Lecture Notes "Financial Mathematics I: Stochastic Calculus, Option Pricing, Portfolio Optimization"

Lecture Notes
“FINANCIAL MATHEMATICS I:
Stochastic Calculus, Option Pricing,
Portfolio Optimization”
Holger Kraft
University of Kaiserslautern
Department of Mathematics
Mathematical Finance Group
Summer Term 2005
This Version: August 4, 2005

CONTENTS 1
Contents
1 Introduction 3
1.1 What is an Option? . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Fundamental Relations . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2 Discrete-time State Pricing with Finite State Space 6

2.1 Single-period Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.1.1 Description of the Model . . . . . . . . . . . . . . . . . . . . 6
2.1.2 Arrow-Debreu Securities . . . . . . . . . . . . . . . . . . . . . 7
2.1.3 Deflator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.1.4 Risk-neutral Measure . . . . . . . . . . . . . . . . . . . . . . 10
2.1.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.2 Multi-period Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.2.1 Modeling Information Flow . . . . . . . . . . . . . . . . . . . 14
2.2.2 Description of the Multi-period Model . . . . . . . . . . . . . 16
2.2.3 Some Basic Definitions Revisited . . . . . . . . . . . . . . . . 19
2.2.4 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.2.5 Main Results . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.2.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3 Introduction to Stochastic Calculus 23

3.1 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.1.1 Why Stochastic Calculus? . . . . . . . . . . . . . . . . . . . . 23
3.1.2 What is a Reasonable Model for Stock Dynamics? . . . . . . 23
3.2 On Stochastic Processes . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.2.1 Cadlag and Caglad . . . . . . . . . . . . . . . . . . . . . . . . 24
3.2.2 Modification, Indistinguishability, Measurability . . . . . . . 25
3.2.3 Stopping Times . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3.3 Prominent Examples of Stochastic Processes . . . . . . . . . . . . . . 29
3.4 Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3.5 Completition, Augmentation, Usual Conditions . . . . . . . . . . . . 34
3.6 Ito-Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3.7 Ito’s Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
4 Continuous-time Market Model and Option Pricing 47

CONTENTS 2
4.1 Description of the Model . . . . . . . . . . . . . . . . . . . . . . . . . 47

4.2 Black-Scholes Approach: Pricing by Replication . . . . . . . . . . . . 49
4.3 Pricing with Deflators . . . . . . . . . . . . . . . . . . . . . . . . . . 53
4.4 Pricing with Risk-neutral Measures . . . . . . . . . . . . . . . . . . . 57
5 Continuous-time Portfolio Optimization 68

5.1 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
5.2 Martingale Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
5.3 Stochastic Optimal Control Approach . . . . . . . . . . . . . . . . . 73
5.3.1 Heuristic Derivation of the HJB . . . . . . . . . . . . . . . . . 73
5.3.2 Solving the HJB . . . . . . . . . . . . . . . . . . . . . . . . . 74
5.3.3 Verification . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
5.4 Intermediate Consumption . . . . . . . . . . . . . . . . . . . . . . . . 76
5.5 Infinite Horizon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
References 86
1 INTRODUCTION 3
1 Introduction
1.1 What is an Option?
• There exist two main variants: call and put.
• A European call gives the owner the right to buy some asset (e.g. stock, bond,
electricity, corn . . . ) at a future date (maturity) for a fixed price (strike price).
• Payoff: max{S(T ) − K; 0}, where S(T ) is the asset price at maturity T and
K is the strike price.
• An American call gives the owner the right to buy some asset during the whole
life-time of the call.
• Put: replace “buy” with “sell”
• Since the owner has the right but not the obligation, this right has a positive
value.
1.2 Fundamental Relations
Consider an option written on an underlying which pays no dividends etc. during

the life-time of the option. In the following we assume that the underlying is a stock.
The time-t call and put prices are denoted by Call(t) and P ut(t). The time-t price
of a zero-coupon bond with maturity T is denoted by p(t, T ).
Proposition 1.1 (Bounds)

(i) For a European call we get: S(t) ≥ Call(t) ≥ max{S(t) − Kp(t, T ); 0}
(ii) For a European put we have: Kp(t, T ) ≥ P ut(t) ≥ max{Kp(t, T ) − S(t); 0}
Proof. (i) The relation S(t) ≥ Call(t) is obvious because the stock can be in-
terpreted as a call with strike 0. We now assume that Call(t) < max{S(t) −
Kp(t, T ); 0}. W.l.o.g. S(t) − Kp(t, T ) ≥ 0. Consider the strategy
• buy one call,
• sell one stock,
• buy K zeros with maturity T ,
leading to an initial inflow of S(t)−Call(t)−Kp(t, T ) > 0. At time T , we distinguish
two scenarios:
1. S(T ) > K: Then the value of the strategy is −S(T ) + S(T ) − K + K = 0.
2. S(T ) ≤ K: Then the value of the strategy is −S(T ) + 0 + K ≥ 0.
Hence, the strategy would be an arbitrage opportunity.
(ii) The relation Kp(t, T ) ≥ P ut(t) is valid because otherwise the strategy
• sell one put,
• buy K zeros with maturity T
1 INTRODUCTION 4
would be an arbitrage strategy. The second relation can be proved similarly to the
relation for the call in (i). 2
Proposition 1.2 (Put-Call Parity)

The following relation holds: P ut(t) = Call(t) − S(t) + Kp(t, T )
Proof. Consider the strategy

• buy one put,
• sell one call,
• buy one stock,
• sell K zeros with maturity T .
It is easy to check that the time-T value of this strategy is zero. Since no additional
payments need to be made, no arbitrage dictates that the time-t value is zero as
well implying the desired result. 2
Remark. This is a very important relationship because it ties together European
call and put prices.
Proposition 1.3 (American Call)

Assume that interest rates are positive. Early exercise of an American call is not
optimal, i.e. Callam (t) = Call(t).
Proof. The following relations hold

(∗)
Callam (t) ≥ Call(t) ≥ max{S(t) − Kp(t, T ); 0} ≥ S(t) − K
where (∗) holds due to Proposition 1.1 (i). Hence, the American call is worth more
alive than dead. 2
Remark.
• Unfortunately, this result does not hold for American puts.
• If dividends are paid, then the result for the American call breaks down as well.
Proposition 1.4 (American Put)

Assume that interest rates are positive. Then the following relations hold:
(i) Callam (t) − S(t) + Kp(t, T ) ≤ P utam (t) ≤ Callam (t) − S(t) + K
(ii) P ut(t) ≤ P utam (t) ≤ P ut(t) + K(1 − p(t, T )).
Proof. (i) The first inequality follows from the put-call parity and Proposition 1.3.
For the second one assume that P utam (t) > Callam (t) − S(t) + K and consider the
following strategy:
• sell one put,
• buy one call,
• sell one stock,
• invest K Euros in the money market account.1
1 The time-t value of the money market account is denoted by M(t). By convention, M (0) = 1.
1 INTRODUCTION 5
By assumption, the initial value of this strategy is strictly positive. For t ∈ [0, T ]
we distinguish to scenarios:
1. S(t) > K: Then the value of the strategy is
0 + (S(t) − K) − S(t) + KM (t) = K(M (t) − 1) ≥ 0
since interest rates are positive and thus M (t) ≥ 1.

2. S(t) ≤ K: Then the value of the strategy is
−(K − S(t)) + 0 − S(t) + KM (t) = K(M (t) − 1) ≥ 0.
Hence, the strategy would be an arbitrage opportunity.

(ii) We have
P ut(t) ≤ P utam (t) ≤ Callam (t) − S(t) + K = Call(t) − S(t) + K

= P ut(t) + S(t) − Kp(t, T ) − S(t) + K = P ut(t) + K(1 − p(t, T )).
2
Remark. If interest rates are zero, then P ut(t) = P utam (t).
2 DISCRETE-TIME STATE PRICING WITH FINITE STATE SPACE 6
2 Discrete-time State Pricing with Finite State

Space
2.1 Single-period Model
2.1.1 Description of the Model
• We consider a single-period model starting today (t = 0) and ending at time

t = T . Without loss of generality T = 1.
• Uncertainty at time t = 1 is represented by a finite set Ω = {ω1 , . . . , ωI } of

states, one of which will be revealed as true. Ω is said to be the state space.
• Each state ωi ∈ Ω can occur with probability P (ωi ) > 0. This defines a
probability measure P : Ω → (0, 1).
• At time t = 0 one can trade in J + 1 assets. The time-0 prices of these

assets are described by the vector S 0 = (S0 , S1 , . . . , SJ ). The state-dependent
payoffs of the assets at time t = 1 are described by the payoff matrix
 
 X0 (ω1 ) · · · XJ (ω1 ) 
 
 
 X0 (ω2 ) · · · XJ (ω2 ) 
X= .
 
.. . . ..
.
 
 . . 
 
 
X0 (ωI ) · · · XJ (ωI )
• To shorten notations, Xij := Xj (ωi ).
• The first asset is assumed to be riskless, i.e. Xi0 = Xk0 = const. for all i,
k ∈ {1, . . . , I}.
• Therefore, at time t = 0 there exists a riskless interest rate given by

X0
r= − 1.
S0
• An investor buys and sells assets at time t = 0. This is modeled via a trading
strategy ϕ = (ϕ0 , . . . , ϕJ )0 , where ϕj denotes the number of asset j which the
investor holds in his portfolio (combination of assets).
Definition 2.1 (Arbitrage)

We distinguish two kinds of arbitrage opportunities:
(i) A free lunch is a trading strategy ϕ with
S0ϕ < 0 and Xϕ ≥ 0.
(ii) A free lottery is a trading strategy ϕ with
S0ϕ = 0 and Xϕ ≥ 0 and Xϕ 6= 0.

Assumptions:
(a) All investors agree upon which states cannot occur at time t = 1.
(b) All investors estimate the same payoff matrix (homogeneous beliefs).
(c) At time t = 0 there is only one market price for each security and each investor
can buy and sell as many securities as desired without changing the market
price (price taker).
(d) Frictionless markets, i.e.

• assets are divisible,
• no restrictions on short sales,2
• no transaction costs,
• no taxes.
(e) The asset market contains no arbitrage opportunities, i.e. there are neither free
lunches nor free lotteries.
2.1.2 Arrow-Debreu Securities
To characterize arbitrage-free markets, the notion of an Arrow-Debreu security is

crucial:
Definition 2.2 (Arrow-Debreu Security)

An asset paying one Euro in exactly one state and zero else is said to be an Arrow-
Debreu security (ADS). Its price is an Arrow-Debreu price (ADP).
Remarks.
• In our model, we have as many ADS as states at time t = 1, i.e. we have I
Arrow-Debreu securities.
• The i-th ADS has the payoff ei = (0, . . . , 0, 1, 0, . . . , 0)0 , where the i-th entry is
1. The corresponding Arrow-Debreu price is denoted by πi .
• Unfortunately, in practice ADSs are not traded.
We can now prove the following theorem characterizing markets which do not con-
tain arbitrage opportunities.
Theorem 2.1 (Characterization of No Arbitrage)

Under assumptions (a)-(d) the following statements are equivalent:
• The market does not contain arbitrage opportunities (Assumption (e)).
2A short sale of an assets is equivalent to selling an asset one does not own. An investor can do
this by borrowing the asset from a third party and selling the borrowed security. The net position
is a cash inflow equal to the price of the security and a liability (borrowing) of the security to
the third party. In abstract mathematical terms, a short sale corresponds to buying a negative
amount of a security.
• There exist strictly positive Arrow-Debreu prices, i.e. πi > 0, i = 1, . . . , I, such

that
XI
Sj = πi · Xij .
i=1
Proof. Suppose (ii) to hold. We consider a strategy ϕ with Xϕ ≥ 0 and Xϕ 6= 0.

Then
(ii) (∗)
S 0 ϕ = π 0 Xϕ > 0,
where (∗) holds because π > 0, Xϕ ≥ 0, and Xϕ 6= 0. For this reason, there are
no free lunches. The argument to exclude free lotteries is similar. The implication
“(i)⇒(ii)” follows from the so-called Farkas-Stiemke lemma (See Mangasarian (1969,
p. 32) or Dax (1997)). 2
Remarks.
• The ADPs are the solution of the following system of linear equations:
S = X 0 π.
• The hard part of the proof is actually the proof of implication “(i)⇒(ii)”. For
brevity, this proof is omitted here.
Given our market with prices S and payoff matrix X, it is now of interest how to
price other assets.
Definition 2.3 (Contingent Claim)

In the single-period model, a contingent claim (derivative, option) is some additional
asset with payoff C ∈ IRI .
Definition 2.4 (Replication)

Consider a market with payoff matrix X. A contingent claim with payoff C can be
replicated (hedged) in this market if there exists a trading strategy ϕ such that
C = Xϕ.
Remark. If an asset with payoff C is replicable via a trading strategy ϕ, by the

no arbitrage assumption its price SC has to be (“law of one price”)
J
X
SC = ϕj · S j .
j=1
Definition 2.5 (Completeness)

An arbitrage-free market is said to be complete if every contingent claim is replica-
ble.
Theorem 2.2 (Characterization of a Complete Market)

Assume that the financial market contains no arbitrage opportunities. Then the
market is complete if and only if the Arrow-Debreu prices are uniquely determined,
i.e.
Rank(X) = I.
Proof. π is unique.
⇐⇒ X 0 π = S has a unique solution.
⇐⇒ Rank (X) = I
⇐⇒ Range (X) = IRI
⇐⇒ Every contingent claim is replicable. 2
Remarks.
• The market is complete if the number of assets with linearly independent payoffs
is equal to the number of states.
• If the number of assets is smaller than the number of states (J < I), the market
cannot be complete.
2.1.3 Deflator
Main result from the previous subsection: In an arbitrage-free market, there

exist strictly positive ADPs such that
I
X
Sj = πi · Xij .
i=1
In this subsection: Using the physical probabilities P (ωi ), i = 1, . . . , I, arbitrage-

free asset prices can be represented as discounted expected values of the correspond-
ing payoffs.
Definition 2.6 (Deflator)

In an arbitrage-free market, a deflator H is defined by
π
H= .
P
Remarks.
• Since the market is arbitrage-free, there exists at least one vector of ADSs π, but
π and thus the deflator H are only unique if the market is complete.
• The ADS π and the probability measure P can be interpreted as random variables
with realizations πi = π(ωi ) and P (ωi ).
Proposition 2.3 (Pricing with a Deflator)

In an arbitrage-free market, the asset prices are given by
Sj = EP [H · Xj ].
Proof.
I I
X X π(ωi ) hπ i
Sj = πi · Xij = P (ωi ) Xj (ωi ) = EP Xj = EP [H · Xj ]
i=1 i=1
P (ωi ) P
Remarks.
• The deflator H is the appropriate discount factor for payoffs at time t = 1.
• The deflator H ist a random variable with realizations π(ωi )/P (ωi ).
• On average, one needs to discount with the riskless rate r because
I I
X π(ωi ) X 1
EP [H] = P (ωi ) · = π(ωi ) = .
i=1
P (ωi ) i=1
1 + r
Interpretation of a Deflator:
• In an equilibrium model one can show that the deflator equals the marginal
rate of substitution between consumption at time t = 0 and t = 1 of a repre-
sentative investor, i.e. (roughly speaking) we have
∂u/∂c1
H= ,
∂u/∂c0
where u = u(c0 , c1 ) is the utility function of the representative investor.
• Setting u00 := ∂u/∂c0 and u01 := ∂u/∂c1 leads to
1 u00
r= −1= − 1,
EP [H] EP (u01 )
which gives the following result:
(i) u00 > E(u01 ) (”‘time preference”’):3 r > 0,

(ii) u00 < E(u01 ): r < 0.
2.1.4 Risk-neutral Measure
Two important observations:

(i) If an investor buys all ADSs, he gets one Euro at time t = 1 for sure, i.e. we get
I I
X 1 X
πi = ⇒ πi · (1 + r) = 1.
i=1
1+r i=1
(ii) In an arbitrage-free market, it holds that πi > 0, i = 1, . . . , I.
3 Intuitively, time preference describes the preference for present consumption over future
consumption.
Proposition 2.4 (Risk-neutral Measure)

In an arbitrage-free market, there exists a probability measure Q defined via
Q(ωi ) = qi := πi · (1 + r)
This measure is said to be the risk-neutral measure or equivalent martingale mea-

sure.
Proof. follows from (i) and (ii). 2
Using the risk-neutral measure, there is a third representation of an asset price:
Proposition 2.5 (Risk-neutral Pricing)

In an arbitrage-free market, asset prices possess the following representation
hX i
j
Sj = E Q ,
R
where R := 1 + r.
Proof.
I I I
X X Xij X Xij hX i
j
Sj = πi · Xij = πi · R · = qi · = EQ .
i=1 i=1
R i=1
R R
2
Remarks.
• Warning: The risk-neutral measure Q is different from the physical measure P .
• Roughly speaking, risk-neutral probabilities are compounded Arrow-Debreu se-
curities.
• The notion “risk-neutral measure” comes from the fact that under this measure
prices are discounted expected values where one needs to discount using the
riskless interest rate.
To motivate the notion “equivalent martingale measure”, let us recall some basic
definitions:
Definition 2.7 (Equivalent Probability Measures)
A Probability Measure Q is said to be continuous w.r.t. another probability measure
P if for any event A ⊂ Ω
P (A) = 0 =⇒ Q(A) = 0.
If Q is continuous w.r.t. P and vice versa, then P and Q are said to be equivalent,
i.e. both measures possess the same null sets.
Theorem 2.6 (Radon-Nikodym)

If Q is continuous w.r.t. P , then Q possesses a density w.r.t. Q, i.e. there exists a
positive random variable D = dQ dP such that
EQ [Y ] = EP [D · Y ]
for any random variable Y . This density is uniquely determined (P -a.s.).

Definition 2.8 (Stochastic Process in a Single-period Model)

Consider a single-period model with time points t = 0, 1. The finite sequence
{Y (t)}t=0,1 forms a stochastic process.
Definition 2.9 (Martingale in a Single-period Model)

Consider a single-period model with finite state space. Uncertainty at time t = 1
is modeled by some probability measure Q. A real-valued stochastic process is said
to be a martingale w.r.t. Q (short: Q-martingale) if
EQ [Y (1)] = Y (0),
where it is assumed that EQ [|Y (1)|] < ∞.
We can now characterize risk-neutral measures as follows:

Proposition 2.7 (Properties of a Risk-neutral Measure)
(i) The discounted price processes {Sj , Xj /R} are martingales under a risk-neutral
measure Q.
(ii) The physical measure P and a risk-neutral measure Q are equivalent.
Proof. (i) follows from Proposition 2.5.

(ii) Since ADPs are strictly positive, we have Q(ωi ) > 0 and P (ωi ) > 0 which gives
the desired result. 2
Remarks.
• Proposition 2.7 is the reason why Q is said to be an equivalent martingale
measure.
• From Propositions 2.3 and 2.5, we get
hX i
j
EQ = Sj = EP [H · Xj ].
R
Therefore, we obtain
EQ [Xj ] = EP [ H · R} ·Xj ],
| {z
=dQ/dP
i.e. H = (dQ/dP )/R. Analogously, one can show dP/dQ = 1/(H · R).
2.1.5 Summary
Theorem 2.8 (No Arbitrage)

Consider a financial market with price vector S and payoff matrix X. If the as-
sumptions (a)-(d) are satisfied, then the following statements are equivalent:
(i) The financial market contains no arbitrage opportunities (assumption (e)).
(ii) There exist strictly positive Arrow-Debreu prices πi , i = 1, . . . , I, such that

I
X
Sj = πi · Xij .
i=1
(iii) There exists a state-dependent discount factor H, the so-called deflator, such
that for all j = 0, . . . , J
Sj = EP [H · Xj ].
(iv) There exists an equivalent martingale measure Q such that the discounted
price processes {Sj , Xj /R} are martingales under Q, i.e. for all j = 0, . . . , J
hX i
j
Sj = EQ
R
Theorem 2.9 (Completeness)

Consider a financial market with price vector S and payoff matrix X. If the as-
sumptions (a)-(e) are satisfied, then the following statements are equivalent:
(i) The financial market is complete, i.e. each additional asset can be replicated.
(ii) The Arrow-Debreu prices πi , i = 1, . . . , I, are uniquely determined.
(iii) There exists only one deflator H.
(iv) There exists only one equivalent martingale Q.
Remarks.
• In a complete market, the price of any additional asset is given by the price of
its replicating portfolio.
• The value of this portfolio can be calculated applying the following theorem.
Theorem 2.10 (Pricing of Contingent Claims)

Consider an arbitrage-free and complete market with price vector S and payoff
matrix X. Let C ∈ IRI be the payoff of a contingent claim. Its today’s price SC
can be calculated by using one of the following formulas:
I
X
0
(i) SC = C π = πi · C(ωi ) (Pricing with ADSs).
i=1
(ii) SC = EP [H · C] (Pricing with the deflator).

hC i
(iii) SC = EQ (Pricing with the equivalent martingale measure).
R
Proof. In an arbitrage-free and complete market, there exist ADPs which are
uniquely determined. The no-arbitrage requirement together with the definition of
an ADP gives formula (i). Formulas (ii) and (iii) follow from (i) using H = π/P
and Q(ωi ) = πi · R. 2
2.2 Multi-period Model
In the previous section we have modeled only two points in time:

t = 0: The investor chooses the trading strategy.
t = T: The investor liquidates his portfolio and gets the payoffs.
This has the following consequences:

• We have disregarded the information flow between 0 and T .
• Every trading strategy was a static strategy (”‘buy and hold”’), i.e. intermediate
portfolio adjustments was not allowed.
In this section
• we will model the information flow between 0 and T .
→ Filtration
• and the investor can adjust his portfolio according to the arrival of new informa-
tion about prices.
→ dynamic (self-financing) trading strategy.
2.2.1 Modeling Information Flow
Motivation
Consider the dynamics of a stock in a two-period binomial model:
t=0 t = 0.5 t=1

1 121

1 110 PPP

PP
P
q
P
100 PP

1 99

PP
PP
q
P
90 P
PP
PP
Pq
P
81
• Due to the additional trading date at time t = 0.5, the investor gets more infor-
mation about the stock price at time t = 1.
• At t = 0 it is possible that the stock price at time t = 1 equals 81, 99 or 121.
• If, however, the investor already knows that at time t = 0.5 the stock price equals
110 (90), then at time t = 1 the stock price can only take the values 121 or 99
(99 or 81).
• It is one of the goals of this section to model this additional piece of information!
Reference Example
To demonstrate how one can model the information flow, we consider the following
example:
t=0 t=1 t=2

1 ω1

1
{ω1 , ω2P
}P

PP
PPq ω2 , ω3
{ω1 , ω2 , ω3P
, ωP
4 } P
1

PP
PPq{ω , ω
}P
P
3 4P
PP
PP q ω
P
4
The state space thus equals: Ω = {ω1 , ω2 , ω3 , ω4 }.

