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First passage time problem for a gauss-markov process

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Problem

Rajarshi Sarkar

University of Nice and Sophia Antipolis and INRIA - Sophia Antipolis

August,2012

Abstract

This report looks into the first passage time problem. First-passage

time problems are deceptively very simple, but at the same time very complex to tackle with sometimes. We know very little about the first-passage

behavior except in some simple cases like standard Wiener process,Wiener

process with drift,and likewise.

I have tried to study three kinds of approaches towards finding an approximate solution of the first-passage time through numerical simulation.They

are, the Euler scheme with the Brownian bridge idea, the fast algorithm

for Gauss-Markov Processes that involves a probabilistic invariant of dichotomic search and the exact algorithm studied for some very specific

kinds of stochastic differential equations. I have numerically compared

the Euler scheme and the Fast algorithm, and stated the analytical result

for obtaining a very nice relation for the first-passage time in case of Exact

Simulation.

Moreover, I have also tried to price a barrier option, a financial instrument

dependent on the approximation of the first-passage time for the price of

the underlying asset.

Introduction

dXt = (Xt , t)dt + (Xt , t)dWt

with

X0 = x0

(1)

where and are smooth enough for us to have existence and uniqueness

properties for the above stochastic differential equation (SDE). We would just

need the two functions and to be Lipschitz on every compact support [0,T]

for every T 0. We seek to simulate or find a random event of the form,

= inf{t > 0; Xt > L}

where, L is the boundary, which can be a constant or some continuous deterministic function.We usually look for in some closed interval of the form [0,T],

since we know that in the case of a Brownian motion with the boundary being

an affine function of time we get, E( ) = . Thus, we usually bound it in some

finite interval.

First passage time or first hitting time or stopping time problems have been

the center of attraction for many years now. It has useful application in biology,physics,finance, to name a few. It is also very interesting to look at the

1

BROWNIAN MOTION

first-passage time problems, since they are related to many fields of Mathematics, such as probability theory, functional analysis, numerical analysis, number

theory.

Despite the importance and varied applications of first-passage times,its only in

very few situations that we explicitly know the law for them. In the case of a

standard Brownian motion, we know the analytical solution for the first-passage

time for a constant boundary L = a. Bachelier, was one of the first to study the

first-passage time problem, followed by Levy. The very famous Bachelier-Levy

formula was derived for the density p of a Brownian motions first passage over

a linear boundary of the form a + bt, as,

a + bt

a

p(t) = 3

t

t2

2

where, (y) = 12 exp y2

Ofcourse, after them lots of people have improved upon their work and added

more to the theory of first-passage time. However, it is still quite unexplored

as there does not exist any simple form for the density function for the firstpassage time for more complicated diffusion processes. Thus, lies the challenge

to be able to simulate and correctly approximate the first-passage time for such

processes. We embark on this journey, looking at Gauss-Markov processes and

some interesting processes.

First, we look into some results for the Brownian motion and then the GaussMarkov process, which will be later useful when we use the algorithms.

Second, we look into the Euler scheme for numerically approximating the firstpassage time problem.

Third, we look into the Fast Algorithm developed by Taillefumier and Magnasco

in their paper [1] and try to implement it.

Fourth, we try and compare the Euler scheme and the Fast Algorithm.

Fifth, we look into a new method of simulating exactly the path for a diffusion

process[3]. We, very quickly realise the restriction of such a method, however it

is still mathematically very interesting to see the development of such a method.

Here, we just give an analytical result pertaining to the first-passage time. We

find the law for the first-passage time as some function of another first-passage

time, which we already know how to simulate.

Last, but not least, we look into the Financial application of the first-passage

time in pricing a barrier option.

Notations : The notations for a Brownian motion or a Wiener process will be

B(.) and W (.).

Brownian Motion

We will look into some properties for, first a standard Brownian motion and

then for, a Brownian motion with drift. We first state the probability distribution function for the first-passage time for a standard Brownian motion and

then we look into the probability density function for a Brownian motion with

drift. In the process of doing so, we also look into the law of the maximum of

a Brownian bridge conditioned on the two extreme values of the bridge.

BROWNIAN MOTION

B = {B(t), Ft ; 0 t T } is our standard Brownian motion(Wiener process)

on some probability space (, F, P ). We look for the law of the first-passage

time defined as a = inf{t > 0; B(t) a}.

In order to find the law of our first-passage time, we look into the law of the

maximum M (T ) = sup0tT B(t).

Interestingly, the law can be derived in a very simple way by the use of a

key property of the Brownian motion - Reflection Principle. It tells us that

the Brownian motion reflected after they hit any barrier, preserves the same

motion(distribution) as the original Brownian motion. Thus, if our barrier is a

constant L = a, then we can show that,

d = B(t) if t < a

B(t)

d = 2B(a ) B(t) = 2a B(t) if t a

B(t)

Then B(t)

Now, its is very simple to show that a < , as we know that limsupn B(n) =

.

Our main goal is to find the probability density function for the first-passage

time. Thus,

P (a < T )

Now, we see we can look into the same thing from a different point of view as

P (a T ) = P (M (T ) a). Thus,

P (M (T ) a) = P (M (T ) a, B(T ) a) + P (M (T ) a, B(T ) < a)

2

R 1

y

exp 2T

dy

Now, since P (M (T ) a, B(T ) a) = P (B(T ) a) = a 2T

Thus, we work with the other part, i.e P (M (T ) a, B(T ) < a). We know, from

[) = 2B(a ) B(T ) = 2a B(T ) , as in this

the Reflection Principle, that B(T

case we are assuming that T . Thus, we get, that if B(T ) < a, then

[) = 2a B(T ) > 2a a = a, and moreover as the law of B

b and that of B

B(T

are same, we get,

[) > a) = P (B(T

[) > a)

P (M (T ) a, B(T ) < a) = P (M (T ) a, B(T

= P (B(T ) > a)

Thus, we get,

P (M (T ) a) = 2P (B(T ) > a)

2

R

y

1

Thus, P (a T ) = P (M (T ) a) = 2P (B(T ) > a) = 2 2T

exp 2T

dy

a

By differentiating the above relation with respect to T, we get the probability

BROWNIAN MOTION

2

a

.

density function of a (T ) as 3 a exp 2T

T 22 2

a

Thus, fa (t) = 3

exp a2t

t2

We now, look into the first-passage time for a drifted Brownian motion.

W b = {W (t)b = B(t) bt, Ft ; 0 t T } be a Brownian motion with a drift

term bt. Let this process be defined over the same probability space (, F, P ).

Now, we are interested in the first-passage time,

ab = inf{t > 0; W (t)b = B(t) bt a}.

Thus, like before we look into the law for the maximum of W .

Let, M (T )b = sup0tT W (t)b = sup0tT (B(t) bt).

P (ab < T ) = P (M (T )b a)

Now, we know that exp 2bB(t) 2b2 t 0tT is a martingale Thus, letting

R(t) = exp 2bB(t) 2b2 t , we seek to apply Doobs optional stopping theorem. Now, if we let = min(ab , T ), thus making a bounded stopping time.

Now, Doobs optional stopping theorem says, if X is a martingale with respect to some filtration F, and we have a stopping time that is bounded, i.e,

() < N , for some N N . Then ,

E(X ) = E(X0 )

Now, since our R(t) is a martingale, the R(t)1ab <T is a martingale also. Thus,

we have E R(T )1ab <T = E R(0)1ab <T . Also, from the optional stopping

theorem we get that E R()1ab <T = E R(0)1ab <T

Thus, we have,

E R(T )1ab <T = E R()1ab <T

= E R(ab )1ab <T

Thus, writing the expectation in the integral form we get,

Z

Z

2

exp 2bB(T ) 2b T dP =

exp 2bB(ab ) 2b2 ab dP

ab <T

ab <T

Now, we know that W (ab )b = B(ab ) bab = a, thus the right hand side is,

Z

Z

exp 2bB(ab ) 2b2 ab dP =

exp 2b(B(ab ) bab ) dP

ab <T

ab <T

Z

=

exp (2ba) dP

ab <T

BROWNIAN MOTION

Thus we get,

P (ab < T ) = exp(2ba)

exp 2bB(T ) 2b2 T dP

ab <T

Z

= exp(2ba)

exp 2bB(T ) 2b2 T dP

M (T )b a

Z

= exp(2ba)

exp 2bB(T ) 2b2 T dP

sup0tT (B(t)bt)a

such that under Q, W (t) is a standard Brownian motion. Recalling Girsanovs

Theorem,

Given a Brownian motion B = {Bt ; 0 t T }, defined on the probability

space (, F, P ), for some T > 0, and given a left-continuous

and adapted pro

RT

cess u = {ut ; 0 t T }, such that E 0 u2t dt < . Now, if we set

!

Z

Z T

1 T 2

ut dt

Z = exp

ut dBt

2 0

0

and if E(Z) = 1, then we can define A , Q(A) = E(1A Z). Then Q is

a probability measure equivalent to P , moreover the process W u = {Wtu =

Rt

Bt + 0 u2s dBs ; o t T }, is a standard Brownian motion under this new

probability measure Q with respect to the filtration F = {Ft ; 0 t T }.

2

dQ

Thus, the change of probability measure dP

= exp bB(T ) b 2T . Thus, we

b2 T

need to change the measure from P to Q, thus using dP

=

dQ = exp bB(T ) + 2

b2 T

exp bW (T ) 2

Z

dP

P (ab < T ) = exp(2ba)

exp (2b(B(T ) bT ))

dQ

dQ

sup0tT (B(t)bt)a

Z

b2 T

dQ

= exp(2ba)

exp (2bW (T )) exp bW (T )

2

sup0tT (B(t)bt)a

Z

b2 T

= exp(2ba)

exp bW (T )

dQ

2

sup0tT (B(t)bt)a

Again taking help of the reflection principle, we know that,

Q(M (T ) > a, W (T ) < x) = Q2a (W (T ) < x) = Q(W (T ) < x 2a) f or

Q(M (T ) > a, W (T ) > x) = Q(W (T ) > x) f or

xa

Thus dividing the domain of the integration into two parts, we get,

Z a

b2 T

exp bx

fW (T ) (x 2a) dx+

P (ab < T ) = exp(2ba)

2

Z

b2 T

exp(2ba)

exp bx

fW (T ) (x) dx

2

a

x<a

BROWNIAN MOTION

2

1

x

and denoting, P (W (T ) < y) = (y) =

where, fW (T ) (x) = 2T

exp 2T

Ry

2

x

1

dx, we get,

exp 2T

2T

P (ab

b2 T

(x 2a)2

1

< T ) = exp(2ba)

exp bx

exp

dx+

2

2T

2T

Z

b2 T

1

x2

exp bx

exp(2ba)

exp

dx

2

2T

2T

a

Z

a + bT

bT a

P (ab < T ) = 1

+ exp(2ba)

T

T

Upon, differentiating with respect to all the measurable sets ab < T , we get the

probability density function as,

a

(a + bt)2

fab (t) = 3 exp

2t

t 2 2

This is the very famous Bachelier - Levy formula

Now, we look at how we can generate a Brownian bridge Btx,y , where t1 t t2

and we know the value of the Brownian motion at the two extreme points of

the interval [t1 , t2 ] as Bt1 = x and Bt2 = z. From now on we fix the value of t

as some value between t1 and t2 .

Now, let us assume a process of the form, Btx,y = {Bt ; t1 t t2 |Bt1 = x, Bt2 =

y}.

Let,

Y, = Bt1 + Btx,y Bt2

for, t1 t t2 . Finally, we would want this Y, to give us some clue on how

to generate Btx,y with the help of three independent random variables. Thus

to begin with, lets find the law of Y, . To find the law, we take help of the

independent increment property of Brownian motion, Bt1 q (Bt Bt1 ) q (Bt2

Bt ).

