. It is necessary to use the Cauchy principal value when testing against Schwartz the Hilbert transform. The function J (x) is the n-th order Bessel
n n
6
function of first kind. Here sgn(ξ) is the sign function. This rule follows rule with 101. together with the fac
as distributions. The function J (x) is the zeroth order
0
5
Bessel function of first kind. we can transform all polynomials. It admits a unique meromorphic extension to a tempered distribution.
is the Chebyshev polynomial of the firs
. . This rule is useful in studyin
0
If Re α > −1.. Combining thi
9
functions. The function u(x) is the Heaviside unit step function. This time the as Cauchy principal value. −4.) The dual of rule 309. 301. The function a holomorphic function from the right half-plane to the space of tempered distributions. This result can be deriv that
from 302 and 102.
This is a generalization of 315. Note that 1/x is not a distribution. also denoted −2. 1/xn is the homogeneous distribution defined by the distributional derivative
8
is the n-th distribution derivative of the
from rules 107 and 301. then
is a locally
1
integrable function.Fourier transform
62
7
Here. and 312. this follows from rules 101.. This function is known as the Dirac for α ≠
2
Fourier transforms need to be considere
3
4
comb function. n is a natural number and Dirac delta function. The function T (x kind. and so a tempered distribution.

by analytic continuation. and is expressed using J1 (the order 1 Bessel function of the first kind).3)
Formulas for general n-dimensional functions
Function Fourier transform unitary. See homogeneous distribution.13) To 502: See Riesz potential. The function Γ(x) is the gamma function. Thm.. ordinary frequency Fourier transform unitary. ξy. −n−1. IV. To 401: Both functions are Gaussians. angular frequency
500
501
502
Remarks To 501: The function χ[0.
.1]. This is the Airy distribution. Thm. ordinary frequency Fourier transform unitary. angular frequency
Remarks To 400: The variables ξx. angular frequency Fourier transform non-unitary. but then the function and its Fourier transforms need to be understood as suitably regularized tempered distributions.1] is the indicator function of the interval [0. The formula also holds for all α ≠ −n.. with order n/2+δ. To 402: The function is defined by circ(r)=1 0≤r≤1. ωy. (Stein & Weiss 1971. The integrals are taken over the entire plane. The function Jn/2 + δ is a Bessel function of the first kind.Fourier transform
63
Two-dimensional functions
Functions (400 to 402) Fourier transform unitary. Taking n = 2 and δ = 0 produces 402. (Stein & Weiss 1971. νx and νy are real numbers. 4.3. angular frequency Fourier transform non-unitary. which may not have unit volume. ωx. and is 0 otherwise. .

Brooks/Cole. Fourier Series and Integrals. Die Grundlehren der mathematischen Wissenschaften. (2001). • Dym. J. Inc. An introduction to Harmonic Analysis. ISBN 978-0122264511.). (1976). (1949). New York: D. (1954). • Campbell. B. ISBN 0-13-035399-X. ed. ISBN 0071160434. (2003). N. • Duoandikoetxea. Ross. ISBN 0-534-37660-6
. Loukas (2004).). A Student's Guide to Fourier Transforms (2nd ed. Analysis on locally compact Abelian groups. New Your: McGraw-Hill • Fourier. H (1985). B. Abstract harmonic analysis. Princeton University Press.Fourier transform
64
See also
• • • • • • • • • • • • • • • Fourier series Fast Fourier transform Laplace transform Discrete Fourier transform • DFT matrix Discrete-time Fourier transform Fourier–Deligne transform Fractional Fourier transform Linear canonical transform Fourier sine transform Short-time Fourier transform De Groot Fourier Transform Fourier inversion theorem Analog signal processing Transform (mathematics) Integral transform • Hartley transform • Hankel transform • Symbolic integration
References
• Boashash. Gerald (1994). ISBN 0-486-63331-4 • Knapp. Van Nostrand Company.. Fourier Integrals for Practical Applications. II: Structure and analysis for compact groups. Arthur. ISBN 0-13-578782-3 • Katznelson. New York: Cambridge University Press. (1970). • Kaiser. Linear Partial Differential Operators. Springer-Verlag. (2002). George. 1.. Academic Press. • Erdélyi. Ronald (1948). Théorie Analytique de la Chaleur [1]. Vol. • James. Paris • Grafakos. • Hörmander. Tables of Integral Transforms. L. Boston: McGraw-Hill. Anthony W. Prentice-Hall. Joseph (1822). Classical and Modern Fourier Analysis. David (2000). Birkhäuser.F. Foster. ed. A First Course in Fourier Analysis. American Mathematical Society. Dover. R. Yitzhak (1976). Fourier Analysis. Volume 1. ISBN 0-8176-3711-7 • Kammler. Berlin. Princeton University Press • Bracewell. New York: Springer-Verlag. (2000). Kenneth A. J. ISBN 978-3540006626.. A Friendly Guide to Wavelets. Oxford: Elsevier Science. Mark (2002). MR0262773. Prentice Hall. Band 152. Chandrasekharan K. ISBN 0-8218-2172-5. ISBN 978-0-691-09089-4 • Pinsky. Time-Frequency Signal Analysis and Processing: A Comprehensive Reference. Introduction to Fourier Analysis and Wavelets. Representation Theory of Semisimple Groups: An Overview Based on Examples [2]. ISBN 0-521-00428-4. The Fourier Transform and Its Applications (3rd ed. Fourier Transforms. Javier (2001). • Hewitt. Edwin. McKean. H. ISBN 0080443354 • Bochner S.

ISBN 978-0-691-08078-9. com/ f-transform/ index. thefouriertransform. ISBN 0-691-11384-X. dspdimension. (1968). • Stein. New York: Wiley. Shakarchi. D. ISBN 0-8493-2876-4.Fourier transform • Polyanin.J. Boca Raton: CRC Press. Princeton University Press. fullerton. • Rudin. com/ ?id=QCcW1h835pwC [3] http:/ / www. dspdimension. (1998). V. ISBN 0471303577. edu/ mathews/ c2003/ FourierTransformMod. com/ fftlab/ [6] http:/ / www. • Yosida. Introduction to Fourier Analysis on Euclidean Spaces. academicearth. Stephan Bernsee's FFTlab [5] (Java Applet) Stanford Video Course on the Fourier Transform [6] Tables of Integral Transforms [7] at EqWorld: The World of Mathematical Equations. htm [8] http:/ / mathworld. westga. Manzhirov. Rami (2003). (1995). Walter (1987). Weiss.). html [9] http:/ / math. ISBN 3-540-58654-7. htm [5] http:/ / www. Functional Analysis. • Stein.: Princeton University Press. com [4] http:/ / www. com/ FourierTransform. Princeton. ru/ en/ auxiliary/ aux-inttrans. G. com/ admin/ dft-a-pied/ [11] http:/ / www. fourier-series. com/ courses/ the-fourier-transform-and-its-applications [7] http:/ / eqworld. Elias. ISBN 0-07-100276-6.
65
External links
• • • • • • • • • ~ Fourier Transform Tutorial [3] Fourier Series Applet [4] (Tip: drag magnitude or phase dots up or down to change the wave form). html [10] http:/ / www. google. edu/ ~jhasbun/ osp/ Fourier. Mathews [9] The DFT “à Pied”: Mastering The Fourier Transform in One Day [10] at The DSP Dimension An Interactive Flash Tutorial for the Fourier Transform [11]
References
[1] http:/ / books.. Springer-Verlag. A. ipmnet. "Fourier Transform [8]" from MathWorld. html
. Weisstein. Fourier Series and Optical Transform Techniques in Contemporary Optics. Eric W. Handbook of Integral Equations. Elias. wolfram. R. • Wilson. Fourier Analysis: An introduction. Singapore: McGraw Hill. com/ ?id=TDQJAAAAIAAJ& printsec=frontcover& dq=Th%C3%A9orie+ analytique+ de+ la+ chaleur& q [2] http:/ / books. Guido (1971). K. Fourier Transform Module by John H. google. Real and Complex Analysis (Third ed. N.. A.

Thus
is a strictly positive local martingale.
History
Results of this type were first proved by Cameron–Martin in the 1940s and by Girsanov in 1960. This special case is sufficient for risk-neutral pricing in the Black-Scholes model and in many other models (e. Let be a Wiener process on the Wiener probability space . The theorem is especially important in the theory of financial mathematics as it tells how to convert from the physical measure which describes the probability that an underlying instrument (such as a share price or interest rate) will take a particular value or values to the risk-neutral measure which is a very useful tool for evaluating the value of derivatives on the underlying. They have been subsequently extended to more general classes of process culminating in the general form of Lenglart (1977). all continuous models). on the right side each path of the process is colored according to its likelihood under the martingale measure Q.Girsanov's theorem
66
Girsanov's theorem
In probability theory. and a probability measure Q can be defined on
such that
we have Radon–Nikodym derivative
Then for each t the measure Q restricted to the unaugmented sigma fields
is equivalent to P restricted to
.
Significance
Girsanov's theorem is important in the general theory of stochastic processes since it enables the key result that if Q is a measure absolutely continuous with respect to P then every P-semimartingale is a Q-semimartingale.e.
Statement of theorem
We state the theorem first for the special case when the underlying stochastic process is a Wiener process. the Girsanov theorem (named after Igor Vladimirovich Girsanov) tells how stochastic processes change under changes in measure.
Visualisation of the Girsanov theorem — The left side shows a Wiener process with negative drift under a canonical measure P. The density transformation from P to Q is given by the Girsanov theorem. Let be a measurable process
adapted to the natural filtration of the Wiener process Given an adapted process with define
where
is the stochastic exponential (or Doléans exponential) of X with respect to W. i. .g.

which the exponential martingale described above is not (for ).
Comments
In many common applications. the process X is defined by
For X of this form then a sufficient condition for that
to be a martingale is Novikov's condition which requires
The stochastic exponential
is the process Z which solves the stochastic differential equation
The measure Q constructed above is not equivalent to P on
as this would only be the case if the
Radon–Nikodym derivative were a uniformly integrable martingale. and by computing
it follows by Levy's characterization of Brownian Motion that this is a Q Brownian Motion. The fact that is continuous is trivial.Girsanov's theorem Furthermore if Y is a local martingale under P then the process
67
is a Q local martingale on the filtered probability space
.
Application to finance
This theorem can be used to show the Black-Scholes model under the unique risk neutral measure. by Girsanov's theorem it is a Q local martingale.
Corollary
If X is a continuous process and W is Brownian Motion under measure P then
is Brownian motion under Q.e. is specified by
See also
• Cameron–Martin theorem
. i. Q. the measure in which the fair value of a derivative is the discounted expected value.

-A. greenend. X.r. Ito's lemma states where is the gradient of ƒ w. uk/ ~alanb/ stoc-calc. Itō's lemma is used in Itō stochastic calculus to find the differential of a function of a particular type of stochastic process.t. Meyer.t. the term f.Xj ] is the quadratic covariation process of Xi and Xj. and twice continuously differentiable and real valued function f on Rd. and is a vector of Itō process.
Continuous semimartingales
More generally.
References
[1] http:/ / www. It is named after its discoverer. then
This immediately implies that ƒ(t. f(X) is a semimartingale satisfying
In this expression. t. x) of two real variables t and x.r. It is the stochastic calculus counterpart of the chain rule in ordinary calculus and is best memorized using the Taylor series expansion and retaining the second order term related to the stochastic component change. the above formula also holds for any continuous d-dimensional semimartingale X = (X1. And some people prefer to presenting the formula in another form with cross variation shown explicitly as follows.i represents the partial derivative of f(x) with respect to xi.X2.Xd).
External links
• Notes on Stochastic Calculus [1] which contains a simple outline proof of Girsanov's theorem. chiark. pdf
Itô's lemma
In mathematics. The lemma is widely employed in mathematical finance and its best known application is in the derivation of the Black–Scholes equation used to value options.[1]
Itō drift-diffusion processes
In its simplest form. Zeitschrift für Wahrscheinlichkeit 39 (1977) pp 65–70. is the Hessian matrix of ƒ w. X) is itself an Itō drift-diffusion process. "Probabilités et potentiel -.Théorie de Martingales" Chapitre VII. In higher dimensions. X. Itō's lemma states the following: for an Itō drift-diffusion process
and any twice differentiable function ƒ(t.r.t. Lenglart "Transformation de martingales locales par changement absolue continu de probabilités".Girsanov's theorem
68
References
• C. Ito's Lemma is also referred to currently as the Itō–Doeblin Theorem in recognition of the recently discovered work of Wolfgang Doeblin. Kiyoshi Itō. Hermann 1980 • E. org. and [Xi. is the partial differential w.….
. Dellacherie and P.

as a result of a jump.Itô's lemma
69
Poisson jump processes
We may also define functions on discontinuous stochastic processes.Yt-. which is a left-continuous process. a semimartingale is a càdlàg process. Then
Let z be the magnitude of the jump and let jump is
be the distribution of z.Xd) is a d-dimensional semimartingale and f is a twice continuously differentiable real valued function on Rd then f(X) is a semimartingale. Itō's Lemma for is then Itō's lemma for a process which is the sum of a drift-diffusion process and a jump process is just the sum of the Itō's lemma for the individual parts. The jumps are written as ΔYt = Yt . For any cadlag process Yt.
. Write for the non-infinitesimal change in
for the value of S as we approach t from the left. The expected magnitude of the
Define Then
. which ensures that the jump of the right hand side at time t is Δf(Xt). Let h be the jump intensity. the left limit in t is denoted by Yt-. If
jumps by
then
jumps by
. a compensated process and martingale. and an additional term needs to be added to the formula to ensure that the jumps of the process are correctly given by Itō's lemma. h could be a constant.
is
drawn from distribution which may depend on . and This differs from the formula for continuous semimartingales by the additional term summing over the jumps of X. a deterministic function of time or a stochastic process. In general. dg and .X2.…. The
Let Write
be a discontinuous stochastic process. which need not be continuous. Itō's lemma states that if X = (X1. The survival probability change in the survival probability is So is the probability that no jump has occurred in the interval . The Poisson process model for jumps is that the probability of one jump in the interval is plus higher order terms.
Non-continuous semimartingales
Itō's lemma can also be applied to general d-dimensional semimartingales. as
Consider a function
of jump process
. Then.

Deleting the dt2 and dt dB terms. Applying Itō's lemma with f(S) = log(S) gives
It follows that log(St) = log(S0) + σBt + (μ − σ2/2)t. Applying Itō's lemma with f(Y) = log(Y) gives
Exponentiating gives the solution
. The formal proof is beyond the scope of this article. The latter can be shown if we prove that since The proof of this statistical property is however beyond the scope of this article. the dt2 and dt dB terms disappear but the dB2 term tends to dt. Assume the Itō process is in the form of
Expanding f(x. which is not done here. Instead.
Examples
Geometric Brownian motion
A process S is said to follow a geometric Brownian motion with volatility σ and drift μ if it satisfies the stochastic differential equation dS = S(σdB + μdt). t) in a Taylor series in x and t we have
and substituting a dt + b dB for dx gives In the limit as dt tends to 0. substituting dt for dB2. for a Brownian motion B. and exponentiating gives the expression for S. and collecting the dt and dB terms. It is sometimes denoted by Ɛ(X). we obtain
as required. we can derive Itō's lemma by expanding a Taylor series and applying the rules of stochastic calculus.Itô's lemma
70
Informal derivation
A formal proof of the lemma requires us to take the limit of a sequence of random variables.
The Doléans exponential
The Doléans exponential (or stochastic exponential) of a continuous semimartingale X can be defined as the solution to the SDE dY = Y dX with initial condition Y0 = 1.

fu-berlin.8.Itô's lemma
71
Black–Scholes formula
Itō's lemma can be used to derive the Black–Scholes formula for an option. and Financial Markets.com • Informal proof (http://www.
Notes
[1] [2] [3] [4] "Stochastic Calculus :: Itô–Döblin formula". Michael Stastny (http:/ / mahalanobis.htm). wilmottwiki. If this trading strategy is followed. Suppose a stock price follows a Geometric Brownian motion given by the stochastic differential equation dS = S(σdB + μ dt). physik. John Wiley and Sons. if the value of an option at time t is f(t. Paperback ISBN 981-238-107-4. Prof. Polymer Physics.quantnotes. Sections 4. World Scientific (Singapore). then the total value V of this portfolio satisfies the SDE
This strategy replicates the option if V = f(t.ftsmodules. optiontutor
. quantnotes. Thayer Watkins • Discussion (http://www. This textbook also derives generalizations of Itō's lemma for non-Wiener (non-Gaussian) processes. 4th edition.sjsu. Path Integrals in Quantum Mechanics. American Mathematical Society 4.M1
External links
• Derivation (http://www2._Domingo http:/ / books. ISBN 9780471274797.1 and 4. and any cash held is assumed to grow at the risk free rate r. Itō's lemma gives
The term (∂f/∂S) dS represents the change in value in time dt of the trading strategy consisting of holding an amount ∂f/∂S of the stock. twoday.2. Pages 36–39. • Hagen Kleinert (2004). net/ stories/ 756201/ ) http:/ / www.htm).S). On stochastic differential equations.edu/faculty/watkins/ito. com/ wiki/ index.com/fundamentals/backgroundmaths/ito.com/public/texts/optiontutor/chap6. com/ books?id=wjs5hENNjL4C& pg=PA36& dq=jump+ ito+ lemma#PPA38. • Bernt Øksendal (2000). Then. Statistics. Springer. Also available online: PDF-files [2]. 5th edition. An Introduction with Applications. Stochastic Differential Equations. Memoirs. de/ ~kleinert/ b5 http:/ / www. corrected 2nd printing. • Domingo Tavella [3] (2002).htm). google. Combining these equations gives the celebrated Black-Scholes equation
See also
• Wiener process • Itō calculus • Feynman–Kac formula
References
• Kiyoshi Itō (1951).St). ISBN 3-540-63720-6. php/ Tavella. 1–51. Quantitative Methods in Derivatives Pricing: An Introduction to Computational Finance [4].

"Stochastic Processes Applied in Finance". and units of the bond. The theorem only asserts the existence of the representation and does not help to find it explicitly. Robert. p213-226. Zeitschrift fuer Wahrscheinlichkeitstheorie und verwandte Gebiete 36. it is possible in many cases to determine the form of the representation using Malliavin calculus. there exists an F-previsible process . if is any other Q-martingale. If X is a square integrable random variable measurable with respect
Consequently
Application in finance
The martingale representation theorem can be used to establish the existence of a hedging strategy. Similar theorems also exist for martingales on filtrations induced by jump processes. 1976
. unique up to sets of measure 0. such that
with probability one. Then. such that and let be the augmentation of the filtration generated by . Benoît. by Markov chains. 2002 • Elliott.
References
• Montin. then there exists a predictable process C which is adapted with respect to . Suppose that is a Q-martingale process. the martingale representation theorem states that a random variable which is measurable with respect to the filtration generated by a Brownian motion can be written in terms of an Itô integral with respect to this Brownian motion. "Stochastic Integrals for Martingales of a Jump Process with Partially Accessible Jump Times". and N can be written as:
The replicating strategy is defined to be: • hold • hold units of the stock at the time t. the value of the portfolio is:
and it's easy to check that the strategy is self-financing: the change in the value of the portfolio only depends on the change of the asset prices .Martingale representation theorem
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Martingale representation theorem
In probability theory.
Statement of the theorem
Let to be a Brownian motion on a standard filtered probability space . whose volatility is always non-zero. for example.
At the expiration day T.

x2.. Mathematical models are used not only in the natural sciences (such as physics... a branch of mathematical logic.. engineers. A slightly more realistic and largely used population growth model is the logistic function. psychology.Mathematical model
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Mathematical model
Note: The term model has a different meaning in model theory. However. meteorology) and engineering disciplines. physicists.. • Model of a particle in a potential-field... statistical models. that is:
subject to:
This model has been used in general equilibrium theory.. xn). particularly to show existence and Pareto efficiency of economic equilibria.n each with a market price p1. biology.2. statisticians. earth science. the fact that this particular formulation assigns numerical values to levels of satisfaction is the source of criticism (and even ridicule). and this usage is the reverse of the sense explained below. but also in the social sciences (such as economics. x2.... depending on the amounts of commodities x1. p2.. pn. xn in such a way as to maximize U(x1. sociology and political science). operations research analysts and economists use mathematical models most extensively. The potential field is given by a function V : R3 → R and the trajectory is a solution of the differential equation
Note this model assumes the particle is a point mass.. • Model of rational behavior for a consumer.
. However. for example. In this model we consider a particle as being a point of mass which describes a trajectory in space which is modeled by a function giving its coordinates in space as a function of time.. differential equations.
Examples of mathematical models
• Population Growth. as a model of planetary motion. • Neighbour-sensing model explains the mushroom formation from the initially chaotic fungal network. These and other types of models can overlap. which is certainly known to be false in many cases in which we use this model. Mathematical models can take many forms. xn consumed. The process of developing a mathematical model is termed mathematical modelling (also written modeling). and its extensions. A mathematical model is a description of a system using mathematical language.... The problem of rational behavior in this model then becomes an optimization problem. Modelling requires selecting and identifying relevant aspects of a situation in the real world. A simple (though approximate) model of population growth is the Malthusian growth model. An artifact which is used to illustrate a mathematical idea may also be called a mathematical model. The model further assumes that the consumer has a budget M which is used to purchase a vector x1. or game theoretic models. x2.. it is not an essential ingredient of the theory and again this is an idealization. The consumer is assumed to have a cardinal utility function U (cardinal in the sense that it assigns numerical values to utilities).. with a given model involving a variety of abstract structures. including but not limited to dynamical systems.. In this model we assume a consumer faces a choice of n commodities labeled 1.

random variables. engineers can build a descriptive model of the system as a hypothesis of how the system could work. and linear models may have nonlinear expressions in them. in a statistical linear model. if the objective functions and constraints are represented entirely by linear equations. in control of a system. they use a mathematical model. but this can be problematic if one is trying to study aspects such as irreversibility. input. The variables represent some properties of the system. is often associated with phenomena such as chaos and irreversibility. and output variables. If all the operators in a mathematical model exhibit linearity. and operators that act on these variables. Nonlinearity. input variables. Objectives and constraints of the system and its users can be represented as functions of the output variables or state variables. Similarly. which are abstractions of quantities of interest in the described systems. Similarly. 2. the output variables are dependent on the state of the system (represented by the state variables). as it is some measure of interest to the user. The values of the variables can be practically anything. then the model is regarded as a linear model. The variables are not independent of each other as the state variables are dependent on the decision. Furthermore. If one or more of the objective functions or constraints are represented with a nonlinear equation. A model is considered to be nonlinear otherwise. deterministic models perform the same way for a given set of initial conditions. but it may be nonlinear in the predictor variables. etc. nonlinear: Mathematical models are usually composed by variables. it is assumed that a relationship is linear in the parameters. Decision variables are sometimes known as independent variables. measured system outputs often in the form of signals. and event occurrence (yes/no). In analysis.
. Depending on the context. counters. Linear vs. and exogenous variables. which are strongly tied to nonlinearity. timing data. in a stochastic model. then the model is known as a nonlinear model. functions. Exogenous variables are sometimes known as parameters or constants. a differential equation is said to be linear if it can be written with linear differential operators. The actual model is the set of functions that describe the relations between the different variables. The question of linearity and nonlinearity is dependent on context. an objective function is also known as an index of performance. Although there is no limit to the number of objective functions and constraints a model can have. probabilistic (stochastic): A deterministic model is one in which every set of variable states is uniquely determined by parameters in the model and by sets of previous states of these variables. using or optimizing the model becomes more involved (computationally) as the number increases. for example. state variables. A common approach to nonlinear problems is linearization. engineers can try out different control approaches in simulations. or try to estimate how an unforeseeable event could affect the system. Although there are exceptions. boolean values or strings.
Classifying mathematical models
Many mathematical models can be classified in some of the following ways: 1. even in fairly simple systems. exogenous variables.Mathematical model
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Background
Often when engineers analyze a system to be controlled or optimized. Therefore.
Building blocks
There are six basic groups of variables: decision variables. the resulting mathematical model is defined as linear. A mathematical model usually describes a system by a set of variables and a set of equations that establish relationships between the variables. the variables are generally represented by vectors. real or integer numbers. For example. In a mathematical programming model. for example. Since there can be many variables of each type. nonlinear systems and models tend to be more difficult to study than linear ones. random. The objective functions will depend on the perspective of the model's user. differential operators. Deterministic vs. Conversely. but it can still have nonlinear expressions in it. which can be algebraic operators.

Bayesian statistics provides a theoretical framework for incorporating such subjectivity into a rigorous analysis: one specifies a prior probability distribution (which can be subjective) and then updates this distribution based on empirical data. An example of when such approach would be necessary is a situation in which an experimenter bends a coin slightly and tosses it once. dynamic: A static model does not account for the element of time. Therefore the white-box models are usually considered easier. Often the a priori information comes in forms of knowing the type of functions relating different variables. A black-box model is a system of which there is no a priori information available.
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A priori information
Mathematical modelling problems are often classified into black box or white box models. Practically all systems are somewhere between the black-box and white-box models. the true probability that the coin will come up heads is unknown. and variable states are not described by unique values. how rapidly does the medicine amount decay. because if you have used the information correctly. experience. Using a priori information we could end up. Dynamic models typically are represented with difference equations or differential equations. and is then given the task of predicting the probability that the next flip comes up heads. Static vs. or expert opinion.
Subjective information
Sometimes it is useful to incorporate subjective information into a mathematical model. we know that usually the amount of medicine in the blood is an exponentially decaying function. then the model will behave correctly. After bending the coin. If there is no a priori information we would try to use functions as general as possible to cover all different models. so the experimenter would need to make an arbitrary decision (perhaps by looking at the shape of the coin) about what prior distribution to use. These parameters have to be estimated through some means before one can use the model. if we make a model of how a medicine works in a human system. A white-box model (also called glass box or clear box) is a system where all necessary information is available. 3. This can be done based on intuition. The problem with using a large set of functions to describe a system is that estimating the parameters becomes increasingly difficult when the amount of parameters (and different types of functions) increases. Usually it is preferable to use as much a priori information as possible to make the model more accurate. or based on convenience of mathematical form. recording whether it comes up heads. according to how much a priori information is available of the system. but rather by probability distributions. An often used approach for black-box models are neural networks which usually do not make assumptions about incoming data.[1]
. while a dynamic model does. In black-box models one tries to estimate both the functional form of relations between variables and the numerical parameters in those functions. since otherwise one would guess 1 or 0 as the probability of the next flip being heads. Incorporation of the subjective information is necessary in this case to get an accurate prediction of the probability. for example. so this concept is useful only as an intuitive guide for deciding which approach to take. For example. with a set of functions that probably could describe the system adequately. and what is the initial amount of medicine in blood? This example is therefore not a completely white-box model. which would be almost certainly wrong.Mathematical model randomness is present. But we are still left with several unknown parameters.

If the modelling is done by a neural network. it can make the model difficult to understand and analyze. a common approach to test this fit is to split the data into two disjoint subsets: training data and verification data. the simplest one is the most desirable. that is. Tools from nonparametric statistics can sometimes be used to evaluate how well data fits a known distribution or to come up with a general model that makes only minimal assumptions about the model's mathematical form. because each separate part induces some amount of variance into the model. more mathematical tools have been developed to test the fit of statistical models than models involving Differential equations. In more conventional modelling through explicitly given mathematical functions. including numerical instability. For example Newton's classical mechanics is an approximated model of the real world. it can be more difficult to test the validity of the general mathematical form of a model.
Training
Any model which is not pure white-box contains some parameters that can be used to fit the model to the system it is intended to describe. This question can be difficult to answer as it involves several different types of evaluation. For example. decision theory. Additionally. the essential idea being that among models with roughly equal predictive power. While added complexity usually improves the realism of a model. The training data are used to estimate the model parameters. explanations tend to become more complex before a Paradigm shift offers radical simplification.
Model evaluation
A crucial part of the modelling process is the evaluation of whether or not a given mathematical model describes a system accurately. Defining a metric to measure distances between observed and predicted data is a useful tool of assessing model fit. a loss function plays a similar role. In statistics. In models with parameters. Thomas Kuhn argues that as science progresses. and can also pose computational problems. An accurate model will closely match the verification data even though this data was not used to set the model's parameters.
Fit to empirical data
Usually the easiest part of model evaluation is checking whether a model fits experimental measurements or other empirical data. as long as particle speeds are well below the speed of light. While it is rather straightforward to test the appropriateness of parameters. when modelling the flight of an aircraft. and we study macro-particles only. In general. However. the uncertainty would increase due to an overly complex system.
.Mathematical model
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Complexity
In general. the optimization of parameters is called training. we could embed each mechanical part of the aircraft into our model and would thus acquire an almost white-box model of the system. It is therefore usually appropriate to make some approximations to reduce the model to a sensible size. model complexity involves a trade-off between simplicity and accuracy of the model. and some economic models. Occam's Razor is a principle particularly relevant to modelling. Still. Engineers often can accept some approximations in order to get a more robust and simple model. parameters are determined by curve fitting. Newton's model is quite sufficient for most ordinary-life situations. This practice is referred to as cross-validation in statistics. the computational cost of adding such a huge amount of detail would effectively inhibit the usage of such a model.

Likewise. and the same question for events or data points outside the observed data is called extrapolation. If the model was constructed based on a set of data.Mathematical model
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Scope of the model
Assessing the scope of a model.[2] . One can argue that a model is worthless unless it provides some insight which goes beyond what is already known from direct investigation of the phenomenon being studied. one must determine for which systems or situations the known data is a "typical" set of data. The question of whether the model describes well the properties of the system between data points is called interpolation. he did not measure the movements of molecules and other small particles.
See also
• • • • • • • • • • • • • • • • Agent-based model Biologically inspired computing Cliodynamics Computer simulation Decision engineering Differential equations Dynamical systems Model Model (economics) Mathematical biology Mathematical models in physics Mathematical diagram Mathematical psychology Mathematical sociology Simulation Statistical model
. This is usually (but not always) true of models involving differential equations. in evaluating Newtonian classical mechanics. As the purpose of modelling is to increase our understanding of the world. determining what situations the model is applicable to. but also on its ability to extrapolate to situations or data beyond those originally described in the model. As an example of the typical limitations of the scope of a model. the validity of a model rests not only on its fit to empirical observations. even though his model is quite sufficient for ordinary life physics. we can note that Newton made his measurements without advanced equipment. but macro particles only. It is then not surprising that his model does not extrapolate well into these domains. that is. can be less straightforward.
Philosophical considerations
Many types of modelling implicitly involve claims about causality. so he could not measure properties of particles travelling at speeds close to the speed of light. An example of such criticism is the argument that the mathematical models of Optimal foraging theory do not offer insight that goes beyond the common-sense conclusions of evolution and other basic principles of ecology.

Introduction to modeling via differential equations (http://www. R. Mathematical Modelling for Earth Sciences.stanford. ( 2006 ). Model-making in physics (http://www.. • Plus teacher and student package: Mathematical Modelling.it/patrone/ differential_equations_intro. Introduction to Social Macrodynamics: Compact Macromodels of the World System Growth (http://cliodynamics. es. and S.unige. 3-17 • Korotayev A. The Nature of Mathematical Modelling.J. Models in Science (http://plato. Inference.-S. the online mathematics magazine produced by the Millennium Mathematics Project at the University of Cambridge.Annual Review of Ecology and Systematics. with critical remarks. (2008). Michael P.htm).maths. html) Brings together all articles on mathematical modelling from Plus. E. Contemporary Physics. ISBN 0-486-41180-X • Lin.Mathematical model
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References
[1] MacKay.pl?cp=&lang=en& blang=en&list=14&page=Book&id=34250). (http://plus. Mathematics Applied to Deterministic Problems in the Natural Sciences. Mathematical Modelling Techniques.org/issue44/package/index.. C. ISBN 0-486-68131-9 • Bender. (1998).ru/index.. ( 1999 ) 'A Tutorial on Mathematical Modelling' (http://www. 15. & Segel.First Page Image (http:/ / arjournals. Hartmann. New York : Dover. January 1980.diptem. 15(1):523 . (Spring 2006 Edition)
.informaworld. ( 1988 ).ISBN 0521570956 • Yang. L. ISBN 0-89871-229-7 • Gershenfeld. An Introduction to Mathematical Modelling.A.ru/cgi-bin/db. [ 1978 ] ( 2000 ). and Learning Algorithms. Dudedin Academic. annualreviews. Malkov A.com/smpp/ content~content=a752582770~db=all~order=page). ISBN 1903765927 Specific applications • Peierls.edu/entries/models-science/). F.php?option=com_content& task=view&id=124&Itemid=70). Rutherford [ 1978 ] ( 1994 ).C. 1146/ annurev. Software • List of computer simulation software Philosophical background • Frigg.A. org/ doi/ abs/ 10. Moscow : Editorial URSS (http://urss. Cambridge.causascientia. New York : Dover. D. 002515?journalCode=ecolsys)
Further reading
Books • Aris. Information Theory. Cambridge University Press. ISBN 0521642981 [2] Optimal Foraging Theory: A Critical Review . Rudolf. (2003-2004). Khaltourina D. 110184..org/ math_stat/Tutorial. X. N. Volume 21 (1).pdf) PDF (264 KiB) • Patrone. ISBN 5-484-00414-4
External links
General reference material • McLaughlin. Philadelphia : SIAM. in: The Stanford Encyclopedia of Philosophy.

Monte Carlo methods are often used in simulating physical and mathematical systems.[3]
Overview
. Because of their reliance on repeated computation of random or pseudo-random numbers. It is a widely successful method in risk analysis when compared with alternative methods or human intuition. particularly multidimensional integrals with complicated boundary conditions. and cellular structures (see cellular Potts model).[1] Monte Carlo simulation methods are especially useful in studying systems with a large number of coupled degrees of freedom. More broadly. such as fluids. When Monte Carlo simulations have been applied in space exploration and oil exploration. These methods are also widely used in mathematics: a classic use is for the evaluation of definite integrals. actual observations of failures. strongly coupled solids. cost overruns and schedule overruns are routinely better predicted by the simulations than by human intuition or alternative "soft" methods. these methods are most suited to calculation by a computer and tend to be used when it is unfeasible or impossible to compute an exact result with a deterministic algorithm. disordered materials. Monte Carlo methods are useful for modeling phenomena with significant uncertainty in inputs. such as the calculation of risk in business.[2] The term "Monte Carlo method" was coined in the 1940s by physicists working on nuclear weapon projects in the Los Alamos National Laboratory.Monte Carlo method
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Monte Carlo method
Monte Carlo methods (or Monte Carlo experiments) are a class of computational algorithms that rely on repeated random sampling to compute their results.

Despite having most of the necessary data. their work required a code name. then inscribe a circle within it. two other common properties of Monte Carlo methods: the computation's reliance on good random numbers. Being secret. we aggregate the results into our final result. also. At the end. the center of the circle. the approximation of will become more accurate both as the grains are dropped more uniformly and as more are dropped. However. we define a domain of inputs: in this case. Next. 3. From plane geometry. Thus. Uniformly scatter some objects of uniform size throughout the square. 3. they will not be uniformly distributed.
Notice how the approximation follows the general pattern of Monte Carlo algorithms. the ratio of the area of an inscribed circle to that of the surrounding square is . the value of method: can be approximated using a Monte Carlo
1. the approximation of . First a player makes some random shots. Aggregate the results of the individual computations into the final result. such as the average distance a neutron would travel in a substance before it collided with an atomic nucleus or how much energy the neutron was likely to give off following a collision. Next the player applies algorithms (i. these approaches tend to follow a particular pattern: 1. grains of rice or sand. The name is a reference to the Monte Carlo Casino in Monaco where Ulam's uncle would borrow money to gamble.[4] Physicists at Los Alamos Scientific Laboratory were investigating radiation shielding and the distance that neutrons would likely travel through various materials. 2. the objects should fall in
The Monte Carlo method can be illustrated as a game of Battleship. Perform a deterministic computation using the inputs. Generate inputs randomly from the domain using a certain specified probability distribution. 2. First. Draw a square on the ground. the term describes a large and widely-used class of approaches. the problem could not be solved with analytical calculations. An approximation will also be poor if only a few grains are randomly dropped into the whole square.
History
Enrico Fermi in the 1930s and Stanisław Ulam in 1946 first had the idea.[1] [5] [6]
.Monte Carlo method
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There is no single Monte Carlo method. For example. and so our approximation will be poor. then perform a computation on each input (test whether it falls within the circle). counting the number of objects in the circle and dividing by the total number of objects in the square will yield an approximation for . If grains are purposefully dropped into only. it's the square which circumscribes our circle.
the areas in approximately the same ratio. for example. Von Neumann chose the name "Monte Carlo". 4. Multiplying the result by 4 will then yield an approximation for itself. Thus. For example.e. instead. Note. Ulam later contacted John von Neumann to work on it. 4. we generate inputs randomly (scatter individual grains within the square). Since the two areas are in the ratio . Finally based on the outcome of the random sampling and the algorithm the player can determine the likely locations of the other player's ships. Define a domain of possible inputs. a battleship is four dots in the vertical or horizontal direction). John von Neumann and Stanislaw Ulam suggested that the problem be solved by modeling the experiment on a computer using chance. and its slow convergence to a better approximation as more data points are sampled.

physical chemistry. Uses of Monte Carlo methods require large amounts of random numbers. and operations research.
Engineering
Monte Carlo methods are widely used in engineering for sensitivity analysis and quantitative probabilistic analysis in process design. In the 1950s they were used at Los Alamos for early work relating to the development of the hydrogen bomb. Buffon's needle.. Monte Carlo methods underpin the design of mineral processing flowsheets and contribute to quantitative risk analysis. Specific areas of application include:
Physical sciences
Monte Carlo methods are very important in computational physics. In experimental particle physics. • in geostatistics and geometallurgy. and related applied fields. The Rand Corporation and the U. For example. it was only after electronic computers were first built (from 1945 on) that Monte Carlo methods began to be studied in depth. though were severely limited by the computational tools at the time. Therefore. The Monte Carlo method is widely used in statistical physics. The need arises from the interactive.S. and became popularized in the fields of physics. Air Force were two of the major organizations responsible for funding and disseminating information on Monte Carlo methods during this time. physical chemistry. and the work on small samples by William Sealy Gosset). and have diverse applications from complicated quantum chromodynamics calculations to designing heat shields and aerodynamic forms.g. and they began to find a wide application in many different fields. understanding their behavior and comparing experimental data to theory. Monte Carlo simulation methods are especially useful for modeling phenomena with significant uncertainty in inputs and in studying systems with a large number of coupled degrees of freedom.
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Applications
As mentioned. • in microelectronics engineering. they were not considered a general method until the popularity of the Monte Carlo method spread. Though examples of an "inverted" approach do exist historically. e. The general difference usually described about a Monte Carlo form of simulation is that it systematically "inverts" the typical mode of simulation. Monte Carlo methods were central to the simulations required for the Manhattan Project.[8] Monte Carlo methods are also used in the ensemble models that form the basis of modern weather forecasting operations.
. see Monte Carlo method in statistical physics. and it was their use that spurred the development of pseudorandom number generators. which were far quicker to use than the tables of random numbers which had been previously used for statistical sampling. but are more specifically traced to the pre-electronic computing era. Previous methods of simulation and statistical sampling generally did the opposite: using simulation to test a previously understood deterministic problem. co-linear and non-linear behaviour of typical process simulations. particularly Monte Carlo molecular modeling as an alternative for computational molecular dynamics as well as to compute statistical field theories of simple particle and polymer models [7] .Monte Carlo method Random methods of computation and experimentation (generally considered forms of stochastic simulation) can be arguably traced back to the earliest pioneers of probability theory (see. This enables designers to estimate realistic 3 sigma corners and effectively optimise circuit yields. treating deterministic problems by first finding a probabilistic analog (see Simulated annealing). these methods are used for designing detectors. or on vastly large scale of the galaxy modelling. Monte Carlo methods are applied to analyze correlated and uncorrelated variations in analog and digital integrated circuits.

for the efficiency of not having to track which permutations have already been selected). and a Monte Carlo simulation. is a Monte Carlo simulation of the behavior of repeatedly tossing a coin. An approximate randomization test is based on a specified subset of all permutations (which entails potentially enormous housekeeping of which permutations have been considered).Whitney U test can be conducted using asymptotic critical values. It is important to differentiate between a simulation. This is a simulation. but if the value is greater than 0. and assigning values less than or equal to 0. This is a Monte Carlo method of determining area. • The area of an irregular figure inscribed in a unit square can be determined by throwing darts at the square and computing the ratio of hits within the irregular figure to the total number of darts thrown. but not a simulation. Sawilowsky listed the characteristics of a high quality Monte Carlo simulation: • • • • • • the pseudo-random number generator has certain characteristics (e. The Type I error and power properties of statistics are obtainable for data drawn from classical theoretical distributions (e. A Monte Carlo study is a technique that can be used to solve a mathematical or statistical problem.Monte Carlo method
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Applied statistics
Monte Carlo methods are generally used for two purposes in applied statistics. or via exact methods by specifying the time limit to be alloted to the analysis. A simulation is a fictitious representation of reality.[9] The second purpose for Monte Carlo methods. is to provide a more efficacious approach to data analysis than the time consuming (and often impossibility to compute) permutation methodology.. and yet not as time consuming to obtain as are exact tests. e.50 designate the outcome as tails.g.[10]
. One purpose is to provide a methodology to compare and contrast competing statistics for small sample.1].50 as heads and greater than 0. For example. a two independent samples Wilcoxon Rank Sum / Mann . normal curve.1] can be used to simulate the tossing of a coin: If the value is less than or equal to 0. found frequently as an option to asymptotic or exact tests in statistics software. realistic data conditions. a Monte Carlo option by specifing the number of samples. The Monte Carlo approach is based on a specified number of randomly drawn permutations (exchanging a minor loss in precision if a permutation is drawn twice . A Monte Carlo simulation uses repeated sampling to determine the properties of some phenomenon. in SPSS version 18 with the Exact module installed. Monte Carlo study. but not a Monte Carlo simulation. g. • Drawing a large number of pseudo-random uniform variates from the interval [0.or more frequently .50 as tails. such as permutation tests. a long “period” before repeating values) the pseudo-random number generator produces values that pass tests for randomness the number of repetitions of the experiment is sufficiently large to ensure accuracy of results the proper sampling technique is used the algorithm used is valid for what is being modeled the study simulates the phenomenon in question. Monte Carlo methods are also a compromise between approximate randomization and permutation tests. infinite sample size and infinitesimally small treatment effect). Cauchy distribution) for asymptotic conditions (i. but such results often have little bearing on statistics' properties for realistic conditions.50 designate the outcome as heads. The Monte Carlo option is more accurate than relying on hypothesis tests' asymptotically derived critical values. Examples: • Drawing a pseudo-random uniform variate from the interval [0.

Monte Carlo simulation versus “what if” scenarios
The opposite of Monte Carlo simulation might be considered deterministic modeling using single-point estimates. One of the main problems that this approach has in game playing is that it sometimes misses an isolated. see quantifying uncertainty under corporate finance. very good move.
. This is because the “what if” analysis gives equal weight to all scenarios. or to evaluate financial derivatives.
Games
Monte Carlo methods have recently been applied in game playing related artificial intelligence theory. The results provide probabilities of different outcomes occurring. worst case. Monte Carlo methods are typically used to generate these users and their states. a comparison of a spreadsheet cost construction model run using traditional “what if” scenarios. and cinematic special effects. and most likely case).[12] For example. The network performance is then evaluated and.[11] By contrast. as tactical decisions tend to rely on a small number of crucial moves which are easily missed by the randomly searching Monte Carlo algorithm.
Telecommunications
When planning a wireless network. Monte Carlo methods used in these cases allow the construction of stochastic or probabilistic financial models as opposed to the traditional static and deterministic models. and the results recorded for each so-called “what if” scenario.Monte Carlo method
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Design and visuals
Monte Carlo methods have also proven efficient in solving coupled integral differential equations of radiation fields and energy transport. and then run again with Monte Carlo simulation and Triangular probability distributions shows that the Monte Carlo analysis has a narrower range than the “what if” analysis. their locations and the services they want to use. thereby enhancing the treatment of uncertainty in the calculation.
Finance and business
Monte Carlo methods in finance are often used to calculate the value of companies. see stochastic modelling.[13] For further discussion. to evaluate investments in projects at a business unit or corporate level. if results are not satisfactory. design. Most notably the game of Go and Battleship have seen remarkably successful Monte Carlo algorithm based computer players. design must be proved to work for a wide variety of scenarios that depend mainly on the number of users. These approaches are often strong strategically but weak tactically. with applications in video games. computer generated films. the network design goes through an optimization process. Each uncertain variable within a model is assigned a “best guess” estimate. Various combinations of each input variable are manually chosen (such as best case. and thus these methods have been used in global illumination computations which produce photorealistic images of virtual 3D models. architecture. Monte Carlo simulation considers random sampling of probability distribution functions as model inputs to produce hundreds or thousands of possible outcomes instead of a few discrete scenarios. For use in the insurance industry.

for functions of vectors. equally spaced grid points over a two-dimensional surface are required. but there are approximate methods available: from simply making up an integrable function thought to be similar. In general. (See Curse of dimensionality. A similar approach involves using low-discrepancy sequences instead—the quasi-Monte Carlo method. Monte Carlo methods are used in mathematics to solve various problems by generating suitable random numbers and observing that fraction of the numbers which obeys some property or properties. Understandably. deterministic quadrature methods can be very inefficient. A refinement of this method is to somehow make the points random. it can be estimated by randomly selecting points in 100-dimensional space. the same spacing on the grid would require 10100 points—far too many to be computed. this works very well for functions of one variable.
Integration
Deterministic methods of numerical integration usually operate by taking a number of evenly spaced samples from a function. Integration methods • Direct sampling methods • Importance sampling • Stratified sampling • Recursive stratified sampling • VEGAS algorithm • Random walk Monte Carlo including Markov chains • Metropolis-Hastings algorithm • Gibbs sampling
. In other words. the points should be drawn from a distribution similar in form to the integrand. The most common application of the Monte Carlo method is Monte Carlo integration. quadrupling the number of sampled points will halve the error. to one of the adaptive routines discussed in the topics listed below. and taking some kind of average of the function values at these points. The method is useful for obtaining numerical solutions to problems which are too complicated to solve analytically. By the law of large numbers. 100 dimensions is by no means unusual.Monte Carlo method
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Use in mathematics
In general.) Monte Carlo methods provide a way out of this exponential time-increase. but more likely to come from regions of high contribution to the integral than from regions of low contribution. since in many physical problems. To numerically integrate a function of a two-dimensional vector. As long as the function in question is reasonably well-behaved.e. If the vector has 100 dimensions. doing this precisely is just as difficult as solving the integral in the first place. For instance a 10x10 grid requires 100 points. Quasi-Monte Carlo methods can often be more efficient at numerical integration because the sequence "fills" the area better in a sense and samples more of the most important points that can make the simulation converge to the desired solution more quickly. regardless of the number of dimensions. this method will display convergence—i. a "dimension" is equivalent to a degree of freedom. However.

even in cases where no explicit formula for the a priori distribution is available. if n is not prime. but another one without. obtaining a maximum likelihood model is usually not sufficient. Another powerful and very popular application for random numbers in numerical simulation is in numerical optimization. Hence. the Metropolis algorithm.Monte Carlo method
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Optimization
Most Monte Carlo optimization methods are based on random walks. and x proves it so. idea. but different. in the general case. These problems use functions of some often large-dimensional vector that are to be minimized (or maximized). If 10 different random x say that "n is probably prime" when it is not. See also Las Vegas algorithm for a related. and an inspection of the marginal probability densities of interest may be impractical.). but with a guarantee of not getting this answer when it is wrong too often — in this case at most 25% of the time. Essentially. or even useless. we have observed a one-in-a-million event. But it is possible to pseudorandomly generate a large collection of models according to the posterior probability distribution and to analyze and display the models in such a way that information on the relative likelihoods of model properties is conveyed to the spectator. Optimization methods • • • • • Evolution strategy Genetic algorithms Parallel tempering Simulated annealing Stochastic optimization
• Stochastic tunneling
Inverse problems
Probabilistic formulation of inverse problems leads to the definition of a probability distribution in the model space. but sometimes moving against the gradient. say. There are also applications to engineering design. For details. A classic example is Rabin's algorithm for primality testing: for any n which is not prime. a random x has at least a 75% chance of proving that n is not prime. In the general case we may have a large number of model parameters. see Mosegaard and Tarantola (1995). can be generalized. tending to move in directions which lead to a lower function. The traveling salesman problem is another optimization problem. some moments may not be defined. This can be accomplished by means of an efficient Monte Carlo method. the program will move around a marker in multi-dimensional space. The best-known importance sampling method. and this gives a method that allows analysis of (possibly highly nonlinear) inverse problems with complex a priori information and data with an arbitrary noise distribution. the a posteriori probability in the model space may not be easy to describe (it may be multimodal. the theory linking data with model parameters is nonlinear. When analyzing an inverse problem. where a lucky choice can find the correct result. This probability distribution combines a priori information with new information obtained by measuring some observable parameters (data). as we normally also wish to have information on the resolution power of the data.[15]
Computational mathematics
Monte Carlo methods are useful in many areas of computational mathematics. etc. Many problems can be phrased in this way: for example a computer chess program could be seen as trying to find the optimal set of. but x says that it might be. 10 moves which produces the best evaluation function at the end. we have observed at most a 1-in-4 event. In general a Monte Carlo algorithm of this kind produces one correct answer with a guarantee n is composite. As.
. such as multidisciplinary design optimization.[14] or Tarantola (2005).

particularly for simulations involving atomic clusters • In biomolecular simulations • In polymer physics • Bond fluctuation model • In computer science • Monte Carlo algorithm
. such as primality testing. Models used to predict the drift of a life raft or movement of an oil slick at sea. but typically they should pass a series of statistical tests.[17] • Search And Rescue and Counter-Pollution. making it easy to test and re-run simulations. Monte Carlo simulation methods do not always require truly random numbers to be useful — while for some applications. • In probabilistic design for simulating and understanding the effects of variability • In physical chemistry. The only quality usually necessary to make good simulations is for the pseudo-random sequence to appear "random enough" in a certain sense. to model the transport of current carriers • Environmental science. unpredictability is vital (see Davenport (1995)).Monte Carlo method
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Monte Carlo and random numbers
Interestingly.[16] Many of the most useful techniques use deterministic.
See also
General
• Auxiliary field Monte Carlo • Bootstrapping (statistics) • Demon algorithm • • • • • • • • • • Evolutionary computation FERMIAC Markov chain Molecular dynamics Monte Carlo option model Monte Carlo integration Quasi-Monte Carlo method Random number generator Randomness Resampling (statistics)
Application areas
• Graphics. and most common ones. What this means depends on the application. a version of the Metropolis-Hastings algorithm is also used for ray tracing where it is known as Metropolis light transport • Modeling light transport in biological tissue • Monte Carlo methods in finance • Reliability engineering • In simulated annealing for protein structure prediction • In semiconductor device research. particularly for ray tracing. dealing with contaminant behavior • In geophysics. pseudo-random sequences. Testing that the numbers are uniformly distributed or follow another desired distribution when a large enough number of elements of the sequence are considered is one of the simplest. to invert seismic refraction data.

g. with applications in radiotherapy • MONK — Serco Assurance's code for the calculation of k-effective of nuclear systems Modelling of foam and cellular structures Modeling of tissue morphogenesis Computation of holograms Phylogenetic analysis.g.e. photons. a code to calculate the penetration and energy deposition of ions in matter.Monte Carlo method • Las Vegas algorithm • LURCH • Computer go • General Game Playing • Modeling the movement of impurity atoms (or ions) in plasmas in existing and tokamaks (e. self-organized criticality Direct simulation Monte Carlo Dynamic Monte Carlo method Kinetic Monte Carlo Quantum Monte Carlo Quasi-Monte Carlo method using low-discrepancy sequences and self avoiding walks Semiconductor charge transport and the like Electron microscopy beam-sample interactions Stochastic optimization Cellular Potts model Markov chain Monte Carlo Cross-entropy method Applied information economics Monte Carlo localization Evidence-based Scheduling Binary collision approximation List of software for Monte Carlo molecular modeling
. • Nuclear and particle physics codes using the Monte Carlo method: • GEANT — CERN's simulation of high energy particles interacting with a detector. electrons) in three-dimensional systems by means of the Monte Carlo method • EGS — Stanford's simulation code for coupled transport of electrons and photons • PEREGRINE: LLNL's Monte Carlo tool for radiation therapy dose calculations • BEAMnrc — Monte Carlo code system for modeling radiotherapy sources (LINAC's) • PENELOPE — Monte Carlo for coupled transport of photons and electrons.: DIVIMP). • FLUKA — INFN and CERN's simulation package for the interaction and transport of particles and nuclei in matter • SRIM.LANL's radiation transport codes • MCU: universal computer code for simulation of particle transport (neutrons. Bayesian inference. e. • CompHEP. PYTHIA — Monte-Carlo generators of particle collisions • MCNP(X) . Markov chain Monte Carlo
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• • • •
Other methods employing Monte Carlo
• • • • • • • • • • • • • • • • • Assorted random models. i.

H.
. .Monte Carlo method
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Notes
[1] Douglas Hubbard "How to Measure Anything: Finding the Value of Intangibles in Business" pg.1063/1. gov/ cgi-bin/ getfile?00326886. pdf [15] http:/ / www. Acta Numerica. Freitas. MI: JMASM.” Second Edition. J. desmangeophysics. ISBN 0387543694. 13. no. (2004). doi:10. pdf [5] Charles Grinstead & J. Judgement under Uncertainty: Heuristics and Biases. G. Reading: Addison-Wesley. Augusta H. R. p. Volume 86. R. T. Gordon. showing graph [14] http:/ / www. jussieu. Anderson. • Metropolis. fr/ ~tarantola/ Files/ Professional/ Papers_PDF/ MonteCarlo_latex. E. Neil (2001). Algorithms. org/ 10. Monte Carlo Methods. http:/ / www. ISBN 0387212396. 10-11. ubc. M. London: Methuen. [10] Sawilowsky. New York: Springer. Monte Carlo: Concepts. 143290). ISBN 0387951466. cs. com/ wb/ pages/ home/ product/ users-manual. New York: Springer. gov/ la-pubs/ 00326866.L. "Multiscale modeling of polymer materials using field-theoretic methodologies: a survey about recent developments" (http:/ / www. • Gould.2307/2280232. Part 2. 2000. • Doucet. • Berg. Astrophysics and Space Science. The Monte Carlo Method in Condensed Matter Physics. Teller. Kurt (1995). 1997 [6] H. Markov Chain Monte Carlo Simulations and Their Statistical Analysis (With Web-Based Fortran Code). 1986..). Fahoome. 218-225. 1145/ 143242. C. • Caflisch. Nando de. Nicholas. ca/ ~nando/ papers/ mlintro. Arianna W. [11] David Vose: “Risk Analysis. Rosenbluth. "Metropolis. jussieu. html [16] Davenport. ISBN 038794527X. Baeurle (2009). Monte Carlo and quasi-Monte Carlo methods.. • Binder. New York: Springer. You think you've got trivials? Journal of Modern Applied Statistical Methods. Dodd. pp.. John Wiley & Sons. Rosenbluth. . NJ: World Scientific. pp. • Hammersley. A Quantitative Guide. . Kevin (1997). Monte-Carlo simulations of galaxy systems.1007/s10910-008-9467-3. "Equation of State Calculations by Fast Computing Machines". ISBN 9813083263. Retrieved 2007-08-19. acm. A. American Mathematical Society. php
References
• Metropolis. New York: Springer. 14. S. 2009 [3] Nicholas Metropolis (1987). Arnaud. [7] Stephan A. [12] Ibid. J. John Wiley & Sons. • Kahneman. Journal of the American Statistical Association (American Statistical Association) 44 (247): 335–341. p. Teller. (1975). 7. Jan (1988). N. lanl. (2003). [8] H. 1–49. Springer Netherlands (http:/ / www. P. [4] http:/ / people. com/ content/ rp3g1q05j176r108/ fulltext. pdf). (1949). Ulam. Statistics via Monte Carlo Simulation with Fortran. (2004). fr/ ~tarantola/ Files/ Professional/ SIAM/ index.. Stochastic Simulation in Physics. Applications to Physical Systems. lanl. Tversky. Cambridge University Press. Handscomb. and Applications. D. Monte Carlo Statistical Methods (2nd ed. p. Bernd A. ISBN 0416523404. [17] Desman Geophysics . An Introduction to Computer Simulation Methods. ipgp. 16 [13] Ibid. Hackensack. MacGillivray. • MacKeown. springerlink. D. Shlomo S. • Robert.. Harvey. pdf) [9] Sawilowsky. (2003). ISBN 9812389350. 46. (1995). ISBN 0-9740236-0-4. Marshall N. Los Alamos Science (1987 Special Issue dedicated to Stanislaw Ulam): 125–130.. Journal of Mathematical Chemistry 46 (2): 363–426. Laurie Snell "Introduction to Probability" pp. doi:10. 1982. J. • Fishman. (1998). "The Monte Carlo Method" (http://jstor. springerlink. John Wiley & Sons. 17. 96-108. S. S. Tobochnik. Rochester Hills. G. ISBN 020116504X. 2(1).. com/ content/ xl057580272w8703/ ). Journal of Chemical Physics 21 (6): 1087." (http:/ / library. Cambridge University Press. Gail C. pdf) Los Alamos Science. ipgp. C. Monte Carlo and the MANIAC. Sequential Monte Carlo methods in practice. Number 2 / September. P.1699114.seismic refraction inversion users manual. doi:. "Primality testing revisited" (http:/ / doi.. (1982). PMID 18139350. New York: Springer. Edward (1953). 2007 [2] Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to Fix It".org/stable/2280232).. doi:10. "The beginning of the Monte Carlo method" (http:/ / library. Casella.

net/ programming/approximate-and-double-check-probability-problems-using-monte-carlo-method/) at Orcik Dot Net
.fr/~tarantola/Files/Professional/ SIAM/index..princeton.ipgp. Inverse Problem Theory (http://www.cooper.co. Savvakis C.phy.Overview and Concept (http://www. Albert (2005). J.gov/csep/CSEP/MC/MC.html). Winston • Monte Carlo Methods .Monte Carlo method • Rubinstein. Tarantola.uk • Molecular Monte Carlo Intro (http://www.html).php?option=com_content& view=article&id=47:monte-carlo&catid=34:statistics&Itemid=53). Giancarlo Vercellino • Approximate And Double Check Probability Problems Using Monte Carlo method (http://orcik.com/k/giancarlo-vercellino/ pricing-using-monte-carlo-simulation/11d5i2rgd9gn5/3#). • Tarantola.microsoft. Mathworld • Introduction to Monte Carlo Methods (http://www.com/MonteCarloMethod.cfm?abstract_id=265905). 100 (B7): 12431–12447.chem. Wayne L.html).html).). Kroese. Geophys. Savvides • Monte Carlo Method Example (http://waqqasfarooq. (2007). New York: John Wiley & Sons. Computational Science Education Project • The Basics of Monte Carlo Simulations (http://www.ornl. Y.aspx) (for Microsoft Excel). University of Nebraska-Lincoln • Introduction to Monte Carlo simulation (http://office. P. D.uk/montecarlo/concept.com/sol3/papers.google.edu/engineering/chemechem/monte. Res.com/waqqasfarooq/index.edu/~achremos/Applet1-page.1029/94JB03097. Prof.jussieu.co. doi:10.html). "Monte Carlo sampling of solutions to inverse problems". a practical example.ssrn.brighton-webs.com/en-us/excel-help/ introduction-to-monte-carlo-simulation-HA010282777. The Application of Monte Carlo Methodology in Project Appraisal. ISBN 0898715725. ISBN 9780470177938. Simulation and the Monte Carlo Method (2nd ed. A step-by-step guide to creating a monte carlo excel spreadsheet • Pricing using Monte Carlo simulation (http://knol. Cooper Union • Monte Carlo techniques applied in physics (http://www.wolfram. Klaus.htm) • Risk Analysis in Investment Appraisal (http://papers.unl.asp).edu/zeng/joy/mclab/mcintro.
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External links
• Overview and reference list (http://mathworld. • Mosegaard. Philadelphia: Society for Industrial and Applied Mathematics. brighton-webs. Albert (1995). R.

• Insurance companies use numerical programs for actuarial analysis. much of numerical analysis is concerned with obtaining approximate solutions while maintaining reasonable bounds on errors. The approximation of the square root of 2 is four sexagesimal figures.
General introduction
The overall goal of the field of numerical analysis is the design and analysis of techniques to give approximate but accurate solutions to hard problems.
Babylonian clay tablet BC 7289 (c. 1 + 24/60 + [1] [2] 51/602 + 10/603 = 1. in carpentry and construction. Instead. but in the 21st century.. • Car companies can improve the crash safety of their vehicles by using computer simulations of car crashes. Ordinary differential equations appear in the movement of heavenly bodies (planets. being able to compute square roots) is extremely important. modern numerical
analysis does not seek exact answers. Since the mid 20th century. which is about six decimal figures. • Airlines use sophisticated optimization algorithms to decide ticket prices. Much like the Babylonian approximation of . the variety of which is suggested by the following. 1800–1600 BC) with annotations. Image by Bill Casselman. • Computing the trajectory of a spacecraft requires the accurate numerical solution of a system of ordinary differential equations. One of the earliest mathematical writings is the Babylonian tablet BC 7289.Numerical analysis
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Numerical analysis
Numerical analysis is the study of algorithms that use numerical approximation (as opposed to general symbolic manipulations) for the problems of continuous mathematics (as distinguished from discrete mathematics). stochastic differential equations and Markov chains are essential in simulating living cells for medicine and biology. optimization occurs in portfolio management.41421296. The interpolation algorithms nevertheless may be used as part of the software for solving differential equations. for instance.[3] Numerical analysis continues this long tradition of practical mathematical calculations. • Hedge funds (private investment funds) use tools from all fields of numerical analysis to calculate the value of stocks and derivatives more precisely than other market participants. The rest of this section outlines several important themes of numerical analysis. stars and galaxies). computers calculate the required functions instead. Before the advent of modern computers numerical methods often depended on hand interpolation in large printed tables. Such simulations essentially consist of solving partial differential equations numerically. the length of the diagonal in a unit square. airplane and crew assignments and fuel needs. numerical linear algebra is important for data analysis. the life sciences and even the arts have adopted elements of scientific computations. Being able to compute the sides of a triangle (and hence.
Numerical analysis naturally finds applications in all fields of engineering and the physical sciences..
. This field is also called operations research. • Advanced numerical methods are essential in making numerical weather prediction feasible. which gives a sexagesimal numerical approximation of . because exact answers are often impossible to obtain in practice.

