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Introduction to

I.
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Stochastic Calculus Applied to Finance
Damien Loolberton
L'Universite ff!:farne France la Vallee

and
Bernard Lapeyre
L'Ecole Nationale des Ponts et Chaussees France

Translated by Nicolas Rabeau
Centre for Quantitative Finance Imperial College, London . and Merrill Lynch Int. Ltd., London and '

Francois Mantion
Centrefor Quantitative Finance Imperial College London

CHAPMAN & HALUCRC
Boca Raton London New York Washington, D.C.

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Library

of Congress Cataloging-in-Publication

Data Introduction Options Arbitrage and put/call parity Black-Scholes model and its extensions Contents of the book Acknowledgements 1 Discrete-time models 1.1 Discrete-time formalism 1.2 Martingales and arbitrage opportunities 1.3 Complete markets and option pricing 1.4 Problem: Cox, Ross and Rubinstein model Optimal stopping problem and American options 2.1 Stopping time 2.2 The Snell envelope 2.3 Decomposition of supennartingales 2.4 Snell envelope and Markov chains 2.5 Application io American options 2.6 Exercises Brownian motion and stochastic differential equations 3.1 General comments on continuous-time processes 3.2 Brownian motion 3.3 Continuous-time martingales 3.4 Stochastic integral and Ito calculus 3.5 Stochastic differential equations 3.6 Exercises vii
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Catalog record is available from the Library of Congress

This book contains information obtained from authentic and highly regarded sources. Reprinted material is quoted with permission, and sources are indicated. A wide variety of references are listed. Reasonable efforts have been made to publish reliable data and information, but the author and the publisher cannot assume responsibility for the validity of all materials or for the consequences of their use. Apart from any fair dealing for the purpose of research or private study, or criticism or review, as permitted under the UK Copyright Designs and Patents Act, 1988, this publication may not be reproduced, stored or transmitted, in any form or by any means, electronic or mechanical, including photocopying, microfilming, and recording, or by any information storage or retrieval system, without the prior permission in writing of the publishers, or in the case of reprographic reproduction only in accordance with the terms of the licenses issued by the Copyright Licensing Agency in the UK, or in accordance with the terms of the license issued by the appropriate Reproduction Rights Organization outside the UK. The consent of CRC Press LLC does not extend to copying for general distribution, for promotion, for creating new works, or for resale. Specific permission must be obtained in writing from CRC Press LLC for such copying. Direct all inquiries to CRC Press LLC, 2000 N.W. Corporate Blvd., Boca Raton, Florida 33431. Trademark Notice: Product or corporate names may be trademarks or registered trademarks, used only for identification and explanation, without intent to infringe. and are

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Visit the CRC Press Web site at www.crcpress.com
First edition 1996 First CRC reprint 2000 © 1996 by Chapman & Hall No claim to original U.S. Government works International Standard Book Number 0-412-71800-6 Printed in the United States of America 234567890 Printed on acid-free paper

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Black-Scholes and Merton results have developed to become clearer.2 Conditional expectation A. Representation of martingales Pricing and hedging options in the Black-Scholes model American options in the Black-Scholes model Exercises Contents 63 63 Introduction 65 67 72 77 5 Option pricing and partial differential equations 5. in order to describe the behaviour of markets or to derive computing methods.3 Pricing and hedging options 7.5 Black-Scholes model Description of the model Change of probability.1 4.2 4.1 Simulation and financial models 8.3 Exercises 95 95 103 110 118 6 121 121 127 136 The objective of this book is to give an introduction to the probabilistic techniques required to understand the most widely used financial models.2 Solving parabolic equations numerically 5. the appearance of probability theory in financial modelling is not recent. a bond. in trying to build up a "Theory of Speculation' . by a certain date. financial quantitative analysts have used more sophisticated mathematical concepts. From 1973. the publications by Black and Scholes (1973) and Merton (1973) on option pricing and hedging gave a new dimension to the use of probability theory in finance.1 Normal random variables A.3 American options 5. for a certain strike price.2 Some useful algorithms 8. 168 170 Appendix A. more general and mathematically more rigorous.3 4.4 Exercises Simulation and algorithms for financial models 8. • the underlying asset: typically.3 Exercises Asset models with jumps 7.2 Some classical models 6.1 European option pricing and diffusions 5. it can be a stock. discovered what is now called Brownian motion.1 Modelling principles 6.4 4.2 Dynamics of the risky asset 7. a currency and so on. to buy or sell a certain amount of a financial asset. 174 178 179 183 .4 Exercises Interest rate models 6. The theory seems to be advanced enough to attempt to make it accessible to students. Options Our presentation concentrates on options.1 Poisson process 7. In fact. An option gives its holder the right. Bachelier (1900).3 Separation of convex sets References Index 173' 173. The writer of the option needs to specify: • the type of option: the option to buy is called a call while the option to sell is a put. Since then. such as martingales or stochastic integration. I~ the last few years.vi 4 The 4. 7 141 141 143 150 159 8 161 161 . as the option markets have evolved. but not the obligation. because they have been the main motivation in the construction of the theory and still are the most spectacular example of the relevance of applying stochastic calculus to finance. At the beginning of this century.

viii • the amount of an underlying asset to be purchased or sold;

Introduction

Introduction put/call parity is true for all t

ix

<T

• the expiration date: if the option can be exercised at any time before maturity, it is called an American option but, if it can only be exercised at maturity, it is called a European option; • the exercise price which is the price at which the transaction is done if the option is exercised. The price of the option is the premium. When the option is traded on an organised market, the premium is quoted by the market. Otherwise, the problem is to price the option. Also, even if the option is traded on an-organised market, it can be interesting to detect some possible abnormalities in the market. Let us examine the case of a European call option on a stock, whose price at time t is denoted by St. Let us call T the expiration date and K the exercise price. Obviously, if K is greater than ST, the holder of the option has no interest whatsoever in exercising the option. But, if ST > K, the holder makes a profit of ST _ K by exercising the option, i.e. buying the stock for K and selling it back on the market at ST. Therefore, the value of the call at maturity is given by (ST _ K)+

Ct _ Pt

= St

_ K e-r(T-t).

To understand the notion of arbitrage, let us show how we could make a riskless profit if, for instance,

c, .; Pt > S, _ K e-r(T-t).
At time t, we purchase a share of stock and a put, and sell a call. The net value of the operation is

Ct _

Pt _

St.

If this amount is positive, we invest it at rate r until time T, whereas if it is negative we borrow it at the same rate. At time T, two outcomes are possible: • ST > K: the call is exercised, we deliver the stock, receive 'the amount K and clear the cash account to end up with a wealth K + er(T -t) (Ct _ P, _ St) .> O. • ST ::; K: we exercise the put and clear our bank account as before to finish with the wealth K + er(T-t)(ct _ Pt _ St) > O. In both cases, we locked in a positive profit without making any initial endowment: this is an example of an arbitrage strategy. There are many similar examples in the book by Cox and Rubinstein (1985). We will not review all these formulae, but we shall characterise mathematically the notion of a financial market without arbitrage opportunity.

= max (ST

_ K,O).

If the option is exercised, the writer must be able to deliver a stock at price K. It means that he or she must generate an amount (ST _ K)+ at maturity. At the time of writing the option, which will be considered as the origin of time, Sr is unknown and therefore two questions have to be asked: . 1. How much should the buyer pay for the option? In other words, how should we price at time t 0 an asset worth (ST _ K)+ at time T? That is the problem, of pricing the option.

=

2. How should the writer, who earns the premium initially, generate an amount (ST - K)+ at time T? That is the problem of hedging the option. Arbitrage and put/call parity We can only answer the two previous questions if we make a few necessary assumptions. The basic one, which is commonly accepted in every model, is the absence of arbitrage opportunity in liquid financial markets, i.e. there is no riskless profit available in the market. We will translate that into mathematica1.terms in the first chapter. At this point, we will only show how we can derive formulae relating European put and call prices. Both the put and the call which have maturity T and exercise price K are contingent on the same underlying asset which is worth St at time t. We shall assume that it is possible to borrow or invest money at a constant rate r. Let us denote by Ct and P; respectively the prices of the call and the put at time t. Because of the absence of arbitrage opportunity, the following equation called

Black-Scholes

model and its extensions

Even though no-arbitrage arguments lead to many interesting equations, they are not sufficient in themselves for deriving pricing formulae. To achieve this, we need to model stock prices more precisely. Black and Scholes were the first to suggest a model whereby we can derive an explicit price for a European call on a' stock that pays no dividend. According to their model, the writer of the option can hedge himself perfectly, and actually the call premium is the amount of money needed at time 0 to replicate exactly the payoff (ST _ K)+ by following their dynamic hedging strategy until maturity. Moreover, the formula depends on only one non-directly observable parameter, the so-called volatility. It is by expressing the profit and loss resulting from a certain trading strategy as a stochastic integral that we can use stochastic calculus and, particularly, Ito formula, to obtain closed form results. In the last few years, many extensions of the Black-Scholes methods have been considered. From a thorough study of the Black-Scholesmodel, we will attempt to give to the reader the means to understand those extensions. r

x

Introduction

Introduction

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Contents of the book The first two chapters are devoted to the study of discrete time models. The link between the mathematical concept of martingale and the economic notion of arbitrage is brought to light. Also, the definition of complete markets and the pricing of options in these markets are given. We have decided to adopt the formalism of Harrison and Pliska (1981) and most of their results are stated in the first chapter, taking the Cox, Ross and Rubinstein model as an example. The second chapter deals with American options. Thanks to the theory of. optimal stopping in a discrete time set-up, which uses quite elementary methods, we introduce the reader to all the ideas that will be developed in continuous time in subsequent chapters. Chapter 3 is an introduction to the main results in stochastic calculus that we will use in Chapter 4 to study the Black-Scholes model. As far as European options are concerned, this model leads to explicit formulae. But, in order to analyse American options or to perform computations within more sophisticated models, we need numerical methods based on the connection between option pricing and partial differential equations. These questions are addressed in Chapter 5. Chapter 6 is a relatively quick introduction to the main interest rate models and Chapter 7 looks at the problems of option pricing and hedging when the price of the underlying asset follows a simple jump process. In these latter cases: perfect hedging is no longer possible and we must define a criterion to achieve optimal hedging. These models are rather less optimistic than the Black-Scholes model and seem to tie closer to reality. However, their mathematical treatment is still a matter of research, in the framework of so-called incomplete markets. Finally, in order to help the student to gain a practical understanding, we have included a chapter dealing with the simulation of financial models and the use of computers in the pricing and hedging of options. Also, a few exercises and longer questions are listed at the end of each chapter. This book is only an introduction ,to a field that has already benefited from considerable research. Bibliographical notes are given in some chapters to help the reader to find complementary information. We would also like to warn the reader that some important questions in financial mathematics are not tackled. Amongst them are the problems of optimisation and the questions of equilibrium for which the reader might like to consult the book by D. Duffie (1988).· A good level in probability theory is assumed to read this book: The reader is referred to Dudley (1989) and Williams (1991) for prerequisites. Ho~ever, some basic results are also proved in the Appendix. Acknowledgements This book is based on the lecture notes taught at l'Ecole Nationale des Ponts et Chaussees since 1988. The-organisation of this lecture series would not have

been possible without the encouragement ofN. Bouleau. Thanks to his dynamism, CERMA (Applied Mathematics.Institute of ENPC) started working on financial modelling as early as 1987, sponsored by Banque Indosuez and subsequently by Banque Intemationale de Placement. Since then, we have benefited from many stimulating discussions with G. Pages and other academics at CERMA, particularly O. Chateau and G. Caplain. A few people kindly ~ead the earlier draft of our book and helped us with their remarks. Amongst them are S. Cohen, O. Faure, C. Philoche, M. Picque and X. Zhang. Finally, we thank our colleagues at the university and at INRIA for their advice and their motivating comments: N. EI Karoui, T. Jeulin, J.F. Le Gall and D. Talay.

