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\documentclass[11pt,a4paper]{article}
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\begin{document}
\section{Mathematical Foundations}\label{mathematical-foundations}
This page develops the core mathematics underlying Optimiz-rs's Rust kernels --- from first principles through advanced theory. Each section opens with a \textbf{definition block}, builds intuition through \textbf{examples and diagrams}, and closes with a \textbf{notebook micro-check}. For complete walkthroughs see \texttt{examples/notebooks/}.
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{1 · Differential Evolution (DE)}\label{differential-evolution-de}
\subsubsection{Background}\label{background}
DE is a gradient-free population-based optimizer for \(f: \mathbb{R}^d \to \mathbb{R}\), not required to be smooth or convex. At generation \(g\) we maintain \(N\) candidate solutions \(\{\mathbf{x}_{i,g}\} \subset \mathbb{R}^d\).
\textbf{Key insight:} The difference vector \(\mathbf{x}_{r_2}-\mathbf{x}_{r_3}\) is an unbiased directional finite-difference of \(f\), so DE implicitly estimates curvature without Jacobians.
\subsubsection{\texorpdfstring{1.1 Geometric Intuition --- Mutation in \(\mathbb{R}^2\)}{1.1 Geometric Intuition --- Mutation in \textbackslash mathbb\{R\}\^{}2}}\label{geometric-intuition-mutation-in-mathbbr2}
\begin{verbatim}
x_r3 *
|
| F*(x_r2 - x_r3) F = scale factor in [0,2]
| ------------------>
x_r2 * * v_i (mutant)
\\ /
\\________________/
(difference vec)
x_r1 *------------------------------------------------> v_i
base vector mutation vector added
\end{verbatim}
\begin{itemize}
\item
\(\mathbf{r}_1, \mathbf{r}_2, \mathbf{r}_3\) are three \textbf{distinct} randomly selected parents.
\item
The mutant \(\mathbf{v}_i\) lands on the other side relative to \(\mathbf{x}_{r_1}\).
\item
\textbf{Crossover} then mixes \(\mathbf{v}_i\) and \(\mathbf{x}_i\) dimension-by-dimension with probability \(CR\), producing trial vector \(\mathbf{u}_i\).
\item
\textbf{Selection} keeps \(\mathbf{u}_i\) only if it improves over \(\mathbf{x}_i\) --- pure greedy.
\end{itemize}
\subsubsection{1.2 Operators}\label{operators}
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.2857}}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.4286}}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.2857}}@{}}
\toprule\noalign{}
\begin{minipage}[b]{\linewidth}\raggedright
Step
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Formula
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Role
\end{minipage} \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
Mutation (rand/1) & \(\mathbf{v}_{i,g} = \mathbf{x}_{r_1} + F(\mathbf{x}_{r_2}-\mathbf{x}_{r_3})\) & explore \\
Binomial crossover & \(u_{i,j} = v_{i,j}\) if \(U(0,1)<CR\) or \(j=j_\text{rand}\) & mix dimensions \\
Greedy selection & \(\mathbf{x}_{i,g+1} = \mathbf{u}_{i,g}\) iff \(f(\mathbf{u})\le f(\mathbf{x})\) & exploit \\
\end{longtable}
}
\textbf{Convergence (informal):} Under bounded population diversity and Lipschitz \(f\), the best-so-far value converges a.s. to a stationary point as \(N,g\to\infty\) (Price et al.~2005).
\subsubsection{1.3 Self-Adaptive jDE (Optimiz-rs default)}\label{self-adaptive-jde-optimiz-rs-default}
Parameters \(F,CR\) are per-individual and reset stochastically each generation:
\[
F_i^{g+1} = \begin{cases} F_{\min} + r_1 F_{\max} & r_2 < \tau_1,\\ F_i^g & \text{otherwise,}\end{cases}
\qquad
CR_i^{g+1} = \begin{cases} U(0,1) & r_3 < \tau_2,\\ CR_i^g & \text{otherwise.}\end{cases}
\]
\(\tau_1=\tau_2=0.1\) by default. On rugged landscapes this produces bimodal \(F\) histograms concentrated near 0.8 --- a sign the landscape is highly multimodal.
\subsubsection{1.4 Example --- Minimising the Rastrigin Function}\label{example-minimising-the-rastrigin-function}
The Rastrigin function \(f(\mathbf{x}) = 10d + \sum_i[x_i^2 - 10\cos(2\pi x_i)]\) has \(\approx 10^d\) local minima (global minimum \(f^*=0\) at \(\mathbf{x}^*=\mathbf{0}\)).
\textbf{Why gradient methods fail:} The gradient \(\partial_{x_i}f = 2x_i + 20\pi\sin(2\pi x_i)\) oscillates rapidly --- any gradient step hops between basins.
\textbf{Why DE succeeds:} The difference vector \(F(\mathbf{x}_{r_2}-\mathbf{x}_{r_3})\) spans the characteristic basin width (\textasciitilde1.0), enabling inter-basin jumps.
\begin{verbatim}
Rastrigin 1D sketch (d=1):
f(x)
| * * * <- local minima (many)
| * * * * * *
|* *
| * *
+------|------+------|-- x
-1 0 1
^
global min f=0
\end{verbatim}
\textbf{Typical jDE convergence} (\(d=10\), \(N=100\), \(\tau_1=\tau_2=0.1\)):
\begin{verbatim}
Gen Best f Mean F Mean CR
---- ------- ------- -------
1 48.3 0.50 0.50
50 12.1 0.78 0.31
200 3.4 0.82 0.24 <- F clusters near 0.8 (bimodal)
500 0.0 0.83 0.22 <- converged
\end{verbatim}
\begin{tcolorbox}[colback=thmbg!60,colframe=optgold,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Theorem / Key Idea}} — Tip — Diagnosing Stagnation},breakable]
If best-$f$ does not decrease for 100+ generations:
1. **Check $F$ histogram.** Bimodal near 0.8 -> landscape is multimodal (increase $N$).
Collapsed near 0 -> diversity loss; restart with random perturbation.
2. **Check $CR$ distribution.** Uniform -> dimensions not interacting.
Collapsed near 0 -> DE treating dimensions independently (separable function).
3. **Increase $N$** to $\approx 10d$ for $d > 20$.
\end{tcolorbox}
\textbf{Notebook check} (\texttt{05\_performance\_benchmarks.ipynb}): Plot \(F_i, CR_i\) histograms every 50 generations; expect values clustering in \([0.5,0.9]\) on hard problems.
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{2 · Stochastic Processes}\label{stochastic-processes}
These form the probabilistic backbone of all continuous-time models in Optimiz-rs. We build the theory from scratch: random walk → Brownian motion → Itō calculus → SDEs → jump-diffusions.
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsubsection{2.1 Brownian Motion}\label{brownian-motion}
\paragraph{2.1.0 Intuitive Construction --- From Random Walk to BM}\label{intuitive-construction-from-random-walk-to-bm}
\textbf{Step 1 --- Discrete random walk.} Flip a fair coin \(n\) times per unit time. Define \(\xi_k = +1\) (heads) or \(-1\) (tails) i.i.d. After \(n\) steps of size \(1/\sqrt{n}\):
\[S^{(n)}_t = \frac{1}{\sqrt{n}}\sum_{k=1}^{\lfloor nt \rfloor} \xi_k.\]
By the \textbf{Central Limit Theorem}, as \(n\to\infty\): \(S^{(n)}_t \xrightarrow{d} W_t \sim \mathcal{N}(0,t)\).
\begin{verbatim}
Coin-flip random walk (n=20 steps per unit time):
W_t
+2 | * *
| * * *
0 | * * * * *
|* * *
-2 | *
+----------------------------> t
0 0.5 1.0
n → ∞ ("zoom out"): jagged → smooth BM fan
\end{verbatim}
\textbf{Step 2 --- Scaling limit.} The normalization \(1/\sqrt{n}\) is crucial: - Without it, variance grows as \(n\) (diverges). - With \(n^{-1/2}\): variance = \(n \cdot (1/\sqrt{n})^2 \cdot t = t\) --- exactly right.
This is why \(W_t \sim \mathcal{N}(0,t)\): \textbf{variance accumulates linearly in time}.
\begin{tcolorbox}[colback=defbg!60,colframe=optblue,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Definition}} — Definition — Wiener Process},breakable]
A stochastic process $W = (W_t)_{t\ge 0}$ on $(\Omega,\mathcal{F},\mathbb{P})$
is a *standard Brownian motion* if:
1. $W_0 = 0$ a.s.
2. Increments are **independent**: $W_t - W_s \perp \mathcal{F}_s$ for $t>s$.
3. $W_t - W_s \sim \mathcal{N}(0, t-s)$ for all $0\le s<t$.
4. Paths $t\mapsto W_t(\omega)$ are **continuous** a.s.
\end{tcolorbox}
\paragraph{2.1.1 Key Analytical Properties}\label{key-analytical-properties}
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.3333}}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.3000}}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.3667}}@{}}
\toprule\noalign{}
\begin{minipage}[b]{\linewidth}\raggedright
Property
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Formula
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Intuition
\end{minipage} \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
Mean & \(\mathbb{E}[W_t] = 0\) & No drift --- symmetric random walk \\
Variance & \(\operatorname{Var}(W_t) = t\) & Uncertainty grows with time \\
Covariance & \(\operatorname{Cov}(W_s,W_t) = \min(s,t)\) & Shared history up to first time \\
Non-differentiability & \(\lim_{h\to 0}(W_{t+h}-W_t)/h\) diverges a.s. & Too ``rough'' for ordinary calculus \\
Quadratic variation & \([W]_T = T\) & Core source of Itō correction term \\
Self-similarity & \(c^{-1/2}W_{ct} \overset{d}{=} W_t\) & Fractal structure, Hurst \(H=\tfrac12\) \\
\end{longtable}
}
\textbf{Quadratic variation derivation (step by step):}
Partition \([0,T]\) into \(n\) pieces of width \(\Delta = T/n\). Sum of squared increments:
\[\sum_{k=0}^{n-1}(W_{t_{k+1}}-W_{t_k})^2 \overset{?}{=} T \quad \text{as } n\to\infty.\]
\textbf{Step 1} --- Each increment: \((W_{t_{k+1}}-W_{t_k})^2 \sim \Delta \cdot \chi_1^2\), so \(\mathbb{E}[(W_{t_{k+1}}-W_{t_k})^2] = \Delta\).
\textbf{Step 2} --- Sum of means: \(\sum_{k=0}^{n-1} \Delta = n\Delta = T\).
\textbf{Step 3} --- Variance of the sum: \(\operatorname{Var}\!\left(\sum (W_{t_{k+1}}-W_{t_k})^2\right) = n \cdot 2\Delta^2 = 2T^2/n \xrightarrow{n\to\infty} 0\).
\textbf{Conclusion:} \(\sum (W_{t_{k+1}}-W_{t_k})^2 \xrightarrow{L^2} T\). We write \(dW_t^2 = dt\).\\
This \textbf{single identity} is the engine of all Itō calculus.
\begin{tcolorbox}[colback=thmbg!60,colframe=optgold,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Theorem / Key Idea}} — Why dW² = dt is remarkable},breakable]
In ordinary calculus, $dx^2 \approx dx \cdot dx \to 0$ (second-order infinitesimal).
For Brownian motion, $(dW)^2 = dt$ is **first-order** — it does **not** vanish!
Physically: BM paths oscillate so rapidly ($\sim t^{0.5}$ scale) that their squared
increments accumulate at rate $1$ — comparable to the drift $dt$.
