Lecture Notes Stochastic Calculus

Steven Shreve: Stochastic Calculus and Finance
P RASAD C HALASANI Carnegie Mellon University chal@cs.cmu.edu S OMESH J HA Carnegie Mellon University sjha@cs.cmu.edu
THIS IS A DRAFT: PLEASE DO NOT DISTRIBUTE c Copyright; Steven E. Shreve, 1996
October 6, 1997
Contents
1 Introduction to Probability Theory 1.1 1.2 1.3 1.4 1.5 The Binomial Asset Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . . Finite Probability Spaces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lebesgue Measure and the Lebesgue Integral . . . . . . . . . . . . . . . . . . . . General Probability Spaces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5.1 1.5.2 1.5.3 1.5.4 1.5.5 1.5.6 1.5.7 Independence of sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Independence of -algebras . . . . . . . . . . . . . . . . . . . . . . . . . Independence of random variables . . . . . . . . . . . . . . . . . . . . . . Correlation and independence . . . . . . . . . . . . . . . . . . . . . . . . Independence and conditional expectation. . . . . . . . . . . . . . . . . . Law of Large Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . Central Limit Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 11 16 22 30 40 40 41 42 44 45 46 47 49 49 50 52 52 53 54 55 57 58
2 Conditional Expectation 2.1 2.2 2.3 A Binomial Model for Stock Price Dynamics . . . . . . . . . . . . . . . . . . . . Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conditional Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 2.3.2 2.3.3 2.3.4 2.3.5 2.4 An example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Denition of Conditional Expectation . . . . . . . . . . . . . . . . . . . . Further discussion of Partial Averaging . . . . . . . . . . . . . . . . . . . Properties of Conditional Expectation . . . . . . . . . . . . . . . . . . . . Examples from the Binomial Model . . . . . . . . . . . . . . . . . . . . .
Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2 3 Arbitrage Pricing 3.1 3.2 3.3 Binomial Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General one-step APT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-Neutral Probability Measure . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 3.3.2 3.4 3.5 Portfolio Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Self-nancing Value of a Portfolio Process . . . . . . . . . . . . . . . . 59 59 60 61 62 62 63 64 67 67 69 70 70 73 74 77 77 79 81 85 85 86 88 89 91 91 92 94 97 97
Simple European Derivative Securities . . . . . . . . . . . . . . . . . . . . . . . . The Binomial Model is Complete . . . . . . . . . . . . . . . . . . . . . . . . . . .
4 The Markov Property 4.1 4.2 4.3 4.4 4.5 Binomial Model Pricing and Hedging . . . . . . . . . . . . . . . . . . . . . . . . Computational Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Markov Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.1 Different ways to write the Markov property . . . . . . . . . . . . . . . . Showing that a process is Markov . . . . . . . . . . . . . . . . . . . . . . . . . . Application to Exotic Options . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5 Stopping Times and American Options 5.1 5.2 5.3 American Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Value of Portfolio Hedging an American Option . . . . . . . . . . . . . . . . . . . Information up to a Stopping Time . . . . . . . . . . . . . . . . . . . . . . . . . .
6 Properties of American Derivative Securities 6.1 6.2 6.3 6.4 The properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proofs of the Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compound European Derivative Securities . . . . . . . . . . . . . . . . . . . . . . Optimal Exercise of American Derivative Security . . . . . . . . . . . . . . . . . .
7 Jensens Inequality 7.1 7.2 7.3 Jensens Inequality for Conditional Expectations . . . . . . . . . . . . . . . . . . . Optimal Exercise of an American Call . . . . . . . . . . . . . . . . . . . . . . . . Stopped Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8 Random Walks 8.1 First Passage Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.5 8.6 8.7 8.8 8.9
The Strong Markov Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 General First Passage Times . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Example: Perpetual American Put . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Difference Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Distribution of First Passage Times . . . . . . . . . . . . . . . . . . . . . . . . . . 107
8.10 The Reection Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 9 Pricing in terms of Market Probabilities: The Radon-Nikodym Theorem. 9.1 9.2 9.3 9.4 9.5 111
Radon-Nikodym Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 Radon-Nikodym Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 The State Price Density Process . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Stochastic Volatility Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . 116 Another Applicaton of the Radon-Nikodym Theorem . . . . . . . . . . . . . . . . 118 119
10 Capital Asset Pricing
10.1 An Optimization Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 11 General Random Variables 123
11.1 Law of a Random Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 11.2 Density of a Random Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 11.3 Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 11.4 Two random variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 11.5 Marginal Density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 11.6 Conditional Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 11.7 Conditional Density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 11.8 Multivariate Normal Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . 129 11.9 Bivariate normal distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130 11.10MGF of jointly normal random variables . . . . . . . . . . . . . . . . . . . . . . . 130 12 Semi-Continuous Models 131
12.1 Discrete-time Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
8.4
Expectation of
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
8.3
The moment generating function for
8.2
is almost surely nite . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
97 99
4 12.2 The Stock Price Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132 12.3 Remainder of the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 12.4 Risk-Neutral Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 12.5 Risk-Neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 12.6 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 12.7 Stalking the Risk-Neutral Measure . . . . . . . . . . . . . . . . . . . . . . . . . . 135 12.8 Pricing a European Call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 13 Brownian Motion 139
13.1 Symmetric Random Walk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 13.2 The Law of Large Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 13.3 Central Limit Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 13.4 Brownian Motion as a Limit of Random Walks . . . . . . . . . . . . . . . . . . . 141 13.5 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 13.6 Covariance of Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 13.7 Finite-Dimensional Distributions of Brownian Motion . . . . . . . . . . . . . . . . 144 13.8 Filtration generated by a Brownian Motion . . . . . . . . . . . . . . . . . . . . . . 144 13.9 Martingale Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 13.10The Limit of a Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 13.11Starting at Points Other Than 0 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 13.12Markov Property for Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . 147 13.13Transition Density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 13.14First Passage Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 14 The It Integral o 153
14.1 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 14.2 First Variation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 14.3 Quadratic Variation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 14.4 Quadratic Variation as Absolute Volatility . . . . . . . . . . . . . . . . . . . . . . 157 14.5 Construction of the It Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 o 14.6 It integral of an elementary integrand . . . . . . . . . . . . . . . . . . . . . . . . 158 o 14.7 Properties of the It integral of an elementary process . . . . . . . . . . . . . . . . 159 o 14.8 It integral of a general integrand . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 o
5 14.9 Properties of the (general) It integral . . . . . . . . . . . . . . . . . . . . . . . . 163 o 14.10Quadratic variation of an It integral . . . . . . . . . . . . . . . . . . . . . . . . . 165 o 15 It s Formula o 167
15.1 It s formula for one Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . 167 o 15.2 Derivation of It s formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168 o 15.3 Geometric Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 15.4 Quadratic variation of geometric Brownian motion . . . . . . . . . . . . . . . . . 170 15.5 Volatility of Geometric Brownian motion . . . . . . . . . . . . . . . . . . . . . . 170 15.6 First derivation of the Black-Scholes formula . . . . . . . . . . . . . . . . . . . . 170 15.7 Mean and variance of the Cox-Ingersoll-Ross process . . . . . . . . . . . . . . . . 172 15.8 Multidimensional Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . 173 15.9 Cross-variations of Brownian motions . . . . . . . . . . . . . . . . . . . . . . . . 174 15.10Multi-dimensional It formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175 o 16 Markov processes and the Kolmogorov equations 177
16.1 Stochastic Differential Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 16.2 Markov Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 16.3 Transition density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 16.4 The Kolmogorov Backward Equation . . . . . . . . . . . . . . . . . . . . . . . . 180 16.5 Connection between stochastic calculus and KBE . . . . . . . . . . . . . . . . . . 181 16.6 Black-Scholes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 16.7 Black-Scholes with price-dependent volatility . . . . . . . . . . . . . . . . . . . . 186 17 Girsanovs theorem and the risk-neutral measure 189
17.2 Risk-neutral measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 18 Martingale Representation Theorem 197
18.1 Martingale Representation Theorem . . . . . . . . . . . . . . . . . . . . . . . . . 197 18.2 A hedging application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 18.4 18.3 -dimensional Girsanov Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . 199
-dimensional Martingale Representation Theorem . . . . . . . . . . . . . . . . . 200
18.5 Multi-dimensional market model . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
17.1 Conditional expectations under
. . . . . . . . . . . . . . . . . . . . . . . . . . 191
6 19 A two-dimensional market model 19.2 Hedging when 203
20 Pricing Exotic Options
20.1 Reection principle for Brownian motion . . . . . . . . . . . . . . . . . . . . . . 209 20.2 Up and out European call. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212 20.3 A practical issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218 21 Asian Options 219
21.1 Feynman-Kac Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 21.2 Constructing the hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 21.3 Partial average payoff Asian option . . . . . . . . . . . . . . . . . . . . . . . . . . 221 22 Summary of Arbitrage Pricing Theory 223
22.1 Binomial model, Hedging Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . 223 22.2 Setting up the continuous model . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 22.3 Risk-neutral pricing and hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 22.4 Implementation of risk-neutral pricing and hedging . . . . . . . . . . . . . . . . . 229 23 Recognizing a Brownian Motion 233
23.1 Identifying volatility and correlation . . . . . . . . . . . . . . . . . . . . . . . . . 235 23.2 Reversing the process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236 24 An outside barrier option 239
24.1 Computing the option value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 24.2 The PDE for the outside barrier option . . . . . . . . . . . . . . . . . . . . . . . . 243 24.3 The hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 25 American Options 247
25.1 Preview of perpetual American put . . . . . . . . . . . . . . . . . . . . . . . . . . 247 25.2 First passage times for Brownian motion: rst method . . . . . . . . . . . . . . . . 247 25.3 Drift adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249 25.4 Drift-adjusted Laplace transform . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 25.5 First passage times: Second method . . . . . . . . . . . . . . . . . . . . . . . . . 251

19.1 Hedging when
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 209
7 25.6 Perpetual American put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252 25.7 Value of the perpetual American put . . . . . . . . . . . . . . . . . . . . . . . . . 256 25.8 Hedging the put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257 25.9 Perpetual American contingent claim . . . . . . . . . . . . . . . . . . . . . . . . . 259 25.10Perpetual American call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259 25.11Put with expiration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260 25.12American contingent claim with expiration . . . . . . . . . . . . . . . . . . . . . 261 26 Options on dividend-paying stocks 263
26.1 American option with convex payoff function . . . . . . . . . . . . . . . . . . . . 263 26.2 Dividend paying stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264 26.3 Hedging at time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266 267
27 Bonds, forward contracts and futures
27.1 Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 27.2 Hedging a forward contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 27.3 Future contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270 27.4 Cash ow from a future contract . . . . . . . . . . . . . . . . . . . . . . . . . . . 272 27.5 Forward-future spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272 27.6 Backwardation and contango . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273 28 Term-structure models 275
28.1 Computing arbitrage-free bond prices: rst method . . . . . . . . . . . . . . . . . 276 28.2 Some interest-rate dependent assets . . . . . . . . . . . . . . . . . . . . . . . . . 276 28.3 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 28.4 Forward rate agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 28.6 Computing arbitrage-free bond prices: Heath-Jarrow-Morton method . . . . . . . . 279 28.7 Checking for absence of arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . 280 28.8 Implementation of the Heath-Jarrow-Morton model . . . . . . . . . . . . . . . . . 281 29 Gaussian processes 285 28.5 Recovering the interest from the forward rate . . . . . . . . . . . . . . . . . . 278
29.1 An example: Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286 30 Hull and White model 293
' $ (&%#
! "
8 30.1 Fiddling with the formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295 30.2 Dynamics of the bond price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296 30.3 Calibration of the Hull & White model . . . . . . . . . . . . . . . . . . . . . . . . 297 30.4 Option on a bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299 31 Cox-Ingersoll-Ross model 303 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
31.2 Kolmogorov forward equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 31.3 Cox-Ingersoll-Ross equilibrium density . . . . . . . . . . . . . . . . . . . . . . . 309 31.4 Bond prices in the CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310 31.5 Option on a bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313 31.6 Deterministic time change of CIR model . . . . . . . . . . . . . . . . . . . . . . . 313 31.7 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315 31.8 Tracking down in the time change of the CIR model . . . . . . . . . . . . . 316 319
32 A two-factor model (Dufe & Kan)
32.2 Zero-coupon bond prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321 32.3 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323 33 Change of num raire e 325
33.1 Bond price as num raire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 e 33.2 Stock price as num raire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328 e 33.3 Merton option pricing formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 34 Brace-Gatarek-Musiela model 335 . . . . . . . . . . . . . . . . . . . . . . . . . 335
34.2 Brace-Gatarek-Musiela model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336 34.3 LIBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337 34.4 Forward LIBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338 34.6 Implementation of BGM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 34.7 Bond prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342 34.8 Forward LIBOR under more forward measure . . . . . . . . . . . . . . . . . . . . 343 34.5 The dynamics of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
34.1 Review of HJM under risk-neutral
' A $ )BB&@9
32.1 Non-negativity of
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
' $ 10)#
31.1 Equilibrium distribution of
' 6$3 75542
9 34.9 Pricing an interest rate caplet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343 34.10Pricing an interest rate cap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 34.11Calibration of BGM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 34.12Long rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346 34.13Pricing a swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346 35 Notes and References 349
35.1 Probability theory and martingales. . . . . . . . . . . . . . . . . . . . . . . . . . . 349 35.2 Binomial asset pricing model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349 35.3 Brownian motion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 35.4 Stochastic integrals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 35.5 Stochastic calculus and nancial markets. . . . . . . . . . . . . . . . . . . . . . . 350 35.6 Markov processes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351 35.7 Girsanovs theorem, the martingale representation theorem, and risk-neutral measures.351 35.8 Exotic options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 35.9 American options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 35.10Forward and futures contracts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 35.11Term structure models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 35.12Change of num raire. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 e 35.13Foreign exchange models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 35.14REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
10
Chapter 1
Introduction to Probability Theory

1.1 The Binomial Asset Pricing Model
The binomial asset pricing model provides a powerful tool to understand arbitrage pricing theory and probability theory. In this course, we shall use it for both these purposes. In the binomial asset pricing model, we model stock prices in discrete time, assuming that at each step, the stock price will change to one of two possible values. Let us begin with an initial positive stock price . There are two positive numbers, and , with
such that at the next period, the stock price will be either or . Typically, we take and to satisfy , so change of the stock price from to represents a downward movement, and change of the stock price from to represents an upward movement. It is common to also have , and this will be the case in many of our examples. However, strictly speaking, for what we are about to do we need to assume only (1.1) and (1.2) below. Of course, stock price movements are much more complicated than indicated by the binomial asset pricing model. We consider this simple model for three reasons. First of all, within this model the concept of arbitrage pricing and its relation to risk-neutral pricing is clearly illuminated. Secondly, the model is used in practice because with a sufcient number of steps, it provides a good, computationally tractable approximation to continuous-time models. Thirdly, within the binomial model we can develop the theory of conditional expectations and martingales which lies at the heart of continuous-time models. With this third motivation in mind, we develop notation for the binomial model which is a bit different from that normally found in practice. Let us imagine that we are tossing a coin, and when we get a Head, the stock price moves up, but when we get a Tail, the price moves down. We denote the price at time by if the toss results in head (H), and by if it 11
D C ' e$ ! EX4@0b4C
DC EX
DC ESF
D EC
DC RQ
C D YF
AF PIHG6 DC D C F ' c$ ! ES4d5b4C ! a ` F UWVTUT6
D EC
(1.1)
12
S2 (HH) = 16
S (H) = 8 1 S2 (HT) = 4 S =4 0 S1 (T) = 2 S2 (TH) = 4
S2 (TT) = 1
results in tail (T). After the second toss, the price will be one of:
After three tosses, there are eight possible coin sequences, although not all of them result in different stock prices at time . For the moment, let us assume that the third toss is the last one and denote by
the set of all possible outcomes of the three tosses. The set of all possible outcomes of a random experiment is called the sample space for the experiment, and the elements of are called sample points. In this case, each sample point is a sequence of length three. We denote the -th component of by . For example, when , we have , and . at time depends on the coin tosses. To emphasize this, we often write . The stock price Actually, this notation does not quite tell the whole story, for while depends on all of , depends on only the rst two components of , depends on only the rst component of , and does not depend on at all. Sometimes we will use notation such just to record more explicitly how depends on . Example 1.1 Set , and . We have then the binomial tree of possible stock prices shown in Fig. 1.1. Each sample point represents a path through the tree. Thus, we can think of the sample space as either the set of all possible outcomes from three coin tosses or as the set of all possible paths through the tree. To complete our binomial asset pricing model, we introduce a money market with interest rate ; $1 invested in the money market becomes in the next period. We take to be the interest
q PC ' d$ C c @r
p h f D 7iF g@EC e q c ! x # ' q eA ! d$ q C EC
Figure 1.1: Binomial tree of stock prices with
e e eA c e eA e c eA c c eA e e cA c e cA e c cA c c c 1w@1w@1wd1@Bww"wdBwdu
D ' e$ ! C ' e e$ q A D C F ' e$ ! C F ' c e$ q 7EC q t@0s4Qt@07PC uEXSt@&b4S4d@07PC A D C F ' c$ ! C ' e c$ q C A D F ' c$ ! C F ' c c$ q bRSXtd5yxQ4@w57PvuEC q td5s4Yrdd57PC ' A ireAuqx1l!d$k p f vWF g D C !q j ' Aq A! $ sresxeihdg q fC c e c @w '# n $ uHh1Sm ! xC t C DC
CHAPTER 1. Introduction to Probability Theory
13
rate for both borrowing and lending. (This is not as ridiculous as it rst seems, because in a many applications of the model, an agent is either borrowing or lending (not both) and knows in advance which she will be doing; in such an application, she should take to be the rate of interest for her activity.) We assume that
The model would not make sense if we did not have this condition. For example, if , then the rate of return on the money market is always at least as great as and sometimes greater than the return on the stock, and no one would invest in the stock. The inequality cannot happen unless either is negative (which never happens, except maybe once upon a time in Switzerland) or . In the latter case, the stock does not really go down if we get a tail; it just goes up less than if we had gotten a head. One should borrow money at interest rate and invest in the stock, since even in the worst case, the stock price rises at least as fast as the debt used to buy it. With the stock as the underlying asset, let us consider a European call option with strike price and expiration time . This option confers the right to buy the stock at time for dollars, and so is worth at time if is positive and is otherwise worth zero. We denote by
the value (payoff) of this option at expiration. Of course, actually depends only on , and we can and do sometimes write rather than . Our rst task is to compute the arbitrage price of this option at time zero. Suppose at time zero you sell the call for dollars, where is still to be determined. You now have an obligation to pay off if and to pay off if . At the time you sell the option, you dont yet know which value will take. You hedge your short shares of stock, where is still to be determined. You can use position in the option by buying the proceeds of the sale of the option for this purpose, and then borrow if necessary at interest rate to complete the purchase. If is more than necessary to buy the shares of stock, you dollars invested invest the residual money at interest rate . In either case, you will have in the money market, where this quantity might be negative. You will also own shares of stock. If the stock goes up, the value of your portfolio (excluding the short position in the option) is
and you need to have
. Thus, you want to choose
and
so that (1.3)
If the stock goes down, the value of your portfolio is
and you need to have
. Thus, you want to choose
and
to also have (1.4)
! h
e ! ~
F r # n Hpq4 s
# n r I`
D ! v' c ! v~ s @DECX5$ Du ' $ ds! u ' $ }y! u 6 ' $ ! C { z y x v XBA s |dyxb)uTw'
DG D C D D D G u
llDEsDGWD u suT1Ed5b4lGtd5s! u ' C $ ' # n $ n ' c$ ! C D ' c$ D Du ' c$ d5s! u A l' D C D W D u suHt1E$ ! C D $'# n $ n ' c
lsDElDGD u suHt10b4lGt@0s! u ' C $ ' # n $ n ' e$ ! C D ' e$ ' e @0$ ! u D Du A ' D C D $ ' # n $ n ' e$ ! C D llEsGWD u suT1E@&b4sG
(1.2)
F # n fHpHo ' $ ! C$ ' $ s 4dyx5gtds! u Du ! s 4C v ' s @EY5$ DCF # '! $ e}b! u Du D ! s 4C Du # 6 ks t # r vW
14 These are two equations in two unknowns, and we solve them below Subtracting (1.4) from (1.3), we obtain
so that
This is a discrete-time version of the famous delta-hedging formula for derivative securities, according to which the number of shares of an underlying asset a hedge should hold is the derivative (in the sense of calculus) of the value of the derivative security with respect to the price of the underlying asset. This formula is so pervasive the when a practitioner says delta, she means the derivative (in the sense of calculus) just described. Note, however, that my denition of is the number of shares of stock one holds at time zero, and (1.6) is a consequence of this denition, not the denition of itself. Depending on how uncertainty enters the model, there can be cases in which the number of shares of stock a hedge should hold is not the (calculus) derivative of the derivative security with respect to the price of the underlying asset. To complete the solution of (1.3) and (1.4), we substitute (1.6) into either (1.3) or (1.4) and solve for . After some simplication, this leads to the formula
This is the arbitrage price for the European call option with payoff formula, we dene
at time . To simplify this
so that (1.7) becomes
Because we have taken , both and are dened,i.e., the denominator in (1.8) is not zero. , and because they sum to , we can regard Because of (1.2), both and are in the interval them as probabilities of and , respectively. They are the risk-neutral probabilites. They appeared when we solved the two equations (1.3) and (1.4), and have nothing to do with the actual probabilities of getting or on the coin tosses. In fact, at this point, they are nothing more than a convenient tool for writing (1.7) as (1.9). We now consider a European call which pays off dollars at time . At expiration, the payoff of this option is , where and depend on and , the rst and second coin tosses. We want to determine the arbitrage price for this option at time zero. Suppose an agent sells the option at time zero for dollars, where is still to be determined. She then buys shares
D G
e c 'A6 ss)$ F gW ' e$ (0y! u Ed5s! u r I t D u n ' c$ # n A uTWeoF F x A WqHF x ' # H n $ # n ! u # n '@0b! ' # q oF n ' c $ W# F n T e$ u uHt1F Ed5y! u WH D u n $
A'' e C ' c C ' e l"@0$ ! Wrd5$ ! 5$ D t@0$ ! u rd5$ ! u ' c p ! ' C 4d5$ ' c @0&$ee y!! q4d5s!! C G ' @$ u ' c$ u D s qC Du qu Du v ' s q 5Vx q u C$ e c D Du
(1.5)
(1.6)
(1.7)
(1.8)
(1.9)
15
dollars in the money market to nance this. At time , the agent has of stock, investing a portfolio (excluding the short position in the option) valued at
After the rst coin toss, the agent has dollars and can readjust her hedge. Suppose she decides to now hold shares of stock, where is allowed to depend on because the agent knows what value has taken. She invests the remainder of her wealth, in the money market. In the next period, her wealth will be given by the right-hand side of the following equation, and she wants it to be . Therefore, she wants to have
Although we do not indicate it in the notation, and depend on and , the outcomes of the rst two coin tosses. Considering all four possible outcomes, we can write (1.11) as four equations:
We now have six equations, the two represented by (1.10) and the four represented by (1.11), in the six unknowns , , , , , and . To solve these equations, and thereby determine the arbitrage price at time zero of the option and the hedging portfolio , and , we begin with the last two
Subtracting one of these from the other and solving for mula
and substituting this into either equation, we can solve for
'' e$ ! C' e$ ! ' e$ $ ' # n $ n ' e e$ q C' e$ ! l"@&i4"@&b`Wt@0l! suHt1E@0uP"@&y` A '' e$ ! C' e$ ! ' e$ $ ' # n $ n ' c e$ q C' e$ ! lw@0s4"@0s`r0y! suT1Ed@0uP"@&y` A'' c$ ! C' c$ ! ' c$ $ ' # n $ n ' e c$ q C' c$ ! lwy4wy`4i! suTebPwy` A'' c C' c ' c $'# n $ n ' c c C' c l"d5$ ! "d5$ ! W4d5$ ! suHt1Yd$ q w$ !
' e$ @&y!` ' e$ C' $ ! e$ l"'@0s!4"e0b`Wt'@&i! ' # n ' e e $ q C ' e $ ! ' e e$ $suTne$P@0iP"@0b @&bq u A ' e ! C e$ ' e $ ' n $ y'"@0$s4"'@&y!`4@0$i! su#Ht1nE'd@0iP"@0b 0bq u c e$ q C' e$ ! ' c e$ ' e @&$ ! d5$ ! D ' c
, we obtain the delta-hedging for-
and therefore depend on Although we do not indicate it in the notation, the rst coin toss. Thus, there are really two equations implicit in (1.10):
, the outcome of
q x
! C! 4"`T! ! ! ! 'D CD lsEsGWD $ ' # n $ n ' e $ ! C D x ' e $ u suTt1E@0bxiG @0s! A ' D C D $ ' # n $ n ' c$ ! C D yiEsWD u suTed5bxiG d5y! x ' c $
! qu q PC '! C! $'# n $ n q C! l"4B`Wt! ibTh1tPB`q u
# n ' e ('@e0$ q u Ed@0$ q u H 4@0$ ! e n' c e e $ q C ' c e$ q A '@0ee 7PW4'dc@e0$7fC ' e $ ! ' e $ 0uq u 4d@07q u t@0s`
Du
! ! 4C ' D C D $ ' # n $ n ! C D x llEsGWD u suT1rxsG@! ' e$ 0b!
' c$ ' e$ ! ' c$ ! D d5b! @&b` d5y G D u
D CD ElGD u
(1.10)
@0uq u ' e e$ d@&7q u ' c e$ 7q u ' e c$ ' c c dd5$ q u
qu
(1.11)
(1.12)
(1.13)
16 Equation (1.13), gives the value the hedging portfolio should have at time if the stock goes down between times and . We dene this quantity to be the arbitrage value of the option at time if , and we denote it by . We have just shown that (1.14)
The hedger should choose her portfolio so that her wealth if agrees with dened by (1.14). This formula is analgous to formula (1.9), but postponed by one step. The rst two equations implicit in (1.11) lead in a similar way to the formulas
and
, where
is the value of the option at time if
, dened by (1.16)
This is again analgous to formula (1.9), postponed by one step. Finally, we plug the values and into the two equations implicit in (1.10). The solution of these equations for and is the same as the solution of (1.3) and (1.4), and results again in (1.6) and (1.9). denotes the value at The pattern emerging here persists, regardless of the number of periods. If time of a derivative security, and this depends on the rst coin tosses , then at time , after the rst tosses are known, the portfolio to hedge a short position shares of stock, where should hold
and the value at time outcomes
of the derivative security, when the rst , is given by
coin tosses result in the
1.2 Finite Probability Spaces

Let
be a set with nitely many elements. An example to keep in mind is (2.1)
of all possible outcomes of three coin tosses. Let be the set of all subsets of . Some sets in are , , , and itself. How many sets are there in ?
' e @0$ ! u
(1.15)
' c td5$ !
(1.17)
(1.18)
e ! AA! $ '"AsElt1"issldX u SdBsEyx1wssiihdQ u 4T tByxe"sisldbEl u n ' cA! AA! $ # n '! AA! $! ! AA! Eyx11isssh o eA! AA! $ C ' cA! AA! $ A '@wsElxe1ssisdXPqf'cAs!ElxeA"sisAs!}$QPC ! A ! ' eA! AA! $ @"sEyx1"isii}Q u fsElxe"siss}7 u t' Ey 1wssiA ! d$ Ey
x1"isiAs A ! u
e e e e e cA c e cA e c cA c c c s w"w@jwddb e e eA c e eA e c eA c c eA e e cA c e cA e c cA c c c 1w@1w@1wd1@Bww"wdBwdu
('ebq u Ed5uq u fH d5s! u c$ n ' c c $ # n x ' c $ c! ' c$ y! u '@w5uPqfd7PC ' c $ ! e c$ q C ' c c$ q ' e c$ ' c c$ bq u fd7q u 4b`
e ! @0$ ! ' e ' e e$ ((@0uq u Sd@07q u 4T n ' c e$ # n
! AA! Elt1"isssh
x0y! u ' e$ ' e$ 0y! u
' y e"sisA ! d$ Ey ! A ! `
D D G ' e$ ' e$ 0y! u u @0s! ' c$ y! u
' c$ ' c$ d5y! u td5s!
e ! g `
17
(i)
Probability measures have the following interpretation. Let be a subset of . Imagine that is the set of all possible outcomes of some random experiment. There is a certain probability, between and , that when that experiment is performed, the outcome will lie in the set . We think of as this probability.
For example,
which is another way of saying that the probability of
As in the above example, it is generally the case that we specify a probability measure on only some of the subsets of and then use property (ii) of Denition 1.1 to determine for the remaining sets . In the above example, we specied the probability measure only for the sets containing a single element, and then used Denition 1.1(ii) in the form (2.2) (see Problem 1.4(ii)) to determine for all the other sets in .
wG
(i)
Denition 1.2 Let be a nonempty set. A -algebra is a collection following three properties:
c ! Y E E Y p E e e c A c e c A e c c A c c c A q p Un p q In Vw"w@j"dddbp
of subsets of
' $ 5
b Qlp ' $ 5
For
, we dene
on the rst toss is .
A b qq A bq q A 7q
~sp e e e q 7! @w@sp e c e e e c 7! @wbp e c c u @wdbp q !
Example 1.2 Suppose a coin has probability in (2.1), dene
for
and
for
. For the individual elements of
(2.2)
with the
! P ! fB ' $ lu5 l g
(ii) If
is a sequence of disjoint sets in
, then
A i)6
A ~@sp c e e q q ! c c e A 7! ! @sp q A 7 c e c q q ! @@wbp c c c A u! @ddbp
Denition 1.1 A probability measure properties:
is a function mapping
into
with the following
ssiAsBs q A! $ t'
' $ 5
18
Here are some important -algebras of subsets of the set
in Example 1.2:
To simplify notation a bit, let us dene
and let us dene
on the rst two tosses
so that
We interpret -algebras as a record of information. Suppose the coin is tossed three times, and you are not told the outcome, but you are told, for every set in whether or not the outcome is in that set. For example, you would be told that the outcome is not in and is in . Moreover, you might be told that the outcome is not in but is in . In effect, you have been told that the rst toss was a , and nothing more. The -algebra is said to contain the information of the rst toss, which is usually called the information up to time . Similarly, contains the information of
Q S BA S BA A A S A S BA Y w BA Y w BA BA A A A A A xYSBrBBA )b
A Q
AQ A Q
A Q
!
A A A ! Q4@BA )b
so that
A e e eA c e eA e c eA c c eA e e cA c e cA e c cA c c c A Q1w@lyQww@sQw"w@jbXjd"wdbyA t
A 11www@sQw"w@jjd"wdbyA t e e eA c e eA e c eA c c eA e e cA c e cA e c cA c c c A
and all sets which can be built by taking unions of these The set of all subsets of
A Q
on the rst toss
A X
on the rst toss
e e e e A c e e A e c e A c c e x s"w1@w@wd@iq c e e c A c e c A e c c A c c c x b|jw"wddb
! @ P
e e e e eA c e e s"w@ix S c e e c eA c c e sw@"wd@sx S e c e e cA c e c wbwBw@wbx c c e c c A c c c x dbjdBwddb
(iii) If
is a sequence of sets in , then
!
w@
A t A
issAuBAiq@i A! g q @ D ! q @
(ii) If
, then its complement
, is also in .
19
contains full the rst two tosses, which is the information up to time . The -algebra information about the outcome of all three tosses. The so-called trivial -algebra contains no information. Knowing whether the outcome of the three tosses is in (it is not) and whether it is in (it is) tells you nothing about
Example 1.3 Let be given by (2.1) and consider the binomial asset pricing Example 1.1, where , and . Then , , and are all random variables. For example, . The random variable is really not random, since for all . Nonetheless, it is a function mapping into , and thus technically a random variable, albeit a degenerate one. A random variable maps into , and we can look at the preimage under the random variable of sets in . Consider, for example, the random variable of Example 1.1. We have
The complete list of subsets of
and sets which can be built by taking unions of these. This collection of sets is a -algebra, called the -algebra generated by the random variable , and is denoted by . The information content of this -algebra is exactly the information learned by observing . More specically, suppose the coin is tossed three times and you do not know the outcome , but someone is willing , whether is in the set. You might be told, for example, that is to tell you, for each set in not in , is in , and is not in . Then you know that in the rst two tosses, there was a head and a tail, and you know nothing more. This information is the same you would have gotten by being told that the value of is . Note that dened earlier contains all the sets which are in , and even more. This means that the information in the rst two tosses is greater than the information in . In particular, if you see the rst two tosses, you can distinguish from , but you cannot make this distinction from knowing the value of alone.
A A A A rYSjBA ) p qC Y @X7HPHGf Hlb7BSf duPC y pA ' $ q
we can get as preimages of sets in
q PC 'q C$ BP
qC
'q C$ "P5
q PC
q PC
' $q dbfC
pA i7Sf
Let us consider the interval
. The preimage under
of this interval is dened to be
is:
f ' $D }EC
' e e e$ q C ' c e e$ q 7t@0bftd@0uPC ASf4'@ewc@0$7qPCP'dcc07P4@w57Prd@w5uPC e e$ q C ' e e c$ q C ' c e c$ q A ' e c c$ q C ' c c c$ q )s4@wd5uP4dd5uPC
RC
q PC
Denition 1.4 Let be a nonempty nite set and let random variable is a function mapping into .
be the -algebra of all subsets of
AAq A! AD w"sisi@"B"7
Denition 1.3 Let be a nonempty nite set. A ltration is a sequence of -algebras such that each -algebra in the sequence contains all the sets contained by the previous -algebra.
@
DEC q ! D PC 4C EC
S j 'q C$ "P5h
q PC
D F ' e c c$ q svEC t@wd57PC pq f D F WEC !q
q @
. A
20 Denition 1.5 Let be a nonemtpy nite set and let be the -algebra of all subsets of . Let be a random variable on . The -algebra generated by is dened to be the collection of all sets of the form , where is a subset of . Let be a sub- -algebra of . We say that is -measurable if every set in is also in . Note: We normally write simply rather than .
Denition 1.6 Let be a nonempty, nite set, let be the -algebra of all subsets of , let be , and let be a random variable on . Given any set , we a probabilty measure on dene the induced measure of to be
In other words, the induced measure of a set tells us the probability that takes a value in . In the case of above with the probability measure of Example 1.2, some sets in and their induced measures are:
at the number , and a mass of size at the number . A common way to record this information is to give the cumulative distribution function of , dened by
if if if if
By the distribution of a random variable , we mean any of the several ways of characterizing . If is discrete, as in the case of above, we can either tell where the masses are and how large they are, or tell what the cumulative distribution function is. (Later we will consider random variables which have densities, in which case the induced measure of a set is the integral of the density over the set .) Important Note. In order to work through the concept of a risk-neutral measure, we set up the denitions to make a clear distinction between random variables and their distributions. A random variable is a mapping from to , nothing more. It has an existence quite apart from discussion of probabilities. For example, in the discussion above, , regardless of whether the probability for is or .
' e e e$ q C ' c e e$ q G@&bPkd@&7PC
In fact, the induced measure of
places a mass of size
at the number
, a mass of size
(2.3)
q fC fHGs 7 A A )sjIf A ' q C $ x ' Af STjI A tYHP S$ A 7w ) 6 A l qPC 'Y5$ 7 l q q qC ! q ! Vt'rY$ ~uPup SiB)6 q C A q p A7' 4TB)6 $ ' A A7' t $ $ ' A 6 ' $ ' )t5 t7$
' wtd$ y
Q p x @$ '
' $ ' h $ !q
dtd$ ' wA l ' $ c h ' wA $ l l l l
q PC
on , i.e., a way of assigning probabilities The distribution of a random variable is a measure to sets in . It depends on the random variable and the probability measure we use in . If we set the probability of to be , then assigns mass to the number . If we set the probability assigns mass to the number . The distribution of has changed, but of to be , then the random variable has not. It is still dened by
Thus, a random variable can have more than one distribution (a market or objective distribution, and a risk-neutral distribution). In a similar vein, two different random variables can have the same distribution. Suppose in the binomial model of Example 1.1, the probability of and the probability of is . Consider a European call with strike price expiring at time . The payoff of the call at time is the random , which takes the value if or , and takes the value in variable every other case. The probability the payoff is is , and the probability it is zero is . Consider also a European put with strike price expiring at time . The payoff of the put at time is , or . Like the payoff of the call, the payoff of the which takes the value if put is with probability and with probability . The payoffs of the call and the put are different random variables having the same distribution.
(2.4)
Notice that the expected value in (2.4) is dened to be a sum over the sample space . Since nite set, can take only nitely many values, which we label . We can partition the subsets , and then rewrite (2.4) as
Denition 1.7 Let be a nonempty, nite set, let be the -algebra of all subsets of , let a probabilty measure on , and let be a random variable on . The expected value of dened to be
v BP5$ 'q C
is a into
!q
q PC
' e e e$ q C ' c e e$ q 7t@0bftd@0uPC ASf4'@ewc@0$7qPCP'dcc07P4@w57Prd@w5uPC e e$ q C ' e e c$ q C ' c e c$ q A ' e c c$ q C ' c c c$ q )s4@wd5uP4dd5uPC
AA! )"sislE
e c c wd
QuYb Y h p Y 7) lp Y t Y yp "'d$ t ' lp "d$
' Qlp "}$
e e e g p p c c c ! d p p
s !
21
b) x
!fB !fB !fB !fB b) x Y)~ l"issXlEt! AA !
l !
6 c e e @g ! p
f l
' wA $
c l
v XlH q 5$ 'f C
!q
be is
22 Thus, although the expected value is dened as a sum over the sample space , we can also write it as a sum over .
Denition 1.8 Let be a nonempty, nite set, let be the -algebra of all subsets of , let be a probabilty measure on , and let be a random variable on . The variance of is dened to be the expected value of , i.e., Var
1.3 Lebesgue Measure and the Lebesgue Integral

In this section, we consider the set of real numbers , which is uncountably innite. We dene the Lebesgue measure of intervals in to be their length. This denition and the properties of measure determine the Lebesgue measure of many, but not all, subsets of . The collection of subsets of we consider, and for which Lebesgue measure is dened, is the collection of Borel sets dened below. We use Lebesgue measure to construct the Lebesgue integral, a generalization of the Riemann integral. We need this integral because, unlike the Riemann integral, it can be dened on abstract spaces, such as the space of innite sequences of coin tosses or the space of paths of Brownian motion. This section concerns the Lebesgue integral on the space only; the generalization to other spaces will be given later.
' lsY5$
Var
One again, we can rewrite (2.5) as a sum over , then
rather than over . Indeed, if
takes the values
Q f f f f ~n f Tn s uQ |s XsQ s n f f n uPbp sPbp s XiPbyp ss q C n y )f q C l n q C f 'rY lESj5 sTP@5 ss $ n ' $ f n ' $ e e e ' e e e$ q C n c e e ' c e e$ q C sp w@07fTx@sp "d@07Pn sp "@w@&$ q Irsp "dd@0$ q n e c e ' e c e C n c c e ' c c e C ewbp "@bPIr@wbp "d@w57Pn e c ' e e c$ q C n c e c ' c e c$ q C e c c ' e c c$ q C n c c c ' c c c$ q dbp "@wd57PTrdup "dd7PC
! P ! fB q ' WS5$ uS p q ' WS5$ 4' $
u) Qlp q ' P'd$ $ x ' $ q' W '`$ "A $
q PC
To make the above set of equations absolutely clear, we consider (2.3). The denition of is
with the distribution given by
qC PG
qC PG A B"isiA !
(2.5)
23
, is the smallest -algebra containing all open Denition 1.9 The Borel -algebra, denoted intervals in . The sets in are called Borel sets.
is in , where and are real numbers. Since is By denition, every open interval a -algebra, every union of open intervals is also in . For example, for every real number , the open half-line
is a Borel set, as is
This shows that every closed interval is Borel. In addition, the closed half-lines
and
are Borel. Half-open and half-closed intervals are also Borel, since they can be written as intersections of open half-lines and closed half-lines. For example,
"sisA q A ! b A
This means that every set containing nitely many real numbers is Borel; if then
Every set which contains only one real number is Borel. Indeed, if
is a real number, then
' $ 5
Tu5WPXB1b%wBY ' A $ ' A $ A
! fb BA pQ @b n
' A $ A $ A lTS5WQw1gSwBY5$
! fb A B4Wp Be$ A
! fb n A IBY tTBY ' A
XuXb
!f H
' $ ~
is Borel. Since
is a -algebra, every complement of a Borel set is Borel, so
' A $ ' A Tu5WPXB1$
For real numbers
and , the union
contains
' $ 5~
' $ 5
Every set which can be written down and just about every set imaginable is in discussion of this fact uses the -algebra properties developed in Problem 1.3.
! Pu 'A lQ4W5$ tXB1$ 'A
! fu ' n A TBY5$ rTS$ ' A
' $ 5
' $ 5
' $ ~
'A lBY5$
' $ 5
. The following
24
This means that the set of rational numbers is Borel, as is its complement, the set of irrational numbers. There are, however, sets which are not Borel. We have just seen that any non-Borel set must have uncountably many points. Example 1.4 (The Cantor set.) This example gives a hint of how complicated a Borel set can be. We use it later when we discuss the sample space for an innite sequence of coin tosses.
has two pieces. From each of these pieces, remove the middle half, i.e., remove the open set
The remaining set
has four pieces. Continue this process, so at stage , the set length . The Cantor set
is dened to be the set of points not removed at any stage of this nonterminating process. Note that the length of , the rst set removed, is . The length of , the second set removed, . The length of the next set removed is , and in general, the length of the is -th set removed is . Thus, the total length removed is
and so the Cantor set, the set of points not removed, has zero length. Despite the fact that the Cantor set has no length, there are lots of points in this set. In particular, none of the endpoints of the pieces of the sets is ever removed. Thus, the points
are all in . This is a countably innite set of points. We shall see eventually that the Cantor set has uncountably many points.
! P x p f s s A s f iA s s s A A )6 q s s s A s s A s x q
q @
s s issA uf A s A s ssiA q
! !q f q !
! fB A p
A s A i 7iA f A f )6 A A A!
fA )6 !
The remaining set
iA f Pf A f
x !
A i)6
Consider the unit interval
, and remove the middle half, i.e., remove the open interval
has
pieces, and each piece has
Aq A! 1sisiQib
In fact, every set containing countably innitely many numbers is Borel; if
, then
!f XuXb H
! ! n !
25
Lebesgue measure is dened to be the measure on which assigns the measure of each interval to be its length. Following Williamss book, we denote Lebesgue measure by . A measure has all the properties of a probability measure given in Problem 1.4, except that the total measure of the space is not necessarily (in fact, ), one no longer has the equation
in Problem 1.4(iii), and property (v) in Problem 1.4 needs to be modied to say:
To see that the additional requirment
is needed in (v), consider
We specify that the Lebesgue measure of each interval is its length, and that determines the Lebesgue measure of all other Borel sets. For example, the Lebesgue measure of the Cantor set in Example 1.4 must be zero, because of the length computation given at the end of that example. The Lebesgue measure of a set containing only one point must be zero. In fact, since
for every positive integer , we must have
6 D @)uu
Letting
, we obtain
p BA G ETbuETG6 n D D
n BA p b
! P
Then
, so
, but
'! $ HB5
tQQ boy ' $ D 6 ' ! $ D tu P 5QE A' 1issyTBA) lTB)p t@lTB A' A q A' A ! '! $ HB5 ! fB ' l)$| yb ' $ 5~
q ! si@H
Aq A! sisi@s
(v) If
is a sequence of sets in
with
and
!P ! fB $ l'i@5 ' $ 5~
(ii) If
'' $ A " 5~wG 5$
' $ $ 5dt' 5 ' $ D t 5QE
ssisqBs A A! 6 ' $ t5
(i)
is a sequence of disjoint sets in
, then
'' $ A " 5~wG 5$