Example for the interpretation of the states.
ω1 : DAX stands at 5000 at t = 1 and at 6000 at time t = 2.
First Approach to Model the Flow of Information
Definition 2.10 (Partition)

A partition of the state space is a set {A1 , . . . , AK } of subsets Ak ⊂ Ω of a state
space Ω such that
• the subsets Ak are disjoint, i.e. Ak ∩ Al = ∅,
• Ω = A1 ∪ . . . ∪ AK .
Example. {{ω1 , ω2 }, {ω3 , ω4 }}.
Definition 2.11 (Information Structure)

An information structure is a sequence {Ft }t of partitions F0 , . . ., FT such that
• F0 = {ω1 , . . . , ωI } (”‘ At the beginning each state can occur.”’),
• FT = {{ω1 }, . . . , {ωI }} (”‘ At the end, one knows for sure which
state has occurred. ”’),
• the partitions become finer over time.
Example.
F0 = {{ω1 , ω2 , ω3 , ω4 }}.
F1 = {{ω1 , ω2 }, {ω3 , ω4 }}.
F2 = {{ω1 }, {ω2 }, {ω3 }, {ω4 }}.
Remarks.
• Problem: This intuitive definition cannot be generalized to the continuous-time
case.
• However, it provides a good intuition of what information flow actually means.
Second Approach to Model the Flow of Information: Filtration
Definition 2.12 (σ-Field)

A system F of subsets of the state space Ω is said to be a σ-field if
(i) Ω ∈ F,
(ii) A ∈ F ⇒ AC ∈ F,
∞
S
(iii) for every sequence {An }n∈IN with An ∈ F we have An ∈ F.
n=1
Remark. For a finite σ-field, it is sufficient if finite (instead of infinite) unions of

events belong to the σ-field (see requirement (iii) of Definition 2.12).
Example. {∅, {ω1 , ω2 }, {ω3 , ω4 }, Ω}.
Definition 2.13 (Filtration)

Consider a state space F. A family {Ft }t of sub-σ-fields Ft , t ∈ I, is said to be a
filtration if Fs ⊂ Ft , s ≤ t and s, t ∈ I. Here I denotes some ordered index set.
Remark. In our discrete time model, we can always use filtrations with the fol-
lowing properties (P(Ω) denotes the power-set of Ω):
• F0 = {∅, Ω} (”‘At the beginning, one has no information.”’),
• FT = P(Ω) (”‘At the end one is fully informed.”’),
• F0 ⊂ F1 ⊂ . . . ⊂ FT (”‘The state of information increases over time.”’).
Example. F0 = {∅, Ω}, F1 = {∅, {ω1 , ω2 }, {ω3 , ω4 }, Ω}, F2 = P(Ω).
Some facts about filtrations:

• Filtrations are used to model the flow of information over time.
• At time t, one can decide if the event A ∈ Ft has occurred or not.
• Taking conditional expectation E[Y |Ft ] of a random variable Y means that one
takes expectation on the basis of all information available at time t.
2.2.2 Description of the Multi-period Model
Properties of the Model:

• Trading takes place at T + 1 dates, t = 0, . . . , T .
• Investors can trade in J + 1 assets with price processes (S0 (t), . . . , SJ (t)), t =
0, . . . , T .
• Sj (t) denotes the price of the j-th asset at time t.
• The range of Sj (t) is finite.
• Trading of an investor is modeled via his trading strategy ϕ(t) = (ϕ0 (t), . . . , ϕJ (t))0 ,
where ϕj (t) denotes the number of asset j at time t in the investor’s portfolio.
• A trading strategy needs to be predictable, i.e. on the basis of all information
about prices S(t − 1) at time t − 1 the investor selects his portfolio which he holds
until time t.
• The value of a trading strategy at time t is given by:


 S(t)0 ϕ(t) = J Sj (t)ϕj (t)
P
für t = 1, . . . , T

j=0
Vϕ (t) =
 S(0)0 ϕ(1) = PJ S (0)ϕ (1)

für t = 0
j=0 j j
Definition 2.14 (Contingent Claim)

A contingent claim leads to a state-dependent payoff C(t) at time t, which is mea-
surable w.r.t. Ft .
Remarks.
• A typical contingent claim is a European call with payoff C(T ) = max{S(T ) −
K; 0}, where S(T ) denotes the value of the underlying at time T and K the strike
price.
• American options are no contingent claims in the sense of Definition 2.14, but
one can generalize this definition accordingly.
• Recall the following paradigm: Arbitrage-free pricing of a contingent claim
means finding a hedging (replication) strategy of the corresponding payoff.
• In the single-period model: The price of the replication strategy is then the price
of the contingent claim.
• In the multi-period model we need an additional requirement: The replication
strategy should not require intermediate inflows or outflows of cash.
• Only in this case, the initial costs are equal to the fair price of the contingent
claim.
• This leads to the notion of a self-financing trading strategy.
Definition 2.15 (Self-financing Trading Strategy)

A trading strategy ϕ(t) = (ϕ1 (t), . . . , ϕJ (t)) is said to be self-financing if for t =
1, . . . , T − 1
J
X J
X
S(t)0 ϕ(t) = S(t)0 ϕ(t + 1) ⇐⇒ Sj (t) · ϕj (t) = Sj (t) · ϕj (t + 1).
j=0 j=0
Remarks.
• To buy assets, the investor has to sell other ones.
• For this reason, the portfolio value changes only if prices change and not if the
numbers of assets in the portfolio change.
Notation:
• Change of the value of strategy ϕ at time t:
∆Vϕ (t) := Vϕ (t) − Vϕ (t − 1)
• Price changes at time t
∆S(t) = (∆S0 (t), . . . , ∆SJ (t)) := (S0 (t) − S0 (t − 1), . . . , SJ (t) − SJ (t − 1))
• Gains process of the trading strategy ϕ at time t:

J
X
ϕ(t)0 ∆S(t) = ϕj (t)∆Sj (t)
j=0
• Cumulative gains process of the trading strategy ϕ at time t:

t
X t X
X J
Gϕ (t) := ϕ(τ )0 ∆S(τ ) = ϕj (τ )∆Sj (τ )
τ =1 τ =1 j=0
Proposition 2.11 (Characterization of a Self-financing Trading Strategy)

A self-financing trading strategy ϕ(t) has the following properties:
(i) The value of ϕ changes only due to price changes, i.e.
∆Vϕ (t) = ϕ(t)0 ∆S(t).
(ii) The value of ϕ is equal to its initial value plus the cumulative gains, i.e.
t
X
Vϕ (t) = Vϕ (0) + Gϕ (t) = Vϕ (0) + ϕ(τ )0 ∆S(τ ).
τ =1
Proof. (i) For a self-financing strategy ϕ, we obtain
∆Vϕ (t) = Vϕ (t) − Vϕ (t − 1)

J
X J
X
= Sj (t)ϕj (t) − Sj (t − 1)ϕj (t − 1)
j=0 j=0
J J
(∗) X X
= Sj (t)ϕj (t) − Sj (t − 1)ϕj (t)
j=0 j=0
J
X
= ϕj (t) Sj (t) − Sj (t − 1)
j=0
J
X
= ϕj (t)∆Sj (t)
j=0
= ϕ(t)0 ∆S(t).
The equality (∗) is valid because ϕ is self-financing.

(ii) Any (not necessary self-financing) trading strategy satisfies
t
X
Vϕ (t) = Vϕ (0) + ∆Vϕ (τ ).
τ =1
Since ϕ is assumed to be self-financing, by (i), we obtain

t
X
Vϕ (t) = Vϕ (0) + ∆Vϕ (τ ).
τ =1
t
(i) X
= Vϕ (0) + ϕ(τ )0 ∆S(τ )
τ =1
= Vϕ (0) + Gϕ (t).
Remarks.
• In continuous-time models, the relation (i) is still valid if ∆ is replace by d.
• Unfortunately, the intuitive relation
S(t)0 ϕ(t) = S(t)0 ϕ(t + 1)
has no continuous-time equivalent.
2.2.3 Some Basic Definitions Revisited
The notion of a self-financing trading strategy is also important to generalize the

following definitions to the multi-period setting:
Definition 2.16 (Arbitrage)

We distinguish two kinds of arbitrage opportunities:
(i) A free lunch is a self-financing trading strategy ϕ with
Vϕ (0) < 0 und Vϕ (T ) ≥ 0.
(ii) A free lottery is a self-financing trading strategy ϕ with
Vϕ (0) = 0 und Vϕ (T ) ≥ 0 und Vϕ (T ) 6= 0.
Definition 2.17 (Replication of a Contingent Claim)

A contingent claim with payoff C(T ) is said to be replicable if there exists a self-
financing trading strategy ϕ such that
C(T ) = Vϕ (T ).
The trading strategy ϕ is said to be a replication (hedging) strategy for the claim
C(T ).
Remarks.
• By definition, a replication strategy of a claim leads to the same payoff as the
claim.
• In general, replication strategies are dynamic strategies, i.e. at every trading
date the hedge portfolio needs to be adjusted according to the arrival of new
information about prices.
The definition of a complete market remains the same:
Definition 2.18 (Completeness)

An arbitrage-free market is said to be complete if each contingent claim can be
replicated.
2.2.4 Assumptions
(a) All investors agree upon which states cannot occur at times t > 0.
(b) All investors agree upon the range of the price processes S(t).
(c) At time t = 0 there is only one market price for each security and each investor
can buy and sell as many securities as desired without changing the market
price (price taker).
(d) Frictionless markets, i.e.

• assets are divisible,
• no restrictions on short sales,4
• no transaction costs,
• no taxes.
(e) The asset market contains no arbitrage opportunities, i.e. there are neither free
lunches nor free lotteries.
2.2.5 Main Results
Conventions:
• The 0-th asset is a money market account, i.e. it is locally risk-free with
t
Y
S0 (0) = 1 und S0 (t) = (1 + ru ), t = 1, . . . , T,
u=1
where ru denotes the interest rate for the period [τ − 1, τ ].

• The discounted (normalized) price processes are defined by
Sj (t)
Zj (t) := .
S0 (t)
• The money market account is thus used as a numeraire.
Definition 2.19 (Martingal)

A real-valued adapted process {Y (t)}t , t = 0, . . . , T , with E[|Y (t)|] < ∞ is a mar-
tingale w.r.t. a probability measure Q if for s ≤ t
EQ [Y (t)|Fs ] = Y (s).
Remark. A martingale is thus a process being on average stationary.
Important Facts:
4A short sale of an assets is equivalent to selling an asset one does not own. An investor can do
this by borrowing the asset from a third party and selling the borrowed security. The net position
is a cash inflow equal to the price of the security and a liability (borrowing) of the security to
the third party. In abstract mathematical terms, a short sale corresponds to buying a negative
amount of a security.
• A multi-period model consists of a sequence of single-period models.

• Therefore, a multi-period model is arbitrage-free if all single-period models are
arbitrage-free (See, e.g., Bingham/Kiesel (2004), Chapter 4).
For these reasons, the following three theorems hold:
Theorem 2.12 (Characterization of No Arbitrage)

If assumptions (a)-(d) are satisfied, the following statements are equivalent:
(i) The financial market contains no arbitrage opportunities (assumption (e)).
(ii) There exist a state-dependent discount factor H, the so-called deflator, such
that for all time points s, t ∈ {0, . . . , T } with s ≤ t and all assets j = 0, . . . , J
we have
EP [H(t)Sj (t)|Fs ]
Sj (s) = ,
H(s)
i.e. all prices can be represented as discounted expectations under the physical
measure.
(iii) There exists a risk-neutral probability measure Q such that all discounted
price processes Zj (t) are martingales under Q, i.e. for all time points s, t ∈
{0, . . . , T } with s ≤ t and all assets j = 1, . . . , J we have
Sj (s) h S (t) i
j
Zj (s) = EQ [Zj (t)|Fs ] ⇐⇒ = EQ

Fs
S0 (s) S0 (t)
Remarks.
• The equivalence “No Arbitrage ⇔ Existence of Q” is known as Fundamental
Theorem of Asset Pricing.
• Unfortunately, in continuous-time models this equivalence breaks down.
• However, the implication “Existence of Q ⇒ No Arbitrage”’ is still valid,
Theorem 2.13 (Pricing of Contingent Claims)

Consider a financial market satisfying assumptions (a)-(e) and a contingent claim
with payoff C(T ). Then we obtain for s, t ∈ {0, . . . , T } with s ≤ t:
(i) The replication strategy ϕ for the claim is unique, i.e. the arbitrage-free price
of the claim is uniquely determined by
C(s) = Vϕ (s).
(ii) Using the deflator, we can calculate the claim’s time-s price
EP [H(t)C(t)|Fs ]
C(s) = .
H(s)
(iii) The following risk-neutral pricing formula holds:

h C(t) i
C(s) = S0 (s) · EQ Fs .

S0 (t)
Remarks.
• Result (i) says that the today’s price of a claim is uniquely determined by its
replication costs, i.e. C(0) = Vϕ (0).
• From (iii) we get
C(s) h C(t) i
= EQ Fs ,

S0 (s) S0 (t)
i.e. the discounted price processes of contingent claims are Q-martingales as well.
Note that one needs to discount with the money market account.
• If interest rates are constant, then from (iii)
h C(T ) i E [C(T )]
Q
C(0) = EQ = .
(1 + r)T (1 + r)T
• Pricing of contingent claims boils down to computing expectations under the

risk-neutral measure.
Theorem 2.14 (Completeness)

Consider a financial market satisfying assumptions (a)-(e). Then the following
statements are equivalent
(i) The market is complete.
(ii) There exists a unique deflator H.
(iii) There exists a unique martingale measure Q.
2.2.6 Summary
The following results are important:

• It is always valid that a financial market contains no arbitrage opportunities if
an equivalent martingale measure exists.
• In our discrete model, the converse is also valid: If the market contains no arbi-
trage opportunities, there exists a martingale measure.
• If a martingale measure Q exists, the discounted price processes are Q-martingales.
• If a unique martingale measure exists, the market contains is arbitrage-free and
complete.
• If a unique martingale measure exists, the today’s price of a contingent claim is
given by the following Q-expectation
h C(T ) i
C(0) = EQ .
S0 (T )
3 INTRODUCTION TO STOCHASTIC CALCULUS 23
3 Introduction to Stochastic Calculus
3.1 Motivation
3.1.1 Why Stochastic Calculus?
• In the previous section, the investor was able to trade at finitely many dates
t = 0, . . . , T only.
• In a continuous-time model, trading takes place continuously, i.e. at any date

in the time period [0, T ].
• Consequently, price dynamics are modeled continuously.
• In continuous-time models asset dynamics are modeled via stochastic differ-

ential equations.
Example “Black-Scholes Model”. Two investment opportunities:

• money market account: riskless asset with constant interest rate r modeled via
an ordinary differential equation (ODE):
dM (t) = M (t)rdt, M (0) = 1.
• stock: risky asset modeled via a stochastic differential equation (SDE)

h i
dS(t) = S(t) µdt + σdW (t) , S(0) = s0 ,
where W is a Brownian motion.
In this section we answer the following questions:
Q1 What is a Brownian motion?
Q2 What is the meaning of dW (t)? → Stochastic Integral
Q3 What are stochastic differential equations and do explicit solutions exist? →

Variation of Constant
Q4 How does the dynamics of contingent claims look like? → Ito Formula
3.1.2 What is a Reasonable Model for Stock Dynamics?
Model for the Money Market Account

The solution of the ODE B 0 (t) = r · B(t) with B(0) = 1 is
B(t) = b0 exp(rt)
and thus
ln(B(t)) = ln(b0 ) + r · t.
Model for the Stock

The result for the money market account motivates the following model for the
stock dynamics:
ln(S(t)) = ln(s0 ) + α · t + “randomness”
Notation: Y (t) = “randomness”, i.e. Y (t) = ln(S(t)) − ln(s0 ) − α · t
Reasonable properties of Y :
1) no tendency, i.e. E[Y (t)] = 0,
2) increasing with time t, i.e. Var(Y (t)) increases with t,
3) no memory, i.e. for Y (t) = Y (s) + [Y (t) − Y (s)] the difference [Y (t) − Y (s)]
• depends only on t − s and
• is independent of Y (s),
Properties which would make life easier:
4) normally distributed, i.e. Y (t) ∼ N (0, σ 2 t), σ > 0,
5) continuous.
3.2 On Stochastic Processes

Definition 3.1 (Stochastic Process)
A stochastic process X defined on (Ω, F) is a collection of random variables {Xt )}t∈I ,
i.e. σ{Xt } ⊂ F.
Remark. As otherwise stated, our stochastic processes take values in the mea-
surable space (IRn , B(IRn )), i.e. the n-dimensional Euclidian space equipped with
σ-field of Borel sets. Therefore, every Xt is (F, B(IRn ))-measurable.
3.2.1 Cadlag and Caglad
Definition 3.2 (Cadlag and Caglad Functions)

Let f : [0, T ] → IRn be a function with existing left and right limits, i.e. for each
t ∈ [0, T ] the limits
f (t−) = lim f (s), f (t+) = lim f (s)

s%t s&t
exist. The function f is cadlag if f (t) = f (t+) and caglad if f (t) = f (t−).
A cadlag function cannot jump around too widly as the next proposition shows.
Proposition 3.1
(i) A cadlag function f can have at most a countable number of discontinuities, i.e.
{t ∈ [0, T ] : f (t) 6= f (t−)} is countable.
(ii) For any ε > 0, the number of discontinuities on [0, T ] larger than ε is finite.
Proof. See Fristedt/Gray (1997).
3.2.2 Modification, Indistinguishability, Measurability
Recall the following definition:
Definition 3.3 (Filtration)

Consider a σ-field F. A family {Ft } of sub-σ-fields Ft , t ∈ I, is said to be a
filtration if Fs ⊂ Ft , s ≤ t and s, t ∈ I. Here I denotes some ordered index set.
Definition 3.4 (Adapted Process)

A process X is said to be adapted to the filtration {Ft }t∈I if every Xt is measurable
w.r.t. Ft , i.e. σ{Xt } ⊂ Ft .
Remarks.
• The notation {Xt , Ft }t∈I indicates that the process X is adapted to {Ft }t∈I .
• For fixed ω ∈ Ω, the realization {Xt (ω)}t is said to be a path of X. For this reason,
a stochastic process can be interpreted as function-valued random variable.
Definition 3.5 (Modification, Indistinguishability)

Let X and Y be stochastic processes.
(i) Y is a modification of X if
P (ω : Xt (ω) = Yt (ω)) = 1 for all t ≥ 0.
(ii) X and Y are indistinguishable if
P (ω : Xt (ω) = Yt (ω) for all t ≥ 0) = 1,
i.e. X and Y have the same paths P -a.s.
Example. Consider a positive random variable τ with a continuous distribution.

Set Xt ≡ 0 and Yt = 1{t=τ } . Then Y is a modification of X, but P (Xt =
Yt for all t ≥ 0) = 0.
Proposition 3.2 (Modification, Indistinguishability)

Let X and Y be stochastic processes.
(i) If X and Y are indistinguishable, then Y is a modification of X and vice versa.
(ii) If X and Y have right-continuous paths and Y is a modification of X, then X
and Y are indistinguishable.
(iii) Let X be adapted to {Ft }. If Y is a modification of X and F0 contains all
P -null sets of F, then Y is adapted to {Ft }t .
Proof. (i) is obvious.

(ii) Since Y is a modification of X, we have
P (ω|Xt (ω) = Yt (ω) for all t ≥ [0, ∞) ∩ Q ) = 1.
By the right-continuity assumption, the claim follows.

(iii) Exercise. 2
If X is an (adapted) stochastic process, then every Xt is (F, B(IRn ))-measurable

((Ft , B(IRn ))-measurable). However, X is actually a function-valued random vari-
able, and so, for technical reasons, it is often convenient to have some joint measur-
ability properties.
Definition 3.6 (Measurable Stochastic Process)

A stochastic process is said to measurable, if for each A ∈ B(IRn ) the set {(t, ω) :
Xt (ω) ∈ A} belongs to the product σ-field B(IRn ) ⊗ F, i.e. if the mapping
(t, ω) 7→ Xt (ω) : ([0, ∞) × Ω, B([0, ∞)) ⊗ F) → (IRn , B(IRn ))
is measurable.
Definition 3.7 (Progressively Measurable Stochastic Process)
A stochastic process is said to progressively measurable w.r.t. the filtration {Ft }, if
for each t ≥ 0 and A ∈ B(IRn ) the set {(s, ω) ∈ [0, t] × Ω : Xs (ω) ∈ A} belongs to
the product σ-field B([0, t]) ⊗ Ft , i.e. if the mapping
(s, ω) 7→ Xs (ω) : ([0, t] × Ω, B([0, t]) ⊗ Ft ) → (IRn , B(IRn ))
is measurable for each t ≥ 0.
Remark. Any progressively measurable process is measurable and adapted (Exer-

cise). The following proposition provides the extent to which the converse is true.
Proposition 3.3
If a stochastic process is measurable and adapted to the filtration {Ft }, then it has
a modification which is progressively measurable w.r.t. {Ft }.
Proof. See Karatzas/Shreve (1991, p. 5).
Fortunately, if a stochastic process is left- or right-continuous, a stronger result can

be proved:
Proposition 3.4
If the stochastic process X is adapted to the filtration {Ft } and right- or left-
continuous, then X is also progressively measurable w.r.t. {Ft }.
Proof. See Karatzas/Shreve (1991, p. 5).
Remark. If X is right- or left-continuous, but not necessarily adapted to {Ft },

then X is at least measurable.
3.2.3 Stopping Times
Consider a measurable space (Ω, F). An F- measurable random variable τ : Ω →

I ∪ {∞} where I = [0, ∞) or I = IN is said to be a random time. Two special
classes of random times are of particular importance.
Definition 3.8 (Stopping Time, Optional Time)

(i) A random time is a stopping time w.r.t. the filtration {Ft }t∈I if the event
{τ ≤ t} ∈ Ft for every t ∈ I.
(ii) A random time is an optional time w.r.t. the filtration {Ft }t∈I if the event
{τ < t} ∈ Ft for every t ∈ I.
Propositions 3.5 and 3.6 show how both concepts are connected.
Proposition 3.5
If τ is optional and c > 0 is a positive constant, then τ + c is a stopping time.
Proof. Exercise.
Definition 3.9 (Continuity of Filtrations)

(i) A filtration {Gt } is said to be right-continuous if
\
Gt = Gt+ := Gt+ε
ε>0
(ii) A filtration {Gt } is said to be left-continuous if

( )
[
Gt = Gt− := σ Gs
s<t
Remark. Let X be stochastic process.