This is the **only** reason Itō's lemma has an extra term.
\end{tcolorbox}
\textbf{Multiple sample paths} --- the fan widens as \(\propto\sqrt{t}\):
\begin{verbatim}
W_t
+2 | ...........
| .... .....
0 |.. ..... <- E[W_t] = 0 (all paths centered)
| ....--......
-2 | ........
+--------------------------> t
0 T
Width ~ 2*sqrt(t) (95% of paths stay within +/- 2*sqrt(t))
Each dot is a BM path — different because different coin flips.
As T grows, the "trumpet" opens wider.
\end{verbatim}
\textbf{Example --- Geometric BM:} \(S_t = S_0 \exp\!\bigl((\mu-\tfrac12\sigma^2)t + \sigma W_t\bigr)\) is the Black-Scholes price model. Log-normal marginals; continuous, nowhere-differentiable paths:
\begin{verbatim}
S_t
| .---.
| .--./ \----.
| / \---------.
|/
+-------------------------------> t
0 T
\end{verbatim}
\textbf{Multiple sample paths} --- the fan widens as \(\propto\sqrt{t}\):
\begin{verbatim}
W_t
+2 | ...........
| .... .....
0 |.. ..... <- E[W_t] = 0 (all paths centered)
| ....--......
-2 | ........
+--------------------------> t
0 T
Width grows as sqrt(t) (68% of paths stay within +/- sqrt(t))
\end{verbatim}
\textbf{Example --- Geometric BM:} \(S_t = S_0 \exp\!\bigl((\mu-\tfrac12\sigma^2)t + \sigma W_t\bigr)\) is the Black-Scholes price model. Log-normal marginals; continuous, nowhere-differentiable paths:
\begin{verbatim}
S_t
| .---.
| .--./ \\----.
| / \\---------.
|/
+-------------------------------> t
0 T
\end{verbatim}
\subsubsection{2.2 Itō Calculus}\label{itux14d-calculus}
\paragraph{2.2.0 Why You Cannot Use Ordinary Integration}\label{why-you-cannot-use-ordinary-integration}
Attempt to define \(\int_0^T W_t\,dW_t\) using a Riemann sum: pick \(W_{t_k}\) at the \textbf{left endpoint} → get one answer; pick \((W_{t_k}+W_{t_{k+1}})/2\) (midpoint) → get a \emph{different} answer.
This ambiguity occurs because \(W\) is not of bounded variation. \textbf{Itō's convention} (left endpoint) is the only one that produces a \textbf{martingale} --- ensuring no look-ahead.
\begin{tcolorbox}[colback=defbg!60,colframe=optblue,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Definition}} — Definition — Itō Integral},breakable]
For adapted $f \in \mathcal{L}^2$ (i.e. $\mathbb{E}\!\int_0^T f_t^2\,dt < \infty$):
$$\int_0^T f_t\,dW_t \;:=\; L^2\text{-}\lim_{|\pi|\to 0} \sum_{k} f_{t_k}(W_{t_{k+1}}-W_{t_k}).$$
Key guarantees:
- **Zero mean:** $\mathbb{E}\!\left[\int_0^T f_t\,dW_t\right] = 0$.
- **Itō isometry:** $\mathbb{E}\!\left[\left(\int_0^T f_t\,dW_t\right)^2\right] = \mathbb{E}\!\int_0^T f_t^2\,dt$.
- **Martingale:** $M_t = \int_0^t f_s\,dW_s$ satisfies $\mathbb{E}[M_t\mid\mathcal{F}_s]=M_s$.
\end{tcolorbox}
\textbf{Itō isometry --- proof sketch:}\\
Let \(I_T = \sum_k f_{t_k}\Delta W_k\) (simple process). Then:
\[\mathbb{E}[I_T^2] = \sum_{j,k}\underbrace{\mathbb{E}[f_{t_j}\Delta W_j \cdot f_{t_k}\Delta W_k]}_{\text{cross terms}}\]
For \(j \neq k\) (say \(j < k\)): \(f_{t_j}\Delta W_j\) and \(f_{t_k}\) are both \(\mathcal{F}_{t_k}\)-measurable, while \(\Delta W_k\) is \textbf{independent} of \(\mathcal{F}_{t_k}\) with mean 0 → cross term \(= 0\).
For \(j = k\): \(\mathbb{E}[f_{t_j}^2 (\Delta W_j)^2] = \mathbb{E}[f_{t_j}^2]\Delta t_j\) (independence of \(f_{t_j}\) and \(\Delta W_j\)).
\[\Rightarrow \mathbb{E}[I_T^2] = \sum_k \mathbb{E}[f_{t_k}^2]\Delta t_k \xrightarrow{|\pi|\to 0} \mathbb{E}\int_0^T f_t^2\,dt. \quad \checkmark\]
\paragraph{2.2.1 Itō's Lemma --- Full Derivation}\label{itux14ds-lemma-full-derivation}
\begin{tcolorbox}[colback=thmbg!60,colframe=optgold,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Theorem / Key Idea}} — Theorem — Itō's Lemma},breakable]
For $dX_t = \mu_t\,dt + \sigma_t\,dW_t$ and $F \in C^{1,2}([0,T]\times\mathbb{R})$:
$$\boxed{dF(t,X_t) = \partial_t F\,dt + \partial_x F\,dX_t + \tfrac{1}{2}\sigma_t^2\,\partial_{xx}F\,dt}$$
Expanded:
$$dF = \underbrace{\left(\partial_t F + \mu_t\,\partial_x F + \tfrac12\sigma_t^2\,\partial_{xx}F\right)}_{\text{drift}}\,dt
+ \underbrace{\sigma_t\,\partial_x F}_{\text{diffusion}}\,dW_t.$$
\end{tcolorbox}
\textbf{Derivation --- Taylor expand \(F(t+dt, X_{t+dt})\):}
\[dF = \partial_t F\,dt + \partial_x F\,dX + \tfrac12\partial_{xx}F\,(dX)^2 + \underbrace{\partial_{tx}F\,dt\,dX + \ldots}_{\to 0} \]
Compute \((dX)^2\) using the \textbf{Itō multiplication table}:
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}lll@{}}
\toprule\noalign{}
× & \(dt\) & \(dW_t\) \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
\(dt\) & \(0\) & \(0\) \\
\(dW_t\) & \(0\) & \(dt\) \\
\end{longtable}
}
\[\begin{aligned}
(dX_t)^2 &= (\mu_t\,dt + \sigma_t\,dW_t)^2 \\
&= \mu_t^2\underbrace{(dt)^2}_{0} + 2\mu_t\sigma_t\underbrace{dt\cdot dW_t}_{0} + \sigma_t^2\underbrace{(dW_t)^2}_{dt}\\
&= \sigma_t^2\,dt.
\end{aligned}\]
Substituting:
\[dF = \partial_t F\,dt + \partial_x F(\mu_t\,dt + \sigma_t\,dW_t) + \tfrac12\partial_{xx}F\cdot\sigma_t^2\,dt\]
\[= \left(\partial_t F + \mu_t\partial_x F + \tfrac12\sigma_t^2\partial_{xx}F\right)dt + \sigma_t\partial_x F\,dW_t. \quad \checkmark\]
\textbf{The extra term \(\tfrac12\sigma^2\partial_{xx}F\,dt\) is the ``Itō correction''.}\\
In ordinary calculus \((dW)^2=0\), so it vanishes. In stochastic calculus, BM oscillates so rapidly that \((dW)^2 = dt\) --- a first-order effect.
\textbf{Multidimensional version} (for vector \(\mathbf{X}\in\mathbb{R}^n\), matrix noise):
\[dF = \partial_t F\,dt + \sum_i \partial_{x_i}F\,dX_i + \tfrac12\sum_{i,j}\partial_{x_ix_j}F\,d[X_i,X_j]_t\]
where \(d[X_i, X_j]_t = d\langle X_i, X_j\rangle_t\) is the quadratic co-variation.
\paragraph{2.2.2 Worked Examples of Itō's Lemma}\label{worked-examples-of-itux14ds-lemma}
\textbf{Example 1 --- GBM, derive explicit solution:}
SDE: \(dS_t = \mu S_t\,dt + \sigma S_t\,dW_t\).
\textbf{Goal:} Find \(S_t\) in closed form.
\textbf{Step 1} --- Guess \(F(t,x) = \log x\). Compute partials: \(\partial_t F = 0\), \(\partial_x F = 1/x\), \(\partial_{xx}F = -1/x^2\).
\textbf{Step 2} --- Apply Itō's lemma:
\[d(\log S_t) = 0 + \frac{1}{S_t}\,dS_t + \tfrac12\cdot(-\tfrac{1}{S_t^2})\cdot\sigma^2 S_t^2\,dt\]
\[= \frac{\mu S_t\,dt + \sigma S_t\,dW_t}{S_t} - \tfrac12\sigma^2\,dt\]
\[= \left(\mu - \tfrac12\sigma^2\right)\,dt + \sigma\,dW_t.\]
\textbf{Step 3} --- Integrate (deterministic integral + Itō integral):
\[\log S_T - \log S_0 = \left(\mu-\tfrac12\sigma^2\right)T + \sigma W_T.\]
\textbf{Step 4} --- Exponentiate:
\[\boxed{S_T = S_0\exp\!\left[\left(\mu - \tfrac12\sigma^2\right)T + \sigma W_T\right].}\]
The \textbf{Itō correction} \(-\tfrac12\sigma^2 T\) lowers the expected log-return: \(\mathbb{E}[\log S_T] = \log S_0 + (\mu-\tfrac12\sigma^2)T\), but \(\mathbb{E}[S_T] = S_0 e^{\mu T}\) (Jensen's inequality explains the gap: \(e^{\mathbb{E}[X]} < \mathbb{E}[e^X]\) for non-degenerate \(X\)).
\begin{verbatim}
log S_t
| Ito correction: slope = mu - sigma^2/2 (lower than mu!)
| _.-'
| / <- Without Ito correction, slope would be mu (wrong!)
|/
+----------------------------> t
E[log S_t] = log S_0 + (mu - sigma^2/2)*t
(time-averaged growth, always less than mu for sigma > 0)
\end{verbatim}
\textbf{Example 2 --- Itō product rule (\(d(X_t Y_t)\)):}
By Itō's lemma applied to \(F(x,y) = xy\):
\[d(X_t Y_t) = Y_t\,dX_t + X_t\,dY_t + d[X,Y]_t\]
where \(d[X,Y]_t = \sigma_X\sigma_Y\,dt\). Compare to ordinary calculus: \(d(xy) = y\,dx + x\,dy\) (no cross term because \((dx)^2=0\)).
\textbf{Example 3 --- Integration by parts for stochastic integrals:}
\[\int_0^T W_t\,dW_t = \tfrac12 W_T^2 - \tfrac12 T.\]
Ordinary calculus would give \(\int_0^T W_t\,dW_t = \tfrac12 W_T^2\). The \(-\tfrac12 T\) correction comes from the quadratic variation.
