zvi wienerconttimefin - 5 slide 1 financial engineering continuous time finance zvi wiener...
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![Page 1: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/1.jpg)
Zvi Wiener ContTimeFin - 5 slide 1
Financial Engineering
Continuous Time Finance
tel: 02-588-3049
![Page 2: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/2.jpg)
Zvi Wiener ContTimeFin - 5 slide 2
Futures Contracts Mark to market Convergence property Spot-futures parity Cost-of-carry Martingale Risk-neutral Measure Forwards and Futures Girsanov’s Theorem and its counterpart Feynman-Kac Formula Stochastic optimization The Maximum Principle
![Page 3: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/3.jpg)
Zvi Wiener ContTimeFin - 5 slide 3
Futures Markets
Futures and forward contracts are similar to options in that they specify purchase or sale of some underlying security at some future date.
However a future contract means an obligation of both sides.
It is a commitment rather than an investment.
![Page 4: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/4.jpg)
Zvi Wiener ContTimeFin - 5 slide 4
Basics of Futures Contracts
Delivery of a commodity at a specified place, price, quantity and quality.
Example: no. 2 hard winter wheat or no. 1 soft red wheat delivered at an approved warehouse by December 31, 1997.
![Page 5: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/5.jpg)
Zvi Wiener ContTimeFin - 5 slide 5
Basics of Futures Contracts
Long position – commits to purchase the commodity.
Short position – commits to deliver.
At maturity: Profit to long = Spot pr. at maturity – Original futures pr.
Profit to short = Original futures pr. –Spot pr. at maturity
it is a zero sum game
![Page 6: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/6.jpg)
Zvi Wiener ContTimeFin - 5 slide 6
Futures Markets
The initial investment is zero however some margin is required.
The later cash flow is mark-to-market for a future contract and is concentrated in one point for the forward contract.
Futures are standardized and not specify the counterside.
![Page 7: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/7.jpg)
Zvi Wiener ContTimeFin - 5 slide 7
Futures Markets Currencies
– all major currencies, including cross rate Agricultural
– corn, wheat, meat, coffee, sugar, lumber, rice Metals and Energy
– copper, gold, silver, oil, gas, aluminum Interest Rates Futures
– eurodollars, T-bonds, LIBOR, Municipal, Fed funds Equity Futures
– S&P 500, NYSE index, OTC, FT-SE, Toronto
![Page 8: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/8.jpg)
Zvi Wiener ContTimeFin - 5 slide 8
Mechanism of Trading
Long Shortcommodity
money
ClearinghouseLong Short
![Page 9: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/9.jpg)
Zvi Wiener ContTimeFin - 5 slide 9
Marking to Market
Example: initial margin on corn is 10%.
1 contract is for 5,000 bushels,
price of one bushel is 2.2775,
so you have to post the initial margin =
$1,138.75 = 0.1*2.2755*5000
If the futures price goes from 2.2775 to 2.2975
the clearinghouse credits the margin account of the long position for 5000 bushels x 2 cents or $100 per contract.
![Page 10: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/10.jpg)
Zvi Wiener ContTimeFin - 5 slide 10
Marking to Market
Your balance
time
Maint.margin
margin call
Initialmargin
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Zvi Wiener ContTimeFin - 5 slide 11
Marking to Market and Margin
The current futures price for silver delivered in five days is $5.10 (per ounce).
One futures contract is for 5,000 ounces
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Zvi Wiener ContTimeFin - 5 slide 12
Marking to Market and Margin
Day Futures Price
0 (today) $5.10
1 $5.20
2 $5.25
3 $5.18
4 $5.18
5 $5.21
![Page 13: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/13.jpg)
Zvi Wiener ContTimeFin - 5 slide 13
Marking to Market and MarginDay Futures P&L/oz. Margin
1 $5.20 5.20-5.10= 0.10 500
2 $5.25 5.25-5.20= 0.05 250
3 $5.18 5.18-5.25=-0.07 -350
4 $5.18 5.18-5.18= 0.00 0
5 $5.21 5.21-5.18= 0.03 150
Total: $550
Compare the total to forward: (5.21–5.10)5000
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Zvi Wiener ContTimeFin - 5 slide 14
Convergence Property
The futures price and the spot price must converge at maturity.