• Loosely speaking, left-continuity of {FtX } means that Xt can be guessed by ob-
serving Xs , 0 ≤ s < t.
• Right-continuity means intuitively that if Xs has been observed for 0 ≤ s ≤ t,
then one cannot learn more by peeking infinitesimally far into the future.
Proposition 3.6
Every stopping time is optional, and both concepts coincide if the filtration is right-
continuous.
S
Proof. Consider a stopping time τ . Then {τ < t} = t>ε>0 {T ≤ t − ε} and
{T ≤ t − ε} ∈ Ft−ε ⊂ Ft , i.e. τ is optional. On the other hand, consider an optional
T
time τ w.r.t. a right-continuous filtration {Ft }. Since {τ ≤ t} = t+ε>u>t {T < u},
T
we have {τ ≤ t} ∈ Ft+ε for every ε > 0 implying {τ ≤ t} = ε>0 Ft+ε = Ft+ = Ft .
2
Remark. In our applications, we will always work with right-continuous filtrations.5
5 See Definition 3.18.

Proposition 3.7
(i) Let τ1 and τ2 be stopping times. Then τ1 ∧τ2 = min{τ1 , τ2 }, τ1 ∨τ2 = max{τ1 , τ2 },
τ1 + τ2 , and ατ1 with α ≥ 1 are stopping times.
(ii) Let {τn }n∈IN be a sequence of optional times. Then the random times
sup τn , inf τn , limn→∞ τn , limn→∞ τn

n≥1 n≥1
are all optional. Furthermore, if the τn ’s are stopping times, then so is supn≥1 τn .
Proof. Exercise.
Proposition and Definition 3.8 (Stopping Time σ-Field)

Let τ be a stopping time of the filtration {Ft }. Then the set
{A ∈ F : A ∩ {τ ≤ t} ∈ Ft for all t ≥ 0}
is a σ-field, the so-called stopping time σ-field Fτ .
Proof. Exercise.
Proposition 3.9 (Properties of a Stopped σ-Field)

Let τ1 and τ2 be stopping times.
(i) If τ1 = t ∈ [0, ∞), then Fτ1 = Ft .
(ii) If τ1 ≤ τ2 , then Fτ1 ⊂ Fτ2 .
(iii) Fτ1 ∧τ2 = Fτ1 ∩ Fτ2 and the events
{τ1 < τ2 }, {τ2 < τ1 }, {τ1 ≤ τ2 }, {τ2 ≤ τ1 }, {τ1 = τ2 }
belong to Fτ1 ∩ Fτ2 .
Proof. Exercise.
Definition 3.10 (Stopped Process)

(i) If X is a stochastic process and τ is random time, we define the function Xτ on
the event {τ < ∞} by
Xτ (ω) := Xτ (ω) (ω)
If X∞ (ω) is defined for all ω ∈ Ω, then Xτ can also be defined on Ω, by setting
Xτ (ω) := X∞ (ω) on {τ = ∞}.
(ii) The process stopped at time τ is the process {Xt∧τ }t∈[0,∞) .
Proposition 3.10 (Measurability of a Stopped Process)

(i) If the process X is measurable and the random time τ is finite, then the function
Xτ is a random variable.
(ii) If the process X is progressively measurable w.r.t. {Ft }t∈[0,∞) and τ is a stopping
time of this filtration, then the random variable Xτ , defined on the set {τ < ∞} ∈
Fτ , is Fτ -measurable, and the stopped process {Xτ ∧t , Ft }t∈[0,∞) is progressively
measurable.
Proof. Karatzas/Shreve (1991, p. 5 and p. 9).

Remark. The following result is obvious: If X is adapted and cadlag and τ is a
stopping time, then
Xt∧τ = Xt 1{t<τ } + Xτ 1{t≥τ } .
is also adapted and cadlag.
Definition 3.11 (Hitting Time)

Let X be a stochastic process and let A ∈ B(IRn ) be a Borel set in IRn . Define
τA (ω) = inf{t > 0 : Xt (ω) ∈ A}.
Then τ is called a hitting time of A for X.
Proposition 3.11
Let X be a right-continuous process adapted to the filtration {Ft }.
(i) If Ao is an open set, then the hitting time of Ao is an optional time.
(ii) If Ac is a closed set, then the random variable
τ̃Ac (ω) = inf{t > 0 : Xt (ω) ∈ Ac or Xt− (ω) ∈ Ac }.
is a stopping time.
S
Proof. (i) For simplicity n = 1. We have {τAo < t} = s∈Q ∩[0,t) {Xs ∈ Ao }. The
inclusion ⊃ is obvious. Suppose that the inclusion ⊂ does not hold. Then we have
Xi ∈ Ao for some i ∈ IR \ Q and i < t, but Xq 6∈ Ao for all q ∈ Q with q < t.
Since Ao is open, there exists a δ > 0 such that (Xi − δ, Xi + δ) ⊂ Ao . Therefore,
Xq 6∈ (Xi − δ, Xi + δ). However, then there exists a sequence (qn )n∈IN with qn & s0
and qn ∈ Q ∩ [0, t), but Xqn 6→ Xi which is a contradiction to the right-continuity
of X.
(ii) See Karatzas/Shreve (1991, p. 39) and Protter (2005, p. 5). 2
Remarks.
• If the filtration is right-continuous, then the hitting time τAo is a stopping time.
• If X is continuous , then the stopping time τ̃Ac is a hitting time of Ac .
• Even if X is continuous, in general the hitting time of Ao is not a stopping time.
For example, suppose that X is real-valued, that for some ω, Xt (ω) ≤ 1 for t ≤ 1,
and that X1 (ω) = 1. Let Ao = (1, ∞). Without looking slightly ahead of time 1,
we cannot tell wheter or not τAo = 1.
3.3 Prominent Examples of Stochastic Processes

Theorem and Definition 3.12 (Brownian Motion)
(i) A Brownian motion is an adapted, real-valued process {Wt , Ft }t∈[0,∞) such that
W0 = 0 a.s. and
• Wt − Ws ∼ N (0, t − s) for 0 ≤ s < t “stationary increments”

• Wt − Ws independent of Fs for 0 ≤ s < t “independent increments”
exists and is said to be a one-dimensional Brownian motion.
(ii) An n-dimensional Brownian motion W := (W1 , . . . , Wn ) is an n-dimensional
vector of independent one-dimensional Brownian motions.
Proof. Applying Kolmogorov’s extension theorem,6 it is straightforward to prove

the existence of a Brownian motion. See, e.g., Karatzas/Shreve (1991, pp. 47ff). 2
Theorem 3.13 (Kolmogorov’s Continuity Theorem)

Suppose that the process X = {Xt }t∈[0,∞) satisfies the following condition: For all
T > 0 there exist positive constants α, β, C such that
E[|Xt − Xs |α ] ≤ C · |t − s|1+β , 0 ≤ s, t ≤ T.
Then there exists a continuous modification of X.
Proof. See Karatzas/Shreve (1991, pp.53ff).
Corollary 3.14 (Continuous Version of the Brownian Motion)

An n-dimensional Brownian motion possesses a continuous modification.
Proof. One can show that
E[|Wt − Ws |4 ] = n(n + 2)|t − s|2 .
Hence, we can apply Kolmogorov’s continuity theorem with α = 4, C = n(n + 2),

and β = 1. 2
Remark. We will always work with this continuous version.
Definition 3.12 (Poisson Process)

A Poisson process with intensity λ > 0 is an adapted, integer-valued cadlag process
N = {Nt , Ft }t[0,∞) such that N0 = 0, and for 0 ≤ t < ∞, the difference Nt − Ns is
independent of Fs and is Poisson distributed with mean λ(t − s).7
3.4 Martingales
Definition 3.13 (Martingale, Supermartingale, Submartingale)
A process X = {Xt }t∈[0,∞) adapted to the the filtration {Ft }t∈[0,∞) is called a
martingale (resp. supermartingale, submartingale) with respect to {Ft }t∈[0,∞) if
(i) Xt ∈ L1 (dP ), i.e. E[|Xt |] < ∞.
6 Kolmogorov’s extension theorem basically says that for given (finite-dimensional) distributions
satisfying a certain consistency condition there exists a probability space and a stochastic process
such that its (finite-dimensional) distributions coincide with the given distributions. See, e.g.,
Karatzas/Shreve (1991, p. 50).
7 A random variable Y taking values in IN ∪ {0} is Poisson distributed with parameter λ > 0 if
P (Y = n) = e−λ λn /(n!), n ∈ IN .
(ii) if s ≤ t, then E[Xt |Fs ] = Xs , a.s. (resp. E[Xt |Fs ] ≤ Xs , resp. E[Xt |Fs ] ≥ Xs ).
Examples.
• Let W be a one-dimensional Brownian motion. Then W is a martingale and W 2
is a submartingale.
• The arithmetic Brownian motion Xt := µt + σWt , µ, σ ∈ IR, is a martingale for
µ = 0, a submartingale for µ > 0, and a supermartingale for µ < 0.
• Let N be a Poisson process with intensity λ. Then {Nt − λt}t is a martingale.
Definition 3.14 (Square-Integrable)

Let X = {Xt , Ft }t∈[0,∞) be a right-continuous martingale. We say that X is square-
integrable if E[Xt2 ] < ∞ for every t ≥ 0. If, in addition, X0 = 0 a.s. we write
X ∈ M2 (or X ∈ Mc2 if X is also continuous).
Proposition 3.15 (Functions of Submartingales)

(i) Let X = (X1 , . . . , Xn ) with real-valued components Xk be a martingale w.r.t.
{Ft }t∈[0,∞) and let ϕ : IRn → IR be a convex function such that E[|ϕ(Xt )|] < ∞
for all t ∈ [0, ∞). Then ϕ(X) is a submartingale w.r.t. {Ft }t∈[0,∞)
(ii) Let X = (X1 , . . . , Xn ) with real-valued components Xk be a submartingale w.r.t.
{Ft }t∈[0,∞) and let ϕ : IRn → IR be a convex, non-decreasing function such that
E[|ϕ(Xt )|] < ∞ for all t ∈ [0, ∞). Then ϕ(X) is a submartingale w.r.t. {Ft }t∈[0,∞)
Proof. follows from Jensen’s inequality (Exercise). 2
For any X ∈ M2 and 0 ≤ t < ∞, we define

∞
||X||n ∧ 1
q X
||X||t := E[Xt2 ] and ||X|| := .
n=1
2n
Note that ||X − Y || defines a the pseudo-metric on M2 . If we identify indistinguish-

able processes, the pseudo-metric ||X − Y || becomes a metric on M2 .8
Proposition 3.16
If we identify indistinguishable processes, the pair (M2 , ||) is a complete metric
space, and Mc2 is a closed subset of M2 .
Proof. See, e.g., Karatzas/Shreve (1991, pp. 37f).
An important question now arises: What happens to the martingale property of a

stopped martingale? For bounded stopping times, nothing changes.
Theorem 3.17 (Optional Sampling Theorem, 1st Version)

Let X = {Xt , Ft }t∈[0,∞) be a right-continuous submartingale (supermartingale) and
let τ1 and τ2 be bounded stopping times of the filtration {Ft } with τ1 ≤ τ2 ≤ c ∈ IR
a.s. Then
E[Xτ2 |Fτ1 ] ≥ (≤)Xτ1
8 Thismeans: (i) ||X − Y || ≥ 0 and ||X − Y || = 0 iff X = Y . (ii) ||X − Y || = ||Y − X||. (iii)
||X − Y || = ||X − Z|| + ||Z − Y ||.
If the stopping times are unbounded, in general, this result does only hold if X can
be extended to ∞ such that X̃ := {Xt , Ft }t∈[0,∞] is still a sub- or supermartingale.
Theorem 3.18 (Sub- and Supermartingale Convergence)

Let X = {Xt , Ft }t∈[0,∞) be a right-continuous submartingale (supermartingale)
and assume supt≥0 E[Xt+ ] < ∞ (supt≥0 E[Xt− ] < ∞). Then the limit X∞ (ω) =
limt→∞ Xt (ω) exists for a.e. ω ∈ Ω and E|X∞ | < ∞.
Proof. See Karatzas/Shreve (1991, pp. 17f).
This proposition ensures that a limit exists, but it is not clear at all if X̃ is a sub- or
supermartingale. To solve this problem, we need to require the following condition:
Definition 3.15 (Uniform Integrability)

A familiy of random variables (U )a∈A is uniformly integrable (UI) if
Z
lim sup |Uα |dP = 0.
n→∞ a {|Uα |≥n}
Using the definition, it is sometimes not easy to check if a family of random variables
is uniformly integrable.
Theorem 3.19 (Characterization of UI)

Let (U )a∈A be a subset of L1 . The following are equivalent:
(i) (U )a∈A is uniformly integrable.
(ii) There exists a positive, increasing, convex function g defined on [0, ∞) such that
g(x)
lim = +∞ and sup E[g ◦ |Uα |] < ∞.
x→∞ x a∈A
Remark. A good choice is often g(x) = x1+ε with ε > 0.
Proposition 3.20
The following conditions are equivalent for a nonnegative, right-continuous sub-
martingale X = {Xt , Ft }t∈[0,∞) :
(i) It is a uniformly integrable family of random variables.
(ii) It converges in L1 , as t → ∞.
(iii) It converges P -a.s. (t → ∞) to an integrable random variable X∞ , such that
{Xt , Ft }t∈[0,∞] is a submartingale.
For the implication “(i)⇒(ii)⇒(iii)”, the assumption of nonnegativity can be dropped.
Theorem 3.21 (UI Martingales can be closed)

The following conditions are equivalent for a right-continuous martingale X =
{Xt , Ft }t∈[0,∞) :
(i) It is a uniformly integrable family of random variables.
(ii) It converges in L1 , as t → ∞.
(iii) It converges P -a.s. (t → ∞) to an integrable random variable X∞ , such that
{Xt , Ft }t∈[0,∞] is a martingale, i.e. the martingale is closed by Y .
(iv) There exists an integrable random variable Y , such that Xt = E[Y |Ft ] a.s. for
all t ≥ 0.
If (iv) holds and X∞ is the random variable in (c), then E[Y |F∞ ] = X∞ a.s.
We now formulate a more general version of Doob’s optional sampling theorem:
Theorem 3.22 (Optional Sampling Theorem, 2nd Version)

Let X = {Xt , Ft }t∈[0,∞] be a right-continuous submartingale (supermartingale)
with a last element X∞ and let τ1 and τ2 be stopping times of the filtration {Ft }
with τ1 ≤ τ2 a.s. Then
E[Xτ2 |Fτ1 ] ≥ (≤)Xτ1
Proof. See, e.g., Karatzas/Shreve (1991, pp. 19f).
Proposition 3.23 (Stopped (Sub)-Martingales)

Let X = {Xt , Ft }t∈[0,∞) be an adapted right-continuous (sub)-martingale and let
τ be a bounded stopping time. The stopped process {Xt∧τ , Ft }t∈[0,∞) is also an
adapted right-continuous (sub)-martingale.
Proof. Exercise.
Remarks.
• The difficulty in this proposition is to show that the stopped process is a (sub)-
martingale for the filtration {Ft }. It is obvious that the stopped process is a
(sub)-martingale for {Ft∧τ }.
• If {Xt , Ft }t∈[0,∞] is a UI right-continuous martingale, then the stopping time τ
may be unbounded (See Protter (2005, p. 10)).
Corollary 3.24 (Conditional Expectation and Stopped σ-Fields)

Let τ1 and τ2 be stopping times and Z be an integrable random variable. Then
E[E[Z|Fτ1 ]|Fτ2 ] = E[E[Z|Fτ2 ]|Fτ1 ] = E[Z|Fτ1 ∧τ2 ], P − a.s.
Proof. Exercise.
For technical reasons, we sometimes need to weaken the martingale concept.
Definition 3.16 (Local Martingale)

Let X = {Xt , Ft }t∈[0,∞) be a (continuous) process. If there exists a non-decreasing
(n)
sequence {τn }n∈IN of stopping times of {Ft }, such that {Xt := Xt∧τn , Ft }t∈[0,∞)
is a martingale for each n ≥ 1 and P (limn→∞ τn = ∞) = 1, then we say that X is
a (continuous) local martingale.
Remark.
• Every martingale is a local martingale (Choose τn = n).
• However, there exist local martingales which are no martingales. Especially,
E[Xt ] need not to exist for local martingales.
Proposition 3.25
A non-negative local martingale is a supermartingale.
Proof. follows from Fatou’s lemma (Exercise). 2
This concept can be applied to other situations (e.g. locally bounded, locally square
integrable):
Definition 3.17 (Local Property)

Let X be a stochastic process. A property π is said to hold locally if there exists a
sequence of stopping times {τn }n∈IN with P (limn→∞ τn = ∞) = 1 such that X (n)
has property π for each n ≥ 1.
3.5 Completition, Augmentation, Usual Conditions
The following definition is very important:
Definition 3.18 (Usual Conditions)

A filtered probability space (Ω, G, P, {Gt }) satisfies the usual conditions if
(i) it is complete,9
(ii) G0 contains all the P -null sets of G, and
(iii) {Gt } is right-continuous.
In the sequel, we impose the following

Standing assumption: We always consider a filtered probability space (Ω, F, P, {Ft })
satisfying the usual conditions.
One of the main reasons for this assumption is that the following proposition holds:
Proposition 3.26
Let (Ω, G, P, {Gt }) satisfy the usual conditions. Then every martingale for {Gt }
possesses a unique cadlag modification.
Proof. See, e.g. Karatzas/Shreve (1991, pp. 16f).
Unfortunately, we are confronted with the following result.
Proposition 3.27
The filtration {FtW } is left-continuous, but fails to be right-continuous.
9Aprobability space is complete if for any N ⊂ Ω such that there exists an Ñ ∈ G with N ⊂ Ñ
and P (Ñ ) = 0, we have N ∈ G.
S
Fortunately, there is a way out. Let F∞ := σ{ t≥0 Ft } and consider the space
W
(Ω, F∞ , P ). Define the collection of P -null sets by
W
N := {A ⊂ Ω : ∃B ∈ F∞ with A ⊂ B, P (B) = 0}.
The P -augmentation of {FtW } is defined by Ft := σ{FtW ∪ N } and is called the

Brownian filtration.
Theorem 3.28 (Brownian Filtration)
The Brownian filtration, is left- and right-continuous. Besides, W is still a Brownian
motion w.r.t. the Brownian filtration.
This is the reason why we work with the Brownian filtration instead of {FtW }. For
a Poisson process, a similar result holds.
Proposition 3.29 (Augmented Filtration of a Poisson Process)
The P -augmentation of the natural filtration induced by a Poisson process N is
right-continuous. Besides, N is still a Poisson process w.r.t. this P -augmentation.
The proofs of the previous results can be found in Karatzas/Shreve (1991), pp. 89ff.
Remark. More generally, one can prove the following results:
(i) If a stochastic process is left-continuous, then the filtration {FtX } is left-continuous.
(ii) Even if X is is continuous, {FtX } need not to be right-continuous.
(iii) For an n-dimensional strong Markov process X the augmented filtration is
right-continuous.
3.6 Ito-Integral
Our goal is to define an integral of the form:

Z t
X(s)dW (s),
0
where X is an appropriate stochastic process. From the Lebesgue-Stieltjes theory
we know that for a measurable function f and a processes A of finite variation on
[0, t] one can define
Z t n−1
X (k+1)t
f (s)dA(s) = lim f kt
n · A n − A kt
n .
0 n→∞
k=0
However, the variation of a Brownian motion is unbounded on any interval. There-

fore, naive stochastic integration is impossible (See Protter (2005, pp. 43ff)).
Good News: We can define a stochastic integral in terms of L2 -convergence!
Agenda. (disregarding measurability for the moment)
1st Step. Define a stochastic integral for simple processes κ (constant process
except for finitely many jumps).
Z t
It (κ) := κs dWs :=?
0
2nd Step. Every L2 [0, T ]-process X can be approximated by a sequence {κ(n) }n

of simple processes such that
"Z #
T
||X − κ(n) ||2T := E (X(s) − κ(n) (s))2 ds → 0.
0
3rd Step. For each n the stochastic integral

Z t
(n)
It (κ ) = κ(n) (s) dW (s)
0
is a well-defined random variable and the sequence {It (κ(n) )}n converges (in some
sense) to a random variable I
4th Step. Define the stochastic integral for a L2 [0, T ]-process X as follows:
Z t Z t
X(s) dW (s) := lim It (κ(n) ) = lim κ(n) (s) dW (s).
0 n→∞ n→∞ 0
5th Step. Extend the definition by localization.

Standing Assumption. {Ft } is the Brownian filtration of a Brownian motion W .
1st Step.
Definition 3.19 (Simple Process)

A stochastic process {κt }t∈[0,T ] is a simple process if there exist real numbers 0 =
t0 < t1 < . . . < tp = T , p ∈ IN , and bounded random variables Φi : Ω → IR,
i = 0, 1, . . . , p such that Φ0 is F0 -measurable, Φi is Fti−1 -measurable, and for all
ω ∈ Ω we have
p
X
κt (ω) = Φ0 (ω)1{0} (t) + Φi (ω)1(ti−1 ,ti ] (t)
i=1
Remarks.
• κt is Fti −1 -measurable for t ∈ (ti−1 , ti ] (measurable w.r.t. the left-hand side of
the interval).
• κ is a left-continuous step function.
Definition 3.20 (Stochastic Integral for Simple Processes)

For a simple process κ and t ∈ [0, T ] the stochastic integral I(κ) is defined by
Z t X
It (κ) := κs dWs := Φi (Wti ∧t − Wti−1 ∧t )
0 1≤i≤p
Proposition 3.30 (Stochastic Integral for Simple Processes)

For a simple process κ we have:
(i) The integral I(κ) = {It (κ)}t∈[0,T ] is a continuous martingale for {Ft }t∈[0,T ] .
hR i
t
(ii) E (It (κ))2 = E 0 κ2s ds for all t ∈ [0, T ].
h 2 i hR i
T
(iii) E sup0≤t≤T |It (κ)| ≤ 4E 0 κ2s ds
Proof. (i) Exercise.