, then
A )6
' $ 5~
Denition 1.10 Let function mapping
be the -algebra of Borel subsets of into with the following properties:
. A measure on
is a
26 The Lebesgue measure of a set containing countably many points must also be zero. Indeed, if , then
The Lebesgue measure of a set containing uncountably many points can be either zero, positive and nite, or innite. We may not compute the Lebesgue measure of an uncountable set by adding up the Lebesgue measure of its individual members, because there is no way to add up uncountably many numbers. The integral was invented to get around this problem. In order to think about Lebesgue integrals, we must rst consider the functions to be integrated.
Denition 3.4 is purely technical and has nothing to do with keeping track of information. It is difcult to conceive of a function which is not Borel-measurable, and we shall pretend such functions dont exist. Hencefore, function mapping to will mean Borel-measurable function mapping to and subset of will mean Borel subset of .
the set indicated by . We dene the Lebesgue integral of
to be
Let be a nonnegative function dened on dene the Lebesgue integral of to be
w ' $ ' $ Y5tHSr D x D 7 p)BE7 7 %!f ! )P l'i@$QDy D @E7iQ x D E7
, possibly taking the value
is simple and
and each
is a real number. We dene the Lebesgue integral of
AX h A Xw
A)6 A ' $ 7 gtY5QQ
where each
is of the form
if if
A ' $ lY5QQi
%!fB ' $ tS54
A simple function
from
to
is a linear combination of indicators, i.e., a function of the form
to be
at some points. We
for every
' $ D D l@Qgx E X r'Y5$r b x
Denition 1.12 An indicator function and . We call
from
to
is a function which takes only the values
' $ ~ ' $ 5Wv
' $ 5
Denition 1.11 Let
be a function from to . We say that is Borel-measurable if the set is in whenever . In the language of Section 2, we want the -algebra generated by to be contained in .
!f ! f )66 ~uXbuE t5QE D ' $ D
' $ Sx qb
1sisA q A ! b
27 is integrable.
Finally, let be a function dened on , possibly taking the value at some points and the value at other points. We dene the positive and negative parts of to be
respectively, and we dene the Lebesgue integral of
provided the right-hand side is not of the form , since (or equivalently,
Let be a function dened on , possibly taking the value other points. Let be a subset of . We dene
is the indicator function of .
The Lebesgue integral just dened is related to the Riemann integral in one very important way: if the Riemann integral is dened, then the Lebesgue integral agrees with the Riemann integral. The Lebesgue integral has two important advantages over the Riemann integral. The rst is that the Lebesgue integral is dened for more functions, as we show in the following examples. Example 1.5 Let be the set of rational numbers in , and consider set, has Lebesgue measure zero, and so the Lebesgue integral of over
To compute the Riemann integral , we choose partition points and divide the interval into subintervals . In each subinterval there is a rational point , where , and there is also an irrational point , where . We approximate the Riemann integral from above by the upper sum
and we also approximate it from below by the lower sum
s x ' $ A ! A Aq A! A! A D i)BsE) (isi(1YBBR 1RBu) ! D tsiVEUw)V6
A s)6
x
! fB !fB A7t' !Ey q 5$X h' !El q s' t $ $ 6h' 5t #$ A! iSBsEyS
6 '! $ )tBEySqS5X@6
Ap h A pw
A s6
6 D )E ! D
!fB ! fB '! $ ' #$ hBElYWSssi5t
A)6 A x ' 7 gS$
where
x D A D v D H Tn DE7 D E7 v w AD uE7 D H v x D E@ AQX6By'S5$tQYuY5$ QXlSxu)uY5$ v A { z y x ' A 6 A ' $ { z y x '

to be . If both ), we say that and is integrable. at some points and the value if if
It is possible that this integral is innite. If it is nite, we say that
A i)6 ' $ QwS5t ! D
' $ X"S5t
)
are nite at
. Being a countable is
28 , the upper sum is always and the lower sum is No matter how ne we take the partition of always . Since these two do not converge to a common value as the partition becomes ner, the Riemann integral is not dened. Example 1.6 Consider the function
It follows that
Now consider the Riemann integral , which for this function is the same as the . When we partition into subintervals, one of these will contain Riemann integral the point , and when we compute the upper approximating sum for , this point will contribute times the length of the subinterval containing it. Thus the upper approximating sum is . On the other hand, the lower approximating sum is , and again the Riemann integral does not exist. The Lebesgue integral has all linearity and comparison properties one would expect of an integral. In particular, for any two functions and and any real constant ,
D 7 ! E n D
D ! E "
Finally, if
and
' $ ' $ SfY5t
and whenever
for all
, we have
are disjoint sets, then
6
' $ ! QYS5t E!
A D 7 A7DE7 n D E@ 7
' $ ' $ S5tHY5r
is simple and
6 6D D )@XbuE E7
sDES ~DE 7 7 D 7 D' n ESSG5$
A s
' $ XSY5t
E7 D
' $ ! QYS5t E!
)BE7 D
' A TB)6
for some
, and thus has Lebesgue integral
A) 6 A6 )`
if if
for every
This is not a simple function because simple function cannot take the value function which lies between and is of the form
) 6 A6 )
if if
. Every simple
A )6 x ' $ A S5t
A )6 x ' $ A gS54
A s)6
29
There are three convergence theorems satised by the Lebesgue integral. In each of these the situation is that there is a sequence of functions converging pointwise to a limiting function . Pointwise convergence just means that
There are no such theorems for the Riemann integral, because the Riemann integral of the limiting function is too often not dened. Before we state the theorems, we given two examples of pointwise convergence which arise in probability theory.
These converge pointwise to the function
Example 1.8 Consider a sequence of normal densities, each with mean and the -th having variance :
These converge pointwise to the function
We have again for every , so , but . The function is not the Dirac delta; the Lebesgue integral of this function was already seen in Example 1.6 to be zero.
This is the case in Examples 1.7 and 1.8, where
D 7Ei
A D 7Ei
D yb E7
y b
D E7s
bo y
If
is dened, then Fatous Lemma has the simpler conclusion
D 7i
A pA A lssB7dBEi
Theorem 3.1 (Fatous Lemma) Let verging pointwise to a function . Then
be a sequence of nonnegative functions con-
6 D d
DE7)i boy ) 6 A )6 A6 ) S5t A x ' $
if if
6 6 D @E@
9 D "87Tby TE7
D dE7)i
D @E7Xs
We have
for every , so
, but
& %p x ' $ 2 ) S5$ 6 D E7)i b`y G w tS5t 6 ' $
for every
Example 1.7 Consider a sequence of normal densities, each with variance mean :
G w
and the -th having
A pA lsi)B BA
for every
& $ '%p x ' $ 530)' # Y5i 421 (
' $ ' Y5ttS$ y b
30 . We could modify either Example 1.7 or 1.8 by setting if is even, if is odd. Now if is even, but if is odd. The has two cluster points, and . By denition, the smaller one, , is and the larger one, , is . Fatous Lemma guarantees that even the smaller cluster point will be greater than or equal to the integral of the limiting function. The key assumption in Fatous Lemma is that all the functions take only nonnegative values. Fatous Lemma does not assume much but it is is not very satisfying because it does not conclude that
There are two sets of assumptions which permit this stronger conclusion.
Then
where both sides are allowed to be
Theorem 3.3 (Dominated Convergence Theorem) Let be a sequence of functions, which may take either positive or negative values, converging pointwise to a function . Assume that there is a nonnegative integrable function (i.e., ) such that
Then
and both sides will be nite.
1.4 General Probability Spaces

Denition 1.13 A probability space (i) (ii) (iii)
, a nonempty set, called the sample space, which contains all possible outcomes of some random experiment; , a -algebra of subsets of ; , a probability measure on , i.e., a function which assigns to each set a number , which represents the probability that the outcome of the random experiment lies in the set .
j
A7DEi yb DE7 Q 7 ' $ ' $ Sf S5i
for every
for every
consists of three objects:
p A isiA)BA7Si D AD 7Ei yb E7 Q 7 G j si'S5QiHY5$7quHSb7IG6 $ ' ' $ !
4 w D HE7
A pA A isi)B7 dBSi
Theorem 3.2 (Monotone Convergence Theorem) Let converging pointwise to a function . Assume that
be a sequence of functions
for every
D7 b )By p p D 7 D 7Ei D yb E7 ' A "A $ ' `"A $
DE7 ui"87Ty 9 !fb uDE7 b 7p 6 D E A ' $ s6 5
while but sequence
U D p igj
31 has the following
In particular, (d) (Continuity from below.) If
We have already seen some examples of nite probability spaces. We repeat these and give some examples of innite probability spaces as well. Example 1.9 Finite coin toss space. Toss a coin times, so that is the set of all sequences of and which have components. We will use this space quite a bit, and so give it a name: . Let be the collection of all subsets of . Suppose the probability of on each toss is , a number between zero and one. Then the probability of is . For each in , we dene
We can dene this way because has only nitely many elements, and so only nitely many terms appear in the sum on the right-hand side of (4.1).
b x 5 Qlp ' $
' $ 5
For each
, we dene
is q H !
(d) (Continuity from above.) If
with
q ! ss@H
T WPVAHA Ga U SQAA Ga E lp T R P I H F D x R I F D ' AAq A! $ Qr1wssist1sd x
!fB $ l'S5 yb l g isiA q BA ! !fB ' lS5$ yb Aq A! isisBs
' B $ n ' $ ' $ lCA IP@ A
' $ r ' $ l5 HA
@
(d) If
and
are sets in
and
, then
with
(c) (Finite additivity) If
is a positive integer and
l' $ TBisE' ! 5 t' jBis ! 5 n n $ $ AA! "siss ! P ! fB ' $ lu5 l g
are disjoint sets in
isiA q BA !
(b) (Countable additivity) If
6 ' $ t75
(a)
. is a sequence of disjoint sets in , then
Remark 1.1 We recall from Homework Problem 1.4 that a probability measure properties:
, then
, then
, then
(4.1)
32 Example 1.10 Innite coin toss space. Toss a coin repeatedly without stopping, so that is the set of all nonterminating sequences of and . We call this space . This is an uncountably innite space, and we need to exercise some care in the construction of the -algebra we will use here.
, where ranges over the positive In the -algebra , we put every set in every -algebra integers. We also put in every other set which is required to make be a -algebra. For example, the set containing the single sequence
is not in any of the -algebras, because it depends on all the components of the sequence and not just the rst components. However, for each positive integer , the set
We next construct the probability measure on which corresponds to probability for and probability for . Let be given. If there is a positive integer such that , then the description of depends on only the rst tosses, and it is clear how to dene . For example, suppose , where these sets were dened earlier. Then is in . We set and , and then we have
In other words, the probability of a
on the second toss is .
c ' n $g n q t@ST5 h@ ' $ ' $ ' $ ' $ q @ tS5 5 ' $ 5 Y G q j
Wv '`"A $
@
is also in
on every toss
! fb c u
c b
is in
and hence in
. Therefore,
on the rst
on the rst
tosses
tosses
on every toss
c c c c c c b~essdddu
c b
q @
Because sets.
is a -algebra, we must also put into it the sets ,
, and all unions of the four basic
e @e
The set of all sequences which begin with
A c @e
A e c
A c wc
c q A c ! ' A A q A! $ x1wt ssib41uxei}gql
c q A e ! ' A A q A! $ Wxe@t ssib41uxei}gql
eqx1Awct! ssib41uxei}gql ' A A q A! $
e q A e ! ' A A q A! $ gxe@t ssib41uxei}gql
For each positive integer , we dene example, contains four basic sets,
to be the -algebra determined by the rst
tosses. For
x
x Y x S x
A i)6
33
for which there is no positive integer such that . Such Let us now consider a set is the case for the set on every toss . To determine the probability of these sets, we write them in terms of sets which are in for positive integers , and then use the properties of probability measures listed in Remark 1.1. For example,
and
According to Remark 1.1(d) (continuity from above),
A similar argument shows that if so that , then every set in which contains and ) has probability zero, and hence very set only one element (nonterminating sequence of which contains countably many elements also has probabiliy zero. We are in a case very similar to Lebesgue measure: every point has measure zero, but sets can have positive measure. Of course, are those which contain uncountably many the only sets which can have positive probabilty in elements.
and we also dene the random variable
is either zero or one, takes values in the interval . Indeed, , and the other values of lie in between. We dene a dyadic rational number to be a number of the form , where and are integers. For example, is a dyadic . For example, rational. Every dyadic rational in (0,1) corresponds to two sequences
The numbers in (0,1) which are not dyadic rationals correspond to a single have a unique binary expansion.
H f t1siwdd@w5$ t1sid5$ ' c c c c c e c ' e e e e e c c
A is)6
d(isdd5$ ' c c c c E8
Since each
6 ' e e e e t(isd&$
A e @x A c
if if
Aq 8A! issiwsP8
In the innite coin toss space, we dene a sequence of random variables
! P d Xp 8 ' ' $ 4d$
6 x ' $ dQE8
c bp
If
, then
on every toss
; otherwise,
on every toss
e c G6 G6 c bp @ c up y u @
on every toss
on the rst
tosses
6 @ y b@
c b
on the rst
tosses
on every toss
on the rst three tosses
AYss cb c b
on the rst toss
by
; these numbers
! fu c b
c u c u
c up
34 Whenever we place a probability measure on . For example, if we set
First toss is First toss is
First two tosses are
First two tosses are First two tosses are First two tosses are
Continuing this process, we can verify that for any positive integers
we have
In other words, the -measure of all intervals in whose endpoints are dyadic rationals is the same as the Lebesgue measure of these intervals. The only way this can be is for to be Lebesgue measure.
We conclude this example with another look at the Cantor set of Example 3.2. Let be the subset of in which every even-numbered toss is the same as the odd-numbered toss immediately preceding it. For example, is the beginning of a sequence in , but is not. Consider now the set of real numbers
The numbers between can be written as , but the sequence must begin with either or . Therefore, none of these numbers is in . Similarly, the numbers between can be written as , but the sequence must begin with or , so none of these numbers is in . Continuing this process, we see that will not contain any of the numbers which were removed in the construction of the Cantor set in Example 3.2. In other words, . With a bit more work, one can convince onself that in fact , i.e., by requiring consecutive coin tosses to be paired, we are removing exactly those points in which were removed in the Cantor set construction of Example 3.2.
3 ' ed ! A e!d ! $
abI T ` Y
e wc
a Y bI T c
sA6 3 3 3 ew@e c e ceee ' d$ 3 ' !q A ! $ 'd$ Q abI T Yc q '}$ x 3 c c e e e e c d@wc
It is interesing to consider what construct the probability measure
would look like if we take a value of on .
other than
!q
X f @dc c e A f @wc A f @We c A f @ee A p @Wc A p @e

and
A i)6 p p Xp A I vX p A Xp H vX G6
q ' "A $ !
p ~sA f p f p A p p f A p f A 6 p ~sA p p p A 6
h h h h h
A s6 e wc
c @e
on , we have a corresponding induced measure in the construction of this example, then we have
satisfying
when we
35
In addition to tossing a coin, another common random experiment is to pick a number, perhaps using a random number generator. Here are some probability spaces which correspond to different ways of picking a number at random. Example 1.11 Suppose we choose a number from in such a way that we are sure to get either , or . Furthermore, we construct the experiment so that the probability of getting is , the probability of getting is and the probability of getting is . We describe this random experiment by taking to be , to be , and setting up the probability measure so that
The probability measure described in this example is , the measure induced by the stock price , when the initial stock price and the probability of is . This distribution was discussed immediately following Denition 2.8. Example 1.12 Uniform distribution on . Let and let , the collection of all Borel subsets containined in . For each Borel set , we dene to be the Lebesgue measure of the set. Because , this gives us a probability measure. This probability space corresponds to the random experiment of choosing a number from so that every number is equally likely to be chosen. Since there are innitely mean numbers in , this requires that every number have probabilty zero of being chosen. Nonetheless, we can speak of the probability that the number chosen lies in a particular set, and if the set has uncountably many points, then this probability can be positive. I know of no way to design a physical experiment which corresponds to choosing a number at random from so that each number is equally likely to be chosen, just as I know of no way to toss a coin innitely many times. Nonetheless, both Examples 1.10 and 1.12 provide probability spaces which are often useful approximations to reality. Example 1.13 Standard normal distribution. Dene the standard normal density
uDE7o2 @ x ' $ H
Let
and for every Borel set
, dene (4.2)
A 6 bB)5$
This determines for every set . For example, the probability of the interval is , because this interval contains the numbers and , but not the number .
A s6 A i)6
A is)6
~XiQp A f @sp @A f uQp f ! c p q y f
& $ f"p
A i)6 D '5$%DEh'@$ A s6 ' A $ &is)6 ~ A s)6
x ' $ # S52
' $ ~d
A i)6
f D gRC
' $ 5
' $ 5~gg
' $ 5
A s6
q PC
36
This corresponds to choosing a point at random on the real line, and every single point has probability zero of being chosen, but if a set is given, then the probability the point is in that set is given by (4.2). The construction of the integral in a general probability space follows the same steps as the construction of Lebesgue integral. We repeat this construction below. Denition 1.14 Let i.e., a mapping from If be a probability space, and let , possibly also taking the values
to
be a random variable on this space, .
is an indicator, i.e,
If
is a simple function, i.e,
If
is nonnegative but otherwise general, we dene
is simple and
for every
for every
and
for every
. With this sequence, we can dene
A A pA A lssB7jSS8
In fact, we can always construct a sequence of simple functions
' }$ d8 ' $
x QS8 yb X ' $ dRY8 uy tdj8 ' $ ' $8 ' $q8 ' $! 8 sidQYTd7dbPTo6
8 XT8 )B x Q
where each
is a real number and each
!P fB ! l'u@$ s Q x v X fB ! A l'}$ ' t}$ y'@5$ xg X
for some set
, we dene
is a set in
A@w A w
if if
, we dene
such that
& $ fQ p %p # xwBY x A q
g
6 ' ' td$ 4d$
A wBY
' A "A $
If
in (4.2) is an interval
, then we can write (4.2) as the less mysterious Riemann integral:
37
where then we dene
The expectation of a random variable
The above integral has all the linearity and comparison properties one would expect. In particular, if and are random variables and is a real constant, then
If
for every
, then
In fact, we dont need to have for every in order to reach this conclusion; it is has probability one. When a condition holds with enough if the set of for which probability one, we say it holds almost surely. Finally, if and are disjoint subsets of and is a random variable, then
We restate the Lebesgue integral convergence theorem in this more general context. We acknowledge in these statements that conditions dont need to hold for every ; almost surely is enough. Theorem 4.4 (Fatous Lemma) Let be a sequence of almost surely nonnegative random variables converging almost surely to a random variable . Then
or equivalently,
A X A X8 T X n
! Q ! I Q X %i n ' 8 ' d$d$ 'd$d $ 8 ' X8 X H X QYn $ ' 8
S 9 b "87 y T A X "87Tby T Q 9
Q x Q x Q
is dened to be
A pA A lis)7S
' $ 8 ' dd$
If
is a set in
and
x X I Q v Q AQX6l'd$ QYuyx'}$ QXld$ )uod$ v A {z A6A' { z y x ' AH X H Q v A

is a random variable, we dene
If
is integrable, i.e,
38 Theorem 4.5 (Monotone Convergence Theorem) Let variables converging almost surely to a random variable
Then
or equivalently,
Theorem 4.6 (Dominated Convergence Theorem) Let be a sequence of random variables, converging almost surely to a random variable . Assume that there exists a random variable such that almost surely for every Then
or equivalently,
In Example 1.13, we constructed a probability measure on by integrating the standard normal density. In fact, whenever is a nonnegative function dened on satisfying , we call a density and we can dene an associated probability measure by
We shall often have a situation in which two measure are related by an equation like (4.3). In fact, the market measure and the risk-neutral measures in nancial markets are related this way. We say with respect to , and we write that in (4.3) is the Radon-Nikodym derivative of
The probability measure weights different parts of the real line according to the density . Now suppose is a function on . Denition 1.14 gives us a value for the abstract integral
which is an integral with respec to Lebesgue measure over the real line. We want to show that
AD 2 uE7E
AD 2 uE7o
X
We can also evaluate
D E
' $ l 5~j
for every
D 2
p A lssABA7vdB Y b S y A QX y u Q is q
almost surely
A pA A lsi)B BY
be a sequence of random
. Assume that
2 ' A "' $~"G 5$ S yb A X b y Q 4 8T
D E X W2 X
X
D E2 5 x ' $
' A ' $ A l 5"G5$
! G6 7
(4.3)
(4.4)
(4.5)
for in (4.5) and an equation which is suggested by the notation introduced in (4.4) (substitute cancel the ). We include a proof of this because it allows us to illustrate the concept of the standard machine explained in Williamss book in Section 5.12, page 5. The standard machine argument proceeds in four steps.
This is true because it is the denition of
Step 3. Now that we know that (4.5) holds when is a simple function, we consider a general nonnegative function . We can always construct a sequence of nonnegative simple functions such that
and
for every
. We have already proved that
D 2 uE
X
We let get
and use the Monotone Convergence Theorem on both sides of this equality to
for every
A G
D 2 E7)i Qi 7 X wj ' $ ' $ Y5Ps uy tY5t ' $ ' $ q ' $ ! isY5QiHS7bIS5bT6
A pA issB7`BA
where each
is a real number and each
is an indicator function. Then
for every
Step 2. Now that we know that (4.5) holds when is an indicator function, assume that simple function, i.e., a linear combination of indicator functions. In other words,
D 2 bEE ! )P D2 v Ys t P ! DE7uY 2 P ! XrY 7 ! )P XYs v Q t u Y !fB A l'Y5$)Si ' $ tS5t
D bE2
'5$ ' $ 5
Step 1. Assume that is an indicator function, i.e., that case, (4.5) becomes
for some Borel set
sr bpp
q
' S$ Sx ' $
39
. In
is a
40 Step 4. In the last step, we consider an integrable function , which can take both positive and negative values. By integrable, we mean that
From Step 3, we have
Subtracting these two equations, we obtain the desired result:
1.5 Independence
In this section, we dene and discuss the notion of independence in a general probability space , although most of the examples we give will be for coin toss space.
1.5.1 Independence of sets
Suppose a random experiment is conducted, and is the outcome. The probability that is . Suppose you are not told , but you are told that . Conditional on this information, the probability that is
The sets and are independent if and only if this conditional probability is the uncondidtional probability , i.e., knowing that does not change the probability you assign to . This discussion is symmetric with respect to and ; if and are independent and you know that , the conditional probability you assign to is still the unconditional probability . Whether two sets are independent depends on the probability measure . For example, suppose we toss a coin twice, with probability for and probability for on each toss. To avoid trivialities, we assume that . Then
' $ A
q ~esp A S Wcsp @ewcbp A q @dbp e e c c G6
v
' $ pA pfT5 5 ' $ x ' $ y
$ ' $ l'x$ "'5 hwT g j
Denition 1.15 We say that two sets
and
D 2 7EE u DE2 D E72 v 7 7 X v QE
H X A 7 H Q v 7 D u2 AD u2 v
are independent if

Q Q v
g
c
X
' $ 5
' A BwA $ ' $ 5
(5.1)
41
These sets are independent if and only if
, which is the case if and only if
If , then , the probability of one head and one tail, is . If you are told that the coin tosses resulted in a head on the rst toss, the probability of , which is now the probability of a on the second toss, is still . Suppose however that . By far the most likely outcome of the two coin tosses is , and . However, if you the probability of one head and one tail is quite small; in fact, are told that the rst toss resulted in , it becomes very likely that the two tosses result in one head and one tail. In fact, conditioned on getting a on the rst toss, the probability of one and one is the probability of a on the second toss, which is .
1.5.2 Independence of -algebras
No matter which set we choose in and which set we choose in the probabilties is the probability of the intersection.
, we will nd that the product of
e cA c c wBwdb
These two -algebras are independent. For example, if we choose the set the set from , then we have
c c c eA c c e cA c c q @dbp @wdb rwBwu A q t' S n q s' S n q gW"wup bwBwdbp $ $ c eA c c e cA c c
e eA e cA c eA c c A Q1wbQd1dbyA )
c eA c c @wdb
Let
be the -albegra determined by the second toss:
contains the sets
from
!
Example 1.14 Toss a coin twice, and let be given by (5.1). Let determined by the rst toss: contains the sets
A wf
for every
e eA c eA e cA c c A Q1sQw"dbyA )
Denition 1.16 Let and be sub- -algebras of set in is independent of every set in , i.e,
. We say that
and
are independent if every
be the -algebra
and
e e
!q
)6 )vpA 6 ' $
!q
S q p S hfT5 ' $ A p ' $ ' $ q A w@5 A p ' $ Y A A S n q h@5 ' $
7 )6
' $ ' $ ' $ pA "5 hT5
ewbw c c eA e c @"u
)6 6 !q
' $ A
e c e cA c c wBwu
Let set one
and and one . Then
. In words, is the set . We compute
on the rst toss and
is the
!q
42 Example 1.14 illustrates the general principle that when the probability for a sequence of tosses is dened to be the product of the probabilities for the individual tosses of the sequence, then every set depending on a particular toss will be independent of every set depending on a different toss. We say that the different tosses are independent when we construct probabilities this way. It is also possible to construct probabilities such that the different tosses are not independent, as shown by the following example. Example 1.15 Dene
and for every set , dene to be the sum of the probabilities of the elements in . Then , so is a probability measure. Note that the sets on rst toss and on second toss have probabilities and , so the product of the probabilities is . On the other hand, the intersection of and contains the single element , which has probability . These sets are not independent.
1.5.3 Independence of random variables
Now the pair pair
The set in this last equation is a subset of the plane . In particular, i.e, a set of the form , where and . In this case,
AQGsw ' 8 $ 8 Gw"A % Hg H q q H X G"A %p t' $ A ' 8 $ ' 8 "A $ q A 8 x ' G HvQwUsp x$
takes values in the plane
8Q
Similarly, the measure induced by
A G HQ p @5$ x '
Suppose and on to be
are independent random variables. We dened earlier the measure induced by
is
, and we can dene the measure induced by the
could be a rectangle,
e e cA c e c D C F q C wBw@wbiEXSPb
ample, the sets are indepedent sets.
and
ce1Acdc"Awc@ewBAwcdcdcb e e c F qPC l G 8
Denition 1.17 says that for independent random variables and is independent of every set dened in terms of . In the case of
, every set dened in terms of and just considered, for ex-
of the stock at time In the probability space of three independent coin tosses, the price independent of . This is because depends on only the rst two coin tosses, whereas either or , depending on whether the third coin toss is or .
l G
q PC
Denition 1.17 We say that two random variables and are independent. generate
c c db c eA c c @"wdb ! bq e A c wcBwdcb c@"wcdbp eA c e cA c c wBwdbp c eA c c @wdb c b e A c wcdcb ! c b $ g' ' $ @ c e e c A ~sp A @Wsp A p @up @A @dbp e e c c e eA c eA e cA c c 1w@1@wBwdb
for the individual elements of to be
and
are independent if the -algebras they
q PC
' 8$ &
l G
' $
is is
43
In other words, for independent random variables and , the joint distribution represented by the measure factors into the product of the marginal distributions represented by the measures and . A joint density for
is a nonnegative function
Not every pair of random variables has a joint density, but if a pair does, then the random variables and have marginal densities dened by
Suppose and have a joint density. Then and are independent variables if and only if the joint density is the product of the marginal densities. This follows from the fact that (5.2) is and , write (5.1) in terms equivalent to independence of and . Take of densities, and differentiate with respect to both and .
which is dened in terms of the random variable . Therefore, this set is in . (In general, we have that every set in is also in , which means that contains at least as much information as . In fact, can contain strictly more information than , which means that will contain all the sets in and others besides; this is the case, for example, if .) In the same way that we just argued that every set in is also in , we can show that every set in is also in . Since every set in is independent of every set in , we conclude that every set in is independent of every set in .
' h q $
' 8$ 0
' d$ A
' $
' $ x
' $
' $ ' $ A A '' Qt"d$ riflhdv l $ e ' $
' d$ @Ah
' $ ' $ A
' 8$ 04d
P ROOF : Let us denote and is of the form a typical set in
. We must consider sets in
Theorem 5.7 Suppose and are independent random variables. Let to . Then and are also independent random variables.
1g A $
A $ X1gH
' fg $
These have the properties
8 G IvÀ Y' $ ! A$ ' A A' G HPXSY5$ 5$ ' SY' $ ' $ SS)P5$ A A ' A ' 8 wA $ @XS' f5$ ! hw5$ A ' ' P5$ A 8 ' ' lpA$ 5$ 8 h Gwvsp uc p Gs iw 8
such that
'p5$ ' $ A ' 8$ & ' $ A 8 ' 8$ 04
"A $ ' 8
' tY5$
' $ A
' f $
' d$ A
and
and
are independent if and only if
(5.2)
and
be functions from
and
. But
44 be a sequence of random variables. We say that these random Denition 1.18 Let variables are independent if for every sequence of sets and for every positive integer ,
1.5.4 Correlation and independence
provided all the expectations are dened. P ROOF : Let trying to prove becomes
and
be indicator functions. Then the equation we are
The variance of a random variable
is dened to be
Var
The covariance of two random variables Cov
and
is dened to be
Cov Var
Var
For independent random variables, the correlation coefcient is zero. Unfortunately, two random variables can have zero correlation and still not be independent. Consider the following example.
The last claim is easy to see. If almost surely.
and
were independent, so would be
and
, but in fact,
q 8
d 8 d
Example 1.16 Let be a standard normal random variable, let the distribution . Dene standard normal random variable, and are uncorrelated, but
be independent of and have . We show that is also a and are not independent.
According to Theorem 5.8, for independent random variables, the covariance is zero. If both have positive variances, we dene their correlation coefcient
and
which is true because and general functions and .
are independent. Now use the standard machine to get the result for
8 p i W8 i' 8 $ Sp &8s' q &$h "A $ g x ' 8 8 q ' $ x 8 A 8 QwUsp bj p Gwvsw sw 8
A 8 l'&$rG sE' r @&r"' r $ ' 8$ $
' 8 0$ ' 8 ' $ "A $
8 8 6 uk kp ju Ukp d d
' $ $ ! ' 4
x ' 8 $ j "A P
Theorem 5.8 If two random variables to , then
and
are independent, and if and
A $ sisl' q w q Bl' ! w ! A $
' $ ' q $ ' ! $ ' q ! $ l)5 siPl5 "l5 tQ(isdtr5

are functions from
A A ssisq l!
'S5$ pS5r ' $
8 q q

We next check that is standard normal. For , we have
45
Since is standard normal, which shows that is also standard normal. Being standard normal, both Cov and
Where in
We conclude this section with the observation that for independent random variables, the variance , of their sum is the sum of their variances. Indeed, if and are independent and then
This argument extends to any nite number of random variables. If we are given independent random variables , then Var Var Var Var
1.5.5 Independence and conditional expectation.

We now return to property (k) for conditional expectations, presented in the lecture dated October 19, 1995. The property as stated there is taken from Williamss book, page 88; we shall need only the second assertion of the property:
The point of this statement is that if is independent of , then the best estimate of based on the information in is , the same as the best estimate of based on no information.
SG
(k) If a random variable
' 8 wA $ q 6 6 d l l q d q 8 twA $ ' 8 8 8 p ~ ip 8 p @ p Q Qp p p p n u p b Qp I|kp b p d n d n ud p Qp Hud Usp Tnud Usp Usp ud 8 8 8 8 w
and and and and , and we have have expected value zero. Therefore, does the measure put its mass, i.e., what is the distribution of ? Var Var is independent of a -algebra
' 8 l0$ n S' p n ' G80$ n 8 )p W8 & q HS' $ $p i q '8p W80nP'G8p W08$s' W STn q ' W ' 8 i q 8p W n
, then
' lX $
n n ' BsiPq $
n' "! $
Q nBsi4q P! $ ' n n "issyq l! AA A
$ $ $ g
x ' d A$
Var
Var
Var
8 In gd
i q @ WIA5y ' d d$g
(5.3)
46
The left-hand side of this equation is
, and the right hand side is
The partial averaging equation holds because and are independent. The partial averaging equation for general independent of follows by the standard machine.
1.5.6 Law of Large Numbers

There are two fundamental theorems about sequences of independent random variables. Here is the rst one. be a sequence of independent, identically Theorem 5.9 (Law of Large Numbers) Let distributed random variables, each with expected value and variance . Dene the sequence of averages
We are not going to give the proof of this theorem, but here is an argument which makes it plausible. We will use this argument later when developing stochastic calculus. The argument proceeds in two for every . We next check that Var as . In steps. We rst check that other words, the random variables are increasingly tightly distributed around as . For the rst step, we simply compute
times
For the second step, we rst recall from (5.3) that the variance of the sum of independent random variables is the sum of their variances. Therefore, Var Var
As
, we have Var
j 6 q ' &$ 6 8
8 o p n n n m n n t Ssin T d i IBis4q TP! GSp n
! f q q q
6 '8 t)S&$ !f '8 t)S0$
S8 8
Then
converges to
almost surely as
If is an indicator of some set , which by assumption must be independent of averaging equation we must check is
j "lisA)A7jA p n Bisn q n ! x 8 A A sislq s!
l'fT5 X %i Q ! $ ! l ' $ ' $ A "@ X ' $ ! XSx
f
, then the partial
To show this equality, we observe rst that also check the partial averaging property
Q X
is
-measurable, since it is not random. We must
for every
47
1.5.7 Central Limit Theorem

The Law of Large Numbers is a bit boring because the limit is nonrandom. This is because the denominator in the denition of is so large that the variance of converges to zero. If we want to prevent this, we should divide by rather than . In particular, if we again have a sequence of independent, identically distributed random variables, each with expected value and variance , but now we set
As , the distributions of all the random variables have the same degree of tightness, as measured by their variance, around their expected value . The Central Limit Theorem asserts that as , the distribution of approaches that of a normal random variable with mean (expected value) zero and variance . In other words, for every set ,
& $ PX ) %p # ~ kp yb d s q e Hr |d q 6 td ! P ! fB ' d t%|A$ q d # q
then each
has expected value zero and Var
Var
A Pd lsiPPW q PP ! $ |d x # $ n' ' $ n n '
Y8
# S8
48
Chapter 2
Conditional Expectation
Please see Hulls book (Section 9.6.)
2.1 A Binomial Model for Stock Price Dynamics

Stock prices are assumed to follow this simple binomial model: The initial stock price during the period under study is denoted . At each time step, the stock price either goes up by a factor of or down by a factor of . It will be useful to visualize tossing a coin at each time step, and say that
Note that we are not specifying the probability of heads here. Consider a sequence of 3 tosses of the coin (See Fig. 2.1) The collection of all possible outcomes (i.e. sequences of tosses of length 3) is
A typical sequence of will be denoted , and will denote the th element in the sequence . to denote the stock price at time (i.e. after tosses) under the outcome . Note We write depends only on . Thus in the 3-coin-toss example we write for instance, that
Each is a random variable dened on the set . More precisely, let . Then is a -algebra and is a measurable space. Each is an -measurable function , that is, is a function where is the Borel -algebra on I . We will see later that R is in fact 49
PC H
A Aq A! 1Sisis1s ' $ dQPC ' $ dQPC e e eA c e eA e c eA c c eA c c eA e e cA c e cA e c cA c c c Q"w@"w"1d"Bw"wdBwddb
' vV $ u
PC ' q A ! $ q C t ' A q A ! $ q C t ' $ q l|esdbflxeu|esduPd7PC
A ' ! $ ! C t ' A q A ! $ ! C t ' $ ! l"dyxl1i|esds4db4C
down by a factor of
if it comes out tails ( ).
the stock price moves up by a factor of
if the coin comes out heads ( ), and
D EC
' wA $
h h
! E C
50
= 3 2 S2 (HH) =u S0 = 2 S (H) = uS0 1 1= S0 1 = S (T) = dS0 1 = 2 2 S2 (TT) = d S0 3 = S3 (TTT) = d 3 S 0 = 3 = 2 = 2 S2 (HT) = ud S 0 S2 (TH) = ud S 0 = 3 = 3 = 3 S3 (HHT) = u2 d S0 S3 (HTH) = u2 d S0 S3 (THH) = u2 d S0 3 S3 (HHH) = u S 0
S3 (HTT) = d 2 u S0 S3 (THT) = d 2 u S0 S3 (TTH) = d 2 u S0
Figure 2.1: A three coin period binomial model. measurable under a sub- -algebra of . Recall that the Borel -algebra is the -algebra generated by the open intervals of I . In this course we will always deal with subsets of I that belong to . R R For any random variable dened on a sample space and any , we will use the notation:
Assumption 2.1
2.2 Information
Denition 2.1 (Sets determined by the rst tosses.) We say that a set is determined by the rst coin tosses if, knowing only the outcome of the rst tosses, we can decide whether the outcome of all tosses is in . In general we denote the collection of sets determined by the rst tosses by . It is easy to check that is a -algebra.
z {y
Example 2.1 In the 3 coin-toss example, the collection
of sets determined by the rst toss consists of:
AA pA BXsis)7G
PC
Note that the random variable
is
-measurable, for each
The sets we dene
etc, are dened similarly. Similarly for any subset
of
q
' XGwx}$ HlxGw t A X ' Q x}$ Hlw t
6 t t F yQ r lQ A A
CHAPTER 2. Conditional Expectation

1. 2. 3. 4.
51
,
The collection 1. 2. 3.
4. , 5. The complements of the above sets,
6. Any union of the above sets (including the complements), 7. and .
Denition 2.2 (Information carried by a random variable.) Let be a random variable . is determined by the random variable if, knowing only the value We say that a set of the random variable, we can decide whether or not . Another way of saying this is that for every , either or . The collection of susbets of determined by is a -algebra, which we call the -algebra generated by , and denote by .
these sets are called the atoms of the -algebra In general, if is a random variable
, then
1. 2. 3.
4. Complements of the above sets, 5. Any union of the above sets, 6. , 7. .
h h Q| } | } h hQ'VVeQVh V| h W' 5h'WG Q| } }
Example 2.2 (Sets determined by
) The -algebra generated by
Qj A$ E ' ! ' $ h ' $ '' H "|}$
$ r' h H
! $ E
If the random variable tion of sets
takes nitely many different values, then
is generated by the collec-
is given by
consists of the following sets:
'd$ T
' t $
' t $
! rwP' $
~ 'VVeQVhV| } 'QQ~ | } 'VSQG~ Q| } } 'WG~ Q| y 'VVQVVQQ~ V| ~ } 'VSQWVSQ|

, , . , , ,
of sets determined by the rst two tosses consists of:
q' $ !E q r
52
2.3 Conditional Expectation

In order to talk about conditional expectation, we need to introduce a probability measure on our coin-toss sample space . Let us dene
is the probability of ,
the coin tosses are independent, so that, e.g., , .
Denition 2.3 (Expectation.)
If
then
and
We can think of
Let us estimate , given . Denote the estimate by . From elementary probability, is a random variable whose value at is dened by
If or , then even without knowing , we know that
. If we know that . We dene
If or , then even without knowing , we know that
. If we know that . We dene
D EC q
D EC q
C ' c e e$ ' q ! C$ ' e e e$ ' q ! C$ 7DEX td@0llPC 4 t@&sBfC x5j DC ' $! EX tdbxC ' q }$bPC D ' $q RC q gduPC c e e H bEYF4'@ewccsBfC x5j Pddd5sPC 45j DC $ 'q ! C$ ' c c c$ 'q ! C$ DRCStdbxC F ' $! Ft'duPC $q D F ' $q RC q td7fC e c c w ' q ! C$ lPC 45j
cddq c c q PC
If the value of
is known, then the value of
e e e
' q ! C$ lfC 45j h ' C d$ q
where
. Properties of
should depend on , i.e., it is a random variable. should also be known. In particular, , then
'q ! C$ BPC 4
2.3.1 An example
' 5j $ b l'd$ "'|}$ $ Q d' 5j w 6 t ' w d$
as a partial average of
A q t@w ' e c c$
' $ ' l} "d$ t
' q C ! 5j C$ A l' qPC 45j d8 ! C$ ' $ 8
is the probability of
q ' $ t ' $ r d u 5 h
q PC
! 4C
' egt Ih $ ' A 6$ si)5q h 'q ! C$ PC 45j
h h
etc.
if if
over the set .
, then
$ $
A '' $ q C$ ' $ 'q ! C$ lwdsP5rIh|diBPC 4 ! X"4C X1lPC x5j ' q ! C$ ' $ ' $ ' q ! C $ D C' n F bEwQTp5$ !q QB54G dsPC 45j ! C D C' n F E"XT$ Y DC n DC EQ q S tEX q ESF q S tEYF q n DC n DC XB4C !
If
, then or
. If we know . We then take a weighted
' $q d7fC
S q Y n q n q Y n q 5 ' $ p C CF C D X ! C D S ! C D XSF DCF ' $q EXS}7PC e c eA c c eA e e cA c e c w"jd@1wBw@wbvq
, then we do not know whether average:
For
where
XB4C X"PC 45j ! 'q ! C$ 'q C$ P5j h ' q 5 ' q C ! 5j h C$ C$ 'q ! C$ PC 45j A ' $ ' q ! C$ lY5f tSPC 45j qPC 'q ! C$ PC 45j D EC DC EQ C q F C' n F ' $ D QY D "XT5$ !q 4Sf D F EC q DC ESF
For every set is -measurable. is random only through dependence on , has two fundamental properties: if if if
2.3.2 Denition of Conditional Expectation
where is the function dened above.
In other words,
In conclusion, we can write
Let on
Please see Williams, p.83.
The random variable
Then
Furthermore,
be a probability space, and let be a sub- -algebra of . Let be a random variable . Then is dened to be any random variable that satises:
'P j $
' A Bj"A ' A j"A
(a)
is -measurable, we dene . We also write 53
54
Existence. There is always a random variable satisfying the above properties (provided that ), i.e., conditional expectations always exist.
Notation 2.1 For random variables
, it is standard notation to write
Here are some useful ways to think about
A random experiment is performed, i.e., an element of is selected. The value of is partially but not fully revealed to us, and thus we cannot compute the exact value of . . Because this estimate Based on what we know about , we compute an estimate of depends on the partial information we have about , it depends on , i.e., is a function of , although the dependence on is often not shown explicitly. If the -algebra contains nitely many sets, there will be a smallest set in containing , which is the intersection of all sets in containing . The way is partially revealed to us is that we are told it is in , but not told which element of it is. We then dene to be the average (with respect to ) value of over this set . Thus, for all in this set , will be the same.
2.3.3 Further discussion of Partial Averaging

The partial averaging property is
( ' $ u E u
Lemma 3.10 If
is any -measurable random variable, then provided
H E $ ' j u
Note that
is a -measurable random variable. In fact the following holds:
' $ 1 E j
We can rewrite this as
'd$e8 'de8 $
' |d$
7@'|}$ 3 8'd$j8 8 lp
Uniqueness. There can be more than one random variable is another one, then almost surely, i.e.,
' |}$
A X ' $ Q"E j
Q X8 ' $ E j l"'&$P $ ' $ ' 8 j t 8 j 8

satisfying the above properties, but if
8 "A
8 3 g8
(b) For every set
, we have the partial averaging property
' $ |d"8
H
3 8
(3.1)
(3.2)
, (3.3)
55
Proof: To see this, rst use (3.2) and linearity of expectations to prove (3.3) when is a simple -measurable random variable, i.e., is of the form , where each is in and each is constant. Next consider the case that is a nonnegative -measurable random variable, can be written as the limit of an increasing sequence but is not necessarily simple. Such a of simple random variables ; we write (3.3) for each and then pass to the limit, using the Monotone Convergence Theorem (See Williams), to obtain (3.3) for . Finally, the general measurable random variable can be written as the difference of two nonnegative random-variables , and since (3.3) holds for and it must hold for as well. Williams calls this argument the standard machine (p. 56). Based on this lemma, we can replace the second condition in the denition of a conditional expectation (Section 2.3.2) by:
2.3.4 Properties of Conditional Expectation

