Finance Without Brownian Motions: An Introduction to Simplified Stochastic Calculus

Cass Business School Research Paper, 2019

30 Pages Posted: 23 Dec 2019 Last revised: 8 Apr 2020

See all articles by Aleš Černý

Aleš Černý

Cass Business School, City, University of London

Johannes Ruf

London School of Economics & Political Science (LSE) - London School of Economics

Date Written: December 8, 2019

Abstract

The paper introduces a simple way of recording and manipulating general stochastic processes without explicit reference to a probability measure. In the new calculus, operations traditionally presented in a measure-specific way are instead captured by tracing the behaviour of jumps (also when no jumps are physically present). The calculus is fail-safe in that, under minimal assumptions, all informal calculations yield mathematically well-defined stochastic processes. The calculus is also intuitive as it allows the user to pretend all jumps are of compound Poisson type. The new calculus is very effective when it comes to computing drifts and expected values that possibly involve a change of measure. Such drift calculations yield, for example, partial integro-differential equations, Hamilton–Jacobi–Bellman equations, Feynman–Kac formulae, or exponential moments needed in numerous applications. We provide several illustrations of the new technique, among them a novel result on the Margrabe option to exchange one defaultable asset for another.

Keywords: Émery formula, semimartingale representation, simplified calculus, multiplicative compensator, Girsanov's theorem

JEL Classification: C60, G11, G13

Suggested Citation

Černý, Aleš and Ruf, Johannes, Finance Without Brownian Motions: An Introduction to Simplified Stochastic Calculus (December 8, 2019). Cass Business School Research Paper, 2019. Available at SSRN: https://ssrn.com/abstract=3500384 or http://dx.doi.org/10.2139/ssrn.3500384

Aleš Černý (Contact Author)

Cass Business School, City, University of London ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Johannes Ruf

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

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