(ii) For simplicity, t = tk+1 . Then
k X
X k
E[It (κ)2 ] =

E Φi Φj (Wti − Wti−1 )(Wtj − Wtj−1 ) .
i=1 j=1
1st case: i > j.

E Φi Φj (Wti − Wti−1 )(Wtj − Wtj−1 ) = E E Φi Φj (Wti − Wti−1 )(Wtj − Wtj−1 )|Fti−1
= E[Φi Φj (Wtj − Wtj−1 )(E[Wti |Fti−1 ] −Wti−1 )]
| {z }
=Wti−1
= 0.
2nd case i = j.
E Φ2i (Wti − Wti−1 )2 = E Φ2i E[(Wti − Wti−1 )2 |Fti−1 ] = E[Φ2i (ti − ti−1 )]

Hence, " #
k
X Z t
2
E[It (κ) ] = E Φ2i (ti − ti−1 ) = E κ2s ds .
i=1 0
(iii) Apply (i), (ii), and Doob’s inequality (see Kartzas/Shreve (1991, p. 14): For a
right-continuous martingale {Mt } with E[Mt2 ] < ∞ for all t ≥ 0 we have
" 2 #
E sup |Mt | ≤ 4E[MT2 ].
0≤≤T
It remains to check:
k
hX i k
X
E[It (κ)2 ] = E Φ2i (ti − ti−1 ) ≤ T E Φ2i < ∞,

| {z }
i=1 i=1
≤T
since, by Definition 3.19, Φ is bounded. 2

Remarks.
• Stochastic integrals over [t, T ] are defined by
Z T Z T Z t
κs dWs := κs dWs − κs dWs .
t 0 0
• Let κ1 and κ2 be simple processes and a, b ∈ IR. The stochastic integral for
simple processes is linear, i.e.
It (aκ1 + bκ2 ) = aIt (κ1 ) + bIt (κ2 ).
This follows directly from Definition 3.20. Note that linear combinations of simple
functions are simple.
Rt
• For κ ≡ 1, 0 1 dWs = Wt . Hence,
Z t 2 Z t
E dWs = E[Wt2 ] = t = ds.
0 0
√
This is the reason why people sometimes write dWt = dt, which is wrong from
a mathematical point of view.
2nd Step. Every L2 [0, T ]-process X can be approximated by a sequence {κ(n) }n

of simple processes.
Define the vector space
L2 [0, T ] L2 [0, T ], Ω, F, P, {Ft }t∈[0,T ]

:=
( )
hZ T i
:= {Xt , Ft }t∈[0,T ] : progressively measurable, real-valued with E Xs2 ds < ∞
0
with (semi-)norm "Z #

T
||X||2T := E Xs2 ds ,
0
where we identify processes for which X = Y only Lebesgue ⊗ P -a.s.

For simple processes the mapping κ → I(κ) induces a norm on the vector space of
the corresponding stochastic integrals via
 !2  "Z #
Z T T
Prop. 3.30 (ii)
||I(κ)||2LT := E  κs dWs  = E κ2s ds = ||κ||2T .
0 0
Since the mapping I(X) is linear and norm preserving, it is an isometry, called the
Ito isometry.
Proposition 3.31 (Simple Processes Approximate L2 [0, T ]-processes)

The linear subspace of simple processes is dense in X ∈ L2 ([0, T ]), i.e. for all
X ∈ L2 [0, T ] there exists a sequence {κ(n) }n of simple processes with
"Z #
T
||X − κ(n) ||T = E (Xs − κ(n) 2
s ) ds → 0 ( as n → ∞)
0
Proof. Assume that X ∈ L2 [0, T ] is continuous and bounded. Choose

n
2X −1
(n)
κt (ω) := X0 (ω)1{0} (t) + XkT /2n (ω)1(kT /2n ,(k+1)T /2n ] (t).
k=0
Since X is bounded, {κ(n) }n is uniformly bounded and we can apply the dominated
convergence theorem to obtain the desired result.
For the general case, see Karatzas/Shreve (1991, p. 133). 2
3rd and 4th Step.

Define
Mc2 ([0, T ]) := {M : M continuous martingale on [0, T ] w.r.t. {Ft },

E[Mt2 ] < ∞ for every t ∈ [0, T ]

Theorem and Definition 3.32 (Ito Integral for X ∈ L2 [0, T ])

There exists a unique linear mapping J : L2 [0, T ] → Mc2 ([0, T ]) with the following
properties:
(i) If κ is simple, then P (Jt (κ) = It (X) for all t ∈ [0, T ]) = 1.

hR i
t
(ii) E[Jt (X)2 ] = E 0 Xs2 ds “Ito isometry”
J is unique in the following sense: If there exists a second mapping J 0 satisfying (i)
and (ii) for all X ∈ L2 [0, T ], then J(X) and J 0 (X) are indistinguishable.
For X ∈ L2 [0, T ], we define
Z t
Xs dWs := Jt (X)
0
for every t ∈ [0, T ] and call it the Ito integral or stochastic integral of X (w.r.t. W ).
Proof. Let X ∈ L2 [0, T ].

(a) Let {κ(n) }n be an approximating sequence, i.e. ||X − κ(n) ||T → 0 as n → ∞.
Since {κ(n) }n is also a Cauchy sequence w.r.t. || · ||T , we obtain for every t ∈ [0, T ]
(as n, m → ∞):
hZ t i
I linear Ito Isom.
E[(It (κ(n) )−It (κ(m) ))2 ] = E[It (κ(n) −κ(m) )2 ] = E (κ(n) −κ(m) )2 ds → 0.
0
Hence, {It (κ(n) )}n is a Cauchy sequence in the ordinary L2 (Ω, Ft , P ) for random
variables (t fixed!) which is a complete space and thus
L2
It (κ(n) ) −→ Zt ,
P
where Zt is Ft -measurable and E[Zt2 ] < ∞. Since It (κ(n) ) −→ Zt as well, there
exists a subsequence {nk }k such that
a.s.
(1) It (κ(nk ) ) −→ Zt
as k → ∞, i.e. Zt is only P -a.s. unique (may depend on sequence!).

(b) Z is a martingale: Note that It (κ(n) ) is a martingale for all n ∈ IN . By the
definition of the conditional expected value, we thus get
Z Z
(n)
It (κ ) dP = Is (κ(n) ) dP
A A
for s < t and for all A ∈ Fs and n ∈ IN . The L2 -convergence (1) leads to (as
n → ∞)10
Z Z Z Z
Zt dP ←− It (κ(n) ) dP = Is (κ(n) ) dP −→ Zs dP.
A A A A
Since Z is adapted, (ii) is proved.

(c) By Proposition 3.26, Z possesses a right-continuous modification {Jt (X), Ft }t∈[0,T ]
still being a square-integrable martingale. Applying Doob’s inequality and the
Borel-Cantelli Lemma, one can prove that J(X) is even continuous (Exercise).
(d) Jt (X) is independent of the approximating sequence: Let {κ(n) }n and
L2 L2
{κ̃(n) }n be two approximating sequences for X with It (κ(n) ) −→ Zt and It (κ̃(n) ) −→
10 See Bauer (1992, MI, p. 92 and p. 99).
Z̃t . Then {κ̂(n) }n with κ̂(2n) = κ(2n) (even) and κ̂(2n+1) = κ̃2n+1 (odd) is an
approximating sequence for X with {It (κ̂(n) )}n converges in L2 to both Zt and Z̃t .
Thus they need to coincide with Jt (X) P -a.s.11
(e) Ito isometry:
h i hZ t i hZ t i
2 (∗) (n) 2 (n) 2 (∗∗)
Xs2 ds

E Jt (X) = lim E It (κ ) = lim E (κs ) ds = E
n→∞ n→∞ 0 0
2
L
(∗) holds because It (κ(n) ) −→ Jt (X) (as n → ∞). This is the L2 -convergence in
the ordinaryL2 (Ω, Ft , P ).
L2
(∗∗) holds because κ(n) −→ X (as n → ∞). This is the L2 -convergence in ([0, T ] ×
Ω, B[0, T ] ⊗ F, Lebesgue ⊗ P ).12
(n)
(f) Linearity of J follows from the linearity of I and from the fact that if {κX }n
(n) (n) (n)
approximates X and {κY }n approximates Y , then {aκX + bκY }n approximates
aX + bY (a, b ∈ IR). Therefore,

(n) (n) (n) (n)
aJt (X) + bJt (Y ) = a lim It (κX ) + b lim It (κY ) = lim It aκX + bκY
n→∞ n→∞ n→∞
= Jt (aX + bY ).
(g) Uniqueness of J: Let J 0 be a linear mapping with properties (i) and (ii).
Then
(∗) (i)
Jt0 (X) = Jt0 ( lim κ(n) ) = lim Jt0 (κ(n) ) = lim It (κ(n) ) = Jt (X) P − a.s.
n→∞ n→∞ n→∞
0
for all t ∈ [0, T ]. Since J(X) and J (X) are continuous processes, by Proposition
3.2 (ii), they are indistinguishable, i.e. P (Jt (X) = Jt0 (X) for all t ∈ [0, T ]) = 1. The
equality (∗) holds because linear mappings are continuous. 2
5th Step. The class of admissible integrands can be extended. Define
H 2 [0, T ] := H 2 [0, T ], Ω, F, P, {Ft }t∈[0,T ]

n
:= {Xt , Ft }t∈[0,T ] : progressively measurable, real-valued with
Z T o
P Xs2 ds < ∞ = 1
0
2
In general, for X ∈ H [0, T ] it can happen that
"Z #
T
2 2
||X||T = E Xs ds = ∞.
0
Therefore, the Ito isometry needs not to hold and the approximation argument
breaks down. Fortunately, one can use a localization argument:13
n Z t o
τn (ω) := T ∧ inf t ∈ [0, T ] : Xs2 (ω) ds ≥ n ,
0
(n)
Xt (ω) := Xt (ω)1{τn (ω)≥t} .
11 See
Bauer (1992, MI, p. 130).
12 Both
(∗) and (∗∗) are a consequence of Bauer (1992, MI, p. 92).
13 Every τ is a stopping time because it is the first-hitting time of [n, ∞) for the continuous
R tn
process { Xs2 ds}t . See Proposition 3.11.
0
(n)
Hence, Xt (ω) ∈ L2 [0, T ] and J(X (n) ) is defined and a martingale for fixed n ∈ IN .
Now define
Jt (X) := Jt (X (n) ) for X ∈ H 2 [0, T ] and 0 ≤ t ≤ τn .
Note that
• Jt (X (n) ) = Jt (X (m) ) for all 0 ≤
Rt ≤ τn ∧ τm , i.e.
J is well-defined,
T 2
• limn→∞ τn = T a.s. (since P 0 Xs ds < ∞ = 1, i.e. there exists an event
A with P (A) = 1 such that for all ω ∈ A there exists an c(ω) > 0 with
RT 2
0
Xs (ω) ds ≤ c(ω).)
Important Results.
• By construction, for X ∈ H 2 [0, T ] the process {Jt (X)}t∈[0,T ] is a continuous local
martingale with localizing sequence {τn }n .
• J is still linear, i.e. Jt (aX + bY ) = aJt (X) + bJt (Y ) for a, b ∈ IR and X,
Y ∈ H 2 [0, T ]. (Choose τn := τnX ∧ τnY as localizing sequence of aX + bY , where
{τnX }n is the localizing sequence of X.)
• E[Jt (X)] needs not to exist.
Definition 3.21 (Multi-dimensional Ito Integral)

Let {W (t), Ft } be an m-dimensional Brownian motion and {X(t), Ft } an IRn,m -
valued progressively measurable process with all components Xij ∈ H 2 [0, T ]. Then
we define the Ito integral of X w.r.t. W as
 
Pm R t
 j=1 0 X 1j (s)dW j (s) 
Z t
..
 
X(s) dW (s) :=   , t ∈ [0, T ],
 
.
0  
 P 
m Rt
j=1 0 Xnj (s)dWj (s)
Rt
where 0
Xij (s)dWj (s) is an one-dimensional Ito integral.
3.7 Ito’s Formula
Recall our
Standing assumption: (Ω, F, P, {Ft }) is a filtered probability space satisfying
the usual conditions.
Additional Assumption: {Wt , Ft } is a (multi-dimensional) Brownian motion of
appropriate dimension.
Definition 3.22 (Ito Process)

Let W be an m-dimensional Brownian motion.
(i) {X(t), Ft } is said to be a real-valued Ito process if for all t ≥ 0 it possesses the
representation
Z t Z t
X(t) = X(0) + α(s) ds + β(s)0 dW (s)
0 0
Z t m Z
X t
= X(0) + α(s) ds + βj (s)0 dWj (s)
0 j=1 0
for an F0 - measurable random variable X(0), and progressively measurable pro-

cesses α, β with
Z t m Z t
X
(2) |α(s)| ds < ∞, βj2 (s) ds < ∞, P − a.s. for all t ≥ 0.
0 j=1 0
(ii) An n-dimensional Ito process X = (X (1) , . . . , X (n) ) is a vector of one-dimensional

Ito processes X (i) .
Remarks.
• To shorten notations, one sometimes uses the symbolic differential notation
dX(t) = α(t)dt + β(t)0 dW (t)
• It can be shown that the processes α and β are unique up to indistinguishability.

• By (2), we have βj ∈ H 2 [0, T ].
• For a real-valued Ito process X and a real-valued progressively measurable process
Y , we define Z t Z Z t t
Ys dXs := Ys αs ds + Ys βs0 dWs
0 0 0
Definition 3.23 (Quadratic Variation and Covariation)

Let X (1) and X (2) two real-valued Ito processes with
Z t Z t
(i)
X (t) = X(0) + (i)
α (s) ds + β (i) (s)0 dW (s),
0 0
where i ∈ {1, 2}. Then,

m Z t
(1) (2)
X
< X (1) , X (2) >t := βj (s) βj (s) ds
j=1 0
is said to be the quadratic covariation of X (1) and X (2) . In particular, < X >t :=<
X, X >t is said to be the quadratic variation of an Ito process X.
Remarks. The definition may appear a bit unfounded. However, one can show
the following (see Karatzas/Shreve (1991, pp. 32ff)): For fixed t ≥ 0, let Π =
{t0 , . . . , tn } with 0 = t0 < t1 < . . . < tn = t be a partition of [0, t]. Then the p-th
variation of X over the partition Π is defined by (p > 0)
n
(p)
X
Vt (Π) = |Xtk − Xtk−1 |p .
k=1
The mesh of Π is defined by ||Π|| = max1≤k≤n |tk − tk−1 |. For X ∈ Mc2 , it holds
that
(2)
lim Vt (Π) =< X >t in probability.
||Π||→0
The main tool for working with Ito processes is Ito’s formula:
Theorem 3.33 (Ito’s Formula)

Let X be an n-dimensional Ito process with
Z t m Z
X t
Xi (t) = Xi (0) + αi (s) ds + βij (s) dWj (s).
0 j=1 0
Let f : [0, ∞) × IRn → IR be a C 1,2 -function. Then

Z t
f (t, X1 (t), . . . , Xn (t)) = f (0, X1 (0), . . . , Xn (0)) + ft (s, X1 (s), . . . , Xn (s)) ds
0
n Z
X t
+ fxi (s, X1 (s), . . . , Xn (s)) dXi (s)
i=1 0
n Z
X t
+0.5 fxi xj (s, X1 (s), . . . , Xn (s)) d < Xi , Xj >s ,
i,j=1 0
where all integrals are defined.
Proof. For simplicity, X(0) = const., n = m = 1, and f : IR → IR.

1st step. By applying a localization argument, we can assume that
Z t Z t Z t
Mt := βs dWs , Bt := αs ds, B̂t := |αs | ds,
0 0 0
Rt
0
βs2 ds, and thus X are uniformly bounded by a constant C. Hence, the relevant
support of f , f 0 , and f 00 is compact implying that these functions are bounded as
well. Besides, M is a martingale (since β ∈ L2 [0, T ]).
2nd step. Let Π = {t0 , . . . , tp } be a partition of [0, t]. Taylor expension leads to
(Note: f (Xtk ) = f (Xtk−1 ) + f 0 (Xtk−1 )(Xtk − Xtk−1 ) + . . ..)
p
X
f (Xt ) − f (X0 ) = (f (Xtk ) − f (Xtk−1 ))
k=1
Xp p
X
= f 0 (Xtk−1 )(Xtk − Xtk−1 ) + 0.5 f 00 (ηk )(Xtk − Xtk−1 )2
k=1 k=1
| {z } | {z }
(∗) (∗∗)
with ηk = Xtk−1 + θk (Xtk − Xtk−1 ), θk ∈ (0, 1).

3rd step. Convergence of (*). We get
p
X p
X
(∗) = f 0 (Xtk−1 )(Btk − Btk−1 ) + f 0 (Xtk−1 )(Mtk − Mtk−1 ) .
k=1 k=1
| {z } | {z }
A1 (Π) A2 (Π)
(i) For ||Π|| → 0, we obtain (Lebesgue-Stieltjes theory)

Z t Z t
a.s.,L1
A1 (Π) −→ f 0 (Xs )dBs = f 0 (Xs )αs ds
0 0
0
(ii) Approximate f (Xs ) by a simple process
p
X
YsΠ (ω) := f 0 (X0 )1{0} (s) + f 0 (Xtk−1 (ω))1(tk−1 ,tk ] (s).
k=1
Rt
Note that A2 (Π) = 0
YsΠ dMs .14 By the Ito isometry,
Z t 2 Z t 2
0 0
E f (Xs ) dMs − A2 (Π) = E (f (Xs ) − YsΠ )βs
dWs
0 0
Z t
L2
= E (f 0 (Xs ) − YsΠ )2 βs2 ds −→ 0,
0
where the limit follows from the dominated convergence theorem (as ||Π|| → 0).
Therefore,15 (as ||Π|| → 0)
Z t Z t
L1
(∗) = A1 (Π) + A2 (Π) −→ f 0 (Xs )αs ds + f 0 (Xs ) dMs
0 0
4th step. Convergence of (**). It can be shown that (See Korn/Korn (1999,
pp. 53ff))
Z t
L1
(∗∗) −→ f 00 (Xs )βs2 ds.
0
5th step. By steps 2-4, there exists a subsequence {Πk }k , such that the integrals
converges a.s. towards the corresponding limits. Therefore, for fixed t both sides
of Ito’s formula are equal a.s. Since both sides are continuous processes in t, by
Proposition 3.2 (ii), they are indistinguishable. 2
Remark. Often a short-hand symbolic differential notation is used (f : [0, ∞) ×

IR → IR)
df (t, Xt ) = ft (t, Xt )dt + fx (t, Xt )dXt + 0.5fxx (t, Xt )d < X >t
Examples.
• Xt = t and f ∈ C 2 leads to the fundamental theorem of integration.
• Xt = h(t) and f ∈ C 2 leads to the chain rule of ordinary calculus.
• Xt = Wt and f (x) = x2 :
Z t
Wt2 = 2 Ws dWs + t
0
• Xt = x0 + αt + σWt , x0 , α, β ∈ IR, and f (x) = ex .
df (Xt ) = f 0 (Xt )dXt + 0.5f 00 (Xt )d < X >t

h i
= f (Xt ) αdt + σdWt + 0.5σ 2 dt
h i
= f (Xt ) (α + 0.5σ 2 )dt + σdWt .
Therefore, the solution of the stock price dynamics in the Black-Scholes model,
dSt = St [µdt + σdWt ], reads
2
(3) St = s0 e(µ−0.5σ )t+σWt
.
14 This
is actually a consequence of the more general definition of Ito integrals in Karatzas/Shreve
(1991, pp. 129ff).
15 L2 -convergence implies L1 -convergence
• Ito’s product rule: Let X and Y be Ito processes and f (x, y) = x · y Then
(omitting dependencies)
d(XY ) = fx dX + fy dY + 0.5 fxx d < X > +0.5 fyy d < Y > + fxy d < X, Y >
|{z} |{z} |{z}
=0 =0 =1
= XdY + Y dX + d < X, Y >
Definition 3.24 (Stochastic Differential Equation)

If for a given filtered probability space (Ω, F, P, {Ft }) there exists an adapted pro-
cess X with X(0) = x ∈ IRn fixed and
Z t m Z
X t
Xi (t) = xi + αi (s, X(s)) ds + βij (s, X(s)) dWj (s)
0 j=0 0
P -a.s. for every t ≥ 0 and i ∈ {1, . . . , n}, such that

 
Z t Xm
|αi (s, X(s))| + 2
βij (s, X(s)) ds < ∞
0 j=1
P -a.s. for every t ≥ 0 and i ∈ {1, . . . , n}, then X is a strong solution of the stochastic
differential equation (SDE)
(4) dX(t) = α(t, X(t))dt + β(t, X(t))dW (t)

X(0) = x,
where α : [0, ∞) × IRn → IRn and β : [0, ∞) × IRn → IRn,m are given functions.
Theorem 3.34 (Existence and Uniqueness)

If the coefficients α and β are continuous functions satisfying the following global
Lipschitz and linear growth conditions for fixed K > 0
||α(t, z) − α(t, y)|| + ||β(t, z) − β(t, y)|| ≤ K||z − y||,

||α(t, y)||2 + ||β(t, y)||2 ≤ K 2 (1 + ||y||2 ),
z, y ∈ IR, then there exists an adapted continuous process X being a strong solution
of (4) and satisfying
E[||Xt ||2 ] ≤ C(1 + ||x||2 )eCT for all t ∈ [0, T ],
where C = C(K, T ) > 0. X is unique up to indistinguishability.
Proof. See Korn/Korn (1999, pp. 128ff).
In general, there do not exist explicit solutions to SDEs. However, the important
family of linear SDEs admits explicit solutions:
Proposition 3.35 (Variation of Constants)

Fix x ∈ IR and let A, a, B, b be progressively measurable real-valued processes with
(P -a.s. for every t ≥ 0)
Z t
(|A(s)| + |a(s)|) ds < ∞,
0
m Z
X t
Bj (s)2 + b2j (s) ds < ∞.

j=1 0
Then the linear SDE

m
X
dX(t) = (A(t)X(t) + a(t))dt + (Bj (t)X(t) + bj (t))dWj (t),
j=1
X(0) = x,
possesses an adapted Lebesgue ⊗ P -unique solution

   
Z t m m Z t
1 a(u) −
X X b j (u)
X(t) = Z(t) x + Bj (u)bj (u) du + dWj (u) ,
0 Z(u) j=1 j=1 0 Z(u)
where
Z t Z t
(5) Z(t) = exp A(u) − 0.5||B(u)||2 du + B(u)0 dW (u) .
0 0
is the solution of the homogeneous SDE
dZ(t) = Z(t) [A(t)dt + B(t)0 dW (t)] ,

Z(0) = 1.
Proof. For simplicity, n = m = 1. As in (3), one can show that Z solves the
homogeneous SDE. To prove uniqueness, note that Ito’s formula leads to

1 1
(−A + B 2 )dt − BdW .

d =
Z Z
Let Z̃ be another solution. Then, by Ito’s product rule,

1 1 1 1
d Z̃ = Z̃d + dZ̃+ < , Z̃ >
Z Z Z Z
Z̃ Z̃ Z̃
= (−A + B 2 )dt − BdW + [Adt + BdW ] − B 2 dt = 0
Z Z Z
implying Z̃ Z1 = const. Due to the initial condition, we obtain Z̃ = Z.
To show that X satisfies the linear SDE, define Y := X/Z. Ito’s product rule
applied to Y Z gives the desired result. To prove uniqueness, let X and X̃ be two
solutions to the linear SDE. Then X̂ := X̃ − X solves the homogeneous SDE
dX̂ = X̂[Adt + BdW ]
with X̂0 = 0. Applying Ito’s product rule to 0 · Z shows X̂t = 0 a.s. for all t ≥ 0. 2
4 CONTINUOUS-TIME MARKET MODEL AND OPTION PRICING 47
Example. In Brownian models the money market account and stocks are modeled
via (i = 1, . . . , I)
(6) dS0 (t) = S0 (t)r(t)dt, S(0) = 1,

 
m
X
dSi (t) = Si (t) µi (t)dt + σij (t)dWj (t) , S(0) = si0 > 0.
j=1
Applying “variation of constants” leads to

Rt
r(s) ds
S0 (t) = e 0 ,
Rt Pm 2 Pm R t
µi (s)−0.5 σij (s) ds+ σij (s)dWj (s)
Si (t) = si0 e 0 j=1 j=1 0 .
4 Continuous-time Market Model and Option Pric-

ing
4.1 Description of the Model
We consider a continuous-time security market as given by (6).