Please see Willams p. 88. Proof sketches of some of the properties are provided below.
Proof: Just take
in the partial averaging property to be . is thus an unbiased estimator of the random variable
The conditional expectation of
Proof: The partial averaging property holds trivially when is replaced by . And since is -measurable, satises the requirement (a) of a conditional expectation as well.
(c) (Linearity)
Proof: Take . This set is in since is -measurable. Partial averaging implies . The right-hand side is greater than or equal to zero, and the left-hand side is strictly negative, unless . Therefore, .
6 ' $ `@
'P j $
X k Q P $ ' %H w' ' j $ 6 $dlE j y
6 r ' $ HP j
(d) (Positivity) If
almost surely, then
l4 q $ n ' ' $ ' $ j q IP4 ! j ! hr q q Hn ! ! 5j
If the information content of on is itself.
is sufcient to determine
, then the best estimate of
based
tP j ' $
6 Hr
6 ' $ 5
(b) If
is -measurable, then
(a)
( u ( j u ' $
(b) For every -measurable random-variable
, we have (3.4)
! i f u u
v u
l' $ ' ' $ $ j t"E j
u v u u
56 (h) (Jensens Inequality) If
Recall the usual Jensens Inequality:
is a sub- -algebra of means that contains more information than . If we estimate based on the information in , and then estimate the estimator based on the smaller amount of information in , then we get the same result as if we had estimated directly based on the information in .
((b) with
If of
is independent of and , then nothing is gained by including the information content in the estimation of .
$ ' l' j h j $
In particular, if
is independent of
(k) (Role of Independence) If
is independent of
, then
, then
d u
l'P $ ' ' A $ $ j twb5P ' A $ $ El' t5
Take -measurable).
X d d ' P $ j d G 8 5$j Q8 ' 8 8 ' $ d E j U8 A X d X8 8
(a) (b)
is -measurable;
. Then satises (a) (a product of -measurable random variables is also satises property (b), as we can check below:
Proof: Let only if
be a -measurable random variable. A random variable
is
'f Aj d$
When conditioning on , the -measurable random variable
' $ d ' y P Aj d$
(j) (Taking out what is known) If
is -measurable, then
acts like a constant.
if and
l' $j t'` P j ' $ $
(i) (Tower Property) If
is a sub- -algebra of , then
' $ $ r $ y"' j 5tfh' x '' $ $ r ' lw 5tfP ' tAj $ $ H ' $ e TXw t
is convex and
, then

ixC q X ! ' ' q $ ' "! PC5j "X q q w'Q F C n
nF nF $
$ $
! ' q 5j C$
' $ q C' n $ ' $ 'q C$ lduP"X F gtds R5j

A similar argument one time step later shows that

)lds"` P5j A ' $ '! q C$ ' $ |di' ! q 5j l ' 5 C$ $
X(' ! q 5j C$
A q QlPC
must be constant on and
QPC X"" P i q '! q C$ '! q C$ X"" P i

. Notice that
2.3.5 Examples from the Binomial Model
'! q C$ B` f5j tBB4k` A A A !
Recall that
'! q C$ B` P5j
On the other hand,
A' $ ! C' n $ ' $'! q C$ )lds4"X F tdlB P A ' $ ! C' n $ ' $ '! q C$ w)ldyx"Q F gh|diB P5j H)Slds4"X pF $ A' $! C' n D C F' EY"X n pF $ C ' $ C$ D QYF n D C q F dl' ! q GH)bEXSF n D AD C ' $ '! q C$ EC q F tdlB` P5j uDECXSF q i n D S EC q F q XlPC
This nal expression is Similarly, We can also write Therefore, We compute Now since
'! C$ " E
We leave the verication of this equality as an exercise. We can verify the Tower Property, for instance, from the previous equations we have
Thus in both cases we have
must satisfy the partial averaging property,
. (linearity) . 57
58
2.4 Martingales
The ingredients are: A probability space
A sequence of random variables
. This is called a stochastic process.
Conditions for a martingale: is -measurable. If you know the information in , then you know the value of 1. Each . We say that the process is adapted to the ltration .
Example 2.3 (Example from the binomial model.) For
we already showed that
For , we set , the trivial -algebra. This -algebra contains no information, and any -measurable random variable must be constant (nonrandom). Therefore, by denition, is that constant which satises the averaging property
The right hand side is
, and so we have
In conclusion,
If If If
then then then
is a martingale. is a submartingale. is a supermartingale.
' bG ! v Aj $
A supermartingale tends to go down, i.e. the second condition above is replaced by ; a submartingale tends to go up, i.e. .
y z
2. For each ,
. Martingales tend to go neither up nor down.
q q q ! q D wGis`xG
A sequence of -algebras , with the property that . Such a sequence of -algebras is called a ltration.
i
k z
kG y U z SU@
G y z G z
r $ f' ! v Aj
WASsisl!TbD A A p")isss!`wAbG A A D ' A B`"A $

.
z h e y U
S%SU% W y S%SU% W y S%SU% Wy
' qtuG ! v Aj $
Gw Gw fiGw
h h h

Chapter 3
Arbitrage Pricing
3.1 Binomial Pricing
Return to the binomial pricing model Please see:
Example 3.1 (Pricing a Call Option) Suppose (interest rate), . (In this and all examples, the interest rate quoted is per unit time, and the stock prices are indexed by the same time periods). We know that
Find the value at time zero of a call option to buy one share of stock at time 1 for $50 (i.e. the strike price is $50). The value of the call at time 1 is
Suppose the option sells for $20 at time 0. Let us construct a portfolio: 1. Sell 3 options for $20 each. Cash outlay is
2. Buy 2 shares of stock for $50 each. Cash outlay is $100. 3. Borrow $40. Cash outlay is
59
V h V
if if
if if
W S%
C i
C G U
Cox, Ross and Rubinstein, J. Financial Economics, 7(1979), 229263, and Cox and Rubinstein (1985), Options Markets, Prentice-Hall.
60
This portfolio thus requires no initial investment. For this portfolio, the cash outlay at time 1 is: Pay off option Sell stock Pay off debt
The arbitrage pricing theory (APT) value of the option at time 0 is
Assumptions underlying APT:
Unlimited short selling of stock.
Unlimited borrowing.
No transaction costs.
Agent is a small investor, i.e., his/her trading does not move the market.
3.2 General one-step APT

Suppose a derivative security pays off the amount at time 1, where is an -measurable random variable. (This measurability condition is important; this is why it does not make sense to use some stock unrelated to the derivative security in valuing it, at least in the straightforward method described below).
regardless of whether the stock goes up or down.
We want to choose
and
so that
GGib@uVAVbQS UiyQAU@U
Then wealth at time 1 is
iGC
Invest negative).
iu
Buy
shares of stock at time 0. (
in the money market, at risk-free interest rate . (
Sell the security for
at time 0. (
is to be determined later). is also to be determined later) might be
Important Observation: The APT value of the option does not depend on the probabilities of and .
V Q
ww U%Q h
CHAPTER 3. Arbitrage Pricing
61
The last condition above can be expressed by two equations (which is fortunate since there are two unknowns):
Note that this is where we use the fact that the derivative security value is a function of , is known for a given , is known (and therefore non-random) at that as well. i.e., when Subtracting the second equation above from the rst gives (2.3)
3.3 Risk-Neutral Probability Measure

! % $# "
Let be the set of possible outcomes from by the formula

!
coin tosses. Construct a probability measure

B E 8 7 5 4 2 0 B @ 8 7 5 4 2 0 FA9) 63D CA9) 631
% $#
G #$
is called the risk-neutral probability measure. We denote by tion 2.4 says
the expectation under
Then and . Since , we have and . Thus, probabilities. We will return to this later. Thus the price of the call at time 0 is given by

@Q
We have already assumed . We now also assume be an arbitrage opportunity). Dene

G @ iA f Q bUyAAuAb b bh iyA U A GibQfAUAAk

W iA @ V

P f c I
( & ') UU ' % $#
G $#
Q

Plug the formula (2.3) for
into (2.1):
(otherwise there would
are like
(2.4)
on
. Equa-
Ak GibQSfAkx3@bfVS k GibQSfUAVbQS yA yAU i bQS

(2.1) (2.2)

% $#
s W X W V q b R fVSuQ6 Y6 FR kcSr@Q R kcS 6 ed c6fVS W X W V R

Proof: We have Proof: Theorem 3.12 Under is a martingale.
8 ( T Sk@VSQ R
% #$
W G bfVSC d x QS W Uh' UQdU

, which need not be 0.
W 6
UU A
% R fVS V SU ed cR fVS X W V gf ed cR fVS X W V I h`@ @ ed cR fVS X W V b H ed cR fVS X W V ` W X W V a6 Y6 FR kVS

b
8 ( U Sk%SQ T R
The portfolio process is
3.3.1 Portfolio Process
Theorem 3.11 Under
62
is the number of shares of stock held between times
, the discounted stock price process
, where
and
Ci
3.3.2 Self-nancing Value of a Portfolio Process
( h
G #$
% $#
Each

is
Then each
Dene recursively
Start with nonrandom initial wealth
is
-measurable. (No insider trading).
, the discounted self-nancing portfolio process value -measurable. .
is a martingale.
(3.2) (3.1)

Therefore,
G $#
63
3.4 Simple European Derivative Securities

Denition 3.1 () A simple European derivative security with expiration time is an -measurable random variable . (Here, is less than or equal to , the number of periods/coin-tosses in the model).
w A w h
Proof: We rst observe that if martingale property

i
is a martingale, i.e., satises the
for each
, then we also have
When , the equation (4.2) follows directly from the martingale property. For we use the tower property to write
& R w
w A
Theorem 4.13 (Corollary to Theorem 3.12) If a simple European security , the APT value at time of is for each
%v G
h 6 D6y G #$ ` W Tv G i d hDQ WS wA w R QS G $# Q i ` i
9 `
&
w hD `
%&
G #$
i
G #$
G #$
h 6 ` w
&
v
G #$
v G
G #$
v
GU
v
In this case, for
, we call
the APT value at time
! w
w h
U A
Denition 3.2 () A simple European derivative security a constant and a portfolio process given by (3.2) satises process
x y
is said to be hedgeable if there exists such that the self-nancing value
of
. is hedgeable, then (4.1)
"
R QS R fcS S D6 ` W V cR fVS G $# X W ed R QS S t ` #$ R @ G u S D6 ` W #$ V cR @ G r X W e6 S t ` R VS G #$ ` X W V DdW e6 cR VS

(Theorem 3.11)
(requirement (b) of conditional exp.) (taking out what is known) (property (b))
Q w `
U
UU
w A
(4.2) ,
64 We can continue by induction to obtain (4.2).
If the simple European security is hedgeable, then there is a portfolio process whose selfnancing value process satises . By denition, is the APT value at time of . Theorem 3.12 says that
is a martingale, and so for each ,
Therefore,
3.5 The Binomial Model is Complete

Can a simple European derivative security always be hedged? It depends on the model. If the answer is yes, the model is said to be complete. If the answer is no, the model is called incomplete.
w A
Starting with initial wealth is the process
Proof: Let and be dened by (5.1) and (5.2). Set and dene the self-nancing value of the portfolio process by the recursive formula 3.2:
We need to show that
We proceed by induction. For , (5.3) holds by denition of some value of , i.e., for each xed , we have
U UU Q%i U UU Q U UU Q i i v GU Di T Q x W GUk' UfVSrd 6 W R h U w R w U R w UU w A U R h U w R fVS G $# w w W UU 6 W V U Q3d UU c3d UV U Q U 6 W W
, the self-nancing value of the portfolio process
. Assume that (5.3) holds for
` w UV U Q6 A
Theorem 5.14 The binomial model is complete. In particular, let tive security, and set
w R 6
` w Wx A w R @ G #$ fVS Sb `wA w R6fVS G #$ 6 w w 6QS G $# 6QS ` R R i VS U R @S

w w R
be a simple European deriva-
w 1
VS G #$ QS U Qi
U
w A
(5.1)
(5.2)
(5.3)
W GAkdi kdi iAk6 bk6iyAkdi W W W W kdi iAkWdi I W W W y H bk6iyAkdi W k6i Ak6i W bQSf kikdi d A W W W 6 A 6 W W Gb@uAkdx 3dAk6i W kWW6iAkW6 ibfVSrGb@uAkWd' U@iA Wd W Akd W W i5kdi iAkdi Q
Since will be xed for the rest of the proof, we simplify notation by suppressing these symbols. For example, we write the last equation as
G U Q b U Qkdi i V U Qk6i @ Q W W W U U QS `Ddi R VS G #$ U Qi 8 ( a 6QSQ T R

6
i R kcS S A ` w R 6 G #$ w ` W ` w R 9P6 1 w 6VS G #$ G #$
` W X W V R D6i e6 c6VS
G #$
G UU QUdi U Qk6 W W W W UU QUdi V U Qk6
We need to show that
In other words,
We prove the rst equality; the second can be shown similarly. Note rst that
is a martingale under
% $#
We compute
. In particular,
65
66
v z o o
w vx
w u
C0 { xu } x u0 { u0 } { } U u0 } o n ~ o d c | {
{ |
t u t vt s r p o bhq
%fv G %@
Recall that is the given simple European derivative security, and the value and portfolio processes are given by:
4.1 Binomial Model Pricing and Hedging
Example 4.1 (Lookback Option) Consider a simple European derivative security with expiration 2, with payoff given by (See Fig. 4.1):
j i V 6 0m kkhlf d n j ig e i GU v
W 0f S% U Qk6y V U Q3d U U Q W W UU QUdiy V U Qk6i W W ` w R i 6 h1 w SkVS G $# QS i

w
Notice that
V x Q x o o y w o o
Using these values, we can now compute:
The payoff is thus path dependent. Working backward in time, we have:
The Markov Property
Chapter 4
67
oo a

a e o o vd S o W"
{ { U G U e G b |e1 { { g z 5 |eA G G { { h v0h G b |h~ G G

V Q z V o Q oo
o
Example 4.2 (European Call) Let with expiration time 2 and payoff function
Note that
hG { o ~ G o } G { h o o ~ o o } o e u h U o { o } x o { o } { o cU o } x V o g Q o o U o
Dene etc.
u 6
Working forward in time, we can check that
68
to be the value of the call at time

S =4 0
Figure 4.1: Stock price underlying the lookback option.
S (H) = 8 1
S1 (T) = 2
when
. Then
S2 (TT) = 1
S2 (TH) = 4
S2 (HT) = 4
S2 (HH) = 16
, and consider a European call
CHAPTER 4. The Markov Property

In particular,
U o { o } VG z o { o } { o F o } U z o z 8 o U Ue o
69
4.2 Computational Issues

i !
For a model with periods (coin tosses), equations of the form

"
has
elements. For period , we must solve
For example, a three-month option has 66 trading days. If each day is taken to be one period, then and . There are three possible ways to deal with this problem: 1. Simulation. We have, for example, that
( 1 f vyhPU
and so we could compute by simulation. More specically, we could simulate coin tosses under the risk-neutral probability measure. We could store the . We could repeat this several times and take the average value of as an value of approximation to . 2. Approximate a many-period model by a continuous-time model. Then we can use calculus and partial differential equations. Well get to that.
" ( A
& & & & GF Gc wxc xkc
3. Look for Markov structure. Example 4.2 has this. In period 2, the option in Example 4.2 has three possible values , rather than four possible values If there were 66 periods, then in period 66 there would be 67 possible stock price values (since the nal price depends only on the number of up-ticks of the stock price i.e., heads so far) and hence only 67 possible option values, rather than .
f hh P
W W V U Qk6i UU QUdi Q U UU Q W
hG St GSu u e u e
{G $# ( R kcS
& & & USD D %D
( AG $# ( ` A ( U Q
Let
be the number of shares in the hedging portfolio at time
when
. Then
"
70
4.3 Markov Processes

Technical condition always present: We consider only functions on I and subsets of I which are R R Borel-measurable, i.e., we only consider subsets of I that are in and functions R such that is a function .
4.3.1 Different ways to write the Markov property
(If we x and dene , then the equations in (b) and (c) are the same. However in (b) we have a condition which holds for every function , and in (c) we assume this condition only for functions of the form . A main result in the theory of Laplace transforms is that if the equation holds for every of this special form, then it holds for every , i.e., (c) implies (b).)
~` b G $ `
` 3P
` b `
where .)
. (Since
we dont need to assume that
` 6 W
(d) (Agreement of characteristic functions) For every

v ` d W
, we have
hG $
W 6 A6
bG $
G $
(c) (Agreement of Laplace transforms.) For every
for which
, we have
m $ $
e w
(b) (Agreement of expectations of all functions). For every (Borel-measurable) function for which , we have
W d
W S `hd % $ ` W 6 Q6$ G $ b W6 ` Q6$ G $ $
W v6 ` W
G$
` W U h6 % $
` W Sx 6
S 16 W
(a) (Agreement of distributions). For every
, we have
W d
(The Markov Property). For each on is the same as the distribution of

i
, the distribution of conditioned on .
aQ T
W d f" G
ckbY`
G $
G $
G$
T U
hv `
The stochastic process
is adapted to the ltration
, and
conditioned
Denition 4.1 () Let be a probability space. Let be a ltration under be a stochastic process on . This process is said to be Markov if:
f h $ $
8 ( aUQ T
!
P
W ` 6 G $
xC
!
8 ( a T
R c
. Let
appears, we could just as Remark 4.1 In every case of the Markov properties where well write for some function . For example, form (a) of the Markov property can be restated as:

where is a function that depends on the set . Conditions (a)-(d) are equivalent. The Markov property as stated in (a)-(d) involves the process at a current time and one future time . Conditions (a)-(d) are also equivalent to conditions involving the process at time and multiple future times. We write these apparently stronger but actually equivalent conditions below. Consequences of the Markov property. Let be a positive integer.
$ 4 d W W 6 W W U d 6 U d $ W
(B) For every function
for which
, we have
Remark. All these Markov properties have analogues for vector-valued processes.
Once again, every expression of the form can also be written as function depends on the random variable represented by in this expression.
Y X 7
7 Y hY W |W
hY V
` dUSfG $
G$
S ` X 7 e
u 4 d $ W
7 Y hY hY V W |W
G$
(D) For every
we have
mh`
WS
7 Y 7 Y
7 e
7 Y hY hY W |W
` hY)fhY G $
G$
S `
7 Y 7 Y W W hY
u 4 d $ W
U 6 W
hY
G$
(C) For every
for which
WS
S 4 6 U 6 G $ Sx 4 6 U d G $ ` W W ` W W h ` 4 6 UU 6 G $ m t W W ` $ $ e 4 W U 6 % $ S 4 6 UU 6 ` W W
` h 4 6 W
W W
U 6 W
(A) For every
, we have
, where the
W6
` 4 6 W
4 6 W
W W U 66
(A) For every

%$
,
%$
` W G d % $
W S ` 4 6
ri
For every
, we have
dU `

G$
71
%$
72
6$ c
Since both and
Example 4.3 It is intuitively clear that the stock price process in the binomial model is a Markov process. We will formally prove this later. If we want to estimate the distribution of based on the information in , the only relevant piece of information is the value of . For example,
is a function of . Note however that form (b) of the Markov property is stronger then (3.2); the Markov property requires that for any function ,
u
Consider a model with 66 periods and a simple European derivative security whose payoff at time 66 is
w Ya
is a function of
. Equation (3.2) is the case of
are equal to the RHS of (3.1)), they are equal to each other, and this is property (A) with
G Q
Now take conditional expectation on both sides of the above equation, conditioned on use the tower property on the left, to obtain
` W W W S W6 G6 d
6 S6 ` W W W G6 d $ G $ & W 9Yd ` W ` & W F6 cd $ G $G6 d $ G $ W W cd 9 6 F6 ` W ` & W & W $ G $G 6 d $ G $ W W c6 W b `96x Gcd W ` & W & W 6 d $ G $ G $ $ W c6 d `v F6 & W P 6 W $ G $ $ W & W `&W &W W W tcd cd d 6
(Denition of conditional probability) (Tower property) (Taking out what is known) (Markov property, form (a).) (Remark 4.1) (Markov property, form (b).)
e bu
|e u n {
`&W x hF6
` & W F6
S6 G6 d ` W W W
& W F6
& W F6
u
G$
eu bh }
W 6
W 6
` & W cd
d W
6 W
bu
& W cd
bu e
%$
%$
G$
W d
d W
Proof that (b) Consider
(A). (with
in (A)) Assume (b). Then (a) also holds (take
%$
u h
).
, and (3.1)
%$ u
(3.2)

The value of this security at time 50 is
9
73
because the stock price process is Markov. (We are using form (B) of the Markov property here). In other words, the -measurable random variable can be written as
e 6d 66
for some function , which we can determine with a bit of work.
4.4 Showing that a process is Markov

The following lemma will be very useful in showing that a process is Markov:
Lemma 4.15 (Independence Lemma) Let and . Let be a sub- -algebra of . Assume
be random variables on a probability space
Note that
and
are not independent (unless . If we take , but

o d
or
). For example, one of the sets in from and from

d
is , then
m d d td { d b hd n n
d d td n
d r o S o o
Then and from , then
are independent. For example, if we take and
from
and
Q C
d o Gm V G Q G
e e
!
Let
be the -algebra of sets determined by the second toss, i.e.,
contains the four sets
c F
i V Q) Gf
Example 4.4 Consider the two-period binomial model. Recall that by the rst toss, i.e., contains the four sets
is the -algebra of sets determined
We say that a random variable by , is independent of .
is independent of a -algebra
if
, the -algebra generated
Denition 4.2 (Independence) Let be a probability space, and let algebras of . We say that and are independent if for every and
Ya
$ G% P % $ f% $
Y } i |e { |e } |e { {
i
P
!
and be sub- , we have
is -measurable.
Then
G$
Remark. In this lemma and the following discussion, capital letters denote random variables and lower case letters denote nonrandom variables.
Example 4.5 (Showing the stock price process is Markov) Consider an -period binomial model. Fix a
uhy e fQbu @ u
be any function and set
. Then
The Independence Lemma asserts that

}
Not only have we shown that the stock price process is Markov, but we have also obtained a formula for as a function of . This is a special case of Remark 4.1.
u
4.5 Application to Exotic Options

Consider an -period binomial model. Dene the running maximum of the stock price to be
"
Examples:
( ( cA
( v
"
Consider a simple European derivative security with payoff at time
4 4 a h
bu
e bu
bu
e bu
6u
e bSu
Thus
}
and
are equal and form (b) of the Markov property is proved.
of
u h
This shows the stock price is Markov. Indeed, if we condition both sides of the above equation on use the tower property on the left and the fact that the right hand side is -measurable, we obtain
u h
and
depends only on the
st toss,
uh u { n A h d 6 } u h } 6u I u e bu H
{ 1
{ ~ u
6u dbu e
bu
e bbu
time
and dene
and
. Then
if
and
is independent of . Dene
, so that
bu e
G c ` VhG $
d
Y z e { u h e bu
d
Let
be a function of two variables, and dene
74
is independent of ;
if
. Since
is -measurable. Let

R ( R (
( ( v

G $#
( c ` ( (
@ @
( A
( ( ( ( 3 cA A %" G i
% $# i S
` W 6i
is Markov. (Here we are working under Lemma 5.16 The two-dimensional process the risk-neutral measure I , although that does not matter). P
the second equality being a consequence of the fact that . Since the RHS is a function of , we have proved the Markov property (form (b)) for this two-dimensional process.
ib G5
d

ib1 6 A d d bA d AG $#
d d G5U Ayy A W 6fh 6A dh 6A W W W 6 d d A% $# A% $# W 6 d W 6fy dh W

8 ( 6Uh AQ T
Stepping back one step, we can compute

G #$
Continuing with the exotic option of the previous Lemma... Let denote the value of the derivative security at time . Since is a martingale under , we have
Q i R fVS
` W A 6
d
cA$ g cAi ( ( ( ( W ( ( ( ( g g cAi

W
At the nal time, we have

i
Gh A
W 6 A
G $#
The Independence Lemma implies

Dene Proof: Fix . We have
i
where
and
is independent of
indicates the maximum of two quantities. Let
. Let
(Lookback option);
be a function of two variables. We have (Knock-in Barrier option). , so 75
b W W y 36kgUhU %6
and the value of the option at time is . Since this is a simple European option, the hedging portfolio is given by the usual formula, which in this case is
t
d
y x i W W k6 A A36 f c
R (
d
( c
A3
R
( A
6
6
( v

i 1 A
( v

fV
%
R
( v
The general algorithm is so that This leads us to dene 76
Chapter 5
Stopping Times and American Options

5.1 American Pricing
Let us rst review the European pricing formula in a Markov model. Consider the Binomial model with periods. Let be the payoff of a derivative security. Dene by backward recursion:
Now consider an American option. Again a function is specied. In any period , the holder of the derivative security can exercise and receive payment . Thus, the hedging portfolio should create a wealth process which satises almost surely. , and the wealth process
i
American algorithm.
UA
Then
is the value of the option at time .
W W b 36 1k6 f Q
77
GA
This is because the value of the derivative security at time is at least value at that time must equal the value of the derivative security.
i
%@" GU
GA
b 6 zV 6 W W
i Y x
GA
( i
Then
is the value of the option at time , and the hedging portfolio is given by
W k6 iA36k Q W W
( cA A (
( i
"

v w
w 'c hc w & { b c w e { c b |e| { { e w V 'c h{ w & b c w e { c 5 { { |e e
{ o
vd S o W" Q
Example 5.1 See Fig. 5.1. Then
Let us now construct the hedging portfolio for this option. Begin with initial wealth as follows:
e
78
Figure 5.1: Stock price and nal value of an American put option with strike price 5.
S =4 0
S (H) = 8 1
S (T) = 2 1
S2 (TT) = 1
S2 (TH) = 4
S2 (HT) = 4
S2 (HH) = 16 v2 (16) = 0
v (4) = 1 2
v (1) = 4 2
. Set
. Compute .
w bhp w sr ! #% w { " s r o t o Qbhp 8 v w G
Uw s r bhp ! % s r # o {| o bhp e sr bhp ! " s r o Qbhp
U $ o #
A v 6 A 6 c G $# ` W W

` W W X W V Ux R kcS6 v6Ak6 e6 cR QS5G $#

When do you consume? If The value process is the smallest process with these properties.
G
i
(0fVSCUbQfQ6Ac QS W ( W ) kcSd
W 6
w x
& { 'c0 ~ 0 & { '' A 0 & { '' w 1 e w { 1 e i 5 { { A V o e w & { 'Q w A 0 o w ~ { U i G b { { |1 Q 8 o o z z e x
CHAPTER 5. Stopping Times and American Options
Using
Here,
5.2 Value of Portfolio Hedging an American Option
We get different answers for
Now let us compute
The value satises
"
i
GA
or, equivalently,
The discounted value of the portfolio is a supermartingale.
is the amount consumed at time .
results in
(Recall that
! If we had
):
, the value of the European put, we would have
. 79
80 and the holder of the American option does not exercise, then the seller of the option can consume to close the gap. By doing this, he can ensure that for all , where is the value dened by the American algorithm in Section 5.1.
In the previous example,
and
. Therefore,
so there is a gap of size 1. If the owner of the option does not exercise it at time one in the state , then the seller can consume 1 at time 1. Thereafter, he uses the usual hedging portfolio
In the example, we have to exercise whenever its value
Denition 5.1 (Stopping Time) Let tion. A stopping time is a random variable
Example 5.2 Consider the binomial model with , so be the value functions dened for the American put with strike price 5. Dene
D e u u h h u 6Y~bt
The stopping time corresponds to stopping the rst time the value of the option agrees with its intrinsic value. It is an optimal exercise time. We note that

We verify that
is indeed a stopping time:
Example 5.3 (A random time which is not a stopping time) In the same binomial model as in the previous example, dene
o n d S o S% " f C " GU i 3 fhAi Q6Q T 4 ! x TmD5" GG Dmuf4 Q T Q ! e 8 ( TaQ P ! x A bGA bUAk" b W W U k6kxU36k
. It is optimal for the owner of the American option agrees with its intrinsic value . be a probability space and let be a ltrawith the property that:
if if
1 b A 3 & 3 ` & & fV V8 & 3 Y G|AU G #$ & & & & 1 b%AkU b|AU 2 bxk% D 8 p o E %u W~bA@ C
o
A B
B) B )
az
A@9 7 8
. Let

where . In other words, random variable is given by
81
if if if
5.3 Information up to a Stopping Time
Example 5.4 In the binomial model considered earlier, let
The atoms of
are
Notation 5.1 (Value of Stochastic Process at a Stopping Time) If is a probability space, is a ltration under , is a stochastic process adapted to this ltration, and is a stopping time with respect to the same ltration, then is an -measurable random variable whose value at is given by
!
DV Qf G yB QfQ 7 Q
but
B B
G` X V R '`R R 8 ( U T
The set
is determined by time , but the set
is not. Indeed,
if if
i.e.,
R "
8 p e ku ku %u Y~bA@ 7
B) B )
7 7 Ux 7 Q 7
The collection of sets determined by
is a -algebra, which we denote by
x T 4 Q ii Y fAi Gx
! m
Denition 5.2 Let that
be a stopping time. We say that a set
B V o yB Q
y B
Ux
We verify that is not a stopping time:
V Q) B
is determined by time provided
H I V

PQ
F G A@ D F 8
t t b
p
stops when the stock price reaches its minimum value. This
8 ( UUQ T
i h q S eS i h p S
H
I o
c H g
V o
I o
G { o 0 o { H o A Q o I H o o
e o S
o o I
o
I o I o
e S c e c S
o H o I o H o I
c eS d
o H u
B )
` D
G$
R `X G` YfG $
R W
"
"
"
8 ( ax iQ T
(or Theorem 3.17 (Optional Sampling) Suppose that gale. Let and be bounded stopping times, i.e., there is a nonrandom number
8 Ux T T
If
Taking expectations, we obtain is a supermartingale, then implies If is a martingale, then
82
almost surely, then
, and in particular, . implies
almost surely.
) is a submartinsuch that
. If
8 GT T
G$
G$
C %" X f W R R V 4 X %R f ba R V 4 X R

` G $ G$ G$
Example 5.5 In the example 5.4 considered earlier, we dene probability measure, the discounted stock price process
for all . Under the risk-neutral is a martingale. We compute
hi u
In every case we have gotten (see Fig. 5.2)

I
H c
,

B f
G G
8 T U T
V 4
and for
Q
The atoms of
are
and
. Therefore,
83
(16/25) S (HH) = 10.24 2
(4/5) S (H) = 6.40 1 (16/25) S2 (HT) = 2.56 S =4 0 (16/25) S2 (TH) = 2.56 (4/5) S (T) = 1.60 1
(16/25) S2 (TT) = 0.64
Figure 5.2: Illustrating the optional sampling theorem.
84
Chapter 6
Properties of American Derivative Securities

6.1 The properties
Denition 6.1 An American derivative security is a sequence of non-negative random variables such that each is -measurable. The owner of an American derivative security can exercise at any time , and if he does, he receives the payment .
i
(b) The discounted value process
is the smallest supermartingale which satises
almost surely.
is an optimal exercise time. In particular

is an optimal exercise time. (d) The hedging portfolio is given by
85
%" U
i
U Q36 U Q%6 W W U d U 6 U Q W W
T U
R 9r R fVS
r icDA iQ
G #$
f4
(c) Any stopping time
which satises
t4
where the maximum is over all stopping times
satisfying
6
` R R 1r R 6QS G $# Q U i R
i 9 ui x r 8 ( a R fVSQ T
(a) The value
of the security at time
is
8 ( UsQ T r
almost surely.
"
U GU
i
ifì r u`
8 ( i 6VSQ T R
Q
"
i
8 ( a T
%i R k@VS E GR w S kr ` R R R VS G $# a ` y R r R y R 6fVS G $# ` W R R 9Yd ` y r y R 6VS G #$ G $#
W R y VPd ` y r GR R QSAG #$ 6 ed cR QS W X W V W di

is a supermartingale. , i.e.,
8 ( T SkcSQ R
i i
G #$ E
` R r R 6QS R xr
"
w GR @ 4
8 ( UxvQ T r
W ` 6 G $# f V V xr Qi
. Then the owner of the derivative security (e) Suppose for some and , we have should exercise it. If he does not, then the seller of the security can immediately consume
Let Dene
6.2 Proofs of the Properties
86
and still maintain the hedge.
be a sequence of non-negative random variables such that each is -measurable. to be the set of all stopping times satisfying almost surely. Dene also
Lemma 2.18
r ui
Proof: Take
f4
Proof: Let
x '4
Because
Lemma 2.19 The process
is also in
` W 6i eW6 VcR6@ X
G $#
x '4
and
Lemma 2.20 If
attain the maximum in the denition of
to be the constant .
is a supermartingale, then for every . , we have is another process satisfying a.s.,
a.s.
b U d U 6 @ V W W ` W G U QS D6i G $# @ V U )V U (
We prove the rst equality; the proof of the second is similar. Note rst that
W W G UU QUdi U Qk6 W U 6 W UU d UU UU G UU c T U" UG Ui Q i i ii x i ( W GU' UQSVd 6 W W UU c 36 W V U Q3d UU ckdi UV U Q W U Q k6i W 8 ( Ui R k@VSQ ( T 6i eW6 VcR fVS G $#i R QS q QS ` W X ` W x D6i G #$ @ Q i

(
Lemma 2.21 Dene
% kVS

kVS kVS
k@VS E GR w b 1W ` R R R VS G #$ a w ` R G ~r R R VS G #$ aE R

i
G $#
`R 1W R R Q
x "f4 Y R k@VS 8 ( i 6QSQ T R
We need to show that Proof: Then Set Since Therefore,
Proof: The optional sampling theorem for the supermartingale
CHAPTER 6. Properties of American Derivative Securities
We proceed by induction on . The induction hypothesis is that , i.e., for each xed we have and dene recursively is a supermartingale,
must be non-negative almost surely. Dene
implies
for some 87
88 will be xed for the rest of the proof, we will suppress these symbols. For Since example, the last equation can be written simply as
We compute
6.3 Compound European Derivative Securities

In order to derive the optimal stopping time for an American derivative security, it will be useful to study compound European derivative securities, which are also interesting in their own right. different simple European derivative A compound European derivative security consists of securities (with the same underlying stock) expiring at times ; the security that expires at time has payoff . Thus a compound European derivative security is specied by the process , where each is -measurable, i.e., the process is adapted to the ltration . Hedging a short position (one payment). Here is how we can hedge a short position in the th European derivative security. The value of European derivative security at time is given by
i "
and the hedging portfolio for that security is given by
Thus, starting with wealth time we have wealth .

4
, and using the portfolio
, we can ensure that at
Hedging a short position (all payments). Superpose the hedges for the individual payments. In other words, start with wealth . At each time , rst make the payment and then use the portfolio
T U
% UU
W GAk6 k6 AUdi 5kdiAkdiA W W W W W W k6i iAkdi W W GbfVSC kdi5yA k6 ( U)'iAk@QS W W kW6iAkWd UbQSfAkdx kdA%6i W ( W kU' UQSiAkd Ak6 W W W 5kdi iAkdi Q ) ( " G

X R 4 V 4 U X 4 V A V X 4 U Q X 6V4W V U Q X 6V4W i X X U c 4 dVW V U Q 4 6VW U Q X 4 V
U
GU
X U(
8 4 T 4
Q Di
fUUC
( v
6
"
` 4 ( 4 R fVS G $# Q X 4 V
X & W Pcd
X W V f Y6 V
X 4
8 4 (
G UU Q (
UQ
8 U T ( 8 4 T 4 (
( s
Q
CHAPTER 6. Properties of American Derivative Securities

( C
89 , we
and the hedging portfolio is . You can borrow and consume it immediately. This leaves you with wealth . In each period , receive the payment and then use the portfolio . At the nal time , after receiving the last payment , your wealth will reach zero, i.e., you will no longer have a debt.
6.4 Optimal Exercise of American Derivative Security

In this section we derive the optimal exercise time for the owner of an American derivative security. be an American derivative security. Let be the stopping time the owner plans to Let use. (We assume that each is non-negative, so we may assume without loss of generality that the owner stops at expiration time if not before). Using the stopping time , in period the owner will receive the payment In other words, once he chooses a stopping time, the owner has effectively converted the American derivative security into a compound European derivative security, whose value is
The owner of the American derivative security can borrow this amount of money immediately, if he chooses, and invest in the market so as to exaclty pay off his debt as the payments are
Lemma 4.22
is maximized by the stopping time
Proof: Recall the denition
| `
Gupy sGGw vUGw ~ s Gb } sw | Gbt w k w
received. Thus, his optimal behavior is to use a stopping time
which maximizes
pe} am ip l sj sw
f ge
$ ( fVS
4 4 R
Guq0 { vw k w ~ s Gpy am p pk xyp m 0wuvs ~s p i Gpypam p ~ s sw } | i
l k dj { Gf 2 f 6G`t'n
$pe p
( s
Q
Suppose you own a compound European derivative security

( X 4 (
. Compute
corresponding to all future payments. At the nal time , after making the nal payment will have exactly zero wealth.
8 4 T 4 ( "
i e
{p x us p Uzk yp m 0wvtrqe
8 4
G #$
8 T R ( akQ "
8 4
f k
a
"
} | sw
m l k a6fi Gf vj
f h
f k f m l afi Gf f Guy j
, the
It follows that also attains the maximum in (4.1), and is therefore an optimal exercise time for the American derivative security.
Gu0 Gu0 { t w k sw ~ s w k w ~ s
# # #
Gu0 { w w k w ~ s Gu0 w w sw Gu py~ s Gu0 w k Gw w Gw Gf 2 f 6G`t n l k dj

a.s.
"
w 2 w k
#
Gq0 sGGw vw k w ~ s bt
attains the maximum in the formula
# # #
w w w { A w k sw Gpy
{ Gu0 Ga k w ~s Gu0 sw ~s Gu0 w ~s } sw |
Let be a stopping time which maximizes , i.e., Because is a supermartingale, we have from the optional sampling theorem and the inequality following:
~ s
#
Therefore,
qA w k w
Gpy
~ s w w
#
w k2 w Gq0
~s
#
But we have dened
We have just shown that if
Taking expectations on both sides, we obtain and so we must have
Y n n
then
and
90
almost surely. The optional sampling theorem implies a.s. (4.1)
{ ~ s ~ s Gb ~ s
This implies
is linear
W W G b
is linear
Jensens Inequality
Chapter 7
7.1 Jensens Inequality for Conditional Expectations
Lemma 1.23 If
{ 9~ s 9~ s a W j l Gd { ~ s ~ s v ~ s h s se
is convex and :
Proof: Since
Now let
For instance, if
is convex we can express it as follows (See Fig. 7.1):
lie below . Then,
u ~ s s u ~ ~ s ~ s
91
u9
W%
, then
92
Figure 7.1: Expressing a convex function as a max over linear functions.
Proof:
7.2 Optimal Exercise of an American Call

This follows from Jensens inequality. Corollary 2.25 Given a convex function where . For instance, is the payoff function for an American call. Assume that . Consider the American derivative security with payoff in period . The value of this security is the same as the value of the simple European derivative security with nal payoff , i.e.,
Proof: Because
is convex, for all
we have (see Fig. 7.2):
"
bn
where the LHS is the European value and the RHS is the American value. In particular optimal exercise time.
is an
% Uq0 w w ~ s Gt i w % i
{ f f f ~ s f 6f ~ s a ytYa { { 0t W { d 6 rC s e
#
Theorem 1.24 If
is a martingale and
is convex then
m a6fi l f Uj
Guy
~ s
m l a6fi f sj
#
is a submartingale.
Therefore,
and this last expression is the value of the European derivative security. Of course, the LHS cannot be strictly less than the RHS above, since stopping at time is always allowed, and we conclude that
# # #
f f f
Gu0 Gq0 { i i 2~ s w w w ~ s Gb Gu0 Gq0 i i 2~ s w w w ~ s Gb Gq0 { i G q0 ~ s Uu0 i ~ s g~ s w w ~ s vw i i Gq0 Gpy { vw i i ~ s w w m a6fi l f f Uuq0 j Gq0 n f f p Gq0 6f ~ s t f p Gq0 6f ~ s f % u Gq0 % Gu0 6f ~ s f f 6f } 6f | ~s % u 6f $f
# # # P # # #
So is a submartingale. Let optional sampling theorem implies
and
CHAPTER 7. Jensens Inequality
( x, g( x))
( x, g(x))
Figure 7.2: Proof of Cor. 2.25
be a stopping time satisfying
"
Therefore, the value of the American derivative security is Taking expectations, we obtain
(x,g(x))
. The 93
94
S2 (HH) = 16
S (H) = 8 1 S2 (HT) = 4 S =4 0 S1 (T) = 2 S2 (TH) = 4
S2 (TT) = 1
Figure 7.3: A three period binomial model.
7.3 Stopped Martingales
Example 7.1 (Stopped Process) Figure 7.3 shows our familiar 3-period binomial example. Dene if if
Then
Theorem 3.26 A stopped martingale (or submartingale, or supermartingale) is still a martingale (or submartingale, or supermartingale respectively).
l vv{ U {{ j
Proof: Let The set
{ w 6f f x f G0wu s w x f G0wu s f 6f~ s x f Gw0u s w x f G0wu s u u f f x 6f G0wvs w x f G0wv s ~ s f w } f | ~ s t Ul Uj gl nUj f n f l Uj n m l afi f sj
be a martingale, and is in , so the set
qq Ip p pE ` G0' bE bb bp 2YqA' qp { {{ vs{ bd } | w f

if if if if
be a stopping time. Choose some is also in . We compute
Let be a stochastic process and let stopped process
be a stopping time. We denote by
m afi l w f sj
m l a6fi Gf vj
the
CHAPTER 7. Jensens Inequality
95
96
Chapter 8
Random Walks
8.1 First Passage Time
Toss a coin innitely many times. Then the sample space is the set of all innite sequences of and . Assume the tosses are independent, and on each toss, the probability of is , as is the probability of . Dene
The process Brownian motion. Dene
is a symmetric random walk (see Fig. 8.1) Its analogue in continuous time is
If never gets to 1 (e.g., ), then . The random variable is called the rst passage time to 1. It is the rst time the number of heads exceeds by one the number of tails.
It is shown in a Homework Problem that