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1

Discrete-time models

The objective of this chapter is to present the main ideas related to option theory within the very simple mathematical framework of discrete-time models. Essentially, we are exposing the first part of the paper by Harrison and Pliska (1981). Cox, Ross and Rubinstein's model is detailed at the end of the chapter in the form of a problem with its solution. 1.1 Discrete-time formalism

1.1.1 Assets
A discrete-time financial model is built on a finite probability space (n, F, P) equipped with a filtration, i.e. an increasing sequence of o-algebras included in F: Fo, F1, •.. , F N. F n can be seen as the information available at time nand is sometimes called the a-algebra of events up to time n. The horizon N will often correspond to the maturity of the options. From now on, we will assume that Fo = {0,n}, FN = F = P(D) and Vw E n, P ({w}) > o. The market consists in (d + 1) financi~l assets, whose prices at time n are given by the non- negative random variables S~, S~, ... , S~, measurable with respect to _:[n (investors know past arid present prices but 'obviously not the future ones). vector Sn = (S~, S~, ... , S~) is the vector of prices at time n. The asset indexed by 0 is the riskless asset and we have sg = 1. If the return of the riskless asset over one period is constant and equal to r, we will obtain S~ ~ (1 + rt.'The coefficient f3n 1/ S~ is interpreted as the discount factor (from time n to time 0): if an amount_,§n is invested.inthe riskless a~et at time 0, then one dollar will be available at tim~ n. The assets indexed by i 1 ... d are called risky assets.

nie

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1.1.2 Strategies Atrading strategy is defined as a stochastic Rrocess (i.e. a_se_q~e in the discrete Old)) . i c!!.~e)rP = .(:('rPn, r/!_n,···, r/!_n O'5,n'5,N In lR. d+l where rPn denotes the number of

Vn(¢» Sn) = ¢>n+1.Sn is the net gain caused by the price changes between times nand n + I-:--Hei1ce. . .I. the investor readjusts his positions from ¢>n to ¢>n+1 without bringing Q! consuming any wealth. . the portfolio is worth ¢>n+l. The equivalence between (i) and (iii) follows from the fact that ¢>n.1. 0 «s. ¢>d) is self-financing is Vo. . there exists a unique predictable pr~ce~s (¢>~)O<n'<N such that the strategy ¢J =' (¢>o.¢>n. Remark 1.¢>1.Sn+l a~d . ~ (iii) For any n E {I. are equivalent 1. (ii): Foranyn E {I.. Vo + ¢>~S~ ~ ~~. Proposition 1.. Vn(~) = ». .1. hence its value. ¢>~))O<n<N and for and its initial value- Proposition 1.SJ with'{Jn = 1/ S~ and = (1. (JnS.Sj-l = {JjSj .I. we can prove the following proposition. once the new prices S~~. Proof..Sn if and only if = ¢>n+l. .2 The following (i)' The strategy ¢>is self-financing..(Sn+1'or to Vn+1(¢» . Definition 1.4 A'~trategy ¢>is admissible foranyn E {O. + ¢>jt::..3 Admissible strategies and arbitrage We did not make any assumption on the sign of the quantities ¢>~..are decided with respect to the information available at time (n -1) and kept until time n when new quotations are available. .N (this is only justified because t::. A strategy is called self-financing if the following equation is satisfied for all nE {O.Sj is the vector Sj . (JnS~) is the v~tor of disc0l!... .Sn.. ..Sn = ¢>n+1.....¢>~.:.Sj.nted prices.. s: Vn(¢» = {In (¢>n. Short-selling and borrowing is allowed but the value of our portfolio must be' positive at all times. The interpretation is the following: at time ~. Proof. ¢>bis Fo-measurable ViE{O..=0 Its discounted value is This proposition shows that.We just have to check that ¢>ois predictable.N}. More precisely. n «: o /1' .' ....e. If ¢>~< for i ~ 1.N}. process (( ¢>~.N-I} ¢>n.".1.If ¢>~-: 0. i.s: = L¢>~S~.. . are quoted.Sn = ¢>n+l. The following proposition makes this clear in tenns of discounted prices.n:::.. The equivalence between (i) and (ii) results from Remark 1. . the discounted value of his portfolio. ¢>~) . ° j=1 where 6.I. ..Sj is the vector Sj ."lhe profit or loss realised by following a self-financing strategy is only due to the price moves.Sj + ..Sn = ¢>n+1'S..1..Sn+1 .....2 Discrete-time models Discrete-time formalism 3 shares of asset i held in the portfolio at time n. -1 d -d) ITw~" Ifeequation ~ which defines ¢>~.1 The equality ¢>n. if an investor follows a self-financing strategy. . is completely defined by the ~itial wealth and the strategy (¢>~.3 For any predictable any Fo-measurable variable Vo.. .Sj . +~ Z:: j=1 (1¢>jt::.Sn+1 . This assumption means that the positions in the portfolio at time n (¢>~.. if it is self-financing and !jVn( ¢» ~ ° .. ¢>is predictable.Sj-l. Vn(¢» = Vo(¢» + L¢>j' j=1 n t::. we have borrowed the amount I¢>~Iin the riskless asset. but this is obvious = ¢>n+dSn+l -Sn).1. ¢>~) O:::. . The self-financing condition implies Vn (¢» ¢>~+ ¢>~S~ + .d} { and. .1..1. At time n +'1.¢>n+1. .{Jj-1Sj-l. we say that we are short a number ¢>~of asset i.Sn is obviously equivalent to ¢>n+1. N}. ...Sn) = «:s: = 0).Sn. The value of the portfolio at time n is the scalar product d where t::. for n ~ 1: ¢>~is Fn_1-measurable..

P ({w}) > 0..N defined by -Xo Xn HoMo = HoMo + H16M1 + . Obviously. we consider a finite probability space (D. o The following proposition is a very useful characterisation of martingales. That shows that (Xn) is a martingale. thus for any n: E (Mn) = E (M~). These definitions can be extended to the multidimensional case: for instance. 1. = Mnfor all n ifE (Mn+1IFn) ~ Mnforalln:S N-1. saying that the price (S~)O:Sn:SN of the asset i is a martingale implies that. + Hn6. Definition 1. 4. vi ~ 0 for n ~ 1.3 Let (Mn)05.2 An adapted sequence (Hn)05. u.N' (Xn) is sometimes called the martingale transform of (Mn) by (Hn).Mn)IFn) = = 'I i r In this section.XnlFn) . F.1 An adapted sequence (Mn)O:sn:SN of real random variables is: o o o Hn+1E (Mn+1 O.2. o .N of random variables is predictable if. The notion of arbitrage (possibility of riskless profit) can be formalised as follows: Definition 1. .Mn) = 0 becomes 2.2.2. - MnlFn) since Hn+1 is Fn-measurable . X!.Mn = Mn .2. ) = O.'. The following properties are easily derived from the previous definition and stand as a good exercise to get used to the concept of conditional expectation. E(XN) = E(Xo) O. = E (XnIFn) = Xn. equipped with a filtration (Fnh~n:SN (without necessarily assuming that FN = F. A consequence of this proposition and Proposition 1. Proposition 1.N be a martingale and (Hn)O<n<N a predictable sequence with respect to the filtration (Fn)O<n<N' Den-ote 6.N of JRd-valued random variables is a martingale if each . the expected value of the wealth generated by following a self-financing strategy is equal to the initial wealth. The conditional expectation plays a central role in this definition and the reader can refer to the Appendix for a quick review of its properties.1 Martingales and martingale transforms Definition 1. is Fn~l measurable.Mj)) ~O. a sequence (Mn)O~n5. 1. at each time n.Mn for any predictable process (Hn) is also a martingale.2.N is a martingale if and only if E Proof. by Proposition 1. E(iA (Mj+1 .4 Discrete-time models Martingales and arbitrage opportunities 5 The investor must be able to pay back his debts (in riskless or risky asset) at any time . the best estimate (in the least-square sense) of S~+l is given by S~.3.n5. Most models exclude any arbitrage opportunity and the objective of the next section is to characterise these models with the notion of martingale. Moreover. Clearly.a real-valued. we notice that if j E {1. nor Fo = {0..2. a supermartingale ifE (Mn+1IFn) :S Mnfor all 'Ii :S N . for any Fj-measurable A.. (t. E (Mn+jIFn) == u. Conversely.2 Martingales and arbitrage opportunities In order to analyse the connections between martingales and arbitrage. Clearly. . (Hn) = the sequence (~n) = 0 ~~d. 1.n5. defined by Xo If (Mn) is a ~artingale.5 An arbitrage strategy is an admissible strategy with zero initial value and non-zero final value.Mn-1.1. we can associate the sequence (Hn) defined by Hn= 0 for n 1= j + 1 and Hj+1 lA. we have . for all n ~ 1.n5.1. for n > 0 E (Xn+1 . E (Hn+1Uvfn+1 .1.4 An ~dapted sequen~e of real random variables (M ~) i~ a ~artingale if and only iffor any predictable sequence (Hn). (Mn)O:sn5. n.. 6. = n.n5. P). D}).martingale..component is. If (Mnk:~o is a martingale. similar properties can be shown for supermartingales and submartingales. A sequence -(Xn)O:Sn:SN of random variables is adapted to the filtration ~ffor any n. (Xn) is an adapted sequence. The sequence (Xn)o5.. In a financial context.1. . N}. with F = P(D) and Vw E D. is Fn -measurable.' Hence 'A E (Xn+1IFn) a martingale ifE (Mn+lIFn) asubmartingale :S N . Hence. Proposition 1. 3. The sum of two martingales is a martingale. Xn bn=l Hn6.. = is predictable and E (2::=1 Hn6. Proof.Mn forn ~1 is a martingale with respect to (Fn)05. we must first define a martingale on a fjnite probability space.2 is that if the discounted prices of the assets are martingales.

for any wEn. there exists a (unique) process (¢~) su~h that the strategy (( ¢~.______. . the subspace V does not intersect r There~ore. For any predictable ¢ p. th~ fact tha! this value is positive at any time. OJ ('ljJ) ~ 0 for all j E {O. ~:_yui1!£.'. N . there exists (A (w)tEo such that: " C!n = Ew Theorem 1. I} WhIChIs..2. L: A(W)X(W) w > O." . n ifj measurable. Moreover. N. with VN (¢) ~O. We can now introduce a new process 'ljJ u n where A is the event {On(¢) < o}. with ¢ predictable process in IRd. Because ¢ is predictable and A is Fnif j '5. That contradicts the assumption of market viability and completes the proof of the lemma. N} and 0 N ('ljJ) > 0 on A. (b) The proof of the converse implication is more tricky.2. - - 2..2. That is the cumulative discounted gain realised by following the self-financing strategy¢. ¢~) we associate the process defined by Proof.. The market is viable if and only if for any admissible strategy ¢: Vo (¢) = 0 => VN (¢) ¢ r.!le~~he:-disc_ounte_4_pric_e__s... ¢~)) is self-financing with zero initial value....6. PI (A) = 0 ¢} P2 (A) = O. then E* (VN(¢)) 7 = 0.. As a result of the convex sets separation theorem (see the Appendix). . 0 N(¢) ~¢_I. N} the market is obviously not viable.3. According to Lemma 1. Let us call r the convex cone of strictly positive random variables. It follows from the definition 0) > 0 and '1m> n if j '5. P (On(¢)< Om(¢) ~ O.1. for any self-financing strategy L:A(W)ON w (¢) (w) = 0. = sup {kiP (Ok (¢) < 0) > o}..2. for all wEn. .. P" equivalent to P means that. martingales. Let us assume that we define n that E r. (1.7 . . if we deno~e by E* the expectation under measure P*. E* (VN (¢)) = E* (Vo (¢)). (. 'ljJ is also predictable..' (¢n). Let us get back to the discrete-time models introduced in the first section.2.6 jfthe market is viable.if and only' if there exists-a-probabil_ity .2 Viable financial markets Discrete-time models Martingales and arbitrage opportunities If. First.. 0 I.. .1. ifOn(¢) ~ 0 for all n E {O. Property 2.5 The market is viable if there is no arbitrage opportunity..e On(¢) ~ 0 for n = 1. . ¢~. Hence VN (¢) = 0 since P* ({w}) > 0. ( Vn (¢)) is a ~* - VN (¢) and EWI EO A(W') A(W) Va (¢) have the same expectation under P*: . (a) Let us assume that there exists a probability P* equivalent to P under which discounted prices are martingales. Here. 'IX E K. for any predictable process (¢n) in IRd. Second. means that..6 1. Moreover >n thus. is equivalent to P. . The following lemma shows that even if we do not assumethat Gn(¢) are no~-negative. Lemma'I. implies ~hat G N (¢) = O. if j > n of n n '5. P* ({w}) martingale. .f. (b1) To any admissible process (¢. Therefore > 0 for all wEn. .___----. t Recall that two probability measures PI and P2 are equivalent if and only if for any event A. if the On(¢) are not all non-negative. ' (b2) The set V of random varia~es G N (¢).it?oesnoti~tersecttheconvexcompacts·etK {X E fI X(w)"'.3. Definition 1..2) implies n From Property 1: we deduce that A(W) P* defined by _ !.. .2. According to Proposition 1..¢) is the discounted value of this strategy at time n and because the market IS vIabl~. . p·({w}»O. Then. i. .the_strategy is admissi~le and its initial value is zero. The market is viable -_/ . we still have ON(¢) ¢ r. ¢. ._o/-a_s~e__~~_P* - 1. is clearly a vector subspace of IR(where IRo is the set of real random variables defined on n). " so that the probability j=1 = Thus by Proposition 1.mcluded m r.1. ¢d) satisfies -_. any predictable process (¢i. .." .

if ¢ is a selffinancing strategy and if P* is a probability measure equivalent to P under which discounted prices are martingales.d} and any predictable sequence (¢~) in JR. .4. Since ¢ is self-financing. there exists a random variable h ~ 0 which is not attainable.. is a very simple example-of complete market modelling. that. since h is arbitrary.3 Complete markets and option pricing 1. N} Vn(¢) Clearly. we notice that there exists a non-zero random vanable X orthogonal to V.¢~))O<n<N is an JRd-valued pre-- To assume that a financial market is complete is a rather restrictive assumption that does not have such a clear economic justification as the no-arbitrage assumption. . (a) Let us assume that the market is viable and complete.3. Indeed.: It follows fr.) J=I Theore. . we conclude that the discounted prices (§~).2 that the variable hi Se. St. There are some options dependent on the whole path of the underlying asset. the last equality coming from the fact that "Fo = {0. n=I N ~ 0 (in particular if VN(¢) = h). any non-neg~tlve.e. according to Proposition 1. (1. which are actually the two most important in practice. = (V =2 n (¢)) O<n<N -- is a martingale under both PI and P2 It follows .. The interest of complete markets is that it allows us to derive a simple theory of contingent claim pricing and hedging. that we shall study in the next section. = P2 on the whole a-algebra F N assumed to be Remark 1. F). h is a function of S N only. ((¢~.1 Complete markets We shall define a European option" of inaturity N by giving its payoff h 2: 0. if PI and P! are two probability measures under which discounted prices are martingales. Definition 1.~§.. V is a strict subset of the set of all random variables on (0. . For instance.K) +..3 and Remark 1. Therefore if there exists an and.. (§~) are P* martingales.3. Hence.S}y) In those two examples. .. F N-~~asurable random variable h can be written as h VN (¢).. A put on the same underlying asset h 1 SO N = VN _ (¢) = Vo (¢) + L ¢j. We also write P** ({w}) * Or more generally a contingent claim. we have E* 9 (t ¢.1 The contingent claim defined by h is attainable admissible strategy worthli at time N. we know that = O. Y) t-+ E: (XY).?m Proposition 1. the strategy ¢ is admissible. does not belong to V. where ¢ IS an admissible strategy that replicates the contingent claim h. i. then (Vn(¢)) is also a P*-martingale.2 In a viable financial market. = +. SN..3. for n E {O.. == (1 + 211Xlloo X(W)) P*({w}) " . if (b) Let us assume that the market is viable and incomplete. " The probability P* will appear to be the computing tool whereby we can derive closed-form pricing formulae and hedging strategies.3 The market is complete if every contingent claim is attainable. if P* is a probability equivalent to P under which discounted prices are rilru:tingales and if we define the following scalar product on the set of random ~ariables (X. The Cox-Ross-Rubinstein model. 0 = 1. . VN(¢) Uo and + L ¢n'~§n. a call on the underlying SI with strike price K will be defined by setting: h (S}y . . PI equal to F. That is the case of the so-called Asian options where the strike price is equal to the average of the stock prices observed during a certain period of time before maturity .3.~ 1.. O}.2.~§j.8 Discrete-time models Complete markets and option pricing It follows that for all i E {I. Therefore. j=I " N Thus. . ":here Uo is Fo-meas)lrable dictable process. We call V the set of random variables of the form = E* (VN(¢)IFn).1) ... The following theorem gives a precise characterisation of complete. . Definition 1.4 A viable m~rket is complete if and only if there exists a unique probability measure P equivalent to P under which discounted prices are martingales.. . Then. viable financial markets. we just need to find a self-financing strategy worth h at maturity to say that h is attainable.3. for i 1 or i = with the same strike price K will be defined by h (K . Proof.1. Therefore. h is a function of SO. Hence.. Then.3. being a martingale transform. FN-measurable.