22. -4. The algorithm might return any number in that range with an error less than 0.
a 0 1. as is obvious from the names of important algorithms like Newton's method. or Euler's method.17. Using these tables.5 2. The initial values are a = 0.. The canonical work in the field is the NIST publication edited by Abramowitz and Stegun.875 and 2.0625 2. Many great mathematicians of the past were preoccupied by numerical analysis.875
1.24. a 1000-plus page book of a very large number of commonly used formulas and functions and their values at many points.2. but the large listing of formulas can still be very handy. These calculators evolved into electronic computers in the 1940s.. f(a) = -24. one could look up values to plug into the formulas given and achieve very good numerical estimates of some functions.32. But the invention of the computer also influenced the field of numerical analysis. large books were produced with formulas and tables of data such as interpolation points and function coefficients.25 2. since now longer and more complicated calculations could be done. The mechanical calculator was also developed as a tool for hand computation. The function values are no longer very useful when a computer is available. Linear interpolation was already in use more than 2000 years ago.
..875 2. x3 = 8. often calculated out to 16 decimal places or more for some functions.5 1. To facilitate computations by hand.
Direct and iterative methods
Direct vs iterative methods Consider the problem of solving 3x3+4=28 for the unknown quantity x.Numerical analysis
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History
The field of numerical analysis predates the invention of modern computers by many centuries. f(b) = 57.5 3 3
b
mid 1.. Gaussian elimination.0625. b = 3. Subtract 4 Divide by 3 3x3 = 24... apply the bisection method to f(x) = 3x3 . 3x3 + 4 = 28.875 10. For the iterative method. and it was then found that these computers were also useful for administrative purposes. Lagrange interpolation polynomial.
Take cube roots x = 2.25 1. We conclude from this table that the solution is between 1.
2.25
f(mid) -13.

Numerical analysis
92 Discretization and numerical integration
In a two hour race. These methods would give the precise answer if they were performed in infinite precision arithmetic. we have measured the speed of the car at three instants and recorded them in the following table.1) = 10 and f(1. finite precision is used and the result is an approximation of the true solution (assuming stability).3 km. then from 0:40 to 1:20 and finally from 1:20 to 2:00. Time km/h 0:20 1:00 1:40 140 150 180
A discretization would be to say that the speed of the car was constant from 0:00 to 0:40. iterative methods form successive approximations that converge to the exact solution only in the limit. at least for x being not close to zero. iterative methods are not expected to terminate in a number of steps.001) = 1000: a change in x of less than 0. A convergence test is specified in order to decide when a sufficiently accurate solution has (hopefully) been found. This would allow us to estimate the total distance traveled as 93.3 km + 100 km + 120 km = 313. Ill posed problem: Take the function f(x) = 1/(x − 1).
Direct methods compute the solution to a problem in a finite number of steps. Starting from an initial guess. the QR factorization method for solving systems of linear equations. because displacement is the integral of velocity. For instance. In contrast to direct methods. Evaluating f(x) near x = 1 is an ill-conditioned problem. Well-posed problem: By contrast.1 turns into a change in f(x) of nearly 1000. and the simplex method of linear programming. the total distance traveled in the first 40 minutes is approximately (2/3h x 140 km/h)=93. In practice. the function is continuous and so evaluating it is well-posed. Examples include Gaussian elimination.
. which is an example of numerical integration (see below) using a Riemann sum.3 km. Note that f(1.

e. GMRES and the conjugate gradient method.g. the bisection method. What does it mean when we say that the truncation error is created when we approximate a mathematical procedure. and Jacobi iteration.
. We therefore have a truncation error of 0.
The generation and propagation of errors
The study of errors forms an important part of numerical analysis. continuous problems must sometimes be replaced by a discrete problem whose solution is known to approximate that of the continuous problem. This function must be represented by a finite amount of data. For example. discretization induces a discretization error because the solution of the discrete problem does not coincide with the solution of the continuous problem. Similarly. this process is called discretization. Round-off Round-off errors arise because it is impossible to represent all real numbers exactly on a machine with finite memory (which is what all practical digital computers are). Similarly. it will generally propagate through the calculation. the differential element approaches to zero but numerically we can only choose a finite value of the differential element. It follows that a calculation of the type a+b+c+d+e is even more inexact. Truncation and discretization error Truncation errors are committed when an iterative method is terminated or a mathematical procedure is approximated. For instance. For instance. after 10 or so iterations. Some methods are direct in principle but are usually used as though they were not. Once an error is generated. and the approximate solution differs from the exact solution. In computational matrix algebra. and hence the approximation of the mathematical procedure. we conclude that the root is roughly 1. We know that to integrate a function exactly requires one to find the sum of infinite trapezoids. iterative methods are generally needed for large problems.
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Discretization
Furthermore.99 (for example). But numerically one can find the sum of only finite trapezoids. the solution of a differential equation is a function. Iterative methods are more common than direct methods in numerical analysis. to differentiate a function.01. There are several ways in which error can be introduced in the solution of the problem. even though this domain is a continuum.Numerical analysis Even using infinite precision arithmetic these methods would not reach the solution within a finite number of steps (in general). for instance by its value at a finite number of points at its domain. we have already noted that the operation + on a calculator (or a computer) is inexact. For these methods the number of steps needed to obtain the exact solution is so large that an approximation is accepted in the same manner as for an iterative method. in the iteration in the sidebar to compute the solution of . Examples include Newton's method.

Numerical analysis Numerical stability and well-posed problems Numerical stability is an important notion in numerical analysis. An algorithm is called numerically stable if an error, whatever its cause, does not grow to be much larger during the calculation. This happens if the problem is well-conditioned, meaning that the solution changes by only a small amount if the problem data are changed by a small amount. To the contrary, if a problem is ill-conditioned, then any small error in the data will grow to be a large error. Both the original problem and the algorithm used to solve that problem can be well-conditioned and/or ill-conditioned, and any combination is possible. So an algorithm that solves a well-conditioned problem may be either numerically stable or numerically unstable. An art of numerical analysis is to find a stable algorithm for solving a well-posed mathematical problem. For instance, computing the square root of 2 (which is roughly 1.41421) is a well-posed problem. Many algorithms solve this problem by starting with an initial approximation x1 to , for instance x1=1.4, and then computing improved guesses x2, x3, etc... One such method is the famous Babylonian method, which is given by xk+1 = xk/2 + 1/xk. Another iteration, which we will call Method X, is given by xk + 1 = (xk2−2)2 + xk.[4] We have calculated a few iterations of each scheme in table form below, with initial guesses x1 = 1.4 and x1 = 1.42.

Babylonian x1 = 1.4 x2 = 1.4142857... Babylonian x1 = 1.42 x2 = 1.41422535... Method X x1 = 1.4 x2 = 1.4016 Method X x1 = 1.42 x2 = 1.42026896 x3 = 1.42056... ...

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x3 = 1.414213564... x3 = 1.41421356242... x3 = 1.4028614... ...

x1000000 = 1.41421... x28 = 7280.2284...

Observe that the Babylonian method converges fast regardless of the initial guess, whereas Method X converges extremely slowly with initial guess 1.4 and diverges for initial guess 1.42. Hence, the Babylonian method is numerically stable, while Method X is numerically unstable. Numerical stability is affected by the number of the significant digits the machine keeps on, if we use a machine that keeps on the first four floating-point digits,a good example on loss of significance these two equivalent functions

if we compare the results of and

by looking to the two above results, we realize that loss of significance which is also called Subtractive Cancelation has a huge effect on the results, even though both functions are equivalent; to show that they are equivalent simply we need to start by f(x) and end with g(x), and so

Numerical analysis

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the true value for the result is 11.174755... which is exactly g(500)=11.1748 after rounding the result to 4 decimal digits now imagine that you use tens of terms like these functions in your program, your error will increase as you proceed in the program, unless you use the suitable formula of the two functions each time you evaluate either f(x), or g(x), the choice is dependent on the parity of x . • The example is taken from Mathew; Numerical methods using matlab , 3rd ed.

Areas of study

The field of numerical analysis is divided into different disciplines according to the problem that is to be solved.

**Computing values of functions
**

Interpolation: We have observed the temperature to vary from 20 degrees Celsius at 1:00 to 14 degrees at 3:00. A linear interpolation of this data would conclude that it was 17 degrees at 2:00 and 18.5 degrees at 1:30pm. Extrapolation: If the gross domestic product of a country has been growing an average of 5% per year and was 100 billion dollars last year, we might extrapolate that it will be 105 billion dollars this year.

Regression: In linear regression, given n points, we compute a line that passes as close as possible to those n points.

Numerical analysis

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Optimization: Say you sell lemonade at a lemonade stand, and notice that at $1, you can sell 197 glasses of lemonade per day, and that for each increase of $0.01, you will sell one less lemonade per day. If you could charge $1.485, you would maximize your profit, but due to the constraint of having to charge a whole cent amount, charging $1.49 per glass will yield the maximum income of $220.52 per day.

Differential equation: If you set up 100 fans to blow air from one end of the room to the other and then you drop a feather into the wind, what happens? The feather will follow the air currents, which may be very complex. One approximation is to measure the speed at which the air is blowing near the feather every second, and advance the simulated feather as if it were moving in a straight line at that same speed for one second, before measuring the wind speed again. This is called the Euler method for solving an ordinary differential equation.

One of the simplest problems is the evaluation of a function at a given point. The most straightforward approach, of just plugging in the number in the formula is sometimes not very efficient. For polynomials, a better approach is using the Horner scheme, since it reduces the necessary number of multiplications and additions. Generally, it is important to estimate and control round-off errors arising from the use of floating point arithmetic.

**Interpolation, extrapolation, and regression
**

Interpolation solves the following problem: given the value of some unknown function at a number of points, what value does that function have at some other point between the given points? Extrapolation is very similar to interpolation, except that now we want to find the value of the unknown function at a point which is outside the given points. Regression is also similar, but it takes into account that the data is imprecise. Given some points, and a measurement of the value of some function at these points (with an error), we want to determine the unknown function. The least squares-method is one popular way to achieve this.

**Solving equations and systems of equations
**

Another fundamental problem is computing the solution of some given equation. Two cases are commonly distinguished, depending on whether the equation is linear or not. For instance, the equation is linear while is not. Much effort has been put in the development of methods for solving systems of linear equations. Standard direct methods, i.e., methods that use some matrix decomposition are Gaussian elimination, LU decomposition, Cholesky decomposition for symmetric (or hermitian) and positive-definite matrix, and QR decomposition for non-square matrices. Iterative methods such as the Jacobi method, Gauss–Seidel method, successive over-relaxation and conjugate gradient method are usually preferred for large systems.

Numerical analysis Root-finding algorithms are used to solve nonlinear equations (they are so named since a root of a function is an argument for which the function yields zero). If the function is differentiable and the derivative is known, then Newton's method is a popular choice. Linearization is another technique for solving nonlinear equations.

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**Solving eigenvalue or singular value problems
**

Several important problems can be phrased in terms of eigenvalue decompositions or singular value decompositions. For instance, the spectral image compression algorithm [5] is based on the singular value decomposition. The corresponding tool in statistics is called principal component analysis.

Optimization

Optimization problems ask for the point at which a given function is maximized (or minimized). Often, the point also has to satisfy some constraints. The field of optimization is further split in several subfields, depending on the form of the objective function and the constraint. For instance, linear programming deals with the case that both the objective function and the constraints are linear. A famous method in linear programming is the simplex method. The method of Lagrange multipliers can be used to reduce optimization problems with constraints to unconstrained optimization problems.

Evaluating integrals

Numerical integration, in some instances also known as numerical quadrature, asks for the value of a definite integral. Popular methods use one of the Newton–Cotes formulas (like the midpoint rule or Simpson's rule) or Gaussian quadrature. These methods rely on a "divide and conquer" strategy, whereby an integral on a relatively large set is broken down into integrals on smaller sets. In higher dimensions, where these methods become prohibitively expensive in terms of computational effort, one may use Monte Carlo or quasi-Monte Carlo methods (see Monte Carlo integration), or, in modestly large dimensions, the method of sparse grids.

Differential equations

Numerical analysis is also concerned with computing (in an approximate way) the solution of differential equations, both ordinary differential equations and partial differential equations. Partial differential equations are solved by first discretizing the equation, bringing it into a finite-dimensional subspace. This can be done by a finite element method, a finite difference method, or (particularly in engineering) a finite volume method. The theoretical justification of these methods often involves theorems from functional analysis. This reduces the problem to the solution of an algebraic equation.

Software

Since the late twentieth century, most algorithms are implemented in a variety of programming languages. The Netlib repository contains various collections of software routines for numerical problems, mostly in Fortran and C. Commercial products implementing many different numerical algorithms include the IMSL and NAG libraries; a free alternative is the GNU Scientific Library. There are several popular numerical computing applications such as MATLAB, S-PLUS, LabVIEW, and IDL as well as free and open source alternatives such as FreeMat, Scilab, GNU Octave (similar to Matlab), IT++ (a C++ library), R (similar to S-PLUS) and certain variants of Python. Performance varies widely: while vector and matrix operations are usually fast, scalar loops may vary in speed by more than an order of magnitude.[6] [7] Many computer algebra systems such as Mathematica also benefit from the availability of arbitrary precision arithmetic which can provide more accurate results.

Numerical analysis Also, any spreadsheet software can be used to solve simple problems relating to numerical analysis.

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See also

• • • • • • • • Scientific computing List of numerical analysis software List of numerical analysis topics Gram-Schmidt process Numerical differentiation Symbolic-numeric computation Analysis of algorithms Numerical Recipes

Notes

[1] Photograph, illustration, and description of the root(2) tablet from the Yale Babylonian Collection (http:/ / it. stlawu. edu/ ~dmelvill/ mesomath/ tablets/ YBC7289. html) [2] YBC 7289, Bill Casselman (http:/ / www. math. ubc. ca/ ~cass/ Euclid/ ybc/ ybc. html) [3] The New Zealand Qualification authority specifically mentions this skill in document 13004 version 2, dated 17 October 2003 titled CARPENTRY THEORY: Demonstrate knowledge of setting out a building (http:/ / www. nzqa. govt. nz/ nqfdocs/ units/ pdf/ 13004. pdf) [4] This is a fixed point iteration for the equation , whose solutions include . The iterates always

move to the right since . Hence converges and diverges. [5] The Singular Value Decomposition and Its Applications in Image Compression (http:/ / online. redwoods. cc. ca. us/ instruct/ darnold/ maw/ single. htm) [6] Speed comparison of various number crunching packages (http:/ / www. sciviews. org/ benchmark/ ) [7] Comparison of mathematical programs for data analysis (http:/ / www. scientificweb. com/ ncrunch/ ncrunch5. pdf) Stefan Steinhaus, ScientificWeb.com

References

• Gilat, Amos (2004). MATLAB: An Introduction with Applications (2nd edition ed.). John Wiley & Sons. ISBN 0-471-69420-7. • Hildebrand, F. B. (1974). Introduction to Numerical Analysis (2nd edition ed.). McGraw-Hill. ISBN 0-070-28761-9. • Leader, Jeffery J. (2004). Numerical Analysis and Scientific Computation. Addison Wesley. ISBN 0-201-73499-0. • Trefethen, Lloyd N. (2006). "Numerical analysis" (http://web.comlab.ox.ac.uk/oucl/work/nick.trefethen/ NAessay.pdf), 20 pages. In: Timothy Gowers and June Barrow-Green (editors), Princeton Companion of Mathematics, Princeton University Press.

External links

Journals • Numerische Mathematik (http://www-gdz.sub.uni-goettingen.de/cgi-bin/digbib.cgi?PPN362160546), volumes 1-66, Springer, 1959-1994 (searchable; pages are images). (English) (German) • Numerische Mathematik at SpringerLink (http://www.springerlink.com/content/0029-599X), volumes 1-112, Springer, 1959–2009 • SIAM Journal on Numerical Analysis (http://siamdl.aip.org/dbt/dbt.jsp?KEY=SJNAAM), volumes 1-47, SIAM, 1964–2009 Software and Code

Numerical analysis • Lists of free software for scientific computing and numerical analysis (http://norma.mas.ecp.fr/wikimas/ ScientificComputingSoftware) (English) (French) • Numerical methods for Fortran programmers (http://people.sc.fsu.edu/~tomek/Fortran/num_meth.html) • Java Number Cruncher (http://www.apropos-logic.com/nc/) features free, downloadable code samples that graphically illustrate common numerical algorithms • Excel Implementations (http://www.ifh.uni-karlsruhe.de/people/fenton/Lectures.html) • Several Numerical Mathematical Utilities (in Javascript) (http://www.akiti.ca/Mathfxns.html) Online Texts • Numerical Recipes (http://www.nr.com/oldverswitcher.html), William H. Press (free, downloadable previous editions) • First Steps in Numerical Analysis (http://kr.cs.ait.ac.th/~radok/math/mat7/stepsa.htm#Numerical Analysis), R.J.Hosking, S.Joe, D.C.Joyce, and J.C.Turner • Numerical Analysis for Engineering (http://ece.uwaterloo.ca/~dwharder/NumericalAnalysis/), D. W. Harder • CSEP (Computational Science Education Project) (http://www.phy.ornl.gov/csep/CSEP/TEXTOC.html), U.S. Department of Energy Online Course Material • Numerical Methods (http://www.damtp.cam.ac.uk/user/fdl/people/sd103/lectures/nummeth98/index. htm#L_1_Title_Page), Stuart Dalziel University of Cambridge • Lectures on Numerical Analysis (http://www.math.upenn.edu/~wilf/DeturckWilf.pdf), Dennis Deturck and Herbert S. Wilf University of Pennsylvania • Numerical methods (http://www.ifh.uni-karlsruhe.de/people/fenton/LectureNotes/Numerical-Methods.pdf), John D. Fenton University of Karlsruhe • Numerical Methods for Science, Technology, Engineering and Mathematics (http://numericalmethods.eng.usf. edu/), Autar Kaw University of South Florida • Numerical Analysis Project (http://math.fullerton.edu/mathews/numerical.html), John H. Mathews California State University, Fullerton • Numerical Methods - Online Course (http://www.math.jct.ac.il/~naiman/nm/), Aaron Naiman Jerusalem College of Technology • Numerical Methods for Physicists (http://www-teaching.physics.ox.ac.uk/computing/NumericalMethods/ NMfP.pdf), Anthony O’Hare Oxford University • Lectures in Numerical Analysis (http://kr.cs.ait.ac.th/~radok/math/mat7/stepsa.htm#Numerical Analysis), R. Radok Mahidol University • Introduction to Numerical Analysis for Engineering (http://ocw.mit.edu/OcwWeb/Mechanical-Engineering/ 2-993JSpring-2005/CourseHome/), Henrik Schmidt Massachusetts Institute of Technology

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Real analysis

100

Real analysis

Real analysis, or theory of functions of a real variable is a branch of mathematical analysis dealing with the set of real numbers. In particular, it deals with the analytic properties of real functions and sequences, including convergence and limits of sequences of real numbers, the calculus of the real numbers, and continuity, smoothness and related properties of real-valued functions.

Scope

Real analysis is an area of analysis which studies concepts such as sequences and their limits, continuity, differentiation, integration and sequences of functions. By definition, real analysis focuses on the real numbers, often including positive or negative infinity.

**Order properties of the real numbers
**

The real numbers have several important lattice-theoretic properties that are absent in the complex numbers. Most importantly, the real numbers form an ordered field, in which addition and multiplication preserve positivity. Moreover, the ordering of the real numbers is total, and the real numbers have the least upper bound property. These order-theoretic properties lead to a number of important results in real analysis, such as the monotone convergence theorem, the intermediate value theorem and the mean value theorem. However, while the results in real analysis are stated for real numbers, many of these results can be generalized to other mathematical objects. In particular, many ideas in functional analysis and operator theory generalize properties of the real numbers --- such generalizations include the theories of Riesz spaces and positive operators. Also, mathematicians consider real and imaginary parts of complex sequences, or by pointwise evaluation of operator sequences.

**Relation to complex analysis
**

Real analysis is closely related to complex analysis, which studies broadly the same properties of complex numbers. In complex analysis, it is natural to define differentiation via holomorphic functions, which have a number of useful properties, such as repeated differentiability, expressability as power series, and satisfying the Cauchy integral formula. However, in real analysis, it is usually more natural to consider differentiable, smooth, or harmonic functions, which are more widely applicable, but may lack some more powerful properties of holomorphic functions. Also results such as the fundamental theorem of algebra are simpler when expressed in terms of complex numbers. Techniques from the theory of analytic functions of a complex variable are often used in real analysis --- such as evaluation of real integrals by residue calculus.

Key concepts

The foundation of real analysis is the construction of the real numbers from the rational numbers, usually either by Dedekind cuts, or by completion of Cauchy sequences. Key concepts in real analysis are real sequences and their limits, continuity, differentiation, and integration. Real analysis is also used as a starting point for other areas of analysis, such as complex analysis, functional analysis, and harmonic analysis, as well as motivating the development of topology, and as a tool in other areas, such as applied mathematics. Important results include the Bolzano-Weierstrass and Heine-Borel theorems, the intermediate value theorem and mean value theorem, the fundamental theorem of calculus, and the monotone convergence theorem.

Real analysis Various ideas from real analysis can be generalized from real space to general metric spaces, as well as to measure spaces, Banach spaces, and Hilbert spaces.

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See also

• List of real analysis topics • Complex analysis • Real analysis on time scales - a unification of real analysis with calculus of finite differences

Bibliography

• Aliprantis, Charalambos D; Burkinshaw, Owen (1998). Principles of real analysis (Third ed.). Academic. ISBN 0-12-050257-7. • Browder, Andrew (1996). Mathematical Analysis: An Introduction. Undergraduate Texts in Mathematics. New York: Springer-Verlag. ISBN 0-387-94614-4. • Bartle, Robert G. and Sherbert, Donald R. (2000). Introduction to Real Analysis (3 ed.). New York: John Wiley and Sons. ISBN 0-471-32148-6. • Abbott, Stephen (2001). Understanding Analysis. Undergradutate Texts in Mathematics. New York: Springer-Verlag. ISBN 0-387-95060-5. • Rudin, Walter. Principles of Mathematical Analysis. Walter Rudin Student Series in Advanced Mathematics (3 ed.). McGraw-Hill. ISBN 978-0070542358. • Dangello, Frank and Seyfried, Michael (1999). Introductory Real Analysis. Brooks Cole. ISBN 978-0395959336. • Bressoud, David (2007). A Radical Approach to Real Analysis. MAA. ISBN 0-883857472.

External links

• • • • • • • • Analysis WebNotes [1] by John Lindsay Orr Interactive Real Analysis [2] by Bert G. Wachsmuth A First Analysis Course [3] by John O'Connor Mathematical Analysis I [4] by Elias Zakon Mathematical Analysis II [5] by Elias Zakon Trench, William F. (2003). Introduction to Real Analysis [6]. Prentice Hall. ISBN 978-0-13-045786-8 Earliest Known Uses of Some of the Words of Mathematics: Calculus & Analysis [7] Basic Analysis: Introduction to Real Analysis [8] by Jiri Lebl

References

[1] [2] [3] [4] [5] [6] [7] [8] http:/ / www. math. unl. edu/ ~webnotes/ contents/ chapters. htm http:/ / www. mathcs. org/ analysis/ reals/ index. html http:/ / www-groups. mcs. st-andrews. ac. uk/ ~john/ analysis/ index. html http:/ / www. trillia. com/ zakon-analysisI. html http:/ / www. trillia. com/ zakon-analysisII. html http:/ / ramanujan. math. trinity. edu/ wtrench/ texts/ TRENCH_REAL_ANALYSIS. PDF http:/ / www. economics. soton. ac. uk/ staff/ aldrich/ Calculus%20and%20Analysis%20Earliest%20Uses. htm http:/ / www. jirka. org/ ra/

Partial differential equation

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**Partial differential equation
**

In mathematics, partial differential equations (PDE) are a type of differential equation, i.e., a relation involving an unknown function (or functions) of several independent variables and their partial derivatives with respect to those variables. Partial differential equations are used to formulate, and thus aid the solution of, problems involving functions of several variables; such as the propagation of sound or heat, electrostatics, electrodynamics, fluid flow, and elasticity. Seemingly distinct physical phenomena may have identical mathematical formulations, and thus be governed by the same underlying dynamic. A visualisation of a solution to the heat equation on a two dimensional plane They find their generalization in Stochastic partial differential equations. Just as ordinary differential equations often model dynamical systems, partial differential equations often model multidimensional systems.

Introduction

A partial differential equation (PDE) for the function is of the form and F is a linear function of u and its derivatives if, by replacing u with v+w, F can be written as

if, by replacing u with ku, F can be written as If F is a linear function of u and its derivatives, then the PDE is linear. Common examples of linear PDEs include the heat equation, the wave equation and Laplace's equation. A relatively simple PDE is

This relation implies that the function u(x,y) is independent of x. Hence the general solution of this equation is

where f is an arbitrary function of y. The analogous ordinary differential equation is

which has the solution

where c is any constant value (independent of x). These two examples illustrate that general solutions of ordinary differential equations (ODEs) involve arbitrary constants, but solutions of PDEs involve arbitrary functions. A solution of a PDE is generally not unique; additional conditions must generally be specified on the boundary of the region where the solution is defined. For instance, in the simple example above, the function can be determined if is specified on the line .

**Existence and uniqueness
**

Although the issue of the existence and uniqueness of solutions of ordinary differential equations has a very satisfactory answer with the Picard–Lindelöf theorem, that is far from the case for partial differential equations. There is a general theorem (the Cauchy–Kowalevski theorem) that states that the Cauchy problem for any partial differential equation that is analytic in the unknown function and its derivatives has a unique analytic solution. Although this result might appear to settle the existence and uniqueness of solutions, there are examples of linear

Partial differential equation partial differential equations whose coefficients have derivatives of all orders (which are nevertheless not analytic) but which have no solutions at all: see Lewy (1957). Even if the solution of a partial differential equation exists and is unique, it may nevertheless have undesirable properties. The mathematical study of these questions is usually in the more powerful context of weak solutions. An example of pathological behavior is the sequence of Cauchy problems (depending upon n) for the Laplace equation

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with initial conditions

where n is an integer. The derivative of u with respect to y approaches 0 uniformly in x as n increases, but the solution is

This solution approaches infinity if nx is not an integer multiple of π for any non-zero value of y. The Cauchy problem for the Laplace equation is called ill-posed or not well posed, since the solution does not depend continuously upon the data of the problem. Such ill-posed problems are not usually satisfactory for physical applications.

Notation

In PDEs, it is common to denote partial derivatives using subscripts. That is:

Especially in (mathematical) physics, one often prefers the use of del (which in cartesian coordinates is written ) for spatial derivatives and a dot for time derivatives. For example, the wave equation (described below) can be written as (physics notation), or (math notation), where Δ is the Laplace operator. This often leads to misunderstandings in regards of the -(delta)operator.

For a source whose strength is normalized to 1. where f(x) is an arbitrary function. that is
If f represents a very small but intense source of heat. or the difference in air pressure in a tube. a general solution of the heat equation has the form
where F is an arbitrary function. Using the Fourier transform. multiplied by the strength of the source. The heat equation and similar diffusion equations are useful tools to study random phenomena. The Cauchy problem for this equation consists in specifying . General solutions of the heat equation can be found by the method of separation of variables. The Cauchy problem for this equation consists in prescribing the initial displacement and velocity of a string or other medium:
where f and g are arbitrary given functions.Partial differential equation
104
Examples
Heat equation in one space dimension
The equation for conduction of heat in one dimension for a homogeneous body has the form
where u(t. then the preceding integral can be approximated by the delta distribution. or the magnitude of an electromagnetic field in a tube.
Wave equation in one spatial dimension
The wave equation is an equation for an unknown function u(t. To satisfy the initial condition. the result is
and the resulting solution of the heat equation is
This is a Gaussian integral.x) depends only upon the data on the segment of the initial line that is cut out by the characteristic curves
. and α is a positive constant that describes the rate of diffusion. x) of the form
Here u might describe the displacement of a stretched string from equilibrium.x) is temperature. The solution of this problem is given by d'Alembert's formula:
This formula implies that the solution at (t. They are examples of Fourier series for periodic f and Fourier transforms for non-periodic f. and c is a number that corresponds to the velocity of the wave. F is given by the Fourier transform of f. It may be evaluated to obtain
This result corresponds to a normal probability density for x with mean 0 and variance 2αt. Some examples appear in the heat equation article.

Spherical waves Spherical waves are waves whose amplitude depends only upon the radial distance r from a central point source. Connection with holomorphic functions Solutions of the Laplace equation in two dimensions are intimately connected with analytic functions of a complex variable (a. Radiation from an antenna corresponds to the case where G is identically zero. where the effect of a point source appears (with small amplitude) instantaneously at every point in space. and their gradients are orthogonal. it is the real part of an analytic function.
. This behavior is very different from the solution for the heat equation.a. Therefore a general solution for spherical waves has the form
where F and G are completely arbitrary functions. For such waves.k. the influence of the data at any given point on the initial line propagates with the finite velocity c: there is no effect outside a triangle through that point whose sides are characteristic curves. The solution given above is also valid if t is negative. If f=u+iv. This feature of undistorted propagation of waves is not present if there are two spatial dimensions.Partial differential equation that are drawn backwards from that point. Thus the wave form transmitted from an antenna has no distortion in time: the only distorting factor is 1/r. then the Cauchy–Riemann equations state that
and it follows that
Conversely. given any harmonic function in two dimensions. These curves correspond to signals that propagate with velocity c forward and backward. at least locally. and the explicit formula shows that the solution depends smoothly upon the data: both the forward and backward Cauchy problems for the wave equation are well-posed.
Laplace equation in two dimensions
The Laplace equation for an unknown function of two variables φ has the form
Solutions of Laplace's equation are called harmonic functions. holomorphic functions): the real and imaginary parts of any analytic function are conjugate harmonic functions: they both satisfy the Laplace equation. the three-dimensional wave equation takes the form
105
This is equivalent to
and hence the quantity ru satisfies the one-dimensional wave equation. Conversely. Details are given in Laplace equation.

fjktgi jytir. the derivatives of φ may be computed by differentiating under the integral sign. The solution was given by Poisson:
106
Petrovsky (1967.li7l thavendiran. This behavior is typical for solutions of elliptic partial differential equations: the solutions may be much more smooth than the boundary data. It is:
). and one can verify that φ is analytic.
is not constant and is equal to
. even if u is continuous but not necessarily differentiable. p. It is
where
and
are constants and
is the imaginary unit. If r<1. It is
.
Euler–Tricomi equation
The Euler–Tricomi equation is used in the investigation of transonic flow. then the equation may be simplified to
In the one-dimensional case where equation. 248) shows how this formula can be obtained by summing a Fourier series for φ.
The Dym equation
The Dym equation is named for Harry Dym and occurs in the study of solitons. in a velocity field . we may seek a harmonic function that takes on the values u(θ) on a circle of radius one.Partial differential equation A typical boundary value problem A typical problem for Laplace's equation is to find a solution that satisfies arbitrary values on the boundary of a domain. For example.
Advection equation
The advection equation describes the transport of a conserved scalar If the velocity field is solenoidal (that is. This is in contrast to solutions of the wave equation. the equation is referred to as Burgers'
Ginzburg–Landau equation
The Ginzburg–Landau equation is used in modelling superconductivity. and more general hyperbolic partial differential equations. which typically have no more derivatives than the data.

The general problem of this type is solved in Sturm–Liouville theory. Wind instruments typically correspond to vibrations of an air column with one end open and one end closed. and the frequencies of the other modes are all multiples of this frequency. They form the overtone series of the string. The mode with n=1 is called the fundamental mode. and it leads to a series of odd overtones. Since the string is tied down at the ends. and they are the basis for musical acoustics. The boundary conditions then imply that X is a multiple of sin kx. u must also satisfy the boundary conditions
as well as the initial conditions
The method of separation of variables for the wave equation
leads to solutions of the form
where
where the constant k must be determined. and the
. Such values of k2 are called the eigenvalues of the Laplacian in D.y) is in D. The initial conditions may then be satisfied by representing f and g as infinite sums of these modes. The corresponding boundary conditions are
The method of separation of variables can also be applied in this case. The constant k must be determined to allow a non-trivial v to satisfy the boundary condition on C. Each term in the sum corresponds to a mode of vibration of the string. The boundary condition is variables leads to the form which in turn must satisfy
if
is on
.Partial differential equation
107
Initial-boundary value problems
Many problems of mathematical physics are formulated as initial-boundary value problems. then u satisfies the one-dimensional wave equation in the region where 0<x<L and t is unlimited. Vibrating string If the string is stretched between two points where x=0 and x=L and u denotes the amplitude of the displacement of the string. Vibrating membrane If a membrane is stretched over a curve C that forms the boundary of a domain D in the plane. The method of separation of
The latter equation is called the Helmholtz Equation. its vibrations are governed by the wave equation
if t>0 and (x. and k must have the form
where n is an integer.

and the Euler–Tricomi equation is hyperbolic where x>0. Just as one classifies conic sections and quadratic forms into parabolic. replacing by and likewise for other variables (formally this is done by a Fourier transform). 2002).. B. Also see the list of non-linear partial differential equations.
the PDE is second-order in that region.
Equations of second order
Assuming . : hyperbolic equations retain any discontinuities of functions or derivatives in the initial data. the above equations are linear in the sense that they can be written in the form Au = f for a given linear operator A and a given function f.
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Other examples
The Schrödinger equation is a PDE at the heart of non-relativistic quantum mechanics. The classification provides a guide to appropriate initial and boundary conditions. Solutions smooth out as the transformed time variable increases. second-order partial differential equations can be classified as parabolic. hyperbolic. However. solutions of Laplace's equation are analytic within the domain where they are defined. within the interior of the region where the equation and solutions are defined. and Einstein's field equations of general relativity. x2 . and elliptic based on the discriminant . hyperbolic or elliptic. If there are n independent variables x1. and the Euler–Tricomi equation is elliptic where x<0. Other important non-linear equations include the Navier–Stokes equations describing the flow of fluids.. the general second-order PDE in two independent variables has the form
where the coefficients A. 2. The motion of a fluid at supersonic speeds can be approximated with hyperbolic PDEs. : solutions of elliptic PDEs are as smooth as the coefficients allow. the discriminant (of the associated quadratic form) is
of 4 dropped for simplicity.
Classification
Some linear. here a quadratic form) being most significant for the classification. the discriminant in a PDE is given by due to the convention of the xy term being 2B rather than B. Others such as the Euler–Tricomi equation have different types in different regions. Except for the Dym equation and the Ginzburg–Landau equation. with the top degree (a homogeneous polynomial. 1. C etc. . For example. xn. but solutions may assume boundary values that are not smooth. The Euler–Tricomi equation has parabolic type on the line where x=0. The Sturm–Liouville theory may be extended to this elliptic eigenvalue problem (Jost. An example is the wave equation. : equations that are parabolic at every point can be transformed into a form analogous to the heat equation by a change of independent variables. The motion of a fluid at subsonic speeds can be approximated with elliptic PDEs. In the WKB approximation it is the Hamilton–Jacobi equation. 3.. a general linear partial differential equation of second order has the form
.
converts a constant-coefficient PDE into a polynomial of the same degree.Partial differential equation associated solutions are the eigenfunctions of the Laplacian in D. the same can be done for a second-order PDE at a given point. This form is analogous to the equation for a conic section: More precisely. may depend upon x and y. If
over a region of the xy plane. and to smoothness of the solutions. with the factor
formally.

Elliptic: The eigenvalues are all positive or all negative. 1. and the differential equation restricts the data on S: the differential equation is internal to S. where the unknown u is now a vector with m components. Hyperbolic: There is only one negative eigenvalue and all the rest are positive. A first-order system is hyperbolic at a point if there is a space-like surface S with normal ξ at that point.
Systems of first-order equations and characteristic surfaces
The classification of partial differential equations can be extended to systems of first-order equations. 2. given any non-trivial vector η orthogonal to ξ. In the hyperbolic case. There is only limited theory for ultrahyperbolic equations (Courant and Hilbert. then it may be possible to determine the normal derivative of u on S from the differential equation. If a hypersurface S is given in the implicit form
where φ has a non-zero gradient. Ultrahyperbolic: There is more than one positive eigenvalue and more than one negative eigenvalue. Parabolic : The eigenvalues are all positive or all negative. 1962). then the surface is characteristic. A first-order system Lu=0 is elliptic if no surface is characteristic for L: the values of u on S and the differential equation always determine the normal derivative of u on S. If the data on S and the differential equation determine the normal derivative of u on S.. The partial differential equation takes the form
where the coefficient matrices Aν and the vector B may depend upon x and u. the equation
has m real roots λ1. 2. In the elliptic case. this cone has m sheets. and the coefficient matrices are m by m matrices for . This means that. If the data on S and the differential equation do not determine the normal derivative of u on S. λm. The geometrical interpretation of this condition is as follows: the characteristic form Q(ζ)=0 defines a cone (the normal cone) with homogeneous coordinates ζ. or there is only one positive eigenvalue and all the rest are negative. and a scalar multiplier λ. The system is strictly hyperbolic if these roots are always distinct.. and there are no zero eigenvalues. and the axis ζ = λ ξ runs inside these sheets: it does not intersect any of them. then S is non-characteristic.Partial differential equation
109
The classification depends upon the signature of the eigenvalues of the coefficient matrix. the normal cone has no real sheets. then S is a characteristic surface for the operator L at a given point if the characteristic form vanishes:
The geometric interpretation of this condition is as follows: if data for u are prescribed on the surface S. 3. λ2. 1. save one that is zero.
. . But when displaced from the origin by η. this axis intersects every sheet. 4..

and is called the method of characteristics. The quantum trajectories are quantum characteristics with the use of which one can calculate the evolution of the Wigner function.
. A simple but important example is the Euler–Tricomi equation
which is called elliptic-hyperbolic because it is elliptic in the region x < 0. one reduces a PDE to a PDE in fewer variables.
Method of characteristics
In special cases. and the domain is generally a rectangle (a product of intervals). which diagonalizes the heat equation using the eigenbasis of sinusoidal waves. an infinite sum of solutions such as a Fourier series is appropriate. one can find characteristic curves on which the equation reduces to an ODE – changing coordinates in the domain to straighten these curves allows separation of variables. one may find characteristic surfaces.Partial differential equation
110
Equations of mixed type
If a PDE has coefficients that are not constant. An important example of this is Fourier analysis. If the domain is finite or periodic. hyperbolic in the region x > 0.
Integral transform
An integral transform may transform the PDE to a simpler one. This generalizes to the method of characteristics. More generally. in particular a separable PDE. it is possible that it will not belong to any of these categories but rather be of mixed type. Those equations are infinite-order PDEs. The solution for a point source for the heat equation given above is an example for use of a Fourier integral. and degenerate parabolic on the line x = 0. which is an ODE if in one variable – these are in turn easier to solve. The equation of evolution of the Wigner function is infinite-order PDE also.
Analytical methods to solve PDEs
Separation of variables
In the method of separation of variables. in the semiclassical expansion one has a finite system of ODEs at any fixed order of . and is also used in integral transforms. which are called separable partial differential equations. Separable PDEs correspond to diagonal matrices – thinking of "the value for fixed x" as a coordinate. This corresponds to diagonalizing an operator. but an integral of solutions such as a Fourier integral is generally required for infinite domains. However. This is possible for simple PDEs. each coordinate can be understood separately.
Infinite-order PDEs in quantum mechanics
Weyl quantization in phase space leads to quantum Hamilton's equations for trajectories of quantum particles.

Methods for non-linear equations
See also the list of nonlinear partial differential equations. The Riquier–Janet theory is an effective method for obtaining information about many analytic overdetermined systems. This is analogous in signal processing to understanding a filter by its impulse response. Nevertheless.
. existence and uniqueness results (such as the Cauchy–Kowalevski theorem) are often possible. the particular solutions may then be combined to obtain more general solutions. The h-principle is the most powerful method to solve underdetermined equations.Partial differential equation
111
Change of variables
Often a PDE can be reduced to a simpler form with a known solution by a suitable change of variables. Many interesting problems in science and engineering are solved in this way using computers. Alternatives are numerical analysis techniques from simple finite difference schemes to the more mature multigrid and finite element methods. always be solved) by finding the fundamental solution (the solution for a point source). sometimes high performance supercomputers. as are proofs of important qualitative and quantitative properties of solutions (getting these results is a major part of analysis). For example the Black–Scholes PDE
is reducible to the heat equation
by the change of variables (for complete details see Solution of the Black Scholes Equation [1])
Fundamental solution
Inhomogeneous equations can often be solved (for constant coefficient PDEs. The method of characteristics (Similarity Transformation method) can be used in some very special cases to solve partial differential equations. some techniques can be used for several types of equations. exist for specific equations like nonlinear Schrödinger equation. Still. In some cases. Computational solution to the nonlinear PDEs. homogeneous PDE is again a solution. the Split-step method. a PDE can be solved via perturbation analysis in which the solution is considered to be a correction to an equation with a known solution. then taking the convolution with the boundary conditions to get the solution. There are no generally applicable methods to solve non-linear PDEs.
Superposition principle
Because any superposition of solutions of a linear.

Bäcklund transform and finally finding exact analytic solutions to the PDE. (1962). etc. physics. He also emphasized the subject of transformations of contact. New York: Springer-Verlag. • John. R. • Jost.
. meshfree finite element method. ISBN 0849344883. Nail H (1993). extended finite element method (XFEM). & Hilbert. • Ibragimov. (2002).
See also
• • • • • • • • Boundary value problem Difference equation Laplace transform applied to differential equations List of dynamical systems and differential equations topics Matrix differential equation Ordinary differential equation Separation of variables Stochastic partial differential equations
References
• Courant.
Numerical methods to solve PDEs
The three most widely used numerical methods to solve PDEs are the finite element method (FEM). Other versions of FEM include the generalized finite element method (GFEM). F. the continuous infinitesimal transformations of solutions to solutions (Lie theory). ISBN 0821807722. A general approach to solve PDE's uses the symmetry property of differential equations. Providence: CRC-Press. New York: Springer-Verlag. New York: Wiley-Interscience. (1982). The FEM has a prominent position among these methods and especially its exceptionally efficient higher-order version hp-FEM.). J. engineering. finite volume methods (FVM) and finite difference methods (FDM). recursion operators. Providence: American Mathematical Society. L. and many other disciplines. be referred to a common source. spectral finite element method (SFEM). Symmetry methods have been recognized to study differential equations arising in mathematics. 1-3.
Almost-solution of PDE
Almost-solution of PDE is a concept introduced by a Russian mathematician Vladimir Miklyukov in connection with research of solutions with nonremovable singularities. D. (1998). Methods of Mathematical Physics. to find its Lax pairs. II. C. discontinuous Galerkin finite element method (DGFEM). Partial Differential Equations. and that ordinary differential equations which admit the same infinitesimal transformations present comparable difficulties of integration. ISBN 0387954287. by the introduction of what are now called Lie groups. He showed that the integration theories of the older mathematicians can. ISBN 0387906096. Partial Differential Equations.Partial differential equation
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Lie Group Methods
From 1870 Sophus Lie's work put the theory of differential equations on a more satisfactory foundation. Lie algebras and differential geometry are used to understand the structure of linear and nonlinear partial differential equations for generating integrable equations. • Evans. Continuous group theory. CRC Handbook of Lie Group Analysis of Differential Equations Vol. Partial Differential Equations (4th ed.

htm [4] http:/ / eqworld.Partial differential equation • Lewy. unl. shtml [2] http:/ / eqworld.. • Zwillinger. ru/ en/ pde-en. ipmnet. (2004). Handbook of First Order Partial Differential Equations. ipmnet. Boca Raton: Chapman & Hall/CRC Press. Y. (2005). B. & Rubinstein. D. (2002). (2002).wolfram.com Partial Differential Equations [6] at mathworld. & Dolezel. P. V. • Polyanin. exampleproblems. ru/ en/ methods/ meth-pde. • Polyanin. • Pinchover..). A. Hans (1957). Boca Raton: Chapman & Hall/CRC Press. D. • Polyanin. • Solin. ru/ en/ solutions/ eqindex/ eqindex-pde. archive. Saunders Co. & Zaitsev. Partial Differential Equations: Index [3] at EqWorld: The World of Mathematical Equations. P. London: Taylor & Francis. htm [5] http:/ / www. mephi. (2003). (2005). org/ web/ 20080411030405/ http:/ / www. 2nd Series 66 (1): 155–158. php/ Main_Page [8] http:/ / www. NJ: J. Handbook of Linear Partial Differential Equations for Engineers and Scientists. New York: Cambridge University Press. & Moussiaux. Example problems with solutions [5] at exampleproblems. • Petrovskii. Partial Differential Equations and the Finite Element Method. ru/ wiki/
. G. ISBN 158488438X. Partial Differential Equations: Methods [4] at EqWorld: The World of Mathematical Equations. Zaitsev. Partial Differential Equations. Hoboken. Annals of Mathematics. An Introduction to Partial Differential Equations. D. htm [3] http:/ / eqworld. php?title=Partial_Differential_Equations [6] http:/ / mathworld. math. Segeth. edu/ wiki/ index. Boca Raton: Chapman & Hall/CRC Press. V. ISBN 0127843957. D. primat. ISBN 0521848865. math. wolfram. A.
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External links
• • • • • • • Partial Differential Equations: Exact Solutions [2] at EqWorld: The World of Mathematical Equations. A. html [7] http:/ / tosio. Handbook of Nonlinear Partial Differential Equations. the nonlinear equations encyclopedia [8]
References
[1] http:/ / web. Higher-Order Finite Element Methods. F. J. Handbook of Differential Equations (3rd ed. I. • Solin. ISBN 1584883553. Philadelphia: W. ISBN 0471720704. edu/ ~sdunbar1/ Teaching/ MathematicalFinance/ Lessons/ BlackScholes/ Solution/ solution. (1997). "An example of a smooth linear partial differential equation without solution". Wiley & Sons. ISBN 041527267X. I. com/ PartialDifferentialEquation. com/ wiki/ index. Boston: Academic Press. F.com Dispersive PDE Wiki [7] NEQwiki. toronto. ipmnet. A. (1967). ISBN 1584882999.. K.

Gambling shows that there has been an interest in quantifying the ideas of probability for millennia. when repeating the experiment. finance. Bayesians. a measure of the authority of a witness in a legal case in Europe. science. Jakob Bernoulli's Ars Conjectandi (posthumous. The probability of a random event denotes the relative frequency of occurrence of an experiment's outcome. assign probabilities to any statement whatsoever.
Etymology
The word Probability derives from latin word probabilitas that can also mean probity. which is used extensively in such areas of study as mathematics."[4] However. in contrast. 1713) and Abraham de Moivre's Doctrine of Chances (1718) treated the subject as a branch of mathematics. Frequentists consider probability to be the relative frequency "in the long run" of outcomes. however. In fact. Frequentists talk about probabilities only when dealing with experiments that are random and well-defined. is used as a measure of the weight of empirical evidence.[5] Aside from some elementary considerations made by Girolamo Cardano in the 16th century.[2] [3]
History
The scientific study of probability is a modern development. A probable action or opinion was one such as sensible people would undertake or hold. See Ian Hacking's The Emergence of Probability and James Franklin's The Science of Conjecture for histories of the early development of the very concept of mathematical probability. in legal contexts especially. In a sense. is a way to represent an individual's degree of belief in a statement. The reprint (1757) of this memoir lays down the axioms that positive and negative errors are equally probable. the term 'probable' (Latin probabilis) meant approvable. but a memoir prepared by Thomas Simpson in 1755 (printed 1756) first applied the theory to the discussion of errors of observation. even when no random process is involved. "Before the middle of the seventeenth century. 1722). there are two broad categories of probability interpretations. and was applied in that sense. to opinion and to action. and that there are certain assignable limits within which all errors may be supposed to fall. According to Richard Jeffrey. this differs much from the modern meaning of probability. gambling. which. The theory of errors may be traced back to Roger Cotes's Opera Miscellanea (posthumous. whose adherents possess different (and sometimes conflicting) views about the fundamental nature of probability: 1. and philosophy to draw conclusions about the likelihood of potential events and the underlying mechanics of complex systems. in the circumstances.Probability
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Probability
Probability is a way of expressing knowledge or belief that an event will occur or has occurred. and often correlated with the witness's nobility. The concept has been given an exact mathematical meaning in probability theory.
Interpretations
The word probability does not have a consistent direct definition. statistics. the doctrine of probabilities dates to the correspondence of Pierre de Fermat and Blaise Pascal (1654).
. or an objective degree of rational belief. for a Bayesian. univocally. but exact mathematical descriptions of use in those problems only arose much later. 'probable' could also apply to propositions for which there was good evidence. and is arrived at from inductive reasoning and statistical inference. Probability.[1] 2. given the evidence. Christiaan Huygens (1657) gave the earliest known scientific treatment of the subject. continuous errors are discussed and a probability curve is given.

the -axis is an asymptote. and Artemas Martin). Friedrich Bessel (1838). is well known.
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being a constant depending on precision of observation. and Morgan Crofton (1870).[7] As an example. Wolstenholme. Robert Adrain. On the geometric side (see integral geometry) contributors to The Educational Times were influential (Miller. Gauss gave the first proof which seems to have been known in Europe (the third after Adrain's) in 1809. Watson. Adolphe Quetelet (1853). If both the events A and B occur on a single performance of an experiment this is called the intersection or joint probability of A and B. and Giovanni Schiaparelli (1875). Augustus De Morgan and George Boole improved the exposition of the theory. an Irish-American writer. 1856). the area enclosed is 1. F. Helmert (1872). James Ivory (1825. The method of least squares is due to Adrien-Marie Legendre (1805). being any error and its probability. If two events. the event of A not occurring). denoted as . Littrow (1833). Didion. if two coins are flipped the chance of both being heads is
. He represented the law of probability of errors by a curve . Hagen (1837). its probability is given by P(not A) = 1 . 1812). Richard Dedekind (1860). p(A) or Pr(A). nor probability 1 events certain. The rather subtle distinction between "certain" and "probability 1" is treated at greater length in the article on "almost surely". Gauss (1823). but one which led to unmanageable equations. first deduced the law of facility of error. the converses are not always true: probability 0 events are not always impossible. and a certain event has a probability of 1. 1826). He gave two proofs. A and B are independent then the joint probability is
[8]
for example. McColl. editor of "The Analyst" (1808). The modern theory of probability based on the measure theory was developed by Andrey Kolmogorov (1931). Further proofs were given by Laplace (1810. 2. who introduced it in his Nouvelles méthodes pour la détermination des orbites des comètes (New Methods for Determining the Orbits of Comets). Daniel Bernoulli (1778) introduced the principle of the maximum product of the probabilities of a system of concurrent errors. the probability of the error being 0. The opposite or complement of an event A is the event [not A] (that is. Crofton. the chance of not rolling a six on a six-sided die is 1 – (chance of rolling a six) .Probability Pierre-Simon Laplace (1774) made the first attempt to deduce a rule for the combination of observations from the principles of the theory of probabilities. the probable error of a single observation. and Karl Pearson. Peters's (1856) formula for . and
a scale factor ensuring that the area under the
curve equals 1. However. In the nineteenth century authors on the general theory included Laplace. the second being essentially the same as John Herschel's (1850). 1774). and laid down three properties of this curve: 1. In ignorance of Legendre's contribution. Liagre. Other contributors were Ellis (1844).P(A). Donkin (1844.
Mathematical treatment
In mathematics.[6] An impossible event has a probability of 0. He also gave (1781) a formula for the law of facility of error (a term due to Lagrange. 3. it being certain that an error exists. a probability of an event A is represented by a real number in the range from 0 to 1 and written as P(A). it is symmetric as to the -axis. See Complementary event for a more complete treatment. W. De Morgan (1864). Sylvestre Lacroix (1816). Andrey Markov introduced the notion of Markov chains (1906) playing an important role in theory of stochastic processes and its applications. Hermann Laurent (1873). Glaisher (1872).

the chance of rolling a 1 or 2 on a six-sided die is If the events are not mutually exclusive then
For example. sets are interpreted as events and probability itself as a measure on a class of sets. If two events are mutually exclusive then the probability of either occurring is
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For example. probability is taken as a primitive (that is. when drawing a single card at random from a regular deck of cards.Q. such as the Dempster-Shafer theory or possibility theory.K) (or one that is both) is . In Kolmogorov's formulation (see probability space).Probability If either event A or event B or both events occur on a single performance of an experiment this is called the union of the events A and B denoted as . because of the 52 cards of a deck 13 are hearts. Conditional probability is the probability of some event A. except for technical details. There have been at least two successful attempts to formalize probability. namely the Kolmogorov formulation and the Cox formulation.
. the laws of probability are the same. There are other methods for quantifying uncertainty.
Summary of probabilities
Event A not A A or B A and B Probability
A given B
Theory
Like other theories. given the occurrence of some other event B. and 3 are both: here the possibilities included in the "3 that are both" are included in each of the "13 hearts" and the "12 face cards" but should only be counted once. and any results are then interpreted or translated back into the problem domain. 12 are face cards. In both cases. In Cox's theorem. These formal terms are manipulated by the rules of mathematics and logic. and is read "the probability of A. It is defined by
[9]
If
then
is undefined. in terms that can be considered separately from their meaning. but those are essentially different and not compatible with the laws of probability as they are usually understood. not further analyzed) and the emphasis is on constructing a consistent assignment of probability values to propositions. Conditional probability is written P(A|B). the theory of probability is a representation of probabilistic concepts in formal terms—that is. given B". the chance of getting a heart or a face card (J.

such as that of quantum decoherence being the cause of an apparent random collapse. An assessment by a commodity trader that a war is more likely vs. A good example is the effect of the perceived probability of any widespread Middle East conflict on oil prices which have ripple effects in the economy as a whole. at present there is a firm consensus among physicists that probability theory is necessary to describe quantum phenomena. this also assumes knowledge of inertia and friction of the wheel.
Relation to randomness
In a deterministic universe. often measuring well-being using methods that are stochastic in nature. Accordingly. Physicists face the same situation in kinetic theory of gases. weight. Another significant application of probability theory in everyday life is reliability. smoothness and roundness of the ball. and signals other traders of that opinion. such as automobiles and consumer electronics. Governments typically apply probabilistic methods in environmental regulation where it is called "pathway analysis".Probability
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Applications
Two major applications of probability theory in everyday life are in risk assessment and in trade on commodity markets. especially in a democracy. and choosing projects to undertake based on statistical analyses of their probable effect on the population as a whole. less likely sends prices up or down. but. where the system. Others never came to terms with the loss of determinism. according to the prevailing Copenhagen interpretation. while deterministic in principle. Many consumer products. A revolutionary discovery of 20th century physics was the random character of all physical processes that occur at sub-atomic scales and are governed by the laws of quantum mechanics. Accordingly. and how they contribute to reputations and to decisions. utilize reliability theory in the design of the product in order to reduce the probability of failure. is fundamental. the randomness caused by the wave function collapsing when an observation is made. Of course. The wave function itself evolves deterministically as long as no observation is made. it may be of some importance to most citizens to understand how odds and probability assessments are made. Albert Einstein famously remarked in a letter to Max Born: Jedenfalls bin ich überzeugt. The probability of failure may be closely associated with the product's warranty. In the case of a roulette wheel. based on Newtonian concepts.02·1023) that only statistical description of its properties is feasible.
. the probabilities are not assessed independently nor necessarily very rationally. daß der Alte nicht würfelt. (I am convinced that God does not play dice). then the number on which the ball will stop would be a certainty. there is no probability if all conditions are known. is so complex (with the number of molecules typically the order of magnitude of Avogadro constant 6. variations in hand speed during the turning and so forth. if the force of the hand and the period of that force are known. This means that probability theory is required to describe nature. and on peace and conflict. The theory of behavioral finance emerged to describe the effect of such groupthink on pricing. Although alternative viewpoints exist. It can reasonably be said that the discovery of rigorous methods to assess and combine probability assessments has had a profound effect on modern society. on policy. A probabilistic description can thus be more useful than Newtonian mechanics for analyzing the pattern of outcomes of repeated rolls of roulette wheel.

(2001). Johns Hopkins University Press. Springer -Verlag. Induction and Statistical Inference. (2005) Probabilistic Symmetries and Invariance Principles. 2006. pp.
References
• Kallenberg. ISBN 0-387-25115-4 • Kallenberg. Cambridge University Press. The Science of Conjecture: Evidence and Probability Before Pascal. Ian Hacking. 504 pp ISBN 0-471-67969-0.. Springer Series in Statistics. J. 54-55 . O. ISBN 0-387-95313-2 • Olofsson.C. 113. page 29. [9] Olofsson. 2nd ed. New York. ISBN 0521685575. 22. Statistics. Peter (2005) Probability. Probability and the Art of Judgment. (1992). Ian Hacking.
. page 35.. (2005) Page 8. Daniel Garber. 650 pp.Probability
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See also
• • • • • • • • • • • • • • • • • • • • • Black Swan theory Calculus of predispositions Chance (disambiguation) Class membership probabilities Decision theory Equiprobable Fuzzy measure theory Game theory Gaming mathematics Information theory Important publications in probability Measure theory Negative probability Probabilistic argumentation Probabilistic logic Random fields Random variable List of scientific journals in probability List of statistical topics Stochastic process Wiener process
Notes
[1] The Logic of Statistical Inference. R. [7] Olofsson. 2003 [4] Jeffrey. 127 [6] Olofsson. Cambridge University Press. 510 pp. Peter. and Stochastic Processes. Wiley-Interscience. 9780521685573 [3] The Cambridge History of Seventeenth-century Philosophy. O. pp. 1965 [2] The Emergence of Probability: A Philosophical Study of Early Ideas about Probability. (2002) Foundations of Modern Probability. page 9 [8] Olofsson. ISBN 0-521-39459-7 [5] Franklin.

1957).soton. of Southampton) (http://www. • Richard von Mises "The unlimited extension of the validity of the exact sciences was a characteristic feature of the exaggerated rationalism of the eighteenth century" (in reference to Laplace).
External links
• Probability and Statistics EBook (http://wiki. "It may be that the race is not always to the swift.htm) • Earliest Uses of Symbols in Probability and Statistics (http://jeff560. — HTML index with links to PostScript files (http://omega. p 9.ucla.html) on Earliest Uses of Various Mathematical Symbols (http://jeff560.soton. by Charles Grinstead. uk/staff/aldrich/Figures. celiagreen. 1812. Probability. Dover edition.edu/~chance/teaching_aids/books_articles/ probability_book/book. uk/staff/aldrich/Probability Earliest Uses. and Truth.php/EBook) • Edwin Thompson Jaynes.uk/raw/money/express_unit_risk/) with BBC raw • Introduction to Probability .economics. (1996).com/historical/young/index.html) • A tutorial on probability and Bayes’ theorem devised for first-year Oxford University students (http://www.htm) • Probability and Statistics on the Earliest Uses Pages (Univ.pdf) • pdf file of An Anthology of Chance Operations (1963) (http://ubu.but that is the way to bet.edu/etj/prob/book.html) at UbuWeb • Probability Theory Guide for Non-Mathematicians (http://probability. Statistics. of Southampton) (http://www. Probability Theory: The Logic of Science.html) and PDF (http:// bayes.html).com/charlesmccreery/statistics/bayestutorial.ro) • Understanding Risk and Probability (http://www.dartmouth.infarom.org/shabbychef/ numas_text/) (GNU Free Documentation License)
. nor the battle to the strong .economics.tripod. Laurie Snell Source (http://bitbucket.eBook (http://www.edu:8008/JaynesBook.tripod.ac.ac.edu/socr/index.Probability
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Quotations
• Damon Runyon." • Pierre-Simon Laplace "It is remarkable that a science which began with the consideration of games of chance should have become the most important object of human knowledge.com/mathsym." Théorie Analytique des Probabilités.co.stat. Preprint: Washington University. 1981 (republication of second English edition.albany.com/stat.pdf) (first three chapters) • People from the History of Probability and Statistics (Univ.wustl.bbc.

which they describe underlies the mathematical discipline of probability theory. There is spread or variability in almost any value that can be measured in a population (e. each with probability 1/2.).g. The categorical distribution describes the result of an experiment with a fixed. When the random variable takes values in the set of real numbers. the toss of a fair coin is a categorical distribution. a random variable is defined as a measurable function X from a probability space to measurable space . in physics many processes are described probabilistically. has a familiar "bell curve" shape and approximates many different naturally occurring distributions over real numbers. almost all measurements are made with some intrinsic error.Probability distribution
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Probability distribution
In probability theory and statistics. sales growth. also known as the Gaussian distribution. Two of the most important ones are the normal distribution and the categorical distribution. height of people. whose value at each real x is the probability that the random variable is smaller than or equal to x. while probability distributions are often more appropriate. and the science of statistics. The normal distribution.
Probability distributions of real-valued random variables
Because a probability distribution Pr on the real line is determined by the probability of a real-valued random variable X being in a half-open interval (-∞. x]. traffic flow. etc. or the probability of the value falling within a particular interval (when the variable is continuous). a probability distribution identifies either the probability of each value of a random variable (when the variable is discrete). For these and many other reasons. often called the "bell curve".
Formal definition
In the measure-theoretic formalization of probability theory. where the possible outcomes are heads and tails. There are various probability distributions that show up in various different applications. The concept of the probability distribution and the random variables The Normal distribution. the probability distribution is completely characterized by its cumulative distribution function:
. finite number of outcomes.[1] The probability distribution describes the range of possible values that a random variable can attain and the probability that the value of the random variable is within any (measurable) subset of that range. from the kinetic properties of gases to the quantum mechanical description of fundamental particles. simple numbers are often inadequate for describing a quantity. durability of a metal. For example. the probability distribution is completely described by the cumulative distribution function. A probability distribution is the pushforward measure X*P = PX −1 on .

a probability distribution is called continuous if its cumulative distribution function for all . as these do not preserve non-negativity or total integral 1 – but they are closed under convex combination. is continuous and.
. For a more complete list. For many familiar discrete distributions. Discrete distributions are characterized by a probability mass function. multivariate. such that
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Continuous probability distribution By one convention. actually-observed quantities may cluster around multiple values. a probability distribution is discrete if there is a finite or countable set whose probability is 1. it is assumed that the values cluster around a single point.) Note also that all of the univariate distributions below are singly-peaked.
Common probability distributions
The following is a list of some of the most common probability distributions. • Probability distributions are not a vector space – they are not closed under linear combinations. continuous. therefore. A discrete random variable is a random variable whose probability distribution is discrete. These distributions can be characterized by a probability density function: a non-negative Lebesgue integrable function defined on the real numbers such that
Discrete distributions and some continuous distributions (like the Cantor distribution) do not admit such a density. there are discrete distributions for which this countable set is dense on the real line.Probability distribution Discrete probability distribution A probability distribution is called discrete if its cumulative distribution function only increases in jumps. Such quantities can be modeled using a mixture distribution. a continuous random variable is a random variable whose probability distribution is continuous. the set of possible values is topologically discrete in the sense that all its points are isolated points.
Terminology
The support of a distribution is the smallest closed interval/set whose complement has probability zero. Similarly. It may be understood as the points or elements that are actual members of the distribution. that is. which groups by the nature of the outcome being considered (discrete. the probability measure of singletons
Another convention reserves the term continuous probability distribution for absolutely continuous distributions. • The probability density function of the difference of two independent random variables is the cross-correlation of their density functions. grouped by the type of process that they are related to. In practice. More precisely. But. thus forming a convex subset of the space of functions (or measures). etc.
Some properties
• The probability density function of the sum of two independent random variables is the convolution of each of their density functions. see list of probability distributions.

the prototypical power law distribution
Related to real-valued quantities that are assumed to be uniformly distributed over a (possibly unknown) region
• Discrete uniform distribution. for the number of "positive occurrences" (e. the outcome of a fair die) • Continuous uniform distribution. for binomial-type observations but where the quantity of interest is the number of failures before a given number of successes occurs • Geometric distribution.g.) given a fixed number of total occurrences.g. with a given probability)
Basic distributions • Bernoulli distribution.g.g. for a single such quantity whose log is exponentially distributed. the "opposite" of sampling without replacement)
. errors. etc. offsets)
• Normal distribution (aka Gaussian distribution). for the number of "positive occurrences" (e. successes. using sampling with replacement • Hypergeometric distribution. for binomial-type observations but where the quantity of interest is the number of failures before the first success. yes votes. for the number of "positive occurrences" (e. for a finite set of values (e. yes votes. etc.g.) given a fixed total number of independent occurrences • Negative binomial distribution. prices.g. a special case of the negative binomial distribution Related to sampling schemes over a finite population • Binomial distribution. using sampling without replacement • Beta-binomial distribution. incomes.g. yes/no) • Binomial distribution. successes. for the number of "positive occurrences" (e. for the outcome of a single Bernoulli trial (e. the most common continuous distribution • Multivariate normal distribution (aka multivariate Gaussian distribution).) given a fixed number of total occurrences. successes. etc.g.) given a fixed number of total occurrences. sampling using a Polya urn scheme (in some sense. populations)
• Log-normal distribution.Probability distribution
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Related to real-valued quantities that grow linearly (e. for a single such quantity whose log is normally distributed • Pareto distribution. for continuously-distributed values
Related to Bernoulli trials (yes/no events. yes votes. for a single such quantity. for vectors of correlated outcomes that are individually Gaussian-distributed
Related to positive real-valued quantities that grow exponentially (e. successes. success/failure. etc. yes votes.

g. for the time before the next Poisson-type event occurs
Useful for hypothesis testing related to normally-distributed outcomes
• Chi-square distribution. for inference regarding the sample variance of normally-distributed samples (see chi-square test) • Student's t distribution. 313–314. useful for inference regarding the mean of normally-distributed samples with unknown variance (see Student's t-test) • F-distribution. conjugate to the rate parameter of a Poisson distribution or exponential distribution. the distribution of the ratio of a standard normal variable and the square root of a scaled chi squared variable. the distribution of a sum of squared standard normal variables. generalzation of the gamma distribution
See also
• • • Copula (statistics) • Cumulative distribution function • Histogram • Inverse transform sampling • Likelihood function • List of statistical topics • Probability density function Random variable Riemann–Stieltjes integral application to probability theory
Notes
[1] Everitt. given a fixed number of total outcomes. the distribution of the ratio of two scaled chi squared variables. conjugate to the categorical distribution and multinomial distribution. for a single probability (real number between 0 and 1). etc. with a given probability for each outcome)
• Categorical distribution. a generalization of the hypergeometric distribution
Related to events in a Poisson process (events that occur independently with a given rate)
• Poisson distribution. for the number of each type of catergorical outcome. a generalization of the Bernoulli distribution • Multinomial distribution. (2006) The Cambridge Dictionary of Statistics. for a vector of probabilities that must sum to 1. useful e. for the number of occurrences of a Poisson-type event in a given period of time • Exponential distribution. yes/no/maybe in a survey). Third Edition. generalization of the beta distribution • Wishart distribution. ISBN 0521690277
. for a non-negative scaling parameter.Probability distribution
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Related to categorical outcomes (events with K possible outcomes. a generalization of the binomial distribution • Multivariate hypergeometric distribution. pp. Cambridge University Press. the precision (inverse variance) of a normal distribution. but using sampling without replacement. for inferences that involve comparing variances or involving R-squared (the squared correlation coefficient)
Useful as conjugate prior distributions in Bayesian inference
• Beta distribution. useful e. similar to the multinomial distribution. for a single categorical outcome (e. B. conjugate to the inverse of the covariance matrix of a multivariate normal distribution. Cambridge.g.g. for a symmetric non-negative definite matrix.S. • Dirichlet distribution. conjugate to the Bernoulli distribution and binomial distribution • Gamma distribution.

ucla. xjtek.com • Interactive Discrete and Continuous Probability Distributions (http://www. PDF & quantiles.htm).com • Statistical Distributions .com
. Written using open-source C++ from the Boost.org) Math Toolkit library.socr.html).edu • A Compendium of Common Probability Distributions (http://www.causascientia.com/content/ebook.edu/htmls/ SOCR_Distributions.html).com/continuous.com).com/contdistroverview.com/ watch?v=AUSKTk9ENzg) from Index Funds Advisors IFA.com/eqcat/8) in Quant Equation Archive.ifa. socr.sitmo. youtube. vosesoftware.net/projects/distexplorer/). Distribution Explorer: a mixed C++ and C# Windows application that allows you to explore the properties of 20+ statistical distributions.pdf).com (http://www. xycoon.com • Probability Distributions (http://www.org/math_stat/Dists/ Compendium. (http://www.covariable. sitmo. and calculate CDF. • Explore different probability distributions and fit your own dataset online .Overview (http://www.net (http://sourceforge.youtube.com • A Probability Distribution Calculator (http://www.com • Sourceforge. covariable.boost.pdf) • A Compendium of Distributions (http://www.vosesoftware.Probability distribution
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External links
• An 8-foot-tall (2.xycoon.interactive tool (http://www. com/anylogic/demo_models/111/).4 m) Probability Machine (named Sir Francis) comparing stock market returns to the randomness of the beans dropping through the quincunx pattern.xjtek.ucla.org (http://www.

