STATE PRICE DENSITY, ESSCHER TRANSFORMS, PRICING OPTIONS ON STOCKS, BONDS, AND FOREIGN EXCHANGE RATES

Yong Yao*

AND

ABSTRACT
The state price density is modeled as an exponential function of the underlying state variables, and the Esscher transform is used to specify the forward-risk-adjusted measure. With the aid of state price densities, Esscher transforms, and characteristic functions, this paper provides a consistent framework for pricing options on stocks, interest rates, and foreign exchange rates. The framework discussed is quite general and is related to many popular models.

1. INTRODUCTION
The idea of the state price density can be traced back to Arrows paper The Role of Securities in the Optimal Allocation of Risk Bearing (1953) and Debreus book The Theory of Value (1959). The authors introduced contingent contracts, each paying one unit of money in one specic state of nature and nothing in any other state. These contingent contracts are widely recognized as the fundamental building blocks of modern nancial-asset-pricing theories and nancial engineering. The prices of the contingent contracts are called state prices. The state price per unit of probability is referred to as the state price density. Rubinstein (1976) pioneered the pricing of European call options by explicitly specifying the state price density. He obtained the BlackScholes formula for the log-normal model. His approach was extended by Heston (1993), who obtained a Black-Scholes-type closed-form formula for European call options in the log-gamma model and the log-negative-binomial model. Turnbull and Milne (1991) and Constantinides (1992) were among the rst to model the term structure of interest rates by explicitly specifying the state price density. Their approach was ex-

* Yong Yao, A.S.A., Ph.D., is a Principal at DFA Capital Management Inc., 100 Manhattanville Road, Purchase, NY 10577, email: yy@dfa.com.

tended in Rogers (1997) and Yao (1998, 2000). The state price (density) and its applications have been extensively discussed in the nance literature. Some examples are Ait-Sahalia and Lo (1998, 2000), Banz and Miller (1978), Breeden and Litzenberger (1978), Cochrane (2001), Dufe (1992), Dybvig (1988a,b), Merton (1990), and Sharpe (1995, 1998). Contingent contracts are not a novelty in the insurance and actuarial science areas. Before the development of modern nancial derivative markets, insurance claims were examples of contingent contracts that could be found in actual markets. In a series of papers, Borch (1990) systematically used the Arrow-Debreu framework in determining insurance premiums in the context of a competitive equilibrium market (see also Bu hlmann 1980, 1984 and Aase 1993a,b). The method of Esscher transforms is a timehonored tool in actuarial science. Gerber and Shiu (1994, 1996) successfully used Esscher transforms in pricing stock options and obtained many important results. The authors assumed that the risk-free interest rate is constant over time. They used several special cases of the Levy process to describe the future evolution of the logarithm of the stock price(s). The authors independently obtained the same results as Heston (1993). The use of Esscher transforms in pricing stock options has also been discussed in papers such as Bu hlmann et al. (1998) and Chan (1999)
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and in books such as Bingham and Kiesel (1998), Panjer (2001), and Shiryaev (1998). This paper extends the Gerber and Shiu work and uses Esscher transforms in modeling the term structure of interest rates and pricing options when the interest rates are stochastic. This extension, however, is not a straightforward one. First, Gerber and Shiu calculated the price of options as the expected value under the riskneutral measure discounted at the risk-free short rate. When interest rates are constant over time, the discount factors are deterministic functions of time to maturity. This simplies the calculations involved and makes the use of Esscher transforms possible. When interest rates are stochastic, the efcient approach to option pricing is that the price is calculated as the expected value under the forward-risk-adjusted measure discounted by the price of the default-free zerocoupon bond. So we need to investigate whether Esscher transforms can be used to specify the forward-risk-adjusted measure. Second, Gerber and Shiu used stochastic processes with independent and stationary increments to model the stock return. Interest rates have a tendency to be pulled back to some longrun level, a phenomenon known as mean reversion. So we need to use processes that exhibit the mean reversion property to model interest rates. Extension of the Gerber-Shiu framework is built on the following observations. When the interest rates are deterministic, the forward-riskadjusted measure is the same as the risk-neutral measure. Yao (1994) showed that the Esscher transform of a Levy process can always be represented as a stochastic exponential. So, in the Gerber-Shiu framework, the state price density can be represented in an exponential form. The exponential type of the state price density has been used explicitly or implicitly in many papers, for example, Black and Scholes (1973), Merton (1973), Rubinstein (1977), Vasicek (1977), and Cox, Ingersoll, and Ross (1985), Rabinovitch (1989), Constantinides (1992), Heston (1993), Dufe and Kan (1996), Rogers (1997), and Yao (1998, 2000). Motivated by these observations, this paper models the term structure of interest rates by specifying the state price density as an exponential function of state variables. The forward-riskadjusted measure is an Esscher measure in the