N = S~E* .e.1..n::. Indeed. we shall think in terms of a backward induction starting at time N. the writer has to earn the maximum between Z N -1' and the amount necessary at time N . by statistical means) in order to price the option. If we assume that the interest rate over one period is constant and equal to r.n::. At any time.. 1. the investor is perfectly hedged.Nis a P* -rnartingale. F) equipped with the filtration (Fn). it makes sense to price the option at time N .1 of an admissible strategy paying off Z N at time N. Because E* (X) = 0. Let h be an F N-measurable. It is the smallest P* -supermartingale that domin~te~ the sequence (in) to '. I? If the holder exercises straight away he will earn Z N -1. non-negative random variable and ¢ be an admissible strategy replicating the contingent claim hence defined.10 Discrete-time models Complete markets and option pricing 11 with IIXlloo = 8UPwEn IX(w)l.~Sn) =0 follows from Proposition 0 for any predictable process (( ¢~.. Let us . the value of an admissible strategy replicating h is completely determined by h. If.2.N is a supermartingale dominating (in)O::.. At what price should we sell the option at time N . We could have just considered a measurable space (fl. we defin~ the American option price for n :: 1.n::.N.N. is a P* -supermartingale. S~_I E* (iNIFN-I)' with iN = ZN /S~. In other words. As we see. in the case of the put. From the equality . at time N .N·It 1.N.6 The "sequence (Un) Proposition . the value of the option at maturity is obviously equal to UN = Z N. that defines a new probability measure equivalent to P and different from P*. In other words. we would only define the set of all possible states and the evolution of the information over time. . at time 0.K) +.: O<n<N We should note that. As soon as the probability space and the filtration are specified. S~_IE* ( iNI ~N-l)) .S~) +' In order to define the price of the option associated with (Zn)O::..1 as The sequence (Vn) O::. (t. IFn) .N is a P** -m_artingale.. Un-I = max ( in-I.. where Zn is the immediate profit made by exercising the option at time n. In the case of an American option on the stock SI with strike price K. = 1.3 Introduction to American options Since an American option can be exercised at any time between 0 and N. we do not need to find the true probability of the possible events (say.3.5 It is important notice that the computation of the option price only requires the knowledge of P* and not P.3. The analysis of the Cox-Ross-Rubinstein ii.N by and more generally (.n::. Zn = (K . Zn (S~ . Un-I = ~ax ( Z~-I' . we shall define it as a positive sequence (Zn) adapted to (Fn).4 that (Sn)O::.1. or he might exercise at time N in which case the writer must be ready to pay the amount ZN. . Vo (¢) '-' By induction.. O<n<N . n = 0. the discounted price of the American option is generally not a martingale underP".3.2 Pricing and hedging contingent claims in complete markets The market is assumed to be viable and complete and we denote by P* the unique probability measure under which the discounted ~rices of finan~ial assets are martingales. i. = Un/ S~ be the discounted price of the American option. Remark 1. .1 to generate ZN at time N. In other words. Moreover E** model will show how we can compute the option price and the hedging strategy in practice. Proof. as opposed to the European case. ! r E* (Un IFn-1 )) . ¢n. E* (Un IFn-1) ) .e. the writer wants the maximum between Z N -1 and the value at time N . . Therefore.. 1. S~_IE* ( ~~ Fn-1 I )) .n::. it follows that (Un)O::. .¢~))O::. an investor sells the option for' S~ = and (1 + r)" 1 Un-I let = max ( Zn-I. It seems quite natura] to call Vn (¢) the price of the option: that is the wealth needed at time n to replicate h at time N by following the strategy ¢. i.* (:~). he can follow a replicating strategy ¢ in order to generate an amount h at time N. = E* (h/ s~) Vn(¢) .n::.3. and consequently UN-I that is = max (ZN-I. E.

. we have " = 1+ r and therefore E·(Tn+d = 1 + r.. ' CO. Each N -tuple represents the successive values of the ratio Sn+l/ Sn. ' N.f for n i = 1 + b). TN XN). Then Problem: Cox. . As a result. . Therefore. b[ and we write p (b . Ross and Rubinstein model = == = The Cox-Ross-Rubinstein model is a discrete-time version of the Black-Scholes model. Deduce 'that r must belong to[c. we can purchase one share of the risky asset.4 Problem: Cox. n} and F pen). (a) Derive the put/call parity equation 1. we have Discrete-time models that dominates (Zn)O~n~N. according to Question 1. 1. P{(XI.' . If the market is viable.. It considers only one risky asset whose price is Sn at time n."" Sn) generated by the random variables SI.. 2. We realised a profit equal to SN . we denote S~ (1 + r)".KIFn) Sn-K(l+r)-(N-n). Fn = a(TI. n 0. .Pn = Sn . and a riskless asset whose return is r over one period of time. 1 + b[. (resp. we pay the loan back and sell the risky asset.P(Ti = E(Tn+dFn) = E(Tn+d = p(l + a) + (1 . 1. we have + b) = 1 + r = 1 + r. TN). b[ for the market to be arbitrage-free. If (XI. ••• .Sn' The assumption that each singleton in has a strictly positive probability implies that P is defined uniquely up to equivalence.1. 1 + b}.: = 1.r)/(b _ a). under which (Sn) is a martingale. ShowTthat (~n) IS a P-martingale if and only if the random variables TI. We have shown that the very fact that (Sn) is a P-martingale uniquely deterrni~es the distribution of the N-tuple (T1.. Conclude that the market is arbitrage-free and complete. Show that the discounted price E(Tn+lIFn) (Sn) is a martingale under P if and only if = 1"+ r. N . for n = 1. we prove that for any xi E {I + a.. . . We now introduce the variables Tn = Sn/Sn-l. 4. with -1 < a < b: IfTi are independent and satisfy peT. . = 1 + a) = P = 1 . the market is arbitrage-free and complete. = 1. . identically distributed (lID) and their distribution is grven by: P(TI 1+ a) p 1. TN) under P. At time N. (Sn) is a P-martingale. N and if i. knowing P is equivalent to knowing the law of the N -tuple (TI. we necessarily have (1 + r) E]l + a. 1 + b} N. We also assume that Fo {0.N. put) on a share of stock. . it is strictly positive with non-zero probability. ' E·(Tn+IIFn) s: C. . ofa European call (resp..nversely. Thus.(K . That shows that the variables T. knowing the put/call prices in their conditional expectation form. the a-algebra Fn is equal to a(SI. N . len - Pn = = = (1 + r)-(N-n)E· (1 + r)-(N-n)E· «SN . By borrowing an amount So at time 0. . hence the measure P itself. There is arbitrage opportunity.pif Xi = 1 + b. E(Tn+IIFn) = 1 + r. Moreover.P(TI 1+ b).So(1 + r)N which is always positive..) = IIPi i=l = = = where Pi = P if Xi = 1 + a and Pi = 1. + a)E (1{Tn+1=l+a}IFn) Then. We denote by C.. If we deEote E· the expectation with respect to the probability measure P" under which (Sri) is a martingale. T2. N. By Sn+l = Sn(l+a) { Sn(1 + b)..t. . We' also remark that for n 2: 1. . . The set of possible states is then {I + a. N are mdependent. .. Tn).1. n= E (1{Tn+1=l+a}IFn) + E (1{Tn+1=IH}IFn) = = = = ~mplie~that E (l{Tn+l=l+a}IF~) = P and E (1{Tn+1=IH}IFn) induction. Tn-l whence 2: E· (Tn IFn-l) 2: E· (Un IFn-I ) Tn-I 2: max ( Zn-I. there exists a probability P" equivalent to P.p. 0 :::.. The equality E(Sn+I'IFn) = is equivalent to E(Sn+dSnIFn) == 1. ' Assume for instance that r :S a. From now o~. Give examples of arbitrage strategies if the no-arbitrage condition derived in Question (2. the following equality P = 0. '<In E {O. The risky asset is modelled as follows. 5.1. For n 1. T2. : . . T2.K(1 + r)-(N-n).I..12 now consider a supermartingale (Tn)O~n~N TN 2: [.. we can write = + (1 + b)E (1{Tn+1=IH}IFn) The initial stock price So is given. are lID under measure P and that P(Ti = 1 + a) = p..) is not satisfied. Fn-measurable and this last equality is actually equivalent to E(Tn+dFn) = 1 + r. w_eassume that r E la.. Since Tn+l is either equal to 1 + a or 1 + b with non-zero probability..XN) is one element of n. To be consistent with the previous sections. XN)} P(TI XI. between two consecutive periods the relative price change is either a or b. : .. P (TI n = XI.I}. since SN 2: So(1 + a)N.N . If r 2: b w_e make a riskless profit by short-selling the risky can asset. .K)+ . . Ross and Rubinstein model 13 3. . . 2: ii. since Sn is. Pn) the value at time n.n :::. = x. with strike price K and maturity N. E· (Un IFn-I )) = Un-I' o A backward induction proves the assertion that (Tn) dominates (Un). .p)(1 and thus. according to Question I.SN )+IFn) (SN ..

are Fn_1-measurable. will be expressed in terms offunction c. . : H~(I + rt + HnSn-1(I + b) Subtracting one from the othtr. the put price at time 0 is given by p'(N) 6. when N converges to infinity.IT t: - K) : Fn). . Show that we can write en = c(n. The real number R is interpreted as the instantaneous rate at all times between 0 and T. is independent of F« and since S« is Fn-measurable. + Since under the probability P". a/VN}.N.1(I + a) = c(n.((1 + RT/N)-N K .JFi and log((l + b)/(l + r» a/. Sn-l(I Sn--:l(I + a» + b». we conclude that N->oo (a) Let (YN)N~l be a sequence of random variables equal to YN=xi'+xf+"'+x~ t I· irn p'(N) 0 It is precisely to be able to work with a bounded function that we studied the put first. continuous function and because the sequence (YN) converges in law. belong to {-a/VN.Sn-l only and._ ~o n=l IT Tn) + + r)" + HnSn = c(n. n.SoeY)+. where c is the function defined by c(n. Show that the replicating strategy of a call is characterised by' a quantity Hn b. under measure P* .So exp(YN») + Sn). VN eulVN .So exp(YN») + -Soexp(yN»)+)1 _ e-RTI. Show that the sequence (YN) converges in law towards a Gaussian variable with mean J.x(I+b»-c(n. ~hevariables Xf" = log(Ti/(1 + are valued in {-a/VN. the previous equality implies s: with YN' = L::=I log(Tn/(I + r». (1 + iUJ1. IimN->oo tPYN(u) in law.=n+l . Sn-l) at time n.LN. Moreover r» H~(1 and + r)n + HnSn. and are lID under probability P".(y) = (K e-RT .(a).14 Discrete-time models Problem: Cox. a. = exp (iuJ1. 'Since H~ and H.a2u2 /2).a2u2/2N + a(I/N») N. For a certain N. . Proposition A. with limN-+oo(N J. We have H~(I = o = = (1 + RT/N)-N'E" E" (K'.= 2 -a /2. where b.2.(YN» = (1 _ 2p)~ . we get XI' 15 areIll). When we write SN = S« n::n+l Ti.LN) = J. and their mean is equal to J. -.e-ulVN VN Therefore.:. (b). the sequence (YN) satisfies the conditions of Question 7. for each N.. + (b) Give explicitly the asymptotic prices of the put and the call at time O. we study the asymptotic case when N converges to-infinity. In order to do that. = (1 + r)-(N-n)E" ((Sn . = 2 ulVN -ulVN ( = c(n.n).JFi. = = < K 1(1 + RT/N)-N Since -rj. x ) = c(n. We can now use the model to price a call or a put with maturity T on a single stock.:ergenceof the characteristic function tPYN of YN. . K . a2 can be seen as the limit variance. ' = IE" (((1 + RT/N)-N (KeRT I.. they are functions of Sv.L. We obtain tPYN(U) c. -e -e ~. Ross and Rubinstein model where. is a bounded t. r andp.S in the Appendix allows us to write: C« = c(n. since is equal to Sn-l (1 + a) or Sn-l (1 + b). the random variable n::n+l T. of the variable log(S N ). b. with J1. We denote H~ the number of riskless assets in the replicating portfolio. + (x(I Hence. .a/VN}. and r = RT/N. rl (1 _ p)N-n-i + a)i (1 + b)N-n-i - K) ... log((l + a)/(l + r» = -a/. we are able to write E"(XiN) IPJN) E" (-rj.x(I+a» x(b _ a) . Sn). 1.L and variance a2• Wejust need to study the con.(n. Sn) where c is a function of K. which proves the convergence N-n ""' ~ (N-n-J)!J! i=O (N . 7. it turns out that D. because eRT limN-+oo(1 + r)N. x) (1 +r)-(N-n) = E(exp(iuYN» = IIE (exp(iuXf"») N i=l = (E (exp(iuXf»)t = E" (x i=n+l IT t: - K) r . According to the assumptions. . the random variables the last equality comes from the fact that (Sn) is a P" -martingale. If we write -rj.