( & ( & f (& f 120 f ( & )'%#! f ( & $ " m l af vf j af Gf j m l
8.2
is almost surely nite

and where
97
m { s{v{ ' ' p f p f ' p
p p
if if
{{{ svf n { l f U` n j
ml Wff j
{{ vs{ f
98
Mk k
e e + 2 1
Figure 8.2: Illustrating two functions of

for every xed (See Fig. 8.2 for an illustration of the various functions involved). We want in (2.1), but we have to worry a bit that for some sequences , . to let
Furthermore,
, because we stop this martingale when it reaches 1, so
n 2 n
( &
w f
( &
&
( &
w 6f
'
As
A C #D@ B@ A w f w (& (& {
We consider xed
, so
if if
are martingales. (Take in part (i) of the Homework Problem and take (v).) Since and a stopped martingale is a martingale, we have
7 8
w f
f
2 e e + 1
in part (2.1)
Figure 8.1: The random walk process
&
( &
w f
( &
5 6
~ s w f 4~ s
bf
9 2
'
CHAPTER 8. Random Walks
99
In addition,
For all
i.e.,
We know there are paths of the symmetric random walk which never reach level 1. We have just shown that these paths collectively have no probability. (In our innite sample space , in each path individually has zero probability). We therefore do not need the indicator (2.2), and we rewrite that equation as (2.3)
Solution:
( & ( & & X ( & X
&
( &
s X
Let
be given. We want to nd
so that
8.3 The moment generating function for

9 2
n l Uj s
m l af Gf j nj { l U9W s n l Uj s ~ s
( & ( & { ( & ~s w
so we can let
U V
'
Letting
, and using the Bounded Convergence Theorem, we obtain (2.2)
, we have
in (2.2), using the Bounded Convergence Theorem again, to conclude
( & ( & & x Tyu s ( & S w w ( & ( & S { " x Tw0u s ( & ~ s w
w f
Recall Equation (2.1):
{ n 2 n
{(& w
if if
A EC @
A@
w 6f
and
( ( )& (
&
&
( &
( &
w f
w f
(
Q I G F RPHB( &
&
( &
5 6
( &
~s w 6f
( &
A f
` { XX ` X 0 X ` $ X X d X X w n d ~ s w 4~ s
X
X
`
w 2~ s X

w 2~ s X
X (
( & ( & X X `
&
9 2
{
9 2
( & ( & ( & ~s
{
X
X
`
(&
X ` X X X b X bc X 0 0 X X (& X (& {
X
` Y a
Recall Equation (2.3):
8.4 Expectation of
9 2
We want
With
We take the negative square root:
100
, so we must have
and
s X
so Recall that this becomes
We have computed the moment generating function for the rst passage time to 1. related by . Now , so (3.1)

e fX
101 in the equation
Using the Monotone Convergence Theorem, we can let
to obtain
Thus in summary:
8.5 The Strong Markov Property

The random walk process
is a Markov process, i.e.,
random variable depending only on same random variable
In discrete time, this Markov property implies the Strong Markov property: random variable depending only on same random variable
for any almost surely nite stopping time .
8.6 General First Passage Times

Dene
Then is the number of periods between the rst arrival at level 1 and the rst arrival at level 2. The distribution of is the same as the distribution of (see Fig. 8.3), i.e.,
{f {{ f sv{ f f
{ vw {{ sw ss{ w w
n {{ vs{ i h l
v { EX
X X
{ "~ s n l U9W s nj l f U` n j
{ "~ s n ` X w n ~ s X
` X h c
f ' Uj ` n g
w qpw 2~ s X
~ s ~ s m l Wf f j ~ s
r s
~ s n
vn
, and payoff function
f f '
0 g X
s { X 0
X 0 X
X
`
Dw 2~ s X
In general,
X
`
X
`
{ sw 4~ s Bpw 2~ s $ X X r sw qpw tX~ s r

, Take expectations of both sides to get
{ 0 X X ` $ X sr w sw r r Pw Bpw tX~ s sw X r r Pw Pw Bpw tX~ s sw X r r X t~ s X Pw r r sw r Pw Bw p u xyPw r r w Bpw X sw wXv~ s

r P
For
Consider the binomial model, with neutral probabilities are ,
8.7 Example: Perpetual American Put
102
Mk
Figure 8.3: General rst passage times.
, and thus
(strong Markov property)
(taking out what is known)
2 1
not random
. The risk
v EX

W#
103 . Suppose
Rule 0: Stop immediately.
Rule 1: Stop as soon as stock price falls to 2, i.e., at time
Rule 2: Stop as soon as stock price falls to 1, i.e., at time
Because the random walk is symmetric under , has the same distribution under as the stopping time in the previous section. This observation leads to the following computations of value. Value of Rule 1:
W#
Value of Rule 2:
This suggests that the optimal rule is Rule 1, i.e., stop (exercise the put) as soon as the stock price falls to 2, and the value of the put is if . Suppose instead we start with , and stop the rst time the price falls to 2. This requires 2 down steps, so the value of this rule with this initial stock price is

We dene
In general, if for some , and we stop when the stock price falls to 2, then steps will be required and the value of the option is
#
{ { r C w G~ u 0 s u ~s r Cw r Cw g n Ws j { l f U` n
{{ vs{ ' o p { c p h { p { g wfr DCe dC w ~ s o { { c p C w ~ s
{l
{ { p C w ~ s s $p C w | }
j f U` g n
$ w | g n } g
#
}r C w|
where

is a symmetric random walk under the risk-neutral measure, denoted by . Here are some possible exercise rules:
down
104 for some , then the initial price is at or below 2. In this case, we exercise If immediately, and the value of the put is
Proposed exercise rule: Exercise the put whenever the stock price is at or below 2. The value of as we just dened it. Since the put is perpetual, the initial time is no this rule is given by different from any other time. This leads us to make the following:
How do we recognize the value of an American derivative security when we see it? There are three parts to the proof of the conjecture. We must show: (a) (b) (c)
is a supermartingale,
is the smallest process with properties (a) and (b).
Proof: (a). Just check that

p p h p { c p h
for
This is straightforward.
Proof: (b). We must show that
By assumption,
h
for some . We must show that
If
, then
and
{ o o
for
Note: To simplify matters, we shall only consider initial stock prices of the form always of the form , with a possibly different .
{ p h { { p { { p { { p {{ p Y p p h h { g p Y p { p p p h h oh p gf { f h { f % h { f 6f ~ s f
p p
Conjecture 1 The value of the perpetual put at time
{{ vv{ ' o p
is
h
h h
m a6fl f j m l af m f h k f j f h f i h
o p
p u
, so
is

c
105 and
There is a gap of size .

h
There is a gap of size 1. This concludes the proof of (b). Proof: (c). Suppose (a) (b)
is some other process satisfying:
is a supermartingale.
We must show that
Actually, since the put is perpetual, every time
provided we let in (7.2) be any number of the form . With appropriate (but messy) conditioning , the proof we give of (7.2) can be modied to prove (7.1). on
Suppose now that
for some
j {l o f U` l f U` n j o p { p W h
so if
for some
, then (a) implies
, i.e.,
. Let
For
{ p p vt p p h p p p p
p h % { f 9f
is like every other time, so it will sufce to show (7.2)
ml aff j f i f f m l afi Gf sj
p q
If
, then
and
g n n # h o v0 { { { Y h ph p
(7.1)
o f
If
, then
106 Then
Because
is a supermartingale
Comment on the proof of (c): If the candidate value process is the actual value of a particular exercise rule, then (c) will be automatically satised. In this case, we constructed so that is and if we exercise the put the rst time the value of the put at time if the stock price at time is ( , or later) that the stock price is 2 or less. In such a situation, we need only verify properties (a) and (b).
8.8 Difference Equation

If we imagine stock prices which can fall at any point in , not just at points of the form for integers , then we can imagine the function , dened for all , which gives the value of the perpetual American put when the stock price is . This function should satisfy the conditions:
d
(c) At each , either (a) or (b) holds with equality. In the example we worked out, we have For
This suggests the formula

h
We then have (see Fig. 8.4): (a) (b)
for every
W { a w u v { p p he o s p t p { g p e o h
a W w h W h p a h i
(b)
a i
W r D q ah
(a)
For
except for
{ w h
{ w w ~ s p { g p h 6 f
w ~ s w w ~ s 9
m f f al Y f j o
W a h
107
v(x) 5
(3,2)
Figure 8.4: Graph of
Check of condition (c):
If or , then both (a) and (b) are strict. This is an artifact of the discreteness of the binomial model. This artifact will disappear in the continuous model, in which an analogue of (a) or (b) holds with equality at every point.

8.9 Distribution of First Passage Times
we recall that
We will use this moment generating function to obtain the distribution of . We rst obtain the Taylor series expasion of as follows:
Let
be a symetric random walk under a probability measure
, with
s y
l f U` n j
s Ya
w 2~ s X
X w 2~ s
ml afGf j
If
, then (b) holds with equality:
If
, then (a) holds with equality.
W%
x x x
. Dening
{
0
m { l o G9W s p X p w 2~ s nj X s o o m p $ X o p X X X z w 2~ s X
X
{p
v o o m p $ p o 8s o o m p p m o p $ o am p p } p | z ` W%

W
z
ms o 8 o p 8s u } o p} } { E} p } ~ } {sv{ { {{ sv{ o o E} } ~ | } {p { W 0 o sv{ } W } p z p o E} p s{ v{ } ~ } p | z { f C wr De p {{ { W 0 sv{ W | z p W z W 0 z W 0 W z z ` a z z z

108
But also, So we have
The Taylor series expansion of
is given by
109
Figure 8.5: Reection principle.
Therefore,
8.10 The Reection Principle
To count how many paths reach level 1 by time , count all those for which double count all those for which . (See Figures 8.5, 8.6.)
{{ vv{ ' o
s o $ o l o U9W s nj o p l U9W s nj
Figure 8.6: Example with
and
g p
{ l q l p j9W s p 9W s l l j l ag p 9W s l j
s { 0 o o $ o p 8s o o 8 o ss 8s p o o o o 8 o o o ss s 8 s p o o o o 8 o o o p 8 ms ms o o ms o o m o p o p j j l q p 9W s l p 9 W s p 9W s j j 9W s l l r p l o U9W s l o G9W s l o U9W s nj nj nj o p 9W s j p 9W s j r p 9W s l o U9W s j nj

,
For 110
In other words,
Chapter 9
Pricing in terms of Market Probabilities: The Radon-Nikodym Theorem.

9.1 Radon-Nikodym Theorem
Theorem 1.27 (Radon-Nikodym) Let I and P be two probability measures on a space . satisfying , we also have . Then we say that Assume that for every is absolutely continuous with respect to I . Under this assumption, there is a nonegative random P variable such that (1.1)
Remark 9.1 Equation (1.1) implies the apparently stronger condition
Remark 9.2 If is absolutely continuous with respect to I , and I is absolutely continuous with P P respect to , we say that I and are equivalent. I and are equivalent if and only if P P
(Let
and
be related by the equation
to see that (1.2) and (1.3) are the same.)
111
If I and P are equivalent and is the Radon-Nikodym derivative of Radon-Nikodym derivative of I w.r.t. , i.e., P
w.r.t. I , then P
{ i ~ s 9~ s {
~ s
exactly when
Ws { d i W s
W#
~s
W#
W#
for every random variable

W#
for which
~ s ~ s ~ s
W#
W#
W#
and
is called the Radon-Nikodym derivative of
with respect to I . P
is the (1.2) (1.3)
$z
W#
t d i W s
Tg
W#
W#
W#
112
Example 9.1 (Radon-Nikodym Theorem) Let of length 2. Let correspond to probability for
and
for . Then
, so
9.2 Radon-Nikodym Martingales

Let be the set of all sequences of coin tosses. Let I be the market probability measure and let P be the risk-neutral probability measure. Assume
Dene the I -martingale P
Proof:
{ W s f
Ws
or equivalently,
f d
s f t~ s
s~ s
Note that Lemma 2.28 implies that if

#
is
-measurable, then for any
{ f ~ s { f t~ s)~ s f ~ s~ s ~ s
~s
Lemma 2.28 If
is
We can check that
is indeed a martingale:
-measurable, then
f ~ s ~ s {f f t~ s f f t~ s~ s f 6f t~ s { {vv{ f ~ s f { { WW ss
W#
W#
so that I and P
are equivalent. The Radon-Nikodym derivative of
with respect to I is P
q vb v`
9
#
i W s W s
and
for , and let
, the set of coin toss sequences correspond to probability for
q b q`0bbv
b p pA
W#
CHAPTER 9. Pricing in terms of Market Probabilities

Z2 (HH) = 9/4 1/3 Z (H) = 3/2 1 1/3 Z =1 0 2/3 Z2 (HT) = 9/8 1/3 Z (T) = 3/4 1 2/3 Z2 (TT) = 9/16 Z2 (TH) = 9/8
113
2/3
(Lemma 2.28)
W
(Partial averaging)
(Lemma 2.28)
9.3 The State Price Density Process

In order to express the value of a derivative security in terms of the market probabilities, it will be useful to introduce the following state price density process:
Example 9.2 (Radon-Nikodym Theorem, continued) We show in Fig. 9.1 the values of the martingale We always have , since
p t
Proof: Note rst that
{ vs{ f f {{
{ p f~ s pp p ~ s o
d
Ws W s f d d s p f ~ s T W s p f ~ s pp
Uq0
f p p ~ s p
Lemma 2.29 If
is
-measurable and
Figure 9.1: Showing the are for I , not . P

W#
values in the 2-period binomial model example. The probabilities shown
, then
is
-measurable. So for any
, we have
o i pk6p p p am ip l p p j
{ p w k w ~ s e GiG w p Gq0 Gq0 ~ s pp e GG w p p w k w w Gu0 Gq0 p ~ s e GG w p p w k w o { vw k w ~ s s GiG w Gq0 sGGw ~ s i vw k w w Gq0 sGiG w ~ s vw k w m l k afi Gf sj {pp p f e f ~ s p p f e f ~ s ~ s p p p ~ s am fp l p p j p f e f ~ s p Gu0 Gq0 p p f e f f ~ s p Gu0 p Gq0 p f e f p ~s p o Guf e 0f ~ s { ~ s f Gu0 ~s
is a martingale under I , as we can check below: P
f ef f
ef
We then have the following pricing formulas: For a Simple European derivative security with payoff at time ,
f ge
(a) 114
Remark 9.4 Note that
Now for an American derivative security
Remark 9.3
More generally for
(b)
More generally for
is a supermartingale under I , P , , : (Lemma 2.28) (Lemma 2.29)

() = 1.44 2 S2 (HH) = 16 1/3 1() = 1.20 S (H) = 8 1 1/3 S =4 0 2/3 0 = 1.00 2/3 () = 0.72 2 S2 (HT) = 4 S2 (TH) = 4 () = 0.72 2
115
1/3 S1 (T) = 2 () = 0.6 1 2/3
2() = 0.36 S2 (TT) = 1
(c)
is the smallest process having properties (a) and (b).
Example 9.3 (Radon-NikodymTheorem, continued) We illustrate the use of the valuation formulas for European and American derivative securities in terms of market probabilities. Recall that , . The state price values are shown in Fig. 9.2.
Compare with the risk-neutral pricing formulas:
Now consider an American put with strike price 5 and expiration time 2. Fig. 9.3 shows the values of . We compute the value of the put under various stopping times :
4 q 'Eb' `'b '
(0) Stop immediately: value is 1. (1) If
9 v b v qv v T v 6 b v b 6 b T bb v v s bb bb q b ` i s s b bb v b
, the value is
For a European Call with strike price 5, expiration time 2, we have
We interpret by observing that at time if occurs.
is the value at time zero of a contract which pays $1
W#
Figure 9.2: Showing the state price values
. The probabilities shown are for I , not P
Ws f
am ip l p p j
q
116
(5 - S (HH))+= 0 2 2 (HH) (5 - S2(HH))+= 0
+ (5 - S (H)) = 0 1 += 0 (H) (5 - S (H)) 1 1 1/3 (5-S 0)+=1 + 0 (5-S 0) =1 2/3 + (5 - S1(T)) = 3 (T) (5 - S (T))+ = 1.80 1 1
1/3
2/3 1/3
+ (5 - S2(HT)) = 1 + 2 (HT) (5 - S2(HT)) = 0.72 (5 - S (TH))+= 1 2 + (TH) (5 - S (TH)) = 0.72 2 2
2/3
+ (5 - S2(TT)) = 4 + 2 (TT) (5 - S2(TT)) = 1.44
(2) If we stop at time 2, the value is
We see that (1) is optimal stopping rule.
9.4 Stochastic Volatility Binomial Model

)#ri# H)ca2
Let I be the market probability measure, and assume P equivalent. Dene

#
v8 2 fi 2 #
~
cf #
aa
and for
c8 #
H82 #
Let
be the risk-neutral probability measure:
8Va'D
Let are
be the set of sequences of -measurable. Also let
tosses, and let
rs
Figure 9.3: Showing the values P I , not .

W#
for an American put. The probabilities shown are for
, where for each ,
. Then I and P
are

i #Vcym2 c i E4
117
We dene the money market price process as follows:

#
We then dene the state price process to be

i c2
As before the portfolio process is . The self-nancing value process (wealth process) , the non-random initial wealth, and consists of
i V) c28V))V)|c|fif)c )T
and the following processes are martingales under I : P

i E8
and
We thus have the following pricing formulas:

Simple European derivative security with payoff
at time :
American derivative security
The usual hedging portfolio formulas still work.
' & $ (%%# # # ! ")

d a
#
#
and
' & $ (%%# ! "
Then the following processes are martingales under
V)
o)
Note that
is
-measurable.
)V
8V
#2T8
sm)'D
118
9.5 Another Applicaton of the Radon-Nikodym Theorem

Let be a probability space. Let be a sub- -algebra of , and let be a non-negative random variable with . We construct the conditional expectation (under ) of given . On , dene two probability measures
if for some , this is just the denition of , and the rest follows from the standard machine. If and , then , so . In other words, the measure is absolutely continuous with respect to the measure . The Radon-Nikodym theorem implies that there exists a -measurable random variable such that
# c'58 # 1 5 @v9 # 5 c'8%0
i.e.,
This shows that has the partial averaging property, and since is -measurable, it is the conditional expectation (under the probability measure ) of given . The existence of conditional expectations is a consequence of the Radon-Nikodym theorem.
1 5 @v9
A 0 G4
c F
E C %D
E C B8 # R 5
0 E 4%C
5 c6
1 P5
1 Qv5
Whenever
is a -measurable random variable, we have
A 1 5 B@v9
1 5 @v9
0 E C 5 42%D'8 #
5 8
0 5 76
0 4
0 4s~
H IF
Chapter 10
Capital Asset Pricing

10.1 An Optimization Problem
Consider an agent who has initial wealth as to maximize
Here, (BC) stands for Budget Constraint. Remark 10.2 If is any random variable satisfying (BC), i.e.,
c
then there is a portfolio which starts with initial wealth and produces at time . To see this, just regard as a simple European derivative security paying off at time . Then is its value at time 0, and starting from this value, there is a hedging portfolio which produces .

Remarks 10.1 and 10.2 show that the optimal obtained by solving the following Constrained Optimization Problem: Find a random variable which solves:
for the capital asset pricing problem can be
Equivalently, we wish to
119
c W US srpXVi
$ h
Maximize
Subject to
c W US g4fe
Maximize
c d
c 7
a 4b8
Y È8
Remark 10.1 Regardless of the portfolio used by the agent,

W US XVT
and wants to invest in the stock and money markets so
is a martingale under I , so P
')
sr
x t
Equation (1.1) implies

w D V)
T V x t
) D
Ti
o8V sV
))
x t
x t
and
))
V)
#2m x t
f x t
)V t I' t x t x t '
t
)V
t
V)
t |
x yt
x yt
fi
cwGv ) ) ) t fi
sr
) s) W US t XVi
sr
s r c s #vdvr
)V
r c m8pdr )) r Tp)
c t 8iu t
120
Subject to
c Pq
$ h
There are
sequences
in . Call them
sr p
We can thus restate the problem as:
Maximize
Subject to
In order to solve this problem we use:
Theorem 1.30 (Lagrange Multiplier) If
Maxmize
Subject to
g'
))
Plugging this into (1.2) we get
sr
I'T x t
For our problem, (1.1) and (1.2) become

then there is a number
such that
solve the problem
. Adopt the notation
(1.2) (1.1)
c W US c W US x eXVT eXVe
c W US XVe
#a
c W US x eXVT oc %
W US QXVd

c c W U PpXVS
From (1.5) we have
x c
%
'oc
f
W US t o XV7' x t '
W U t t XVS x t
The function
t fa r t ' t
'
t qy
W US t t XV7' t ' x c x c

x c
'dc
V)
#'
x c
x t
Therefore,
Thus we have shown that if
CHAPTER 10. Capital Asset Pricing
solves the problem
Maximize Subject to
c W US pXVT
Theorem 1.31 If
Proof: Fix
We maximize
then
over
and so Taking expectations, we have and let Let be any random variable satisfying is maximized at and dene is given by (1.4), then : , i.e., solves the problem (1.3). (1.5) (1.4) (1.3) 121
#s#'D
V) ))
REfif
io|D
)) V)
REf
m & o|D k
m k h j if )( nl %'D
V)
h j if Rf
' D
)V
m4
gm
W US XVT
In summary, capital asset pricing works as follows: Consider an agent who has initial wealth and wants to invest in the stock and money market so as to maximize
and the optimal portfolio is given by
The optimal
122
is
h f ig
Since
so is a martingale under I , we have P , i.e.,
Chapter 11
General Random Variables

11.1 Law of a Random Variable
Thus far we have considered only random variables whose domain and range are discrete. We now consider a general random variable dened on the probability space . Recall that: is a -algebra of subsets of .
%c5 5 8 s vsH
P I is a probability measure on
11.2 Density of a Random Variable

r )t~ p
123
v a H Q9
t ' t
%C
a 6
The density of
(if it exists) is a function
such that
a %8
where the probabiliy on the right is dened since in Williams book this is denoted by .
is often called the Law of
v sH pv2
8H
v Q
a 9
{ a |8
z a sI c8
Thus any random variable by
induces a measure
on the measurable space
H p
n'p r
i.e., 11.1)
is a random variable if and only if
is a function from
to
v u
a %22@|
A function is a random variable if and only if for every Borel subsets of I ), the set R
A Px8vR 8 a a R 2w )
q r p
, i.e.,
nu r p
t t
is dened for every
. (the -algebra of
(See Fig. dened
124
R B
.
{X B}
Figure 11.1: Illustrating a real-valued random variable
We then write where the integral is with respect to the Lebesgue measure on I . R is the Radon-Nikodym derivative of with respect to the Lebesgue measure. Thus has a density if and only if is absolutely continuous with respect to Lebesgue measure, which means that whenever has Lebesgue measure zero, then
H p
11.3 Expectation
~ #w r p
Theorem 3.32 (Expectation of a function of
) Let
be given. Then
which are true by denition. Now use the standard machine to get the equations for general .
t ' t
a @
a 8
aa
Proof: (Sketch). If
for some
, then these equations are
'sa
t ' t
t s t
y X' t XC
g 2w a
v t C
D' t
y X

H t I' t
CHAPTER 11. General Random Variables
125
(X,Y)
C y { (X,Y) C} x
F

Figure 11.2: Two real-valued random variables
11.4 Two random variables

F v
be two random variables dened on the space . Then Let (see Fig. 11.2) called the joint law of , dened by measure on
s vsHp
induce a
that satises
f t t k v t yC C
F 's8a
d)
k f 4 C y C y t t
F
We compute the expectation of a function of
k f y
is the Radon-Nikodym derivative of
with respect to the Lebesgue measure (area) on
in a manner analogous to the univariate case:
HQ v
)tcr
f t ' t k
#p
k f
C yC
F
'4i
F
k f y
The joint density of
is a function
p Q v
F v
F Qv
cR 2i
n r
k f y
p v
F
k f
v a H p~9
f t t k t 4G%C C
'8
vd6f C
F fd'F ) a~ g r p F k f
F 2 B2i) F 4
k f XC R 8 t t
where
'd6
f t t k C C f aI k y 2aPI 2v F a F @
a 8
y
Suppose
F v
11.5 Marginal Density
126
has joint density
. Let
ga
k f
Therefore,
is the (marginal) density for
Suppose
11.6 Conditional Expectation
has joint density . Let be given. Recall that depends on through , i.e., there is a function ( depending on ) such that
R F )
How do we determine ?
We can characterize using partial averaging: Recall that . Then the following are equivalent characterizations of :
be given. Then
for some
(6.4) (6.3) (6.2) (6.1)
8H
v Q
a 9
k f 4' v8 H C C y t t

d8 q8 y
H XC
mH
a 9
v4 F
'i F
F qi
F 2 5 8i'@v9
E C
fbE F
C
v H Qa
a F 5 F 2 ovi'P5
n i Gi ( %vp nX"|Xn
. Let
|
i) xq
f v EF V t C t t
DTcF V
f C t t k v t XG%C
8H p
F 82i
dF )a
'8
~f v C t t t
~ #@ r p ~f p r #Bd t
A function any function
11.7 Conditional Density
is called a conditional density for
given
tr
and
(Here is the function satisfying
depends on , but
~f
Theorem 7.33 If
Proof: Just verify that dened by (7.1) satises (6.4): For
v Q
Example 11.1 (Jointly normal random variables) Given parameters: have the joint density
s
F fd'F )
and then replace the dummy variable
~f v XC t t t
c8f
The function
F 4fdF )
'd6
m Vj 'd f v XG%C C t t t
8 k f t
~f t
F
has a joint density
k f
In conclusion, to determine
Notation 11.1 Let be the function satisfying
and (7.1) becomes
is often written as
does not.)
by the random variable , then
(a function of ), rst compute
: provided that for (7.2) (7.1) 127
'8
F )
9i g
PC " % `
X
. Therefore,
PC )
~ g
In the -variable,
q Qi
o e q
{ z q
y
i
o i)
(i 6
Qi
{ z "
{ z V8| B
P ~ PC % Gi PC
using the substitution
Gi
"% i i
" Gi i
The exponent is
We can compute the Marginal density of
128
as follows
Conditional density. From the expressions
o )
we have
Thus
is normal with mean 0 and variance
is a normal density with mean
and variance
Gi o o ) i)
9i e

From the above two formulas we have the formulas
129
Taking expectations in (7.3) and (7.4) yields
Based on , the best estimator of is . This estimator is unbiased (has expected error zero) and the expected square error is . No other estimator based on can have a smaller expected square error (Homework problem 2.1).
11.8 Multivariate Normal Distribution

Please see Oksendal Appendix A. , and the corresponding Let denote the column vector of random variables column vector of values . has a multivariate normal distribution if and only if the random variables have the joint density
Here,
where
is the variance of
2 )
V)
r 2 8W 2 r
y ~
y ~%
i.e. the th element of is if and only if is diagonal, i.e.,
. The random variables in
&
T8 T
8g c
y r P % c r 2
qs8
and
is an
nonsingular matrix.
is the covariance matrix
T
&
&
q Gi
q Gi %
)V
))
r s
|T8 r
`
n `
"%
@ ~ ~! ( vXvf8 (" 'i4o

(7.3)
&
&
y
V)
))
)r ) t t
y iR
(7.4)
(7.5)
(7.6)
are independent
5 24
i
y 2 r h r r
)V )
) 01 #!
5 4 3 2
) 01 #!
cR
(&$! '%"
&
r y rr 2 r 8Tr t
Let denote a column vector with components in , and let have a and mean vector . Then the moment multivariate normal distribution with covariance matrix generating function is given by
If any random variables have this moment generating function, then they are jointly normal, and we can read out the means and covariances. The random variables are jointly normal and independent if and only if for any real column vector
P )) r 8GP)%
))
t '
V)
Vr
t R t
# & )) P )rs8% & 5
( r 5 Y & )V Y ! Y C Y C
&
! "
&
))
r )yi8
r y VPr
r 2 v2 y t )iT t
" D r r 2 y r iT' t
11.10 MGF of jointly normal random variables
!
r 2 2 r ( " vX
'ir
fk t 8 t
and we have the formula from Example 11.1, adjusted to account for the possibly non-zero expectations:
r r " 92 |2
("

m P j s j r r 2 r 2 vf2
r 2 f2
m s j m s j
r 2 2
r y r y 8e)iP|j%
Take
c%
Thus,
11.9 Bivariate normal distribution

130
in the above denitions, and let
a d F a d F a
V)
o m)a
V)
r a 2 F )a )~8'V
))
r F F T9Rfi2
6 B DC
)V
5 24
) 01 A!
5 4 2
i V)
) 01 A!
9&$! @'%"
f
Let be a collection of independent, standard normal random variables dened on where I is the market measure. As before we denote the column vector P by therefore have for any real colum vector ,
s PH
76
&
F
)V
F )
&
If we know then we know
Dene the discrete-time Brownian motion (See Fig. 12.1):
12.1 Discrete-time Brownian Motion
Semi-Continuous Models
Chapter 12
, then we know
. Conversely, if we know . Dene the ltration
)V
r a Vx))Ha
d )V 8aTDv a F a r a r F a )~9)HF V) V) a r Va ~a F v r F )v)F
Theorem 1.34
a T`
Proof:
is a martingale (under I ). P
131

a a
, . We
F
)V
2 r r
g
y F |fy2
( !
cf
s 2 r r
y a %ic2
( !
a 8V8
a dR )Td fi F Y
r H8G8 ! E
E F
F fi c8 f
7E
a 4 )Td F
a cR )ifi8

Theorem 1.35
Proof: Note that
which is a function of
Given parameters:
The stock price process is then given by
a a
y t t
a `
Note that
12.2 The Stock Price Process
Then
Use the Independence Lemma. Dene
132
, the volatility. , the mean rate of return.
, the initial stock price.
2 t
B k
is a Markov process.
alone. Figure 12.1: Discrete-time Brownian motion.
1 Y1
k 2 Y2 Y 3 3 4 Y 4
g fi fi
V)
U !G)f U Xfifd ! ! U W|f)
V)
#)g4'
U! VT
2 { | 2 r r

y %iv fi
fif
r
133
P %! 82
P ! ! r P ! 2 r Q I! V F fy2
The other processes in the market are dened as follows.
F y2 z
XV7 W US
R mft
W US XV7y
Thus
m )fi
and
S ' R
fif
W US XVX
S @ R
Denition 12.1 Let

i V) 8
Money market process:
Discounted wealth process:
12.4 Risk-Neutral Measure
Portfolio process:
12.3 Remainder of the Market
CHAPTER 12. Semi-Continuous Models
Each
is
Wealth process:
Each
given, nonrandom.
is
-measurable.
-measurable.
be a probability measure on
76
, we say that
is a risk-neutral measure. , equivalent to the market measure I . If P
t t
t t
134

Proof:
12.5 Risk-Neutral Pricing

Let
be the payoff at time , and say it is
-measurable. Note that
may be path-dependent.
Hedging a short position:
Sell the simple European derivative security

Receive
at time 0.
i V)
Remark 12.1 Hedging in this semi-continuous model is usually not possible because there are not enough trading dates. This difculty will disappear when we go to the fully continuous model.
12.6 Arbitrage
c
Denition 12.2 An arbitrage is a portfolio which starts with

#'#
(I here is the market measure). P
Theorem 6.37 (Fundamental Theorem of Asset Pricing: Easy part) If there is a risk-neutral measure, then there is no arbitrage.
#a
If there is a risk-neutral measure
, then
and ends with
satisfying
Construct a portfolio process
which starts with
and ends with
f g Y ~ f f ~ Y f
` a
f fi
g Y
a martingale under
, regardless of the portfolio process used to generate it.
Theorem 4.36 If
is a risk-neutral measure, then every discounted wealth process
is
t t t t
2 r
y o !
(v
2 r
y
( !
2 r
f (v
U P!

F 2 8 Vfi%

! F 2
fi
fif
2 r r
y ic fi
(v
f f
fif
)HV 2 r r
( 2 r |fy2 y F r ~! ( y F a Rfd62 !
s r 2 r
y %ic
a 2
( ! F v
s v%s V) r F )v)F
76
t t t
co
9H#a
'#c
'#c
'#
c'#a
c'#a
h fb Y iT # Y

, and let be the nal wealth corresponding Proof: Let be a risk-neutral measure, let to any portfolio process. Since is a martingale under ,
Suppose
` a 9'# ` c
'#
(6.1) and (6.2) imply
If
Therefore,
12.7 Stalking the Risk-Neutral Measure
This is not an arbitrage.
Recall that
, the market measure is risk neutral. If . . We have .
d Wy
cy
are independent, standard normal random variables on some probability space
. We have
, we must seek further. (6.2) (6.1) 135
g'
76 Y
5 j9
E C 5 %'8 Y

( ! F g %hD
g
h ) 01
( ! ! (

(v !
5 24
gr
F g ohD
( !

2 r d
( !
(v (v 2 r d 2 r r ! !

F ` 2 ! F
)V
fi
P F U f|fi7fF fiF
2 r
r r (
2 r
'
P U e'F |2
2 r
y F %i'fi2
under which We want a probability measure dom variables. Then we would have
fF
U P
! ! x!
(v (v (v
f f f
fi f
The quantity
where
136
is denoted and is called the market price of risk.
Then
Dene
Properties of :
Cameron-Martin-Girsanovs Idea: Dene the random variable
for all
j5
In other words,
is a probability measure. and are independent, standard normal ran-
5 8
t t

{ |
g
r
#
r r z
p
f f

! ! ( ( !
! (
h h

gr

(v
! (v

g X
F i

gr g
F g |#X
f f
F g ohD
h TF g

5 %%v9

g F
F 7
V)
g W
are independent, standard normal under
F 7 F
We show that

Verication:
Compute the moment generating function of
g W
F 7

almost surely.
is a risk-neutral measure. For this, it sufces to show that
: Independent, standard normal under I , and P
for every random variable
under
))
: 137
% cyH
E C
5 '8
Y
r
F g %hD f
V)
pi
!

(
F f7
t
F
g W
t t
F v
V)
r F )v)F
E s
{
s
q Xis r
r 2 r
2 r
E y2
( (
b! !
z
r
i U!
vxwqu 24 5
2 ) 01
rt s U !
5 24
2 r
F F i F
h 2 h 2
) 01 A! ) 01
!
5 24
2 r
y y %isT%ia'
f f
P U e
y %ic
5 24
2 r
h 2 a 2
) 01 A!
!
P 2 r r
Stock price at time
Payoff at time
12.8 Pricing a European Call
138
is
is
since
. Price at time zero is
is normal with mean 0, variance , under
This is the Black-Scholes price. It does not depend on .

F f
q X

q X
Chapter 13
Brownian Motion
13.1 Symmetric Random Walk
Toss a fair coin innitely many times. Dene
Set

13.2 The Law of Large Numbers

We will use the method of moment generating functions to derive the Law of Large Numbers:
Theorem 2.38 (Law of Large Numbers:)
139
r d"
almost surely, as
if if
H f
c
'
r a
! r

! r
z ( !
c'
r

! r r r S !
z W U XVS
! rr ! t r r ! !
{ X
! r
{ 4

5 24
Theorem 3.39 (Central Limit Theorem)
We use the method of moment generating functions to prove the Central Limit Theorem.
13.3 Central Limit Theorem
! r
! r
( ! h

which is the m.g.f. for the constant 0.
c '
W U XVS
Y r
z W U 4fS c'
W U XVS
which implies,
! r
z
f
) 01
! !
c c'
Proof:
Therefore,
Let
140
. Then
Standard normal, as (Def. of
r d"
! T'
Y r
Proof:
(Independence of the
(LH pitals Rule) o ) s)
m
a
m j
a
'D
m j
13.4 Brownian Motion as a Limit of Random Walks
r !
(LH pitals Rule) o
! r
which is the m.g.f. for a standard normal random variable.
! r T'
Y r
r !
r S V!
r
r r r
S
r r
S S
'rd
! ! r ! r ! r S r ! { ! r ! r z t r r ! ! r t { ! r ! r XVS z WU
W U XVS
! r
z W U 4fS c'
W U XVS
so that,
Therefore,
Y r
Let
CHAPTER 13. Brownian Motion
Let
be a positive integer. If
If
is not of the form , then dene . Then
j a
Here are some properties of

is of the form , then set
by linear interpolation (See Fig. 13.1). (LH pitals Rule) o 141
f s s )
cs#p m c#
m m
s s s
a 8 j S ' a j
j a

p Bo m
#) s) m )D
j a a j 8
S' R
h h
f s f s
) )
S ' R
m m
a j
)D
j a
p BVD m
j a
m j
a
142
Figure 13.1: Linear Interpolation to dene
Also note that:
Properties of
Properties of
is a continuous function of .
` dmy m j
a j T'o m
j a
and
To get Brownian motion, let
k/n
in
(Please refer to Oksendal, Chapter 2.)
13.5 Brownian Motion

r
are independent. . (Approximately normal) (Approximately normal)
VD D m j a s j a t
(k+1)/n
8)
T' a a
))
a r a r mRs T'8| 9F V)
r ~
A random variable properties:
13.6 Covariance of Brownian Motion
S e A' F '
F v
c V)
r F )v)F
F R t t t
T'RPF a a
WPW A
y a
(, F,P)
1.
g'#a
2.
is a continuous function of ;
D a
3.
Let
then
and
has independent, normally distributed increments: If
be given. Then and are jointly normal. Moreover,

) a
Figure 13.2: Continuous-time Brownian Motion.
(see Fig. 13.2) is called a Brownian Motion if it satises the following
are independent,
are independent, so
B(t) = B(t,)
and
D a
) a
7f
f j i f )h ) a sV7'y8)V7 g f a a f a r B)7ad P)7T'y88V7 gyvV7 f f a a f a a f a A'sy8 a a gy S@ ofT's)ha8 f f a S @ R R g)h a ) 7Hy a
f h
7f
a a a ) dsV 'y 8 c
7f
7f f g g
143
7q D)
V) r 88V88)88V888)8 V)
r r ps o s V) sps n o a a n V) 8v a Io8sv n a r a r 8)8)8V8)V8)8)8V)8V8)8)8V)8V8)8)8V)8V8)8)V8)8V8) v r a a V) r v r a a a o vRP V) 8vir s is r a nn a a r a a Ioo n

P
) a W
))
a r a 8 8 WPW2
V)
r ~
Thus for any
144
(not necessarily
mklfTD)7fa a Wf
Required properties:
13.8 Filtration generated by a Brownian Motion
is jointly normal with covariance matrix
` f
be given. Then
13.7 Finite-Dimensional Distributions of Brownian Motion
Let
For each ,
H vd H t f QDo7Xp mvQV7% f a f a H HQ v pHtf y D T' a )) m aT' r a )DT' a a a W#Q%rT~WPW rr r ya
in . Do this for all possible numbers required by the -algebra properties.

y
is
This
Here is one way to construct
are independent of
For each and for
contains exactly the information learned by observing the Brownian motion upto time . is called the ltration generated by the Brownian motion. . -measurable, . First x . Let , the Brownian motion increments ), we have and and . Then put in every other set be given. Put the set
D ) D
7q
t t
2r 2
r s s c

) V
f )7 ()fs g r 'P)7'D8 r f a a ' r h r ~! ( )7f S g f r f a R a g ( f VX r g 's)hy8hd ! s)7 f X| r g r 's)hy8ahd ! ( V7f c f a g
7f
) j )
f h
f f G)Xs r g r
a a a 's) d) TD 8 d
f h
r g r
a y %
h g
( !
Theorem 9.41 Let
2g
a V D
a V d B) D g a a
a a a a y) )V dfs) y 8 gp) Vy
7f
7f
7f
7f
f h
7f
7f
Theorem 9.40 Brownian motion is a martingale.
13.9 Martingale Property
Proof: Let
f WG
Proof: Let
13.10 The Limit of a Binomial Model
is a martingale.
Consider the th Binomial model with the following parameters:
7f
g h
Up factor. (
f cBV7 )y
f WG
t s t
Down factor. be given. Then be given. Then be given. Then ). 145
t t t t t
m j

r )

v r ) 2 Pd

}~ r x %s w
r 2
2 r 2 r

w r
r
2 r

z
2
}~ %s 2 | w rx r
W U XVS
2 r 2
z {c

W U D4fS
2
W US D4f
2
'
W U DXVS
W U DXVS
2 r
W US 'DXV"
y
m j
W U XVS
x w yt W
r r 2
r t
'
W U t DXVS
ds
m j
m j
2p Hp
r r
'dP ' p
u u
' g'dP s
uu u F
u u
Let rst
146
denote the number of tosses. Then
in the rst
tosses, and let
In the th model, take
which implies,
steps per unit time. Set
. Let
denote the number of
for some , and let
v m Ds b j
'
2

v m Ds b j

m j
m j

Theorem 10.42 As
where is a Brownian motion. Note that the correction martingale.
2 r
a 2 D `
dP
Under
, the price process
, the distribution of
r d9
As so
Proof: Recall that from the Taylor series we have
, the distribution of
is a martingale.
approaches the distribution of
2 r
a D 2
W U 4fS
r
converges to the distribution of
is necessary in order to have a
. in the
147
B(t) = B(t,) x t
(, F, Px)
Figure 13.3: Continuous-time Brownian Motion, starting at
13.11 Starting at Points Other Than 0

(The remaining sections in this chapter were taught Dec 7.)
For a Brownian motion that starts at , denote the corresponding probability measure by (See Fig. 13.3), and for such a Brownian motion we have:
Note that: If , then
puts all its probability on a completely different set from I . P
13.12 Markov Property for Brownian Motion

We prove that Theorem 12.43 Brownian motion has the Markov property. Proof: Let
be given (See Fig. 13.4).
Independent of
-measurable
I%7
~aW
Q7a
l l Q7aX~ W7a@ %h
The distribution of
under
is the same as the distribution of
under I . P
' a7
@e T ah
H~sl7a7
For a Brownian motion
that starts at 0, we have:
m7 HQ7ah hQ7
Hm7 h@' a ' G%haXsha' IG 7

Use the Independence Lemma. Dene
same distribution as
In fact Brownian motion has the strong Markov property.
Then
148
Example 13.1 (Strong Markov Property) See Fig. 13.5. Fix
' e ' 'l % l @ ~pX
sl7m7
Then we have:
B(s)
Figure 13.4: Markov Property of Brownian Motion.
restart
and dene
s+t
'e yw ya

3
is a martingale, and
y ymC 3 a "T
"
D 7 yh H~s7m7 D %7m 7 %7m7 Q7 H7m7 D 7 Ha7 7 C p~CIl ' D

to in time , and
Let be the probability that the Brownian motion changes value from let be dened as in the previous section.
D
Fix
Fix
13.14 First Passage Time
13.13 Transition Density
. Then . Dene
Figure 13.5: Strong Markov Property of Brownian Motion.
restart +t
149
D
' F m Fm Fm F m lF m m F
H F m
C
3
6 7
y s
m ' G y
( )
& '
'e
0
$ # %
We have
150
if if

yw ywa y y m y

l

We use the Reection Principle below (see Fig. 13.6).

A '
6 7
Conclusion. Brownian motion reaches level is innite.