models discussed here. It is found that Esscher transforms provide a consistent and efcient framework for pricing options on stocks, interest rates, and foreign exchange rates. With deterministic interest rates, the forward-risk-adjusted measure is the same as the risk-neutral measure. Thus, this paper generalizes the Gerber-Shiu framework to price options in a stochastic interest rate environment. From this perspective, Gerber and Shiu (1994, 1996) were among the rst to price options by explicitly specifying the state price density in the insurance and actuarial science areas. Esscher transforms can also be used to give other changes of probability measure such as those discussed in Geman, El Karoui, and Rochet (1995). For the purpose of this paper I will focus on the forward-risk-adjusted measure. I will also focus on specifying the forward-risk-adjusted measure in the general framework. Several examples in the diffusion context are provided as illustrations of the general framework. The outline of the paper is as follows. Section 2 discusses a dynamic asset-pricing model and uses the state price density to represent the risk-neutral measure and the T-maturity forward-risk-adjusted measure. Section 3 reformulates the Gerber-Shiu framework in terms of the state price density. Sections 4, 5, and 6 demonstrate how to use Esscher transforms to price interest rate options, stock options with stochastic interest rates, and foreign currency options with stochastic interest rates, respectively. Section 7 illustrates the framework discussed in this paper in the diffusion context. Conclusions are given in Section 8.

2. STATE PRICE DENSITY OF MEASURE

AND

CHANGES

2.1 A Dynamic Asset Pricing Model Consider a stochastic intertemporal economy, where uncertainty is represented by a probability space (, F, P) equipped with a ltration {Ft: 0 t T*}. Here represents the set of states of the world. The investors information up to time t is given by Ft. The beliefs of investors are represented by the (actual) measure P. All economic activities will be assumed to take place on a nite horizon [0, T*], where T* is a positive constant. For any t and T, 0 t T T*, it is assumed

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that there exists a positive state price density process {(t, T)}, such that the price (or the present value) V(t) at time t of a claim to a payoff z(T) at some future time T is given by V t Ett, T zT, (2.1)

The default-free discount bond price is the expected value of the state price density. 2.2 The Equivalent Martingale Measure For one unit of currency invested in a money market account at time t 0, its value at time t will be B t exp

where Et[ ] denotes the conditional expectation given the information Ft available up to time t, taken with respect to the measure P. To be consistent, V(T) must be equal to z(T) and (0, 0) is equal to 1. So Equation (2.1) can be rewritten as V t Ett, TVT. (2.2)

t 0

rs ds ,

The existence and characterization of a state price density can be obtained either in preference-based equilibrium models or in arbitragebased models. As noted in the preface of Dufe (1992), the most important unifying principle is that any of these three conditions (arbitrage, optimality, and equilibrium) implies that there are state prices, meaning positive discount factors, one for each state and date, such that the price of any security is merely the state-price weighted sum of its future payoffs (p. xiii). In the equilibrium framework, the state price density is called a stochastic discount factor or price kernel. In the no-arbitrage models the state price density is often called the risk-neutral density or state-price deator (see also Ait-Sahalia and Lo 1998, 2000 and Cochrane 2001). Denote (t) (0, t). In the preference-based equilibrium models and in arbitrage-based models, we have that (t, T) (T)/(t). (See Dufe 1992 for details.) From Equation (2.2), we obtain t V t EtTVT, t 0; (2.3)

where r(t) is the short rate or instantaneous spot rate prevailing at time t. From the martingale pricing equation, Equation (2.3), we know that t the process {(t) exp[0 r(s) ds]} is a positive martingale with initial value 1. Dene a probability measure Q such that its Radon-Nikodym derivative with respect to (actual) measure P is given by dQ T exp dP

T 0

rs ds .