ly the same ideas to answer the same questions when the stock IS carrying dIvId. . F. Dalang. 1983).3 The reader can verify. Stricker (1990) and Delbaen and Schachermayer (~994».(198. C~N) e-. .2 As in the previous chapter. Morton and Willinger (1990) and ~orton (1989». the exercise date is described by a random variable called stopping time. Huang and Litzenbe~ger (19~8) a~p. . Actually.N . 1. dedicated to finance. P)..1. d2 =d 1- a and . the optimal stopping problem.a'. Hamson and Kreps (1979). that II is a stopping time if and only if. The purpose of this chapter is to address the pricing and hedging of American options and to establish the link between these questions and the optimal stopping problem. Remark 1. the problem is much more tricky (cf. We will use this equivalent definition to generalise the concept of stopping time to the continuous-time setting. T?e theorem of characterisation of complete markets can also be proved WIth infinite probability spaces (cf. as an exercise.SoF(-d1). Definition 2. The application of these concepts to American options will be described in Section 2.. for any n E {O.1 Stopping time The buyer of an American option can exercise its right at any time until maturity. Rubinstein (1985). {II = n} E F~. .4.2/2dx -00 The price of the call follows easily from put/call parity limN-+oo = SoF(d 1)- K e-RT F(d2). n} E Fn. An elementary presentation of the Cox-Ross-Rubmstem model IS given m the book by I. which is the fundamental concept used to solve. .. for any nE {O. which will enable us to model exercise strategies for American options. 1".j2. Remark 2:t. the results presented in this chapter remain true almost surely.n:::. We will also define the Snell envelope.1.1 We note that the only non-directly observable parameter is . .. except in Section 2. However.e.5. In continuous time. In a discrete-time model built on a finite filtered space (S1. we assume that F P(S1) and P( {w}) > 0. To do so. (Fn)O:::. we will not assume Fo = {0. The decision to exercise or not at time n will be made according to the information available at time n.16 Discrete-time models = .en~s. . . Notes: We have assumed throughout this chapter that the risky assets were not offering any dividend.1 A random variable II taking values in {O. Vw E S1. so that where dl lim N-+oo 2 Optimal stopping problem and American options pJN) = Ke-RTF(-d2) .1. F(d) = _l_jd . Th~ theory of complete markets in continuous-time was developed by H~rns~n and Ph~ka . we shall tackle this question in Chapter 4.. 1. 2.~This hypothesis is nonetheless not essential: if it does not hold. .2. N} i~'a stopping time if. = (log (x/ K) + RT + a2/2)/a. = ~ . The integral can be expressed easily i~ terms of the cumulative normal distribution F.Nt {II :::. S1} and F N = F. ( Remark 2. However.lts interpretation as a variance suggests that it should be estimated by statistical methods. Cox and M. we will need to define the notion of optimal stopping time.N}.5.

we consider an adapted sequence (Zn)O~n~N' sequence (Un)O~n~N as follows: E ((U::+1 .3 of Chapter 1). 0 = 1{vo2':j} .I . if(Xn) is a martingale (resp. .Uj. Zk-d X. by stopping adequately the sequence (Un). (XvAn) is also a martingale with respect to (Fn). as the following proposition shows. o = = ZN max (Zn..e.Un) = l{n+l~vo} (Un+l 1- j=1 Un). The stopped sequence (X~)O<n<N is adapted. i'(Un+lIFn)) "in:::. nAvo O<n<N IS a martmga e. since it is the martingale transform of (Xn). Proof.N the set of stopping times taking 1 . U'. Proof. a submartingale) using the predictability and the non-negativity of (¢>j)o~j ~N. Proof. We already know.1 The random variable defined by Let us introduce now the concept of a 'sequence stopped at a stopping time'.vol. then rX~) is a martingale (resp. a supermartingale).1.E (Un+lIFn) and we deduce .I}. Un E(Un+lIFn). E (ZvIFo)..2. on the set {v = j} we have = Xv(w)An XJ Xn (w) .U::o) IFn) which proves that U'» is a martingale. {vo = k} = > Zo} n··· n {Uk-I> Proposition 2. we can show that if the sequence (Xn) is a supermartingale (resp. = .6 of Chapter 1. Moreover. and define the In this section.' .::: IUn = Zn} 0 (2. n XvAn = Xo + L ¢>jix. Let (Xn)O<n<N be a sequence adapted to the filtration (Fn)O<n<N and let v be a stopping time. Vo is a well-defined element of {O 1 N} a d Vo ' ""'. we have 1 n {Uk = Zd E Fk. j .. We see that. n if j > n.- 19 X~ (w) i. for n E {OJ 1. we write as ill the proof of Proposition 2. > UVo n+l - uvo n = {n+l~vo} (Un+l . a supermartingale).maximises the expected gain given Fo. . W.N is a finite set since is assumed to be finite. for n .2 The stopping time Vo satisfies {n n + 1 n Uo = E (ZvoIFo) = sup. + 1 :::.18 Optimal stopping problem and American options The Snell envelope Proposition 2. j=1 n Xj-1) . + where ¢>j L ¢>j6..1. U::+ U::o = . . In the remainder. N} N' h rr: .. once t at In.1) is a stopping time and the stopped sequence (U) . va ues In . vETo. U'.N . By definition. .3. By definition. -: U::o) IFn) = l{n+l~vo}E ((Un+l - E (Un+dFn))IFn) +1< v } 0 because {n Hence + 1 ~ vo} E Fn (since the complement of {n is {v 0_ < 2. . = max (Zn' E (Un+lIFn)) and on the set {n Zn.call it the Snell envelope of the sequence (Zn)O<n<N. it is possible to obtain a martingale. So that. To demonstrate that (U~o) is a martingale. the stopped sequence is stilla supermartingale (resp. The martingale property of the sequence U'» gives the following result which relates the concept of Snell envelope to the optimal stopping problem. N':__l.N = If we.3. = inf {n n we X~ = Note that Xx. It is clear then that (XvAn)~<::<N is adapted to the filtration (Fn)O~n~N. by Proposition 1. .N) a. is greater than Zn (with equality for n =. and for k . think ~f Zn as the total winnings of a gambler after n games. . Similarly.. we see that stopping ~t tlmevvo. Consequently Ui.} is the complement of the set {v < j} = v {v:::.2 The Snell-envelope . Ui. . Corollary 2. a submartingale). Furthermore.2. that (Un)O<n<N is the smallest supermartingale that dominates the sequence (Zn)O<n<N. . The study of this sequence is motivated by our first approach _ofAmerican options (Section 1.4: U::o = UnAvo = Uo. and taking the conditional expectation on 'both sides of the equality E ((U::+1 n}).:::. we have Uo = U~o = E (U~ IFo) = E (Uvo IFo) = E (Zvo IFo) .I}. we shall note Tn. It suggests that. the process (¢>n)O<n<N is predictable. if (Xn) is a martingale. Since UN = Z N. Since U ° IS a martingale. == 0.E (Un+lIFn)) 1 . (w) = Xv(w)(w) (= { if j :::. on {v = j}). have . The sequence stopped at time v is defined as .din the case of a strict inequality.¢>n+l (Un+l . where ¢>j = 1{j~v}' Since {j :::.:::1 {VO = {Uo ~} = {Uo = Zo} E Fo.4 Let (Xn) be an adapted sequence and v be a stopping time.

null at O. ~ E (U"IFn). j=O N-l L: l{I..2) holds. From Un = Mn . Optimality of 1/ is then ensured by Corollary 2.n5. ii-: =' E (V"IFn). Uo E(Z"IFo).N E (Z"n IFn) . If the stopped sequence U" is a martingale.3."L: which proves 0 N-l ) l{~ax=j}Uj + l{"fnax::N}UN E (UJ+t!Fj)) But we have u. therefore v. It is straightforward to see that I/max is a stopping time using the fact that = it is sufficient to prove Uo ~ E (U"l\nl. Proof. if 1/ is optimal. = N.2. (Mn) and (An) are entirely determined using the previous equations and we see that (Mn) is a martingale and that (An) is predictable and non-decreasing (because (Un) is a supermartingale).5 A stopping time v is optimal ifand only if . Proof.Mn .N has the unique following decomposition: Un = Mn .(An+1 . = 0 is Mo = Uo and Ao = O. . = Mn+l .Un E (Z"IFo) = sup E (Z"IFo) Io.N is a martingale.N is predictable.2. conditioning both sides with respect to Fn and using the properties of M ~ We can see that I/o is optimal. Definition 2.An and because Aj = 0.: . We can then give a characterisation of the largest optimal stopping time for (Zn) using the non-decreasing process (An) ~f the Doob decomposition of (U~): Proposition 2.2) Mn+1 .fnaxnd conclude that U"fnax is a martingale.An) . if that 1/ Optimal stopping problem and American options E Io. since U" is a supermartingale.2. O} if AN if AN :f:. The following result gives a characterisation of optimal stopping times that shows that I/o is the smallest optimal stopping time.2.. sup E (Z"IFn) = "E/n. An+1 :f:. = E (U"IFo) 0 The following decomposition (commonly called 'Doob decomposition') is used in viable complete market models to associate any supermartingale with a trading strategy for which consumption is allowed (see Exercise 5 for that matter).n5. O.4 A stopping time 1/ is called optimal for the sequence (Zn)O<n<N if -- Un+1 . Uo = E(U"IFo) and consequently.Un ~A.3.. where (Mn) is a martingale and (An) is a non-decreasing. that (U::) is a martingale.2 gives u.1 Every supermartingale (Un)05. To a show the optimality of l{.(An+l .. It is clearly seen that the only solution for n Then we must have 2.E (Un+1IFn) .20 On the other hand. U" { and =(U"l\n)05. =0 Therefore E (U"IFo) = E (Z"IFo) and since U" ~ Z. Theorem 2. we have = Uo = E (Z"IFo) S E (U"IFo) . { inf {n. where I/n = inf {j ~ nlUj = Zj}. Remark > > E (UNIFo) E (Z"IFo).An) and = E (Un+lIFn) z.N So that.2 The largest optimal stopping time for (Zn) is given by 1/"".3 Decomposition of supermartingaJes 21 Uo which yields the result. + l{I.n5. But.o) (based on the supermartingale property of (U~) we get We note that = E (U"IFo) = E (E (U"IFn)IFo).fo) E (U"l\nIFo) ~ E (U"IF.2. for J S Ifu.fnax=j}max (Zj.'ax.Mn = Un+1 . .fnax=N}ZN' j=O .3 An immediate generalisation of Corollary 2. Since E (U"IFo) Uo and from the following inequalities \An)o5.' U" = Z".An. Proof. Conversely. Proposition 2. So Decomposition of supe rmartingales 2. the stopped sequence U" is a supermartingale.2. 0 Suppose then that (Un) is the Snell envelope of an adapted sequence (Zn). we deduce that Uv= = MI.N. if (2. (2.). predictable process.

w~ have E· (VN(¢!)IFn) E· (MNIFn) . as in Sections 1. For the seque?ce (Vn (¢!)) Vn(¢!) is a p. y) = 1 for all x E' E. X. Aj 0 and > 0. is a Markov chain with respect to. the Snell envelope (Un) Proposition u. null at O.3. = Z Ifuv. the sequence CUn) 'defined by ii. We deduce from the above Section 2.. . and ib is afunctionfrom N x E to JR. = sup' E· ( ZvlFn) . . The matrix P = (P(x. of the sequence (Zn). we defined the value process (Un) of an American option described by the sequence (Zn)..Xn-l = Xn-l. Thus.2 that . which establishes the claim.3.the Snell envelope. The chain is said to be homogeneous does not depend on n.Aj+l < Uj. ' 2. Since the market is complete. The matrix P has non-negative . Xn-l. 2.. we have " . = S~ From Section 2.5. F. = Un/ S~ (discounted price of the option) is. x) '<IxE E and.)O:::. E (Uj+IIFj)) = Zj. The modelling will be based on the filtered space (fl. by the system P(Xn+l = ylXo = Xo.Aj+l and.·) It remains to show that it is the greatest optimal stopping time.1 A sequence (Xn)O:::.E(Av) = E(Uo) .).1 Hedging American options In Section 1.n~N ).n:::. (Fn)O:::.. under P" .Y)EEXE' Indexed byE x . then P f is indeed the product of the two matrices P and f. VN (¢!) = MN. if (Xn) is adapted and iffor any real-valued functIon f on E.Xn). Note that. we can write ' vETn.P and.22 Optimal stopping problem and American options Application to American options I I. On a filtered probability space ( n. v ii. Y of E. y)f(y). if the value P(x. = max (Zj.N random variables taking values in of = x) = P(Xn+l = ylXn = x) . ' 'C The following proposition is an immediate consequence of the latter definition and the definition of a Snell envelope. E(Uv) = E(Mv) . = Mn . (F". definedby Fn = a(Xo. j}..Xn). 23 Aj+l We have E (Uj+IIFj) M.2 Let (Zn) be an adapted sequence defined by Zn = 'ljJ(n. entries and satisfies: LYEE P(x. we have 2. for any integer n 2: 1 and any elements Xo. F. UN { Un = = ZN max (Zn' S~E· (Un+l/ S~+lIFn)) '<In:S N-1. vETn.N E· (. .E(Av) < E(Uo) o 2.P notion of a Markov chain with respect to the filtration: Definition 2. If v is a stopping time such that v 2: Vrnax and P (v > vrnax) > 0.4. there is a self-financing strategy ¢!such that VN (¢!) i. So that finally UIfuv. itis said to be a stochastic matrix. . .E. . It can also be easily seen that a Markov chain.its natural filtration.. where P f represents thefunction which maps x E E toP f(x) = LYEE P(x..3. Xl.. Then. ' ii. we can define tlie .1.4. . u(n. where (Mn) is a Pt-martingale and (An) is an increasing predictable process.3 of Chapter 1. taking values in E. x) = 'ljJ(N.4 Snell envelope and Markov chains The aim of this section is to compute Snell envelopes in a Markovian setting.N ) . where (Xn) is a homogeneous Markov chain with transition matrix P. E (f (Xn~d IFn) = P f (Xn) . It follows that U. then = max ('ljJ(n. . From now on.An. on the set {vrn". for n :s N .n:::. • = = = of the sequence (Zn) is given by Un = u(n. o = SNM-N.N sup and consequently E is a homogeneous Markov chain with respect to the filtration (Fn)O<n<N' with transition matrixP. -martingale. Xn).~ IFn) .5 Application to American options and UV cannot be a martingale.3. is then called the transition matrix of the chain.1 and 1.3 of Chapter 1. if one interprets real-valued functions on E as matrices with a single column indexed by E. as defined at the beginning of the section. we will denote by P" the unique probability under which the discounted asset prices are martingales. we will work in a viable complete market. so Uj = Mj and E (Uj+IIFj) = Mj . where the function u is defined by u(N. Pu(n + 1. y))(X. y) = P (Xn+l = ylXn = x) Xn . A sequence (Xn)n~O of random variables taking their values in a finite set E is called a Markov chain if.)) .e.