4 @

8 9 3 4 5
( )
& '

1 2
y
! "
Let
Let
to get
$ #
Letting
Differentiation of (14.3) w.r.t.
Let
in (14.1), using the Bounded Convergence Theorem, to get
, we obtain
. We have the m.g.f.:
, so
yields
with probability 1. The expected time to reach level (14.4) (14.3) (14.2) (14.1)
1 B3
6 7
@H
4 @ U
4 @

Laplace transform formula:

d V V d eV b ` E T E c a
X Y
V W
p ' ' H ' H

` U E T R S

E G
6 E
Using the substitution
6 F H PI
then Density:
which follows from the fact that if
Figure 13.6: Reection Principle in Brownian Motion.
we get
t shadow path
151
Brownian motion
152
Chapter 14
The It Integral o
The following chapters deal with Stochastic Differential Equations in Finance. References: 1. B. Oksendal, Stochastic Differential Equations, Springer-Verlag,1995 2. J. Hull, Options, Futures and other Derivative Securities, Prentice Hall, 1993.
14.1 Brownian Motion

x
2.
is a continuous function of ,
y Y G f
3. If
, then the increments

f
are independent,normal, and
14.2 First Variation
153
Quadratic variation is a measure of volatility. First we will consider rst variation, function .
)`
e au a m yT h au a m
y Y
p P
p 7
1.
Technically,
g wvu t
r s
p q
h i
(See Fig. 13.3.) Brownian motion,

g c
aX a %Q aX a Q%T e j y a yj W m
,
is given, always in the background, even when not explicitly mentioned. , has the following properties:
~a a
U
, of a
154
f(t)
t2 t 1
U
Thus, rst variation measures the total amount of up and down motion of the path. The general denition of rst variation is as follows:
i y f
Denition 14.1 (First Variation) Let
be a partition of
The mesh of the partition is dened to be
Suppose is differentiable. Then the Mean Value Theorem implies that in each subinterval there is a point such that
X %
ee e gf e
d 7f
)`
We then dene
For the function pictured in Fig. 14.1, the rst variation over the interval
U U U U U U 5 7f B)`
@ ' ~ @~ ' y
U
@U
Figure 14.1: Example function
. is given by:
Q%T y%Q%
G
c7f
, i.e.,
i
'e
X
i U
e e
i f h y U i U

m oU l

f U U

Denition 14.2 (Quadratic Variation) The quadratic variation of a function on an interval is

i U
e
P i U
In particular, the paths of Brownian motion are not differentiable.

r
m
p q m l
p q7 p

m l
yT
f
@
U f j f y h
ee e gf e
eegf e e
eegf e e

m eU l
j h f h y

y U U
f y h
eenf e e

m eU l
@
U f f y h
kf
ee e gf e

U 5 7f )` h y
f j h
Then

y U U
or more precisely, Theorem 3.44 and
Remark 14.1 (Quadratic Variation of Differentiable Functions) If is differentiable, then , because
14.3 Quadratic Variation

and
CHAPTER 14. The It Integral o
155

f f
u u
yj
{ z
j h
% e
y

|
s i P
| ts
X X e e T C e % X A
f h } ~ y f h y P s f h
{ z
m
y y s
yj X
P P
j h

y P

This has expectation 0, so
s
C X A C as a X A
T
P P

f h y
ee e gf e
e F
s f

. To simplify notation, set
ts
f u
aX a

y

be a partition of Proof: (Outline) Let . Dene the sample quadratic variation
yQ%Q f
y f
Then
A
f
For
Consider an individual summand
We want to show that
156
, the terms
and
e F
y y
are independent, so
(if
is normal with mean 0 and variance
, then
Thus we have )
u
{ z
w x

157
Remark 14.2 (Differential Representation) We know that
We showed above that

{ z
which we can write informally as
14.4 Quadratic Variation as Absolute Volatility

i
On any time interval
, we can sample the Brownian motion at times

and compute the squared sample absolute volatility

h y
This is approximately equal to

l
As we increase the number of sample points, this approximation becomes exact. In other words, Brownian motion has absolute volatility 1. Furthermore, consider the equation
This says that quadratic variation for Brownian motion accumulates at rate 1 at all times along almost every path.
'e
H aX a7
Q%T
' ~a ~a
G
'
When
is small,
e H mu m7 % X C e F ~' aX a7
is very small, and we have the approximate equation
yj e F H mX a7 a
T
P
ee e gf e P P
{ z
As
, so
158
14.5 Construction of the It Integral o

The integrator is Brownian motion following properties: , with associated ltration
We want to dene the It Integral: o
This wont work when the integrator is Brownian motion, because the paths of Brownian motion are not differentiable.
14.6 It integral of an elementary integrand o

i y f
Let
be a partition of
f
Think of
as the price per unit share of an asset at time .
m m
The functions
and
can be interpreted as follows:
Assume that is constant on each subinterval elementary process.
y y
, i.e.,
(see Fig. 14.2). We call such a
Remark 14.3 (Integral w.r.t. a differentiable function) If we can dene

U c f c U c
Q%T y
y Y
m y
S
G
@~
y%Q%
~y
2.
is square-integrable:
1.
is
The integrand is
, where (i.e., is adapted)
-measurable
is a differentiable function, then
3. For are independent of

T
, the increments .
mu m y%Q% mu a au m
3 ~ %%j ~a
2.
is
-measurable,
Q7
1.
every set in
is also in
~a
, and the
an
a
c c f
e c c
a
c c
m y
c
~
Linearity If Adaptedness For each is

t
mu~a % 3 y aX a y ~ au m 3 mX a y 3 as a mXa y 3 as a D m ~a ~ % 3 %Q%

y y y f y h f f f f f
0=t0
( t ) = ( t ) 0
Figure 14.2: An elementary function .
Think of
Think of trading date
as the number of shares of the asset acquired at trading date .
Then the It integral o
14.7 Properties of the It integral of an elementary process o
f f
y y
In general, if
then ,
y
f
can be interpreted as the gain from trading at time ; this gain is given by:
as the trading dates for the asset.
t1
( t ) = ( t 1 )
-measurable.
( t ) = ( t 2 )
t2
( t )= ( t 3 )
t3
t4 = T
and held until 159
mX%7m H as h%7 m m H aX m7% y

y y y
3 3 Q7 %7
h
H
y
mX m7% y as a7Q y
h
aX~a y aX m y D mX m y aX m y ~
h y y y y f y h c

160
Figure 14.3: Showing and in different partitions.
and
mH y
c c f
Theorem 7.45 (Martingale Property)
Proof: Let be given. We treat the more difcult case that and and subintervals, i.e., there are partition points and such that Fig. 14.3).
aX~a C y mX m y
y y f y h
We prove the martingale property for the elementary process case.
We compute conditional expectations:
r
Write is a martingale. Martingale is a martingale.

t l s t l+1
.....
k+1
are in different (See
e % C ~ as a7
y y y y f y h
m
y s y f & y h s y s s y f
y h
~ "
y
y y
y
jy
as a y "
f y h f
I %h H auQ D m % y %7 m %h H mu a a 3 Q7 H as a7Q y Q7
Since the cross terms have expectation zero,

f y s y h h

y y
s
H aX~a7QC y
P
~ mu m7% y
y
Q7
Each
Proof: To simplify notation, assume
Theorem 7.46 (It Isometry) o
These rst two terms add up to
has expectation 0, and different
. We show that the third and fourth terms are zero.
, so
are independent. 161
162
path of
path of
0=t0
t1
t2
t3
t4 = T
i
14.8 It integral of a general integrand o

Fix
. Let be a process (not necessarily an elementary process) such that

p
is
-measurable,
Proof: Fig. 14.4 shows the main idea.
In the last section we have dened
for every . We now dene
~a ~
Theorem 8.47 There is a sequence of elementary processes

such that
Figure 14.4: Approximating a general process by an elementary process
, over
yT ' 3 y
m~
~a 3
y
f
S
@~ ~ 3
f
163
The only difculty with this approach is that we need to make sure the above limit exists. Suppose and are large positive integers. Then
14.9 Properties of the (general) It integral o
Here is any adapted, square-integrable process.
Linearity. If
and
Martingale. Continuity.
is a martingale.
is a continuous function of the upper limit of integration . .
Example 14.1 () Consider the It integral o
We approximate the integrand as shown in Fig. 14.5
It Isometry. o
a
mH y
then

a
e c c
m y
Adaptedness. For each ,
is
a y
-measurable.
which is small. This guarantees that the sequence
@ y ~ H @ ~y ' y y @ ~ ~a ~ H
has a limit.
f c f y y y f f
(It Isometry:) o
"
~ " ~ ~
{ z
h @

h
7 h
@ h
@ j
h @
h

7 h @ 7 h @
h @
pp

nr
gr
7 h @
pp

u7u
y

164
Figure 14.5: Approximating the integrand
a
c
T/4
2T/4
if if
uvD
if
D
u
so
We compute To simplify notation, we denote By denition,
3T/4
with
, over
a y
c f
mH a
c c

c U U
T
U

) s h
Theorem 10.48 (Quadratic variation of It integral) Let o
T m m
c c f

c U U f c

c U U U

7 h @

7 h
Remark 14.4 (Reason for the
Therefore,
@
The extra term there, because
In contrast, for Brownian motion, we have
gr
7 h
Let
or equivalently
but
Then
~
m l
14.10 Quadratic variation of an It integral o

and use the denition of quadratic variation to get
comes from the nonzero quadratic variation of Brownian motion. It has to be term) If is differentiable with , then 165
(It integral is a martingale) o
j h
j h
yyy e %
y m l P P T
yy X %Q 7aX ha % h 7 I
y y h m l m l y y P
7 7
y f
Q
m l m l m l
h y
~y
7mu 7m % y mQ y %%j y%Q% y %Q% f ' ~a ~a

f y f
'~

y
c
This holds even if is not an elementary process. The quadratic variation formula says that at each time , the instantaneous absolute volatility of is . This is the absolute volatility of the Brownian motion scaled by the size of the position (i.e. ) in the Brownian motion. Informally, we can write the quadratic variation formula in differential form as follows:
Proof: (For an elementary process ). Let for . To simplify notation, assume
~ ~
Compare this with
166
be the partition for , i.e., . We have
It follows that
P
Q y

so Then Let us compute . Let
be a partition
Chapter 15
It s Formula o
15.1 It s formula for one Brownian motion o
We want a rule to differentiate expressions of the form , where is a differentiable were also differentiable, then the ordinary chain rule would give function. If
which could be written in differential notation as
However, is not differentiable, and in particular has nonzero quadratic variation, so the correct formula has an extra term, namely,
This is It s formula in differential form. Integrating this, we obtain It s formula in integral form: o o
Remark 15.1 (Differential vs. Integral Forms) The mathematically meaningful form of It s foro mula is It s formula in integral form: o
167
H m7
H m7
h
U c c H U U
p 'D H~ah fmH~ah
m7
H
HHa7
mHm7 ' Hm7
f a H a7 D H m 7 H~a7
f a H a7 H m7 H~a7
U c c U U c c U U
@ m7
U U
H~ah
Ha7
~a
~a
168 This is because we have solid denitions for both integrals appearing on the right-hand side. The rst,
is an It integral, dened in the previous chapter. The second, o
is a Riemann integral, the type used in freshman calculus. For paper and pencil computations, the more convenient form of It s rule is It s formula in differo o ential form:
U U U
There is an intuitive meaning but no solid denition for the terms and appearing in this formula. This formula becomes mathematically respectable only after we integrate it.
15.2 Derivation of It s formula o
In this case, Taylors formula to second order is exact because

X
is a quadratic function.
C ah
mX
C aX
y Y
Fix
and let
be a partition of
. Using Taylors formula, we write:
In the general case, the above equation is only approximate, and the error is of the order of . The total error will have limit zero in the last step of the following argument.
% 7
Q s h f% 7 X h 7 7
U @
a @C as m m m H m7 mX m C ah H m7 H m7 H m7 y %%Q
Let
be numbers. Taylors formula implies
' 7
Consider
, so that
~a m7 @H~a7 ~a H~a7
mH a7
c T @U f
H a7
Hm7
7
a
c

T
~a
'
U
~a @H~ A @ G ' Hm
U U U U U U

U U
~ay
7
G c f
m 7 f a H m7 fy m m
U c c m l
We let
15.3 Geometric Brownian motion
This is It s formula in integral form for the special case o
CHAPTER 15. It s Formula o
Denition 15.1 (Geometric Brownian Motion) Geometric Brownian motion is
f f
H m7 H m7
U U
where
Dene
and Geometric Brownian motion in integral form is
@H~
Thus, Geometric Brownian motion in differential form is

H~a
U
According to It s formula, o Then so and to obtain
are constant.
169
170
15.4 Quadratic variation of geometric Brownian motion

In the integral form of Geometric Brownian motion,
is not differentiable. It has quadratic variation
15.5 Volatility of Geometric Brownian motion

on
is
As , the above approximation becomes exact. In other words, the instantaneous relative volatility of is . This is usually called simply the volatility of .

15.6 First derivation of the Black-Scholes formula

Wealth of an investor. An investor begins with nonrandom initial wealth and at each time , holds shares of stock. Stock is modelled by a geometric Brownian motion:
@H
y Y
9
Fix volatility of
. Let
be a partition of
. The squared absolute sample
Hm
Thus the quadratic variation of we write

is given by the quadratic variation of

a
@H
y Q%Q
is differentiable with
. This term has zero quadratic variation. The It integral o
~
f
the Riemann integral

`
a
c

G c
. In differential notation,
9v 1
171
can be random, but must be adapted. The investor nances his investing by borrowing or lending at interest rate .
The differential of this value is

G
satisfying the terminal condition

f
If an investor starts with and uses the hedge for all , and in particular, .

F H~ ~ H y 7
C
'
In conclusion, we should let
be the solution to the Black-Scholes partial differential equation
'
H F
(where
and
) which simplies to
'
But we have set we obtain
, and we are seeking to cause
to agree with . Making these substitutions,
2
'
Equating the
coefcients, we obtain:
H~
To ensure that coefcients, we obtain the

for all , we equate coefcients in their differentials. Equating the -hedging rule:
, then he will have
H F @ w F
A hedging portfolio starts with some initial wealth time tracks . We saw above that
2
and invests so that the wealth
' @ @ f3 f
Value of an option. Consider an European option which pays the value of this option at time if the stock price is option at each time is
at time . Let denote . In other words, the value of the
m ' D w a@HF @V w F a H @H~ ~ '%~ ~ ~F ~ H~ F

Risk premium

~ H
H~
@ @ H
2
F

Let
denote the wealth of the investor at time . Then
at each
y
a
y
a
jb
jb
y ~y y y y y y @ ~y 3 ~y
jb
jb
jb
@
!
y
d T
l H~y l y '
d c d c c f d
H y
c f G
y ~y
c f d
d
n
n
H y 3 y a 3 3 a ' '~y '~y ~a ' @y 'H~y ~a 3 'H~y ~y ~a y ~y ~y y f ~y y H3

@U
U U
h a 3
c U
H y
G c c u
a y
@HH3 l ~y
G
We apply It s formula to compute o
where
15.7 Mean and variance of the Cox-Ingersoll-Ross process
172
The Cox-Ingersoll-Ross model for interest rates is
and
are positive constants. In integral form, this equation is
. This is
Hy
c
~
T
3 y

If
We solve for
Integration yields
which implies that
Differentiation yields
Taking expectations and remembering that the expectation of an It integral is zero, we obtain o
The mean of
, then
. The integral form of the CIR equation is
for every . If
, then
, where
exhibits mean reversion: . We obtain
~ mu m Q%Q mu a %QT
is
b b
~y @
d
y
d
yy
G c

d

T
y

a
c
c @

G c
Variance of
. The integral form of the equation derived earlier for
~
T
y
G c
Using the formula already derived for algebra we obtain
Denition 15.2 ( -dimensional Brownian Motion) A -dimensional Brownian Motion is a process

jb
y
b
Associated with a -dimensional Brownian motion, we have a ltration
H~ y%Q% ~ h ~a
H

jb
jb d
y y A y

jb
T ~ ~y
d
with the following properties:
15.8 Multidimensional Brownian Motion
d 7
{ z
d 7
@
which implies that
Differentiation yields
Taking expectations, we obtain
Each
is a one-dimensional Brownian motion;
y
C
If
, then the processes
and
For each , the random vector
For each
T
are independent of

, the vector increments
and integrating the last equation, after considerable
-measurable; are independent.
is
such that 173
h y
{ z
T e C X e Q X s Q X u
y y
{ z
% X % X u X u s
y y
yT
f
f h
The increments appearing on the right-hand side of the above equation are all independent of one another and all have mean zero. Therefore,
X Q X
y
i f
%Q%
to be
y v
y e
y T ~
. For
v i y
' ~
is a one-dimensional Brownian motion, we have the informal equation

15.9 Cross-variations of Brownian motions
174
Because each component
Proof: Let of and on
However, we have:
Theorem 9.49 If
We compute

h y j h y { z
But expectation
All the increments appearing in the sum of cross terms are independent of one another and have mean zero. Therefore,
and . It follows that
&
As
, we have
. First note that
be a partition of
, so
converges to the constant
{ z
are independent of one another, and each has
, dene the sample cross variation
Uf
F iF U
'e f H H f H " F
U U
F H H F
c c U U
F F U

a@
D H
i
~ @ @ % H 'w @ @ @ H H 'w
and and
c 3 c c c H 3 c

' @e
3 3
15.10 Multi-dimensional It formula o
To keep the notation as simple as possible, we write the It formula for two processes driven by a o two-dimensional Brownian motion. The formula generalizes to any number of processes driven by a Brownian motion of any number (not necessarily the same number) of dimensions.
Such processes, consisting of a nonrandom initial condition, plus a Riemann integral, plus one or more It integrals, are called semimartingales. The integrands o and can be any adapted processes. The adaptedness of the integrands guarantees that and are also adapted. In differential notation, we write
l
c c c f f
c ~ H F F
c
Let
In integral form, with is
Let be a function of three variables, and let have the corresponding It formula: o
Given these two semimartingales
and
be processes of the form
and

where
U U
, for
as decribed earlier and with all the variables lled in, this equation
, the quadratic and cross variations are:
, and
be semimartingales. Then we
175
176
Chapter 16
Markov processes and the Kolmogorov equations

16.1 Stochastic Differential Equations
Consider the stochastic differential equation:
Here and are given functions, usually assumed to be continuous in chitz continuous in ,i.e., there is a constant such that
for all
f
The solution process will be adapted to the ltration generated by the Brownian motion. If you know the path of the Brownian motion up to time , then you can evaluate .

Example 16.1 (Drifted Brownian motion) Let

2
be a constant and

, so
177
If
is given and we start with the initial condition
Wl
V y ~F ~F Q7a %7F 7 HQ7F h F
Let be given. A solution to (SDE) with the initial condition satisfying

f
is a process
y F
mF 'H F
(SDE) and Lips-
D

D
c f d
d
F

178
then
Given the initial condition
16.2 Markov Property
We have the Markov property

7f
In other words, if you observe the path of the driving Brownian motion from time 0 to time , and based on this information, you want to estimate , the only relevant information is the value of . You imagine starting the at time at value , and compute the expected value of .
f
F H H F p H F
the expectation of condition
, given that
. Now let
F H F
H F
H F F
Let
be given and let
be a function. Denote by
be given, and start with initial
Again, to compute the differential w.r.t. , treat

c 2
and
as constants:
V y
the solution is
Example 16.2 (Geometric Brownian motion) Let and
3V
3V y
To compute the differential w.r.t. , treat
and
as constants:
be constants. Consider
V

2'u n
f I Q h v s eQ f IG
Q h I v s IG r kRTeQ f
i Ff s
v jG Y ~}wz
i o c
q S VW
z i@D
cwQ h v s eG F I I h Q h xv s PG I I v f z
v S { z D x Q h IG b v Q s IG |k@yiRedHwedb a tu Q h P7HsQ s P7b IG b v IG q S Q s IG VTnPgE q S uQ h PHE IG
f r Q h I v s IG tRTPQ f
i f s
v jG Y Q Q h IG b v Q s IG b VqekRe7p0tedG
o i c
Q IG b D Q IG Re7@'RegE
Y I D Q IG E j S Q IG E mXlRPgkuTRPgD
Q q IG RtP(U
h I v s RTI
s I
h Q h gv s eG I I f Q Q I eeCQ h v s edWG IG U Y qG v v
@Q h v s PG I I Q s IG tegE
S Q q s I h I TFR0TtiReG y q S Q h IG rpiRegE
Q h I v s IG U Y tRweu7q
f Q IG b D Y I D U S Q IG E Redca`XWVTRPHFD
A9 ) & 0('(
9 9 9 @
'g 4
$% #
B C

% " $ #
) & 0('

g
Y
Denote by
g
The Markov property says that for
2 31
! "
the density (in the
16.3 Transition density
CHAPTER 16. Markov processes and the Kolmogorov equations
variable) of
Note that depends on and and dont depend on .
h RI
!6 875

or equivalently,
i f s
v jG ~dv
Fi S z
The derivative is The random variable with initial condition

Q q I RtPG y i
@D
S z '@D
and we are making the change of variable
Example 16.4 (Geometric Brownian motion) Recall that the solution to the SDE
Conditioned on , i.e.,
Example 16.3 (Drifted Brownian motion) Consider the SDE
, the random variable
, is Geometric Brownian motion:
only through their difference
has density
, conditioned on
or equivalently,
i " i
z @D @D
and for every ,
is normal with mean
. This is always the case when
Q h xv s eG I I
. In other words,
and variance
179
) i(
(
) i
Yg
g

0
Y
(
iYg
& (T

& '
'
j
&
'g
i@f B QRIgvpG f s
v Q I v G j wRxa8@dY i f s
Q IG RegE
e 6
I v a Q IG RegE
Q I v B Rgd8G f
Y Q I v G j qRp@pY
Q v Q G E t exgw|HG e(w S B RPG Q I f q 0@D i f s # S q 7@D i f s Fe q q e i qi q (C(wS Q v CxpG y h d# gwv
Q I v Ra8G f Q I v i RxdG f i Ff s
i cf s
v Q I v G j 0Rp@Y Y Q I v G j qRa8@aY
D Q q I @FR0WetPG
f "@D
h f
I Q h gv s eQ f IG
i @f s
v jG v
Fe f
16.4 The Kolmogorov Backward Equation
i e 6 (w( wv i Q IG E eRegdS 9 9 9 9 CxH|8gG (w 6 Q v Q G E h t
Ixvd
g#
S Q G cg
I v p I v xd
S Q v Q G E gCxH|HG t
Q h I v s I @ RTPG Q h I v s I kRxTPG v
i S S D Q q s I h I W@wtRPG
v { D x Q s IG cx'egE a tu
Therefore,
where
Using the transition density and a fair amount of calculus, one can compute the expected payoff from a European call:
Therefore,
180
Consider
The variables
and let
and
be the transition density. Then the Kolmogorov Backward Equation is:
in
are called the backward variables.
'g
In the case that and their difference becomes

are functions of alone, . We then write
depends on rather than
and
only through , and
(KBE)
(
g
(KBE)
!
'
j
) i

& l

& '

&
k y
f q f Fee
i f s f i i Y
q j iuS y
h f
@CQ f
i@f s
v jG v
i @ y
S Q q TFR0TqG y
f Q IG b D Q IG Re7@'RegE
Y I D Q IG E j S Q IG E mXlRPgkuTRPgD
f f B f Q U v q v e"@HwG Y y v Q U v q v G "@wHU y 6 S
S t y s f Y U y
f S f Y v f Q U v q v ecpgG y y f q q t S Y S f U v q v @Hw U v q v @pHp y y y y q f S S U v q v @wH y y y f f B Y Y v 6 S Q U v q v G "@pHpU Q"@UgqpvG v y @ h v v f CQ"@UHvqpvG feQ"@UgvqpvG @ F h S v S f eQcUgvqpvG (y y @ F S Q q TFR0`G y f h f Q Q U Y qG v Ce"@aWG v Q IG b D Y I D U S Q IG E Re7@d`XWVTRPHFD
Let
16.5 Connection between stochastic calculus and KBE
It is true but very tedious to verify that satises the KBE
Example 16.6 (Geometric Brownian motion)
This is the Kolmogorov backward equation.
Therefore,
Example 16.5 (Drifted Brownian motion)
Consider
be a function, and dene
(5.1) 181
& i
&
& & i
&
&
w w
& &
w

&
j
A R

9A 9 9
)i !
A9 9 9 9 B

B 9A 9 9 9
!6 6

!6
9A 9
'
!
B

!6
9A
2 31
B
9 9 9 @

l
(
&
( i
'

) &
! !
# # # # !
'
j
i
j
&

'
j
& ('(

' '
j
& l

Theorem 5.50 Starting at
0
j
It s formula implies o

# 0

where
2 x1
Let
5
so
Proof: According to the Markov property,
Therefore, the Kolmogorov backward equation implies
182
be an initial condition for the SDE (5.1). We simplify notation by writing
. Then
, the process
satises the martingale property:
(Markov property) rather than


In integral form, we have
1
183
Thus by two different arguments, one based on the Kolmogorov backward equation, and the other based on It s formula, we have come to the same conclusion. o Theorem 5.51 (Feynman-Kac) Dene

The Black-Scholes equation is a special case of this theorem, as we show in the next section. Remark 16.1 (Derivation of KBE) We plunked down the Kolmogorov backward equation without any justication. In fact, one can use It s formula to prove the Feynman-Kac Theorem, and use o the Feynman-Kac Theorem to derive the Kolmogorov backward equation.
16.6 Black-Scholes
) i

the solution is

x

With initial condition
&
&
@'
Consider the SDE

(&
) i
T0
and
0
7mip'
Then
) i
& l
& '

where
&
2 31
i
We know that is a martingale, so the integral for all . This implies that the integrand is zero; hence

must be zero
(FK)
&
&
) X
& (T
! c
l0

T
) i

j j
9A 9 B

!
!6

) i
j
qi

qi
) i
mip w !
Recall the Independence Lemma: If then
! c
l0

Dene
where
184
is a function to be specied later.
is a -eld,
is -measurable, and
is independent of ,
With geometric Brownian motion, for
B
9 9
!6

where
-measurable
e
e
1 1

Wqiq Wqiq 2 31
! 3
The independence lemma implies

! 3

'
'

'
Now where We thus have
, we have
independent of
) i0 0 e 0
j j jg
i
j

i e i' e i' e @ '
j j j
jn
e '

1
e q@
jn
2 31
! c e q@'
) 1 )
! 1
'

T0
2 x1
CW
&
&
9A
) i
9 9 9 @
9A 9 B 9
A9 9 9 9 2 71 B

BC 9A 9 9 9
!6 6
!6
Note that the random variable whose conditional expectation is being computed does not depend on . Because of this, the tower property implies that , is a martingale: For ,
9A
2 g1
9 B C

9 @
!6
This is a special case of Theorem 5.51.
This is a special case of Theorem 5.51 (Feynman-Kac).
) i
j
& l

& '
&
2 2 2 31
l

We have shown that
Because formula,
This leads us to the equation
Along with the above partial differential equation, we have the terminal condition
'

T

Furthermore, if condition
is a martingale, the sum of the
for some
&
j
at time if
Finally, we shall eventually see that the value at time of a contingent claim paying
. Therefore, , then also terms in . This gives us the boundary must be 0. By It s o is 185
2 x1
C

0
j
& '
q l0 &

jg
"e6
) & 0(
jn
B "
6
2 g1

j
In terms of the transition density
Even if is some other function (e.g., satises the Black-Scholes PDE (BS) derived above.
7

p#
! e q
qi
The Feynman-Kac Theorem now implies that
cl

e q@
jn
"
'
jn
and
In the case of a call,
for geometric Brownian motion (See Example 16.4), we have the stochastic representation
Compare this with the earlier derivation of the Black-Scholes PDE in Section 15.6.
Plugging these formulas into the partial differential equation for and cancelling the pearing in every term, we obtain the Black-Scholes partial differential equation:
186
16.7 Black-Scholes with price-dependent volatility
e q@
also satises the terminal condition

c 0
j
0
j
&
, a put),
is still given by and (SR) (BS) ap-
6
T l0
g
187
and the boundary condition
An example of such a process is the following from J.C. Cox, Notes on options pricing I: Constant elasticity of variance diffusions, Working Paper, Stanford University, 1975:
2 31
2 31
T0 1 ' i
where . The volatility sponding Black-Scholes equation is

c 2 1
decreases with increasing stock price. The corre-
& |
2 31
&
l 1
c
(&
188
Chapter 17
Girsanovs theorem and the risk-neutral measure

(Please see Oksendal, 4th ed., pp 145151.) Theorem 0.52 (Girsanov, One-dimensional) Let , be a Brownian motion on a probability space . Let , be the accompanying ltration, and let , be a process adapted to this ltration. For , dene
2 2
and dene a new probability measure by

) r
Caveat: This theorem requires a technical condition on the size of . If

r
everything is OK. We make the following remarks:

is a matingale. In fact,

189
&
& (
& (
&
# qi
) i
& (
& (

2 1
Under
, the process
, is a Brownian motion.
&
2 x1
2 1
&
&
2 1
#
&
mi
#
|
&
2 31
190
1 1

so

is a probability measure.

in terms of
. Let
denote expectation under
. If
is a random variable, then

) "
Now use Williams standard machine. and

r

. The intuition behind the formula

&
#
but since and , this doesnt really tell us anything useful about we consider subsets of , rather than individual elements of .

Distribution of
. If is constant, then
)i mi
Removal of Drift from . The change of measure from To see this, we compute
C qi
to
removes the drift from
(Substitute
&
mi
) &
&
$ %
&
7mi`
mi
"mi` !
qi
"
&
d#
Under , variance :
is normal with mean 0 and variance , so

is normal with mean

C
|

is that we want to have

1 |

) "

&

#
&

To see this, consider rst the case
#
, where
. We have

3
&

#
is a probability measure. Since

, we have
for every

3

. In particular
. Thus,
and
CHAPTER 17. Girsanovs theorem and the risk-neutral measure

1
191
We can also see that

2

Because
&qi ! G% $ &qi ! $% &qi !
$ %
we have

Means change, variances dont. When we use the Girsanov Theorem to change the probability measure, means change but variances do not. Martingales may be destroyed or created. Volatilities, quadratic variations and cross variations are unaffected. Check:
)
17.1 Conditional expectations under

2 31
Lemma 1.53 Let
. If
is
A
-measurable, then
) RR

Proof:
qC

2 31
because
, is a martingale under
&
&) & (x
"
qC
( ) '
&

C
& |

&
&
Under mean
, is normal with mean zero and variance and variance .
. Under
) &
) &
qi " ) & qi " 7qiV &
qi
"
&
&

by arguing directly from the density formula
is normal with
) X A

C 2
2 31
g

&
&
& w & & r &
)g(& (& &
) i

& (&

& |

& & A
2 x1
C

Although we have proved Lemmas 1.53 and 1.54, we have not proved Girsanovs Theorem. We will not prove it completely, but here is the beginning of the proof.
Lemma 1.55 Using the notation of Girsanovs Theorem, we have the martingale property
&
A & C

8C A 8C

6
B C

A
A ) RC 2
C

Lemma 1.54 (Bayes Rule) If
192
is
-measurable and
2 31
Next we use Bayes Rule. For

& A
Proof: It is clear that property. For , we have
Therefore,
Proof: We rst check that
is
, (Lemma 1.53 again) -measurable. We check the partial averaging . Recall (Taking in what is known) (Lemma 1.53) , then (1.1)
193
Denition 17.1 (Equivalent measures) Two measures on the same probability space which have the same measure-zero sets are said to be equivalent. The probability measures dened by and

of the Girsanov Theorem are equivalent. Recall that

)
5
17.2 Risk-neutral measure

2 2 w1
Stock price:

The processes and are adapted to the ltration. The stock price model is completely general, subject only to the condition that the paths of the process are continuous. Wealth of an agent, starting with several ways:

Risk premium
6
Market price of risk=
@ )9
& l
(&
S3
&
e
u3
&
&
78
(&
Capital gains from Stock

5
Interest earnings
& C
x
k & (
& l
& l
& l
2 31
Interest rate:
. The process
is adapted. . We can write the wealth process differential in
As usual we are given the Brownian motion: , with ltration dened on a probability space . We can then dene the following.

) i
&
2 a1
3 4
&
1 2
(&
S3

If
, then
&
|
&
&

If of
, then to obtain
Because
for every , we can invert the denition
& |
#

&
is
W

Denition 17.2 (Risk-neutral measure) A risk-neutral measure (sometimes called a martingale measure) is any probability measure, equivalent to the market measure , which makes all discounted asset prices martingales.

eeT
ee
) i

' &

S3

&
&
&
S3
) i

&
# |

) C

(&
&

u3
&
5 5 Q

&
(& & l
& |

S3
&

3 u4
(&
& l

&
&
&
j
&

&
B F D D G E
B I F D D R |
) C

B D R I F D
&

5 Q
& C

& l

B D E H F D B D E H F D
B I F D D P E
&
&
&
&
B D G E C F D
Under Then 194
Changing the measure. Dene
The discounted formulas are
Notation:
Discounted processes:
TS
and
are martingales.

For the market model considered here,
195
Look back
This is because
1

, so
) B s 6
X

) B
6
2 1

l
If there is a hedging portfolio, i.e., a process , then satises

1
h v e D Q e G iHg(fl`
Q v Q G `G egH|8'aS
Q Q G ` |Ce|lbv
Q IG RP'`
# 3dS c
s th r p iqS
G S
l
Example 17.1
Y
European call European put Asian call
, whose corresponding wealth process
Risk-neutral valuation. Consider a contingent claim paying an at time .
is the unique risk-neutral measure. Note that because .

1
we must assume that
-measurable random variable
W %
u3
&
U e me 3 e V
& (
qi|
where
& |
#
eeT
'
196
Chapter 18
Martingale Representation Theorem

18.1 Martingale Representation Theorem
See Oksendal, 4th ed., Theorem 4.11, p.50.

then is a martingale. Now we see that if is a martingale adapted to the ltration generated by the Brownian motion , i.e, the Brownian motion is the only source of randomness in , then

18.2 A hedging application

2 2 1

Homework Problem 4.5. In the context of Girsanovs Theorem, suppse that the ltration generated by the Brownian motion (under ). Suppose that is a Then there is an adapted process , such that
A ) 2
is -martingale.
197
2 g1
l &
2 1

for some
& |
& (
l
'
Remark 18.1 We already know that if

&

&
In particular, the paths of
are continuous. is a process satisfying
2 31
A 2 2 1 2 31
Theorem 1.56 Let be a Brownian motion on the ltration generated by this Brownian motion. Let relative to this ltration. Then there is an adapted process
. Let , be , be a martingale (under ) , such that
2 31
&
l
2 31
) X
g3
5
A9 9

l
) 2
2 g1
l &

2 g1
) i

&

&
A )

|

&
& |
& # mi
& |

|

&
mi

&

&

1 2l

3 4
&
Let
Then
198
be a portfolio process. The corresponding wealth process
According to Homework Problem 4.5, there is an adapted process
2 71
2 31

B R

9 9
6
X

) X 2
l
2 1
5
Let be an -measurable random variable, representing the payoff of a contingent claim at time . We want to choose and , so that
&
u3
&
5 u
& 2 1
Set i.e.,
Dene the
-martingale
and choose
5
vb e T
so that , such that satises
|

h &
8 &
8
#
& ) "i

) & # mi
) ) F)
&
#

&
2 1
) ) F)
C
| 1 2
A
y
&
) ) )
&
&
qi

A9 2
C
2 x1
9 9
B C

A9 9 9 9

9 X 6 w 6 X A 9 9 9 9 6
X

The Martingale Representation Theorem guarantees the existence of a hedging portfolio, although it does not tell us how to compute it. It also justies the risk-neutral pricing formula
) X A9
'
9 9
B
s 6
X

A9 )
2 31
9 9
6
X

2
With this choice of
2 1
18.3
where
so
In particular,
CHAPTER 18. Martingale Representation Theorem
Theorem 3.57 ( -dimensional Girsanov) dimensional Brownian motion on
2 1
&
For
2 31
-dimensional Girsanov Theorem
dene the accompanying ltration, perhaps larger than the one generated by , we have ; , -dimensional adapted process. ,a 199 ;
200 Then, under

, the process

is a -dimensional Brownian motion.
Corollary 4.59 If we have a -dimensional adapted process then we can dene and as in Girsanovs Theorem. If , is a martingale under relative to , then there is a -dimensional adpated process such that

18.5 Multi-dimensional market model

, and let following:
A A 2 2 1
F
Let
)
, be a -dimensional Brownian motion on some , be the ltration generated by . Then we can dene the
Stocks

Accumulation factor
) h &
C1
Here,
and
are adpated processes.
) ) F)
) ) F)
) ) F)
2 1
2 x1
2 31
& |
2 31
&
& ) (@i
@i & )
) ) F)
If , is a martingale (under -dimensional adpated process
) relative to , such that
the ltration generated by the Brownian motion
& |
|
&
qi
1 C

&
2 1
) ) ) F
2 g1
C&
Theorem 4.58 on
21 A )
a -dimensional Brownian motion .
&
) ) F)
2 1
2 x1
18.4
-dimensional Martingale Representation Theorem
2 g1
) ) )

&
, then there is a
&
CHAPTER 18. Martingale Representation Theorem

Discounted stock prices
201
Risk Premium
3 C F

Case I: (Unique Solution). For Lebesgue-almost every and -almost every , (MPR) has a unique solution . Using in the -dimensional Girsanov Theorem, we dene a unique risk-neutral probability measure . Under , every discounted stock price is a martingale. Consequently, the discounted wealth process corresponding to any portfolio process is a martingale, and this implies that the market admits no arbitrage. Finally, the Martingale Representation Theorem can be used to show that every contingent claim can be hedged; the market is said to be complete. Case II: (No solution.) If (MPR) has no solution, then there is no risk-neutral probability measure and the market admits arbitrage. Case III: (Multiple solutions). If (MPR) has multiple solutions, then there are multiple risk-neutral probability measures. The market admits no arbitrage, but there are contingent claims which cannot be hedged; the market is said to be incomplete. Theorem 5.60 (Fundamental Theorem of Asset Pricing) Part I. (Harrison and Pliska, Martingales and Stochastic integrals in the theory of continuous trading, Stochastic Proc. and Applications 11 (1981), pp 215-260.): If a market has a risk-neutral probability measure, then it admits no arbitrage. Part II. (Harrison and Pliska, A stochastic calculus model of continuous trading: complete markets, Stochastic Proc. and Applications 15 (1983), pp 313-316): The risk-neutral measure is unique if and only if every contingent claim can be hedged.

Market price of risk. The market price of risk is an adapted process satisfying the system of equations (MPR) above. There are three cases to consider:

) ) F)
x
) ) F)
For 5.1 to be satised, we need to choose
, so that (MPR)
& |
&
e & F
) ) F)
&

&
C1
1 C

&
3
(5.1)
F t
202
4 1 )
3 1 4
&
mi
) & & & & & 3t'e 3 3 3 't & 3 & & & & & & 3 l 3 & (& (& & & 3 j 3 2 2 1 ) ) B &
3
Ql
3 d
(& &
3 T
& 1 6 & &

1

&
A 2 A
Let
In what follows, all processes can depend on and , but are adapted to simplify notation, we omit the arguments whenever there is no ambiguity.
2 1
2 31
A two-dimensional market model
Chapter 19
be a two-dimensional Brownian motion on be the ltration generated by .
2 g1
Stocks:
3 w
We assume
In other words,
has instantaneous variance
has instantaneous variance
3 3 e
and
have instantaneous covariance
Accumulation factor:
The market price of risk equations are
Note that
203
3 e
(MPR) . Let . To
g iS g hS
f S f #S g iS g hS f S f #S
F F F y y
A9 )
2 x1
9 9
6
X

|

A
X
) B & 3
&
6
5
& @
&
3 &
5
5 5
&
5
& @
(&
&
&
&
&
5
&
&
We have changed the mean rates of return of the stock prices, but not the variances and covariances.
) B & 3
& &
3 e 3 js
& 7 6 (& & (&
) i

&
&

A ) h
&
&
&
&| # qi
3 e
@ 3 3 1

3
3
1
provided
The solution to these equations is
204
Suppose
Then
19.1 Hedging when
m rqp4l n o n m
Let

is the unique risk-neutral measure. Dene
be
-measurable. Dene the .
. Then (MPR) has a unique solution
-martingale ; we dene
CHAPTER 19. A two-dimensional market model

The Martingale Representation Corollary implies
) &
205
We have
&
3 e
We solve the equations

3
Every
A
-measurable random variable can be hedged; the market is complete.
The stocks are perfectly correlated. The market price of risk equations are

1
The process
is free. There are two cases:
&
&
3 T4
3 4
1
&
& 1 &

&
The case
is analogous. Assume that
s uo
19.2 Hedging when

. Then
) X
l
2 31
we have
and in particular,

l
for the hedging portfolio
. With this choice of
and setting
& 3
#
l
3
) &
&
3 l't
#
5
l 3
&
| &
&

(MPR)

X
) & & &

3 5
& @
2 1
1 2
3 g f g 3 U
'3
) q
q
& B B & & 3 1 6
3 1 &
3 3
1 1
6 6

&
&

5
T3
5 g g 3 U f f 3 U
) q
5

g
&
& @
&
& @ &
3
5
&
& @
&
&
f
There is no solution to (MPR), and consequently, there is no risk-neutral Case I: measure. This market admits arbitrage. Indeed
) q
W
Case II:
206
have the solution
3 1
Let be an -measurable random variable. If be hedged. For example, if

&
5
(&
3 &
&
w & @
3 '
1
5 5
&
3
1
Hedging:
Notice that
f U
and

Then
Suppose
is free; there are innitely many risk-neutral measures. Let
or
depend on
does not appear.
The market price of risk equations
Set
, then there is trouble.

Positive
depends on
be one of them.
, then it can probably not
& T &
) &
&
&
&
&
|

A9 )
2 g1
9 9
B C

6
X
|

To get so
We can write
CHAPTER 19. A two-dimensional market model
More precisely, we dene the
to match
, we must have -martingale 207
208
&
&
qi
"

&
&
mi
{ | z
"
c
c }
&
&
h (&
mi
"
&
&
&
{ "
qi
z

$
@!
) i

@wxh u v y
y
20.1 Reection principle for Brownian motion
With drift. Let
So the joint density is
Then we have:
Pricing Exotic Options
Chapter 20
Dene
Without drift.
209
s

210
2m-b
shadow path
m b Brownian motion
Figure 20.1: Reection Principle for Brownian motion without drift
m m=b (B(T), M(T)) lies in here
b

t
Figure 20.2: Possible values of
)
G&
&
$ % $

&
&qi) !

&
$

!
&
qi mi !
$ %
&
)
$ &
z
&

z
#
{
#
z
'
!
)
$ &
z

v
&
&qi3 !
z
#
{

t
#
z
$ %
eqiq !
!
'
!
)
&
&
qi
"

$
&
&
t
) i A
y i
w u @~Q
) & # Cqi ! G$% Cqi ! $% Cqi !