Thus, splitting, the above relation as,

Y, = aBt1 + b(Btx,y Bt1 ) + c(Bt2 Btx,y )

we get,

a b =

bc=1

c =

BROWNIAN MOTION

a=1

b=1

c =

Now, we can take the Laplace transform of the above expression as;

x,y

x,y

E(eiY, ) = E ei(aBt1 +b(Bt Bt1 )+c(Bt2 Bt ))

x,y

x,y

E(eiY, ) = E eiaBt1 eib(Bt Bt1 ) eic(Bt2 Bt )

now,as Bt1 q(Btx,y Bt1 )q(Bt2 Btx,y ), that is Bt1 independent of (Btx,y Bt1 ),

which in turn is independent of (Bt2 Btx,y ), and we know that for two independent events X, Y , E(XY ) = E(X)E(Y ), thus we can take the expectation

of the independent events separately.

x,y

E(eiY, ) = e

1

2

2 (a) t1

E(eiY, ) = e

Bt1 )

1

2

2 (b) (tt1 )

x,y

)E(eic(Bt2 Bt

1

2

2 (c) (t2 t)

1 2

2

2

2

2 (a t1 +b (tt1 )+c (t2 t))

Thus, we get a Gaussian random variable with mean 0 and variance (a2 t1 +

b2 (t t1 ) + c2 (t2 t)). Assume that Y, is independent of Bt1 and Bt2 , since

the idea is to get an unbiased Brownian motion from Y, , in the sense, we want

Y, to be independent of both Bt1 and Bt2 .Thus, we take the covariance to

seek the condition for independence. ;

Cov(Y, , Bt1 ) = Cov(aBt1 , Bt1 ) + Cov(b(Btx,y Bt1 ), Bt1 ) + Cov(c(Bt2 Btx,y ), Bt1 )

Cov(Y, , Bt1 ) = at1

as, Bt1 q (Btx,y Bt1 ) and also Bt1 q (Bt2 Btx,y ). Now, we want the covariance

to be 0. Thus, we get ,

at1 = 0

(1 )t1 = 0

since, t1 6= 0;

+ =1

Similarly,

Cov(Y, , Bt2 ) = Cov(Bt1 , Bt2 ) + Cov(Btx,y , Bt2 ) + Cov(Bt2 , Bt2 )

Cov(Y, , Bt2 ) = t1 + t t2

BROWNIAN MOTION

as we know that for a Brownian motion, Cov(Bs , Bt ) = min(s, t). Again, this

covariance value is equal to 0. Thus,

t1 + t t2 = 0

Now, from the previous result we know,

T hus,

=1

(1 )t1 + t t2 = 0

t t1

=

t2 t1

t2 t

thus, =

t2 t1

Thus, we have the complete relation between the biased Brownian motion(the Brownian bridge) Btx,y and the unbiased one which we construct from

the Y, . We know, Bt1 = x and Bt2 = y. Thus, what we have is,

Btx,y = Bt1 + Bt2 + Y,

t2 t

t t1

Btx,y =

x+

y + Y,

t2 t1

t2 t1

Now, we know that, Y, N (0, a2 t1 + b2 (t t1 ) + c2 (t2 t))

Knowing the values of a, b, c, we can directly put the values into the above

equation and get the final value of Y, .

(t2 t)(t t1 )

Y, N

(t2 t1 )

Thus, finally we get,

t2 t

x+

t2 t1

t2 t

=

x+

t2 t1

Btx,y =

Btx,y

t t1

y + B (t2 t)(tt1 )

t2 t1

(t2 t1 )

t t1

t2 t

B tt1

y+

t2 t1

t2 t1 t2 t

Now, we look into the law of the first-passage time in the case of a Brownian

bridge. Thus, for every 0 tx tz 1 and for reals x,z,L with x, z <

L, considering the first passage time as, tx = inf{t > tx |Bt > L}. Then

conditioning to Btx = x and Btz = z, we get,

2(L x)(L z)

P (tx < tz |Btx = x, Btz = z) = exp

tz tx

Proof : We know that Bt is a Gaussian random variable N (0, t). Now, we

are looking for something like P (tx < tz |Btx = x, Btz = z).To study this

probability, we first introduce the maximum of the process between time tx and

tz . as;

Mtx ,tz = suptx ttz Bt

GAUSS-MARKOV PROCESS

Now,we know that from probability theory, P (Mtx ,tz > L|Btx = x, Btz = z) =

P (Mtx ,tz > L, Btz = z|Btx = x)

.

P (Btz = z|Btx = x)

We know from the strong Markov property for a Brownian motion, (Bt+s |Bu ; 0

u s) = (Bt+s |Bs ), where t 0, and from the reflection property, as discussed

previously, we get,

P (Mtx ,tz > L, Btz < z|Btx = x) = P (Mtx ,tz > L, Btz > 2L z|Btx = x)

= P (Btz > 2L z|Btx = x)

since, we have assumed in the beginning that z < L.

Thus,

Z

((y x0 ) (x x0 ))2

1

exp

P (Btz > 2Lz|Btx = x) = p

dy

2(tz tx )

2(tz tx ) 2Lz

By differentiation of the above expression with respect to z and L, we get,

2(2l (x + z))

(2l (x + z))2

p

P (Btz dz, Mtx ,tz dl|Btx = x) =

exp

dzdl

2(tz tx )

2(tz tx )

Also, since Bt follows a Gaussian distribution, we can write,

(z x)2

1

P (Btz dz|Btx = x) = p

exp

2(tz tx )

2(tz tx )

Thus, we get,

P (Mtx ,tz dl|Btx = x, Btz

2(2l (x + z))

exp

= z) =

tz tx

2(l x)(l z)

tz tx

dl

Integrating the above value, only on those measurable sets for which Mtx ,tz L,

we get exactly the probability for the process to reach the boundary(barrier)

in-between the times tx and tz .

2(L x)(L z)

P (Mtx ,tz > L|Btx = x, Btz = z) = exp

tz tx

T hus,

2(L x)(L z)

P (tx < tz |Btx = x, Btz = z) = exp

tz tx

Thus, we get a very nice representation for the first-passage time for a Brownian

bridge.

Gauss-Markov Process

Mathematical Calculations

Definitions

Given some probability space (,F,P ); where is the sample space, F is its

associated field and P is the probability measure equipped with the (,F),

GAUSS-MARKOV PROCESS

10

Gauss-Markov process if ;

1. X is a Gaussian process, if for any integers n and positive reals t1 < t2 <

< tn , the random vector (Xt1 ,Xt2 ,. . . ,Xtn ) has a joint Gaussian distribution.

Meaning, for any reals a1 ,a2 ,. . . ,an , random variable

n

X

ai Xti

i=1

2. X is a Markov process, if for any s,t 0 and A B(R)

P (Xt+s A|Fs ) = P (Xt+s A|Xs )

which states that the conditional probability distribution of future states Xt+s ,

given the present state and all the past states Fs , depends only on the present

state Xs . Now, we define the first-passage time problem. Let us say, Xt0 = x0

L and take into account the random variable sL on (,F,P )

sL () = inf{t s|Xt () L}

The random variable sL is defined as the stopping time with respect to Ft and

is known as the first passage time of X for a boundary L.The first passage time

problem also consist of determining the distribution of sL on [s,+).

Doobs Integral Representation

Let W = {Wt , Ft ; 0 t T} denote a standard real Wiener process on some

probability space (,F,P ).We consider the class of real Gaussian Markov process X = {Xt ,Ft ;0 t T} solution to the following stochastic differential equation;

dXt = (t)Xt dt + (t)dWt

with X0 = x0 ;

where is a bounded function and is a continuous,bounded, positive function.

Now, we can solve this equation by using variation of parameters.

Let Yt be the solution of the differential equation;

dYt = (t)Yt dt

Rt

with Y0 = 1; then, we get, Yt = exp( 0 (u) du) for any 0 t T

Now we consider Xt = Yt Zt for some Zt . Applying Itos formula, we get

dXt = Zt dYt + Yt dZt + d < Yt , Zt >

Z t

dXt = Zt (t)Yt dt + exp(

(u) du)dZt

0

Z t

dXt = (t)Xt dt + exp(

(u) du)dZt

0

Rt

From this we get, (t)dWt = exp( 0 (u) du)dZt with Z0 = x0 and from further

simplification we get,

Z t

Z s

Z t = x0 +

exp(

(u) du)(s) dWs

0

GAUSS-MARKOV PROCESS

11

Rt

Rt

Rs

Thus we get, Xt = exp( 0 (u) du)(x0 + 0 exp( 0 (u) du)(s) dWs ).

Thus defining the functions g, h and f as,

Z t

g(t) = exp(

(u) du)

0

Z t

Z s

h(t) =

exp(2

(u) du)(s)2 ds

0

0

Z t

f (t) = exp(

(u) du)(t)

0

Xt

= f (t)dWt

d

g(t)

with X0 = x0

with the solution being;

Z

Xt = g(t)(x0 +

f (s) dWs )

0

Now, we can see that the Xt is a RGaussian random variable with mean being

t

g(t)x0 and the variance being g(t)2 0 f (s)2 ds or g(t)2 .h(t).

Discrete Construction of Gauss-Markov Processes

Given some reals tx < ty < tz , the conditioning formula for a Gauss-Markov process gives a distribution of Xty , knowing Xtx =x and Xtz =z[2]. It can be shown

that the corresponding probability density is the Gaussian law N ((ty ),(ty )),

where (ty ) denotes the time dependent mean,

(ty ) =

g(ty ) h(tz ) h(ty )

x+

z

g(tx ) h(tz ) h(tx )

g(tz ) h(tz ) h(tx )

(ty )2 = g(ty )2

h(tz ) h(tx )

heavily on two results. First one being Doobs integral representation which

gives an expression for the probability P (Xt = x|Xt0 = x0 ) of a general GaussMarkov process.

2

x0

x

g(t)

g(t0 )

1

p

exp

P (Xt [x, x+dx]|Xt0 = x0 ) =

dx

2(h(t) h(t0 )

g(t) 2(h(t) h(t0 ))

iff h(t) 6= h(t0 ). Second result being the fact that we can actually evaluate

P (Xty [y, y + dy]|Xtx = x, Xtz = z) with tx < ty < tz , the probability of Xt

knowing the values at times tx and tz as x and z respectively. This is because X

is a Markov process, thus a sample path which starts from x and terminates at

GAUSS-MARKOV PROCESS

12

at x and finishing at y and another one starting at y and ending at z. Thus

after normalization of the absolute probability for a path to go to z from x, we

have,

P (Xty [y, y+dy]|Xtx = x, Xtz = z) =

P (Xtz [z, z + dz]|Xtx = x)

Thus, we use the above two properties to derive the law of Xty given the values

of Xtx = x and Xtz = z given that tx < ty < tz .

P (Xty [y, y+dy]|Xtx = x, Xtz = z) =

1

g(ty ) 2(h(ty )h(tx ))

exp

p(Xtz [z, z + dz]|Xtx = x)

2 !

2 !

y

g(tx )

g(ty )

x

2(h(ty )h(tx ))

g(tz )

1

2(h(tz )h(tx ))

g(tz )

1

2(h(tz )h(ty ))

exp

z

g(ty )

g(tz )

y

2(h(tz )h(ty ))

dydz

2

( g(tzz ) g(txx ) )

exp 2(h(t

dz

z )h(tx ))

We got this representation from the first result due to Doobs representation.

