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If Z N(0, 1) under a measure P, h is an integrable function, and c is a constant Multidimensional Diffusions, Quadratic Covariation, and Its Formula
then
EP [e c Z h (Z )] = e c /2 EP [h (Z + c )].
2
If X := (X 1 , X 2 , . . . , X n )0 is a n -dimensional diffusion process with form
Z t Z t
Let X N(0,Q ), h be a integrable function of x Rn , and c Rn . Then
0 1
c 0Q c
X (t ) = X (0) + (s ) d s + (s ) d W (s ),
EP [e c X
h (X )] = e 2 EP [h (X + c )]. 0 0
Correlating Brownian Motions where (t ) Rn m and W is a m -dimensional Brownian motion. The quadration
covariation of the components X i and X j is
Let (W (t ))t 0 and (W
f(t ))t 0 be independent Brownian motions. Given a correla- Z t
tion coefficient [1, 1], define X i , X j (t ) = i (s )0 j (s ) d s ,
c(t ) := W (t ) + 1 2 W
f(t ),
p
W 0
or in differential form d X i , X j (t ) = i (t )0 j (t ) d t , where i (t ) is the i th column
then (W
c(t ))t 0 is a Brownian motion and E[W (t )W
c(t )] = t . Rt
of (t ). The quadratic variation of X i (t ) is X i (t ) = 0 i (s )0 i (s ) d s .
Identifying Martingales The multi-dimensional It formula for Y (t ) = f (t , X 1 (t ), . . . , X n (t )) is
If X t = X (t ) is a diffusion process satisfying f X n
f
d X (t ) = (t , X t ) d t + (t , X t )d W (t ) d Y (t ) = (t , X 1 (t ), . . . , X n (t ))d t + (t , X 1 (t ), . . . , X n (t ))d X i (t )
t i =1
xi
RT
and EP [( 0 (s , X s )2 d s )1/2 ] < (or, (t , x ) c |x | as |x | ), then n
1 X 2f
X is a martingale X is driftless (i.e., (t ) 0 with P-prob. 1). + (t , X 1 (t ), . . . , X n (t ))d X i , X j (t ).
2 i , j =1 xi x j
Novikovs Condition The (vector-valued) multi-dimensional It formula for
In the case d X (t ) = (t )X (t ) d W (t ) for some F -previsible process ((t ))t 0 , then Y (t ) = f (t , X (t )) = (f1 (t , X (t )), . . . , fn (t , X (t )))0
we have the simpler condition
ZT where fk (t , X ) = fk (t , X 1 , . . . , X n ) and Y (t ) = (Y1 (t ), Y2 (t ), . . . , Yn (t ))0 is given component-
1 wise (for k = 1, . . . , n ) as
EP exp (s )2 d s < X is a martingale. n
2 0 fk (t , X (t )) X fk (t , X (t ))
d Yk (t ) = dt + d X i (t )
Its Formula t i =1
xi
n
For X t = X (t ) given by d X (t ) = (t ) d t + (t ) d W (t ) and a function g (t , x ) that is 1 X 2 fk (t , X (t ))
+ d X i , X j (t ).
twice differentiable in x and once in t . Then for Y (t ) = g (t , X t ), we have 2 i , j =1 xi x j
g g 1 2g
d Y (t ) = (t , X t ) d t + (t , X t ) d X t + (t )2 (t , X t )d t . Stochastic Exponential
t x 2 x2
The Product Rule The stochastic exponential of X is Et (X ) = exp(X (t ) 21 X (t )). It satisfies
Given X (t ) and Y (t ) adapted to the same Brownian motion (W (t ))t 0 , E (0) = 1, E (X )E (Y ) = E (X + Y )e X ,Y , E (X )1 = E (X )e X ,X .
d X (t ) = (t )d t + (t )d W (t ), d Y (t ) = (t ) d t + (t ) d W (t ). The process Z = E (X ) is a positive process and solves the SDE
Then d (X (t )Y (t )) = X (t ) d Y (t ) + Y (t ) d X (t ) + d X , Y (t ). dZ =Z dX , Z (0) = e X (0) .
| {z }
(t )(t ) d t
Solving Linear ODEs
In the other case, if X (t ) and Y (t ) are adapted to two different and independent
Brownian motions (W (t ))t 0 and (W f(t ))t 0 , The linear ordinary differential equation
d X (t ) = (t ) d t + (t ) d W (t ), d Y (t ) = (t ) d t + (t ) d W f(t ). d z (t )
= m (t ) + (t )z (t ), z (a ) = ,
Then d (X (t )Y (t )) = X (t ) d Y (t ) + Y (t ) d X (t ) as d X , Y (t ) = 0. dt
for a t b has solution given by
Radon-Nikodm Derivative Z t Z t
Given P and Q equivalent measures and a time horizon T , we can define a random z (t ) = t + t 1
u m (u) d u , t := exp (u ) d u ,
variable dd QP defined on P-possible paths, taking positive real values, such that a a
Z t
Z t
Z t
dQ
EQ [X T ] = EP X T , for all claims X T knowable by time T , = exp (u) d u + m (u ) exp (r ) d r d u .
dP a a u
EQ [X t |Fs ] = 1
s EP
[t X t |Fs ], for s t T ,
Solving Linear SDEs
where t is the process EP [ dd QP |Ft ].
