IDEAS home Printed from https://ideas.repec.org/p/arx/papers/2609.09470.html

Geometric and Arithmetic Likelihood Aggregation for Diffusions with Heterogeneous Volatility

Author

Listed:
  • Jan Vecer

Abstract

We study how to combine diffusion models that disagree about drift and covariance. Candidate-first relative-entropy minimization gives geometric pooling, whereas expert-first minimization gives the arithmetic mixture associated with weighted logarithmic wealth. Different quadratic variations can make path-space entropy infinite, and the arithmetic mixture need not be a Markov diffusion. We therefore specify a local criterion combining drift information, normalized by the second argument's covariance, with quadratic transport between Gaussian shocks in a fixed state metric. A Gaussian identity and an Euler convergence estimate justify this chosen criterion. The expert-first projection has posterior-mean drift and an inverse-covariance penalty for drift dispersion; in one dimension this penalty increases volatility. For Ornstein--Uhlenbeck experts with a common mean-reversion rate, coefficient regularity holds on the full horizon for common volatility and away from the initial time for heterogeneous volatilities. The candidate-first problem has a Hamilton--Jacobi--Bellman characterization. Its matrix covariance selector reduces by congruence to a Bures--Wasserstein barycenter. The condition $H+\lambda M\succ0$, with value Hessian $H$ and state metric $M$, is sharp for finiteness of the unrestricted local covariance problem; compact constraints keep that problem finite. A covariance-disagreement budget interprets the penalty parameter. Linear--quadratic, exact-transition, and financial examples distinguish dynamic volatility reduction, drift-dispersion inflation, and martingale restrictions.

Suggested Citation

  • Jan Vecer, 2026. "Geometric and Arithmetic Likelihood Aggregation for Diffusions with Heterogeneous Volatility," Papers 2609.09470, arXiv.org.
  • Handle: RePEc:arx:papers:2609.09470
    as