. then en =Cn using the martingale property of (Sn). ~ en. . optimal dates of exercise are optimal stopping times for the sequence (Zn).1. N}. Prove the equality Cn ~ E· (CNIFn) Hence = E· (cNIFn) = cn. To illustrate the last proposition. the writer makes a profit VT (cjJ) . Hence: ~n ~ K(l + r)-(N-n) ~ Sn . one may consult Neveu (1972).iruu VJ. Cn en. we also have en 2: (Sn .. Notes: For further discussions . then UT > ZT or AT > O.K)+. E Fn f'(. For the discounted value - \. 2.1 Let Cn be the value at time n of an American option described by an adapted sequence (Zn)O<n<N and let en be the value at time n of the European option defined by the FN--measurable random variable h = Z N. 2. it is obvious that the writer of the option can hedge himself perfectly: once he receives the premium Uo = Vo(cjJ).n Aj+! i. = = Sn-K(l+r) - . Aj+! i. he can generate a wealth equal to Vn(cjJ) at time n which is bigger than Un and a fortiori Zn. .. en is the price at time n of a European call with maturity N and strike price K on one unit of the risky asset and Cn is the price of the corresponding American call. there would be some arbitrage opportunities by trading the options. . There is equality between the price of the European call and the price of the corresponding American call.0 }) cn (1 + r)-NE· ((SN . (by exercising the option).N}. What is the optimal date to exercise the option? The date of exercise is to be chosen among all the stopping times. with price Sn at time n and a constant riskless interest rate. If he hedges himself using the strategy cjJ as defined above and if the buyer exercises at time T which is not optimal. This property does not hold for the put. Chapter 5. so that S~ (1 + r )". Show that F. E(XIFv) = j=O L l{v=j}E(XIFj).K(l + r)-NIFn) -N . We have = (which is equal to inf {j.An. F.5. at that time.5..5. . which is a martingale under P". For the theory of optimal stopping in the continuous case. . 1. nor in the case of calls on currencies or dividend paying stocks. where An = S~ An.5. . . see El Karoui (1981) and Shiryayev (1978). with notations of Proposition 2.In E {O. To make this point clear. 11m" + 2.1. Thus an optimal date T of exercise is such that UT ~ ZT' On the other hand. Let X be a real-valued random variable. if we take Zn = (Sn . = > E· (SN . there is no point in exercising after the time lima> o Remark 2.. he creates a portfolio whose value is strictly bigger than the .option's at times 11m" + 1.2 One checks readily that if the relationships of Proposition 2.O} because.K. N. C. In both cases. . As _a result. we have Cn ~ en. is a sub-a-algebra of F N.l.5. the set of events A such that A n {II = n}. N 3. . Show that the random variable II (C n) is a supermartingale ~nder p. Section 1.In E {O. We denote by F. which allows us to say that efT is a martingale.24 and consequently Therefore Optimal stopping problem and American options Exercises 25 If en ~ Zn for any n then the sequence (cn). appears to be a supermartingale (under P") and an upper bound of the sequence (in) and consequently Un = Vn(cjJ).rany s.6 Exercises Exercise 1 Let II be a stopping time with respect to a filtration (Fn)O<n<N. From the previous equality. c. Therefore we set. As en'~ 0. under probability p". Proof.. (_ '. is often called 'a-algebra of events determined prior to the stopping time II'. let us consider the case of a market with a single risky asset. Moreover. following the strategy cjJ from that time. Chapter VI and Dacunha-Castelle and Duflo (1986). T :::.N}. - The inequality Cn ~ en makes sense since the American option entitles the holder to more rights than its European counterpart. Cn ::. Then. there is no point in exercising at time n when U« > Zn. For the buyer of the option. because he would trade an asset worth Un (the option) for an amount Zn.5..Zn which is positive. = 2. we have is Fv-measurable. for r ~ O. nE{O. lima>. as a second condition.2 American options and European options ' Proposition 2. Then. if en ~ Zn for any n.K)+IFn) provides the holder with a wealth UJ. equal to r ~ 0 on each period. = inf {j. .' \.ZT UT + AT .K)+ and by Proposition 2. let us considerthe writer's point of view.1 did not hold.iruu (cjJ) and..on the Snell envelope and optimal stopping. . - 1. selling the optio.

Show that F".' :s N . Show that there is' a real number z" E [0.). ...).Sn and Vn(¢) = Show the equivalence between the following conditions: s. N}. Any endowment being excluded and the new positions being decided given prices at time n.S~ are quoted.. 3. . once the new prices S~. the investor readjusts his positions from ¢n to ¢n+l and selects the wealth 'Yn+l to be consumed at time n + 1.'Y).xV". An agent holds the American put at time 0..1. (Hint: first consider the case T = N..x)+ and.3) gives the relationship between the processes ¢ and 'Y and replaces the self-financing condition of Chapter 1. 1.d+ 1 and let 'Y be a predictable process taking values in JR. 0 is convex and 4. Let (Zn) be an adapted sequence. show that there is a trading strategy with consumption (¢.x) = sup E· ((1 + r)-"'(K ".Sn = ¢n.ETo. From the last formula. TI7=1 2. for z".) can be expressed as Pam(O. '.(1 + a)) + (1 .)+). x) (a) The pair (¢. for n 2: 1. n n = (K .N Exercise 3 Show that v is optimal according to Definition 2. 'Y) such that Vn(¢) = Un for any n E {O. x) = (K . representing the numbers of assets held in the portfolio and 'Y bnh<n<N is a predictable process taking values in JR.. . For which values of the spot So would he rather exercise his option immediately? . K] such that. < 0. 'Y) defines a trading strategy with consumption. for n .+. show that the function x !-t'Pam(O.) = = = sup E (Z".x)) 1+ r (c) For any n E {I.2. Equation (2. Show that the function Pam(O. for any n E{O. = E(MTIF".r)/(b = max ( (K .. Vn = u. 'Y) hedging (Zn) satisfies Vn(¢) 2: Un. we deduce ¢n+l. for x E [z". Let (Un) be an adapted sequence such that (Un) is a supermartingale under p ". Using the Doob decomposition. ..N}. = M". We say that a trading strategy with consumption (¢. ". eFT' 5. Pam (0. . d+l.26 4. f(n+1.N Exercise 4 The purpose of this exercise is to study the American put in the model of Cox-Ross-Rubinstein. show that E (Uo) and more generally E (Un) Exercise 5 Consumption strategies.(n + 1.3) sup E (Z". at time n. x) > 5.N Exercise 2 Let (Un) be the Snell envelope of an adapted sequence (Zn). 1.. (b) For any n E {l. . :. j=1 j=1 Pam(n. . The self-financing strategies defined in Chapter 1 ruled out any consumption.Nis defined by: Vo 1 and. Show that the hedging strategy ofthe American put is determined by a quantity Hn ~(n. We set Vn(¢)'= ¢n.a). . N}.»: Pn= Pam(n. p)P~.. representing the wealth consumed at any time. 2. Sn-d of the risky asset to be held at time n.x)+.4 if and only if E (Z".ETo. 1. In the remainder. then (V~(¢)) is a supermartingale under p ". Show that the price P n. Without assuming that Fo is trivial.x(1 + b)) . Under the same hypothesis. .'Y) hedges the American option defined by (Zn) if Vn(¢) 2: Zn for any n E {a. ". Consumption strategies can be introduced in the following way: at time n.n::. 4..x)+.. (2.x) non-increasing. x) is defined by Pam(N..+.. show that if (Mn) is a martingale. we have 6.'Yn+l. j=1 j=1 where the sequence of random 'variables (Vn)O::. Let T Optimal stopping problem and American options be a stopping time such that T Exercises 27 2: u. N}J. .x) with f(n + 1. Notations are those of Chapter 1. where ¢ is a predictable process taking values in IR.. Let ¢ be a predictable process taking values in JR. 3. Show that if the pair (¢.x) andp (b. Sn) where Pam(n. Pam(O. we assume that the market is viable and complete and we denote by P" the unique probability under which the assets discounted prices are martingales. K/C1 + a)N[.N = = pPam(n + 1. whose value is precisely the value (Un) of the American option. where ~ can be written as a function of Pam. 1. n n .). We assume a x :s (K . N}.x)+ and. Give their joint law under p ". . where the U/s are some random variables.. of an American put on a share with maturity N and strike price K can be written as So a trading strategy with consumption will be defined as a pair (¢. 'Y) defines a trading strategy with consumption.. prove that any trading strategy with consumption (¢..ETn.Sn = . Show that there is at least one trading strategy with consumption that hedges (Zn).) sup E (ZT)' TETo. Also.

the technical aspects are more advanced and more difficult to handle than in discrete-time. We will be giving a few mathematical. namely the Ito calculus. It is advisable that. In particular. In practice. . the price changes in the market are actually so _ frequent that a discrete-time model can barely follow the moves. Let x be a non-negative number representing the investor's endowment and let 'Y = bnh<n<N be a predictable strategy taking values in IR+. We had the opportunity to see the importance of the concepts of martingales. the most widely used model is the continuous-time Black-Scholes model which leads to an extremely simple formula. In continuous-time. the reader passes over the proofs in small print. Why do we consider continuous-time models? The primary motivation comes from the nature of the processes that we want to model.28 Optimal stopping problem and American options 5. we shall construct the stochastic integral and introduce the differential calculus associated with it. we shall introduce the mathematical tools needed to model financial assets and to price options. Indeed. Then we shall state the concept of martingale in a continuous-time set-up and.. The first two chapters of this book were dealing with discrete-time models.definitions in order to understand continuous-time models. such that the pair (¢. in his dissertation called Theorie de la speculation. for any n E {O. we shall define the Brownian motion since it is the core concept orthe Black-Scholes model and appears in most financial asset models.time processes? . On the other hand. selffinancing strategy and Snell envelope. as they-are very technical. finally. In particular. . Show that bn) is budget-feasible from endowment x if 3 = Brownian motion and stochastic differential • equations and only if E· (L::=l 'Yj / SJ-l) ~ x. the connections between stochastic processes and finance are not recent.. We are going to elaborate on these ideas in a continuous-time framework.1 General comments on continuous-time processes What do we exactly mean by continuous. 3. As we mentioned in the Introduction. continuous-time models lead to more explicit computations. but he also derived opt jon pricing formulae. 'Y) defines a trading strategy with consumption satisfying: Vo(¢) x and Vn(¢) 20. N}. The consumption process (1-n) is said to be budget-feasible from endowment x if there is a predictable process ¢ taking values in IRd+ 1. . is not only among the first to look at the properties of Brownian motion. but the main ideas are fundamentally the same. upon first reading. Bachelier (1900). even if numerical methods are sometimes required.