\textbf{Verification via Itō's lemma:} Set \(F(t,x) = x^2/2\): \(dF = x\,dW + \tfrac12\cdot 1 \cdot dt = W_t\,dW_t + \tfrac12\,dt\). Integrate: \(\tfrac12 W_T^2 - 0 = \int_0^T W_t\,dW_t + \tfrac12 T\) → result follows. ✓
\paragraph{2.2.3 Itō vs Stratonovich}\label{itux14d-vs-stratonovich}
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.2222}}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.2889}}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.4889}}@{}}
\toprule\noalign{}
\begin{minipage}[b]{\linewidth}\raggedright
Property
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Itō integral
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Stratonovich integral (\(\circ\))
\end{minipage} \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
Chain rule & Modified (\(+\tfrac12\sigma^2\partial_{xx}F\) term) & Standard calculus chain rule \\
Martingale & Yes (if \(f\) adapted) & No in general \\
Use in finance & Natural (no look-ahead) & Physics, geometry \\
Conversion & \(\int f\circ dW = \int f\,dW + \tfrac12\int \partial_x f\,\sigma\,dt\) & (same identity) \\
SDE solutions & Different numerics needed & Standard ODE methods work \\
\end{longtable}
}
\textbf{Conversion formula} --- Itō \(\to\) Stratonovich:
\[\int_0^T f(X_t)\circ dW_t = \int_0^T f(X_t)\,dW_t + \tfrac{1}{2}\int_0^T f'(X_t)\sigma_t\,dt.\]
\textbf{Rule of thumb:} Use Itō in finance (causality, no-arbitrage); use Stratonovich in physics/differential geometry (coordinate-invariant chain rule).
\subsubsection{2.3 General Itō SDEs}\label{general-itux14d-sdes}
\[dX_t = b(t, X_t)\,dt + \boldsymbol{\sigma}(t, X_t)\,dW_t,\quad X_0 = x_0.\]
\paragraph{2.3.0 Existence, Uniqueness and Picard Iteration}\label{existence-uniqueness-and-picard-iteration}
\begin{tcolorbox}[colback=thmbg!60,colframe=optgold,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Theorem / Key Idea}} — Theorem — Strong Solution Existence (Picard–Lindelöf for SDEs)},breakable]
If $b$ and $\sigma$ are **globally Lipschitz** in $x$ (uniformly in $t$):
$\|b(t,x)-b(t,y)\| + \|\sigma(t,x)-\sigma(t,y)\| \le L\|x-y\|$,
and satisfy **linear growth**: $\|b(t,x)\|^2 + \|\sigma(t,x)\|^2 \le C^2(1+\|x\|^2)$,
then there exists a **unique strong solution** with $\mathbb{E}\!\left[\sup_{t\le T}\|X_t\|^2\right] < \infty$.
\end{tcolorbox}
\textbf{Picard iteration --- construct the solution step by step:}
Set \(X_t^{(0)} = x_0\) (constant). For \(n\ge 0\):
\[X_t^{(n+1)} = x_0 + \int_0^t b(s, X_s^{(n)})\,ds + \int_0^t \sigma(s, X_s^{(n)})\,dW_s.\]
\textbf{Intermediate step --- bound the error:}
Let \(\varepsilon_n(t) = \mathbb{E}\!\left[\sup_{s\le t}|X_s^{(n+1)}-X_s^{(n)}|^2\right]\).
By Doob's \(L^2\)-inequality and Lipschitz:
\[\varepsilon_{n+1}(t) \le 2(L^2 T + L^2)\int_0^t \varepsilon_n(s)\,ds.\]
By induction: \(\varepsilon_n(t) \le C \cdot \frac{(2L^2(T+1)t)^n}{n!} \to 0\). Geometric series → \(X^{(n)}\) is Cauchy in \(L^2\) → converges to the unique solution.
\textbf{Intuition:}
\begin{verbatim}
Picard iteration (simplest case: dx = f(x) dt):
X^(0): --------- x_0 (constant)
X^(1): x_0 + int_0^t f(x_0) ds = x_0 + f(x_0)*t (linear approx)
X^(2): x_0 + int_0^t f(X^(1)) ds (use X^(1) in drift)
X^(3): ...
Each iteration captures one more "correction layer":
n=0: constant n=1: linear n=2: quadratic ...
\end{verbatim}
\paragraph{2.3.1 The Fokker-Planck Equation --- How Densities Evolve}\label{the-fokker-planck-equation-how-densities-evolve}
If \(X_t\) has density \(p(t,x)\), then \(p\) satisfies the \textbf{Fokker-Planck (Kolmogorov forward) PDE}:
\[\frac{\partial p}{\partial t} = -\frac{\partial}{\partial x}[b(t,x)\,p] + \frac{1}{2}\frac{\partial^2}{\partial x^2}[\sigma^2(t,x)\,p].\]
\textbf{Derivation sketch:} For any test function \(\phi\):
\[\frac{d}{dt}\mathbb{E}[\phi(X_t)] = \mathbb{E}[\mathcal{L}\phi(X_t)] = \mathbb{E}\!\left[b\,\phi' + \tfrac12\sigma^2\phi''\right]\]
using Itō's lemma on \(\phi(X_t)\). Integration by parts in the \(x\)-integral transfers derivatives from \(\phi\) to \(p\), giving the Fokker-Planck equation.
\textbf{Visual --- density flows rightward (positive drift) and spreads (positive diffusion):}
\begin{verbatim}
p(t, x) — probability density at time t
t=0: | peak at x_0
| ***
| * * <- narrow initial density
| * *
+-----------------> x
x_0
t=T/2: | peak shifted right
| ***
| * * <- wider (diffusion spreads it)
| * *
+-----------------> x
x_0 + mu*T/2
t=T: | peak drifted further
| ***
| * * <- even wider
| * *
+--------------------------> x
x_0 + mu*T
\end{verbatim}
\textbf{For OU: \(b = \kappa(\theta-x)\), \(\sigma\) = const} → stationary solution \(p_\infty(x) = \mathcal{N}(\theta, \sigma^2/2\kappa)\).
\paragraph{2.3.2 Common SDE Reference Table}\label{common-sde-reference-table}
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}
>{\raggedright\arraybackslash}p{(\linewidth - 8\tabcolsep) * \real{0.1304}}
>{\raggedright\arraybackslash}p{(\linewidth - 8\tabcolsep) * \real{0.0725}}
>{\raggedright\arraybackslash}p{(\linewidth - 8\tabcolsep) * \real{0.2754}}
>{\raggedright\arraybackslash}p{(\linewidth - 8\tabcolsep) * \real{0.2464}}
>{\raggedright\arraybackslash}p{(\linewidth - 8\tabcolsep) * \real{0.2754}}@{}}
\toprule\noalign{}
\begin{minipage}[b]{\linewidth}\raggedright
Process
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
SDE
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Closed-form \(X_t\)
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Stationary dist.
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Use in Optimiz-rs
\end{minipage} \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
Brownian motion & \(dX = \sigma\,dW\) & \(X_0 + \sigma W_t\) & --- & Noise baseline \\
Geometric BM & \(dX = \mu X\,dt + \sigma X\,dW\) & \(X_0 e^{(\mu-\sigma^2/2)t+\sigma W_t}\) & Log-normal & Price model \\
Ornstein-Uhlenbeck & \(dX = \kappa(\theta-X)\,dt + \sigma\,dW\) & (see §2.4) & \(\mathcal{N}(\theta, \sigma^2/2\kappa)\) & Spread model \\
CIR & \(dX = \kappa(\theta-X)\,dt + \sigma\sqrt{X}\,dW\) & (Bessel process) & Gamma\((2\kappa\theta/\sigma^2, \sigma^2/2\kappa)\) & Volatility, rates \\
SABR & \(dF = \sigma F^\beta dW^1\), \(d\sigma = \nu\sigma\,dW^2\) & (no closed form) & --- & Volatility model \\
\end{longtable}
}
\paragraph{2.3.3 Numerical Schemes for SDEs}\label{numerical-schemes-for-sdes}
When no closed form exists, discretize with step \(\Delta t\):
\textbf{Euler-Maruyama} (simplest, strong order 0.5):
\[X_{t+\Delta t} \approx X_t + b(t,X_t)\,\Delta t + \sigma(t,X_t)\,\Delta W_t\]
where \(\Delta W_t = \sqrt{\Delta t}\,Z\), \(Z\sim\mathcal{N}(0,1)\).
\textbf{Milstein} (includes first-order Itō correction, strong order 1.0):
\[X_{t+\Delta t} \approx X_t + b\,\Delta t + \sigma\,\Delta W_t + \tfrac12\sigma\,\sigma_x\bigl[(\Delta W_t)^2 - \Delta t\bigr].\]
The extra term \(\tfrac12\sigma\sigma_x[(\Delta W_t)^2 - \Delta t]\) comes from applying Itō's lemma to \(\sigma(X_t)dW_t\).
\begin{verbatim}
Error comparison (log scale):
| Euler-Maruyama (slope = 0.5)
| *
| *
| *
| * Milstein (slope = 1.0)
| o
| o
| o
+----------------------------> log(Delta_t)
(Milstein converges MUCH faster: halving dt reduces error by 4x instead of 2x)
\end{verbatim}
\subsubsection{2.4 Ornstein-Uhlenbeck (Mean-Reversion)}\label{ornstein-uhlenbeck-mean-reversion}
Used in Optimiz-rs's \texttt{sparse\_mean\_reversion} and \texttt{ou\_estimator} modules:
\[dX_t = \kappa(\theta - X_t)\,dt + \sigma\,dW_t.\]
\textbf{Intuition --- restoring force:} The drift is a spring pulling \(X_t\) back to \(\theta\):
\begin{verbatim}
X_t
| upper band: theta + sigma/sqrt(2*kappa)
| .--. . ___ <-- random excursions
| / v /\ / \
|/ v / \ ----- long-run mean: theta (equilibrium)
| \ \....
| \___/
| lower band: theta - sigma/sqrt(2*kappa)
+-------------------------------> t
Arrows: mean-reversion pull toward theta with speed kappa.
Half-life = ln(2) / kappa.
Strong kappa: tight oscillations around theta (faster spring)
Weak kappa: slow drift back (loose spring, more "random walk" like)
\end{verbatim}
\paragraph{2.4.1 Closed-Form Solution --- Step by Step}\label{closed-form-solution-step-by-step}
\textbf{Step 1 --- Integrating factor.} Rewrite the SDE as:
\[dX_t + \kappa X_t\,dt = \kappa\theta\,dt + \sigma\,dW_t.\]
Multiply both sides by the integrating factor \(e^{\kappa t}\) and recognize the left-hand side:
\[d\!\left(e^{\kappa t}X_t\right) = e^{\kappa t}dX_t + \kappa e^{\kappa t}X_t\,dt = e^{\kappa t}\kappa\theta\,dt + e^{\kappa t}\sigma\,dW_t.\]
(Here we used Itō's product rule: \(d(e^{\kappa t}X_t) = e^{\kappa t}dX_t + X_t\cdot\kappa e^{\kappa t}dt\) --- no quadratic variation cross term since \(e^{\kappa t}\) is deterministic.)
