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sdemrd

SDE with Mean-Reverting Drift (SDEMRD) model

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Description

Creates and displays a SDE object whose drift rate is expressed in mean-reverting drift-rate form and which derives from the sdeddo class (SDE from drift and diffusion objects).

Use sdemrd objects to simulate of sample paths of NVars state variables expressed in mean-reverting drift-rate form, and provide a parametric alternative to the linear drift form (see sdeld). These state variables are driven by NBrowns Brownian motion sources of risk over NPeriods consecutive observation periods, approximating continuous-time stochastic processes with mean-reverting drift-rate functions.

The sdemrd object allows you to simulate any vector-valued SDEMRD of the form:

dXt=S(t)[L(t)−Xt]dt+D(t,Xtα(t))V(t)dWt

where:

  • Xt is an NVars-by-1 state vector of process variables.

  • S is an NVars-by-NVars matrix of mean reversion speeds.

  • L is an NVars-by-1 vector of mean reversion levels.

  • D is an NVars-by-NVars diagonal matrix, where each element along the main diagonal is the corresponding element of the state vector raised to the corresponding power of α.

  • V is an NVars-by-NBrowns instantaneous volatility rate matrix.

  • dWt is an NBrowns-by-1 Brownian motion vector.

Creation

Syntax

SDEMRD = sdemrd(Speed,Level,Alpha,Sigma)
SDEMRD = sdemrd(___,Name,Value)

Description

SDEMRD = sdemrd(Speed,Level,Alpha,Sigma) creates a default SDEMRD object.

example

SDEMRD = sdemrd(___,Name,Value) creates a SDEMRD object with additional options specified by one or more Name,Value pair arguments.

Name is a property name and Value is its corresponding value. Name must appear inside single quotes (''). You can specify several name-value pair arguments in any order as Name1,Value1,…,NameN,ValueN.

The SDELD object has the following displayed Properties:

  • StartTime — Initial observation time

  • StartState — Initial state at time StartTime

  • Correlation — Access function for the Correlation input argument, callable as a function of time

  • Drift — Composite drift-rate function, callable as a function of time and state

  • Diffusion — Composite diffusion-rate function, callable as a function of time and state

  • Speed — Access function for the input argument Speed, callable as a function of time and state

  • Level — Access function for the input argument Level, callable as a function of time and state

  • Alpha — Access function for the input argument Alpha, callable as a function of time and state

  • Sigma — Access function for the input argument Sigma, callable as a function of time and state

  • Simulation — A simulation function or method

example

Input Arguments

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Speed represents the parameter S, specified as an array or deterministic function of time.

If you specify Speed as an array, it must be an NVars-by-NVars matrix of mean-reversion speeds (the rate at which the state vector reverts to its long-run average Level).

As a deterministic function of time, when Speed is called with a real-valued scalar time t as its only input, Speed must produce an NVars-by-NVars matrix. If you specify Speed as a function of time and state, it calculates the speed of mean reversion. This function must generate an NVars-by-NVars matrix of reversion rates when called with two inputs:

  • A real-valued scalar observation time t.

  • An NVars-by-1 state vector Xt.

Data Types: double | function_handle

Level represents the parameter L, specified as an array or deterministic function of time.

If you specify Level as an array, it must be an NVars-by-1 column vector of reversion levels.

As a deterministic function of time, when Level is called with a real-valued scalar time t as its only input, Level must produce an NVars-by-1 column vector. If you specify Level as a function of time and state, it must generate an NVars-by-1 column vector of reversion levels when called with two inputs:

  • A real-valued scalar observation time t.

  • An NVars-by-1 state vector Xt.

Data Types: double | function_handle

Alpha represents the parameter D, specified as an array or deterministic function of time.

If you specify Alpha as an array, it represents an NVars-by-1 column vector of exponents.

As a deterministic function of time, when Alpha is called with a real-valued scalar time t as its only input, Alpha must produce an NVars-by-1 matrix.

If you specify it as a function of time and state, Alpha must return an NVars-by-1 column vector of exponents when invoked with two inputs:

  • A real-valued scalar observation time t.

  • An NVars-by-1 state vector Xt.

Data Types: double | function_handle

Sigma represents the parameter V, specified as an array or a deterministic function of time.

