# sdeddo

Stochastic Differential Equation (SDEDDO) model from Drift and Diffusion components

## Description

Creates and displays sdeddo objects, instantiated with objects of classdrift and diffusion. These restricted sdeddo objects contain the input drift and diffusion objects; therefore, you can directly access their displayed parameters.

This abstraction also generalizes the notion of drift and diffusion-rate objects as functions that sdeddo evaluates for specific values of time t and state Xt. Like sde objects, sdeddo objects allow you to simulate sample paths of NVars state variables driven by NBrowns Brownian motion sources of risk over NPeriods consecutive observation periods, approximating continuous-time stochastic processes.

This method enables you to simulate any vector-valued SDEDDO of the form:

 $d{X}_{t}=F\left(t,{X}_{t}\right)dt+G\left(t,{X}_{t}\right)d{W}_{t}$ (1)
where:

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

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

• F is an NVars-by-1 vector-valued drift-rate function.

• G is an NVars-by-NBrowns matrix-valued diffusion-rate function.

## Creation

### Description

example

SDEDDO = sdeddo(DriftRate,DiffusionRate) creates a default SDEDDO object.

example

SDEDDO = sdeddo(___,Name,Value) creates a SDEDDO 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 SDEDDO 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

• A — Access function for the drift-rate property A, callable as a function of time and state

• B — Access function for the drift-rate property B, callable as a function of time and state

• Alpha — Access function for the diffusion-rate property Alpha, callable as a function of time and state

• Sigma — Access function for the diffusion-rate property Sigma, callable as a function of time and state

• Simulation — A simulation function or method

### Input Arguments

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DriftRate is a user-defined drift-rate function and represents the parameter F, specified as a vector or object of class drift.

DriftRate is a function that returns an NVars-by-1 drift-rate vector when called with two inputs:

• A real-valued scalar observation time t.

• An NVars-by-1 state vector Xt.

Alternatively, DriftRate can also be an object of class drift that encapsulates the drift-rate specification. In this case, however, sde uses only the Rate parameter of the object. For more information on the drift object, see drift.

Data Types: double

DiffusionRate is a user-defined diffusion-rate function and represents the parameter G, specified as a matrix or object of class diffusion.

DiffusionRate is a function that returns an NVars-by-NBrowns diffusion-rate matrix when called with two inputs:

• A real-valued scalar observation time t.

• An NVars-by-1 state vector Xt.

Alternatively, DiffusionRate can also be an object of class diffusion that encapsulates the diffusion-rate specification. In this case, however, sde uses only the Rate parameter of the object. For more information on the diffusion object, see diffusion.

Data Types: double

## 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, sdeddo applies the same initial value to all state variables on all trials.

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

If StartState is a matrix, sdeddo 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

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:

$F\left(t,{X}_{t}\right)=A\left(t\right)+B\left(t\right){X}_{t}$

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

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:

$G\left(t,{X}_{t}\right)=D\left(t,{X}_{t}^{\alpha \left(t\right)}\right)V\left(t\right)$

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

 interpolate Brownian interpolation of stochastic differential equations (SDEs) for SDE, BM, GBM, CEV, CIR, HWV, Heston, SDEDDO, SDELD, or SDEMRD models simulate Simulate multivariate stochastic differential equations (SDEs) for SDE, BM, GBM, CEV, CIR, HWV, Heston, SDEDDO, SDELD, SDEMRD, Merton, or Bates models simByEuler Euler simulation of stochastic differential equations (SDEs) for SDE, BM, GBM, CEV, CIR, HWV, Heston, SDEDDO, SDELD, or SDEMRD models simByMilstein Simulate BM, GBM, CEV, HWV, SDEDDO, SDELD, SDEMRD sample paths by Milstein approximation

## Examples

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The sdeddo class derives from the base sde class. To use this class, you must pass drift and diffusion-rate objects to the sdeddo function.

Create drift and diffusion rate objects:

F = drift(0, 0.1);      % Drift rate function F(t,X)
G = diffusion(1, 0.3);  % Diffusion rate function G(t,X)

Pass the functions to the sdeddo function to create an object obj of class sdeddo:

obj = sdeddo(F, G)      % dX = F(t,X)dt + G(t,X)dW
obj =
Class SDEDDO: SDE from Drift and Diffusion Objects
--------------------------------------------------
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
A: 0
B: 0.1
Alpha: 1
Sigma: 0.3

In this example, the object displays the additional parameters associated with input drift and diffusion objects.

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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, sdeddo 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