Stochastic Calculus: Summary. by Celine Azizieh (Université Libre de Bruxelles)

Stochastic Calculus - Summary of tools
Céline Azizieh
Université Libre de Bruxelles
November 2018
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Stochastic Calculus - Outline
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
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2. Martingales
3. Brownian Motion
7. Girsanov Theorem
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
Financial modelling: Probabilistic framework
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We consider the set of “all possible states of the world” Ω, with a

“sigma-algebra” F representing all "admissible" events to which a
probability will be attributed.
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probability will be attributed. Mathematicians speak about the notion of
“measurable space” Ω, F .
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In financial modelling, Ω represents the different possible evolution
scenarios in a given market:
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scenarios in a given market: each “scenario” ω > Ω typically represents
a possible evolution in time of the prices of a set of financial
instruments.
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instruments.
Scenarios are hence the “elementary events” in our modelling
framework.
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instruments.
Scenarios are hence the “elementary events” in our modelling
framework.
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Let us recall that a probability measure is a mapping:
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PF 0, 1 A ( PA
such that:
PA > 0, 1 for all A > F ,
P Ω 1,
If Ai i > N0 are 2 by 2 disjoint, then:
P 8i >N0 Ai Qª P A
i 1
i
(sigma-additivity)
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PF 0, 1 A ( PA
such that:
P Ω 1,
P 8i >N0 Ai Qª P A
i 1
i
(sigma-additivity)
We will always work on a probability space Ω, F , P in which
elementary events represent typically
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PF 0, 1 A ( PA
such that:
P Ω 1,
P 8i >N0 Ai Qª P A
i 1
i
(sigma-additivity)
We will always work on a probability space Ω, F , P in which
elementary events represent typically the evolution of a given market
during a given time interval.
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Stochastic process and filtration
The prices of financial assets,
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The prices of financial assets, or more generally, of market

variables
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variables (e.g.: interest rates, exchange rates, etc),
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variables (e.g.: interest rates, exchange rates, etc), will be
modelled by stochastic processes in continuous time,
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modelled by stochastic processes in continuous time, i.e. the
given of a random variable at each instant t:
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X 0, ª Ω R t, ω ( X t, ω
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X 0, ª Ω R t, ω ( X t, ω

such that for each fixed t, X t, . Ω R is a random variable.
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X 0, ª Ω R t, ω ( X t, ω

Hence:
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X 0, ª Ω R t, ω ( X t, ω

Hence:
For a fixed scenario ω, we have a trajectory
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X 0, ª Ω R t, ω ( X t, ω

Hence:
For a fixed instant t, we have a random variable
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X 0, ª Ω R t, ω ( X t, ω

Hence:
For a fixed instant t, we have a random variable
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Now, if t represents time,
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Now, if t represents time, in order to model concepts like the progressive

arrival of information, causality and predictability,
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arrival of information, causality and predictability, we should normally
introduce the concept of filtration.
In a dynamical framework, when time passes, information is progressively
revealed to the observer
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revealed to the observer quantities seen as stochastic at t=0 are not
stochastic anymore at a future instant t A 0 if their value is revealed in the
mean time, i.e. given the available information at t A 0.
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Without entering into details, one can say that a filtration represents the
growing information that becomes available progressively when time passes...
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Now, in order to avoid formalism, we will just suppose that market variables
are modelled by stochastic processes whose value at t is known "as soon as
we have reached instant t".
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Now, in order to avoid formalism, we will just suppose that market variables
are modelled by stochastic processes whose value at t is known "as soon as
we have reached instant t".
This leads to the so-called notion of adapted process : intuitively, a process
Xt is adapted when the value of the r.v. Xt is known as soon as we have
reached instant t.
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2. Martingales
3. Brownian Motion
7. Girsanov Theorem
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Martingales Conditional expectation
Conditional expectation
An important type of processes used in financial modelling are of

particular interest:
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particular interest: martingales.
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Before defining martingales,
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Before defining martingales, let us recall the concept of conditional
expectation ,
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expectation , that will play an important role.
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Suppose that X and Y are two random variables, where Y takes a
finite number of possible values.
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finite number of possible values. The conditional expectation of X
given Y : E X SY corresponds to a new random variable whose value
is known as soon as the value of Y is known:
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E X SY ω E X SY Y ω .
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The last conditional expectation is taken w.r.t. an event.
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The last conditional expectation is taken w.r.t. an event.
This means that it takes value E X SY yi with probability P Y yi .
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Remark
1 We can interpret E X SY as a function of ω
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Remark
1 We can interpret E X SY as a function of ω or as a function of y :
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Remark
E X SY ω or E X SY y .
Actually, the value of E X SY is known as soon as the value of Y

is known , so we can see it as a function of Y : E X SY f Y .
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Remark

2 This concept can be extended in a broader context, i.e. if Y is non
necessarily discrete anymore. See for instance [Karr] for more
details.
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Remark

2 This concept can be extended in a broader context, i.e. if Y is non
necessarily discrete anymore. See for instance [Karr] for more
details.
3 If Y is replaced by a random vector, or n random variables
Y1 , Y2 , ..., Yn , the definition can be directly extended for defining
E X SY1 , ..., Yn .
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In practice
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In practice
1 If X , Y are discrete:
E X SY y Qx P X
i
i xi SY y Q x P XP Yx , Yy
i
i

i

y
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In practice
E X SY y Qx P X
i
i
i

i

y
2 If X , Y has a joint density f x, y (see later) and Y has density

fY y , then one can show:
E X SY y S R
x
f x, y
f Y y
dx
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In practice
E X SY y Qx P X
i
i
i

i

y

E X SY y S R
x
f x, y
f Y y
dx SR
xfX SY x, y dx
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In practice
E X SY y Qx P X
i
i
i

i

y

E X SY y S R
x
f x, y
f Y y
dx SR
xfX SY x, y dx
We call fX SY x, y the conditional density of X given Y y.
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One recall the following properties:
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E X SY is a function of Y
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E X SY is a function of Y (it is "σ Y -measurable")
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E E X SY E X : in average, the conditional expectation of a
random variable given another rv preserves the expectation.
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E g Y SY g Y : the conditional expectation of a function of Y,
given Y, is simply that function. This is an easy consequence of
the definition.
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the definition.
E Xg Y SY g Y E X SY
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the definition.
E aX bZ SY aE X SY bE Z SY where X , Y , Z are rvs and
a, b > R (linearity of the conditional expectation).
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the definition.
E aX bZ SY aE X SY bE Z SY where X , Y , Z are rvs and
a, b > R (linearity of the conditional expectation).
E X SY E X if X , Y are independent (straightforward
consequence of the definition).
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Martingales Martingales in discrete time
Martingales: Definitions and basic comments
We are now ready to define a martingale.
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We can introduce this concept in a discrete or in a continuous time
environment.
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environment.
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environment.
Definition (Discrete time martingale w.r.t. a stochastic process)
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environment.

