STATE PRICE DENSITY, ESSCHER TRANSFORMS, PRICING OPTIONS ON STOCKS, BONDS, AND FOREIGN EXCHANGE RATES

Yong Yao*

AND

ABSTRACT
The state price density is modeled as an exponential function of the underlying state variables, and the Esscher transform is used to specify the forward-risk-adjusted measure. With the aid of state price densities, Esscher transforms, and characteristic functions, this paper provides a consistent framework for pricing options on stocks, interest rates, and foreign exchange rates. The framework discussed is quite general and is related to many popular models.

1. INTRODUCTION
The idea of the state price density can be traced back to Arrow’s paper “The Role of Securities in the Optimal Allocation of Risk Bearing” (1953) and Debreu’s book The Theory of Value (1959). The authors introduced contingent contracts, each paying one unit of money in one specific state of nature and nothing in any other state. These contingent contracts are widely recognized as the fundamental building blocks of modern financial-asset-pricing theories and financial engineering. The prices of the contingent contracts are called state prices. The state price per unit of probability is referred to as the state price density. Rubinstein (1976) pioneered the pricing of European call options by explicitly specifying the state price density. He obtained the BlackScholes formula for the log-normal model. His approach was extended by Heston (1993), who obtained a Black-Scholes-type closed-form formula for European call options in the log-gamma model and the log-negative-binomial model. Turnbull and Milne (1991) and Constantinides (1992) were among the first to model the term structure of interest rates by explicitly specifying the state price density. Their approach was ex-

* Yong Yao, A.S.A., Ph.D., is a Principal at DFA Capital Management Inc., 100 Manhattanville Road, Purchase, NY 10577, email: yy@dfa.com.

tended in Rogers (1997) and Yao (1998, 2000). The state price (density) and its applications have been extensively discussed in the finance literature. Some examples are Ait-Sahalia and Lo (1998, 2000), Banz and Miller (1978), Breeden and Litzenberger (1978), Cochrane (2001), Duffie (1992), Dybvig (1988a,b), Merton (1990), and Sharpe (1995, 1998). Contingent contracts are not a novelty in the insurance and actuarial science areas. Before the development of modern financial derivative markets, insurance claims were examples of contingent contracts that could be found in actual markets. In a series of papers, Borch (1990) systematically used the Arrow-Debreu framework in determining insurance premiums in the context of a competitive equilibrium market (see also Bu ¨ hlmann 1980, 1984 and Aase 1993a,b). The method of Esscher transforms is a timehonored tool in actuarial science. Gerber and Shiu (1994, 1996) successfully used Esscher transforms in pricing stock options and obtained many important results. The authors assumed that the risk-free interest rate is constant over time. They used several special cases of the Levy process to describe the future evolution of the logarithm of the stock price(s). The authors independently obtained the same results as Heston (1993). The use of Esscher transforms in pricing stock options has also been discussed in papers such as Bu ¨ hlmann et al. (1998) and Chan (1999)
104

STATE PRICE DENSITY, ESSCHER TRANSFORMS,

AND

PRICING OPTIONS

105

and in books such as Bingham and Kiesel (1998), Panjer (2001), and Shiryaev (1998). This paper extends the Gerber and Shiu work and uses Esscher transforms in modeling the term structure of interest rates and pricing options when the interest rates are stochastic. This extension, however, is not a straightforward one. First, Gerber and Shiu calculated the price of options as the expected value under the riskneutral measure discounted at the risk-free short rate. When interest rates are constant over time, the discount factors are deterministic functions of time to maturity. This simplifies the calculations involved and makes the use of Esscher transforms possible. When interest rates are stochastic, the efficient approach to option pricing is that the price is calculated as the expected value under the forward-risk-adjusted measure discounted by the price of the default-free zerocoupon bond. So we need to investigate whether Esscher transforms can be used to specify the forward-risk-adjusted measure. Second, Gerber and Shiu used stochastic processes with independent and stationary increments to model the stock return. Interest rates have a tendency to be pulled back to some longrun level, a phenomenon known as mean reversion. So we need to use processes that exhibit the mean reversion property to model interest rates. Extension of the Gerber-Shiu framework is built on the following observations. When the interest rates are deterministic, the forward-riskadjusted measure is the same as the risk-neutral measure. Yao (1994) showed that the Esscher transform of a Levy process can always be represented as a stochastic exponential. So, in the Gerber-Shiu framework, the state price density can be represented in an exponential form. The exponential type of the state price density has been used explicitly or implicitly in many papers, for example, Black and Scholes (1973), Merton (1973), Rubinstein (1977), Vasicek (1977), and Cox, Ingersoll, and Ross (1985), Rabinovitch (1989), Constantinides (1992), Heston (1993), Duffie and Kan (1996), Rogers (1997), and Yao (1998, 2000). Motivated by these observations, this paper models the term structure of interest rates by specifying the state price density as an exponential function of state variables. The forward-riskadjusted measure is an Esscher measure in the

models discussed here. It is found that Esscher transforms provide a consistent and efficient framework for pricing options on stocks, interest rates, and foreign exchange rates. With deterministic interest rates, the forward-risk-adjusted measure is the same as the risk-neutral measure. Thus, this paper generalizes the Gerber-Shiu framework to price options in a stochastic interest rate environment. From this perspective, Gerber and Shiu (1994, 1996) were among the first to price options by explicitly specifying the state price density in the insurance and actuarial science areas. Esscher transforms can also be used to give other changes of probability measure such as those discussed in Geman, El Karoui, and Rochet (1995). For the purpose of this paper I will focus on the forward-risk-adjusted measure. I will also focus on specifying the forward-risk-adjusted measure in the general framework. Several examples in the diffusion context are provided as illustrations of the general framework. The outline of the paper is as follows. Section 2 discusses a dynamic asset-pricing model and uses the state price density to represent the risk-neutral measure and the T-maturity forward-risk-adjusted measure. Section 3 reformulates the Gerber-Shiu framework in terms of the state price density. Sections 4, 5, and 6 demonstrate how to use Esscher transforms to price interest rate options, stock options with stochastic interest rates, and foreign currency options with stochastic interest rates, respectively. Section 7 illustrates the framework discussed in this paper in the diffusion context. Conclusions are given in Section 8.

2. STATE PRICE DENSITY OF MEASURE

AND

CHANGES

2.1 A Dynamic Asset Pricing Model Consider a stochastic intertemporal economy, where uncertainty is represented by a probability space (⍀, F, P) equipped with a filtration {Ft: 0 Յ t Յ T*}. Here ⍀ represents the set of states of the world. The investors’ information up to time t is given by Ft. The beliefs of investors are represented by the (actual) measure P. All economic activities will be assumed to take place on a finite horizon [0, T*], where T* is a positive constant. For any t and T, 0 Յ t Յ T Յ T*, it is assumed

106

NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 5, NUMBER 3

that there exists a positive state price density process {␨(t, T)}, such that the price (or the present value) V(t) at time t of a claim to a payoff z(T) at some future time T is given by V ͑ t ͒ ϭ Et͓␨͑t, T͒ z͑T͔͒, (2.1)

The default-free discount bond price is the expected value of the state price density. 2.2 The Equivalent Martingale Measure For one unit of currency invested in a money market account at time t ϭ 0, its value at time t will be B ͑ t ͒ ϭ exp

where Et[ ⅐ ] denotes the conditional expectation given the information Ft available up to time t, taken with respect to the measure P. To be consistent, V(T) must be equal to z(T) and ␨(0, 0) is equal to 1. So Equation (2.1) can be rewritten as V ͑ t ͒ ϭ Et͓␨͑t, T͒V͑T͔͒. (2.2)

ͫ͵ ͬ
t 0

r͑s͒ ds ,

The existence and characterization of a state price density can be obtained either in preference-based equilibrium models or in arbitragebased models. As noted in the preface of Duffie (1992), “the most important unifying principle is that any of these three conditions (arbitrage, optimality, and equilibrium) implies that there are ‘state prices,’ meaning positive discount factors, one for each state and date, such that the price of any security is merely the state-price weighted sum of its future payoffs” (p. xiii). In the equilibrium framework, the state price density is called a stochastic discount factor or price kernel. In the no-arbitrage models the state price density is often called the risk-neutral density or state-price deflator (see also Ait-Sahalia and Lo 1998, 2000 and Cochrane 2001). Denote ␨(t) ϭ ␨(0, t). In the preference-based equilibrium models and in arbitrage-based models, we have that ␨(t, T) ϭ ␨(T)/␨(t). (See Duffie 1992 for details.) From Equation (2.2), we obtain ␨͑ t ͒ V ͑ t ͒ ϭ Et͓␨͑T͒V͑T͔͒, t Ն 0; (2.3)

where r(t) is the short rate or instantaneous spot rate prevailing at time t. From the martingale pricing equation, Equation (2.3), we know that t the process {␨(t) exp[͐0 r(s) ds]} is a positive martingale with initial value 1. Define a probability measure Q such that its Radon-Nikodym derivative with respect to (actual) measure P is given by dQ ϭ ␨͑T͒ exp dP

ͫ͵ ͬ
T 0

r͑s͒ ds .