By factorizing the part inside the exponential, we get,

P (Xty [y, y + dy]|Xtx = x, Xtz = z) =

2

g(ty ) h(ty )h(tx )

g(ty ) h(tz )h(ty )

x

+

z

y

g(tz ) h(tz )h(tx )

1

q

exp

dy

(h(t

)h(t

))(h(t

y

x

z )h(ty ))

(h(t

)h(t

))(h(t

)h(t

))

2

y

x

z

y

2

2g(t

)

y

2g(ty )

h(t

)h(t

)

z

x

h(tz )h(tx )

Thus getting the desired result that Xty with the knowledge that Xtx = x ,

g(t ) h(t )h(t )

Xtz = z, does indeed have a Gaussian law with mean (ty ) = g(txy ) h(tzz )h(txy ) x+

g(ty ) h(ty )h(tx )

g(tz ) h(tz )h(tx ) z

.

h(tz )h(tx )

First we look into the time-changed Wiener process X with a constant boundary

L.Time changed Weiner

R t process means, thats X is a solution for equal to

zero.Thus Xt = x0 + 0 f (s) dWs

Thus, for every 0 tx tz 1 and for reals x,z,L with x, z < L, considering

the first passage time as, tx = inf{t > tx |Xt > L}. Then conditioning to

Xtx = x and Xtz = z, we get,

2(L x)(L z)

P (tx < tz |Xtx = x, Xtz = z) = exp

h(tz ) h(tx )

Rt 2

with h(t) = tx f (u) du

Rt

Proof : We know that Xt = x0 + 0 f (s) dWs is a Gaussian random variable

Rt

N (x0 , 0 f 2 (s) ds). Now, we are looking for something like P (tx < tz |Xtx =

x, Xtz = z).To study this probability, we first introduce the maximum of the

process between time tx and tz . as;

Mtx ,tz = suptx ttz Xt

GAUSS-MARKOV PROCESS

13

Now,we know that from probability theory, P (Mtx ,tz > L|Xtx = x, Xtz = z) =

P (Mtx ,tz > L, Xtz = z|Xtx = x)

.

P (Xtz = z|Xtx = x)

We know from the strong Markov property for a Wiener process, (Xt+s |Xu ; 0

u s) = (Xt+s |Xs ), where t 0, and from the reflection property, as discussed

previously, we get,

P (Mtx ,tz > L, Xtz < z|Xtx = x) = P (Mtx ,tz > L, Xtz > 2L z|Xtx = x)

= P (Xtz > 2L z|Xtx = x)

since, we have assumed in the beginning that z < L.

Thus,

Z

((y x0 ) (x x0 ))2

1

p

exp

dy

P (Xtz > 2Lz|Xtx = x) =

2(h(tz ) h(tx ))

2(h(tz ) h(tx )) 2Lz

By differentiation of the above expression with respect to z and L, we get,

(2l (x + z))2

2(2l (x + z))

dzdl

exp

P (Xtz dz, Mtx ,tz dl|Xtx = x) = p

2(h(tz ) h(tx ))

2(h(tz ) h(tx ))

Also, since Xt follows a Gaussian distribution, we can write,

1

(z x)2

P (Xtz dz|Xtx = x) = p

exp

2(h(tz ) h(tx ))

2(h(tz ) h(tx ))

Thus, we get,

P (Mtx ,tz dl|Xtx = x, Xtz = z) =

2(2l (x + z))

exp

h(tz ) h(tx )

2(l x)(l z)

h(tz ) h(tx )

dl

Integrating the above value, only on those measurable sets for which Mtx ,tz L,

we get exactly the probability for the process to reach the boundary(barrier)

in-between the times tx and tz .

2(L x)(L z)

P (Mtx ,tz > L|Xtx = x, Xtz = z) = exp

h(tz ) h(tx )

T hus,

2(L x)(L z)

P (tx < tz |Xtx = x, Xtz = z) = exp

h(tz ) h(tx )

Another result, which will finally help us to attain the final result on the

probability of crossing a constant boundary for a Gauss-Markov process.

Let W = {Wt , Ft ; 0 t 1} denote a standard real Wiener process on some

probability space (, F, P ). For, every 0 t 1 and every reals x, z, Lx , Lz

with x < Lx and z < Lz , consider the first-passage time tx = inf{t tx |Wt

L(t)}. where L is the affine function joining (tx , x) to (tz , z). Then conditioning

on Wtx = x and Wtz = z, we have

2(Lx x)(Lz z)

P (tx < tz |Wtx = x, Wtz = z) = exp

tz tx

GAUSS-MARKOV PROCESS

14

thus it looks like L(t) = a + bt where,

a=

tz Lx tx Lz

,

tz tx

b=

tz t

tz tx Lx

ttx

tz tx Lz ,

Lz Lx

tz tx

Now,we can change the first-passage time problem with an affine boundary to

a drifted Brownian motion Wt0 = Wt bt with a constant boundary a.

tx = inf{t tx |Wt a + bt} = inf{t tx |Wt bt a} = t0x

We will be using the Girsanovs Theorem to change the probability measure to

make this drifted Brownian motion into a standard one under this new probability measure.

The process defined for t tx is;

b2

Zt = exp b(Wt x) (t tx )

2

This is a martingale with E(Zt ) = 1 as Ztx = 1.Also, from the above expression

of Zt , we can deduce E(Zt ) = 1, from the result of characteristic function for a

Brownian motion;

b2

E(Zt ) = E exp b(Wt x) (t tx )

2

2

b

= E (exp (b(Wt x))) exp (t tx )

2

2

2

b

b

= exp

(t tx ) exp (t tx )

2

2

=1

Thus, we get;

E(Zt ) = 1

We can now define a new probability measure; Q, under which Wt0 is a standard

Weiner process with variance equal to t.To test this fact,

b2

Q(Wt0z [z 0 , z 0 + dz 0 ]|Wt0x = x0 = x btx ) = E 1Wtz [z,z+dz]|Wtx =x exp b(z x) (tz tx )

2

2

1

(z x)

b2

=p

exp

+ b(z x) (tz tx ) dz

2(tz tx )

2

2(tz tx )

2

1

(z x b(tz tx ))

=p

exp

dz

2(tz tx )

2(tz tx )

1

(z 0 x0 )2

p

=

exp

dz 0

2(t

t

)

2(tz tx )

z

x

if we let z 0 = z btz . Thus, under Q, Wt0 is indeed a standard Brownian motion.

Now we know that the two probability measures are equivalent. Also, we

define the relation between the two measures as;

Q(A) = EP (1A Ztz )

GAUSS-MARKOV PROCESS

15

where, A Ftx ,tz where, Ftx ,tz means the natural filtration generated by the

original Weiner process Wt tx t tz . Now, Wt0x = x0 = x btx and

Wt0z = z 0 = z btz .

We guess that, the two events, dB 0 = {Wt0z [z 0 , z 0 + dz 0 ]|Wt0x = x0 } and

dB = {Wtz [z, z + dz]|Wtx = x}, have the same probability under the two

probability measure Q and P respectively. In both the cases, we just evaluate the probability of a Brownian motion being equal to z 0 and z, thanks to

Girsanovs theorem. However, when Wt0z = z 0 , simultaneously Wtz = z. Thus,

they have the same law and thus the same probability.

!

2

(z 0 x0 )

1

0

exp

P (dB) = Q(dB ) = p

2(tz tx )

2(tz tx )

If, Mt0x ,tz is the maximum of the path (Wt0 )tx ttz .

Mt0x ,tz = suptx ttz Wt0 = suptx ttz (Wt bt)

Lets, consider the infinitesimal event dE = {Wtz dz, suptx ttz (Wt bt)

d|Wtx = x} and dE 0 = {Wt0z dz 0 , suptx ttz Mt0x ,tz d|Wt0x = x0 }. Again

by Girsanovs theorem, we know that,

P (dE) = Q(dE 0 )

Now, from the previous result we explicitly know the representation of the above

probabilities. Thus,

!

2

(2 (x0 + z 0 ))

2(2 (x0 + z 0 )

0

dz 0 d

exp

Q(dE ) = p

2(tz tx )

2(tz tx )(tz tx )

We need, Q(Mt0x ,tz > a|Wt0x = x0 , Wt0z = z 0 ). By the law of conditional probability we know that,

Q(Mt0x ,tz > a|Wt0x = x0 , Wt0z = z 0 ) =

Q(dE 0 )

=

Q(Wt0z = z 0 |Wt0x = x0 )

Q(dB 0 )

Thus, we get

P (suptx ttz (Wt bt) d|Wtx = x, Wtz = z) = Q(Mt0x ,tz d|Wt0x = x0 , Wt0z = z 0 )

2(2 (x0 + z 0 ))

2( x0 )( z 0 )

=

exp

d

tz tx

tz tx

Now, integrating the above relation over all the measurable sets for which

Mt0x ,tz > a, we get the final result on probability as,

2(a x0 )(a z 0 )

P (suptx ttz (Wt bt) > a|Wtx = x, Wtz = z) = exp

tz tx

Thus, putting back the original values of a =

Lx

and b = Ltzz t

we get,

x

tz Lx tx Lz 0

,x

tz tx

= xbtx , z 0 = zbtz ,

P (suptx ttz (Wt bt) > a|Wtx = x, Wtz = z) = P (tx < tz |Wtx = x, Wtz = z)

2(Lx x)(Lz z)

= exp

tz tx

GAUSS-MARKOV PROCESS

16

We can extrapolate this result to get the same for a time changed Wiener

process(Brownian motion). If we define B = {Bt , Ft ; 0 t T } as the solution

of the SDE, dBt = f (t)dWt for some smooth,bounded function f . Letting,

Btx = x1 and Btz = z1 and the affine boundary being the same, then we can

also say,

2(Lx x1 )(Lz z1 )

P (suptx <t<tz Bt > a + bt|Btx = x1 , Btz = z1 ) = exp

h(tz ) h(tx )

where h(t) =

Rt

t0

f (u)2 du.

Now, we turn our attention on the problem at hand, that is the GaussMarkov process.

Let W = {Wt , Ft ; 0 t T } denote a standard real Wiener process on

some probability space (, F, P ). Let X = {Xt , Ft ; 0 t T } is a real

adapted centered Gauss-Markov process on (, F, P ), defined by the equation,

dXt = (t)Xt dt + (t)dWt

with

X0 = x0

function and being positive,bounded and homogeneously Holder continuous

function. For every, 0 tx < tz T and for any reals x, z, Lx , Lz with x < Lx

and z < Lz , we consider the first-passage time tx = inf{t > tx |Xt > (t)}

where for tx < t < tz ,

(t) =

g(t) h(t) h(tx )

Lx +

Lz

g(tx ) h(tz ) h(tx )

g(tz ) h(tz ) h(tx )

is the expectation of Xt knowing that Xtx = Lx and Xtz = Lz . Then conditioning to Xtx = x and Xtz = z we have,

2(Lx x)(Lz z)

P (tx < tz |Xtx = x, Xtz = z) = exp

g(tz )g(tx )(h(tz ) h(tx ))

process of the form being discussed here. Thus, then X has the form of,

Z t

Xt = g(t)(x0 +

f (u) dWu )

0

Rt

Rt

where, g(t) = exp( 0 (u) du) and f (t) = exp( 0 (u) du)(t) and h(t), is a

Rs

Rt

2

part of the variance for the process Xt , being equal to 0 exp(2

0 (u) du)(s) ds.

Xt

Xt

Thus, we see that g(t)

is a time changed Wiener process, as d g(t)

= f (t)dWt .

Thus, we can apply both the above proved results very nicely to this proof.

We also see, by the definition of the boundary in consideration, we get (tx ) =

Lx and (tz ) = Lz .

EULER SCHEME

17

Lz

Lx

, Kz = g(t

, x0 = g(txx ) , z 0 = g(tzz ) , for any reals x, z, Lx , Lz ,

Let, Kx = g(t

x)

z)

with x < Lx and z < Lz . Now, lets define the affine boundary which we are

going to consider in the first step which joins (h(tx ), Kx ) and (h(tz ), Kz ) for

tx < t < tz as,

L(t) =

h(tz ) h(t)

h(t) h(tx )

Kx +

Kz

h(tz ) h(tx )

h(tz ) h(tx )

0

0

Now, we consider the first-passage time of the form h(t

= inf{h(t) > h(tx )|Wh(t)

>

x)

0

L(t)}, where Wt is the time changed Wiener process defined by the SDE ,

dWt0 = f (t)dWt .