The SP Yn n>N0 is a martingale w.r.t. the SP Xn n>N0

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environment.


(i) Yn is σ X1 , . . . , Xn -measurable for all n;
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environment.


(ii) E SYn S @ ª for all n;
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environment.


(iii) E Yn1 SX1 , . . . , Xn Yn a.s. for all n;
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environment.


(iii) E Yn1 SX1 , . . . , Xn Yn a.s. for all n;
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Remarks:
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Remarks:
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Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
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Remarks:
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
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Remarks:
3 (iii) E Yn E Y0 for all n (mean-stationarity).
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Remarks:
4 Using (iii), we also have (for k 2, 3, . . .)
E Ynk SX1 , ..., Xn
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Remarks:
E Ynk SX1 , ..., Xn EE Ynk SX1 , ..., Xnk TX1 , ..., Xn
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Remarks:
E Ynk 1 SX1 , ..., Xn
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Remarks:
E Ynk 1 SX1 , ..., Xn
...
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Remarks:
E Ynk 1 SX1 , ..., Xn
... E Yn1 SX1 , ..., Xn
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Remarks:
E Ynk 1 SX1 , ..., Xn
... E Yn1 SX1 , ..., Xn
Yn a.s. for all n.
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Remarks:
E Ynk 1 SX1 , ..., Xn
... E Yn1 SX1 , ..., Xn
Yn a.s. for all n.
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Often in finance, we will consider stochastic processes in continuous

time.
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time. Martingales can also be defined in this framework.
Definition (Continuous time martingale)
A stochastic process Mt t C0 is a martingale w.r.t. a process Xt t if for
all t:
1 Mt is σ Xs , s B t -measurable
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all t:
2 E SMt S @ ª
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all t:
2 E SMt S @ ª
3 E Mt SXu , u B s Ms for all s @ t.
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all t:
2 E SMt S @ ª
Interpretation: accumulated gains of a player in an equilibrated game
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all t:
2 E SMt S @ ª
Interpretation: accumulated gains of a player in an equilibrated game
In particular, E Mt M0 .
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Example of martingale: random walk
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Let X1 , X2 , . . . be i.i.d. with
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn P n
i 1 Xi .
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Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.
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Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
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Let Yn Sn n
P
i 1 Xi .
If p q 1~2, the RW is said to be symmetric.
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Let Yn Sn n
P
i 1 Xi .
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case.
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Let Yn Sn n
P
i 1 Xi .
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
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Let Yn Sn n
P
i 1 Xi .
(iii):
E Yn1 SX1 , ..., Xn
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Let Yn Sn n
P
i 1 Xi .
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn
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Let Yn Sn n
P
i 1 Xi .
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn
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Let Yn Sn n
P
i 1 Xi .
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn E Yn SX1 , ..., Xn E Xn1 SX1 , ..., Xn
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Let Yn Sn n
P
i 1 Xi .
(iii):
Yn E Xn1
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Let Yn Sn n
P
i 1 Xi .
(iii):
Yn E Xn1 Yn 0
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Let Yn Sn n
P
i 1 Xi .
(iii):
Yn E Xn1 Yn 0
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Let Yn Sn n
P
i 1 Xi .
(iii):
Yn E Xn1 Yn 0 Yn a.s. for all n,

where we used that Yn is a function of X1 , ..., Xn and that Xn1 X1 , ... ÙÙ
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2. Martingales
3. Brownian Motion
7. Girsanov Theorem
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Brownian motion
Brownian Motion: Motivation
Binomial model on several periods (discrete time model):

Deterministic model (not constant return ik on period k ):
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Brownian motion

S n S 0 M1n
k 1
ik S 0 Me
n
k 1
δk
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Brownian motion

S n S 0 M1
n
k 1
ik S 0 Me
n
k 1
δk
Stochastic model :
S n S 0 Me
n
k 1
Yk
où Y1 , ..., Yn are i.i.d. :
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Brownian motion

S n S 0 M1n
k 1
ik S 0 Me
n
k 1
δk
Stochastic model :
S n S 0 Me
n
k 1
Yk
où Y1 , ..., Yn are i.i.d. :

δσ 1~2
Yi
δσ 1~2
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Brownian motion

S n S 0 M1n
k 1
ik S 0 Me
n
k 1
δk
Stochastic model :
S n S 0 Me
n
k 1
Yk
où Y1 , ..., Yn are i.i.d. :

δσ 1~2
Yi
δσ 1~2
We can rewrite: Yi δ σXi
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Brownian motion

S n S 0 M1n
k 1
ik S 0 Me
n
k 1
δk
Stochastic model :
S n S 0 Me
n
k 1
Yk
où Y1 , ..., Yn are i.i.d. :

δσ 1~2
Yi
δσ 1~2
1 1~2
We can rewrite: Yi δ σXi where Xi .
1 1~2
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Brownian motion
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
We hence obtain the cumulative log-return until n:
logS n~S 0
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
logS n~S 0 QY

n
i 1
i δn
¯

determ. trend
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
logS n~S 0 QY

n
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
logS n~S 0 QY

n
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk
In particular,
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
logS n~S 0 QY

n
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk
In particular, the moments of cumulative log-returns are given by:
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
logS n~S 0 QY

n
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk

E log S n~S 0 δn
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
logS n~S 0 QY

n
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk

E log S n~S 0 δn
var log S n~S 0 σ 2 n
(variance proportional to time)
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Brownian motion
We will now consider passing to a continuous time model.
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Brownian motion

This will be done in two steps:
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Brownian motion