Such a success/failure experiment is also called a Bernoulli experiment or Bernoulli trial. when n = 1. the binomial distribution is the discrete probability distribution of the number of successes in a sequence of n independent yes/no experiments.1] — success probability in each trial support: pmf: cdf: mean: median: mode: variance: skewness: ex. p)
parameters: n ∈ N0 — number of trials p ∈ [0. n }
In probability theory and statistics. ….Binomial distribution
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Binomial distribution
Probability mass function
Cumulative distribution function
notation:
B(n. The binomial distribution is the basis for the popular binomial test of
.kurtosis: entropy: mgf: cf: pgf: np ⌊np⌋ or ⌈np⌉ ⌊(n + 1)p⌋ or ⌊(n + 1)p⌋ − 1 np(1 − p) k ∈ { 0. In fact. each of which yields success with probability p. the binomial distribution is a Bernoulli distribution.

. the expression ƒ(k. In this case.. 1. the resulting distribution is a hypergeometric distribution. n. The formula can be understood as follows: we want k successes (pk) and n − k failures (1 − p)n − k. m is known as the most probable (most likely) outcome of Bernoulli trials.Binomial distribution statistical significance.
. Note that the probability of it occurring can be fairly small. As another example. The distribution of this random number is a binomial distribution with n = 10 and p = 1/6. k) different ways of distributing k successes in a sequence of n trials. However. and there are C(n. k). 2. with the exception of one case where (n + 1)p is an integer. nCk. the k successes can occur anywhere among the n trials. if the random variable K follows the binomial distribution with parameters n and p.
Specification
Probability mass function
In general. It is frequently used to model number of successes in a sample of size n from a population of size N. Since the samples are not independent (this is sampling without replacement). The distribution of this random number is a binomial distribution with n = 3 and p = 1/2. In creating reference tables for binomial distribution probability..
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Examples
An elementary example is this: roll a standard die ten times and count the number of fours. there are two maximum values for m = (n + 1)p and m − 1. p). for N much larger than n. flip a coin three times and count the number of heads. usually the table is filled in up to n/2 values. its behavior is not arbitrary. and widely used. n. we write K ~ B(n. However. p) is monotone increasing for k < m and monotone decreasing for k > m. the binomial distribution is a good approximation. one must look to a different k and a different p (the binomial is not symmetrical in general). This is because for k > n/2. . However. The probability of getting exactly k successes in n trials is given by the probability mass function:
for k = 0. or nCk. also denoted C(n. the probability can be calculated by its complement as
So. not a binomial one. where
is the binomial coefficient (hence the name of the distribution) "n choose k". There is always an integer m that satisfies
As a function of k.

Suppose first that we have a single Bernoulli trial. X is a binomially distributed random variable). There are two possible outcomes: 1 and 0. In particular. p) (that is. Hoeffding's inequality yields the bound
and Chernoff's inequality can be used to derive the bound
Moreover. then the expected value of X is
and the variance is
This fact is easily proven as follows.e. The expected value in this trial will be equal to μ = 1 · p + 0 · (1−p) = p. the first occurring with probability p and the second having probability 1 − p. i. since the following expression holds for all k ≥ 3n/8[1]
Mean and variance
If X ~ B(n. the greatest integer less than or equal to x.Binomial distribution
127
Cumulative distribution function
The cumulative distribution function can be expressed as:
where
is the "floor" under x. The mean and the variance of such distributions are equal to the sums of means and variances of each individual trial:
. as follows:
For k ≤ np.
It can also be represented in terms of the regularized incomplete beta function. upper bounds for the lower tail of the distribution function can be derived. The generic binomial distribution is a sum of n independent Bernoulli trials. The variance in this trial is calculated similarly: σ2 = (1−p)2·p + (0−p)2·(1−p) = p(1 − p). these bounds are reasonably tight when p = 1/2.

p) and Y ~ B(m. and it may even be non-unique. Symbolically. its distribution is
Bernoulli distribution
The Bernoulli distribution is a special case of the binomial distribution.
.Binomial distribution
128
Mode and median
Usually the mode of a binomial B(n. and mode coincide. X ~ B(1. Defining pB as the probability of both happening at the same time. • • • •
Covariance between two binomials
If two binomially distributed random variables X and Y are observed together. However when (n + 1)p is an integer and p is neither 0 nor 1.
Relationship to other distributions
Sums of binomials
If X ~ B(n. then X + Y is again a binomial variable. is the sum of n independent Bernoulli trials.[4] The median is unique and equal to m = round(np) in cases when either p ≤ 1 − ln 2 or p ≥ ln 2 or |m − np| ≤ min{p. each with the same probability p. then m = n/2 is the unique median. in the case n = 1 we have
The first term is non-zero only when both X and Y are one. then the mean. Using the definition of covariance. These cases can be summarized as follows: In general. 1 − p} }. median. Conversely. Bern(p). this reduces to the variance formula given above. 1 − p} (except for the case when p = ½ and n is odd). and μX and μY are equal to the two probabilities.[3] A median m cannot lie too far away from the mean: |m − np| ≤ min{ ln 2. estimating their covariance can be useful. any number m in the interval ½(n − 1) ≤ m ≤ ½(n + 1) is a median of the binomial distribution. then the distribution has two modes: (n + 1)p and (n + 1)p − 1. If p = 1/2 and n is even. p) distribution is equal to ⌊(n + 1)p⌋. there is no single formula to find the median for a binomial distribution.[2] Any median m must lie within the interval ⌊np⌋ ≤ m ≤ ⌈np⌉. p) are independent binomial variables. this gives and for n such trials again due to independence
If X and Y are the same variable. When p is equal to 0 or 1.[3] [4] • When p = 1/2 and n is odd. B(n. p) has the same meaning as X ~ Bern(p). However several special results have been established: If np is an integer. where n = 1. where ⌊ ⌋ is the floor function. p). max{p. the mode will be 0 and n correspondingly. any binomial distribution.

Normal approximation
If n is large enough. This approximation.[5] Various rules of thumb may be used to decide whether n is large enough. In this case. and p is far enough from the extremes of zero or unity: • One rule is that both x=np and n(1 − p) must be greater than 5. n=7752). historically. then an excellent approximation to B(n. p).5
The approximation generally improves as n increases (at least 20) and is better when p is not near to 0 or 1. the specific number varies from source to source. is a huge time-saver (exact calculations with large n are very onerous). if a suitable continuity correction is used. p) is given by the normal distribution
Binomial PDF and normal approximation for n = 6 and p = 0. If Y has a distribution given by the normal approximation. which is a sum of n independent non-identical Bernoulli trials Bern(pi). it can be shown that the inflection points occur at
The following is an example of applying a continuity correction: Suppose one wishes to calculate Pr(X ≤ 8) for a binomial random variable X. • That rule[5] is that for n > 5 the normal approximation is adequate if
• Another commonly used rule holds that the normal approximation is appropriate only if everything within 3 standard deviations of its mean is within the range of possible values. some sources give 10 which gives virtually the same results as the following rule for large n until n is very large (ex: x=11.Binomial distribution
129
Poisson binomial distribution
The binomial distribution is a special case of the Poisson binomial distribution. it was the first use of the normal distribution.5 is the continuity correction. then the skew of the distribution is not too great. If X has the Poisson binomial distribution with p1 = … = pn =p then X ~ B(n. the uncorrected normal approximation gives considerably less accurate results. known as de Moivre–Laplace theorem. that is if
• Also as the approximation generally improves. The addition of 0.5). and depends on how good an approximation one wants. then Pr(X ≤ 8) is approximated by Pr(Y ≤ 8. However. introduced in Abraham de Moivre's book
.

According to two rules of thumb.
Generating binomial random variates
• Luc Devroye. a "proportion z-test. which allows a more precise estimate of the unknown parameter p.[6] For example. Therefore the Poisson distribution with parameter λ = np can be used as an approximation to B(n. then the Binomial(n. W. B.
130
Poisson approximation
The binomial distribution converges towards the Poisson distribution as the number of trials goes to infinity while the product np remains fixed. as a proportion of the expected value. New York: Springer-Verlag.05. • Kachitvichyanukul. Nowadays. Discrete Univariate Distributions [8]. Communications of the ACM 31: 216–222. the proportions would follow an approximate normal distribution with mean equal to the true proportion p of agreement in the population and with standard deviation σ = (p(1 − p)/n)1/2. 1986. If you sampled groups of n people repeatedly and truly randomly. the sample proportion and estimator of p. That loose statement cannot be taken literally because the thing asserted to be approached actually depends on the value of n. Non-Uniform Random Variate Generation. • As n approaches ∞ while p remains fixed. "Binomial random variate generation". the distribution of
approaches the normal distribution with expected value 0 and variance 1. gets smaller.. Large sample sizes n are good because the standard deviation. and n is approaching infinity." for the value of p using x/n. V. or if n ≥ 100 and np ≤ 10. suppose you randomly sample n people out of a large population and ask them whether they agree with a certain statement. p) is a sum of n independent. Schmeiser. (1988). p) of the binomial distribution if n is sufficiently large and p is sufficiently small. See especially Chapter X.
See also
• • • • Bean machine / Galton box Binomial proportion confidence interval Logistic regression Sample_size#Estimating_proportions
.Binomial distribution The Doctrine of Chances in 1738. doi:10.[7]
Limits
• As n approaches ∞ and p approaches 0 while np remains fixed at λ > 0 or at least np approaches λ > 0. p) distribution approaches the Poisson distribution with expected value λ. it can be seen as a consequence of the central limit theorem since B(n. identically distributed Bernoulli variables with parameter p. This fact is the basis of a hypothesis test. in a common test statistic.1145/42372. The proportion of people who agree will of course depend on the sample. This result is a specific case of the Central Limit Theorem.42381. this approximation is good if n ≥ 20 and p ≤ 0. This result is sometimes loosely stated by saying that the distribution of X approaches the normal distribution with expected value np and variance np(1 − p).

p. Median and Mode in Binomial Distributions". cz/ ~matousek/ prob-ln. doi:10. [5] Box. Counts Control Charts" (http:/ / www.org) Many resources for teaching Statistics including Binomial Distribution • "Binomial Distribution" (http://demonstrations.M. nist. [2] Neumann. [8] http:/ / cg. K.edu/htmls/SOCR_Distributions. • Binomial Distribution (http://www. "Mean. nist. 2007. (1995). "Über den Median der Binomial. 130. cuni. gz). ps. [6] NIST/SEMATECH. Statistics & Probability Letters 23: 21–21.3. Vondrak.Binomial distribution
131
References
[1] Matousek.shtml) Properties and Java simulation from cut-the-knot • Statistics Tutorial: Binomial Distribution (http://stattrek.and Poissonverteilung" (in German).4.aspx)
. Buhrman. "7. carleton. itl.html) • SOCR Binomial Distribution Applet (http://www. htm).com/Lesson2/Binomial.x. Statistics for experimenters. pdf
External links
• Web Based Binomial Distribution Calculator (with arbitrary precision) (http://www. scs. J. (1966).org/Curriculum/Probability/BinomialDistribution. Wissenschaftliche Zeitschrift der Technischen Universität Dresden 19: 29–33.com/BinomialDistribution/) by Chris Boucher. "The smallest uniform upper bound on the distance between the mean and the median of the binomial and Poisson distributions"..tb00681. htm) e-Handbook of Statistical Methods.1467-9574. e-Handbook of Statistical Methods. J. ca/ ~luc/ chapter_ten. mff. (1980).3. Wolfram Demonstrations Project. Wiley.causeweb. J: The Probabilistic Method (lecture notes) (http:/ / kam.1016/0167-7152(94)00090-U.html) • CAUSEweb.2.com/apps/binomial.1111/j.wolfram. [4] Hamza. Statistica Neerlandica 34 (1): 13–18. [3] Kaas.1980.edu/lowry/binomialX. doi:10. gov/ div898/ handbook/ pmc/ section3/ pmc331.php) • Binomial Probabilities Simple Explanation (http://faculty.ucla.socr.com/ bpdcalc/) • Binomial Distribution Web App (http://limfinity. "6. P.cut-the-knot.adsciengineering. itl. Hunter and Hunter (1978). gov/ div898/ handbook/ prc/ section2/ prc24. [7] NIST/SEMATECH. R. Does the proportion of defectives meet requirements?" (http:/ / www.vassar.org (http://www.1.

Log-normal distribution
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Log-normal distribution
Log-normal Probability density function
Cumulative distribution function
notation: parameters: σ2 > 0 — squared scale (real). +∞)
support: pdf: cdf: mean: median: mode: variance: skewness: ex. μ ∈ R — location x ∈ (0.kurtosis:
.

the attenuation caused by shadowing or slow fading from random objects is often assumed to be log-normally distributed.
Cumulative distribution function
where erfc is the complementary error function. (This is true regardless of the base of the logarithmic function: if loga(Y) is normally distributed. if X is log-normally distributed. its expected value (mean).
Mean and standard deviation
If X is a lognormally distributed variable. then X = exp(Y) has a log-normal distribution. then Y = log(X) is normally distributed. a long-term discount factor can be derived from the product of short-term discount factors. and standard deviation are
Equivalently. then so is logb(Y). for any two positive numbers a. It is occasionally referred to as the Galton distribution or Galton's distribution. See log-distance path loss model. after Francis Galton.) Log-normal is also written log normal or lognormal. see text) representation is asymptotically divergent but sufficient for numerical purposes
In probability theory.Log-normal distribution
133
entropy: mgf: cf: Fisher information: (defined only on the negative half-axis. parameters μ and σ can be obtained if the values of mean and variance are known:
. b ≠ 1. variance. For example. and Φ is the standard normal cdf. A variable might be modeled as log-normal if it can be thought of as the multiplicative product of many independent random variables each of which is positive. the variable’s logarithm is normally distributed).
Characterization
Probability density function
The probability density function of a log-normal distribution is:
where μ and σ are the mean and standard deviation of the variable’s natural logarithm (by definition. a log-normal distribution is a probability distribution of a random variable whose logarithm is normally distributed. In wireless communication. likewise. If Y is a random variable with a normal distribution. in finance.

To bring the numerical values of parameters μ.1. where
and σ2 < 0. The simplest representation is obtained by Taylor expanding e itX and using formula for moments above.Log-normal distribution The geometric mean of the log-normal distribution is . n ≤ N. In particular. The sum of series first converges to the value of φ(t) with arbitrary high accuracy if m is small enough. however it is sufficient for numerically evaluating the characteristic function at positive as long as the upper limit in sum above is kept bounded. σ into the domain where strong inequality holds true one could use the fact that if X is log-normally distributed then Xm is also log-normally distributed with parameters μm. and the geometric standard deviation is equal to .
This series representation is divergent for Re(σ2) > 0. that is. the inequality could be satisfied for sufficiently small m.
. and left part of the strong inequality is satisfied. 0].
Moments
For any real or complex number s. In fact.
Characteristic function and moment generating function
The characteristic function E[e itX] has a number of representations.
134
Mode and median
The mode is the point of global maximum of the pdf function. but only exists on the half-interval (−∞. then the (1 − α)-confidence interval for X will be
where q* is the (1 − α/2)-quantile of the standard normal distribution: q* = Φ−1(1 − α/2). the sth moment of log-normal X is given by
A log-normal distribution is not uniquely determined by its moments E[Xk] for k ≥ 1. σm. The integral itself converges for Im(t) ≤ 0. there exists some other distribution with the same moments for all k. Since . If considerably larger number of terms are taken into account the sum eventually diverges when the right part of the strong inequality is no longer valid. Another useful representation was derived by Roy Lepnik (see references by this author and by Daniel Dufresne below) by means of double Taylor expansion of e(ln x − μ)2/(2σ2). it solves the equation (ln ƒ)′ = 0:
The median is such a point where FX = ½:
Confidence interval
If X is distributed log-normally with parameters μ and σ. there is a whole family of distributions with the same moments as the log-normal distribution. The moment-generating function for the log-normal distribution does not exist on the domain R.

and
be independent log-normally distributed variables with possibly varying σ and μ .
Properties
Data that arise from the the log-normal distribution has a symmetric Lorenz curve (see also Lorenz asymmetry coefficient)[1] . then is distributed log-normally. ℓL ℓL and ℓN. we can write the log-likelihood function thus: Since the first term is constant with regard to μ and σ. then Y is
are n independent log-normally distributed variables. but can be reasonably
approximated by another log-normal distribution Z at the right tail. both logarithmic likelihood functions. using the same indices to denote distributions. then the variate
has a Log-normal distribution with parameters
and
. Therefore. To avoid repetition. Hence. it is used in solving the partial differential equation leading to the Black–Scholes formula. A commonly used approximation (due to Fenton and Wilkinson) is obtained by matching the mean and variance:
. The distribution of Y has no closed-form expression. .Log-normal distribution
135
Partial expectation
The partial expectation of a random variable X with respect to a threshold k is defined as g(k) = E[X | X > k]P[X > k]. For a log-normal random variable the partial expectation is given by
This formula has applications in insurance and economics. we observe that
where by ƒL we denote the probability density function of the log-normal distribution and by ƒN that of the normal distribution. and
also distributed log-normally:
• Let parameters. reach their maximum with the same μ and σ. using the formulas for the normal distribution maximum likelihood parameter estimators and the equality above. Its probability density function at the neighborhood of 0 is characterized in (Gao et al. 2009) and it does not resemble any log-normal distribution.. then is a normal random variable.
Maximum likelihood estimation of parameters
For determining the maximum likelihood estimators of the log-normal distribution parameters μ and σ. we can use the same procedure as for the normal distribution. we deduce that for the log-normal distribution it holds that
Generating log-normally-distributed random variates
Given a random variate N drawn from the normal distribution with 0 mean and 1 standard deviation.
Related distributions
• If • If • If is a normal distribution.

W. Ecology 81 (4): 1139-1142. BioScience. com/ sol3/ papers. • If . • If . then X + c is said to have a shifted log-normal distribution with support x ∈ (c. +∞).2.. and has been used as a model for reaction times. 51 (5). 2006.ch/~stahel/lognormal/ bioscience. retrieved October 26.wolfram. "Describing inequality in plant size or fecundity". in Advances in Futures and Options Research. Donal Wales. (2002). then Y = aX is also log-normal. • If and a ≠ 0. Limpert. "The Pricing of Index Options When the Underlying Assets All Follow a Lognormal Diffusion" [2].
References
[1] Damgaard. • Swamee.C.pdf). J. cfm?abstract_id=5735
Citations
• The Lognormal Distribution.
Further reading
• Robert Brooks. Abbt. Near Lognormal Distribution (http://scitation.K. Var[X + c] = Var[X].org/getabs/servlet/ GetabsServlet?prog=normal&id=JHYEFF000007000006000441000001&idtype=cvips&gifs=yes).aip. 2002) can be obtained based on the logistic distribution to get the CDF
This is a log-logistic distribution. volume 7. J. [2] http:/ / papers. and J.ethz. and Brown. This has a similar long tail. P. then Y = Xa is also log-normal. • An exGaussian distribution is the distribution of the sum of a normally distributed random variable and an exponentially distributed random variable. 7(6): 441-444
. then Y = 1⁄X is also log-normal. • Eric W.com/LogNormalDistribution.CO.Log-normal distribution
136
In the case that all
have the same variance parameter
. Jacob Weiner (2000). 341–352 (2001). Journal of Hydrologic Engineering. Weisstein et al. Jon Corson.0. Log Normal Distribution (http://mathworld.A.1890/0012-9658(2000)081[1139:DIIPSO]2. (1957) • Log-normal Distributions across the Sciences: Keys and Clues (http://stat. these formulas simplify to
• If
. ssrn.
Similar distributions
• A substitute for the log-normal whose integral can be expressed in terms of more elementary functions (Swamee. Aitchison. Christian. Electronic document. p. html) at MathWorld. Stahel and M.
E[X + c] = E[X] + c. doi:10. 1994. E.

Journal of the Australian Mathematical Society Series B. vol. 32.au/V32/part3/Leipnik. Centre for Actuarial Studies.soa. • Gao et al.The Characteristic Function (http://anziamj. Leipnik (1991). For the mathematical treatment it is is
sufficient to consider the case α = 1. (http://www.
137
See also
• • • • • • • Normal distribution Geometric mean Geometric standard deviation Error function Log-distance path loss model Slow fading Stochastic volatility
Heat equation
The heat equation is an important partial differential equation which describes the distribution of heat (or variation in temperature) in a given region over time. • Daniel Dufresne (2009).html).y. For the case of variation of temperature u(x. International Journal of Mathematics and Mathematical Sciences.y.
also written
or sometimes
where
is a positive constant and
or
denotes the Laplacian operator.z) and the time variable t. and eventually (after infinite time. the heat equation is
The heat equation predicts that if a hot body is placed in a box of cold water.Log-normal distribution • Roy B.org.pdf).t) is the temperature and the thermal diffusivity
. austms. SUMS OF LOGNORMALS. and subject to no external heat sources) the temperature in the box will equalize.t) of three spatial variables (x. For a function u(x.html). the temperature of the body will decrease.hindawi.com/journals/ijmms/2009/630857.z. (http://www.z.y. University of Melbourne. On Lognormal Random Variables: I . pp 327–347. Asymptotic Behaviors of Tail Density for Sum of Correlated Lognormal Variables. (2009).org/library/proceedings/arch/2009/arch-2009-iss1-dufresne.

where k is the thermal conductivity and u is the temperature. the gradient is an ordinary spatial derivative. the flow rate of heat energy through a surface is proportional to the negative temperature gradient across the surface. not the Laplacian. The diffusion equation. if a bar of metal has temperature 0 and another has temperature 100 and they are stuck together end to end.
Graphical representation of the solution to a 1D heat equation PDE.Heat equation The heat equation is of fundamental importance in diverse scientific fields. The heat equation is used to determine the change in the function u over time. In one dimension. This is essentially saying that temperature comes either from some source or from earlier in time because heat permeates but is not created from nothingness. This is a property of parabolic partial differential equations and is not difficult to prove mathematically (see below). it is the prototypical parabolic partial differential equation. z). The image to the right is animated and describes the way heat changes in time along a metal bar.
where cp is the specific heat capacity and ρ is the mass density of the material. this can be rewritten as . then very quickly the temperature at the point of connection is 50 and the graph of the temperature is smoothly running from 0 to 100. (View animated version)
Another interesting property is that even if u has a discontinuity at an initial time t = t0. For example. (In this section only. the temperature becomes smooth as soon as t > t0. This function will change over time as heat spreads throughout space. In financial mathematics it is used to solve the Black–Scholes partial differential equation. In the absence of work done.
138
General description
Suppose one has a function u which describes the temperature at a given location (x. ΔQ. In mathematics. One of the interesting properties of the heat equation is the maximum principle which says that the maximum value of u is either earlier in time than the region of concern or on the edge of the region of concern. The increase in internal energy in a small spatial region of the material
. and so Fourier's law is
where ux is du/dx. The heat equation is used in probability and describes random walks. y. arises in connection with the study of chemical diffusion and other related processes. In probability theory. That is. the heat equation is connected with the study of Brownian motion via the Fokker–Planck equation. It is also important in Riemannian geometry and thus topology: it was adapted by Richard Hamilton when he defined the Ricci flow that was later used by Grigori Perelman to solve the topological Poincaré conjecture. a change in internal energy per unit volume in the material. a more general version of the heat equation. Δ is the ordinary difference operator. It is also applied in financial mathematics for this reason.
The physical problem and the equation
Derivation in one dimension
The heat equation is derived from Fourier's law and conservation of energy (Cannon 1984).) Choosing zero energy at absolute zero temperature. is proportional to the change in temperature. Δu. By Fourier's law.

and uzz are the second spatial derivatives (thermal conductions) of temperature in the x. Additionally. uyy. The heat equation is the prototypical example of a parabolic partial differential equation. x+Δx]. the change in internal energy in the interval [x-Δx.
Three-dimensional problem
In the special case of heat propagation in an isotropic and homogeneous medium in a 3-dimensional space. t) is temperature as a function of space and time. By Fourier's law. If the medium is not the whole space. y. the
mass density. The coefficient k/(cpρ) is called thermal diffusivity and is often denoted α. respectively. to reverse the solution and conclude something about earlier times or initial conditions from the present heat distribution is very inaccurate except over the shortest of time periods. y. and z directions. As a consequence. . • is the thermal diffusivity. x+Δx] is accounted for entirely by the flux of heat across the boundaries.
• uxx. this is again by the fundamental theorem of calculus. in order to solve the heat equation uniquely we also need to specify boundary conditions for u. with no work done and absent any heat sources or sinks. this equation is
where: • u = u(x. The heat equation is a consequence of Fourier's law of cooling (see heat conduction).
This is true for any rectangle [t−Δt.Heat equation
139
over the time period is given by[1] where the fundamental theorem of calculus was used.[2] By conservation of energy. k. a material-specific quantity depending on the thermal conductivity. • is the rate of change of temperature at a point over time. Consequently. z. Generally. . t+Δt] × [x−Δx. the integrand must vanish identically:
Which can be rewritten as:
or:
which is the heat equation. many different states and starting conditions will tend toward the same stable equilibrium.
. Solutions of the heat equation are characterized by a gradual smoothing of the initial temperature distribution by the flow of heat from warmer to colder areas of an object. this assumption is consistent with observed experiments. and the specific heat capacity. To determine uniqueness of solutions in the whole space it is necessary to assume an exponential bound on the growth of solutions.

• t is the time variable. Although they are not diffusive in nature. The equation is
Idealized physical setting for heat conduction in a rod with homogeneous boundary conditions.
when
Solving the heat equation using Fourier series
The following solution technique for the heat equation was proposed by Joseph Fourier in his treatise Théorie analytique de la chaleur. in watts/L) at a rate given by a known function q varying in space and time. is taken in the spatial variables. as well as other diffusive processes. the heat equation can be simplified.L].
The heat equation governs heat diffusion. published in 1822. but if it is necessary to develop a reasonable speed for the transmission of heat. This could be used to model heat conduction in a rod. a tungsten light bulb filament generates heat.g. like the Black-Scholes or the Ornstein-Uhlenbeck processes. so x ∈ [0. has also been used in image analysis.Heat equation Using the Laplace operator. Δ or
. Since heat density is proportional to temperature in a homogeneous medium. some quantum mechanics problems are also governed by a mathematical analog of the heat equation (see below).[3] Then the heat per unit volume u satisfies an equation
For example. It also can be used to model some phenomena arising in finance. as
140
where the Laplace operator. The heat equation is. the divergence of the gradient. The part of the disturbance outside the forward light cone can usually be safely neglected. the heat equation is still obeyed in the new units. Suppose that a body obeys the heat equation and. generates its own heat per unit volume (e. a hyperbolic problem should be considered instead – like a partial differential equation involving a second-order time derivative.
Internal heat generation
The function u above represents temperature of a body. We assume the initial condition
.
where u = u(x. it is sometimes convenient to change units and represent u as the heat density of a medium. Here • x is the space variable. because its solutions involve instantaneous propagation of a disturbance. t) is a function of two variables x and t. Alternatively. so it would have a positive nonzero value for turned on. and generalized to similar equations over spaces of arbitrary number of dimensions. in violation of special relativity. such as particle diffusion or the propagation of action potential in nerve cells. While the light is turned off. so t ≥ 0. in addition. where L is the length of the rod. and various non-linear analogues. Let us consider the heat equation for one space variable.. the value of for the tungsten filament would be zero. technically. The equation.

Then there exist real numbers A. Then there exist real numbers B. Suppose that λ = 0. both sides are equal to some constant value − λ. C such that
From (3) we get
and therefore B = 0 = C which implies u is identically 0. 2. that is:
141
This solution technique is called separation of variables. the sum of solutions to (1) which satisfy the boundary conditions (3) also satisfies (1) and (3).
This solves the heat equation in the special case that the dependence of u has the special form (4). Therefore.Heat equation where the function f is given and the boundary conditions . Thus:
and
We will now show that solutions for (6) for values of λ ≤ 0 cannot occur: 1. In general. Suppose that λ < 0. Let us attempt to find a solution of (1) which is not identically zero satisfying the boundary conditions (3) but with the following property: u is a product in which the dependence of u on x. We can show that the solution to (1). C such that From equation (3) we conclude in the same manner as in 1 that u is identically 0. Substituting u back into equation (1). 3. C such that and From (3) we get C = 0 and that for some positive integer n. Then there exist real numbers B. t is separated. it must be the case that λ > 0. (2) and (3) is given by
where
.
Since the right hand side depends only on x and the left hand side only on t. B.

Heat equation
142
Generalizing the solution technique
The solution technique used above can be greatly extended to many other types of equations. any eigenvector f of Δ with the boundary conditions f(0)=f(L)=0 is of the form en for some n ≥ 1. We assume q has a density. and as such it is meaningful to speak of the time rate of flow of heat into a region of space. The infinite sequence of functions
for n ≥ 1 are eigenvectors of Δ. • The Fourier law states that heat energy flow has the following linear dependence on the temperature gradient
where A(x) is a 3 × 3 real matrix that is symmetric and positive definite. • The time rate of heat flow into a region V is given by a time-dependent quantity qt(V). This means
Finally. L]. Heat flow is a form of energy flow. The idea is that the operator uxx with the zero boundary conditions can be represented in terms of its eigenvectors. Indeed
Moreover.
∈ N
spans a dense linear subspace of L2(0. This shows that in effect we have
Heat conduction in non-homogeneous anisotropic media
In general. so that
• Heat flow is a time-dependent vector function H(x) characterized as follows: the time rate of heat flowing through an infinitesimal surface element with area d S and with unit normal vector n is
Thus the rate of heat flow into V is also given by the surface integral
where n(x) is the outward pointing normal vector at x. the study of heat conduction is based on several principles. By Green's theorem. This leads naturally to one of the basic ideas of the spectral theory of linear self-adjoint operators. Consider the linear operator Δ u = ux x. the previous surface integral for heat flow into V can be transformed into the volume integral
. The functions en for n ≥ 1 form an orthonormal sequence with respect to a certain inner product on the space of real-valued functions on [0. the sequence {en}n diagonalized the operator Δ. L).

also called a heat kernel. the fundamental solution solves the analogous problem
in -∞<xi<∞. The n-variable fundamental solution is the product of the fundamental solutions in each variable. • In the anisotropic case where the coefficient matrix A is not scalar (i. (Evans 1998) for an introductory treatment. smoothing properties). In one variable. the matrix A is a scalar matrix equal to thermal conductivity. and 0<t<∞. the Green's function is a solution of the initial value problem
where δ is the Dirac delta function.e.. so that to solve the initial value problem with u(x.t=0)=g(x). These can be used to find a general solution of the heat equation over certain domains. The solution to this problem is the fundamental solution
One can obtain the general solution of the one variable heat equation with initial condition u(x. i..0) = g(x) for -∞<x<∞ and 0<t<∞ by applying a convolution:
In several spatial variables. one has
. then an explicit formula for the solution of the heat equation can seldom be written down.Heat equation • The time rate of temperature change at x is proportional to the heat flowing into an infinitesimal volume element. see. if it depends on x).. This is usually done by one-parameter semigroups theory: for instance. is a solution of the heat equation corresponding to the initial condition of an initial point source of heat at a known position.. if A is a symmetric matrix. infinite speed of propagation. convergence toward an equilibrium. • In the case of an isotropic medium.. • The coefficient κ(x) is the inverse of specific heat of the substance at x × density of the substance at x. for instance.e. Though..
Fundamental solutions
A fundamental solution. where the constant of proportionality is dependent on a constant κ
143
Putting these equations together gives the general equation of heat flow:
Remarks.n. thus by the spectral theorem it generates a one-parameter semigroup.
The general solution of the heat equation on Rn is then obtained by a convolution. then the elliptic operator defined by
is self-adjoint and dissipative. i=1. it is usually possible to consider the associated abstract Cauchy problem and show that it is a well-posed problem and/or to show some qualitative properties (like preservation of positive initial data.

This solution is the convolution with respect to the variable of the fundamental solution and the function . Homogeneous heat equation Initial value problem on (-∞. it may not be possible to write it down explicitly.Heat equation
144
The general problem on a domain Ω in Rn is
with either Dirichlet or Neumann boundary data. Therefore. In others. A Green's function always exists.∞) with homogeneous Neumann boundary conditions
. that is. for and so that.∞).
Initial value problem on (0. One further variation is that some of these solve the inhomogeneous equation
where f is some given function of x and t. instance. but unless the domain Ω can be readily decomposed into one-variable problems (see below). about approximation to the identity. This solution is obtained from the preceding formula as applied to the data to so as to be an odd function. according to the general properties of the convolution with respect to differentiation.∞) with homogeneous Dirichlet boundary conditions
Comment.∞)
Comment. the solution
and in particular it satisfies the homogeneous Dirichlet boundary conditions Initial value problem on (0. In some of these. The method of images provides one additional technique for obtaining Green's functions for non-trivial domains.
Some Green's function solutions in 1D
A variety of elementary Green's function solutions in one-dimension are recorded here. letting for all of the initial value problem on is an odd function with respect to the variable
suitably extended for all values of
Correspondingly. according to the specific then converges uniformly to as For . by general facts in various senses.∞) with either Neumann or Dirichlet boundary conditions. if meaning that is continuous on as with is assumed bounded and continuous on is a solution of the same heat equation. it is the semi-infinite interval (0. the spatial domain is the entire real line (-∞. Moreover.

and so is
general properties of the convolution with respect to differentiation. Since is the fundamental solution of . if is assumed continuous on as . it satisfies the homogeneous Neumann boundary conditions
. so as to be an even function of the variable solution of the inhomogeneous problem on values of that is.
This
solution
is
the convolution and the function
with respect to the variable of .Heat equation Comment.∞) homogeneous initial conditions For instance. One verifies that
. so that. letting for all
suitably extended to and Correspondingly.∞) with homogeneous Neumann boundary conditions and initial conditions
Comment. being a smooth function. the solution of the inhomogeneous problem on
suitably extended to for all and
is an odd function with respect to the
and in particular it satisfies the homogeneous Dirichlet boundary conditions
Problem on (0. Moreover. that is. This solution is the convolution in fundamental solution identically 0 for all . according to the specific then with Inhomogeneous heat equation Problem on (-∞. This solution is obtained from the first solution formula as applied to the data extended to values of so as to be an even function. it satisfies the homogeneous Neumann boundary conditions
Problem on (0. thanks to and as in various
the function
is also a solution of the same heat equation.∞) with homogeneous Dirichlet boundary conditions and initial conditions
Comment. that is the evaluation at 0. letting for all solution of the initial value problem on is an even function with respect to the variable suitably for all
145
Correspondingly. so as to be an odd function of the variable variable for all values of that is. that is with respect to both the variables
and
of the and
and the function
both meant as defined on the whole
which is expressed in the language of distributions as
where the distribution
is the Dirac's delta function. the for all
is an even function with respect to the variable
and in particular. being smooth. This solution is obtained from the first formula as applied to the data . letting Correspondingly. meaning that converges uniformly on compacta to with support in
is continuous on
Comment.∞) with homogeneous initial conditions and non-homogeneous Dirichlet boundary conditions
Comment. senses. the
and in particular. by general facts about approximation to the identity. This solution is obtained from the preceding formula as applied to the data .
Problem on (0.

though a bit more complicated. inhomogeneous term. any function u satisfying the above mean-value property on an open is a solution of the heat equation.Heat equation
146
Examples Since the heat equation is linear. that is a super-level set of the fundamental solution of the heat equation:
Notice that for domain of
as
so the above formula holds for any
in the (open) set
large enough. This can be shown by an argument similar to the analogous
one for harmonic functions. and r solve the problems
Mean-value property for the heat equation
Solutions of the heat equations properties of harmonic functions (solutions of and then satisfy a mean-value property analogous to the mean-value ). if solves
where
is a "heat-ball". v.
. to solve
let
where u and v solve the problems
Similarly. For example. Conversely. solutions of other combinations of boundary conditions. Precisely. and initial conditions can be found by taking an appropriate linear combination of the above Green's function solutions. to solve
let
where w.

D is the diffusion coefficient that controls the speed of the diffusive process. where i is the unit imaginary number. then one gets the nonlinear diffusion equation. If a particle is placed at at time . then the probability density function associated with the position vector of the particle will be the following: which is a (multivariate) normal distribution evolving in time. one uses the heat equation
or
Both c and P are functions of position and time. In either case. the Schrödinger equation for a single particle of mass m in the absence of any applied force field can be rewritten in the following way: . which one obtains through the following transformation:
Applying this transformation to the expressions of the Green functions determined in the case of particle diffusion yields the Green functions of the Schrödinger equation. denoted c. but depends on the concentration c (or P in the second case). or • the probability density function associated with the position of a single particle. and is Planck's constant divided by .
. with
Remark: this analogy between quantum mechanics and diffusion is a purely formal one.
Brownian motion
The random trajectory of a single particle subject to the particle diffusion equation (or heat equation) is a Brownian motion. in the case of collective diffusion of a large number of particles.Heat equation
147
Applications
Particle diffusion
One can model particle diffusion by an equation involving either: • the volumetric concentration of particles. This equation is formally similar to the particle diffusion equation. which in turn can be used to obtain the wavefunction at any time through an integral on the wavefunction at t=0: . Physically.
Schrödinger equation for a free particle
With a simple division. and is
the wavefunction of the particle. and is typically expressed in meters squared over second. denoted P. If the diffusion coefficient D is not constant. the evolution of the wavefunction satisfying Schrödinger's equation might have an origin other than diffusion.

Jaeger.. L. Howison & Dewynne 1995). The famous Black–Scholes option pricing model's differential equation can be transformed into the heat equation allowing relatively easy solutions from a familiar body of mathematics. Hartree. units of u should be J/L. "A Practical Method for Numerical Evaluation of Solutions of Partial Differential Equations of the Heat-Conduction Type". Howison. J. (1990). [2] In higher dimensions. J. 47: 891-893. P. American Mathematical Society. P. The heat equation can be efficiently solved numerically using the Crank–Nicolson method of (Crank & Nicolson 1947). doi:10. Am. The dual theoretical-experimental method demonstrated by these authors is applicable to rubber and various other materials of practical interest.
References
• Cannon. Springer. S.
Notes
[1] Here we are assuming that the material has constant mass density and heat capacity through space as well as time. J. "Heat diffusion in a solid sphere and Fourier Theory". H. Oxford University Press. J. D.. Ann. S. ISBN 0-521-30243-9 • Crank.
Further applications
The heat equation arises in the modeling of a number of phenomena and is often used in financial mathematics in the modeling of options. {IEEE Transactions on Pattern Analysis and Machine Intelligence 12 (7): 629-639 • Unsworth.). An abstract form of heat equation on manifolds provides a major approach to the Atiyah–Singer index theorem. (1995). (1979). Leipzig 17 322: 549–560. Phys.C.1002/andp. "Über die von der molekularkinetischen Theorie der Wärme geforderte Bewegung von in ruhenden Flüssigkeiten suspendierten Teilchen". J. is the measurement of the thermal diffusivity in polymers (Unsworth and Duarte). J. the divergence theorem is used instead. Fritz (1991).. ISBN 9780198533689 • Perona.). J.. Cambridge University Press • Carslaw. Partial Differential Equations. The One-Dimensional Heat Equation. Partial Differential Equations (4th ed. Encyclopedia of mathematics and its applications. P.. ISBN 978-0387906096 • Wilmott. Thus instead of being temperature (K). see for instance (Wilmott. doi:10. in spherical coordinates.19053220806 • Evans. John (1984). C. Proceedings of the Cambridge Philosophical Society 43: 50–67. Duarte. and has led to much further work on heat equations in Riemannian geometry. This method can be extended to many of the models with no closed form solution. Many of the extensions to the simple option models do not have closed form solutions and thus must be solved numerically to obtain a modeled option price. Nicolson. The heat equation is also widely used in image analysis (Perona & Malik 1990) and in machine-learning as the driving theory behind graph Laplacian methods.1119/1. Phys. Dewynne.Heat equation
148
Thermal diffusivity in polymers
A direct practical application of the heat equation. "Scale-Space and Edge Detection Using Anisotropic Diffusion". doi:10. R. The Mathematics of Financial Derivatives:A Student Introduction.. Conduction of Heat in Solids (2nd ed. in conjunction with Fourier theory. F. Malik. (1947).11601
. ISBN 0-8218-0772-2 • John. [3] Note that the units of u must be selected in a manner compatible with those of q. although generalizations are given below. (1998).1017/S0305004100023197 • Einstein. (1973). Albert (1905). Addison-Wesley.

the Radon–Nikodym theorem is a result in functional analysis that states that.∞). if a σ-finite measure ν on (X. then Y is said to have the Radon-Nikodym property. as conditional probability is just a special case of it. Specifically. The choice of notation and the name of the function reflects the fact that the function is analogous to a derivative in calculus in the sense that it describes the rate of change of density of one measure with respect to another (the way the Jacobian determinant is used in multivariable integration). f is commonly written dν/dμ and is called the Radon–Nikodym derivative.mathphysics.Σ). such that
for any measurable set A.Heat equation
149
External links
• Derivation of the heat equation (http://www.
. the probability density function of a random variable is the Radon–Nikodym derivative of the induced measure with respect to some base measure (usually the Lebesgue measure for continuous random variables).
Applications
The theorem is very important in extending the ideas of probability theory from probability masses and probability densities defined over real numbers to probability measures defined over arbitrary sets. and ν is a finite-valued signed or complex measure such that . The latter itself is a key concept in probability theory. given a measurable space (X. For example. then f = g μ-almost everywhere. If Y is a Banach space and the generalization of the Radon-Nikodym theorem also holds for functions with values in Y (mutatis mutandis).ipmnet.or complex-valued function g on X such that
for any measurable set A.com/pde/HEderiv. it can be used to prove the existence of conditional expectation for probability measures.
Radon–Nikodym derivative
The function f satisfying the above equality is uniquely defined up to a μ-null set. if g is another function which satisfies the same property.from EqWorld
Radon–Nikodym derivative
In mathematics.html) • Linear heat equations (http://eqworld. that if μ is a nonnegative σ-finite measure.Σ) is absolutely continuous with respect to a σ-finite measure μ on (X.[1] Above the function f was assumed to be complex-valued (or real-valued). and for Otton Nikodym who proved the general case in 1930. there is μ-integrable real. It tells if and how it is possible to change from one probability measure to another. The theorem is named after Johann Radon.Σ). financial mathematics uses the theorem extensively.ru/en/solutions/lpde/heat-toc. Amongst other fields. that is.pdf): Particular solutions and boundary value problems . who proved the theorem for the special case where the underlying space is RN in 1913. Such changes of probability measure are the cornerstone of the rational pricing of derivative securities and are used for converting actual probabilities into those of the risk neutral probabilities. A similar theorem can be proven for signed and complex measures: namely. then there is a measurable function f on X and taking values in [0. All Hilbert spaces have the Radon-Nikodym property.

Radon–Nikodym derivative
150
Properties
• Let ν. then
• If μ ≪ λ and g is a μ-integrable function. then
• If μ ≪ ν and ν ≪ μ. and ν ≪ μ • The Kullback-Leibler divergence from μ to ν is defined to be
• For
the Rényi divergence of order α from μ to ν is defined to be
The assumption of σ-finiteness
The Radon–Nikodym theorem makes the assumption that the measure μ with respect to which one computes the rate of change of ν is sigma-finite. μ. ν is absolutely continuous with respect to μ. then
Further applications
Information divergences
If μ and ν are measures over X. of a Borel set A be defined as the number of elements of A if A is finite. since for a set A one has μ(A) = 0 only if A is the empty set. and then ν(A) is also zero. Then. It is not sigma-finite. and using the above equality. If ν ≪ λ and μ ≪ λ (ν and μ are absolutely continuous in respect to λ). One can check that μ is indeed a measure. Let the counting measure. for some measurable function f one has
for all Borel sets. as not every Borel set is at most a countable union of finite sets. that is. Let ν be the usual Lebesgue measure on this Borel algebra. Consider the Borel sigma-algebra on the real line. one finds
. μ. and λ be σ-finite measures on the same measure space. Taking A to be a singleton set. then
• If ν ≪ μ ≪ λ. A = {a}. Assume that the Radon–Nikodym theorem holds. and +∞ otherwise. then
• If ν is a finite signed or complex measure. Here is an example when μ is not sigma-finite and the Radon–Nikodym theorem fails to hold.

note that μ(P) > 0. There is also a functional-analytic proof. which is a contradiction.
defines a nonnegative measure on Σ.
For finite measures
First. The fact that the remaining part of μ is singular with respect to ν follows from a technical fact about finite measures. for if μ(P) = 0. g ∈ F. Let f1. A1 = {x ∈ A | f1(x) > f2(x)}.
Now. let {fn}n be a sequence of functions in F such that
By replacing fn with the maximum of the first n functions. The supremum of all such functions.N) be a Hahn decomposition for the signed measure ν0 − ε μ. let A be an arbitrary measurable set. The details are given below. then. Let F be the set of those measurable functions f : X→[0. Then one has and therefore. Note that for every A ∈ Σ one has ν0(A∩P) ≥ ε μ(A∩P). Suppose ν0 ≠ 0. Let (P. by the construction of g. that was first given by von Neumann. then (since ν is absolutely continuous in relation to μ) ν0(P) ≤ ν(P) = 0. and hence. one can assume that the sequence {fn} is increasing. Now. then furnishes the Radon-Nikodym derivative. Also. and hence. suppose that μ and ν are both finite-valued nonnegative measures. is zero. along with the monotone convergence theorem. For finite measures μ and ν. and complex measures can be done naturally. max{f1. since g ∈ F.Radon–Nikodym derivative
151
for all real numbers a. f2 ∈ F.
Also. +∞] satisfying
for every A ∈ Σ (this set is not empty. one has
for each A ∈ Σ.f2} ∈ F.
Proof
This section gives a measure-theoretic proof of the theorem. so ν0(P) = 0 and
. there is an ε > 0 such that ν0(X) > ε μ(X). signed. using Hilbert space methods. the idea is to consider functions f with f dμ ≤ dν. and therefore the Lebesgue measure ν. Let g be a function defined as
By Lebesgue's monotone convergence theorem. since μ is finite. and A2 = {x ∈ A | f2(x) ≥ f1(x)}. extending to σ-finite. This implies that the function f. for it contains at least the zero function). Once the result is established for finite measures.

since both g and h are unique up to μ-almost everywhere equality.+∞). as desired. then so is f. As for the uniqueness. So ν0 = 0.+∞) be measurable functions satisfying
for every measurable set A. where both ν1 and ν2 are finite-valued signed measures. Therefore. therefore. since
g + ε 1P ∈ F and satisfies
This is impossible.h : X→[0. f = g μ-almost everywhere. then X can be written as the union of a sequence {Bn}n of disjoint sets in Σ.Radon–Nikodym derivative
152
contradicting the fact that ν0(X) > ε μ (X).+∞).. Then. since g is μ-integrable. including uniqueness. its integral with respect to μ is finite). The union f of those functions is then the required function. at least one of which is μ-integrable (i. It follows that
and so. Then.+∞) such that
for each Σ-measurable subset A of Bn.
For σ-finite positive measures
If μ and ν are σ-finite. the same is true for (g − f)−.
For signed and complex measures
If ν is a σ-finite signed measure. if a f is defined as
then f has the desired properties. Now. one obtains two functions. As for the uniqueness. g. there is a Σ-measurable function fn : Bn→[0. as desired. then it can be Hahn–Jordan decomposed as ν = ν+−ν− where one of the measures is finite. If ν is a complex measure. it can be decomposed as ν = ν1+i ν2. g − f is μ-integrable. the set {x∈X | g(x)=+∞} is μ-null. Clearly. or {x ∈ X | f(x) < g(x)}.h : X→[0. and
In particular. the initial assumption that ν0 ≠ 0 must be false. since each of the fn is μ-almost everywhere unique. For each n. satisfying the Radon–Nikodym theorem for ν+ and ν− respectively. let f.
. for A = {x∈X | f(x) > g(x)}. Applying the previous result to those two measures. Applying the above argument. f = g + i h is the required function. each of which has finite measure under both μ and ν. and thus. It is clear then that f = g−h satisfies the required properties. satisfying the required properties for ν1 and ν2. g. one obtains two functions. respectively.e.g : X→[0. that (g−f)+ = 0 μ-almost everywhere.

pl/ ksiazki/ fm/ fm15/ fm15114. called risk-neutral pricing. pdf) (in French). the risk-neutral measure is unique. This article incorporates material from Radon-Nikodym theorem on PlanetMath. If the markets are complete. under certain weak conditions (absence of arbitrage) there is an alternative way to do this calculation: Instead of first taking the expectation and then adjusting for risk. consequently. the point is to price given exactly the risk aversion we observe in the physical world. Often. occasionally.. the physical measure is called . the calculated expected values need to be adjusted for the risk involved (see also Sharpe ratio). It turns out. Integral. edu. This does not imply the assumption that investors were risk neutral.
References
• Shilov. or Q-measure is a probability measure that results when one assumes that the current value of all financial assets is equal to the expected future payoff of the asset discounted at the risk-free rate. Silverman. "Sur une généralisation des intégrales de M. calculating as if investors were risk neutral). Towards that aim. Note that under the risk-neutral measure all assets have the same expected rate of return. a risk-neutral measure. one can first adjust the probabilities of future outcomes such that they incorporate the effects of risk. the risk-free rate (or short rate). the constructed probabilities are counterfactual. we hypothesize about parallel universes where everybody is risk neutral.Radon–Nikodym derivative
153
Notes
[1] Nikodym. The term physical measure is often abused to
denote the Lebesgue measure.
Risk-neutral measure
In mathematical finance. the measure induced by the corresponding normal density with respect
. The concept is used in the pricing of derivatives. (1930). every asset can be priced by simply taking its expected payoff (i. it is possible if there are no arbitrage opportunities. they constitute the risk-neutral measure. icm.e. which is licensed under the Creative Commons Attribution/Share-Alike License.02. ISBN 0486635198. today's price of a claim on a risky amount realised tomorrow will generally differ from its expected value.
Idea
In an actual economy. trans. is often much simpler to calculate than the first. Fundamenta Mathematicae 15: 131–179. J. and Derivative: A Unified Approach. The risk-neutral measure is the probability measure of that parallel universe where all claims have exactly the prices they have in our real world..0922. Those adjusted. To price assets. They are only computed because the second way of pricing. 'virtual' probabilities are called risk-neutral probabilities. The probabilities over asset outcomes in the real world cannot be impacted. If we used the real-world. JFM 56. prices of assets depend crucially on their risk. O. remunerating those who bear the risk. adjusting the probabilities is a measure transformation to an equivalent martingale measure. Mathematically. Investors typically demand payment for bearing uncertainty. Therefore. The main benefit stems from the fact that once the risk-neutral probabilities are found. E. 1978. and the risk-neutral one . Most commonly.[1] investors are risk-averse and today's price is below the expectation. . and Gurevich. G. L. Richard A. Dover Publications. Measure. physical probabilities. Radon" (http:/ / matwbn. On the contrary. Retrieved 2009-05-11. every security would require a different adjustment (as they differ in riskiness). B. which is an equivalent martingale measure. and then take the expectation under those different probabilities.

Risk-neutral measure to the Lebesgue measure.g. Further suppose that the discount factor from now (time zero) until time is a . and that we use the Black-Scholes model.
Another name for the risk-neutral measure is the equivalent martingale measure. If we define
Girsanov's theorem states that there exists a measure
under which
is a Brownian motion. In the model the evolution of the stock price can be described by Geometric Brownian Motion:
where
is a standard Brownian motion with respect to the physical measure. Suppose we have a two-state economy: the initial . and
.
is known
as the market price of risk. Suppose at a future time derivative (e. If there are more such measures. we can price the
Example 2 — Brownian motion model of stock prices
Suppose our economy consists of 2 assets. then in an interval of prices no arbitrage is possible. This can be re-stated in terms of the physical measure P as units. Differentiating and rearranging yields:
Put this back in the original equation:
. If no equivalent martingale measure exists. is a random variable on the probability space
where
is the Radon–Nikodym derivative of
with respect to
. where describing the market. This is the fundamental theorem of arbitrage-free pricing. then there is a unique arbitrage-free price for each asset in the market. consider a single-period binomial model. arbitrage opportunities do. a call option on a stock) pays Then today's fair value of the derivative is where the risk-neutral measure is denoted by . A probability measure is called . If in a financial market there is just one risk-neutral measure. If the interest rate is . a stock and a risk-free bond. then the risk-neutral probability of an upward stock movement is given by the number
Given a derivative with payoff derivative via
when the stock price moves up and
when it goes down.
154
Usage
Risk-neutral measures make it easy to express the value of a derivative in a formula.
Example 1 — Binomial model of stock prices
Given a probability space risk neutral if for all stock price can go either up to or down to ..

cfm?abstract_id=290044). Example of risk-seeking markets are casinos and lotteries. Since the 1970s. Part II (http://papers.cfm?abstract_id=292724)
Stochastic calculus
Stochastic calculus is a branch of mathematics that operates on stochastic processes.
. Since and are -martingales we can invoke the at martingale representation theorem to find a replicating strategy . . The main benefit of the Stratonovich integral is that it obeys the usual chain rule and does therefore not require Itō's lemma. the Wiener process has been widely applied in financial mathematics and economics to model the evolution in time of stock prices and bond interest rates. Nicolas: Risk-Neutral Probabilities Explained (http://ssrn. This enables problems to be expressed in a co-ordinate system invariant form.
See also
• • • • • • • Mathematical finance Forward measure Fundamental theorem of arbitrage-free pricing Law of one price Rational pricing Brownian model of financial markets Martingale (probability theory)
External links
• Gisiger.) The Stratonovich integral can readily be expressed in terms of the Itō integral. The best-known stochastic process to which stochastic calculus is applied is the Wiener process (named in honor of Norbert Wiener). The (discounted) payoff process of a derivative on the stock is a martingale under all times . For technical reasons the Itō integral is the most useful for general classes of processes but the related Stratonovich integral is frequently useful in problem formulation (particularly in engineering disciplines. The dominated convergence theorem does not hold for the Stratonovich integral. Joseph: Risk-neutral Valuation: A Gentle Introduction (http://papers. which is used for modeling Brownian motion as described by Albert Einstein and other physical diffusion processes in space of particles subject to random forces. consequently it is very difficult to prove results without re-expressing the integrals in Itō form.com/abstract=1395390) • Tham.a holding of stocks and bonds that pays off
155
Notes
[1] At least in large financial markets.com/sol3/papers.ssrn. It allows a consistent theory of integration to be defined for integrals of stochastic processes with respect to stochastic processes.com/sol3/papers. which is invaluable when developing stochastic calculus on manifolds other than Rn. It is used to model systems that behave randomly.ssrn.Risk-neutral measure is the unique risk-neutral measure for the model. The main flavours of stochastic calculus are the Itō calculus and its variational relative the Malliavin calculus.

is defined for a semimartingale
Stratonovich integral
The Stratonovich integral of a semimartingale Itō integral as against another semimartingale Y can be defined in terms of the
where [X. symmetric random walks [1] .
Applications
A very important application of stochastic calculus is in quantitative finance. Stochastic integration based on simple. 3908/
. The alternative notation
is also used to denote the Stratonovich integral. Szabados and B.
External links
• Notes on Stochastic Calculus [1] — A short elementary description of the basic Itō integral.Stochastic calculus
156
Itō integral
The Itō integral is central to the study of stochastic calculus.
References
[1] http:/ / arXiv. Szekely. in which asset prices are often assumed to follow geometric Brownian motion. Y]tc denotes the quadratic covariation of the continuous parts of X and Y. The integral X and locally bounded predictable process H.A new approach which the authors hope is more transparent and technically less demanding. org/ abs/ 0712. • T.

Wiener process
157
Wiener process
In mathematics. It is a key process in terms of which more complicated stochastic processes can be described. As such. the Wiener process gave rise to the study of continuous time martingales. It is the driving process of Schramm-Loewner evolution. In applied mathematics. In pure mathematics. the diffusion of minute particles suspended in fluid. the Wiener process is a continuous-time stochastic process named in honor of Norbert Wiener. it plays a vital role in stochastic calculus. diffusion processes and even potential theory.
A single realization of a one-dimensional Wiener process
The Wiener process has applications throughout the mathematical sciences. and so is useful as a model of noise in electronics engineering. It is often called Brownian motion. It is one of the best known Lévy processes (càdlàg stochastic processes with stationary independent increments) and occurs frequently in pure and applied mathematics. The Wiener process plays an important role both in pure and applied mathematics. instrument errors in filtering theory and unknown forces in control theory. in particular the Black–Scholes option pricing model. a solution to the Schrödinger equation can be represented in terms of the Wiener process) and the study of eternal inflation in physical cosmology. It is also prominent in the mathematical theory of finance.
. It also forms the basis for the rigorous path integral formulation of quantum mechanics A single realization of a three-dimensional Wiener process (by the Feynman-Kac formula. after Robert Brown. economics and physics. In physics it is used to study Brownian motion. the Wiener process is used to represent the integral of a Gaussian white noise process. and other types of diffusion via the Fokker-Planck and Langevin equations.

Like the random walk. An integral based on Wiener measure may be called a Wiener integral. An alternative characterization of the Wiener process is the so-called Lévy characterization that says that the Wiener process is an almost surely continuous martingale with W0 = 0 and quadratic variation [Wt.
. meaning that
is a Wiener process for any nonzero constant α. induced by the Wiener process. This is known as Donsker's theorem. The Wiener measure is the probability law on the space of continuous functions g. Wt] = t (which means that Wt2-t is also a martingale). or other discrete-time stochastic processes with stationary independent increments. W0 = 0 2. A third characterization is that the Wiener process has a spectral representation as a sine series whose coefficients are independent N(0. of which only the property that they are uncorrelated is used. σ ) denotes the normal distribution with expected value μ and variance σ2. This representation can be obtained using the Karhunen-Loève theorem.
N(μ. centered at zero. with g(0) = 0. it is scale invariant. Suppose that t1 < t2.Wiener process
158
Characterizations of the Wiener process
The Wiener process Wt is characterized by three properties:[1] 1. Wt is almost surely continuous 3. The condition that it has independent increments means that if 0 ≤ s1 ≤ t1 ≤ s 2 ≤ t2 then Wt1 − Ws1 and Wt2 − Ws2 are independent random variables. Wt has independent increments with
2
(for 0 ≤ s < t). and the similar condition holds for n increments. Thus
The results for the covariance and correlation follow from the definition that non-overlapping increments are independent.
Properties of a one-dimensional Wiener process
Basic properties
The unconditional probability density function at a fixed time t:
The expectation is zero:
The variance is t:
The covariance and correlation:
The results for the expectation and variance follow immediately from the definition that increments have a normal distribution. Unlike the random walk.1) random variables. The Wiener process can be constructed as the scaling limit of a random walk. the Wiener process is recurrent in one or two dimensions (meaning that it returns almost surely to any fixed neighborhood of the origin infinitely often) whereas it is not recurrent in dimensions three and higher.