Mathematical Assumptions.
• Recall the standing assumption: (Ω, F, P, {Ft }) is a filtrered probability space
satisfying the usual conditions.
• {Wt , Ft } is a (multi-dimensional) Brownian motion of appropriate dimension.
• {Ft } is the Brownian filtration.
• The coefficients r, µ, and σ are progressively measurable processes being uni-
formly bounded.
Notation.
• ϕi (t): number of stock i at time t
• ϕ0 (t)S0 (t): money invested in the money market account at time t
PI
• X ϕ (t) := i=0 ϕi (t)Si (t): wealth of the investor
PI
• Assumption: x0 := X(0) = i=0 ϕi (0)Si (0) ≥ 0 (non-negative initial wealth)
• πi (t) := ϕi (t)Si (t)/X(t): proportion invested in stock i
P
• 1 − i πi : proportion invested in the money market account
Definition 4.1 (Trading Strategy, Self-financing, Admissible)

(i) Let ϕ = (ϕ0 , . . . , ϕI )0 be an IRI+1 -valued process which is progressively measur-
able w.r.t. {Ft } and satisfies (P -a.s.)
Z T I Z
X T
(7) |ϕ0 (t)|dt < ∞, (ϕi (t)Si (t))2 dt < ∞.
0 i=1 0
Then ϕ is said to be a trading strategy.

(ii) If
dX(t) = ϕ(t)0 dS(t)
holds, then ϕ is said to be self-financing.

(iii) A self-financing ϕ is said to be admissible if X(t) ≥ 0 for all t ≥ 0.
Remarks.
• The corresponding portfolio process π is said to be self-financing or admissible
if ϕ is self-financing or admissible (Recall πi = ϕi Si /X). Note that if we work
with π, then we need to require that X(t) > 0 for all t ≥ 0. Otherwise, π is not
well-defined.
• (7) ensures that all integrals are defined.
• Compare the definition (ii) with the result of Proposition 2.11.
• Every trading strategy satisfies
dX(t) = d(ϕ(t)0 S(t)).
Hence, in abstract mathematical terms, self-financing means that ϕ can be put

before the d operator.
• In the following, we always consider admissible trading strategies.
• Since admissible strategies are progressive, investors cannot see into the future
(no clairvoyants).
Definition 4.2 (Arbitrage, Option, Replication, Fair Value)

(i) An admissible trading strategy ϕ is an arbitrage opportunity if (P -a.s.)
X ϕ (0) = 0, X ϕ (T ) ≥ 0, P (X ϕ (T ) > 0) > 0.
(ii) An FT -measurable random variable C(T ) ≥ 0 is said to be a contingent claim,

T ≥ 0.
(iii) An admissible strategy ϕ is a replication strategy for the claim C(T ) if
X ϕ (T ) = C(T ) P − a.s.
(iv) The fair time-0 value of a claim is defined as
C(0) = inf{p : D(p) 6= ∅},
where
D(x) := {ϕ : ϕ admissible and replicates C(T ) and X ϕ (0) = x}
Remark. The strategy in (i) is also known as “free lottery”.
Economical Assumptions.
• All investors model the dynamics of the securities as above.
• All investors agree upon σ, but may disagree upon µ.
• Investors are price takers.
• Investors use admissible strategies.
• Frictionless markets
• No arbitrage (see Definition 4.2 (i))
Proposition 4.1 (Wealth Equation)

The wealth dynamics of a self-financing strategy ϕ are described by the SDE
h i
dX(t) = X(t) (r(t) + π(t)0 (µ(t) − r(t)1))dt + π(t)0 σ(t)dW (t) , X(0) = x0 ,
the so-called wealth equation.
Proof. By definition,
dX = ϕ0 dS
I
X h m
X i
= ϕ0 S0 rdt + ϕi Si µi dt + σij dWj
i=1 j=1
I
X I
X h m
X i
= 1− πi Xrdt + πi X µi dt + σij dWj
i=1 i=1 j=1
h I
X X I
m X i
= X r+ πi (µi − r) dt + πi σij dWj
i=1 j=1 i=1
Remarks.
• Due to the boundedness of the coefficients, by “variation of constants”, the con-
dition (P − a.s.)
Z t
πi (s)2 ds < ∞
0
is sufficient for the wealth equation to possess a unique solution.
• One can directly start with π (instead of ϕ) and require that for the wealth
equation Z t
X(s)2 πi (s)2 ds < ∞
0
4.2 Black-Scholes Approach: Pricing by Replication
We wish to price a European call written on a stock S with strike K, maturity T ,

and payoff
C(T ) = max{S(T ) − K; 0},
where h i
dS(t) = S(t) µdt + σdW (t)
with constants µ and σ. The interest rate r is constant as well.

Assumptions.
• No payout are made to the stocks during the life-time of the call.
• There exists a C 1,2 -function f = f (t, s) such that the time-t price of the call is
given by C(t) = f (t, S(t)).
Then
dC(t) = ft (t, S(t))dt + fs (t, S(t))dS(t) + 0.5fss (t, (S(t))d < S >t

= ft dt + fs S µdt + σdW + 0.5fss S 2 σ 2 dt

= ft + fs Sµ + 0.5fss S 2 σ 2 dt + fs SσdW
Consider a self-financing trading strategy ϕ = (ϕM , ϕS , ϕC ) and choose ϕC (t) ≡

−1. Then
dX ϕ (t) = ϕM (t)dM (t) + ϕS (t)dS(t) − dC(t)

= ϕ0 rM dt + ϕS S µdt + σdW

− ft + fs Sµ + 0.5fss S 2 σ 2 dt − fs SσdW

= ϕM rM + ϕS Sµ − ft − fs Sµ − 0.5fss S 2 σ 2 dt + ϕ1 Sσ − fs Sσ dW
| {z } | {z }
(∗) (∗∗)
Choosing ϕS (t) = fs (t) leads to (∗∗) = 0. Hence, the strategy is locally risk-free
implying (∗) = X ϕ (t)r (Otherwise there is an arbitrage opportunity with the money
market account). Rewriting (*):
(∗) = ϕM rM − ft − 0.5fss S 2 σ 2

= r ϕM M + ϕS S − C
| {z }
=X ϕ
−rfs S + rC − ft − 0.5fss S 2 σ 2 .
| {z }
(∗∗∗)
Therefore, (∗ ∗ ∗) = 0, i.e.
rfs (t, S(t))S(t) − rf (t, S(t)) + ft (t, S(t)) + 0.5fss (t, S(t))S 2 (t)σ 2 = 0.
It follows:
Theorem 4.2 (PDE of Black-Scholes (1973))

In an arbitrage-free market the price function f (t, s) of a European call satisfies the
Black-Scholes PDE
ft (t, s) + rsfs (t, s) + 0.5s2 σ 2 fss (t, s) − rf (t, s) = 0,
(t, s) ∈ [0, T ] × IR+ , with terminal condition f (T, s) = max{s − K, 0}.
Remark. We have not used the terminal condition to derive the PDE. There-
fore, every European (path-independent) option satisfies this PDE. Of course, the
terminal condition will be different.
Question: How should we solve this PDE?

1st approach: Merton (1973). Solve the PDE by transforming it to the heat
equation ut = uxx which has a well-known solution.16
2nd approach. Apply the Feynman-Kac theorem (see below) which states that
the time-0 solution of the Black-Scholes PDE is given by
h i
C(0) = E max{Y (T ) − K, 0}Y (0) = S(0) e−rT ,

where Y satisfies the SDE

h i
dY (t) = Y (t) rdt + σdW (t) , Y (0) = S(0).
Theorem 4.3 (Black-Scholes Formula)

(i) The price of the European call is given by
C(t) = S(t) · N (d1 (t)) − K · N (d2 (t)) · e−r(T −t)
with
ln(S(t)/K) + (r + 0.52 )(T − t)
d1 (t) = √ ,
σ T −t
√
d2 (t) = d1 (t) − σ T − t.
(ii) The trading strategy ϕ := (ϕM , ϕS ) with

C(t) − fs (t, S(t)) · S(t)
ϕM (t) = ,
M (t)
ϕS (t) = fs (t, S(t)),
is self-financing and a replication strategy for the call.
Proof. (i) Compute (exercise)

h i
C(t) = E max{Y (T ) − K, 0}Y (t) = S(t) e−r(T −t) .

(ii) We have
(8) X ϕ (t) = ϕM (t) · M (t) + ϕS (t) · S(t) = C(t).
Hence, (ϕM , ϕS ) replicates the call and is self-financing because

(8)
dX ϕ = dC

Ito
= ft + fs Sµ + 0.5fss S 2 σ 2 dt + fs SσdW
(+)

= r[C − fs S] + fs Sµ dt + fs SσdW
Def. (ϕM , ϕS )

= rM ϕM + ϕS Sµ dt + ϕS SσdW
h i
= ϕM rM dt + ϕS S µdt + SσdW
= ϕM dM + ϕS dS.
16 See, e.g., Korn/Korn (1999, p. 124).
Note: (+) holds due to the Black-Scholes PDE
ft + 0.5fss S 2 σ 2 = r[C − fs S]
2
Remark. Since (ϕM , ϕS ) is self-financing, the strategy (ϕM , ϕS , ϕC ) with ϕC = −1
is self-financing as well because
d(ϕC (t)C(t)) = d(−C(t)) = −dC(t) = ϕC (t)dC(t).
Theorem 4.4 (Feynman-Kac Representation)

Let β and γ be functions of (t, x) ∈ [0, ∞) × IR. Under technical conditions (see
Korn/Korn (1999, p. 136)), there exists a unique C 1,2 -solution F = F (t, x) of the
PDE
(9) Ft (t, x) + β(t, x)Fx (t, x) + 0.5γ 2 (t, x)Fxx (t, x) − rF (t, x) = 0
with terminal condition F (T, x) = h(x) possessing the representation
F (t0 , x) = e−r(T −t0 ) E[h(X(T ))|X(t0 ) = x],
where X satisfies the SDE
dX(s) = β(s, X(s))ds + γ(s, X(s))dW (s)
with initial condition X(t0 ) = x.
Sketch of Proof. (i) Firstly assume r = 0. If F is a C 1,2 -function, we can apply

Ito’s formula
dF = Ft dt + Fx dX + 0.5Fxx d < X > .
Since d < X >= γ 2 dt, we get

dF = Ft dt + Fx βdt + γdW + 0.5γ 2 Fxx dt

= Ft + βFx + 0.5γ 2 Fxx dt + γFx dW.
Suppose that there exists a function F satisfying the PDE, i.e.
Ft + βFx + 0.5γ 2 Fxx = 0
with F (T, x) = h(x). Then

dF = γFx dW
or in integral notation
Z s
F (s, X(s)) = F (t0 , X(t0 )) + γ(u, X(u))Fx (u, X(u))dW (u).
t0
Rs
If E t0 γ(u, Xu )2 Fx (u, Xu )2 du < ∞, the stochastic integral has zero expectation
and thus
F (t0 , x) = E[F (s, X(s)|X(t0 ) = x].
Choose s = T and note that F (T, X(T )) = h(X(T )).

(ii) For r 6= 0, multiply the PDE (9) by e−rt :
Ft (t, x)e−rt + β(t, x)Fx (t, x)e−rt + 0.5γ 2 (t, x)Fxx (t, x)e−rt − rF (t, x)e−rt = 0.
Set G(t, x) := F (t, x)e−rt . Since
Gt (t, x) = Ft (t, x)e−rt − rF (t, x)e−rt ,
we get
Gt (t, x) + β(t, x)Gx (t, x) + 0.5γ 2 (t, x)Gxx (t, x) = 0
with terminal condition G(T, x) = e−rT h(x). Now we can apply (i):
G(t0 , x) = E[e−rT h(X(T ))|X(t0 ) = x].
Substituting G(t0 , x) = e−rt0 F (t0 , x) gives the desired result. 2
Remarks.
• Two crucial points are not proved: Firstly, we have not checked under which
conditions a C 1,2 -function F exists. Secondly, we have not checked under which
conditions γ(·, X)Fx (·, X) ∈ L2 [0, T ].
• To solve the Black-Scholes PDE, choose β(t, x) = rx and γ(t, x) = xσ.
• The Feynman-Kac representation can be generalized to a multidimensional set-
ting, i.e. X is a multidimensional Ito process, with stochastic short rate r = r(X).
4.3 Pricing with Deflators
In a single-period model the deflator is given by (See remark to Proposition 2.7)

1 dQ
H=
1 + r dP
This motivates the definition of the deflator in continuous-time:
1
H(t) := Z(t),
M (t)
where
Z t
M (t) := exp r(s) ds ,
0
Z t Z t
Z(t) := exp −0.5 ||θ(s)||2 ds − θ(s)0 dW (s) ,
0 0
The process θ is implicitly defined as the solution to the following system of linear
equations:
(10) σ(t)θ(t) = µ(t) − r(t)1.
Applying Ito’s product rule yields the following SDE for H:
dH(t) = d(Z(t)M (t)−1 ) = −H(t)[r(t)dt + θ(t)0 dW (t)]
Remarks.
• In this section we are going to work under the physical measure. Nevertheless
we will see later on that Z can be interpreted as a density inducing a change of
measure (Girsanov’s Theorem).
• The system of equations (10) needs not to have a (unique) solution.
• The process θ is said to be the market price of risk and can be interpreted as a
risk premium (excess return per units of volatility).
The following theorem shows that H has indeed the desired properties:
Theorem 4.5 (Arbitrage-free Pricing with Deflator and Completeness)

(i) Assume that (10) has a bounded solution for θ. Let ϕ be an admissible portfolio
strategy. Then {H(t)X ϕ (t)}t∈[0,T ] is both a local martingale and a supermartingale
implying
(11) E[H(t)X ϕ (t)] ≤ X ϕ (0) for all t ∈ [0, T ].
Besides, the market is arbitrage-free.

(ii) Assume that I = m (“# stocks = # sources of risk”) and that σ is uniformly
positive definite.17 Then (10) has a unique solution which is uniformly bounded.
Furthermore, let C(T ) be an FT -measurable contingent claim with
(12) x := E[H(T )C(T )] < ∞
Then there exists a P ⊗ Lebesgue-unique portfolio process ϕ such that ϕ is a repli-

cation strategy for C(T ), i.e. (P -a.s.)
X ϕ (T ) = C(T ),
and X ϕ (0) = x. Hence, the market is complete. The time-t price of the claim
equals
E[H(T )C(T )|Ft ]
C(t) = ,
H(t)
i.e. the process {H(t)C(t)}t∈[0,T ] is a martingale.
Remarks.
• The boundedness assumption in (i) can be weakened.
• The price in (ii) is thus equal to the expected discounted payoff under the phys-
ical measure where we discount with the state-dependent discount factor H, the
deflator.
• Compare (ii) with Theorem 2.13.
Proof. For simplicity, I = 1. (i) Applying Ito’s product rule, one gets for an
admissible ϕ = (ϕ0 , ϕ1 ):18
d(HX ϕ ) = HdX ϕ + X ϕ dH + d < H, X ϕ >

17 Theprocess σ is uniformly positive definite if there exists a constant K > 0 such that
x0 σ(t)σ(t)0 x≥ Kx0 x for all x ∈ IRm and all t ∈ [0, T ], P -a.s. This requirement implies that
σ(t) is regular.
18 Note θσ = µ − r.
= HX ϕ rdt + Hϕ1 S(µ − r)dt + Hϕ1 SσdW − X ϕ Hrdt

−X ϕ HθdW − Hϕ1 Sθσdt
(13) = H(ϕ1 Sσ − X ϕ θ)dW.
Since ϕ is admissible, we have X ϕ (t) ≥ 0. By definition, H(t) ≥ 0 and thus

H(t)X(t) ≥ 0. By Proposition 3.25, HX is a supermartingale which proves (11).
Note that an arbitrage strategy would violate this supermartingale property.
(ii) Clearly, θ = (µ − r)/σ is unique and uniformly bounded by some Kθ > 0.19
Define
E[H(T )C(T )|Ft ]
X(t) :=
H(t)
By definition, X(t) is adapted, X(0) = x, X(t) ≥ 0, and X(T ) = C(T ) (P -a.s.).20
Set M (t) := H(t)X(t) = E[H(T )C(T )|Ft ]. Due to (12), M is a martingale with
M (0) = x. Applying the martingale representation theorem, there exists an {Ft }-
RT
progressively measurable real-valued process ψ with 0 ψ(s)2 ds < ∞ such that
(P − a.s.)
Z t
(14) H(t)X(t) = M (t) = x + ψ(s) dW (s).
0
R·
Since H and 0 ψ(s) dW (s) are continuous, we can choose X to be continuous.
Comparing (13) and (14) yields21
H(ϕ1 Sσ − Xθ) = ψ.
Since there exists a Kσ > 0 such that σ(t) ≥ Kσ for all t ∈ [0, T ],22 we get
ψ/H + Xθ
ϕ1 = .
Sσ
Since X ϕ = ϕ0 M + ϕ1 S for any strategy ϕ, we define
X − ϕ1 S
ϕ0 :=
M
which implies that ϕ is self-financing and X = X ϕ . Since M > 0, H > 0, and
X ≥ 0 are continuous, M as well as H are pathwise bounded away from zero and X
is pathwise bounded from above, i.e. M (ω) ≥ KM (ω) > 0, H(ω) ≥ KH (ω) > 0, and
X(ω) ≤ KX (ω) < ∞ for a.a. ω ∈ Ω. Therefore, the process is a trading strategy
because23
Z T Z T 2
ψ(s)/H(s) + X(s)θ(s)
(ϕ1 (s)S(s))2 ds = ds
0 0 σ(s)
Z T !
2 1 2 2 2
≤ 2 ψ(s) ds + KX Kθ T < ∞,
Kσ2 KH 0
19 Notethat all coefficients are bounded and σ is uniformly positive definite.

20 SinceF0 is the trivial σ-algebra augemented by null sets, is every F0 -measurable random
variable a.s. constant and the conditioned expected value is equal to the unconditioned expected
value.
21 Note that the representation of an Ito process is unique.
22 By assumption, σ is uniformly positive definite.
23 (a + b)2 ≤ 2a2 + 2b2 .
T T
|X(s) − ϕ1 (s)S(s)|
Z Z
|ϕ0 (s)| ds = ds
0 0 M (s)
Z T !
1 2
≤ KX T + 1 + (ϕ1 (s)S(s)) ds < ∞
KM 0
for P -a.s. 2
Theorem 4.6 (Martingale Representation Theorem)

Let {Mt }t∈[0,T ] be a real-valued process being adapted to the Brownian filtration.
(i) If M is a square integrable martingale, i.e. E[Mt2 ] < ∞ for all t ∈ [0, T ], then
there exists a progressively measurable IRm -valued process {ψt }t∈[0,T ] with
"Z #
T
(15) E ||ψs ||2 ds < ∞
0
and Z t
Mt = M 0 + ψs0 dWs , P -a.s.
0
(ii) If M is a local martingale, then the result from (i) holds with
Z T
||ψs ||2 ds < ∞
0
instead of (15).
In both cases, ψ is P ⊗ Lebesgue-unique.
Proof. See Korn/Korn (1999, pp. 81ff).

