English, Article edition: ARBITRAGE IN FRACTAL MODULATED BLACKâSCHOLES MODELS WHEN THE VOLATILITY IS STOCHASTIC ERHAN BAYRAKTAR; H. VINCENT POOR

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Physical Description
  • article
Language
  • English

Edition details

Title
  • ARBITRAGE IN FRACTAL MODULATED BLACKâSCHOLES MODELS WHEN THE VOLATILITY IS STOCHASTIC
Author
  • ERHAN BAYRAKTAR
  • H. VINCENT POOR
Physical Description
  • article
Notes
  • In this paper an arbitrage strategy is constructed for the modified BlackâScholes model driven by fractional Brownian motion or by a time changed fractional Brownian motion, when the volatility is stochastic. This latter property allows the heavy tailedness of the log returns of the stock prices to be also accounted for in addition to the long range dependence introduced by the fractional Brownian motion. Work has been done previously on this problem for the case with constant "volatility" and without a time change; here these results are extended to the case of stochastic volatility models when the modulator is fractional Brownian motion or a time change of it. (Volatility in fractional BlackâScholes models does not carry the same meaning as in the classic BlackâScholes framework, which is made clear in the text.) Since fractional Brownian motion is not a semi-martingale, the BlackâScholes differential equation is not well-defined sense for arbitrary predictable volatility processes. However, it is shown here that any almost surely continuous and adapted process having zero quadratic variation can act as an integrator over functions of the integrator and over the family of continuous adapted semi-martingales. Moreover it is shown that the integral also has zero quadratic variation, and therefore that the integral itself can be an integrator. This property of the integral is crucial in developing the arbitrage strategy. Since fractional Brownian motion and a time change of fractional Brownian motion have zero quadratic variation, these results are applicable to these cases in particular. The appropriateness of fractional Brownian motion as a means of modeling stock price returns is discussed as well.
  • Fractional Brownian motion, arbitrage, stochastic volatility, stochastic integration, fractal market models
  • RePEc:wsi:ijtafx:v:08:y:2005:i:03:p:283-300
Language
  • English
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