Example: is a martingale.
which shows that the quadratic variation of the martingale
.t) the following stochastic process is a martingale:
where a is the polynomial
Example:
the process on is equal to
is a martingale. are independent.Wiener process Substitute the simple identity :
159
Since W(t1) = W(t1) − W(t0) and W(t2) − W(t1).
A class of Brownian martingales
If a polynomial p(x. Thus
Self-similarity
Brownian scaling For every c>0 the process is another Wiener process. for every polynomial p(x.
Time reversal The process Time inversion The process is another Wiener process.t) satisfies the PDE
then the stochastic process
is a martingale. Note that the average features of the function do not change while zooming in. showing
for decreasing
c. for 0 ≤ t ≤ 1 is distributed like for 0 ≤ t ≤ 1.
A demonstration of Brownian scaling. and note that it zooms in quadratically faster horizontally than vertically. which shows that the quadratic variation of on is equal to It
follows that the expected time of first exit of from is equal to More generally.

uncountable). Treated as a function of t (while x is fixed).ε).) The same holds for local decrease. respectively. the local time is a singular function corresponding to a nonatomic measure on the set of zeros of w. each local maximum is sharp in the following sense: if w has a local maximum at t then as s tends to t. a path (sample function) of the Wiener process has all these properties almost surely.t+ε).t). • Zeros of the function w are a nowhere dense perfect set of Lebesgue measure 0 and Hausdorff dimension 1/2 (therefore. t]. w(s) ≤ w(t) for all s in (t-ε. Consider that the local time can also be defined (as the density of the pushforward measure) for a smooth function.Wiener process About functions p(x.t+ε). Quantitative properties Law of the iterated logarithm
Modulus of continuity Local modulus of continuity:
Global modulus of continuity (Lévy):
Local time The image of the Lebesgue measure on [0. The same holds for local minima. • Points of local maximum of the function w are a dense countable set. • The function w is continuous everywhere but differentiable nowhere (like the Weierstrass function). the local time is still continuous. all locally integrable functions.
160
Some properties of sample paths
The set of all functions w with these properties is of full Wiener measure. the function w takes both (strictly) positive and (strictly) negative values on (0.t): first. t]. unless the given
. Then.
for a wide class of functions ƒ (namely: all continuous functions.t) more general than polynomials. see local martingales. that is. (For x outside this interval the local time evidently vanishes. Thus. b) where a and b are the least and the greatest value of w on [0. can and will be chosen to be) continuous. It is strictly positive for all x of the interval (a. The number Lt(x) is called the local time at x of w on [0. all non-negative measurable functions). These continuity properties are fairly non-trivial. the density is discontinuous. (Local increase is a weaker condition than that w is increasing on (t-ε. w(s) ≥ w(t) for all s in (t. That is. the maximum values are pairwise different. no t>0 satisfies the following for some ε in (0.) Treated as a function of two variables x and t. • The function w is of unbounded variation on every interval. however. Qualitative properties • For every ε>0. The density Lt is (more exactly. t] under the map w (the pushforward measure) has a density Lt(·). • The function w has no points of local increase. and second.

x].[2] In both cases a rigorous treatment involves a limiting procedure. In other words. the process is called Brownian excursion. 1] and is called Brownian bridge. 1] appear. roughly speaking.1]. These processes exhaust continuous Lévy processes. The time of hitting a single point x > 0 by the Wiener process is a random variable with the Lévy distribution. the continuity of the local time of the Wiener process is another manifestation of non-smoothness of the trajectory. Two random processes on the time interval [0. such as the value of stocks. since the formula does not work when A geometric Brownian motion can be written
It is a stochastic process which is used to model processes that can never take on negative values. The right-continuous modification of this process is given by times of first exit from closed intervals [0. there is a conflict between good behavior of a function and good behavior of its local time. The stochastic process
is distributed like the Ornstein–Uhlenbeck process. In this sense. With no further conditioning.
. The image above is of the Brownian motion on a special manifold: the surface of a sphere. when conditioning the Wiener process to vanish on both ends of [0. The family of these random variables (indexed by all positive numbers x) is a left-continuous modification of a Lévy process. the process takes both positive and negative values on [0. Conditioned also to stay positive on (0. 1).
161
Related processes
The stochastic process defined by
The generator of a Brownian motion is ½ times the Laplace-Beltrami operator.Wiener process function is monotone. The local time Lt(0) treated as a random function of t is a random process distributed like the process The local time Lt(x) treated as a random function of x (while t is constant) is a random process described by Ray-Knight theorems in terms of Bessel processes.
is called a Wiener process with drift μ and infinitesimal variance σ2.

a nonnegative continuous martingale has a finite limit (as All stated (in this subsection) for martingales holds also for local martingales. a martingale adapted to the Brownian filtration.Wiener process
162
Brownian martingales
Let A be an event related to the Wiener process (more formally: a set. 2Wt = V(4t) where V is another Wiener process (different from W but distributed like W).
Especially. where is the quadratic variation of M on
In general. Its martingale property follows immediately from the definitions.) are of probability 0. t] belongs to A). by definition. if M is a continuous martingale then [0. (See also Doob's martingale convergence theorems) Let
be a continuous martingale. and
Then only the following two cases are possible:
other cases (such as
etc.t].
Complex-valued Wiener process
The complex-valued Wiener process may be defined as a complex-valued random process of the form where are independent Wiener processes (real-valued). but its continuity is a very special fact – a special case of a general theorem stating that all Brownian martingales are continuous. where and is another Wiener process. Using this fact.[3]
. Example. and Xt the conditional probability of A given the Wiener process on the time interval [0.
Time change
Every continuous martingale (starting at the origin) is a time changed Wiener process. Then the process Xt is a continuous martingale. by definition. Corollary. measurable with respect to the Wiener measure. t] (more formally: the Wiener measure of the set of trajectories whose concatenation with the given partial trajectory on [0.
Change of measure
A wide class of continuous semimartingales (especially. A Brownian martingale is. and is a Wiener process. in the space of functions). and the Brownian filtration is. Example. the filtration generated by the Wiener process. of diffusion processes) is related to the Wiener process via a combination of time change and change of measure. the qualitative properties stated above for the Wiener process can be generalized to a wide class of continuous semimartingales. ) almost surely.

(1979). R. Prentice Hall (New Jersey. [3] Navarro-moreno. where and is another is another complex-valued Wiener
163
complex-valued Wiener process. Woods. 7. Continuous martingales and Brownian motion. Statistics. Prob. is a time-changed complex-valued Wiener process.M. "Estimation of Improper Complex-Valued Random Signals in Colored Noise by Using the Hilbert Space Theory" (http:/ / ieeexplore. R. retrieved 2010-03-30
References
• Kleinert. Polymer Physics. Ruiz-molina. World Scientific (Singapore. Time change If f is an entire function then the process Example. (2000) Probability: theory and examples. ieee. For example. J. Path Integrals in Quantum Mechanics.4th edition.Wiener process Self-similarity Brownian scaling. 2004). time reversal. as before). . Probability and Random Processes with Applications to Signal Processing. John W. Textbook ISBN 0-13-020071-9 • Durrett. W. ISBN 0521765390 • Daniel Revuz and Marc Yor.1 [2] Vervaat. second edition. In contrast to the real-valued case. doi:10. 2002).. org/ Xplore/ login. Sect. the martingale is not (here are independent Wiener processes. A relation between Brownian bridge and Brownian excursion. jsp?url=http:/ / ieeexplore.D.C.. Hagen. pdf?arnumber=4957648& authDecision=-203). Cambridge University Press. ieee. Springer-Verlag 1994.2009. IEEE Transactions on Information Theory 55 (6): 2859–2867. M. Ann.2018329. 7. 3rd edition. Paperback ISBN 981-238-107-4 (also available online: PDF-files (http://www.
. time inversion: the same as in the real-valued case. 143-149. a complex-valued martingale is generally not a time-changed complex-valued Wiener process. J.de/~kleinert/b5)) • Stark.1109/TIT.fu-berlin. Fernandez-alcala. and Financial Markets. 4th edition.physik.Henry. Estudillo-martinez.. org/ iel5/ 18/ 4957623/ 04957648. Rotation invariance: for every complex number c such that |c|=1 the process process.
See also
• Wiener sausage • Abstract Wiener space • Classical Wiener space • Chernoff's distribution
Notes
[1] Durrett 1996.

i. is equal in distribution to 4. there is a Lévy process for each infinitely divisible probability distribution: given such a distribution D. by assumption (independent increments and stationarity). is any continuous-time stochastic process that starts at 0. They are a stochastic analog of independent and identically-distributed random variables. 2. which are i.
Properties
Independent increments
A continuous-time stochastic process assigns a random variable Xt to each point t ≥ 0 in time. named after the French mathematician Paul Lévy. multiples and dividing define a stochastic process for positive rational time. more generally. where λ > 0 is the "intensity" or "rate" of the process. the probability distribution of Xs − Xt is normal with expected value 0 and variance s − t.Lévy process
164
Lévy process
In probability theory. the probability distribution of Xs − Xt is a Poisson distribution with expected value λ(s − t). is almost surely right continuous with left limits. In effect it is a random function of t. though one must check continuity and that taking limits gives a well-defined function for irrational time. Independent increments: For any is said to be a Lévy process if. Stationary increments: For any . The increments of such a process are the differences Xs − Xt between its values at different times t < s. and taking limits defines it for real time.
are independent 3.
. almost surely . defining it as a Dirac delta distribution for time 0 defines it for time 0.
Divisibility
Lévy processes correspond to infinitely divisible probability distributions: • The probability distributions of the increments of any Lévy process are infinitely divisible.d.
Stationary increments
To call the increments stationary means that the probability distribution of any increment Xs − Xt depends only on the length s − t of the time interval. Independent increments and stationarity follow by assumption of divisibility. a Lévy process. To call the increments of a process independent means that increments Xs − Xt and Xu − Xv are independent random variables whenever the two time intervals do not overlap and. increments with equally long time intervals are identically distributed. admits càdlàg modification and has "stationary independent increments" — this phrase will be explained below. since the increment of length t is the sum of n increments of length t/n. In the Wiener process. any finite number of increments assigned to pairwise non-overlapping time intervals are mutually (not just pairwise) independent.
Definition
A stochastic process 1. • Conversely. and the most well-known examples are the Wiener process and the Poisson process. In the (homogeneous) Poisson process.

say
finitely
. This expression corresponds to the decomposition of a measure in Lebesgue's decomposition theorem: the drift and diffusion are the absolutely continuous part. corresponding to the absolutely continuous part of a measure and
capturing the drift a and diffusion . Now correspond to these measures continuous linear operators obvious way. . say. for any countable set of times (for ease consider the rationals as follows: if depends only on in the ) define a linear functional.
The process defined by
Constructing a stochastic probability measure
Consider a random process. by the properties of the process. corresponding to the singular continuous part of the singular measure W. corresponding to the pure point part of the singular measure W. and is the indicator function. . This leads to the Lévy–Khintchine representation. Given a Lévy triplet space. Then. If is a Lévy process. is a polynomial function of t. is a compound Poisson process. with independent increments. denote the (borel regular) probability measures on the initial Now for let ʃ a second countable locally compact abelian group Let position and the for increments.
. So one can see that a purely continuous Lévy process is a Brownian motion with drift. and thus the Lévy–Khintchine representation of the process.
Lévy–Itō decomposition
We can also construct a Lévy process from any given characteristic function of the form given in the Lévy–Khintchine representation. The Lévy measure must be such that
A Lévy process can be seen as comprising of three components: a drift. these
Lévy–Khintchine representation
It is possible to characterise all Lévy processes by looking at their characteristic function. a diffusion component and a jump component. • • • there exists three independent Lévy processes. compute appropriate probabilities for properties of paths depending on only finitely many times. then its characteristic function satisfies the following relation: where . is a square integrable pure jump martingale that almost surely has a countable number of jumps on a finite interval. the nth moment functions satisfy a binomial identity: . which lie in the same probability
. These three components. where the random values occur in. many times. while the measure W is the singular measure. such that: is a Brownian motion with drift. is a Lévy process with triplet . These define bona fide probability measures which.Lévy process
165
Moments
In any Lévy process with finite moments. are fully determined by the Lévy–Khintchine triplet .

By Stone-Weierstrass. ams.Lévy process where without loss of generality clearly a positive. let
166
extends (uniquely) to a (linear)
(positive) operator (with norm 1) on its domain. letting . Fortunately. the problem of having to change the countable set of times over which the measure is based can be prevented. By the Riesz representation theorem. (ii) has continuity modulus is nowhere differentiable. Precisely. we have that "almost every path has left limits / is left continuous". pdf
. E. . if and only if: for every countable sequence of times . Roughly we are justified (and compelled to) thinking of the measure as though calculates "the probability" that a path occurs in (when projected onto the times ). of the reals (e. the rationals). (This makes sense. There is no escaping this. and (ii) if is second countable then
has limits/is cts under the topology on has limits/is cts if and only if
converges / converges
to
Verifying how global properties of paths over the real line can be translated into properties considering only countably many times. we are able (Lévy). David (December 2004). we may apply knowledge of the distribution on the increments together with the stochastic measure to check these global properties.g. bounded operator with since . this measure is the unique one satisfying th Whereas initially we knew the probability distributions of a path at given times / over time increments. we have
shown that (i)
-almost-everywhere
then
converges / converges to
. and thus could talk about local properties of the paths in the stochastic process. can be a little tricky. . If we consider a countable dense subset. As an example of our new ability to talk about global properties. ISSN 1088-9477
References
[1] http:/ / www. org/ notices/ 200411/ fea-applebaum. and thus enables us to talk about global properties. the constructed measure above allows us to attach a probability distribution to (almost) the full path space. as it can be
generated by
has left limits/is left cts if and only if . Notices of the American Mathematical Society (Providence.)
See also
• Independent and identically-distributed random variables
External links
• Applebaum. and thus (iii) to check that almost every path is (i) everywhere cts. in the case of the wiener process.g.
whenever
. "Lévy Processes—From Probability to Finance and Quantum Groups" [1] (PDF). . this in turn gives rise to a (unique) (borel regular) probability measure. RI: American Mathematical Society) 51 (11): 1336–1347.

such as jump processes. one must be careful which calculus to use when the SDE is initially written down. SDEs incorporate white noise which can be thought of as the derivative of Brownian motion (or the Wiener process).
Stochastic Calculus
Brownian motion or the Wiener process was discovered to be exceptionally complex mathematically. having very poor numerical convergence. SDE are used to model diverse phenomena such as fluctuating stock prices or physical system subject to thermal fluctuations. however. These are sometimes confusingly called "the Langevin equation" even though there are many possible forms.
Terminology
In physical science. A second form is the Fokker-Planck equation. Typically. This is similar to the Langevin form. thus. 2003) and conveniently. A textbook describing many different algorithms is Kloeden & Platen (1995). The third form is the stochastic differential equation that is used most frequently in mathematics and quantitative finance (see below).
. There are two dominating versions of stochastic calculus. but it is usually written in differential form. Guidelines exist (e. This work was followed upon by Langevin.Stochastic differential equations
167
Stochastic differential equations
A stochastic differential equation (SDE) is a differential equation in which one or more of the terms is a stochastic process. Later Itō and Stratonovich put SDEs on more solid mathematical footing. thus resulting in a solution which is itself a stochastic process. The Wiener process is non-differentiable.
Numerical Solutions
Numerical solution of stochastic differential equations and especially stochastic partial differential equations is a young field relatively speaking.
Background
The earliest work on SDEs was done to describe Brownian motion in Einstein's famous paper. one of the earlier works related to Brownian motion is credited to Bachelier (1900) in his thesis 'Theory of Speculation'. one can readily convert an Ito SDE to an equivalent Stratonovich SDE and back again. SDEs come in two varieties. Øksendal.g. Almost all algorithms that are used for the solution of ordinary differential equations will work very poorly for SDEs. Each of the two has advantages and disadvantages. it requires its own rules of calculus. The Fokker-Planck equation is a partial differential equation that describes the time evolution of the probability distribution function. and at the same time by Smoluchowski. Still. These consist of an ordinary differential equation containing a deterministic part and an additional random white noise term. it should be mentioned that other types of random fluctuations are possible. However. and newcomers are often confused whether the one is more appropriate than the other in a given situation. the Ito stochastic calculus and the Stratonovich stochastic calculus. SDEs are usually written as Langevin equations. corresponding to two versions of stochastic calculus. Milstein method and Runge–Kutta method (SDE). Methods include the Euler–Maruyama method.

the main method of solution is to find the probability distribution function as a function of time using the equivalent Fokker-Planck equation (FPE). Note on "the Langevin equation" The "the" in "the Langevin equation" is somewhat ungrammatical nomenclature. the Fokker-Planck equation can be transformed into the Schrödinger equation by rescaling a few variables) or by writing down ordinary differential equations for the statistical moments of the probability distribution function. the
and
are arbitrary functions and the
are
random functions of time. and it must be specified whether the Langevin equation should be interpreted as an Ito SDE or a Stratonovich SDE. It is also the notation used in publications on numerical methods for solving stochastic differential equations." For example. in that situation the correct solution can often be found using ordinary calculus and in particular the ordinary chain rule of calculus.
Use in probability and mathematical finance
The notation used in probability theory (and in many applications of probability theory. a general coupled set of first-order SDEs is often written in the form:
where
is the set of unknowns. It tells how the probability distribution function evolves in time similarly to how the Schrödinger equation gives the time evolution of the quantum wave function or the diffusion equation gives the time evolution of chemical concentration. but only as a generalized function. the system is said to be subject to additive noise. Other techniques include the path integration that draws on the analogy between statistical physics and quantum mechanics (for example. This notation makes the exotic nature of the random function of time in the physics formulation more explicit. often referred to as "noise terms". SDEs are typically written in the Langevin form and referred to as "the Langevin equation. the Langevin equation is not a well-defined entity on its own. otherwise it is said to be subject to multiplicative noise. Each individual physical model has its own Langevin equation.Stochastic differential equations
168
Use in Physics
In physics. In strict mathematical terms. "a Langevin equation" or "the associated Langevin equation" would conform better with common English usage. This term is somewhat misleading as it has come to mean the general case even though it appears to imply the limited case where : . for instance mathematical finance) is slightly different. Alternatively numerical solutions can be obtained by Monte Carlo simulation. A heuristic (but very helpful) interpretation of the stochastic differential equation is that in a small time interval of length δ the stochastic process Xt changes its value by an amount that is
. in the case of multiplicative noise. Additive noise is the simpler of the two cases. This form is usually usable because there are standard techniques for transforming higher-order equations into several coupled first-order equations by introducing new unknowns. However. This equation should be interpreted as an informal
way of expressing the corresponding integral equation
The equation above characterizes the behavior of the continuous time stochastic process Xt as the sum of an ordinary Lebesgue integral and an Itō integral. can not be chosen as a usual function. A typical equation is of the form
where
denotes a Wiener process (Standard Brownian motion). The Fokker-Planck equation is a deterministic partial differential equation. In physics. The mathematical formulation treats this complication with less ambiguity than the physics formulation. If the are constants. Perhaps.

a strong solution and a weak solution. The difference between the two lies in the underlying probability space (Ω F. The formal interpretation of an SDE is given in terms of what constitutes a solution to the SDE. and it is called an Itō process and not a diffusion process. s ≥ 0.2). ω) |→ Xt(ω) such that X is adapted to the filtration FtZ generated by Z and Bs. the defining equation is called a stochastic delay differential equation.Stochastic differential equations normally distributed with expectation μ(Xt. s ≤ t.
Existence and uniqueness of solutions
As with deterministic ordinary and partial differential equations. and is usually a Markov process. The stochastic process Xt is called a diffusion process. and whether or not it is unique. while σ is called the diffusion coefficient. There are also more general stochastic differential equations where the coefficients μ and σ depend not only on the present value of the process Xt. A weak solution consists of a probability space and a process that satisfies the integral equation. This is so because the increments of a Wiener process are independent and normally distributed. but also on previous values of the process and possibly on present or previous values of other processes too. it is important to know whether a given SDE has a solution. Pr). T] and all x and y ∈ Rn. and with finite second moment:
Then the stochastic differential equation/initial value problem
has a Pr-almost surely unique t-continuous solution (t. where
Let Z be a random variable that is independent of the σ-algebra generated by Bs. An important example is the equation for geometric Brownian motion
169
which is the equation for the dynamics of the price of a stock in the Black Scholes options pricing model of financial mathematics. t) δ and variance σ(Xt. When the coefficients depends only on present and past values of X. §5. Both require the existence of a process Xt that solves the integral equation version of the SDE. and let
be measurable functions for which there exist constants C and D such that
for all t ∈ [0. t)² δ and is independent of the past behavior of the process. Let T > 0. while a strong solution is a process that satisfies the equation and is defined on a given probability space. The following is a typical existence and uniqueness theorem for Itō SDEs taking values in n-dimensional Euclidean space Rn and driven by an m-dimensional Brownian motion B. the proof may be found in Øksendal (2003. In that case the solution process. is not a Markov process. The function μ is referred to as the drift coefficient. There are two main definitions of a solution to an SDE. and
. X.

Stochastic Differential Equations: An Introduction with Applications. • Teugels. Encyclopedia of Actuarial Science.numdam. (1995). Mathematics and its Applications (46). (2003). Chemistry and the Natural Sciences. and Sund B.) (2004). Berlin: Springer.Stochastic differential equations
170
See also
• • • • • Langevin dynamics Local volatility Stochastic volatility Sethi advertising model Stochastic partial differential equations
References
• Adomian.. • P. L. • Øksendal. FL: Academic Press Inc. Handbook of Stochastic Methods: for Physics.. Nonlinear stochastic systems theory and applications to physics. 523–527. W. Dordrecht: Kluwer Academic Publishers Group. Théorie de la speculation (in French). PhD Thesis. • Thomas Mikosch (1998). Chichester: Wiley. Platen. Springer. 415. p. Cootner. George (1986).
. Singapore: World Scientific Publishing. • Bachelier. Orlando.E. J. .. Orlando. Numerical Solution of Stochastic Differential Equations.H. org/item?id=ASENS_1900_3_17__21_0. ISBN 3-540-04758-1. 212. FL: Academic Press Inc. • Adomian. ISBN 981-02-3543-7. Stochastic systems. Elementary Stochastic Calculus: with Finance in View.. (1900). Kloeden and E. George (1989).In English in 1971 book 'The Random Character of the Stock Market' Eds. NUMDAM: http://www. George (1983). Gardiner (2004).. • Adomian. (eds. pp. P. • C. Mathematics in Science and Engineering (169). p. Bernt K. Springer. Nonlinear stochastic operator equations.

such as options.Stochastic volatility
171
Stochastic volatility
Stochastic volatility models are used in the field of Mathematical finance to evaluate derivative securities. The explicit solution of this stochastic differential equation is . By assuming that the volatility of the underlying price is a stochastic process rather than a constant. is the starting point for non-stochastic volatility models such as . these models assume that the underlying volatility is constant over the life of the derivative. and
is a standard gaussian with zero mean and unit standard deviation. governed by state variables such as the price level of the underlying security. and unaffected by the changes in the price level of the underlying security. and the form of model under study. replace the constant volatility with a function . Stochastic volatility models are one approach to resolve a shortcoming of the Black-Scholes model. assume that the derivative's underlying price follows a standard model for geometric brownian motion:
where
is the constant drift (i. these models cannot explain long-observed features of the implied volatility surface such as volatility smile and skew.
and
is another standard gaussian that is correlated with
with constant correlation factor
.
Basic model
Starting from a constant volatility approach. The name derives from the models' treatment of the underlying security's volatility as a random process.
is the constant volatility. it becomes possible to model derivatives more accurately. In particular. and the variance of the volatility process itself. The Maximum likelihood estimator to estimate the constant volatility is . expected return) of the security price
. its expectation value is This basic model with constant volatility Black-Scholes and Cox-Ross-Rubinstein. that models the variance of depends on the particular SV for given stock prices at different times
For a stochastic volatility model.
where
and
are some functions of . among others.e. However. which indicate that implied volatility does tend to vary with respect to strike price and expiration. This variance function is also modeled as brownian motion. the tendency of volatility to revert to some long-run mean value. .

.Stochastic volatility
172
Heston model
The popular Heston model is a commonly used SV model. Chen model.
is the rate at which the volatility reverts toward its long-term mean. Specifically. Brownian motions) with correlation coefficient
. The constant parameters
are such that . Lin Chen in 1994 developed the first stochastic mean and stochastic volatility model. and
deviation. The main feature of the SABR model is to be able to reproduce the smile effect of the volatility smile. 3. the dynamics of the instantaneous interest rate are given by following the stochastic differential equations: . whereas
and
are two correlated
Wiener processes (i. in which the randomness of the variance process varies as the square root of variance. the Heston SV model assumes that volatility is a random process that 1.
The initial values
and
are the current forward price and volatility.
3/2 model
The 3/2 model is similar to the Heston model. a gaussian with zero mean and unit standard . exhibits a tendency to revert towards a long-term mean volatility 2. including the NGARCH.g. and whose source of randomness is correlated (with correlation processes. an index.1) model has the following form for the variance differential:
The GARCH model has been extended via numerous variants. GJR-GARCH. In this case. The standard GARCH(1. as opposed to the square root of the variance as in the Heston model. the differential equation for variance takes the form:
where
is the mean long-term volatility.e. bond. exhibits its own (constant) volatility. and are correlated with the constant correlation value In other words. but assumes that the randomness of the variance process varies with . etc. like . The form of the variance differential is: .
) with the randomness of the underlying's price
SABR volatility model
The SABR model (Stochastic Alpha. . Beta. is. LGARCH. However. . currency or equity) under stochastic volatility : (related to any asset e. EGARCH. It assumes that the randomness of the variance process varies with the variance. at a rate . Rho) describes a single forward interest rate.
Chen model
In interest rate modelings.
is the volatility of the volatility process.
GARCH model
The Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model is another popular model for estimating stochastic volatility.

Calibration is the process of identifying the set of model parameters that are most likely given the observed data. com/ abstract=982221
. html http:/ / www. edu/ nr/ bookcpdf. you start with an estimate for the resulting model.A Three-Factor Model of the Term Structure of Interest Rates and Its Application to the Pricing of Interest Rate Derivatives. A closed-form solution for options with stochastic volatility [3]. uncertainty. javaquant. Hyungsok Ahn.Stochastic volatility . com/ s?platform=gurupa& url=index%3Dblended& keywords=inside+ volatility+ arbitrage http:/ / ssrn. Accelerating the Calibration of Stochastic Volatility Models [5]. pdf http:/ / www. Once the calibration has been performed. compute the residual errors when applying the historic price data to to try to minimize these errors. the set of model parameters can be estimated applying an MLE algorithm such as the Powell Directed Set method [1] to observations of historic underlying security prices. In this case. in the Heston model. complexity and ambiguity Black–Scholes
References
• • • • • Stochastic Volatility and Mean-variance Analysis [2]. and then adjust . SL Heston. (2006). Blackwell Publishers. For instance. Alireza Javaheri. Lin Chen (1996).
References
[1] [2] [3] [4] [5] http:/ / www. cornell. cfm?articleID=245 http:/ / www.. it is
standard practice to re-calibrate the model over time. wilmott. com/ detail.
173
Calibration
Once a particular SV model is chosen. amazon. Inside Volatility Arbitrage [4]. library. (2005). it must be calibrated against existing market data. This process is called Maximum Likelihood Estimation (MLE). Kilin. Fiodar (2006). (1993).
See also
• Chen model • Heston model • Local volatility • • • • • Risk-neutral measure SABR Volatility Model Volatility Volatility. Blackwell Publishers. Stochastic Mean and Stochastic Volatility -. net/ papers/ Heston-original. Paul Wilmott.

• IMS [2]. The finite difference method is often regarded as the simplest method to learn and use. uni-freiburg. the Open Source IMTEK Mathematica Supplement (IMS)
References
[1] http:/ / ocw. where functions are represented in terms of basis functions and the PDE is solved in its integral (weak) form. de/ simulation/ mathematica/ IMSweb/
. • Multigrid methods solve differential equations using a hierarchy of discretizations. • Domain decomposition methods solve boundary value problems by splitting them into smaller boundary value problems on subdomains and iterating to coordinate the solution between the subdomains. However the computational effort is usually higher. which represents functions as a sum of particular basis functions. mit. provided that the solutions are sufficiently smooth. which divides space into regions or volumes and computes the change within each volume by considering the flux (flow rate) across the surfaces of the volume. imtek. • The method of lines.
See also
• List of numerical analysis topics#Numerical partial differential equations • Numerical ordinary differential equations
External links
• Numerical Methods for Partial Differential Equations [1] course at MIT OpenCourseWare. for example using a Fourier series. The result is a system of ODEs in the remaining continuous variable. edu/ courses/ aeronautics-and-astronautics/ 16-920j-numerical-methods-for-partial-differential-equations-sma-5212-spring-2003/ [2] http:/ / www. in which functions are represented by their values at certain grid points and derivatives are approximated through differences in these values. Numerical techniques for solving PDEs include the following: • The finite difference method. • Meshfree methods don't need a grid to work and so may be better suited for some problems. • The finite element method. The finite element and finite volume methods are widely used in engineering and in computational fluid dynamics.Numerical partial differential equations
174
Numerical partial differential equations
Numerical partial differential equations is the branch of numerical analysis that studies the numerical solution of partial differential equations (PDEs). and are well suited to problems in complicated geometries. Spectral methods are generally the most accurate. • The finite volume method. • The spectral method. where all but one variable is discretized.

the discretization will also be nonlinear so that advancing in time will involve the solution of a system of nonlinear algebraic equations. and is numerically stable. the Crank–Nicolson method is a finite difference method used for numerically solving the heat equation and similar partial differential equations.
The method
The Crank–Nicolson method is based on central difference in space. whenever large time steps or high spatial resolution is necessary. If the partial differential equation is nonlinear. it can be shown the Crank–Nicolson method is unconditionally stable. that the method itself is not simply the
average of those two methods. as the equation has an implicit dependence on the solution):
The function F must be discretized spatially with a central difference.[3] However. a system of algebraic equations must be solved. however.Crank–Nicolson method
175
Crank–Nicolson method
In numerical analysis. letting method at
. and the trapezoidal rule in time.[1] It is a second-order method in time. implicit in time. if the partial differential equation is
The Crank–Nicolson stencil for a 1D problem.
. The method was developed by John Crank and Phyllis Nicolson in the mid 20th century. the equation for Crank–Nicolson method is the average of that forward Euler and that backward Euler method at n + 1 (note. especially linear diffusion. giving second-order convergence in time. in one dimension. the less accurate backward Euler method is often used. Note that this is an implicit method: to get the "next" value of u in time. though linearizations are possible. For example. In many problems. For this reason.[2] For diffusion equations (and many other equations). the algebraic problem is tridiagonal and may be efficiently solved with the tridiagonal matrix algorithm.
then. which gives a fast direct solution as opposed to the usual for a full matrix. which is both stable and immune to oscillations. the approximate solutions can still contain (decaying) spurious oscillations if the ratio of time step to the square of space step is large (typically larger than 1/2).

As an example. which we choose to be a constant Ux. Other times. letting : may be efficiently solved by using the tridiagonal matrix algorithm in
which is a tridiagonal problem. and a lateral interaction between longitudinal channels (k). A quasilinear equation. The Crank–Nicolson method (where i represents position & j time) transform each component of the PDE into the following:
Now we create the following constants to simplify the algebra:
. Often the problem can be simplified into a 1-dimensional problem and still yield useful information. that is instead of . Here we model the concentration of a solute contaminant in water. so that
favor of a much more costly matrix inversion. however. it may be possible to estimate using an explicit method and maintain stability.
where C is the concentration of the contaminant and subscripts N and M correspond to previous and next channel. it is possible in some cases to linearize the problem by using the old value for .
Example: 1D diffusion with advection for steady flow. such as (this is a minimalistic example and not general)
would lead to a nonlinear system of algebraic equations which could not be easily solved as above.
whose Crank–Nicolson discretization is then: or. for linear diffusion. an advective component (which means the system is evolving in space due to a velocity field).Crank–Nicolson method
176
Example: 1D diffusion
The Crank–Nicolson method is often applied to diffusion problems. This problem is composed of three parts: the known diffusion equation ( chosen as constant). with multiple channel connections
This is a solution usually employed for many purposes when there's a contamination problem in streams or rivers under steady flow conditions but information is given in one dimension only.

and
. so the expression is simplified to: To solve this linear system of equations we must now see that boundary conditions must be given first to the beginning of the channels: : initial condition for the channel at present time step : initial condition for the channel at next time step : initial condition for the previous channel to the one analyzed at present time step : initial condition for the next channel to the one analyzed at present time step For the last cell of the channels (z) the most convenient condition becomes an adiabatic one. <2>. we realize that it can only be in contact with the previous channel (N). so
This condition is satisfied if and only if (regardless of a null value)
Let us solve this problem (in a matrix form) for the case of 3 channels and 5 nodes (including the initial boundary condition).Crank–Nicolson method
177
and substitute <1>. <4>. <6>. so the expression is simplified to: In the same way. <5>. We then put the new time terms on the left (j + 1) and the present time terms on the right (j) to get: To model the first channel. <3>. We express this as a linear system problem:
where
and
Now we must realize that AA and BB should be arrays made of four different subarrays (remember that only three channels are considered for this example but it covers the main part discussed above). we realize that it can only be in contact with the following channel (M). β and λ into <0>. α. to model the last channel.

Crank–Nicolson method
178
where the elements mentioned above correspond to the next arrays and an additional 4x4 full of zeros. We can now write the scheme as:
. one must iterate the following equation:
Example: 2D diffusion
When extending into two dimensions on a uniform Cartesian grid. however it is required for numerical accuracy.
& The d vector here is used to hold the boundary conditions. In this example it is a 12x1 vector:
To find the concentration at any time.
. The two-dimensional heat equation
can be solved with the Crank–Nicolson discretization of assuming that a square grid is used so that terms and using the CFL number . Please note that the sizes of AA and BB are 12x12: . a low CFL number is not required for stability. This equation can be simplified somewhat by rearranging
For the Crank–Nicolson numerical scheme. the derivation is similar and the results may lead to a system of band-diagonal equations rather than tridiagonal ones. .

Springer. Proc.edu/mathews/n2003/CrankNicolsonMod.
See also
• Financial mathematics • Partial differential equations
References
[1] Tuncer Cebeci (2002). google.2 shows that Crank–Nicolson is unconditionally stable when applied to . Convective Heat Transfer (http:/ / books. ISBN 978-0-387-97999-1. com/ ?id=xfkgT9Fd4t4C& pg=PA257& dq="Crank-Nicolson+ method").. S. For vanilla options. P. google. incorporating changing dividends).[4] Particularly. Cambridge Univ.. P. but can be solved using this method. when extended beyond the standard assumptions (e. that for non-smooth final conditions (which happen for most financial instruments). .fullerton.Crank–Nicolson method
179
Application in financial mathematics
Because a number of other phenomena can be modeled with the heat equation (often called the diffusion equation in financial mathematics). [4] Wilmott.'s (http://math. ISBN 0966846141.g. Dewynne.. J..E. (1947). Camb. J.D. Nicolson. fully implicit finite difference method). is that option pricing problems.1007/BF02127704. Therefore. co. W. ISBN 0521497892. The importance of this for finance. Howison. 43: 50–67.. Berlin. Note however. Numerical Partial Differential Equations: Finite Difference Methods. The Mathematics of Financial Derivatives: A Student Introduction (http:/ / books. Soc. Texts in Applied Mathematics.html)
. the Crank–Nicolson method has been applied to those areas as well. cannot be solved in closed form. this results in oscillation in the gamma value around the strike price. Press. New York: Springer-Verlag. (1995). Phil. doi:10. Example 3.. in/ books?hl=en& q=The Mathematics of Financial Derivatives Wilmott& um=1& ie=UTF-8& sa=N& tab=wp).
External links
• Module for Parabolic P. 22. [2] Crank. J. and thus numerical solutions for option pricing can be obtained with the Crank–Nicolson method.3. special damping initialization steps are necessary (e.g. the Crank–Nicolson method is not satisfactory as numerical oscillations are not damped. . [3] Thomas. "A practical method for numerical evaluation of solutions of partial differential equations of the heat conduction type". (1995). the Black-Scholes option pricing model's differential equation can be transformed into the heat equation.

and central differences. Recurrence relations can be written as difference equations by replacing iteration notation with finite differences. the spacing h may be variable or constant. The approximation of derivatives by finite differences plays a central role in finite difference methods for the numerical solution of differential equations. the error is
The same formula holds for the backward difference:
However. instead of the values at x + h and x:
Finally. and central differences
Only three forms are commonly considered: forward. especially boundary value problems. however. A forward difference is an expression of the form
Depending on the application. Assuming that f is continuously differentiable. the central difference is given by
Relation with derivatives
The derivative of a function f at a point x is defined by the limit
If h has a fixed (non-zero) value. backward. Its error is proportional to square of the spacing (if f is twice continuously differentiable):
The main problem with the central difference method. If a finite difference is divided by b − a. and f(nh)=2 for n even. backward. If f(nh)=1 for n uneven. is that oscillating functions can yield zero derivative. the forward difference divided by h approximates the derivative when h is small.Finite difference
180
Finite difference
A finite difference is a mathematical expression of the form f(x + b) − f(x + a). This is particularly troublesome if the domain of f is discrete. the central difference yields a more accurate approximation.
Forward.
. A backward difference uses the function values at x and x − h. one gets a difference quotient. then f'(nh)=0 if it is calculated with the central difference scheme. The error in this approximation can be derived from Taylor's theorem. then the right-hand side is
Hence. instead of approaching zero.

and central differences.
Arbitrarily sized kernels
Using a little linear algebra. The problem may be remedied taking the average of and . and central differences are respectively given by:
Note that the central difference will. one can fairly easily construct approximations. around the center point. This can be proven by expanding the above expression in Taylor series. the finite difference can be centered about any point by mixing forward. we obtain the central difference approximation of
More generally. for any order of derivative. If necessary. for odd
. or by using the calculus of finite differences. well approximates the Taylor expansion of the desired derivative. This involves solving a linear system such that the Taylor expansion of the sum of those points. As mentioned above. have
multiplied by non-integers. as one approaches the edge of the grid. However. which sample an arbitrary number of points to the left and a (possibly different) number of points to the right of the center point. the combination
approximates f'(x) up to a term of order h2. This is often a problem because
it amounts to changing the interval of discretization. The relationship of these higher-order differences with the respective derivatives is very straightforward:
Higher-order differences can also be used to construct better approximations. the nth-order forward. by using the above central difference formula for and and applying a central difference formula for the derivative of the second derivative of f: at x. backward. where. This is useful for differentiating a function on a grid.Finite difference
181
Higher-order differences
In an analogous way one can obtain finite difference approximations to higher order derivatives and differential operators. The details are outlined in these notes [1].
. one must sample fewer and fewer points on one side. For example. explained below. the first-order difference approximates the first-order derivative up to a term of order h. backward.

Formally inverting the exponential suggests that
This formula holds in the sense that both operators give the same result when applied to a polynomial. This operator satisfies
where
is the shift operator with step
. ƒ(x). and
is an identity operator. to another function. for sufficiently small h. The inverse operator of the forward difference operator is the indefinite sum. Formally applying the Taylor series with respect to h gives the formula
where D denotes the derivative operator. retaining the first two terms of the series yields the second-order approximation to mentioned at the end of the section Higher-order differences.
Calculus of finite differences
The forward difference can be considered as a difference operator. For instance. defined by
. Common applications of the finite difference method are in computational science and engineering disciplines. or. fluid mechanics. especially in numerical differential equations.
. it can be used to obtain more accurate approximations for the derivative. a difference operator maps a function. it may be an asymptotic series. ƒ(x + b) − ƒ(x + a). The analogous formulas for the backward and central difference operators are
The calculus of finite differences is related to the umbral calculus in combinatorics. which maps the function f to Δh[f]. Even for analytic functions. The idea is to replace the derivatives appearing in the differential equation by finite differences that approximate them. mapping f to its derivative f'. The expansion is valid when both sides act on analytic function. etc. The resulting methods are called finite difference methods. However.Finite difference
182
Properties
• For all positive k and n
• Leibniz rule:
Finite difference methods
An important application of finite differences is in numerical analysis. Another possible (and equivalent) definition is The difference operator Δh is linear and satisfies Leibniz rule. which aim at the numerical solution of ordinary and partial differential equations respectively. in
Finite difference of higher orders can be defined in recursive manner as
operators notation. such as thermal engineering. the series on the right is not guaranteed to converge. Similar statements hold for the backward and central difference. In mathematics.

Analogously we can have the backward difference operator
When restricted to polynomial functions f. 2. analytic functions. i. This similarity led to the development of time scale calculus. named after Isaac Newton and in essence the Newton interpolation formula first published in his Principia Mathematica in 1687[2] . Here.e. and have a number of interesting combinatorial properties. but used in discrete circumstances..
Newton series
The Newton series consists of the terms of the Newton forward difference equation. the expression
is the binomial coefficient. the series of products. Difference equations can often be solved with techniques very similar to those for solving differential equations. is the relationship
which holds for any polynomial function f and for some. the forward difference operator is a delta operator. a shift-equivariant linear operator on polynomials that reduces degree by 1. Note also the formal similarity of this result to Taylor's theorem.
. One can find a polynomial that reproduces these values by first computing a difference table and then substituting the differences which correspond to x0 (underlined) into the formula as follows. In this particular case there is an assumption of unit steps for the changes in the values of x. where it plays a role formally similar to that of the derivative. by contrast.
n-th difference
The nth forward difference of a function f(x) is given by
where
is the binomial coefficient. For the case of nonuniform steps in the values of x Newton computes the divided differences. the forward difference series can be extremely hard to evaluate numerically. but not all. To illustrate how one might use Newton's formula in actual practice consider the first few terms of the Fibonacci sequence f = 2. The integral representation for these types of series is interesting because the integral can often be evaluated using asymptotic expansion or saddle-point techniques. Forward differences may be evaluated using the Nörlund–Rice integral. Forward differences applied to a sequence are sometimes called the
binomial transform of the sequence. 4. this is one of the observations that lead to the idea of umbral calculus. because the binomial coefficients grow rapidly for large n. as
is the "falling factorial" or "lower factorial" and the empty product (x)0 defined to be 1..Finite difference The forward difference operator
183
occurs frequently in the calculus of finite differences..

184
Rules for calculus of finite difference operators
Analogous to rules for finding the derivative. The Newton series. Carlson's theorem provides necessary and sufficient conditions for a Newton series to be unique. together with the Stirling series and the Selberg series. However.
All of the above rules apply equally well to any difference operator. exist. we have: • Constant rule: If c is a constant. all of which are defined in terms of scaled forward differences.Finite difference and the resulting polynomial is the scalar product. . in general. a Newton series will not. is a special case of the general difference series. In analysis with p-adic numbers.
• Quotient rule:
or
• Summation rules:
. then
• Linearity: if a and b are constants. if it exists. Mahler's theorem states that the assumption that f is a polynomial function can be weakened all the way to the assumption that f is merely continuous. including • Product rule:
as to
.

difference operators and other Möbius inversion can be represented by convolution with a function on the poset. • Difference operator generalizes to Möbius inversion over a partially ordered set. μ is the sequence (1. 0. Such generalizations are useful for constructing different modulus of continuity. Some partial derivative approximations are:
See also
• • • • • • • • • • • • Finite difference coefficients Taylor series Numerical differentiation Five-point stencil Divided differences Modulus of continuity Time scale calculus Summation by parts Newton polynomial Table of Newtonian series Lagrange polynomial Gilbreath's conjecture
. They are analogous to partial derivatives in several variables. called the Möbius function μ.. .
• As a convolution operator: Via the formalism of incidence algebras.). Another way of generalization is making coefficients point : . An infinite difference is a further generalization. −1.
Finite difference in several variables
Finite differences can be considered in more than one variable. 0. Also one may make step
finite sum above is replaced by an infinite series.. for the difference operator.Finite difference
185
Indefinite sum
The inverse operator of the forward difference operator is the indefinite sum. where the depend depend on .
Generalizations
• A generalized finite difference is usually defined as
where on point :
is its coefficients vector. 0. thus considering weighted finite difference.

stanford.Finite difference
186
References
[1] http:/ / commons. • Robert D. Macmillan and Company.6. Wiley. Richtmyer and K.. djvu [2] see Newton. 2nd ed. Ames.[1] For example. Academic Press. [See also: Dover edition 1960].ps.05 probability that the portfolio will fall in value by more than $1 million over a one day period. 2nd ed. Value at Risk (VaR) is a widely used risk measure of the risk of loss on a specific portfolio of financial assets. 1872. H. Isaac. Lessman. Finite-Difference Equations and Simulations. Dover. Lemma V. wikimedia. assuming markets are normal and there is no trading. Philippe. org/ wiki/ File:FDnotes.. a loss of $1 million or more on this portfolio is expected on 1 day in 20. Morton. ISBN 0-12-056760-1. google. New York.gz). "Mellin transforms and asymptotics: Finite differences and Rice's integrals" (http://www-rocq. there is a 0. Section 1.”[2]
. W. New York.. Numerical Methods for Partial Differential Equations.pdf)
Value at risk
In financial mathematics and financial risk management. 1968. A loss which exceeds the VaR threshold is termed a “VaR break. Finite Difference Equations. George.
External links
• Table of useful finite difference formula generated using [[Mathematica (http://reference. For a given portfolio. Informally.inria. • Levy. • Boole. Section 2. F. A Treatise On The Calculus of Finite Differences. New Jersey. Sedgewick.fr/algo/flajolet/Publications/mellin-rice. Hildebrand.edu/~dgleich/publications/ finite-calculus. Robert (1995). Difference Methods for Initial Value Problems.com/ mathematica/tutorial/NDSolvePDE. • Francis B. probability and time horizon.1016/0304-3975(94)00281-M. Book III.2. Principia. VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) in the given probability level. Prentice-Hall. Case 1 (http:/ / books. Theoretical Computer Science 144 (1–2): 101–124. 1967. (1992). com/ books?id=KaAIAAAAIAAJ& dq=sir isaac newton principia mathematica& as_brr=1& pg=PA466#v=onepage& q& f=false)
• William F. 1977. • Flajolet. doi:10. if a portfolio of stocks has a one-day 5% VaR of $1 million. Englewood Cliffs.html#c:4)] ] • Finite Calculus: A Tutorial for Solving Nasty Sums (http://www.wolfram. ISBN 0-486-67260-3.

so that the VaR in the example above would be called a one-day 95% VaR instead of one-day 5% VaR. A negative VaR would imply the portfolio has a high probability of making a profit. [7] Another inconsistency is VaR is sometimes taken to refer to profit-and-loss at the end of the period. It is also easier theoretically to deal with a point-in-time estimate versus a maximum over an interval. Some longer-term consequences of disasters. VaR marks the boundary between normal days and extreme events. VaR is conventionally reported as a positive number. risk measurement. and sometimes as the maximum loss at any point during the period. VaR is sometimes used in non-financial applications as well. In some extreme financial events it can be impossible to determine losses.Value at risk
187
VaR has five main uses in finance: risk management. such as lawsuits. end-of-day valuation was the only reliable number so the former became the de facto definition.[1] Although it virtually always represents a loss. financial reporting and computing regulatory capital. is to make the loss observable. Institutions can lose far more than the VaR amount. and to restricting loss to things measured in daily accounts. for example a one-day 5% VaR of negative $1 million implies the portfolio has a 95% chance of making more than $1 million over the next day. As people began using multiday VaRs in the second half of the 1990s they almost always estimated the distribution at the end of the period only.[6] The probability level is about equally often specified as one minus the probability of a VaR break.[5]
The 5% Value at Risk of a hypothetical profit-and-loss probability density function
The reason for assuming normal markets and no trading.5.[4]
Details
Common parameters for VaR are 1% and 5% probabilities and one day and two week horizons. stress testing and expected shortfall.[3] Important related ideas are economic capital. all that can be said is that they will not do so very often. backtesting. but in the early 1990s when VaR was aggregated across trading desks and time zones. certainly less than 0. and may be hard to allocate among specific prior decisions. either because market prices are unavailable or because the loss-bearing institution breaks up.[8]
. This generally does not lead to confusion because the probability of VaR breaks is almost always small. although other combinations are in use. The original definition was the latter. loss of market confidence and employee morale and impairment of brand names can take a long time to play out. Therefore the end-of-period definition is the most common both in theory and practice today. financial control.

The same position data and pricing models are used for computing the VaR as determining the price movements. and hybrid versions are typically used in financial control. there is wide scope for interpretation in the definition. within the limits of sampling error.[12]
. Doing so provides an easy metric for oversight and adds accountability as managers are then directed to manage. and that the VaR breaks will be independent in time and independent of the level of VaR. however. and an input into the risk measurement computation of the desk’s risk-adjusted return at the end of the reporting period. A Bayesian probability claim is made. not a system. VaR is adjusted after the fact to correct errors in inputs and computation. it specifies a property VaR must have. that is both a risk-management rule for deciding what risks to allow today. if a trading desk is held to a VaR limit. that the long-term frequency of VaR breaks will equal the specified probability. Instead of probability estimates they simply define maximum levels of acceptable loss for each.[11] A frequentist claim is made. financial reporting and computing regulatory capital. VaR is a system. fraud and rogue trading). but not to incorporate information unavailable at the time of computation. “backtest” has a different meaning. that given the information and beliefs at the time.[1] For risk measurement a number is needed.[9] This has led to two broad types of VaR. not a number.[2] Although some of the sources listed here treat only one kind of VaR as legitimate. trusts. In this interpretation. but with the additional constraint to avoid losses within a defined risk parameter. and pension plans. and making medium term and strategic decisions for the future. one used primarily in risk management and the other primarily for risk measurement. When VaR is used for financial control or financial reporting it should incorporate elements of both. The system is run periodically (usually daily) and the published number is compared to the computed price movement in opening positions over the time horizon.[7] In this context. the subjective probability of a VaR break was the specified level. There is never any subsequent adjustment to the published VaR. as well as a worthwhile critique on board governance practices as it relates to investment management oversight in general can be found in 'Best Practices in Governance". Rather than comparing published VaRs to actual market movements over the period of time the system has been in operation. This claim is validated by a backtest. Essentially trustees adopt portfolio Values-at-Risk metrics for the entire pooled account and the diversified parts individually managed. but not how to compute VaR.[4]
VAR in Governance
An interesting takeoff on VaR is its application in Governance for endowments. Use of VAR in this context. Moreover. most of the recent ones seem to agree that risk management VaR is superior for making short-term and tactical decisions today. many different systems could produce VaRs with equally good backtests. computation errors (including failure to produce a VaR on time) and market movements.Value at risk
188
Varieties of VaR
The definition of VaR is nonconstructive. and there is no distinction between VaR breaks caused by input errors (including Information Technology breakdowns. VAR utilized in this manner adds relevance as well as an easy to monitor risk measurement control far more intuitive than Standard Deviation of Return. [10] To a risk manager. while risk measurement VaR should be used for understanding the past. VaR is retroactively computed on scrubbed data over as long a period as data are available and deemed relevant. a comparison of published VaRs to actual price movements. but wide disagreements on daily VaR values. The distinction is not sharp. For example.

impairment of brand names or lawsuits. Institutions that go through the process of computing their VAR are forced to confront their exposure to financial risks and to set up a proper risk management function. if an institution holds a loan that declines in market price because interest rates go up. conventional statistical methods are reliable. Risk should be analyzed with stress testing based on long-term and broad market data.[4] Rather than assuming a fixed portfolio over a fixed time horizon. Publishing a daily number. on-time and with specified statistical properties holds every part of a trading organization to a high objective standard. One to three times VaR are normal occurrences. Risk managers encourage productive risk-taking in this regime. Positions that are reported. all bets are off. some risk measures incorporate the effect of expected trading (such as a stop loss order) and consider the expected holding period of positions. there is no true risk because you have a sum of many independent observations with a left bound on the outcome. assuming normal markets. because there is little true cost. You expect periodic VaR breaks. In a sense. and not enough about what might happen on the worst days. People tend to worry too much about these risks. Thus the process of getting to VAR may be as important as the number itself. but has no change in cash flows or credit quality. rather than excluding them from the computation.[17] Probability statements are no longer meaningful. Anything that affects profit and loss that is left out of other reports will show up either in inflated VaR or excessive VaR breaks. loss is often defined as change in fundamental value. Instead of mark-to-market. There are many alternative risk measures in finance. mean absolute deviation.” [15] The second claimed benefit of VaR is that it separates risk into two regimes. Finally. For example.[1]
VaR risk management
Supporters of VaR-based risk management claim the first and possibly greatest benefit of VaR is the improvement in systems and modeling it forces on an institution.[16] Outside the VaR limit. a point with a specified probability of greater losses. A casino doesn't worry about whether red or black will come up on the next roulette spin. Sources earlier than 1995 usually emphasize the risk measure. “A risk-taking institution that does not compute VaR might escape disaster. Relatively short-term and specific data can be used for analysis. The loss distribution typically has fat tails. The risk manager should concentrate instead on making sure good plans are in place to limit the loss if possible. later sources are more likely to emphasize the metric.[1] One specific system uses three regimes. and you might get more than one break in a short period of time. Moreover. but an institution that cannot compute VaR will not. Robust backup systems and default assumptions must be implemented. and to survive the loss if not. Or we could try to incorporate the economic cost of things not measured in daily financial statements. because there are enough data to test them. modeled or priced incorrectly stand out. markets may be
. which uses market prices to define loss. Philippe Jorion wrote [13]:[14] [T]he greatest benefit of VAR lies in the imposition of a structured methodology for critically thinking about risk. Probability estimates are meaningful. some risk measures adjust for the possible effects of abnormal markets.[4] The VaR risk metric summarizes the distribution of possible losses by a quantile.Value at risk
189
Risk measure and risk metric
The term “VaR” is used both for a risk measure and a risk metric.[18] Knowing the distribution of losses beyond the VaR point is both impossible and useless. as do data feeds that are inaccurate or late and systems that are too-frequently down. because they happen frequently. expected shortfall and downside risk. In 1997. some systems do not recognize a loss. such as loss of market confidence or employee morale. This sometimes leads to confusion. Common alternative metrics are standard deviation. The VaR risk measure defines risk as mark-to-market loss on a fixed portfolio over a fixed time horizon.[19] 1. Inside the VaR limit.

These affected many markets at once. such as positions marked in different time zones. But since every business contributes to profit and loss in an additive fashion. or a high frequency trading desk with a business holding relatively illiquid positions. but it is seldom referred to as nonparametric VaR. and survive the other 1% of the time. Retrospective analysis has found some VaR-like concepts in this history. but it's pointless to anticipate them. "A risk manager has two jobs: make people take more risk the 99% of the time it is safe to do so. and are prepared to survive them. Of course there will be unforeseeable losses more than ten times VaR. Better to hope that the discipline of preparing for all foreseeable three-to-ten times VaR losses will improve chances for surviving the unforeseen and larger losses that inevitably occur. about one or two per decade.[15] The probability level is chosen deep enough in the left tail of the loss distribution to be relevant for risk decisions. and you may take losses not measured in daily marks such as lawsuits. This usage can be confusing. but not so deep as to be difficult to estimate with accuracy. because it can be estimated either parametrically (for examples. These events are too rare to estimate probabilities reliably.[20] Risk measurement VaR is sometimes called parametric VaR. A reconsideration of history led some quants to decide there were recurring crises. These cannot be combined in a meaningful way. VaR is usually reported alongside other risk metrics such as standard deviation.[4] [6]
History of VaR
The problem of risk measurement is an old one in statistics. because they are out of scale with daily experience. Three to ten times VaR is the range for stress testing.[1] It is also difficult to aggregate results available at different times. Foreseeable events should not cause losses beyond ten times VaR. If they do they should be hedged or insured. variance-covariance VaR or delta-gamma VaR) or nonparametrically (for examples. The triggering event was the stock market crash of 1987. investment management and derivative pricing.[4] In risk measurement. however. So an institution that can't deal with three times VaR losses as routine events probably won't survive long enough to put a VaR system in place. and
. and many financial businesses mark-to-market daily. 3. so risk/return calculations are useless. it is natural to define firm-wide risk using the distribution of possible losses at a fixed point in the future. VaR is the border. you can't know much about them and it results in needless worrying. The inverse usage makes more logical sense. Institutions should be confident they have examined all the foreseeable events that will cause losses in this range.[1] The crash was so unlikely given standard statistical models. This was the first major financial crisis in which a lot of academically-trained quants were in high enough positions to worry about firm-wide survival. It's hard to plan for these events. historical simulation VaR or resampled VaR)."[15]
190
VaR risk measurement
The VaR risk measure is a popular way to aggregate risk across an institution. including ones that were usually not correlated. expected shortfall and “greeks” (partial derivatives of portfolio value with respect to market factors). But VaR did not emerge as a distinct concept until the late 1980s. or the business plan should be changed to avoid them. Financial risk management has been a concern of regulators and financial executives for a long time as well. It's hard to run a business if foreseeable losses are orders of magnitude larger than very large everyday losses. economics and finance. that it called the entire basis of quant finance into question.Value at risk abnormal and trading may exacerbate losses. that overwhelmed the statistical assumptions embedded in models used for trading. because risk management VaR is fundamentally nonparametric. loss of employee morale and market confidence and impairment of brand names. or VaR should be increased. Individual business units have risk measures such as duration for a fixed income portfolio or beta for an equity business. that is it does not depend on assumptions about the probability distribution of future gains and losses. 2. VaR is a distribution-free metric.

and concepts similar to VaR are used in other parts of the accord. or severely illiquid. in at least some markets. The extent to which has proven to be true is controversial.[15] Losses can also be hard to define if the risk-bearing institution fails or breaks up. in non-obvious ways. which makes it true only for parametric VaR.[1] This point has probably caused more contention among VaR theorists than any other. Development was most extensive at J.[18] Much later. If these events were excluded. Since many trading desks already computed risk management VaR.[9] In 1997. which are studied quantitatively using short-term data in specific markets. It was hoped that "Black Swans" would be preceded by increases in estimated VaR or increased frequency of VaR breaks.[16] A measure that depends on traders taking certain actions. There was no effort to aggregate VaRs across trading desks. It was well-established in quantative trading groups at several financial institutions. Major banks and dealers chose to implement the rule by including VaR information in the notes to their financial statements. VaR is the preferred measure of market risk.S. "charlatanism. for example.[9]
. and it was the only common risk measure that could be both defined for all businesses and aggregated without strong assumptions.[1] Worldwide adoption of the Basel II Accord.[18] Abnormal markets and trading were excluded from the VaR estimate in order to make it observable. albeit usually one with fat tails. Two years later. which published the methodology and gave free access to estimates of the necessary underlying parameters in 1994. available within 15 minutes of the market close.[16] It is not always possible to define loss if.[21] If these events were included in quantitative analysis they dominated results and led to strategies that did not work day to day. Risk managers typically assume that some fraction of the bad events will have undefined losses. beginning in 1999 and nearing completion today. Institutions could fail as a result. This was the first time VaR had been exposed beyond a relatively small group of quants. The right equality assumes an underlying probability distribution. the U.[1]
191
Mathematics
"Given some confidence level the VaR of the portfolio at the confidence level is given by the
[3]
smallest number such that the probability that the loss exceeds is not larger than " The left equality is a definition of VaR. gave further impetus to the use of VaR. or because the entity bearing the loss breaks apart or loses the ability to compute accounts. J. P. from everyday price movements. Therefore. notably Bankers Trust. either because markets are closed or illiquid.[18] The financial events of the early 1990s found many firms in trouble because the same underlying bet had been made at many places in the firm. it was the natural choice for reporting firmwide risk.[1] This is risk management VaR."[23] On the other hand. as happened several times in 2008. many academics prefer to assume a well-defined distribution.[9] Risk measurement VaR was developed for this purpose. and avoiding other actions. they do not accept results based on the assumption of a well-defined probability distribution. although neither the name nor the definition had been standardized. they were named "Black Swans" by Nassim Taleb and the concept extended far beyond finance. markets are closed as after 9/11.[15] [18] [21] VaR was developed as a systematic way to segregate extreme events. which are studied qualitatively over long-term history and broad market events. P.Value at risk seldom had discernible economic cause or warning (although after-the-fact explanations were plentiful). can lead to self reference. Securities and Exchange Commission ruled that public corporations must disclose quantitative information about their derivatives activity.[6] Nassim Taleb has labeled this assumption. Morgan CEO Dennis Weatherstone famously called for a “4:15 report” that combined all firm risk on one page. Morgan. before 1990. the methodology was spun off into an independent for-profit business now part of RiskMetrics Group [22]. the profits made in between "Black Swans" could be much smaller than the losses suffered in the crisis.

it should insure against it and take advice from insurers on precautions. and dangerous when misunderstood. After interviewing risk managers (including several of the ones cited above) the article suggests that VaR was very useful to risk experts. A common complaint among academics is that VaR is not subadditive.[4] That means the VaR of a combined portfolio can be larger than the sum of the VaRs of its components.” He further charged that VaR: 1. so it is in the range where the institution should not worry about it. To a practicing risk manager this makes sense. A famous 1997 debate [13] between Nassim Taleb and Philippe Jorion set out some of the major points of contention. 4. of VaR. Losses are part of the daily VaR calculation. to be treated statistically. It would not even be within an order of magnitude of that. and start preparing
. 2.Value at risk
192
Criticism
VaR has been controversial since it moved from trading desks into the public eye in 1994. 4. to be insured. and tracked statistically rather than case-by-case. It is far more important to worry about what happens when losses exceed VaR. robberies are a routine daily occurrence. VaR is the level of losses at which you stop trying to guess what will happen next. Taleb claimed VaR:[24] 1. As institutions get more branches. and sometimes impossible to define. The whole point of insurance is to aggregate risks that are beyond individual VaR limits. to be analyzed case-by-case.[15] Even VaR supporters generally agree there are common abuses of VaR:[6] [9] 1. At that point it makes sense for the institution to run internal stress tests and analyze the risk itself. Making VaR control or VaR reduction the central concern of risk management. Ignored 2. and bring them into a large enough portfolio to get statistical predictability. 3. Assuming plausible losses will be less than some multiple. to near outside VaR. A powerful tool for professional risk managers. except when you have a car accident. you expect two or three losses per year that exceed one-day 1% VaR.500 years of experience in favor of untested models built by non-traders Was charlatanism because it claimed to estimate the risks of rare events. VaR is portrayed as both easy to misunderstand. The entire point of VaR is that losses can be extremely large. In fact. which is impossible Gave false confidence Would be exploited by traders
More recently David Einhorn and Aaron Brown debated VaR in Global Association of Risk Professionals Review [25][15] [26] Einhorn compared VaR to “an airbag that works all the time. As portfolios or institutions get larger. 3. often three. For a very large banking institution. For example.004% chance of being robbed on a specific day. the risk of a robbery on a specific day rises to within an order of magnitude of VaR. A sizable in-house security department is in charge of prevention and control. Referring to VaR as a "worst-case" or "maximum tolerable" loss. 2. to inside VaR. That means they move from the range of far outside VaR. To a risk manager. 3. specific risks change from low-probability/low-predictability/high-impact to statistically predictable losses of low individual impact. A single-branch bank has about 0. 2. Led to excessive risk-taking and leverage at financial institutions Focused on the manageable risks near the center of the distribution and ignored the tails Created an incentive to take “excessive but remote risks” Was “potentially catastrophic when its use creates a false sense of security among senior executives and watchdogs. once you get beyond the VaR point. the general risk manager just tracks the loss like any other cost of doing business. the average bank branch in the United States is robbed about once every ten years. 2009 discussing the role VaR played in the Financial crisis of 2007-2008. It does not pay for a one-branch bank to have a security expert on staff.”
New York Times reporter Joe Nocera wrote an extensive piece Risk Mismanagement [27][28] on January 4. so the risk of robbery would not figure into one-day 1% VaR. It will spend less on insurance and more on in-house expertise. but nevertheless exacerbated the crisis by giving false security to bank executives and regulators.