The linear stochastic differential equation
Cameron-Martin-Girsanov Theorem d Z (t ) = [m (t ) + (t )Z (t )]d t + [q (t ) + (t )Z (t )] d W (t ), Z (a ) = ,
If (W (t ))t 0 is a P-Brownian motion and ((t
R))Tt 0 is an F-previsible process satis- for a t b has solution given by
fying the boundedness condition EP exp 12 0 (t )2 d t < , then there exists a
Z t Z t
Let X be some FT -measurable claim, payable at time T . The arbitrage-free price Define the Fourier transform inversion of the conditional expectation
V of X at time t is
ZT
1b X
T
ZT G (a , b , y ) = EQ exp R (X s )d s e a XT
T y
V (t ) = EQ exp r (s ) d s X Ft , 0
(a , X 0 , T ) 1 ((a + i v b , X 0 , T )e i v y )
t
Z
where Q is the risk-neutral measure. = dv
2 0
v
Market Price Of Risk The i th entry in X is the log asset price and k = l o g (K ), the log strike. d is a vector
whose i th element is 1, else zero. The corresponding call option price is
Let X t = X (t ) be the price of a non-tradable asset with dynamics d X (t ) = (t ) d t + C = G (d , d , k ) K G (0, d , k )
(t )d W (t ) where ((t ))t 0 and ((t ))t 0 are previsible processes and (W (t ))t 0 is
a P-Brownian motion. Let Y (t ) := f (X t ) be the price of a tradable asset where The Heath-Jarrow-Morton Framework
f : R R is a deterministic function. Then the market price of risk is Given a initial forward curve T 7 f (0, T ) then, for every maturity T and under the
t f 0 (X t ) + 12 2t f 00 (X t ) r f (X t ) real-world probability measure P, the forward rate process t 7 f (t , T ) follows
(t ) := , Z t Z t
t f 0 (X t )
f (t , T ) = f (0, T ) + (s , T ) d s + (s , T )0 d W (s ), t T,
and the behaviour of X t under the risk-neutral measure Q is given by 0 0
r f (X t ) 12 2t f 00 (X t ) where (t , T ) R and (t , T ) := (1 (t , T ), . . . , n (t , T )) satisfy the technical condi-
d X (t ) = (t )d W
f(t ) + dt. RT RT
f 0 (X
t) tions: (1) and are previsible and adapted to Ft ; (2) 0 0 |(s , t )| d s d t <
for all T ; (3) sups ,t T k(s , t )k < for all T . The short-rate process is given by
Blacks Model Z t Z t
r (t ) = f (t , t ) = f (0, t ) + (s , t ) d s + (s , t ) d W (s ),
Consider a European option with strike price K on a asset with value VT at ma- 0 0
turity time T . Let FT be the forward price of VT , F0 the current forward price. If
so the cash account and zero coupon T -bond prices are well-defined and obtained
log VT N(F0 , 2 T ) then the Call and Put prices are given by through
C = P (0, T )(F0 (d 1 ) K (d 2 )), P = P (0, T )(K (d 2 ) F0 (d 1 )), Z t ZT
log(EQ (VT )/K ) + 2 T /2 p B (t ) = exp r (s ) d s , P (t , T ) = exp f (t , u) d u .
where d 1 = p and d 2 = d 1 T . 0 t
T
The discounted asset price Z (t , T ) = P (t , T )/B (t ) satisfies
ZT
Forward Rates, Short Rates, Yields, and Bond Prices 1
d Z (t , T ) = Z (t , T ) S 2 (t , T ) (t , u) d u d t + S (t , T )0 d W (t ) ,
The forward rate at time t that applies between times T and S is defined as 2 t
| {z }
1 P (t , T ) b (t ,T )
F (t , T,S ) = log .
S T P (t ,S ) where S (s , T ) :=
RT
(s , u) d u . The HJM drift condition states that
s
The instantaneous forward rate at time t is f (t , T ) = limS T F (t , T,S ). The instan-
taneous risk-free rate or short rate is r (t ) = limT t f (t , T ). The cash account is Q is EMM (i.e., no arbitrage for bonds) b (t , T ) = S (t , T )(t )0 ,
given by f(t ) := W (t ) t (s ) d s is a Q-Brownian motion. If this holds, then under
R
Z t where W 0
B (t ) = exp r (s ) d s , Q, the forward rate process follows
Z t ZT Z t
0
and satisfies d B (t ) = r (t )B (t ) d t with B (0) = 1. The instantaneous forward rates f (t , T ) = f (0, T ) + (s , T ) (s , u)0 d u d s + (s , T ) d W
f(s ),
and the yield can be written in terms of the bond prices as 0
|
s
{z }
0
P means the process stays positive, MR means rt is mean-reverting. Closed form so-
lutions for bond prices and European options exist for all models except for , which
github.com/daleroberts/math-finance-cheat-sheet
describes the evolution of d log(rt ) instead of d rt .