Then Q is a probability measure that is equivalent to the measure P and is called an equivalent martingale measure or a risk-neutral measure. (See Appendices A and C of Duffie 1992 for a short discussion on the Radon-Nikodym derivative.) Q Denote by Et [ ⅐ ] the conditional expectation given the information Ft available at time t, taken with respect to this risk-neutral measure Q. We then have
Q z͑T͒ exp Ϫ Et͓␨͑t, T͒ z͑T͔͒ ϭ Et

that is, the process {␨(t)V(t)} is a martingale. Equation (2.3) is called the martingale pricing equation. A default-free discount bond maturing at time T is a security that will pay one unit of currency at time T and nothing at any other time. Denote the price at time t of this bond as P(t, T). At maturity T we have P(T, T) ϭ 1. Applying Equation (2.2) to P(t, T), we have P ͑ t , T ͒ ϭ Et͓␨͑t, T͔͒. (2.4)

ͫ ͫ ͵ ͬͬ
T t

r͑s͒ ds . (2.5)

2.3 The Forward-Risk-Adjusted Measure The measure QT, defined by ␨͑T͒ dQ T ϭ dP E͓␨͑T͔͒ is a probability measure equivalent to the (actual) measure P. The measure QT is called the T-maturity forward-risk-adjusted measure. The idea of the forward-risk-adjusted measure can be traced back to Merton (1973), who presented the price of

This gives the relationship between the term structure of interest rates and state price density:

STATE PRICE DENSITY, ESSCHER TRANSFORMS,

AND

PRICING OPTIONS

107

a European call option on one stock in terms of the ratio of the stock price to the bond price. Bick (1988) gave a dynamic hedging argument of Merton’s results in terms of forward contracts, and Jamshidian (1989) and Geman (1989) developed the mathematical treatment of the forward-risk-adjusted measure. (See also Pedersen and Shiu 1994 and Geman, Karoui, and Rochet 1995.) QT Denote by Et [ ⅐ ] the conditional expectation given the information Ft available at time t, taken with respect to this T-maturity forward-risk-adjusted measure QT. We have
QT Et͓␨͑t, T͒ z͑T͔͒ ϭ Et͓␨͑t, T͔͒Et ͓ z͑T͔͒.

3. REFORMULATING FRAMEWORK

THE

GERBER-SHIU

(2.6)

Gerber and Shiu (1994, 1996) discussed Esscher transforms in the risk-neutral framework. This framework was developed in Cox and Ross (1976) and extended in Ross (1978), Harrison and Kreps (1979), and Harrison and Pliska (1981). For the purpose of this paper Esscher transforms are put in the framework of directly modeling the state price density. As in Gerber and Shiu (1994, 1996), for j ϭ 1, 2, . . . , n, let Sj(t) denote the price of nondividend-paying stock j at time t and write X j ͑ t ͒ ϭ ln͓Sj͑t͒/Sj͑0͔͒, and X(t) the vector with Xj(t) being the j-th entry. Gerber and Shiu (1994, 1996) assumed that the short rate r ( t ) is a constant and is denoted by ␦. (In these two papers the short rate is called the risk-free force of interest.) In this case, t exp[ Ϫ͐ 0 r ( s ) ds ] ϭ exp[ Ϫ␦ t ]. The RadonNikodym derivative of the risk-neutral measure Q with respect to (original) measure P is given by dQ ϭ ␨͑T͒ exp͓␦T͔. dP We can now assume that the state price density process has the form ␨͑ t ͒ ϭ A ͑ t ͒ exp͑Ϫ␦t ϩ h* ⅐ X͑t͒͒, with the deterministic function A(t) and the parameter vector h* being specified in the following paragraphs. A state price density of this form is implicitly used by Black and Scholes (1973) and explicitly used by Rubinstein (1976) and Heston (1993). In this case we have Z ͑ t ͒ ϵ ␨͑ t ͒ exp

Note that the price of a default-free discount bond, P(t, T), is equal to Et[␨(t, T)]. So we have the equation
QT Et͓␨͑t, T͒ z͑T͔͒ ϭ P͑t, T͒Et ͓ z͑T͔͒.

It is easy to see that, when interest rates are deterministic, the T-maturity forward-risk-adjusted measure is the same as the risk-neutral measure. 2.4 The Esscher Measure Let X(t) be an n-dimensional random process vector and Rn the linear space of column vectors with n real entries. For each t and T, 0 Յ t Յ T Յ T*, we denote M X͑h; t, T͒ ϭ Et͓exp͑h ⅐ X͑T͔͒͒, h ʦ Rn,

the (conditional) moment-generating function for the random variable vector X(T). (In this paper “ ⅐ ” denotes the inner product operation of vectors and matrices.) Let h be a real vector for which E[h ⅐ X(T)] exists. The measure QE, defined by dQ E exp͑h ⅐ X͑T͒͒ ϭ , dP MX͑h; 0, T͒ is a probability measure equivalent to the (actual) measure P. The measure QE is called the Esscher measure of parameter vector h, and the corresponding distribution is called the Esscher transform. See Gerber and Shiu (1994, 1996) for a detailed discussion of these two concepts. Denote by Et[ ⅐ ; h] the conditional expectation given the information Ft available at time t, taken with respect to this Esscher measure QE.

ͫ͵ ͬ
t 0

r͑s͒ ds ϭ A͑t͒ exp͑h* ⅐ X͑t͒͒.

Because the process {Z(t)} is a positive martingale with Z(0) ϭ 1, we have 1 ϭ E͓A͑t͒ exp͑h* ⅐ X͑t͔͒͒ or A͑t͒ ϭ 1 1 ϵ . E͓exp ͑h* ⅐ X͑t͔͒͒ MX͑h*; 0, t͒

108

NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 5, NUMBER 3

That is, the risk-neutral measure, given by dQ exp͑h* ⅐ X͑T͒͒ ϭ , dP MX͑h*; 0, T͒ is an Esscher measure. It is called the risk-neutral Esscher measure in Gerber and Shiu (1994, 1996). In their two papers {X(t)} is a vector of stochastic processes with independent and stationary increments. So we have M X͑h*; t͒ ϭ ͓MX͑h*; 1͔͒t. With this assumption and a constant interest rate, the parameter vector h* is uniquely determined and is a constant vector. Thus, the state price density in these papers is of the form ␨͑ t ͒ ϭ exp͑Ϫ␦t ϩ ͓h* ⅐ X͑t͔͒͒ . ͓MX͑h*; 1͔͒t

4. PRICING INTEREST RATE OPTIONS
As in Section 2, for 0 Յ t Յ T we denote P(t, T) the time-t price of a default-free discount bond maturing at time T. At maturity T we have P(T, T) ϭ 1. From Equation (2.4) we obtain P ͑ t , T ͒ ϭ Et͓␨͑T͒/␨͑t͔͒ ϭ Et͓␨͑T͔͒/␨͑t͒. It is assumed that there is an n-dimensional stochastic process {X(t)} such that the state price density is an exponential function of X, that is, ␨͑ X , t͒ ϭ exp͓Ϫct ϩ ␥ ⅐ ͑X͑t͒ Ϫ X͑0͔͒͒, where ␥ ϭ (␥1, ␥2, . . . , ␥n) and c, ␥1, ␥2, . . . , ␥n are n ϩ 1 real numbers. A state price density of this form was implicitly used by Vasicek (1977), Cox, Ingersoll, and Ross (1985), and Duffie and Kan (1996), and explicitly used by Constantinides (1992), Rogers (1997), and Yao (1998, 2000). In this case the prices of default-free discount bonds are also functions of the state variable vector X and are given by P͑t, T͒ ϭ Et͓exp͑ϪcT ϩ ␥ ⅐ X͑T͔͒͒ . exp͑Ϫct ϩ ␥ ⅐ X͑t͒͒