Remarks.
• All Brownian (local) martingales are stochastic integrals and vice versa!
• The quadratic (co)variation is defined for all (local) Brownian martingales.
Proposition and Definition 4.7 (Quadratic (Co)variation)

(i) Let X, Y be Brownian local martingales. The quadratic covariation < X, Y >
is the unique adapted, continuous process of bounded variation with < X, Y >0 = 0
such that XY − < X, Y > is a Brownian local martingale. If X = Y , this process
is non-decreasing.
(ii) Let (Ω, G, P, {Gt }) be a filtered probability space satisfying the usual conditions
and let X, Y be continuous local martingales for the filtration {Gt }. Then the result
of (i) holds with XY − < X, Y > being a local martingale for {Gt }.
Proof. (i) By the martingale representation theorem, dX = αdW and dY = βdW

with progressively measurable processes α and β. Ito’s product rule yields
d(XY ) = Y dX + XdY + d < X, Y >= Y αdW + XβdW + αβdt.
Since Ito integrals are local Brownian martingales, XY − < X, Y > is a Brownian
martingale. The rest is obvious.
(ii) See Kartzas/Shreve (1991, p. 36). 2
Remark. One can show that if X and Y are square-integrable, then XY − <
X, Y > is a martingale.
4.4 Pricing with Risk-neutral Measures
The deflator is defined as

1
H(t) = Z(t),
M (t)
where
dZ(t) = −Z(t)θ(t)0 dW (t)
is a local martingale. If it is even a martingale, we have E[Z(T )] = 1 and we can

define a probability measure on FT by
Q(A) := E[1A Z(T )], A ∈ FT .
Hence, Z(T ) is the density of Q and we can rewrite the result from Theorem 4.5 as

C(T ) C(T )
C(0) = E[H(T )C(T )] = E Z(T ) = EQ ,
M (T ) M (T )
i.e. the price of a claim equals its expected discounted payoff where we discount with
the money market account (instead of the deflator) and expectation is calculated
w.r.t. the measure Q (instead of the physical measure).
Two important questions arise:
Q1. Under which conditions is Z a martingale? (Novikov condition)
Q2. What happens to the dynamics of the assets if we change to the measure Q?
(Girsanov’s theorem)
Proposition 4.8
RT
Let θ be progressive and K > 0. If 0 ||θ(s)||2 ds ≤ K, then the process {Z(t)}t∈[0,T ]
defined by
(16) dZ(t) = −Z(t)θ(t)0 dW (t), Z(0) = 1,
is a martingale.
Proof. For simplicity, m = 1. The process Z is a local martingale. By variations

of constants, we get
Z t Z t
(17) Z(t) = exp −0.5 θ(s)2 ds − θ(s) dW (s) ≥ 0.
0 0
By Proposition 3.25, it is thus a supermartingale. Hence, it is sufficient to show

that E[Z(T )] = 1. Define
n Z t o
τn := inf t ≥ 0 : θ(s) dW (s) ≥ n .

0
R T ∧τ
Due to (17), for fixed n ∈ IN , we get Z(T ∧τn )2 ≤ e2n and thus 0 n Z(s)2 θ(s)2 ds ≤
K e2n . From (16), we obtain E[Z(T ∧ τn )] = 1. Therefore, the claim is proved if
{Z(T ∧ τn )}n∈IN is UI because in this case
lim E[Z(T ∧ τn )] = E[Z(T )].

n→∞
We obtain the estimate

Z T
|Z(T ∧ τn )|1+ε ≤ exp 0.5(ε + ε2 ) θ(s)2 ds Y (T ∧ τn ),
| {z 0 }
independent of n and bounded by assumption
where
dY (t) = −Y (t)(1 + ε)θ(s)dW (s), Y (0) = 1.
With the same arguments leading to E[Z(T ∧τn )] = 1 we conclude E[Y (T ∧τn )] = 1.
Therefore,
sup E|Z(T ∧ τn )|1+ε < ∞,
n∈IN
which, by Proposition 3.19, proves UI of {Z(T ∧ τn )}n∈IN . 2
Remark. The requirement in the proposition is a strong one. It can be replaced

by the Novikov condition (See Karatzas/Shreve (1991, pp. 198ff)):
h Z T i
E exp 0.5 ||θ(s)||2 ds < ∞.
0
We turn to the second question and define (Q := QT )
(18) Qt (A) := E[1A Z(t)], A ∈ Ft , t ∈ [0, T ].
The following lemma shows that Qt is well-defined.
Lemma 4.9
For a bounded stopping time τ ∈ [0, T ] and A ∈ Fτ , we get QT (A) = Qτ (A).
Proof. The optional sampling theorem (OS) yields (See Theorem 3.17)
OS
QT (A) = E[1A Z(T )] = E[E[1A Z(T )|Fτ ]] = E[1A E[Z(T )|Fτ ]] = E[1A Z(τ )] = Qτ (A).
To prove Girsanov’s theorem, we need some additional tools.
Theorem 4.10 (Levy’s Characterization of the Brownian Motion)

An m-dimensional stochastic process X with X(0) = 0 is an m-dimensional Brow-
nian motion if and only if it is a continuous local martingale with24
< Xj , Xk >t = δjk t.

24 Note that δij = 1{i=j} is the Kronecker delta.
Proof. For simplicity m = 1. Clearly, the Brownian motion is a continuous local

martingale with < W >t = t. To prove the converse, fix u ∈ IR and set f (t, x) =
√
exp(iux + 0.5u2 t) and Zt := f (t, Xt ), where i = −1. Since f ∈ C 1,2 is analytic, a
complex-valued version of Ito’s formula yields
dZ = ft dt + fx dX + 0.5fxx d < X >

= 0.5u2 f dt + iuf dX − 0.5u2 f d < X >
<X>t =t
= iuf dX.
Since an integral w.r.t. a local martingale is a local martingale as well,25 Z is a

(complex-valued) local martingale which is bounded on [0, T ] for every T ∈ IR.
Hence, Z is a martingale implying E[exp(iuXt + 0.5u2 t|Fs ] = exp(iuXs + 0.5u2 s),
i.e.
E[exp(iu(Xt − Xs ))|Fs ] = exp(−0.5u2 (t − s)).
Since this hold for any u ∈ IR, the difference Xt − Xs ∼ N (0, t − s) and Xt − Xs is
independent of Fs . 2
Proposition 4.11 (Bayes Rule)

Let µ and ν be two probability measures on a measurable space (Ω, G) such that
dν/dµ = f for some f ∈ L1 (µ). Let X be a random variable on (Ω, G) such that
Z
Eν [|X|] = |X|f dµ < ∞.
Let H be a σ-field with H ⊂ G. Then
Eν [X|H] Eµ [f |H] = Eµ [f X|H] a.s.
Proof. Let H ∈ H. We start with the left-hand side:

Z Z Z Z Z
Eµ [f X|H] dµ = Xf dµ = Xdν = Eν [X|H] dν = Eν [X|H]f dµ
H H H H H

= Eµ Eν [X|H] · f 1H = Eµ [Eµ [Eν [X|H] · f 1H |H]]
Z
= Eµ [1H Eν [X|H] · Eµ [f |H]] = Eν [X|H] · Eµ [f |H] dµ.
H
2
Lemma 4.12
Let {Yt , Ft }t∈[0,T ] be a right-continuous adapted process. The following statements
are equivalent:
(i) {Zt Yt , Ft }t∈[0,T ] is a local P -martingale.
(ii) {Yt , Ft }t∈[0,T ] is a local QT -martingale.
25 For instants, a Brownian local martingale can be represented as Ito integral.
Proof. Assume (i) to hold and let {τn }n be a localizing sequence of ZY . Then26
Lem 4.9 Bayes EP [Zt∧τn Yt∧τn |Fs ]
EQT [Yt∧τn |Fs ] = EQt∧τn [Yt∧τn |Fs ] =
EP [Zt∧τn |Fs ]
Zs∧τn Ys∧τn
= = Ys∧τn .
Zs∧τn
The converse implication can be proved similarly (exercise). 2
Theorem 4.13 (Girsanov’s Theorem)

We assume that Z is a martingale and define the process {W Q (t), Ft } by
Z t
WjQ (t) := Wj (t) + θj (s) ds, t ≥ 0,
0
j ∈ {1, . . . , m}. For fixed T ∈ [0, ∞), the process {W Q (t), Ft }t∈[0,T ] is an m-
dimensional Brownian motion on (Ω, FT , QT ), where QT is defined by (18).
Proof. For simplicity, m = 1. By Levy’s characterization, we need to show that

(i) {W Q (t), Ft }t∈[0,T ] is a continuous local martingale on (Ω, FT , QT ).
(ii) < W Q >t = t on (Ω, FT , QT ).
ad (i). Ito’s product rule yields
d(ZW Q ) = ZdW Q + W Q dZ + d < W Q , Z >

= ZdW + Zθdt − W Q ZθdW − Zθdt
= (Z − W Q Zθ)dW,
i.e. ZW Q is a local P -martingale. By Lemma 4.12, the process W Q is a local

QT -martingale as well.
ad (ii). Ito’s product rule leads to

d Z · ((W Q )2 − t) = d W Q · (ZW Q ) − d(Z · t)
= W Q d(ZW Q ) + ZW Q dW Q + d < ZW Q , W Q > −Zdt − tdZ
= W Q d(ZW Q ) + ZW Q (θdt + dW ) + (Z − W Q Zθ)dt − Zdt + tθZdW
= W Q d(ZW Q ) + Z(W Q + tθ)dW,
i.e. {Zt · ((WtQ )2 − t)} is a local P -martingale. Applying Lemma 4.12 again yields
that {(WtQ )2 − t} is a local QT -martingale. By Proposition 4.7 (ii), the claim (ii)
follows. 2
Corollary 4.14 (Girsanov II)

If {Mt }t∈[0,T ] is a Brownian local P -martingale and
Z t
1
Dt := d < Z, M >s ,
0 Zs
26 Note
that Yt∧τn is Ft∧τn -measurable, i.e. the conditional expected value can be computed
w.r.t. Qt∧τn instead of QT . Lemma 4.9 ensures that both measures coincide on Ft∧τn . Besides,
Ft∧τn ⊂ FT , i.e. Bayes rule can be applied. Furthermore, by Proposition 3.23, EP [Zt∧τn |Fs ] =
Zs∧τn .
then {Mt − Dt }t∈[0,T ] is a continuous local QT -martingale and < M − D >Q =<
M >, i.e. the quadratic variations of M − D under QT and M under P coincide.
Proof. By the martingale representation theorem, we have dM = αdW for some

progressive α. Hence,
1 1
dD = d < Z, M >= − θZαdt = −θαdt
Z Z
and thus
d(M − D) = αdW + θαdt = αdW Q .
Therefore, M − D is a local Q-martingale. Besides,
d < M − D >Q 2
t = α dt = d < M >t ,
which completes the proof. 2
Theorem 4.15 (Converse Girsanov)

Let Q be an equivalent probability measure to P on FT . Then the density process
{Z(t), Ft }t∈[0,T ] defined by
dQ
Z(t) :=
dP Ft
is a positive Brownian P -martingale possessing the representation
dZ(t) = −Z(t)θ(t)dW (t), Z(0) = 1,
for a progressively measurable m-dimensional process θ with

Z T
(19) ||θ(s)||2 ds < ∞ P − a.s.
0
Proof. Since Q and P are equivalent on FT , both measures are equivalent on Ft ,

t ∈ [0, T ] , i.e. Z(t) > 0 for all t ∈ [0, T ]. Besides, for A ∈ Ft
Z Z Z Z
Lem 4.9
Z(T )dP = dQ/dP |FT = dQ/dP |Ft = Z(t)dP,
Q A A Q
i.e. Z(t) = E[Z(T )|Ft ] implying that Z is a Brownian martingale. By the martingale
representation theorem,
Z t
Z(t) = 1 + ψ(s)0 dW (s)
0
RT
with a progressive process ψ satisfying 0 ||ψ(s)||2 ds < ∞, P − a.s.. Since Z > 0,
we have Z(ω) ≥ KZ (ω) > 0 for a.a. ω ∈ Ω. Defining
ψ(t)
θ(t) = −
Z(t)
thus implies (19) which completes the proof. 2

Definition 4.3 (Doleans-Dade Exponential)

For an Ito process X with X0 = 0 the Doleans-Dade exponential (stochastic ex-
ponential) of X, written E(X), is the unique Ito process Z that is the solution
of Z t
Yt = 1 + Ys dXs .
0
Remarks.
R·
• Therefore, the density Z is sometimes written as E( 0 θs dWs ).
• One can show that E(X)E(Y ) = E(X + Y + < X, Y >) and that (E(X))−1 =
E(−X+ < X, X >).
We now come back to our pricing problem. We set Q := QT . Recall our definitions
1
H(t) := Z(t),
M (t)
where
Z t
M (t) := exp r(s) ds ,
0
Z t Z t
2 0
Z(t) := exp −0.5 ||θ(s)|| ds − θ(s) dW (s) ,
0 0
and θ is implicitly defined by:
(20) σ(t)θ(t) = µ(t) − r(t)1.
For bounded θ, by Girsanov’s theorem, Z(t) = dQ/dP |Ft is a density process for
the measure Qt (A) = E[Z(t)1A ] and {W Q (t), Ft } defined by
Z t
WjQ (t) := Wj (t) + θj (s) ds, t ≥ 0,
0
is a Q-Brownian motion.
Definition 4.4 (Equivalent Martingale Measure)

A probability measure Q is a (weak) equivalent martingale measure if
(i) Q ∼ P and
(ii) all discounted price processes Si /M , i = 1, . . . , I, are (local) Q-martingales.
Remark. An equivalent martingale measure (EMM) is also said to be a risk-neutral

measure.
Proposition 4.16
If Q is a weak EMM and
" #
Z T
(21) E exp 0.5 ||σi (s)||2 ds <∞
0
for every i ∈ {1, . . . , I}, then Q is already an EMM.

Proof. Define Yi := Si /M . Since Q is a weak martingale measure, Yi is a local

Q-martingale. By the martingale representation theorem and the uniqueness of the
representation of an Ito process,
dYi = Yi σi0 dW Q .
By the Novikov condition (21), this is a Q-martingale. 2

Remark. Since we have assumed that σ is uniformly bounded, we need not to
distinguish between EMM and weak EMM.
Theorem 4.17 (Characterization of EMM)

In the Brownian market (6), the following are equivalent:
(i) The probability measure Q is an EMM.
(ii) There exists a solution θ to the system of equations (20) such that the process
R·
Z = E( 0 θs dWs ) is a Girsanov density inducing the probability measure Q.
Proof. Define Yi := Si /M . Assume (i) to hold. Since Q is a martingale measure,
(22) dYi = Yi σi0 dW Q .
Besides, since Q is equivalent to P , by the converse Girsanov, there exists a process

R·
θ such that dQ/dP = E( 0 θs0 dWs ) and dW Q = dW + θdt is a Brownian increment
under Q. Therefore,
dSi = Si [µi dt + σi0 dW ] = Si [(µi − σi0 θ)dt + σi0 dW Q ]
implying
(23) dYi = Yi [(µi − σi0 θ − r)dt + σi0 dW Q ]
Comparing (22) and (23) gives (ii).

On the other hand, assume (ii) to hold. By definition, Q is equivalent to P and
dW Q = dW + θdt is a Q-Brownian increment. Ito’s formula leads to
dYi = Yi [(µi − r)dt + σi0 dW ] = Yi [(µi − r − σi0 θ)dt + σi0 dW Q ] = Yi σi0 dW Q ,
which is Q-martingale increment because σ is assumed to be uniformly bounded. 2
Corollary 4.18 (Q-Dynamics of the Assets)

Under an EMM Q, the dynamicss of asset i are given by
dSi (t) = Si (t)[r(t)dt + σi (t)0 dW Q (t)],
i.e. the drift µ does not matter under Q.

Theorem 4.19 (Arbitrage-free Pricing under Q and Completeness)

(i) Let Q be an EMM and let ϕ be an admissible portfolio strategy. Then {X ϕ (t)/M (t)}t∈[0,T ]
is both a local Q-martingale and a Q-supermartingale implying that
ϕ
X (t)
EQ ≤ X ϕ (0) for all t ∈ [0, T ].
M (t)
Besides, the market is arbitrage-free. If additionally
"Z 2 #
T
Si (s)
(24) EQ ϕi (s) ds < ∞
0 M (s)
for every i = 1, . . . , I, then {X ϕ (t)/M (t)}t∈[0,T ] is a Q-martingale.

(ii) Assume that I = m (“# stocks = # sources of risk”) and that σ is uniformly
positive definite. Then (10) has a unique solution which is uniformly bounded
implying that there exists a unique EMM Q. Besides, the market is complete.
Furthermore, let C(T ) be an FT -measurable contingent claim with
x := EQ [C(T )/M (T )] < ∞
Then the time-t price of the claim equals

C(T )
C(t) = M (t) EQ Ft ,
M (T )
i.e. the discounted price process {C(t)/M (t)}t∈[0,T ] is a Q-martingale.
Proof. (i) Consider

I
X
dX ϕ = ϕ0 dS = Xrdt + ϕi Si σi0 dW Q .
i=1
Since d(1/M ) = −(1/M )rdt,

X 1 I
1 1 X
d = Xd + dX = Si ϕi σi0 dW Q
M M M M i=1
which is a positive local Q-martingale and thus a Q-supermartingale. If (24) is

satisfied, then it is a Q-martingale.
(ii) Since θ is unique, by Theorem 4.17, the EMM Q is unique. The claim price
follows from Theorem 4.5 because H = Z/M . 2
Remark.
• An EMM exists if, for instants, θ is bounded. This follows from Theorem 4.17.
• If ϕ is uniquely bounded, then (24) holds because µ, σ, and r are assumed to be
uniformly bounded.
• If the market is incomplete, then there exist more than one market price of risk
θ. Let Q and Q̃ be two corresponding EMM. If (24) holds, then for an admissible
strategy ϕ we get
ϕ ϕ
X (T ) ϕ X (T )
M (t) EQ Ft = X (t) = M (t) EQ̃ Ft .
M (T ) M (T )
This implies that any EMM assigns the same value to a replicable claim, namly
its replication costs. However, the prices of non-replicable claims may differ
under different EMM. This is the reason why pricing in incomplete markets is so
complicated and in some sense arbitrary.
Corollary 4.20 (Black-Scholes Again)

The price of the European call is given by
C(t) = S(t) · N (d1 (t)) − K · N (d2 (t)) · e−r(T −t)
with
ln(S(t)/K) + (r + 0.52 )(T − t)
d1 (t) = √ ,
σ T −t
√
d2 (t) = d1 (t) − σ T − t.
Proof. By Theorem 4.19,
C(t) = EQ [max{S(T ) − K; 0}] e−r(T −t) ,
where due to Corollary 4.18
dS(t) = S(t)[rdt + σdW Q (t)].
Thus S(T ) has the same distribution as Y (T ) in the proof of Proposition 4.3 and
the result follows. 2
Corollary 4.21 (Q-Dynamics of Claims)

Under the assumptions of Theorem 4.19, the dynamics of a replicable claim C(T )
are given by
(25) dC(t) = C(t)[r(t)dt + ψ(t)0 dW Q (t)]
with a suitable progressively measurable process ψ.
Proof. By Theorem 4.19, C/M is a (local) Q-martingale and thus (25) follows
from the martingale representation theorem. 2
Proposition 4.22 (Black-Scholes PDE Again and Hedging)

Under the assumptions of Theorem 4.19, let C(T ) be a replicable claim with C(t) =
f (t, S(t)) and C(T ) = h(S(T )), where f is a C 1,2 -function.
(i) The pricing function f satisfies the following multi-dimensional Black-Scholes
PDE:
I
X I X
X m
I
ft + fi si r + 0.5 si sk σij σkj fik − rf = 0, f (T, s) = h(s), s ∈ IR+ ,
i=1 i,k=1 j=1
where fi denotes the partial derivative w.r.t. the i-th asset price.
(ii) A replication strategy for C(T ) is given by
ϕi (t) = fi (t, S(t)), i = 1, . . . , I,

PI
where the remaining funds C(t) − i=1 ϕi (t)Si (t) are invested in the money market
PI
account, i.e. ϕM (t) = (C(t) − i=1 ϕi (t)Si (t))/M (t).
Proof. (i) Ito’s formula yields

I
X I X
X m I X
X m
(26) dC = ft + fi Si r + 0.5 fik Si Sk σij σkj dt + fi Si σij dWjQ .
i=1 i,k=1 j=1 i=1 j=1
Since the representation of an Ito process is unique, comparing the drift with the
drift of (25) yields the Black-Scholes PDE.
(ii) Since C(T ) is attainable, there exists a replication strategy ϕ with X ϕ (T ) =
C(T ) and Q-dynamics
I X
X m
ϕ ϕ
dX = X rdt + ϕi Si σij dWjQ ,
i=1 j=1
where due to Theorem 4.19 (ii) the drift equals r.27 Comparing the diffusion part
with the diffusion part of (26) shows that one can choose ϕi = fi . 2
Remarks.
• The strategy in (ii) is said to be a delta hedging strategy.
• Under the conditions of Theorem 4.19 (ii), the delta hedging strategy is the
unique replication strategy.
• In the Black-Scholes model, we get for the European call (see Exercise 29): ϕS =
N (d1 ). Due to the put-call parity, the delta hedge for the put reads ϕS =
−N (−d1 ).
• If I > m, i.e. (“# stocks > # sources of risk”), then in general there exist further
replication strategies, i.e. the choice ϕi = fi in the proof of (ii) is not the only
possible choice.
In Theorem 4.19, we have proved that the following implications hold:

1) Existence of EMM =⇒ No arbitrage
2) Uniqueness of EMM =⇒ Completeness
The following theorems show to which extend the converse is true.
Theorem 4.23 (Existence of a Market Price of Risk)
Assume that the market (6) is arbitrage-free. Then there exists a market price of
risk, i.e. there exists a progressively measurable process θ solving the system (10).
Proof. Define φi := ϕi Si (amount of money invested in asset i) leading to the

following version of the wealth equation:
dX(t) = X(t)r(t)dt + φ(t)0 (µ(t) − r(t)1)dt + φ(t)0 σ(t)dW (t).