1 Modification of the (space and time) scale of the random
walk:
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Brownian motion

walk:
The time periods of 1 are replaced by ∆t,
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Brownian motion

walk:
The time periods of 1 are replaced by ∆t, and jumps of +1 and -1
are replaced by jumps of ∆x and ∆x on each period of time.
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Brownian motion

walk:
The random walk then becomes:
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Brownian motion

walk:
W n ∆x. QX ,
m
i 1
i with m n~∆t
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Brownian motion

walk:
W n ∆x. QX ,
m
i 1
i with m n~∆t
and in terms of moments:
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Brownian motion

walk:
W n ∆x. QX ,
m
i 1
i with m n~∆t

E W n 0
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Brownian motion

walk:
W n ∆x. QX ,
m
i 1
i with m n~∆t

E W n 0
2
Var W n m∆x 2 n ∆x
∆t

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Brownian motion

walk:
W n ∆x. QX ,
m
i 1
i with m n~∆t

E W n 0
2
Var W n m∆x 2 n ∆x
∆t

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Brownian motion
2 Passing to the limit ∆x, ∆t 0
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Brownian motion
We will now consider a sequence of ∆xk , ∆tk
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Brownian motion
We will now consider a sequence of ∆xk , ∆tk with ∆xk , ∆tk 0
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Brownian motion
We will now consider a sequence of ∆xk , ∆tk with ∆xk , ∆tk 0 in

such a way that the limiting process is non-trivial (i.e. non zero
variance).
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Brownian motion

variance).
For this purpose, we will require:
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Brownian motion

variance).
∆xk 2
1
∆tk
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Brownian motion

variance).
∆xk 2
1
∆tk
∆xk
(and not ∆tk 1 !)
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Brownian motion
Construction of BM as limit of a random walk: illustration

3
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion

3
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion

3
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion

3
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion

3
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion

3
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion

3
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion

3
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion
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Brownian motion
One can show that the sequence of processes W k t defined

above converges (in distribution) to a process with continuous
trajectories called Brownian motion:
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Brownian motion

QX
t ~∆tk
W k t ∆xk i W t
i 1
where the limit process W t :
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Brownian motion

QX
t ~∆tk
W k t ∆xk i W t
i 1

is a continuous time process
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Brownian motion

QX
t ~∆tk
W k t ∆xk i W t
i 1

is called:
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Brownian motion

QX
t ~∆tk
W k t ∆xk i W t
i 1

is called:
Standard Brownian motion, or
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Brownian motion

QX
t ~∆tk
W k t ∆xk i W t
i 1

is called:
Wiener process, or
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Brownian motion

QX
t ~∆tk
W k t ∆xk i W t
i 1

is called:
Wiener process, or
"infinitesimal random walk"
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Brownian motion

QX
t ~∆tk
W k t ∆xk i W t
i 1

is called:
Wiener process, or
"infinitesimal random walk"
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Brownian motion
This convergence is actually the dynamic equivalent of the central limit

theorem in the static case:
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Brownian motion

P
If Xn is a sequence of i.i.d. random variables of mean µ and finite
n
variance σ 2 , then we note Sn i 1 Xi , and we have:
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Brownian motion

P
If Xn is a sequence of i.i.d. random variables of mean µ and finite
n
variance σ 2 , then we note Sn i 1 Xi , and we have:
Sn nµ d
º N 0, 1
σ n
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Brownian motion
By construction, this process W t has the following properties:
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Brownian motion

(i) E W k t 0 Ð E W t 0
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Brownian motion

(i) E W k t 0 Ð E W t 0
(ii) var W k
t t
∆Xk 2
∆tk Ð var W t t
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Brownian motion

(i) E W k t 0 Ð E W t 0
(ii) var W k
t t
∆Xk 2
∆tk Ð var W t t
k
(iii) W t = sum of i.i.d. rvs Ð W t N 0, t (Central Limit
Theorem)
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Brownian motion

(i) E W k t 0 Ð E W t 0
(ii) var W k
t t
∆Xk 2
∆tk Ð var W t t
k
(iii) W t = sum of i.i.d. rvs Ð W t N 0, t (Central Limit
Theorem)
(iv) W is a process with independent and stationary increments
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Brownian motion
Brownian Motion: Definition
All these motivate the following definition:
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Brownian motion

Definition (Standard Brownian Motion)
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Brownian motion

A stochastic process Bt 0 B t B T in continuous time is
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Brownian motion

A stochastic process Bt 0 B t B T in continuous time is standard
Brownian motion on 0, T if
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Brownian motion

1 B0 0.
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Brownian motion

1 B0 0.
2 The increments of Bt are independent,
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Brownian motion

1 B0 0.
2 The increments of Bt are independent, i.e. for all finite set of
instants:
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Brownian motion

1 B0 0.
instants:0 B t1 @ t2 @ ... @ tn B T , the random variables
Bt2 Bt1 ,
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Brownian motion

1 B0 0.
Bt2 Bt1 , Bt3 Bt2 , ...
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Brownian motion

1 B0 0.
Bt2 Bt1 , Bt3 Bt2 , ..., Btn Btn1
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Brownian motion

1 B0 0.
are independent.
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Brownian motion

1 B0 0.
are independent.
3 For all 0 B s @ t B T , the increments Bt Bs have a Gaussian
distribution of mean 0 and variance t s.
4 Bt ω is a continuous function of t for almost all ω.
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Brownian motion
Brownian Motion: Illustration
A typical sample path:

1.5
0.5
0
X(t)
-0.5
-1
-1.5
-2
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Time t
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Brownian motion
Brownian Motion: Illustration
A typical sample path:

1.5
0.5
0
X(t)
-0.5
-1
-1.5
-2
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Time t
It can be shown that the sample paths (a.s.) are nowhere differentiable,
although continuous everywhere. 34 / 80
Brownian motion
Non standard Brownian Motion
Brownian motion from level a (instead of 0):
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Brownian motion
Z t a B t
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Brownian motion
Z t a B t
where Bt is a standard BM
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Brownian motion
Z t a B t
Brownian motion from level a, with drift µ and volatility σ
35 / 80
Brownian motion
Z t a B t
Z t a µt σBt
35 / 80
Brownian motion
Z t a B t
Z t a µt σBt
In particular,
E Z t a µt
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Brownian motion
Z t a B t
Z t a µt σBt
In particular,
E Z t a µt
var Z t σ2t
35 / 80
Brownian motion
Non standard Brownian Motion: Illustration
Brownian motion with drift 0.07 volatility 0.2