11 and 14): n Proposition 3. When we talk about a filtration without mentioning anything. • A process can also be considered as a random map: for each w in we associate the map from IR+ to E: t -+ Xt(w). A EFt . at a 'given time t.) for a proof of the following theorem. a process is adapted to its natural filtration. V2ii 2t' dx where dx is the Lebesgue measure on IR.anticipative way. such that for any t 2: 0. In general. . As in discrete-time. 3.2 If (Xt)t>o is a Brownian motion. • We will only work with processes that are indexed on a finite time interval • If Sand T are two stopping times such that S ~ T P a. is Ft-measurable. It will be the core of most financial models. is the following: _1_ exp (_ x2) Definition 3. Brownian motion and stochastic differential equations Brownian motion The a-algebra associated with r is defined as 31 Definition 3. the definition is the following: = This definition induces the distribution of the process Xt. called a path of the process. . if we replace Ft by Ft which is the a-algebra generated by both Ft and N (the a-algebra generated by all the P-null sets of A). E (X?) = t. the distribution of X. we obtain a proper filtration satisfying the desired condition.1 A continuous-time stochastic process in a space E endowed with a 0'. A. S ~ t). .s. Xs(w) is continuous. Remark 3. continuous stochastic process (Xdt~o. X. From now on. a filtration (Ft)t>o is an increasing family of a-algebras included in A The a-algebra Ft represents the information available at time t. the concept of stopping time will be useful. then X. In other words. . One can prove that (refer to Exercises 8.4 From now on. A stopping time .1.. We say that a process (Xtk:~o is adapted to (Ftk~o.1.2. and Y is Ft-measurable then we can show that X is also Ft-measurable. P). is independent of Fs = a(Xu. . In other words Ft contains all the P-null sets of A.3 A Brownian motion is standard if Xo = 0..1. In particular. finite almost surely.2 Brownian motion A particularly important example of stochastic process is the Brownian motion.6 • If S is a stopping time. P) with values in a measurable space (E. u ~ ~ t.2. currencies or interest rates. . adapted process. • If Sand T are two stopping times.1. the index t stands for the time..X. • independent increments: If s ~ t. is a random time that depends on the underlying process in a non. In that case. it is assumed that we are dealing with the natural filtration of the process that we are considering. • A process can be considered as a map from IR+ x into E. Theorem 3. we will be working with filtrations which have the following property If A E A and if P(A) Definition 3. A n {r ~ t} E Fd . {r ~ t} EFt. then S 1\ T inf(S.3 Consider the probability space (n. if S is a stopping time and t is a deterministic time S 1\ t is a stopping time. A. As in discrete-time. E). However.algebra E is a family (Xt)tEIR+ of random variables defined on a probability space (n.5 r is a stopping time with respect to the filtration (Fdt>o if r is a random variable in IR + U { +00 }. The importance of this technical assumption is that if X Y P a. This a-algebra represents the information available before the random time r. 10. we know if the stopping time is smaller than t. whether we consider stocks. Xo have the same We can build a filtration generated by a process (Xt)t>o and we write Ft a(Xs. • continuity: with independent and stationary increments. X.1.Tj. • If S is a stopping time. X. the map S I-t = 0. where rand 0' are constant real numbers. • stationary increments: if'S probability law.9. We call it the natural filtration of the process (Xth~o. this filtration does not satisfy the previous condition. Remark 3. if for any t.a Brownian motion is assumed to be standard if nothing else is mentione~. S is F s measurable. n n E.2. Obviously. .s. Formally. then X s is F s measurable. 'then for any t.s. - Definition 3. = [o.1 A Brownian motion is a real-valued.s . for any t ~ 0.X.2 • In practice. P a. T) is a stopping time. and (Xt)t~O is a continuous. .. but the result is difficult to prove and the reader ought to consult the book by Gihman and Skorohod (1980. We shall always consider that this map is measurable when we endow the product set IR+ x with the product a-algebra B(IR+) x A and when the set E is endowed with Fr = {A E A.1. In other words: P a.Xo is a normal random variable with mean rt and variance a2t. we introduce the concept offiltrat(on. and Xt-s - = s).30. Remark 3. then F s eFT.

Thus E(Xt XsIFs) = E(Xt . A stronger result is the following: Theorem 3.Xs) O.3.foranys • asupermartingaleif. E(MtIFs) because X. . . Xtn) is a Gaussian vector. . u ~ t) eFt.· 3.s)) u.3. . exp (aXt .isindependi!ntofthea-algebraFs.2. then Proof. and Xt-s Remark 3. X. 3. An adaptedfamily (Mt)t>o of integrable random variables. is Ft-measurable. this vector is Gaussian and so is (Xtl' . is also true if t and s are bounded ~topping times. • a submartingale if. X. This result is actually an adaptation of Exercise 1 in Chapter 2 to the continuous case and it is called the optional sampling theorem.XsIFs) = 0. . . E(MtIFs) = Ms..Xs)2IFs) + 2XsE (X. ~ ~ t.4 If (Xt)t>o is a Brownian motion and (Xtl' .. it follows that (Ft). it turns out E (eO'Xt-0'2t/2IFs) As in discrete-time models.Xtn_1) is composed of normal. < t-... X. If (Mt)t>o is a martingale. but the reader ought to refer to Karatzas and Shreve (1988).foranys ~ t. the concept of martingale is a crucial tool to explain the notion of arbitrage.2 and by definition of the Brownian motion). is a normal random variable.Xs)IFs) XsIFs). Proof.5 A real-valued continuous stochastic process is an (Ft)-Brownian motion if it satisfies: ' • For any t 2: 0. - t is an Fi-martingale. A. . is an Ft-martingale.3.3 Continuous-time martingales The last equality is due to the fact that X. = and since (Xt)t?o E ((Xt . The following definition is an extension of the one in discrete-time. then the random vector (Xtl' Xt2 Xt1.. Definition 3. is Fs-measurable.).2 It follows from this definition that. page 173. that E (eO'(Xt-X')IFs) = E (eO'(Xt-x. E(IMtl) < +00 for any tis: • amartingaleif. if s < t. if s <t =··eO'X. Moreover. .X. i. is independent of the a-algebra Fs. then E(Md E(Mo) for any t. Xtn . X. if (Mt)t>o is a martingale. whence Because the Brownian motion has independent and stationary increments. • If s ~ t. Since a standard Brownian motion has an expectation equal to zero. for any s ~ t.e.2. We have just seen that for any t. . ..(a2/2)t) is an Frmartingale. That yields E (X. Hence the first assertion is proved.32 Brownian motion and stochastic differential equations Continuous-time martingales 33 The following theorem emphasises the Gaussian property ofthe Brownian motion.)) E (eO'Xt-.Xs.X. we have E(Xt . - is a martingale E (Xt .X.. Therefore. let us recall that if 9 is a standard normal random variable.. Consider 0 ~ tl < . if 0 ~ tl < .Xs)2 + 2Xs(Xt . E (MtIFs) 2: Ms. . We will not prove this theorem. it is easy to check that an Ft-Brownianmotion is also a Brownian motion with respect to its natural filtration.) E (e0'9Yt=S) exp (~a2(t That completes the proof.tlFs) = X. Definition 3. has a normal distribution with mean zero and variance t.6 The first point of this definition shows that a(Xu. . IFs) = Ms.2... • If s ~ t.-0'2t/2E (i(Xt-X')IFs) Since X. .1 Let us consider a probability space (n.Xtn). If s ~ t then X. Finally. we remark that = The reader ought to consult the Appendix. o Remark 3. to recall some properties of Gaussian vectors. page 19. X.· 0 We shall also need a definition of a Brownian motion with respect to a filtration E ((Xt .Xo have the same law. < t«. is independent of Fs. the property E (M.3 If(Xth?o is a standard FrBrownian motion: ( I.2. X.- = Here are some examples of martingales. Proposition 3.X. P) and a filtration (Fdt>o on this space.s. we know that On the other hand. .. To show the second one. independent random variables (by Theorem 3. 2.

is continuous {Ta ~ If(Mt)o9~T is a continuous martingale. finite almost surely. On the one hand MTalln = exp (aXTalln . In other words. we . is a square integrable martingale. i. o The optional sampling theorem is also very useful to compute expectations involving the running maximum of a martingale. • If M. the processes modelling stock prices are normally functions of one or several Brownian motions.7 (Doob inequality) have E ( sup IMd2) :::. we can show that the second-order moment of sUP09~T IMd can be bounded.EQ+. But one of the most important properties of a Brownian motion is that. We will assume that a Indeed. since XT~ = a when T~ < +00 E (l{Ta<+oo}exp (_ ~2 That wealth appears to be a martingale transform under a certain probability measure such that the discounted price of the stock is a martingale. . UsEQ+. 3.3. and from the optional sampling theorem = E (MTalln) = 1. < 0 is easily solved if we notice that Ta = = inf. y). Theorem 3.5 • This result implies that if 7 is a bounded stopping time then E(MT) E(Mo) (apply the theorem with 71 = 0. there is not any time t in lR + such that dXt / dt exists. < +00. however. and therefore the result is-proved.l s 2: 0. and if 71 ~nd 72 are two stopping times such that 71 ~ 72 ~ K.3. Lebesgue theorem implies that E(l{Ta<+oo}MTJ = 1. Proposition 3. We cannot apply the theorem to Ta which is not necessarily bounded. and its distribution ischaracterised by its Laplace transform E (e->. If a is a real number. -Xs = -a}. Nevertheless. As a result.6). if we follow a self-financing strategy the discounted value of the portfolio with initial wealth Vo is ? t} = n. Also = The case a Remark 3.to}. Ta)) = e-o-a. we consider (Xt)t>o an Ft~Brownian motion. independent increments.1. In the following. = ~} or +00 if that set is empty.3. 2 We shall now apply that result to study the properties of the hitting time of a point by a Brownian motion. E(IMTI ). If M. we call Ta = inf {s 2: 0. 4 09~T The proof of this theorem is the purpose of Exercise 13. Then. where (-Xt)t>o is an Ft-Brownian motion because it is a continuous stochastic process with ze~o mean and variance t and with stationary. On the other hand.Ta) = ~-v'2>:lal. As far as continuous-tim~ models are concerned. where K is a finite real number. j=l n That last set belongs to Ft. {SUPXs s~t >a- E} = n. its paths are not differentiable at any point.s~t {Xs > a .34 Brownian motion and stochastic differential equations Stochastic integral and Ito calculus 35 Theorem 3.EQ+. we show that Ta is a stopping time. Jo f(s)dXs r = Jo f(s) r dX s ds ds. However. limn-Hoo MTalln = MTa and if Ta = +00. if n is a positive integer. therefore limn-Hoo MTaAn = O. we are able to define this type of integral with respect to a Brownian .Sj-d.6 Once again.ss. we show that P(Ta < +00) 1 (which means that the Brownian motion reaches the level a almost surely). X. X. Letus apply the sampling theorem to the martingale M. Ta is a stopping time. if T'. since X. almost surely. This is known as the Doob inequality.4 (optional sampling theorem) If (Mdt>o is a continuous martingale with respect to the filtration (Ft)t~o. it can be proved that for almost every wEn. the same theorem is true if we replace the previous equality by . First. integr~ls of the form J will help us to describe the same idea.(a2/2)t). if (Xt) is a Brownian motion.3. Proof.4 Stochastic integral and Ito calculus if! = (Hn)O<n<N' -- In a discrete-time model. exp (aXt . then MT2 is integrable and By letting a converge to 0. is a submartingale.:l 2: O. T« 1\ n is a bounded stopping time (see Proposition 3. Vo + L Hj(Sj . we write x 1\ y = inf(x..72 = 7 and take the expectation on both sides). we are not able to define the integral above as n.e.a2(Ta 1\ n)/2) < exp (aa). ~ a at any t.

._J + cPk+1(Wt - Wtk)· ~ E (cPicPj(Xi . Definition 3. To prove it.Xi.Xj-119j-1) = O._1At).ds) (I~ s) HsdW is a 'martingale. by definition.1) and (3.Wt. Throughout the text. Also.) ') H. (i~? [H.7) applied to the continuous martingale (f. and if we .2) we conclude that In order to prove this proposition.pj turns out to be a martingale transform of (Xn)nE[O. Proposition 3.3.Xi-1Y) = E (E (cP:(Xi -:-Xi_d E (cP:E((Xi 2 1 1 9i-I)) 9i-I)) . '. finite real number. If i > i we get the same thing.Wt. and we shall call them stochastic integrals. (3.dW. From (3. is a simple process: as a result E ( (Xi ~ Xi_i)21 9i-I) . if i i. t~O 0 -M . . we shall construct this stochastic integral for a set of processes called simple processes. the stochastic integral of a simple process H is the continuous process (I(H)t)O<t<T defined for any t E 'j'tk.Wti_l )2) = ti . t call Mn = fo n HsdWs and 9n Ftn for 0 :::._d 2 • (f~ HsdWs) • E ( ([ is a continuous Ft-martingale. Therefore.Xj-119j-df .pj' The Proposition 1. < tp = T and cPiis Ft'_ -measurable and bounded.HsdWs is clear if we look at the definition. Hs.1') I > s. Moreover.Xj-d)· (3.ti-1.. if i < j. ~ 4E (t H. If we include sand t to the subdivision to = 0 < t1 < .Xj-1) I 9j-1)) ( E (cPicPj(Xi .dWs) : E (lot HudWulFs) = 10. I(H)t Note that I(H)t = L c < i. We shall write f~ HsdWs for I(Hk which proves the continuity oft t-+ I(Hk The following proposition is fundamental. . Indeed.4. < tp = T.Xi-d(Xj .1 Construction of the stochastic integral Suppose that (Wdt~o is a standard Ft-Brownian motion defined on a filtered probability space (fl.2.4.Xj-d) nally. To start with.4._l. w) adapted to the filtration (Fdt~o. is a martingale. A. Xn = Wtn is a 9n-martingale (since (Wt)t>o is a Brownian motion). (Ft)t~o. if io L L E (cPicPj(Xi i=l j=l n n Xi-d(Xj .fact that if it can be written as Ht(w) = where 0 L cPi(w)lJt.. T will be a strictly positive. . (Mn)nE[O.3 of Chapter 1 allows us to conclude that (Mn)nE[O. That is the whole purpose of this section. of t -t f.n :::. w)dWs for a certain class of processes f (s. we have cPi(Wt• . HudWu. = E ([ H~dW.:.dE (Xj . for any t w~ just need to The continuity.2) •E Proof. The third assertion is just a consequence ofDoob inequality (3.. Fi- cPi(Wt•At . The second assertion comes from the.t. we notice that = f~ with cPi9i-1 -measurable.Xi. tk+1l as .Xi-d(Xj = can be written as I(H)t = L l~i~p ~ Xj-d) E (E (cPicPjXi . OJ. 3. we want to show that Mn p is a 9n-martingale.36 Brownian motion and stochastic differential equations Stochastic integral and Ito calculus 37 motion. We are about to give a meaning to the expression f (s. to show that check that. P).ds). we are going to use discrete-time processes.1 (Hdo<t<T is called a simple process -. = E ((Wt• .1) Then.Xi-I) ix..2 If(Ht)o~t~T 09~T Since X. = E (cP:(Xi .pj is a martingale.. E(Xj E (cPicPj(Xi . = O.j(t) i=l 1 p = to < t1 < .