The parameter vector h* is determined so that, for j ϭ 1, 2, . . . , n, {␨(t)Sj(t)} is a martingale. In particular, for each t, 0 Յ t Յ T, we have S j ͑ 0 ͒ ϭ E͓␨͑t͒Sj͑t͔͒. As an illustration of pricing options using this framework, consider a European call option on one stock (the case n ϭ 1). The detailed applications can be found in Gerber and Shiu (1994, 1996). Consider a European call option on the stock with exercise price K and exercise date T. From the last equation and the martingale pricing Equation (2.3), the value of this option (at time 0) is C ϭ E͓exp͑Ϫ␦T͒͑S͑T͒ Ϫ K͒ϩ; h*͔, where xϩ ϭ x if x Ͼ 0, and xϩ ϭ 0 if x Ͻ 0. Let I( A) denote the indicator random variable of an event A. We have C ϭ E͓exp͑Ϫ␦T͒͑S͑T͒ Ϫ K͒I͑S͑T͒ Ͼ K͒; h*͔ ϭ E͓exp͑Ϫ␦T͒S͑T͒I͑S͑T͒ Ͼ K͒; h*͔ Ϫ K exp͑Ϫ␦T͒E͓I͑S͑T͒ Ͼ K͒; h*͔ ϭ S ͑ 0 ͒ Pr͓S͑T͒ Ͼ K; h* ϩ 1͔ Ϫ KP͑0, T͒ Pr͓S͑T͒ Ͼ K; h*͔, with Pr[A; h*] denoting the probability of an event A under the risk-neutral Esscher measure with parameter h*.

From Section 2.3 we know that the T-maturity forward-risk-adjusted measure QT is defined by dQ T exp͑␥ ⅐ X͑T͒͒ ϭ ; dP MX͑␥; T͒ that is, T-maturity forward-risk-adjusted measure QT is an Esscher measure with parameter vector ␥ defined in Section 2.4. In this case we have Et͓␨͑t, T͒ z͑T͔͒ ϭ P͑t, T͒Et͓ z͑T͒; T, ␥͔. Now consider a European call option on default-free discount bonds with exercise price K and exercise date T. Section 7.2.1 provides an example in the diffusion context as an illustration. At exercise date T the payoff of a European call option written on a zero-coupon bond with matures at time T ϩ ⌬ equals ͓ P ͑ T , T ϩ ⌬͒ Ϫ K ͔ ϩ . We know that P(T, T ϩ ⌬) ϭ ET[␨(T ϩ ⌬)]/␨(T). From the last equation and the martingale pricing Equation (2.3), the value of this option (at time 0) is

STATE PRICE DENSITY, ESSCHER TRANSFORMS,

AND

PRICING OPTIONS

109

C ϭ E͕͕ET͓␨͑T ϩ ⌬͔͒ Ϫ K␨͑T͖͒ϩ͖ ϭ E͓␨͑T ϩ ⌬͒I͑P͑T, T ϩ ⌬͒ Ͼ K͔͒ Ϫ KE͓␨͑T͒I͑P͑T, T ϩ ⌬͒ Ͼ K͔͒ ϭ P͑0, T ϩ ⌬͒E͓I͑P͑T, T ϩ ⌬͒ Ͼ K͒; T ϩ ⌬, ␥͔ Ϫ KP͑0, T͒E͓I͑P͑T, T ϩ ⌬͒ Ͼ K͒; T, ␥͔ ϭ P ͑ 0, T ϩ ⌬͒ Pr͓P͑T, T ϩ ⌬͒ Ͼ K; T ϩ ⌬, ␥͔ Ϫ KP͑0, T͒ Pr͓P͑T, T ϩ ⌬͒ Ͼ K; T, ␥͔, where Pr[A; S, ␥] denotes the probability of an event A under the Esscher measure with parameter ␥.

process {Y(t)}. The common component Y(t) is used to model the correlation between the stock prices and interest rates. The parameter vector h* is determined so that, for j ϭ 1, 2, . . . , n, {␨(t)Sj(t)} is a martingale. In particular, for each t, 0 Յ t Յ T we have S j ͑ 0 ͒ ϭ E͓␨͑t͒Sj͑t͔͒. From Section 2.2 we know that the T-maturity forward-risk-adjusted measure QT is defined by dQ T exp͑h* ⅐ X͑T͒ ϩ ␥ ⅐ Y͑T͒͒ ϭ , dP MX,Y͑h*, ␥; T͒ with MX,Y(h*, ␥; T) ϭ Eexp(h* ⅐ X(T) ϩ ␥ ⅐ Y(T)) being the moment generating function for random variables X(T) and Y(T). Thus, in this case T-maturity forward-risk-adjusted measure QT is also an Esscher measure, and we have Et͓␨͑t, T͒ z͑T͔͒ ϭ P͑t, T͒Et͓ z͑T͒; T, h*, ␥͔. Now consider a European call option on the stock S(t) ϭ S1(t) with exercise price K and exercise date T. Section 7.2.2 provides an example in the diffusion context as an illustration. From the last equation and the martingale pricing Equation (2.3), the value of this European call option (at time 0) is C ϭ E͓␨͑T͒͑S͑T͒ Ϫ K͒ϩ͔ ϭ P ͑ 0, T ͒ E͓͑S͑T͒ Ϫ K͒I͑S͑T͒ Ͼ K͒; T, h*, ␥͔ ϭ P ͑ 0, T ͒ E͓S͑T͒I͑S͑T͒ Ͼ K͒; T, h*, ␥͔ Ϫ KP͑0, T͒E͓I͑S͑T͒ Ͼ K͒; T, h*, ␥͔ ϭ S ͑ 0 ͒ E͓I͑S͑T͒ Ͼ K͒; T, h* ϩ H1, 0͔ Ϫ KP͑0, T͒E͓I͑S͑T͒ Ͼ K͒; T, h*, ␥͔ ϭ S ͑ 0 ͒ Pr͓S͑T͒ Ͼ K; T, h* ϩ H1, 0͔ Ϫ KP͑0, T͒ Pr͓S͑T͒ Ͼ K; T, h*, ␥͔. See Section 7.2.2 for an example in the diffusion context, which shows how to calculate two probabilities in the last line of these formulas.

5. PRICING STOCK OPTIONS WITH STOCHASTIC INTEREST RATES
Merton (1973) was the first to extend the BlackScholes model to incorporate stochastic interest rates. Rabinovitch (1989) reformulated the Merton model to a model with the stock price and the short rate as two state variables. This section will extend this work to a more general setting. Let {X(t)} be an n1-dimensional stochastic process with X(0) ϭ 0 and {Y(t)} be an n2-dimensional stochastic process. Assume that X(t) and Y(t) are independent. It is assumed that the state variables in this section are X(t) and Y(t). Based on the discussion until now, we assume the state price density ␨(t) to have the form ␨͑ t ͒ ϭ ␨ 1 ͑ t ͒␨ 2 ͑ t ͒ , where ␨1(t) ϭ exp(h* ⅐ X(t))/MX(h*; t) and ␨2(t) ϭ exp[Ϫct ϩ ␥ ⅐ (Y(t) Ϫ Y(0))]. In this case the prices of default-free discount bonds are given by P͑t, T͒ ϭ Et͓exp͑ϪcT ϩ ␥ ⅐ Y͑T͔͒͒ . exp͑Ϫct ϩ ␥ ⅐ Y͑t͒͒ (5.1)

For j ϭ 1, 2, . . . , n1, let Sj(t) denote the price of nondividend-paying stock j at time t and assume that S j ͑ t ͒ ϭ S j ͑ 0 ͒ exp͑Hj ⅐ X͑t͒ Ϫ ␥ ⅐ Y͑t͒͒. (5.2)

Equation (5.2) states that the dynamics of stock prices are governed by n1-dimensional stochastic process {X(t)} and n2-dimensional stochastic process {Y(t)}. Meanwhile, Equation (5.1) states that the dynamics of prices of default-free discount bonds are governed by n2-dimensional stochastic