0

0

Then, conditioning to Wh(t

= x0 and Wh(t

= z 0 , we get,

x)

z)

2(Kx x0 )(Kz z 0 )

0

0

0

0

0

<

h(t

)|W

=

x

=

z

P (h(t

,

W

)

=

exp

z

h(tx )

h(tz )

x)

h(tz ) h(tx )

We know that h(t) is an increasing function. Now, we look into the event whose

probability we just calculated.

0

0

0

0

0

{h(tx ) < h(tz )|Wh(t

= x0 , Wh(t

= z 0 } = {h(t) (h(tx ), h(tz )), Wh(t)

> L(t)|Wh(t

= x0 , Wh(t

= z0}

x)

z)

x)

z)

0

0

0

= {t (tx , tz ), Wh(t)

> L(t)|Wh(t

= x0 , Wh(t

= z0}

x)

z)

0

0

0

= {t (tx , tz ), g(t)Wh(t)

> g(t)L(t)|g(tx )Wh(t

= x, g(tz )(Wh(t

= z}

x)

z)

0

Now, since we can very easily see that Xt and g(t)Wh(t)

have the same law, thus

for tx t tz , we can deduce that,

0

0

P (h(tz ) < h(tz )|Wh(t

= x0 , Wh(t

= z 0 ) = P (tx < tz |Xtx = x, Xtz = z)

x)

z)

using the fact that, g(t)L(t) = (t) and tx = inf{t > tx |Xt > (t)}. Thus,

finally putting all the values, we get,

2(Lx x)(Lz z)

P (tx < tz |Xtx = x, Xtz = z) = exp

g(tz )g(tx )(h(tz ) h(tx ))

Euler Scheme

We look into the Euler Scheme for the approximation of the first-passage time

for a Gauss-Markov process.

We are given a stochastic differential equation of the form,

dXt = (Xt , t)dt + (Xt , t)dWt

0tT

X0 = x0

where, and are smooth functions. The idea is to apply the time discretization

scheme of the stochastic differential equation in question whose solution is Xt .

EULER SCHEME

18

T

T

, where N N . We denote the quantity N

as

The time discretization step is N

. Thus, the scheme looks like,

b(k+1) = X

bk + (X

bk , k) + (X

bk , k) G k+1 with k {0, 1, .....N 1}

X

X0 = x0

N (0, 1).

We define the first-passage time as = inf{t 0; Xt Lt }, where Lt is the

boundary in question. The boundary can be a simple constant boundary or an

affine boundary also. In this report, we deal with constant boundary only. Now,

we define the first-passage time in accordance with our discrete Euler scheme

T

as e = inf{ti 0; Xti Lti }, where ti = i = i N

. Thus we approximate the e

using the Euler scheme.

Gauss-Markov Process

The Gauss-Markov process has the form;

dXt = (t)Xt dt + (t)dWt

with

X0 = x0

[0,T] for every T > 0 and is a positive homogeneously Holder continuous

function. We work here with an Ornstein-Uhlenbeck process of the form,

dXt = Xt dt + dWt

with

for

0tT

X0 = x0

where is a non-positive real constant, is a positive constant and x0 is a real

T

where N is a Natural number,

constant. T > 0 The Euler scheme, with = N

is,

b(k+1) = X

bk + X

bk + G k+1 for k {0, 1, ....N 1}

X

X0 = x0

N (0, 1).

We look for the first time instance when the discrete process crosses the boundary Lt , thus we define the first-passage time or the first-hitting time as i =

T

inf{ti 0; Xti Lti } where ti = i N

for i {0, 1, ....N }. We note the first time

the crossing happens and denote that as our first-passage time.

Now, what if none of the discrete simulations touches or crosses the boundary.

Even though the discrete points might not cross, the continuous path may still

cross. In such cases, we use an exit probability at each time step to check

EULER SCHEME

19

what is the probability of crossing the boundary by the diffusion process in such

time intervals. Thus, the method will be to obtain the realizations (Xti )0iN

thanks to the Euler scheme and then conditioning on the values of (Xti ) and

(Xti+1 ),we look at the probability for the crossing to happen in-between these

two values, if and only if none of the values cross the boundary. Also we know

that (Xt )ti tti+1 has the law of some form of Brownian bridge.Using results

from the previous section which we have already proved, we get,

2(Lti x)(Lti+1 z)

bt = x, X

bt = z) = exp

P ( (ti , ti+1 )|X

i

i+1

g(ti )g(ti+1 )(h(ti+1 ) h(ti ))

where we have

the fact that > ti . where g(t) = exp(t) and

acknowledged

2 1exp(2t)

. We get these representation from Doobs Integral

h(t) = ()

2

Representation dealt in the last section.

Now, after we find this probability of crossing, we generate a uniform random

variable U(0, 1). We check this probability of exit with . The idea is the

same as before, as we are looking for a Bernoulli event such as whether the

continuous path between the two discrete path cross the boundary or not. We

want to generate a random event such that its probability of success is exactly

the probability of crossing. In this respect we know that, for a uniform random

variable y U(0, 1), P (y x) = x if 0 x 1.Thus, we generate a uniform

random variable, in this case it is and compare it with our probability of exit

p and we know that,

P ( p) = p

Thus, if p, then we accept that the continuous path between Xti and Xti+1

does cross the boundary.

Numerical Results

We look into the Euler scheme simulation of the Ornstein-Uhlenbeck process

with the help of the Brownian bridge concept.

dXt = Xt dt + dWt

with

X0 = x0

The idea in doing so, is we simulate a new value of the process at the time

point. Now, if the value exceeds the value of the boundary, we observe the time

and denote it as the first-passage time. However, if the value does not cross the

boundary value, we check the probability of crossing or exit between the newly

simulated value and its previously generated value (which was also below the

boundary) and compare it with an uniform random variable U(0, 1). The

idea is to generate a random event whose probability of success is same as the

probability of cross p.

Then, with the parameters being ;

= 1.0, = 1.0, x0 = 0.0, initialtime = 0.0, f inaltime = 10.0, timestep =

10

1

216 , = f inaltime time step = 216 , L = 0.5 and M onteCarlonumber =

200000,

EULER SCHEME

20

1.5

"simulate_path.dat"

1

0.5

0

-0.5

-1

-1.5

-2

0

10

Time

We first try to estimate the probability density function(PDF) for the firstpassage time using a kernel density estimator.

Kernel density estimator belongs to the class of non-parametric density estimators used to estimate probability density functions. A non-parametric estimator

have no fixed structure and depends on all the data points to reach the estimate.

Given a set of independent and identically distributed sample points (x1 , x2 , ....., xN )

with an unknown density function f , which we want to estimate.Formally, the

kernel estimator smooth out the contribution of each of the observed sample

points over a local neighborhood of that data point. Thus, the kernel density

estimator for this unknown density function f is,

N

N

1 X

1 1 X

x xi

c

fh (x) =

Kh (x xi ) =

K

N i=1

h N i=1

h

where h is the kernel bandwidth and Kh (x) = h1 K hx .

In, this case we use a smooth kernel

R estimator like the Gaussian kernel function.

Such a function K integrates to 1, K(x) dx = 1, and its a unimodal, smooth

function which peaks at 0. Its a very nice selection as the kernel estimator

function. Now, after we select the kernel estimator function, our job is to choose

a proper bandwidth h, since there is always a trade-off between the bias of the

estimator and its variance. If, we choose a very small value for the bandwidth,

the estimator can give us very spiky estimates(without much smoothing) or

instead if we choose too large a value for the bandwidth, it can lead to over

smoothing of the estimator. However, for Gaussian kernel estimators, we can

approximately find the optimal bandwidth h, with this formula,

h=

4 5

3N

15

=

1.06

1

N5

EULER SCHEME

21

where, is the standard deviation of the set of sample points (x1 , x2 , ...., xN ).

With, this value of h, we get a nice approximate for the pdf of the first-passage

time for the Ornstein-Uhlenbeck process.1 .

1

"firstpassagekernel.dat"

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

0

10

Figure 2: The estimated Probability Density Function(PDF) for the FirstPassage time for an Ornstein-Uhlenbeck process

Now, as we try to estimate the cumulative density function.If we have a

sample data X = {X1 , X2 , ..., XN }, by the law of large number we know that

X1 +X2 +....+XN

converges to E(X).

N

P (X x) = E(1Xx )

N

X

1X i x

N

i=1

where X denotes the sample data set for the first-passage time and N in our

above expression is the Monte-Carlo number, or the number of simulated values

we have in our data set.

Thus, we have the cumulative distribution for the first-passage time.

The cumulative distribution for the first-passage time for the Ornstein-Uhlenbeck

process is,

Now, we know that for this method,we encounter the statistical error due to

the Monte-Carlo simulation.

Now, we know that the statistical error, |E(f (X))

PM

1

V

ariance

f

(X

)|

C

, where C is some positive constant depending

i

i=1

M

M

on the confidence interval of our choice. Thus, we need to calculate the variance

of our sample data of first-passage time. Now, it is very easy to make a mistake

1 The

EULER SCHEME

22

"cumulative_density.dat"

0.9

P(First-passage Time < X)

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

0

10

Ornstein-Uhlenbeck process

in computationally calculating the variance. If, we try to calculate the variance

of a sample data of {x1 , x2 , ....., xn },

PM

V arianceexpected =

i=1

(xi x)2

M

However, such a calculation will lead to a biased calculation. In, order to get

the unbiased form of the variance we see that,

M E(V arianceexpected ) = E(

M

X

(xi x)2 )

i=1

M

X

= E(

(x2i + x2 2xi x))

i=1

M

M

M

X

X

X

= E(

x2i ) + E(

x2 ) 2E(

xi x)

i=1

i=1

i=1

M

X

xi )

i=1

Now, since x =

PM

i=1

xi

, thus,

PM

i=1

xi = M x.

as we know that {x1 , x2 , ....., xn } are independent and identically distributed.

A FAST ALGORITHM

23

Thus, the law of all the sample variables are the same. Now, we know that,

E(x2 ) = V ariance(x) + E(x)2

PM

xi

= V ariance( i=1

) + (mean)2

M

V ariance(x1 )

=

+ (mean)2

M

also, we know that E(x)= E(X) = mean, from the strong law of large numbers.

Also, as they are identically distributed, V ariance(x1 ) = V ariance and E(x1 ) =

E(X) = mean. Thus, we get,

V ariance(x1 )

2

2

M E(V arianceexpected ) = M V ariance(x1 ) + E(x1 ) M

+ (mean)

M

V ariance

2

2

= M V ariance + mean M

+ (mean)

M

= (M 1)V ariance

M V ariance

expected

=unbiased Variance for the sample data .

Thus, we get that

M 1

Thus, with such a choice of variance, we will get an unbiased variance for our

sample data and thus an accurate statistical error.

problem for a Gauss-Markov Process

The paper [1] by Taillefumier and Magnasco details the procedure they follow

to approximate the first-passage time for a Gauss-Markov process with Holder

continuous boundaries, including the Ornstein-Uhlenbeck process. The main

idea behind their algorithm is a probabilistic variant of dichotomic search. Their

method evaluates discrete points in a sample path exactly and then refines this

evaluation recursively only on regions where a passage is estimated to be more

probable.

Introduction

For the class of Gauss-Markov process, which also includes the ever so important

Ornstein-Uhlenbeck process, the numerical approximation was performed in a

new way thanks to the paper [1]. A general Gauss-Markov process has the form;

dXt = (t)Xt dt + (t)dWt

with

X0 = x0

The process was path-wise simulated at high resolution only on regions where

such a resolution was needed. Thus, numerically simulating the process accurately only when it is close to the boundary, but not when far away from the

boundary.