E (J(H). T.T is a martingale.s. = On top of that. (3. the map t t-+ J(H}t. This linear mapping is unique in the following sense.dS) < +00 } . (:Fd~?'o .'12 dS).sw. ::.4.. On the other hand. T.o is a sequence of simple processes converging to H in the previous sense. for any t. '10::. (3.T is in.. (3. T.I(Hc!>(n)) is uniformly convergent. 2. There exists a unique linear mapping J from H to the space of continuous :Ft-maningales thus.7) and from the fact that E(I(Hnm lows that E(J(H). previous properties then p a. We have =E (JoT IHsl2 dS).dS). Proposition 3. there exists a subsequence Hc!>(n) uch that s H = { (Ht)05.) We denote. measurable.4.38 Brownian motion and stochastic differential equations r I Stochastic integral and Ito calculus 39 Remark 3. we can conclude. ' The uniqueness of the extension results from the fact that the set of simple processes is dense in H. the stochastic integral satisfies the following properties: Proposition 3.12 dS). : We now prove (3. Moreover.H. by definition.5) We shall use the fact that if (Hs)s5. P). 1ft::. we notice that (3. In the same way.3) is still true if H E H. T.5 If (Hdo<t<T belongs to H then = E (JoT IH'.T.7) arid since E(SUPt5.r}HsdWs. we obtain . exists a sequence (H'. almost surely. limn-++oo I(Hn)t J(Hh in L2(ft. < tn T and the Ai'S are disjoint and :Ft. there. =l. Consequently I(Hc!>(n))t converges towards a continuous function which will be. it fol- 1.T is a simple process.6).) P a. from (3. we have If t ::.for HE H.:P) norm and. Tj.o an :Ft-Brownian motion.. E (loT H. we are going to extend the concept to a larger class of adapted processes H Therefore. t ::. indeed .. 1fT is an Fi-stopping time p Proof.4.. n-++oo 0 .3 We write by definition iT HsdWs = loT HsdWs -lot HsdW s- A proof of this result can be found in Karatzas and Shreve (1988) (page 134.5).3) Now that we have defined the stochastic integral for simple processes and stated some of its properties. the series whose general term is I(Hc!>(n+1)).H. First = lim E (iT IHs . J(H)t if both J and J' satisfy the = J'(H}t. and we prove (3. t ::. and if A E :Ft. defined on [0. We first consider stopping times of the form T = L:1<i<n ti1A. HsdWs = loT 1{s5.T I(Hnm 2.) s5. suc~ that: 1. then s -+ lA 1{t<s}Hs is still a simple process and it is easy to check from the definition of the integral that loT lAHsl{t<s}dWs = lA iT n. lot HsdWs = J(H}t. First of all.s.T of simple processes such that .adapted process.4 Consider (Wdt?. where o < tl < . 4E (JoT IH. (J(H)SO~t5. This is justified by the fact that the simple processes are dense in Hand' by (3.7). If H E Hand (Hn)n?. If (Hdt5.5) in that case. for any 0::.t5. Taking the limit in (3.7) That implies that (J(H)do<t<T does not depend on the approximating sequence. we prove (3. problem 2.5). J(H)t = I(Hk =E (lot H. From (3.4).'12 dS) = O. because the conditional expectation is continuous in L2(0.

and is equal to H. .robability then SUPt~~ 1}(Hn)tl converges to H~du < liN}.4. It is easy to deduce from the extension property and from the continuity property that if H E 1t then P a.adapted process. = by: on the set il = {(Hs)o~S~T (Fth~o . P) (a subsequence converges almost surely). H~du ~ n} (+00 if that set T is empty). Since T Uo H~du < +oo}. T The following proposition defines an extension of the stochastic integral from 1t to il. = = and then IoT l{s~T}HsdWs = I. Ios H~du ~ on the set {I. I The process t t-+ }(H)t is almost surely continuous.dWs = It l{s~Tn}H:+ldWs. if H E il. Then. IT H. O<t<T -- 41 is not also. To do so. In order to prove this result for an arbitrary stopping time T. = H. I. .5) implies that This last term converges to 0 by dominated co~vergence. It follows that lA. u. H.5) for an arbitrary stopping time. r-. Vt:::. Since {Tn:::.'du<l/N} SUPt~T 1}(H)tl ~ €). we can define almost surely a {faT H~du < n}. and relation (3. IoT l{s>T}HsdWs = llA.6 There exists a unique linear mapping from space of continuous processes defined on [0. that is why we define . on the set Un~oUoT H~du process J(H)t - converges to 10 l{s~T}HsdWs in L2(0. il into the vector P (SUPt~TI}(H)tl ~~) <P (I. . IoT (H. otherwise. We just need to prove the continuity property of J. are adapted and bounded.s.Hs is adapted because this process is zero if s :::. hence they belong to 1t. we show that Tn is a stopping time. Consistently. Extension property: If(Ht}09~T Pa.4. it is true if H E 1t.ds liN} ~ liN) +P (lUoT H.such that: 1. inf {O :::.. we shall need processes which only satisfy a weaker integrability condition than the processes in 1t. }(H)t = J(Hn}t.40 Brownian motion and stochastic differential equations Stochastic integral and Ito calculus Remark 3.)2 ds converges to 0 in . Proof. Moreover It H'. This result is true if H is a simple process and. 0 In the modelling.T. U. The extension property is satisfied by construction. Finally. 1:: 1{S~Tn}HsdWs Thus. l{s~Tn}' Firstly. t. T. we must notice that T can be approximated by a decreasing sequence of stopping times of the previous form.sw. each l{s>qlA. by density. we first notice that \ . Tj. = 1 T T HsdWs. for any t s r. 16 H~du is also Frmeasurable because it is the iimit of I6(Hu A K)2du almost surely as K tends to infinity. then o in probability. J(Hn)t J(Hn+l}t. That completes the proof of (3. Proposition 3. we see immediately that the processes H'.ds < +00 P a. If = U6 H~du ~ n}. Continuity property: If (Hn)n>o is a sequence of processes in il such that If we call TN = inf {s :::. HsdWs. s :::. for any t :::. t} we just need to prove that 16 H~du is Frmeasurable. by definition. therefore T .T.7 It is crucial to notice that in this case (16 HsdWs) necessarily a martingale. Let H E ic. Vt :::.H~du < n} = < n}. it follows from (3. }(H)t J(H}t. }. and H'.T. 2.s:VO is a simple process then :::.5) that. }(H)t t 7' [(Hit. we write 16 HsdWs for }(H)t. and define t. :::. (+00 if this set is empty).s. l<i<n a L T l{s>qHsdWs T L l~i~n -- =L t. therefore it belongs to 1t.

5:.foT IK.T.LJ(Kn)t.t5.s.T is a martingale ifE (fo the inequality E < +00.T is an IR-valuedlto process ifit can be written as As a result. dW. u.dW. called Hand K.9 /f(Mt)05.T Jo (t 2) < +00.)2ds T·' converge to 0 in probability. = K. is a continuous martingale such that We can prove the following proposition (see Exercise 16) which underlines the uniqueness.dW. .Indeed. i. If it were equal to <P (foT H~ds ~ ~ ) +N W? /2 it would be non-negative.t5.TN} = 2 f~ f (s )j(s )ds = In the Brownian case. = ti.e. or to Karatzas and Shreve (1988) for a complete proof. Finally.1'.dW. null at zero. by applying (3. +4/E2E (1: H. (Fdt~o. from the previous section we know that f~ W. for a = x. .42 Brownian motion and stochastic differential equations we get Stochastic integral and Ito calculus differentiable function f(t) null at the origin. It will be called the Ito calculus and the main ingredient is the famous Ito formula. and a non-negative martingale vanishing at zero can only be identically zero.T as then Mt = fot K_.e. 0 = + where • Xo is Fo-measurable. it is impossible to have a similar formula P (~~~IJ(H)tl ~ E) <P (foT H.T Summary: Let 'us consider an Ft-Brownian (Hd095. By construction. . we have f(t)2 2 f~ f(s)df(s). The following example will simply show that a naive extension of the classical differential calculus is bound to fail. K. i 0: 0 =' Xb + it K~ds + 0 Jo r t H. (Xt)05. In particular.H.t5.ds) < +00). < +00 T P a. soonasf: H. H. IK. to prove the continuity of 1. By continuity of J we can take the limit in the equality J(>"Hn J. + f~ Kids We shall state Ito formula for continuous martingales.dW. Let us try to differentiate the function t -t W? in terms of 'dWt'. Indeed.) (SUp 05. < +00 P a.5. = O. the Ito formula allows us to differentiate such a function as t t-t f (Wd if f is twice continuously differentiable. 'lit ~ T.the H. and the two sequences H[' and K[' defined at the beginning of the proof such that fo (H". the fact that if HE it then f: (Ht-H[')2dt converge to 0 in probability and the continuity property yields the uniqueness ofthe extension.T • f: T are Fe-adapted processes.lds • 2 We are about to summarise the conditions needed to define the stochastic integral with respect to a Brownian motion and we want to specify the assumptions that make it a martingale.ds + it H. = 0 dt x dP a.lds < +00. W? 43 whence.ds motion (Wt)t>o and an Ft-adapted process We are able to define the stochastic-integral (J~H. dP a.ds) process Ij'[ H..If (Xt)05.. I {.K.e..ds) E P a. dW s. This is proved in Exercise IS.T and (Ht)095. with P a.8 Let (0. < +00 is satisfied if and only if H.J of the previous decomposition. I{.An Ito process decomposition is unique. .s. Definition 3. This condition is not necessary.4.T is a martingale of the form Xo K. This implies that: (1: H_. 3. then .1 ds < +00 P a. P) be ajilteredprobability space and (Wt)t>o an FtcBrownian motion.ds. That means that if X. = Xo then Xo + t K. + f~ ds x dPa.dW.t5. . • fo IH.LKn)t >"J(Hn)t +J. • (Kt)05. Typically.l ds converges to 0 in probability. )05.s. when (Wd is a standard Brownian motion. .t5:. if f: (H.4) to the process s t-t H. The interested reader should refer to Bouleau (1988) for an elementary proof in the Brownian case. H.s. then SUPt<T IJ(Hn)tl converges to 0 in probability. Proposition 3.4.t5.2 Ito calculus It is now time to introduce a differential calculus based on this stochastic integral.s. _ In order to prove the linearity of J.e.)2ds T and fo (K".ds ~ ~) TN = 2 f~ W.4.s.)o5.dW •.t5. We shall define precisely the class of processes for which the Ito formula is applicable. let us consider two processes belonging to 1i. ds x dP a. is a martingale (because E }ds) 4 E2' (f~W.

We have just proved the existence of a solution to equation (3. W? - In conclusion (3..X)s To put it in a simple way. because f(x) is not a C2 function!). then f(Xt) P a. + lot f:(s.11 We could have obtained the same result (exercise) by applying Ito formulato St = ¢(Zt} . ~ X'o + fat S8 (J-LdS adW:). We must check that conjecture rigorously. it. we can write t is a martingale. let us do a formal calculation.8). We now want to. Ssds and J. X8)ds + ~ fat f~x(S:Xs)d(X. Wt) Wt2 It turns out that =2 i 0 t WsdWs r + "2 '1 = f(O. + This is often written in the symbolic form St = Xo + . Since E = t. f is a junction of class C1.ds) < +00. t Likewise.3 Ito formula is now applicable and yields = x2 and X. + fat f~(s.9) Remark 3.X)8' St = Xo exp ((J-L. s.8) s.10 Let (Xt)09$T J.x) (i. if(t. If f(x) identify K. = Xo + lot K8ds + lot HsdWs. SsdWs 45 exist and at any time t x.8).4. W.9). = Xo + fat J-LSsds + lot aSsdWs. and we obtain whe re. = f(Xo) + lot f'(X. with Zt = (J-L-a2 /2)t+aWt (which is an Ito process) and ¢(x) =nxo exp(x). We are actually looking for an adapted process (Stk:~o such that the integrals . . Wo) + fat f:(s. W8)dWs Furthermore. W)t Wt2.. x) is ajunction which is twice differentiable with respect to x and once with respect to t.)dXs + ~ lot j"(Xs)d(X.8).. 3. and if these partial derivatives are continuous with respect to (t. and f be a twice continuously differentiable function. thus s. since (W. So = Xo· (3.x)=xoexp((J-L-a2/2)t+ax). Xo) Yt = log(St) = log(So) Taking that into account. To do that.s. W)8' io 2ds. r - (J.4.a2/2) + aWt) + lot f~(s.4. Wt) with rJ f(t. we shall use the integration by parts formula. = Wt. We write Yi = log(St) where St is a solution of (3. we apply Ito formula to f(x) =log(x) (at least formally. Ito formulabecomes f(O. = f(t.e. we get t i and o f'(Xs)dXs ' it = 0 f'(Xs)Ksds + it0 f'(X8)HsdWs' and finally Yi = Yo + fat (J-L a2/2) dt - + fat adWt. We are about to prove its uniqueness.~ fat'f~/x(S. We have St = f(t._ t = 2 fat WsdWs. St is an Ito process with K s = J-LS and H s = as 8' 8 Assuming that St is non-negative.44 Brownian motion and stochastic differential equations be an Ito process Stochastic integral and Ito calculus Theorem 3.Xs)dX8 Examples: Ito formula in practice is a solution of equation (3.2). 0 SsJ-Lds+ it 0 SsadWs" as. Ws)ds +. Ws)d(W. by definition Using (3. x) -+ f(t. ~ St (J-Ldt+ adWt). we Let us start by giving an elementary example. = 0 and H8 = 1.tackle the problem of finding the solutions (St}t>o of it confirms the fact that . it seems that + (J-L a2/2) t + aWt.