110

NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 5, NUMBER 3

6. PRICING FOREIGN EXCHANGE RATE OPTIONS WITH STOCHASTIC INTEREST RATES
6.1 A Two-Country Dynamic Asset-Pricing Model Considering an economy with two countries: the domestic country and the foreign country. We will denominate all of the assets in the domestic currency, whose unit will be called a dollar. Let P(t) denote the asset price and ␨(t) the state price density in the domestic country. Denote the exchange rate for the foreign country against the domestic currency by S f(t) (in a dollar’s term) and the price of an asset in the currency of the foreign country by P f(t). At time t the price (in a dollar’s term) of an asset in the foreign country will be P f(t)S f(t). From Equation (2.3) we have ␨͑ t ͒ P f ͑ t ͒ S f ͑ t ͒ ϭ Et͓␨͑T͒ P f͑T͒S f͑T͔͒ or ␨͑T͒S f͑T͒ f ␨͑ t ͒ S f ͑ t ͒ f ͑ t ͒ ϭ E P P ͑T͒ . t S f͑ 0 ͒ S f͑0͒ So if we denote ␨ f(t) ϭ ␨(t)S f(t)/S f(0), then ␨ f ͑ t ͒ P f ͑ t ͒ ϭ Et͓␨ f͑T͒ P f͑T͔͒; that is, ␨ f(t) is a state price density for the foreign country. We now obtain S f͑ t ͒ ϭ S f͑ 0 ͒ ␨ f͑ t ͒ , ␨͑ t ͒ (6.1)

tween the two countries is the ratio of their state price densities: S f ͑ t ͒ ϭ S f ͑ 0 ͒ exp͓͑c f Ϫ c͒t ϩ ͑␥ f Ϫ ␥͒ ⅐ X͑t͔͒. Prices of default-free discount bonds are also functions of the state variable vector X and are given by P͑t, T͒ ϭ
f

Et͓exp͑ϪcT ϩ ␥ ⅐ X͑T͔͒͒ , exp͑Ϫct ϩ ␥ ⅐ X͑t͒͒

Et͓exp͑Ϫc fT ϩ ␥ f ⅐ X͑T͔͒͒ P ͑t, T͒ ϭ . exp͑Ϫc ft ϩ ␥ f ⅐ X͑t͒͒ From Section 2.3 we know that the T-maturity forward-risk-adjusted measures QT in the domesf tic country and QT in the foreign country are defined by dQ T exp͑␥ ⅐ X͑T͒͒ ϭ , dP MX͑␥; T͒
f dQ T exp͑␥ f ⅐ X͑T͒͒ ϭ ; dP MX͑␥ f; T͒

ͫ

ͬ

that is, T-maturity forward-risk-adjusted meaf sures QT and QT are Esscher measures. In this case we have Et͓␨͑t, T͒ z͑T͔͒ ϭ P͑t, T͒Et͓ z͑T͒; T, ␥͔, Et͓␨ f͑t, T͒ z͑T͔͒ ϭ P f͑t, T͒Et͓ z͑T͒; T, ␥ f ͔. Now consider a European call option on the foreign exchange rate with exercise price K and exercise date T. From the last equation and the martingale pricing Equation (2.3), the value of this option (at time 0) is C ϭ E͓␨͑T͒͑S f͑T͒ Ϫ K͒ϩ͔ ϭ E͕͓S f͑0͒␨ f͑T͒ Ϫ K␨͑T͔͒I͑S f͑T͒ Ͼ K͖͒ ϭ E͓S f͑0͒␨ f͑T͒I͑S f͑T͒ Ͼ K͔͒ Ϫ E͓K␨͑T͒I͑S f͑T͒ Ͼ K͔͒ ϭ S f ͑ 0 ͒ E͓␨ f͑T͒I͑S f͑T͒ Ͼ K͔͒ Ϫ KE͓␨͑T͒I͑S f͑T͒ Ͼ K͔͒ ϭ S f ͑ 0 ͒ P f ͑ 0, T ͒ Pr͓S f͑T͒ Ͼ K; T, ␥ f͔ Ϫ KP͑0, T͒ Pr͓S f͑T͒ Ͼ K; T, ␥͔, with Pr[A; T, ␥ f ] denoting the probability of an event A under the Esscher measure with param-

which states that the exchange rate between the two countries is the ratio of their state price densities. 6.2 Pricing Foreign Exchange Rate Options with Stochastic Interest Rates As in Section 4, it is assumed that there is an n-dimensional state variable vector {X(t)} such that the state price densities in both countries are exponential functions of X: ␨͑ X , t͒ ϭ exp͓Ϫct ϩ ␥ ⅐ ͑X͑t͒ Ϫ X͑0͔͒͒, ␨ f ͑ X , t͒ ϭ exp͓Ϫc ft ϩ ␥ f ⅐ ͑X͑t͒ Ϫ X͑0͔͒͒. This model was discussed in Rogers (1997) and Yao (1998). In this case the exchange rate be-

STATE PRICE DENSITY, ESSCHER TRANSFORMS,

AND

PRICING OPTIONS

111

eter ␥ f, and Pr[A; T, ␥] denoting the probability of an event A under the Esscher measure with parameter ␥.

nents of random variable vector X(t), that is, U(t) ϭ ␥ ⅐ X(t). Then the characteristic function of random variable U(t) is given by ⌽ U ͑␰ , t ͒ ϵ E͕exp͓͑ ͱϪ1͒␰U͑t͔͖͒ ϭ M X͑͑ ͱϪ1͒␰␥; 0, t͒. (7.3)

7. EXAMPLES

IN THE

DIFFUSION CONTEXT

7.1 The Esscher Measure and the MomentGenerating Function Assume that the random process vector {X(t)} is governed by stochastic differential equations of the form d X ͑t͒ ϭ ␮͑X͑t͒, t͒dt ϩ ␴͑X͑t͒, t͒ ⅐ dW͑t͒, (7.1)

Inverting the characteristic function, we can calculate the probability distribution of U(t): Pr͕U͑t͒ Ͼ y͖ 1 1 ϭ Ϫ 2 ␲

where ␮(X(t), t) is an n ϫ 1 vector, ␴(X(t), t) is an n ϫ n matrix, and W(t) is an n-dimensional standard Brownian motion under the measure P. Hereafter, whenever it can be done without causing confusion, variable dependence will be omitted for simplicity. Thus, Equation (7.1) will be written in the short form d X ϭ ␮ dt ϩ ␴ ⅐ dW͑t͒.
7.1.1 The Esscher Measure

͵ ͫ
ϱ

Re

⌽U͑␰, t͒ exp͑Ϫ␰ y ͱϪ1͒ ␰ ͱϪ1

0

ͬ

d␰.

(7.4) The last equation will be used to give closed-form formulas for option prices. See Feller (1966) for more details.
7.1.3 Random Processes with a Closed-Form Formula for the Moment-Generating Function

As defined in Section 2.4, the Esscher measure QE of parameter vector h is given by dQ E exp͓h ⅐ X͑T͔͒ ϭ . dP MX͑h; 0, T͒ From Girsanov’s theorem, the process {W Q (t)}, which is given by W Q ͑t͒ ϭ W͑t͒ Ϫ
E
E

Consider a random process {X(t)} that follows a stochastic differential equation of the form dX͑t͒ ϭ ͓a͑t͒ Ϫ b͑t͒ X͑t͔͒ dt ϩ ͱ␣ϩ␤X(t) dW͑t͒. Let MX(h; t, T) ϭ Et{exp[hX(T)]} be the momentgenerating function of the random variable X(T) conditional on information at time t. It can be shown that the moment-generating function, MX(h; t, T), is the solution of the Kolmogorov backward equation of the form 1 ‫ ץ‬2M ‫ץ‬M ‫ץ‬M ͑␣ ϩ ␤X͒ ϭ 0. ϩ ͑ a Ϫ bX ͒ ϩ ‫ץ‬t ‫ץ‬X 2 ‫ץ‬X2 (7.5)

͵

t

0

‫ ץ‬ln MX͑h; s, T͒ ⅐ ␴͑X͑s͒, s͒ ds, ‫ץ‬X

follows a standard n-dimensional Brownian motion under the measure QE, and under this measure, Equation (7.1) can be rewritten as (omitting variable dependence) dX ϭ ␮ ϩ