If you specify Sigma as an array, it must be an NVars-by-NBrowns matrix of instantaneous volatility rates or as a deterministic function of time. In this case, each row of Sigma corresponds to a particular state variable. Each column corresponds to a particular Brownian source of uncertainty, and associates the magnitude of the exposure of state variables with sources of uncertainty.

As a deterministic function of time, when Sigma is called with a real-valued scalar time t as its only input, Sigma must produce an NVars-by-NBrowns matrix. If you specify Sigma as a function of time and state, it must return an NVars-by-NBrowns matrix of volatility rates when invoked with two inputs:

  • A real-valued scalar observation time t.

  • An NVars-by-1 state vector Xt.

Data Types: double | function_handle

Note

Although sdemrd does not enforce restrictions on the signs of Alpha or Sigma, each parameter is specified as a positive value.

Properties

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Starting time of first observation, applied to all state variables, specified as a scalar

Data Types: double

Initial values of state variables, specified as a scalar, column vector, or matrix.

If StartState is a scalar, sdemrd applies the same initial value to all state variables on all trials.

If StartState is a column vector, sdemrd applies a unique initial value to each state variable on all trials.

If StartState is a matrix, sdemrd applies a unique initial value to each state variable on each trial.

Data Types: double

Correlation between Gaussian random variates drawn to generate the Brownian motion vector (Wiener processes), specified as an NBrowns-by-NBrowns positive semidefinite matrix, or as a deterministic function C(t) that accepts the current time t and returns an NBrowns-by-NBrowns positive semidefinite correlation matrix. If Correlation is not a symmetric positive semidefinite matrix, use nearcorr to create a positive semidefinite matrix for a correlation matrix.

A Correlation matrix represents a static condition.

As a deterministic function of time, Correlation allows you to specify a dynamic correlation structure.

Data Types: double

User-defined simulation function or SDE simulation method, specified as a function or SDE simulation method.

Data Types: function_handle

This property is read-only.

Drift rate component of continuous-time stochastic differential equations (SDEs), specified as a drift object or function accessible by (t, Xt.

The drift rate specification supports the simulation of sample paths of NVars state variables driven by NBrowns Brownian motion sources of risk over NPeriods consecutive observation periods, approximating continuous-time stochastic processes.

The drift class allows you to create drift-rate objects using drift of the form:

F(t,Xt)=A(t)+B(t)Xt

where:

  • A is an NVars-by-1 vector-valued function accessible using the (t, Xt) interface.

  • B is an NVars-by-NVars matrix-valued function accessible using the (t, Xt) interface.

The displayed parameters for a drift object are:

  • Rate: The drift-rate function, F(t,Xt)

  • A: The intercept term, A(t,Xt), of F(t,Xt)

  • B: The first order term, B(t,Xt), of F(t,Xt)

A and B enable you to query the original inputs. The function stored in Rate fully encapsulates the combined effect of A and B.

When specified as MATLAB® double arrays, the inputs A and B are clearly associated with a linear drift rate parametric form. However, specifying either A or B as a function allows you to customize virtually any drift rate specification.

Note

You can express drift and diffusion classes in the most general form to emphasize the functional (t, Xt) interface. However, you can specify the components A and B as functions that adhere to the common (t, Xt) interface, or as MATLAB arrays of appropriate dimension.

Example: F = drift(0, 0.1) % Drift rate function F(t,X)

Data Types: struct | double

This property is read-only.

Diffusion rate component of continuous-time stochastic differential equations (SDEs), specified as a drift object or function accessible by (t, Xt.

The diffusion rate specification supports the simulation of sample paths of NVars state variables driven by NBrowns Brownian motion sources of risk over NPeriods consecutive observation periods, approximating continuous-time stochastic processes.

The diffusion class allows you to create diffusion-rate objects using diffusion:

G(t,Xt)=D(t,Xtα(t))V(t)

where:

  • D is an NVars-by-NVars diagonal matrix-valued function.

  • Each diagonal element of D is the corresponding element of the state vector raised to the corresponding element of an exponent Alpha, which is an NVars-by-1 vector-valued function.

  • V is an NVars-by-NBrowns matrix-valued volatility rate function Sigma.

  • Alpha and Sigma are also accessible using the (t, Xt) interface.

The displayed parameters for a diffusion object are:

  • Rate: The diffusion-rate function, G(t,Xt).

  • Alpha: The state vector exponent, which determines the format of D(t,Xt) of G(t,Xt).

  • Sigma: The volatility rate, V(t,Xt), of G(t,Xt).