\textbf{Step 2 --- Integrate both sides from \(0\) to \(t\):}
\[e^{\kappa t}X_t - X_0 = \kappa\theta\int_0^t e^{\kappa s}\,ds + \sigma\int_0^t e^{\kappa s}\,dW_s\]
\[e^{\kappa t}X_t - X_0 = \theta(e^{\kappa t} - 1) + \sigma\int_0^t e^{\kappa s}\,dW_s.\]
\textbf{Step 3 --- Divide by \(e^{\kappa t}\):}
\[\boxed{X_t = \theta + (X_0 - \theta)e^{-\kappa t} + \sigma\int_0^t e^{-\kappa(t-s)}\,dW_s.}\]
\textbf{Interpretation of each term:}
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}
>{\raggedright\arraybackslash}p{(\linewidth - 2\tabcolsep) * \real{0.4000}}
>{\raggedright\arraybackslash}p{(\linewidth - 2\tabcolsep) * \real{0.6000}}@{}}
\toprule\noalign{}
\begin{minipage}[b]{\linewidth}\raggedright
Term
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Meaning
\end{minipage} \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
\(\theta\) & Long-run equilibrium (the ``anchor'') \\
\((X_0-\theta)e^{-\kappa t}\) & Deterministic decay: initial displacement shrinks at rate \(\kappa\) \\
\(\sigma\int_0^t e^{-\kappa(t-s)}dW_s\) & Stochastic part: weighted sum of all past noise shocks, with \textbf{exponential forgetting} \\
\end{longtable}
}
The stochastic integral \(I_t = \sigma\int_0^t e^{-\kappa(t-s)}dW_s\) is a \textbf{Gaussian} random variable (linear functional of Brownian motion) with:
\[\mathbb{E}[I_t] = 0, \qquad \operatorname{Var}(I_t) = \sigma^2\int_0^t e^{-2\kappa(t-s)}\,ds = \frac{\sigma^2}{2\kappa}(1-e^{-2\kappa t}).\]
\textbf{Step 4 --- Marginal distribution:}
\[X_t \sim \mathcal{N}\!\left(\theta + (X_0-\theta)e^{-\kappa t},\;\frac{\sigma^2}{2\kappa}(1-e^{-2\kappa t})\right).\]
As \(t\to\infty\): \(X_t \to \mathcal{N}(\theta, \sigma^2/2\kappa)\) --- the stationary distribution.
\paragraph{\texorpdfstring{2.4.2 Transition Density (Conditional on \(X_s\))}{2.4.2 Transition Density (Conditional on X\_s)}}\label{transition-density-conditional-on-x_s}
\[X_t \mid X_s \sim \mathcal{N}\!\left(\theta + (X_s-\theta)e^{-\kappa(t-s)},\;\frac{\sigma^2}{2\kappa}(1-e^{-2\kappa(t-s)})\right), \quad t > s.\]
This is exact (no approximation) because the OU process is \textbf{linear}. Key formulas:
\[\hat\mu(\tau) = \theta + (X_s-\theta)e^{-\kappa\tau}, \qquad \hat\sigma^2(\tau) = \frac{\sigma^2}{2\kappa}(1-e^{-2\kappa\tau}), \quad \tau=t-s.\]
\begin{verbatim}
Transition density spreading over time:
p(x_t | x_0 = x_0)
t=0: delta function at x_0
|
|* <- spike
t=0.2: | ****
|* * <- bell curve, mean shifted toward theta
t=T: | ****
| * * <- centered at theta, wider
| * *
+-----------> x
\end{verbatim}
\paragraph{2.4.3 Half-Life and Mean-Reversion Speed}\label{half-life-and-mean-reversion-speed}
\textbf{Half-life:} \(\tau_{1/2} = \ln 2/\kappa\) --- time for the initial displacement to halve.
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}lll@{}}
\toprule\noalign{}
\(\kappa\) (per year) & Half-life & Typical use \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
0.2 & 3.5 yr & Long-term macro factors \\
10 & 25 days & Cross-sectional equity spreads \\
55 & 4.6 days & Short-term pair spreads \\
252 & 1 trading day & Intraday alpha signals \\
\end{longtable}
}
\textbf{MLE log-likelihood} (discrete observations at spacing \(\Delta t\)):
\[\ell(\kappa,\theta,\sigma) = -\frac{1}{2}\sum_{i=1}^{n}\left[\log(2\pi\hat\sigma^2) + \frac{(X_{t_i} - \hat\mu_i)^2}{\hat\sigma^2}\right],\]
where \(\hat\mu_i = \theta + (X_{t_{i-1}}-\theta)e^{-\kappa\Delta t}\) and \(\hat\sigma^2 = \frac{\sigma^2}{2\kappa}(1-e^{-2\kappa\Delta t})\).
\textbf{Score equations} (differentiate \(\ell\) and set to zero):
\[\frac{\partial\ell}{\partial\theta} = \sum_i \frac{X_{t_i}-\hat\mu_i}{\hat\sigma^2}(1-e^{-\kappa\Delta t}) = 0,\]
\[\frac{\partial\ell}{\partial\kappa} = \sum_i \frac{(X_{t_i}-\hat\mu_i)}{\hat\sigma^2}(X_{t_{i-1}}-\theta)\Delta t\,e^{-\kappa\Delta t} - \sum_i \frac{\partial\log\hat\sigma^2}{\partial\kappa} = 0.\]
These are nonlinear in \(\kappa\); Optimiz-rs solves them with DE (\texttt{ou\_estimator::fit\_mle()}).
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Calibrating OU to an Equity-Pair Spread},breakable]
**Data:** Daily log-spread $X_t = \log(P_A / P_B)$ for a co-integrated pair,
$n=250$ observations, $\Delta t=1/252$ years.
**Step 1 — MLE:** Maximize $\ell(\kappa, \theta, \sigma)$ using `ou_estimator::fit_mle()`.
**Step 2 — Intermediate verification:** The OU log-likelihood surface:
```
ell(kappa, theta | sigma_hat)
kappa
^
| +++ <- log-lik thickening near true kappa
| +++++
| +++++++
| +++++
| +++
|
+-------------------------> theta
(theta_hat is the sample mean of X_t, very well identified)
(kappa is harder: need long series to identify mean-reversion speed)
```
**Typical results:**
| Parameter | Estimate | Interpretation |
|-----------|----------|----------------|
| $\hat\kappa$ | 55/yr | half-life approx 4.6 days |
| $\hat\theta$ | 0.003 | long-run spread approx 0.3% |
| $\hat\sigma$ | 0.12/yr$^{0.5}$ | daily spread vol approx 0.75% |
**Step 3 — Diagnostic:**
Standardized residuals: $r_i = (X_{t_i} - \hat\mu_i)/\hat\sigma$ should be $\mathcal{N}(0,1)$.
```
r_i histogram vs N(0,1)
| .
| . . <- histogram bars (sample)
|. . .........
| .......... <- N(0,1) curve (theory)
| . .
+------|------|-----> r_i
-2 +2
```
Ljung-Box test: checks for remaining autocorrelation in $r_i$.
**Step 4 — Trading signal:**
Enter when $|X_t - \hat\theta| > 2\hat\sigma_\infty$ where $\hat\sigma_\infty = \hat\sigma/\sqrt{2\hat\kappa}$.
Exit at $X_t = \hat\theta$. Expected holding time $\approx \hat\tau_{1/2} = \ln 2/\hat\kappa \approx 4.6$ days.
**P&L decomposition:**
- Gross expected profit per trade $\approx 2\hat\sigma_\infty = 2\hat\sigma/\sqrt{2\hat\kappa}$.
- Transaction costs must be $< 2\hat\sigma_\infty$ for profitability.
\end{tcolorbox}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{3 · Jump Processes}\label{jump-processes}
Many financial time series exhibit sudden large moves that Brownian motion cannot capture.
\subsubsection{3.1 Poisson Process}\label{poisson-process}
\begin{tcolorbox}[colback=defbg!60,colframe=optblue,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Definition}} — Definition — Poisson Process},breakable]
A counting process $N = (N_t)_{t\ge 0}$ is a *Poisson process with
intensity* $\lambda > 0$ if:
1. $N_0 = 0$.
2. Independent, stationary increments.
3. $\mathbb{P}(N_{t+h}-N_t=1) = \lambda h + o(h)$ and $\mathbb{P}(\Delta N > 1) = o(h)$.
\end{tcolorbox}
Equivalently, \(N_t \sim \text{Poisson}(\lambda t)\) and inter-arrival times are \(\text{Exp}(\lambda)\). The \emph{compensated} process \(\tilde N_t = N_t - \lambda t\) is a martingale.
\textbf{Sample path --- step function with random jumps (\(\lambda=2\) per unit time):}
\begin{verbatim}
N_t
5 | ___________
4 | ___________
3 | ______
2 | ______
1 |____
0 |
+-----|------|-------|------|---------> t
tau1 tau2 tau3 tau4
(Exp(lambda) inter-arrivals, each tau_i ~ Exp(2))
\end{verbatim}
\subsubsection{3.2 Compound Poisson Jump-Diffusion (Merton 1976)}\label{compound-poisson-jump-diffusion-merton-1976}
\[\frac{dS_t}{S_{t^-}} = \mu\,dt + \sigma\,dW_t + d\Bigl(\sum_{k=1}^{N_t}(e^{J_k}-1)\Bigr),\]
with \(N_t\) Poisson(\(\lambda\)) and \(J_k \sim \mathcal{N}(\mu_J, \sigma_J^2)\).
\textbf{Sample path --- smooth diffusion interrupted by sudden jumps:}
\begin{verbatim}
S_t
| ^ jump +15%
| /|
| / |
| / | v jump -20%
| / \\ /|
| / \\_______/ |
| / \\____
| / \\...
| /
+---------------------------------> t
(Brownian between jumps; jump times ~ Poisson)
\end{verbatim}
\textbf{Merton option price} --- Poisson mixture of Black-Scholes prices:
\[C_{\text{Merton}} = \sum_{n=0}^\infty \frac{e^{-\lambda' T}(\lambda' T)^n}{n!}
\cdot C_{\text{BS}}\!\left(S_0, K, T, r_n, \sigma_n^2\right),\]
where \(\lambda' = \lambda e^{\mu_J+\frac12\sigma_J^2}\), \(r_n = r - \lambda(e^{\mu_J+\frac12\sigma_J^2}-1) + n(\mu_J+\tfrac12\sigma_J^2)/T\), and \(\sigma_n^2 = \sigma^2 + n\sigma_J^2/T\).
\textbf{Intuition:} Condition on exactly \(n\) jumps occurring (probability \(e^{-\lambda' T}(\lambda' T)^n/n!\)). In that scenario the world is a BS world with adjusted drift \(r_n\) and total variance \(\sigma^2 T + n\sigma_J^2\). Average over the Poisson distribution of \(n\).
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Fitting Merton to a Crash Event},breakable]
**Observed:** S&P 500, March 2020. Implied vol surface shows a vol smile —
OTM puts are expensive (fat left tail), which pure BS cannot explain.
**Merton calibration** (4 parameters: $\sigma, \lambda, \mu_J, \sigma_J$):
| Parameter | Estimated value | Interpretation |
|-----------|----------------|----------------|
| $\sigma$ | 0.18/yr | baseline diffusion vol |
| $\lambda$ | 3/yr | approx 3 crash events per year |
| $\mu_J$ | -0.12 | average log-jump = -12% |
| $\sigma_J$ | 0.08 | jump size std = 8% |
**Fitting procedure:**
1. Collect implied vols for strikes $K$ and maturities $T$.
2. Minimise $\sum_{K,T}(C_{\text{Merton}}(K,T;\theta) - C_{\text{market}})^2$
via `differential_evolution` (DE is ideal — 4 params, non-convex landscape).
3. **Diagnostic:** Plot Merton vs market smile; expect fit within 0.5 vega.
**Result:** Negative $\mu_J$ captures left-tail skew, explaining costly OTM puts.
\end{tcolorbox}
\subsubsection{3.3 Levy Processes and the Levy-Khintchine Representation}\label{levy-processes-and-the-levy-khintchine-representation}
\begin{tcolorbox}[colback=thmbg!60,colframe=optgold,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Theorem / Key Idea}} — Theorem — Levy-Khintchine},breakable]
Every Levy process (independent stationary increments) has characteristic function
$$\mathbb{E}[e^{i\xi X_t}] = \exp\!\Bigl(t\Bigl[i b\xi - \tfrac{1}{2}\sigma^2\xi^2
+ \int_{\mathbb{R}\setminus\{0\}} \bigl(e^{i\xi z}-1-i\xi z\mathbf{1}_{|z|\le1}\bigr)\nu(dz)\Bigr]\Bigr)$$
where $(b, \sigma^2, \nu)$ is the *Levy triplet* and $\nu$ the *Levy measure*,
satisfying $\int(1\wedge z^2)\nu(dz)<\infty$.