Ron Dembo. John Wiley & Sons (2002). Derivatives Strategy. nytimes. April 1997. McGraw-Hill (2006).com/blogs/satyajitdas/ enclosures/perfectstorms(may2007)1. [7] Michel Crouhy. Quantitative Risk Management: Concepts Techniques and Tools. [15] Aaron Brown. Academic Press (2003). Value at Risk: The New Benchmark for Managing Financial Risk. University of Alabama
. ISBN 978-0470319581 [12] Best Practices in Governance. [22] http:/ / www. Nassim Taleb. Regardless of how VaR is computed.org/). ISBN 978-0470013229 [17] Ezra Zask. asp [14] Philippe Jorion in Nassim Taleb and Philippe Jorion. Regulatory Evaluation of Value-at-Risk Models. Roundtable: The Limits of VaR. Taking the Stress Out of Stress Testing. John Wiley & Sons (2005) ISBN 978-0470013038. Rüdiger Frey and Paul Embrechts. Dan Mudge. GARP Risk Review (June/July 2008). [25] http:/ / www. [3] Alexander McNeil.nytimes. Satyajit Das • “Gloria Mundi” – All About Value at Risk (http://www. Blu Putnam. GARP Risk Review.pdf). George Holt. April 1997. McGraw-Hill (2001) ISBN 978-0071429665 [8] Jose A. The Next Ten VaR Disasters. The Jorion/Taleb Debate.html?dlbk=&pagewanted=all). com/ [23] Nassim Taleb. Dan Mudge. The New York Times Magazine (January 4. December 2007. February 1999. com/ 2009/ 01/ 04/ magazine/ 04risk-t. The Unbearable Lightness of Cross-Market Risk. html?pagewanted=1& _r=1 [28] Joe Nocera. The Essentials of Risk Management. Derivatives Strategy. The Jorion/Taleb Debate. [18] Joe Kolman. Wiley (2007).wilmott.
193
References
[1] Philippe Jorion. A common specific violation of this is to report a VaR based on the unverified assumption that everything follows a multivariate normal distribution. April 1998. 2009)
External links
Discussion • “Perfect Storms” – Beautiful & True Lies In Risk Management (http://www. March 2004. September 1996. org/ download/ GRR/ 2012. Emanuel Derman. Lawrence York.cba. Derivatives Strategy. derivativesstrategy. Private Profits and Socialized Risk. Philippe Jorion. Springer (2004). Richard Tanenbaum. Philippe Jorion. Stan Jonas. Paul Wilmott Introduces Quantitative Finance. Derivative Strategy. Measuring Market Risk.php). Ron Dembo. Nassim Nicholas (2007). The World According to Nassim Taleb. Value-at-Risk: Theory and Practice. Princeton University Press (2005). March 1997. [9] Joe Kolman. Reporting a VaR that has not passed a backtest.Value at risk for anything.gloriamundi. George Holt. ISBN 978-0471405566. ISBN 978-1-4000-6351-2. Richard Sandor. [21] Taleb. Dan Galai and Robert Mark. Michael Onak. April 1998. William Margrabe. Risk Budgeting: Portfolio Problem Solving with Value-at-Risk. On Stressing the Right Size. riskmetrics. [20] Paul Glasserman. [16] Espen Haug. in David Einhorn and Aaron Brown. ISBN 978-0123540102.edu/~rpascala/VaR/VaRForm. Derivatives Strategy. Roundtable: The Limits of Models. Wharton Financial Institutions Center Working Paper 96-51. Nassim Taleb. GARP Risk Review (June/July 2008).com/2009/01/04/magazine/04risk-t. Richard Sandor. 3rd ed. Wilmott Magazine. Derivatives Strategy. Risk Mismanagement. garpdigitallibrary. Stan Jonas. December 1996/January 1997. The Black Swan: The Impact of the Highly Improbable. Joe Nocera NYTimes article. com/ magazine/ archive/ 1997/ 0497fea2.ua. Lopez. 2009 [13] http:/ / www. Derivatives Strategy. Richard Tanenbaum. [19] Aaron Brown. ISBN 978-0071464956 [2] Glyn Holton. John Wiley & Sons (2007). it should have produced the correct number of breaks (within sampling error) in the past. Barry Schachter • Risk Management (http://www. Monte Carlo Methods in Financial Engineering. Emanuel Derman. ISBN 978-0691122557 [4] Kevin Dowd. [6] Aaron Brown. Derivative Models on Models. Private Profits and Socialized Risk. [10] Aaron Brown. [5] Neil Pearson. James Lam and Jim Rozsypal. [27] http:/ / www. Razvan Pascalau. William Margrabe. Blu Putnam. Tools • Online real-time VaR calculator (http://www. [11] Paul Wilmott. pdf [26] David Einhorn in David Einhorn and Aaron Brown. [24] Nassim Taleb in Philippe Jorion in Nassim Taleb and Philippe Jorion. Michael Onak. ISBN 978-0387004518. James Lam and Jim Rozsypal. 4. New York: Random House.

volatility is often viewed as a negative in that it represents uncertainty and risk. volatility is often desirable. and long on the lows of a security. For example. and it may either be an absolute number ($5) or a fraction of the mean (5%). (Mathematica in Education and Research Vol.
. so the most likely deviation after twice the time will not be twice the distance from zero. the volatility increases with the square-root of time as time increases. 7 No. This is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases. 4 1998. or Wiener process.[1] These can capture attributes such as "fat tails". Simon Benninga and Zvi Wiener. the width of the distribution increases as time increases. it is also possible to trade volatility directly. In today's markets. through the use of derivative securities such as options and variance swaps. However. However. Volatility is normally expressed in annualized terms. This phrase is used particularly when it is wished to distinguish between the actual current volatility of an instrument and • actual historical volatility which refers to the volatility of a financial instrument over a specified period but with the last observation on a date in the past • actual future volatility which refers to the volatility of a financial instrument over a specified period starting at the current time and ending at a future date (normally the expiry date of an option) • historical implied volatility which refers to the implied volatility observed from historical prices of the financial instrument (normally options) • current implied volatility which refers to the implied volatility observed from current prices of the financial instrument • future implied volatility which refers to the implied volatility observed from future prices of the financial instrument For a financial instrument whose price follows a Gaussian random walk.
Volatility terminology
Volatility as described here refers to the actual current volatility of a financial instrument for a specified period (for example 30 days or 90 days). See Volatility arbitrage.pdf). volatility most frequently refers to the standard deviation of the continuously compounded returns of a financial instrument within a specific time horizon.upenn. rather than increase linearly. the profit will be greatest when volatility is highest. It is used to quantify the risk of the financial instrument over the specified time period. Since observed price changes do not follow Gaussian distributions.wharton. others such as the Lévy distribution are often used. if an investor is short on the peaks. It is the volatility of a financial instrument based on historical prices over the specified period with the last observation the most recent price. because some fluctuations are expected to cancel each other out.
Volatility for market players
When investing directly in a security.Value at risk • Value-at-Risk (VaR) (http://finance. with other investing strategies.edu/~benninga/mma/MiER74.)
194
Volatility (finance)
In finance.

and amongst the models are Bruno Dupire's Local Volatility. These estimates assume a normal distribution. Two instruments with different volatilities may have the same expected return. and the increasingly popular Heston model of Stochastic Volatility.Volatility (finance)
195
Volatility versus direction
Volatility does not measure the direction of price changes. extreme movements do not appear 'out of nowhere'. so that negative and positive differences are combined into one quantity. if σSD = 0. if the daily logarithmic returns of a stock have a standard deviation of σSD and the time period of returns is P. a time when prices rise quickly (a bubble) may often be followed by prices going up even more. but the instrument with higher volatility will have larger swings in values over a given period of time. Volatility is a poor measure of risk. Of course. "it is only a good measure of risk if you feel that being rich then being poor is the same as being poor then rich". For example.. or going up by an unusual amount. while during other times they might not seem to move at all. all differences are squared. That is. Most typically.
Mathematical definition
The annualized volatility σ is the standard deviation of the instrument's yearly logarithmic returns. or 95%). Then. The generalized volatility σT for time horizon T in years is expressed as: Therefore. or going down by an unusual amount. would indicate returns from approximately -33% to 47% most of the time (19 times out of 20. And an increase in volatility does not always presage a further increase—the volatility may simply go back down again.e. none of these are observed in real markets. whether such large movements have the same direction. merely their dispersion. 'doldrums' can last for a long time as well. T = 1/12 of a year) would be
. during some periods prices go up and down quickly. as explained by Peter Carr. is more difficult to say.[2] It's common knowledge that types of assets experience periods of high and low volatility. or the opposite. the annualized volatility is
A common assumption is that P = 1/252 (there are 252 trading days in any given year). This is because when calculating standard deviation (or variance). This would indicate returns from approximately -3% to 17% most of the time (19 times out of 20. This is termed autoregressive conditional heteroskedasticity. with annual volatility of 5%. Also. or 95%).
Volatility over time
Although the Black Scholes equation assumes predictable constant volatility. in reality stocks are found to be leptokurtotic. a lower volatility stock may have an expected (average) return of 7%. A higher volatility stock. Poisson Process where volatility jumps to new levels with a predictable frequency. with the same expected return of 7% but with annual volatility of 20%. they're presaged by larger movements than usual. Periods when prices fall quickly (a crash) are often followed by prices going down even more.01 the annualized volatility is
The monthly volatility (i. The converse behavior.

not accepted by mainstream financial econometricians. where k is an empirical factor (typically five to ten).
Crude volatility estimation
Using a simplification of the formulas above it is possible to estimate annualized volatility based solely on approximate observations. This would constitute a 1% daily movement.
. the average magnitude of the observations is merely an approximation of the standard deviation of the market index. Of course.798σ. but some people believe α < 2 for financial activities such as stocks. Some people use the formula:
for a rough estimate. the expected value of the magnitude of the observations is √(2/π)σ = 0. 19 April 1997. However. the precise relationship between volatility measures for different time periods is more complicated. however. Some use the Lévy stability exponent α to extrapolate natural processes:
196
If α = 2 you get the Wiener process scaling relation. Assuming that the market index daily changes are normally distributed with mean zero and standard deviation σ.) Mandelbrot's conclusion is. for natural stochastic processes. most financial assets have negative skewness and leptokurtosis. up or down. that is. so this formula tends to be over-optimistic. more generally. on average. This also uses the fact that the standard deviation of the sum of n independent variables (with equal standard deviations) is √n times the standard deviation of the individual variables. These formulas are accurate extrapolations of a random walk. who looked at cotton prices and found that they followed a Lévy alpha-stable distribution with α = 1. has moved about 100 points a day. The net effect is that this crude approach overestimates the true volatility by about 25%. The rationale for this is that 16 is the square root of 256.Volatility (finance) The formula used above to convert returns or volatility measures from one time period to another assume a particular underlying model or process. (See New Scientist. Suppose you notice that a market price index. multiply by 16 to get 16% as the annual volatility. for many days. indexes and so on. To annualize this. which has a current value near 10. or Wiener process.7.
Estimate of compound annual growth rate (CAGR)
Consider the Taylor series:
Taking only the first two terms one has:
Realistically. which is approximately the number of trading days in a year (252).000. you can use the "rule of 16". whose steps have finite variance. This was discovered by Benoît Mandelbrot.

Volatility (finance)

197

See also

• • • • • • • • • • Beta (finance) Derivative (finance) Financial economics Implied volatility IVX Risk Standard deviation Stochastic volatility Volatility arbitrage Volatility smile

References

[1] http:/ / www. wilmottwiki. com/ wiki/ index. php/ Levy_distribution [2] http:/ / www. wilmottwiki. com/ wiki/ index. php/ Volatility#Definitions

• Lin Chen (1996). Stochastic Mean and Stochastic Volatility – A Three-Factor Model of the Term Structure of Interest Rates and Its Application to the Pricing of Interest Rate Derivatives. Blackwell Publishers.

External links

• Complex Options (http://www.optionistics.com/f/strategy_calculator) Multi-Leg Option Strategy Calculator • An introduction to volatility and how it can be calculated in excel, by Dr A. A. Kotzé (http://quantonline.co.za/ Articles/article_volatility.htm) • Interactive Java Applet " What is Historic Volatility? (http://www.frog-numerics.com/ifs/ifs_LevelA/ HistVolaBasic.html)" • Diebold, Francis X.; Hickman, Andrew; Inoue, Atsushi & Schuermannm, Til (1996) "Converting 1-Day Volatility to h-Day Volatility: Scaling by sqrt(h) is Worse than You Think" (http://citeseer.ist.psu.edu/244698. html) • A short introduction to alternative mathematical concepts of volatility (http://staff.science.uva.nl/~marvisse/ volatility.html)

Autoregressive conditional heteroskedasticity

198

**Autoregressive conditional heteroskedasticity
**

In econometrics, AutoRegressive Conditional Heteroskedasticity (ARCH) models are used to characterize and model observed time series. They are used whenever there's reason to believe that, at any point in a series, the terms will have a characteristic size, or variance. In particular ARCH models assume the variance of the current error term or innovation to be a function of the actual sizes of the previous time periods' error terms: often the variance is related to the squares of the previous innovations. Such models are often called ARCH models (Engle, 1982), although a variety of other acronyms is applied to particular structures of model which have a similar basis. ARCH models are employed commonly in modeling financial time series that exhibit time-varying volatility clustering, i.e. periods of swings followed by periods of relative calm.

**ARCH(q) model Specification
**

Suppose one wishes to model a time series with an ARCH process. Let denote the error terms (return residuals, w.r.t. a mean process) i.e. the series terms. These are split into a stochastic piece and a time-dependent standard deviation characterizing the typical size of the terms so that

where (i.e.

is a random variable drawn from a Gaussian distribution centered at 0 with standard deviation equal to 1. and where the series are modeled by

and where

and

.

An ARCH(q) model can be estimated using ordinary least squares. A methodology to test for the lag length of ARCH errors using the Lagrange multiplier test was proposed by Engle (1982). This procedure is as follows: 1. Estimate the best fitting AR(q) model 2. Obtain the squares of the error and regress them on a constant and q lagged values: .

where q is the length of ARCH lags. 3. The null hypothesis is that, in the absence of ARCH components, we have for all . The alternative hypothesis is that, in the presence of ARCH components, at least one of the estimated coefficients must be significant. In a sample of T residuals under the null hypothesis of no ARCH errors, the test statistic TR² follows distribution with q degrees of freedom. If TR² is greater than the Chi-square table value, we reject the null hypothesis and conclude there is an ARCH effect in the ARMA model. If TR² is smaller than the Chi-square table value, we do not reject the null hypothesis.

Autoregressive conditional heteroskedasticity

199

GARCH

If an autoregressive moving average model (ARMA model) is assumed for the error variance, the model is a generalized autoregressive conditional heteroskedasticity (GARCH, Bollerslev(1986)) model. In that case, the GARCH(p, q) model (where p is the order of the GARCH terms terms ) is given by and q is the order of the ARCH

Generally, when testing for heteroskedasticity in econometric models, the best test is the White test. However, when dealing with time series data, this means to test for ARCH errors (as described above) and GARCH errors (below). Prior to GARCH there was EWMA which has now been superseded by GARCH, although some people utilise both.

**GARCH(p, q) model specification
**

The lag length p of a GARCH(p, q) process is established in three steps: 1. Estimate the best fitting AR(q) model . 2. Compute and plot the autocorrelations of by

3. The asymptotic, that is for large samples, standard deviation of

is

. Individual values that are larger

than this indicate GARCH errors. To estimate the total number of lags, use the Ljung-Box test until the value of the these are less than, say, 10% significant. The Ljung-Box Q-statistic follows distribution with n degrees of freedom if the squared residuals are uncorrelated. It is recommended to consider up to T/4 values of n. The

null hypothesis states that there are no ARCH or GARCH errors. Rejecting the null thus means that there are existing such errors in the conditional variance.

**Nonlinear GARCH (NGARCH)
**

Nonlinear GARCH (NGARCH) also known as Nonlinear Asymmetric GARCH(1,1) (NAGARCH) was introduced by Engle and Ng in 1993. . For stock returns, parameter magnitude.[1] [2] This model shouldn't be confused with the NARCH model, together with the NGARCH extension, introduced by Higgins and Bera in 1992. is usually estimated to be positive; in this case, it reflects the leverage effect, signifying that negative returns increase future volatility by a larger amount than positive returns of the same

Autoregressive conditional heteroskedasticity

200

IGARCH

Integrated Generalized Autoregressive Conditional Heteroskedasticity IGARCH is a restricted version of the GARCH model, where the persistent parameters sum up to one, and therefore there is a unit root in the GARCH process. The condition for this is .

EGARCH

The exponential general autoregressive conditional heteroskedastic (EGARCH) model by Nelson (1991) is another form of the GARCH model. Formally, an EGARCH(p,q):

where coefficients, and formulation for

,

is the conditional variance,

,

,

,

and

are

may be a standard normal variable or come from a generalized error distribution. The allows the sign and the magnitude of

[3]

to have separate effects on the volatility. This is

particularly useful in an asset pricing context. Since may be negative there are no (fewer) restrictions on the parameters.

GARCH-M

The GARCH-in-mean (GARCH-M) model adds a heteroskedasticity term into the mean equation. It has the specification:

The residual

is defined as

QGARCH

The Quadratic GARCH (QGARCH) model by Sentana (1995) is used to model asymmetric effects of positive and negative shocks. In the example of a GARCH(1,1) model, the residual process is

where

is i.i.d. and

Autoregressive conditional heteroskedasticity

201

GJR-GARCH

Similar to QGARCH, The Glosten-Jagannathan-Runkle GARCH (GJR-GARCH) model by Glosten, Jagannathan and Runkle (1993) also models asymmetry in the GARCH process. The suggestion is to model where is i.i.d., and

where

if

, and

if

.

TGARCH model

The Threshold GARCH (TGARCH) model by Zakoian (1994) is similar to GJR GARCH, and the specification is one on conditional standard deviation instead of conditional variance:

where if

if .

, and

if

. Likewise,

if

, and

fGARCH

Hentschel's fGARCH model[4] , also known as Family GARCH, is an omnibus model that nests a variety of other popular symmetric and asymmetric GARCH models including APARCH, GJR, AVGARCH, NGARCH, etc.

References

[1] Engle, R.F.; Ng, V.K.. "Measuring and testing the impact of news on volatility" (http:/ / papers. ssrn. com/ sol3/ papers. cfm?abstract_id=262096). Journal of Finance 48 (5): 1749–1778. . [2] Posedel, Petra (2006). "Analysis Of The Exchange Rate And Pricing Foreign Currency Options On The Croatian Market: The Ngarch Model As An Alternative To The Black Scholes Model" (http:/ / www. ijf. hr/ eng/ FTP/ 2006/ 4/ posedel. pdf). Financial Theory and Practice 30 (4): 347–368. . [3] St. Pierre, Eilleen F (1998): Estimating EGARCH-M Models: Science or Art, The Quarterly Review of Economics and Finance, Vol. 38, No. 2, pp. 167-180 (http:/ / dx. doi. org/ 10. 1016/ S1062-9769(99)80110-0) [4] Hentschel, Ludger (1995). All in the family Nesting symmetric and asymmetric GARCH models (http:/ / www. personal. anderson. ucla. edu/ rossen. valkanov/ hentschel_1995. pdf), Journal of Financial Economics, Volume 39, Issue 1, Pages 71-104

• Tim Bollerslev. "Generalized Autoregressive Conditional Heteroskedasticity", Journal of Econometrics, 31:307-327, 1986. • Enders, W., Applied Econometrics Time Series, John-Wiley & Sons, 139-149, 1995 • Robert F. Engle. "Autoregressive Conditional Heteroscedasticity with Estimates of Variance of United Kingdom Inflation", Econometrica 50:987-1008, 1982. (the paper which sparked the general interest in ARCH models) • Robert F. Engle. "GARCH 101: The Use of ARCH/GARCH Models in Applied Econometrics", Journal of Economic Perspectives 15(4):157-168, 2001. (a short, readable introduction) (http://pages.stern.nyu.edu/ ~rengle/Garch101.doc) • Engle, R.F. (1995) ARCH: selected readings. Oxford University Press. ISBN 0-19-877432-X • Gujarati, D. N., Basic Econometrics, 856-862, 2003 • Nelson, D. B. (1991). Conditional heteroskedasticity in asset returns: A new approach, Econometrica 59: 347-370. • Bollerslev, Tim (2008). Glossary to ARCH (GARCH) (ftp://ftp.econ.au.dk/creates/rp/08/rp08_49.pdf), working paper • Hacker, R. S. and Hatemi-J, A. (2005). A Test for Multivariate ARCH Effects (http://ideas.repec.org/a/taf/ apeclt/v12y2005i7p411-417.html), Applied Economics Letters, Vol. 12(7), pp. 411-417.

Brownian Model of Financial Markets

202

**Brownian Model of Financial Markets
**

The Brownian motion models for financial markets are based on the work of Robert C. Merton and Paul A. Samuelson, as extensions to the one-period market models of Harold Markowitz and William Sharpe, and are concerned with defining the concepts of financial assets and markets, portfolios, gains and wealth in terms of continuous-time stochastic processes. Under this model, these assets have continuous prices evolving continuously in time and are driven by Brownian motion processes. This model requires an assumption of perfectly divisible assets and that no transaction costs occur either for buying or selling (i.e. a frictionless market). Another assumption is that asset prices have no jumps, that is there are no surprises in the market.

**Financial market processes
**

Consider a financial market consisting of money-market, is risk free while the remaining financial assets, where one of these assets, called a bond or assets, called stocks, are risky.

Definition

A financial market is defined as 1. A probability space 2. A time interval 3. A -dimensional Brownian process filtration 4. A measurable risk-free money market rate process 5. A measurable mean rate of return process 6. A measurable dividend rate of return process 7. A measurable volatility process such that . . . :

adapted to the augmented

8. A measurable, finite variation, singularly continuous stochastic 9. The initial conditions given by

**The augmented filtration
**

Let be a probability space, and a be D-dimensional Brownian motion stochastic process, with the natural filtration:

If

are the measure 0 (i.e. null under measure

) subsets of

, then define the augmented filtration:

The difference between left-continuous, in the sense that:

and

is that the latter is both

and right-continuous, such that:

while the former is only left-continuous [1] .

Let processes satisfying: Here. which is random. it can be easily seen that if time-dependendent and
is absolutely continuous (i. by Lebesgue's decomposition
resulting in the SDE:
which gives:
Thus. gives the volatility of the -th stock. and has finite variation. the mean rate of return of a stock is higher than that of a bond. adapted. is continuous. almost surely. In order for an arbitrage-free pricing scenario.
. Accounting for this in the model.e. it can be decomposted into and a singularly continuous part . while is its mean rate of return. Define: and at time with . and
. almost surely. gives the yield process
Portfolio and gain processes
Definition
Consider a financial market A portfolio process for this market is an . Because it has finite variation.
like the value of a risk-free savings account with instantaneous interest rate measurable. which are continuous stochastic
Dividend rate
Each stock may have an associated dividend rate process the stock at time giving the rate of divident payment per unit price of : . then the price of the bond evolves . valued process such that:
. and the discounted stock prices are: Note that the contribution due to the discontinuites in the bond price does not appear in this equation. As a premium for the risk originating from these random fluctuations. except with a randomly fluctuating component (called its volatility).
).
Stocks
Stock prices are modeled as being similar to that of bonds. The solution to this is: be the strictly positive prices per share of the stocks. must be as defined above.Brownian Model of Financial Markets
203
Bond
A share of a bond (money market) has price an absolutely continuous part theorem. measurable.

To avoid the case measurable. not
.
received in return for investing in the
Motivation
Consider time intervals . while The term is referred to as the portfolio process. let the time partition go to zero. The portfolio is said to be
-financed if:
The corresponding SDE for the wealth process. it is required that is Therefore. and substitute for
corresponding SDE for the gains process. is determined from and
implies borrowing money from the
implies taking a short position on the stock. Here the number of shares held. Note. in the SDE of is the risk premium process. almost surely. Also. through appropriate substitutions. as defined earlier.Brownian Model of Financial Markets
204
. held in a portfolio during time interval at time of insider trading (i. to get the at time . . the value of can be determined from . the incremental gains at each trading interval from such a portfolio is:
and Define
is the total gain over time
. foreknowledge of the future). while the total value of the portfolio is
. and it is the compensation -th stock.
denotes the dollar amount invested in asset
Income and wealth processes
Definition
Given a financial market . the appropriate value of therefore sometimes money-market. becomes: . A wealth process is then defined as: . that again in this case. It turns out that for a self-financed portfolio.
. The gains process for this porfolio is: We say that the porfolio is self-financed if: .e. and let be the number of shares of asset . due to sources other than the investments in the
and represents the total wealth of an investor at time
. then a cumulative income process is a semimartingale and assets represents the income accumulated over time of the financial market.

Definition
In a financial market associated gains process . there exists a adapted process such that for almost every
Conversely. Also. ). if ) and pays no dividend (i. a self-financed portfolio process . and:
. then the market is viable. a viable market the can have only one money-market (bond) and hence only one risk-free rate.e. it implies the possibility of making an arbitrarily large risk-free profit.
of return is equal to the money market rate (i. i.e. ).
Standard financial market
Definition
A financial market (i) It is viable (ii) The number of stocks is not greater than the dimension satisfies: of the underlying Brownian motion process is said to be standard if:
(iii) The market price of risk process
. Therefore.Brownian Model of Financial Markets
205
Viable markets
The standard theory of mathematical finance is restricted to viable financial markets.
Implications
In a viable market : . This is called the market price of risk and relates the premium for the -the stock with its volatility . almost surely
(iv)
The
positive
process
is
a
martingale
.e. . If such opportunities exists. those in which there are no opportunities for arbitrage. A market in which no
such portfolio exists is said to be viable. almost surely and is said to be an arbitrage opportunity if the strictly.e.e. if there exists a D-dimensional process
such that it satifies the above requirement. then its rate ) and its price tracks that of the bond (i. -th stock entails no risk (i.

from linear algebra. . i.
Corollary
A standard financial market non-singular for almost every is complete if and only if . such that its associated wealth process
Motivation
If a particular investment strategy calls for a payment at time . with respect to the Lebesgue measure. they are equivalent. if there is an satisfies -financed portfolio be an -measurable random variable. in a complete market it is possible to set aside less capital (viz. The market process is said to be complete if every such .
Note that
and
are absolutely continuous with respect to each other. i. it has grown to match the size of .Brownian Model of Financial Markets
206
Comments
In case the number of stocks can be seen that there are combination of the volatilities of replaced by The standard martingale measure is greater than the dimension .e. and the volalatily process is . according to
Girsanov's theorem. and . the amount of which is unknown at time in order to cover the ) and invest it so that at time . is a -dimensional Brownian motion process on the filtration with respect to . in violation of point (ii). . the stocks $n$ whose wolatilies (given by the vector other stocks (because the rank of on
equivalent mutual funds. such that:
. almost surely. then a conservative strategy would be to set aside an amount payment.e. Also.
Definition
Let be a standard financial market. it ) are linear stocks can be is ). for the standard market.
Complete financial markets
A complete financial market is one that allows effective hedging of the risk inherent in any investment strategy.
. Therefore. is defined as: . is financeable. However.

Retrieved 2009-05-29.
The law of one price
The same asset must trade at the same price on all markets ("the law of one price"). ISBN 0387976558.
Rational pricing
Rational pricing is the assumption in financial economics that asset prices (and hence asset pricing models) will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". Ralf. New York: Springer-Verlag. uwaterloo. The Review of Economics and Statistics 51 (3): 247–257. Methods of mathematical finance. (1991). pay the seller on the cheaper market with the proceeds and pocket the difference. Steven E. storage costs.ca/~mboudalh/Merton1971. Where this is not true. R. Where this mismatch can be exploited (i. buy the asset on the market where it has the lower price. Providence.: American Mathematical Society. and is fundamental to the pricing of derivative instruments. R. and sets the price of assets with known future cash flows. arbitrage also equalises the prices of assets with identical cash flows. Ioannis.Brownian Model of Financial Markets
207
Notes
[1] Karatzas. Merton. math. In general. Option pricing and portfolio optimization: modern methods of financial mathematics. Shreve.
Arbitrage mechanics
Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets. Korn. the arbitrageur will: 1.) the arbitrageur "locks in" a risk free profit without investing any of his own money. org/ stable/ 1926560). (1998). dividends etc. transport costs. ISBN 0821821237. doi:10. C. particularly bonds. (1 August 1969). Ioannis. Journal of Economic Theory 3. arbitrage ensures that "the law of one price" will hold. New York: Springer.I. R. Merton. Elke (2001).pdf) (w). ISSN 00346535. This assumption is useful in pricing fixed income securities. ISBN 0387948392.
. after transaction costs.
See also
• Mathematical finance • Monte Carlo method • Martingale (probability theory)
References
Karatzas. Korn.C. Brownian motion and stochastic calculus. Shreve.2307/1926560.e. deliver the asset to the buyer and receive that higher price 3. "Optimum consumption and portfolio rules in a continuous-time model" (http:/ / www. (1970). and simultaneously sell it (short) on the second market at the higher price 2. "Lifetime Portfolio Selection under Uncertainty: the Continuous-Time Case" (http:/ / jstor. Steven E.

the price of the bond must today equal the sum of each of its cash flows discounted at the same rate as each ZCB. He then repays the lender the borrowed amount plus interest. from the same issuer as the bond being valued) with the corresponding maturity. see Bond valuation: Arbitrage-free pricing approach The pricing formula is as below.
An asset with a known future-price
An asset with a known price in the future. 4. Given that the cash flows can be replicated. each cash flow can be matched by trading in (a) some multiple of a zero-coupon bond corresponding to the coupon date. leading to backwardation. as above.e. (a) where the discounted future price is higher than today's price: 1.
. 2. There may be few such parties if short-term demand exceeds supply. Note that this condition can be viewed as an application of the above.Rational pricing
208
Assets with identical cash flows
Two assets with identical cash flows must trade at the same price. fund his purchase of the cheaper asset with the proceeds from the sale of the expensive asset and pocket the difference 3. It will be noted that (b) is only possible for those holding the asset but not needing it until the future date. where the two assets in question are the asset to be delivered and the risk free asset. Were this not the case. as prices are more
. the arbitrageur hands over the underlying. deliver on his obligations to the buyer of the expensive asset. sells forward) and simultaneously buys it today with borrowed money. buys forward) and simultaneously sells (short) the underlying today. 2. 3. Here. must today trade at that price discounted at the risk free rate. He then takes delivery of the underlying and pays the agreed price using the matured investment. See also Fixed income arbitrage. which has appreciated at the risk free rate. where each cash flow Price = is discounted at the rate that matches the coupon date:
Often. he invests the proceeds. using prices instead of rates. the arbitrageur will: 1. The difference between the maturity value and the agreed price is the arbitrage profit. and of equivalent credit worthiness (if possible. The difference between the agreed price and the amount owed is the arbitrage profit. On the delivery date. and receives the agreed price. The arbitrageur agrees to deliver the asset on the future date (i.
Fixed income securities
Rational pricing is one approach used in pricing fixed rate bonds. or (b) in a corresponding strip and ZCB. The arbitrageur agrees to pay for the asset on the future date (i. Where this is not true. (b) where the discounted future price is lower than today's price: 1. On the delivery date. 4. using the cash flows from the cheaper asset.e. he cashes in the matured investment. the formula is expressed as readily available. 3. sell the asset with the higher price (short sell) and simultaneously buy the asset with the lower price 2. Bond credit rating. arbitrage would be possible and would bring the price back into line with the price based on ZCBs.

up or down. The arbitrageur buys the futures contract and sells the underlying today (on the spot market). he invests the proceeds. 4. The risk neutral approach infers expected option value from the intrinsic values at the later two nodes. in a correctly priced derivative contract. the value of the share in the up-state is S × u. though widely used form) both approaches assume a “Binomial model” for the behavior of the underlying instrument. and convenience yields. • In the case where the forward price is higher: 1. and arbitrage pricing is applicable. he returns it now. To do this. Any deviation from this equality allows for arbitrage as follows. The difference between the two amounts is the arbitrage profit. 2. the arbitrageur hands over the underlying. however. (in their simplest. as above). and receives the agreed forward price. Option pricing models therefore include logic that either "locks in" or "infers" this future value. where the value of an asset in the future is known (or expected). dividends. • In the case where the forward price is lower: 1. see: Fundamental theorem of arbitrage-free pricing
Futures
In a futures contract. Methods that lock-in future cash flows assume arbitrage free pricing. he cashes in the matured investment. If S is the current price. then in the next period the price will either be S up or S down. [If he was short the underlying. which has appreciated at the risk free rate. In an option contract. Thus. The difference between the two amounts is the arbitrage profit. dividend yields. and in the down-state is S × d (where u and d are multipliers with d < 1 < u and assuming d < 1+r < u. Here. the derivative price. the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. He then repays the lender the borrowed amount plus interest. On the delivery date. see futures contract pricing. In other words. the strike price (or reference rate). non-dividend paying asset. for a simple. the value of the future/forward.Rational pricing
209
Pricing derivatives
A derivative is an instrument that allows for buying and selling of the same asset on two markets – the spot market and the derivatives market. the rational forward price represents the expected future value of the underlying discounted at the risk free rate (the "asset with a known future-price". He then receives the underlying and pays the agreed forward price using the matured investment. Mathematical finance assumes that any imbalance between the two markets will be arbitraged away. both approaches deliver identical results. see the binomial options model).
. exercise is dependent on the price of the underlying. the "arbitrage free" approach creates a position that has an identical value in either state . 3. . and the spot price will be related such that arbitrage is not possible. Thus.the cash flow in one period is therefore known. On the delivery date. for no arbitrage to be possible. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. 2.
Options
As above. and hence payment is uncertain. given these two states.] 4. will be found by accumulating the present value at time to maturity by the rate of risk-free return . which allows for only two states . 3. and those that infer expected value assume risk neutral valuation. this value can be used to determine the asset's rational price today.
This relationship may be modified for storage costs. Then.

such that the position’s value will be identical in the S up and S down states. The value of a call is then found by equating the two. or whether. The value of a put option can be derived as below. Here. 1) Solve simultaneously for Δ and B such that: i) Δ × S up ." . models a continuous process. which will produce identical cash flows to one option on the underlying share. in the above formulae. and hence the Required rate of return could differ in the up. where: value of position today = value of position in one period ÷ (1 + r) = Δ × S current – value of call The replicating portfolio It is possible to create a position consisting of Δ shares and $B borrowed at the risk free rate. This approach is therefore used in preference to others where it is not clear whether the risk free rate may be applied as the discount rate at each decision point. The best example of this would be under Real options analysis where managements' actions actually change the risk characteristics of the project in question. Delta hedging It is possible to create a position consisting of Δ shares and 1 call sold. we then have: "Δ × S up . in the absence of arbitrage opportunities. and as above. the price of the option today must be the same as the value of the position today. using Δ and B." and "Δ × S down . or may be found from the value of the call using put-call parity.. As above. and the period per time-step is increasingly short. and hence known with certainty (see Delta hedging). instead.the interest rate appears only as part of the construction. As shown above ("Assets with identical cash flows"). S up – strike price ) ( 0. while Black-Scholes. in fact. a premium over risk free would be required. The assumption of binomial behaviour in the underlying price is defensible as the number of time steps between today (valuation) and exercise increases. using Δ.
..B × (1 + r) = ii) Δ × S down .and down-states.. the future payoff is "locked in" using either "delta hedging" or the "replicating portfolio" approach. S down – strike price ) (S up – strike price ) = Δ × S down (S down –
210
2) Solve for the value of the call.B Note that here there is no discounting . the present value of the position must be its expected future value discounted at the risk free rate. this payoff is then discounted. for no arbitrage to be possible. see The Black-Scholes PDE. where: call = Δ × S current . 1) Solve for Δ such that: value of position in one period = Δ × S up strike price) 2) Solve for the value of the call. but may be generalised to other instruments.Rational pricing Although this logic appears far removed from the Black-Scholes formula and the lattice approach in the Binomial options model. since the cash flows produced are identical. The Binomial options model allows for a high number of very short time-steps (if coded correctly). This certain value corresponds to the forward price above ("An asset with a known future price"). Arbitrage free pricing Here. and the result is used in the valuation of the option today.B × (1 + r) = ( 0. The examples below have shares as the underlying. r..B × (1 + r down).B × (1 + r up). it in fact underlies both models. The position created is known as a "replicating portfolio" since its cash flows replicate those of the option.

The expected value is calculated using the intrinsic values from the later two nodes: “Option up” and “Option down”. 1) Solve for p for no arbitrage to be possible in the share. the Net present value of these future cash flows is equal to zero.strike price. These are then weighted by their respective probabilities: “probability” p of an up move in the underlying. both arbitrage free pricing and risk neutral valuation deliver identical results. Given this equivalence. Were this not the case. two counterparties "swap" obligations.e. an Arbitrageur. it is valid to assume “risk neutrality” when pricing derivatives.
211
Swaps
Rational pricing underpins the logic of swap valuation. see swap valuation. Nevertheless.where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit
. relates to the risk-neutral measure as opposed to the actual probability distribution of prices. 0) + (1-p)× Max(S down . and Party B pays a floating rate. the NPV is zero). consider the valuation of a fixed-to-floating Interest rate swap where Party A pays a fixed rate. C. the risk free rate. Meet the cash flow obligations on the position by using the borrowed funds. See Fundamental theorem of arbitrage-free pricing.d ] ÷ [ u . and “probability” (1-p) of a down move.Rational pricing Risk neutral valuation Here the value of the option is calculated using the risk neutrality assumption. effectively exchanging cash flow streams calculated against a notional principal amount. Here. Pocket the difference . The expected value is then discounted at r. Use the received payments to repay the debt on the borrowed funds 4. In fact. and the value of the swap is the present value (PV) of both sets of future cash flows "netted off" against each other. and receive the corresponding payments—which have a higher present value 3. the share price is a Martingale): S = [ p × (up value) + (1-p) ×(down value) ] ÷ (1+r) = [ p × S × u + (1-p) × S × d ] ÷ (1+r) then.strike price. the risk neutral formula does not refer to the volatility of the underlying – p as solved. For example. using p for no arbitrage to be possible in the call. could: 1. and borrow funds equal to this present value 2. Here.e. the “expected value” (as opposed to "locked in" value) is discounted. with u and d as price multipliers as above. the fixed rate would be such that the present value of future fixed rate payments by Party A is equal to the present value of the expected future floating rate payments (i.d ] 2) Solve for call value.. Assume the position with the lower present value of payments. initially. today’s price must represent its expected value discounted at the risk free rate: Option value = [ p × Option up + (1-p)× Option down] ÷ (1+r) = [ p × Max(S up . 0) ] ÷ (1+r) The risk neutrality assumption Note that above. Valuation at initiation To be arbitrage free. today’s price must represent its expected value discounted at the risk free rate (i. Under this assumption. the terms of a swap contract are such that. p = [(1+r) . it can be shown that “Delta hedging” and “Risk neutral valuation” use identical formulae expressed differently.

can be valued by comparison to a Bond with the same schedule of payments. that arbitrage by investors will bring asset prices back into line with the returns expected by the model. since the swap has identical payments to the FRA. • Where the asset price is too high. the Floating leg of an interest rate swap can be "decomposed" into a series of Forward rate agreements. The arbitrageur could therefore: 1. a portfolio with the same net-exposure to each of the macroeconomic factors as the mispriced asset but a different expected return. be considered a "special case" of the APT.)
212
Pricing shares
The Arbitrage pricing theory (APT). the portfolio should have appreciated at the rate implied by the APT. Although based on different assumptions. the CAPM can. specifically. the investor locks-in a guaranteed payoff. Here.e.Rational pricing Subsequent valuation Once traded. The model derived rate of return will then be used to price the asset correctly . and pocket the difference. where sensitivity to changes in each factor is represented by a factor specific beta coefficient:
where • • • is the risky asset's expected return. 2. Here.i. The arbitrageur is then in a position to make a risk free profit as follows: • Where the asset price is too low. a general theory of asset pricing. If the price diverges.
. use the proceeds to buy back the mispriced-asset. The Capital asset pricing model (CAPM) is an earlier. At the end of the period: sell the portfolio. the investor locks-in a positive expected payoff. (more) influential theory on asset pricing. For example. arbitrage should bring it back into line. At the end of the period: sell the mispriced asset. Today: short sell the mispriced-asset and buy the portfolio with the proceeds. arbitrage free pricing must apply as above . 2. See the APT article for detail on the construction of the portfolio. whereas the mispriced asset would have appreciated at more than this rate. the "receive-fixed" leg of a swap. and pocket the difference. The arbitrageur could therefore: 1. Note that under "true arbitrage". bond options and swaptions are equatable. whereas the mispriced asset would have appreciated at less than this rate. use the proceeds to buy back the portfolio.e. is the macroeconomic factor. Today: short sell the portfolio and buy the mispriced-asset with the proceeds. has become influential in the pricing of shares. swaps can also be priced using rational pricing.the asset price should equal the expected end of period price discounted at the rate implied by model.
• is the sensitivity of the asset to factor . can be modelled as a linear function of various macro-economic factors. The APT thus assumes "arbitrage in expectations" — i. the value of this leg is equal to the value of the corresponding FRAs. (Relatedly. in some ways. given that their underlyings have the same cash flows. to perform the arbitrage. where Beta is exposure to changes in value of the Market. • and is the risky asset's idiosyncratic random shock with mean zero. whereas under APT arbitrage. APT holds that the expected return of a financial asset. Similarly. the portfolio should have appreciated at the rate implied by the APT. the CAPM's Securities market line represents a single-factor model of the asset price. the investor “creates” a correctly priced asset (a synthetic asset). is the risk free rate.

Prof. edu/ ~shumway/ courses. lsu. edu/ ~kcb/ Notes/ Arbitrage. edu/ het/ essays/ sequence/ arbitpricing. Chance No Arbitrage in Continuous Time [8]. caltech. cfm?abstract_id=292724 [12] http:/ / www. dir/ noarb. Haas School of Business • • • • Elementary Asset Pricing Theory [5]. ssrn. com/ sol3/ papers. Prof. Tyler Shumway
Risk neutrality and arbitrage free pricing • Risk-Neutral Probabilities Explained [9]. htm [3] http:/ / www. Prof. dir/ f872. C. Investment Analysts Society of Southern Africa The illusions of dynamic replication [15]. The History of Economic Thought Website • The Idea Behind Arbitrage Pricing [2]. htm [2] http:/ / www. K. doc [4] http:/ / www. com/ fundamentals/ futures/ futureforwardpricing. ac. Prof. pdf [9] http:/ / ssrn. Mark Rubinstein. ederman. cfm?abstract_id=290044 [11] http:/ / papers. com/ sol3/ papers. Nicolas Gisiger • Risk-neutral Valuation: A Gentle Introduction [10]. Samy Mohammed. at/ ~wschach/ pubs/ preprnts/ prpr0118a. cfm?abstract_id=291988
. hss. com/ abstract=1395390 [10] http:/ / papers. edu/ academics/ finance/ faculty/ dchance/ Instructional/ TN96-02. part II [4]. fam. Ernst Maug Pricing Futures and Forwards by Arbitrage Argument [13]. quantnotes. Quantnotes The relationship between futures and spot prices [14]. rpi. pdf [8] http:/ / www-personal. ssrn. com/ fundamentals/ basics/ arbitragepricing. Prof. Prof. in-the-money. in-the-money. com/ artandpap/ IV%20Fundamental%20Theorem%20-%20Part%20I. tuwien. edu/ ~olivaa2/ binomial. doc [5] http:/ / www. pdf [7] http:/ / www. za/ images/ file/ indexmain. Part II [11]. pdf [16] http:/ / papers. Prof. umich. com/ new/ docs/ qf-Illusions-dynamic. Border California Institute of Technology The Notion of Arbitrage and Free Lunch in Mathematical Finance [6]. htm [15] http:/ / www. Don M. Emanuel Derman and Nassim Taleb Swaptions and Options [16]. pdf [6] http:/ / www. iassa. ssrn. com/ sol3/ papers. Joseph Tham Duke University Application to derivatives • • • • • Option Valuation in the Binomial Model [12]. htm [14] http:/ / www. com/ artandpap/ IV%20Fundamental%20Theorem%20-%20Part%20II.Rational pricing
213
See also
• • • • • • • • • Efficient market hypothesis Fair value Fundamental theorem of arbitrage-free pricing Homo economicus List of valuation topics Rational choice theory Rationality Risk-neutral measure Volatility arbitrage
External links
Arbitrage free pricing • Pricing by Arbitrage [1]. Walter Schachermayer Risk Neutral Pricing in Discrete Time [7] (PDF). bus. newschool. Quantnotes • "The Fundamental Theorem" of Finance [3]. pdf [13] http:/ / www. co. Don M. quantnotes. Chance
References
[1] http:/ / cepa.

for example. though losses may occur. Traders may. When used by academics. this condition holds for grain but not for securities). purchase the good. an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state. and transport it to another region to sell at a higher price. and in practice. particularly arbitrage mechanics. In practical terms. In principle and in academic use. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or. this is generally only possible with securities and financial products which can be traded electronically. as such. find that the price of wheat is lower in agricultural regions than in cities. "True" arbitrage requires that there be no market risk involved. An arbitrage equilibrium is a precondition for a general economic equilibrium. Two assets with identical cash flows do not trade at the same price. See rational pricing. for further discussion.[1] In the simplest example. an arbitrage is risk-free. risk. The transactions must occur simultaneously to avoid exposure to market risk.Arbitrage
214
Arbitrage
In economics and finance. Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. in simple terms. and even then. any good sold in one market should sell for the same price in another. the profit being the difference between the market prices. The assumption that there is no arbitrage is used in quantitative finance to calculate a unique risk neutral price for derivatives. The term is mainly applied to trading in financial instruments. 3. storage. People who engage in arbitrage are called arbitrageurs (IPA: /ˌɑrbɨtrɑːˈʒɜr/)—such as a bank or brokerage firm. it is also used to refer to differences between similar assets (relative value or convergence trades). in common use.
Arbitrage-free
If the market prices do not allow for profitable arbitrage. commodities and currencies. an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows. stocks. some major (such as devaluation of a currency or derivative). it may refer to expected profit. it is the possibility of a risk-free profit at zero cost. arbitrage occurs by simultaneously buying in one and selling on the other.
Conditions for arbitrage
Arbitrage is possible when one of three conditions is met: 1. when each leg of the trade is executed the prices in the market may have moved. This type of price arbitrage is the most common. derivatives. Where securities are traded on more than one exchange. as in statistical arbitrage. arbitrage (IPA: /ˈɑrbɨtrɑːʒ/) is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance. 2. The same asset does not trade at the same price on all markets ("the law of one price"). the prices are said to constitute an arbitrage equilibrium or arbitrage-free market. but this simple example ignores the cost of transport. Mathematically it is defined as follows:
. the asset does not have negligible costs of storage. in common use. as in merger arbitrage. and other factors. some minor (such as fluctuation of prices decreasing profit margins). such as bonds. for example. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'. In academic use. there are always risks in arbitrage. or the risk that prices may change on one market before both transactions are complete.

one can buy the less expensive one and sell it to the more expensive market. many such jobs appear to be flowing towards China. In this way. (Note that "offshoring" is not synonymous with "outsourcing". by taking the best odds offered by each bookmaker. The activity of other arbitrageurs can make this risky. ETFs trade in the open market. with prices set by market demand. convert them to shares in the ETF. When the price of a stock on the NYSE and its corresponding futures contract on the CME are out of sync. which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London. outsourcing always involves subcontracting jobs to a different company. while fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value. • One example of arbitrage involves the New York Stock Exchange and the Chicago Mercantile Exchange. Rather than exploiting price differences between identical assets. When a discount appears. An ETF may trade at a premium or discount to the value of the underlying assets. the arbitrageur makes a low-risk profit. the odds of making an 'arb' usually last for less than an hour and typically only a few minutes. In popular terms. As bookmakers become more proficient. in order to remain competitive their margins are usually quite low. • Some types of hedge funds make use of a modified form of arbitrage to profit. the belief is that there remains some
. Unlike offshoring. this "triangle arbitrage" is so simple that it almost never occurs. Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a profit against their books. huge bets on one side of the market also alert the bookies to correct the market.Arbitrage and where means a portfolio at time t. this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. which means "to subcontract from an outside supplier or source". Furthermore. • Exchange-traded fund arbitrage – Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself. and hedge any significant differences between the two assets. though some which require command of English are going to India and the Philippines.
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Examples
• Suppose that the exchange rates (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = $12 = £6. At present. Any difference between the hedged positions represents any remaining risk (such as basis risk) plus profit. But more complicated foreign exchange arbitrages. Those with the fastest computers and the most expertise take advantage of series of small differences that would not be profitable if taken individually. this is referred to as offshoring. they will purchase and sell securities. known as a Dutch book. would be arbitrage. and that company can be in the same country as the outsourcing company. an arbitrageur will buy the underlying securities. In reality. assets and derivatives with similar characteristics. for a profit of ¥200. When a significant enough premium appears. a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit.) • Sports arbitrage – numerous internet bookmakers offer odds on the outcome of the same event. Because the differences between the prices are likely to be small (and not to last very long). This profit would typically be between 1% and 5% but can be much higher. such as the spot-forward arbitrage (see interest rate parity) are much more common. and sell them in the open market. rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. • Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule. such as when a business outsources its bookkeeping to an accounting firm. However. an arbitrageur will do the reverse. Different bookmakers may offer different odds on the same outcome of a given event.

In addition. international arbitrage opportunities in commodities. Similarly. The speed at which prices converge is a measure of market efficiency. Similarly.
Risks
Arbitrage transactions in modern securities markets involve fairly low day-to-day risks. as long as the buyers are not prohibited from reselling and the transaction costs of buying. securities and currencies.. and Americans would have to sell the Canadian dollars they received in exchange for the exported cars. Also. Formally. of course. to the different emissions and other auto regulations in the two countries. relative to each other (see interest rate parity). this would make US cars more expensive for all buyers. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high.Arbitrage difference which. and the price of securities in different markets tend to converge to the same prices. and can lead to bankruptcy. on a grand scale. arbitrage transactions have negative skew – prices can get a small amount closer (but often no closer than 0). and Canadian cars cheaper. issued by the various countries. the idea that seemingly very low risk arbitrage trades might not be fully exploited because of these risk factors and other considerations is often referred to as limits to arbitrage. In the academic literature. and enter into a series of matching trades (including currency swaps) to arbitrage the difference. the currency exchange rates. assume that a car purchased in the United States is cheaper than the same car in Canada. Eventually. and as a result. if unchecked. particularly financial crises. due. the features built into the cars sold in the US are not exactly the same as the features built into the cars for sale in Canada. in each category. Arbitrage moves different currencies toward purchasing power parity. our example assumes that no duties have to be paid on importing or exporting cars from the USA to Canada. The day-to-day risks are generally small because the transactions involve small differences in price. while they can get very far apart. and supply of Canadian Dollars. represents pure profit. As a result of arbitrage. but can face extremely high risk in rare situations. even after hedging most risk. most assets exhibit (small) differences between countries. goods. tend to change exchange rates until the purchasing power is equal. Canadians would have to buy American Dollars to buy the cars. The main rare risks are counterparty risk and liquidity risk – that a counterparty to a large transaction or many transactions fails to pay. transport them across the border. In reality. More generally. As an example. a fund may see that there is a substantial difference between U. Both actions would increase demand for US Dollars. Canadians would buy their cars across the border to exploit the arbitrage condition. arbitrage affects the difference in interest rates paid on government bonds. holding and reselling are small relative to the difference in prices in the different markets.
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Price convergence
Arbitrage has the effect of causing prices in different markets to converge. transaction costs. and sell them in Canada. given the expected depreciations in the currencies. The main day-to-day risk is that part of the transaction fails – execution risk. the price of commodities.[2]
. The rare case risks are extremely high because these small price differences are converted to large profits via leverage (borrowed money). Americans would buy US cars. while simultaneously entering into credit default swaps to protect against country risk and other types of specific risk.S. until there is no longer an incentive to buy cars in the US and sell them in Canada. For example. so an execution failure will generally cause a small loss (unless the trade is very big or the price moves rapidly). dollar debt and local currency debt of a foreign country. in all markets. or that one is required to post margin and does not have the money to do so. there would be an appreciation of the US Dollar. taxes. among other things. this may yield a large loss. one must consider taxes and the costs of travelling back and forth between the US and Canada. and other costs provide an impediment to this kind of arbitrage. and in the rare event of a large price move. At the same time.

”
—John Maynard Keynes
Arbitrage trades are necessarily synthetic. risk arbitrage was common. In the extreme case this is merger arbitrage. one trades a security that is clearly undervalued or overvalued. As an example. as above. if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange. arbitrage transactions in the securities markets involve high speed and low risk.Arbitrage
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Execution risk
Generally it is impossible to close two or three transactions at the same instant. then hedges them with CDSes. it may entail considerable risk if borrowed money is used to magnify the reward through leverage. The standard example is the stock of a company. or in the event of a financial crisis when many counterparties fail. a quick shift in prices makes it impossible to close the other at a profitable price. as they involve a short position. arbitrage traders synthesize a put option on their ability to finance themselves. undervalued in the stock market. and the trader is accordingly required to post margin (faces a margin call).
Liquidity risk
“
The market can stay irrational longer than you can stay solvent. therefore.
Counterparty risk
As arbitrages generally involve future movements of cash. whose failure thus poses a threat. the trader may run out of capital (if they run out of cash and cannot borrow more) and go bankrupt even though the trades may be expected to ultimately make money. When the transaction involves a delay of weeks or months. and the problem is to execute two or three balancing transactions while the difference persists (that is. this is more narrowly referred to as a convergence trade. In effect. In the 1980s. profiting from the difference between the bond spread and the CDS premium. due to the stress of the crisis. if one purchases many risky bonds. leveraged trades. in a financial crisis the bonds may default and the CDS writer/seller may itself fail. This hazard is serious because of the large quantities one must trade in order to make a profit on small price differences. giving a large profit to those who bought at the current price—if the merger goes through as predicted.
Mismatch
Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable. Competition in the marketplace can also create risks during arbitrage transactions. such an operation can produce disastrous losses. they are subject to counterparty risk: if a counterparty fails to fulfill their side of a transaction. If the assets used are not identical (so a price divergence makes the trade temporarily lose money). the price of the takeover will more truly reflect the value of the company. there is the possibility that when one part of the deal is closed. or the margin treatment is not identical. when it is seen that the wrong valuation is about to be corrected by events. and in fact risk arbitrage with regard to leveraged buyouts was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken and Ivan Boesky. described below. At some moment a price difference exists. before the other arbitrageurs act). which is about to be the object of a takeover bid. they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This is a serious problem if one has either a single trade or many related trades with a single counterparty. This leaves the arbitrageur in an unhedged risk position. Traditionally. In comparison to the classical quick arbitrage transaction. causing the arbitrageur to face steep losses. One way of reducing the risk is through the illegal use of inside information. In this form of speculation.[3]
. For example.

high income "buy and hold" investors seeking tax-exempt income) as well as the "crossover buying" arising from corporations' or individuals' changing income tax situations (i. Managers aim to capture the inefficiencies arising from the heavy participation of non-economic investors (i. Second. eliminating its relevance over time as the high. insurers switching their munis for corporates after a large loss as they can capture a higher after-tax yield by offsetting the taxable corporate income with underwriting losses).
Municipal bond arbitrage
Also called municipal bond relative value arbitrage. if and when the takeover is completed. The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates. it has not been arbitraged away. However. the carry is greater than the hedge expense. tax-free carry from muni arb can reach into the double digits. or capital structure trades referencing the same asset (in the case of revenue bonds).Arbitrage Prices may diverge during a financial crisis. often termed a "flight to quality". consistent. There are additional inefficiencies arising from the highly fragmented nature of the municipal bond market which has two million outstanding issues and 50. dollars.. The arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond. Since the inefficiency is related to government tax policy. and thus they will lack capital precisely when they need it most. Positive. this hedge fund strategy involves one of two approaches. The relative value trades may be between different issuers. which results in significant. The steeper slope of the municipal yield curve allows participants to collect more after-tax income from the municipal bond portfolio than is spent on the interest rate swap. municipal arbitrage. managers seek relative value opportunities by being both long and short municipal bonds with a duration-neutral book. merger arbitrage generally consists of buying the stock of a company that is the target of a takeover while shorting the stock of the acquiring company. These corporate equivalents are typically interest rate swaps referencing Libor or SIFMA[4] [5]. The end goal is to limit this principal volatility.000 issuers in contrast to the Treasury market which has 400 issues and a single issuer. have the same maturity and are denominated in U.or AA-rated tax-exempt municipal bonds with the duration risk hedged by shorting the appropriate ratio of taxable corporate bonds. over a longer period of time. The bet in this municipal bond arbitrage is that. these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints).e. two similar instruments—municipal bonds and interest rate swaps—will correlate with each other.
. but range-bound principal volatility. Usually the market price of the target company is less than the price offered by the acquiring company. basis risk arises from use of an imperfect hedge. Generally.. they are both very high quality credits. which is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate bond.S. different bonds issued by the same entity. tax-free cash flow accumulates. and hence is structural in nature. managers construct leveraged portfolios of AAA.[3]
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Types of arbitrage
Merger arbitrage
Also called risk arbitrage. Credit risk and duration risk are largely eliminated in this strategy. The bet in a merger arbitrage is that such a spread will eventually be zero.e. The risk is that the deal "breaks" and the spread massively widens. or just muni arb.

Arbitrage in DLCs may
. one can purchase the ADR and expect to make money as its value converges on the original. an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value. In practice. Such arbitrage strategies start paying off as soon as the relative prices of the two DLC stocks converge toward theoretical parity. which can be extracted. stock prices of the twin pair should move in lockstep. DLC share prices exhibit large deviations from theoretical parity. arbitrage positions sometimes have to be kept open for considerable periods of time. When rates move higher. In these situations. in many cases. A convertible bond can be thought of as a corporate bond with a stock call option attached to it. Arbitrage positions in DLCs can be set-up by obtaining a long position in the relatively underpriced part of the DLC and a short position in the relatively overpriced part.Arbitrage
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Convertible bond arbitrage
A convertible bond is a bond that an investor can return to the issuing company in exchange for a predetermined number of shares in the company. but the call option part of a convertible bond moves higher (and the aggregate tends to move lower). • credit spread. while retaining their separate legal identity and existing stock exchange listings. Since the ADR is trading at a value lower than what it is worth. However. When the price of the stock the bond is convertible into moves higher. In the meantime. For instance a Chinese company wishing to raise more money may issue a depository receipt on the New York Stock Exchange. the bond price tends to move lower. the price gap might widen. the bond part of a convertible bond tends to move lower. Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have. rating downgrade) and its credit spread widens. known as ADRs (American Depositary Receipt) or GDRs (Global Depositary Receipt) depending on where they are issued. the price of the bond tends to rise. since there is no identifiable date at which DLC prices will converge. However. after which they would most likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss. Convertible arbitrage consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price.
Depository receipts
A depository receipt is a security that is offered as a "tracking stock" on another foreign market. The price of a convertible bond is sensitive to three major factors: • interest rate. These securities.g. • stock price. However there is a chance that the original stock will fall in value too. He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares. For instance an arbitrageur would first buy a convertible bond. then sell fixed income securities or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to hedge the risk of credit deterioration). If the creditworthiness of the issuer deteriorates (e.
Dual-listed companies
A dual-listed company (DLC) structure involves two companies incorporated in different countries contractually agreeing to operate their businesses as if they were a single enterprise. are typically considered "foreign" and therefore trade at a lower value when first released. In this case there is a spread between the perceived value and real value. the call option part of the convertible bond moves higher (since credit spread correlates with volatility). acquired at a very low price. as the amount of capital on the local exchanges is limited. Eventually what he'd be left with is something similar to a call option on the underlying stock. so by shorting it you can hedge that risk. arbitrageurs may receive margin calls. they are exchangeable into the original security (known as fungibility) and actually have the same value. In integrated and efficient financial markets. but.