Then Q is a probability measure that is equivalent to the measure P and is called an equivalent martingale measure or a risk-neutral measure. (See Appendices A and C of Dufe 1992 for a short discussion on the Radon-Nikodym derivative.) Q Denote by Et [ ] the conditional expectation given the information Ft available at time t, taken with respect to this risk-neutral measure Q. We then have
Q zT exp Ett, T zT Et

that is, the process {(t)V(t)} is a martingale. Equation (2.3) is called the martingale pricing equation. A default-free discount bond maturing at time T is a security that will pay one unit of currency at time T and nothing at any other time. Denote the price at time t of this bond as P(t, T). At maturity T we have P(T, T) 1. Applying Equation (2.2) to P(t, T), we have P t , T Ett, T. (2.4)

T t

rs ds . (2.5)

2.3 The Forward-Risk-Adjusted Measure The measure QT, dened by T dQ T dP ET is a probability measure equivalent to the (actual) measure P. The measure QT is called the T-maturity forward-risk-adjusted measure. The idea of the forward-risk-adjusted measure can be traced back to Merton (1973), who presented the price of

This gives the relationship between the term structure of interest rates and state price density:

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a European call option on one stock in terms of the ratio of the stock price to the bond price. Bick (1988) gave a dynamic hedging argument of Mertons results in terms of forward contracts, and Jamshidian (1989) and Geman (1989) developed the mathematical treatment of the forward-risk-adjusted measure. (See also Pedersen and Shiu 1994 and Geman, Karoui, and Rochet 1995.) QT Denote by Et [ ] the conditional expectation given the information Ft available at time t, taken with respect to this T-maturity forward-risk-adjusted measure QT. We have
QT Ett, T zT Ett, TEt zT.

3. REFORMULATING FRAMEWORK

THE

GERBER-SHIU

(2.6)

Gerber and Shiu (1994, 1996) discussed Esscher transforms in the risk-neutral framework. This framework was developed in Cox and Ross (1976) and extended in Ross (1978), Harrison and Kreps (1979), and Harrison and Pliska (1981). For the purpose of this paper Esscher transforms are put in the framework of directly modeling the state price density. As in Gerber and Shiu (1994, 1996), for j 1, 2, . . . , n, let Sj(t) denote the price of nondividend-paying stock j at time t and write X j t lnSjt/Sj0, and X(t) the vector with Xj(t) being the j-th entry. Gerber and Shiu (1994, 1996) assumed that the short rate r ( t ) is a constant and is denoted by . (In these two papers the short rate is called the risk-free force of interest.) In this case, t exp[ 0 r ( s ) ds ] exp[ t ]. The RadonNikodym derivative of the risk-neutral measure Q with respect to (original) measure P is given by dQ T expT. dP We can now assume that the state price density process has the form t A t expt h* Xt, with the deterministic function A(t) and the parameter vector h* being specied in the following paragraphs. A state price density of this form is implicitly used by Black and Scholes (1973) and explicitly used by Rubinstein (1976) and Heston (1993). In this case we have Z t t exp

Note that the price of a default-free discount bond, P(t, T), is equal to Et[(t, T)]. So we have the equation
QT Ett, T zT Pt, TEt zT.

It is easy to see that, when interest rates are deterministic, the T-maturity forward-risk-adjusted measure is the same as the risk-neutral measure. 2.4 The Esscher Measure Let X(t) be an n-dimensional random process vector and Rn the linear space of column vectors with n real entries. For each t and T, 0 t T T*, we denote M Xh; t, T Etexph XT, h Rn,

the (conditional) moment-generating function for the random variable vector X(T). (In this paper denotes the inner product operation of vectors and matrices.) Let h be a real vector for which E[h X(T)] exists. The measure QE, dened by dQ E exph XT , dP MXh; 0, T is a probability measure equivalent to the (actual) measure P. The measure QE is called the Esscher measure of parameter vector h, and the corresponding distribution is called the Esscher transform. See Gerber and Shiu (1994, 1996) for a detailed discussion of these two concepts. Denote by Et[ ; h] the conditional expectation given the information Ft available at time t, taken with respect to this Esscher measure QE.

t 0

rs ds At exph* Xt.

