ECMM703 ANALYSIS AND COMPUTATION FOR FINANCE Assignment 3: Due noon, 15 January 2020
Overview and Submission information
General guidelines. Please write down your answers clearly quoting numerical values to 3 significant figures, unless otherwise stated. Full marks achieved in this assignment will con- tribute 20% of the final module mark. Usual University penalties apply for late submission unless mitigation is approved. Feedback will be written on your work, and general comments will also appear on ELE.
Submission format. Please submit paper only, (no electronic submission is required) via BART submission. You will need to print out a BART cover sheet, staple your work to this and then hand it in to the Harrison front desk, allowing plenty of time (given there can be long queues at around noon). Any queries, please ask at the front desk for help. You should print out relevant codes that you have written (e.g. scripts and functions) and relevant outputs (e.g. graphs and plots). Analytical calculations and discussions (when asked for) can be done by hand-writing.
Allocation of marks. When solving any particular problem, marks will be awarded for clearly commented (Matlab) codes, and carefully reasoned mathematical solutions. Any diagrams, graphs, etc., should be clear to understand, with good comment or clear labelling. For questions requiring numerical simulation/output, marks will primarily be awarded for demonstrating use of Matlab: little credit will be given for other solution schemes.
Academic Misconduct. All work submitted including functions and scripts must be your own and not copied from other students or other sources (e.g. web pages). Any evidence of possible plagiarism will be investigated following university procedures. You are welcome to discuss ideas and possible methods, of course, with each other and with lecturers, etc., but the work you hand in must be your own.
Main contact for this assignment: Frank Kwasniok (F.Kwasniok@exeter.ac.uk) Questions
1. Study the recurrence properties of the three-state Markov chain described by the transition
matrix
2/3 0 1/3 T = 1 / 4 3 / 4 0 .
1/3 0 2/3
Consider the quantity R(n) = n (Tk) . Using Matlab, plot a graph of R(n) against time n
i k=1 ii i
for each of the states i ∈ {1, 2, 3}. From your graphs, does R(n) remain bounded or diverge to
∞ as n → ∞?
Prove analytically the behaviour and deduce the recurrence properties. [20]
2. Consider i.i.d. random variables {Xi} drawn from a uniform distribution on [0,1]. In the following find scaling sequences an, bn such that an(Mn − bn) converges in distribution to a
i
non-trivial limit function G.
(a) Yi = Xi, and Mn = max{Y1,…,Yn} (b) Ui = 1/Xi, and Mn = max{U1,…,Un}
In each case find first of all the probability distribution function P(Mn ≤ u/an + bn) as a function of un = u/an + bn. Then find suitable scaling sequences an, bn so that you get a non-trivial limit G(u) as n → ∞. The function G(u) will be one of three standard types. [15]
3. Recall the definitions of the excess distribution function and the mean excess function for a random variable X with distribution function F (x) = P (X ≤ x):
Fu(x) = P(X≤u+x|X>u) e(u) = E(X−u|X>u).
For the random variables considered in Question 2, compute these quantities analytically and analysetheirasymptoticbehaviourasu→xF (wherexF istheupperend-pointoftherandom variable X).
Now use Matlab to simulate 10000 realisations of the two random variables and estimate the mean excess function with the Monte Carlo method as a function of u. Plot these estimates against the exact results above. Comment on the comparison. [20]
4. Generate i.i.d. data from the distributions in Question 2, say, n = 10000 realisations. Divide the data up into N blocks of size k (keeping the data in order), so that n = Nk. Take the maximum value Y (i) of each block i so that you get N values, that is, if the data is {X1, . . . , Xn}, then we set
Y(i) =max{X(i−1)k+1,…,Xik}, 1≤i≤N.
Then apply the gevfit scheme in Matlab to this data to estimate the parameters of the GEV distribution. How do these estimates compare to the theoretical values in Question 2?
How do these estimates depend on the block size and number of blocks? That is, you might try keeping n fixed and vary N and k. Does there appear to be an optimal N, k to choose? Increase N and k separately and see if/how the estimates improve. In this case you would need to change n.
Now consider peak-over-threshold modelling. Use the scheme gpfit in Matlab to estimate the parameters of the GPD distribution. Discuss the dependence of the estimates on the threshold
u and the amount of data n. Is the shape parameter ξ the same that you found in the GEV fit above? [20]
5. Consider geometric Brownian motion as a simple model for asset prices described by the Itoˆ stochastic differential equation
dSt = μStdt + σStdWt
on the interval [0, T ] with initial condition S0 = 1. We choose the parameter setting μ = 0.5,
σ=0.3andT =2.
(a) Describe briefly the meaning of the different terms in the above model in a financial context.
(b) Use Matlab to simulate and plot five different trajectories of the above model together in one graph using the Euler-Maruyama scheme with step size δt = 0.001.
(c) Calculate analytically E(St) and Var(St) for 0 ≤ t ≤ T.
(d) Generate 10000 trajectories of the above model with the Euler-Maruyama scheme and use the Monte Carlo method to estimate E(St) and Var(St). Do this with three different time steps δt = 0.1, δt = 0.01 and δt = 0.001. Plot the three estimates of E(St) together with the exact analytical result and do the same for Var(St). Comment on your results.
[25]