27 The representation of the diffusion part follows from rewriting Xπ 0 σdW Q in terms of ϕ =
πX/S.
Assume that there exists a self-financing strategy with
φ(t)0 σ(t) = 0 and φ(t)0 (µ(t) − r(t)1) 6= 0.
This strategy would be an arbitrage since it does not involve risk, but its wealth
equation has a drift different from r. Thus in an arbitrage-free market every vector
in the kernel Ker(σ(t)0 ) should be orthogonal to the vector µ(t) − r(t)1. But the
orthogonal complement of Ker(σ(t)0 ) is Range(σ(t)). Hence, µ(t) − r(t)1 should be
in the range of σ(t), i.e. there exists a θ(t) such that
µ(t) − r(t)1 = σ(t)θ(t)
The progressive measurability of θ is proved in Karatzas/Shreve (1999, pp. 12ff).2

Remark. In this theorem, nothing is said about whether the corresponding process
Z is a martingale. Although a market price of risk exists, it is not clear if an EMM
exists.
Theorem 4.24 (Uniqueness of EMM)

Assume that the market is complete and let Q be an EMM such that {X ϕ (t)/M (t)}t∈[0,T ]
is a Q-martingale for all admissible strategies ϕ with E[X ϕ (T )/M (T )] < ∞. If Q̃
is another EMM, then Q = Q̃, i.e. Q is the unique EMM.
Proof. Fix j ∈ {1, . . . , m}. Since the market is complete, there exists an admissible
trading strategy ϕj such that X ϕj (T ) = Yj (T ), where
Z T
Yj (T ) = exp r(s) ds − 0.5T + WjQ (T ) .
0
From Theorem 4.19, we know that the process X ϕj /M is a local martingale under
Q and Q̃. By assumption, X ϕj /M is even a Q-martingale implying
ϕj
ϕj X (T ) Yj (T )
X (t) = M (t)EQ Ft = M (t)EQ Ft = Yj (t) P − a.s.,
M (T ) M (T )
i.e. Yj is a modification of X ϕj . By Proposition 3.2, X ϕj and Yj are indistinguish-
able. Hence, Yj /M is a local martingale under Q and Q̃. By Theorem 4.17, both
measures are characterized by market prices of risk θ and θ̃ such that
dWjQ (t) = dWj (t) + θ(t)dt,

dWjQ̃ (t) = dWj (t) + θ̃(t)dt.
Therefore,
Z t Z t Z t
Yj (t) Yj (s) Yj (s) Yj (s)
=1+ dWjQ (s) = 1 + dWjQ̃ (s) + (θj (s) − θ̃j (s)) ds.
M (t) 0 M (s) 0 M (s) 0 M (s)
Since Yj /M is a Brownian local Q̃-martingale, the process Yj (θj − θ̃j )/M needs to
be indistinguishable from zero.28 Since Yj /M > 0, the market prices of risk θj and
θ̃j are indistinguishable. Since this holds for every j, we get Q = Q̃. 2
Remarks.
28 Recall that the representation of Ito processes is unique up to indistinguishability.
5 CONTINUOUS-TIME PORTFOLIO OPTIMIZATION 68
• Since {X ϕ (t)/M (t)}t∈[0,T ] is a Q-supermartingale, this process is a Q-martingale

if, for instants, ϕ
X (T )
EQ = X ϕ (0).
M (T )
• Obviously it is sufficient to check if {X ϕj (t)/M (t)}t∈[0,T ] is a Q-martingale for
every j = 1, . . . , m.
5 Continuous-time Portfolio Optimization
5.1 Motivation
In the theory of option pricing the following problem is tackled:

Given: Payoff C(T )
Wanted: Today’s price C(0) and hedging strategy ϕ
In the theory of portfolio optimization the converse problem is considered:

Given: Initial wealth X(0)
Wanted: Optimal final wealth X ∗ (T ) and optimal strategy ϕ∗
Question: What is “optimal”?
1st Idea. Maximze expected final wealth, i.e. maxϕ E[X ϕ (T )].
Problem: Petersburg Paradox. Consider a game where a coin is flipped. If in
the n-th round, the first time head occurs, then the player gets 2n−1 Euros, i.e. the
expected value is
∞
1 1 1 1 X 1
· 1 + · 2 + · 4 + . . . + n · 2n−1 + . . . = = ∞.
2 4 8 2 n=0
2
Hence, investors who maximize expected final wealth should be willing to pay ∞
Euros to play this game! Therefore, maximization of expected final wealth is usually
not a reasonable criterion.
Question: What is the reason for this result?
Answer: People are risk averse, i.e. if they can choose between
• 50 Euros or
• 100 Euros with probability 0.5 and 0 Euros with probability 0.5,
they choose the 50 Euros.
Bernoulli’s idea. Measure payoffs in terms of a utility function U (x) = ln(x), i.e.
1 1 1 1
· ln(1) + · ln(2) + · ln(4) + . . . + n · ln(2n−1 ) + . . .
2 4 8 2
∞ ∞
X 1 n−1
X n−1
= n
· ln(2 ) = ln(2) = ln(2).
n=1
2 n=1
2n
Hence, an investor following this criterion would be willing to pay at most 2 Euros
to play this game.
This idea can be generalized: For a given initial wealth x0 > 0, the investor
maximizes the following utility functional
(27) sup E[U (X π (T ))],

π∈A
where A := {π : π admissible and E[U (X π (T ))− ] < ∞} and

h i
dX π (t) = X π (t) (r(t) + π(t)0 (µ(t) − r(t)1))dt + π(t)0 σdW (t) , X π (0) = x0 ,
and the utility function U has the following properties:
Definition 5.1 (Utility Function)

A strictly concave, strictly increasing, and continuously differentiable function U :
(0, ∞) → IR is said to be a utility function if
U 0 (0) := lim U 0 (x) = ∞, U 0 (∞) := lim U 0 (x) = 0.

x&0 x%∞
Remarks.
• The investor’s greed is reflected by U 0 > 0, i.e. loosely speaking: “More is better
than less”.
• The investor’s risk aversion is reflected by the concavity of U which implies
that for any non-constant random variable Z, by Jensen’s inequality,
E[U (Z)] < U (E[Z]).
i.e. loosely speaking: “A bird in the hand is worth two in the bush”.
There exist two approaches to solve the dynamic optimization problem (27):
1. Martingale approach: Theorem 4.5 ensures that in a complete market any
claim can be replicated.
=⇒ Determine the optimal wealth via a static optimization problem and interpret
this wealth as a contingent claim
2. Optimal control approac: We know that expectations can be represented as
solutions to PDEs (Feynman-Kac theorem)
=⇒ Represent the functional (27) as PDE and solve the PDE
Standing Assumption. We consider a Brownian market (6) with bounded coef-

ficients.
5.2 Martingale Approach
Assumption in the Martingale Approach: The market is complete.

The martingale approach consists of a three-step procedure:
1st step. Compute the optimal wealth X ∗ (T ) by solving a static optimization

problem.
2nd step. Prove that the static optimization problem is equivalent to the dynamic
optimization problem (27)
3rd step. Determine the replication strategy for X ∗ (T ) which, in the context of
portfolio optimization, is said to be the optimal portfolio strategy π ∗ .
1st step. Consider the constrained static optimization problem
sup E[U (X )],

X ∈C
subject to the so-called budget constraint (BC)
E[H(T )X ] ≤ x0
and C := {C(T ) ≥ 0 : C(T ) is FT -measurable and E[U (C(T ))− ] < ∞}.
The BC states that the present value of terminal wealth cannot exceed the initial
wealth x0 (see Theorem 4.5 (i)).
Heuristic solution. Pointwise Lagrangian
L(X , λ) := U (X ) + λ(x0 − H(T )X ).
First-order condition (FOC)
U 0 (X ) − λH(T ) = 0,
i.e. X ∗ = V (λH(T )), where V := (U 0 )−1 : (0, ∞) → (0, ∞) is strictly decreasing.

Since the investor is greedy, the BC is satisfied as equality and we can choose λ∗
such that
(28) Γ(λ) := E[H(T )V (λH(T ))] = x0
leading to λ∗ = Λ(x0 ) := Γ−1 (x0 ).
2nd step. Verify that the heuristic solution is indeed the optimal solution.
Lemma 5.1 (Properties of Γ)

Assume Γ(λ) < ∞ for all λ > 0. Then Γ is
(i) strictly decreasing,
(ii) continuous on (0, ∞),
(iii) Γ(0) := limλ&0 Γ(λ) = ∞, and Γ(∞) := limλ%∞ Γ(λ) = 0.
Proof. (i) V is strictly decreasing on (0, ∞). Since H(t) > 0 for every t ∈ [0, T ],
the function Γ is also strictly decreasing.
(ii) follows from the continuity of H and V as well as the dominated convergence
theorem.29
29 To
check continuity at λ0 , choose some λ1 < λ0 . Then due to (i) we can use Γ(λ1 ) < ∞ as a
majorant.
(iii) Since
lim V (y) = ∞, lim V (y) = 0,
y&0 y%∞
and V is strictly decreasing, the first result follows from the monotonous convergence
theorem and the second from the dominated convergence theorem. 2
Remark. Hence, Λ(x) = Γ−1 (x) exists on (0, ∞) with Λ ≥ 0 and
Λ(0) := lim Λ(x) = ∞, Λ(∞) := lim Λ(x) = 0.

x&0 x%∞
Therefore, one can always find a λ such that (28) is satisfied as equality.
Lemma 5.2
For a utility function U with U −1 = V we get
U (V (y)) ≥ U (x) + y(V (y) − x) for 0 < x, y < ∞.
Proof. By concavity of U , Taylor approximation leads to U (x2 ) ≤ U (x1 ) +

U 0 (x1 )(x2 − x1 ) and thus U (x1 ) ≥ U (x2 ) + U 0 (x1 )(x1 − x2 ) implying
U (V (y)) ≥ U (x) + U 0 (V (y))(V (y) − x) = U (x) + y(V (y) − x).
2
Theorem 5.3 (Optimal Final Wealth)
Assume x0 > 0 and Γ(λ) < ∞ for all λ > 0. Then the optimal final wealth reads
X ∗ = V (Λ(x0 ) · H(T ))
∗
and there exists an admissible optimal strategy π ∗ ∈ A such that X π (T ) = x0 and
∗
X π (T ) = X ∗ , P -a.s.
Proof. By definition of Λ(x0 ), we get E[H(T )X ∗ ] = x0 . Besides, X ∗ > 0 because

V > 0. Hence, X ∗ satisfies all constraints and, by Theorem 4.5 (ii), there exists a
strategy π ∗ replicating X ∗ .
We now verify E[U (X ∗ )− ] < ∞, i.e. π ∗ ∈ A. Due to Lemma 5.2,
U (X ∗ ) ≥ U (1) + Λ(x0 )H(T )(X ∗ − 1).
Therefore,30
E[U (X ∗ )− ] ≤ |U (1)|+Λ(x0 ) E[H(T )(X ∗ +1)] ≤ |U (1)|+Λ(x0 ) (x0 +E[H(T )]) < ∞.
Finally, we show that π ∗ and X ∗ are indeed optimal. Consider some π ∈ A. Due
to Lemma 5.2,
U (X ∗ ) ≥ U (X π (T )) + Λ(x0 )H(T )(X ∗ − X π (T ))

30 a ≥ b implies a− ≤ b− ≤ |b|.
and thus
E[U (X ∗ )] ≥ E[U (X π (T ))] + Λ(x0 )E[H(T )(X ∗ − X π (T ))]

= E[U (X π (T ))] + Λ(x0 ) (x0 − E[H(T )(X π (T ))])
| {z }
BC
≥0
which gives the desired result. 2
3rd step. To determine the optimal strategy π ∗ , one can apply a similar method
as in Proposition 4.22 (ii). This is demonstrated in the following example.
Example “Power Utility with Constant Coefficients”.

We make the following assumptions:
• Power utility function U (x) = γ1 xγ
• I = m = 1 (“one stock, one Brownian motion”)
• The coefficients r, µ, σ are constant.
• σ > 0, i.e. the market is complete.
1
Since V (y) = (U 0 )−1 (y) = y γ−1 , the optimal final wealth reads:
1
X ∗ = V (Λ(x0 )H(T )) = (Λ(x0 )H(T )) γ−1 ,
where
1
(29) H(T ) γ−1 = exp 1
1−γ rT
1
+ 0.5 1−γ θ2 T + 1
1−γ θW (T )
and θ = (µ − r)/σ. On the other hand, the final wealth for a strategy π is given by
Z T Z t
(30) X π (T ) = x0 exp rT + (µ − r)πs − 0.5σ 2 πs2 ds + σπs dWs .
0 0
By comparing the diffusion parts of (29) and (30) we guess the optimal strategy:
1 µ−r
π ∗ (t) =
1 − γ σ2
implying
∗

X π (T ) = exp rT + 1 2
1−γ θ T
1
− 0.5 (1−γ) 2
2θ T +
1
1−γ θW (T ) .
1 γ
Since Γ(λ) = E[H(T )V (λH(T ))] = λ γ−1 E[H(T ) γ−1 ] = x0 , we get
1
2 2
Λ(x0 ) γ−1 = Γ−1 (x0 ) = x0 exp − 1−γ
γ γ
rT − 0.5 1−γ γ
θ2 T − 0.5 1−γ θ T .
Therefore,
1
2 2
X ∗ = (Λ(x0 )H(T )) γ−1 = x0 exp rT + 0.5θ2 T − 0.5 γ
1−γ θ T + 1
1−γ θW (T ) .
It is easy to check that

1 1 γ
2
1−γ − 0.5 (1−γ) 2 = 0.5 − 0.5 1−γ .
∗
Hence, X ∗ = X π (T ) and due to completeness π ∗ is the unique optimal portfolio
strategy.
5.3 Stochastic Optimal Control Approach
Assumption. The coefficients r, µ, σ are constant and I = m = 1.

Define the value function
G(t, x) := sup Et,x [U (X π (T ))],

π∈A
where Et,x [U (X π (T ))] := E[U (X π (T ))|X(t) = x]. Note that G(T, x) = U (x).
5.3.1 Heuristic Derivation of the HJB
We start with a heuristic derivation of the so-called Hamiltion-Jacobi-Bellman

equation (HJB) which is a PDE for G.
Assume that there exists an optimal portfolio strategy π ∗ . We now carry out the
following procedure:
(i) For given (t, x) ∈ [0, T ] × (0, ∞), we consider the following strategies over
[t, T ]:
• Strategy I: Use the optimal strategy π ∗ .
• Strategy II: For an arbitrary π use the strategy

 π on [t, t + ∆]

π̂ =
 π ∗ on (t + ∆, T ]

∗
(ii) Compute Et,x [U (X π (T ))] and Et,x [U (X π̂ (T ))].
(iii) Using the fact that π ∗ is at least as good as π̂ and taking the limit ∆ → 0
yields the HJB.
∗
We set X ∗ := X π and X̂ := X π̂ .
ad (ii).
Strategy I. By assumption, Et,x [U (X ∗ (T ))] = G(t, x).
Strategy II.
Et,x [U (X̂(T ))] = Et,x [Et+∆,X̂(t+∆) [U (X̂(T ))]] = Et,x [Et+∆,X̂(t+∆) [U (X ∗ (T ))]]
= Et,x [G(t + ∆, X̂(t + ∆))] = Et,x [G(t + ∆, X π (t + ∆))],
for any admissible π.

ad (iii). By definition of the strategies,
(31) Et,x [G(t + ∆, X π (t + ∆))] ≤ G(t, x),
where we have equality if π = π ∗ . Given that G ∈ C 1,2 , Ito’s formula yields

Z t+∆ Z t+∆
G(t + ∆, X π (t + ∆)) = G(t, x) + Gt (s, Xsπ )ds + Gx (s, Xsπ )dXsπ
t t
Z t+∆
+0.5 Gxx (s, Xsπ )d < X π >s
t
Z t+∆
= G(t, x) + Gt (s, Xsπ ) + Gx (s, Xsπ )Xsπ (r + πs (µ − r))
t

+0.5Gxx (s, Xsπ )(Xsπ )2 πs2 σ 2 ds
Z t+∆
+ Gx (s, Xsπ )Xsπ πs σ dWs
t
R t+∆
Given Et,x [ t Gx (s, Xsπ )Xsπ πs σ dWs ] = 0, we can rewrite (31):
Z t+∆
t,x
E Gt (s, Xsπ ) + Gx (s, Xsπ )Xsπ (r + πs (µ − r))
t

π π 2 2 2
+0.5Gxx (s, Xs )(Xs ) πs σ ds ≤ 0.
Dividing by ∆ and taking the limit ∆ → 0 we get (Note: X π (t) = x)
Gt (t, x) + Gx (t, x)x(r + πt (µ − r)) + 0.5Gxx (t, x)x2 πt2 σ 2 ≤ 0
for any admissible π. As above, we have equality for π = π ∗ . Therefore, we get the
HJB
sup Gt (t, x) + Gx (t, x)x(r + π(µ − r)) + 0.5Gxx (t, x)x2 π 2 σ 2 = 0.

π
with final condition G(T, x) = U (x).

Remarks.
• Since (t, x) was arbitrarily chosen, the HJB holds for all (t, x) ∈ [0, T ] × (0, ∞).
• Note that we take the supremum over a number π and not over a process.
5.3.2 Solving the HJB
We consider the HJB for an investor with power utility U (x) = γ1 xγ :
sup Gt (t, x) + Gx (t, x)x(r + π(µ − r)) + 0.5Gxx (t, x)x2 π 2 σ 2 = 0.

π
with final condition G(T, x) = γ1 xγ . Pointwise maximization over π yields the

following FOC
(32) Gx (t, x)x(µ − r) + Gxx (t, x)x2 π(t)σ 2 = 0
implying
µ − r Gx (t, x)
π ∗ (t) = − .
σ 2 xGxx (t, x)
Since the derivative of (32) w.r.t. π is Gx x(t, x)x2 σ 2 , the candidate π ∗ is the global
maximum if Gxx < 0.
Substituting π ∗ into the HJB yields a PDE for G:
G2x (t, x)
Gt (t, x) + rxGx (t, x) − 0.5θ2 =0
Gxx (t, x)
with G(T, x) = γ1 xγ . We try the separation G(t, x) = γ1 xγ f (t)1−γ for some function
f with f (T ) = 1 and obtain
f 0 = − 1−γ
γ 1
(r + 0.5 1−γ θ2 ) f.
| {z }
=:K
This is an ODE for f with the solution f (t) = exp(−K(T − t)). Hence, we get the
following candidates for the value function and the optimal strategy:
1 γ
(33) G(t, x) = x exp − (1 − γ)K(T − t) ,
γ
1 µ−r
π ∗ (t) = .
1 − γ σ2
Remark. Our candidate G is indeed a C 1,2 -function. Since γ < 1, we also get
Gxx (t, x) = (γ − 1)xγ−1 f (t) < 0.
5.3.3 Verification
In this section, we show that our heuristic derivation of the HJB has lead to the
correct result.
Proposition 5.4 (Verification Result)
Assume that the coefficients are constant and that the investor has a power utility
function. Then candidates (33) are the value function and the optimal strategy of
the portfolio problem (27), where for γ < 0 only bounded admissible strategies are
considered.
Proof. Let π ∈ A. Since G ∈ C 1,2 , Ito’s formula yields

Z T Z T
π π
G(T, X (T )) = G(t, x) + Gt (s, Xs )ds + Gx (s, Xsπ )dXsπ
t t
Z T
+0.5 Gxx (s, Xsπ )d < X π >s
t
Z T
= G(t, x) + Gt (s, Xsπ ) + Gx (s, Xsπ )Xsπ (r + πs (µ − r))
t
Z T
+0.5Gxx (s, Xsπ )(Xsπ )2 πs2 σ 2 ds + Gx (s, Xsπ )Xsπ πs σ dWs
t
(∗)
Z T
≤ G(t, x) + Gx (s, Xsπ )Xsπ πs σ dWs ,
t
where (∗) holds because G satisfies the HJB.

The right-hand side is a local martingale in T . For γ > 0 we have G > 0 and thus
the right-hand side is even a supermartingale implying
(34) Et,x [ γ1 (X π (T ))γ ] ≤ G(t, x),

RT
where we use G(T, x) = 1 γ
γx . Besides, since Et,x [ t Gx (s, Xs∗ )Xs∗ πs∗ σ dWs ] = 0
(exercise) and for π ∗
Gt (s, Xs∗ ) + Gx (s, Xs∗ )Xs∗ (r + πs∗ (µ − r)) + 0.5Gxx (s, Xs∗ )(Xs∗ )2 (πs∗ )2 σ 2 = 0,
we obtain
Et,x [ γ1 (X ∗ (T ))γ ] = G(t, x),
i.e. G is the value function and π ∗ is the optimal solution.

RT
Since for a bounded strategy π we get E[ t Gx (s, Xsπ )Xsπ πs σ dWs ] = 0, the relation
(34) also holds for γ < 0 and bounded admissible strategies. 2
Remarks.
• For γ < 0 the boundedness assumption of π can be weakened.
• Note that we have not explicitly used the fact that the market is complete.
5.4 Intermediate Consumption
So far the investor has maximized expected utility from terminal wealth only. We
now consider a situation where the investor maximizes
• expected utility from terminal wealth as well as
• expected utility from intermediate consumption.
Assumption. At time t, the investor consumes at a rate c(t) ≥ 0, i.e. over the
RT
interval [0, T ] he consumes 0 c(t) dt.
Remark. Hence, in our model consumption can be interpreted as a continuous
stream of dividends (See Exercise 40).
To formalize the problem we need to generalize the concept of admissibility:
Definition 5.2 (Consumption Process, Self-financing, Admissible)

(i) A progressively measurable, real-valued process {ct }t∈[0,T ] with c ≥ 0 and
RT
0
c(t) dt < ∞ P − a.s. is said to be a consumption process.
(ii) Let ϕ be a trading strategy (see Definition 4.1) and c be a consumption process.
If
dX(t) = ϕ(t)0 dS(t) − c(t)dt
holds, then the pair (ϕ, c) is said to be self-financing.

(iii) A self-financing (ϕ, c) is said to be admissible if X(t) ≥ 0 for all t ≥ 0.
Hence, the investor’s goal function reads

hZ T i
(35) sup E U1 (t, c(t)) dt + U2 (X π,c (T )) ,
(π,c)∈A 0
where U1 is a utility function for fixed t ∈ [0, T ],

n hZ T i o
A := (π, c) : (π, c) admissible and E U1 (t, c(t))− dt + U2 (X π,c (T ))− < ∞
0
and
h i
dX π,c (t) = X π,c (t) (r(t) + π(t)0 (µ(t) − r(t)1))dt + π(t)0 σdW (t) − c(t)dt,
X π,c (0) = x0 .
We set V1 := (U10 )−1 and V2 := (U20 )−1 and define

hZ T i
Γ(λ) := E H(t)V1 (t, λH(t)) dt + H(T )V2 (λH(T ))
0
It is straightforward to generalize the result of Section 5.2.
Theorem 5.5 (Optimal Consumption and Optimal Final Wealth)

Assume x0 > 0 and Γ(λ) < ∞ for all λ > 0. Then the optimal consumption and
the optimal final wealth reads
c∗ (t) = V1 (t, Λ(x0 ) · H(t))

∗
X = V2 (Λ(x0 ) · H(T ))
∗
,c∗
and there exists a portfolio strategy π ∗ such that (π ∗ , c∗ ) ∈ A and X π (T ) = x0
∗ ∗
and X π ,c (T ) = X ∗ , P -a.s.
We will present the solution by using the stochastic control approach. The
value function now reads
hZ T i
G(t, x) := sup Et,x U1 (s, c(s)) ds + U2 (X π,c (T )) .
(π,c)∈A t
As in Section 5.3 we make the following

Assumption. The coefficients r, µ, σ are constant and I = m = 1.
Assume that there exists an optimal strategy (π ∗ , c∗ ). We now carry out the pro-
cedure of Section 5.3:
(i) For given (t, x) ∈ [0, T ] × (0, ∞), we consider the following strategies over
[t, T ]:
• Strategy I: Use the optimal strategy (π ∗ , c∗ ).
• Strategy II: For an arbitrary (π, c) use the strategy

 (π, c)

on [t, t + ∆]
(π̂, ĉ) =
 (π ∗ , c∗ ) on (t + ∆, T ]

RT ∗ ∗ RT
(ii) Compute Et,x [ t U1 (s, c∗ (s)) ds + U2 (X π ,c (T ))] and Et,x [ t U1 (s, ĉ(s)) ds +
U2 (X π̂,ĉ (T ))].
(iii) Using the fact that (π ∗ , c∗ ) is at least as good as (π̂, ĉ) and taking the limit
∆ → 0 yields the HJB.
∗
,c∗
We set X ∗ := X π and X̂ := X π̂,ĉ .
ad (ii).
RT
Strategy I. By assumption, Et,x [ t U1 (s, c∗ (s)) ds + U2 (X ∗ (T ))] = G(t, x).
Strategy II.
hZ T i
Et,x U1 (s, ĉ(s)) ds + U2 (X̂(T ))
t
h hZ T ii
= Et,x Et+∆,X̂(t+∆) U1 (s, ĉ(s)) ds + U2 (X̂(T ))
t
hZ t+∆ hZ T ii
= Et,x U1 (s, ĉ(s)) ds + Et+∆,X̂(t+∆) U1 (s, ĉ(s)) ds + U2 (X̂(T ))
t t+∆
hZ t+∆ hZ T ii
= Et,x U1 (s, c(s)) ds + Et+∆,X̂(t+∆) U1 (s, c∗ (s)) ds + U2 (X ∗ (T ))
t t+∆
hZ t+∆ i
= Et,x U1 (s, c(s)) ds + G(t + ∆, X π,c (t + ∆))
t
for any admissible (π, c).

ad (iii). By definition of the strategies,
h Z t+∆ i
(36) Et,x U1 (s, c(s)) ds + G(t + ∆, X π,c (t + ∆)) ≤ G(t, x),
t
where we have equality if (π, c) = (π ∗ , c∗ ). To shorten notations, we set X := X π,c .

