Approximation of geometric fractional Brownian

motion

Esko Valkeila

TKK, Institute of Mathematics

Mid-term Conference of AMaMeF, Vienna, September 2007

Fractional Brownian motion

Fractional Brownian motion B H is a continuous centered Gaussian

process. Here H ∈ (0, 1) is the self-similarity index and the
covariance of the process B H is given by
1  2H 
EBsH BtH = t + s 2H − |t − s|2H .
2

We obtain the standard Brownian motion W as a special fractional

1
Brownian motion: W = B 2 . The standard Brownian motion is a
martingale, but for H 6= 21 the fractional Brownian motion process
B H is not a semi-martingale.
The parameter H allows us to model dependency in the data, since
for H ∈ ( 12 , 1) the increments of the process B H are positively
correlated.
Fractional Brownian motion as a model in finance
Arbitrage with gfBm

H
Geometric fractional Brownian motion (gfBm) e B is not a
semimartingale, and hence there are arbitrage opportunities by the
FTAP of Delbaen and Schachermayer. The known examples of
arbitrage are based on continuous trading [Dasgupta, Shiryaev,
Salopek], or more and more dense discontinuous trading [Rogers,
Cheridito]; but all these arbitrage strategies are apparently difficult
to realize in practice.
One can show that if one uses Skorohod integrals to define
self-financing strategies, the arbitrage disappears [Hu-Øksendal,
Elliot-van den Hook], but this kind of integrals are difficult to
interpret economically [Sottinen-Valkeila, Björk-Hult].
In pricing model with transaction costs the arbitrage opportunities
with gfBm again disappear [Guasoni,
Guasoni-Rásonyi-Schachermayer].
Approximation to geometric fBm
Introduction

Sometimes approximations give additional information about the

properties of the limiting model. We study here the setup where
we have sequence of positive processes (S n , Fn P n ) approximating
H
(e B , F, P), the fractional Black-Scholes model; the approximation
is understood in the sense of weak convergence.

One approximation is based on ’fractional binomial tree’ [Sottinen];

as a financial model this approximation is complete, but allows
arbitrage.

Another one is based on shot noise process approximation to fBm

[Klüppelberg-Kühn]; as a financial model this is not complete, but
does not allow arbitrage.
Approximation to geometric fBm
Motivation
Yet another type of approximation is based on mixed Brownian –
fractional Brownian model; here
1 2
t+BtH
St = e Wt − 2  ;

in this approximation there is a hedging price for European options

[Schoenmakers-Kloeden, Bender-Sottinen-Valkeila], and this
approximation allows arbitrage, at least in principle, if H ∈ ( 12 , 34 ],
and there is no-arbitrage, if H > 34 [Cheridito].

What happens to the hedging price, if  → 0? For an European

call this limit will be
(S0 − K )+ ;
here K is the strike and the interest rate is assumed to be r = 0.
Clearly this is difficult to interpret.

We give one more approximation, where the approximating pricing

model is complete and arbitrage-free.
One more approximation to gFbm
A complete and no-arbitrage approximation

We will the use the ’teletraffic’ approximation to fractional

Brownian motion [Gaigalas-Kaj]. This goes as follows: let G be a
continuous distribution function with heavy tails. i.e.

1 − G (t) ∼ t −(1+β) (1)

as t → ∞ with β ∈ (0, 1).

Take ηi to be the interarrival times of a renewal counting process
N. Assume that ηi ∼ G for i ≥ 2; for the first
R interarrival time η 1
1 t
assume that it has the distribution G 0 = µ 0 (1 − Gs )ds, so that
the renewal counting process
∞
X
Nt = 1{τk ≤t}
k=1

is stationary, where τ1 = η1 and τk := η1 + · · · + ηk .

One more approximation to gFbm
A complete and no-arbitrage approximation, part II

Take now independent copies N (i ) of N, numbers am ≥ 0,

am → ∞ such that
m
β
→ ∞; (2)
am
using the terminology of Gaigalas and Kaj we can speak of fast
connection rate.
Define the workload process W (m, t) by
m
(i )
X
W (m, t) = Nt ;
k=1

note that the process N m is a counting process, since the

interarrival distribution is continuous. We have that
EW (m, t) = mt µ , since W (m, t) is a stationary process.
One more approximation to gFbm
Approximation as a semimartingale

For the following proposition see Gaigalas and Kaj:

Proposition Assume (1) and (2). Let
r
m 3 β(1 − β)(2 − β) W (m, am t) − mµ−1 am t
Y (t) := µ 2 β .
2 1 1−
2
m am
2

Then Y m converges weakly [in the Skorohod space D] to a

fractional Brownian motion B H , where H = 1 − β2 .
The process Y m is a semimartingale in its own filtration and also
(i )
in the big filtration Fm , where F̄t = σ{Ns : s ≤ t, i = 1, . . . , m},
and Ftm = F̄am t .
One more approximation to gFbm
Approximation as a semimartingale, continuation

To simplify notation put

r
3 β(1 − β)(2 − β)
c(µ, β) := µ 2 ,
2
1 1− β mµ am t
cm := m 2 am 2 and Am
−1
t := cm .
Since the process Y m is a semimartingale, it has a semimartingale
decomposition
Y m = Mm + Hm; (3)
here H m = B m − Am and B m is the compensator of the normalized
aggregated counting process W . Note that the process H m is a
continuous process with bounded variation.
One more approximation to gFbm
Approximation as a semimartingale, continuation