1
0.8
0.6
0.4
0.2
X(t)
−0.2
−0.4
−0.6
−0.8
−1
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Time t
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Brownian motion
Non standard Brownian Motion: Illustration
Brownian motion with drift 0 volatility 0.35

1
0.8
0.6
0.4
0.2
X(t)
−0.2
−0.4
−0.6
−0.8
−1
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Time t
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Brownian motion
Martingales and Brownian motion
Theorem
Let Bt 0 B t B T be a standard Brownian motion. Then the
processes:
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Brownian motion
Theorem
processes:
1 Bt 0 B t B T
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Brownian motion
Theorem
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
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Brownian motion
Theorem
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
3 exp αBt α2 t ~2 0 B t B T , where α is a constant in R
38 / 80
Brownian motion
Theorem
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
are martingales
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Brownian motion
Theorem
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
are martingales w.r.t. process Bt .
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Brownian motion
Theorem
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
are martingales w.r.t. process Bt .
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Brownian motion
Proof
1) Bt is a function of Bs sBt ,
39 / 80
Brownian motion
Proof
E Bt2 t @ ª,
39 / 80
Brownian motion
Proof
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
39 / 80
Brownian motion
Proof
E Bt2 t @ ª,
2) Bt2 t is a function of Bs sBt ,
39 / 80
Brownian motion
Proof
E Bt2 t @ ª,
2) Bt2 t is a function of Bs s Bt ,
E TBt2 t T B E Bt2 t
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Brownian motion
Proof
E Bt2 t @ ª,
E TBt2 t T B E Bt2 t 2t,
39 / 80
Brownian motion
Proof
E Bt2 t @ ª,

E Bt2 t SBu , u B s
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Brownian motion
Proof
E Bt2 t @ ª,

E Bt2 t SBu , u B s Bs2 2Bt Bs t SBu , u B s
2
E Bt Bs
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Brownian motion
Proof
E Bt2 t @ ª,

2
E Bt Bs
E Bt s SBu , u B s t Bs2 2Bs2

2
t s t Bs2 Bs2 s.
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Brownian motion
Proof
E Bt2 t @ ª,

2
E Bt Bs

2
t s t Bs2 Bs2 s.
3) E exp αBt α2 t ~2 SBu , u B s
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Brownian motion
Proof
E Bt2 t @ ª,

2
E Bt Bs

2
t s t Bs2 Bs2 s.
α2 α2 s
E exp α Bt Bs 2
t s SBu , u B s exp αBs 2

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Brownian motion
Proof
E Bt2 t @ ª,

2
E Bt Bs

2
t s t Bs2 Bs2 s.
α2 α2 s
E exp α Bt
2
t s SBu , u B s exp αBs
Bs
2

α2 2
E exp αBt s exp 2 t s exp αBs α2 s
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Brownian motion
Proof
E Bt2 t @ ª,

2
E Bt Bs

2
t s t Bs2 Bs2 s.
α2 α2 s
E exp α Bt
2
t s SBu , u B s exp αBs
Bs
2

α2 2
E exp αBt s exp 2 t s exp αBs α2 s
2
exp αBs α2 s .
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Brownian motion
2. Martingales
3. Brownian Motion
7. Girsanov Theorem
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Stochastic Integral Stochastic integral - Motivation
Stochastic integral - Motivation
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Let us consider a market composed of d assets of price at t :

St St1 , ..., Std , modeled like a vector process
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A trading strategy
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A trading strategy can be modelled by a vector φt describing the
quantities invested in each of the assets at instant t: φt φ1t , ..., φdt
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The value at t of the portfolio obtained by following this strategy is then
given by:
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given by:
Qφ S
d
Vt φ φ1t St1 φ2t St2 ... φdt Std k
t
k
t φt .St
k 1
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given by:
Qφ S
d
t
k
t φt .St
k 1
We will denote by 0 T0 , T1 , ..., Tn1 T the rebalancing instants:
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given by:
Qφ S
d
t
k
t φt .St
k 1
We will denote by 0 T0 , T1 , ..., Tn1 T the rebalancing instants:

between 2 such instants, the composition of the portfolio is supposed
unchanged.
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We can then denote by φi φ1 d

i , ..., φi the composition of the portfolio
between Ti and Ti 1 ,
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We can then denote by φi φ1i , ..., φdi the composition of the portfolio
between Ti and Ti 1 , and rewrite φt as a step function:
φt φ0 I t 0 φ1 IT0 ,T1 φ2 IT1 ,T2 ... φn ITn ,T
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Generally, the rebalancing instants Ti are random (depending e.g. from

the levels reached by some assets in the market...).
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the levels reached by some assets in the market...). The strategy φt
appears as a stochastic process.
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Definition (Simple predictable process)

A process φt (t > 0, T ) that can be represented by
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A process φt (t > 0, T ) that can be represented by is called a simple
predictable process
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A process φt (t > 0, T ) that can be represented by is called a simple
predictable process if moreover the stochastic instants Ti are stopping
times, and if each φi is a bounded random variables whose value is revealed
at Ti (φi > FTi ).
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Example of simple predictable process (one of its component):
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Gain process for a simple trading strategy

If φt is simple (we speak about a “simple trading strategy”),
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If φt is simple (we speak about a “simple trading strategy”), then
the gain realized by the trader between Ti and Ti 1
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the gain realized by the trader between Ti and Ti 1 is equal to:
φ1i ST1i 1 ST1i φ2i ST2i 1 ST2i ... φdi STdi 1 STdi
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φ1i ST1i 1 ST1i φ2i ST2i 1 ST2i ... φdi STdi 1 STdi φi .STi 1 STi
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Remark that here we assumed implicitly that there was no external

money injected in the process, and no consumption: the origin of
the gains is only due to market fluctuations.
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the gains is only due to market fluctuations. We say that the
strategy is self-financing .
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Hence the accumulated capital on 0, T of the trader beginning
with an initial composition given by φ0 ,
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with an initial composition given by φ0 , and due to fluctuations of
the market, can be written as:
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with an initial composition given by φ0 , and due to fluctuations of
the market, can be written as:
GT φ φ0 .S0 Qφ . S
n
i 0
i Ti 1 STi
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Definition (Stochastic integral of a simple predictable process)
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By definition, GT φ is called the
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By definition, GT φ is called the stochastic integral of the simple
predictable process φ φt w.r.t. the price process St , and will be
denoted by :
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denoted by :
S 0
T
φu .dS u
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denoted by :
S 0
T
φu .dS u
In finance, the accumulated capital of a trader following a