Otherwise there will be an arbitrage based on actual delivery.
Sometimes delivery is costly!
![Page 15: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/15.jpg)
Zvi Wiener ContTimeFin - 5 slide 15
Futures Markets
Cash delivery: sometimes is allowed, sometimes is the only way to deliver.
The question of quality is resolved with a conversion factor. The cheapest to deliver option.
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Zvi Wiener ContTimeFin - 5 slide 16
Futures Markets
The S&P 500 futures calls for delivery of $500 times the value of the index. If at maturity the index is at 475, then $500x475=$237,500 cash is the delivery value.
If the contract was written on the futures price 470 (some time ago), who will pay money?
Short side will pay to the long side.
![Page 17: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/17.jpg)
Zvi Wiener ContTimeFin - 5 slide 17
Futures Markets Strategies
Hedging and Speculation – efficient tool for hedging and speculation. A significant leverage effect.
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Zvi Wiener ContTimeFin - 5 slide 18
Basis Risk and Hedging
The basis is the difference between the futures price and the spot price. (At maturity it approaches zero).
This risk is important if the futures position is not held till maturity and is liquidated in advance.
Spread position is when an investor is long a futures with one ttm and short with another.
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Zvi Wiener ContTimeFin - 5 slide 19
Spot-Futures Parity Theorem
Create a riskless position involving a futures contract and the spot position.
Buy one stock for S and take a short futures position in it.
The only difference is from dividends.
Thus F + D – S is riskless.
The amount of money invested is S.
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Zvi Wiener ContTimeFin - 5 slide 20
Spot-Futures Parity Theorem
Create a riskless position involving a futures contract and the spot position.
Buy one stock for S and take a short futures position in it.
The only difference is from dividends.
Thus F + D – S is riskless.
The amount of money invested is S.
S
SDFrf
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Zvi Wiener ContTimeFin - 5 slide 21
Spot-Futures Parity Theorem Cost-of-carry relationship
)1()1( drSDrSF ff
![Page 22: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/22.jpg)
Zvi Wiener ContTimeFin - 5 slide 22
Spot-Futures Parity Theorem Cost-of-carry relationship
Tf drSF )1(
For contract maturing in T periods
![Page 23: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/23.jpg)
Zvi Wiener ContTimeFin - 5 slide 23
Relationship for Spreads
)(12
2
1
12
2
1
)1)(()(
)1()(
)1()(
TTf
Tf
Tf
drTFTF
drSTF
drSTF
This is a rough approximation based on anassumption that there is a single source ofrisk and all contracts are perfectly correlated.
![Page 24: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/24.jpg)
Zvi Wiener ContTimeFin - 5 slide 24
Martingale
X - a stochastic time dependent variable.
Et - expectation based on information available at time t.
Xt is a martingale if for any s > t
Et(Xs) = Xt
![Page 25: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/25.jpg)
Zvi Wiener ContTimeFin - 5 slide 25
Martingale
Most financial variables are not martingales because of the drift component (inflation, interest rates, cost of storage, etc.)
However one can change a numeraire so that the new financial variable becomes a martingale.
What can be chosen for an ABM, GBM?
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Zvi Wiener ContTimeFin - 5 slide 26
Martingale
dX = dt + dZ ABM
Et(Xs) = Xt+ (s-t)
set Yt = Xt- t
then dYt= dt + dZ - dt = dZ
hence Et(Ys) = Yt
![Page 27: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/27.jpg)
Zvi Wiener ContTimeFin - 5 slide 27
MartingaledX = Xdt + XdZ GBM
What is Et(Xs)?
set Yt = Xte-t
dY = e-t dX - e-tXdt =
e-tXdt + e-t XdZ - e-tXdt =
( - )Ydt + YdZ.
