2-EPT probability density function: Difference between revisions

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The class of probability density functions on <math>\mathbb{R}</math> with strictly proper rational characteristic functions are referred to as 2-EPT probability density functions. On <math>[0, \infty)</math> as well as <math>(-\infty, 0)</math> these probability density functions are Exponential-Polynomial-Trigonometric (EPT) functions. An EPT density function on <math>(-\infty, 0)</math> can be represented as <math>f(x)=\textbf{c}_Ne^{\textbf{A}_Nx}\textbf{b}_N</math>. Similarly the EPT density function on <math>[0, -\infty)</math> is expressed as <math>f(x)=\textbf{c}_Pe^{\textbf{A}_Px}\textbf{b}_P</math>. We have that <math>(\textbf{A}_N,\textbf{A}_P)</math> are square matrices, <math>(\textbf{b}_N,\textbf{b}_P)</math> column vectors and <math>(\textbf{c}_N,\textbf{c}_P)</math> row vectors. <math>(\textbf{A}_N,\textbf{b}_N,\textbf{c}_N,\textbf{A}_P,\textbf{b}_P,\textbf{c}_P)</math> is the minimal realization of the 2-EPT function. The general class of probability measures on <math>\mathbb{R}</math> with (proper) rational characteristic functions are densities corresponding to mixtures of the pointmass at zero (``delta distribution") and 2-EPT densities. Unlike phase[[Phase-type]] and matrix analytic distributions the 2-EPT probability density functions are defined on the whole real line. It is shown that the class of 2-EPT densities is closed under many operations and using minimal realizations these calculations are illustrated for the two-sided framework in Sexton and Hanzon<ref>C. Sexton and B. Hanzon: State Space Calculations for two-sided EPT Densities with Financial Modelling Applications, ''www.2-ept.com''</ref>. The most involved operation is the [[convolution]] of 2-EPT densities using state space techniques. Much of the work centers on the ability to decompose the rational characteristic function into the sum of two rational functions with poles located in the open left and resp. open right half plane. The [[variance-gamma distribution]] density is shown to be a 2-EPT density under a parameter restriction and the [[Variance gamma process]] can be implemented to demonstrate the benefits of adopting such an approach for financial modelling purposes. Examples of applications provided include option pricing, computing the Greeks and risk management calculations.

== Notes ==