The Ornstein-Uhlenbeck is the one of the most studied from the class of GaussMarkov processes. It is defined as a process U , a solution to the linear stochastic

differential equation of type,

dUt = Ut dt + dWt ,

A FAST ALGORITHM

with

24

U0 = u0 (deterministic).

For example of a first-passage problem concerning an Ornstein-Uhlenbeck process is the leaky integrate-and-fire neuron. In this model the process Ut

represents the membrane potential of a neuron; any time the voltage crosses a

given threshold value, the cell fires and and emits action potential and resets

its potential to a base value.More general Gauss-Markov processes can be seen

as a Ornstein-Uhlenbeck process with the parameters and depending on

time.Certain assumptions are taken into account.They are :

1.Co-efficient Regularity Assumption : The Gauss-Markov processes are solution of a linear stochastic equation with time-dependent non-positive,bounded

function and with time-dependent positive, homogeneously Holder continuous

function .

2. Barrier Regularity Assumption : The barrier is assumed to be homogeneously

Holder continuous and non-negative.

These determine the regularity of a continuous density function for the firstpassage time and prescribes the speed of convergence of the first-passage time

computation.

Algorithm

We will embark on defining the algorithm, originally constructed by Taillefumier

and Magnasco [1].This algorithm efficiently computes the distribution of firstpassage time for a general class of Gauss-Markov processes X and of continuous

boundary L. It involves recursively implementing the probability variant of the

dichotomic search. A dichotomic search is a search algorithm that operates by

selecting between two distinct alternatives (dichotomies) at each step. It is a

specific type of divide and conquer algorithm. A well-known example is binary

search.

The idea is, to simulate the path of the process using the discrete construction

method. We generate first the final position of the process using the formula,

p

XT = g(T )x0 + g(T ) h(T )

where, is a Gaussian random variable N (0, 1).

Then we simulate XT /2 using the result of the discrete construction of GaussMarkov process. In this way, we keep on dividing and subdividing the domain to

find the values of out process at specific time.The idea behind is the dichotomic

search algorithm. The moment, we come across the value of the process Xt

2

reaching or over-shooting the value of the boundary L; by continuity of the

sample path we know that the crossing has occurred before or at t thus, we disregard continuing the simulation of the sample path for time s following t.We

are only concerned with the part of the process prior to time t and continue our

dichotomic search in that part only.

In the case, when the newly simulated value does not cross the boundary and

so does none of the values on its left and as well as its right, we can check if

the probability for a crossing to happen(we get this value with the help of the

result obtained from the section Gauss-Markov process) is larger than some

prescribed small positive real . We will be checking the probability of crossing

2 where

2k+1

T

2n +1

A FAST ALGORITHM

25

on both sides of that simulated value and then decide to continue the dichotomic

search algorithm in the part where we get a greater probability of crossing

We define a certain depth of search initially, i.e. 2TN . When this depth of

discretization is reached, we decide to look for the first-passage time for this

particular simulation. In the case when one of the simulated values cross the

boundary, the first passage time is the time corresponding to the one which

crosses the boundary first. In the other case, when none of the simulated values

cross the boundary, we check with the probability of crossing and compare the

value with an uniform random variable. If the probability of crossing is bigger

than the uniform random variable, we consider that the continuous path between the two time points in the interval; where the probability of crossing is

being checked for, has actually crossed the boundary and note the mid point of

that interval as the first-passage time.

The idea behind this probabilistic variant of the dichotomic search is to search

for the first-passage time by only simulating the process on some points where

the outcome happen close enough to the boundary L.

We are looking for the first-passage time in the interval [0,1] for a process X

defined by the stochastic differential equation of the form,

dXt = (t)Xt dt + (t)dWt

X0 = x0

where, is a non-positive function, bounded on every compact support [0,T],

T > 0, is a positive homogeneously Holder continuous function and x0 is a

given deterministic constant(real).

We hope to compute the approximate occurrences N of the true first-passage

time , with a time-step as deep as 2N . Assuming, we can generate innumerable independent identically distributed random variables of law N (0, 1) and

also independent identically distributed random variable of law U(0, 1).

1. The values of the sample path at the end point of [0,T] is given by,

p

XT = g(T )x0 + g(T ) h(T ), X0 = x0

2k+2

If we want to

2. Now, lets say, ln,k = 2n2k+1 T , mn,k = 22k+1

n +1 T , rn,k = 2n +1 T .

generate the sample path at mn,k we take help of the values of the sample path

at ln,k and rn,k due to the Markov property of the process. We generate the

sample path as per the result obtained from the discrete construction of the

Gauss-Markov process.

Thus, lets say that we have already simulated the value of the process at these

values ln,k and rn,k as, Xln,k = xn,k and Xrn,k = zn,k then from the result

obtained in the discrete construction of the Gauss-Markov process section we

get, Xmn,k = (mn,k )n,k + (mn,k ) where,

n,k N (0, 1)

A FAST ALGORITHM

26

g(mn,k ) h(mn,k ) h(ln,k )

xn,k +

zn,k

g(ln,k ) h(rn,k ) h(ln,k )

g(rn,k ) h(rn,k ) h(ln,k )

s

(h(mn,k ) h(ln,k ))(h(rn,k ) h(mn,k ))

(mn,k ) = g(mn,k )

h(rn,k ) h(ln,k )

(mn,k ) =

3. For, every 1 n N , the algorithm does not take into account any time

following the occurrence of a value of the sample path above the barrier L.

4. Finally, for n=N , we define the approximate first-passage time N as, the

first time when the sample path crosses the boundary, or if it does not, then we

look into the probability of its crossing within the time lN,k and rN,k by comparing the probability of cross with an uniform random variable distributed

as U(0, 1). If the probability of cross is larger than the then we define the

first-passage time N as the mid point of the lN,k and rN,k for the corresponding

k.

Simulation of an Ornstein-Uhlenbeck process

In this section, we work with an Ornstein-Uhlenbeck process as a representative

of the Gauss-Markov process family. The reason behind choosing an OrnsteinUhlenbeck process is that, is it one of the most popular Gauss-Markov processes.

Moreover, it has varied application in the field of physics,finance to name a few.

The Ornstein-Uhlenbeck process we work with looks like,

dXt = Xt dt + dWt

with

X0 = x0

0tT

real constant also. Moreover, we work with a constant boundary L to simulate

the first-passage time for the above diffusion process.

Of course, all the results pertaining to the Gauss-Markov process we have

described so far will become very simple. However, the idea is to apply the

algorithm to use and see its efficiency and speed.

The algorithm that was put into coding is a slight modification of the above

mentioned one.

The main ideas behind the coded algorithm are;

1.We first choose an initial depth of say 2N where N is relatively large. We

generate the final value by using the formula,

p

XT = g(T )x0 + g(T ) h(T )

and we already know the initial value as X0 = x0 and N (0, 1). We know go

about dividing the domain [0,T] by first generating the value at X T using the

2

values at X0 and XT and taking help of the result from discrete construction

of the Gauss-Markov process. Similarly, we generate X T , X 3T and so on until

4

4

we reach the depth of 2N , i.e, until we simulate the value X TN .

2

2. Once, we have generated all the values of our first round of simulation,

we look for the first time when one of such values crosses the boundary. If, none

of the values cross the boundary, we state that the process does not cross the

A FAST ALGORITHM

27

boundary and we carry on generating a new set of path for the same process.

Otherwise, if we find there exist at least one time instance when the process

crosses over the boundary, we note the first time when it happens as Tf inal .

3. We start to check for probability of crossing in each interval of time 2TN

starting from the initial value of the time chosen, which is 0 in our case, to

the value when it crosses the boundary for the

Thus,

we check the

first time.

probability of crossing between time instances 0, 2TN , 2TN , 22T

N , and so on until

we reach Tf inal .At each interval the probability = p is compared with a positive

small, real, pre-chosen . If p for a particular interval, then we subdivide

that interval like we did for the interval [0,T]. This time again, the depth is

chosen to be 2N with the same N as before.

i

h

(k+1)T

, for some k

4. After, simulating all the values in the interval 2kT

N ,

2N

T

2N

1} where the probability of cross exceeds the value of the ,

T

we look for the time when the value crosses the boundary. If such a time exists

till we reach the Tf inal , then we say it is the first-passage time for the simulated

path. Otherwise, we check the probability of crossing with an uniform random

variable U(0, 1).

Now the question arises, which probability of exit should we consider. In this

simulation, we consider that interval which has the highest probability of exit.

Now,if the probability of exit or crossing is greater than equal to the uniform

variable , we consider the mid-point of that time interval; with reference to

which the probability of crossing was measured, as the first-passage time for the

simulated path.

Numerical Simulation

The equation in question is,

dXt = Xt dt + dWt

with

X0 = x0

0tT

with = 1.0 , = 1.0, x0 = 0.0, the boundary L = 0.5, and finally the

T = 10. The depth is chosen to be 210 . First we simulate the first set of values

for X.

After the initial simulation, we check for the first time the process value has

touched or exceeded the value of the boundary L. We find such a time in this

case, and we go on checking the probability of exit in each interval with an ,

where = 0.0013 . Wherever the probability is greater than the , we simulate

more values of the process in that interval using the same idea as before.

If, one of these new simulated values touch the boundary value or crosses it, the

first one to do so becomes our first-passage time. If, not so, we check in which

interval, the probability of cross was the highest. We will already have had new

values of X simulated in that interval. This time we check the probability of

cross with an uniform random variable U(0, 1) in each of the newly formed

intervals, thanks to the second round of simulation. The first such probability

calculated to be greater than , gives us the result that although the discrete

path does not touch or cross the boundary, but the continuous path between

3 the

idea behind choosing this value of the is justified in the next section

28

1.5

"Initial_Simulation.dat"

1

0.5

0

-0.5

-1

-1.5

-2

0

10

Time

those two time instances does. Thus, we note the mid-point of that particular

interval as our first-passage time for this particular simulation.

Out here, the interval in which the investigation for the first-passage time is

going on is [6.4721, 6.4728]. The precision in discretization is concentrated on

only those intervals, where we suspect the first-passage time might exist. This

is a huge improvement in terms of speed.In this simulation, the first-passage

time is simulated as 6.47267, thus in the range described above.

We do such approximation of the first-passage time for a Monte Carlo number = 1000000, of simulations. Thanks to that we are able to approximate the

cumulative distribution and the density function in the same way as we did for

the Euler scheme, of the first-passage time for the above Ornstein-Uhlenbeck

process.

Here we compare the two previous algorithms in the sense of their speed of simulation, and efficiency. We know that with the Fast algorithm, we will be able

to simulate the first-passage time in less computational time. We attain this,

since we avoid simulating the process; under consideration, any further beyond

a point once we find a crossing has occurred. Instead of simulating with higher

precision over the entire interval, we concentrate only on the region where we

have found our first-passage time to exist.

Of course, there are some instances when the fast algorithm returns an erroneous

first-passage time. This happens when we search for the first-passage time in

an interval where the passage might take place, but its not the first time that

the process is crossing the barrier.

0.52

29

"second_round_of_simulation.dat"

0.51

0.5

0.49

0.48

0.47

0.46

0.45

6.4721

6.4722

6.4723

6.4724

6.4725

6.4726

6.4727

6.4728

Time

the first-passage time in a confined interval

"cumulative_distribution.dat"

0.9

P(First-passage Time < X)

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

0

10

Ornstein-Uhlenbeck Process

30

0.9

"density_kernel.dat"

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

0

10

Figure 7: The kernel approximation of the probability density function for the

first-passage time for an Ornstein-Uhlenbeck process

It is given that for a chosen parameter , with which we compare our probability of crossing at each interval, and for a given depth 2N , we get,

P ( N > + 2N ) = (N, )

that is the probability that a simulated first-passage time does not approximate

a true first-passage time, where, (N, ) 2N . Thus, we see that with a clever

choice of , we can lower this probability.

The choice of is done in this fashion.

ln ln (N 1)ln2 lnT

with such a choice of , we get .