strategy lead naturally to a new concept of integral: the
stochastic integral
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Now, in view of getting some results concerning option prices in a

given stochastic model, we cannot limit ourselves to the case
where φ is a simple strategy.
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Hence we need to give a sense to this stochastic integral / gain
process, also in the case where the composition φt continuously
changes with time.
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changes with time.
We will first give a sense to this integral in the case where St is
a Brownian motion of dimension 1, and where φt is a more
general process (not necessarily simple):
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changes with time.
We will first give a sense to this integral in the case where St is
a Brownian motion of dimension 1, and where φt is a more
general process (not necessarily simple):
S 0
T
φsdBs
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Stochastic Integral Stochastic integral - Definition
Stochastic integral
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Stochastic integral
A first naive idea would consist to define the stochastic integral as

a limit obtained along each trajectory:
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Stochastic integral

S
0
T
φsdBs ω
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Stochastic integral

S
0
T
φsdBs ω lim
maxti ti 1 0 i 1
Qφ
n
ti 1 ω Bti ω Bti 1 ω
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Stochastic integral

S
0
T
φsdBs ω lim
maxti ti 1 0 i 1
Qφ
n
The problem is that (almost all) trajectories of a Brownian motion

are very irregular ...
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Stochastic integral

S
0
T
φsdBs ω lim
maxti ti 1 0 i 1
Qφ
n

are very irregular ... (more precisely, have no bounded variation)
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Stochastic integral

S
0
T
φsdBs ω lim
maxti ti 1 0 i 1
Qφ
n

are very irregular ... (more precisely, have no bounded variation)
and that this limit hence does not exist in general for a given
trajectory ω!
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Stochastic integral
Contrarily to the Riemann integral, the result can depend on the point
yi > ti 1 , ti .
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Stochastic integral
yi > ti 1 , ti . In the Itô integral, we will fix yi ti 1 ;
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Stochastic integral
The stochastic integral will be defined as a limit of Riemann sums,
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Stochastic integral
The stochastic integral will be defined as a limit of Riemann sums, but
not in the sense of "almost sure convergence",
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Stochastic integral
not in the sense of "almost sure convergence", but in "quadratic
convergence" (L2 ).
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Stochastic integral
not in the sense of "almost sure convergence", but in "quadratic
convergence" (L2 ).
Let us recall that
Xn X in quadratic mean (or in L2 iff
YXn X Y2L2 E Xn X 2 0
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Stochastic integral
The Itô integral is actually defined following a rigorous mathematical

construction, that we will not recall here.
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Stochastic integral

construction, that we will not recall here. We can get a good intuition of
it using the following result (Riemann’s representation):
If f R R continuous,
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Stochastic integral

If f R R continuous, and if we consider the partition of 0, T given
by ti i Tn with 0 B i B n,
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Stochastic integral

by ti i Tn with 0 B i B n, then the Itô integral of f Bt w.r.t. Bt is
obtained as the L2 limit of Riemann sums:
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Stochastic integral

by ti i Tn with 0 B i B n, then the Itô integral of f Bt w.r.t. Bt is
obtained as the L2 limit of Riemann sums:
Qf
n
i 1
Bti 1 Bti Bti 1 ÐL
2
S 0
T
f Bs dBs
where the limit is taken in the sense of the quadratic convergence.
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Stochastic Integral Stochastic integral: properties
Integral of a deterministic function
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Proposition (Gaussian integrals)
Let f be a continuous deterministic function,
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Let f be a continuous deterministic function, then
S
t
Xt f sdBs
0
has a Gaussian distribution
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S
t
Xt f sdBs
0
has a Gaussian distribution with zero mean and variance:
S
t
VarXt f 2 u du.
0
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S
t
Xt f sdBs
0
S
t
VarXt f 2 u du.
0
Moreover, if we consider the partition of 0, T given by ti iT

n
for 0 B i B n and
ti > ti 1 , ti , then
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S
t
Xt f sdBs
0
S
t
VarXt f 2 u du.
0
Moreover, if we consider the partition of 0, T given by ti iT

n
for 0 B i B n and
ti > ti 1 , ti , then
Q f t S
n T
lim i Bti Bti 1 f sdBs ,
n ª i 1 0
where the limit is taken in the sense of quadratic convergence and

convergence in probability.
We see that here the choice of ti > ti 1 , ti is free: it does not need to be ti 501 ./ 80
Other properties
Other important properties of the Itô integral are as follows:
R
The Itô integral is defined in general for a square integrable
t
process Xt . The resulting process, 0 X sdB s is a continuous
martingale w.r.t. Bt .1
1
Actually it is equal almost surely to a continuous martingale
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Other properties
R
t
(Itô isometry)
For all 0 B s B t and for all Xt square integrable, we have:
S S
t 2 t
E X ω, u dBu E X ω, u 2 du .(1)
s s
1
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Other properties
R
t
(Itô isometry)
For all 0 B s B t and for all Xt square integrable, we have:
S S
t 2 t
E X ω, u dBu E X ω, u 2 du .(1)
s s
This equality is also true actually if considering conditional

expectations knowing Bs .
1
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Stochastic integral: explicit calculation
In some cases, this integral can be explicitly computed using the

Riemann representation.
Example:
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Example: R 0
t
Bs dBs ?
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Example: R 0
t
Bs dBs ?
If we denote ∆i B Bti Bti 1 and ∆i t ti ti 1 , we have:
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Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B
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Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B QBi
ti 1 Bti Bt2i 1
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Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B QB B
i
ti 1 ti Bt2i 1
1
2
Q B i
2
ti Bt2i 1 Bti
2
Bti 1
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Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B QB B
i
ti 1 ti Bt2i 1
1
2
Q B i
ti
2
Bt2i 1 Bti
2
Bti 1
1 2
2
2
Bt B0
1
2
Q ∆B
i
i
2
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Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B QB B
i
ti 1 ti Bt2i 1
1
2
Q B i
ti
2
Bt2i 1 Bti Bti 1
2

