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11

My understanding is because the Ito's integration definition keeps the martingale property. With Brownian motion $W(t, \omega)$ defined, to define stochastic integration in a Riemann–Stieltjes style: $$\int_0^t f(t, \omega) d W(t, \omega) = \lim_{\| \Delta_n\| \to 0 } \sum_{i=1}^{n} f(\tau_i,\omega) \left ( W(t_i, \omega) - W(t_{i-1}, \omega) \right ) $$ , ...


9

In fact Ito and Stratonovich calculus are both mathematically equivalent. In the following paper you can e.g. see that both derivations lead to the same result, i.e. the Black-Scholes equation: Black-Scholes option pricing within Ito and Stratonovich conventions by J. Perello, J. M. Porra, M. Montero and J. Masoliver From the abstract: Options ...


4

Note that $$P(X_i >s)= \exp\Big(-\int_0^s \lambda_i(u) du \Big),$$ for $i=1, 2$. Then, $$P(\min(X_1, X_2) >s) = P((X_1>s)\cap (X_2>s)) = P(X_1>s)P(X_2>s) = \exp\Big(-\int_0^s (\lambda_1(u)+\lambda_2(u)) du \Big).$$ That is, the hazard function for $\min(X_1, X_2)$ is $\lambda_1(s)+\lambda_2(s)$. Alternatively, note that $$\lambda_i(s) = ...


3

The general effect of quantitative analysis of the markets is to enforce randomness. Suppose a strategic quant finds a predictable pattern where a stock always rises on Tuesdays. His institution will commence buying the stock every Monday, and selling on Tuesday. The trading itself pushes the stock price up on Monday and down on Tuesday (in general), so if ...


3

1) Gatheral expresses everything in forward terms: forward value of the spot and of the call. Consider an asset $A$. You need to hold $A$ at time $T$ but since you don't need it now you don't want to buy it now. Instead you enter a forward contract with someone that says that at time $T$ you will pay the amount $K$ and get the asset in exchange. What ...


3

To price financial instruments such as options, bonds and stocks must be priced so as to be "arbitrage free". The concept of arbitrage can be made precise by one of the fundamental ideas of quantitative finance, the so called Arbitrage Theorem. Put differently the Arbitrage Theorem provides a very elegant and general method for pricing derivative ...


3

Optimization is definitely important in Quantitative Finance, especially for portfolio optimization where we maximize utility of the return of a portfolio as linear weighted vector of asset returns subject to a desired risk level: $$ \max_{w\in[0,1]^n} U(\mu_p(w),\sigma_p(w))\quad s.t. \sum_{i=1}^n w_i=1$$ where $w$ being the portfolio weights, and $U$ ...


3

The initial condition for the backward Kolmogorov PDE is that $$ u(0,x) = g(x) $$ for all $x$ in the relevant domain and not just at a particular point. So if your functions $f$ and $g$ agree only at a single point the initial conditions are in fact different.


2

Look at randommatrixportfolios.com


2

In many cases, clients want to be fully invested and don't want their assets lying around in cash. Hence the budget constraint $\sum_i w_i = 1$ is fairly common in practice. By the way, there are also cases where the constraint $\sum_i w_i = 0$ is applied: the result is a dollar neutral portfolio with long and short positions, but no net investment (short ...


2

I see your argument with the math. "1" is an arbitrary choice of positive numbers, and you could choose anything. In the end, you're going to scale the whole thing to fit your capital anyway. If you are using a numerical optimizer, it will be happier with something noticeably away from 0 and away from infinity, so I recommend choosing a specific positive ...


2

We use Derman and Kani's notations. Arrow-Debreu prices The Arrow-Debreu price $\lambda_i$ is the price of the security $\Lambda_i$ paying \$1 in node $(n, i)$, and \$0 in all other states $(n, j)$, for $j \neq i$. Let $\mathbb{P}_{n,j}$ be the risk-neutral probability of getting to state $(n,j)$, from state $(1,1)$. The price of $\Lambda_i$ is the ...


2

I think the main difference even in this little example is the gain-loss asymmetry which is a known stylized fact: When you look at the big bump both time series posses your artificial one is perfectly symmetric whereas the real one takes longer for going up and then crashes in a relatively shorter time frame. This is a known phenomenon in real financial ...


2

The above question was a typo due to the author -- the expression should be evaluated as \begin{equation} E(t|\mathcal{F}_{s}^{W}) = t \end{equation} due to the reasoning in the question. Sorry for the noise.


2

Some more concrete sources on Barrier option in the B&S setting and PDEs PDE methods for pricing barrier options (quite technical) Pricing Europ ean Barrier Options More of a general remark to PDE approaches in finance Ilya as far as I know the literature on that topic is quite limited. Solving a PDE means solving a PDE - it does not matter in ...


1

Could you please be more specific with your question and post the text here? This will be more helpful for other people visiting the site. Now as far as to where the 1/2 went, usually people put 1/2 in front of the second order term because this will simplify to 1 after the derivation: $$ \frac{\partial x^2}{\partial x} = 2x $$ vs $$ \frac{1}{2} \cdot ...


1

t τ----T A FRA from $\tau$ to $T$ pays the difference between the fixed rate and the actual fixing (Libor), discounted from $T$ back to $\tau$ at the Libor rate. This is from when that was a good measure of the risk free rate, with the idea that you would receive this and invest at Libor from $\tau$ to $T$. Thus the cash flow at $\tau$ is: ...


1

Both the quantity $\frac{1}{p(T_{i-1},T_i)}(A-p(T_{i-1},T_i))^+$ and the quantity $(A-p(T_{i-1},T_i))^+$ are known at time $T_{i-1}$. Then the payment $\frac{1}{p(T_{i-1},T_i)}(A-p(T_{i-1},T_i))^+$ at time $T_i$ discount back to time $T_{i-1}$ is the equivalent payment. That is \begin{align*} \bigg[\frac{1}{p(T_{i-1},T_i)}(A-p(T_{i-1},T_i))^+\bigg] \times ...


1

Portfolio management is about solving problems in the real world. In the real world, it is highly unlikely that EVERY asset has a negative expected return. If all the assets in your universe have negative returns, expand your universe to include a short-term fixed income security that is bound to produce a return greater than (or at a minimum equal to) ...



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