Thus we look into the time and efficiency of the two algorithms with the same

variable values and same depth = 2N . Also, we simulate the first-passage time

in both the algorithms using the same Monte-Carlo number.

6.1

Numerical Results

dXt = Xt dt + dWt

with

X0 = x0

depth = 2N , = 2TN .

We first look into the results obtained from the Euler scheme for the above

SDE. We tabulate the Monte-Carlo number, the delta or the time-step, the

MCN

Delta

1000

11000

170000

2700000

0.039

0.00976

0.002441

0.00061

31

N Expected value Statistical Error

8

10

12

14

1.1566

1.1946

1.2056

1.2162

0.09301

0.0286

0.00727

0.001828

0.11

1.476

117.465

1786.091

expected value E( 1 <T ), the statistical error and the running time for the

algorithm.

We now look into the numerical result for the fast algorithm for the above

SDE.If, we want the probability for an erroneous result for the first-passage time

to be less that 1010 , we need to choose = exp(38.5). However, with such a

small epsilon, computationally, its almost equal to zero, thus we choose a much

bigger = exp(18) and hence the probability of the algorithm returning an

erroneous result also gets higher 103

MCN

Delta

1000

11000

170000

2700000

0.039

0.00976

0.002441

0.00061

N Expected value Statistical Error

8

10

12

14

1.564

1.348

1.246

1.2198

0.1235

0.0335

0.00836

0.00202

0.41

5.833

189.148

2023.65

than the Euler scheme, we do not get that in practice. This may happen due to

the fact that for this particular choice of parameters, the probability of the first

passage time being somewhere closer to the initial time is bigger than it being

nearer to the final time.

Analytical solution for the first-passage time for an Ornstein-Uhlenbeck

process

For the boundary as L = 0 and X0 = 1.0 and keeping the values of the other

things same,

1

f (x) =

2

1

sinh(x)

32

exp(x)

x

exp

+

2sinh(x) 2

The graph of the density function for the case when L = 0.5 and X0 = 0 is,

Comparing it with the density functions estimated with the Euler scheme and

the Fast algorithm respectively.

Thus, we see that the probability density function that we get is a very nice

approximation of the density function for the Ornstein-Uhlenbeck process.

We also see, that the speed of the Fast algorithm, as the Monte-Carlo number

increases, also increases.

32

1.4

"firstpassagekernel.dat"

1.2

the pdf

1

0.8

0.6

0.4

0.2

0

0

10

Figure 8: The graph of the density function using the analytical solution for an

OU process

"firstpassagekernel.dat"

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

0

10

Figure 9: The graph of the density function using the kernel approximation for

an Euler scheme

0.9

33

"density_kernel.dat"

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0

0

10

Figure 10: The graph of the density function using the kernel approximation

for the Fast algorithm

stochastic differential equation exactly. Its a very interesting and quite restricted

approach in the sense, there are some strong restriction to when we can use this

method. For example, it can not be used in a simple case as a Black-Scholes

Model or in the case of a Ornstein-Uhlenbeck processes. However, whenever it

can be put into use, it returns the exact law for the process.

Introduction

This section looks into the exact simulation of a diffusion described by a stochastic differential equation. The paper on exact simulation [3] by Beskos and

Roberts, gives a very nice algorithm to do so. The idea was further extended

in the paper [4] by Beskos,Papaspiliopoulos and Roberts.We look at the more

evolved method, mainly presented in [4]. It involves rejection procedure,whenever

applicable, and the use of Point Poisson Process(PPP) to return exact draws

from any finite-dimensional distribution of the solution of the stochastic differential equation.

Lets W = {Wt ; 0 t T } be a standard Brownian motion. Considering

the general type of a one-dimensional stochastic differential equation;

dXt = b(Xt )dt + (Xt )dWt ,

0 t T,

X0 = x0 R

R 7 R. We know that there exist a weakly unique solution to the above

stochastic differential equation if it can shown that b and are locally Lipschitz

i.e; |b(x)b(y)| C1 |xy| and |(x)(y)| C2 |xy|, where x, y R and C1

34

RT

and C2 are real constants, and E 0 (s)2 ds < holds for some T < . Also,

if the functions are Lipschitz locally, they are also continuous locally, thus the

functions b and also satisfy the locally bounded condition, since continuous

functions are bounded in a compact set.

So,assuming the above mentioned conditions on the functions b and , we

move ahead.

The exact algorithm provides an alternative method to Euler scheme, which

involves no approximation and still it is computationally highly efficient. It

returns exact sample paths. In the following part, we are going to transform

the above stochastic differential equation to a one with = 1.This can be done

by a simple transformation.

dXt = b(Xt )dt + (Xt )dWt

Let, Yt = (Xt ) such that by applying Itos formula on it we get,

1

dYt = (Xt )0 dXt + (Xt )00 (Xt )2 dt

2

1

0

= (Xt ) b(Xt )dt + (Xt )00 (Xt )2 dt + (Xt )0 (Xt )dWt

2

Thus to make the diffusion co-efficient 1, we get,

(Xt )0 (Xt ) = 1

Thus, we get,

Z

(x) =

x0

1

du

(u)

(Xt )00 =

thus, we finally get Yt = (Xt ) =

R Xt

x0

(Xt )0

(Xt )2

1

(s)

ds

Rejection sampling is a very widely used technique in numerical simulation.The

idea is to generate random variables which follow distribution say,f (y). If we

can develop an in-equality of the sort say, f (y) Cg(y);where C is a positive

real constant, and we can easily generate random variable which follow the law

of g(y), then using the rejection algorithm we can generate random variable

which follows the law of f (y). The main algorithm is as follows;

1.

2.

in

3.

4.

Rejection Sampling

Generate Y g

Generate U U(0, 1), where U(0, 1) mean uniform random variable

the range (0,1)

f (Y )

If U Cg(Y

) , return Y

else goto 1.

35

f (y).

Now, lets state a simple result of rejection sampling.

P roposition :

Let be a test function. Now, the rejection sampling gives us a random variable

x which is distributed according to fY .We use the relation fY CfX ; where C

is any positive real number, to generate candidates from fX and use the rejection sampling method as described before. Now, the comparison is made with

fY (x)

then we

a uniform random variable U U(0, 1), in the sense if, U Cf

X (x)

accept the random variable x which was drawn originally from fX , otherwise

we keep on drawing.

Now, we state that,

fY (x)

E((Z)) = E (X)|U

CfX (x)

Proof:

Z

E((Z)) =

(z)fY (z) dz

Z +

fY (z)

fX (z) dz

Cf

X (z)

fY (z)

= CE (Z)

CfX (z)

=C

Now, since

fY (z)

CfX (z)

(z)

if, 0 a 1; a = P (U a) = E(1U a )

E((Z)) = CE (Z)1U fY (z)

CfX (z)

fY (z)

fY (z)

= CE (Z)|U

.P U

CfX (z)

CfX (z)

Now,

fY (z)

P U

= E 1U fY (z)

CfX (z)

CfX (z)

Z

fY (z)

=

fX (z) dz

R CfX (z)

1

=

C

Thus, the probability of rejection or acceptance depends on the constant C

only.

36

Exact Algorithm

Considering the diffusion process Y ={Yt ; 0 t T }, which follows the stochastic differential equation;

dYt = (Yt )dt + dWt

0 t T,

Y0 = y0 R

The drift function is assumed to satisfy the Lipschitz condition and also a

growth bound locally.

The main idea behind this algorithm is applying Girsanovs Theorem to make

the process simple enough to simulate. We apply Girsanovs Theorem once to

change the processYt into a standard Wiener process under some probability

space. Then we apply the Girsanovs theorem to change the probability space

so that under it, the process now becomes a Brownian bridge like process. There

are more intricate details in the process of changing the probabilities, but we

will get to that in detail while explaining the entire process.

We first define a sample space (, F) which is equipped with a probability

measure P . Now, under this measure, the Brownian motion which propels our

diffusion process is defined as W = {Wt ; 0 t T }. We know if we have

transform the diffusion process at hand Yt into a standard Wiener process, we

have to take help of Girsanovs Theorem. Now;

dYt = (Yt )dt + dWt

Now, lets say the new probability measure Q under which Yt is a Wiener process

ft .

of the form W

Some notes on Girsanovs Theorem:

Z

Z t

1 t

|s |2 ds}

Let, Z(t) = exp{

s dWs

2

0

0

!

Z T

1

Novikovs Proposition : EP (exp

|t |2 dt < +

2 0

Then, if {t } is an adapted process satisfying the Novikovs Proposition, and

for each T > 0 Z(T ) is a likelihood ratio: that is, the formula;

Q(F ) = EP (Z(T )1F )

defines a new probability measure on (, F). Girsanovs Theorem describes

the distribution of the stochastic process {W (t)} under this new probability

measure. We define,

Z

t

ft = Wt

W

s ds

0

Then, the Girsanovs Theorem states that under this new probability measure

ft }0tT is a standard Wiener process.

Q,the stochastic process {W

Now, we have to transform the original equation we had, dYt = (Yt )dt+dWt

into a Brownian motion under some new probability measure Q. Thus taking

37

g

WtQ = Wt

dQ

= exp{

dP

s ds

0

T

1

s dWs

2

|s |2 ds}

ft

dYt = ((Yt ) + t )dt + dW

ft , we want ((Yt ) + t ) = 0. Thus,

Now, since we want Yt to be of the form W

we get

ft under the new probability measure Q Thus;

t = (Yt ) and Yt = W

E P (T (Y )) = E Q (T (Y )

dP

)

dQ

Z

= E (T (Y ) exp{

f ) exp{

= E Q (T (W

Z

0

0

T

1

s dWs +

2

|s |2 ds})

fs ) dW

fs 1

(W

2

fs )2 ds})

(W

Thus, we get :

Z T

Z

1 T

dP

f

f

ft )2 dt) = G(W

f)

= exp(

(Wt ) dWt

(W

dQ

2 0

0

R

T

fs ) ds ) < +.

This holds if E Q (exp 21 0 (W

Assuming the Novikovs Proposition, we can define the change of the probability

measure.

RT

ft ) dW

ft

above expression, but the difficulty lies in evaluating exp( 0 (W

R

1 T

2

f

2 0 (Wt ) dt).We can simplify the expression using Itos formula to remove

the Ito integral.

R u Assuming that the drift co-efficient is differential everywhere,

let A(u) = 0 (s) dy. Now, looking at the Itos formula for this function, we

get;

Z

Z T

1 T 0 f

f

f

g

f

(Wt ) dt

(Wt ) dWt = A(WT ) A(W0 )

2 0

0

Thus putting the previous relation into the main equation of probability change,

we get

!

Z T

0

1

2

f ) = exp A(W

g

f

ft ) + (W

ft )) dt

G(W

( (W

T ) A(W0 )

2 0

Now, rejection sampling using the candidates from Brownian motion is possible

f ) is bounded. Now, for that to happen we would

only if we can assure that G(W

38

need A to be bounded, thus increasing the restriction on A.In order to get rid

of this strong condition, we introduce a third probability measure Z, which will

be finally used to construct the candidates for the rejection sampling.

We will use candidate paths from a process which is identical to a Brownian

motion except at the end point, i.e at time T . Such, processes are known as

c

biased Brownian motion, W

P roposition:

Let M = {Mt ; 0 t T }, N = {Nt ; 0 t T } be two stochastic processes

on (, F) with corresponding probability measure M and N . Assuming that

fM and fN are the densities of the ending points MT and NT respectively with

identical support R. If, it is true that (M |MT = ) (N |NT = ) for all R,

then;

fM g

dM

() =

(WT )

dN

fN

Proof:

The property, (M |MT = ) (N |NT = ) for all R can be expressed in a

more rigorous way as ;

g

g

M [A|(W

T )] = N [A|(WT )]

a.s.