Alpha and Sigma enable you to query the original inputs. (The combined effect of the individual Alpha and Sigma parameters is fully encapsulated by the function stored in Rate.) The Rate functions are the calculation engines for the drift and diffusion objects, and are the only parameters required for simulation.

Note

You can express drift and diffusion classes in the most general form to emphasize the functional (t, Xt) interface. However, you can specify the components A and B as functions that adhere to the common (t, Xt) interface, or as MATLAB arrays of appropriate dimension.

Example: G = diffusion(1, 0.3) % Diffusion rate function G(t,X)

Data Types: struct | double

Object Functions

interpolateBrownian interpolation of stochastic differential equations (SDEs) for SDE, BM, GBM, CEV, CIR, HWV, Heston, SDEDDO, SDELD, or SDEMRD models
simulateSimulate multivariate stochastic differential equations (SDEs) for SDE, BM, GBM, CEV, CIR, HWV, Heston, SDEDDO, SDELD, SDEMRD, Merton, or Bates models
simByEulerEuler simulation of stochastic differential equations (SDEs) for SDE, BM, GBM, CEV, CIR, HWV, Heston, SDEDDO, SDELD, or SDEMRD models
simByMilsteinSimulate diagonal diffusion for BM, GBM, CEV, HWV, SDEDDO, SDELD, or SDEMRD sample paths by Milstein approximation
simByMilstein2Simulate BM, GBM, CEV, HWV, SDEDDO, SDELD, SDEMRD process sample paths by second order Milstein approximation

Examples

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Open Live Script

The sdemrd class derives directly from the sdeddo class. It provides an interface in which the drift-rate function is expressed in mean-reverting drift form: dXt=S(t)[L(t)-Xt]dt+D(t,Xtα(t))V(t)dWt.

sdemrd objects provide a parametric alternative to the linear drift form by reparameterizing the general linear drift such that: A(t)=S(t)L(t),B(t)=-S(t).

Create an sdemrd object obj with a square root exponent to represent the model: dXt=0.2(0.1-Xt)dt+0.05Xt12dWt. 

obj = sdemrd(0.2, 0.1, 0.5, 0.05)   % (Speed, Level, Alpha, Sigma)
obj = 
   Class SDEMRD: SDE with Mean-Reverting Drift
   -------------------------------------------
     Dimensions: State = 1, Brownian = 1
   -------------------------------------------
      StartTime: 0
     StartState: 1
    Correlation: 1
          Drift: drift rate function F(t,X(t)) 
      Diffusion: diffusion rate function G(t,X(t)) 
     Simulation: simulation method/function simByEuler
          Alpha: 0.5
          Sigma: 0.05
          Level: 0.1
          Speed: 0.2

sdemrd objects display the familiar Speed and Level parameters instead of A and B.

More About

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Algorithms

When you specify the required input parameters as arrays, they are associated with a specific parametric form. By contrast, when you specify either required input parameter as a function, you can customize virtually any specification.

Accessing the output parameters with no inputs simply returns the original input specification. Thus, when you invoke these parameters with no inputs, they behave like simple properties and allow you to test the data type (double vs. function, or equivalently, static vs. dynamic) of the original input specification. This is useful for validating and designing methods.

When you invoke these parameters with inputs, they behave like functions, giving the impression of dynamic behavior. The parameters accept the observation time t and a state vector Xt, and return an array of appropriate dimension. Even if you originally specified an input as an array, sdemrd treats it as a static function of time and state, by that means guaranteeing that all parameters are accessible by the same interface.

References

[1] Aït-Sahalia, Yacine. “Testing Continuous-Time Models of the Spot Interest Rate.” Review of Financial Studies, vol. 9, no. 2, Apr. 1996, pp. 385–426.

[2] Aït-Sahalia, Yacine. “Transition Densities for Interest Rate and Other Nonlinear Diffusions.” The Journal of Finance, vol. 54, no. 4, Aug. 1999, pp. 1361–95.

[3] Glasserman, Paul. Monte Carlo Methods in Financial Engineering. Springer, 2004.

[4] Hull, John. Options, Futures and Other Derivatives. 7th ed, Prentice Hall, 2009.

[5] Johnson, Norman Lloyd, et al. Continuous Univariate Distributions. 2nd ed, Wiley, 1994.

[6] Shreve, Steven E. Stochastic Calculus for Finance. Springer, 2004.

Version History

Introduced in R2008a

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