ͫ

‫ ץ‬ln MX E ⅐ ␴ ⅐ ␴* dt ϩ ␴ ⅐ dW Q . ‫ץ‬X

ͬ

See Karlin and Taylor (1975) or Øksendal (1998) for more details. Assume that MX(h; t, T) has the functional form M X ͑ h ; t , T ͒ ϭ exp͓A͑h; t, T͒ ϩ B͑h; t, T͒ X͑t͔͒, with A(h; T, T) ϭ 0 and B(h; T, T) ϭ h. Substituting this functional form into Equation (7.5) yields ‫ץ‬A ‫ץ‬B 1 ϩ X ϩ B ͑ a Ϫ bX ͒ ϩ B 2 ͑␣ ϩ ␤ X ͒ ϭ 0. ‫ץ‬t ‫ץ‬t 2 The last equation can be reduced to two equations:

(7.2)

7.1.2 Calculating the Probability Distribution

From the moment-generating function MX(h; t, T), we can obtain the characteristic function of the random variable vector X(T), which is defined by ⌽ X͑h, T͒ ϵ E͕exp͓͑ ͱϪ1͒h ⅐ X͑T͔͖͒. Let U(t) be a linear combination of the compo-

112

NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 5, NUMBER 3

␣ dA ϩ aB ϩ B 2 ϭ 0, dt 2 ␤ dB Ϫ bB ϩ B 2 ϭ 0. dt 2

(7.6a) (7.6b)

dX i ͑ t ͒ ϭ ͓␪ i Ϫ k i X i ͑ t ͔͒ dt ϩ ␯ i ͱ Xi͑t͒ dWi͑t͒, where W1(t) and W2(t) are two independent Brownian motions and all the parameters are positive constants. (It is straightforward to generalize this model to a model with more than two factors.) Then choose the state price density as ␨͑ t ͒ ϭ exp͕Ϫct ϩ ␥1͓X1͑t͒ Ϫ X1͑0͔͒ ϩ ␥2͓X2͑t͒ Ϫ X2͑0͔͖͒, where c is a positive constant, and ␥1 and ␥2 are non-negative constants. Then the time-t price of a default-free discount bond with maturity T is given by P ͑ t , T ͒ ϭ Et͓␨͑T͒/␨͑t͔͒ ϭ exp͕Ϫc͑T Ϫ t͒ ϩ A͑␥1, ␥2; ␶͒ ϩ ͓B1͑␥1; ␶͒ Ϫ ␥1͔X1͑t͒ ϩ ͓B2͑␥2; ␶͒ Ϫ ␥2͔X2͑t͖͒, where ␶ ϭ T Ϫ t, B i ͑␥ i ; ␶͒ ϭ C i ͑␥ i ; ␶͒␥ i exp͓Ϫki␶͔, A ͑␥ 1 , ␥ 2 ; ␶͒ ϭ

Solving Equation (7.6b) and using the condition B(h; T, T) ϭ h yields B͑h; t, T͒ ϭ
T b͑s͒ ds͔ h exp͓Ϫ͐t

1 T T 1Ϫ2 ␤h ͐t ͕exp͓Ϫ͐z b͑s͒ ds͔ dz͖

.

(7.7) Substituting this formula for B(h; t, T) into Equation (7.6a) gives the solution for A(h; t, T). As illustration, we give the functional form for the moment-generating function in two simple cases. In the first case the random process {X(t)} follows a stochastic differential equation of the form dX ͑ t ͒ ϭ ␮ dt ϩ ␴ dW ͑ t ͒ . Then the moment-generating function is given by M X ͑ h ; t , T ͒ ϭ exp͓͑␮h ϩ 1 ␴2h2͒͑T Ϫ t͒ ϩ hX͑t͔͒. 2 In the second case the random process {X(t)} follows a stochastic differential equation of the form dX ͑ t ͒ ϭ ͓␪ Ϫ kX ͑ t ͔͒ dt ϩ ␯ ͱ X ( t ) dW͑t͒. The moment-generating function M(h; t, T) has the functional form M X ͑ h ; t , T ͒ ϭ exp͓A͑h; t, T͒ ϩ B͑h; t, T͒ X͑t͔͒, where 2 kh exp͓Ϫk␶͔ B ͑ h ; ␶͒ ϭ , 2k Ϫ ␯2h͕1 Ϫ exp͓Ϫk␶͔͖

iϭ1

͸ 2␯␪ ln C ͑␥ ; ␶͒,
2 i 2 i i i 2 i

C i ͑␥ i ; ␶͒ ϭ

2ki . 2 k i Ϫ ␯ ␥ i ͕ 1 Ϫ exp͓Ϫki␶͔͖

The yield to maturity is given by y͑t, T͒ ϵ Ϫ ln P͑t, T͒ TϪt A͑␥1, ␥2; ␶͒ ͓B1͑␥1; ␶͒ Ϫ ␥1͔ Ϫ X1͑t͒ TϪt TϪt (7.8)

ϭcϪ

2␪ 2k . A ͑ h ; ␶͒ ϭ 2 ln 2 ␯ 2k Ϫ ␯ h͕1 Ϫ exp͓Ϫk␶͔͖ 7.2 Examples
7.2.1 A Two-Factor Model of the Term Structure of Interest Rates

ͩ

ͪ

Ϫ

͓B2͑␥2; ␶͒ Ϫ ␥2͔ X2͑t͒, TϪt

and the short rate is given by r ͑ t ͒ ϵ lim y͑t, T͒
T3tϩ

To illustrate how to use the Esscher measure to value stock options with stochastic interest rates, assume that two state variables follow CoxIngersoll-Ross processes of the form

ϭϪ

iϭ1

͸ͩ
2

2 ␥i2␯i2 ␥i␪i ϩ c. Ϫ ␥iki Xi͑t͒ Ϫ 2 iϭ1

ͪ

͸

(7.9)

For non-negativity of the short rate, let us choose 2 2 ␥i such that 0 Ͻ ␥i Ͻ 2ki/␯i and c Ն ¥i ϭ1 ␥i␪i.

STATE PRICE DENSITY, ESSCHER TRANSFORMS,

AND

PRICING OPTIONS

113

The value (at time 0) of a European call option on default-free discount bonds with exercise price K and exercise date T is given by C ϭ E͕␨͑T͓͒P͑T, T ϩ ⌬͒ Ϫ K͔ϩ͖. Let A ϭ {␻͉P(T, T ϩ ⌬) Ͼ K} and U(T) ϭ [B1(␥1; ⌬) Ϫ ␥1]X1(T) ϩ [B2(␥2; ⌬) Ϫ ␥2]X2(T). Then the time-t price of a default-free discount bond with maturity T is given by P ͑ T , T ϩ ⌬͒ ϭ exp͕ Ϫ c⌬ ϩ A͑␥1, ␥2; ⌬͒ ϩ U͑T͖͒, A ϭ ͕␻ ͉ U ͑ T ͒ Ͼ ln K ϩ c⌬ Ϫ A͑␥1, ␥2; ⌬͖͒. From Section 4 we have that C ϭ E͓␨͑T ϩ ⌬͒I͑ A͔͒ Ϫ KE͓␨͑T͒I͑ A͔͒ ϭ P ͑ 0, T ϩ ⌬͒ Pr͓A; T ϩ ⌬, ␥͔ Ϫ KP ͑ 0, T ͒ Pr͓A; T, ␥͔, where Pr[A; S, ␥] denotes the probability under the Esscher measure with parameter vector ␥ ϭ (␥1, ␥2). To calculate these two probabilities, we need to give the functional forms of two Esscher measures as well as the characteristic functions of random variable U(T) under these two measures. In this model the two Esscher measures are defined by dQ E exp͑␥1X1͑S͒ ϩ ␥2X2͑S͒͒ , ϭ dP exp͑A͑␥1, ␥2; S͒ ϩ B1͑␥1; S͒ X1͑0͒ ϩ B2͑␥2; S͒ X2͑0͒͒ with S ϭ T ϩ ⌬ and S ϭ T. Under these Esscher measures the state variables follow Cox-IngersollRoss processes of the form dX i ͑ t ͒ ˜ i ͑ S Ϫ t ͒ X i ͑ t ͔͒ dt ϩ ␯ i ͱ X i͑t͒ dW ͑t͒, ϭ ͓␪ i Ϫ k
QE i