The bank will have higher IT costs. 234). Thus. The outsourcing company takes over the installations. Berkshire-Hathaway. and the bank has to expect to recover the loaned
. operating under the Basel I accord. buying in the private market and later selling in the public market. This frees up cashflow usable for new lending by the bank. half of which long in Shell and the other half short in Royal Dutch (Lowenstein.Arbitrage be profitable. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent and LTCM had to close the position and incur a loss. if the real risk is higher than the regulatory risk then it is profitable to make that loan and hold on to it. as described by Alan Greenspan in his October 1998 speech on The Role of Capital in Optimal Banking Supervision and Regulation [9]. This process can increase the overall riskiness of institutions under a risk insensitive regulatory regime.3 billion was invested. Lowenstein (2000) [8] describes that LTCM established an arbitrage position in Royal Dutch Shell in the summer of 1997. whilst publicly held and or exchange listed companies trade on a Price to Earnings multiple (such as a P/E of 10. removing the low risk loan from its portfolio. see also the discussion below). LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade. it is profitable to securitise the loan. tax arbitrage) may be used to refer to situations when a company can choose a nominal place of business with a regulatory. For example. A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell—which had a DLC structure until 2005—by the hedge fund Long-Term Capital Management (LTCM. Exempli gratia. legal or tax regime with lower costs. when Royal Dutch traded at an 8 to 10 percent premium. Simpson. 99). On the other hand. if a publicly traded company specialises in the acquisition of privately held companies. In total $2. which acts as an angel investor retaining equity in private companies which are in the process of becoming publicly traded. Private to public equities arbitrage is a term which can arguably be applied to investment banking in general. an insurance company may choose to locate in Bermuda due to preferential tax rates and policies for insurance companies. A hedge fund that is an example of this type of arbitrage is Greenridge Capital. This can occur particularly where the business transaction has no obvious physical location: in the case of many financial products. regulatory arbitrage (sometimes. to refer to a new defence tactic in hostile mergers and acquisitions where differing takeover regimes in deals involving multi-jurisdictions are exploited to the advantage of a target company under threat. p. which equates to a 10% ROI). In economics. it may be unclear "where" the transaction occurs. from a per-share perspective there is a gain with every acquisition that falls within these guidelines. Regulatory Arbitrage was used for the first time in 2005 when it was applied by Scott V. For example. In the autumn of 1998 large defaults on Russian debt created significant losses for the hedge fund and LTCM had to unwind several positions. According to Lowenstein (p. Regulatory arbitrage can include restructuring a bank by outsourcing services such as IT. a partner at law firm Skadden. With a reserve ratio of 10%. but the real risk of default is lower. see.[6] Background material is available at [7]. buying out the bank's assets and charges a periodic service fee back to the bank. but counts on the multiplier effect of money creation and the interest rate spread to make it a profitable exercise. Example: Suppose the bank sells its IT installations for 40 million USD. but is also very risky. Arps. the bank can create 400 million USD in additional loans (there is a time lag. if a bank.
Regulatory arbitrage
Regulatory arbitrage is where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position. has to hold 8% capital against default risk. provided it is priced appropriately. Private markets to public markets differences may also help explain the overnight windfall gains enjoyed by principals of companies that just did an initial public offering.
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Private to public equities
The market prices for privately held companies are typically viewed from a return on investment perspective (such as 25%).

com. A casino has a statistical arbitrage in every game of chance that it offers—referred to as the house advantage. Such services were previously offered in the United States by companies such as FuturePhone.S. The concept was that because Italian bond futures had a less liquid market. it is actually more expensive to outsource the IT operations as the outsourcing adds a layer of management and increases overhead. treasuries. and their creditors had to arrange a bail-out.
. Because the difference was small. the telecommunication arbitrage companies get paid an interconnect charge by the UK mobile networks and then buy international routes at a lower cost. The bank can often lend (and securitize the loan) to the IT services company to cover the acquisition cost of the IT installations. vigorish or house vigorish.S.S. which were considered a safe investment.6 billion U. treasury debt and buying U. As a result the price on US treasuries began to increase and the return began decreasing because there were many buyers. investors began selling non-U. Because the markets were already nervous due to the Asian financial crisis. The downfall in this system began on August 17. the prices would converge. they would as well. and the return (yield) on other bonds began to increase because there were many sellers (i. dollars in fixed income arbitrage in September 1998. when Russia defaulted on its ruble debt and domestic dollar debt. LTCM had attempted to make money on the price difference between different bonds. FuturePhone (as well as other similar services) ceased operations upon legal challenges from AT&T and other service providers. 1998. This is the reason behind the trend towards outsourcing in the financial sector. Treasury securities and buy Italian bond futures. although it is unclear what sort of profit was realized by the banks that bailed LTCM out.S.S. the local telephone carriers are allowed to charge a high "termination fee" to the caller's carrier in order to fund the cost of providing service to the small and sparsely-populated areas that they serve. Such services are offered in the United Kingdom. officials of the Federal Reserve assisted in the negotiations that led to this bail-out.[11]
Statistical arbitrage
Statistical arbitrage is an imbalance in expected nominal values. on the grounds that so many companies and deals were intertwined with LTCM that if LTCM actually failed. in the short term Italian bond futures would have a higher return than U. treasuries and other bonds to increase.e.Arbitrage money back into its books). This can be at preferential rates.
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Telecom arbitrage
Telecom arbitrage companies allow phone users to make international calls for free through certain access numbers. house edge. The IT services company is free to leverage their balance sheet as aggressively as they and their banker agree to. If the bank can generate 5% interest margin on the 400 million of new loans. Without this money creation benefit. This caused the difference between the prices of U. More controversially. as the sole client using the IT installation is the bank. Thus LTCM failed as a fixed income arbitrage fund. The calls are seen as free by the UK contract mobile phone customers since they are using up their allocated monthly minutes rather than paying for additional calls. the price of those bonds fell). Eventually this caused LTCM to fold.S. a large amount of money had to be borrowed to make the buying and selling profitable. primarily in small towns in the state of Iowa. the bank will increase interest revenues by 20 million. but in the long term. However. it would sell U. In these areas. For example. causing a collapse in confidence in the economic system. bonds.
The debacle of Long-Term Capital Management
Long-Term Capital Management (LTCM) lost 4.[10] These services would operate in rural telephone exchanges. rather than to decrease as LTCM was expecting.

The risk that one trade (leg) fails to execute is thus 'leg risk'. Xiong. go.. Journal of Finance 52. in modern spelling] quelle place est plus avantageuse pour tirer et remettre". D. van Dijk. Kondor. The Risk and Return of Arbitrage in Dual-Listed Companies. "Free International Calls! Just Dial . Journal of Financial Economics 62. Risk in Dynamic Arbitrage: Price Effects of Convergence Trading Journal of Finance 64(2).. A. "arbitre" usually means referee or umpire.A. com/ story. Shaw & Co. and Robert Vishny. investinginbonds. cfm?abstract_id=525282) [7] http:/ / mathijsavandijk.
. June 2008. org/ research/ epr/ 98v04n3/ 9810gree. 1997. 2008. com/ dual-listed-companies/ [8] Lowenstein. purearb. (http:/ / papers. ny. Convergence trading with wealth effects. frb. asp?id=351 [5] http:/ / www.g. R. 2000.Arbitrage
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Etymology
"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration tribunal. [2] See e. Retrieved 2008-12-23. Iowa" (http:/ / abcnews. bondmarkets. [9] http:/ / www.. When genius failed: The rise and fall of Long-Term Capital Management. E. ssrn. Peter. 2001.) In the sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "La science des négocians et teneurs de livres" as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ("L'arbitrage est une combinaison que l’on fait de plusieurs changes. 2009. Andrei. The limits of arbitrage. . the metaphor is of putting on a pair of pants. Wei. (In modern French..638-658. pdf). one leg (trade) at a time. com/ Technology/ story?id=2560255). [4] http:/ / www. com/ purearb/ wp-content/ uploads/ 2009/ 03/ desco_market_insights_vol_1_no_1_20090313. com/ sol3/ papers. 247-292. Rosenthal and M. L. asp?id=1157 [6] de Jong. [3] The Basis Monster That Ate Wall Street (http:/ / www. com/ story. Shleifer. pdf [10] Ned Potter (2006-10-13). 35-55. Random House. analogous concept in Bayesian probability Efficient market hypothesis Immunization (finance) Interest rate parity Intermediation TANSTAAFL Value investing
Notes
[1] As an arbitrage consists of at least two trades. pour connoitre [connaître.)[12]
See also
Types of financial arbitrage
• • • • • • • • • Arbitrage betting Covered interest arbitrage Fixed income arbitrage Political arbitrage Risk arbitrage Statistical arbitrage Triangular arbitrage Uncovered interest arbitrage Volatility arbitrage
Related concepts
• • • • • • • • • Algorithmic trading Arbitrage pricing theory Coherence (philosophical gambling strategy).

the underlying asset to a futures contract may not be traditional "commodities" at all – that is. they differ in certain respects. (http://www. securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates.regulatory-arbitrage. Penguin Press. They are still securities. though they are a type of derivative contract. cnrtl. The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract.com/riskarb. In other words. The party agreeing to buy the underlying asset in the future assumes a long position. oil. or. if it is a cash-settled futures contract. whereas an option grants the buyer the right. Regulatory Arbitrage after the Basel ii framework and the 8th Company Law Directive of the European Union. The contracts are traded on a futures exchange. and the party agreeing to sell the asset in the future assumes a short position. fr/ lexicographie/ arbitrage).com)
Futures contract
In finance. market • Information on arbitrage in dual-listed companies on the website of Mathijs A. the underlying asset or item can be currencies. The future date is called the delivery date or final settlement date. Future contracts are very similar to forward contracts. [12] See "Arbitrage" in Trésor de la Langue Française (http:/ / www. shtml). Stark. Brian J.
223
References
• Greider.oranges. Retrieved 2008-12-23. rights or warrants. gold) of standardized quantity and quality at a specified future date at a price agreed today (the futures price).S. In many cases. ISBN 0-7139-9211-5. Futures contracts are not "direct" securities like stocks. ISBN 9780870943843
External links
• What is Arbitrage? (About. To exit the commitment prior to the settlement date.arbitrageview. Arbitrage. (http://www. except they are exchange-traded and defined on standardized assets. . The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange[1] . to establish a position previously held by the seller of the option. the owner of an options contract may exercise the contract.htm) • ArbitrageView. Dow-Jones Publishers. com/ articles/ 20070207/ 123022.htm) – Arbitrage opportunities in pending merger deals in the U. but both parties of a "futures contract" must fulfill the contract on the settlement date.com) • Institute for Arbitrage. A closely related contract is a forward contract. The seller delivers the underlying asset to the buyer. One World. bonds.com/cs/finance/a/arbitrage. New York. "Phone Call Arbitrage Is All Fun And Games (And Profit) Until AT&T Hits You With A $2 Million Lawsuit" (http:/ / techdirt.com (http://www. Ready or Not. the net gain or loss accrued over the life of the contract is realized on the delivery date. a futures contract is a standardized contract between two parties to buy or sell a specified asset (eg. (http://mathijsavandijk.com) (http://economics. however. com/dual-listed-companies) • What is Regulatory Arbitrage.about. then cash is transferred from the futures trader who sustained a loss to the one who made a profit.[2] Unlike forwards. • Special Situation Investing: Hedging. for financial futures. the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position.rmjinstitute. effectively closing out
. William (1997). and Liquidation. NY 1983. ISBN 0870943847. futures typically have interim partial settlements or "true-ups" in margin requirements. but not the obligation. van Dijk.Arbitrage
[11] Mike Masnick (2007-02-07). For typical forwards.

a poor philosopher from Miletus who developed a "financial device. raw jute and jute goods and bullion.the location where delivery must be made. the minimum permissible price fluctuation. which were called futures contracts. units of foreign currency. or simply futures. and crucially also provides a mechanism for settlement. etc. a fixed number of barrels of oil.
. For example. This contract was based on grain trading and started a trend that saw contracts created on a number of different commodities as well as a number of futures exchanges set up in countries around the world. This can be the notional amount of bonds. Confident in his prediction. which involves a principle of universal application". • The grade of the deliverable.[7]
Standardization
Futures contracts ensure their liquidity by being highly standardized.[5] The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward contracts in 1864. either cash settlement or physical settlement.Futures contract the futures position and its contract obligations.[6] By 1875 cotton futures were being traded in Mumbai in India and within a few years this had expanded to futures on edible oilseeds complex. This could be anything from a barrel of crude oil to a short term interest rate. • The type of settlement. The exchange's clearing house acts as counterparty on all contracts. and after a series of bad harvests – needed a stable conversion to coin.[3]
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Origin
Aristotle described the story of Thales. In the case of physical commodities.[4] The first futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s. When the harvest time came. the notional amount of the deposit over which the short term interest rate is traded. this specifies which bonds can be delivered. to meet the needs of samurai who – being paid in rice. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or poor and because the olive press owners were willing to hedge against the possibility of a poor yield. this specifies not only the quality of the underlying goods but also the manner and location of delivery. as well as the pricing point -. the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulphur content and API specific gravity. • Other details such as the commodity tick. usually by specifying: • The underlying asset or instrument. Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. • The amount and units of the underlying asset per contract. • The last trading date. sets margin requirements. he made agreements with local olive press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. and many presses were wanted concurrently and suddenly. Futures contracts. and made a large quantity of money. • The currency in which the futures contract is quoted. • The delivery month. In the case of bonds. he let them out at any rate he pleased. (but not future or future contract) are exchange-traded derivatives.

The Initial Margin requirement is established by the Futures exchange. in times of high volatility a broker can make a margin call or calls intra-day. Often referred to as “variation margin”. Also referred to as performance bond margin. typically 5%-15% of the contract's value. financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. the amount or percentage of initial margin is set by the exchange concerned. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Calls for margin are usually expected to be paid and received on the same day.
. in contrast to other securities Initial Margin (which is set by the Federal Reserve in the U. however. exchanges also use the term “maintenance margin”. The maximum exposure is not limited to the amount of the initial margin. In case of loss or if the value of the initial margin is being eroded. Some U. This enables traders to transact without performing due diligence on their counterparty. the broker will make a margin call in order to restore the amount of initial margin available. Initial margin is the equity required to initiate a futures position. which in effect defines by how much the value of the initial margin can reduce before a margin call is made. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Margins are determined on the basis of market risk and contract value. To minimize counterparty risk to traders. The clearing house becomes the buyer to each seller. Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Customer margin Within the futures industry.Futures contract
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Margin
To minimize credit risk to the exchange. However. so that in the event of a counterparty default the clearer assumes the risk of loss. Futures Commission Merchants are responsible for overseeing customer margin accounts. This is a type of performance bond. Markets). and the seller to each buyer. Initial margin is set by the exchange. traders must post a margin or a performance bond. the broker has the right to close sufficient positions to meet the amount called by way of margin. If a position involves an exchange-traded product. margin called for this reason is usually done on a daily basis. however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. After the position is closed-out the client is liable for any resulting deficit in the client’s account. most non-US brokers only use the term “initial margin” and “variation margin”.S. If not.S. trades executed on regulated futures exchanges are guaranteed by a clearing house.

representing the amount of their trading capital that is being held as margin at any particular time. could not be settled by delivery of the referenced item . The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires. a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour. purchasing underlying components of those indexes to hedge against current index positions. This is an exciting time for arbitrage desks. as well as the final settlement price for that contract. Margin-equity ratio is a term used by speculators. for most CME and CBOT contracts.Futures contract A futures account is marked to market daily. A trader. For example. The broker may set the requirement higher. it occurs only on a minority of contracts. The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. If the margin drops below the margin maintenance requirement established by the exchange listing the futures. the increase in volume is caused by traders rolling over positions to the next contract or.
. or the closing value of a stock market index. At this moment also. but rather it is a security deposit. Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. the March futures become the nearest contract.S. Most are cancelled out by purchasing a covering position . ROM may be calculated (realized return) / (initial margin). buying a contract to cancel out an earlier sale (covering a short).i. and by the exchange to the buyers of the contract. this happens on the third Friday of certain trading months. at the expiration of the December contract. a margin call will be issued to bring the account back up to the required level.that is. For many equity index and interest rate futures contracts (as well as for most equity options). Ice Brent futures use this method. Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account. such as a short term interest rate index such as Euribor.the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange.a cash payment is made based on the underlying reference rate. as a practical matter. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. In practice. the exchanges require a minimum amount that varies depending on the contract and the trader. For example if a trader earns 10% on margin in two months. of course. Physical delivery is common with commodities and bonds.[8] Cash settled futures are those that. The low margin requirements of futures results in substantial leverage of the investment. The Nymex crude futures contract uses this method of settlement upon expiration • Cash settlement . However. how would one deliver an index? A futures contract might also opt to settle against an index based on trade in a related spot market. but may not set it lower. On the expiry date. if he doesn't want to be subject to margin calls. and can be done in one of two ways. which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge.e. Expiry (or Expiration in the U. or selling a contract to liquidate an earlier purchase (covering a long).) is the time and the day that a particular delivery month of a futures contract stops trading. On this day the t+1 futures contract becomes the t futures contract. as specified per type of futures contract: • Physical delivery . that would be about 77% annualized.
226
Settlement .physical versus cash-settled futures
Settlement is the act of consummating the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself. in the case of equity index futures. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. can set it above that.

In a perfect market the relationship between futures and spot prices depends only on the above variables. Here. the futures price in fact varies within arbitrage boundaries around the theoretical price. In this scenario there is only one force setting the price. will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r. the forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away.
Pricing via expectation
When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing cannot be applied. for a simple.for example on crops before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date) . Thus. non-dividend paying asset. dividends. restrictions on short selling) that prevent complete arbitrage. treasury bond futures.
Arbitrage arguments
Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply. This is typical for stock index futures. the value of the future/forward. supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship.Futures contract
227
Pricing
When the deliverable asset exists in plentiful supply. In a deep and liquid market. or may be freely created. and convenience yields. differential borrowing and lending rates. .
. However. or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known as cornering the market). when the deliverable commodity is not in plentiful supply or when it does not yet exist . dividend yields. as expressed by supply and demand for the futures contract. which is simple supply and demand for the asset in the future. Here the price of the futures is determined by today's supply and demand for the underlying asset in the futures. Thus.g. the market clearing price for the futures may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down. in practice there are various market imperfections (transaction costs. with continuous compounding
This relationship may be modified for storage costs. F(t). as the arbitrage mechanism is not applicable. then the price of a futures contract is determined via arbitrage arguments. and futures on physical commodities when they are in supply (e. By contrast. or may be freely created.the futures price cannot be fixed by arbitrage. agricultural crops after the harvest).
or. in a shallow and illiquid market.

energy. Soybeans. and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century. etc.Futures contract
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Relationship between arbitrage arguments and expectation
The expectation based relationship will also hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability. Pork.
Contango and backwardation
The situation where the price of a commodity for future delivery is higher than the spot price. The reverse. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Soy Products. or where a far future delivery price is lower than a nearer future delivery. currencies or intangibles such as interest rates and indexes. natural gas and unleaded gas
. when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. Wheat. Although contract trading began with traditional commodities such as grains. Silver). follow the links. currency and currency indexes.liffe). there are more than 90 futures and futures options exchanges worldwide trading to include: [9] • CME Group (formerly CBOT and CME) -. a speculator is expected to break even when the futures market fairly prices the deliverable commodity. Index (Dow Jones Industrial Average). Various Interest Rate derivatives (including US Bonds). heating oil. reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities. is known as contango. This innovation led to the introduction of many new futures exchanges worldwide. With this pricing rule. In other words: a futures price is martingale with respect to the risk-neutral probability. Metals (Gold. Today. or where a far future delivery price is higher than a nearer future delivery. where the price of a commodity for future delivery is lower than the spot price. equities and equity indexes.) • IntercontinentalExchange (ICE Futures Europe) . see List of traded commodities. For a list of tradable commodities futures contracts. S&P. • • • • • Foreign exchange market Money market Bond market Equity market Soft Commodities market
Trading on commodities began in Japan in the 18th century with the trading of rice and silk. For information on futures markets in specific underlying commodity markets. exchange trading has expanded to include metals.formerly the International Petroleum Exchange trades energy including crude oil. securities (such as single-stock futures). Butter. Cattle. such as the London International Financial Futures Exchange in 1982 (now Euronext. Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). meat and livestock. is known as backwardation. government interest rates and private interest rates. Exchanges Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets.Currencies. Agricultural (Corn. Index (NASDAQ.
Futures contracts and exchanges
Contracts There are many different kinds of futures contracts. Milk). See also the futures exchange article.

heating oil. zinc.softs: grains and meats.into which merged Singapore International Monetary Exchange (SIMEX) • ROFEX .KRX • Singapore Exchange . Index futures include EURIBOR.softs: cocoa.formerly New York Board of Trade .Rosario (Argentina) Futures Exchange
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Codes
Most Futures contracts codes are four characters. Inactive market in Baltic Exchange shipping. gold. In other words. CAC 40. aluminum and palladium • Dubai Mercantile Exchange • Korea Exchange . TOPIX Futures) • Tokyo Commodity Exchange TOCOM • Tokyo Financial Exchange [10] . AEX index. coal.TFX . aluminium.metals: copper. copper.SAFEX • Sydney Futures Exchange • Tokyo Stock Exchange TSE (JGB Futures.Futures contract • NYSE Euronext . Third (month) futures contract codes are • • • • • • • • • • • • January = F February = G March = H April = J May = K June = M July = N August = Q September = U October = V November = X December = Z
Example: CLX0 is a Crude Oil (CL). tin and steel • IntercontinentalExchange (ICE Futures U. who seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper". lead. the third character identifies the month and the last character is the last digit of the year.which absorbed Euronext into which London International Financial Futures and Options Exchange or LIFFE (pronounced 'LIFE') was merged. FTSE 100. RNP Futures) • London Metal Exchange .
. the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract. natural gas. November (X) 2010 (0) contract. The first two characters identify the contract type.
Who trades futures?
Futures traders are traditionally placed in one of two groups: hedgers. SpotNext RepoRate Futures) • Osaka Securities Exchange OSE (Nikkei Futures. cotton. silver.S. and speculators. who have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes. propane. OverNight CallRate Futures. nickel. sugar • New York Mercantile Exchange CME Group. coffee. while they have no practical use for or intent to actually take or make delivery of the underlying asset.SGX . gasoline. orange juice. (LIFFE had taken over London Commodities Exchange ("LCE") in 1996).energy and metals: crude oil. • South African Futures Exchange . platinum.) .(Euroyen Futures.

These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest.
. "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap. This type of report is referred to as the 'Commitments of Traders Report'.
230
Options on futures
In many cases. A put is the option to sell a futures contract. The Portfolio manager often "equitizes" cash inflows in an easy and cost effective manner by investing in (opening long) S&P 500 stock index futures. Futures are often used since they are delta one instruments. so that they can plan on a fixed cost for feed. This also preserves balanced diversification. and a call is the option to buy a futures contract. For example. This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual 500 stocks just yet. An example that has both hedge and speculative notions involves a mutual fund or separately managed account whose investment objective is to track the performance of a stock index such as the S&P 500 stock index. livestock producers often purchase futures to cover their feed costs. The Commission has the right to hand out fines and other punishments for an individual or company who breaks any rules. the option strike price is the specified futures price at which the future is traded if the option is exercised. In modern (financial) markets. The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment that has more than 20 participants. farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price. from a hedger to a speculator. an independent agency of the United States government. Although by law the commission regulates all transactions. in traditional commodity markets. each exchange can have its own rule.Futures contract Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. maintains a higher degree of the percent of assets invested in the market and helps reduce tracking error in the performance of the fund/account. For both. the portfolio manager can close the contract and make purchases of each individual stock. The social utility of futures markets is considered to be mainly in the transfer of risk. making it easier for them to plan.
Futures contract regulations
All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC). sometimes called simply "futures options". which is the most popular method for pricing these option contracts. Similarly. When it is economically feasible (an efficient amount of shares of every individual position within the fund or account can be purchased). options are traded on futures. See the Black-Scholes model. COT-Report or simply COTR. and under contract can fine companies for different things or extend the fine that the CFTC hands out. for example. and increased liquidity between traders with different risk and time preferences.

T). Therefore. it's impossible for almost any individual producer to 'hedge' efficiently when relying on the final settlement of a futures contract for SRW. • During any time interval . The trend is for the CBOT to continue to restrict those entities that can actually participate in settling commodities contracts to those that can ship or receive large quantities of railroad cars and multiple barges at a few selected sites. SRW futures have settled more than 20¢ apart on settlement day and as much as $1. while forwards are traded over-the-counter. the ability of the markets to discern the appropriate value of a commodity reflecting current conditions. while forwards are not. is degraded in relation to the discrepancy in price and the inability of producers to enforce contracts with the commodities they represent. has made no comment as to why this trend is allowed to continue since economic theory and CBOT publications maintain that convergence of contracts with the price of the underlying commodity they represent is the basis of integrity for a futures market.T) and is entitled to receive J. Only a few participants holding CBOT SRW futures contracts are qualified by the CBOT to make or receive delivery of commodities to settle futures contracts. Thus futures are standardized and face an exchange.
• The spot price of obtaining the futures contract is equal to zero. • Futures are margined. and have different funding.Futures contract
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Definition of futures contract
Following Björk[11] we give a definition of a futures contract. • At time T. We describe a futures contract with delivery of item J at the time T: • There exists in the market a quoted price F(t. for all time t such that
Nonconvergence
Some exchanges tolerate 'nonconvergence'. while forwards are customized and face a non-exchange counterparty. the holder receives the amount .
. the holder pays F(T. which has oversight of the futures market in the United States. It follows that the function of 'price discovery'.00 difference between settlement days. . they are different in two main respects: • Futures are exchange-traded. the failure of futures contracts and the value of the physical commodities they represent to reach the same value on 'contract settlement' day at the designated delivery points. The Commodity Futures Trading Commission. Thus futures have significantly less credit risk. An example of this is the CBOT (Chicago Board of Trade) Soft Red Winter wheat (SRW) futures.[12]
Futures versus forwards
While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price. which is known as the futures price at time t for delivery of J at time T.

however. an unrealized gain (loss) can build up. Thus: • Futures are highly standardized. where no daily true-up takes place in turn creates credit risk for forwards. to the holder of the other side of the future. rather. rather than an individual party. The threshold amount for daily futures variation margin for institutional investors is often $1. This means that the "mark-to-market" calculation would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin"). or can simply be a signed contract between two parties. This true-ing up occurs by the "loss" party providing additional collateral. In most cases involving institutional investors. That is. due to movements in the price of the underlying asset. or that the buyer will be unable to pay for it on the delivery date or the date at which the opening party closes the contract. the loss party wires cash to the other party.
Margining
Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market).Futures contract
232
Exchange versus OTC
Futures are always traded on an exchange. Forwards do not have a standard. the shortfall or variation margin would typically be shored up by the investor wiring or depositing additional cash in the brokerage account. The counterparty for delivery on a futures contract is chosen by the clearing house. the risk of a forward contract is that the supplier will be unable to deliver the referenced asset. The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. this differs from futures which get 'trued-up' typically daily by a comparison of the market value of the future to the collateral securing the contract to keep it in line with the brokerage margin requirements. it builds up as unrealized gain (loss) depending on which side of the trade being discussed. They may transact only on the settlement date. and in any event. the spread in exchange rates is not trued up regularly but. Simply put. via margin accounts. the forward contract specifies to whom to make the delivery. This means that there will usually be very little additional money due on the final day to settle the futures contract: only the final day's gain or loss. the daily futures-settlement failure risk is borne by an exchange. being over-the-counter. The fact that forwards are not margined daily means that. The result is that forwards have higher credit risk than futures. that futures contract costs $90. a large differential can build up between the forward's delivery price and the settlement price. the daily variation margin settlement guidelines for futures call for actual money movement only above some insignificant amount to avoid wiring back and forth small sums of cash. the time the contract is closed prior to expiration) assuming the parties must transact at the underlying currency's spot price to facilitate receipt/delivery. More typical would be for the parties to agree to true up. but not so much for futures.000.
. Again. The situation for forwards. In addition. On day 51. In a forward though. further limiting credit risk in futures. whereas forwards always trade over-the-counter. for example. so if the buyer of the contract incurs a drop in value. a futures contract with a $100 delivery price (on the same underlying asset as the future) costs $88. and that funding is charged differently. Example: Consider a futures contract with a $100 price: Let's say that on day 50. every quarter. being exchange-traded. whereas forwards can be unique. This means that entire unrealized gain (loss) becomes realized at the time of delivery (or as what typically occurs. • In the case of physical delivery. not the gain or loss over the life of the contract. This money goes.

gov. vol. International Herald Tribune. doi:10. trans. Options. New Jersey 07458: Pearson Prentice Hall. theIFM. 2004 [12] Henriques. 453. [7] Inter-Ministerial task force (chaired by Wajahat Habibullah) (May 2003). become bankrupt). Politics. Futures and Other Derivatives (excerpt by Fan Zhang) (http:/ / fan. 2. CME Group. 2008
. book 1. org/ gfb). strictly speaking.Futures contract A forward-holder. in/ htmldocs/ reports/ rep03. p. due to the path dependence of funding. co.g. Forward Markets Commission (India). ISBN 0-13-063085-3. for a futures this gain or loss is realized daily. php). (2005). John C. Upper Saddle River. may pay nothing until settlement on the final day. zhang. the clearing house interposes itself on every trade. a futures contract is not. potentially building up a large balance.1016/0378-4266(89)90028-9 [6] "timeline-of-achievements" (http:/ / www. Ulrike (September 1989). Benjamin Jowett. com/ index. iht.). Steven M. This difference is generally quite small though. The Great Books of the Western World. cfm?locator=PSZ3R9& PMDbSiteId=2781& PMDbSolutionId=6724& PMDbCategoryId=& PMDbProgramId=12881& level=4). D Mysterious discrepancies in grain prices baffle experts (http:/ / www. a European derivative: the total gain or loss of the trade depends not only on the value of the underlying asset at expiry. So. chap. while under mark to market accounting. html). [10] http:/ / www. while for a forward contract the gain or loss remains unrealized until expiry. for both assets the gain or loss accrues over the holding period. fmc. 288. The only risk is that the clearing house defaults (e. "Forwards and futures in tokugawa-period Japan:A new perspective on the Djima rice market". 2008. com/ articles/ 2008/ 03/ 27/ business/ commod. but also on the path of prices on the way. however. Arthur. Journal of Banking & Finance 13 (4-5): 487–513. jp/ en/ [11] Björk: Arbitrage theory in continuous time. Cambridge university press. Economics: Principles in action (http:/ / www. gl/ ecref/ futures) (6th ed. March 23. Thus. ISBN 0-13-149908-4. Prentice-Hall. cmegroup. "Convergence of Securities and Commodity Markets report" (http:/ / www. Thus there is no risk of counterparty default. Accessed April 12. while the forward's spot price converges to the settlement price. [2] Forward Contract on Wikinvest [3] Hull.
233
See also
• List of finance topics • • • • • • • • • • • Freight derivatives Fuel price risk management List of traded commodities Seasonal spread trading Prediction market 1256 Contract Oil-storage trade Onion Futures Act Grain Futures Act Commodity Exchange Act London Metal Exchange
Notes
[1] Sullivan. this may be reflected in the mark by an allowance for credit risk. . htm). With an exchange-traded future. 11. [8] Cash settlement on Wikinvest [9] Futures & Options Factbook (http:/ / www. tfx. [4] Aristotle. which is considered very unlikely. pp. but holders of futures experience that loss/gain in daily increments which track the forward's daily price changes. Sheffrin (2003). Institute for Financial Markets. [5] Schaede. Note that. futures and forwards with equal delivery prices result in the same total loss or gain. except for tiny effects of convexity bias (due to earning or paying interest on margin). com/ company/ history/ timeline-of-achievements. pearsonschool. .

Futures & Options (http://www.theifm. • CME Group futures contracts product codes (http://www. Steven (2000).stm) • Energy Futures Databrowser (http://mazamascience. now part of CME Group • • • • • • Commodity Futures Trading Commission National Futures Association Kansas City Board of Trade New York Board of Trade now ICE New York Mercantile Exchange.uk/1/hi/magazine/7559032. p. New York: Springer. Basingstoke. • Lioui.inc). Poncet.Futures contract
234
References
• The Institute for Financial Markets (http://www. now part of CME Group • Chicago Mercantile Exchange.theifm. (1996). DC: The IFM.com/Energy/NYMEXFutures/) Current and historical charts of NYMEX energy futures chains. ISBN 0333764471.org) (2003). • Arditti.bbc. Keith (1997).S. ISBN 0875845606. Abraham.theifm. org/index. • Redhead. Futures. and Mortgage Securities. ISBN 013241399X. Dynamic Asset Allocation with Forwards and Futures. Hampshire: Macmillan Press.cmegroup. Options and Swaps. Fred D. Washington. An Introduction To Global Financial Markets (3rd ed.). 237. Financial Derivatives: An Introduction to Futures. London: Prentice-Hall. • The Institute for Financial Markets' Futures & Options Factbook (http://www. ISBN 0387241078. Forwards. Interest Rate Swaps. Futures exchanges and regulators
• Chicago Board of Trade.org/gfb)
U. • Valdez. Boston: Harvard Business School Press.com/product-codes-listing/)
. Patrice (2005). now part of CME Group Minneapolis Grain Exchange
External links
• BBC Oil Futures Investigation (http://news. Derivatives: A Comprehensive Resource for Options.cfm?inc=education/focourse.co.

To derive the put-call parity relationship. The value at expiry is
respectively. or do these prices merely fall into place? Well. must be equal. they differ. then
be determined in other situations. because option prices are typically not adjusted for ordinary interest. they should be included in dividends. If the bond interest . someone else could go long: purchasing the cheaper portfolio then immediately selling the more expensive one (since they have the same value at expiry). be an underlying a financial instrument. and relying on the background assumption that the market is sufficiently ideal to prevent arbitrage The following example uses stock options with no dividends. So the value of the portfolios at expiry is the same. This example demonstrates how put-call relationships may
. Hence it follows that for all times . option bonds. put-call parity defines a relationship between the price of a call option and a put option—both with the identical strike price and expiry. Now consider two portfolios:
{{{}}} Here value of a bond that matures at time . Let be their excercise (strike) price.Put–call parity
235
Put–call parity
In financial mathematics. (2) At first glance.. Put–call parity can be derived in a manner that is largely model independent. Otherwise if at some time before expiry. those who set rate (or force of
. let of .e. metaphysically. their is a confusion about who sets these prices: do people go about constantly setting the prices of financial instruments?. their price at all times before expiry. the theory only admits that the cause of prices. call. We claim that since the market always prevents arbitrage (risk-less profit). I. compounded continuously) is constantly .
Derivation
Relationships between the value of a call and put of an underlying variable. is the market forces.. are merely agents (efficient means) of this cause. Let be the expiry of the call and put options of be the share. etc.
Note: (1) If a stock pays dividends. and put prices of : : one one put call option + one + share . . may be determined by considering different portfolio bundles. which necessarily applies to European options. {{{}}} The value at expiry is . the assumption is that the options are not exercised before expiration day.

• Parity of implied volatility: In the absence of dividends or other costs of carry (such as when a stock is difficult to borrow or sell short). The original work of Bronzin is a book written in German and is now translated and published in English in an edited work by Hafner and Zimmermann (Vinzenz Bronzin's option pricing models. These properties define price limits. His book was re-discovered by Espen Gaarder Haug in the early 2000s and many references from Nelson's book are given in Haug's book "Derivatives Models on Models".
• the left part of the equation is called "fiduciary call" • the right side of the equation is called "protective put"
. is the same as buying a put and buying shares of stock. Put–call parity only holds for European options. the defining characteristic of a modern mortgage. of Options and Arbitrage" in 1904 that describes the put-call parity in detail.C.B.[1]
Other arbitrage relationships
Note that there are several other (theoretical) properties of option prices which may be derived via arbitrage considerations. Shares and Options.Put–call parity
236
History
Nelson. where you have the right to exercise before expiration. which had higher interest rates than the usury laws of the time would have normally allowed. the implied volatility of calls and puts must be identical. The Relation Between Put and Call Prices. describes the important role that put-call parity played in developing the equity of redemption. Henry Deutsch describes the put-call parity in 1910 in his book "Arbitrage in Bullion. Its first description in the "modern" literature appears to be Hans Stoll's paper. or American options if they are not exercised early. dividends and the risk free rate. See links below. 2nd Edition". published a book: "The A. the relationship between price. from 1969. Stocks. Coins. then buying a call.
Put-call Parity and American Options
For American options. Equivalence of calls and puts is very important when trading options. in Medieval England Russell Sage used put-call parity to create synthetic loans.
Implications
Put–call parity implies: • Equivalence of calls and puts: Parity implies that a call and a put can be used interchangeably in any delta-neutral portfolio. The work of professor Bronzin was just recently rediscovered by professor Wolfgang Hafner and professor Heinz Zimmermann. London: Engham Wilson but in less detail than Nelson (1904). and the relationship between the prices of various types of options. Michael Knoll. the appropriateness of early exercise. an option arbitrage trader in New York. Bills. T) term in the above equation. Mathematics professor Vinzenz Bronzin also derives the put-call parity in 1908 and uses it as part of his arbitrage argument to develop a series of mathematical option models under a series of different distributions. If is the call's delta. this affects the B(t. Springer Verlag). in The Ancient Roots of Modern Financial Innovation: The Early History of Regulatory Arbitrage. and selling shares of stock.

sjsu. Prof. When out-of-the-money. investopedia. 330–331.com • Put-Call Parity and Arbitrage Opportunity (http://www. Prof. Futures and Other Derivatives (5th ed.investopedia.htm). pp.). then the option has an intrinsic value of USD $0. Michael Knoll's history of Put-Call Parity • Other abitrage relationships • Arbitrage Relationships for Options (http://www.bus.asp).
Options
An option is said to have intrinsic value if the option is in-the-money. nellco.novy-marx/teaching/35100/ Lectures/lec03. Options.
. For a call option
while for a put option
For example.chicagobooth. It is ordinarily calculated by summing the future income generated by the asset.edu/robert.pdf) (PDFDi). if the strike price for a call option is USD $1 and the price of the underlying is USD $1. Campbell R.quantnotes.com/fundamentals/options/putcallparity.org/upenn/wps/papers/49/).20. quantnotes. Prentice Hall. (2002). John C. Don M. Harvey
Intrinsic value (finance)
In finance.edu/academics/finance/ faculty/dchance/Instructional/TN99-05. htm). Prof. Robert Novy-Marx • Tools • Option Arbitrage Relations (http://www.htm).edu/~charvey/Classes/ba350/optval/arbitrage/arbitrage. The total value of an option is the sum of its intrinsic value and its time value.com/articles/optioninvestor/05/ 011905.com • The Ancient Roots of Modern Financial Innovation: The Early History of Regulatory Arbitrage (http://lsr. The intrinsic value for an in-the-money option is calculated as the absolute value of the difference between the current price (S) of the underlying and the strike price (K) of the option. ISBN 0-13-009056-5. its intrinsic value is zero. Chance • No-Arbitrage Bounds on Options (http://faculty. Thayer Watkins • Rational Rules and Boundary Conditions for Option Pricing (http://www. Prof.
External links
• Put-Call parity • Put-Call Parity Relationship (http://www. floored to zero. It is also frequently called fundamental value.pdf). and discounting it to the present value.edu/faculty/watkins/arb.duke.Put–call parity
237
References
[1] Hull.20. intrinsic value refers to the value of a security which is intrinsic to or contained in the security itself.lsu.

securities analysts may use fundamental analysis — as opposed to technical analysis — to estimate the intrinsic value of a company. a similar approach may be used. is to view intrinsic value as the value of a business' ongoing operations. investopedia. This calculation can be done using the gordon model. as opposed to its accounting based book value. These cash flows would include rent. inflation. and then buy that business when its price is at a discount to its intrinsic value. Warren Buffett is known for his ability to calculate the intrinsic value of a business. it is calculated via discounted cash flow valuation. maintenance and property taxes. though related approach.Intrinsic value (finance)
238
Equity
In valuing equity. The "intrinsic value" of real estate is therefore defined as the net present value of all future net cash flows which are foregone by buying a piece of real estate instead of renting it in perpetuity. or break-up value. Here the "intrinsic" characteristic considered is the expected cash flow production of the company in question. Intrinsic value is therefore defined to be the present value of all expected future net cash flows to the company. An alternative. com/ terms/ i/ intrinsicvalue.
See also
• • • • Net Realizable Value Option time value Option (finance) Expected value
External links
• Investopedia [1]
References
[1] http:/ / www. asp
.
Real Estate
In valuing real estate.

The option value will never be lower than its intrinsic value. If the option has a positive monetary value. This price will reflect the "likelihood" of the option finishing "in-the-money". For an out-the-money option. or
As seen on the graph. If an option is out-of-the-money at expiration. and thus the higher the option price.[3]
. Numerically.Intrinsic Value.e. Time value is simply the difference between option value and intrinsic value. thus an option can never have a negative value. For this reason we assume that the owner of the option will never choose to lose money by exercising. as above. being a function of the option price. Time value is also known as extrinsic value. its intrinsic value and its time value. Prior to expiration. where the option value is simply its intrinsic value.
Option value
Option value (i. More specifically.e.the higher the chance of this occurring.
Time value
Time value is. Volatile prices of the underlying instrument can stimulate option demand. its holder will simply abandon the option and it will expire worthless.i. i. it is referred to as being in-the-money.Option time value
239
Option time value
In finance. or instrumental value.
Intrinsic value
The intrinsic value of an option is the value of exercising it now. and converges towards zero with time. An important factor is the option's volatility. The sensitivity of the option value to the amount of time to expiry is known as the option's "theta". otherwise it is referred to as being out-of-the-money. the change in time value with time is non-linear. enhancing the value. the intrinsic value of a call option is positive when the underlying asset's spot price S exceeds the option's strike price K. the further in the future the expiration date . see The Greeks. the full call option value (intrinsic and time value) is the red line. The time value of an option is not negative (because the option value is never lower than the intrinsic value). time value is zero. the value of an option consists of two components. or .e. for an in-the-money option the chance in the money decreases.
Option Value
As seen on the graph.[1] Value of a call option: Value of a put option: . this value depends on the time until the expiration date and the volatility of the underlying instrument's price. an option's time value reflects the probability that the option will gain in intrinsic value or become profitable to exercise before it expires[2] . price) is found via a predictive formula such as Black-Scholes or using a numerical method such as the Binomial model. At expiration. the longer the time to exercise . however the fact that the option cannot have negative value also works in the owner's favor. Time Value = Option Value . the difference between option value and intrinsic value.

com/opt/basics5. wolfram.html). biz. In finance.yahoo. so the time value can be negative. or in standard deviations. A call option is out-of-the-money when the strike price is above the spot price of the underlying security. It can be measured in percentage probability. a call has positive intrinsic value (and is called "in the money"). In the case of a European option. investopedia. htm) 22 August 2007 [3] Options: Time Value (http:/ / demonstrations. for an American option if the time value is never negative.Option time value
240
See also
• Intrinsic value • Naked call • Time value of money
References
[1] Understanding Option Pricing (http:/ / www. The time value of an option is a function of the option value less the intrinsic value.com
Moneyness
"In the money" redirects here. Thus if the current (spot) price of the underlying security is above the agreed (strike) price. A put option is in-the-money when the strike price is above the spot price.
OTM: Out-of-the-money
An out-of-the-money option has no intrinsic value. while a put has zero intrinsic value. you cannot choose to exercise it at any time.yahoo. An at-the-money option has no intrinsic value. A call option is in-the-money when the strike price is below the spot price. only time value. for the poker term. moneyness is a measure of the degree to which a derivative is likely to have positive monetary value at its expiration.
Intrinsic value and time value
The intrinsic value (or "monetary value") of an option is the value of exercising it now. com/ articles/ optioninvestor/ 07/ options_beat_market. in the risk-neutral measure. A put option is out-of-the-money when the strike price is below the spot price. It is also viewed as the value of not exercising the option immediately. wolfram.
ITM: In-the-money
An in-the-money option has positive intrinsic value as well as time value. com/ OptionsTimeValue/ ).
.com
External links and references
• Basic Options Concepts: Intrinsic Value and Time Value (http://biz. see In the money (poker).
ATM: At-the-money
An option is at-the-money if the strike price is the same as the spot price of the underlying security on which the option is written. com/ futures-education/ option-premium-valuation. It equates to uncertainty in the form of investor hope. asp) Hans Wagner [2] Option premium valuation (http:/ / www. you exercise it: this yields a boundary condition. oxfordfutures.

Options as a Strategic Investment (4th ed.
Which are used?
Buying an ITM option is effectively lending money in the amount of the intrinsic value. "ATM Forward". not the expected return on the underlying. with a positive value meaning an in-the-money call option and a negative value meaning an out-of-the-money call option (with signs reversed for a put option). (2002). then a call struck at 110 is ATMF but not ATM. Consequently. while a moneyness of 1 yields an approximately
References
• McMillan. a call option with a $120 strike is out-of-the-money and a put option with a $120 strike is in-the-money. if the spot price for USD/JPY is 120. Further. In other words. instead of . A call option with a strike of $80 is in-the-money (100 – 80 = 20 > 0). Moneyness is measured in standard deviations from this point. via 84% probability of expiring ITM. This choice of parameterisation means that the moneyness is zero when the forward price of the underlying. Lawrence G.).
thus a moneyness of 0 yields a 50% probability of expiring ITM. New York : New York Institute of Finance. ISBN 0-7352-0197-8. an ITM call can be replicated by entering a forward and buying an OTM put (and conversely). Beware that (percentage) moneyness is close to but different from Delta: .
. and so forth. equals the strike price. A call or put option with a strike of $100 is at-the-money. and the forward price one year hence is 110. for a call (conversely for a put). where is the standard normal cumulative distribution function. it is the number of standard deviations the current price is above the ATMF price. Such an option is often referred to as at-the-money-forward. Conversely. ed. one may define moneyness quantitatively.Moneyness
241
Spot versus forward
Assets can have a forward price (a price for delivery in future) as well as a spot price. For instance. When one uses the Black-Scholes model to value the option. If we define the moneyness (of a call) as
where d1 and d2 are the standard Black-Scholes parameters then
where T is the time to expiry. discounted at the risk-free rate. Note that is the risk-free rate. A put option with a strike at $80 is out-of-the-money (80 – 100 = –20 < 0).
Example
Suppose the current stock price of IBM is $100. One can also measure it as a percent. One can also talk about moneyness with respect to the forward price: thus one talks about ATMF. Thus a 25 Delta call option has approximately (but not exactly) 25% moneyness. ATM and OTM options are the main traded ones.

"The Pricing of Options and Corporate Liabilities. It follows from this that the return has a Normal distribution (Then the price of the underlying has a Log-normal distribution). • There are no restrictions on short selling. consisting of a long position in the stock and a short position in [calls on the same stock].[1] The fundamental insight of Black–Scholes is that the option is implicitly priced if the stock is traded. 1976). Merton was the first to publish a paper expanding the mathematical understanding of the options pricing model and coined the term Black–Scholes options pricing model. the authors show that "it is possible to create a hedged position. Though ineligible for the prize because of his death in 1995. Black was mentioned as a contributor by the Swedish academy. Thorp. The model develops partial differential equations whose solution.
. 1973). and dividend payout (Merton. transaction costs and taxes (Ingersoll. it is possible to buy any fraction of a share). Merton and Scholes received the 1997 Nobel Prize in Economics (The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) for their work."[3] Several of these assumptions of the original model have been removed in subsequent extensions of the model. James Boness. • The price follows a Geometric Brownian motion with constant drift and volatility. 1976). A. Paul Samuelson. and Edward O. • The underlying does not pay a dividend (see below for extensions to handle dividend payments). • All securities are infinitely divisible (i. This restriction has been removed in later extensions of the model. the Black–Scholes formula.. • There are no transaction costs or taxes. whose value will not depend on the price of the stock.e. From these conditions in the market for an equity (and for an option on the equity). This often implies the validity of the efficient-market hypothesis. Robert C. The model was first articulated by Fischer Black and Myron Scholes in their 1973 paper. • Options use the European exercise terms.Black–Scholes
242
Black–Scholes
The Black–Scholes model is a mathematical description of financial markets and derivative investment instruments. Sheen T. • There is no arbitrage opportunity. Modern versions account for changing interest rates (Merton. is widely used in the pricing of European-style options.[2]
Model assumptions
The Black–Scholes model of the market for a particular equity makes the following explicit assumptions: • It is possible to borrow and lend cash at a known constant risk-free interest rate. Kassouf. Treynor. which dictate that options may only be exercised on the day of expiration." The foundation for their research relied on work developed by scholars such as Jack L.

as well as market equilibrium. denote time. we rely on the assumptions on the
Simulated Geometric Brownian Motions with Parameters from Market Data
As per the assumptions.g. To do this. is:
.
where is a Wiener process. by and
. So
accounts for all volatility/risk in the price history of the stock. and replace respectively.
the volatility of the stock's returns. (Later we shall specify the option as a (European) call or put. where this derivative is either a call or a put option. it depends only on the price of the asset and time. . the exercise (strike) price of the option. continuously compounded. and
is a Wiener process. : during the lifetime of the derivative (i. underlying asset. a stock).
Itō's lemma for two variables we have for all times
(provided we assume
is twice continuously differentiable with respect to
and once with respect to
). (1) Some minor calculations. Under the assumptions this is governed by geometric brownian motion.
be the price of the derivative. continuously hold one option and shares of the underlying financial instrument. Since almost surely every such path is continuous.e. the annualized risk-free interest rate. be the price of the asset (as below).
(2) Consider the following trading strategy (delta-hedging). We generally let denote the duration of the option. In particular
where
is the drift rate. how evolves over time.
be a derivative based on
.) . the price of the underlying asset is a geometric Brownian motion.Black–Scholes
243
Notation
Let be the underlying asset (e. viz. The price of this portfolio at any time . the option). we may assume is continuous. Then by .
Mathematical model
The thing to be determined is the price of the derivative.

For all times
which is called the Black–Scholes (second order) partial differential equation.) Putting this together readily determines a governing equation for the price of the derivative. which differs from the real world measure. then at the next instant sell the portfolio and return the money with interest. then at the next instant. that at any time
. earn interest on the money. This latter method gives the price as the expectation of the option payoff under a particular probability measure.
Black–Scholes formula
Black–Scholes European Call Option Pricing Surface
The Black Scholes formula calculates the price of European put and call options. fluctuations in the underlying variables will not give rise to [significant] changes in .e. is: i. If the derivative. buy the original portfolio at the updated price. purchase the portfolio. If a put option the boundary condition is
where
. we have that. . . The value of a call option for a non-dividend paying underlying stock in terms of the Black–Scholes parameters is: .
where is the risk-free interest rate. since as .
Note: Black and Scholes reasoned that market forces will prevent delta-hedging.Black–Scholes Also the instantaneous profit. at any time at the end of an infinitesimal interval . It is also possible to use a risk-neutrality argument. (Otherwise either (i) one could borrow money at some time. It can be obtained by solving the Black–Scholes partial differential equation. the payoff of purchasing this portfolio then selling it
244
Now to prevent this kind of arbitrage (delta-hedging). it must be so. Clearly one of these will allow for a risk-free profit if equality does not hold. or (ii) one could short-sell the portfolio. is a call option. then we have the boundary condition: . called the risk-neutral measure. This applies applies above.
Other derivations Above we used the method of arbitrage-free pricing ("delta-hedging") to derive some PDE governing option prices given the Black–Scholes model. The boundary conditions are determined by what a put/call option is worth at expiry. in any infinitesimal period of time.

additional information is required — viz. To this end we apply the transformations with domain over with domain Then the Black–Scholes PDE becomes a heat equation
with boundary conditions for all for all for all Using the standard method for solving a wave equation we have
Which yields
. The solution of the PDE gives the value of the option at any earlier time and in fact equals .. for which the PDE above has boundary conditions for all for all for all The last condition gives the value of the option at the time that the option matures. Note that both of these are probabilities in a measure theoretic sense. respectively. To actually solve the PDE.
Derivation
We now show how to get from the general Black–Scholes PDE to a specific valuation for an option. Consider as an example the Black–Scholes price of a call option.Black–Scholes
245
. the drift term in the physical measure. the time till expiry. the market price of risk. transform the equation into a diffusion/wave equation which may be solved using standard methods. To calculate the probability under the real ("physical") probability measure.
In turn. and neither of these is the true probability of expiring in-the-money under the real probability measure. the price of a corresponding put option based on put-call parity is:
Interpretation
are the probabilities of the option expiring in-the-money under the equivalent exponential martingale probability measure (numéraire = stock) and the equivalent martingale probability measure (numéraire = risk free asset). The equivalent martingale probability measure is also called the risk-neutral probability measure. or equivalently.

Black–Scholes
246
where
are as above. In this case.
Instruments paying continuous yield dividends
For options on indexes. t + dt) is then modelled as
for some constant q (the dividend yield). more realistic than a proportional dividend) are more difficult to value. some sensitivities are usually quoted in scaled-down terms. The model may also be used to value European options on instruments paying dividends. American options and options on stocks paying a known cash dividend (in the short term. and by 365 or 252 (1 day decay based on either calendar days or trading days per year). which can be seen directly from put-call
In practice. closed-form solutions are available if the dividend is a known proportion of the stock price. Reverting the transformations yields the solution above. Under this formulation the arbitrage-free price implied by the Black–Scholes model can be shown to be
where now
is the modified forward price that occurs in the terms
and
:
.000 (1bp rate change). The dividend payment paid over the time period [t. is often reported divided by 10. it is reasonable to make the simplifying assumption that dividends are paid continuously.
Extensions of the model
The above model can be extended for variable (but deterministic) rates and volatilities. to match the scale of likely changes in the parameters.
Greeks
The Greeks under Black–Scholes are given in closed form.
and
formulas are the same for calls and puts. and that the dividend amount is proportional to the level of the index. below:
What Calls Puts
Note that the parity. For example. by 100 (1 vol point change). and a choice of solution techniques is available (for example lattices and grids).

In short. • the assumption of a stationary process.
Black–Scholes in practice
The Black–Scholes model disagrees with reality in a number of ways. such events would be very rare if returns were lognormally distributed.
Instruments paying discrete proportional dividends
It is also possible to extend the Black–Scholes framework to options on instruments paying discrete proportional dividends. This is useful when the option is struck on a single stock. which can be hedged with Gamma hedging.. nor is the risk-free interest actually known (and is not constant over time). yielding volatility risk. It is widely employed as a useful approximation. yielding tail risk. • the assumption of instant. which can be hedged with out-of-the-money options. The price of a call option on such a stock is again
where now
is the forward price for the dividend paying stock. yielding gap risk.. cost-less trading. yielding liquidity risk. One significant limitation is that in reality security prices do not follow a strict stationary log-normal process. A typical model is to assume that a proportion price of the stock is then modelled as of the stock price is paid out at pre-determined times t1.. Among the most significant limitations are: • the underestimation of extreme moves. • the assumption of continuous time and continuous trading. in practice there are many other sources of risk. some significant.
The normality assumption of the Black–Scholes model does not capture extreme movements such as stock market crashes.
Results using the Black–Scholes model differ from real world prices because of simplifying assumptions of the model. but proper application requires understanding its limitations – blindly following the model exposes the user to unexpected risk.Black–Scholes
247
Exactly the same formula is used to price options on foreign exchange rates.
. while in the Black–Scholes model one can perfectly hedge options by simply Delta hedging. but are observed much more often in practice. Pricing discrepancies between empirical and the Black–Scholes model have long been observed in options that are far out-of-the-money. corresponding to extreme price changes. . The variance has been observed to be non-constant leading to models such as GARCH to model volatility changes. except that now q plays the role of the foreign risk-free interest rate and S is the spot exchange rate. t2. which can be hedged with volatility hedging. The
where n(t) is the number of dividends that have been paid by time t. This is the Garman-Kohlhagen model (1983). which is difficult to hedge.

Despite the existence of the volatility smile (and the violation of all the other assumptions of the Black–Scholes model). A typical approach is to regard the volatility surface as a fact about the market. and hedging these Greeks mitigates the risk caused by the non-constant nature of these parameters. strikes. This is reflected in the Greeks (the change in option value for a change in these parameters. however. durations and exercise prices. Rather than quoting option prices in terms of dollars per unit (which are hard to compare across strikes and tenors). and slightly lower for high strikes. the volatility surface (the three-dimensional graph of implied volatility against strike and maturity) is not flat. results from the model are often useful in practice and helpful in setting up hedges in the correct proportions to minimize risk. and thus added sources of risk. which leads to trading of volatility in option markets. with higher implied volatility for higher strikes. rather than assuming a volatility a priori and computing prices from it. an option's theoretical value is a monotonic increasing function of implied volatility. the Black–Scholes PDE and Black–Scholes formula are still used extensively in practice. and so on. One reason for the popularity of the Black–Scholes model is that it is robust in that it can be adjusted to deal with some of its failures. which gives the implied volatility of an option at given prices.Black–Scholes Nevertheless. one can use the model to solve for volatility. Rather than considering some parameters (such as volatility or interest rates) as constant. chiefly by minimizing these risks and by stress testing. Commodities often have the reverse behaviour to equities. a coordinate transformation from the price domain to the volatility domain is obtained. option prices can thus be quoted in terms of implied volatility. traders prefer to think in terms of volatility as it allows them to evaluate and compare options of different maturities. Although volatility is not constant.
248
The volatility smile
One of the attractive features of the Black–Scholes model is that the parameters in the model (other than the volatility) — the time to maturity. All other things being equal. Even when the results are not completely accurate. This has been described as using "the wrong number in the wrong formula to get the right price. and the current underlying price — are unequivocally observable. and higher volatilities in both wings. one considers them as variables. particularly when analyzing the directionality that prices move when crossing critical points. The typical shape of the implied volatility curve for a given maturity depends on the underlying instrument. In this application of the Black–Scholes model. or equivalently the partial derivatives with respect to these variables). Currencies tend to have more symmetrical curves. the strike. and use an implied volatility from it in a Black–Scholes valuation model. It is used both as a quoting convention and a basis for more refined models. If the Black–Scholes model held. It is a useful approximation. Black–Scholes pricing is widely used in practice. they serve as a first approximation to which adjustments can be made. with implied volatility lowest at-the-money. Solving for volatility over a given set of durations and strike prices one can construct an implied volatility surface. Even when more advanced models are used. Equities tend to have skewed curves: compared to at-the-money. In practice. then the implied volatility for a particular stock would be the same for all strikes and maturities. Other defects cannot be mitigated by modifying the model. the Black–Scholes model can be tested. implied volatility is substantially higher for low strikes."[5] This approach also gives usable values for the hedge ratios (the Greeks). By computing the implied volatility for traded options with different strikes and maturities. and these are instead managed outside the model. Additionally.
.[4] for it is easy to calculate and explicitly models the relationship of all the variables. notably tail risk and liquidity risk.

Now a simple no-arbitrage argument shows that the theoretical future value of a derivative paying one share of the stock at time T. In either case. Then S0 is known. and so with payoff S. Assume that
is a normal random variable with mean
and variance
.This is simply like the interest rate and bond price relationship which is inversely related. Define
. This volatility may make a significant contribution to the price. is
where r is the risk-free interest rate. then
where
is the standard normal cumulative distribution function. interest rates are not constant . beginning with the Black model. Another consideration is that interest rates vary over time. but S is a random variable. we have
Now let
and use the corollary to the lemma to verify the statement above about the mean of S.they vary by tenor.
Interest rate curve
In practice.
Alternative formula derivation
Let S0 be the current price of the underlying stock and S the price when the option matures at time T. Define the theoretical value of a derivative as the present value of the expected payoff in this sense.Black–Scholes
249
Valuing bond options
Black–Scholes cannot be applied directly to bond securities because of pull-to-par. A large number of extensions to Black–Scholes. and the simple Black–Scholes model does not reflect this process. all of the prices involved with the bond become known. For a call option with exercise price K this discounted expectation (using risk-neutral probabilities) is
The derivation of the formula for C is facilitated by the following lemma: Let Z be a standard normal random variable and let b be an extended real number. It follows that the mean of S is
for some constant q (independent of T). especially of long-dated options. it may be possible to lend out a long stock position for a small fee. This suggests making the identification q = r for the purpose of pricing derivatives. In the special case b = −∞. have been used to deal with this phenomenon. this can be treated as a continuous dividend for the purposes of a Black–Scholes valuation. Define
If a is a positive real number. thereby decreasing its volatility.
Short stock rate
It is not free to take a short stock position. Similarly. giving an interest rate curve which may be interpolated to pick an appropriate rate to use in the Black–Scholes formula. As the bond reaches its maturity date.

the value of the option today is not the expectation of the value of the option at expiry. of course.) The value is instead computed using the expectation under another distribution of probability. but here the subscript is merely a mnemonic. Define
and observe that
The rest of the calculation is straightforward. but when S is reinterpreted as a real variable. It is only then that we can ask about its solution. discounted with the risk-free rate. initially. the letters in the numerators and denominators are. This other distribution of probability is called the "risk neutral" probability. real functions of real variables. But after the substitution of a stochastic process for one of the arguments they become stochastic processes. discounted with the risk-free rate.
Remarks on notation
The reader is warned of the inconsistent notation that appears in this article. initially. The Black–Scholes PDE is. Although the "elementary" derivation leads to the correct result. a statement about the stochastic process S. of the value of the option at expiry. why the formula refers to the risk-free interest rate while a higher rate of return is expected from risky investments.Black–Scholes
250
and observe that
for some b. it is incomplete as it cannot explain. The parameter u that appears in the discrete-dividend model and the elementary derivation is not the same as the parameter that appears elsewhere in the article. In elementary terms. it becomes an ordinary PDE. In the partial derivatives. For the relationship between them see Geometric Brownian motion. Thus the letter S is used as: (1) a constant denoting the current price of the stock (2) a real variable denoting the price at an arbitrary time (3) a random variable denoting the price at maturity (4) a stochastic process denoting the price at an arbitrary time It is also used in the meaning of (4) with a subscript denoting time.
. This limitation can be overcome using the risk-neutral probability measure. but the concept of risk-neutrality and the related theory is far from elementary. and the partial derivatives themselves are. real variables. (So the basic capital asset pricing model (CAPM) results are not violated.

"Theory of Rational Option Pricing" (http://jstor. com/ blogs/ paul/ index. 1997 Press release (http:/ / nobelprize.org/sici?sici=0005-8556(197321)4:1<141:TOROP>2. 1181
References
Primary references
• Black.org/stable/3003143). html) Black. John C.0. using simulation in the valuation of options with complicated features. unwarranted use of the model spiralled into the worldwide October 1987 crash.0. FX and interest-rate options (1999) http:/ / papers. Fischer. dwarfing recent market hiccups. a variant of the Black–Scholes option pricing model. Binomial options model. Monte Carlo option model. ssrn.jstor. Myron Scholes (1973). (1973). is still used extensively. doi:10. when in reality. and Other Derivatives". for example. "The Pricing of Options and Corporate Liabilities". Robert C. (http://links. org/ nobel_prizes/ economics/ laureates/ 1997/ press. Financial mathematics.. NATURE|Vol 455|30 Oct 2008 OPINION ESSAY p. Journal of Political Economy 81 (3): 637–654.[6] Jean-Philippe Bouchaud argues: 'Reliance on models based on incorrect axioms has clear and large effects.jstor.CO.2-P) (Black and Scholes' original paper. wilmott. The Black–Scholes model[7] . Fischer. Bell Journal of Economics and Management Science (The RAND Corporation) 4 (1): 141–183.org/sici?sici=0022-3808(197305/ 06)81:3<637:TPOOAC>2.2307/3003143. Twenty years ago. stock prices are much jerkier than this. Heat equation.
See also
• • • • • Black model. to which the Black–Scholes PDE can be transformed. the Dow Jones index dropped 23% in a single day. cfm?abstract_id=1012075 Jean-Philippe Bouchaud (Capital Fund Management.) • Merton. But it assumes that the probability of extreme price changes is negligible. (http:// links. (1997). physic professor at École Polytechnique): Economics needs a scientific revolution.1086/260062." to make them more compatible with mainstream neoclassical economic theory. Journal of Political Economy 81 (3): 637–654. http:/ / www. ISBN ISBN 0-13-601589-1.Black–Scholes
251
Criticism
Espen Gaarder Haug and Nassim Nicholas Taleb argue that the Black–Scholes model merely recast existing widely used models in terms of practically impossible "dynamic hedging" rather than "risk. a financial art piece • Stochastic volatility
Notes
[1] [2] [3] [4] [5] [6] [7] Nassim Taleb and Espen Gaarder Haug: "Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula" Nobel prize foundation.2-0&origin=repec) • Hull. com/ sol3/ papers.
• Real options analysis • Black Shoals. "The Pricing of Options and Corporate Liabilities".CO. which is a discrete numerical method for calculating option prices. Futures. doi:10. which was invented in 1973 to price options. "Options. Prentice Hall.
. which contains a list of related articles. cfm/ 2008/ 4/ 29/ Science-in-Finance-IX-In-defence-of-Black-Scholes-and-Merton R Rebonato: Volatility and correlation in the pricing of equity.