$ %
where
2 31
Set
Let
Since

But also,
Under
CHAPTER 20. Pricing Exotic Options
is arbitrary, we conclude that be a function of two variables. Then is a Brownian motion (without drift), so , is a Brownian motion (without drift) on . Dene 211
(MPR)
Hh
k "e 3
t 3
qiq ! 3
! eqiq
T4 q
eCf e
$ S 3 e e
6 ' q 1 q T

) i
D @w~| u y i
y
G$
t 3
! &qi
|
) i

T
3
|

G$
&qi ! 3
A @ @ @ )9
k
3
7
7 3 6
78
qi ! &qi 3

&
& '

@
3 w
e e
S d
' qT
) X

w u @~}
y y h S
e e
Let
where
To simplify notation, assume that the option is
We compute,

(&

where,
Consequently, where Because

1
20.2 Up and out European call.
212
is the risk-neutral measure, be given. The payoff at time
is already the risk-neutral measure, so the value at time zero of is
& &
The standard method for all these integrals is to complete the square in the exponent and then recognize a cumulative normal distribution. We carry out the details for the rst integral and just

) T& (&
&
"
mi
# 1
mi
z
z
m m m
" " "
#
{
mi
z z {
# 1
&
&
mi

q
{
"
"
qi
9 9 9 z
mi qi
! "mi` 3
z
q q 1

&
! qiq 3
#
z {
qi
"
$ 3
! qiq
#
z
#
z
q w
z { z
& & ) ) (3eF) 2
)
We consider only the case
Figure 20.3: Possible values of
~ m
~ M(T)
~ b
(B(T), M(T)) lies in here
so
2 31
The other case,
leads to

2 g1
We compute
: and the analysis is similar.
x=y
x ~ B(T)
. 213
"e 3
"e 3

h h 3 h

c
6
h

3 h
qi

3

c
c
m 1
w
)
h
c
3 g
3 3

c

mi !
g
#
3 {
) X
& $ (&
3
& "
w3
mi
z
#

1

mi
#
z
" q
& &

w3 3 P
w3

3
3 u
03
where
Putting all four integrals together, we have to obtain In the rst integral we make the change of variable give the result for the other three. The exponent in the rst integrand is 214
215
v(t,L) = 0
+ v(T,x) = (x - K)
v(t,0) = 0
Figure 20.4: Initial and boundary conditions.

j fC
If we let
we obtain the classical Black-Scholes formula

4 tPeC d P qPuPeC
If we replace by and replace by in the formula for , we obtain a formula for , the value of the option at the time if . We have actually derived the formula under the assumption , but a similar albeit longer formula can also be derived for . We consider the function
e E
This function satises the terminal condition

I C
and the boundary conditions

eQPfC
We show that
satises the Black-Scholes equation

h d j
PEj
tedtI e# PEj eQ P e fC Pu
HRe# Qd
fC
$" " "
" e E
$" " " 1 " % &f % 4
1 % $" " "
te
de
5 76Q
t I
e
" e E
$tI "
" " 1 "
ea! f! Q
te3feb
(Ee
$" " "
" e E
t dtI
e#
Qdtefeb)fC
(Ee#
I' eb0% t

(Ee#Q
fCe#Q
tee R

$ t" H
" "
e I
$" " "
E

% f
" e E
te
e
I'f|h
I)f
(Re#v
% &
" e E
t dt
"Q
IfCQdt
$" " "
Ib'fh
IbfC
% &f
" #e E
e a!

hte "bfC
Re
dfe&iQx
Proof: First note that
Let
Let
is a martingale.
Theorem 2.61 The process
216
be given, and choose
be given and dene the stopping time
. If

On the other hand, if
e#f!
But when

Suppose
1 b2
In both cases, we have
so we may write
, we have
. Then , then the Markov property implies , then
QI Ct te
itff
udf
tPeCQP
f
V
C D8
Ct
Qtf
e 8
hf
C H8
tff
fI Q
A tff e 9 8
eQ
b'
1 T
"QIt
1 8
5 4e
G F (
C H8
Q RP 5 I Be 1 8 (
G F
5 Be
G 2 F ( E 7 Re
tPeQdeb'feb0% )
C D8
C
e#uBt fCe# @8 A 9
Integrate from to
For
Because
teb'feb)f
E 7
(E
The Hedge
Let
then follows.
The PDE
is a martingale. Therefore,
be the wealth process corresponding to some portfolio
Then
and
We should take
, we compute the differential
is also a martingale, the Riemann integral
A stopped martingale is still a martingale
if if
. Then
. 217
W X U
eb
ueb
218
v(T, x)
v(t, x)
Figure 20.5: Practial issue.
20.3 A practical issue

Y
In particular, the hedging portfolio can become very negative near the knockout boundary. The hedger is in an unstable situation. He should take a large short position in the stock. If the stock does not cross the barrier , he covers this short position with funds from the money market, pays off the option, and is left with zero. If the stock moves across the barrier, he is now in a region of near zero. He should cover his short position with the money market. This is more expensive than before, because the stock price has risen, and consequently he is left with no money. However, the option has knocked out, so no money is needed to pay it off. Because a large short position is being taken, a small error in hedging can create a signicant effect. Here is a possible resolution. Rather than using the boundary condition
eQ fC tff Qf
V
solve the PDE with the boundary condition

eu
Y `
2. The value of the portfolio is always sufcient to cover a hedging error of size of the short position.
1.
remains bounded; times the dollar
f
where is a tolerance parameter, say %. At the boundary, short position. The new boundary condition guarantees:
t f
Qdf
f
For
but near ,
has the form shown in the bottom part of Fig. 20.5.
is the dollar size of the
e ve4
1
8
s %i
tf
C
e &cd
8 fu
d 8
G F
e
8 f
G F
b c
f
C D8
fC
Dene the undiscounted expected payoff
QP
f 8
Payoff:
Introduce an auxiliary process
f
we have the solutions
With the initial conditions
Value of the payoff at time zero:
Stock:
Asian Options
Chapter 21
by specifying
219
it
d
b u #
ut e
C
F
e cd
q p h f rig
1
8
G F
G F
b c
1
8
iP
bQ
31 8
G F
hf#Qf
8
V
U j 8
8
V C D8
U
U
C H8
8 4
H 8
V V

U 8
e Gb eHRe#QHGRef e
"Q
hcCt e b e h
e t
31 8
e v
iw
e ve
iw
e y"
The function
One can solve this equation rather than the equation for .
1 E
eHRe GR e
fC
G F
hf@
e b iGcGRef e
e b hcHGR e h 1
eQ
u ' 1
is the option value at time , where
x j 1 1
1
the terminal condition
Start with the stock price
21.2 Constructing the hedge
The PDE for
One can solve this equation. Then
and the boundary condition
21.1 Feynman-Kac Theorem
220
is
satises the PDE
. The differential of the value
of a portfolio
f
P
so that We want to have is (1.1)
"
1 8
thf 9 ht f
hPb eIEQPf
iP h
eCQI
e4
eQ
Pthe" e
e## Q
Pthee
E 7
IEe u #
QCGR e
eC
8 f
b c
f I

u u
C H8
CH8 fbt f h 8 h 8 8 8
tffC j 8 8 Q
31 8
Compare this with
because both these processes satisfy the same stochastic differential equation, starting from the same initial condition.
C H8
fbf
8 f
U 8
G F
hfP 8
Take
The differential of the value of the option is
CHAPTER 21. Asian Options
21.3 Partial average payoff Asian option
1 8
G F
hf
Qf
U
If
PthPeQP
Now suppose the payoff is
tff
just as before. For
The hedge is given by and boundary condition with terminal condition

Qd
where
The function
x
V
at time . This value is
satises the Black-Scholes PDE . We compute , we compute next the value of a derivative security which pays off , then (From Eq. 1.1) 221
222 Remark 21.1 While no closed-form for the Asian option price is known, the Laplace transform (in the variable ) has been computed. See H. Geman and M. Yor, Bessel processes, Asian options, and perpetuities, Math. Finance 3 (1993), 349375.

)
Chapter 22
Summary of Arbitrage Pricing Theory

A simple European derivative security makes a random payment at a time xed in advance. The value at time of such a security is the amount of wealth needed at time in order to replicate the security by trading in the market. The hedging portfolio is a specication of how to do this trading.

22.1 Binomial model, Hedging Portfolio

8
Evolution of the value of a portfolio:
so that

(four equations)
223
There are four unknowns:
. Solving the equations, we obtain:
d e
Given a simple European derivative security use a portfolio processes

V
, we want to start with a nonrandom
@V
d
e4
Let Let
be the set of all possible sequences of coin-tosses. We have no probabilities at this point. be given. (See Fig. 2.1)
and
224
The probabilities of the stock price paths are irrelevant, because we have a hedge which works on every path. From a practical point of view, what matters is that the paths in the model include all the possibilities. We want to nd a description of the paths in the model. They all have the property
If we change , then we change , and the pricing and hedging formulas on the previous page will give different results. We reiterate that the probabilities are only introduced as an aid to understanding and computation. Recall: Dene Then
@V
i.e.,
x U
In continuous time, we will have the analogous equation

8
@V
x U
d
f
x U
@V
xU
x U
The paths of
accumulate quadratic variation at rate
per unit time.
PE
w R
PE
Let
. Then
p p qo r S E
k n
QRP
% &
UI

U 8
PE
PE
PE
t d
R
1 E
k m l
QRP
PE
UI U
U U It
8 8
8 U 8
j
1 1
It
PE
hi
fh g
d d
G G

V U

V U
CHAPTER 22. Summary of Arbitrage Pricing Theory

If we introduce a probability measure under which martingale, regardless of the portfolio used. Indeed,
@V x U
225 is a martingale, then
| 7{ U | 7{
We need to choose and so that

q
8
The solution of these equations is

j
8
22.2 Setting up the continuous model

Now the stock price , is a continuous function of . We would like to hedge along every possible path of , but that is impossible. Using the binomial model as a guide, we choose and try to hedge along every path for which the quadratic variation of accumulates at rate per unit time. These are the paths with volatility . To generate these paths, we use Brownian motion, rather than coin-tossing. To introduce Brownian motion, we need a probability measure. However, the only thing about this probability measure which ultimately matters is the set of paths to which it assigns probability zero.
f PE f f hf
j 1 } x 8
x 8
q%
%
$"
"
"
"
x !
x}
y
%
, and compute
| {
To nd the risk-neutral probability measure
~ l
under which
is a martingale, we denote
$"
"
"
"
y a
%$ "
"
"
"
xU
xU
xU G
xU
Suppose we want to have must have
, where
is some
-measurable random variable. Then we
$ "x "
"
"
G $ "w " Q t"P
"
will also be a
x U
a $" " "
"
U x
z y
226

, the paths of per unit time. We want to dene

C
so that the paths of accumulate quadratic variation at rate per unit time. Surprisingly, the choice of in this denition is irrelevant. Roughly, the reason for this is the following: Choose . Then, for ,
w
Since we are interested in hedging along every path, except possibly for a set of paths which has probability zero, the choice of is irrelevant.
The most convenient choice of so and
is
i
f
C D8
8 f
df 8
. With this choice of ,
then this set of paths has positive probability when
p h if 7 Pudf
is dened by
f
If a set of stock price paths has a positive probability when

C
is dened by
f
In other words, regardless of whether we use or in the denition of paths. The mathematically precise statement is the following:

f
C g
p h 3if
p h if
PQdfe
~d
p h if
Pudf
is a continuous function of . If we replace However, there is an such that

by
, then
is a different function.
, we will see the same

f
G7
p h if
Pudf
PQdf
df
accumulate quadratic variation at rate
f
f

f
w
Let

, be a Brownian motion dened on a probability space
. For any

z
227 is made, we have

C D8
and
is the risk-neutral measure. If a different choice of

f
S Q I RP 8 f df 8 p h if G PQdf C U
22.3 Risk-neutral pricing and hedging

z y
Let
denote the risk-neutral measure. Then

hf
C 8
Evolution of the value of a portfolio:

8 ftf
V
which is equivalent to
f f
x
Now suppose is a given -measurable random variable, the payoff of a simple European derivative security. We want to nd the portfolio process , and initial portfolio value so that . Because must be a martingale, we must have
i
V
This is the risk-neutral pricing formula. We have the following sequence:
% f
$"
"
"
"
E E Ea E {
Regardless of the portfolio used,

a
f
C 8
f
f
f 8 f
8 f
tf
E { E
f
f
xU
xU
so
E
C 8
f
Then
x 8
hf
where
is a Brownian motion under
. Set
has the same paths as . We can change to the risk-neutral measure Brownian motion, and then proceed as if had been chosen to be equal to
, under which .
fI
C H8 E
Q tP
fC
8
I
8 f
f 8
C C
E E {
is a
(3.1)
(3.2)
(3.3)
228 1.
a
is given,

V
under . We next use the corollary to the Martingale Representation Theorem (Homework Problem 4.5) to show that
f
C 8
for some proecss . Comparing (3.4), which we know, and (3.2), which we want, we decide to dene
fBf f
x
Remark 22.1 Although we have taken and to be constant, the risk-neutral pricing formula is still valid when and are processes adapted to the ltration generated by . If they depend on either or on , they are adapted to the ltration generated by . The validity of the risk-neutral pricing formula means: 1. If you start with
a C C a
Remark 22.2 In general, when there are multiple assets and/or multiple Brownian motions, the risk-neutral pricing formula is valid provided there is a unique risk-neutral measure. A probability measure is said to be risk-neutral provided
% f
$"
"
"
"
xU
2. At each time , the value
of the hedging portfolio in 1 satises
hf
then there is a hedging portfolio
, such that
and it will end with value

y x !
$"
"
"
"
From (3.3), the denition of
, we see that the hedging portfolio must begin with value
hf
Then (3.4) implies (3.2), which implies (3.1), which implies that the portfolio process .
hf
V
To carry out step 3, we rst use the tower property to show that
z y
dened by (3.3) is a martingale
hf
U
3. Construct so that (3.2) (or equivalently, (3.1)) is satised by the dened in step 2.
R { R f
V
f~
df
xU
hf
2. Dene
, by (3.3) (not by (3.1) or (3.2), because we do not yet have
). ,
(3.4)
(3.5) , is the value of

it has the same probability-zero sets as the original measure;
229
it makes all the discounted asset prices be martingales.
To see if the risk-neutral measure is unique, compute the differential of all discounted asset prices and check if there is more than one way to dene so that all these differentials have only terms.
C 8 C
22.4 Implementation of risk-neutral pricing and hedging

To get a computable result from the general risk-neutral pricing formula
%
a x
one uses the Markov property. We need to identify some state variables, the stock price and possibly other variables, so that
% " "
is a function of these variables.
where
0D( F 0y
&y' ( )H
7 g
7B'Bt6
0H
046
46
Take
and
to be the state variables. Dene
D(
Example 22.2 Assume and
44t
and
is a martingale under are constant.
"
" y'
"
"
46Bt6
04
Then
y y'
y'``
( H6
0HBt6
Example 22.1 Assume and variable. Dene
are constant, and
$"
"
$"
" " "
y x
f f
xU U ( (
. We can take the stock price to be the state
C 8
G F
P
xU
C 8
In every case, we get an expression involving to be a martingale. We take the differential and set the term to zero. This gives us a partial differential equation for , and this equation must hold wherever the state processes can be. The term in the differential of the equation is the differential of a martingale, and since the martingale is
&4646Bt6
)0D(&'
4 46
" " " F " y'0&H&' " " % 4 " &46464t W
46
" y y'
046
hi h h fh 07Bx4t F I hh W
r S y' p p p p p p qo
6 Q RP )0D(&'
&y(x 4 46 04t'0&46&t646#
46&46&t6)446t4
4@464t " " " % 46
46 4
46@&44t " &y(x D
46
Then
Take
Example 22.3 (Homework problem 4.2)
and
230
and
46
46
Then
and
to be the state variables. Dene
we can solve for

8
f
. This is the argument which uses (3.4) to obtain (3.5).

.
46464t
4604&t6) &46&t6'
'&46&4Bt6
)4
46 4&t6)4 4 46&46Bt6
4 46 46 4
D46
7B'Bt6
D3
% 0 t % HD R
3(
##
t #
R
4 46 46
0&46@&46Bt6
4&t6
( S 46&46Bt6
Q RP F I 46 46
0&Hx(
where it should be noted that
The partial differential equation satised by
Example 22.4 (Continuation of Example 22.3)
. We have
, and all other variables are functions of
4t
where (see (3.2))
is
, and
. We want to choose
4`
4&t6'
Therefore, we should take

&46&t6)`
to be . We have so that
231
232
Chapter 23
Recognizing a Brownian Motion

2. 3. Then
is a martingale,
f f
, (i.e., informally
is a Brownian motion. is normal, with . We shall show that the
Since the moment generating function characterizes the distribution, this shows that is normal with mean 0 and variance , and conditioning on does not affect this, i.e., is independent of . We compute (this uses the continuity condition (1) of the theorem)
f
C H8 E
so
S Q P RtRI 8 5
uses cond. 3
233
f
if
Proof: (Idea) Let be given. We need to show that mean zero and variance , and is independent of conditional moment generating function of is
$
C H8
1 d
'E

5 u
C H8
5 i
C H8
1 d f
$"
" E E
"
"
C H8
F 2 E
C H8
5 i
5 #i
5 Q
5 8
f
1. the paths of
C
are continuous,
).
Theorem 0.62 (Levy) Let , such that:

C
be a process on
, adapted to a ltration
d C
if
C
$" " " " (E E " " " E 5
5 Q
$"
5 #
E 'R
5 Qd
5 x
5 ec
5 ecf
1
hf
f
| 8
5 Qf
5 Qd
$" " " " E 6 5 if QdG
% &
$" " " " E 6 5 a! F
$" " " " E 1
% &
5 Q
% &
5 f
$" " " " % 4
G
E 5 i 1 G F !
Q q
C D8
$ "
" " "
C D8
5 i
1 5 1
G F F
% 4

C H8
C H8
Now

We dene
so that
Plugging in , we get
Therefore, and It follows that 234
is a martingale (by condition 2), and so
8
C D8
t t
C D8
C D8

C D8
8 8
8 8
8 8

C D8
C H8
C D8
C D8
t t
C D8
8
C H8

C H8

C D8
8 8

C D8
C H8
t t
C H8
C D8
t
C D8
8 8
C C
C H8
Dene processes
23.1 Identifying volatility and correlation
CHAPTER 23. Recognizing a Brownian Motion
Let
and
Dene
be independent Brownian motions and
and
The Brownian motions
Then
and
Therefore,
and similarly
and
have continuous paths, are martingales, and
are Brownian motions. The stock prices have the representation
and
by
are correlated. Indeed, 235
8
A 8
8 9
8 9
C D8
C D8 C D8
8
8
C D8
~ C D8 ~
t ic
C D8
C D8

8 C D8
C D8
8 8
e~
C D8
e~ u
eQ
t t t t
n
8 8
8 8
Suppose we are given that
where
23.2 Reversing the process
236
and
are Brownian motions with correlation coefcient . We want to nd
If
This corresponds to
A simple (but not unique) solution is (see Chapter 19)
so that
, then there is no
and
Continuing in the case

t ic
t ic
, we have
CHAPTER 23. Recognizing a Brownian Motion
237
so both
and
We can now apply an Extension of Levys Theorem that says that Brownian motions with zero are independent Brownians. cross-variation are independent, to conclude that
Qd 8
C D8
C H8
are Brownian motions. Furthermore,
238
Chapter 24
An outside barrier option

Barrier process:
hf
d 8
Stock process:
C H8
at time , where

d
Remark 24.1 The option payoff depends on both the and processes. In order to hedge it, we will need the money market and two other assets, which we take to be and . The risk-neutral measure must make the discounted value of every traded asset be a martingale, which in this case means the discounted and processes.

239
C H8
C 8
C D8
C 8
We want to nd
and
and dene
ee
f
dB
iG }d
P4x
. The option pays off:

b2i%e
where
, and
and
are independent Brownian motions on some
C H8
C D8
f f
d
d ~
8 f
$
240 so that
C 8 E ee R
We must have (0.1)

We solve to get
x
We shall see that the formulas for and do not matter. What matters is that (0.1) and (0.2) uniquely determine and . This implies the existence and uniqueness of the risk-neutral measure. We dene
The value of the option at time zero is

dB H e
y
We need to work out a density which permits us to compute the right-hand side.
i.e., the correlation between
and
is .
8
e~
tP
hPe
Remark 24.2 Under both
and
has volatility
has volatility
and
Under , and are independent Brownian motions (Girsanovs Theorem). risk-neutral measure.

z y
C 8
C D8
C D8
8
d C 8
z 8
C D8
8 8 8 8
q if p h
(0.2)
is the unique
p h 3if
PQ
q
C
t

C 8
8 8
W
p h 3if
8 d
d
g g
p h if p h if
P P
f if C
iG }d

Set

s R
df
C
gif q p h
P

C 8
d d 8
Then
From the above paragraph we have
p h 3if p h 3if
PQ PQ
C 8

d d
C iz
The joint density of
so so The stock process. so Recall that the barrier process is and
CHAPTER 24. An outside barrier option
, appearing in Chapter 20, is 241
Furthermore, the pair of random variables is independent of are independent under . Therefore, the joint density of the random vector is
ee
%
E
E k
G
p h if
P
y
e ee E R
B H
We know the joint density of
24.1 Computing the option value
242
. The density of
is
because
C h
The answer depends on and . It also depends on depend on nor . The parameter appearing in the answer is
Remark 24.3 If we had not regarded as a traded asset, then we would not have tried to set its mean return equal to . We would have had only one equation (see Eqs (0.1),(0.2))
to determine and . The nonuniqueness of the solution alerts us that some options cannot be hedged. Indeed, any option whose payoff depends on cannot be hedged when we are allowed to trade only in the stock.

y C z
p h if
The option value at time zero is
and
. It does not
(1.1)

k
P
8 l y 8 8
p h 3if

W p h 3if
4 4 5 5

p h 3if
P
G F
e#Q heC
0 ' $ 2 3 1) (& #"!k k %

tP
d
C 8
and
C iz
e Q
y
P
hPeC

d
243 , then
h R
8 8 d
If we have an option whose payoff depends only on original equation for ,
is superuous. Returning to the
we should set
z
Now we have only Brownian motion, there will be only one , namely,
and we are on our way.
24.2 The PDE for the outside barrier option

Returning to the case of the option with payoff
ee
E
we obtain a formula for

e%
E 5 6
u u
u i
C 8
C 8
d 4
tf
if e
C 8
8
. We compute
tf
if e#
P
and
t
iPeC
P
by replacing , and Now start at time 0 at process

P
by
, and respectively in the formula for . . Using the Markov property, we can show that the stochastic
E A C A@ FDB
8 6 97
Bt
u #
eIEQGR e
y E
fC
9 He#Q
so with
we have
so
(Levys theorem), and
C D8
C D8
C H8
C D8
244
y L v(t, x, L) = 0, x >= 0
x v(t, 0, 0) = 0
"

Setting the
term equal to 0, we obtain the PDE
The terminal condition is
and the boundary conditions are
e4
Figure 24.1: Boundary conditions for barrier option. Note that
is xed.
~e
eQ
de
u u
"QIPef
u i
Ge
eQH
CGR e
f
e
8
V
U d
8 U V
U 8
Let denote the number of shares of stock held at time , and let denote the number of shares of the barrier process . The value of the portfolio has the differential
f
V
d
8
e
8
tf
if e
8

d 8
f
C 8
f
d
e u

8 f
e u e#u
e
8
% f C 8
f
C 8
f 8 f

f 8
e u
f e
8
d C
d

% u C 8
C 8
C 8
e Q
hffC e E
8
eQ
%
eHRe QHPefC
eQCPefCeQI
ue
This is the usual Black-Scholes formula in .
This is the usual Black-Scholes formula in .
u u
the terminal condition is
The boundary conditions are
the terminal condition is
xe
eQ
Cte e
e
On the is
boundary, the option value
On the boundary, the barrier is irrelevant, and the option value is given by the usual Black-Scholes formula for a European call.
be
eQIt" e q
efC
where that
After setting the
24.3 The hedge
term to 0, we have the equation
The boundary condition is
, and
are functions of . Note
tf
d
h f
tf
hff
Therefore,
C
e
245
f
d
hff hff
Qdf Qdf
V
htf
tP
hPeQP
U d U
8 f
V
fe#
8
To get
hffudf
and This is equivalent to 246 for all , we must have
Chapter 25
American Options
This and the following chapters form part of the course Stochastic Differential Equations for Finance II.
25.1 Preview of perpetual American put

C D8
25.2 First passage times for Brownian motion: rst method

(Based on the reection principle)

z C
Let
be a Brownian motion under
, let
be given, and dene

df
is called the rst passage time to . We compute the distribution of . 247

The plan is to comute and then maximize over to know the distribution of .

to nd the optimal exercise price. We need
if if
tt
I % Pe
fe4
C e4
iQi
I % 7i Qd
V
iQ
"
`
Let
be given. Suppose we exercise the rst time the stock price is
tf
|
Intrinsic value at time

G H
or lower. We dene
f
S
8
p h 3if
U V 4 3T
F
" "
p h 3if
4

F
4 5 w R "" 3 wR

p h if
p h 3if
4
F
8 8
4 5 3
8
p h 3if
5 iG @
Dene
We make the change of variable
8
f
C 8
Now Therefore, From the rst section of Chapter 20 we have 248 Figure 25.1: Intrinsic value of perpetual American put
in the integral to get
K
Intrinsic value
Stock price
ji
p h 3if
gz u d
z y
iz
y
hf C
z 8
f C "
CiQx
C C
G G
C
p h 3if
f df C
p h 3if
e Q
gz
X `
G F
I X Y5
p h 3if
p h 3if

F v
S
8
p h 3if
U V 4
W
z gz
W W W
f 8
gz
so
For
Reference: Karatzas/Shreve, Brownian motion and Stochastic Calculus, pp 196197.
25.3 Drift adjustment
Reference: Karatzas and Shreve, Brownian Motion and Stochastic Calculus, pp 95-96.
Under
We x a nite time xed, dene
Dene
We also have the Laplace transform formula
CHAPTER 25. American Options
, the process
, dene
and change the probability measure only up to
, is a (nondrifted) Brownian motion, so

$
(See Homework)
. More specically, with 249
f
C
Qx
e4
Q 8
p h if
G F
I X Y5
df
C e&iQx
ji
p h 3if

8 8
#
8
p h if
G F

G F
#
W
p h if

#
p h 3if G F
y #
u
y y y y y

% % b
p h if p h if
$ "
" "
d d

"
p h 3if
p h if
I be a I b a I ab| I a b

I ab I a be
For
ji
Since
Therefore,
250
is arbitrary, this must in fact be the correct formula for all
For for nondrifted Brownian motion:
25.4 Drift-adjusted Laplace transform

we have .
Recall the Laplace transform formula for
C g
p h 3if
df
c V
q
b z
f f c Dc etViQ c T T

e hQ
c V
c !X
et iQ%
c V
I 5#i X e YX
G
4 I a
#
#
I 5 X
e YX

Y
Pq

#
I X Y5

Y
"
'
d
Y
the Laplace transform is
where in the last step we have used the formula for
with
replaced by
c dPX

T 4
e Q
G F
c V
p h 3if
c V
G F
p h 3if
p h 3if
G F
I 5 X
If
, then
I 5# X
e YX

I ` X
if
, then
for every
#
Therefore,
I ` X
(Recall that
Letting
e
Y
If
If
we obtain
25.5 First passage times: Second method
Let
(Based on martingales) , then , then and using the Monotone Convergence Theorem in the Laplace transform formula ). , so . 251
be given. Then
ggg p
c
f
C p
ih
Q RP
gggi h
I fhh
ggg

g gg
p h f 3in
p qo
p h f 3in
df P 8
C D8
e4
e4
eb0f
p h 3if
e

ef
eh
eb
ef
e)f
for the rst passage time for nondrifted Brownian motion.

Y
I X Y5#i QiX

# #
i Q
4 I
p h 3if
Q Q
deb0f
C #
ebf
deb0f
p h if
C g d

p h if
de0f

C #
eb
C g
p h 3if
deb0f
C #
p h 3if C
eb C g de)f
eb)f
ebg
There are two possibilities. For those
this is justied by the Bounded Convergence Theorem. Therefore,
We want to take the limit inside the expectation. Since
is a martingale, so
252
is also a martingale. We have
for which
p h 3if
p h if d
Q
d
eb0f
d
where we understand
Therefore,
For those
for which
to be zero if
Let
25.6 Perpetual American put

T
e
, so
. We have again derived the Laplace transform formula , . ,
U
y w x
u F u Y

Intrinsic value of the put at time :
We want to choose the largest possible constant. The constant is

'
U

v 9
U
w x
v 9
h
V V
s t
s t

p h 3if
c dt

PE
q r
PE
V V
I % 7e
i t
PE PE
f
C
"
& & &
Q Q Q
"
df"
tfV
Let
"
The curves Therefore,

T
We compute the exponent
Dene
be given. Dene for
are all of the form
. 253
254
value
K-x K 2 (K - L) (x/L)-2r/
Stock price
Figure 25.2: Value of perpetual American put
value
C3 x C2 x C1 x
-2r/ 2
-2r/ 2 -2r/ 2
Stock price
Figure 25.3: Curves.
U
'
'
v 9
ec %

V
V
W W
and
Since
We have Note that

x
where to get We solve
Solution to the perpetual American put pricing problem (see Fig. 25.4):
we have 255
f gYq
(7.4)
In other words, solves the linear complementarity problem: (See Fig. 25.5).
k ~x~p d q
t pd q qo o k q p k 51o n
h f ~ p x k o d q t q q x ~ q q dk q ~xk k x ~ d k ~ q q o k p1o k 1d k n p k n q p51o1#n k p5k11k 51dn k o n p ko q

, then , then
p d xk 5k o p o q q r q
256
25.7 Value of the perpetual American put
Set
b p o (h f p h HVke 1o D`Y p o 7(~ qr j e } { x ~dk | p w Vp wz x o o y 1dn p ko qv t ulskQi k p ko 51dn q r de 5 f g 9 Y

. If , then
If
mQjh l k i
If
mQjh l k i
If
t l k Qi
where , then
Figure 25.4: Solution to perpetual American put.
L*
K-x
Stock price
-2r/ (K - L* )(x/L* )
(7.3) (7.2) (7.1)
value
257
Figure 25.5: Linear complementarity For all ,
One of the inequalities (a) or (b) is an equality.
and is the boundary between them. If the stock price is in , the owner of the put should not exercise (should continue). If the stock price is in or at , the owner of the put should exercise (should stop).
p o
p o
or equivalently,
p s o
p o
p p o p os p o o q q p Q o pp h o o dn
Let be given. Sell the put at time zero for stock and consuming at rate at time . The value
. Invest the money, holding shares of of this portfolio is governed by
o p o p 7(~ o p s P(~ p o 7(~ q
25.8 Hedging the put

p h 1o
hQ n k k q n q n k p5k owp51odnk k qr
p o
p os p Q o
p o
p ut h
The half-line
is divided into two regions:
pk o n qv h n k 5k q n q n
gk
sk

(a) (b) (c)
258
We should set
To hedge the put when , short one share of stock and hold in the money market. As long as the owner does not exercise, you can consume the interest from the money market position, i.e.,
3.
is the smallest process with properties 1 and 2. be a supermartingale satisfying
We use (8.1) to prove (8.2) for
, i.e.,
pp h o 1o !n
pp h 1o
z p ho o |{Dy 1 q
w1o i p h
Case I:
We have
Proof of (8.3), assuming
is a supermartingale satisfying (8.1):
p o
If is not zero, we can take to be the initial time and adapt the argument below to prove property (8.2).
to be the initial stock price, and then
t l
p h o p1o !n 1s p ho f h ijh p o o!n7(~ p p o Q
Then property 3 says that
t Ql
i h
p o p
o 7(~ p s o qr Q
Explanation of property 3. Let
t Ql
i jh
2.
1.
p p o !n 7(~ o p o p o P(~ p p o !n 7(~ o qv p Q p o o !n 7(~ p p o dn 7(~ o
Properties of
is a supermartingale (see its differential above). ;
f d q
p p o 1n o p m o

p o
p o
lp o p p o !n o qr l Hp o
Remark 25.1 If
, then

(8.1) (8.2) (8.3)
P5( p o p p o 1p o o n 77(~ P(~ f Yq p o p o o p o 7(~ p n n o p p o o p o n p 7p o dn 7~ o p p p o o p o p o !n q 7(~ p p o n p s o o f ( po Y f
The discounted value of the put satises
259
25.9 Perpetual American contingent claim

p p o x o
Intinsic value:
where the supremum is over all stopping times. Optimal exercise rule: Any stopping time Characterization of :
which attains the supremum.
25.10 Perpetual American call

q p o 57~ o (
Theorem 10.63
k !
p ko 51dn
p ko 51dn
o !n 7(~
3.
is the smallest process with properties 1 and 2.
t Ql
l jh
p o P(~ p o
o !n 7(~
2.
pp o pp o p p o
o !n 7(~
1.
is a supermartingale; ;
p o x 7~ p o
Value of the American contingent claim:
pp h o 1o !n f 5Y p p | {z y o r o 7(~ q P Q 5Y o Dp
(Fatous Lemma) (by 8.1)
(See eq. 7.2)
5Y
(D
p o D
p ko 51dn
Q 1s p ho
Now let
to get
(Since
5Y
o Dp p h o pt o Q 1s Q 1o p h
h u
Case II:
: For
, we have (Stopped supermartingale is a supermartingale) )
D z | Y(1 y { (
p o p o q r e h
.
p ko 1dn
ki7p o
7~
l Q p
p o 57~ o
p o 7(~ p o e
and dene
k po h k pk1!n o
7~ k f q g 7(~ p o 7(~ q p p o o 7(~ e q p ko p o o 7(~ Q 51dn p q j Q
Now start with
Let
Then:
Proof: For every ,
260
1.
is a supermartingale (in fact,
p1o !n 1 p h o p ho p p o o 7~ p o q Q
2.
t Ql
i jh
Therefore,
to get
, i.e.,
p ko 1!n
.
Value of the put:
~ p p o r o (Y ~ f q k p o
See Fig. 25.6. It can be shown that jump.
There is no optimal exercise time.
Remark 25.2 No matter what
Intrinsic value:
Expiration time:
25.11 Put with expiration
we choose,
(value of the put at time if
stopping time
is a martingale);
are continuous across the boundary, while )
n n n
Y 5k dn p o
Let
p h 1o
be given. Then has a
! h
p k o
p1ox k n h n k n k n n q q q
p p o x1Y (~ o ~
Y(1 (
p o 5k dn
Value of the contingent claim:
pp o x o h e
i k i sQjh k
q r
p k !n o
n k n k n n Yq q h n n h n d q k q r n
k h p k !n o n k n h n k n q k n q r k
1.
q ui
p p o !n 7(~ o o 7(~ p p o !n 7(~ o Q i h p o !n 7(~ p o
2.
ui
i jh
p o p
Then
Intrinsic value:
25.12 American contingent claim with expiration
Expiration time:
3.
At every point . .
p ut h
Characterization of : Let
p h 1o
Figure 25.6: Value of put with expiration
be given. Then is a supermartingale; , either (a) or (b) is an equality. ; 261 (b) (c) (a)
2. 3.
If
, then there is no optimal exercise time along the particular path .
p o x p o
p p o
The optimal exercise time is
d(h o n
bdje
p p o !n 7(~ o p p o 7(~ o p p o o !n 7(~ Q i h p o !n 7(~ p o
ui
1.
262
p Bo
is a supermartingale; ;
Chapter 26
Options on dividend-paying stocks

26.1 American option with convex payoff function
p

where and are processes and a.s. This stock pays no dividends. be a convex function of , and assume . (E.g., ). An Let American contingent claim paying if exercised at time does not need to be exercised before expiration, i.e., waiting until expiration to decide whether to exercise entails no loss of value.
263
p o
pp o o
pp o o x
p o
Consider a European contingent claim paying is
p o p o i po ppo x o p o p o f
at time
p o
p o
p to
and
, so
. The value of this claim at time
d i
i h
p 5o
sq
po i jh p o
Let
be the time of expiration of the contingent claim. For
p ko 51x f p51ox p h o p k o 1x q d i p k x x d x 51x hp oo p k o q
Proof: For
and
, we have
k 1o
p ko 1x
p o h
(*)
pp o o p ho 1 k h p o i ih h o p o Q p o p o p o
Theorem 1.64 Consider the stock price process
i i d Qjh p ko 51
264
Figure 26.1: Convex payoff function Therefore,
(by (*)) (Jensens inequality)
is a martingale)
This shows that the value of the European contingent claim dominates the intrinsic value of the American claim. In fact, except in degenerate cases, the inequality
is strict, i.e., the American claim should not be exercised prior to expiration.
26.2 Dividend paying stock
Let and
be constant, let be a dividend coefcient satisfying
pp ko k 1x 1o
ui
p o p o p p o o p o p p o po o p o pp o o
i jh
p o
l f d
p o ox p Q p o
l h
p p o f p o p o po p o
p Q o p o o x d p o d p o d p o d p o p o p Q o
p ko 51x p k o 51x p p o x o
.... .... . ..... ......... .. ..... . ..... ....... . . ..... . .... .... .... .... .... .... .... .... .... .... .... .... .... ..... ..... ..... ..... ..... ..... .. . . ...... . . . . . . . . . . . ..... . . . .. .. .. . . . .... .... .... .... .... .... .... .... .... .... .... .... .... ..... ..... ..... ..... ..... ........ . . .... ...... ..... . . ...... . . . . ....... . . . . ........ . . .......... . . . . . . ........... . . ............ . . ..............
CHAPTER 26. Options on dividend paying stocks
265 be the time of dividend payment. The stock
Consider an American call on this stock. At times , it is not optimal to exercise, so the value of the call is given by the usual Black-Scholes formula
This function satises the usual Black-Scholes equation

%
and boundary condition
The hedging portfolio is
p h o
1.
p p o
Proof: We only need to show that an American contingent claim with payoff need not be exercised before time . According to Theorem 1.64, it sufces to prove
k 85Y 0 p k p
p o o n ui l p p m o f i jh p o o i p % ui jh h h o % i p f o dn p o k 1o p 5k o q d q
( 7 6 &
Y e
(where
) with terminal condition
i jh
h k %
% 5
% q
i h
Theorem 2.65 For
, the value of the American call is
p p o o (73 ~ ~4 2 3 p k o % f e p p o o % 01kpY o dn p o k 1o p 5k q d q ( & )Y'e
where
%
p o p
p 5k o
At time
, immediately before payment of the dividend, the value of the call is
p p o Y p
o !n o q d
At time
, immediately after payment of the dividend, the value of the call is
, where
p # $
! "
o Vp
o k
where
at time
ui
l i jh
p t o pp o p o Y d o p p o o p o Vp q o q u q q p o p o p ( o p h o u q ( 5k pp q o ~ u~ o (~ p k o q d q o uk o q pp 5k q p o k !n
p ho 1e
be an expiration time, and let Let price is given by
266
Since
, we have immediately that
To prove that is convex in , we need to show that is convex is . Obviously, is convex in , and the maximum of two convex functions is convex. The proof of the convexity of in is left as a homework problem.
is the number of shares of stock held by the hedge immediately after payment of the dividend. The post-dividend position can be achieved by reinvesting in stock the dividends received on the stock held in the hedge. Indeed,
# of shares held when dividend is paid
dividends received price per share when dividend is reinvested
Case II: . The owner of the option should exercise before the dividend payment at time and receive . The hedge has been constructed so the seller of the option has before the dividend payment at time . If the option is not exercised, its value drops from to , and the seller of the option can pocket the difference and continue the hedge.
k 1o
pkpY o dn o k q d kq q
p s o
4 A 3 B
p s o
p o m
where
p pkpY o o p n o p 5k ospY q d o q d q d p k 5pY o dn 5k o p q d
Case I: . The option need not be exercised at time have
p o Y p po p o q d p s
o o %
k 1olHp5kpY o !n o q d
k o
o p s o q d o sY p s q d o
pkpY o !n o q d p o
p m o
p o s
Let
@ 9
26.3 Hedging at time

(should not be exercised if the inequality is strict). We
p5kpY d o !n o q 0 phpY h o dn p o h 1o q d q
& Y'e
p h o
o p5kpY d o !n k q
p 5k o
h h !n p o p 5k o %
%
2.
is convex in .
uq
k 1o
Chapter 27
Bonds, forward contracts and futures

F p G
Here, and are adapted processes, and we have already switched to the risk-neutral measure, which we call . Assume that every martingale under can be represented as an integral with respect to . Dene the accumulation factor
I ) H
p o
Given
dollars at time , one can construct a portfolio of investment in the stock and money 267
U V
p o
A zero-coupon bond, maturing at time , pays 1 at time to the risk-neutral pricing formula, its value at time
and nothing before time . According is
3o E
Let be a Brownian motion (Wiener process) on some sider an asset, which we call a stock, whose price satises
p o
Q R
p o p o Q p o p o p o
p o
p 53o
p3o P
q S T e p p o to p o e p o
p o (
p o
p o
ei
i h mp o
H
p o
C
C D
. Con-
268
martingale
If is random for all , then is not zero. One generally has three different instruments: the stock, the money market, and the zero coupon bond. Any two of them are sufcient for hedging, and the two which are most convenient can depend on the instrument being hedged.
p t o
i.e., . Then given above is zero. If, at time , you are given invest only in the money market, then at time you will have
f d
p 53o
p o p o p o p o q (
p 3o
p o
p o
p o
If
is nonrandom for all , then
i umi
f d 3s p o
p o
p o
p o
If, at any time ,
and we use the portfolio
p s o
We set
o p o p o p s o p Q7p o o o p C om p oQ p o p o p s p o o q
The value of a portfolio satises
, then we will have
dollars and you always
p o
p o p o
p o p o p o p o p o f pC P p h p3o 53o o tp o p o C p5o p3o P p h 1o p o C p p3o o p53o P p o d
p o p o f p o p o
p o
market so that the portfolio value at time
is 1 almost surely. Indeed, for some process ,
{ p z o
p o
p Q o
p t o
p o
(*)
CHAPTER 27. Bonds, forward contracts and futures
269
27.1 Forward contracts

We continue with the set-up for zero-coupon bonds. The -forward price of the stock at time is the -measurable price, agreed upon at time , for purchase of a share of stock at time , chosen so the forward contract has value zero at time . In other words,
This implies that

W
27.2 Hedging a forward contract

Enter a forward contract at time 0, i.e., agree to pay for a share of stock at time . At time zero, this contract has value 0. At later times, however, it does not. In fact, its value at time is
p h o
This suggests the following hedge of a short position in the forward contract. At time 0, short -maturity zero-coupon bonds. This generates income
p o
p o W p o
Remark 27.1 (Value vs. Forward price) The -forward price the forward contract. The value of the contract at time is zero. time which will be paid for the stock at time .
is not the value at time of is the price agreed upon at
p o
po p h 1o p o p o 1o pp h
p h 1o
po p o p o
P P
p h o
p o p o p p o
p h o
p f p o p o W aq p o
W X
p o p o p o f q W p p o o p to q W p o p o o
p h 1o p h 1o
W X
o 1o p h W Xq p o ph1o W Xq p o p to po p o
We solve for
ui
i h
p o
p p o
W X
p o p o f p o p o p o e h
p h 1o
p o o
p o p o p o p o p o
p h 1o
p o
d
W
p o
p o
270 Buy one share of stock. This portfolio requires no initial investment. Maintain this position until time , when the portfolio is worth
A short position in the forward could also be hedged using the stock and money market, but the implementation of this hedge would require a term-structure model.
27.3 Future contracts

Future contracts are designed to remove the risk of default inherent in forward contracts. Through the device of marking to market, the value of the future contract is maintained at zero at all times. Thus, either party can close out his/her position at any time. Let us rst consider the situation with discrete trading dates
. At time Enter a future contract at time , taking the long position, when the future price is , when the future price is , you receive a payment . (If the price has fallen, you make the payment . ) The mechanism for receiving and making these payments is the margin account held by the broker.
b
at times
. The value at time
of this sequence is
Because it costs nothing to enter the future contract at time , this expression must be zero almost surely.
p ~
p o p o Rp o p o go p p o d u Gc f q c d 3 ~ t c c 3 b P ff Vbf b 9 d i d e p p p o p o o o q q
ff VVf
d i
d e
d i
d e
By time
, you have received the sequence of payments
p o
p o
d e
p o
d e
pp o p o o q p o q d e
d i
d e
b
p o
is
-measurable.
Vp o y wxp o q c c c p 53o
Q 1
4 ig h f
dP
u vc t sr p q
I )
p o
d e
On each
, is constant, so
b V
f f bVf
p h 1o
Deliver the share of stock and receive payment
p h o
W X
p to
p o l
W
p h 1o l
P
W X
q h
p o
c 3
c 3
d e
e d

The continuous-time version of this condition is
271
satisfying
Theorem 3.66 The unique process satisfying (a) and (b) is
On the other hand, if (b) holds, then the martingale