Given that G ∈ C 1,2 , Ito’s formula yields
Z t+∆ Z t+∆
G(t + ∆, Xt+∆ ) = G(t, x) + Gt (s, Xs )ds + Gx (s, Xs )dXs
t t
Z t+∆
+0.5 Gxx (s, Xs )d < X >s
t
Z t+∆
= G(t, x) + Gt (s, Xs ) + Gx (s, Xs )Xs (r + πs (µ − r)) − Gx (s, Xs )cs
t

+0.5Gxx (s, Xs )(Xs )2 πs2 σ 2 ds
Z t+∆
+ Gx (s, Xs )Xs πs σ dWs
t
R t+∆
Given Et,x [ t Gx (s, Xs )Xs πs σ dWs ] = 0, we can rewrite (36):
Z t+∆ Z t+∆
t,x
E U1 (s, cs ) ds + Gt (s, Xs ) + Gx (s, Xs )Xs (r + πs (µ − r))
t t

2 2 2
−Gx (s, Xs )cs + 0.5Gxx (s, Xs )(Xs ) πs σ ds ≤ 0.
Dividing by ∆ and taking the limit ∆ → 0 we get (Note: X(t) = x)
U1 (t, ct ) + Gt (t, x) + Gx (t, x)x(r + πt (µ − r)) − Gx (t, x)ct + 0.5Gxx (t, x)x2 πt2 σ 2 ≤ 0
for any admissible (π, c). As above, we have equality for (π, c) = (π ∗ , c∗ ). Therefore,
we get the HJB
n
(37) sup U1 (t, c) + Gt (t, x) + Gx (t, x)x(r + π(µ − r)) − Gx (t, x)c
π,c
o
+0.5Gxx (t, x)x2 π 2 σ 2 = 0
with final condition G(T, x) = U2 (x).

Remarks.
• Since (t, x) was arbitrarily chosen, the HJB holds for all (t, x) ∈ [0, T ] × (0, ∞).
• Note that we take the supremum over a number (π, c) and not over a process.
Example “Power Utility”. We consider the following power utility functions

1
U1 (t, c) = e−αt cγ ,
γ
−αT 1 γ
U2 (x) = e x ,
γ
where α ≥ 0 resembles the investor’s time preferences. The HJB reads
n
sup e−αt γ1 cγ + Gt (t, x) + Gx (t, x)x(r + π(µ − r)) − Gx (t, x)c
π,c
o
+0.5Gxx (t, x)x2 π 2 σ 2 = 0.
with final condition G(T, x) = e−αT γ1 xγ . The FOCs read
Gx (t, x)x(µ − r) + Gxx (t, x)x2 π(t)σ 2 = 0

e−αt cγ−1 − Gx (t, x) = 0
implying
µ − r Gx (t, x)
π ∗ (t) = −
σ 2 xGxx (t, x)
α 1
c∗ (t) = e γ−1 t Gxγ−1 (t, x)
Substituting (π ∗ , c∗ ) into the HJB yields
α
1−γ γ−1
γ
t γ−1 G2x (t, x)
γ e Gx (t, x) + Gt (t, x) + rxGx (t, x) − 0.5θ2 = 0.
Gxx (t, x)
We try the separation G(t, x) = γ1 xγ f β (t) for some function f with f (T ) = 1 and
some constant β. Simplifying yields

α
1−γ − 1−γ t β+γ−1 β 0 1 2
γ e f γ−1 + γ f + r + 0.5 1−γ θ f =0
Choosing β = 1 − γ leads to
α

1−γ − 1−γ t 1−γ 0
γ e + γ f
1
+ r + 0.5 1−γ θ2 f = 0,
which can be rewritten as

f 0 = Kf + g,
α
γ
with K := − 1−γ 1
(r + 0.5 1−γ θ2 ) and g(t) := −e γ−1 t . This is an inhomgeneous ODE
for f . Variations of Constants yields
Z T
g(s)
f (t) = f H (t) f (T ) − H
ds ,
t f (s)
where f H (t) = e−K(T −t) is the solution of the corresponding homogeneous ODE
(see Section 5.3). Hence,
Z T
α
f (t) = e−K(T −t) 1 + e− 1−γ s+K(T −s) ds
|t {z }
≥0
n o
eKT (1−γ) α α
= e −K(T −t)
1− α+K(1−γ) e−( 1−γ +K)T − e−( 1−γ +K)t .
Especially, f > 0. Hence, we get the following candidates for the value function
and the optimal strategy:
1 γ 1−γ
(38) G(t, x) = x f (t),
γ
1 µ−r
π ∗ (t) = ,
1 − γ σ2
X ∗ (t) − 1−γ
α
c∗ (t) = e t
.
f (t)
Remark.
• Our candidate G is indeed a C 1,2 -function. Since γ < 1, we also get Gxx (t, x) =
(γ − 1)xγ−1 f (t) < 0.
• Clearly, it needs to be shown that these candidates are indeed the value function
and the optimal strategy! This can be done analogously to Proposition 5.4. For
the convenience of the reader, the proof of this verification result is also presented.
function. Then the candidates (38) are the value function and the optimal strategy
of the portfolio problem (35), where for γ < 0 only bounded portfolio strategies π
are considered.
Proof. Let (π, c) ∈ A. Since G ∈ C 1,2 , Ito’s formula yields

Z T
G(T, X π,c (T )) + e−αs γ1 cγs ds
t
Z T Z T
= G(t, x) + Gt (s, Xsπ,c )ds + Gx (s, Xsπ,c )dXsπ,c
t t
Z T Z T
1 −αs γ
+0.5 Gxx (s, Xsπ,c )d <X π,c
>s + γe cs ds
t t
Z T
= G(t, x) + Gt (s, Xsπ,c ) + Gx (s, Xsπ,c )Xsπ,c (r + πs (µ − r)) − Gx (s, Xsπ,c )cs
t

+0.5Gxx (s, Xsπ,c )(Xsπ,c )2 πs2 σ 2 + γ1 e−αs cγs ds
Z T
(39) + Gx (s, Xsπ,c )Xsπ,c πs σ dWs
t
RT
It is straightforward to show that Et,x [ t Gx (s, Xs∗ )Xs∗ πs∗ σ dWs ] = 0 (exercise).
Besides, G satisfies the HJB, i.e. for (π, c) = (π ∗ , c∗ )
Gt (s, Xs∗ ) + Gx (s, Xs∗ )Xs∗ (r + πs∗ (µ − r)) − Gx (s, Xs∗ )c∗s
+0.5Gxx (s, Xs∗ )(Xs∗ )2 (πs∗ )2 σ 2 + γ1 e−αs (c∗s )γ = 0,
we obtain
hZ T i
∗
(40) E t,x
[G(T, X (T ))] + E t,x
e−αs γ1 (c∗s )γ ds = G(t, x).
t
implying
hZ T i
E t,x
[e−αT γ1 X ∗ (T )γ ] +E t,x
e−αs γ1 (c∗s )γ ds = G(t, x)
t
because G(T, x) = e−αT γ1 xγ .

Finally, we need to show that for all (π, c) ∈ A
hZ T i
E t,x
[e−αT γ1 X π,c (T )γ ] +E t,x
e−αs γ1 cγs ds ≤ G(t, x).
t
Since G satisfies the HJB, for all (π, c) ∈ A we get
Gt (s, Xsπ,c ) + Gx (s, Xsπ,c )Xsπ,c (r + πs (µ − r)) − Gx (s, Xsπ,c )cs

+0.5Gxx (s, Xsπ,c )(Xsπ,c )2 (πs )2 σ 2 + γ1 e−αs (cs )γ ≤ 0.
Therefore, (39) yields

Z T Z T
(41) G(T, X π,c (T )) + e−αs γ1 cγs ds ≤ G(t, x) + Gx (s, Xsπ,c )Xsπ,c πs σ dWs
t t
and now two cases are distinguished.

1st case: γ > 0. The right-hand side of (41) is a local martingale in T . Since
for γ > 0 the left-hand side is greater than zero, this is even a supermartingale
implying
hZ T i
(42) t,x π,c
E [G(T, X (T ))] + E t,x
e−αs γ1 cγs ds ≤ G(t, x)
t
and thus
hZ T i
Et,x [e−αT γ1 X π,c (T )γ ] + Et,x e−αs γ1 cγs ds ≤ G(t, x).
t
2nd case: γ < 0. Since for a bounded strategy π we obtain

Z T
E[ Gx (s, Xsπ )Xsπ πs σ dWs ] = 0,
t
the result of the 1st case also holds for γ < 0 and bounded admissible strategies. 2
Remark. If we set c ≡ 0, the previous proof is identical to the proof of Proposition
5.4.
5.5 Infinite Horizon
If the optimal portfolio decision over the life-time of an investor is to be deter-

mined, then the investment horizon lies very far into the future. For this reason, it
reasonable to approximate this situation by a portfolio problem with T = ∞.
Hence, the investor’s goal function reads

hZ ∞ i
(43) sup E U1 (t, c(t)) dt ,
(π,c)∈A 0
where
n hZ ∞ i o
A := (π, c) : (π, c) admissible and E U1 (t, c(t))− dt < ∞
0
and
h i
dX π,c (t) = X π,c (t) (r(t) + π(t)0 (µ(t) − r(t)1))dt + π(t)0 σdW (t) − c(t)dt,
X π,c (0) = x0 .
As in the previous section we make the following

Assumption 1. The coefficients r, µ, σ are constant and I = m = 1.
Additionally, we make the
Assumption 2. U1 (t, c(t)) = e−αt U (c(t)), where α ≥ 0 and U is a utility function.
The value function is given by

hZ ∞ i
G(t, x) := sup E t,x
e−αs U (c(s)) ds .
(π,c)∈A t
Lemma 5.7
The value function has the representation
G(t, x) = e−αt H(x),
where H is a function depending on wealth only.
Proof. We obtain
hZ ∞ i
αt
G(t, x)e = sup E t,x
e−α(s−t) U (c(s)) ds
(π,c)∈A t
hZ ∞ i
= sup E0,x e−αs U (c(s)) ds =: H(x)
(π,c)∈A 0
Hence, the HJB (37) can be rewritten as follows:

n
sup e−αt U (c) + Gt (t, x) + Gx (t, x)x(r + π(µ − r)) − Gx (t, x)c
π,c
o
+0.5Gxx (t, x)x2 π 2 σ 2 =
n o
sup U (c) − αH(x) + Hx (x)x(r + π(µ − r)) − Hx (x)c + 0.5Hxx (x)x2 π 2 σ 2 = 0
π,c
Example “Power Utility”. Let U (c) = γ1 cγ . Then the FOCs read
Hx (x)x(µ − r) + Hxx (x)x2 π(t)σ 2 = 0

cγ−1 − Hx (x) = 0
implying
µ − r Hx (x)
π ∗ (t) = −
σ 2 xHxx (x)
1
c∗ (t) = Hxγ−1 (x).
Substituting (π ∗ , c∗ ) into the HJB leads to
1−γ
γ
Hx2 (x)
γ−1
γ Hx (x) − αH(x) + rxHx (x) − 0.5θ2 = 0.
Hxx (x)
We try the ansatz H(x) = γ1 xγ k β for some constants k and β. Simplifying yields
β
1−γ γ−1
γ k − α
γ
1
+ r + 0.5 1−γ θ2 = 0
Choosing β = γ − 1 leads to

γ
k= 1−γ
α
γ
1
− r − 0.5 1−γ θ2 .
Our ansatz is only reasonable if k ≥ 0. For γ < 0 this is valid in any case. For
γ > 0 we need to assume that
(44) 1
α ≥ γ(r + 0.5 1−γ θ2 ).
Hence, we get the following candidates for the value function and the optimal strat-
egy:
1 −αt γ γ−1
(45) G(t, x) = e x k ,
γ
1 µ−r
π ∗ (t) = ,
1 − γ σ2
c∗ (t) = k X ∗ (t).
Remark. In contrast to the previous section, the investor now consumes a time-
independent constant fraction of wealth.

function where for γ < 0 only bounded portfolio strategies π are considered. If (44)
holds as strict inequality, i.e.
(46) 1
α > γ(r + 0.5 1−γ θ2 ),
then the candidates (45) are the value function and the optimal strategy of the
portfolio problem (43).
Proof. Let (π, c) ∈ A. Analogously to the proof of Proposition 5.6, we get the
relations (42) and (40) for the candidate G for the value function of this subsection
given by (45)
hZ T i
Et,x [G(T, X π,c (T ))] + Et,x e−αs γ1 cγs ds ≤ G(t, x)
t
hZ T i
Et,x [G(T, X ∗ (T ))] + Et,x e−αs γ1 (c∗s )γ ds = G(t, x).
t
Firstly note that, by the monotonous convergence theorem,31 for any consumption
process c
hZ T i hZ ∞ i
−αs γ
(47) lim E t,x
e cs ds = E t,x
e−αs cγs ds .
T →∞ t t
∗ 1 −αT
Secondly, since G(T, X (T )) = γe X ∗ (T )γ k γ−1 , we get
Et,x [G(T, X ∗ (T ))] = 1 γ−1 −αT t,x

γk e E [X ∗ (T )γ ]
γ
1
θ 2 −0.5 1
θ 2 −k}T + 1−γ
h i
1 γ−1 −αT γ t,x γ{r+ 1−γ θW (T −t)
= (1−γ)2
γk e x E e
2 2 γ 2 2
1 1
1 γ−1 γ −αT +γ{r+ 1−γ θ −0.5 (1−γ)2 θ −k+0.5 (1−γ)2 θ }T
= γk x e
1 γ−1 γ −kT
(48) = γk x e −→ 0 as T → ∞,
since (46) ensures that k > 0. Therefore,

hZ ∞ i
E t,x
e−αs γ1 (c∗s )γ ds = G(t, x).
t
To prove
hZ ∞ i
(49) E t,x
t
two cases are distinguished.
1st case: γ > 0. Since in this case G(T, X π,c (T )) ≥ 0, the relation (49) follows
immediately from (42).
2nd case: γ < 0. Since in this case G < 0, the proof is more involved. From (42)
it follows that
n o hZ T i
t,x π,c
sup E [G(T, X (T ))] + E t,x
π,c t
and we obtain the following estimate

n o n h io
0 ≥ sup Et,x [G(T, X π,c (T ))] = sup Et,x γ1 e−αT X π,c (T )γ k γ−1
π,c π,c
(∗) n h Z T io
t,x 1 −αT
≥ sup E γ e
π,c
X (T ) + γ
e−αs γ1 cγs ds k γ−1
π,c t
n h io n h io
t,x 1 −αT
≥ sup E γ e X π,0
(T )γ
k γ−1
= sup E t,x 1
γ X π,0
(T )γ
e−αT k γ−1
π π
(+) 1 2
1 γ γ(r+0.5 1−γ θ )(T −t) −αT γ−1 (46)
= γx e e k −→ 0 as T → ∞,
RT
where (∗) is valid because t
e−αs γ1 cγs ds ≤ 0 and (+) follows from Proposition 5.4.
This establishes (49). 2
Remarks.
• The relation
lim Et,x [G(T, X π,c (T ))] = 0
T →∞
is the so-called transversality condition.

31 We
emphasize that 1/γ is deliberately omitted because without this factor the argument of
the expected value is positive.
• For γ > 0 the property (48) can be proved by using a different argument:
0 ≤ Et,x [G(T, X ∗ (T ))] = Et,x [ γ1 X ∗ (T )γ ] e−αT k γ−1

∗
≤ Et,x [ γ1 X π ,0
(T )γ ] e−αT k γ−1
≤ sup Et,x [ γ1 X π,0 (T )γ ] e−αT k γ−1
π
(+) 1 2
1 γ γ(r+0.5 1−γ θ )(T −t) −αT γ−1 (46)
= γx e e k −→ 0 as T → ∞
where (+) follows from Proposition 5.4. Applying this argument one can avoid
some tedious calculations.
• As in Proposition 5.4, the boundedness assumption for γ < 0 can be weakened.
References
Bingham, N. H. ; R. Kiesel (2004): Risk-neutral valuation, 2nd ed., Springer, Hei-

delberg.
Björk, T. (2004): Arbitrage theory in continuous time, 2nd ed., Oxford University
Press, Oxford.
Dax, A. (1997): An elementary proof of Farkas’ lemma, SIAM Review 39, 503-507.
Duffie, D. (2001): Dynamic asset pricing theory, 3rd ed., Princeton University Press,
Princeton.
Karatzas, I.; S. E. Shreve (1991): Brownian motion and stochastic calculus, 2nd ed.,
Springer, New York.
Karatzas, I.; S. E. Shreve (1999): Methods of mathematical finance, Springer, New

York.
Korn, R. (1997): Optimal portfolios, World Scientific, Singapore.
Korn, R.; E. Korn (1999): Optionsbewertung und Portfolio-Optimierung, Vieweg,

Braunschweig/Wiesbaden.
Korn, R.; E. Korn (2001): Option pricing and portfolio optimization - Modern meth-
ods of financial mathematics, AMS, Providence, Rhode Island.
Mangasarian, O. L. (1969): Nonlinear programming, New York.
Merton, R. C. (1990): Continuous-time finance, Basil Blackwell, Cambridge MA.
Protter, P. (2005): Stochastic integration and differential equations, 2nd ed., Springer,
New York.
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Lecture Notes

Mathematical Finance Group

Summer Term 2005

This Version: August 4, 2005

2 Discrete-time State Pricing with Finite State Space 6

3 Introduction to Stochastic Calculus 23

4 Continuous-time Market Model and Option Pricing 47

4.1 Description of the Model . . . . . . . . . . . . . . . . . . . . . . . . . 47

5 Continuous-time Portfolio Optimization 68

1.1 What is an Option?

• There exist two main variants: call and put.

• Put: replace “buy” with “sell”

1.2 Fundamental Relations

Consider an option written on an underlying which pays no dividends etc. during

Proposition 1.1 (Bounds)

Proposition 1.2 (Put-Call Parity)

Proof. Consider the strategy

Proposition 1.3 (American Call)

Proof. The following relations hold

Proposition 1.4 (American Put)

0 + (S(t) − K) − S(t) + KM (t) = K(M (t) − 1) ≥ 0

since interest rates are positive and thus M (t) ≥ 1.

−(K − S(t)) + 0 − S(t) + KM (t) = K(M (t) − 1) ≥ 0.

Hence, the strategy would be an arbitrage opportunity.

P ut(t) ≤ P utam (t) ≤ Callam (t) − S(t) + K = Call(t) − S(t) + K

2 Discrete-time State Pricing with Finite State

2.1 Single-period Model

2.1.1 Description of the Model

• We consider a single-period model starting today (t = 0) and ending at time

• Uncertainty at time t = 1 is represented by a finite set Ω = {ω1 , . . . , ωI } of

• At time t = 0 one can trade in J + 1 assets. The time-0 prices of these

• To shorten notations, Xij := Xj (ωi ).

• Therefore, at time t = 0 there exists a riskless interest rate given by

Definition 2.1 (Arbitrage)

S0ϕ < 0 and Xϕ ≥ 0.

(ii) A free lottery is a trading strategy ϕ with

S0ϕ = 0 and Xϕ ≥ 0 and Xϕ 6= 0.

(d) Frictionless markets, i.e.

2.1.2 Arrow-Debreu Securities

To characterize arbitrage-free markets, the notion of an Arrow-Debreu security is

Definition 2.2 (Arrow-Debreu Security)

Theorem 2.1 (Characterization of No Arbitrage)

• There exist strictly positive Arrow-Debreu prices, i.e. πi > 0, i = 1, . . . , I, such

Proof. Suppose (ii) to hold. We consider a strategy ϕ with Xϕ ≥ 0 and Xϕ 6= 0.

Definition 2.3 (Contingent Claim)

Definition 2.4 (Replication)

Remark. If an asset with payoff C is replicable via a trading strategy ϕ, by the

Definition 2.5 (Completeness)

Theorem 2.2 (Characterization of a Complete Market)

Main result from the previous subsection: In an arbitrage-free market, there

In this subsection: Using the physical probabilities P (ωi ), i = 1, . . . , I, arbitrage-

Definition 2.6 (Deflator)

Proposition 2.3 (Pricing with a Deflator)

where u = u(c0 , c1 ) is the utility function of the representative investor.

• Setting u00 := ∂u/∂c0 and u01 := ∂u/∂c1 leads to

which gives the following result:

(i) u00 > E(u01 ) (”‘time preference”’):3 r > 0,

2.1.4 Risk-neutral Measure

Two important observations:

(ii) In an arbitrage-free market, it holds that πi > 0, i = 1, . . . , I.

Proposition 2.4 (Risk-neutral Measure)

This measure is said to be the risk-neutral measure or equivalent martingale mea-

Proof. follows from (i) and (ii). 2