˜ i͑ T ; S ͒ ϭ B

h i ͓͑ C i ͑␥ i ; S ͔͒ 2 exp͓Ϫki S͔͒ , 1 Ϫ hi␯i2Ci͑␥i; S͕͒1 Ϫ exp͓Ϫki S͔͖ 2ki , 2 k i Ϫ ␯ ␥ i ͕ 1 Ϫ exp͓Ϫki S͔͖
2 i

C i ͑␥ i ; S ͒ ϭ

h i ϭ ␰͓ B i ͑␥ i ; ⌬͒ Ϫ ␥ i ͔ ͱ Ϫ1. With the aid of this characteristic function, we can calculate the probability of U ( T ) under the Esscher measure with parameter vector ␥ ϭ (␥1, ␥2): 1 1 Pr͓A; S, ␥͔ ϭ Ϫ 2 ␲

͵

ϱ

Re

0

ϫ

΄

⌽U͑␰, T; S͒

ϫ exp͑Ϫ␰͓ln K ϩ c⌬ Ϫ A͑␥; ⌬͔͒ ͱϪ1͒ ␰ ͱϪ1

΅

d␰,

where S ϭ T ϩ ⌬ and S ϭ T.
REMARK 1

From Equation (7.8), for j ϭ 1, 2, we have y ͑ t , t ϩ ⌬ j͒ ϭ ␣ j ϩ ␤ 1j X 1͑ t ͒ ϩ ␤ 2j X 2͑ t ͒ , where ␣j ϭ c Ϫ ␤ 1j ϭ Ϫ ␤ 2j ϭ Ϫ A ͑␥ 1 , ␥ 2 ; ⌬ j ͒ , ⌬j

B1͑␥1; ⌬j͒ Ϫ ␥1 , ⌬j B2͑␥2; ⌬j͒ Ϫ ␥2 . ⌬j

2 ˜ i(S Ϫ t) ϭ ki Ϫ Bi(␥; S Ϫ t)␯i where k . So the characteristic functions of random variable U(T) are obtained from Equations (7.3) and (7.7):

We can solve for X1 and X2 in terms of y(t, t ϩ ⌬1) and y(t, t ϩ ⌬2). This gives a yield-factor model of the term structure of interest rates discussed in Duffie and Kan (1996).
REMARK 2

˜ ͑T; S͒ ϩ B ˜ 1͑T; S͒ X1͑0͒ ⌽ U ͑␨ , T ; S ͒ ϭ exp͓A ˜ 2͑T; S͒ X2͑0͔͒, ϩB where ˜ ͑T; S͒ A ϭ 1 , ͸ 2␯␪ lnͩ1 Ϫ h ␯ C ͑␥ ; S͕͒ 1 Ϫ exp͓Ϫk S͔͖ͪ
2 i 2 i 2 i i i i i

It follows from Equation (7.9) that, if we choose c ϭ ␥1␪1 ϩ ␥2␪2, then r ͑ t ͒ ϭ ␣ 1X 1͑ t ͒ ϩ ␣ 2X 2͑ t ͒ ,
2 2 where, for i ϭ 1, 2, ␣i ϭ ␥iki Ϫ ␥i ␯i /2. So we have

dr ͑ t ͒ ϭ ␮͑ t ͒ dt ϩ ␣ 1 ␯ 1 ͱ X 1͑t͒ dW1͑t͒

ϩ ␣2␯2 ͱX2͑t͒ dW2͑t͒,

iϭ1

where ␮(t) ϭ (␣1␪1 ϩ ␣2␪2) Ϫ [␣1k1 X1(t) ϩ

114

NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 5, NUMBER 3

␣2k2 X2(t)]. From the last equation we know that the instantaneous variance of changes in the short rate is V ͑ t ͒ ϭ ͑␣ 1 ␯ 1 ͒ 2 X 1 ͑ t ͒ ϩ ͑␣ 2 ␯ 2 ͒ 2 X 2 ͑ t ͒ . We can solve for X1 and X2 in terms of r and V. This gives a two-factor model of the term structure of interest rates discussed in Longstaff and Schwartz (1992).
REMARK 3

Here c Ն ␥␪ and 0 Ͻ ␥ Ͻ 2k/␯2 are chosen. The stock price is assumed to follow the process S ͑ t ͒ ϭ S ͑ 0 ͒ exp͕X1͑t͒ Ϫ ␥͓X2͑t͒ Ϫ X2͑0͔͖͒. The parameter h* is determined so that {␨(t)S(t)} is a martingale. In particular, for each t, 0 Յ t Յ T, we have S ͑ 0 ͒ ϭ E͓␨͑t͒S͑t͔͒. Substituting the formulas assumed for ␨(t) and S(t) gives 1ϭE

Let dYi(t) ϭ ϪkiYi(t)dt ϩ ␴i͌Yi(t) dWi(t), and Xi(t) ϭ [Yi(t)]2. Then we have dX i ͑ t ͒ ϭ ͓␴ Ϫ 2 k i X i ͑ t ͔͒ dt ϩ 2 ␴ i ͱ X i͑t͒ dWi͑t͒.
2 i

ͫ

exp͕h*X1͑t͖͒

1 2 exp͕͓␮h* ϩ 2 ␴ h*2͔t͖

exp͕Ϫct ϩ ␥͓X2͑t͒

By choosing the state price density ␨͑ t ͒ ϭ exp͕Ϫct ϩ ␥1 X1͑t͒ ϩ ␥2 X2͑t͖͒, we have a two-factor Constantinides (1992) model and can give a closed-form formula for the European option on default-free discount bonds.
7.2.2 Pricing Stock Options with Stochastic Interest Rates

Ϫ X2͑0͔͖͒ exp͕X1͑t͒ Ϫ ␥͓X2͑t͒ Ϫ X2͑0͔͖͒ , and simplifying the last equation yields 1ϭ exp͕Ϫct͖ exp͕͓͑h* ϩ 1͒␮ ϩ 2 ␴2͑h* ϩ 1͒2͔͖
1 2 exp͕͓h*␮ ϩ 2 ␴ h*2͔t͖ 1

ͬ

.

To illustrate how to use the Esscher measure to value stock options with stochastic interest rates, assume that the two-dimensional random process vector X(t) follows dX 1 ͑ t ͒ ϭ ␮ dt ϩ ␴ dW 1 ͑ t ͒ , dX 2 ͑ t ͒ ϭ ͓␪ Ϫ kX 2 ͑ t ͔͒ dt ϩ ␯ ͱ X 2͑t͒ dW2͑t͒, where W1(t) and W2(t) are two independent Brownian motions and all the parameters are positive constants. It is assumed that X1(0) ϭ 0. Next choose the state price density as ␨͑ t ͒ ϭ ␨ 1 ͑ t ͒␨ 2 ͑ t ͒ , where ␨ 1͑ t ͒ ϭ exp͓h*X1͑t͔͒
1 2 exp͕͓␮h* ϩ 2 ␴ ͑h*͒2͔t͖

This gives the following equation, which determines h*: ␮ ϩ h*␴2 ϭ c Ϫ 1 ␴ 2. 2 Let A ϭ {␻͉P(T, T ϩ ⌬) Ͼ K} and U(T) ϭ X1(T) Ϫ ␥[X2(T) Ϫ X2(0)]}. Then we have A ϭ ␻ U ͑ T ͒ Ͼ ln

ͭͯ

ͫ ͬͮ

K . S͑0͒

From Section 5 we know that the value (at time 0) of a European call option on the stock with exercise price K and exercise date T is given by C ϭ S ͑ 0 ͒ Pr͓S͑T͒ Ͼ K; T, h* ϩ 1, 0͔ Ϫ KP͑0, T͒ Pr͓S͑T͒ Ͼ K; T, h*, ␥͔. (7.11)

,

␨ 2 ͑ t ͒ ϭ exp͕Ϫct ϩ ␥͓X2͑t͒ Ϫ X2͑0͔͖͒. In this case the prices of default-free discount bonds are given by Et͕exp͓ϪcT ϩ ␥X2͑T͔͖͒ P͑t, T͒ ϭ . exp͓Ϫct ϩ ␥X2͑t͔͒