U V
satises
this implies
p o 3
p 53o
U e
p o
P q p o
p o 5
i jh i f p 53o
p o 5
p o
p 3o
Proof: We rst show that (b) holds if and only if is also a martingale, so
ui jh h i U Vp o p o 5 f po p o ui j9p i h o
is a martingale. If
i jh p o
p o
Denition 27.1 The -future price of the stock is any
-adapted stochastic process
p o
Note that appearing in the discrete-time version is approximating a stochastic integral.
-measurable, as it should be when
a.s., and
f
(a) (b) is a martingale, then
i jh
c
U V
p o
p o 5
p o 53
P
pto p o e
p o 53
p p53o 5o P d p 5o
p 3o
h d
p o p o
p 5o
d p 3o
U
p o
p o p o d
S T
p o
p o 5
S T
p o
p o p o
p o
p 3o
p o
S T
p 53o
272
and so
is a martingale (its differential has no
With a future contract, entered at time 0, the buyer receives a cash ow (which may at times be negative) between times 0 and . If he still holds the contract at time , then he pays at time for an asset valued at . The cash ow received between times 0 and sums to
Thus, if the future contract holder takes delivery at time , he has paid a total of
27.5 Forward-future spread

p o
Future price:
p h 1o
p h 1o
p o
If
and
are uncorrelated,
p o p o
pp o o
p o
p h 1o
p o
Forward-future spread:
p o
p o
p o
pt o p o
p o
Forward price:
W
pto p o e
p h 1o
p o
for an asset valued at
p o
p o
p ho 1
p h 1o
With a forward contract, entered at time 0, the buyer agrees to pay The only payment is at time .
for an asset valued at
27.4 Cash ow from a future contract

W
p ho 1
p o
p o
p h 1o
pp o
Clearly (a) is satised. By the tower property, is the only martingale satisfying (a).
is a martingale, so (b) is also satised. Indeed, this
f
.
ui
i h
p o po p o e
Now dene
term).
p o t
p ho 13o
p o 3
p o
P
p ho 1
273
This is the case that a rise in stock price tends to occur with a fall in the interest rate. The owner of the future tends to receive income when the stock price rises, but invests it at a declining interest rate. If the stock price falls, the owner usually must make payments on the future contract. He withdraws from the money market to do this just as the interest rate rises. In short, the long position and . The buyer of the future is in the future is hurt by positive correlation between compensated by a reduction of the future price below the forward price.
27.6 Backwardation and contango

f p o
C
We have
The expected future spot price of the stock under
is
f g
p o
Because
is nonrandom,
and
are uncorrelated under
p o p o
p h o f p h p o e o q C d e( H p o p o (~ f e p o p o W p p o p o o p o p h o u p q o C p h ( o u p q o p o C ( 7 p o e
p o
Then
, and
po p to f p H q to q
p o p o p o H p 3o o H p
( p o
(~
Dene
p o
u p o
po
Suppose
p to
f
. Therefore,
p h 1o
i p h H1o
p o
p o
If
and
are positively correlated, then
274
p o
p ho 1
If then
, then
This situation is called normal backwardation (see Hull). If . This is called contango.
p h 1o
p h 1o e
The future price at time
is
po l h p1o
Chapter 28
Term-structure models
C
In a term-structure model, we take the zero-coupon bonds (zeroes) of various maturities to be the primitive assets. We assume these bonds are default-free and pay $1 at maturity. For , let price at time of the zero-coupon bond paying $1 at time . Theorem 0.67 (Fundamental Theorem of Asset Pricing) A term structure model is free of arbitrage if and only if there is a probability measure on (a risk-neutral measure) with the same probability-zero sets as (i.e., equivalent to ), such that for each , the process
Remark 28.1 We shall always have
for some functions
and
. Therefore
275
p o
p o p o p o 5 i p p o o p o p o d
i jh
p o
p o
p o
p o p o q j p o p o d p o i p p o t
i 5
p o p o p o p o
i Qi
i h
ho 1e
i h i f ui j9p o i h
Suppose we are given an adapted interest rate process lation factor

Q
ui
i jh
i
H
p5o P
p o p t o
i jp o i h i h 9p o p o
H
Throughout this discussion, , and

W
is a Brownian motion on some probability space is the ltration generated by . . We dene the accumu-
p o
F p h
3o E
276 , the mean rate of return of under , is so is a risk-neutral measure if and only if the interest rate . If the mean rate of return of under is not at each time and for each maturity , we should change to a measure under which the mean rate of return is . If such a measure does not exist, then the model admits an arbitrage by trading in zero-coupon bonds.
H
28.1 Computing arbitrage-free bond prices: rst method

Begin with a stochastic differential equation (SDE)
The solution is the factor. If we want to have -factors, we let be an -dimensional be a function Brownian motion and let be an -dimensional process. We let the interest rate of . In the usual one-factor models, we take to be (e.g., Cox-Ingersoll-Ross, HullWhite).
We showed in Chapter 27 that
for some process . Since and there is no arbitrage.
has mean rate of return
under
is a risk-neutral measure
28.2 Some interest-rate dependent assets

p o f d
d RH
ui
i h
p o
Call option on a zero-coupon bond: Bond matures at time Price at time is
p o
Coupon-paying bond: Payments
at times
. Price at time is
. Option expires at time
uui i
p o
ff VVf
i jh
p o p t o p o p o p p o p o o
Vp o U
i h p o
Now that we have an interest rate process prices to be
, we dene the zero-coupon bond
p o
p o
n
p o
p o
p o
p Q o
p o p Q o
pt o H p o
n
p o
m 5
p o p Q o
b H
p o
p 3o
f f bVf
sq S ( e po p o p o
p o
k l
p Q o
p o
p o
p Q o
p Q o
CHAPTER 28. Term-structure models
277
28.3 Terminology
Denition 28.1 (Term-structure model) Any mathematical model which determines, at least theoretically, the stochastic processes
for all
28.4 Forward rate agreement

Let be given. Suppose you want to borrow $1 at time with repayment , at an interest rate agreed upon at time . To synthesize a forward-rate (plus interest) at time agreement to do this, at time buy a -maturity zero and short -maturity zeroes. The value of this portfolio at time is
p o
xo
p o P p t o p
A q
The forward rate is

p s
xo
p 5
or equivalently,
p f t o
p r
At time , you receive $1 from the -maturity zero. At time effective interest rate on the dollar you receive at time is
, you pay $ given by
3 2 q 3 2 Y
p q
p p5 o
3 2 q 3 2 Y
p o p5
p 5
ui i
p 5 o p p o o q o p
is equivalent to determining
ui i
i jh
i jh
p o o p
p p o p o
Determining
p o
xo
q d
p t o
or equivalently,
p s o
t o p p
Denition 28.2 (Yield to maturity) For -measurable random-variable satisfying
, the yield to maturity
ui
is the . The (4.1)
i jh q
t o p i uh t(
p t o

p i p 5
l i
ho 1
i h
p o
p o
t
sq p o
t
p o f p o
t
sq
p o p o o t u p u u q u p o u q p o
.
Up o
p 3o

p o p o f q

q p 3o
yp o q p o
Vp o U
sq
S ( e
x 9 w $"v
p o u u e u p o u e p o
d p o
p o
p t o p 5 o
You can agree at time to receive interest rate at each time . If you invest $ at time and receive interest rate at each time between and , this will grow to
p o
p 5 o
t
sq
p t o
u u
p o p 5 o

xo
p 5 o
u u
xo
xo
p o
This is the instantaneous interest rate, agreed upon at time , for money borrowed at time .
Conclusion: at time .
On the other hand,
so
Integrating the above equation, we obtain
278
28.5 Recovering the interest

from the forward rate
p
C
pp o p
q o
~ }
p o p o o p f p pC o o p o t q o p5 o sq ~ } t o 5 o p q q p 5 o t

p 5 o
p o
~ }
|
C
p o
U |
p1 ko pk1 o p k 5o f } } } e e e p o p o p q o q p o f 2 3 2 C { y y {z | {z p p o q Uz 5 oH q p o S S p o p5 o p o u p o q C p o p o q

t
p o
Now
i jh
53o p
C
p 3o P
p o mq ( t p p u t o t o t uisix 3o h p i i h p sj 3H o p 3H P 1o o p h
p o ho t 1
28.6 Computing arbitrage-free bond prices: Heath-Jarrow-Morton method
For each
, let the forward rate be given by
Here
and
In other words,
p o
C
p o p o
and Then Let Recall that
~ }
p o
are adapted processes. 279
f
and
p 3o
C
p 3o P
pt o P o p h
t
p o
h 3o p ho i ih p 3oH 1r i jh f ui i ui i f
, let for all
i jh
H i h i f p o(Gt o p pp t o pp t o
p o(G o p pp o p o p o t o p p C o o p o p q t o p o p p C o o q p o p
under
o q o p o q o p p o

Then
f p 53o P
Not only does (7.1) imply (7.2), (7.2) also implies (7.1). This will be a homework problem.
uui i
i jh
p 5 o
p o
uui i
i jh
p 5 o
i Y eui
i jh
p o o p
Suppose (7.1) does not hold. Then neutral measure. Let
o p o p o H H p3o p3( P o p o q q I ( C P p o o p53( p o C i h o p

C
ui
p H o
Differentiating this w.r.t.
p o 5 H
i.e.,
p o
In order for
28.7 Checking for absence of arbitrage
280
is a risk-neutral measure if and only if
to have mean rate of return
p t o
Differentiation w.r.t.
yields the equivalent condition
Theorem 7.68 (Heath-Jarrow-Morton) For each , be adapted processes, and assume , be a deterministic function, and dene
t i jh 1o i p h i i reh 3o p
t
, we obtain
is not a risk-neutral measure, but there might still be a riskbe an adapted process, and dene
, we must have
and . Let (7.4) (7.3) (7.2) (7.1)
p o(G o p p p t o o
p t o
p o
281
is a family of forward rate processes for a term-structure model Then without arbitrage if and only if there is an adapted process , satisfying (7.3), or equivalently, satisfying (7.4).
and volatility
. The excess mean rate of return, above the interest rate, is
and when normalized by the volatility, this becomes the market price of risk
The no-arbitrage condition is that this market price of risk at time does not depend on the maturity of the bond. We can then set
and (7.3) is satised. (The remainder of this chapter was taught Mar 21) Suppose the market price of risk does not depend on the maturity , so we can solve (7.3) for . Plugging this into the stochastic differential equation for , we obtain for every maturity :
Because (7.4) is equivalent to (7.3), we may plug (7.4) into the stochastic differential equation for to obtain, for every maturity :
28.8 Implementation of the Heath-Jarrow-Morton model

Choose
p o
p o
p o o u p p o p f p o Q C p (G o u o o p p p
p o p
p o p p p t o o o q
pp o p o t o q p o
ui jh i uf ui jh i i
p o f pp p t o o o q
pp p t o o o q
Remark 28.2 Under
, the zero-coupon bond with maturity
has mean rate of return
i sh p o
p o p p q o p o o o
p o o p
p ( o
i o o
o p
i
H
p o
i gh o p
p o
282 These may be stochastic processes, but are usually taken to be deterministic functions. Dene
Because all pricing of interest rate dependent assets will be done under the risk-neutral measure , under which is a Brownian motion, we have written (8.1) and (8.3) in terms of rather than . Written this way, it is apparent that neither nor will enter subsequent computations. , and the process The only process which matters is (8.4)
C
From (8.3) we see that . Equation (8.4) implies
i h 1o p h
In conclusion, to implement the HJM model, it sufces to have the initial market data and the volatilities
p o
ueui i
i h
p o
p o
This is because vanish.
and so as approaches
(from below), the volatility in
ueujh i i
p o
obtained from
is the volatility at time of the zero coupon bond maturing at time (8.5) must
i mh 1o i p h
and then the zero-coupon bond prices are determined by the initial conditions , gotten from the market, combined with the stochastic differential equation
p o
p uiei h 5 o i p p o i ueui h o i p p H o
p o
ui
p o p o p o q
i jh
p ( o
p o
this determines the interest rate process
p o
p o Q p o t o p
p o
p o
p o
t ui
p o
i h
p o
Then
for
is determined by the equation (8.1)
ueujh i i
1o p h
xo
p h 1o
uujh t 1o i i p h
Let
be determined by the market; recall from equation (4.1):
f p 53o P
p p
(8.2) (8.3)
o H p o q p53o 53( C p o C o(Gp o Q p
sq I ( p o 5 P o p o
P
p o
p t3o H p o p o C p H o
t t
283 and satisfy (8.5). We can then dene
and (8.4) will be satised because
Remark 28.3 It is customary in the literature to write rather than and rather than , is the symbol used for the risk-neutral measure and no reference is ever made to the so that market measure. The only parameter which must be estimated from the market is the bond volatility , and volatility is unaffected by the change of measure.
H
i h o p
We then let be a Brownian motion under a probability measure , be given by (8.3), where is given by (8.2) and initial conditions
C
, and we let by (8.1). In (8.1) we use the
p o H p 5 o
ueujh i i
pt o u 1o p h
u
p o p p q o o
xo
We require that
p o
u u
p o
p h 1o
p o
be differentiable in
p o
284
d b
f f bVf
p Vo
d e
p Q o
d e
u d t

is the row vector
ff Vbf
Denition 29.1 (Gaussian Process) A Gaussian process the property that for every set of times
Gaussian processes
Chapter 29
, , is a stochastic process with , the set of random variables
p Q p Q o p o o f f bVf b i i i jh i p b Q VVf o f f
Remark 29.1 If
is jointly normally distributed.
is a Gaussian process, then its distribution is determined by its mean function
p oQ p o e
and its covariance function
p o k k f"ippVo o ~ pVo p o fVVf q f q q d Db b d e k Hp Q ( k Hp Q o o f f bVf b H p Q b p Q o o ff VVf b p oRpV3o o p pV3oQBo p 3o i e p p o f
where
Indeed, the joint density of
is the covariance matrix
f f bVf o p b o p i ff Vbf b b f f b ff p V b f o i Vbf Vbf o p ff ff Vbf p o i Vbf p o ff

b
, is the row vector
is
, and
D o p
p o
p Vo
i i i
p o ib f f b p bVf o i p o i
The moment generating function is
ff VVf
k k
where
285
p n 1o
t
t
j j
P Q n p n 1o f I )( P Q n p n 1o P t I e p Vo j P n p n 1o wd t j | { Dz y P P n p1o n n p no V po V t o P t pV3o C e p b3o p o b3( t t C
t t
f p 3o
p3o
P
p 3o
i
p5 P o p o
C
p Q o
h p o
p o 5
S
S
To prove that a process is Gaussian, one must show that has either a density or a moment generating function of the appropriate form. We shall use the m.g.f., and shall cheat a bit by considering only two times, which we usually call and . We will want to show that
b
ff Vbf
p Q o
pb3o
C
pp V3o
pb3o pp V3o C p xVo o o p

C i
p o
h p o
29.1 An example: Brownian Motion
286
Brownian motion then
is a Gaussian process with
and
. Indeed, if
i jh
Theorem 1.69 (Integral w.r.t. a Brownian) Let dom function. Then
p o
C C o
f p V3o p C b3o e f V3o p C C j
p o o q C p o
C e p 3o Q e i
Proof: (Sketch.) We have
f
C
p o V3Q
This shows that
t(
Therefore,
is a Gaussian process with
is normal with mean 0 and variance and

Martingale
p o b3Q
be a Brownian motion and
. a nonran(1.1) ,
te

i h i p1o n
:

I )
b3o p

H
o
V3o p
Vo p pb3o p o t Vo p1o n p t
p n 1o
C
p no 1(
h p n o
C
Vo p
t
C
pn1( P o
p Vo
n p n 1o o p n f ot
pn1( o
p o
Now let
CHAPTER 29. Gaussian processes
be given. Just as before,
p o p o f
C
We now compute the m.g.f. for
n 1o p n o p o p Q7V3Q f n 1o P n 1o P p n p o p n h p Q o p o V3Q 5 e P P 5 U U P f P S S ( P P Qn p n 1o p n p n 1o o I )( Q n p1o n n n1o P p p 3o I )( Qn p n 1o f i 4 f t o I7( d 5s e Q pV3o $ 4 tG t I e Qn n1o 4 p t o I)( V3o 4 p i e p o p Q b3Qo p o
(1.1) 1.2
Vo p

te
t t
p n o
C
p Vo t
t t
This shows that
pb3o p o p Vo p o
The solution to this ordinary differential equation with initial time is
pn o

f f bVf
l i sh
to get
Take
Integrate from to to get
conditional expectations and use the martingale property
is jointly normal with
, where
(1.2) 287
288
Remark 29.2 The hard part of the above argument, and the reason we use moment generating functions, is to prove the normality. The computation of means and variances does not require the use of moment generating functions. Indeed,
Therefore,
P n o p n p b3o f o p o p pp o o o p o b3o V3Q q p QBVb3Q p Q7b3Q
If were a stochastic proess, the It isometry says o
However, when is stochastic, is not necessarily a Gaussian process, so its distribution is not determined from its mean and covariance functions. Remark 29.3 When is nonrandom,
C
is also Markov. We proved this before, but note again that the Markov property follows immediately from (1.2). The equation (1.2) says that conditioned on , the distribution of depends only on ; in fact, is normal with mean and variance .
p Q o
n 1o p n f
po n
p 3o
p b3o
p5 P o o p Q
pV3o
i jh
and the same argument used above shows that for
| V3Q p o
V3o Q p
pp o b3Q
{ z b3o p
p o
p QVV3Q o o p o
p n 1o
y p o V
I q
p o V
p b3o
o p o p Q7b3Q
o o p o ppV3oQ q p QBVb3Q i i sjh
by the It isometry. For o
po n
pb3o
p Q o
For xed
h p o p o
p ho 1Q
is a martingale and
, so
p 3o
p5 P o
p Q o
p o V3Q

y= v=
289
z
z z
s y t (a)
y=
s v (b)
s v y t (c)
Proof: (Partial) Computation of : Let be given. It is shown in a homework problem that is a jointly normal pair of random variables. Here we observe that
and we verify that (1.3) holds.
n x 3x p o p o f
p o 53Q
p3x P o
i h
p n 1o
p o p o e
p 3o
zi
p 3o
p o p o p V3so
Then
is a Gaussian process with mean function
and covariance function
p x o
p5op53o P
p ( o
h p o
p o
5o p
p53( P o
p o
p o
Theorem 1.70 Let Dene
be a Brownian motion, and let
and
n (
Figure 29.1: Range of values of
for the integrals in the proof of Theorem 1.70.
be nonrandom functions.
(1.3)
n p3 3x o p o n p o 3x p o
p oxp3 o

p x3 o p o
p n o

p oxp3 o

p o
p n p o 1o G3x
p3 1o Gp o p n o
P
p o
P
p n p o o G3x

px 1o Gp x o p n o
P
p n 1o n n
p x o
p o 3x

p1o n
px p o o

po n
p 3x o p o
P P o p o n o p n p 3x P P P o p o n 1o p n x p 3x p 3oQ o p p 3x P P o p o p Q7p3oQ7p x3x P P o o p o e p oQ7p o P p3oQ73x P f p o e o p o p 3o p V3 Q e
Remark 29.4 Unlike the process
We have
290
, the process
p o 3Q
P
p s o
p 53o
p o 3(
P
p Q o
(See Fig. 29.1(c))
(See Fig. 29.1(b))
(See Fig. 29.1(a))
is
p n 1o
P P P
p n 1o p n 1o
P
p n 1o
P
p V3o
b3o p
neither Markov nor a martingale. For
where we have used the fact that is a martingale. The conditional expectation , nor is it a function of alone. not equal to
p o
p o V3
p o V3
291
is
p3x V3Q b3s o p o p o
pV3oQ7p3ox p o b3s
p V3o
p o 3Q
p o 3x p o b3s p o p o 53Q73x l i jh
P
p53oQ7p3x o
p Vo
p s o
292
P V
p3o o p 5o
~ 1
~ p 3o e
i
P p h o
~ p o e
3o p
C
p5o o
53o p
p53o
p 3o
P p h 1o
p o
Integrating, we get
e e
p p o p o u p o 5 o f p o C p o p o f
7p o

Then
p 3o
p o p o p o
where , and
p o
C
Consider
p o p p o o p o u p o p o q p H1o
are nonrandom functions of .
so
p o p o 53H
P p h 1o
~ p o e
The process
From Theorem 1.69 in Chapter 29, we see that
We can solve the stochastic differential equation. Set
Hull and White model
Chapter 30
is also Markov. is a Gaussian process with mean function (0.2) (0.1)
293
p o
n f
p1o n o
p o 3H
~ P
p ho 1r p h t 1o
where
t 1j 1o 1o p ho p h p h q q d( P Q n ~ p n 1o ~ P p5o p h 1o ~ P P q ~ q I ( P p o P pd qo p o pd qo (
x&
p o
p h 1o
n f
p po 3o 7 o p Q1 o
P P P p3oH p h p o 1o ~ o g x p o P P p h 1o w
p o f
The price at time 0 of a zero-coupon bond paying $1 at time
p 5o
P p h o
P ~ P p o 9 ~ p o e
p o
3o p
C
P p5o o p Q o p o P
and its variance is
According to Theorem 1.70 in Chapter 29,
Then
We want to study
294
. To do this, we dene
is normal. Its mean is
is (0.3)
p1o n
po
p o
&
Because is a Markov process, this should be random only through a dependence on
p o
p oj o p o p p o q q t( UVp o p53o p o f sq ST e h pt 1oj pt h1o p1o h h p h 1o f q q ~ P p h o p1o n q

of the zero-coupon bond:
p no 1H
n f
P ~ p no 1H p n w 3o ~ P ~ p3oH o p53oH ~ P P
CHAPTER 30. Hull and White model
Figure 30.1: Range of values of
Consider the price at time
Therefore,
Note that (see Fig 30.1)
30.1 Fiddling with the formulas
for the integral.
. In fact, 295
p ho r
u = t
p o
C U V
p o p o p o p o bVf f f

p o
p o
o p f p o p o q p p o p o p o p o p o p o t o p q
p h 1o p o p o p 3o uq p 5o
p o p n 1o q
P
p 5o
p n 1o
The reason for these changes is the following. We are now taking the initial time to be rather than should be replaced by Recall that zero, so it is plausible that
n f Vbf ff
VVf P ff

f n
x
p1o n o q
p n 1o
p o p r o
where
Similarly, see that the
and this should be replaced by
296
should be replaced by terms cancel. In
. Making these replacements in , however, the term does not cancel.
p ho 1j
p o p 3o
Let
30.2 Dynamics of the bond price
to obtain the bond price, its differential must be of the form
p 3o
S (1T e
p o
Because we have used the risk-neutral pricing formula
q p o C p o q q p o
p o p o p o p o op o p o
q q p o q p o p o
t or o p o p p p t o q q t( p o p t o
and
we have denote the partial derivatives with respect to . From the formula , we
p h 1o
p o p
h o j
po n o q
p o
p o p u p o p o
p o p H o p h 1o p o p o p o q q t ~ p o p n1o p r o o ~ 3o P p p o p o 1o p o q
p o
C
p t o
Therefore, we must have
We leave the verication of this equation to the homework. After this verication, we have the formula
p o p o p o p o p p q o p o o
.
p o
p o
p o p o p o Bx o p t o p o p o o p p o p q q q q
Suppose we obtain determine the functions
30.3 Calibration of the Hull & White model
In particular, the volatility of the bond price is
Recall:
for all , , and
from market data (with some interpolation). Can we for all ? Not quite. Here is what we can do.
Step 1. From 4 and 5 we solve for
We take the following input data for the calibration:
1.
ueuh 1o i i p h
2.
p h o
3.
uiuijh p o o h p h ui ijh p o p h 1o
; ;
5. 4.
(usually assumed to be constant); ; 297
, i.e., the volatility at time zero of bonds of all maturities.
k s!
h h d p k 1o p5khh h do k s! h 51o p k
}
n f
po n o q q p h 1o
1r p ho
P po p 3o f u o u p h
u
q e
p o p o
h e u
u

p h t 1o
u
We can then compute
Step 2. From the formula
p h 1o
P ~ p no 1H p ho 1j o ~ p ho t 1j h e 1o p h
We can use this formula to determine
p o q p o p o p f uieuh po p ho 1r u i pto o p p o f u q P n p1o 1j u n p to p ho o q u P n 1j u ~ p1o n p o 1 p ho q u P n x U ~ p no p no p ho 1j u o q 1HP u ~ 1S P n " ~ ~ pno U p no p ho 1j u o q ~ 1H ~ u 1S uujh to i i p
From assumption 4 and step 1, we know all the coefcients in this equation. From assumption 3, . We can solve the equation numerically to determine the function we have the initial condition .
This gives us an ordinary differential equation for , i.e.,
We now have
p to
we can solve for
298
Remark 30.1 The derivation of the ordinary differential equation for requires three differentiations. Differentiation is an unstable procedure, i.e., functions which are close can have very different derivatives. Consider, for example,
p o
p ho 1H
i jh p H o
o
u u u u
for all
for all
. Recall that
as follows:
known function of
u u
P p53o p p o o 4 4 ~ f e x& P 4 p53oH7 ~ p h 4 ~ 1o p o 4 e p o
n f n
~

P 4
p1o n

P 4
p o 3H
P 4
~ 1o p h p 3o
p k o f p
t
p o r p o q q D r p o p q
.
Then
Assumption 5 for the calibration was that we know the volatility at time zero of bonds of all maturities. These volatilities can be implied by the prices of options on bonds. We consider now how the model prices options.
Consider a European call option on a zero-coupon bond with strike price The bond matures at time . The price of the option at time 0 is
h d p5khh o h d k s!
h d
p ko 5
}
p ko 511
t
p k 51o
}

h h d d
i 51o p k
}
p k 5o
t
for many values of .
we have
but because
30.4 Option on a bond
and expiration time
We observed at the beginning of this Chapter (equation (0.3)) that
p 53o
p53o 4 P p o ~ q ( o p o o z o q p p o o x q ut
We also observed (equation (0.1)) that
5~
5~

4
j ~
where
is the joint density of
is normal with
U z
p 53o
P 4
S x&
U z
p 53o
P 4
is normal with 299 .
p k 1o
Because of the Markov property, this is random only through a dependence on . To compute this option price, we need the joint distribution of conditioned on . This
p o
p o
p o
p 3o
p o
j p o q
p o
k
S
p i o (i x q d q d q d d r D o p o p
P p 3o i 4 P pp o p o H5o o pp p 53o o 4 q q UVpp o p o o 3o pp p 5o o P i f q 4 S T e
The option on the bond has price at time zero of
The price of the option at time
In fact,
7p o
p 53o
where
300
is dened in Equation 0.2.
is jointly normal, and the covariance is
is
(4.2) (4.1)
p o o 4 o q p o p p D q
~ e o o
o
5~
5~
d(
p 3o
U e
p o
p 5o
sq S e
p o
y U V
f p o p
n q
p n 1o p o o
p o
p 5o
p o n
p 3o
P4 ~ ~ 4 o ip o p 53o p o q 4 S ~ e p 3o o 4 4 ~ e p o pp o p o o p o q e 4 ~ 4 ~ p o p o p o p o e ~ p1o n 4 4 ~ vp o p5o p o q 4 ~ e ~ ~ p o 4

U V
p o
p 53o
pair of random variables has a jointly normal conditional distribution, and
Advantages of the Hull & White model:
The variances and covariances are not random. The means are random through a dependence on .
Short-comings of the Hull & White model:
2. Interest rate is normally distributed, and hence can take negative values. Consequently, the bond price
r p o q
1. Leads to closed-form pricing formulas.
2. Allows calibration to t initial yield curve exactly.
1. One-factor, so only allows parallel shifts of the yield curve, i.e.,
p o p o p o q t(
p o p o
i
p o e
can exceed 1.
so bond prices of all maturities are perfectly correlated.
p o
301
302
Chapter 31
Cox-Ingersoll-Ross model
In the Hull & White model, is a Gaussian process. Since, for each , is normally distributed, . The Cox-Ingersoll-Ross model is the simplest one which there is a positive probability that avoids negative interest rates.
is called the Orstein-Uhlenbeck process. It always has a drift toward the origin. The solution to this stochastic differential equation is
This solution is a Gaussian process with mean function
Dene If
, we have
I 'H
There are innitely many values of 303
for which
Qh p o h Q hQHp o p o d p o H p o Vfbf p o p o p o f f P p 3o i ~ d
and for each ,
, but (see Fig. 31.1)
53o p
p o
c C
c C
p o
P o p h
p h 1o
p o e
p o q
~ p o e
and let
be the solution to the stochastic differential equation
p h 1o p h 1o 1o p h ff Vbf
We begin with a -dimensional Brownian motion constants. For , let be given so that
. Let
and
p o
ff Vbf
h l QHp o p h Ho
p o
VVf d ff
be
u t
p 53o
p 53o P p 3o
p o
C
u t
p o
p o p o
p o
u t
p o

u t t
p o q ~ p o u t Q q q u t
u t t
p o
It s formula implies o
88
h f
h k 8 $8 t t k VVf k k ff h Q p o
. Then
ff VVf
h p o
H
If
Let
304
, (see Fig. 31.1)
There is at least one value of
r(t) = X2 (t) 1
Figure 31.1:
x2
can be zero.
for which
if if
p k
k 1o k
Dene
( X (t), X (t) ) 2 1 x 1 t
CHAPTER 31. Cox-Ingersoll-Ross model

Then
C
305
is a martingale,
C
so
is a Brownian motion. We have
The Cox-Ingersoll-Ross (CIR) process is given by
If
happens to be an integer, then we have the representation
This is not a good parameter choice.
p ~
o p o q d
For
is normal with mean zero and variance
p h o
p h 1o
p h 1o
h Q
~ p h o
f f bVf
p o
For example, here is the distribution of
for xed
. Let
be given. Take
With the CIR process, one can derive formulas under the assumption that integer, and they are still correct even when is not an integer.
h Q
There is at least one value of
for which
h p o
p o d q bf d ff p h 1o h o p h
If
(i.e.,
), then
h u
There are innitely many values of
for which
f d
h p o
but we do not require
to be an integer. If
(i.e.,
p o
h Q
u t
p o
We dene
), then
p o
p o
p o
p o
p Q p o
p o
is a positive
1o p o
u t u t
p o
306
and variance
. Then
p | o { z y
Normal squared and independent of the other term
Chi-square with freedom
degrees of
31.2 Kolmogorov forward equation

Consider a Markov process governed by the stochastic differential equation
p o
p p oo p o p Qo
p o
We computed the mean and variance of
in Section 15.7.
p o
We make the change of variable
. The limiting density for
p o
{ d
p o
p o
p o
t u
As with
, we have , and so the limiting distribution of is times a chi-square degrees of freedom. The chi-square density with degrees of freedom is
is
p o i p o
u t
p o
p o
p o
h up o
As
. We have
x 9 w v
31.1 Equilibrium distribution of

p o
Thus
has a non-central chi-square distribution.
p h 1o
(0.1)
p o ~
~ { p Do u z y i p o i p o ~ Dt ~u
p o p o i
p o
is normal with mean
P ppV3oQo p p o # p p o p p o pp ho o p o o 1Qx p x b3Qo bgQo m V3Qo b3o p pp o pp o Vo b3Qo P C pp o V3Qo V3Q#` VQo m V3Q( P 1Qx p Qx pp o o pp o pp o o pp ho o p o o
p o
C
p p oQo p o p o
p p oQo p o p o p p Qo # p o o m p Qo
which vanishes near
p o o p Qx
p o 3 P p o p o o p x k p Q o h k
p o h p k 1o
We start at at time 0. Then is random with density variable). Since 0 and will not change during the following, we omit them and write than . We have
Because we are going to apply the following analysis to the case for all .
Figure 31.2: The function
, we assume that
(in the rather
p o
p Q o
p o x
Let be a smooth function of Fig. 31.2). It s formula implies o
p o 3
for any function .
p k 1o h
p ho
h p Q o
so The Kolmogorov forward equation (KFE) is a partial differential equation in the forward variables and . We derive it below. and for all large values of (see 307
f
at that and nearby
Uep o
q p
im
u u
u pp p o p o po u q o 3o m o
u pp p 7 o p3o p u q o 3o m o
u p o p o p3o x P u
| p p o o p3o u x P P u f
u u
p o p3o
pp o 3o o p
m
p o p3o 3o # P p

If there were a place where (KFE) did not hold, then we could take points, but take to be zero elsewhere, and we would obtain
u u
h j3x p o
pp o 3o o p
m
u u
{ Dzu p ) o p3o
u | P p3o P sq u u
|u P p3o P q
u
{ Dzu y p o 3o p p 3o P y { Dzu p o 3o 3x p p o

p o p3o p3o P
m
p p 3o 3o 3o # P P p p 3o p3o p3o P P 1Qx pp ho o

m
This last equation holds for every function

u u S
p o
p3ox P q
p o 3x P p o
Therefore,
u u
p o 3x q
p o 3o 3o # P p p p o 3o m 3o P p p
p o 3x P p o
p o 3x P p o
or equivalently,
or equivalently,
Integration by parts yields
Differentiate with respect to to get
308
of the form in Figure 31.2. It implies that
(KFE)
p o
p o 3 P
u u
u u
p o
p o p 1o q q p o p q q q
We want to verify the equilibrium Kolmogorov forward equation for the CIR process:
~

f d h
p 3o
p 3o
u u
u p p pp p o 3o 3o o m o u q
p o
p 3o
p o
If the process
p Q o
We compute
p o
Letting
t Q
where
31.3 Cox-Ingersoll-Ross equilibrium density
When an equilibrium density exists, it is the unique solution to this equation satisfying
In order for this limit to exist, we must have
We computed this to be
in (KFE), we obtain the equilibrium Kolmogorov forward equation
has an equilibrium density, it will be
(EKFE) 309
p p o o
p o q p o p q 1o
q p # o
q o ! p o
p 1o q q d q q p o q q p o ! q p o f
q d q
p o
p o
the tower property implies that this is a martingale. The Markov property implies that is random only through a dependence on . Thus, there is a function of the three dummy variables such that the process is the function evaluated at , i.e.,
p o
p o

p p o o p t o f p o p o p o p 53o
P
Up o
U V
p o
p o
p 53o
sq T e S
p o
p o
C
p o
p Q p o
1o p o
p q
p q p
p o
p q 1o q q q p 1o q q p 1o ! p q q q 1o p q q q q 1o d p q q q t q p o p o p q q
p # o o p f u p o p Q p o o u p o o u p u u p o p p p o p o 17o q
31.4 Bond prices in the CIR model
1o d q q 1o p o
1o d 1o 5p q 1o p q
1o p o
as expected.
The LHS of (EKFE) becomes
Now
310
The interest rate process
p o
u u
where
p h 1o
Because
p5o P q
I
is given. The bond price process is is given by
p t o
p 3o j p o p `h p t o o q d q p t o
p 3o p o q q d q h p o p o q q q q q 7 q p o q q 2
~ 2 (~ p o } e d
Surprisingly, this equation has a closed form solution. Using the Hull & White model as a guide, we look for a solution of the form
ul ijh h f h t o P o p p p 1o p p t o t o q q
Setting the term to zero, we obtain the partial differential equation
7 f p 1o q q
equals
p o o p p o f p o p p o o pt p o o t p
p o p p o Q q p o o R Q
p o o 7 p53o P
p3o P q
q
d
Because pute
p p o o
The terminal condition is
f
(4.1)
p t o
bVf f f
sq
I
( (
I )
p 3o P
where
p j h o
p o
and then set
We rst solve the ordinary differential equation and the partial differential equation becomes The expression in
. Then we have is a martingale, its differential has no term. We com311
p p h d h o o p p h 1o o
P
p 5o
p o
p
h h p p o or q p o q t( p t o p j o q p o p o p o p p o 1o p o u q
C
p o o p
U 3
p o
p 53o
T S
Thus in the CIR model, we have
f ~ p p q o o
o j
h p t r o
9 ~ q p p q o o p q (~ $ xo p p o o p o o p p t q q p p o o q p o f p o q
where
where
ul
i jh
j p o
p o
t(
do not depend on , the function . Similarly, and , and we have
p j o p o
and
It is tedious but straightforward to check that the solutions are given by
so
312
and
and
are given by the formulas above. Because the coefcients in
depends on and are functions of
only through their difference . We write instead of
p o
p o q
p o
where
f 9 p o p j o q xo o p o p o p o
We have
p p h 1o o
Now
for each , almost surely, so
is strictly decreasing in . Moreover,
h p Qw5o
313
But also, so
and
is strictly inreasing in .
31.5 Option on a bond

The value at time of an option on a bond in the CIR model is
where is the expiration time of the option, is the maturity time of the bond, and . As usual, is a martingale, and this leads to the partial differential equation (where .) The terminal condition is
Other European derivative securities on the bond are priced using the same partial differential equation with the terminal condition appropriate for the particular security.
31.6 Deterministic time change of CIR model

p o
Process time scale: In this time scale, the interest rate equation
is given by the constant coefcient CIR
Real time scale: In this time scale, the interest rate
is given by a time-dependent CIR equation
i ui
i h
Vp o U
p h p o o p !n o f q p !n o n 7 ul ijh h h n p n 1o n n f q q p p o d 53o P o n f p
f h
p p o p o p p o zp o p H o o p o o q f C p o p o p o p p o Q p o q 1o
por po p1o h p p h 1o o q q t( p p h 1o o f q

Q
p o
t o p p h pr o 1o h por p h p h h 1o 1o
p3o P sq
R
ptor o p
( p 5o
4
p h o
S ( e
p p o dn o
314
A period of high interest rate volatility
Figure 31.3: Time change function.
We need to determine the relationship between and . We have
and this will be
if we set
p p o o o p
p o
p o
p o
p p o o
p o
p t h 1o o p h
p h 1o o p h
p o
With
, make the change of variable
p o P p h 1o o p h sq f P p o p t h 1o o p h
p o
where
, and
and
are as dened previously.
3 2
denote the price at real time of a bond with maturity Let is . We want to set things up so
p j o p o p t o ~ 2 1 3 (~ p o p o } e
p o
There is a strictly increasing time change function Fig. 31.3).
"
which relates the two time scales (See when the interest rate at time
. . . . . . . . . . . . . . . .
p o
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
"
p o

Process time
Real time
in the rst integral to get
p7! h ph1o o l Hp h 1o o p h q q xo xo h 1o p h l H h 1o o t l p p h i h q t p ho 1j p h p h o o f p ho h r h o o p h p h
p p o 1oj o 1o h pp h

p o pp o h1o oj o 1o o p pp p h

p1o h p h 1o
p h o o p h

q
or equivalently,
fgp h p h1o h p h 1o o p h 1or p1o q q d p h 1o o p h p h 1o h q pp H o p o j o p p o p p p o p o o
o j o
pp H o p o j o

fgp j o p q p o p q p o p o
i
p o
o p o q d e( p o o q ( p o p o p p o o p o ~

do not depend on and are time dependent.
where
31.7 Calibration
Suppose we know
and
only through
for all
Take and the functions equation for
The right-hand side of this equation is increasing in the having limit at , i.e.,
so the equilibrium distribution of seems reasonable. These values determine . Take (we justify this in the next section). For each , solve the :
, since, in the real time scale, the model coefcients
. We calibrate by writing the equation
variable, starting at 0 at time
p o
p h 1o
p h o o p h

p h o
p o
Since is
(*) has a unique solution for each . For
so
p o
l p o
. If
. Thus
, then
is a strictly increasing time-change-function with the right properties. , this solution 315 and (*)
f p o p o p o j q $ Y xo p p t o o p o o p

r o p o p h
where , determined by market data, is strictly increasing in , starts at 1 when and goes to zero as . Therefore, is as shown in Fig. 31.4.
p h 1o o p h
xo
t Q
o j H o o pp o pp

p h 1o
p h 1o d
p h 1o o p h
p h 1o
h 1o o p p h

In the real time scale associated with the calibration of CIR by time change, we write the bond price as
h o o p p h
p h 1o
t 1o p h
u u
u u
p h 1o p h 1o
xo
xo u u
z P
f x ~ o j p ~ o

p 5o

q p h 1o f
Hxo
P
xo
p 53o
q
P
( e 1o p h
u
p h 1o

31.8 Tracking down
x w $G)
Consider the function
p h 1o
p h 1o o p h q h
xo
The calibration of CIR by time change requires that we nd a strictly increasing function such that
Here
thereby indicating explicitly the initial interest rate. The above says that
Justication:
316
Result for general term structure models:
and
are given by
p o r
p o
in the time change of the CIR model
(cal) with
p h 1o
317
Strictly increasing
Figure 31.4: Bond price in CIR model
Figure 31.5: Calibration The function is zero at , is strictly increasing in , and goes to as . This is because the interest rate is positive in the CIR model (see last paragraph of Section 31.4). To solve (cal), let us rst consider the related equation
(cal)
t p u o
t Q
p o
l p o
If , then . If dened a time-change function than (cal).
, then . As , . We have thus which has all the right properties, except it satises (cal) rather
p o r o p
p h 1o
p h o o p h
xo
p o
p o
Fix
and dene
to be the unique
for which (see Fig. 31.5)
pp o oj p o o p
.... .... ..... ..... ..... ..... ..... ..... .... .... .... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
poj to p
p h 1o
p h 1o
p h 1o o p h
p h 1o o p h
p o
ptor o p
xo
xo
q p h 1o
Goes to
p h 1o o p h
t u
xo
h f q p ho 1 q
7p o
p o $
p p h1o q h o 5 7p o p $ p o
p o
U q d S p h o d h o q p o $ d p o S
p o q
p o $

p o
p o
p o
p ho p p ho 11 15h q h o f d d p o p o q p o p o
$
f d
p h 1o
p h 1o d p h 1o 1o p h
p h p h 1o o p h o f h 1o p h p h p ho 1o1 11 1 p ho p ho f ph1o ph1o o p h p p p 1o 1h o o P p h 1o o p h

so also satises (cal). From (cal) we compute , so we have
u
u u
xo
We conclude by showing that
p h 1o
p h 1o
Computation of
p h 1o
Computation of
p h 1o
Note that is the initial interest rate, observed in the market, and is striclty positive. Dividing by , we obtain
We show in a moment that
318
: : ,
p o
p h 1o
p h 1o
(i
p o
p o
C
p o i q d p o i p o f C o C C p o p o p
C C
p o p
q d
p o i o p o p C p o p o p
C
o o
k k
u p u p
m 5
p o m5 p o
p p o o k p p o o k
u
P
A two-factor model (Dufe & Kan)
Chapter 32
Let us dene:
Interest rate at time
p o
p o
Let , differential equations
be given, and let
Yield at time on a bond maturing at time
and
p Y o
p o
h 1 o p ho h p h
where
and
o o
and
Then
is a Brownian motion with
are independent Brownian motions. To simplify notation, we dene
319
be given by the coupled stochastic
(SDE2) (SDE1)
p f
i o
hQ o 1o p h p h
will stay strictly positive provided that:
p o i p C p m q
m

k k

k k
p o
C
p D m
p o C p m o m D p (i q C D
k
p o p p 7D k d C o
k
is a Brownian motion. We shall choose the parameters so that:
(i (i d p q
p i o o
C
(i o k i p m
7p s ok C D k
o k k
o o
32.1 Non-negativity of
where
320
Assumption 1: For some ,
and (SDE1) and (SDE2) make sense. These can be rewritten as
From our discussion of the CIR process, we recall that
p m q m (i o 7
p o
Then
Assumption 2:
p ho 1
o o #
and
Assumption 3:
Under Assumptions 1,2, and 3,
almost surely,
(SDE2) (SDE1)
p o f p o
C C
p o p o
k k
p u D u p
m 5
p o m5 o p l t i h
p p o o k p p o o k QHp s h o
o o
p o o p k o k r q p 5k q p o k q t(
(PDE)
h f p x
p
m s
4 px k p k o x k k o ( i 4 5 k p k k k o ' k o p ' 5 k o q k q m m k k k k p 5k 1o k 4 u u C C 4 4 4 i 4 P D p o p 5 o q Q 3o sq m I ( k k k k 4 4 4 4 Q 3o P p sq q q I ( p o p o o Q p
is
p53o P sq
p o p o o
p53o P sq
I
f p 5k 1o k
U V
p o
p53o p p oV p o o q q 1S e k k q

Since the pair of processes is Markov, this is random only through a dependence on . Since the coefcients in (SDE1) and (SDE2) do not depend on time, the bond price . Thus, there is a function depends on and only through their difference of the dummy variables and , so that
p o
p Y p o o
U V
p o
is
p 53o
sq
S (1 e
p o
The value at time
valid for all

I
We seek a solution of the form
The partial differential equation for
is a martingale. We compute its stochastic differential and set the
The usual tower property argument shows that
32.2 Zero-coupon bond prices
CHAPTER 32. A two-factor model (Dufe & Kan)
and all
of a zero-coupon bond paying $1 at time
satisfying term equal to zero. 321
(*)
h k
k k
5k 1o k o k k p q k o k o k k q
p o
m s
p o p oV p o ( p o i p Y m p o m p o p o q q p o o p Y p o ( p o i p o p o p o 5p k q q k k p o p oY p o ( p o i p o p o p o d q q k k p p k o 5 p p k oY p o px k k o (i p o 5 p o s p m k k p k p o k k
k
o k o q p p o
k
k 5k 1o k o q k 5p k h k 1o
(PDE) becomes
k 1o k 4 k 1o k k 1o 4 4 k k 1o k 4 k 1o k k 1o k o p o
p 5k 1o p o k p f p k 1o p V p o p k o p 5k 1o p o p k p k o p Y p k o p k o p o q p k p 5k k1o p o p o k p o k q p q q q p j p h Q o h por 1o h p h p h 1o f k k p h k 9 1o k !