Because the process {Z(t)} is a positive martingale with Z(0) 1, we have 1 EAt exph* Xt or At 1 1 . Eexp h* Xt MXh*; 0, t

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That is, the risk-neutral measure, given by dQ exph* XT , dP MXh*; 0, T is an Esscher measure. It is called the risk-neutral Esscher measure in Gerber and Shiu (1994, 1996). In their two papers {X(t)} is a vector of stochastic processes with independent and stationary increments. So we have M Xh*; t MXh*; 1t. With this assumption and a constant interest rate, the parameter vector h* is uniquely determined and is a constant vector. Thus, the state price density in these papers is of the form t expt h* Xt . MXh*; 1t

4. PRICING INTEREST RATE OPTIONS

As in Section 2, for 0 t T we denote P(t, T) the time-t price of a default-free discount bond maturing at time T. At maturity T we have P(T, T) 1. From Equation (2.4) we obtain P t , T EtT/t EtT/t. It is assumed that there is an n-dimensional stochastic process {X(t)} such that the state price density is an exponential function of X, that is, X , t expct Xt X0, where (1, 2, . . . , n) and c, 1, 2, . . . , n are n 1 real numbers. A state price density of this form was implicitly used by Vasicek (1977), Cox, Ingersoll, and Ross (1985), and Dufe and Kan (1996), and explicitly used by Constantinides (1992), Rogers (1997), and Yao (1998, 2000). In this case the prices of default-free discount bonds are also functions of the state variable vector X and are given by Pt, T EtexpcT XT . expct Xt

The parameter vector h* is determined so that, for j 1, 2, . . . , n, {(t)Sj(t)} is a martingale. In particular, for each t, 0 t T, we have S j 0 EtSjt. As an illustration of pricing options using this framework, consider a European call option on one stock (the case n 1). The detailed applications can be found in Gerber and Shiu (1994, 1996). Consider a European call option on the stock with exercise price K and exercise date T. From the last equation and the martingale pricing Equation (2.3), the value of this option (at time 0) is C EexpTST K; h*, where x x if x 0, and x 0 if x 0. Let I( A) denote the indicator random variable of an event A. We have C EexpTST KIST K; h* EexpTSTIST K; h* K expTEIST K; h* S 0 PrST K; h* 1 KP0, T PrST K; h*, with Pr[A; h*] denoting the probability of an event A under the risk-neutral Esscher measure with parameter h*.

From Section 2.3 we know that the T-maturity forward-risk-adjusted measure QT is dened by dQ T exp XT ; dP MX; T that is, T-maturity forward-risk-adjusted measure QT is an Esscher measure with parameter vector dened in Section 2.4. In this case we have Ett, T zT Pt, TEt zT; T, . Now consider a European call option on default-free discount bonds with exercise price K and exercise date T. Section 7.2.1 provides an example in the diffusion context as an illustration. At exercise date T the payoff of a European call option written on a zero-coupon bond with matures at time T equals P T , T K . We know that P(T, T ) ET[(T )]/(T). From the last equation and the martingale pricing Equation (2.3), the value of this option (at time 0) is

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C EETT KT ET IPT, T K KETIPT, T K P0, T EIPT, T K; T , KP0, TEIPT, T K; T, P 0, T PrPT, T K; T , KP0, T PrPT, T K; T, , where Pr[A; S, ] denotes the probability of an event A under the Esscher measure with parameter .

process {Y(t)}. The common component Y(t) is used to model the correlation between the stock prices and interest rates. The parameter vector h* is determined so that, for j 1, 2, . . . , n, {(t)Sj(t)} is a martingale. In particular, for each t, 0 t T we have S j 0 EtSjt. From Section 2.2 we know that the T-maturity forward-risk-adjusted measure QT is dened by dQ T exph* XT YT , dP MX,Yh*, ; T with MX,Y(h*, ; T) Eexp(h* X(T) Y(T)) being the moment generating function for random variables X(T) and Y(T). Thus, in this case T-maturity forward-risk-adjusted measure QT is also an Esscher measure, and we have Ett, T zT Pt, TEt zT; T, h*, . Now consider a European call option on the stock S(t) S1(t) with exercise price K and exercise date T. Section 7.2.2 provides an example in the diffusion context as an illustration. From the last equation and the martingale pricing Equation (2.3), the value of this European call option (at time 0) is C ETST K P 0, T EST KIST K; T, h*, P 0, T ESTIST K; T, h*, KP0, TEIST K; T, h*, S 0 EIST K; T, h* H1, 0 KP0, TEIST K; T, h*, S 0 PrST K; T, h* H1, 0 KP0, T PrST K; T, h*, . See Section 7.2.2 for an example in the diffusion context, which shows how to calculate two probabilities in the last line of these formulas.