To calculate these two probabilities, we need to give the functional forms of the two Esscher measures as well as the characteristic functions of random variable U(T) under these two measures. The first probability in Equation (7.11) is calculated under the Esscher measure QE, which is given by exp͑h* ϩ 1͒ X1͑T͒ dQ E ϭ . dP exp͕͓␮͑h* ϩ 1͒ ϩ 1 ␴2͑h* ϩ 1͒2͔T͖
2

STATE PRICE DENSITY, ESSCHER TRANSFORMS,

AND

PRICING OPTIONS

115

Under this Esscher measure, the state variable vector X follows:
Q dX 1 ͑ t ͒ ϭ ͑␮ ϩ 1 ␴ 2 ͒ dt ϩ ␴ dW 1 ͑t͒, 2
E

Q dX 1 ͑ t ͒ ϭ ͑␮ Ϫ 1 ␴ 2 ͒ dt ϩ ␴ dW 1 ͑t͒, 2
E

dX 2 ͑ t ͒ ϭ ͕␪ Ϫ ͓ k Ϫ B ͑␥ ; ␶͒␯ 2 ͔ X 2 ͑ t ͖͒ dt
E

Q dX 2 ͑ t ͒ ϭ ͓␪ Ϫ kX 2 ͑ t ͔͒ dt ϩ ␯ ͱ X 2͑t͒ dW 2 ͑t͒.

Q ϩ ␯ ͱ X 2͑t͒ dW 2 ͑t͒.
E

So the characteristic function of random variable U(T) is given by ⌽ U ͑␨ , T ; h *, ␥͒ ϭ exp͕͓͑c ϩ 1 ␴2͒␰ ͱϪ1 Ϫ 1 ␴2␰2͔T 2 2 ˜ ͑h2; T͒ ϩ B ˜ ͑h2; T͒ X2͑0͖͒, ϩA where ˜ ͑ h 2; T ͒ ϭ B h 2 exp͓ϪkT͔ , 1 Ϫ h2␯2͕1 Ϫ exp͓ϪkT͔͖

So the characteristic function of random variable U(T) is given by ⌽ U ͑␨ , T ; h *, ␥͒ ϭ exp͕͓͑c Ϫ 1 ␴2͒␰ ͱϪ1 Ϫ 1 ␴2␰2͔T 2 2 ៮ ͑h2; T͒ ϩ B ៮ ͑h2; T͒ X2͑0͖͒, ϩA where ៮ ͑h2; T ͒ ϭ B h 2 ͓ C ͑␥ ; T ͔͒ 2 exp͓ϪkT͔ , 1 Ϫ h2␯2C͑␥; T͕͒1 Ϫ exp͓ϪkT͔͖

2␪ 1 ˜ ͑ h 2 ; T ͒ ϭ 2 ln , A 2 ␯ 1 Ϫ h2␯ ͕1 Ϫ exp͓ϪkT͔͖ h 2 ϭ Ϫ␥␰ ͱϪ1. With the aid of this characteristic function, we can calculate the probability: 1 1 Pr͓S͑T͒ Ͼ K; T, h* ϩ 1, 0͔ ϭ Ϫ 2 ␲

ͩ

ͪ

៮ ͑h2; T͒ ϭ A C ͑␥ ; T ͒ ϭ

1 2␪ , 2 ln 2 ␯ 1 Ϫ h2␯ C͑␥; T͕͒1 Ϫ exp͓ϪkT͔͖ 2k , 2 k Ϫ ␯ ␥͕ 1 Ϫ exp͓ϪkT͔͖
2

ͩ

ͪ

h 2 ϭ Ϫ␥␰ ͱϪ1. The second probability is given by 1 1 Pr͓S͑T͒ Ͼ K; T, h*, ␥͔ ϭ Ϫ 2 ␲

͵

ϱ

Re

0

ϫ

΄

⌽U͑␰, T; h* ϩ 1, 0͒ ␰ ͱϪ1

ϫ exp͑Ϫ␰͕ln͓K/S͑0͔͖͒ ͱϪ1͒

΅

ϫ d␰.
REMARK

ͫ

͵

ϱ

Re

0

⌽U͑␰, T; h*, ␥͒ exp͕Ϫ␰ ln͓K/S͑0͔͒ ͱϪ1͖ ␰ ͱϪ1

ͬ

d␰.

The second probability in Equation (7.11) is calculated under the Esscher measure QE, given by exp͓h*X1͑T͒ ϩ ␥X2͑T͔͒ dQ E ϭ dP exp͕͓␮h* ϩ 1 ␴2h*2͔T
2

Letting ␥ ϭ 0 in this model, the stock price will follow a log-normal process S ͑ t ͒ ϭ S ͑ 0 ͒ exp͓X1͑t͔͒. The value (at time 0) of a European call option is given by C ϭ S ͑ 0 ͒ Pr͓S͑T͒ Ͼ K; T, h* ϩ 1͔ Ϫ K exp͑ϪcT͒ Pr͓S͑T͒ Ͼ K; T, h*͔,

,

ϩ A͑␥; T͒ ϩ B͑␥; T͒ X2͑0͖͒ where B ͑␥ ; T ͒ ϭ A ͑␥ ; T ͒ ϭ 2 k ␥ exp͓ϪkT͔ , 2k Ϫ ␯2␥͕1 Ϫ exp͓ϪkT͔͖ 2k 2␪ . 2 ln 2 ␯ 2k Ϫ ␯ ␥͕1 Ϫ exp͓ϪkT͔͖

where

ͩ

ͪ

Pr͓S͑T͒ Ͼ K; T, h* ϩ 1͔

Under this Esscher measure the state variable vector X follows

1 1 ϭ Ϫ 2 ␲

͵

ϱ

Re

0

΄

1 2 1 2 2 exp͕͓͑c ϩ 2 ␴ ͒␰ ͱϪ1 Ϫ 2 ␴ ␰ ͔T

Ϫ ␰ ln͓K/S͑0͔͒ ͱϪ1͖ ␰ ͱϪ1

΅

d␰,

116

NORTH AMERICAN ACTUARIAL JOURNAL, VOLUME 5, NUMBER 3

Pr͓S͑T͒ Ͼ K; T, h*͔

1 1 ϭ Ϫ 2 ␲

͵

ϱ

Re

0

΄

1 2 1 2 2 exp͕͓͑c Ϫ 2 ␴ ͒␰ ͱϪ1 Ϫ 2 ␴ ␰ ͔T

Ϫ ␰ ln͓K/S͑0͔͒ ͱϪ1͖ ␰ ͱϪ1

΅

d␰.

lands. I would like to thank Theo K. Dijkstra of the University of Groningen, Chris Rogers of the University of Bath, U. K., and especially Elias S. W. Shiu of the University of Iowa for their advice and help. All errors are my responsibility alone. REFERENCES
AASE, K. K. 1993a. “Premium in a Dynamic Model of Reinsurance Market.” Scandinavian Actuarial Journal 134 – 60. ———. 1993b. “Equilibrium in a Reinsurance Syndicate: Existence, Uniqueness and Characterization.” ASTIN Bulletin 23: 185–211. AIT-SAHALIA, Y., AND A. W. LO. 1998. “Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices.” Journal of Finance 53: 499 –548. ———. 2000. “Nonparametric Risk Management and Implied Risk Aversion.” Journal of Econometrics 94: 9 –51. ARROW, K. J. 1953. “The Role of Securities in the Optimal Allocation of Risk Bearing.” English version published in Review of Economic Studies 31 (April 1964): 91– 6. BANZ, R. W., AND M. H. MILLER. 1978. “Prices for State-Contingent Claims: Some Estimates and Application.” Journal of Business 51: 653–72. BICK, A. 1988. “Producing Derivative Assets with Forward Contracts.” Journal of Financial and Quantitative Analysis 23: 153– 60. BINGHAM, N. H. R., AND R. KIESEL. 1998. Risk-Neutral Valuation: Pricing and Hedging of Financial Derivatives. New York: Springer. BLACK, F., AND M. SCHOLES. 1973. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy 81: 637–54. BORCH, K. 1990. Economics of Insurance. Amsterdam: NorthHolland. BREEDEN, D., AND R. LITZENBERGER. 1978. “Prices of State-Contingent Claims Implicit in Option Prices.” Journal of Business 51: 621–51. ¨ HLMANN, H. 1980. “An Economic Premium Principle.” ASTIN BU Bulletin 11: 52– 60. ———. 1984. “The General Economic Premium Principle.” ASTIN Bulletin 14: 13–21. ¨ HLMANN, H., F. DELBEAN, P. EMBRECHTS, AND A. N. SHIRYAEV. 1998. BU “On Esscher Transforms in Discrete Finance Models.” ASTIN Bulletin 28: 171– 86. CHAN, T. 1999. “Pricing Contingent Claims on Stocks Driven by Levy Processes.” Annals of Applied Probability 9(2): 504 – 28. COCHRANE, J. H. 2001. Asset Pricing. Princeton, NJ: Princeton University Press. CONSTANTINIDES, G. M. 1992. “A Theory of the Nominal Term Structure of Interest Rates.” Review of Financial Studies 5: 531–53. COX, J. C., J. E. INGERSOLL, JR., AND S. A. ROSS. 1985. “A Theory of the Term Structure of Interest Rates.” Econometrica 53: 385– 407.