\end{tcolorbox}
\textbf{Levy measure tail shapes:}
\begin{verbatim}
nu(dz)/dz
Gaussian BM: nu = 0 (no jump component, only diffusion)
Compound Poisson (rare large jumps):
| ^ ^ (discrete point masses at fixed jump sizes)
+--*----*---> z
Variance Gamma (smooth exponential decay):
|\\
| \\.
| \\...___
+---------> z (heavier left tail than Gaussian)
alpha-stable (power-law heavy tail):
|\\
| \\.....
+-----------> z (infinite variance, very fat tail)
\end{verbatim}
\textbf{Levy Process Zoo}
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}lll@{}}
\toprule\noalign{}
Process & Levy measure \(\nu\) & Use case \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
Brownian motion & \(\nu=0\) & continuous diffusion \\
Compound Poisson & finite measure & rare large jumps \\
Variance Gamma & \(\nu(dz)\propto e^{-c|z|}/|z|\) & equity returns \\
CGMY & power-law with exponential cutoff & heavy tails, \(Y\in(0,2)\) \\
\(\alpha\)-stable & \(c|z|^{-1-\alpha}\) & infinite-variance regimes \\
\end{longtable}
}
\subsubsection{3.4 SDEs with Jumps --- Generator and Ito Formula}\label{sdes-with-jumps-generator-and-ito-formula}
\[dX_t = b(X_{t^-})\,dt + \sigma(X_{t^-})\,dW_t
+ \int_{\mathbb{R}} c(X_{t^-}, z)\,\tilde N(dt, dz),\]
where \(\tilde N(dt,dz) = N(dt,dz) - \nu(dz)\,dt\) is the \emph{compensated jump measure}.
\textbf{Ito formula for jump-diffusions:}
\[dF(X_t) = \mathcal{L}F\,dt + \partial_x F\,\sigma\,dW_t
+ \int\bigl[F(X_{t^-}+c)-F(X_{t^-})\bigr]\tilde N(dt,dz),\]
where the \emph{generator} is
\[\mathcal{L}F = b\,\partial_x F + \tfrac12\sigma^2\partial_{xx}F
+ \int\bigl[F(x+c)-F(x)-c\,\partial_x F\bigr]\nu(dz).\]
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{4 · Optimal Control (HJB, PMP, Jumps)}\label{optimal-control-hjb-pmp-jumps}
\textbf{Big picture.} Optimal control asks: \emph{given a stochastic system we can steer with a control \(u_t\), what policy minimises expected cost?} Three complementary tools answer this:
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}
>{\raggedright\arraybackslash}p{(\linewidth - 6\tabcolsep) * \real{0.1667}}
>{\raggedright\arraybackslash}p{(\linewidth - 6\tabcolsep) * \real{0.2222}}
>{\raggedright\arraybackslash}p{(\linewidth - 6\tabcolsep) * \real{0.3056}}
>{\raggedright\arraybackslash}p{(\linewidth - 6\tabcolsep) * \real{0.3056}}@{}}
\toprule\noalign{}
\begin{minipage}[b]{\linewidth}\raggedright
Tool
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Solves
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Scales to
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Intuition
\end{minipage} \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
HJB PDE & Value function \(V(t,x)\) & Low dim (PDE grid) & Dynamic programming \\
PMP & Optimal paths \((X_t,p_t)\) & High dim (ODE) & Adjoint sensitivity \\
HJBI & Same as HJB + jumps & Low dim & Non-local integral term \\
\end{longtable}
}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsubsection{4.1 Stochastic HJB}\label{stochastic-hjb}
\textbf{Setup.} The state \(X_t \in \mathbb{R}^d\) evolves as
\[dX_t = b(X_t,u_t)\,dt + \sigma(X_t,u_t)\,dW_t,\]
and we minimise the total expected cost
\[J(t,x;u) = \mathbb{E}\!\left[\int_t^T \ell(X_s,u_s)\,ds + g(X_T)\,\Big|\,X_t=x\right].\]
The \textbf{value function} \(V(t,x) = \inf_u J(t,x;u)\) satisfies:
\[-\partial_t V = \inf_{u\in\mathcal{U}}\Bigl[\ell(x,u) + \nabla_x V^{\!\top} b(x,u)
+ \tfrac12\operatorname{Tr}\bigl(\sigma\sigma^{\!\top}(x,u)\,\nabla_x^2 V\bigr)\Bigr],
\quad V(T,\cdot)=g.\]
\textbf{Intuition --- three terms inside the infimum:} - \(\ell(x,u)\) --- instantaneous running cost (pay now). - \(\nabla_x V^\top b\) --- drift of the value function (first-order Taylor in state change). - \(\tfrac12\operatorname{Tr}(\sigma\sigma^\top\nabla^2 V)\) --- curvature correction due to noise (stochastic analogue of the second-order Taylor term).
Under smooth \(V\), the \textbf{feedback law} is \(u^\star(t,x) = \arg\min_u[\ell(x,u)+\nabla_x V^\top b(x,u)].\)
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Optimal Portfolio Allocation (Merton 1969)},breakable]
Investor wealth $X_t$ follows
$dX_t = (r + u_t(\mu-r))X_t\,dt + u_t\sigma X_t\,dW_t$,
where $u_t\in\mathbb{R}$ is the fraction invested in the risky asset.
Minimise $-\mathbb{E}[\log X_T]$ (maximise expected log-utility).
**Ansatz:** $V(t,x) = \ln x + f(t)$. Substituting into HJB:
$$f'(t) = -r - \frac{(\mu-r)^2}{2\sigma^2},\qquad f(T)=0.$$
The **optimal Merton rule** is constant:
$$u^\star = \frac{\mu-r}{\sigma^2} \quad (\text{fraction in risky asset}).$$
Invest a fixed fraction proportional to the Sharpe ratio, inversely to variance —
independent of wealth and time.
\end{tcolorbox}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\textbf{LQR special case} (\(\ell = x^\top Q x + u^\top R u\), \(b=Ax+Bu\), \(\sigma\) constant): \(V(t,x)=x^\top P(t)x + v(t)\) with \(P\) solving the \emph{matrix Riccati ODE}:
\[-\dot P = A^\top P + PA - PBR^{-1}B^\top P + Q,\quad P(T)=Q_T.\]
The optimal control is \textbf{linear feedback}: \(u^\star_t = -R^{-1}B^\top P(t)X_t\).
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Optimal Inventory (Almgren-Chriss liquidation)},breakable]
Liquidate $X_0$ shares by time $T$. Inventory $X_t$, trading rate $u_t<0$:
$$dX_t = u_t\,dt, \quad
\ell(x,u) = \underbrace{\alpha x^2}_{\text{risk}} + \underbrace{\beta u^2}_{\text{impact}}.$$
This is a **deterministic LQR** with
$A=0$, $B=1$, $Q=\alpha$, $R=\beta$.
The Riccati solution gives the TWAP-like schedule
$$u^\star(t,x) = -\frac{\alpha}{\beta}\cdot\frac{\sinh(\kappa(T-t))}{\sinh(\kappa T)}\cdot X_0,
\quad \kappa=\sqrt{\alpha/\beta}.$$
Large $\kappa$ (high risk aversion or low impact cost) -> aggressive front-loaded selling.
\end{tcolorbox}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsubsection{4.2 Pontryagin Maximum Principle}\label{pontryagin-maximum-principle}
The PMP avoids the curse of dimensionality --- it converts HJB into a \textbf{two-point boundary-value ODE} in \((X_t, p_t)\), feasible when a PDE grid is intractable.
\begin{tcolorbox}[colback=thmbg!60,colframe=optgold,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Theorem / Key Idea}} — Theorem (PMP)},breakable]
Define the **Hamiltonian** $\mathcal{H}(x,u,p) = \ell(x,u)+p^\top b(x,u)$.
If $(X^\star, u^\star)$ is optimal, there exists a **costate** process $p_t$ with:
$$\dot p_t = -\nabla_x \mathcal{H}(X_t^\star, u_t^\star, p_t),\quad p_T = \nabla_x g(X_T^\star),$$
and the optimality condition $u_t^\star = \arg\min_u \mathcal{H}(X_t^\star, u, p_t)$ holds a.e.
\end{tcolorbox}
\textbf{Costate intuition.} \(p_t\) is the \emph{shadow price} of state \(X_t\):
\[p_t = \nabla_x V(t, X_t^\star) = \frac{\partial (\text{optimal cost-to-go})}{\partial x}.\]
This is exactly the adjoint / backpropagation equation of deep learning --- PMP is the continuous-time version of gradient backpropagation through a dynamical system.
\textbf{Algorithm (shooting method):}
\begin{verbatim}
1. Guess costate p_0
2. Integrate forward: dX = b(X, u*(X,p)) dt (state ODE)
3. Integrate backward: dp = -grad_x H(X, u*, p) dt (costate ODE)
4. Check boundary condition: p_T = grad g(X_T)
5. If not satisfied -> update p_0 (Newton / gradient) -> go to 2
\end{verbatim}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — PMP for the Merton Problem},breakable]
With $\ell = 0$, $g(x) = -\ln x$, $b = (r+u(\mu-r))x$,
the Hamiltonian is $\mathcal{H}(x,u,p) = p(r+u(\mu-r))x$.
**Costate ODE:**
$\dot p_t = -\partial_x \mathcal{H} = -p_t(r+u^\star(\mu-r))$,
with terminal $p_T = -1/X_T^\star$.
**Optimality condition** $\partial_u\mathcal{H}=0$ recovers $u^\star = (\mu-r)/\sigma^2$.
The costate path $p_t = -e^{-(T-t)(r+(\mu-r)u^\star)}/X_t^\star$ confirms that the
shadow price scales inversely with wealth — poorer investors value state more.
\end{tcolorbox}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
The costate pair \((X_t^\star, p_t)\) moves along Hamiltonian geodesics on \(T^\star\mathbb{R}^d\) --- a direct link to symplectic geometry (§10.4).
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsubsection{4.3 HJB with Jumps (HJBI)}\label{hjb-with-jumps-hjbi}
When the state can jump (§3.4), the HJB equation gains a \textbf{non-local integral operator}:
\[-\partial_t V = \inf_{u}\Bigl[\ell + \nabla V^\top b + \tfrac12\operatorname{Tr}(\sigma\sigma^\top\nabla^2 V)
+ \underbrace{\int\bigl[V(x+c(x,u,z))-V(x)-\nabla V^\top c(x,u,z)\bigr]\nu(dz)}_{\text{expected value change from jumps}}\Bigr].\]
\textbf{Intuition for the integral term.} A jump of size \(c\) moves the state from \(x\) to \(x+c\), changing the value function by \(V(x+c)-V(x)\). The compensator \(\nabla V^\top c\) subtracts the linear part already counted in the drift.
The \texttt{optimal\_control} module discretises the integral on truncated support using Gaussian quadrature.
