Stochastic Calculus for Quantitative Finance

Stochastic Calculus for Quantitative Finance

Alexander A. Gushchin

Table of Contents

Cover image

Title page

Copyright page

Basic Notation

Preface

List of Statements

Definitions

Examples

Exercises

Remarks

Propositions

Theorem

Lemmas

Corollaries

1: General Theory of Stochastic Processes

Abstract

1.1 Stochastic basis and stochastic processes

1.2 Stopping times

1.3 Measurable, progressively measurable, optional and predictable σ-algebras

1.4 Predictable stopping times

1.5 Totally inaccessible stopping times

1.6 Optional and predictable projections

2: Martingales and Processes with Finite Variation

Abstract

2.1 Elements of the theory of martingales

2.2 Local martingales

2.3 Increasing processes and processes with finite variation

2.4 Integrable increasing processes and processes with integrable variation. Doléans measure

2.5 Locally integrable increasing processes and processes with locally integrable variation

2.6 Doob–Meyer decomposition

2.7 Square-integrable martingales

2.8 Purely discontinuous local martingales

3: Stochastic Integrals

Abstract

3.1 Stochastic integrals with respect to local martingales

3.2 Semimartingales. Stochastic integrals with respect to semimartingales: locally bounded integrands. Itô’s formula

3.3 Stochastic exponential

3.4 Stochastic integrals with respect to semimartingales: the general case

3.5 σ-martingales

Appendix

A.1 Theorems on monotone classes

A.2 Uniform integrability

A.3 Conditional expectation

A.4 Functions of bounded variation

Bibliographical Notes

Chapter 1

Chapter 2

Chapter 3

Appendix

Bibliography

Index

Copyright

First published 2015 in Great Britain and the United States by ISTE Press Ltd and Elsevier Ltd

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Notices

Knowledge and best practice in this field are constantly changing. As new research and experience broaden our understanding, changes in research methods, professional practices, or medical treatment may become necessary.

Practitioners and researchers must always rely on their own experience and knowledge in evaluating and using any information, methods, compounds, or experiments described herein. In using such information or methods they should be mindful of their own safety and the safety of others, including parties for whom they have a professional responsibility.

To the fullest extent of the law, neither the Publisher nor the authors, contributors, or editors, assume any liability for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions, or ideas contained in the material herein.

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© ISTE Press Ltd 2015

The rights of Alexander A. Gushchin to be identified as the author of this work have been asserted by him in accordance with the Copyright, Designs and Patents Act 1988.

British Library Cataloguing-in-Publication Data

A CIP record for this book is available from the British Library

Library of Congress Cataloging in Publication Data

A catalog record for this book is available from the Library of Congress

ISBN 978-1-78548-034-8

Printed and bound in the UK and US

Basic Notation

indicates the end of the proof.

The symbol := means put by definition.

.

= d-dimensional Euclidean space.

.

= the set of natural numbers.

a ∨ b = max{a, b}, a ∧ b = min{a, b.

a+ = a ∨ 0, a− = (−a.

.

= the indicator function of the set B.

E = expectation.

= conditional expectation with respect to the σ.

= the smallest σ-algebra containing the σ.

= the smallest σ-algebra containing the σ, α ∈ A.

Preface

The arbitrage theory for general models of financial markets in continuous time is based on the heavy use of the theory of martingales and stochastic integration (see the monograph by Delbaen and Schchermayer [DEL 06]). Our book gives an exposition of the foundations of modern theory of stochastic integration (with respect to semimartingales. It follows traditions of the Strasbourg School of Stochastic Processes. In particular, the exposition is inspired by the monograph by Dellacherie [DEL 72]) in Chapter 1 and by the course by Meyer [MEY 76] in Chapters 2 and 3. In Chapter 1, the so-called general theory of stochastic processes is developed. The second chapter is devoted to detailed study of local martingales and processes with finite variation. The theory of stochastic integration with respect to semimartingales is a subject of Chapter 3. We do not consider vector stochastic integrals, for which we refer to Shiryaev and Cherny [SHI 02]. The last section is devoted to a-martingales and the Ansel–Stricker theorem. Some results are given without proofs. These include the section theorem, classical Doob’s theorems on martingales, the Burkholder–Davis–Gundy inequality and Itô’s formula.

Our method of presentation may be considered as old-fashioned, compared to, for example, the monograph by Protter [PRO 05], which begins with an introduction of the notion of a semimartingale; in our book, semimartingales appear only in the final chapter. However, the author’s experience based on the graduate courses taught at the Department of Mechanics and Mathematics of Moscow State University, indicates that our approach has some advantages.

The text is intended for a reader with a knowledge of measure-theoretic probability and discrete-time martingales. Some information on less standard topics (theorems on monotone classes, uniform integrability, conditional expectation for nonintegrable random variables and functions of bounded variation) can be found in the Appendix. The basic idea, which the author pursued when writing this book, was to provide an affordable and detailed presentation of the foundations of the theory of stochastic integration, which the reader needs to know before reading more advanced literature on the subject, such as Jacod [JAC 79], Jacod and Shiryaev [JAC 03], Liptser and Shiryayev [LIP 89], or a literature dealing with applications, such as Delbaen and Schchermayer [DEL 06].

The text is accompanied by more than a hundred exercises. Almost all of them are simple or are supplied with hints. Many exercises extend the text and are used later.

The work on this book was partially supported by the International Laboratory of Quantitative Finance, National Research University Higher School of Economics and Russian Federation Government (grant no. 14.A12.31.0007). I wish to express my sincere thanks to Tatiana Belkina for a significant and invaluable assistance in preparing the manuscript.

Alexander Gushchin, Moscow, May 2015

List of Statements

Definitions

Examples

Exercises

Remarks

Propositions

Theorem

Lemmas

Corollaries

1

General Theory of Stochastic Processes

Abstract

To describe the dynamics of random phenomena in time, the notion of a stochastic basis is used in stochastic calculus.

Keywords

Bounded measurable processes

Càdlàg process

Measurable sets

Optional section theorem

Predictable s-algebras

Predictable section theorem

Predictable stopping times

Right- and left continuous process

Stochastic process

Totally inaccessible stopping times

1.1 Stochastic basis and stochastic processes

To describe the dynamics of random phenomena in time, the notion of a stochastic basis is used in stochastic calculus.

Definition 1.1

A filtration of sub-σ-algebras of the σ. A stochastic basis ).

If a discrete filtration is given, i.e. a nondecreasing family of sub-σ, then it can be extended to a filtration in the sense of , where [·] is the integer part of a number.