1 2
2
2
Bt B0
1
2
Q ∆B
i
i
2 1 2 1
B
2 t 2
Q ∆B
i
i
2
,
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Q ∆B
We can see that
2
i t
i
in L2 .
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Q ∆B
We can see that
2
i t
i
in L2 . We then get:
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Q ∆B
We can see that
2
i t
i
in L2 . We then get:
S 0
t
Bs dBs
1 2 1
B t.
2 t 2
Remark
We just saw that “∆i B 2 behaves like ∆i t”, i.e., formally:
2
dBt dt
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2. Martingales
3. Brownian Motion
7. Girsanov Theorem
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Itô formula and Stochastic Differential Equations Differential notation
Stochastic differential: notation
Introduction of the differential notation:
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b bs, ω adapted integrable process
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σ σ s, ω adapted square-integrable process
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We can hence construct a new process X t by integration of b and σ:
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X t X 0 S 0
t
bsds S 0
t
σ sdB s
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X t X 0 S 0
t
bsds S 0
t
σ sdB s
We say that X is an Itô process, and we use the notation
dX t bt dt σ t dB t
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Itô formula and Stochastic Differential Equations Itô formula
Stochastic differential: calculation rules
The Itô stochastic integral leads to other calculation rules than in the
classical calculus:
Classical calculus:
1 2
2
f t S 0
t
f sdf s
Stochastic calculus:
1 2
2
B t
??
S 0
t
B sdB s ??
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One can easily see that:
S 0
t
B s dB s
1 2
2
1
B t t
2
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S 0
t
B s dB s
1 2
2
1
B t t
2
2 S0
t
B s dB s S 0
t
ds B 2 t
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S 0
t
B s dB s
1 2
2
1
B t t
2
2 S0
t
B s dB s S 0
t
ds B 2 t
which means by using differential notations:
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S 0
t
B s dB s
1 2
2
1
B t t
2
2 S0
t
B s dB s S 0
t
ds B 2 t
d B 2 t 2B t dB t dt
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S 0
t
B s dB s
1 2
2
1
B t t
2
2 S0
t
B s dB s S 0
t
ds B 2 t
d B 2 t 2B t dB t dt
the usual chain rule does not work anymore...
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Itô formula: case of f Bt
Theorem (Itô formula)
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Let f R R twice differentiable, then a.s. for all t > 0, T :
58 / 80
f Bt f 0 S 0
t
f Bs dBs
1
2
S
0
t
f Bs ds. (2)
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f Bt f 0 S 0
t
f Bs dBs
1
2
S
0
t
f Bs ds. (2)
In differential notations:
1
d f Bt f Bt dBt f Bt dt
2
The proof is a consequence of Taylor development of order 2 and of
the fact that a Brownian motion has a quadratic variation on 0, T
equal to T , leading to an additional term w.r.t standard calculus.
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Itô formula with time and space variables
We now consider a function of two variables: f t, x ,
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We now consider a function of two variables: f t, x , and we are

interested in d f t, Bt .
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interested in d f t, Bt . We will assume that f is twice differentiable.
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Theorem (Itô formula in dim 2)
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For each function f twice differentiable, we have the representation
f t, Bt f 0, 0 S t
0 ∂x
∂f
s, Bs dBs
S 0
t ∂f
∂t
s, Bs ds
1 t ∂2f
S
2 0 ∂x 2
s, Bs ds a.s.
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f t, Bt f 0, 0 S t
0 ∂x
∂f
s, Bs dBs
S 0
t ∂f
∂t
s, Bs ds
1 t ∂2f
S
2 0 ∂x 2
s, Bs ds a.s.
In differential notation, this becomes:
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f t, Bt f 0, 0 S t
0 ∂x
∂f
s, Bs dBs
S 0
t ∂f
∂t
s, Bs ds
1 t ∂2f
S
2 0 ∂x 2
s, Bs ds a.s.
In differential notation, this becomes:
∂f ∂f 1 ∂2f
d f t, Bt t, Bt dBt t, Bt dt t, Bt dt
∂x ∂t 2 ∂x 2
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Formal calculation rules
Remark that the calculation rule is identical if we consider f t, Xt

where dXt bt dt σ t dB t (with b, σ satisfying the ad-hoc
integrability properties).
Actually, the different formulations of the Itô formula suggest the
following formal calculation rules:
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dt.dt 0
dB t .dB t dt
dB t .dt 0
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dt.dt 0
dB t .dB t dt
dB t .dt 0
We recover the Itô formula by applying a Taylor development of order 2
combined with those rules
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61 / 80
E.g. Case Y t f t, B t :
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dYt
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∂f
dYt t, Bt dt
∂t
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∂f ∂f
dYt t, Bt dt t, Bt dBt
∂t ∂x
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∂f ∂f 1 ∂2f
dYt t, Bt dt t, Bt dBt t, Bt dBt dBt
∂t ∂x 2 ∂x 2
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∂f ∂f 1 ∂2f
dYt t, Bt dt t, Bt dBt t, Bt dBt dBt
∂t ∂x 2 ∂x 2
1 ∂2f ∂2f
t, Bt dt.dt t, Bt dt.dB t
2 ∂t 2 ∂x∂t
∂f ∂f 1 ∂2f
t, Bt dt t, Bt dBt t, Bt dt
∂t ∂x 2 ∂x 2
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Stochastic differential equations
Stochastic calculus allows to express efficiently the dynamics of

stochastic processes, given in the form of stochastic differential
equations.
Many continuous time financial models are expressed by means of
such equations.
For instance, the stock price in Black-Scholes model is assumed to
satisfy the following SDE:
dSt µSt dt σSt dBt
whose solution is easily obtained by applying Itô lemma to the new

process Yt lnSt :
St S0 eµ 2 σ t σBt
1 2
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Stochastic differential equations
Another important example is the Ornstein-Uhlenbeck process, behind