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Optimal Execution with Jump Risk},breakable]
Extend the inventory model with Poisson order-flow shocks:
$$dX_t = u_t\,dt + \Delta J_t,\quad \Delta J_t \sim \text{Compound Poisson}(\lambda, \mathcal{N}(0,\sigma_J^2)).$$
With Gaussian jumps, the HJBI reduces to the same LQR Riccati ODE but with
**effective diffusion** $\sigma_{\text{eff}}^2 = \lambda\sigma_J^2$.
Key insight: order-flow risk acts like additional Brownian volatility, accelerating
the optimal sell schedule.
\end{tcolorbox}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsubsection{4.4 Viscosity Solutions}\label{viscosity-solutions}
When \(V\) fails to be \(C^{1,2}\) --- degenerate diffusion, constraints, or non-smooth terminal conditions --- classical solutions may not exist. \textbf{Viscosity solutions} (Crandall-Lions 1983) provide a rigorous weak notion that restores existence and uniqueness.
\begin{tcolorbox}[colback=defbg!60,colframe=optblue,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Definition}} — Definition — Viscosity Subsolution},breakable]
A continuous $V$ is a viscosity *subsolution* if for every smooth $\phi$
touching $V$ **from above** at $(t_0,x_0)$:
$$-\partial_t\phi(t_0,x_0) \le \inf_u\Bigl[\ell(x_0,u) + \nabla_x\phi^\top b + \tfrac12\operatorname{Tr}(\sigma\sigma^\top\nabla^2\phi)\Bigr].$$
A *supersolution* reverses the inequality. The unique viscosity **solution** is both.
\end{tcolorbox}
\textbf{Practical interpretation:} Classical: ``\(V\) satisfies the PDE pointwise.'' Viscosity: ``\(V\) satisfies the PDE in an averaged sense --- even at kinks.''
Optimiz-rs's backward DP converges to the viscosity solution under CFL: \(\Delta t \le C\,(\Delta x)^2\).
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — American Option as a Viscosity Problem},breakable]
American put payoff $g(x) = (K-x)^+$ gives the **variational inequality**:
$$\min\Bigl(-\partial_t V - \mathcal{L}_{\text{BS}}V,\; V - (K-x)^+\Bigr) = 0.$$
- **Continuation region** ($V > g$): Black-Scholes PDE holds.
- **Exercise region** ($V = g$): option exercised immediately.
At the free boundary: $\partial_x V$ is continuous (*smooth-pasting*) but $\partial_{xx}V$ is not
— $V$ is $C^1$ but not $C^2$. Viscosity theory handles this kink rigorously.
\end{tcolorbox}
\textbf{Backward DP grid schema:}
\begin{verbatim}
t=T [ g(x_1) g(x_2) ... g(x_n) ] terminal condition
t=T-1 [ V^1 V^2 ... V^n ] one backward step
.
.
t=0 [ V_0^1 V_0^2 ... V_0^n ] -> optimal policy u*(x,0)
\end{verbatim}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{5 · Mean Field Games (1D Solver)}\label{mean-field-games-1d-solver}
MFG couples a \textbf{backward HJB} (individual value) with a \textbf{forward Fokker-Planck} (population density):
\[\begin{aligned}
\text{HJB (backward): } &
-\partial_t u - \nu\partial_{xx}u + H(x,\partial_x u, m) = 0, & u(T,x)&=g(x),\\
\text{Fokker-Planck (forward): } &
\partial_t m - \nu\partial_{xx}m - \partial_x(m\,\partial_p H) = 0, & m(0,x)&=m_0(x).
\end{aligned}\]
\textbf{Coupling:} \(H\) depends on \(m\) (mean-field interaction), creating a fixed-point problem.
\textbf{Backward-forward information flow:}
\begin{verbatim}
t = 0 t = T
m_0 (known) g(x) (known)
| |
| Fokker-Planck (forward -->) |
| evolves population density m |
| |
v v
m(t,x) <----- mutually consistent --- u(t,x)
HJB (backward <--)
optimal value function
Each agent uses u to choose optimal control.
Population density m feeds back into u via H(x, du, m).
Fixed point: m and u are simultaneously consistent (Nash equilibrium).
\end{verbatim}
\textbf{Fixed-point algorithm:}
\begin{verbatim}
1. Initialise m^0 = m_0 (e.g. Gaussian)
2. Solve HJB backward -> u^{k+1}
3. Extract optimal drift: alpha*(x,t) = -d_p H(x, d_x u^{k+1}, m^k)
4. Solve Fokker-Planck forward with alpha* -> m^{k+1}
5. Check ||m^{k+1} - m^k||_1 < eps; if not, k++ -> go to 2
\end{verbatim}
\textbf{Convergence:} For monotone coupling (Lasry-Lions 2007), the system has a unique solution and the fixed-point iteration contracts.
\textbf{Practical tip:} Monitor both \(\|m^{k+1}-m^k\|_1\) and \(\|u^{k+1}-u^k\|_\infty\); divergence of either signals non-monotone coupling or too large a time step.
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Optimal Liquidation with Many Agents},breakable]
**Setup:** $N \gg 1$ traders each hold $x_t$ shares and must liquidate by $T$.
Aggregate selling rate $\bar u_t = \int u\,m(t,dx)$ depresses the price.
**Mean-field Hamiltonian:**
$$H(x, p, m) = \inf_u \Bigl[\alpha x^2 + \beta u^2 + pu\Bigr]
+ \underbrace{\gamma \bar u(m)}_{\text{aggregate impact}}\,x.$$
**Nash equilibrium insight:** Each trader liquidates faster when they believe others sell
slowly (first-mover advantage), but this belief is self-defeating in equilibrium.
The MFG fixed point is **more aggressive** than the single-agent Almgren-Chriss schedule
because each agent accounts for crowd impact.
\end{tcolorbox}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{6 · Kalman Filtering}\label{kalman-filtering}
\subsubsection{6.1 Linear-Gaussian State Space}\label{linear-gaussian-state-space}
\[\mathbf{x}_t = F\mathbf{x}_{t-1} + \mathbf{w}_t,\; \mathbf{w}_t\sim\mathcal{N}(0,Q); \qquad
\mathbf{y}_t = H\mathbf{x}_t + \mathbf{v}_t,\; \mathbf{v}_t\sim\mathcal{N}(0,R).\]
\textbf{Predict:}
\[\hat{\mathbf{x}}^-_t = F\hat{\mathbf{x}}_{t-1},\quad P^-_t = FP_{t-1}F^\top+Q.\]
\textbf{Update:}
\[K_t = P^-_t H^\top(HP^-_t H^\top + R)^{-1},\quad
\hat{\mathbf{x}}_t = \hat{\mathbf{x}}^-_t + K_t(\mathbf{y}_t - H\hat{\mathbf{x}}^-_t),\quad
P_t = (I-K_t H)P^-_t.\]
\(K_t\) is the \emph{Kalman gain} --- it interpolates between full prior trust (\(K\to0\)) and full observation trust (\(K\to H^{-1}\)).
\textbf{Bayesian update --- uncertainty ellipses shrinking:}
\begin{verbatim}
Before observation (predict): After observation (update):
+------------------+ +--------+
| | | |
| p(x | y_1:t-1) | ----> |p(x|y_t)|
| wide ellipse | | tight |
+------------------+ +--------+
Kalman gain K interpolates between:
K -> 0 (huge R, ignore y_t) => x_hat = prior
K -> H^-1 (R=0, trust y_t) => x_hat = H^-1 y_t
\end{verbatim}
\textbf{Covariance convergence:} \(P_t \to P_\infty\) (algebraic Riccati solution) exponentially fast when \((F,H)\) is observable.
\subsubsection{6.2 Information-Theoretic View}\label{information-theoretic-view}
The Kalman filter computes the exact conditional mean \(\hat{\mathbf{x}}_t = \mathbb{E}[\mathbf{x}_t \mid \mathbf{y}_{1:t}]\) in Gaussian models and minimises \(D_{\mathrm{KL}}(p(\mathbf{x}_t|\mathbf{y}_{1:t})\,\|\,\mathcal{N}(\hat{\mathbf{x}}_t, P_t))\) over all Gaussian approximations.
\subsubsection{6.3 Continuous-Time Limit (Kalman-Bucy)}\label{continuous-time-limit-kalman-bucy}
For \(d\mathbf{X}_t = A\mathbf{X}_t\,dt + B\,d\mathbf{W}_t\), \(d\mathbf{Y}_t = C\mathbf{X}_t\,dt + d\mathbf{V}_t\), the error covariance satisfies the \emph{Riccati ODE}:
\[\dot P = AP + PA^\top + BQB^\top - PC^\top R^{-1}CP,\qquad P(0)=P_0.\]
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Tracking a Noisy AR(1) Signal},breakable]
**Model:** Latent trend $x_t = 0.95 x_{t-1} + w_t$ ($Q=0.01$);
noisy observation $y_t = x_t + v_t$ ($R=1.0$).
Steady-state: $P_\infty \approx 0.17$, so $K_\infty \approx 0.15$.
Kalman weights the new observation at 15%, prior at 85%.
```
P_t
1.0 |*
0.8 | \\
0.6 | \\
0.4 | \\___
0.2 | \\__________________ P_inf ~ 0.17
+--------------------------------> t
(fast convergence to steady-state uncertainty)
```
**Implication:** With $R/Q = 100$ (much noisier obs than process), the filter heavily
smooths observations — useful for noisy financial signals like tick prices.
\end{tcolorbox}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{7 · MCMC (Metropolis-Hastings and Langevin)}\label{mcmc-metropolis-hastings-and-langevin}
\subsubsection{7.1 Metropolis-Hastings}\label{metropolis-hastings}
For target \(\pi(x) \propto e^{-U(x)}\) and proposal \(q(x'\mid x)\):
\[\alpha(x\to x') = \min\!\Bigl(1, \frac{\pi(x')q(x\mid x')}{\pi(x)q(x'\mid x)}\Bigr).\]
\textbf{Detailed balance} \(\pi(x)\alpha(x\to x') = \pi(x')\alpha(x'\to x)\) ensures \(\pi\) is the unique stationary distribution.
\textbf{Optimal scaling:} With Gaussian proposal, step \(h^\star \approx 2.38/\sqrt{d}\) (Roberts-Gelman-Gilks 1997) targets \textasciitilde23-45\% acceptance.
\textbf{Energy landscape and accept/reject:}
\begin{verbatim}
U(x) (negative log-posterior)
| * * <- local minima (modes of pi)
| / \\ / \\
| / \\ / \\
| / *___* \\ <- saddle between modes
| / \\
+-------------------------> x
Proposal x' = x + h * xi:
If U(x') < U(x): always accept (moving downhill)
If U(x') > U(x): accept with prob exp(-(U(x')-U(x)))
Prevents getting trapped in local minima.
\end{verbatim}
\textbf{Trace plot of a well-mixed chain:}
\begin{verbatim}
x_t
+2 | . . . . . . <- upper mode
| . . . . . .
0 |... ... <- transitions between modes
| . . . . .
-2 | . . .. <- lower mode
+-----------------------------> t
(crossing between modes = good mixing)
\end{verbatim}
\subsubsection{7.2 Langevin Dynamics (MALA)}\label{langevin-dynamics-mala}
Metropolis-Adjusted Langevin proposal:
\[x' = x - \tfrac{h^2}{2}\nabla U(x) + h\,\xi, \quad \xi\sim\mathcal{N}(0,I_d),\]
a discretisation of the \emph{overdamped Langevin SDE}:
\[dX_t = -\nabla U(X_t)\,dt + \sqrt{2}\,dW_t,\]
whose stationary distribution is exactly \(\pi \propto e^{-U}\).