5. PRICING STOCK OPTIONS WITH STOCHASTIC INTEREST RATES

Merton (1973) was the rst to extend the BlackScholes model to incorporate stochastic interest rates. Rabinovitch (1989) reformulated the Merton model to a model with the stock price and the short rate as two state variables. This section will extend this work to a more general setting. Let {X(t)} be an n1-dimensional stochastic process with X(0) 0 and {Y(t)} be an n2-dimensional stochastic process. Assume that X(t) and Y(t) are independent. It is assumed that the state variables in this section are X(t) and Y(t). Based on the discussion until now, we assume the state price density (t) to have the form t 1 t 2 t , where 1(t) exp(h* X(t))/MX(h*; t) and 2(t) exp[ct (Y(t) Y(0))]. In this case the prices of default-free discount bonds are given by Pt, T EtexpcT YT . expct Yt (5.1)

For j 1, 2, . . . , n1, let Sj(t) denote the price of nondividend-paying stock j at time t and assume that S j t S j 0 expHj Xt Yt. (5.2)

Equation (5.2) states that the dynamics of stock prices are governed by n1-dimensional stochastic process {X(t)} and n2-dimensional stochastic process {Y(t)}. Meanwhile, Equation (5.1) states that the dynamics of prices of default-free discount bonds are governed by n2-dimensional stochastic

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6. PRICING FOREIGN EXCHANGE RATE OPTIONS WITH STOCHASTIC INTEREST RATES

6.1 A Two-Country Dynamic Asset-Pricing Model Considering an economy with two countries: the domestic country and the foreign country. We will denominate all of the assets in the domestic currency, whose unit will be called a dollar. Let P(t) denote the asset price and (t) the state price density in the domestic country. Denote the exchange rate for the foreign country against the domestic currency by S f(t) (in a dollars term) and the price of an asset in the currency of the foreign country by P f(t). At time t the price (in a dollars term) of an asset in the foreign country will be P f(t)S f(t). From Equation (2.3) we have t P f t S f t EtT P fTS fT or TS fT f t S f t f t E P P T . t S f 0 S f0 So if we denote f(t) (t)S f(t)/S f(0), then f t P f t Et fT P fT; that is, f(t) is a state price density for the foreign country. We now obtain S f t S f 0 f t , t (6.1)

tween the two countries is the ratio of their state price densities: S f t S f 0 expc f ct f Xt. Prices of default-free discount bonds are also functions of the state variable vector X and are given by Pt, T
f

EtexpcT XT , expct Xt

Etexpc fT f XT P t, T . expc ft f Xt From Section 2.3 we know that the T-maturity forward-risk-adjusted measures QT in the domesf tic country and QT in the foreign country are dened by dQ T exp XT , dP MX; T
f dQ T exp f XT ; dP MX f; T

that is, T-maturity forward-risk-adjusted meaf sures QT and QT are Esscher measures. In this case we have Ett, T zT Pt, TEt zT; T, , Et ft, T zT P ft, TEt zT; T, f . Now consider a European call option on the foreign exchange rate with exercise price K and exercise date T. From the last equation and the martingale pricing Equation (2.3), the value of this option (at time 0) is C ETS fT K ES f0 fT KTIS fT K ES f0 fTIS fT K EKTIS fT K S f 0 E fTIS fT K KETIS fT K S f 0 P f 0, T PrS fT K; T, f KP0, T PrS fT K; T, , with Pr[A; T, f ] denoting the probability of an event A under the Esscher measure with param-

which states that the exchange rate between the two countries is the ratio of their state price densities. 6.2 Pricing Foreign Exchange Rate Options with Stochastic Interest Rates As in Section 4, it is assumed that there is an n-dimensional state variable vector {X(t)} such that the state price densities in both countries are exponential functions of X: X , t expct Xt X0, f X , t expc ft f Xt X0. This model was discussed in Rogers (1997) and Yao (1998). In this case the exchange rate be-

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eter f, and Pr[A; T, ] denoting the probability of an event A under the Esscher measure with parameter .

nents of random variable vector X(t), that is, U(t) X(t). Then the characteristic function of random variable U(t) is given by U , t Eexp 1Ut M X 1; 0, t. (7.3)

7. EXAMPLES

IN THE

DIFFUSION CONTEXT

7.1 The Esscher Measure and the MomentGenerating Function Assume that the random process vector {X(t)} is governed by stochastic differential equations of the form d X t Xt, tdt Xt, t dWt, (7.1)

Inverting the characteristic function, we can calculate the probability distribution of U(t): PrUt y 1 1 2

where (X(t), t) is an n 1 vector, (X(t), t) is an n n matrix, and W(t) is an n-dimensional standard Brownian motion under the measure P. Hereafter, whenever it can be done without causing confusion, variable dependence will be omitted for simplicity. Thus, Equation (7.1) will be written in the short form d X dt dWt.
7.1.1 The Esscher Measure

Re

U, t exp y 1 1

d.