M [A] = EN [1A

fM g

(WT )]

fN

Now,

EN [1A

fM g

fM g

g

(WT )] = EN [EN [1A

(WT )|(W

T )]]

fN

fN

fM g

g

= EN [

(WT )EN [1A |(W

T )]]

fN

fM g

g

(WT )N [A|(W

= EN [

T )]]

fN

g

= EM [N [A|(W

T )]]

g

= EM [M [A|(W

T )]]

g

= EM [EM [1A |(W

T )]]

= M [A]

Now, we use the above proposition to get the density function for

the final posi

g

f

tion for the biased Brownian motion. We want to get rid of the exp A(W

T ) A(W0 )

f ). Thus, changing the probability measure from Q to Z we want

part from G(W

the change of probability to be of the form;

dQ

g

f

= exp A(W

T ) + A(W0 )

dZ

g

= C1 exp A(W

T)

39

f0 ) .

where C1 is a constant of the form exp A(W

Now, from the previous preposition, we know that;

dQ

=

dZ

1

2T

y0 )

)

exp( (WT2T

g

hT

where, hT is the density of the end point of the biased Brownian motion. The

numerator for the above expression comes from the fact that under the probag

bility measure Q, we have a Brownian motion W

T N (0, T ). Thus, we get the

final expression for the density function hT ;

!

2

g

(W

1

T y0 )

g

exp A(WT )

hT =

2T

C1 2T

Now, we see that,

dP

dP dQ

=

.

dZ

dQ dZ

1

= exp

2

ct ) + (W

ct )) dt

( (W

0

Thus,to recapitulate the notations used so far, under the probability measure

f is a Brownian

P , W is a Brownian motion, under the probability measure Q, W

c is a biased Brownian motion in

motion and under the probability measure Z, W

d

the sense that the end point, i.e. W

T is distributed according to some probability

density function hT .

Now, we can go ahead in our endevour if we assume that the expression

0

inside the integral 12 ( (.) + 2 (.)) is bounded from below at least. If it is so,

0

k1 and k2 R s.t. k1 21 ( (.) + 2 (.)) k2 , then we can define a new

0

function (.) = 12 ( (.) + 2 (.)) k1 .

Thus, we will get,

!

Z T

dP

ct ) dt

= C2 exp

(W

dZ

0

R

T

where C2 is a constant that come from exp 0 k dt .

Thus, for any test function , we get,

Z

c ) exp

EP ((Y )) = C2 .EZ (W

!!

ct ) dt

(W

= C2 .EZ

!!

Z

c )|something whose probability of happening is

(W

exp

ct ) dt

(W

0

Z

P

exp

!!

ct ) dt

(W

0

Z

EP ((Y )) = EZ

(W

exp

0

!!

c

(Wt ) dt

40

Now comes the most important part of this section, the algorithm to generate

the exact sample path for the solution of the stochastic differential equation.

Algorithm

The main difficulty in ourapproach will be

to find something whose success of

RT

c

happening is equal to exp 0 (Wt ) dt . However, we are lucky to have the

Point Poisson Process, which helps

Rus to give us a situation where we can get

T

ct ) dt .

the success of something as exp 0 (W

A Point Poisson Process(PPP) on a domain D(e.g [0,T] x [0,K]) with intensity

I(t, x) is a collection set of random points {(t1 , x1 ), (t2 , x2 ), ......., (t(I) , x(I) )}

in the domain D, where is a random function of the intensity I.We define

N (A, ), for A D and defined on a probability space (, F, P ). We

define N (A, .) to denote the measure or the number of points of the Point Poisson Process in the set A D for one realization of the process.

Characterization of a Point Poisson Process :

For all A D, N (A, ) for a particular realization of the random

process,

R

is a random variable in itself with a Poisson law of parameter A I(t, x) dtdx.

That is, the random variable NA = N (A, ), has the representation as ,

R

R

( A I(t, x) dtdx)k exp A I(t, x) dtdx

P (NA = k) =

k!

For all subsets A and B of D, with empty intersection of points,implies that NA

and NB are also independent random variables.

A particular case can be with an intensity I = 1 and D = [0,T] x [0,K]. In

this case the random

number of points in a set A D, NA , has a Poisson law

R

with mean = A I(t, x) dtdx = V olume(A).

In such a PPP, {(t1 , x1 ), (t2 , x2 ), ......, (t , x )} where is some random function

of our intensity and we choose the time to increase as t1 t2 ..... t , in that

case the time is distributed according to exponential law as, tk+1 tk E(K)

such that tk [0, T ]k, where K is the upper bound for the spacial co-ordinate,

in this case x [0, K] . Also, the space variable is distributed according to the

law of uniform random variable as, xk U(0, K) for all k.

Proof : Now, with the intensity we choose, i.e I = 1 , we can get the above

relations. Also, remembering that the above relations and the proof that will

follow will only be valid for the chosen intensity and the chosen set D.

With I = 1, we get

R

A

41

P (x1 > ) = P (No. of points in[0, ]x[0, t1 ] = 0, No. of points in[, K]x[0, t1 ] = 1|

No. of points in[0, K]x[0, t1 ] = 1)

= P (N[0,]x[0,t1 ] = 0, N[,K]x[0,t1 ] = 1|N[0,K]x[0,t1 ] = 1)

= P (N[,K]x[0,t1 ] = 1|N[0,K]x[0,t1 ] = 1)

V olume([, K]x[0, t1 ]) exp(V olume([, K]x[0, t1 ])) exp(V olume([0, ]x[0, t1 ])

V olume([0, K]x[0, t1 ]) exp(V olume([0, K]x[0, t1 ]))

(K )t1

=

Kt1

=1

K

Thus,

P (x1 ) = 1 (1

)=

K

K

Thus, we obtain the fact that the space variable is uniformly distributed on the

domain [0,K], owing this to the intensity chosen as 1.

Now, we look into the distribution of tk by looking into t1 .

P (t1 > ) = P (N o.of pointson[0, ]x[0, K] = 0)

= exp(V olume([0, ]x[0, K]))

= exp(K)

Thus,

P (t1 ) = 1 exp(K)

Thus, we get that t1 E(K). Now,if we translate the origin to the previously

generated value, tk and simulate the next value as tk+1 tk E(K)

We needed

R to generate

something whose probability of success would have been

T

c

exp 0 (Wt ) dt . Now we can see that with the help of PPP, we can simct )] such that if N =

ulate a PPP with unit intensity on [0,T] x [0, sup0tT (W

ct )}; t [0, T ], then ;

number of points of the PPP below the graph of {t, (W

!

Z T

ct ) dt

P (N = 0) = exp

(W

0

P (N = 0) = exp(Volume of A)

ct )};

wher, A= the part of the space-time axis which lies under the graph of {t, (W

t [0, T ].

RT

ct ) dt, so putting the pieces together, we get

Thus, Volume of A = 0 (W

!

Z T

c

P (N = 0) = exp

((Wt ) dt

0

42

Thus, we finally get the random event whose probability of success is exactly

what we were looking for.

Now, we are in a position to write the proper algorithm for the simulation

of the exact path for the diffusion process in question.

Exact Simulation

1. Generate a random variable (T ) hT , and set (0) = 0

2. Generate a Point Poisson Process(PPP) on the domain [0,T] x [0,K], where K

ct ), with unit intensity4 . Thus, ts+1 ts E(K) and xs+1 xs

= sup0tT (W

U(0, K)

3. We generate all the interim values of the process at all the times generated

from the PPP, using the concept of the Brownian

0 bridge

4. We compare the the values of ((ti )) = 12 ((ti )) + 2 ((ti )) k; where

(ti ) is the value of the process at some generated time ti , thanks to PPP,

[

with our space variable of the PPP to the scope of, ((t

i )) < xi . If, this holds

0

for all the i s such that ti T , then we accept the path as our exact simulated

path of our original process as the two processes X and are equal in law.

[

5. If ti (ti T ), s.t.((t

i )) xi , then we back to step 1.

Exact Simulation

1. Generate (T ) hT and set (0) = 0

2. Generate a PPP on [0,T] x [0,K] with unit intensity

3. Generate the values of the process at all the interim time

points generated with the help of the PPP, using the concept of

the Brownian bridge

4. If, ((ti )) < xi i, s.t ti T ; where (ti ) is the value of the process at the time ti and xi is the space variable generated during

the PPP, then end

5. Else goto 1

The above algorithm returns an exact skeleton of the desired process X at

a finite number of time points.

Numerical Simulation

We are restricted on our choiceof the SDE, mainly because of the bounded0

ness criteria of 21 (.) + 2 (.) . In a later paper[4], they showed how the

0

idea can be extended to the case when limsupx 12 (x) + 2 (x) < or

4 Intensity being 1 means there is an equal of probability of choosing any point in the

domain, thus no point is more favourable than another

0

limsupx 21 (x) + 2 (x) < .

dXt = sin(Xt )dt + dWt

X0 = x0

We know that Xt and (t) are equal in law, Thus, simulating the accepted path

for gives us the exact path for X.

x0 = X0 = 10.5, T imef inal = 10.0, sup0tT ((ti )) = sup0tT 21 cos((ti )) + sin2 ((ti )) +

9

9

1

2 = 8 . Thus, K = 8 .

We have the exact skeleton of the process defined by the SDE,

10.5

"samplepath.dat"

10

9.5

8.5

8

0

10

15

20

25

30

Time

We, know look into the first-passage time for such a process. How to simulate the first-passage time in this case.

Now, after implementing the exact simulation, we accept a path with values

of the diffusion in question at some time points between initial time =0 and

final time = T. The time points in between are evaluated such that, every

Tk+1 Tk is exponentially distributed with parameter K(where K is the sup

of the function ). Now, we are interested in the first passage time. We have

Tk+1 , Tk , XTk+1 , XTk .Let us denote XTk+1 = y, XTk = x, and Tk+1 = t1 , Tk = t2

just for convenience stake. Now, we look into the probability of the process

Now, since we are dealing here with Brownian bridge, we will give the following results for Brownian bridge. Thus, from now on we will be recognizing

x,y .

our diffusion process in question with a Brownian bridge of the form Bg

Now, what we are dealing here is a biased Brownian motion(Brownian

x,y = {B ; t t t |B = x, B = y}. We want to see, how we can

bridge) Bg

t 1

2

t1

t2

represent this biased Brownian motion with the help of an unbiased Brownian

motion.Let our unbiased Brownian motion be represented as B = {Bt ; t 0}.

x,y

Y, = Bt1 + Bg

Bt2

t

unbiased Brownian motion that we so want to associate with.

We get the above expression from previous result on the construction of a Brownian bridge,i.e. we have the complete relation between the biased Brownian

x,y

motion Bg

and the unbiased one which we construct from the Y, . We know,

t

Bt1 = x and Bt2 = y. Thus, what we have is,

x,y

Bg

= Bt1 + Bt2 + Y,

t

t

t t1

2t

x,y

Bg

=

x+

y + Y,

t

t2 t1

t2 t1

Now, we know that, Y, N (0, a2 t1 + b2 (t t1 ) + c2 (t2 t))

Knowing the values of a, b, c, we can directly put the values into the above

equation and get the final value of Y, .

(t2 t)(t t1 )

Y, N

(t2 t1 )

Thus, finally we get,

t2 t

x,y

Bg

=

x+

t

t2 t1

t2 t

x,y

Bg

=

x+

t

t2 t1

t t1

y + B (t2 t)(tt1 )

t2 t1

(t2 t1 )

t t1

t2 t

y+

B tt1

t2 t1

t2 t1 t2 t

Thus, we have been able to relate our biased Brownian motion with an unbiased

one.

The next job will be to look into the first-passage of our biased Brownian motion

with the help of results known to us for unbiased Brownian motions(even with

drift).

