IDEAS home Printed from https://ideas.repec.org/p/pra/mprapa/5811.html
   My bibliography  Save this paper

Ito Processes with Finitely Many States of Memory

Author

Listed:
  • McCauley, Joseph L.

Abstract

We show that Ito processes imply the Fokker-Planck (K2) and Kolmogorov backward time (K1) partial differential eqns. (pde) for transition densities, which in turn imply the Chapman-Kolmogorov equation without approximations. This result is not restricted to Markov processes. We define ‘finite memory’ and show that Ito processes admit finitely many states of memory. We then provide an example of a Gaussian transition density depending on two past states that satisfies both K1, K2, and the Chapman-Kolmogorov eqn. Finally, we show that transition densities of Black-Scholes type pdes with finite memory are martingales and also satisfy the Chapman-Kolmogorov equation. This leads to the shortest possible proof that the transition density of the Black-Scholes pde provides the so-called ‘martingale measure’ of option pricing.

Suggested Citation

  • McCauley, Joseph L., 2007. "Ito Processes with Finitely Many States of Memory," MPRA Paper 5811, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:5811
    as

    Download full text from publisher

    File URL: https://mpra.ub.uni-muenchen.de/5811/1/MPRA_paper_5811.pdf
    File Function: original version
    Download Restriction: no

    References listed on IDEAS

    as
    1. 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.
    2. J. L. McCauley & G. H. Gunaratne & K. E. Bassler, 2006. "Martingale Option Pricing," Papers physics/0606011, arXiv.org, revised Feb 2007.
    3. 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.
    4. McCauley, Joseph L. & Gunaratne, Gemunu H. & Bassler, Kevin E., 2007. "Martingale option pricing," MPRA Paper 2151, University Library of Munich, Germany.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Bassler, Kevin E. & Gunaratne, Gemunu H. & McCauley, Joseph L., 2007. "Empirically Based Modeling in the Social Sciences and Spurious Stylized Facts," MPRA Paper 5813, University Library of Munich, Germany.

    More about this item

    Keywords

    Ito process; martingale; stochastic differential eqn.; Langevin eqn.; memory; nonMarkov process; Fokker-Planck eqn.; Kolmogorov’s backward time eqn.; Chapman-Kolmogorov eqn.; Black-Scholes eqn;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • C20 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - General

    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:pra:mprapa:5811. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Joachim Winter) or (Rebekah McClure). General contact details of provider: http://edirc.repec.org/data/vfmunde.html .

    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 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.

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

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.