This is the Black-Scholes (1973) option-pricing formula in terms of the characteristic functions of a random variable.

8. CONCLUSION
In this paper, by modeling the state price density as an exponential function of underlying state variables, it has been shown that the well-known Esscher transform can be used to specify the forward-risk-adjusted measure. With the aid of the state price density, the Esscher transform, and the characteristic function, this paper provides a consistent framework for pricing options on stocks, interest rates, and foreign exchange rates. The framework discussed here is quite general and is related to many popular models, for example, Black and Scholes (1973); Constantinides (1992); Cox, Ingersoll, and Ross (1985); Duffie and Kan (1996); Heston (1993); Merton (1973); Rabinovitch (1989); Rubinstein (1976); and Vasicek (1977). This paper is a generalization of Gerber and Shiu (1994, 1996), in which Esscher transforms are used to define the risk-neutral measure and price options with constant risk-free interest rates. When interest rates are deterministic, the forward-risk-adjusted measure degenerates to the risk-neutral measure. The framework discussed in this paper can be applied to address the valuation problems of equity or fixed-income linked life insurance policies, interest-rate-sensitive products, and options and guarantees, such as annuity purchase options and minimum rate guarantees. It can also be used to measure and manage the risks associated with these products.

ACKNOWLEDGMENTS
This paper was written while the author was working at the Department of Finance and Accounting, University of Groningen, The Nether-

STATE PRICE DENSITY, ESSCHER TRANSFORMS,

AND

PRICING OPTIONS

117

COX, J. C., AND S. A. ROSS. 1976. “The Valuation of Options for Alternative Stochastic Processes.” Journal of Financial Economics 3: 145– 66. DEBREU, G. 1959. The Theory of Value: An Axiomatic Analysis of Economic Equilibrium. Cowles Foundation for Research in Economics at Yale University. New York: John Wiley & Sons. DUFFIE, D. 1992. Dynamic Asset Pricing Theory. Princeton, NJ: Princeton University Press. DUFFIE, D., AND R. KAN. 1996. “A Yield-Factor Model of Interest Rates.” Mathematical Finance 6: 379 – 406. DYBVIG, P. H. 1988a. “Distributional Analysis of Portfolio Choice.” Journal of Business 61: 369 –93. ———. 1988b. “Insufficient Dynamic Portfolio Strategies or How to Throw Away a Million Dollars in the Stock Market.” Review of Financial Studies 1: 67– 88. FELLER, W. 1966. An Introduction to Probability Theory and Its Applications. Vol. 2. New York: John Wiley & Sons. GEMAN, H. 1989. “The Importance of the Forward Neutral Probability in a Stochastic Approach of Interest Rates.” Working paper, ESSEC. GEMAN, H., N. EL KAROUI, AND J. C. ROCHET. 1995. “Changes of Numeraire, Changes of Probability Measure, and Option Pricing.” Journal of Applied Probability 32: 443–58. GERBER, H. U., AND E. S. W. SHIU. 1994. “Option Pricing by Esscher Transforms.” Transactions of the Society of Actuaries 46: 99 –140. ———. 1996. “Actuarial Bridges to Dynamic Hedging and Option Pricing.” Insurance: Mathematics and Economics 18: 183–218. HARRISON, J. M., AND D. M. KREPS. 1979. “Martingales and Arbitrage in Multiperiod Securities Markets.” Journal of Economic Theory 20: 381– 408. HARRISON, J. M., AND S. R. PLISKA. 1981. “Martingales and Stochastic Integrals in the Theory of Continuous Trading.” Stochastic Processes and Their Applications 11: 215– 60. HESTON, S. 1993. “Invisible Parameters in Option Prices.” Journal of Finance 48: 933– 47. JAMSHIDIAN, F. 1989. “An Exact Bond Option Formula.” Journal of Finance 44: 205–9. KARLIN, S., AND H. M. TAYLOR. 1975. A First Course in Stochastic Processes. New York: Academic. LONGSTAFF, F., AND E. SCHWARTZ. 1992. “A Two-Factor Interest Rate Model and Contingent Claims Valuation,” Journal of Finance 47: 1259 – 82. MERTON, R. C. 1973. “Theory of Rational Option Pricing.” Bell Journal of Economics and Management Science 4: 141– 83. ———. 1990. Continuous-Time Finance. Cambridge, MA: Basil Blackwell. ØKSENDAL, B. 1998. Stochastic Differential Equations: An Introduction with Applications. 5th ed., Berlin: Springer. PANJER, H., ED. 2001. Financial Economics: With Applications to

Investments, Insurance and Pensions. Schaumburg, IL: Actuarial Foundation. PEDERSEN, H., AND E. S. W. SHIU. 1994. “Evaluation of the GIC Rollover Option.” Insurance: Mathematics and Economics 14: 117–27. RABINOVITCH, R. 1989. “Pricing Stock and Bond Options When the Default-Free Rate Is Stochastic.” Journal of Financial and Quantitative Analysis 24: 447– 457. ROGERS, L. C. G. 1997. “The Potential Approach to the Term Structure of Interest Rates and Foreign Exchange Rates.” Mathematical Finance 7: 157–76. ROSS, S. A. 1976. “Options and Efficiency.” Quarterly Journal of Economics 90: 75– 89. ———. 1978. “A Simple Approach to the Valuation of Risky Streams.” Journal of Business 3: 453–76. RUBINSTEIN, M. 1976. “The Valuation of Uncertain Income Streams and the Pricing of Options.” Bell Journal of Economics 7: 407–25. Reprinted (1989) in Theory of Valuation: Frontier of Modern Financial Theory, ed. M. Bhattacharya and G. M. Constantinides, Vol. 1, pp. 25– 43. Totowa, NJ: Rowman & Littlefield. SHARPE, W. F. 1995. “Nuclear Financial Economics.” In Risk Management: Problems & Solutions, ed. W. H. Beaver and G. Parker, pp. 17–36. New York: McGraw-Hill. ———. 1998. “Financial Economics and the Management of Investments.” Unpublished manuscript, Stanford University. SHIRYAEV, A. N. 1998. Essentials of Stochastic Finance: Facts, Models, Theory. Vol. 3. N.J.: World Scientific. TURNBULL, S., AND F. MILNE. 1991. “A Simple Approach to InterestRate Option Pricing.” Review of Financial Studies 5: 87– 120. VASICEK, O. A. 1977. “An Equilibrium Characterization of the Term Structure.” Journal of Financial Economics 5: 177– 88. YAO, Y. 1994. “Discussion of H. U. Gerber and E. S. W. Shiu’s Option Pricing by Esscher Transforms.” Transactions of the Society of Actuaries 46: 168 –73. ———. 1998. “Moment Generating Function Approach to Pricing Interest Rate and Foreign Exchange Rate Claims.” Working paper, University of Groningen. ———. 2000. Modeling Interest Rates, Foreign Exchange Rates, and Stock Prices: An Integrated Approach to Modeling, Valuation, and Financial Risk Management. Ph.D. dissertation, University of Groningen. Rotterdam: Labyrint Publication.

Discussions on this paper can be submitted until Jan. 1, 2002. The author reserves the right to reply to any discussion. Please see the Submission Guidelines for Authors on the inside back cover for instructions on the submission of discussions.

Sign up to vote on this title
UsefulNot useful