What is Et(Ys)?
![Page 28: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/28.jpg)
Zvi Wiener ContTimeFin - 5 slide 28
Martingale
dY = ( - )Ydt + YdZ
then d(lnY) = ( - - 0.5 2) dt + dZ
lnYt = lnY0 + ( - - 0.5 2) t + Z
if a~N(, ), then E(ea) =exp(+0.52)
lnYt~N(lnY0 + ( - - 0.5 2) t, t)
Then E0(Yt) = Y0exp(( - - 0.5 2)t+0.52t).
![Page 29: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/29.jpg)
Zvi Wiener ContTimeFin - 5 slide 29
Martingale
E0(Yt) = Y0exp(( - - 0.5 2)t+0.52t).
Set =
E0(Yt) = Y0
Et(Ys) = Yt - martingale!
What is the economic meaning of Y?
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Zvi Wiener ContTimeFin - 5 slide 30
Equivalent Martingale Measure
Harrison and Kreps
Harrison and Pliska
There exists a risk neutral probability measure.
There exists an equivalent martingale measure.
For a detailed explanation, see Duffie.
Extension to a stochastic volatility, see Grundy,
Wiener.
![Page 31: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/31.jpg)
Zvi Wiener ContTimeFin - 5 slide 31
Forward Contract
)()(exp0 t
T
t
Qt FWdssrE
T
t
Qt
T
t
Qt
t
dssrE
WdssrEF
)(exp
)(exp
if W and r are independent Ft=EtQ(W)
![Page 32: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/32.jpg)
Zvi Wiener ContTimeFin - 5 slide 32
Futures Contract
WEQtt
Mark-to-market procedure equatesthe instantaneous price to zero.
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Zvi Wiener ContTimeFin - 5 slide 33
Girsanov’s Theorem
Let dX = (X,t)dt + (X,t)dZ.
If there exist and , such that = - ,
then there exists a new probability measure equivalent to the original one, such that
relative to the new measure the original process X becomes:
dX = (X,t)dt + (X,t)dZ*
![Page 34: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/34.jpg)
Zvi Wiener ContTimeFin - 5 slide 34
by a change of the probability measure (note B*),if there exists a process such that .
Girsanov’s TheoremGirsanov’s Theorem
can be transformed totdZtXdttXdX ),(),(
*tdZtXdttXdX ),(),(
![Page 35: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/35.jpg)
Zvi Wiener ContTimeFin - 5 slide 35
),( tXFchange of variables
tdZtXdttXdX ),(),( can be transformed to
(Girsanov)tdZtXdttXdX ),(),( *1.
tdZtadtdF )(... (Theorem 1)2.
tdZtFadtdF )(... (Theorem 1’)3.
![Page 36: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/36.jpg)
Zvi Wiener ContTimeFin - 5 slide 36
Monotonic change of variables preserves order
x
y
x x y y2 1 2 1
2
y2
x
1
1
y
x
![Page 37: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/37.jpg)
Zvi Wiener ContTimeFin - 5 slide 37
Monotonic change of variables preserves order
x
y1
x
11 PrPr yyxx
1
![Page 38: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/38.jpg)
Zvi Wiener ContTimeFin - 5 slide 38
tdZxdttxdx )(),(
change of variables: x
K
xdx
xy)(
1)(
K
xxd
xxy
x
K
lnˆ1
ˆ1
)(
Constant volatility case: tdBxdttxdx ˆ),(
tdZdtx
x
txdy
2
)('
)(
),(
leads to
Example
![Page 39: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/39.jpg)
Zvi Wiener ContTimeFin - 5 slide 39
Theorem 1. The diffusion process
is transformed by the following change of variables
into a process with a deterministic diffusion parameter
dZtadtFtadF )(2
)( 21
Free parameters:a(t) – defines the resulting diffusion parameterA(t) – defines zero level of the new variable
tdZtxdttxdx ),(),(
dt
tatxF
x
tA
)( ),(
)(),(
![Page 40: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/40.jpg)
Zvi Wiener ContTimeFin - 5 slide 40
Feynman-Kac Formula
0.52fxx + fx + ft - rf + h=0
f(X,T) = g(X)
The solution is given by:
)(),(),( ,,, TTt
T
t
ssttx XgdssXhEtXf
T
t
dXr
st e
),(
, the discount factor
![Page 41: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/41.jpg)
Zvi Wiener ContTimeFin - 5 slide 41
Stochastic Optimization
In many cases financial assets involve decisions. In some cases we should assume that decision makers are rational and try to use an optimal decision, in some cases we assume not rational behavior.
