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Fokker-Planck and Chapman-Kolmogorov equations for Ito processes with finite memory

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McCauley, Joseph L.

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Abstract

The usual derivation of the Fokker-Planck partial differential eqn. (pde) assumes the Chapman-Kolmogorov equation for a Markov process [1,2]. Starting instead with an Ito stochastic differential equation (sde), we argue that finitely many states of memory are allowed in Kolmogorov’s two pdes, K1 (the backward time pde) and K2 (the Fokker-Planck pde), and show that a Chapman-Kolmogorov eqn. follows as well. We adapt Friedman’s derivation [3] to emphasize that finite memory is not excluded. We then give an example of a Gaussian transition density with 1-state memory satisfying both K1, K2, and the Chapman-Kolmogorov eqns. We begin the paper by explaining the meaning of backward time diffusion, and end by using our interpretation to produce a very short proof that the Green function for the Black-Scholes pde describes a Martingale in the risk neutral discounted stock price.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 2128.

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Date of creation: 22 Feb 2007
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Handle: RePEc:pra:mprapa:2128

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Related research
Keywords: Stochastic process; martingale; Ito process; stochastic differential eqn.; memory; nonMarkov process; 2 backward time diffusion; Fokker-Planck; Kolmogorov’s partial differential eqns.; Chapman-Kolmogorov eqn.; Black- Scholes eqn.;

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Find related papers by JEL classification:
C69 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Other
G0 - Financial Economics - - General

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  1. Duffie, Darrell, 1988. "An extension of the Black-Scholes model of security valuation," Journal of Economic Theory, Elsevier, vol. 46(1), pages 194-204, October. [Downloadable!] (restricted)
  2. J. L. McCauley & G. H. Gunaratne & K. E. Bassler, 2006. "Martingale Option Pricing," Quantitative Finance Papers physics/0606011, arXiv.org, revised Feb 2007. [Downloadable!]
  3. McCauley, Joseph L. & Gunaratne, Gemunu H. & Bassler, Kevin E., 2007. "Martingale option pricing," MPRA Paper 2151, University Library of Munich, Germany. [Downloadable!]
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  1. McCauley, Joseph L. & Bassler, Kevin E. & Gunaratne, Gemunu h., 2007. "Martingales, the efficient market hypothesis, and spurious stylized facts," MPRA Paper 5303, University Library of Munich, Germany. [Downloadable!]
  2. McCauley, Joseph L. & Bassler, Kevin E. & Gunaratne, Gemunu H., 2007. "Martingales, Detrending Data, and the Efficient Market Hypothesis," MPRA Paper 2256, University Library of Munich, Germany. [Downloadable!]
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