MALA converges in \(O(d^{1/3})\) steps vs \(O(d)\) for RW-MH --- key advantage for high-dimensional posteriors.
\textbf{MALA vs RW-MH trajectory comparison:}
\begin{verbatim}
RW-MH (random walk): MALA (gradient-guided):
. . . ^ -grad U (towards mode)
. . . . --> /
. . . /. .
(diffusive, slow mixing) (directed, fast mixing)
\end{verbatim}
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Calibrating OU Parameters via MCMC},breakable]
**Goal:** Full Bayesian inference on $(\kappa, \theta, \sigma)$ of an OU process.
**Prior:** $\kappa \sim \text{Gamma}(2,0.1)$, $\theta \sim \mathcal{N}(0,1)$,
$\sigma \sim \text{HalfNormal}(0.5)$.
**MALA chain** ($d=3$, step $h=0.02$):
```
Iteration kappa theta sigma log-post
--------- ----- ----- ----- --------
1000 42.1 0.003 0.11 125.3
2000 55.3 0.003 0.12 128.7 <- burn-in complete
3000 58.1 0.003 0.12 129.2
50000 54.8 0.003 0.12 128.9 <- stable posterior
```
**Marginal posterior** (kappa): 95% CI $[44, 67]$, peak at 55/yr —
wider than the MLE point estimate, reflecting genuine parameter uncertainty.
\end{tcolorbox}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{8 · Hidden Markov Models (HMM)}\label{hidden-markov-models-hmm}
\subsubsection{8.1 Model}\label{model}
Latent Markov chain \(Z_t \in \{1,\ldots,K\}\) with transition matrix \(A_{ij}=\mathbb{P}(Z_t=j\mid Z_{t-1}=i)\) generates observations \(Y_t \mid Z_t=k \sim B_k(y)\).
\textbf{State machine diagram (\(K=3\) regimes):}
\begin{verbatim}
A_12 A_23
+------------+ +------------+
| State 1 |------->| State 2 |-------> State 3
| (Bull) | | (Neutral) | (Bear/Crash)
+------------+<-------+------------+<--------
A_21 A_32
Each state k emits Y_t ~ B_k(y):
B_1: N(mu=+0.05, sigma=0.12) high return, low vol
B_2: N(mu=+0.00, sigma=0.18) flat, medium vol
B_3: N(mu=-0.08, sigma=0.35) crash regime, high vol
Transition matrix A:
A = [ 0.97 0.02 0.01 ] (row 1: from State 1)
[ 0.01 0.97 0.02 ] (row 2: from State 2)
[ 0.05 0.05 0.90 ] (row 3: from State 3)
(rows sum to 1; diagonal = regime persistence)
\end{verbatim}
\subsubsection{8.2 Baum-Welch (EM)}\label{baum-welch-em}
\textbf{E-step (forward-backward):}
\[\alpha_t(k) = B_k(y_t)\sum_j \alpha_{t-1}(j)A_{jk}, \qquad
\beta_t(k) = \sum_j A_{kj}B_j(y_{t+1})\beta_{t+1}(j).\]
\[\gamma_t(k) = \frac{\alpha_t(k)\beta_t(k)}{\sum_j \alpha_t(j)\beta_t(j)}, \qquad
\xi_t(j,k) = \frac{\alpha_t(j)A_{jk}B_k(y_{t+1})\beta_{t+1}(k)}{\mathcal{L}}.\]
\textbf{M-step:}
\[\hat A_{jk} = \frac{\sum_t \xi_t(j,k)}{\sum_t\gamma_t(j)}, \qquad
\hat\mu_k = \frac{\sum_t \gamma_t(k)\,y_t}{\sum_t \gamma_t(k)}.\]
\textbf{Information-theoretic view:} Baum-Welch is EM on the complete-data log-likelihood; each iteration monotonically increases \(\mathcal{L}(\theta)\) by Jensen's inequality.
\textbf{Viterbi trellis diagram (\(K=3\), \(T=4\)):}
\begin{verbatim}
State t=1 t=2 t=3 t=4
1 delta1(1) --> delta2(1) --> delta3(1) --> delta4(1)
\ \\ //
2 delta1(2) --> delta2(2) --> delta3(2) --> delta4(2)
\ \ \
3 delta1(3) --> delta2(3) --> delta3(3) --> delta4(3)
delta_t(k) = max_j [ delta_{t-1}(j) * A_jk * B_k(y_t) ]
psi_t(k) = argmax (backtrack pointer -> records best prev state)
After forward pass: trace back from t=T to t=1 via psi to get MAP sequence
z_1*, z_2*, z_3*, z_4*
\end{verbatim}
\textbf{Viterbi (MAP path):} \(\delta_t(k) = \max_j \delta_{t-1}(j)A_{jk} \cdot B_k(y_t)\), \(O(TK^2)\).
\textbf{Quality check:} Log-likelihood must be non-decreasing; confusion matrix of Viterbi labels vs ground truth validates regime recovery.
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Equity Regime Detection (S&P 500)},breakable]
**Data:** S&P 500 daily log-returns, 2000-2023, $T=5820$ observations.
**Fit $K=3$ HMM** using `hmm::fit_baum_welch()` with 20 random restarts.
**Estimated regime parameters:**
| Regime | Ann. return | Ann. vol | Avg duration |
|--------|------------|---------|-------------|
| Bull | +18% | 10% | 350 days |
| Neutral | +2% | 17% | 80 days |
| Bear | -40% | 38% | 25 days |
**Smoothed state probabilities** $\gamma_t(k)$:
```
P(Bull) 1.0|XXXXXXXXXX XXXXXXXXXX XXXXX
| XXXXXXXX XXXXXXXX
0.0 +-------------------------> t (years)
2000 2003 2008 2020 2023
^ ^ ^
dot-com bust GFC COVID crash
```
**Use in Optimiz-rs:** Regime beliefs $\gamma_t$ feed as features into
`differential_evolution` to switch risk-aversion $\alpha$ dynamically.
\end{tcolorbox}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{9 · Information Theory}\label{information-theory}
\subsubsection{9.1 Entropy and KL Divergence}\label{entropy-and-kl-divergence}
\begin{tcolorbox}[colback=defbg!60,colframe=optblue,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Definition}} — Definition — KL Divergence},breakable]
For densities $p, q$:
$$D_{\mathrm{KL}}(p\,\|\,q) = \int p(x)\log\frac{p(x)}{q(x)}\,dx \;\ge\; 0,$$
with equality iff $p=q$ a.e. (Gibbs inequality). Non-symmetric.
\end{tcolorbox}
\textbf{KL asymmetry --- a critical practical distinction:}
\begin{verbatim}
p = N(0,1) (narrow Gaussian) q = N(0,4) (wide Gaussian)
D_KL(p||q): integrate under p.
p lives mostly in [-2,2] where q is large -> small penalty.
D_KL(p||q) is small. (q "covers" p)
D_KL(q||p): integrate under q.
q places mass in [-6,6]; in tails p is tiny but q is not -> large penalty.
D_KL(q||p) is large. (p does NOT cover q)
Rule of thumb:
D_KL(p||q): fitting q to match p (mean-seeking, mode-averaging)
D_KL(q||p): q must cover p (mode-seeking, mode-fitting)
\end{verbatim}
\textbf{Connection to model selection:} AIC \(= 2k - 2\ln\hat{\mathcal{L}}\) and BIC \(= k\ln n - 2\ln\hat{\mathcal{L}}\) bound \(D_{\mathrm{KL}}(p_{\text{true}}\,\|\,p_\theta)\).
\subsubsection{9.2 Fisher Information}\label{fisher-information}
\begin{tcolorbox}[colback=defbg!60,colframe=optblue,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Definition}} — Definition — Fisher Information Matrix},breakable]
For parametric model $p(x;\theta)$:
$$\mathcal{I}(\theta)_{ij}
= \mathbb{E}_{x\sim p}\!\left[\partial_{\theta_i}\log p\;\partial_{\theta_j}\log p\right]
= -\mathbb{E}\!\left[\partial^2_{\theta_i\theta_j}\log p\right].$$
\end{tcolorbox}
\textbf{Fisher information as curvature of the log-likelihood:}
\begin{verbatim}
log L(theta | x_obs)
| .----.
| ./ \.
| ./ \.
| ./ \.
+-----------------------> theta
theta*
I(theta*) = -d^2/dtheta^2 log L at the peak
High I (sharp peak): theta well-identified, low estimation variance
Low I (flat peak): theta hard to identify, high estimation variance
Cramer-Rao: Var(theta_hat) >= 1 / I(theta) for any unbiased estimator
\end{verbatim}
\textbf{Cramer-Rao bound:} Any unbiased estimator \(\hat\theta\) satisfies \(\operatorname{Cov}(\hat\theta) \succeq \mathcal{I}(\theta)^{-1}\). MLE achieves equality asymptotically.
\textbf{Example:} For \(B_k = \mathcal{N}(\mu_k,\sigma_k^2)\): \(\mathcal{I}(\mu_k)=\sigma_k^{-2}\), \(\mathcal{I}(\sigma_k^2)=(2\sigma_k^4)^{-1}\). Higher emission variance -\textgreater{} smaller Fisher info -\textgreater{} less certain parameter estimates.
\subsubsection{9.3 Mutual Information and Feature Relevance}\label{mutual-information-and-feature-relevance}
\[I(X;Y) = D_{\mathrm{KL}}\bigl(p(X,Y)\,\|\,p(X)p(Y)\bigr) = H(X) - H(X\mid Y) \ge 0.\]
\textbf{Interpretation:} \(I(X;Y)\) = how much knowing \(Y\) reduces uncertainty about \(X\). \(X \perp Y \Rightarrow I=0\). \(Y\) determines \(X\) fully \(\Rightarrow I = H(X)\).
\textbf{mRMR criterion} (minimum redundancy, maximum relevance) for the sparse module:
\[\max_{Y_i} \Bigl[I(Y_i;\text{target}) - \frac{1}{|S|}\sum_{Y_j\in S}I(Y_i;Y_j)\Bigr].\]
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Entropy of HMM Regime Probabilities},breakable]
Define discrete regime distribution at time $t$:
$$\mathbf{p}_t = (\gamma_t(1), \gamma_t(2), \gamma_t(3)).$$
**Regime entropy** $H_t = -\sum_k \gamma_t(k)\log \gamma_t(k) \in [0, \log 3]$:
| Date | P(Bull) | P(Neutral) | P(Bear) | $H_t$ | Certainty |
|------|---------|-----------|---------|-------|-----------|
| 2019-12 | 0.92 | 0.07 | 0.01 | 0.36 | High (Bull clear) |
| 2020-03 | 0.01 | 0.12 | 0.87 | 0.54 | Medium (Bear likely) |
| 2020-06 | 0.42 | 0.45 | 0.13 | 1.05 | Low (mixed) |
Max entropy $\log 3 \approx 1.10$ = fully uncertain.
**Trading filter:** Only trade when $H_t < 0.7$ (certain regime).
\end{tcolorbox}
\subsubsection{9.4 Natural Gradient (Preview)}\label{natural-gradient-preview}
Classical gradient descent ignores parameter-space geometry. The \emph{natural gradient} replaces \(\nabla_\theta\mathcal{L}\) with \(\mathcal{I}(\theta)^{-1}\nabla_\theta\mathcal{L}\), giving a reparametrisation-invariant update --- see §10.2 for the full geometric development.