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Zvi Wiener ContTimeFin - 5 slide 42
A Time-Homogeneous Problem
Values do not depend on time explicitly.
A financial asset V, which depends on a set of variables X, and time t.
Control variable .
0
0 ),(max dsXueEV rs
dZsXdsXdX ),(),(
![Page 43: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/43.jpg)
Zvi Wiener ContTimeFin - 5 slide 43
A Time-Homogeneous Problem
Sometimes the control variable is a constant, sometimes it is a function of time and state.
The expected cash flow is:
ECF = u(X, )ds
The capital gain is:
CG = dV = VxdX+0.5Vxx(dX)2
The expected capital gain is:
ECG = (Vx+0.52Vxx)dt
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Zvi Wiener ContTimeFin - 5 slide 44
A Time-Homogeneous Problem
The value of V does not depend on time.
The optimally managed total return per unit of
time is given by:
ETR = max(ECF+ECG)=
max[u(X, )+ (X, )Vx +0.52 (X, )Vxx]
It must be equal the risk free return:
rV= max[u(X, )+ (X, )Vx +0.52 (X, )Vxx]
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Zvi Wiener ContTimeFin - 5 slide 45
The Maximum Principle
X follows an ABM with parameters and .
An asset pays continuous cash flow at the rate Xdt.
There is no limited liability option.
A manager can influence the growth rate of X.
Suppose that for any one has to pay 2dt to
managers.
What is the optimal strategy?
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Zvi Wiener ContTimeFin - 5 slide 46
The Maximum Principle
dZdsdXts
dsXeEV rs
..
max0
20
xxx VVXrV 22 5.0max
![Page 47: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/47.jpg)
Zvi Wiener ContTimeFin - 5 slide 47
The Maximum Principle
xxx VVXrV 22 5.0max
xopt
x
V
V
5.0
20
Note that Shimko assumes that one can not replacea manager, thus opt is constant and hence Vxx=0.
![Page 48: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/48.jpg)
Zvi Wiener ContTimeFin - 5 slide 48
The Maximum Principle
With this assumption we get V=2X opt + C
34
1
2)2(
rr
XV
XCXrrV optopt
![Page 49: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/49.jpg)
Zvi Wiener ContTimeFin - 5 slide 49
The Maximum Principle
Assuming one-time decision we can value thesecurity as a sum of linearly growing perpetuity(ABM) minus a level perpetuity (constant paymentof 2 forever.
rrr
XV
2
2
Optimizing with respect to we obtain:
34
1
rr
XV
![Page 50: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/50.jpg)
Zvi Wiener ContTimeFin - 5 slide 50
The Maximum Principle
Without this assumption we get:
xxx VVXrV 22 5.025.0
A non-linear ODE, must be solved numerically.
What are the appropriate boundary conditions?
![Page 51: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/51.jpg)
Zvi Wiener ContTimeFin - 5 slide 51
Multiple State Variables
Consider a perpetually lived value-maximizing monopolist who produces output at a rate of qdt, but faces a stochastically varying demand.
