Financial Modelling Using Discrete Stochastic Calculus

In the present report, a review of discrete calculus on directed graphs is presented. It is found that the binary tree is a special directed graph that contains both the exterior calculus and stochastic calculus as different continuum limits are taken. In the latter case, we arrive at something that may be referred to as “discrete stochastic calculus.” The resulting discrete stochastic calculus may be applied to any stochastic financial model and is guaranteed to produce results that converge in the continuum limit. Discrete stochastic calculus is applied to the Black-Scholes model for an illustration. The resulting algorithm generated by discrete stochastic calculus agrees with that of the Cox-Ross-Rubinstein model, as it should. The results presented here are preliminary and are intended to encourage others to learn discrete stochastic calculus and apply it to more complicated financial models.

category: papers

Revised on January 5, 2009 at 19:23:15
by
Eric Forgy