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{10 · Differential Geometry}\label{differential-geometry}
\subsubsection{10.1 Riemannian Manifolds}\label{riemannian-manifolds}
\begin{tcolorbox}[colback=defbg!60,colframe=optblue,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Definition}} — Definition — Riemannian Manifold},breakable]
A *Riemannian manifold* $(M, g)$ is a smooth manifold $M$ with a
*metric tensor* $g_p$: a symmetric, positive-definite bilinear form on each
tangent space $T_p M$.
\end{tcolorbox}
\textbf{Three canonical curvatures:}
\begin{verbatim}
K > 0 (sphere S2) K = 0 (flat R2) K < 0 (hyperbolic H2)
(N) | /
/|\ | /
/ | \ geodesics --+-- parallel / geodesics
/ | \ reconverge (N-S) | lines / diverge exponentially
\end{verbatim}
\textbf{Tangent space --- linear approximation at \(p\):}
\begin{verbatim}
M (curved 2D surface): TpM (flat tangent plane at p):
.~~~~. ___________
/ \ --> | TpM |
| p * | | * p |
| | |___________|
\ /
.~~~~.
(not flat globally, but TpM is flat locally — used for calculus on M)
\end{verbatim}
\textbf{Geodesics} satisfy:
\[\ddot\gamma^k + \sum_{i,j}\Gamma^k_{ij}\,\dot\gamma^i\dot\gamma^j = 0,\]
where \(\Gamma^k_{ij} = \tfrac12 g^{kl}(\partial_i g_{jl}+\partial_j g_{il}-\partial_l g_{ij})\) are the \emph{Christoffel symbols} encoding intrinsic curvature.
\subsubsection{10.2 Information Geometry and Fisher-Rao Metric}\label{information-geometry-and-fisher-rao-metric}
The statistical manifold \(\mathcal{M} = \{p(\cdot;\theta)\}\) carries the \textbf{Fisher-Rao metric} \(g_{ij}(\theta) = \mathcal{I}(\theta)_{ij}\).
\textbf{Standard vs natural gradient:}
\begin{verbatim}
Standard gradient descent: Natural gradient descent:
theta_{k+1} = theta_k - eta * grad L theta_{k+1} = theta_k - eta * I^{-1} grad L
Parameter space = flat R^d. Parameter space = Riemannian (metric I(theta)).
Ignores curvature. Adapts step to local geometry.
Slow on ill-conditioned I. Invariant to reparametrisation.
O(kappa(I)) iterations. O(1) iterations on exponential families.
\end{verbatim}
\textbf{Natural gradient (Amari 1998):}
\[\theta \leftarrow \theta - \eta\,\mathcal{I}(\theta)^{-1}\nabla_\theta\mathcal{L}.\]
\textbf{KL geometry:} \(D_{\mathrm{KL}}(p_\theta\,\|\,p_{\theta+d\theta}) = \tfrac12\,d\theta^\top\mathcal{I}(\theta)\,d\theta + O(\|d\theta\|^3)\), confirming Fisher-Rao as the intrinsic KL metric.
\textbf{Dually flat structure:} Exponential families \(p(x;\theta)=h(x)\exp(\theta^\top T(x)-A(\theta))\) have \(K=0\) --- explaining exact Newton/natural-gradient convergence.
\begin{tcolorbox}[colback=notebg!60,colframe=optgreen,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Example}} — Example — Natural Gradient on a Gaussian Model},breakable]
For $p(x;\theta) = \mathcal{N}(\mu, \sigma^2)$, $\theta=(\mu,\sigma^2)$:
$$\mathcal{I}(\theta) = \begin{pmatrix} 1/\sigma^2 & 0 \\ 0 & 1/(2\sigma^4) \end{pmatrix}.$$
**Natural gradient** of $\mathcal{L} = -\log p(x_{\rm obs};\theta)$:
$$\tilde\nabla_\theta\mathcal{L} = \mathcal{I}^{-1}\nabla\mathcal{L} = \begin{pmatrix}\mu-x \\ \sigma^2 - (x-\mu)^2/2\end{pmatrix}.$$
One Newton step on this exponential family finds the MLE exactly because the
Hessian equals $\mathcal{I}$ (dually flat, $K=0$).
\end{tcolorbox}
\subsubsection{10.3 Lie Groups and Geometric Control}\label{lie-groups-and-geometric-control}
\begin{tcolorbox}[colback=defbg!60,colframe=optblue,fonttitle=\bfseries\sffamily,title={\textsf{\textbf{Definition}} — Definition — Lie Group},breakable]
A *Lie group* $G$ is a smooth manifold with a group structure where
multiplication and inversion are smooth. The *Lie algebra* $\mathfrak{g} = T_e G$
linearises the group at the identity.
\end{tcolorbox}
\textbf{Matrix Lie group hierarchy:}
\begin{verbatim}
GL(n,R) general linear group (all invertible n x n real matrices)
|
|--- SL(n,R) special linear (det = 1)
|
|--- O(n) orthogonal (R'R = I)
| |
| +---- SO(n) special orthogonal (det = +1, pure rotations)
| Used in: portfolio factor rotation, PCA constraints
|
+--- Sp(2n,R) symplectic (preserves symplectic form omega)
Used in: Hamiltonian mechanics, PMP sections 4.2 and 10.4
Heisenberg group H(n): upper triangular with 1s on diagonal.
Used in: path-signature feature maps (lab_signature_methods)
\end{verbatim}
\textbf{Left-invariant control system on \(G\):}
\[\dot g(t) = g(t)\,\xi(t), \quad g\in G,\; \xi(t)\in\mathfrak{g}.\]
PMP on Lie groups yields the \emph{Lie-Poisson (Euler-Poincare) equations} (Holm-Marsden-Ratiu), providing structure-preserving optimal trajectories.
\subsubsection{10.4 Symplectic Geometry and Hamiltonian Structure}\label{symplectic-geometry-and-hamiltonian-structure}
The phase space \((T^\star M, \omega)\) carries the symplectic 2-form \(\omega = \sum_i dp_i \wedge dq_i\). Hamilton's equations preserve \(\omega\) (\emph{Liouville's theorem} --- phase-space volume conserved).
\textbf{Connection to PMP:} The costate pair \((X_t^\star, p_t)\) solves Hamilton's equations, i.e., the PMP is a symplectic flow on \(T^\star\mathbb{R}^d\).
\textbf{Symplectic integrators} (Stormer-Verlet, Ruth-Forest) preserve \(\omega\) discretely, keeping the Hamiltonian nearly constant over long horizons --- critical for multi-year allocation back-tests in Optimiz-rs.
\subsubsection{10.5 Sectional Curvature and Landscape Geometry}\label{sectional-curvature-and-landscape-geometry}
The sectional curvature \(K(\sigma)\) governs how quickly nearby geodesics diverge:
\begin{verbatim}
K > 0 (sphere): geodesics converge -> compact optimiser trajectories
K = 0 (flat ): Euclidean behaviour -> Newton / natural gradient exact
K < 0 (hyper.): exponential spread -> efficient landscape exploration
\end{verbatim}
For exponential families in natural/mean parameters \(K=0\) --- explaining exact Newton convergence without curvature correction.
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{Quick Reference}\label{quick-reference}
{\def\LTcaptype{none} % do not increment counter
\begin{longtable}[]{@{}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.1800}}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.4400}}
>{\raggedright\arraybackslash}p{(\linewidth - 4\tabcolsep) * \real{0.3800}}@{}}
\toprule\noalign{}
\begin{minipage}[b]{\linewidth}\raggedright
Concept
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Key equation / object
\end{minipage} & \begin{minipage}[b]{\linewidth}\raggedright
Optimiz-rs module
\end{minipage} \\
\midrule\noalign{}
\endhead
\bottomrule\noalign{}
\endlastfoot
Brownian motion & \(W_t - W_s \sim \mathcal{N}(0,t-s)\) & \texttt{point\_processes} \\
Ito SDE & \(dX=b\,dt+\sigma\,dW\) & \texttt{ou\_estimator} \\
Poisson / Compound Poisson & \(N_t\sim\text{Poisson}(\lambda t)\) & \texttt{point\_processes} \\
Levy process & triplet \((b,\sigma^2,\nu)\) & \texttt{point\_processes} \\
HJB PDE & \(-\partial_t V = \inf_u[\ell + \nabla V^\top b + \tfrac12\operatorname{Tr}\sigma\sigma^\top\nabla^2 V]\) & \texttt{optimal\_control} \\
HJBI (jumps) & \(+\int[V(\cdot+c)-V-\nabla V^\top c]\nu\,dz\) & \texttt{optimal\_control} \\
PMP costate & \(\dot p = -\nabla_x\mathcal{H}\), \(u^\star=\arg\min_u\mathcal{H}\) & \texttt{optimal\_control} \\
MFG (HJB + KFP) & fixed-point \(u,m\) & \texttt{mean\_field\_games} \\
Kalman filter & \(K_t = P^-H^\top(HP^-H^\top+R)^{-1}\) & \texttt{optimal\_control} \\
MALA & \(x'=x-\tfrac{h^2}{2}\nabla U+h\xi\) & \texttt{mcmc} \\
HMM & Baum-Welch EM + Viterbi & \texttt{hmm} \\
Fisher information & \(\mathcal{I}_{ij}=\mathbb{E}[\partial_i\ell\,\partial_j\ell]\) & \texttt{hmm}, \texttt{sparse} \\
Natural gradient & \(\mathcal{I}^{-1}\nabla_\theta\mathcal{L}\) & \texttt{differential\_evolution} \\
Riemannian / Lie geometry & Christoffel symbols, Lie-Poisson equations & experimental \\
DE (jDE) & mutation + crossover + selection & \texttt{differential\_evolution} \\
\end{longtable}
}
\begin{center}\rule{0.5\linewidth}{0.5pt}\end{center}
\subsection{References}\label{references}
\begin{enumerate}
\def\labelenumi{\arabic{enumi}.}
\item
Oksendal, B. \emph{Stochastic Differential Equations}, 6th ed.~Springer, 2003.
\item
Cont, R. \& Tankov, P. \emph{Financial Modelling with Jump Processes}. CRC Press, 2004.
\item
Fleming, W.H. \& Soner, H.M. \emph{Controlled Markov Processes and Viscosity Solutions}. Springer, 2006.
\item
Lasry, J.-M. \& Lions, P.-L. ``Mean field games.'' \emph{Jpn. J. Math.} \textbf{2} (2007) 229-260.
\item
Amari, S. \emph{Information Geometry and Its Applications}. Springer, 2016.
\item
do Carmo, M.P. \emph{Riemannian Geometry}. Birkhauser, 1992.
\item
Holm, D.D., Marsden, J.E. \& Ratiu, T.S. ``The Euler-Poincare equations.'' \emph{Adv. Math.} \textbf{137} (1998).
\item
Price, K.V., Storn, R.M. \& Lampinen, J.A. \emph{Differential Evolution}. Springer, 2005.
\item
Roberts, G.O., Gelman, A. \& Gilks, W.R. ``Weak convergence of Metropolis algorithms.'' (1997).
\item
Merton, R.C. ``Option pricing when underlying stock returns are discontinuous.'' \emph{JFE} \textbf{3} (1976).
\item
Crandall, M.G. \& Lions, P.-L. ``Viscosity solutions of Hamilton-Jacobi equations.'' \emph{Trans. AMS} (1983).
\item
Almgren, R. \& Chriss, N. ``Optimal execution of portfolio transactions.'' \emph{J. Risk} \textbf{3} (2001).
\item
Carmona, R. \& Delarue, F. \emph{Probabilistic Theory of Mean Field Games}. Springer, 2018.
\end{enumerate}
\end{document}
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