(7.4) The last equation will be used to give closed-form formulas for option prices. See Feller (1966) for more details.
7.1.3 Random Processes with a Closed-Form Formula for the Moment-Generating Function

As dened in Section 2.4, the Esscher measure QE of parameter vector h is given by dQ E exph XT . dP MXh; 0, T From Girsanovs theorem, the process {W Q (t)}, which is given by W Q t Wt
E
E

Consider a random process {X(t)} that follows a stochastic differential equation of the form dXt at bt Xt dt X(t) dWt. Let MX(h; t, T) Et{exp[hX(T)]} be the momentgenerating function of the random variable X(T) conditional on information at time t. It can be shown that the moment-generating function, MX(h; t, T), is the solution of the Kolmogorov backward equation of the form 1 2M M M X 0. a bX t X 2 X2 (7.5)

ln MXh; s, T Xs, s ds, X

follows a standard n-dimensional Brownian motion under the measure QE, and under this measure, Equation (7.1) can be rewritten as (omitting variable dependence) dX

ln MX E * dt dW Q . X

See Karlin and Taylor (1975) or ksendal (1998) for more details. Assume that MX(h; t, T) has the functional form M X h ; t , T expAh; t, T Bh; t, T Xt, with A(h; T, T) 0 and B(h; T, T) h. Substituting this functional form into Equation (7.5) yields A B 1 X B a bX B 2 X 0. t t 2 The last equation can be reduced to two equations:

(7.2)

7.1.2 Calculating the Probability Distribution

From the moment-generating function MX(h; t, T), we can obtain the characteristic function of the random variable vector X(T), which is dened by Xh, T Eexp 1h XT. Let U(t) be a linear combination of the compo-

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dA aB B 2 0, dt 2 dB bB B 2 0. dt 2

(7.6a) (7.6b)

dX i t i k i X i t dt i Xit dWit, where W1(t) and W2(t) are two independent Brownian motions and all the parameters are positive constants. (It is straightforward to generalize this model to a model with more than two factors.) Then choose the state price density as t expct 1X1t X10 2X2t X20, where c is a positive constant, and 1 and 2 are non-negative constants. Then the time-t price of a default-free discount bond with maturity T is given by P t , T EtT/t expcT t A1, 2; B11; 1X1t B22; 2X2t, where T t, B i i ; C i i ; i expki, A 1 , 2 ;

Solving Equation (7.6b) and using the condition B(h; T, T) h yields Bh; t, T
T bs ds h expt

1 T T 12 h t expz bs ds dz

(7.7) Substituting this formula for B(h; t, T) into Equation (7.6a) gives the solution for A(h; t, T). As illustration, we give the functional form for the moment-generating function in two simple cases. In the rst case the random process {X(t)} follows a stochastic differential equation of the form dX t dt dW t . Then the moment-generating function is given by M X h ; t , T exph 1 2h2T t hXt. 2 In the second case the random process {X(t)} follows a stochastic differential equation of the form dX t kX t dt X ( t ) dWt. The moment-generating function M(h; t, T) has the functional form M X h ; t , T expAh; t, T Bh; t, T Xt, where 2 kh expk B h ; , 2k 2h1 expk

i1

2 ln C ; ,
2 i 2 i i i 2 i

C i i ;

2ki . 2 k i i 1 expki

The yield to maturity is given by yt, T ln Pt, T Tt A1, 2; B11; 1 X1t Tt Tt (7.8)

2 2k . A h ; 2 ln 2 2k h1 expk 7.2 Examples

7.2.1 A Two-Factor Model of the Term Structure of Interest Rates

B22; 2 X2t, Tt

and the short rate is given by r t lim yt, T

T3t

To illustrate how to use the Esscher measure to value stock options with stochastic interest rates, assume that two state variables follow CoxIngersoll-Ross processes of the form

i1

2 i2i2 ii c. iki Xit 2 i1

(7.9)

For non-negativity of the short rate, let us choose 2 2 i such that 0 i 2ki/i and c i 1 ii.

