Stochastic processes induced by Dirichlet (B-) splines: modelling multivariate asset price dynamics

Kaishev, V. K. (2010). Stochastic processes induced by Dirichlet (B-) splines: modelling multivariate asset price dynamics (Report No. Actuarial Research Paper No. 195). London, UK: Faculty of Actuarial Science & Insurance, City University London.

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We consider a new class of processes, called LG processes, defined as linear combinations of independent gamma processes. Their distributional and path-wise properties are explored by following their relation to polynomial and Dirichlet (B-) splines. In particular, it is shown that the density of an LG process can be expressed in terms of Dirichlet (B-) splines, introduced independently by Ignatov and Kaishev (1987, 1988, and 1989) and Karlin et al. (1986). We further show that the well known variance-gamma (VG) process, introduced by Madan and Seneta (1990), and the Bilateral Gamma (BG) process, recently considered by Küchler and Tappe (2008) are special cases of an LG process. Following this LG interpretation, we derive new (alternative) expressions for the VG and BG densities and consider their numerical properties. The LG process has two sets of parameters, the B-spline knots and their multiplicities, and offers further flexibility in controlling the shape of the Levy density, compared to the VG and the BG processes. Such flexibility is often desirable in practice, which makes LG processes interesting for financial and insurance applications.

Multivariate LG processes are also introduced and their relation to multivariate Dirichlet and simplex splines is established. Expressions for their joint density, the underlying LG-copula, the characteristic, moment and cumulant generating functions are given. A method for simulating LG sample paths is also proposed, based on the Dirichlet bridge sampling of Gamma processes, due to Kaishev and Dimitrova (2009). A method of moments for estimation of the LG parameters is also developed. Multivariate LG processes are shown to provide a competitive alternative in modelling dependence, compared to the multivariate asymmetric VG process considered by Cont and Tankov (2004) and Luciano and Schoutens (2006), and to its generalization by Luciano and Semeraro (2007) and Semeraro (2008). Application of multivariate LG processes in modelling the joint dynamics of multiple exchange rates is also considered.

Item Type: Monograph (Working Paper)
Uncontrolled Keywords: LG process, (multivariate) variance gamma process, bilateral gamma process, Dirichlet spline, B-spline, simplex spline, Dirichlet bridge sampling, cumulants, FX modelling
Subjects: H Social Sciences > HG Finance
Divisions: Cass Business School > Faculty of Actuarial Science & Insurance > Faculty of Actuarial Science & Insurance Actuarial Research Reports

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