. This implies the initial conditions satisfying (*)
We must have
We get three equations:
We want to nd
because
322
corresponds to
for
. We have
(IC)
(3) (2) (1)
p o q p p o q p o
(h o o b p o i q p o q p 5 p o m m (h p o o (i q p o q p Y p o k (hl k d
k
p ho 1r p o p1o h p o p h 1o p o
p o o q p b p o (i q p o q p o
k
p o
CHAPTER 32. A two-factor model (Dufe & Kan)
323
We rst solve (1) and (2) simultaneously numerically, and then integrate (3) to obtain the function .
32.3 Calibration
p p oY p p o p o o p o o P oj P p b p o q P q P q
P
and the yield is
This equation must hold for every value of
and
, which implies that
We must choose the parameters
so that these three equations are satised.
Y i w b m
But we have set up the model so that Thus
is the yield at time of a bond maturing at time
h h p o o r P p P f p o p o p j o o p P Y p o p P o p o f P p o P p j o o p p P Y p o p P o p o f P d
o p V p o o
p Po
p o
xo
P q d
h Q
Let
be given. The value at time of a bond maturing at time
p j o
is
324
Chapter 33
Change of num raire e

Consider a Brownian motion driven market model with time horizon . For now, we will have one asset, which we call a stock even though in applications it will usually be an interest rate dependent claim. The price of the stock is modeled by
where the interest rate process and the volatility process are adapted to some ltration . is a Brownian motion relative to this ltration, but may be larger than the ltration generated by . This is not a geometric Brownian motion model. We are particularly interested in the case that the interest rate is stochastic, given by a term structure model we have not yet specied. We shall work only under the risk-neutral measure, which is reected by the fact that the mean rate . of return for the stock is We dene the accumulation factor
The zero-coupon bond prices are given by
325
U V
p o
p 53o
p o
p o
sq
po p o e
1 e S
p o p o p o
p o
p o p o
so that the discounted stock price
is a martingale. Indeed,
i p o h
p o
p o
p o p o u p o
Q R
p3o P
I )
p o (
p o p o p o
p o
C
(0.1)
i h p o
326 so
of the stock is the price set at time for delivery of one share of stock The -forward price at time with payment at time . The value of the forward contract at time is zero, so
Denition 33.1 (Num raire) Any asset in the model whose price is always strictly positive can be e taken as the num raire. We then denominate all other assets in units of this num raire. e e
Example 33.1 (Money market as num raire) The money market could be the num raire. At time , the e e stock is worth units of money market and the -maturity bond is worth units of money market.
g 3 g
We will say that a probability measure is risk-neutral for the num raire if every asset price, e divided by , is a martingale under . The original probability measure is risk-neutral for the num raire (Example 33.1). e Theorem 0.71 Let be a num raire, i.e., the price process for some asset whose price is always e strictly positive. Then dened by
H
is risk-neutral for
Example 33.2 (Bond as num raire) The -maturity bond could be the num raire. At time e e is worth units of -maturity bond and the -maturity bond is worth 1 unit.
H
p o
p o o p u
p ho 1u
p o p o
H
Therefore,
p o
p t o o p p o W q p o pt o p o p o W q p o p o po o p o p p o p Wq W o pto p o Rt o pp pto o h p o e
is also a martingale (tower property).
W a
p o
p o
p o
e p o
H
p o
H
p o p o
e
, the stock

G3
G3

Fix and let
h vh3Xr
H
p o
p o p o ptu o o p p o p o s tu
p o p s o p o p o p o p o
p o
p o p o q po p tou p o f po 1ou p h p u o p o pu o p h p o o ui jh i i
p o
Let be an asset price. Under , is a martingale. We must show that under , is a martingale. For this, we need to recall how to combine conditional expectations with change of measure (Lemma 1.54). If and is -measurable, then
d p h 1o o p h p ho 1u d p h o p o p u o f d E p o p h o p E 3o o p u d
#
H
p t3o
H
p o
H
p u o p o
p ho 1u
Proof: Because
and we see that
Note:
CHAPTER 33. Change of num raire e
and
are equivalent, i.e., have the same probability zero sets, and
is the price process for some asset,
is a probability measure.
H
33.1 Bond price as num raire e

#
p o

which is the martingale property for
Therefore,
be the num raire. The risk-neutral measure for this num raire is e e

under
. is a martingale under . Therefore, 327
po p o ts
328
Because this bond is not dened after time , we change the measure only up to time using and only for .
, i.e.,
This is a martingale under
, and so has a differential of the form

5
33.2 Stock price as num raire e

Let be the num raire. In terms of this num raire, the stock price is identically 1. The riske e neutral measure under this num raire is e
e
Denominated in shares of stock, the value of the -maturity bond is
This is a martingale under
, and so has a differential of the form
G$
8 Y6
@ ' S
G$
8 6 $a
Theorem 2.72 The volatility words, (2.1) can be rewritten as
Q `
G sG$T E 1 1 X 2W
where generality that

e
. We may assume without loss of
in (2.1) is equal to the volatility

(
HI @ S V e
G$
T U
x3
S e
Q R
H I
H P
We write
rather than
from now on.
G 8 3h$6 @ E 1 1 FD( B
i.e., a differential without a term. The process . We may assume without loss of generality that
1 1 35A
1 1 45352
C @ '
8 6 97G$
)
is called the stock is
-forward measure. Denominated in units of
(
# # " % '& $ ! # % " H ) @ B
-maturity bond, the value of the
(1.1)
(2.1)
in (1.1). In other
(2.1)
x x x x
0 0 0 0
h3
p q A o VElyk3 B G ri 5 n H FI ) E lyk3) B G WmEly3 B i k H 0 5 0 I Ely k k ) B 5 G WimEly ) B I Hd 0 d x h f e# xgh% H h f e# xgd$ H

G3
Wi

d gi
h f e# jgh% H
Wi
d 9' 0
h f e# xgh% H
i $WI
5
d 8 6
Under is a Brownian motion. Under this measure, has volatility and mean rate of return . The change of measure from to makes a martingale, i.e., it changes the mean return to zero, but the change of measure does not affect the volatility. Therefore, in (2.1) must be and must be
G$
8 Y6
#
H P 8 #
G$
r )
G$
@' S i Q hY6ye 8 v i 8 6 h$a ) @ V w 2i G$ r8 6y5i v 8 hY6xi ) e t e r @ V v5e G$ h$6 8 i p r8 6 ) r ) e i he ff b ) 5e v Gi f u b ) ) ) ) ) b S

Ge
) t s c f b r gc ahf g39c phgb i cf e e q
33.3 Merton option pricing formula

v 5e @ i e H H @ @
G$
e X
Proof: Let
The price at time zero of a European call is
8 6
r8 %6
i V
Q )
c d1b
, so
. Then 329
i r 5h3 x3
is not constant, we still have the explicit
Px
r 3i r8 6 pxhrv i r 3i r8 6 hrv v
r x3 r8 6 i
G3 x3
r r8 6 i r 3 r8 6
r 5a 8 G i{ ~ } $6 o 0 @ i x3 n 0 ~ } i{ 8Y6 x3 v k @ G n 0 ~ i}{ r x3 @ k r8 6 iP 8 $6 E k Fly3 B G3 5 n ) v us @ w gG3 0
r i r8 6 I
r r8 6 v
G3 x3
5a r h3 ~i}{ 8$6 o 0 8 6 v @ x3 n zH H ~ } S o p h3 i{|o 8 r @ 0 r 6 iI 8 $6 3 H H n I 0 w v us xgtx3

e
r i y z r8 6 I
This is a completely general formula which permits computation as soon as we specify we assume that is a constant , we have the following:
G$
8 Y6
and we have the usual Black-Scholes formula. When formula
0 0
~ } i{ ~ } i{
8 $6 $6 8
r
If is constant, then

g7G 8 Y6 r
~ } !{
8 Y6
x3
) 8 6
where Similarly,
!{ ~ }
8 Y6
G3
H I
)
G
8 6
8 6
where
330
, . If

331 , the value of a European call expiring

Ge
where
This formula also suggests a hedge: at each time , hold bonds.

Ge
We want to verify that this hedge is self-nancing. Suppose we begin with $ and at each time hold shares of stock. We short bonds as necessary to nance this. Will the position in ? If so, the value of the portfolio will always be the bond always be
3 e
and we will have a hedge.
Mathematically, this question takes the following form. Let
At time , hold shares of stock. If is the value of the portfolio at time , then will be invested in the bond, so the number of bonds owned is and the portfolio value evolves according to
The value of the option evolves according to

e 1 1 5A e i 3 Ix3 G$ i IG$ Ge r i 0 ' 0 0 V 7e v 5Ge e $e v he
If
, will
for
Formulas (3.1) and (3.2) are difcult to compare, so we simplify them by a change of num raire. e This change is justied by the following theorem. Theorem 3.73 Changes of num raire affect portfolio values in the way you would expect. e Proof: Suppose we have a model with assets with prices . At each time , hold shares of asset , , and invest the remaining wealth in asset . Begin with a nonrandom initial wealth , and let be the value of the portfolio at time . The number of shares of asset held at time is
i 3e
Ge r 5
#
#%! "h #
G$
50
G$
Ge 5 8 ~ } i r i{ Xu 6 i mey r8 6 i e e 8 ~ } i r ) i{ Xu 6 e eiy r8 6 v e ) 0 i WGi e i r Wihe 5 0 0 qXq r

r G$ i
Ge e
0 i he r 5hWGe 5i
Gi 5ae
1 1 5

0 i i WPi i
i Ie
v $e
0 V
i s AXqq
Gi
x3
Pi
8 $6
As this formula suggests, if at time is
is constant, then for
r 5xi
Ge
shares of stock and short
r 5 0
e i
(3.1)
(3.2)
0 0 i v 0 0 0 Wi 0 i W e 50 W i
Now Therefore,
0 e 0 e 0 A
S S Q ' S Q 0 0 v v S Q` V 0 v S Q` 0 A S S Q s $Xq 5
v Q
0 0' Q 0 ' A v

Then
i5 e
e5 0 0 e
e5
Let and 332
qXq e
, not
0 ' 0
0 V A 0 0 i 'v ' A

and we only get to specify Note that
be a num raire, and dene e
evolves according to the equation
, in advance.
333
We return to the European call hedging problem (comparison of (3.1) and (3.2)), but we now use the zero-coupon bond as num raire. We still hold e shares of stock at each time . In terms of the new num raire, the asset values are e
i
The portfolio value evolves according to
In the new num raire, the option value formula e

Gi
becomes
This is a homework problem.
glGi r 5 re i
To show that the hedge works, we must show that
Gi r 5 Wi i
Ge
5 $Gi 5 v
Ge
5Gi 5 v
v 5e
and
Gi
e
gGe
r 5re i
r 5G$
iGe
Bond:
he
i Pi
i v e l5i
h 5a e e 0 5ai
Stock:
(3.1)
(3.2)
i s PqX
Gi
) 5pi
This is the formula for the evolution of a portfolio which holds , and all assets and the portfolio are denominated in units of
shares of asset ,
Ge
5a
334
@ '
6 v y$
6 a
1 1 45352 @ '
-maturity bond.
e
G$
G$
i P
G$
ah

satisfy
v u gs P i v u zgs e P h| i

. The bond prices
G eG$
@ '
$6 Ph 6
G
6 v |5
G$
34.1 Review of HJM under risk-neutral
Brace-Gatarek-Musiela model
Chapter 34
Forward rate at time for borrowing at time
z
6 G$6
h h
The interest rate is
where
A simple choice we would like to use is
To implement HJM, you specify a function
where
is the constant volatility of the forward rate. This is not possible because it leads to
volatility of
335
6 G$ r aIG$ aIG$ 6 6
k W6
$
aeh
Ix$
|v$G$ P v y$G$ P

e q
i Iq e q i I$
q
x3
$Wi i i i Iq i
x3
v i i f
where
s
ge
i f
The problem with the above equation is that the term grows like the square of the forward rate. To see what problem this causes, consider the similar deterministic ordinary differential equation
and Heath, Jarrow and Morton show that solutions to this equation explode before .
This solution explodes at
k Fax3
New variables:
34.2 Brace-Gatarek-Musiela model
336
. We have
Current time
Time to maturity
i y2
Bond prices:
Forward rates:
(2.4) (2.1) (2.3) (2.2)
$xip|5G v I$ v u g s p i n p v u gs y%h i v 3z 2 C n v u gs p Y i n v |5G lI$
i a2h
v u gw gs i y | v u gs $ I | Px$ yv Phx$|v 8$
x$
e

@ V @ '
6 i rP
V $
i rx$
i We
v u%h
u%h v
v u9G
v
$
(2.8)

6 a 6
$
We will now write
@V G$ h 6WiP G$ heah @ V ge $6|5 v ah 6 6 i 6 haP6

rather than
h
We now derive the differentials of
where
CHAPTER 34. Brace-Gatarek-Musiela model
and
differential applies only to rst argument
|% v h
(2.5),(2.2)
r w @ ' r G d % e 6 u% v 6 v @ V e v 6 v $|$ $6 6
I$
Also,
(2.6),(2.4)
v |$ G
6 i WP
v |5he
34.3 LIBOR
(2.1)
I$
Fix time
(say, .
(2.8)
differential applies only to rst argument
year). $ invested at time in a -maturity bond grows to $ 1 at is dened to be the corresponding rate of simple interest:

v y%
z
|5 v q2 k
, analogous to (2.5) and (2.6) We have
. In this notation, the HJM model is
(2.10) (2.9) (2.7) (2.6) (2.5) 337
@ V
T 5
. Can do this at time by shorting bonds maturing at time . The value of this portfolio at time is one bond maturing at time
We cannot have a log-normal model for because solutions explode as we saw in Section 34.1. For xed positive , we can have a log-normal model for .
a Dgs v u I | uma v $q
zgs v u P | $q
Connection with forward rates:
w gs I v u i y | $q | $q y $q E
gs v u v u w gs i y4$ v vgs u P uv iVB IG$| v uvm

v gD|F
v $$
v y5
$ i D|vF v v uF|5
d $q " # d " # d $q# " " d
34.4 Forward LIBOR
338
is still xed. At time , agree to invest $
at time
v yP
yvy5 v k `
r
so
The forward LIBOR
is dened to be the simple (forward) interest rate for this investment:
, with payback of $1 at time
and going long
xed
i y 25
Fgs I$ w v u i2y5 $ $q ! { $q Fgs w v u
v au%G$
is the continuously compounded rate.
is the simple rate over a period of duration .
34.5 The dynamics of
3'VW
We want to choose
yv$ Xq G G (sR6

, appearing in (2.5) so that (4.2) (4.1)
6 h
p @ ' e e |m 6 6 i v v V rIy4$ 6 |F$ |v 6 i v v 6 i v V$W|F| e|v n p r 6 i v r V$ rIy4 6 v @ ' e V$ 6W|F$ 6 i v v r r i r Gy4 6h v$DPum v i v n $V$uv zgu4s v s | v P | $q $q zg4 v us P %q $q l Fgs w v u i y
$
$q
@' e V 6Wi|vF 6 v r r w 6 6 v v r G$ d i r Gyv4$ d $$Wiy4| r @' w $6 $q v% r G d $| $q 6 v $q | $q

|
e
@ '
6 v |5
G
r w 6 d $| v P
Recall (2.9):
. This is the BGM model, and is a subclass of HJM models, for some corresponding to particular choices of .
G W
and
Therefore,
(4.1), (5.1)
#
339
(5.2) (5.1)
G G (3
e
@ V
Tv |v v 6 T v $ $$ r r T
|v $ 7|F$ 6 v 6 v T
i
@ '
T v $%
v 6 T v y4 $|$$ I$
Then
6 i v he WDum 6
V $
uv
Ve
@ '
v %
v y4$ 6 e W|F$ 6 V |v 6 i v v $
Therefore,
i v VWy4$ e|v zg s v u VWi|vF$ (I $q i y

%q
Obtain the initial forward LIBOR curve
from market data. Choose a forward LIBOR volatility function (usually nonrandom)

G (
34.6 Implementation of BGM

5 $T
Take
$
w gs v u
Plugging this into (5.4) yields
Note that (5.3) is equivalent to
But
340
to be given by
(5.4) (5.3) (5.4) (5.3)
v |%h I$|$ ei|hh5iXG T 6 i y4 6 $ T v
6 7
$x
6 i v rIy4$x6
yv
T
Remark 34.3 From (5.3) we have
e
6 6
G G
G$5uv @' v i 5 iX|G$ v $ eiWG$Th5 @ ' v v i % |5h Ve
i T erhU i T erhUIh5
i |G
i i i|G
i eyh aIG$5

q
uz 1 6 o 1 G yA3
1 G uA3
Because LIBOR gives no rate information on time periods smaller than , we must also choose a partial bond volatility function
for maturities less than from the current time variable .
With these functions, we can for each
Plugging the solution into (5.3), we obtain
solve (5.4) to obtain
for
is
is o
Remark 34.1 BGM is a special case of HJM with HJMs In BGM, is usually taken to be nonrandom; the resulting
Remark 34.2 (5.4) (equivalently, (5.4)) is a stochastic partial differential equation because of the term. This is not as terrible as it rst appears. Returning to the HJM variables and , set
1 G uz
If we let
and (5.4) and (5.4) become
Then
and we continue recursively.
, then
We saw before (eq. 4.2) that as
and so
generated recursively by (5.3). is random.
. We then solve (5.4) to obtain
(6.1) 341
1 1 A
i W|hd 6
v 5i
`
G3G G
F
G3
p r
G
i 6 hd d
r @ ' Ih i i hd 6
i n
v u gs
e
Vh
@ '
eX
i |h 6
i p S e
G
v %
G$
he
xi
G$5e |G r |1 i T G$5 1 r iX|G$ r X i T

G
G$
G$5|v r euG r q i T
# " $ d! f " qh # " f $ d # d @ V Vee v i 5 e h 6

Remark 34.4 Although the term in (6.1) has the term to this equation do not explode because
h5
so
Therefore, the limit as
342
of (6.1) is given by equation (2.5):
involving
i 6 |G$a
Let
y
Girsanovs Theorem implies that
This is a martingale, and we can use it to switch to the forward measure
# '& # " $ d!
Q `

v u w gs
The solution
34.7 Bond prices
to this stochastic differential equation is given by
From (2.6) we have
. , solutions
h3 G$
he
v i D|G Rr$h5da yW v i r$h5da i e v |r r$h5d i i % e

i
yvr5a 1 1 W$h5d i

v yr
yv511A k U
Consider a oating rate interest payment settled in arrears. At time , the oating rate interest the LIBOR at time . A caplet protects its owner by payment due is requiring him to pay only the cap if . Thus, the value of the caplet at time is . We determine its value at times .
v ur
gG
(x
W|Gd r T i r i r @ V e Wi|Gd r T d $ i i rrhdT r v u @ ' mgs `P Wihd r T d % i i rGdT I

h5
a a5
G
i r|Gd r T
r Ih $ i
@ V
i WrGdT
v u mgs
v u gs
h35
p rGd r T i
r Ih $ i
@ V
i WrGdT
h35
aIG$5
so
Vi
@ '
v $
@ $ V e v i u%X|h 6
G$5 e
G$5e rhU i T i T rhUIG$5
We assume that
and mean
r r i
and
Case I:
is normal with variance
34.8 Forward LIBOR under more forward measure
34.9 Pricing an interest rate caplet
From (6.1) we have
is nonrandom. Then
(9.1) (8.2) (8.1) 343
i u
T Ui
i 1 1 Xry535A
gGG$5 1 D
r r S S ~i{Ie Q } i5i Q ~ }{ i i 3Wi e v 7 v u gs w WxeqB i E d $ Pzd1b x

Set
v u gs e WxiqB i E qB
G$5
% v yrhD7e $ x %
e e
e
i r v u gs
G$5
i e WG
$ # $ yh3 Gyr v v 5 v v uh8ur

e W5h5d $ i v urG$ i |rG$ v v D|Wh3 he urG$ v e x$G i

5
v |r(
where is normal under with variance Furthermore, is independent of .
yWG Gi v e v yrh
From (8.1) and (8.2) we have
v y
.
A
5
Case II: Recall that
1 1 35A
We have
where
344
and mean
r r i
i |Gh r T
a5h5
and (9.2) is called the Black caplet formula.
b v d urG$
In the case of constant , we have

e
T 7e $
a i $
v |r
e
Then
(9.2) .
gy h
$ $Xqxg
G3
Y
dr T
z
qq

dr T
X

i F
dr T

x3
x3
9
dr T
i | r T
T dU T
Let us suppose
i W|Gh r T
gGG35
b v d |rh3D7Px $
at time
e
e
s X$a$qXx8a r
a
Rl
A cap is a series of payments
34.10 Pricing an interest rate cap
Let
at time
i `Xq
2
i rI
The interest rate caplet on
v yr
h3
Then depends on
If we know the caplet price know caplet prices
where (dened in the last section) depends on
34.11 Calibration of BGM
The value at time of the cap is the value of all remaining caplets, i.e.,
is a deterministic function of its second argument, i.e.,
, we can back out the squared volatility
dr T
XqXx3 $
x3
X $
where
z zd r T X d r T o o X qX $ o
In this case, we may assume that
, we can back out
is constant on each of the intervals has time-zero value . If we (11.1) 345
346 and choose these constants to make the above integrals have the values implied by the caplet prices.
To implement BGM, we need both
, and
We can now solve (or simulate) to get

or equivalently, using the recursive procedure outlined at the start of Section 34.6.

34.12 Long rates
The long rate is determined by long maturity bond prices. Let that is 20 or 30 years. Then be a large xed positive integer, so
where the last equality follows from (4.1). The long rate is
34.13 Pricing a swap

s
X$|v
s A$XXq|iyv
|v
Let
be given, and set
7v
Now is the volatility at time of a zero coupon bond maturing at time , it is reasonable to set Since is small (say year), and
V
dr T
eD idD$|v zgs v u P $ # v u gs I
i zd
X
X
1 G yAX
$~i}{ $ ~ } i{ % $ yv
1 G uA3
G G UGs
G G `3
G (
sG(Ph T dr T
l $
G a
1 y
$$
IdT $ 6
If we know caplet prices tiate to discover and

for all
, we can back out for all .
and then differen-
hr T
(see (2.6)).
G$
In contrast to the cap formula, which depends on the term structure model and requires estimation of , the swap formula is generic.

which makes the time
v h5vXqU5 G$ i h G$
e
|v
i $G$
X G Xi hWiXq|i r G Wi hW hl i r svqXUv5 hG|v i G$ 55 G$ G|v i hl v hGyv qP G e i i i5x$ d

for maturity

hGyv i q hG|v i e i # " h G hGyv qi e i G Q S e Wi i i i P h| i
m
i mhe WIx$

i
The swap is the series of payments
at time
i RqX
The forward swap rate at time value of the swap equal to zero:
e
i r5

The value of the swap at time is
Px$
For
1 1 5A
Now
Px$
We compute
yv
so
, the value of the swap is
is the value of
G$
347
348
Chapter 35
Notes and References

35.1 Probability theory and martingales.
Probability theory is usually learned in two stages. In the rst stage, one learns that a discrete random variable has a probability mass function and a continuous random variable has a density. These can be used to compute expectations and variances, and even conditional expectations. Furthermore, one learns how transformations of continuous random variables cause changes in their densities. A well-written book which contains all these things is DeGroot (1986). The second stage of probability theory is measure theoretic. In this stage one views a random variable as a function from a sample space to the set of real numbers . Certain subsets of are called events, and the collection of all events forms a -algebra . Each set in has a probability . This point of view handles both discrete and continuous random variables within the same unifying framework. A conditional expectation is itself a random variable, measurable with respect to the conditioning -algebra. This point of view is indispensible for treating the rather complicated conditional expectations which arise in martingale theory. A well-written book on measure-theoretic probability is Billingsley (1986). A succinct book on measure-theoretic probability and martingales in discrete time is Williams (1991). A more detailed book is Chung (1968). The measure-theoretic view of probability theory was begun by Kolmogorov (1933). The term martingale was apparently rst used by Ville (1939), although the concept dates back to 1934 work of L vy. The rst complete account of martingale theory is Doob (1953). e

35.2 Binomial asset pricing model.

The binomial asset pricing model was developed by Cox, Ross & Rubinstein (1979). Accounts of this model can be found in several places, including Cox & Rubinstein (1985), Dothan (1990) and Ritchken (1987). Many models are rst developed and understood in continuous time, and then binomial versions are developed for purposes of implementation. 349
350
35.3 Brownian motion.

In 1828 Robert Brown observed irregular movement of pollen suspended in water. This motion is now known to be caused by the buffeting of the pollen by water molecules, as explained by Einstein (1905). Bachelier (1900) used Brownian motion (not geometric Brownian motion) as a model of stock prices, even though Brownian motion can take negative values. L vy (1939, 1948) discove ered many of the nonintuitive properties of Brownian motion. The rst mathematically rigorous construction of Brownian motion was carried out by Wiener (1923, 1924). Brownian motion and its properties are presented in a numerous texts, including Billingsley (1986). The development in this course is a summary of that found in Karatzas & Shreve (1991).
35.4 Stochastic integrals.

The integral with respect to Brownian motion was developed by It (1944). It was introduced to o nance by Merton (1969). A mathematical construction of this integral, with a minimum of fuss, is given by ksendal (1995). The quadratic variation of martingales was introduced by Fisk (1966) and developed into the form used in this course by Kunita & Watanabe (1967).
35.5 Stochastic calculus and nancial markets.

Stochastic calculus begins with It (1944). Many nance books, including (in order of increasing o mathematical difculty) Hull (1993), Dothan (1990) and Dufe (1992), include sections on It s o integral and formula. Some other books on dynamic models in nance are Cox & Rubinstein (1985), Huang & Litzenberger (1988), Ingersoll (1987), and Jarrow (1988). An excellent reference for practitioners, now in preprint form, is Musiela & Rutkowski (1996). Some mathematics texts on stochastic calculus are ksendal (1995), Chung & Williams (1983), Protter (1990) and Karatzas & Shreve (1991). Samuelson (1965, 1973) presents the argument that geometric Brownian motion is a good model for stock prices. This is often confused with the efcient market hypothesis, which asserts that all information which can be learned from technical analysis of stock prices is already reected in those prices. According to this hypothesis, past stock prices may be useful to estimate the parameters of the distribution of future returns, but they do not provide information which permits an investor to outperform the market. The mathematical formulation of the efcient market hypothesis is that there is a probability measure under which all discounted stock prices are martingales, a much weaker condition than the claim that stock prices follow a geometric Brownian motion. Some empirical studies supporting the efcient market hypothesis are Kendall (1953), Osborne (1959), Sprenkle (1961), Boness (1964), Alexander (1961) and Fama (1965). The last of these papers discusses other distributions which t stock prices better than geometric Brownian motion. A criticism of the efcient market hypothesis is provided by LeRoy (1989). A provocative article on the source of
CHAPTER 35. Notes and References

stock price movements is Black (1986).
351
The rst derivation of the Black-Scholes formula given in this course, using only It s formula, o is similar to that originally given by Black & Scholes (1973). An important companion paper is Merton (1973), which makes good reading even today. (This and many other papers by Merton are collected in Merton (1990).) Even though geometric Brownian motion is a less than perfect model for stock prices, the Black-Scholes option hedging formula seems not to be very sensitive to deciencies in the model.
35.6 Markov processes.

Markov processes which are solutions to stochastic differential equations are called diffusion processes. A good introduction to this topic, including discussions of the Kolmogorov forward and backward equations, is Chapter 15 of Karlin & Taylor (1981). The other books cited previously, ksendal (1995), Protter (1990), Chung & Williams (1983), and Karatzas & Shreve (1991), all treat this subject. Kloeden & Platen (1992) is a thorough study of the numerical solution of stochastic differential equations. The constant elasticity of variance model for option pricing appears in Cox & Ross (1976). Another alternative model for the stock price underlying options, due to F llmer & Schweizer (1993), has o the geometric Ornstein-Uhlenbeck process as a special case. The Feynman-Kac Theorem, connecting stochastic differential equations to partial differential equations, is due to Feyman (1948) and Kac (1951). A numerical treatment of the partial differential equations arising in nance is contained in Wilmott, Dewynne and Howison (1993, 1995) and also Dufe (1992).
35.7 Girsanovs theorem, the martingale representation theorem, and risk-neutral measures.
Girsanovs Theorem in the generality stated here is due to Girsanov (1960), although the result for constant was established much earlier by Cameron & Martin (1944). The theorem requires a technical condition to ensure that , so that is a probability measure; see Karatzas & Shreve (1991), page 198. The form of the martingale representation theorem presented here is from Kunita & Watanabe (1967). It can also be found in Karatzas & Shreve (1991), page 182. The application of the Girsanov Theorem and the martingale representation theorem to risk-neutral pricing is due to Harrison & Pliska (1981). This methodology frees the Brownian-motion driven model from the assumption of constant interest rate and volatility; these parameters can be random through dependence on the path of the underlying asset, or even through dependence on the paths of other assets. When both the interest rate and volatility of an asset are allowed to be stochastic, the Brownian-motion driven model is mathematically the most general possible for asset prices without jumps.
352 When asset processes have jumps, risk-free hedging is generally not possible. Some works on hedging and/or optimization in models which allow for jumps are Aase (1993), Back (1991), Bates (1988,1992), Beinert & Trautman (1991), Elliott & Kopp (1990), Jarrow & Madan (1991b,c), Jones (1984), Madan & Seneta (1990), Madan & Milne (1991), Mercurio & Runggaldier (1993), Merton (1976), Naik & Lee (1990), Schweizer (1992a,b), Shirakawa (1990,1991) and Xue (1992). The Fundamental Theorem of Asset Pricing, as stated here, can be found in Harrison & Pliska (1981, 1983). It is tempting to believe the converse of Part I, i.e., that the absence of arbitrage implies the existence of a risk-neutral measure. This is true in discrete-time models, but in continuous-time models, a slightly stronger condition is needed to guarantee existence of a risk-neutral measure. For the continuous-time case, results have been obtained by many authors, including Stricker (1990), Delbaen (1992), Lakner (1993), Delbaen & Schachermayer (1994a,b), and Fritelli & Lakner (1994, 1995). In addition to the fundamental papers of Harrison & Kreps (1979), and Harrison & Pliska (1981, 1983), some other works on the relationship between market completeness and uniqueness of the risk-neutral measure are Artzner & Heath (1990), Delbaen (1992), Jacka (1992), Jarrow & Madan (1991a), M ller (1989) and Taqqu & Willinger (1987). u
35.8 Exotic options.

The reection principle, adjusted to account for drift, is taken from Karatzas & Shreve (1991), pages 196197. Explicit formulas for the prices of barrier options have been obtained by Rubinstein & Reiner (1991) and Kunitomo & Ikeda (1992). Lookback options have been studied by Goldman, Sosin & Gatto (1979), Goldman, Sosin & Shepp (1979) and Conz & Viswanathan (1991). e Because it is difcult to obtain explicit formulas for the prices of Asian options, most work has been devoted to approximations. We do not provide an explicit pricing formula here, although the partial differential equation given here by the Feynman-Kac Theorem characterizes the exact price. Bouaziz, Bryis & Crouhy (1994) provide an approximate pricing formula, Rogers & Shi (1995) provide a lower bound, and Geman & Yor (1993) obtain the Laplace transform of the price.
35.9 American options.

A general arbitrage-based theory for the pricing of American contingent claims and options begins with the articles of Bensoussan (1984) and Karatzas (1988); see Myneni (1992) for a survey and additional references. The perpetual American put problem was solved by McKean (1965). Approximation and/or numerical solutions for the American option problem have been proposed by several authors, including Black (1975), Brennan & Schwartz (1977) (see Jaillet et al. (1990) for a treatment of the American option optimal stopping problem via variational inequalities, which leads to a justication of the Brennan-Schwartz algorithm), by Cox, Ross & Rubinstein (1979) (see Lamberton (1993) for the convergence of the associated binomial and/or nite difference schemes)
353
and by Parkinson (1977), Johnson (1983), Geske & Johnson (1984), MacMillan (1986), Omberg (1987), Barone-Adesi & Whalley (1987), Barone-Adesi & Elliott (1991), Bunch & Johnson (1992), Broadie & Detemple (1994), and Carr & Faguet (1994).
35.10 Forward and futures contracts.

The distinction between futures contracts and daily resettled forward contracts has only recently been recognized (see Margrabe (1976), Black (1976)) and even more recently understood. Cox, Ingersoll & Ross (1981) and Jarrow & Oldeld (1981) provide a discrete-time arbitrage-based analysis of the relationship between forwards and futures, whereas Richard & Sundaresan (1981) study these claims in a continuous-time, equilibrium setting. Our presentation of this material is similar to that of Dufe & Stanton (1992), which also considers options on futures, and to Chapte 7 of Dufe (1992). For additional reading on forward and futures contracts, one may consult Dufe (1989).
35.11 Term structure models.

The Hull & White (1990) model is a generalization of the constant-coefcent Vasicek (1977) model. Implementations of the model appear in Hull & White (1994a,b). The Cox-Ingersoll-Ross model is presented in (1985a,b). The presentations of these given models here is taken from Rogers (1995). Other surveys of term structure models are Dufe & Kan (1994) and Vetzal (1994). A partial list of other term structure models is Black, Derman & Toy (1990), Brace & Musiela (1994a,b), Brennan & Schwartz (1979, 1982) (but see Hogan (1993) for discussion of a problem with this model), Dufe & Kan (1993), Ho & Lee (1986), Jamshidian (1990), and Longstaff & Schwartz (1992a,b). The continuous-time Heath-Jarrow-Morton model appears in Heath, Jarrow & Morton (1992), and a discrete-time version is provided by Heath, Jarrow & Morton (1990). Carverhill & Pang (1995) discuss implementation. The Brace-Gatarek-Musiela variation of the HJM model is taken from Brace, et al. (1995). A summary of this model appears as Reed (1995). Related works on term structure models and swaps are Flesaker & Hughston (1995) and Jamshidian (1996).
35.12 Change of num raire. e

This material in this course is taken from Geman, El Karoui and Rochet (1995). Similar ideas were used by by Jamshidian (1989). The Merton option pricing formula appears in Merton (1973).
35.13 Foreign exchange models.

Foreign exchange options were priced by Biger & Hull (1983) and Garman & Kohlhagen (1983). The prices for differential swaps have been worked out by Jamshidian (1993a, 1993b) and Brace & Musiela (1994a).
354
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Lecture Notes Stochastic Calculus

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Lecture Notes Stochastic Calculus

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Steven Shreve: Stochastic Calculus and Finance

THIS IS A DRAFT: PLEASE DO NOT DISTRIBUTE c Copyright; Steven E. Shreve, 1996

Simple European Derivative Securities . . . . . . . . . . . . . . . . . . . . . . . . The Binomial Model is Complete . . . . . . . . . . . . . . . . . . . . . . . . . . .

8 Random Walks 8.1 First Passage Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8.5 8.6 8.7 8.8 8.9

10 Capital Asset Pricing

10.1 An Optimization Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 11 General Random Variables 123

12.1 Discrete-time Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

The moment generating function for

is almost surely nite . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17.2 Risk-neutral measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 18 Martingale Representation Theorem 197

-dimensional Martingale Representation Theorem . . . . . . . . . . . . . . . . . 200

18.5 Multi-dimensional market model . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

17.1 Conditional expectations under

6 19 A two-dimensional market model 19.2 Hedging when 203

20 Pricing Exotic Options

19.1 Hedging when

27 Bonds, forward contracts and futures

32 A two-factor model (Dufe & Kan)

34.1 Review of HJM under risk-neutral

31.1 Equilibrium distribution of

' 6$3 75542

Introduction to Probability Theory

AF   PIHG6 DC D C F  ' c$ ! ES4d5b4C  ! a ` F    UWVTUT6

S (H) = 8 1 S2 (HT) = 4 S =4 0 S1 (T) = 2 S2 (TH) = 4

p  h  f  D 7iF g@EC e  q c  ! x  # ' q eA ! d$ q C EC

Figure 1.1: Binomial tree of stock prices with

CHAPTER 1. Introduction to Probability Theory

and you need to have

. Thus, you want to choose

If the stock goes down, the value of your portfolio is

and you need to have

. Thus, you want to choose

to also have (1.4)

D ! v' c  ! v~ s @DECX5$ Du ' $ ds! u ' $ }y! u 6 ' $ ! C { z y x v XBA s |dyxb)uTw'

F  # n  fHpHo ' $ ! C$  ' $ s 4dyx5gtds! u Du ! s 4C v ' s @EY5$ DCF # '! $ e}b! u Du D ! s 4C Du # 6 ks t # r vW

at time . To simplify this

so that (1.7) becomes

CHAPTER 1. Introduction to Probability Theory

and substituting this into either equation, we can solve for

, we obtain the delta-hedging for-

! qu q PC '! C! $'# n $ n q C!  l"4B`Wt! ibTh1tPB`q u

! ! 4C ' D C D $ ' # n $ n ! C D x llEsGWD u suT1rxsG@! ' e$ 0b!

' c$ ' e$ ! ' c$ ! D d5b! @&b` d5y G D u

@0uq u ' e e$ d@&7q u ' c e$ 7q u ' e c$  ' c c dd5$ q u

is the value of the option at time if

and the value at time outcomes

of the derivative security, when the rst , is given by

coin tosses result in the

1.2 Finite Probability Spaces

be a set with nitely many elements. An example to keep in mind is (2.1)

e ! @0$ ! ' e ' e e$ ((@0uq u Sd@07q u 4T n ' c e$ # n

x0y! u  ' e$ ' e$ 0y! u

D D G ' e$  ' e$ 0y! u u @0s! ' c$ y! u

' c$  ' c$ d5y! u td5s!

CHAPTER 1. Introduction to Probability Theory

which is another way of saying that the probability of

on the rst toss is .

~sp  e e e q 7! @w@sp  e c e  e e c 7! @wbp  e c c u @wdbp q !

Example 1.2 Suppose a coin has probability in (2.1), dene

. For the individual elements of

is a sequence of disjoint sets in

A ~@sp  c e e q q !  c c e A 7! ! @sp q A 7  c e c q q ! @@wbp  c c c A u! @ddbp

Denition 1.1 A probability measure properties:

AF PIHG6 DC D C F ' c$ ! ES4d5b4C ! a ` F UWVTUT6

p h f D 7iF g@EC e q c ! x # ' q eA ! d$ q C EC

D ! v' c ! v~ s @DECX5$ Du ' $ ds! u ' $ }y! u 6 ' $ ! C { z y x v XBA s |dyxb)uTw'

F # n fHpHo ' $ ! C$ ' $ s 4dyx5gtds! u Du ! s 4C v ' s @EY5$ DCF # '! $ e}b! u Du D ! s 4C Du # 6 ks t # r vW

! qu q PC '! C! $'# n $ n q C! l"4B`Wt! ibTh1tPB`q u

! ! 4C ' D C D $ ' # n $ n ! C D x llEsGWD u suT1rxsG@! ' e$ 0b!

@0uq u ' e e$ d@&7q u ' c e$ 7q u ' e c$ ' c c dd5$ q u

e ! @0$ ! ' e ' e e$ ((@0uq u Sd@07q u 4T n ' c e$ # n

x0y! u ' e$ ' e$ 0y! u

D D G ' e$ ' e$ 0y! u u @0s! ' c$ y! u

' c$ ' c$ d5y! u td5s!

~sp e e e q 7! @w@sp e c e e e c 7! @wbp e c c u @wdbp q !

A ~@sp c e e q q ! c c e A 7! ! @sp q A 7 c e c q q ! @@wbp c c c A u! @ddbp

e e e e eA c e e s"w@ix S c e e c eA c c e sw@"wd@sx S e c e e cA c e c wbwBw@wbx c c e c c A c c c x dbjdBwddb

A A A A rYSjBA ) p qC Y @X7HPHGf Hlb7BSf duPC y pA ' $ q

' e e e$ q C ' c e e$ q 7t@0bftd@0uPC ASf4'@ewc@0$7qPCP'dcc07P4@w57Prd@w5uPC e e$ q C ' e e c$ q C ' c e c$ q A ' e c c$ q C ' c c c$ q )s4@wd5uP4dd5uPC

D F ' e c c$ q svEC t@wd57PC pq f D F WEC !q

' e e e$ q C ' c e e$ q G@&bPkd@&7PC

dtd$ ' wA l ' $ c h ' wA $ l l l l

' e e e$ q C ' c e e$ q 7t@0bftd@0uPC ASf4'@ewc@0$7qPCP'dcc07P4@w57Prd@w5uPC e e$ q C ' e e c$ q C ' c e c$ q A ' e c c$ q C ' c c c$ q )s4@wd5uP4dd5uPC

QuYb Y h p Y 7) lp Y t Y yp "'d$ t ' lp "d$

!fB !fB !fB !fB b) x Y)~ l"issXlEt! AA !

! P ! fB q ' WS5$ uS p q ' WS5$ 4' $

u) Qlp q ' P'd$ $ x ' $ q' W '`$ "A $

Tu5WPXB1b%wBY ' A $ ' A $ A

! fb n A IBY tTBY ' A

! Pu 'A lQ4W5$ tXB1$ 'A

! fu ' n A TBY5$ rTS$ ' A

'' $ A " 5~wG 5$

' $ $ 5dt' 5 ' $ D t 5QE

ssisqBs A A! 6 ' $ t5

'' $ A " 5~wG 5$

w ' $ ' $ Y5tHSr D x D 7 p)BE7 7 %!f ! )P l'i@$QDy D @E7iQ x D E7