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The value (at time 0) of a European call option on default-free discount bonds with exercise price K and exercise date T is given by C ETPT, T K. Let A {P(T, T ) K} and U(T) [B1(1; ) 1]X1(T) [B2(2; ) 2]X2(T). Then the time-t price of a default-free discount bond with maturity T is given by P T , T exp c A1, 2; UT, A U T ln K c A1, 2; . From Section 4 we have that C ET I A KETI A P 0, T PrA; T , KP 0, T PrA; T, , where Pr[A; S, ] denotes the probability under the Esscher measure with parameter vector (1, 2). To calculate these two probabilities, we need to give the functional forms of two Esscher measures as well as the characteristic functions of random variable U(T) under these two measures. In this model the two Esscher measures are dened by dQ E exp1X1S 2X2S , dP expA1, 2; S B11; S X10 B22; S X20 with S T and S T. Under these Esscher measures the state variables follow Cox-IngersollRoss processes of the form dX i t i S t X i t dt i X it dW t, i k
QE i

i T ; S B

h i C i i ; S 2 expki S , 1 hii2Cii; S1 expki S 2ki , 2 k i i 1 expki S

2 i

C i i ; S

h i B i i ; i 1. With the aid of this characteristic function, we can calculate the probability of U ( T ) under the Esscher measure with parameter vector (1, 2): 1 1 PrA; S, 2

Re

U, T; S

expln K c A; 1 1

d,

where S T and S T.
REMARK 1

From Equation (7.8), for j 1, 2, we have y t , t j j 1j X 1 t 2j X 2 t , where j c 1j 2j A 1 , 2 ; j , j

B11; j 1 , j B22; j 2 . j

2 i(S t) ki Bi(; S t)i where k . So the characteristic functions of random variable U(T) are obtained from Equations (7.3) and (7.7):

We can solve for X1 and X2 in terms of y(t, t 1) and y(t, t 2). This gives a yield-factor model of the term structure of interest rates discussed in Dufe and Kan (1996).
REMARK 2

T; S B 1T; S X10 U , T ; S expA 2T; S X20, B where T; S A 1 , 2 ln1 h C ; S 1 expk S

2 i 2 i 2 i i i i i

It follows from Equation (7.9) that, if we choose c 11 22, then r t 1X 1 t 2X 2 t ,

2 2 where, for i 1, 2, i iki i i /2. So we have

dr t t dt 1 1 X 1t dW1t

22 X2t dW2t,

i1

where (t) (11 22) [1k1 X1(t)

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2k2 X2(t)]. From the last equation we know that the instantaneous variance of changes in the short rate is V t 1 1 2 X 1 t 2 2 2 X 2 t . We can solve for X1 and X2 in terms of r and V. This gives a two-factor model of the term structure of interest rates discussed in Longstaff and Schwartz (1992).
REMARK 3

Here c and 0 2k/2 are chosen. The stock price is assumed to follow the process S t S 0 expX1t X2t X20. The parameter h* is determined so that {(t)S(t)} is a martingale. In particular, for each t, 0 t T, we have S 0 EtSt. Substituting the formulas assumed for (t) and S(t) gives 1E

Let dYi(t) kiYi(t)dt iYi(t) dWi(t), and Xi(t) [Yi(t)]2. Then we have dX i t 2 k i X i t dt 2 i X it dWit.
2 i

exph*X1t

1 2 exph* 2 h*2t

expct X2t

By choosing the state price density t expct 1 X1t 2 X2t, we have a two-factor Constantinides (1992) model and can give a closed-form formula for the European option on default-free discount bonds.
7.2.2 Pricing Stock Options with Stochastic Interest Rates

X20 expX1t X2t X20 , and simplifying the last equation yields 1 expct exph* 1 2 2h* 12
1 2 exph* 2 h*2t 1

To illustrate how to use the Esscher measure to value stock options with stochastic interest rates, assume that the two-dimensional random process vector X(t) follows dX 1 t dt dW 1 t , dX 2 t kX 2 t dt X 2t dW2t, where W1(t) and W2(t) are two independent Brownian motions and all the parameters are positive constants. It is assumed that X1(0) 0. Next choose the state price density as t 1 t 2 t , where 1 t exph*X1t
1 2 exph* 2 h*2t

This gives the following equation, which determines h*: h*2 c 1 2. 2 Let A {P(T, T ) K} and U(T) X1(T) [X2(T) X2(0)]}. Then we have A U T ln