Exemplars. Wiley.com
Derivation and solution
• Proving the Black-Scholes Formula (http://knol. doi:10.quantnotes. planetmath. sagepub.com • Solution of the Black–Scholes Equation Using the Green's Function (http://www. The book takes a critical look at the Black.org. Scholes and Merton model. Wiley. Disunity and Performativity in Financial Economics". March 2008 Issue of portfolio. Merton and Scholes: Their work and its consequences.abstract.uci.html). Performing Theory: The Historical Sociology of a Financial Derivatives Exchange".htm). • Triana.portfolio.com • Whither Black-Scholes? (http://www. "Constructing a Market.com/fundamentals/ options/riskneutrality. not a Camera: How Financial Models Shape Markets. ISBN 0-262-13460-8.edu/ ~sl1544/KnownClosedForms.htm). April 2008 Issue of Forbes. Black. G (2007). quantnotes. (http://sss. An Engine. Donald.html).com/fundamentals/options/solvingbs.
. Yuval Millo (2003).org/encyclopedia/ AnalyticSolutionOfBlackScholesPDE. Scholes and Merton model. Thayer Watkins • Solving the Black-Scholes Equation (http://www. doi:10. Capital Ideas: The Improbable Origins of Modern Wall Street. Social Studies of Science 33 (6): 831–868. "An Equation and its Worlds: Bricolage.1086/374404. December 1997 link (http://www.com • Arbitrage-free pricing derivation of the Black-Scholes Equation (http://www.1177/0306312703336002.google. Simon Leger • Step-by-step solution of the Black-Scholes PDE (http://planetmath. ISBN 9780470013229.quantnotes. Donald (2006). Derivatives: Models on Models. MIT Press.com/fundamentals/ options/black-scholes. ISBN 0-02-903012-9.edu/~silverma/ bseqn/bs/bs. Pablo (2009).html) • MacKenzie.htm). E.htm).
External links
Discussion of the model
• Ajay Shah. "Option Pricing and Hedging from Theory to Practice". Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?. pdf) • Inside Wall Street's Black Hole (http://www. (http://www. American Journal of Sociology 109 (1): 107–145. or an alternative treatment (http://www.com/news-markets/national-news/portfolio/2008/02/ 19/Black-Scholes-Pricing-Model?print=true) by Michael Lewis. quantnotes.pdf) (includes discussion of other option types).journals.Black–Scholes
252
Historical and sociological aspects
• Bernstein.nyu. Economic and Political Weekly.sjsu.mayin.
Further reading
• Haug. Dennis Silverman • Solution via risk neutral pricing or via the PDE approach using Fourier transforms (http://homepages. The book gives a series of historical references supporting the theory that option traders use much more robust hedging and pricing principles than the Black. Prof.com. quantnotes.org/ajayshah/PDFDOCS/Shah1997_bms.uchicago. Donald (2003).com/cgi/content/abstract/33/6/831) • MacKenzie.edu/faculty/ watkins/blacksch.html) by Pablo Triana. Prof. ISBN 9780470406755. The Free Press.edu/AJS/journal/issues/v109n1/060259/brief/060259. • MacKenzie.physics.com/opinions/2008/04/07/ black-scholes-options-oped-cx_ptp_0408black.quantnotes. Peter (1992).forbes.com/k/the-black-scholes-formula#) • The risk neutrality derivation of the Black-Scholes Equation (http://www. XXXII(52):3337-3342.

Nassim Taleb and Espen Gaarder Haug • The illusions of dynamic replication (http://www.html)
Historical
• Trillion Dollar Bet (http://www.php) • Price and Hedge Simulation based on Black Scholes Option Price (http://www.ederman.global-derivatives.com • Real Time • Black-Scholes tutorial based on graphic simulations (http://www.pdf).com/black_scholes.
253
Revisiting the model
• Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula (http://papers.com).edu/~rpascala/revertGBM/BSOPMRForm.com/sol3/ papers.ua.cfm?abstract_id=1012075).wordpress.bbc. Emanuel Derman and Nassim Taleb • When You Cannot Hedge Continuously: The Corrections to Black-Scholes (http://www.stanford. Emanuel Derman • In defence of Black Scholes and Merton (http://www.com/new/docs/qf-Illusions-dynamic. com/price-hedge-simulation.org/wgbh/nova/stockmarket/)—Companion Web site to a Nova episode originally broadcast on February 8.ederman.cba.com • VBA sourcecode for Black Scholes and Greeks (http://www.cfm/2008/4/29/ Science-in-Finance-IX-In-defence-of-Black-Scholes-and-Merton). Stephen Marlowe • Real-time calculator of Call and Put Option prices when the underlying follows a Mean-Reverting Geometric Brownian Motion (http://www.pbs. espenhaug. Manabu Kishimoto • The Black-Scholes Equation (http://terrytao.com/new/ docs/risk-non_continuous_hedge.ssrn. Paul Wilmott
Computer implementations
• Sourcecode • Black–Scholes in Multiple Languages (http://www.shtml) A TV-programme on the so-called Midas formula and the bankruptcy of Long-Term Capital Management (LTCM)
.Black–Scholes • On the Black-Scholes Equation: Various Derivations (http://www. a mathematical Holy Grail that forever altered the world of finance and earned its creators the 1997 Nobel Prize in Economics.html).pdf).co.wilmott. "The film tells the fascinating story of the invention of the Black-Scholes Formula.com/2008/07/01/the-black-scholes-equation/) Expository article by mathematician Terence Tao.uk/science/horizon/1999/midas.optionanimation.com/blogs/paul/index.espenhaug.exotic-options-and-hybrids.pdf). global-derivatives." • BBC Horizon (http://www. 2000.txt).edu/~japrimbs/Publications/ OnBlackScholesEq.com/code/vba/ BSEuro-Greeks.

The pricing of commodity contracts. Mark B. Univ. Kohlhagen (1983).the forward price represents the undiscounted expected future value. • Garman. Its primary applications are for pricing bond options.) is the cumulative normal distribution function. Black's model can be generalized into a class of models known as log-normal forward models.
See also
• Financial mathematics • Black-Scholes
External links
• 'Greeks' Calculator using the Black model [1].Black model
254
Black model
The Black model (sometimes known as the Black-76 model) is a variant of the Black-Scholes option pricing model. The Black formula for a European call option on an underlying strike at K. The assumption that the spot price follows a log-normal process is replaced by the assumption that the forward price at maturity of the option is log-normally distributed. 2. 3.
The Black formula
The Black formula is similar to the Black-Scholes formula for valuing stock options except that the spot price of the underlying is replaced by the forward price F. of Alabama
References
• Black. interest rate caps / floors. and N(. 231-237. and Steven W. Fischer (1976). Journal of Financial Economics.
. From there the derivation is identical and so the final formula is the same except that the spot price is replaced by the forward .
Derivation and assumptions
The derivation of the pricing formulas in the model follows that of the Black-Scholes model almost exactly. also referred to as LIBOR market model. 167-179. Razvan Pascalau. Foreign currency option values. and swaptions. It was first presented in a paper written by Fischer Black in 1976. Journal of International Money and Finance. continuously compounded. expiring T years in the future is
The put price is
where
where r is the risk-free discount rate.

for other uses see BOPM (disambiguation). et Sondermann. Monte Carlo simulation is computationally time-consuming. As a consequence.
.
Use of the model
The Binomial options pricing model approach is widely used as it is able to handle a variety of conditions for which other models cannot easily be applied. sequential calculation of the option value at each preceding node. the binomial options pricing model (BOPM) provides a generalizable numerical method for the valuation of options. it is more accurate. Sandmann. Asian options). K. and then working backwards through the tree towards the first node (valuation date). however (cf. calculation of option value at each final node. various versions of the binomial model are widely used by practitioners in the options markets. 52(1). For these reasons. particularly for longer-dated options on securities with dividend payments.Black model • Miltersen. In finance. D.
255
References
[1] http:/ / www. represents a possible price of the underlying at a given point in time. edu/ ~rpascala/ greeks2/ GFOPMForm. Each node in the lattice. the model is readily implementable in computer software (including a spreadsheet). 2. price tree generation.. This is largely because the BOPM is based on the description of an underlying instrument over a period of time rather than a single point. Valuation is performed iteratively. Ross and Rubinstein (1979). K. for a number of time steps between the valuation and expiration dates.g. 3. Being relatively simple. (1997): „Closed Form Solutions for Term Structure Derivates with Log-Normal Interest Rates“. and Monte Carlo option models are commonly used instead. Essentially. The binomial model was first proposed by Cox. the model uses a "discrete-time" (lattice based) model of the varying price over time of the underlying financial instrument. The value computed at each stage is the value of the option at that point in time. real options) and for options with complicated features (e. Monte Carlo methods in finance). Option valuation using this method is. php
Binomial options pricing model
BOPM redirects here. Journal of Finance. cba. a three-step process: 1. ua.
Methodology
The binomial pricing model traces the evolution of the option's key underlying variables in discrete-time.. 409-430.. starting at each of the final nodes (those that may be reached at the time of expiration)..g. binomial methods are less practical due to several difficulties. it is used to value American options that are exercisable at any time in a given interval as well as Bermudan options that are exercisable at specific instances of time. Although computationally slower than the Black-Scholes formula. For options with several sources of uncertainty (e. as described. This is done by means of a binomial lattice (tree).

if . value. the option value is then found for each node. and "probability" (1-p) of a down move.e. the price will be the same as if it had moved down and then up (d. At each step. i. From the condition that the variance of the log of the price is . Ross.e.d). at expiration of the option — the option value is simply its intrinsic. it is assumed that the underlying instrument will move up or down by a specific factor ( step of the tree (where."probability" p of an up move in the underlying. This property also allows that the value of the underlying asset at each node can be calculated directly via formula. then in the next
The up and down factors are calculated using the underlying volatility. we have:
The above is the original Cox. The node-value will be:
where: : Number of up ticks : Number of down ticks
STEP 2: Find Option value at each final node
At each final node of the tree — i. & Rubinstein (CRR) method. The Trinomial tree is a similar model. allowing for an up. by definition. . down or stable path. starting at the penultimate time step. such as "the equal probabilities" tree. So. and thus accelerates the computation of the option price. In overview: the "binomial value" is found at each node. for a call option Max [ (K – S). expected value is calculated using the option values from the later two nodes (Option up and Option down) weighted by their respective probabilities -.u) — here the two paths merge or recombine. the risk free
. and does not require that the tree be built first. today's fair price of a derivative is equal to the expected value of its future payoff discounted by the risk free rate. there are other techniques for generating the lattice. then the model takes the greater of binomial and exercise value at the node. see Risk neutral valuation. 0 ]. for a put option: Where: K is the Strike price and S is the spot price of the underlying asset
STEP 3: Find Option value at earlier nodes
Once the above step is complete. The CRR method ensures that the tree is recombinant. Therefore. using the risk neutrality assumption. If exercise is permitted at the node. period the price will either be or and ). This property reduces the number of tree nodes. or exercise. Max [ (S – K).Binomial options pricing model
256
STEP 1: Create the binomial price tree
The tree of prices is produced by working forward from valuation date to expiration. and working back to the first node of the tree (the valuation date) where the calculated result is the value of the option. or ) per is the current price. 0 ]. The expected value is then discounted at r. The steps are as follows: 1) Under the risk neutrality assumption. and the time duration of a step. measured in years (using the day count convention of the underlying instrument). if the underlying asset moves up and then down (u.

.. there is no option of early exercise.e. the value at each node is: Max (Binomial Value. • For a European option. • For a Bermudan option. arbitrage-free pricing.. or
257
where is the option's value for the node at time . at nodes where early exercise is not allowed. n) { ' T.
is chosen such that the related Binomial distribution simulates the geometric Brownian motion of the underlying stock with parameters r and σ. Exercise Value).
for i:= 0 to n { ' initial values at time T p(i):= K. height of the binomial tree deltaT:= T/ n. only the binomial value applies. strike price ' n. exp(-r* deltaT). sigma. It is the value of the option if it were to be held — as opposed to exercised at that point. Exercise Value). for "Option up" / "Option down" as appropriate. • For an American option.i. given the evolution in the price of the underlying to that point. at each node). the value at nodes where early exercise is allowed is: Max (Binomial Value. (Note that the alternative valuation approach. K.. then (3) the value at the node is the exercise value.) 2) This result is the "Binomial Value". if p(i)< 0 then p(i)=0. }
. In calculating the value at the next time step calculated . since the option may either be held or exercised prior to expiry. one step closer to valuation . expiration time ' S. q.the model must use the value selected here.1). evaluate the possibility of early exercise at each node: if (1) the option can be exercised.n).Binomial options pricing model rate corresponding to the life of the option. although is easily generalised for calls and for European and Bermudan options: function americanPut(T. and the binomial value applies at all nodes. see "delta-hedging".r × Δt).e. It represents the fair price of the derivative at a particular point in time (i. r. and (2) the exercise value exceeds the Binomial Value. p0:= p1:= (up* exp(-r* deltaT).. in the formula at the node. S. up:= exp(sigma* sqrt(deltaT)).p0. It follows that in a risk-neutral world futures price should have an expected growth rate of zero and therefore we can consider for futures. The following formula to compute the expectation value is applied at each node: Binomial Value = [ p × Option up + (1-p) × Option down] × exp (. is the dividend yield of the underlying corresponding to the life of the option. stock price ' K. The following algorithm demonstrates the approach computing the price of an American put option.. 3) Depending on the style of the option.S* up^(2* i... yields identical results.exp(-q* deltaT))* up/ (up^ 2.

See also
• Trinomial tree . ' binomial value exercise:= K. calculate .Binomial options pricing model for j:= n.
258
-th dividend. To model discrete dividend payments in the binomial model. • Black-Scholes: binomial lattices are able to handle a variety of conditions for which Black-Scholes cannot be applied. apply the following rule: • At each time step.1 to 0 step -1 { ' move to earlier times for i:= 0 to j { p(i):= p0* p(i)+ p1* p(i+1).j). for all where is the present value of the at each node ( . this binomial distribution approaches the normal distribution assumed by Black-Scholes. In fact. ' exercise value if p(i)< exercise then p(i)= exercise. and the binomial model thus provides a discrete time approximation to the continuous process underlying the Black-Scholes model. for European options without dividends. the binomial model value converges on the Black-Scholes formula value as the number of time steps increases. . the CRR binomial method can be viewed as a special case of explicit finite difference method for Black-Scholes PDE. • Mathematical finance. In addition. it is common to model dividends as discrete payments on the anticipated future ex-dividend dates. the use of continuous dividend yield. • Real options analysis . when analyzed as numerical procedure.a similar model with three possible paths per node. The binomial model assumes that movements in the price follow a binomial distribution. Instead. } Discrete dividends In practice. • Stochastic Volatility
. • Monte Carlo option model. ).S* up^ (2* i. used in the valuation of options with complicated features that make them difficult to value through other methods. which has a list of related articles.where the BOPM is widely used. } } return americanPut:= p(0). Subtract this value from the value of the security price
Relationship with Black-Scholes
Similar assumptions underpin both the binomial model and the Black-Scholes model. in the formula above can lead to significant mis-pricing of the option near an ex-dividend date. for many trials. .

Prof. Ross. Don M. The Investment Analysts Society of Southern Africa Convergence of the Binomial to the Black-Scholes Model [8]PDF (143 KB) . John C. Prof. global-derivatives. Chance • Binomial Models for Fixed Income Analytics [17]. Don M. Chance
• Some notes on the Cox-Ross-Rubinstein binomial model for pricing an option [9]. Stephen A. Jr.ca • Option Pricing: Extending the Basic Binomial Model [13]. Prof. Bartter.com Online • European and American Option Trees [22]. umanitoba. global-derivatives." Journal of Financial Economics 7: 229-263. and Brit J. 1979.Binomial options pricing model
259
References
• Cox. Robert M. Rendleman. Peter Ekman • American Options . Quantnotes • Pricing Bermudan Options [12].com Fixed income derivatives • Binomial Pricing of Interest Rate Derivatives [16]PDF (76. and Mark Rubinstein. Ross.[1] • Richard J. Rob Thompson • Binomial Option Pricing Model [10] by Fiona Maclachlan. Rich Tanenbaum Other tree structures • A Synthesis of Binomial Option Pricing Models for Lognormally Distributed Assets [14].com Binomial Option Pricing [5] (PDF). "Option Pricing: A Simplified Approach. David Backus • Binomial Term Structure Models [18]. global-derivatives. Rubinstein) [4].overview [15].Binomial Method [20]. Simon Benninga and Zvi Wiener
Computer Implementations
Spreadsheets • Binomial Options Pricing Spreadsheet [19].Binomial Method [21]. Quantnotes Binomial Method (Cox. doi:10. The Quant Equation Archive. Jan-Petter Janssen Programming Languages • C [23] • Fortran [24] • Mathematica [6] • S-Plus [24]
.com • European Options . Don M. Conroy The Binomial Option Pricing Model [6]. 1979. Prof. Chance • Binomial and Trinomial Trees .2307/2327237
External links
Discussion
• • • • • • • The Binomial Model for Pricing Options [2]..3 KB) . "Two-State Option Pricing". sitmo. Thayer Watkins Using The Binomial Model to Price Derivatives [3]. Journal of Finance 24: 1093-1110. Simon Benninga and Zvi Wiener Options pricing using a binomial lattice [7]. The Wolfram Demonstrations Project
Variations
American and Bermudan options • American Options and Lattice Model Pricing [11].

a Monte Carlo option model uses Monte Carlo methods to calculate the value of an option with multiple sources of uncertainty or with complicated features. stat. (Since the underlying random process is the same. pdf [13] http:/ / www. (3) These payoffs are then averaged and (4) discounted to today. xls http:/ / developingtrader. edu/ academics/ finance/ faculty/ dchance/ Instructional/ TN97-14. com/ options/ european-options. com/ artandpap/ Option%20Pricing%20-%20A%20Simplified%20Approach. doc [2] http:/ / www. umanitoba. com/ xls/ American-Binomial. The technique applied then. co. pdf [17] http:/ / pages. Glasserman showed how to price Asian options by Monte Carlo. lsu. comcast. A. [1] The term 'Monte Carlo method' was coined by Stanislaw Ulam in the 1940s. edu/ academics/ finance/ faculty/ dchance/ Research/ ASynthesisofBinomialOptionPricingModels. S. wharton. darden. Monte Carlo valuation relies on risk neutral valuation. htm [12] http:/ / www. com/ binomial. wharton. htm http:/ / www. iassa. za/ articles/ 048_1998_05. In 2001 F. quantnotes. "payoff") of the option for each path.[1] Here the price of the option is its discounted expected value. com/ freebies. global-derivatives. This result is the value of the option. upenn. So: . [2] Here the price of the underlying instrument is usually modelled such that it follows a geometric Brownian motion with constant drift and volatility .e. and (2) to then calculate the associated exercise value (i. com/ fundamentals/ options/ americanoptions. xls [21] [22] [23] [24] http:/ / www. stern. lsu. pdf [9] http:/ / math. disklectures. php [20] http:/ / www. edu/ ~benninga/ mma/ MiER73. bus. cs. pdf [19] http:/ / www. ca/ ~tulsi/ Final/ May27/ XiaoLiuFinal. is (1) to generate several thousand possible (but random) price paths for the underlying (or underlyings) via simulation.Binomial options pricing model
260
References
[1] http:/ / www. com/ BinomialOptionPricingModel/ [11] http:/ / www. global-derivatives. sitmo. virginia. M. the value of a european option here should be the same as under Black Scholes). htm [14] http:/ / www. edu/ thompson/ math778/ CRRmodel/ [10] http:/ / demonstrations. hunter. edu/ ~dbackus/ 3176/ adlec3. pdf [7] http:/ / www. net/ ~laghan3/ options. pdf [18] http:/ / finance. pdf [8] http:/ / www. htm [3] http:/ / www. see further under Black-Scholes. wolfram. cgi?class=whitepaper& doc=advanced. edu/ faculty/ watkins/ binomial. lsu. edu/ ~benninga/ mma/ MiER63. com/ fundamentals/ options/ binomial. upenn. for enough price paths. although relatively straight-forward. see risk neutrality and Rational pricing: Risk Neutral Valuation. ps. com/ display_whitepaper. php http:/ / home. htm [4] http:/ / www.
. edu/ conroyb/ derivatives/ Binomial%20Option%20Pricing%20_f-0943_. Broadie and P. nyu.
Methodology
In terms of theory. bus. com/ eqcat/ 14 [16] http:/ / www. html
Monte Carlo option model
In mathematical finance. cuny. bus. rice.[2] This approach. sjsu. Schwartz developed a practical Monte Carlo method for pricing American-style options. In 1996. edu/ ~dobelman/ download/ bsopm. Longstaff and E. quantnotes. edu/ academics/ finance/ faculty/ dchance/ Instructional/ TN00-08. in-the-money. pdf [15] http:/ / www. pdf [6] http:/ / finance. com/ xls/ European-Binomial. The first application to option pricing was by Phelim Boyle in 1977 (for European options). savvysoft. where is found via a random sampling from a normal distribution. global-derivatives. allows for increasing complexity: • An option on equity may be modelled with one source of uncertainty: the price of the underlying stock in question. php#binomial [5] http:/ / faculty.

some models even allow for (randomly) varying statistical (and other) parameters of the sources of uncertainty. php?aId=4b0d2207d4169ee155591c70efa19c63& articleId=139) [8] Rich Tanenbaum: Battle of the Pricing Models: Trees vs Monte Carlo (http:/ / www. for each randomly generated yield curve we observe a different resultant bond price on the option's exercise date. pdf) [3] Peter Carr and Guang Yang: Simulating American Bond Options in an HJM Framework (http:/ / www. for bond options [3] the underlying is a bond. puc-rio. edu/ academics/ finance/ faculty/ dchance/ Instructional/ TN96-03. realoptions. such as the impact of commodity prices or inflation on the underlying. • Monte Carlo Methods allow for a compounding in the uncertainty.Simulation (http:/ / www. [5] For example. it is often used in analysing real options [1] where management's decision at any point is a function of multiple underlying variables. in a sense. pdf) [6] global-derivatives. see Heston model. edu/ research/ carrp/ papers/ pdf/ hjm. They are. bus. see Cholesky decomposition: Monte Carlo simulation. [8] see further under Monte Carlo methods in finance. erasmusenergy. • Simulation can be used to value options where the payoff depends on the value of multiple underlying assets [6] such as a Basket option or Rainbow option. Josh Gray and Marc Hazzard: Alternative Valuation Methods for Swaptions: The Devil is in the Details (http:/ / www. • As required. The same approach is used in valuing swaptions. in models incorporating stochastic volatility. Here.
References
Notes
[1] Marco Dias: Real Options with Monte Carlo Simulation (http:/ / www. an additional source of uncertainty will be the exchange rate: the underlying price and the exchange rate must be separately simulated and then combined to determine the value of the underlying in the local currency. With faster computing capability this computational constraint is less of a concern. this bond price is then the input for the determination of the option's payoff.
261
Application
As can be seen. savvysoft. com/ resources/ pdf/ swaptions. global-derivatives. Since simulation can accommodate complex problems of this sort. the short rate). Monte Carlo Methods are particularly useful in the valuation of options with multiple sources of uncertainty or with complicated features which would make them difficult to value through a straightforward Black-Scholes style computation.e. where the underlying is denominated in a foreign currency. a method of last resort.[7] Further.or even a numeric technique.com: Basket Options . correlation between assets is similarly incorporated. [1] [5] Conversely. Miguel Gravet and Jorge Urzua: The valuation of multidimensional American real options using the LSM simulation method (http:/ / www. can also be introduced. html) [2] Don Chance: Teaching Note 96-03: Monte Carlo Simulation (http:/ / www. if an analytical technique for valuing the option exists . the stochastic process of the underlying(s) may be specified so as to exhibit jumps or mean reversion or both. however. ind/ faq4. lsu. nyu. correlation between the underlying sources of risk is also incorporated. com/ downloadattachment. the volatility of the underlying changes with time. org/ papers2005/ Cortazar_GU052RealOptionsParis. For the models used to simulate the interest-rate see further under Short-rate model.Monte Carlo option model • In other cases. Further complications. math. [4] where the value of the underlying swap is also a function of the evolving interest rate. but the source of uncertainty is the annualized interest rate (i. pdf) [5] Gonzalo Cortazar. Here. The technique is thus widely used in valuing Asian options [8] and in real options analysis. For example. the source of uncertainty may be at a remove. For example.Monte Carlo methods will usually be too slow to be competitive. com/ treevsmontecarlo. In all such models. php?option=com_content& task=view& id=26#MCS) [7] Les Clewlow. br/ marco. pdf) [4] Carlos Blanco. fea. com/ index. Chris Strickland and Vince Kaminski: Extending mean-reversion jump diffusion (http:/ / www. such as a (modified) pricing tree [8] . htm)
.

cdlib. (http://spears. Y.pdf).doc).html). Krehbiel. global-derivatives. Prof.com/link/monte_carlo_method.riskglossary. Bernt Arne Ødegaard. Valuing American options by simulation: a simple least squares approach (http://repositories.pdf).okstate.php). McLeish. edu/~mnb2/broadie/Assets/bg_ms_1996.A.com/references/ MonteCarlo/mc6.Monte Carlo option model
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Articles
• Boyle.com) • MonteCarlo Simulation in Finance (http://www.bi. Oklahoma State University–Stillwater • Applications of Monte Carlo Methods in Finance: Option Pricing (http://www. Phelim P. Chance.aspx) (freeware) valuation and Greeks of vanilla and exotic options
External links
• Monte Carlo Simulation (http://www. Management Science.ru/en/products_options_calculator. and E.com
. • Longstaff F.edu/~rluss/orf557/ MC_American_Opt_Pricing. Monte Carlo Statistical Methods (2005) ISBN 0-387-21239-6
Software
• Fairmat (freeware) modeling and pricing complex options • MG Soft (http://www. George Casella. Peter Fink (reprint at quantnotes.org/anderson/fin/1-01/).com/publications/ papers/Fink-montecarlo. Spanier. Claremont Graduate University • Option pricing by simulation (http://finance-old. riskglossary.global-derivatives. Don M.smartquant. Glasserman. Options: A Monte Carlo Approach (http://ideas.doc). (1996) 269-285. Journal of Financial Economics 4. Lai and J.pdf).quantnotes.pptx). Robert. Astrid Prajogo.edu/home/tlk/legacy/fin5883/notes7_s05.columbia.no/~bernt/gcc_prog/recipes/recipes/node12. M.repec.okstate. (1977) 323-338 • Broadie. Estimating Security Price Derivatives Using Simulation (http://www.com/maths/k-o. 113-148
Resources
Books
• Don L.mgsoft.org/a/eee/jfinec/v4y1977i3p323-338. 42.htm).pdf)..bus. Review of Financial Studies 14 (2001). Timothy L.edu/academics/finance/faculty/dchance/Instructional/ TN96-03. Norwegian School of Management • The Longstaff-Schwartz algorithm for American options (http://www. Princeton University • Monte Carlo Method (http://www.S. contd. Schwartz.princeton.edu/home/tlk/legacy/fin5883/notes6_s05.com • Monte Carlo Derivative valuation (http://spears.lsu. Louisiana State University • Pricing complex options using a simple Monte Carlo Simulation (http://www. Monte Carlo Simulation & Finance (2005) ISBN 0-471-67778-7 • Christian P. and P. html).

However. expirations. where the typical graph turns up at either end. This implied volatility is best regarded as a rescaling of option prices which makes comparisons between different strikes. The pattern displays different characteristics for different markets and results from the probability of extreme moves.
. and short X% delta put. Sometimes the term "smirk" is used to describe a skewed smile. the resulting graph is typically downward sloping for equity markets. the volatility smile is a long-observed pattern in which at-the-money options tend to have lower implied volatilities than in. For other markets. which refers to how implied volatility differs for related options with different maturities.5 RRx + Flyx Putx = ATMx . This means it is usually possible to compute a unique implied volatility from a given market price for an option.Volatility smile
263
Volatility smile
In finance. the price is a strictly increasing function of volatility.
Volatility smiles and implied volatility
In the Black-Scholes model. high strike) equity options is typically lower than for at-the-money equity options. and underlyings easier and more intuitive. on the other hand. the implied volatilities of options on foreign exchange contracts tend to rise in both the downside and upside directions. An implied volatility surface is a 3-D plot that combines volatility smile and term structure of volatility into a consolidated view of all options for an underlier. such as for equity options. is Y% delta fly which mean Long Y% delta call. a quantitative analyst will calculate the implied volatility from liquid vanilla options and use models of the smile to calculate the price of more complex exotic options. For example. Adjustments to this value is undertaken by incorporating the values of Risk Reversal and Flys (Skews) to determine the actual volatility measure that may be used for options with a delta which is not 50.or out-of-the-money options. except in the case of American options with dividends whose early exercise could be optimal.0. the more familiar term "volatility smile" is used. Callx = ATMx + 0. Long Y% delta put. a small tilted smile is often observed near the money as a kink in the general downward sloping implicit volatility graph. For markets where the graph is downward sloping. the theoretical value of a vanilla option is a monotonic increasing function of the Black-Scholes volatility. In equity markets. When implied volatility is plotted against strike price.[1] Modelling the volatility smile is an active area of research in quantitative finance. the implied volatility for upside (i. Typically.e. or valley-shaped for currency markets. Furthermore. and short ATM call. Market practitioners use the term implied-volatility to indicate the volatility parameter for ATM (at-the-money) option. such as FX options or equity index options. Butterfly. the term "volatility skew" is often used. Equity options traded in American markets did not show a volatility smile before the Crash of 1987 but began showing one afterwards.5 RRx + Flyx Risk reversals are generally quoted X% delta risk reversal and essentially is Long X% delta call. A closely related concept is that of term structure of volatility.

it is well-observed that realized volatility for stock prices rises significantly on the day that a company reports its earnings. The anticipated resolution date of patent litigation can impact technology stocks. However. the impact of upcoming results of a drug trial can cause implied volatility swings for pharmaceutical stocks. At the same time. For instance. a trailing 21-day period).
. in this case. in contrast. The market incorporates many other types of events into the term structure of volatility. options on commodity futures typically show increased implied volatility just prior to the announcement of harvest forecasts. we also see characteristic differences in implied volatility. Options that mature earlier exhibit a larger swing in implied volatility than options with longer maturities. For instance. Correspondingly. struck at $100 and expiring in 6 months. and not the underlier. the historical volatility for IBM for the previous 21 day period might be 17% (all volatilities are expressed in annualized percentage moves). we see that implied volatility for options will rise during the period prior to the earnings announcement. may have an implied volatility of 18%. Historical volatility is a direct measure of the movement of the underlier’s price (realized volatility) over recent history (e. Implied volatility. Other option markets show other behavior. For instance. is set by the market price of the derivative contract itself. For instance. Options on US Treasury Bill futures show increased implied volatility just prior to meetings of the Federal Reserve Board (when changes in short-term interest rates are announced). the dominant effect is related to the market's implied impact of upcoming events.g. while the put option struck at $105 and expiring in 1 month may have an implied volatility of 21%.Volatility smile
264
Implied volatility and historical volatility
It is helpful to note that implied volatility is related to historical volatility. the IBM call option. and then fall again as soon as the stock price absorbs the new information. however the two are distinct. Therefore. etc. different derivative contracts on the same underlier have different implied volatilities.
Term structure of volatility
For options of different maturities.

the implied volatility of an option with a given absolute strike does not change. "sticky delta". The implied volatility surface simultaneously shows both volatility smile and term structure of volatility. For this surface. Option traders use an implied volatility plot to quickly determine the shape of the implied volatility surface.
. and to identify any areas where the slope of the plot (and therefore relative implied volatilities) seems out of line. and the days to maturity. and X and Y axes represent the option delta. a 20 delta put must have the same implied volatility as an 80 delta call.
265
Implied volatility surface
It is often useful to plot implied volatility as a function of both strike price and time to maturity.Volatility smile Volatility term structures list the relationship between implied volatilities and time to expiration. as well as a volatility term structure indicating an anticipated event in the near future. The result is a 2-D curved surface whereby the current market implied volatility (Z-axis) for all options on the underlier is plotted against strike price and time to maturity (X & Y-axes). How the surface changes over time (especially as spot changes) is called the evolution of the implied volatility surface. The graph shows an implied volatility surface for all the call options on a particular underlying stock price. Common heuristics include: • "sticky strike" (or "sticky-by-strike". The term structures provide another method for traders to gauge cheap or expensive options. we can see that the underlying symbol has both volatility skew (a tilt along the delta axis). see moneyness for why these are equivalent terms): if spot changes. • "sticky moneyness" (aka.
Evolution: Sticky
An implied volatility surface is static: it describes the implied volatilities at a given moment in time. The Z-axis represents implied volatility in percent. the implied volatility of an option with a given moneyness does not change. Note that to maintain put-call parity. or "stick-to-strike"): if spot changes.

pp. The Volatility Smile and Its Implied Tree (RISK. Volatility Smile Modeling with Mixture Stochastic Differential Equations [5] (PDF)
References
[1] [2] [3] [4] [5] John C. Implied Binomial Trees [3] (PDF) • Optionistics. 32-39) [2] (PDF) • Mark Rubinstein. Daily Skew Charts [4] • Damiano Brigo. com/ i/ volatility_skew http:/ / www. pdf
. Francesco Rapisarda and Giulio Sartorelli. Futures and Other Derivatives. pp. optionistics. haas. Fabio Mercurio. damianobrigo. Hull.
266
Modeling volatility
Methods of modelling the volatility smile include stochastic volatility models and local volatility models. ederman.1994. pdf http:/ / www. edu/ finance/ WP/ rpf232. while sticky delta would predict that the implied volatility of the $120 strike option would be whatever the $100 strike option's implied volatility was before the move (as these are both ATM at the time). 139-145. 5th edition. page 335 http:/ / www. sticky strike would predict that the implied volatility of a $120 strike option would be whatever it was before the move (though it has moved from being OTM to ATM). 7-2 Feb. Options.Volatility smile So if spot moves from $100 to $120.
See also
• • • • • • • Volatility (finance) Stochastic volatility Bruno Dupire SABR Volatility Model Jim Gatheral Steven Heston Emanuel Derman
• Damiano Brigo • Fabio Mercurio
External links
• Emanuel Derman. berkeley. it/ tokyo2002smile. pdf http:/ / www. com/ new/ docs/ gs-volatility_smile.

when applied as an input to . and f is a pricing model that depends on σ. along with other inputs. The value
is the volatility implied by the market price
. Put in other terms. Non-option financial instruments that have embedded optionality. Or. mathematically:
where C is the theoretical value of an option. of the underlying. Implied volatility. we apply the implied volatility back into the pricing model. when used in a particular pricing model. a forward-looking measure. or: To verify. meaning that a higher value for volatility results in a higher theoretical value of the option. XYZ stock is currently trading at $51.
Motivation
An ordinary option pricing model. The risk-free interest rate is 5%. on 100 shares of non-dividend-paying XYZ Corp. f() and we generate a theoretical value of $2. yields a theoretical value for the option equal to the current market price of that option. such that
where
is the market price for an option. Using a standard Black-Scholes pricing model. Inputs to pricing models vary depending on the type of option being priced and the pricing model used. or the
implied volatility. The function f is monotonically increasing in σ. assume that there is some inverse function g() = f−1(). it is the volatility that.Implied volatility
267
Implied volatility
In financial mathematics. the implied volatility of an option contract is the volatility implied by the market price of the option based on an option pricing model.
.0004:
which confirms our computation of the market implied volatility. Conversely. in general. can also have an implied volatility. differs from historical volatility because the latter is calculated from known past returns of a security. In other words. the volatility implied by the market price is 18. such as an interest rate cap. the value of an option depends on an estimate of the future realized volatility.25 and the current market price of is $2. will result in a particular value for C. The option is struck at $50 and expires in 32 days.7%. uses a variety of inputs to derive a theoretical value for an option. σ. there can be at most one value for σ that.
Example
A European call option. However.00. by the inverse function theorem. such as Black-Scholes. .

that is.2%. not as a measure of future stock moves. Instead.0%. It is a mistake to confuse a price. Seen in this light.Implied volatility
268
Solving the inverse pricing model function
In general. The implied volatility of the option is determined to be 18.
Implied volatility as a price
Another way to look at implied volatility is to think of it as a price. however it requires the first partial derivative of the option's theoretical value with respect to volatility. does not have a closed-form solution for its inverse. it is still considered cheaper on a volatility basis. it usually turns out that Brent's method is more efficient as a root-finding technique. Statistical estimates depend on the time-series and the mathematical structure of the model used. i. for most practical pricing models. then the next most important factor in determining the value of the option will be its implied volatility. two of the most commonly used are Newton's method and Brent's method. it should not be surprising that implied volatilities might not conform to what a particular statistical model would predict. Prices are determined by supply and demand. yielding an implied volatility of 17. f(). which implies a transaction. a buyer and a seller. A short time later. particularly between professional traders. A price requires two counterparties. This is because the price of an option depends most directly on the price of its underlying security. which is also known as vega (see The Greeks). however the number we get is not a price. a root finding technique is used to solve the equation:
While there are many techniques for finding roots. . such as a binomial model. this is not the case and vega must be derived numerically. g(). This is because the underlying needed to hedge the call option can be sold for a higher price. it is often important to use the most efficient method when calculating implied volatilities. Newton's method provides rapid convergence. a pricing model function.34. Prices are different in nature from statistical quantities: We can estimate volatility of future underlying returns using any of a large number of estimation methods. Even though the option's price is higher at the second measurement. If an option is held as part of a delta neutral portfolio. Implied volatility is so important that options are often quoted in terms of volatility rather than price. a portfolio that is hedged against small moves in the underlier's price.
. which is merely what comes out of a calculation. If the pricing
model function yields a closed-form solution for vega.50 with the underlying trading at $42. When forced to solve vega numerically. which is the case for Black-Scholes model. However.e. Because options prices can move very quickly.
Implied volatility as measure of relative value
Often. the option is trading at $2. In this view it simply is a more convenient way to communicate option prices than currency. the implied volatility of an option is a more useful measure of the option's relative value than its price.
Example
A call option is trading at $1. with the result of a statistical estimation. Implied volatilities are prices: They have been derived from actual transactions. then Newton's method can be more efficient.10 with the underlying at $43.05.

cba. and the passage of time.Implied Volatility Index (an expected stock volatility over a future period for any of US securities and exchange traded instruments). See stochastic volatility and volatility smile for more information.v51.A Powerful Indicator in Trading [5]"
References
[1] [2] [3] [4] [5] http:/ / www. Historic Volatility [4]" • "Option Volatility .J. but. ua. Journal of Banking and Finance 5 (3): 363–381. Univ. the QQV (QQQQ volatility measure).. html http:/ / www. This is generally viewed as evidence that an underlier's volatility is not constant. "Implied volatility skews and stock index skewness and kurtosis implied by S" [3]. "Implied volatility". pdf http:/ / www. "Standard deviations implied in option prices as predictors of future stock price variability" [2] . S. by Razvan Pascalau. retrieved 2009-07-07
External links
• Interactive Java Applet "Implied Volatility vs. smartquant. (1981). retrieved 2009-07-07 • Mayhew. doi:10.1016/0378-4266(81)90032-7. For instance. (1997). frog-numerics. com/ option-volatility
. the CBOE Volatility Index (VIX) is calculated from a weighted average of implied volatilities of various options on the S&P 500 Index. edu/ ~rpascala/ impliedvol/ BSOPMSForm. IVX . options based on the same underlier but with different strike value and expiration times will yield different implied volatilities.2469/faj. com/ references/ Volatility/ vol17. as well as options and futures derivatives based directly on these volatility indices themselves.Implied volatility
269
Non-constant implied volatility
In general. the underlier's recent variance. There are also other commonly referenced volatility indices such as the VXN index (Nasdaq 100 index futures volatility measure).
Computer implementations
• Real-time calculator of implied volatilities when the underlying follows a Mean-Reverting Geometric Brownian Motion [1]. php http:/ / ideas. C. Su. The Journal of Derivatives (SUMMER 1997).1916 • Corrado. instead depends on factors such as the price level of the underlier.n4. (1995). of Alabama
References
• Beckers. T. repec.
Volatility instruments
Volatility instruments are financial instruments that track the value of implied volatility of other derivative securities. doi:10. com/ ifs/ ifs_LevelA/ HistVolaVsVDAX. Financial Analysts Journal 51 (4): 8–20. org/ a/ eee/ jbfina/ v5y1981i3p363-381. html http:/ / optiontradingfortune. S.

a forward swap rate. or a forward is described by a parameter . The under the value of this option is equal to the suitably discounted expected value of the payoff
known. The SABR model is widely used by practitioners in the financial industry. The general case can be solved approximately by means of an asymptotic expansion in the parameter . The volatility of the forward both and of stochastic differential equations: . Beta. we force the SABR model price of the option into the form of the Black model valuation formula. It is convenient to express the solution in terms of the implied volatility of the option. We have also set
or the arithmetic average
and
.
and
are two correlated Wiener satisfy the conditions : in fact. the SABR model is a stochastic volatility model. which attempts to capture the volatility smile in derivatives markets. no closed form expression for this probability distribution is struck at . especially in the interest rates derivatives markets.SABR Volatility Model
270
SABR Volatility Model
In mathematical finance.
is often referred to as the volvol. and . this parameter is small and the approximate solution is actually quite accurate. for clarity. is approximately given by: where. Then the implied volatility. The name stands for "Stochastic Alpha. The constant parameters
The above dynamics is a stochastic version of the CEV model with the skewness parameter the CEV model if The parameter lognormal volatility of the volatility parameter . a call) on the forward probability distribution of the process Except for the special cases of . Here. Deep Kumar. Rho". Namely. this solution has a rather simple functional form. we have set and (such as the geometric average . is very easy to implement in computer code. SABR is a dynamic model in which
are represented by stochastic state variables whose time evolution is given by the following system
with the prescribed time zero (currently observed) values processes with correlation coefficient .
Dynamics
The SABR model describes a single forward stock price. The value denotes a conveniently chosen midpoint between ).
and
. and its meaning is that of the
Asymptotic solution
We consider a European option (say. and lends itself well to risk management of large portfolios of options in real time. which expires years from now. Also significantly. which is the value of the lognormal volatility parameter in Black's model that forces it to match the SABR price. Under typical market conditions. Andrew Lesniewski. and Diana Woodward. referring to the parameters of the model. it reduces to
. such as a LIBOR forward rate. It was developed by Patrick Hagan.

pdf http:/ / arxiv. [1] . html http:/ / arxiv. 0998v3 http:/ / www. edu/ ~lrb/ sabrAll. org/ pdf/ physics/ 0602102v1
.
See also
• Volatility (finance) • Stochastic Volatility • Risk-neutral measure
External links
• Managing Smile Risk.The original paper introducing the SABR model.Correction to Hagan et al.SABR Volatility Model The function entering the formula above is given by
271
Alternatively. one can express the SABR price in terms of the normal Black's model. • Fine Tune Your Smile .Refined risk management under the SABR model. [3] • A SUMMARY OF THE APPROACHES TO THE SABR MODEL FOR EQUITY DERIVATIVE SMILES [4] • UNIFYING THE BGM AND SABR MODELS: A SHORT RIDE IN HYPERBOLIC GEOMETRY. columbia. Hagan et al. pdf http:/ / www. Then the implied normal volatility can be asymptotically computed by means of the following expression: It is worth noting that the normal SABR implied volatility is generally somewhat more accurate than the lognormal implied volatility. com/ insights/ sabr/ sabr. riskworx. Bartlett [2] . us/ papers/ published/ HedgingUnderSABRModel. P. B. org/ abs/ 0708. • Hedging under SABR Model. PIERRE HENRY-LABORD`ERE [5]
References
[1] [2] [3] [4] [5] http:/ / www. math. lesniewski.

and
and
are constants. MSM captures the outliers. the next-period multiplier
is drawn from a fixed distribution
with
. The return process the number of parameters is the same for all
is often a discrete distribution that can take the values is then specified by the parameters . returns are specified as where and are constants and { } are independent standard Gaussians. has a positive support. compute value-at-risk. and let denote the return over two consecutive periods. In MSM. MSM is used by practitioners in the financial industry to forecast volatility. MSM compares favorably with standard volatility models such as GARCH(1.
is a standard Brownian motion. the Markov-switching multifractal (MSM) is a model of asset returns that incorporates stochastic volatility components of heterogeneous durations [1] [2] .
or . Note that
Continuous time
MSM is similarly defined in continuous time. the distribution with equal probability.and out-of-sample. and is independent of Binomial MSM In empirical applications. Each
drawn from distribution
with probability with probability
. The sequence is approximately geometric .1) and FIGARCH both in. The marginal distribution has a
unit mean.Markov Switching Multifractal
272
Markov Switching Multifractal
In financial econometrics. at low frequency. In currency and equity series. and is otherwise left unchanged. The price process follows the diffusion:
where component follows the dynamics:
.
drawn from distribution with probability with probability
The transition probabilities are specified by . log-memory-like volatility persistence and power variation of financial returns. and price derivatives.
MSM specification
The MSM model can be specified in both discrete time and continuous time.
Discrete time
Let denote the price of a financial asset. Volatility is driven by the first-order
latent Markov state vector:
Given the volatility state probability
.

For instance.
is set equal to the ergodic distribution of
. continuous-time MSM converges to a multifractal diffusion. The Markov dynamics are characterized by the with components has Gaussian density .
for
Closed-form Likelihood
The log likelihood function has the following analytical expression:
Maximum likelihood provides reasonably precise estimates in finite samples [3] .
Other estimation methods
When has a continuous distribution.
whose sample paths take a continuum of local Hölder exponents on any finite time interval. estimation can proceed by simulated method of moments
[6] [4] [5]
. For binomial MSM.
. there are transition matrix volatility state. we can define the conditional
The initial vector all . Given past returns. the Markov state vector takes finitely many values . the return possible states in binomial MSM.
Inference and closed-form likelihood
When has a discrete distribution. and .Markov Switching Multifractal The intensities vary geometrically with :
273
When the number of components
goes to infinity. or
simulated likelihood via a particle filter
. for any . The vector is computed recursively: ' where . Conditional on the
Conditional distribution
We do not directly observe the latent state vector probabilities: .

Related approaches
MSM is a stochastic volatility model [14] [15] with arbitrarily many frequencies. guaranteeing a strictly stationary process. [4] Calvet. Calvet and Fisher[7] report considerable gains in exchange rate volatility forecasts at horizons of 10 to 50 days as compared with GARCH(1. MSM builds on the convenience of regime-switching models.1016/j.1093/jjfinec/nbh003. Adlai Fisher (2004). pdf) (Available at ). Hamilton [16] .1093/jjfinec/nbh003. [3] Calvet.2005. [6] Calvet. Laurent.008. (http:/ / www. Journal of Business and Economic Statistics 26: 194–210. doi:10. Journal of Econometrics 131: 179–215.1). and Fractionally Integrated GARCH [10] . [7] Calvet. "Forecasting multifractal volatility". Adlai Fisher (2004). "How to Forecast long-run volatility: regime-switching and the estimation of multifractal processes". doi:10.Markov Switching Multifractal
274
Forecasting
Given . Thomas (2008). Laurent. The models have had some success in explaining the excess volatility of stock returns compared to fundamentals and the negative skewness of equity returns. Lux[11] obtains similar results using linear predictions.01. doi:10. Laurent. MSM provides a pure regime-switching formulation of multifractal measures. Journal of Econometrics 105: 27–58. the conditional distribution of the latent state vector at date is given by:
MSM often provides better volatility forecasts than some of the best traditional models both in and out of sample. Laurent. Regime-switching and the estimation of multifractal processes. [17] . cirano. and Samuel Thompson (2006). Adlai Fisher. Adlai Fisher (2001). Journal of Financial Econometrics 2: 49–83. Laurent.
. MSM has been used to analyze the pricing implications of multifrequency risk.
Applications
Multiple assets and value-at-risk
Extensions of MSM to multiple assets provide reliable estimates of the value-at-risk in a portfolio of securities [12] . MSM is closely related to the MMAR [18] . "How to Forecast long-run volatility: regime-switching and the estimation of multifractal processes". [5] Lux. "The Markov-switching multifractal model of asset returns: GMM estimation and linear forecasting of volatility". [2] Calvet. qc. MSM improves on the MMAR’s combinatorial construction by randomizing arrival times. which were advanced in economics and finance by James D. Adlai Fisher (2002). Laurent.1016/S0304-4076(01)00069-0. Journal of Financial Econometrics 2: 49–83.1093/jjfinec/nbh003. which were pioneered by Benoit Mandelbrot [19] [20] [21] .
Asset pricing
In financial economics. ca/ realisations/ grandes_conferences/ risques_financiers/ 25-10-02/ Calvet-Fisher. "Volatility comovement: a multifrequency approach". They have also been used to generate multifractal jump-diffusions [13] . Journal of Financial Econometrics 2: 49–83.jeconom. Adlai Fisher (2004). "How to Forecast long-run volatility: regime-switching and the estimation of multifractal processes". Markov-Switching GARCH [8] [9] . doi:10.
See also
• • • • • Brownian motion Markov chain Multifractal model of asset returns Multifractal Stochastic volatility
References
[1] Calvet. doi:10.

"Option values under stochastic volatility: theory and empirical estimates". [17] Hamilton. (1982). "The Fractal Geometry of Nature". the spot price of the underlying security. Empirical Economics 27: 363–394. "A new approach to the economic analysis of nonstationary time series and the business cycle" (http:/ / jstor. intentionally.. [9] Klaassen. and Samuel Thompson (2006). . Stephen (1986). "Modeling the conditional distribution of interest rates as a regime-switching process".008. the Greeks are the quantities representing the sensitivities of the price of derivatives such as options to a change in underlying parameters on which the value of an instrument or portfolio of financial instruments is dependent. New Palgrave Dictionary of Economics 2nd edition. Journal of Econometrics 73: 151–184.[4] . (1999).1016/j. B. [21] Mandelbrot. Collectively these have also been called the risk sensitivities[1] . H. Adlai Fisher and Benoit Mandelbrot (1997). Elsevier . [19] Mandelbrot. (1974).1016/0304-405X(96)00875-6. and the rate of return of a risk-free investment) and to the option's value. New York: Wiley. These quantities were discovered by the then relatively unknown Financial Mathematicians. Tim. James (2008). Franc (2002). the volatility of that price. Journal of Business and Economic Statistics 26: 194–210. delta. "Improving GARCH volatility forecasts with regime-switching GARCH".1007/s001810100100. [14] Taylor. doi:10. [18] Calvet. second-order derivatives are in green. Note that vanna is used. "Modeling and pricing long memory in stock market volatility". Greeks which are a first-order derivative are in blue. [13] Calvet. Laurent.jeconom. Laurent. Thomas (2008). doi:10. doi:10. "Multifractal Volatility: Theory. Adlai Fisher. New York: Freeman.01.Academic Press. B. "A multifractal model of asset returns". Econometrica (The Econometric Society) 57 (2): 357–84.2005. doi:10.
Use of the Greeks
Spot Price (S) Value (V) Delta ( Vega ( Gamma ( ) ) ) Delta Gamma Vanna Speed Volatility ( ) Vega Vanna Vomma Zomma Ultima Time to Expiry ( ) Theta Charm DvegaDtime Color Totto Risk-Free Rate (r) Rho
Vomma
The table (called "the Mamma. Laurent. doi:10. "Regime-Switching Models". James (1987). Palgrave McMillan Ltd. doi:10.1017/S0022112074000711. Discussion Papers .: 1164–1166.1016/0304-4076(95)01736-4. [10] Bollerslev. Adlai Fisher (2008). in two places as the two sensitivities are mathematically equivalent. Journal of Fluid Mechanics 62: 331–58. Mikkelsen (1996). risk measures[2] or hedge parameters[3] . "The Markov-switching multifractal model of asset returns: GMM estimation and linear forecasting of volatility". ") shows the relationship of the more common sensitivities to the four primary inputs into the Black–Scholes model (namely. Springer. James (1989). Journal of Financial Economics 19: 351–372.2307/1912559. doi:10. [20] Mandelbrot.Markov Switching Multifractal
[8] Gray. "Volatility comovement: a multifrequency approach". [16] Hamilton. Dr Rishi Norris and Sir James Sood. Stephen (1996). The name is used because the most common of these sensitivities are often denoted by Greek letters. O. Journal of Econometrics 131: 179–215.
. org/ stable/ 1912559). "Multifractals and 1/f Noise: Wild Self-Affinity in Physics". [11] Lux. "Intermittent turbulence in self-similar cascades: divergence of high moments and dimension of the carrier".1016/0304-405X(87)90009-2. the time remaining until the option expires. and third-order derivatives are in yellow.
275
Greeks (finance)
In mathematical finance. [15] Wiggins. Journal of Financial Economics 42: 27–62. Forecasting and Pricing".. Cowles Foundation Yale University. B. [12] Calvet. gamma. vega and vomma. "Modelling Financial Time Series".

the trader might expect the option to have a 25% probability of expiring in-the-money. At-the-money puts and calls have a delta of approximately[7] 0. Time and Volatility.5 and −0. Delta is always positive for long calls and short puts and negative for long puts and short calls. This portfolio will then retain its total value regardless of which direction the price of XYZ moves.0 for a long call (and/or short put) and 0. if a portfolio of options in XYZ (expressed as shares of the underlying) is +2. For example. Each Greek measures the sensitivity of the value of a portfolio to a small change in a given underlying parameter. this approximation rapidly goes out the window when looking at a term of just a few years. and the portfolio rebalanced accordingly to achieve a desired exposure.25. The remaining sensitivities in this list are common enough that they have common names. The Greeks in the Black–Scholes model are relatively easy to calculate. The most common of the Greeks are the first order derivatives: Delta.0 and −1.75.15. measures the rate of change of option value with respect to changes in the underlying asset's price. Theta and Rho as well as Gamma. so that component risks may be treated in isolation. As a proxy for probability Some option traders also use the absolute value of delta as the probability that the option will expire in-the-money (if the market moves under Brownian motion)[6] . For example.5 respectively (however. see for example delta hedging. these numbers are commonly presented as a percentage of the total number of shares represented by the option contract(s). of the option with respect to the underlying instrument's price .0.
Delta is the first derivative of the value Practical use
Even though delta will be a number between 0. the trader could delta-hedge his entire position in the underlying by buying or shorting the number of shares indicated by the total delta. a second-order derivative of the value function. especially those who seek to hedge their portfolios from adverse changes in market conditions.0 for a long put (and/or short call). those Greeks which are particularly useful for hedging delta. the trader would be able to delta-hedge the portfolio by selling short 275 shares of the underlying. and are very useful for derivatives traders. with the ATM call commonly having a delta
. Similarly. a desirable property of financial models.Greeks (finance) The Greeks are vital tools in risk management. if a put contract has a delta of −0. Although rho is a primary input into the Black–Scholes model. (Albeit for only small movements of the underlying.25.0 and 1.
276
First-order Greeks
Delta
Delta[5] .
. This is convenient because the option will (instantaneously) behave like the number of shares indicated by the delta. if an American call option on XYZ has a delta of 0. The total delta of a complex portfolio of positions on the same underlying asset can be calculated by simply taking the sum of the deltas for each individual position. Vega. the trader might estimate that the option has appropriately a 15% chance of expiring in-the-money. For example. gamma and vega are well-defined for measuring changes in Price. the overall impact on the value of an option corresponding to changes in the risk-free interest rate is generally insignificant and therefore higher-order derivatives involving the risk-free interest rate are not common. a short amount of time and not-withstanding changes in other market conditions such as volatility and the rate of return for a risk-free investment). but this list is by no means exhaustive. For this reason. Since the delta of underlying asset is always 1. if an out-of-the-money call option has a delta of 0. it will gain or lose value just like 25% of 100 shares or 25 shares of XYZ as the price changes for small price movements.

) Vega[8] measures sensitivity to volatility. Vega can be an important Greek to monitor for an option trader. exact calculation for the probability of an option finishing in the money is its Dual Delta.
. The total theta for a portfolio of options can be determined by simply taking the sum of the thetas for each individual position.58 and if we follow the same approach then delta of a call with same strike should be −1. per underlying share the option's value will gain or lose as volatility rises or falls by 1%. it is useful to divide the result by the number of days per year to arrive at the amount of money. so delta should be = opposite sign ( abs(delta) − 1). and with no dividend yield. The Greek letter that is used is called nu . The value of an option is made up of two parts: the intrinsic value and the time value. . or each will have a 50% chance of expiring in-the-money.58. The
. if the delta of a call is 0.42 then one can compute the delta of the corresponding put at the same strike price by 0. so a call with strike $50 on a stock with price $60 would have intrinsic value of $10. Theta is always negative for long calls and puts and positive for short (or written) calls and puts. the sum of the absolute values of the delta of each option will be 1. Vega is the derivative of the option value with respect to the volatility of the underlying.00 If the value of delta for an option is known. though this is rare. By convention. The intrinsic value is the amount of money you would gain if you exercised the option immediately. which is the first derivative of option price with respect to strike. For example.Greeks (finance) over 0. The correct.58.. especially in volatile markets since some of the value of option strategies can be particularly sensitive to changes in volatility.42 − 1 = −0. underlying and maturity but opposite right by subtracting 1 from the known value.70)." Practical use The mathematical result of the formula for theta (see below) is expressed in value/year. is extremely dependent on changes to volatility. strike price and time to maturity.
277
Vega
(Despite the myth that Vega is not actually the name of any Greek letter. measures the sensitivity of the value of the derivative to the passage of time (see Option time value):
the "time decay. it in fact is. The term kappa. The value of an option straddle.60 or 0. Practical use Vega is typically expressed as the amount of money. as is tau. Relationship between call and put delta Given a European call and put option for the same underlying. for example. one can compute the value of the option of the same strike price. whereas the corresponding put would have zero intrinsic value. per share of the underlying that the option loses in one day.
Theta
Theta[9] . is sometimes used (by academics) instead of vega.which is Greek for 'Vega'. While in deriving delta of a call from put will not follow this approach eg – delta of a put is −0. .

Fugit
The fugit is the optimal date to exercise an american or bermudan option. It is also then the (negative) derivative of theta with respect to the underlying's price. there is less chance of this happening. It is often useful to divide this by the number of days per year to arrive at the delta decay per day.
Color
Color[13] . measures the instantaneous rate of change of delta over the passage of time.
.Greeks (finance) time value is the worth of having the option of waiting longer when deciding to exercise. for example you can represent flows of an american swaption like the flows of a swap starting at the fugit multiplied by delta then use these to compute sensitivities. gamma decay or DgammaDtime[14] measures the rate of change of gamma over the passage of time. measures sensitivity to the applicable interest rate. For this reason. Even a deeply out of the money put will be worth something as there is some chance the stock price will fall below the strike. This use is fairly accurate when the number of days remaining until option expiration is large. charm itself may change quickly. Practical use The mathematical result of the formula for charm (see below) is expressed in delta/year. Rho is the derivative of the option value with
respect to the risk free rate. per share. Charm has also been called DdeltaDtime[12] . When an option nears expiration. Charm is a second-order derivative of the option value. Color can be an
. Color is a third-order derivative of the option value. as time approaches maturity. Practical use Rho is typically expressed as the amount of money.
278
Rho
Rho[10] . so the time value of an option is decreasing with time. rendering full day estimates of delta decay inaccurate. rho is the least used of the first-order Greeks. Charm can be an important Greek to measure/monitor when delta-hedging a position over a weekend. once to price and once to time. the value of an option is least sensitive to changes in the risk-free-interest rates. Except under extreme circumstances. Thus if you are long an option you are short theta: your portfolio will lose value with the passage of time (all other factors held constant). However.0%. twice to underlying asset price and once to time. It is useful to compute it for hedging pupose.
Higher-order Greeks
Charm
Charm[11] or delta decay. that the value of the option will gain or lose as the rate of return of a risk-free investment rises or falls by 1.

alpha (the return in excess of the risk-free rate) is reduced.
279
DvegaDtime
DvegaDtime[15] . Speed can be important to monitor when delta-hedging or
. in neutralizing the gamma of a portfolio. color itself may change quickly. rendering full day estimates of gamma change inaccurate. as this will ensure that the hedge will be effective over a wider range of underlying price movements.
. measures the rate of change in the delta with respect to changes in the underlying price. Practical use It is common practice to divide the mathematical result of DvegaDtime by 100 times the number of days per year to reduce the value to the percentage change in vega per one day. This is also sometimes referred to as the gamma of the gamma [19] or DgammaDspot[20] .Greeks (finance) important sensitivity to monitor when maintaining a gamma-hedged portfolio as it can help the trader to anticipate the effectiveness of the hedge as time passes. Of course. Practical use The mathematical result of the formula for color (see below) is expressed in gamma/year. When a trader seeks to establish an effective delta-hedge for a portfolio. This use is fairly accurate when the number of days remaining until option expiration is large.
. or elasticity[17] is the percentage change in option value per percentage change in the
underlying price. sometimes called gearing. a measure of leverage. Gamma is
the second derivative of the value function with respect to the underlying price. DvegaDtime is the second derivative of the value function.
. When an option nears expiration. measures the rate of change in the vega with respect to the passage of time. Gamma is important because it corrects for the convexity of value. the trader may also seek to neutralize the portfolio's gamma. It is often useful to divide this by the number of days per year to arrive at the change in gamma per day.
Gamma
Gamma[16] . Speed is the third derivative of the value function with respect to the underlying spot price.
Speed
Speed[18] measures the rate of change in Gamma with respect to changes in the underlying price.
Lambda
Lambda. once to volatility and once to time. omega.

)
Zomma
Zomma[29] measures the rate of change of gamma with respect to changes in volatility.
Vomma
Vomma[26] . Vomma is positive for options away from the money. long-vomma position can be constructed from ratios of options at different strikes. stated another way. is a second order derivative of the option value. also referred to as DvegaDspot and DdeltaDvol[24] . Vega Convexity[28] . twice to underlying asset price and once to volatility. Vega gamma or dTau/dVol measures second order sensitivity to volatility. and initially increases with distance from the money (but drops off as vega drops off). Zomma can be a useful sensitivity to monitor when maintaining a gamma-hedged portfolio as zomma will help the trader to anticipate changes to the effectiveness of the hedge as volatility changes.
Vanna
Vanna[23] .Greeks (finance) gamma-hedging a portfolio.
280
Ultima
Ultima[21] measures the sensitivity of the option vomma with respect to change in volatility. or. or alternately. And an initially vega-neutral. Ultima is a third-order derivative of the option value to volatility. which can be scalped in a way analogous to long gamma. the partial of vega with respect to the underlying instrument's price.or vega-hedged portfolio as vanna will help the trader to anticipate changes to the effectiveness of a delta-hedge as volatility changes or the effectiveness of a vega-hedge against change in the underlying spot price. Zomma has also been referred to as DgammaDvol[30] .
. It is mathematically equivalent to DdeltaDvol[25] . Volga[27] . Vomma is the second derivative of the option value with respect to the volatility. a position will become long vega as implied volatility increases and short vega as it decreases. With positive vomma. vomma measures the rate of change to vega as volatility changes. Vanna can be a useful sensitivity to monitor when maintaining a delta. Ultima has also been referred to as DvommaDvol[22] . (Specifically. the sensitivity of the option delta with respect to change in volatility. vomma is positive where the usual d1 and d2 terms are of the same sign. once to the underlying spot price and once to volatility. Zomma is the third derivative of the option value. which is true when d2 > 0 or d1 < 0.

Annual Dividend Yield .. Time to Maturity.
Calls value delta vega theta Puts
(phi) is the standard normal
is the standard normal cumulative distribution function.Greeks (finance)
281
Black-Scholes
The Greeks under the Black-Scholes model are calculated as follows.. Risk-Free Rate . Strike Price .
rho gamma
vanna
charm
speed
zomma
color
DvegaDtime
vomma Ultima (TBA)
dual delta dual gamma
where
. Note that the gamma and . . where probability density function and For a given: Stock Price . and Volatility vega formulas are the same for calls and puts.