Vasicek model:
dXt ab Xt dt σdBt
The solution of this equation can be easily obtained up to an Itô
integral, allowing a lot of explicit computations.
In general, properties of the Itô integral are useful to get properties of
solutions to these equations, assumed to be satisfied by market
variables (e.g. moments, type of distribution...). These properties are
useful in order to control accuracy of simulations, to ease calibration
on historical data,...
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2. Martingales
3. Brownian Motion
7. Girsanov Theorem
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Valuation and arbitrage Arbitrage opportunity
Arbitrage opportunity
Suppose again that we are in a market with d risky assets and a risk
free asset (risk free rate r ).
An arbitrage opportunity is a self-financing strategy2 is a zero-cost
strategy that can lead to a positive terminal gain, without any
probability of intermediate loss.
2
no consumption, no injection of money
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Formally, if we denote by Vt φ the value of the portfolio obtained
when following this strategy, this means:
P t > 0, T , Vt φ C 0
¦ 1, P VT φ A 0 A 0
P V 0 φ 0 1
2
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Formally, if we denote by Vt φ the value of the portfolio obtained
when following this strategy, this means:
P t > 0, T , Vt φ C 0
¦ 1, P VT φ A 0 A 0
P V 0 φ 0 1
N.B.: the assumption of self-financing is important: it is trivial to find strategies which
are not self-financing but verify the property above (exercise: it suffices to inject cash
just before maturity...)
2
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Arbitrage-free pricing rules
In most pricing models, we will always assume that there is no

arbitrage opportunity.
A first consequence of absence of arbitrage is the law of one price:
two self-financing strategies with the same terminal payoff must have
the same value at all times, otherwise the difference would generate
an arbitrage.
This fact is at the origin of the pricing of financial products by using
replication arguments (replicating or hedging portfolio).
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Valuation and arbitrage Fundamental results of asset pricing
Result 1: Fundamental theorem of asset pricing
We say that a probability measure Q is equivalent to P is they have the

same set of possible scenarios:
QA 0 PA 0
An equivalent measure is Q called a martingale measure if discounted

assets (ert St t are martingales under Q.
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QA 0 PA 0

In practice, one can see that the expected return under Q of all assets
is then equal to the risk free rate.
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QA 0 PA 0

is then equal to the risk free rate. This is why such a measure is also
called a risk neutral probability measure.
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QA 0 PA 0

is then equal to the risk free rate. This is why such a measure is also
called a risk neutral probability measure.
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One can show that whatever the model used, a market is arbitrage free
if and only if there exists an equivalent martingale measure3 .
Theorem (First fundamental theorem of asset pricing)
A market model defined by Ω, F , Ft , P and asset prices St t > 0,T is
arbitrage free if and only if there exists a probability measure Q P
such that the discounted asset prices ert St are martingales with
respect to Q.
In that case, one can show that derivative products can be priced
(without arbitrage) by using the expectation under Q of their
discounted payoff: EQ payoff T erT
3
see [Harrison-Kreps, 1979], [Harrison-Pliska, 1983], [Delbaen, Schachermayer,
1994]
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Result 2: Market Completeness
A self-financing strategy φ0t , φt is a replication strategy for a derivative

product on S 1 , ..., S d delivering a stochastic payoff H at T if:
S S
T T
H V0 φt dSt φ0t dSt0 P a.s.
0 0
A market is said complete if any contingent claim admits a replication

strategy.
Theorem (Second fundamental theorem of asset pricing)

An arbitrage free market defined by the assets St0 , St1 , ..., Std , described as
stochastic processes on Ω, F , Ft , P, is complete if and only if there exists a
unique martingale measure Q P.
69 / 80
In summary: pricing and hedging of contingent assets
1 Equivalence between the no arbitrage opportunity assumption

(NAO) and the existence of a martingale measure / risk-neutral
measure
2 Equivalence between completeness of the market and
uniqueness of the martingale / risk neutral measure
3 In an arbitrage free complete market, the price of any contingent
asset is equal to the expectation under the risk-neutral measure of
its discounted payoff
70 / 80
In summary: pricing and hedging of contingent assets
Pricing
In a complete and arbitrage free market, if H is a contingent asset
whose payoff is paid in T , its price Πt H at instant t is given by:
Πt H EQ er T t H T SFt
Hedging
In a complete and arbitrage free market, any contingent asset H is
replicable by a self-financing strategy φ :
VT Φ ω H T , ω ¦ ω>Ω
71 / 80
2. Martingales
3. Brownian Motion
7. Girsanov Theorem
72 / 80
Girsanov theorem
Change of measure in a continuous time framework
73 / 80
Girsanov theorem
When using a geometric Brownian motion like in

Black-Scholes-Merton model,
73 / 80
Girsanov theorem

Black-Scholes-Merton model, we will try to identify an equivalent
measure, called risk – neutral, under which all financial assets have
an expected return equal to the risk free rate r .
73 / 80
Girsanov theorem

an expected return equal to the risk free rate r . Once this measure is
known, the price of derivatives is known (numerically at least).
73 / 80
Girsanov theorem

This will imply a change of drift of the process:
73 / 80
Girsanov theorem

dS t δS t dt σS t dW t
73 / 80
Girsanov theorem

r δ r S t dt σS t dW t
73 / 80
Girsanov theorem

rS t dt σS t dW t δ r S t dt
73 / 80
Girsanov theorem

rS t dt σS t dW t
73 / 80
Girsanov theorem

rS t dt σS t dW t
where we denote by
73 / 80
Girsanov theorem

rS t dt σS t dW t
δr
where we denote by W t W t t
σ
73 / 80
Girsanov theorem

rS t dt σS t dW t
δr
where we denote by W t W t t (Brownian motion with drift
σ
under the real world measure P).
73 / 80
Girsanov theorem
The process W is
74 / 80
Girsanov theorem
The process W is not a standard Brownian motion under the real

world probability (presence of a drift).
74 / 80
Girsanov theorem

The Girsanov thm answers to the following questions:
74 / 80
Girsanov theorem

How to change measure s.t. W becomes a standard Brownian
motion under the new measure?
74 / 80
Girsanov theorem

More generally, what becomes the process W when we change
the measure, passing to an equivalent one?
74 / 80
Girsanov theorem

More generally, what becomes the process W when we change
the measure, passing to an equivalent one?
For that purpose, we recall the concept of Radon-Nikodym derivative:
this concept captures the measure change, and allows to make explicit
computations under the new measure Q.
74 / 80
Girsanov theorem
Radon-Nykodym derivative and measure changes
A general result, called the Radon-Nikodym theorem, implies that if a

measure Q is equivalent to a measure P, then there exists a random
variable Z C 0 such that
75 / 80
Girsanov theorem