Assume that the demand is linear p = a - bq, where p is the price of the good, and a, b are given by:
b
a
dZqbadtqbagdb
dZqbadtqbafda
),,(),,(
),,(),,(
dtdZdZ ba
![Page 52: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/52.jpg)
Zvi Wiener ContTimeFin - 5 slide 52
Multiple State Variables
The initial conditions are a(0)=a0, b(0)=b0.
Assume that the cost of production is zero.
The value of the firm is V, such that:
0
0 )(max qdsbqaeEV rs
q
![Page 53: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/53.jpg)
Zvi Wiener ContTimeFin - 5 slide 53
Multiple State Variables
The expected cash flow is:
(a-bq)qdt
The capital gain component is:
dV = Vada+Vbdb+0.5Vaa(da)2+Vabdadb+0.5Vbb(db)2
The expected capital gain is:
ECG=E[dV]=fVa+ gVb+0.52Vaa+Vab+0.52Vbb
![Page 54: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/54.jpg)
Zvi Wiener ContTimeFin - 5 slide 54
Multiple State Variables
The maximum total return is:
max(TR) = max(ECF+ECG) = rV
Therefore
bbabaabaq
VVVgVfVqbqarV 22 5.05.0)(max
The first order condition is:
05.0)(5.02 bbqqqabaaqbqaq VVVVgVfbqa
![Page 55: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/55.jpg)
Zvi Wiener ContTimeFin - 5 slide 55
Multiple State VariablesAssume that
f(a,b,q) = af0
g(a,b,q) = bg0
(a,b,q) = a0
(a,b,q) = b0
The value of the firm is:
bbabaaba VbabVVaVbgVafb
arV 2
02
0020
200
2
5.05.04
)22(4 2000
2000
2
gfrb
aV
![Page 56: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/56.jpg)
Zvi Wiener ContTimeFin - 5 slide 56
Optimal Asset Allocation
Merton 1971.
Utility function: U= r - 0.5A2
Here r is the expected rate of return and - its standard deviation.
A - is the individual’s coefficient of risk aversion.
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Zvi Wiener ContTimeFin - 5 slide 57
Optimal Asset Allocation
Denote by - proportion invested in risky assets. Then
fP rrr )1( 222 P
![Page 58: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/58.jpg)
Zvi Wiener ContTimeFin - 5 slide 58
Optimal Asset Allocation
Maximizing utility with respect to , we get:
02
1)1( 22
Pf ArrU
2
A
rr fopt
![Page 59: Zvi WienerContTimeFin - 5 slide 1 Financial Engineering Continuous Time Finance Zvi Wiener mswiener@mscc.huji.ac.il tel: 02-588-3049](https://reader035.vdocuments.us/reader035/viewer/2022081515/56649d3b5503460f94a16435/html5/thumbnails/59.jpg)
Zvi Wiener ContTimeFin - 5 slide 59
Dynamic Asset Allocation
How one can apply the Girsanov’s theorem?
Perfect markets, no taxes, costs, restrictions.
The budget equation:
rPdtdP
XdZXdtdX
XdZWdtcWrPXWdW ])1([
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Zvi Wiener ContTimeFin - 5 slide 60
Dynamic Asset AllocationThe objective function is to maximize the expected lifetime discounted utility.
XdZWdtcWrPXWdWts
dsscUeEJ s
c
])1([..
))((max0
0,
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Zvi Wiener ContTimeFin - 5 slide 61
Problem 4.3
The height of a tree at time t is given by Xt, where Xt follows an ABM. We must decide when to cut the tree.
The tree is worth $1 per unit of height, and if the tree is cut down at time at height Y, then its value today is:
V = e-rY.
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Zvi Wiener ContTimeFin - 5 slide 62
Problem 4.3
a. What PDE must the value of the tree satisfy?
b. What are the boundary conditions?
c. Value the tree, assuming that the value is zero
when the tree’s height is -.
d. What is the optimal cutting policy?