The Complete Guide to Option Pricing Formulas. Espen Gaardner (2007).Greeks (finance)
282
See also
• • • • Alpha (finance) Beta coefficient Delta neutral Greek letters used in mathematics
References
[1] Banks. ISBN 0-13-636002-5 0-13-099661-0. the (1/2)σ2 term). Wilmott Magazine. ISBN 0071389970. [5] Haug. the effect of interest rates on forward prices will also cause the call delta to increase. ISBN 0071389970. but has written it here in the US spelling to match the style of the existing article. McGraw-Hill Professional. "Know Your Weapon. [22] Haug. The Complete Guide to Option Pricing Formulas. McGraw-Hill Professional. McGraw-Hill Professional. [7] There is a slight bias for a greater probability that a call will expire in-the-money than a put at the same strike when the underlying is also exactly at the strike.). McGraw-Hill Professional. "Know Your Weapon. The Complete Guide to Option Pricing Formulas. [20] Espen Gaarder Haug. 9780071453158. 9780071389976. p. [19] Macmillan. McGraw-Hill Professional. Espen Gaardner (2007). Part 2". 9780071389976. ISBN 0071389970. 53 [16] Haug. [11] Haug. Wilmott Magazine. McGraw-Hill Professional.. p. ISBN 0071389970. Espen Gaardner (2007). Espen Gaardner (2007).Strike). 9780786310258. asp). Wilmott Magazine. Part 1". "Know Your Weapon. 9780071389976. (1993). this asymmetry can be effectively eliminated. Espen Gaardner (2007). However.
[8] Haug. [14] Espen Gaarder Haug. in markets that exhibit contango forward prices (positive basis). McGraw-Hill Professional. 799. "Know Your Weapon. p. [23] Haug. The Complete Guide to Option Pricing Formulas. Part 1".
. The Complete Guide to Option Pricing Formulas. Options as a Strategic Investment (3rd ed. 742. The Complete Guide to Option Pricing Formulas. 55 [21] Haug.. The options applications handbook: hedging and speculating techniques for professional investors. The Complete Guide to Option Pricing Formulas. 308.. 9780071389976. ISBN 0071389970. ISBN 0071389970.. Neil (1996). 9780071389976. May 2003. ISBN 0-13-636002-5. [2] Macmillan. Espen Gaardner (2007). Black–Scholes and beyond: option pricing models. (1993). . McGraw-Hill Professional. McGraw-Hill Professional. 9780071389976. [6] Suma. May 2003. ISBN 0071389970. 9780071389976. Siegel. The Complete Guide to Option Pricing Formulas. ISBN 0786310251. [9] Haug.). New York Institute of Finance. p. McGraw-Hill Professional. Paul (2006). 9780071389976. Espen Gaardner (2007). [3] Chriss.
Yet the "bias" to the call remains (ATM delta > 0. [18] Haug. p. McGraw-Hill Professional. Espen Gaardner (2007). Also. Lawrence G. p. 263. John. Espen Gaardner (2007). 56 [15] Espen Gaarder Haug. McGraw-Hill Professional. [10] Haug. [4] Chriss. This bias is due to the much larger range of prices that the underlying could be within at expiration for calls (Strike. The Complete Guide to Option Pricing Formulas. Espen Gaardner (2007). p. Espen Gaardner (2007). Black–Scholes and beyond: option pricing models. [12] Espen Gaarder Haug. com/ university/ option-greeks/ greeks2. with large strike and underlying values. Erik. The Complete Guide to Option Pricing Formulas. p. ISBN 0071389970. ISBN 0786310251. Lawrence G. "Options Greeks: Delta Risk and Reward" (http:/ / www. 308. The Complete Guide to Option Pricing Formulas. Wilmott Magazine. investopedia. July/August 2003. ISBN 0071389970. 9780786310258. Options as a Strategic Investment (3rd ed. Retrieved 7 Jan 2010. McGraw-Hill Professional. Part 1". May 2003. 9780071389976. 51 [13] This author has only seen this referred to in the English spelling "Colour".+inf) than puts (0.50) due to the expected value of the lognormal distribution (namely. McGraw-Hill Professional. New York Institute of Finance. ISBN 0071389970. [17] Haug. Neil (1996). p. 9780071389976. 9780071389976. ISBN 0071453156. ISBN 0071389970.

p. of Alabama
. "Know Your Weapon.Uwe Wystup (http://www. Part 2". • Volga.pdf). Vanilla Options . Wilmott Magazine.com (http://www. Charm.quantnotes. Color: Vanilla Options . Chris Murray • Online real-time option prices and Greeks calculator when the underlying is normally distributed (http://www. 9780071389976. July/August 2003. 55
283
External links
Discussion • Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula (http://papers.php). Part 1". 52 [27] Espen Gaarder Haug. "Know Your Weapon.Uwe Wystup (http://www. Speed.htm). Part 2". Vanna. Part 1". Speed. May 2003. Part 1". Univ. p. McGraw-Hill Professional. Wilmott Magazine. 51 [26] Espen Gaarder Haug.com/KnowYourWeapon. May 2003. Wilmott Magazine. "Know Your Weapon.ua. Nassim Taleb and Espen Gaarder Haug Theory • Delta: quantnotes. "Know Your Weapon.de/ PraktikumFinanzmathematik/library/vanilla_fxoptions. Razvan Pascalau. The Complete Guide to Option Pricing Formulas. Gamma symmetry.ssrn.com/optiongreeks).pdf) Online tools • Surface Plots of Black-Scholes Greeks (http://cdmurray80.edu/~rpascala/greeks/NBOPMForm. p. Wilmott Magazine. July/August 2003. ISBN 0071389970.com/fundamentals/options/thegreeks-delta. Saddle Gamma: Vanilla Options . 52 [28] Espen Gaarder Haug.institute. Espen Gaardner (2007). Vanna.com/sol3/ papers.mathfinance. "Know Your Weapon. cba. Charm. 52 [29] Haug. Gamma.cfm?abstract_id=1012075).googlepages.Espen Haug (http://www. • Delta. 51 [25] Espen Gaarder Haug. Wilmott Magazine.mathfinance. Part 2". [30] Espen Gaarder Haug. Wilmott Magazine. May 2003.espenhaug. "Know Your Weapon. July/August 2003.Greeks (finance)
[24] Espen Gaarder Haug. GammaP. p.de/ FXRiskBook/chap-1. p. p.pdf).

3905/jod. Here. a finite difference model can be derived. com/ pages/ author. The Mathematics of Financial Derivatives: A Student Introduction. in-the-money. "The Valuation of Warrants: Implementing a New Approach" (http:/ / ideas. then. • The value of the option today. org/ pss/ 2330152). ISBN 0-13-009056-5. In fact. [5] Rubinstein. (or at any time/price combination. in general. (January 1977). see Stencil (numerical analysis).2000. such that the option is deeply in or out of the money. 2. as a function of (at least) time and price of underlying. Journal of Financial and Quantitative Analysis (University of Washington School of Business Administration) 13 (3): 461 – 474. E. such that the value at each lattice point is specified as a function of the value at later and adjacent points. E. doi:10. [2] Schwartz. The option is valued as follows:[3] • Maturity values are simply the difference between the exercise price of the option and the value of the underlying at each point. the PDE is expressed in a discretized form. . html). using a technique such as Crank–Nicolson or the explicit method: 1. (1995).[2] Finite difference methods can solve derivative pricing problems that have.. repec. htm).. S.[1] and are therefore usually employed only when other approaches are inappropriate. starting at the time step preceding maturity and ending at time = 0.[2] Here. John C.Finite difference methods for option pricing
284
Finite difference methods for option pricing
Finite difference methods for option pricing are numerical methods used in mathematical finance for the valuation of options. when standard assumptions are applied it can be shown that the explicit technique encompasses the binomial and trinomial tree methods. .) is then found by interpolation. org/ a/ eee/ jfinec/ v4y1977i1p79-93. "On the Relation Between Binomial and Trinomial Option Pricing Models" (http:/ / web. Futures and Other Derivatives (5th ed. • Values at other lattice points are calculated recursively. (2002). ISBN 0521497892. Prentice Hall. [4] Brennan.[5]
References
[1] Hull. org/ web/ 20070622150346/ www.). [3] Wilmott. time runs from 0 to maturity and price runs from 0 to a "high" value. doi:10. like tree-based methods. and the valuation obtained. the value at each point is then found using the technique in question. Journal of Derivatives 8 (2): 47 – 50. essentially. (September 1978). using finite differences. are a special case of the explicit finite difference method. . the PDE is discretized per the technique chosen.
. (2000). At the same time. As above. Once in this form.2307/2330152. • Values at the boundary prices are set based on moneyness or arbitrage bounds on option prices. The approach is due to the fact that the evolution of the option value can be modelled via a partial differential equation (PDE).[4] Tree based methods. archive. Dewynne.319149. Cambridge University Press. see for example Black–Scholes PDE. J. this approach is limited in terms of the number of underlying variables. and for problems with multiple dimensions. P. M. Schwartz. the same level of complexity as those problems solved by tree approaches. Options. jstor. Journal of Financial Economics 4: 79–94. M. these methods and tree-based methods are able to handle problems which are equivalent in complexity. Howison. "Finite Difference Methods and Jump Processes Arising in the Pricing of Contingent Claims: A Synthesis" (http:/ / www. doi:10. Monte Carlo methods for option pricing are usually preferred. and the evolution in the option price is then modelled using a lattice with corresponding dimensions.[1] Finite difference methods were first applied to option pricing by Eduardo Schwartz in 1977.. where the underlying is at its spot price. suitably parameterized. here.1016/0304-405X(77)90037-X.

at each node the price has three possible paths: an up. Ntwiga.
.ca/~rjones/bus864/notes/notes2.lsu.[1] It can also be shown that the approach is equivalent to the explicit finite difference method for option pricing.au.stat.econ.[2]
Formula
Under the trinomial method. In the above formulae: number of time steps.edu/academics/finance/faculty/ dchance/Instructional/TN97-02.sfu. R.cornell.cs.math.pdf).bus. Louisiana State University. is the length of time per step in the tree and is simply time to maturity divided by the is the risk-free interest rate. columbia. Jouni Kerman.pdf).pdf) (includes Matlab Code).Finite difference methods for option pricing
285
External links
• Option Pricing Using Finite Difference Methods (http://www.edu/~kerman/optionpricing. Prof. and is conceptually similar. Tom Coleman.ind/katia-num. the underlying stock price is modeled as a recombining tree. Numerical Solution of Black-Scholes Equation (http://www.br/marco.aims. is its dividend yield. Prof.puc-rio. where. down and stable or middle path.ac. Katia Rocha.pdf). Courant Institute of Mathematical Sciences.cs.B. Jones. is the volatility of the underlying. or where
(the structure is recombining)
and the corresponding probabilities are:
. pdf). Cornell University • Numerically Solving PDE’s: Crank-Nicholson Algorithm (http://www.dk/ vip_htm/cmunk/noter/PDENOTE. Chance. Claus Munk.za/~bundi/Thesis.html#finite-differences).[3] These values are found by multiplying the value at the current node by the appropriate factor .edu/Info/Courses/Spring-98/CS522/ content/lab4. University of the Western Cape • The Finite Difference Method (http://www. D. New York University • Introduction to the Numerical Solution of Partial Differential Equations in Finance (http://mit. Don M.pdf). cornell. • Finite Difference Approach to Option Pricing (http://www. Simon Fraser University • Numerical Methods for Option Pricing: Binomial and Finite-difference Approximations (http://www.pdf). University of Aarhus • Numerical Methods for the Valuation of Financial Derivatives (http://users. It is an extension of the Binomial options pricing model. Instituto de Pesquisa Econômica Aplicada
Trinomial tree
The Trinomial tree is a lattice based computational model used in financial mathematics to price options.edu/Info/Courses/Spring-98/CS522/content/lecture2. It was developed by Phelim Boyle in 1986.

htm) [3] Trinomial Tree. php/ options-database-topmenu/ 13-options-database/ 15-european-options#Trinomial) [2] Mark Rubinstein (http:/ / web. and the binomial model is then preferred due to its simpler implementation. com/ index. The model is best understood visually . "Option Valuation Using a Three-Jump Process". For exotic options the trinomial model (or adaptations) is sometimes more stable and accurate. warwick.
See also
• Binomial options pricing model • Valuation of options • Option: Model implementation
References
[1] Trinomial Method (Boyle) 1986 (http:/ / www. 1986. uk/ fac/ sci/ maths/ people/ staff/ oleg_zaboronski/ fm/ trinomial_tree_2008. while the moments are matched approximately[4] (and with increasing accuracy for smaller time-steps). pdf) [5] http:/ / www. in-the-money. as the number of steps increases.
286
Application
The trinomial model is considered[6] to produce more accurate results than the binomial model when less time steps are modelled.
. by working backwards from the final nodes to today. ac. regardless of step-size. net/ options/ binomialtree. these factors and probabilities are specified so as to ensure that the price of the underlying evolves as a martingale.see. global-derivatives. org/ web/ 20070622150346/ www.later nodes and their corresponding probabilities. For vanilla options. sitmo. Once the tree of prices has been calculated. hoadley. com/ pages/ author. the results rapidly converge. International Options Journal 3. net/ options/ calculators. hoadley.Trinomial tree As with the binomial model. for example Trinomial Tree Option Calculator [5] (Peter Hoadley).as opposed to two . The difference being that the option value at each non-final node is determined based on the three . com/ eq/ 441) [4] Pricing Options Using Trinomial Trees (http:/ / www2. the option price is found at each node largely as for the binomial model. archive. geometric Brownian motion (http:/ / www. htm)
External links
• Phelim Boyle. 7-12. aspx?tree=T [6] On-Line Options Pricing & Probability Calculators (http:/ / www. and is therefore used when computational speed or resources may be an issue.

to continue . you can choose to stop tossing it and get paid (in dollars. Each day you are offered advertising it. A sequence of random variables 2. then are the sequences associated
with this problem.
Definition
Stopping rule problems are associated with two objects: 1. if (n is some large number. If Xi (for i ≥ 1) forms a sequence of independent. Optimal stopping problems can often be written in the form of a Bellman equation. Each time. economics. Secretary problem ( is a finite sequence) You are observing a sequence of objects which can be ranked from best to worst. A sequence of 'reward' functions . Optimal stopping problems can be found in areas of statistics. perhaps) are the ranks of the objects.
) is the sequence of offers for your house. You wish to maximise the amount you get paid by choosing a stopping rule. An elegant solution to the secretary
. the theory of optimal stopping is concerned with the problem of choosing a time to take a particular action. This problem was solved in the early 1960s by several people. say) the average number of heads observed. you can choose to either stop observing or continue • If you stop observing. minimise your expected loss)
Examples
Coin tossing ( converges) You have a fair coin and are repeatedly tossing it. If you sell your house on day In this example. identically distributed random variables with distribution
and if
then the sequences House selling (
. before it is tossed. you will earn . where
You have a house and wish to sell it. the sequence ( You wish to maximise the amount you earn by choosing a stopping rule. you will receive reward • You want to choose a stopping rule to maximise your expected reward (or equivalently.Optimal stopping
287
Optimal stopping
In mathematics. A key example of an optimal stopping problem is the secretary problem. and
are the objects associated with this problem. and at each step . and and is the chance you pick the best object if you stop intentionally rejecting objects at step i. in order to maximise an expected reward or minimise an expected cost. and the sequence of reward functions
is how much you will earn.
does not necessarily converge) for your house. and pay . and mathematical finance (related to the pricing of American options). You wish to choose a stopping rule which maximises your chance of picking the best object.:
Given those objects. Here. the problem is as follows: • You are observing the sequence of random variables. and are therefore often solved using dynamic programming. whose joint distribution is something assumed to be known which depend on the observed values of the random variables in 1.

and R.Optimal stopping problem and several modifications of this problem is provided by the more recent odds algorithm of optimal stopping (Bruss algorithm). php [3] http:/ / www. retrieved on 21 June 2007 • Thomas S. American Scientist. edu/ ~tom/ Stopping/ Contents. "Who solved the secretary problem?" Statistical Science. Search theory Economists have studied a number of optimal stopping problems similar to the 'secretary problem'.
References
[1] http:/ / www. 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cashflows. The interest rate derivatives market is the largest derivatives market in the world." Newsletter of the European Mathematical Society. or a consumer's search for a low-priced good. These structures are popular for investors with customized cashflow needs or specific views on the interest rate movements (such as volatility movements or simple directional movements) and are therefore usually traded OTC. Journal of Economic Literature 43. 14-20. usually domestic or foreign short rates and Forex rates.282-296.
288
References
• T. fr/ ewb_pages/ f/ fiche-article-savoir-quand-s-arreter-22670. Modeling of interest rate derivatives is usually done on a time-dependent multi-dimensional Lattice ("tree") built for the underlying risk drivers. and typically call this type of analysis 'search theory'. The Bank for International Settlements estimates that the notional amount outstanding in June 2009 [1] were US$437 trillion for OTC interest rate contracts. html
Interest rate derivative
An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate.(2000) • F. see Short-rate model. Wright (2005). math. 959–88. Rogerson. americanscientist. Vol. 126-133 (2009). Hill. 1384–1391. P. According to the International Swaps and Derivatives Association.
. (2006) • R. 'Search-theoretic models of the labor market: a survey'. 97. Thomas Bruss. "Sum the odds to one and stop. 25% for commodity options and 10% for stock options.. Search theory has especially focused on a worker's search for a high-wage job. Issue 62. see financial engineering. 4. org/ issues/ feature/ 2009/ 2/ knowing-when-to-stop/ 1 [2] http:/ / www. Vol." Annals of Probability. Ferguson. pourlascience. R. "The art of a right decision: Why decision makers want to know the odds-algorithm. and US$342 trillion for OTC interest rate swaps. "Knowing When to Stop [1]". 28. Vol. Thomas Bruss. (For French translation. pp. Specialised simulation models are also often used. ucla. see cover story [2] in the July issue of Pour la Science (2009)) • Optimal Stopping and Applications [3]. This compares with 75% for foreign exchange options. (1989) • F. Shimer.

Interest rate derivative
289
Types
Vanilla
The basic building blocks for most interest rate derivatives can be described as "vanilla" (simple. • A funding leg usually consists of series of fixed coupons or floating coupons (LIBOR) plus fixed spread. • An exotic coupon leg typically consists of a functional dependence on the past and current underlying indices (LIBOR. traded over the counter). There may also be some range-accrual and knock-out features inherent in the exotic coupon definition. The payer of the exotic coupon leg usually has a right to cancel the deal on any of the coupon payment dates.
. CMS rate. FX rate) and sometimes on its own past levels. caps. floors) Interest rate swap based upon two floating interest rates
Exotic derivatives
Building off these structures are the "exotic" interest rate derivatives (least liquid. basic derivative structures. examples of which are: • • • • Range accrual swaps/notes/bonds In-arrears swap Constant maturity swap (CMS) or constant treasury swap (CTS) derivatives (swaps. such as: • • • • • • • • • Power Reverse Dual Currency note (PRDC or Turbo) Target redemption note (TARN) CMS steepener [2] Snowball [3] Inverse floater Strips of Collateralized mortgage obligation Ratchet caps and floors Bermudan swaptions Cross currency swaptions
Most of the exotic interest rate derivatives can be classified as having two payment legs: a funding leg and an exotic coupon leg. as in Snowballs and TARNs. usually most liquid): • • • • • • • • Interest rate swap (fixed-for-floating) Interest rate cap or interest rate floor Interest rate swaption Bond option Forward rate agreement Interest rate future Money market instruments Cross currency swap (see Forex swap)
Quasi-vanilla
The next intermediate level is a quasi-vanilla class of (fairly liquid) derivatives. resulting in the so-called Bermudan exercise feature.

the issuer also enters into Bermudan swaption when the bond is brought to market with exercise dates equal to callable dates for the bond. In this way.
Bermudan swaption
Suppose a fixed-coupon callable bond was brought to the market by a company.London Interbank Offered Rate) stays within a pre-determined band. The interest rate cap is actually a series of individual interest rate caplets. Therefore. ISBN 0471242918 • Damiano Brigo.com/ basic-fixed-income-derivative-hedging. this would still leave the issuer with the interest rate swap. The interest rate cap is paid for upfront. the swaption is exercised. Wiley.Interest rate derivative
290
Example of interest rate derivatives
Interest rate cap
An interest rate cap is designed to hedge a company’s maximum exposure to upward interest rate movements. Since it is callable however.php) . ISBN 978-3-540-22149-4. It establishes a maximum total dollar interest amount the hedger will pay out over the life of the cap. the issuer may redeem the bond back from investors at certain dates during the life of the bond. 2006 ed. in this case. This option adds to the yield of the note. risk. net/ asia-risk/ feature/ 1496874/ rate-steepeners-rise [3] http:/ / www. entered into an interest rate swap to convert the fixed coupon payments to floating payments (perhaps based on LIBOR). aspx
Further reading
• Hull. com/ derivatives-resources/ wiki/ snowballs.e.
External links
• Basic Fixed Income Derivative Hedging (http://www. the buyer of the note has sold to the issuer. effectively canceling the swap leaving no more interest rate exposure for the issuer. Futures and Other Derivatives. Interest Rate Models . John C. csv) at end-June 2009. This note pays interest only if the floating interest rate (i.financial-edu. Prentice Hall. Inflation and Credit (2nd ed. and then the purchaser realizes the benefit of the cap over the life of the instrument.).Theory and Practice with Smile. Fabio Mercurio (2001). org/ statistics/ otcder/ dt1920a.com.
Range accrual note
Suppose a manager wished to take a view that volatility of interest rates will be low. bis. This note effectively contains an embedded option which.
.
See also
• mathematical finance • financial modeling
References
[1] Bank for International Settlements "Semiannual OTC derivatives statistics" (http:/ / www. If called. Sixth Edition. The issuer however. Retrieved 31 January 2010 [2] http:/ / www. If the bond is called. fincad.Article on Financial-edu. ISBN 0131499084 • Marhsall. John F (2000). (2005) Options. He or she may gain extra yield over a regular bond by buying a range accrual note instead. each being an individual option on the underlying interest rate index. Dictionary of Financial Engineering. Springer Verlag. the bond yields more than a standard bond. if volatility remains low.

usually written rt is the (annualized) interest rate at which an entity can borrow money for an infinitesimally short period of time from time t. which do not capture the mean reversion of interest rates. among them the best known are the Longstaff and Schwartz two factor model and the Chen three factor model (also called "stochastic mean and stochastic volatility model"): 1. In the Black–Karasinski model a variable Xt is assumed to follow an Ornstein–Uhlenbeck process and rt is assumed to follow . 5. if we model the evolution of rt as a stochastic process under a risk-neutral measure Q then the price at time t of a zero-coupon bond maturing at time T is given by
where
is the natural filtration for the process. . The Longstaff–Schwartz model supposes the short rate dynamics is given by: . . This means that instantaneous forward rates are also specified by the usual formula
Particular short-rate models
Throughout this section represents a standard Brownian motion under a risk-neutral probability measure and its differential.
The short rate
The short rate. However no-arbitrage arguments show that. The Black–Derman–Toy model has volatility and otherwise. The Ho–Lee model models the short rate as 4. The Hull–White model (also called the extended Vasicek model) posits many presentations one or more of the parameters and are not time-dependent. is given by : . Other than Rendleman–Bartter and Ho–Lee. these models can be thought of as special cases of Ornstein–Uhlenbeck processes. . Specifying the current short rate does not specify the entire yield curve. 1. defined as . Thus specifying a model for the short rate specifies future bond
prices. where the short rate is
2. The Rendleman–Bartter model models the short rate as 2. 7. for time-dependent short rate . The Vasicek model models the short rate as 3. The Cox–Ingersoll–Ross model supposes 6. under some fairly relaxed technical conditions.
. a short-rate model is a mathematical model that describes the future evolution of interest rates by describing the future evolution of the short rate. In
Multi-factor short-rate models
Besides the above one-factor models. there are also multi-factor models of the short rate. The Chen model which has a stochastic mean and volatility of the short rate.Short rate model
291
Short rate model
In the context of interest rate derivatives.

Interest Rate Models – An Introduction.Short rate model
292
Other interest rate models
The other major framework for interest rate modelling is the Heath–Jarrow–Morton framework (HJM).. is often preferred for models of higher dimension. Cambridge University Press. This makes general HJM models computationally intractable for most purposes. and Risk Management. ISBN 978-0-521-55289-9. The Journal of Risk. Princeton University Press.G. The Cox–Ingersoll–Ross and Hull–White models in one or more dimensions can both be straightforwardly expressed in the HJM framework.. • Jessica James and Nick Webber (2000). Modern Pricing of Interest-Rate Derivatives. ISBN 978-3-540-22149-4. 2006 ed.
.
References
• Martin Baxter and Andrew Rennie (1996). 1999. Princeton University Press. Unlike the short rate models described above. including as it does the Brace–Gatarek–Musiela model and market models. • Rajna Gibson. Cairns (2004). • Andrew J. Interest Rate Dynamics. Inflation and Credit (2nd ed. Interest Rate Models – Theory and Practice with Smile. Wiley Finance. • Riccardo Rebonato (2002). this can be a big simplification. rather than just the short rate. 1(3): 37–62. ISBN 0-471-97523-0. Interest Rate Modelling. The great advantage of HJM models is that they give an analytical description of the entire yield curve. Springer Verlag. this class of models is generally non-Markovian. ISBN 0-691-08973-6. For some purposes (e. ISBN 3-540-60814-1. Other short rate models do not have any simple dual HJM representation. Modeling the Term Structure of Interest Rates: An overview. Springer. valuation of mortgage backed securities). Fabio Mercurio (2001). François-Serge Lhabitant and Denis Talay (2001). ISBN 0-691-11894-9. • Lin Chen (1996). • Damiano Brigo.g. Financial Calculus.). The HJM framework with multiple sources of randomness.. Derivatives Pricing.

Typically α is left as a user input (for example it may be estimated from historical data). it belongs to the class of no-arbitrage models that are able to fit today's term structure of interest rates. The model is still popular in the market today.the Vasicek model θ has t dependence .the Hull-White model θ and α also time-dependent . it has dynamics
There is a degree of ambiguity amongst practitioners about exactly which parameters in the model are time-dependent or what name to apply to the model in each case. The first Hull–White model was described by John C. notice that the change in r is negative if r is currently "large" (greater than θ(t)/α) and positive if the current value is small. σ is determined via calibration to a set of caplets and swaptions readily tradeable in the market. When and are constant.Hull–White model
293
Hull–White model
In financial mathematics. It is relatively straight-forward to translate the mathematical description of the evolution of future interest rates onto a tree or lattice and so interest rate derivatives such as bermudan swaptions can be valued in the model. θ is calculated from the initial yield curve describing the current term structure of interest rates.
The model
One-factor model
The model is a short-rate model. That is. and is of the form:
Where
has an initial value of 0 and follows the process:
Analysis of the one-factor model
For the rest of this article we assume only has t-dependence. Hull and Alan White in 1990. the stochastic process is a mean-reverting Ornstein-Uhlenbeck process. In its most generic formulation. Itô's lemma can be used to prove that
which has distribution
where
is the normal distribution.
. In general. Neglecting the stochastic term for a moment. the Hull–White model is a model of future interest rates.the extended Vasicek model
Two-factor model
The two-factor Hull–White model (Hull 2006:657–658) contains an additional disturbance term whose mean reverts to zero. The most commonly accepted hierarchy has θ constant .

whereas we did not specify a measure at all for the original Hull-White process. Because interest rate caps/floors are equivalent to bond puts and calls respectively.
is the expectation taken with respect to the forward measure. Jamshidian's trick applies to Hull-White (as today's value of a swaption in HW is a monotonic function of today's short rate). A fairly substantial amount of algebra shows that it is related to the original parameters via
Note that this expectation was done in the S-bond measure. the value at time 0 of a derivative which has payoff at time S. Thus knowing how to price caps is also sufficient for pricing swaptions. we have from the fundamental theorem of arbitrage-free pricing. the general calculation used for Black-Scholes shows that
where
and
Thus today's value (with the P(0.
Here.
. This does not matter . the above analysis shows that caps and floors can be priced analytically in the Hull–White model.S) multiplied back in) is:
Here σP is the standard deviation of the log-normal distribution for P(S.Hull–White model
294
Bond pricing using the Hull-White model
It turns out that the time-S value of the T-maturity discount bond has distribution (note the affine term structure here!)
where
Note that their terminal distribution for P(S.
Derivative pricing
By selecting as numeraire the time-S bond (which corresponds to switching to the S-forward measure). thus
show that the time T forward price
Thus it is possible to value many derivatives V dependent solely on a single bond P(S.T) analytically when working in the Hull–White model.the volatility is all that matters and is measure-independent.T) is lognormally distributed.T). Moreover that standard arbitrage arguments for a payoff at time T given by V(T) must satisfy . For example in the case of a bond put
Because P(S.T) is distributed log-normally.

Articles • Damiano Brigo. No. Diploma Thesis. Vol 3. pp 26–36 • John Hull and Alan White. Options. "Using Hull-White interest rate trees." Journal of Derivatives. • John Hull and Alan White.). org/ web/ */ www. 2006 ed. N. "Implementation of Hull-White´s No-Arbitrage Term Structure Model" [1].). (2006). "Interest Rate Derivatives: Models of the Short Rate". Futures. 657–658. "Numerical procedures for implementing term structure models II. OCLC 60321487. as explained for example in Brigo and Mercurio (2001). ppt
. 3 (Spring 1996). pp 59–67.Hull–White model
295
Trees and lattices
However valuing vanilla instruments such as caps and swaptions is useful primarily for calibration. (June 1993) pp 235–254 • John Hull and Alan White. Inflation and Credit (2nd ed. Center for Central European Financial Markets
References
[1] http:/ / web. The real use of the model is to value somewhat more exotic options such as bermudan swaptions on a lattice or other derivatives in a multi-currency context such as Quanto Constant Maturity Swaps. 4 (1990) pp. Vol. com/ ny/ financeinfo/ Diplomnew. • John Hull and Alan White. Upper Saddle River. Fall 1994. Springer Verlag. angelfire. ed. 3. "The pricing of options on interest rate caps and floors using the Hull-White model" in Advanced Strategies in Financial Risk Management. John C. and Other Derivatives (6th ed. "One factor interest rate models and the valuation of interest rate derivative securities. ISBN 978-3-540-22149-4. Winter 1994. No. Chapter 4. Fabio Mercurio (2001). 573–592 • Eugen Puschkarski. archive. pp. Interest Rate Models — Theory and Practice with Smile. The Review of Financial Studies. LCCN 2005-047692. No 2. Vol 28." Journal of Financial and Quantitative Analysis.
See also
• Vasicek model • Cox-Ingersoll-Ross model
References
Notes • Hull. pp 37–48 • John Hull and Alan White." Journal of Derivatives. "Numerical procedures for implementing term structure models I.J: Prentice Hall. "Pricing interest-rate derivative securities". ISBN 0131499084." Journal of Derivatives. pp 7–16 • John Hull and Alan White.

It is a type of "one factor model" (short rate model) as it describes interest rate movements as driven by only one source of market risk. Consequently. which dampens the effect of the random shock on the rate. Ross as an extension of the Vasicek model.
. The most general approach is in Maghsoodi (1996).Cox–Ingersoll–Ross model
296
Cox–Ingersoll–Ross model
In mathematical finance. An interest rate of zero is also precluded if the condition is met. The standard deviation factor. when the rate is at a low level (close to zero). also named the CIR process:
where Wt is a Wiener process modelling the random market risk factor. The bond price is exponential affine in the interest rate:
Extensions
Time varying functions replacing coefficients can be introduced in the model in order to make it consistent with a pre-assigned term structure of interest rates and possibly volatilities. Ingersoll and Stephen A. is exactly the same as in the Vasicek model.
Bond pricing
Under the no-arbitrage assumption. A more tractable approach is in Brigo and Mercurio (2001b) where an external time-dependent shift is added to the model for consistency with an input term structure of rates. The drift factor. A significant extension of the CIR model to the case of stochastic mean and stochastic volatility is given by Lin Chen(1996) and is known as Chen model. which pushes the rate upwards (towards equilibrium).
The model
The CIR model specifies that the instantaneous interest rate follows the stochastic differential equation. a(b − rt). It ensures mean reversion of the interest rate towards the long run value b. . the standard deviation also becomes close to zero. with speed of adjustment governed by the strictly positive parameter a. the Cox–Ingersoll–Ross model (or CIR model) describes the evolution of interest rates. its evolution becomes dominated by the drift factor. It was introduced in 1985 by John C. avoids the possibility of negative interest rates for all nonnegative values of a
and b. More generally. Cox. a bond may be priced using this interest rate process. Jonathan E. The model can be used in the valuation of interest rate derivatives. when the rate gets close to zero.

Chen model is listed along with the models of Robert C. Robert A. "Solution of the extended CIR Term Structure and Bond Option Valuation". Inflation and Credit (2nd ed.C. Springer Verlag. Stephen A. Fabio Mercurio (2001). Econometrica 53: 385–407. Different variants of Chen model are still being used in financial institutions worldwide. Y. ISBN 978-3-540-22149-4. Andersen et al. Mathematical Finance (6): 89–109. • Cox. devote a section to cover Chen model in their review article.
Chen model
In finance. devote a paper to test Chen model and other models. the Chen model is a mathematical model describing the evolution of interest rates. Ross. Finance & Stochastics 5 (3): 369–388. • Maghsoodi.2307/1911242. The dynamics of the instantaneous interest rate are specified by the stochastic differential equations:
In an authoritative review of modern finance (Continuous-Time Methods in Finance: A Review and an Assessment). Ingersoll and S. Darrell Duffie. • Damiano Brigo. J. Gallant et al. doi:10. Oldrich Vasicek. devote a paper to study and extend Chen model. Merton. It is a type of "three-factor model" (short rate model) as it describes interest rate movements as driven by three sources of market risk. (1996). Upper Saddle River.E. It was the first stochastic mean and stochastic volatility model and it was published in 1994 by the economist Lin Chen. Cox. • Brigo. Gibson et al. John C. Futures and Other Derivatives. Options. Jarrow. James and Webber devote a section to discuss Chen model in their book. J. and Emanuel Derman as a major term structure model. John Hull..). ISBN 0-13-009056-5. John C. "A deterministic-shift extension of analytically tractable and time-homogeneous short rate models". Damiano and Fabio Mercurio (2001b). Wibowo and Cai devotes their PhD dissertations to testing Chen model and other competing models.Cox–Ingersoll–Ross model
297
See also
• • • • Hull-White model Vasicek model Chen model CIR process
References
• Hull.
. Interest Rate Models — Theory and Practice with Smile. NJ: Prentice Hall. "A Theory of the Term Structure of Interest Rates".A. Ross (1985). (2003). 2006 ed.

). Dynamic Term Structure Modeling: The Fixed Income Valuation Course. Soto. edu/ lcai/ lili_files/ JobMarketPaper. • Jessica James and Nick Webber (2000). Lund (2004). • Sanjay K. Gloria M. • Wibowo A.G. 135-168. Fabozzi and Moorad Choudhry (2007). Natalia A. Rutgers University. • Gallant. pdf [2] http:/ / eprints. Tauchen (1997. L.00261. and Jumps in the Short-Term Interest Rate. and J. The Journal of Finance 55 (54): 1569–1622. Stochastic Volatility. A. and Instruments 5: 1–88. The Handbook of European Fixed Income Securities. 435. Suresh M. Northwestern University. • Cai. • Sundaresan. rutgers. Benzoni... doi:10. Nawalkha.. Derivatives Pricing. Institutions. Interest Rate Modelling. (2008). ETH. • Andersen. and Risk Management. (2000). Specification Testing for Multifactor Diffusion Processes:An Empirical and Methodological Analysis of Model Stability Across Different Historical Episodes [1].. Wiley Finance. • Lin Chen (1996).Chen model
298
See also
• Lin Chen in Harvard PhD Event
References
• Lin Chen (1996). Financial Markets. L. Working Paper. • Rajna Gibson. RiskLab. ISBN 978-3540608141. Wiley Finance. Continuous-time identification of exponential-affine term structure models [2]. Springer. "Stochastic Mean and Stochastic Volatility — A Three-Factor Model of the Term Structure of Interest Rates and Its Application to the Pricing of Interest Rate Derivatives". Wiley Finance..François-Serge Lhabitant and Denis Talay (2001). "Continuous-Time Methods in Finance: A Review and an Assessment". and G. Mean Drift. nl
.1111/0022-1082.R. eemcs. T. Estimation of Continuous Time Models for Stock Returns and Interest Rates. Macroeconomic Dynamics 1. utwente. Modeling the Term Structure of Interest Rates: A Review of the Literature. Beliaeva (2007).
References
[1] http:/ / econweb. Interest Rate Dynamics. (2006). Lecture Notes in Economics and Mathematical Systems. Twente University. • Frank J.

.. • Damiano Brigo's lecture notes on the LIBOR market model for the Bocconi University fixed income course [3]
References
• Brace.LIBOR Market Model
299
LIBOR Market Model
The LIBOR market model. with. D. • Miltersen. 127-154. One can write the different rates dynamics under a common pricing measure. leading to the need of numerical methods such as monte carlo simulation or approximations like the frozen drift assumption.e. as lognormal processes
Here. e. et Musiela.
External links
• Java applets for pricing under a LIBOR market model and Monte-Carlo methods [1] • Sample chapters of the book "Mathematical Finance" (ISBN 0470047224) [2]. hence the term "market model". It is used for pricing interest rate derivatives. also known as the BGM Model (Brace Gatarek Musiela Model. The LIBOR market model may be interpreted as a collection of forward LIBOR dynamics for different forward rates with spanning tenors and maturities.. The quantities that are modeled. autocaps.
. K. in contrast to the Black model. K.
denotes the forward rate for the period
. 7(2). M. For each single forward rate the model corresponds to
the Black model. and in this case forward rates will not be lognormal under the unique measure in general. target redemption notes. especially exotic derivatives like Bermudan swaptions. i. Sandmann. is a financial model of interest rates.g. (1997): „Closed Form Solutions for Term Structure Derivates with Log-Normal Interest Rates“. zero coupon swaptions. a derivation of the LIBOR market model drift. 409-430. This formula is the market standard to quote cap prices in terms of implied volatilities. Mathematical Finance. the LIBOR market model describes the dynamic of a whole family of forward rates under a common measure. rather than the short rate or instantaneous forward rates (like in the Heath-Jarrow-Morton framework) are a set of forward rates (also called LIBORs). 52(1). A. a Black model leading to a Black formula for interest rate caps. each forward rate being consistent with a Black interest rate caplet formula for its canonical maturity. et Sondermann. in reference of the names of some of the inventors). Each forward rate is modeled by a lognormal process under its forward measure... Gatarek.
Model dynamic
The LIBOR market model models a set of forward rates . among many others. for example the forward measure for a preferred single maturity. The novelty is that. which have the advantage of being directly observable in the market. D. ratchet caps and floors. (1997): “The Market Model of Interest Rate Dynamics”. Journal of Finance. and whose volatilities are naturally linked to traded contracts. constant maturity swaps and spread options.

Jan 1995). Examples include a one-factor. two state model (O. Models developed according to the HJM framework are different from the so called short-rate models in the sense that HJM-type models capture the full dynamics of the entire forward rate curve. Cornell University. and later multi-factor versions.). Mathematical Finance. html
Heath–Jarrow–Morton framework
The Heath–Jarrow–Morton (HJM) framework is a general framework to model the evolution of interest rate curve – instantaneous forward rate curve in particular (as opposed to simple forward rates). Journal of Fixed Income. The instantaneous forward rate from time . It is defined by: (1) The basic relation between the rates and the bond prices is given by: (2) Consequently. making it computationally feasible. They show that if the volatility structure of the forward rates satisfy certain conditions.
Mathematical formulation
The class of models developed by Heath.
Framework
The key to these techniques is the recognition that the drifts of the no-arbitrage evolution of certain variables can be expressed as functions of their volatilities and the correlations among themselves. christian-fries. 1. it/ bocconi. Robert A. 1. while the short-rate models only capture the dynamics of a point on the curve (the short rate). The HJM framework originates from the work of David Heath. de/ finmath/ book/ [3] http:/ / www. models developed according to the general HJM framework are often non-Markovian and can even have infinite dimensions. Ritchken and L. A number of researchers have made great contributions to tackle this problem.LIBOR Market Model
300
References
[1] http:/ / www. damianobrigo. de/ finmath/ applets/ [2] http:/ / www. In other words. For direct modeling of simple forward rates please see the Brace–Gatarek–Musiela Model as an example. christian-fries. 1992. Cheyette. satisfy for any : is the continuous compounding rate available at time as seen
The assumption of the HJM model is that the forward rates
. However. and Bond pricing and the term structure of interest rates: a new methodology (1989) – working paper (revised ed. especially Bond pricing and the term structure of interest rates: a new methodology (1987) – working paper. 5. Cornell University. Jarrow and Morton (1992) is based on modeling the forward rates. Jarrow and Andrew Morton in the late 1980s. "Term Structure Dynamics and Mortgage Valuation". the bank account grows according to: (3) since the spot rate at time is . no drift estimation is needed. No. yet it does not capture all of the complexities of an evolving term structure. then an HJM model can be expressed entirely by a finite state Markovian system. P. Sankarasubramanian in "Volatility Structures of Forward Rates and the Dynamics of Term Structure".

(9) It follows from (5) and (9). Under the martingale probability measure and the equation for the forward rates becomes: (14) This equation is used in pricing of bonds and its derivatives.
301
. Let (6) Then (7) Using Leibniz's rule for differentiating under the integral sign we have that: (8) where By Itō's lemma. we must have that (10) (11) Rearranging the terms we get that (12) Differentiating both sides by . we have that (13) Equation (13) is known as the no-arbitrage condition in the HJM model.Heath–Jarrow–Morton framework (4) where the processes are continuous and adapted. For this assumption to be compatible with the assumption of the existence of martingale measures we need the following relation to hold: (5) We find the return on the bond in the HJM model and compare it (5) to obtain models that do not allow for arbitrage.

upenn. Vladimir I Pozdynyakov. A. cfm?abstract_id=123170
. Radhakrishnan New York University
References
[1] http:/ / repository. Econometrica.R. issue 1. University of Pennsylvania • An Empirical Study of the Convergence Properties of the Non-recombining HJM Forward Rate Tree in Pricing Interest Rate Derivatives [2]. Robert A. 60. vol.Heath–Jarrow–Morton framework
302
See also
• • • • • Ho–Lee model Hull–White model Black–Derman–Toy model Chen model Brace–Gatarek–Musiela Model
External links and references
• Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation. David Heath. edu/ dissertations/ AAI3015358/ [2] http:/ / papers. com/ sol3/ papers.2307/2951677 • Heath–Jarrow–Morton model and its application [1]. 1992. ssrn. pages 77–105 doi:10. Jarrow and Andrew Morton.

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Schomerus. Michael Hardy. Christiaan. SU Linguist.collins. PCock. JavOs. Faradayplank. Wordsmith. ArnoldReinhold. Benjamin. Christopher Connor. Sandym. Vegaswikian. From That Show!. Bearas. Lprideux. Xieyihui. Ben pcc. Cp111. Farmhouse121.php?oldid=393344825 Contributors: 62.php?oldid=395038275 Contributors: A quant. Protonk.t. Cyde. Cje. Justin73. Qwfp. Voyagerfan5761. Cje. ShaunMacPherson. Rose Garden. SimonP. Phgao. Edward. Jcsellak. Bluegrass.org/w/index. Taxman.php?oldid=392378504 Contributors: Aav. Inferno. Arthena. Doulos Christos.Brown. Burntsauce. Heheman3000. Sosobra. Dandrake. Jloo. Gaius Cornelius. Benjai. Alansohn. Coolcaesar. Road Wizard. RedWolf. Euphrosyne.php?oldid=391371537 Contributors: 4l3xlk. RDSeabrook. Gauge. Michael Hardy. Pete5. Woohookitty. Favonian. Siroxo. AaCBrown. Arthena. Alesander.php?oldid=388827024 Contributors: Albertod4. Kuru. Psb777. Wcspaulding. Pgreenfinch. Dickpenn. Kymacpherson. Drusus 0. Sadads. Helon. Enchanter. Swerfvalk. Piet Delport. Tsancoso. Juxo. Mulad. Melcombe. Albmont. Heman. Starkodder. Feco. Msubronson.Wolfowitz. Htournyol. Benja. DanielDeibler. Bender235. Reedy. I do not exist. Nelson50. Fortdj33. Jmarkuso. Zootm.t. Jburt1. Tassedethe.S. Dfeldmann. Davezes. Rinconsoleao. Bookandcoffee. LilHelpa. Pt johnston. CSWarren. Jitse Niesen. Bogdanb.wikipedia. GraemeL. Stephen B Streater. Duesentrieb.php?oldid=364889473 Contributors: Ben pcc. Jorunn. Anwar saadat. Smallbones. Llywelyn. Salih. Cradel. Cllectbook. Cburnett. Rich Farmbrough. Drusus 0. Gfk. Fabee. Roundhouse0.wikipedia. Fintor.php?oldid=328998024 Contributors: Chris the speller. Finnancier. Tinyforebrain. Gurch. Conversion script. -oo0(GoldTrader)0oo-. Fredbauder. Ughh. Eric Kvaalen. 20 anonymous edits Rational pricing Source: http://en. McLowery. AdamSmithee. Cherkash. Giftlite. Jitse Niesen. Kwertii. Walkerma. Canadaduane. Humanengr. Jsm0711. Asperal. Rgclegg. Pseudomonas. Personline. Philip Trueman. Random user. JJL. Kdpinsf. Mushroom. GB fan. Gandalf013.org/w/index. Jonathan Callahan. Mild Bill Hiccup. Novacatz. Catofgrey. Bfinn. Fintor.wikipedia. Bomac. From That Show!. Phil Boswell.php?oldid=394439336 Contributors: Brianga. Lamro. Whimsics. LaidOff. Ryguasu. Michael Hardy. Finnancier. Urocyon. ZenerV. Bobblewik.php?oldid=392613880 Contributors: Alexxandros. Eug. Ronnotel. Ehn. Mattis. Henrygb. Cburnett. Fintor. Scientiae Defensor. Assbackward. Kku. 66 anonymous edits Intrinsic value (finance) Source: http://en. Yurik.. V35322. Tide rolls. Rjwilmsi. UberScienceNerd. Ulner.php?oldid=377298768 Contributors: A. Hede2000. Ehn. Giganut. Jgonion. Griffgruff. Excirial. Ryanrs. Complexfinance. Snapperman2. Kwamikagami. Zippymobile. Tesseran.64. Donreed.ch. DocendoDiscimus. John Quiggin. Timwiut. Maurreen. Palouser1. Furrykef. Hu12. Toby Bartels. Czalex. Gurubrahma. John Quiggin. Shawn@garbett. NEARER. MementoVivere. Maurreen. Mydogategodshat. Oblonej. John Laxson. Edward. Espoo.zitkeviciute. Enchanter. Stifle. Juro. RockMagnetist. Who. Ulner.Article Sources and Contributors
R. Cleared as filed. MrOllie. Michael Hardy. Berland. KelleyCook. Tarquin. Wyattmj. Zhenqinli. Charles Matthews. Boc236. Hu12. Mathsfreak. CRoetzer. Speedplane. Wavelength. Rainwarrior. Mu. Phys0111. Dzordzm. Efutures. FreplySpang. Wnissen. Sam Hocevar.wikipedia. Ru elio. Ramin Nakisa. Sijo Ripa. Loodog.wikipedia. MathFacts. Satori Son. Ronnotel. VerySmartNiceGuy. Vikramsidhu. Simishag. LeaveSleaves. Feuer.wikipedia. Hobsonlane. Rangek. Noldo22. Fergusdog. WikiPier. Supasheep. JohnOwens. RocketPaul77.org/w/index. Rmhermen. Superale85. Chadernook. Kungfuadam. Ddantas. Mtg1977. Pentti71. Wk muriithi.org. Charles Matthews. Cutter. HotBridge. Argoreham. Swerfvalk. Hypersphere.fa. John Fader. AnnaFrance. Ninly. RJN.org/w/index. Taxman. Ptrf. Anwhite. Eeekster.php?oldid=394620955 Contributors: Abhinav. KimYungTae. Woohookitty. Iridescent. LARS.org/w/index. SDC. Geschichte. Rumpelstiltskin223. Jonathan Drain. OliAtlason. Zurich Risk. Fuhghettaboutit. Zvika. Egopaint. Gene Nygaard.j. Marishik88. Baeksu. Jbaphna. Smallbones.Örvarr. Tiger888. Fenice. Sydal. Jlang. John Comeau. GoingBatty. TheEmanem. 46 anonymous edits Finite difference Source: http://en. Spencer195.wikipedia. JHP. Taxman. Oren0. Bender235. Brenoneri. Wtmitchell. Ac101. GeneralBob. BigJohnHenry. Cyktsui. Xavid. Chrylis. Moskvax. Froufrou07. Phil Boswell. UweD. Infinity0. Allstar784. Natalya. BenFrantzDale. Informationisacommodity. Sigmundur. Soap. Cmathio. Ergative rlt. Fintor. Nburden. GraemeL. Commander Keane. Delaszk. Yabancı. Jewzip. Radagast83. Dkeditor. Ensign beedrill. LearnK. DominicConnor. Innohead. Lightdarkness. HappyInGeneral. A. Snehalkanakia. JJL. Iamrndy. Andrewpmack. Ronnotel. Johnleemk. Lambiam. Wikomidia. Cyanide2600. X96lee15. William M. Liveandplay. Hascott. Wushi-En. BenFrantzDale. Letournp. SunCreator. Tassedethe. ALLurGroceries. Pelotas. Neutiquam. Ronnotel. Jbergquist. Woohookitty. Hadal. Nilanjansaha27. Ronnotel. CheckURmath. Dcamp314. Warbler271. Pcxtrader. S. Amir Aliev. PizzaMargherita. Btyner. SpacemanSpiff. Luizabpr. Mevalabadie. Oleg Alexandrov. Markhurd. Feco. Ehdr. Woohookitty.b. Seanhunter. Profitip. Docu. Lamro. Hu12. Vovchyck. Insightfullysaid. Landroni. Eijkhout. Firsfron. Ciphers. Fox. Hu12. Hu12. Bondegezou. LDLee. Salahx. Tsuchan. LARS. The Anome. DerHexer. Roadrunner. Lord of Penguins. Leifern. Avriette. Ulner. Michael Hardy. Pgreenfinch. Dpbsmith. Roadrunner. Qazzt. Stirfutures. Grazfather. Wysinwygaa. Charvest. DominicConnor. ACEngert. Vgranucci. Martinp. Sjc. Ladnunwala. Christofurio. Irbisgreif. Koavf. When Muffins Attack. Fastfission. Investor123. OwenX. Roadrunner. Flyhighplato. Jimmyshek. GraemeL. That Guy. Jitse Niesen. Beganlocal. Riskbooks. Bryan Derksen.xxx. Orzetto. Volemak. JHP. Btyner. 151 anonymous edits Brownian Model of Financial Markets Source: http://en. DeadEyeArrow. Pcb21. Larry Lawrence. 55 anonymous edits Arbitrage Source: http://en. Joy.php?oldid=389302066 Contributors: 360Portfolios. Drusus 0. Daniel Dickman. Mark Meeker.wikipedia. Yone Fernandes. Pilotguy. DomCleal. Mariocastrogama. Sargdub. The Man in Question. 17 anonymous edits
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Daniel5127. Jerryseinfeld. Tekhnofiend. MrOllie. Berland. Den fjättrade ankan. Colonies Chris. PamD. Barcturus. SKL. BadSeed. Skomorokh. Zven.delanoy. Andycjp. Charles Matthews. Chris Edgemon. Henrygb. Pauly04. Wallpaperdesktop. Sjakkalle. Olejasz. Aaron Brenneman. MithrandirAgain.wikipedia. Whisky brewer.friedrich. 169 anonymous edits Autoregressive conditional heteroskedasticity Source: http://en. Jtkiefer. K12345wiki. Davidcam.. Marudubshinki. Umofomia. UffeHThygesen. JRR Trollkien. Elwikipedista. Kiefer. Chepurko. Lamro. Zylorian. Melcombe. Nbarth. Jimmy Pitt. SubSeven. Will Beback. CliffC. Voorlandt. Shawnc. Calcuscribe. Msankowski. Drmies. CBM. Reinoutr. UnitedStatesian. Piloter. Albmont. Mojtaba-taheri-1983. Btyner. Alch0. Ukexpat. Marcika. Foxjwill.org/w/index. Jerryseinfeld. Int21h. Innerproduct. Geomatster. Tedder. DocendoDiscimus. Craig t moore. Gandalf61. Merube 89. Schmiteye. D15724C710N. Wcspaulding.t. Fintor. Doc9871. Brentdax. Jayanta Sen. Voxpuppet. EcoMan. Edward. ShelfSkewed. GeorgeBoole. Taxman. Tobias Hoevekamp. N5iln.wikipedia. Finnancier. Gaius Cornelius. A Softer Answer. Rhobite. Ronnotel. SJP. Aldanor. Pentti71. Phineas Ravenscroft. Finnancier. Enchanter. GraemeL. Sigita. Feco. Heresiarch. Altenmann. WordyGirl90. Mikie yorkie. Ulner. Nk. Xp54321. Jni.org/w/index. IvanLanin. Michael Hardy. Idleguy. Rjwilmsi. David Shay. Knowledge2. Didickman. JoePonzio.wikipedia. Coneslayer. Pitchfork4. Tsirel. Dan100. EntmootsOfTrolls. Pohick2. Kevinhsun. Nlu. BrokenSegue. Mattis. Michael Hardy. Rich Farmbrough.php?oldid=394280506 Contributors: "alyosha". Bender235. Roadrunner. Bissinger. Alex Bakharev. Forlornturtle. Pgreenfinch. Ronnotel. 33 anonymous edits Numerical partial differential equations Source: http://en. 43 anonymous edits Stochastic volatility Source: http://en. Namaxwell. DocendoDiscimus. JIP. Kupirijo. Finnancier.e. Mike40033. Sam Korn. Cyanoa Crylate. Hectorthebat. Deconstructhis. Edgar181. Hopefully acceptable username. Gaius Cornelius. Pgreenfinch. Kozuch. Laudaka. Jeremiahmurray. Fintor. Lhfriedman. Umalee.253. Zaphod Beeblebrox. Taral. Wikomidia. Wooyi. Abeliavsky. Oli Filth. Ian Pitchford. Nbarth. KnightRider. Flockmeal. Wongm. SgtThroat. Charvest. Gzornenplatz. 216 anonymous edits Volatility (finance) Source: http://en. NeuronExMachina. Bombastus.org/w/index. HyDeckar. Darkildor. Uaqeel. Jfeckstein. Keenan Pepper. Effco. Thomas Arelatensis. MrVoluntarist. Benna. Westmorlandia. Discospinster. Furrykef. Nbarth.php?oldid=382341931 Contributors: ElectricRay. Cyktsui. Polly Ticker. Paul Matthews. Evil Monkey. AdRock. DocendoDiscimus. Hairy Dude. Sullivan. Bobknowitall. Sgcook. Andrew Reynolds. JohnCD. Plasticup. Wikidemon. Xiaoyanggu. Gede.org/w/index. Dicklyon. Brw12. Random user. Nutcracker. Spinningspark. Rich Farmbrough. Calair. Chiinners. Emperorbma. Hu12. Ruziklan. Mebits. That Guy. Chimpex. Conant Webb. D6. Cronholm144. Ozob. Giftlite. Josh Parris. Karol Langner. Neutrality. Tickenest. Ian Pitchford. Artman772000. Julesd. Linas. Magicmike. Adler. Outriggr.wikipedia. Smallman12q. Chenyu.org/w/index. Aimsoft. Alcatrank. Vina. Myasuda. Bennoro. LilHelpa. Jerryseinfeld. Philip Trueman. Pichler. Honza Záruba.org/w/index. Salih. Pontus. DenisHowe. 26 anonymous edits Stochastic differential equations Source: http://en. Joshuaali. Gparker. Xian. Mitchan.org/w/index. Oleg Alexandrov. OwenX. The Thing That Should Not Be. Christian List. Amartya ray2001. Tigergb. Bobo192.wikipedia. Wile E. Yahya Abdal-Aziz. Srleffler. Erxnmedia. Slicing. 516 anonymous edits Put–call parity Source: http://en. Mir76. Atrick. Rmaus. Coder Dan. Kizor. Matt Raines. Pgreenfinch. Jensp. Rduinker. TakuyaMurata. Waltke. Desolidirized. Jnmclarty. Michael Hardy. Renamed user 4. KKramer. LachlanA. FilipeS.php?oldid=19592160 Contributors: Agmpinia. Johnpseudo. Melcombe. Enchanter. RBecks. Paine Ellsworth. Redthoreau. Sandym. Advancedfutures. Random user. Feco. Willking1979. Gerhard Schroeder. Fenice. Nshuks7. Tristanreid. Jkeene. Plinkit. Oleg Alexandrov. Sullivan. Avraham. Beetstra. Dvavasour. Trade2tradewell. Saturnight. R'n'B. Aleator. Kopeti5. Crazycomputers. Jphillips. Firsfron. Scootey. Alias Flood. 4 anonymous edits Crank–Nicolson method Source: http://en. Marudubshinki. Bethnim. RayBirks. Beetstra. Zain Ebrahim111. Gavin. Sgcook. Hairy Dude. Time9. TastyPoutine. Btyner. Connolley. Athaenara. JHG. Capricorn42. 4twenty42o. Fintor. Fenice. SpuriousQ. Information Arbitrage. Oleg Alexandrov. Versageek. ZackDude. Giftlite. Frank Lofaro Jr. Michael Hardy. Solarapex. Mauri. Angelic editor. Islander. Tide rolls. JLaTondre. Jafcbs. Nutcracker. The Anome. Rich Farmbrough. 120 anonymous edits Value at risk Source: http://en. DMCer. Michael Hardy. Alexasmith. Gregalton. AtomikWeasel. Euchiasmus. Altenmann.wikipedia. Isis. Praet123. Mactuary. Pnm. Vald. Sharik. Alast0r. Pcb21. Ben pcc. Christofurio. Bobo192. PeterM. Hyperbola. Salsia. Avenged Eightfold. Btyner. LOL. RoyBoy. Nbarth. Kyng. KrisK.. Lamro. Maksim-e. Shawnc. Veinor. B. Kwertii. Wongm. Kingpin13. Noldo22. Sławomir Biały. Expofutures. Kjm. Jackmass. J. Jose Ramos. Ryguillian. Lyst.

Christofurio.wikipedia. Pt johnston. Lamro. Dpwkbw. LilHelpa. Css. Gena1982.wikipedia. Michael Hardy. Gaschroeder. 3 anonymous edits Optimal stopping Source: http://en. Nbarth. Antoniekotze. 602 anonymous edits Black model Source: http://en. Razorflame. GraemeL. AndrewHowse. Rich Farmbrough. Iridescent. Hu12. Fintor. Fsiler. Heresiarch. Leyanese. Autoreplay. Fijimf.php?oldid=380344332 Contributors: AdamSmithee. Pikiwyn. Gabbe. Fabrictramp. Melcombe. Wile E. Goliat 43. Lfchuang.. Enchanter. IstvanWolf. Jphillips. Cpsdcann. Edward. Shimgray. It's-is-not-a-genitive. Stebulus. Bssc81.php?oldid=257223711 Contributors: Centrx. Fintor. Pcb21. Csl77. Oleg Alexandrov. Ronnotel. That Guy.php?oldid=391804946 Contributors: Biscuittin. Piloter. Saibod. DanMS. Asperal. Sgcook. Woohookitty.. MarkSweep. Michael Hardy.wikipedia. 14 anonymous edits Chen model Source: http://en. Oli Filth. Silly rabbit. Hu12. Ronnotel. Fintor. Gizbic. Linas. Roadrunner. Piloter.php?oldid=359965470 Contributors: BetFut. Feco. Ernie shoemaker. Oli Filth. Christofurio. Bkessler.org/w/index. ProfessorTarantoga. GraemeL. Gabbe. Woohookitty. EvanCarroll. Alanb. 14 anonymous edits Interest rate derivative Source: http://en. Danielfranciscook. Sumeetakewar. Woohookitty. Jdthood. Forwardmeasure. Sgcook. Hu12. Wknight94. JaGa. Amit1law. BD2412.org/w/index.org/w/index. Sgcook. Smaines. Jigneshkerai89.php?oldid=388574261 Contributors: A Train. Gauge. Ivanptg. Yamamoto Ichiro. 28 anonymous edits Hull–White model Source: http://en. Roadrunner. ST47. Finnancier. NYArtsnWords. Michael Hardy. Fintor. Lancastle. Galizur. Ercolev. Ratesquant. Davejagoda. Fsiler. GeneralBob. Rinconsoleao. Willsmith. Michael Hardy. Materialscientist.wikipedia. Piloter.croce. Jitse Niesen. Dostanden.php?oldid=394821703 Contributors: -Ozone-. LeYaYa. Olejasz. Guy M. WebScientist. Who. Giftlite. Bobo192. AdamSmithee. Good Olfactory. Stevenmitchell. Roadrunner. Joshfinnie. Viz. Duja. Skittleys.php?oldid=356011722 Contributors: AdamSmithee. Jadair10. Dr. Wlmsears. Gxti. Tawker. SDC. Thoreaulylazy. Hu12. Charles Matthews. Maximus Rex. PtolemyIV. 29 anonymous edits Markov Switching Multifractal Source: http://en. MrOllie. Lamro. Crasshopper. Mikc75. Qwfp. Ekotkie. Williamv1138. Prasantapalwiki. Pretzelpaws. Smallbones. From That Show!. Graft. Moneyneversleeps. David Eppstein. Leszek Jańczuk. Dan Guan. Nshuks7. Coder Dan. Domino. Geremy78. Ulner. KnightRider. 67 anonymous edits Binomial options pricing model Source: http://en. CyberSco. Camiflower. Tiles. Feco. Mewbutton. Fenice. Cburnett. Feco. Slakr. Katharineamy. AdrianTM. Gadget850.org/w/index. Tassedethe. Chrisvls. Bankert. Pontus. Macrakis. Finnancier. Sbratu. Kimbly. Dudegalea. Ulner. EdJohnston. Christofurio. Brianegge. Leifern. Pontus.php?oldid=388951552 Contributors: Captain Disdain. Finnancier. GeneralBob. Ustaudinger. Brad22dir. Bhadani. Vonfraginoff. Hadal. Erechtheus. Dysprosia.php?oldid=376271493 Contributors: Anticipation of a New Lover's Arrival. Goodnightmush. Anwar saadat. Favonian. 34 anonymous edits Cox–Ingersoll–Ross model Source: http://en. Hu12. Alfanje. Qxz. Jay. Beetstra. CliffC. Smallbones11.wikipedia. Tomeasy. Sebculture. Rich Farmbrough. Mathiastck. Kaslanidi. ProfessorTarantoga. Undpgh. Ulner. DerHias. Rich Farmbrough. Korhantoker1. Makreel. Smallbones. Kungfuadam. Whtsmith. Glane23. DARTH SIDIOUS 2. Fintor.wikipedia. Jphillips. Kcordina. Nbarth.wikipedia. Islandbay. Choas. Kasprowicz. JMSwtlk. のぼりん. Dthomsen8. PP Jewel. Ioannes Pragensis. DocendoDiscimus. Garnett9. Avikar1. Fintor.007. Michael Hardy. Reuben. Michael Hardy. PigFlu Oink.wikipedia. Michael Hardy. JustAGal. Oleg Alexandrov. Islandbay. Melcombe. Fintor. Kbrose. Bankert. Vercalos. Michael Hardy. DocendoDiscimus. Radicalsubversive.Article Sources and Contributors
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