K . S0

From Section 5 we know that the value (at time 0) of a European call option on the stock with exercise price K and exercise date T is given by C S 0 PrST K; T, h* 1, 0 KP0, T PrST K; T, h*, . (7.11)

2 t expct X2t X20. In this case the prices of default-free discount bonds are given by EtexpcT X2T Pt, T . expct X2t

To calculate these two probabilities, we need to give the functional forms of the two Esscher measures as well as the characteristic functions of random variable U(T) under these two measures. The rst probability in Equation (7.11) is calculated under the Esscher measure QE, which is given by exph* 1 X1T dQ E . dP exph* 1 1 2h* 12T
2

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115

Under this Esscher measure, the state variable vector X follows:

Q dX 1 t 1 2 dt dW 1 t, 2
E

Q dX 1 t 1 2 dt dW 1 t, 2
E

dX 2 t k B ; 2 X 2 t dt
E

Q dX 2 t kX 2 t dt X 2t dW 2 t.

Q X 2t dW 2 t.
E

So the characteristic function of random variable U(T) is given by U , T ; h *, expc 1 2 1 1 22T 2 2 h2; T B h2; T X20, A where h 2; T B h 2 expkT , 1 h221 expkT

So the characteristic function of random variable U(T) is given by U , T ; h *, expc 1 2 1 1 22T 2 2 h2; T B h2; T X20, A where h2; T B h 2 C ; T 2 expkT , 1 h22C; T1 expkT

2 1 h 2 ; T 2 ln , A 2 1 h2 1 expkT h 2 1. With the aid of this characteristic function, we can calculate the probability: 1 1 PrST K; T, h* 1, 0 2

h2; T A C ; T

1 2 , 2 ln 2 1 h2 C; T1 expkT 2k , 2 k 1 expkT
2

h 2 1. The second probability is given by 1 1 PrST K; T, h*, 2

Re

U, T; h* 1, 0 1

explnK/S0 1

d.
REMARK

Re

U, T; h*, exp lnK/S0 1 1

d.

The second probability in Equation (7.11) is calculated under the Esscher measure QE, given by exph*X1T X2T dQ E dP exph* 1 2h*2T
2

Letting 0 in this model, the stock price will follow a log-normal process S t S 0 expX1t. The value (at time 0) of a European call option is given by C S 0 PrST K; T, h* 1 K expcT PrST K; T, h*,

A; T B; T X20 where B ; T A ; T 2 k expkT , 2k 21 expkT 2k 2 . 2 ln 2 2k 1 expkT

where

PrST K; T, h* 1

Under this Esscher measure the state variable vector X follows

1 1 2

Re

1 2 1 2 2 expc 2 1 2 T

lnK/S0 1 1

d,

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PrST K; T, h*

1 1 2

Re

1 2 1 2 2 expc 2 1 2 T

lnK/S0 1 1

d.

lands. I would like to thank Theo K. Dijkstra of the University of Groningen, Chris Rogers of the University of Bath, U. K., and especially Elias S. W. Shiu of the University of Iowa for their advice and help. All errors are my responsibility alone. REFERENCES
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This is the Black-Scholes (1973) option-pricing formula in terms of the characteristic functions of a random variable.

8. CONCLUSION
In this paper, by modeling the state price density as an exponential function of underlying state variables, it has been shown that the well-known Esscher transform can be used to specify the forward-risk-adjusted measure. With the aid of the state price density, the Esscher transform, and the characteristic function, this paper provides a consistent framework for pricing options on stocks, interest rates, and foreign exchange rates. The framework discussed here is quite general and is related to many popular models, for example, Black and Scholes (1973); Constantinides (1992); Cox, Ingersoll, and Ross (1985); Dufe and Kan (1996); Heston (1993); Merton (1973); Rabinovitch (1989); Rubinstein (1976); and Vasicek (1977). This paper is a generalization of Gerber and Shiu (1994, 1996), in which Esscher transforms are used to dene the risk-neutral measure and price options with constant risk-free interest rates. When interest rates are deterministic, the forward-risk-adjusted measure degenerates to the risk-neutral measure. The framework discussed in this paper can be applied to address the valuation problems of equity or xed-income linked life insurance policies, interest-rate-sensitive products, and options and guarantees, such as annuity purchase options and minimum rate guarantees. It can also be used to measure and manage the risks associated with these products.

ACKNOWLEDGMENTS
This paper was written while the author was working at the Department of Finance and Accounting, University of Groningen, The Nether-

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