Up to a constant we have that the square bracket of the

martingale part M m of the semimartingale Y m is

W (m, am t)
[M m , M m ]t = C 2−β
.
mam
L1 (P)
But our assumption imply that [M m , M m ]t → 0, as m → ∞.
P
With the Doob inequality we obtain that sup s≤t |Msm | → 0, and
fBm is the limit of a sequence of continuous processes with
bounded variation.
One more approximation to gFbm
End of act one

It is not difficult to check that the solution to the linear equation

dStm = St−
m
dYsm

converges weakly in the Skorohod space to geometric fractional

Brownian motion.
But we know from the previous discussion that here fBm is a limit
of processes with bounded variation. But it is well known that in
market models driven by continuous processes with bounded
variation there are arbitrage opportunities, unless the driver process
is equal to the interest rate.
Further properties of the approximation
Completeness

Next we show that our approximation is complete. We can use the

results of Dzhaparidze – he shows using pathwise arguments, that
counting process models are always compete.
Let N be a counting process, α > 0 and γ > 0 are constants, and
consider the pathwise solution S to the following linear equation

dSt = St− (αdNt − γdt) with S0 = s;

then the unique solution to this is

Y
St = se −γt (1 + α∆Ns ) = se −γt (1 + α)Nt .
s≤t

Denote the jump times N by τk , k = 1, 2, . . . .

Further properties of the approximation
Completeness, continuation

j
The Poisson probabilities pj (λ) are defined by pj (λ) = λj! e −λ for
λ > 0. One can include the value λ = 0 by defining p j (0) = δj0 ,
where (
1, if j = 0
δj0 =
0, if otherwise
P
is the Kronecker delta. Put also F (j 0 ; λ) = j>j0 pj (λ).
Let WT be a functional of the price process path S t , 0 ≤ t ≤ T . If
the price process S has a state sk (T ), then the value functional
WT has a state wk (T ). Recall that a market model is complete, if
we can find a self-financing strategy π such that
Z T
WT = VTπ = v + πs dSs .
0
Further properties of the approximation
Completeness, continuation

Dzhaparidze shows that if the define the strategy π by

∞
X (1 + α) wj+k (T ) − wj+k+1 (T )
πs = pj (λ (T − s)) , (4)
α
j=0

then we obtain self-financing strategy π, which replicates the claim

W (T ); in (4) λ = αγ .
Consider the pricing of an European option (S T − K )+ in the
Poisson market model. Then the fair price C E of this option is
given by
C E = S0 F (j0 ; (1 + α)λT ) − KF (j0 ; λT ), (5)
where  
K
log S0 + γT
j0 = b c (6)
log(1 + α)
Approximation price

We can now apply the above to the approximating model S m . We

have that
β
am2
α = αm = c(µ, β) 1 ,
m2
β

m am2
γ = γ = c(µ, β)µ 1 and
m2
γm
λ = λm = = µ.
αm
From (2) we obtain that αm → 0, γ m → 0, and if K > S0 , then
j0 → ∞, and if K < S0 , then j0 → −∞. Put this in (5) and we
obtain that the limiting price is (S 0 − K )+ .
Further properties of the approximation
No-arbitrage property

The basic randomness of the approximating pricing model

sequence S m comes from the workload process W m . We can show
that there exists a probability measure Q m such that W m is a
Poisson process with intensity m µ.
What happens with the approximation? Recall that S m = E(Y m ).
But Y m = M m + Lm , where Lm is a continuous process, and hence
[M m , Lm ] = 0. So using Yor’s formula for stochastic exponents we
can write the approximating sequence as
m
Stm = S0 e Lt E(M m )t ,
ucp
where E(M m ) → 1 with respect to the measure P m .
Further properties of the approximation
No-arbitrage property

We know that the approximation (S m , Fm , P m ) weakly converges

to the geometric fBm. On the other hand, with respect to the
martingale measure Q m the sequence Y m is a martingale
ucp ucp
sequence, Y m −→ 0 with respect to Q m , and S m −→ S0 with
respect to Q m . So in the price (S0 − K )+ as a limit

(S0 − K )+ = lim EQ m (STm − K )+

m

for the European call.

References

Bender, C., Sottinen, T., and Valkeila, E. (2006).

Pricing by hedging beyond semimartingales.
Preprint.
Dzhaparidze, K.O. (2000).
Introduction to option pricing in a securities market.
CWI SYLLABUS, Amsterdam.
Gaigalas, R., and Kaj, I. (2003).
Convergence of scaled renewal processes and a packet arrival
model.
Bernoulli, 9, 671–703.
Guasoni, P., (2006).
No arbitrage under transaction costs, with fractional Brownian
motion and beyond.
Math. Finance, 16, (2006), 569–582.
References, cont
Klüppelberg, C., and Kühn, C. (2004).
Fractional Brownian motion as a weak limit of Poisson shot
noise processes — with applications to finance.
Stochastic Processes and their Applications, 113, 333–251.
Schoenmakers, J., Kloeden, P. (1999)
Robust option replication for a Black-Scholes model extended
with nondeterministic trends.
JAMSA, 12, 113–120.
Sottinen, T. (2001).
Fractional Brownian motion, random walks and binary market
models.
Finance and Stochastics, 5, 343–355.
Valkeila, E. (2007).
On the approximation of geometric fractional Brownian
motion.
13 pages. In preparation.