We define the first-passage time for our original process as,

x,y

x,y

L = inf{t [t1 , t2 ]; Bg

L}

t

and the first-passage time for Brownian motion with drift will be defined as,

45

, = inf{t 0; Bt + t}

P (Lx,y > s)

where =

where,

x,y

= P (Bg

u < L; t1 u s)

t2 u

u t1

t2 u

=P

B ut1 < L; t1 u s

x+

y+

t2 t1

t2 t1

t2 t1 t2 u

Ly

Lx

s t1

+

u ; 0 u

= P Bu <

t2 s

t2 t1

t2 t1

s t1

= P , >

t2 s

Lx

t2 t1

and =

Ly .

t2 t1

xt2 + t1

f or 0 x

x+1

We, know the distribution of the random variable , from the very famous

Bachelier - Levy formula,

( + u)2

f, (u) = 3 exp

, f or u > 0

2u

u 2 2

g(x) =

Thus, this way we can actually derive the analytical result for the first-passage

time for the biased Brownian motion in each interval, and in return get the

first-passage time for the original diffusion process X in each such intervals.

European vanilla option is a contract giving the option holder the right to buy or

sell one unit of underlying assets at a prescribed price, known as exercise price or

strike price K, at a prescribed time, known as expiration date T. Barrier options

are similar to standard vanilla options except that the option is knocked out or

in if the underlying asset price hits the barrier price, B, before expiration date.

Since 1967, barrier options have been traded in the over-the-counter (OTC)

market and nowadays are the most popular class of exotic options. Therefore it

is quite important to develop accurate and efficient methods to evaluate barrier

option prices in financial derivative markets.

Pricing a barrier option is done mainly with the help of the expectation approach,which requires the knowledge of the risk-neutral probability density of

the underlying asset price as it breaches the barrier from above or below.Barrier

option prices are then obtained, by integrating the discounted pay-off function

for the barrier option over the calculated density.

Let the underlying asset price St follows the following stochastic differential

equation(SDE),

dSt = (St , t)dt + (St , t)dWt ,

with

St0 = s0

Now, by the above described method, we will get the price of the barrier option

as,

V (s0 , T ) = E Q ((ST 1 >T )|St0 = s0 )

46

(ST 1 >T ) is the discounted pay-off function which depends only on the price

of the asset at the maturity and E Q is the expectation calculated under the

risk-neutral probability. In case of a complete market, this risk-neutral probability is unique.

We take into account the case of knock out barrier options, which means they

will be worthless once the asset price hits the boundary or the barrier, in this

case which is B. If, we assume a very simple pay-off function of the form

(ST 1 >T ) = exp(r(T t0 ))max(ST K, 0) and (ST 1 T ) = 0. Here, K

represents the strike price and r is the interest rate obtained from risk less asset

and T is the maturity time or the expiration time.

In order to approximate the price of the option according to the formula mentioned above, we employ a Monte-Carlo method, which is a very simple and

robust numerical method. The main drawback of such a method is its slow

rate of convergence. From, Central Limit Theorem, we know that the statistical

error,

M

CN

X

s.d

1

f (STj ) | C

|E(f (ST ))

M CN j=1

M CN

where M CN denotes the number of Monte-Carlo simulations, s.d is the standard

deviation of our sample data and C is a constant depending on our confidence

interval. Thus, we see that in order to lower the statistical error, we have to

either increase the number of simulations or decrease the standard deviation or

in turn the variance.

We look into the Euler scheme to model the price of a barrier option.The

SDE under consideration is;

dSt = (St , t)dt + (St , t)dWt

with

St0 = s0

where and are known as the drift function and the volatility function respectively.We want these functions to be Lipschitz on any compact support [0,T] for

any T0. This condition will give us the existence and the uniqueness result

for the above SDE. Once, we have established these results, we look forward to

simulate the asset price. It is done, with the help of the Euler scheme.

T

where = N

with N = number of discretization points, k, k + 1 denotes the

kth and the k + 1th iterated solution of the above

SDE and G N (0, 1).

Also, we know that W(k+1) Wk N (0, ) = N (0, 1)

What we are interested is in, E(f (ST )), which is suppose to give us the price

of the option concerned. Here f (ST 1 >T ) is the pay-off function associated

to the diffusion and T is the expiration or the maturity time. For a typical

European Call Option, the pay-off function is ; f (ST ) = max((ST K), 0)

where K is the strike price5 .

5 Strike price is the priced determined by the buyer(seller) of the option, such that if the

price of the option goes beyond(under) the determined strike price, the buyer(seller) of the

option can still buy(sell) at the strike price.

47

Now we employ Monte-Carlo method to approximate E(f (ST )). We simulate, lets say, MCN(the number of Monte-Carlo simulations) values of XTm using

the above mentioned Euler Scheme and approximate the E(f (ST )) by;

m

E(f (ST ))

1 X i

(S K)

m i=1 T

Now, in following the Euler scheme, we know that there is a weak error due

to discretization which is of the order 1. However, we can get rid of this error.

The error mainly comes from the fact, that the discrete path may not cross

the boundary, but the continuous path between two discrete values may still be

able to cross the boundary. This can be checked if we introduce the concept of

crossing probability associated to Brownian bridge. This crossing probability

has been introduced before. We are merely just recalling it. Thus, as before, we

compare this probability of cross p with an uniform random variable . If the

uniform random variable p, then we accept that the path between two values of the price of the asset, has indeed crossed the boundary, iff the two values

are below the boundary. Now, we know that the expression for this probability

of cross is not the simple. We know it for some cases. Since, we are dealing

with Gauss-Markov processes, we will assume that the price of the underlying

asset is a Gauss-Markov process and its SDE is given by,

dSt = (t)St dt + (t)dWt

with

St0 = s0

positive constant.

In this case we can very easily define the probability of cross,

Thus, we define ,

2(B x)(B z)

P (supti tti+1 St |Sti = x, Sti+1 = z) = exp

g(ti )g(ti+1 )(h(ti+1 ) h(ti ))

R

t

T

where, ti = i N

for i {0, 1, ...., N 1}, g(t) = exp t0 (u) du and h(t) =

R

Rt

u

(u)

exp

(s)

ds

du. We get these functions, g and h from the

t0

t0

Doobs Integral Representation, proved previously.

We now just have to compare this probability of exit or cross, after we simulate a new value of the price which is below the boundary. We compare it

with a uniform random variable . The idea behind doing so, is we are looking

for a random event whose probability of success is equal to the probability of

exit or cross. Now, we know that for an uniform random variable U(0, 1),

P ( < p) = p 0 p 1. Thus, the probability of success of < p

is same as the probability of exit. This helps us to get rid of the error due

to discretization due to the application of the Euler scheme for the numerical

approximation.

48

Numerical Simulation

For the numerical simulation purpose, we simulate the price according to the

following equation,

dSt = St dt + dWt

with

S0 = s0

where, = 0.01, = 1.0, x0 = 10.5, strike K = 11.0 The Euler scheme looks

likes,

S(k+1) = Sk + Sk + G k+1

where k = 2kT

N for k {0, 1, ..., N 1} for a certain N , and we know that

The pay-off function in this case is chosen to be (ST 1St < B0 t T ) =

max(ST K, 0).

Thus, we simulate the values of the asset price at the discrete points until the

value crosses the boundary B = 12.8. If the value does not cross the boundary,

we check with the exit probability. We stop the simulation, once we get one of

the simulated values cross the boundary or we get the continuous path between

two simulated values cross the boundary.

Here is the simulation of the asset price We simulate the above Euler scheme for

12

"process_path.dat"

11.5

11

10.5

10

9.5

9

8.5

0

10

Time

some Monte-Carlo number to get the price for the option. We price the option

in a fashion such as, we check for the price of the asset to cross the boundary.

If, we attain a value due to the Euler scheme which crosses the boundary, we

immediately put the price data of the option due to that particular simulation

as 0. We also put the price as 0, when we get that the continuous path between

two simulated values cross the boundary. Each such Monte-Carlo simulations

add to the sample data for the price of the option and we finally calculate the

49

price as,

PM

i=1

(STi K)

M

taking only those values of STi s whose entire simulated path is below the boundary value, in this case it being B and also if the final value STi is greater than

K.

Table 3: Pricing the Option - Euler Scheme

Monte-Carlo Number N

Price

Statistical Error

10000

100000

1000000

8

9

10

0.000319

0.001

0.0038

0.00028

0.00012

0.000082

to simulate the price of the option. We follow the Doob Integral representation

to simulate the final value for the price and use the discrete construction for the

Gauss-Markov processes to simulate all the middle values.

Now, after the application of the fast algorithm, if we do not find a single

value of the asset price crossing the boundary B or the probability of crossing

is always falling short of the uniform random variable generated, we simply add

(ST K) to the sample data for our pay-off function if ST > K. Otherwise,

the moment we find one of the values crossing the boundary either in the first

round of simulation or in the second round of simulation on confined intervals,

we immediately add 0 to our sample data for the pay-off function.

The method of finally obtaining the price of the option, represented as the

expected value of the pay-off function as,

!

PM

i

i=1 (ST K)

E((ST 1St <B0tT )) = E(max(ST K, 0)) = E

M

where M is the Monte-Carlo number of simulations done.

European barrier option.

Monte-Carlo Number N

Price

Statistical Error

10000

100000

1000000

8

9

10

0.000298

0.000989

0.00372

0.00032

0.00023

0.000076

10

10

CONCLUSION

50

Conclusion

We look into the first-passage problem mainly pertaining to Gauss-Markov process, barring the Exact simulation algorithm. It is true that we know how the

probability density function for the case of an Ornstein-Uhlenbeck process looks

like, however the expression is quite cumbersome and long. What, we were most

interested here were general Gauss-Markov processes. We may have simulated

only Ornstein-Uhlenbeck like processes, but our aim was to give general results.

We see, that when applicable the Exact simulation algorithm returns very accurate results for the first-passage time. It just takes help of the first-passage time

for a Brownian motion over an affine boundary, which is very simple to simulate

since we know exactly the density for it. However, the algorithm restrict its

usage to a great deal.

a lot. Also, my initial purpose of working on this report was mainly the financial application part, however the more I worked on this topic the more I

started to cherish it and thus finally the section on financial application found

itself almost towards the end, thus showing my change of motivation. I found

the problem more interesting rather than the application it has, thus increasing

my interest on first-passage time problems in general.

11

Acknowledgment

I would like to thank the entire Team of TOSCA in INRIA, Sophia, specially

Etienne Tanre for his constant support and guidance at every step of my report.

Without his support, this report would not have been possible. I would also

like to extend my gratitude to Denis Talay for welcoming me into the group

TOSCA to write my Master report, Francois Delarue our coordinator, James

Inglis and Camilo Andres Garcia Trillos for the numerous talks and discussion

which helped me in ways more than one. Finally, I would like to thank Bruno

Rubino, of University of LAquila, Italy, for giving me this wonderful opportunity to study in the course MATHMODS.

References

[1] Thibaud Taillefumier, Marcelo O.Magnasco (2010) A Fast algorithm for

the First-Passage Times of Gauss-Markov processes with Holder Continuous Boundaries.

[2] Thibaud Taillefumier (2008) A Discrete Construction for Gauss-Markov

Processes.

[3] Alexandros Beskos,Omiros Papaspiliopoulos and Gareth O.Roberts (2006)

Retrospective Exact Simulation of Diffusion Sample Paths with Applications.

[4] A.Beskos and Gareth O.Roberts (2004) Exact Simulation of Diffusion.

REFERENCES

51

Barrier options.

[6] Peter W.Buchen Pricing European Barrier Options

[7] I.Karatzas and S.Shreve Brownian motion and Stochastic Calculus

[8] Jim Pitman Point Poisson Process

[9] A C - Primer

[10] E.Gobet Weak approximation of killed diffusion using Euler scheme

[11] Griselda Deelstra Remarks on boundary crossing results for Brownian

motion

[12] David Williams Probability with Martingales

[13] Pierre Patie On first passage time problems motivated by financial applications

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