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

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  • McCauley, Joseph L.

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.

Suggested Citation

  • McCauley, Joseph L., 2007. "Fokker-Planck and Chapman-Kolmogorov equations for Ito processes with finite memory," MPRA Paper 2128, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:2128
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    File URL: https://mpra.ub.uni-muenchen.de/2128/1/MPRA_paper_2128.pdf
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    References listed on IDEAS

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    1. McCauley, Joseph L. & Gunaratne, Gemunu H. & Bassler, Kevin E., 2007. "Martingale option pricing," MPRA Paper 2151, University Library of Munich, Germany.
    2. McCauley, J.L. & Gunaratne, G.H. & Bassler, K.E., 2007. "Martingale option pricing," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 380(C), pages 351-356.
    3. J. L. McCauley & G. H. Gunaratne & K. E. Bassler, 2006. "Martingale Option Pricing," Papers physics/0606011, arXiv.org, revised Feb 2007.
    4. 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.
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    Cited by:

    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.
    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.
    3. Hua, Jia-Chen & Chen, Lijian & Falcon, Liberty & McCauley, Joseph L. & Gunaratne, Gemunu H., 2015. "Variable diffusion in stock market fluctuations," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 419(C), pages 221-233.

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    More about this item

    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;
    All these keywords.

    JEL classification:

    • C69 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Other
    • G0 - Financial Economics - - General

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