    Download full text from publisher

    File URL: https://arxiv.org/pdf/2609.09470
    File Function: Latest version
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Jan Vecer, 2026. "Numeraire Invariance of Entropy-Projected Martingale Measures," Papers 2609.08605, arXiv.org.
    2. Jan Vecer & Mark Richard & Stephen Taylor, 2025. "Portfolio optimization beyond utility maximization: the case of driftless markets," The European Journal of Finance, Taylor & Francis Journals, vol. 31(3), pages 318-347, February.
    3. Backhoff-Veraguas, Julio & Källblad, Sigrid & Robinson, Benjamin A., 2025. "Adapted Wasserstein distance between the laws of SDEs," Stochastic Processes and their Applications, Elsevier, vol. 189(C).
    4. Beatrice Acciaio & Daniel Krv{s}ek & Gudmund Pammer, 2024. "Multicausal transport: barycenters and dynamic matching," Papers 2401.12748, arXiv.org, revised Jan 2025.
    5. Marco Frittelli, 2000. "The Minimal Entropy Martingale Measure and the Valuation Problem in Incomplete Markets," Mathematical Finance, Wiley Blackwell, vol. 10(1), pages 39-52, January.
    6. Julio Backhoff-Veraguas & Daniel Bartl & Mathias Beiglbock & Manu Eder, 2019. "Adapted Wasserstein Distances and Stability in Mathematical Finance," Papers 1901.07450, arXiv.org, revised May 2020.
    7. Julio Backhoff-Veraguas & Daniel Bartl & Mathias Beiglböck & Manu Eder, 2020. "Adapted Wasserstein distances and stability in mathematical finance," Finance and Stochastics, Springer, vol. 24(3), pages 601-632, July.
    8. Cox, John C. & Ingersoll Junior, Jonathan E. & Ross, Stephen A., 2007. "A theory of the term structure of interest rates," RAE - Revista de Administração de Empresas, FGV-EAESP Escola de Administração de Empresas de São Paulo (Brazil), vol. 47(2), April.
    9. Ali E. Abbas, 2009. "A Kullback-Leibler View of Linear and Log-Linear Pools," Decision Analysis, INFORMS, vol. 6(1), pages 25-37, March.
    10. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," The Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. C. Neri & L. Schneider, 2012. "The Impact of the Prior Density on a Minimum Relative Entropy Density: A Case Study with SPX Option Data," Papers 1201.2616, arXiv.org, revised Sep 2013.
    2. Zhang Chen & Chen Kay, 2026. "Historical Developments in Probability Measures for Asset Pricing: From State Prices to Modern Pricing Kernels," Papers 2605.27658, arXiv.org.
    3. Ahmad Aghapour & Erhan Bayraktar & Fengyi Yuan, 2025. "Dynamic data generation and dynamic portfolio selection: an application of a score-based diffusion model," Papers 2507.09916, arXiv.org, revised Aug 2026.
    4. Thomas Kokholm & Martin Stisen, 2015. "Joint pricing of VIX and SPX options with stochastic volatility and jump models," Journal of Risk Finance, Emerald Group Publishing Limited, vol. 16(1), pages 27-48, January.
    5. Darren Shannon & Grigorios Fountas, 2021. "Extending the Heston Model to Forecast Motor Vehicle Collision Rates," Papers 2104.11461, arXiv.org, revised May 2021.
    6. Yang, Nian & Chen, Nan & Wan, Xiangwei, 2019. "A new delta expansion for multivariate diffusions via the Itô-Taylor expansion," Journal of Econometrics, Elsevier, vol. 209(2), pages 256-288.
    7. Almeida, Thiago Ramos, 2024. "Estimating time-varying factors’ variance in the string-term structure model with stochastic volatility," Research in International Business and Finance, Elsevier, vol. 70(PA).
    8. Marlon R. Moresco & Mélina Mailhot & Silvana M. Pesenti, 2025. "Uncertainty Propagation and Dynamic Robust Risk Measures," Mathematics of Operations Research, INFORMS, vol. 50(3), pages 1939-1964, August.
    9. Chenxu Li, 2014. "Closed-Form Expansion, Conditional Expectation, and Option Valuation," Mathematics of Operations Research, INFORMS, vol. 39(2), pages 487-516, May.
    10. Levendorskii, Sergei, 2004. "Consistency conditions for affine term structure models," Stochastic Processes and their Applications, Elsevier, vol. 109(2), pages 225-261, February.
    11. O. Samimi & Z. Mardani & S. Sharafpour & F. Mehrdoust, 2017. "LSM Algorithm for Pricing American Option Under Heston–Hull–White’s Stochastic Volatility Model," Computational Economics, Springer;Society for Computational Economics, vol. 50(2), pages 173-187, August.
    12. Almut Veraart & Luitgard Veraart, 2012. "Stochastic volatility and stochastic leverage," Annals of Finance, Springer, vol. 8(2), pages 205-233, May.
    13. Bjork, Tomas, 2009. "Arbitrage Theory in Continuous Time," OUP Catalogue, Oxford University Press, edition 3, number 9780199574742.
    14. Gaetano Bua & Daniele Marazzina, 2021. "On the application of Wishart process to the pricing of equity derivatives: the multi-asset case," Computational Management Science, Springer, vol. 18(2), pages 149-176, June.
    15. Prosper Dovonon, 2013. "Conditionally Heteroskedastic Factor Models With Skewness And Leverage Effects," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 28(7), pages 1110-1137, November.
    16. Najafi, Alireza & Taleghani, Rahman, 2022. "Fractional Liu uncertain differential equation and its application to finance," Chaos, Solitons & Fractals, Elsevier, vol. 165(P2).
    17. Chen, Bin & Song, Zhaogang, 2013. "Testing whether the underlying continuous-time process follows a diffusion: An infinitesimal operator-based approach," Journal of Econometrics, Elsevier, vol. 173(1), pages 83-107.
    18. Javier de Frutos & Victor Gaton, 2018. "An extension of Heston's SV model to Stochastic Interest Rates," Papers 1809.09069, arXiv.org.
    19. Jaros{l}aw Gruszka & Janusz Szwabi'nski, 2023. "Portfolio Optimisation via the Heston Model Calibrated to Real Asset Data," Papers 2302.01816, arXiv.org.
    20. Philipp Harms & David Stefanovits & Josef Teichmann & Mario V. Wuthrich, 2015. "Consistent Re-Calibration of the Discrete-Time Multifactor Vasi\v{c}ek Model," Papers 1512.06454, arXiv.org, revised Sep 2016.

    More about this item

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:arx:papers:2609.09470. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: arXiv administrators (email available below). General contact details of provider: https://arxiv.org/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.