QA EP IA Z
75 / 80
Girsanov theorem

QA EP IA Z
Variable Z is called the Radon-Nikodym derivative of Q with respect

to P, or the density of Q with respect to P.
75 / 80
Girsanov theorem

QA EP IA Z
Variable Z is called the Radon-Nikodym derivative of Q with respect

to P, or the density of Q with respect to P.
Hence, knowing Z means knowing Q: all expectations under Q can be
computed from expectations under P.
In particular, EP Z 1 (set A Ω in the relation above).
75 / 80
Girsanov theorem
Girsanov theorem
Theorem (Girsanov’s theorem)

Let W t, ω ; t > 0, T , ω > Ω be a standard Brownian motion defined
on a probability space Ω, F , P.
Let W be a process defined by:
W t W t θt
76 / 80
Girsanov theorem
Girsanov theorem

W t W t θt
for some fixed θ in R.
76 / 80
Girsanov theorem
Girsanov theorem

W t W t θt
for some fixed θ in R. Then the process W is a standard Brownian

motion under the new measure Q equivalent to P whose density is
defined by:
76 / 80
Girsanov theorem
Girsanov theorem

W t W t θt
for some fixed θ in R. Then the process W is a standard Brownian

motion under the new measure Q equivalent to P whose density is
defined by:
θ2
Y T exp θW T T
2
76 / 80
agenda
2. Martingales
3. Brownian Motion
7. Girsanov Theorem
77 / 80
Black-Scholes model
Black-Scholes’ formula
Assumptions of Black-Scholes’ model

1 The market contains one risky asset (stock), supposed to follow a
geometric Brownian motion (dSt t dt σSt dWt )
2 The market contains a risk free asset (saving account), with
(continuously compounded) rate of return r
3 The market is perfect
4 No dividend is distributed on the risky asset during the considered
period 4
5 No transaction costs, assets are infinitely divisible, no constraint
on short selling, no constraint for borrowing at the risk-free rate
4
see later for the case with dividends
78 / 80
Black-Scholes model
Black-Scholes formula: approach by martingale measure
To get the price of a European call (strike K , maturity T ) on the stock

in this model, a possible approach is :
1 Identify explicitly an equivalent martingale measure Q (risk neutral
measure)
2 Finding the dynamics of the stock price under that measure Q
3 Compute the price of the call as EQ erT S T K
Actually, Girsanov theorem allows to find the measure Q (point 1) and
to get the dynamics of the stock under that measure. It suffices to
apply this result with θ µσr .
One can moreover show that Black-Scholes model is complete: we
have uniqueness of the risk neutral measure.
79 / 80
Black-Scholes model
Black-Scholes formula: approach by martingale measure
C S, t er T t S ª xdF x

K
e
r T t
S ª KdF x
K

F is the CDF of S T knowing S t S, leading to
C S, t SΦd1 Ker T t Φd2
with
logS ~K r 12 σ 2 T t
d1 º
σ T t
logS ~K r 21 σ 2 T t º

d2 º d1 σ T t
σ T t
Black-Scholes’ formula
80 / 80

Stochastic Calculus: Summary. by Celine Azizieh (Université Libre de Bruxelles)

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Université Libre de Bruxelles

Financial modelling: Probabilistic framework

Financial modelling: Probabilistic framework

We consider the set of “all possible states of the world” Ω, with a

Financial modelling: Probabilistic framework

We consider the set of “all possible states of the world” Ω, with a

Financial modelling: Probabilistic framework

We consider the set of “all possible states of the world” Ω, with a

Financial modelling: Probabilistic framework

We consider the set of “all possible states of the world” Ω, with a

Financial modelling: Probabilistic framework

We consider the set of “all possible states of the world” Ω, with a

Financial modelling: Probabilistic framework

We consider the set of “all possible states of the world” Ω, with a

Financial modelling: Probabilistic framework

Let us recall that a probability measure is a mapping:

Financial modelling: Probabilistic framework

Let us recall that a probability measure is a mapping:

Financial modelling: Probabilistic framework

Let us recall that a probability measure is a mapping:

Financial modelling: Probabilistic framework

Let us recall that a probability measure is a mapping:

Stochastic process and filtration

The prices of financial assets,

Stochastic process and filtration

The prices of financial assets, or more generally, of market

Stochastic process and filtration

The prices of financial assets, or more generally, of market

Stochastic process and filtration

The prices of financial assets, or more generally, of market

Stochastic process and filtration

The prices of financial assets, or more generally, of market

Stochastic process and filtration

The prices of financial assets, or more generally, of market

X 0, ª  Ω R t, ω  ( X t, ω

Stochastic process and filtration

The prices of financial assets, or more generally, of market

X 0, ª  Ω R t, ω  ( X t, ω

Stochastic process and filtration

The prices of financial assets, or more generally, of market

X 0, ª  Ω R t, ω  ( X t, ω

Stochastic process and filtration

The prices of financial assets, or more generally, of market

X 0, ª  Ω R t, ω  ( X t, ω

Stochastic process and filtration

The prices of financial assets, or more generally, of market

X 0, ª  Ω R t, ω  ( X t, ω

Stochastic process and filtration

The prices of financial assets, or more generally, of market

X 0, ª  Ω R t, ω  ( X t, ω

Stochastic process and filtration

Stochastic process and filtration

Now, if t represents time,

Stochastic process and filtration

Now, if t represents time, in order to model concepts like the progressive

Stochastic process and filtration

Now, if t represents time, in order to model concepts like the progressive

Stochastic process and filtration

Now, if t represents time, in order to model concepts like the progressive

Stochastic process and filtration

Now, if t represents time, in order to model concepts like the progressive

Stochastic process and filtration

X 0, ª Ω R t, ω ( X t, ω

X 0, ª Ω R t, ω ( X t, ω

X 0, ª Ω R t, ω ( X t, ω

X 0, ª Ω R t, ω ( X t, ω

X 0, ª Ω R t, ω ( X t, ω

X 0, ª Ω R t, ω ( X t, ω

Actually, the value of E X SY is known as soon as the value of Y

Actually, the value of E X SY is known as soon as the value of Y

Actually, the value of E X SY is known as soon as the value of Y

2 If X , Y has a joint density f x, y (see later) and Y has density

2 If X , Y has a joint density f x, y (see later) and Y has density

2 If X , Y has a joint density f x, y (see later) and Y has density

We call fX SY x, y the conditional density of X given Y y.

E Ynk SX1 , ..., Xn