)dX.46 cesses. + (X.adW.. From the integration by parts formula. 3.dY. Z. Then Brownian motion and stochastic differential equations Stochastic integral and Ito calculus In this case.4 Multidimensional Ito formula We apply a multidimensional version of Ito formula when 1is a function of'several Ito processes which are themselves functions of several Brownian motions.adWs). Theorem 3.13 If we consider two real numbers a.s. H.2/2)t verification that we have just Gone shows that + a'Wt) + lot 1'(X.)H.s. + J.adW. = Xo + lot This process is given by S. we have 47 Proposition 3. + lot X.8) and assume that (Xt)t>o is another one.L +.). x. P a.L and a Brownian motion (Wt}t>o and a strictly positive constant T. XtZt is equal to XoZo. Y)t Therefore r It (Xo d(XtZt) = + XtZt{(-J. we can compute the differential of x. We attempt to compute the stochastic differential of the quantity Define .' .Ldt+ adWd . XtYi = XoYo with the following convention (X. t ).. The processes X. St is actually a martingale (see Proposition 3.) = 1+ lot Z.a. + J. this proves that +2J. it turns out that X. Zt = -S = exp (( -J.dX.4.z.12 (integration by parts formula) Let Xt and Yi be two Ito prox. Z)t = (L X. K. ·oJ s. + 10 o We now have the tools to show that equation (3. (J.XtZta2dt l = 0. ' . J. e be an open set in lR and (Xt)O<t<T an Ito process which stays in e at all times.'.)d(X.L a2 /2) t - + a Wt) is a solution of (3. I I :.4.ds I~ I[ "It ~ 0. if Xt is a strictly positive process. . = XOZ. + Ys) + H~)2ds H.z.4.)t = -Io.(H. = Xo + J.(X. there exists a unique Ito process (SdO. This .15 Let I(Xt) /= 1(.ds. Then Zt = exp((J.0) J.4.H~ds. = 1+ lot This result allows us to apply Ito formula to 10g(Xd for instance.T which satisfies. P a.L' . + ~ lot f"(X.8) has a unique solution. Hence. and Zt being continuous. which implies that Proof. K~ds + J. = XOZt-1 = St. H:2 ds. y? XtYi = XoYo = + 10 tt Y02 + 2 J. and the z. We have just proved the following theorem: xg + 2 J. By Ito formula (Xt + Yi)2 = + YO)2 + Y. X. If we consider a function 1 frcnn.3) called the exponential martingale of Brownian motion.L'=' -J. x.3.a 2)/2 t . Xl.:::. • When J. + lot Y.l = St. (( -J. Remark 3.dY. t H. + J.L + a2 and a' = -a. - L Z. Recall th~ .14 • The process St that we just studied will model the evolution of a stock price in the Black-Scholes model.aWt So .e to lR which is twice continuously differentia~le. "It ~ 0.ds + J. H~dWs.dWs and Yi = Yo + J.Lds+ adW. we can derive an extension of Ito formula in that case Remark 3.as.for any t ~ T.L'ds + a'dW.(J. St. + 10 Y. .dY.dX. = Xo exp ( (J. X.s.dX.L= 0. By subtracting equalities 2 and 3 from the first one.L + (2) ds . t a2 x.4.L+a2)dt-adWt) XtZt (J. Y.

5.P L. Xt) dWt The following theorem gives sufficient conditions on b and a to guarantee the existence and uniqueness of a solution of equation (3. ·. where all the (WDt. .idWi S Remark 3. Xa Remark 3.aw]. 2 ds < +00 P a.5.4..) x.3 lfb and a are continuous functions and K < +00 such that • (X..x~. whether we are speaking about stocks or interest rate processes. ..:a adapted to Ft.::-a are independent standard Ft-Brownian motions. 3.a«.i dWi s s i:=l then.4.s.s.. . we can define a multidimensional Ito process.s.. ..P L.. t fa x1.17 (Xt)a9~T is an Ito process 'I ri I Stochastic differential equations 49 J~ H~dWDt = J~ HsH~ds.m Hj.. .Xs)ds+ fa O'(s. This definition leads to the cross-variation stated in the previous proposition.. Definition 3.Xi)s . • (J~n./0) is an Fi-adapted stochastic process (Xt)t. - t t 'v't~O Pa.. I Ito theorem Whatdowe mean by a solution of(3. Definition 3. • JoT IKslds • JoT (H. X%. . if there exists a constant • (J~tc. < +00 ~ a. 2 a '-I 1.-m=l Hi.Xs)ds + fat O'(s.xv.::-a satisfies (3.e.48 Brownian motion and stochastic differential equations version will prove to be very useful when we model complex interest rate structures for instance. We can now consider some more general equations of the type where: • Kt and all the processes (Hi) are adapted to (Ft).. . Let us first study some properties of the solutions to these equations. J~ H~dW/)t = 0 if i y': j.x.2. Wn k..18 Let (Xl. i.. . a Hi.Xs)dWs.::-a that satisfies: • For any t ~ 0. Xs)dWs !at Ib(s. 5' 82 j . A.mds s s '{ ex. . (3.10) Ito formula becomes: Proposition These equations are called stochastic differential equations and a solution of (3.. These equations are useful to model most financial assets.5:1 We consider a probability space (0.Xfn t + fat ~~ (s..Xs)lds exist + "'f 'n 8 8. Xs)ds and J~ O'(s.::-a. Xi) s = .. we can define formally the cross-va-ri~tion of X and Y (denoted by (X. 3.t=Z+ fa b(s.s.Xs)dWs.5 Stochastic differential equations • (J~HsdWti.Xs)12dS < +00 P a. .".XJ. if j is twice differentiable with respect to x and once differentiable with respect to t.10) as .. . the integrals J~ b(s. X:)dX. .5. we often write equation (3. = 0 if (Xt)a9~T is an Ito process. 3. -1 solution to equation (3.X~.. XiXi • (Xt)t. we studied in detail the solutions to the equation if x. x) j(O.4. with continuous partial derivatives in (t. a : IR+ x IR --+ IR. = x + fat Xs(/Lds + O'dWs). +~ with: L i-8-(s.P) equipped with a filtratioh (Ft)t. X:)d(Xi.. Xt) dt Z + a (t. ../0). Along these lines.4. Theorem·3.) be n Ito processes Xi'= t = Z + fat b(s.".1 0) is called a diffusion.1-. a Fa-measurable randomvariable Z and finally an Fe-Brownian motion (Wdt>a..16 We call standard p-dimensional FrBrownian motion an IRPvalued process (Wt = (Wl.2 Formally.. • ax: = Kids + S 5 .10). Y)t is bilinear and symmetric..4. We also have functions b : IR+ x IR --+ IR. d(Xi ./s..J==l Hi.. Y)s) through the following properties: b (t.19 If (Xs)a<t<T and (Ys)a<t<T are two Ito processes..X:)ds' Definition 3.1O)? Xi a + i t «: n a s ds +~ '" P it . < +00 andfatIO'(s. In Section 3.

above by k(T) = (2(K2T2 + 4K2T)) 1/2. alb and J(T) ::. and define Tn = inf{s ~ 0. Ys))2dS) u'(t) = e-bt(f(s) < 2(K2T2 + 4K2T)E '( sup IXt .b(t. then J(T) ::. K(l + Ixl) 3.10) always belongs to c. 'E(Z2) < +00 then.10) admits a unique solution in the interval [0. Ys))dsI 2 + 2(K2T + 4K2) E (suPO~U~SIlTn IXuI2)) dS) . Xs)d~ + lot a(s. That proves the uniqueness of a solution of equation (3. . it turns out that ~ is a contraction from E into c. On the other hand. Moreover. a + b fo J(s)ds.0)dWsI2) O~t~T 0 O~s~T IXsI2) < +00 The uniqueness oj the solution means that if (Xt)O<t<T and (Yt)O<t<T are two solutions oJ(3. Lemma 3. a + b lot r(s)ds. this solution (Xs)O~s~T satisfies E ( sup whence II~(X) -~(Y)II ::. -sr In order to complete the proof. Proof. We define the set O~t~T 1~(0)tI2) ::. su~h that E (~~~IXsI2) < +oo} . ~ -Yi. if we denote by 0 the process that is identically equal to zero and if we notice that (a + b + C)2 ::. t 09~T (I 0 < 2E (sup Ib(s.(s)ds) o ::. Let us write u(t) o I = e-bt f. t ::. a(l + ebT). Ys))dWsI2) and therefore by inequality (3.0)dSI2 + sup Ilt a(s.10) which belongs to E is a fixed point of~. we can say that ' -c) ~(X)t = Z + lot b(s. Let X be a solution of (3. then P a. T. if X is a fixed point of ~. Ys)ldS) 2) . -Proof.a(s. Klx .Xs) +sUPO~t~T If~(a(s.10) in the class c. Xs) .. let us recall the Gronwall lemma. ~(X) is well defined and furthermore if X and Y are both in E we can use the fact that (a + b)2 ::.x)l::. That completes the proof of the existence forT small enough. On the other hand. IXsl > n} andr(t) = E (suPO<S<tIlTn IXsI2). t ::. We deduce that ~ is a mapping from E to E with a Lipschitz norm bounded from E = {(XS)O~S~T' Ft-adapted continuous processes. E (suPO~u~tIlTn IXuI2) s 3 ( E(Z2) < 3 (E(Z2) +E (I~IITn K(l + IXsl)ds f If X belongs to E.10). it is a solution of (3. X.5. x f~ This yields the following inequality (1 + . . b(s.4) E (sup 1~(X)t . Ib(t.~s) . = .a(t.1O). Ib(t. If we assume that T is small enough so that k(T) < 1. Xs)dWs.Y)1 ::.50 Brownian motion and stochastic differential equations Stochastic differential equations 51 1. '10 ::. ae-bt. a(l + ebT). Together with the norm IIXII (E (sUPO<s<T IXsI2)) 1/2 C is a complete normed vector space. (2(K2T2 + 4K2T))1/2 IIX . .10). 3(a2 + b2 + c2) 1~(0)tI2 ::.YII.x) .a(s.~(Y)tI2 +4E (I~IITn K2(1 + IXsI)2ds)) <' 2 (suPO~t~T'lf~(b(S. Thus it has a fixed point in c.b(s. It is easy to check that In(t) is finite and continuous. 3(E(Z2) + K2T2 + 4K2T) < +00. Let ~ be the function that maps a process (Xs)O~s~T into a process (~(X)s)O~s~T defined by . J(s)ds. Using the same comparison arguments as before. 0 +8E (loT (a(s.x) .b It f. T. for any T ~ 0. In order to show the existence of a solution. 2(a2 + b2) to write that 1~(X)t . In order to prove the uniqueness in the whole class of Ito processes. (3. we just need to show that a solution of (3.yl 2. a solution of (3.x)1 + la(t.~(Y)tI2) ret) ::. J(t) ::.Y)1 + la(t.4 (Gronwalll~mma) If J is a continuous function such that for any 0::. Moreover. 3 (Z2 + Therefore E (SUp sup Ilt 0 09~T b(S. T].Yi12) 09~T By first-order integration we obtain u(T) ::. Then. Xs) . we are going to use the theorem of existence of a fixed point for a contracting mapping.s.

[Tin. this solution satisfies for anyT E ( sup IXsI2) < +00. n (I~ (e~~)2ds) Var(Xt) < +00...fo~ any t and for any i ::. = xe'-ct. An are real numbers and if 0 ::.5. since X. For an arbitrary T..}ecsdWs = mi + lot h(s)dWs.yl . we just notice that < K < +00. T]. We consider • W = (WI.l)T In. This generalisation proves to be useful in finance when we want to model baskets of stocks or currencies. x) ) . Therefore X belongs to [. 0 Then A1Xtt + . W") an lR" -valued FrBrownian motion.lb(t. It follows from Fatou lemma that. (3.s.ec')t oe" dWt and thus = (ai. This enables us to compute the mean and variance of Xt: E(Xt) (since E = xe-ct x.x)h~i~n . E(IZI2) + la(t.. j=l ai. = Zi + it o bi(s. + ae-ct• lo+oo l{s~t. Al Xtt + Xt• 53 In our case.. b" ( s . a2~-2ctE 2 (J 2. x). Similarly X. E(Xt))2) -2ct (lot eCsdWs ) (lote2cSd~)' .. .. . Xs) dWs. K(I + Ixl) = 1-.. l~j~" a.[(n . we have fn(T) < K < +oo.3 Multidimensional stochastic differential equations 3. 0 (e 2) The theorem of existence and uniqueness of a solution of (3...whereKisafunctionofTindependent of n..5.similar to the one in the scalar case. • a: n+ X lRn --+ lRnx" (which is the set of n x p matrices). . E ( sup IXsI2) O~s~T . a(s.x) It can be' written explicitly. J~ecsdWs E ((Xta2 E thereforeits expectation is zero).5:5 If x E lRn. it yields Furthermore (X.l~j~". = Z + lot b (s.y)1 3. + AnXtn = E7=1 Aimi + J~(E7=I Adi(S)) dWs which is indeed a normal random variable (since it is a stochastic integral of a deterministic function of time).11). .11) can be stated as: Theorem 3. lal = El~i~n. This means J/ .x) .y)1 ~ Klx . if we consider Yi parts.j(s.Xs)ds + tit . the process (Xtk~o is Gaussian. x) = (bl ( s. there exists a unique solution to (3. processes evolve in lRn. Z") an Fo-measurable random variable in lR ". : .a(t. for any T.j(s. . is a normal random variable. It follows that dYi e cSdW s· • z = (Zl. 3. O~s~T The proof is very . We can also prove that X. b(s . we consider a large enough integer n and think successively on the intervals [0.» and integrate by The analysis of stochastic differential equations can be extended to the case when . . Xo = = x. . Moreover. Tin]. More precisely. Ib(t. tl < . Xs) ds + lot a (s. • b: lR + x lRn --+ lRn. and that completes the proof for small T. < t-: the random variable + AnXtn is normal.. 2T In]. we are looking for a process (Xt)O<t<T with values in lRn.Xs)dWj. ...x)1 + la(t. we denote by Ixl the Euclidean norm of x and if nx 2 a E lR ".j' We assume that 1. = 0 because d(ect) Xt = xe -ct + ae -ct it o = cectdt.x)l::.11) + ae-ctE (lot eCSdWs) = xe-ct is a martingale null at time 0 and . We are also interested in the following stochastic differential equation: '. .2 The Omstein-Ulhenbeck Omstein-Ulhenbeck process process is the unique solution of the following equation: { ax. To convince ourselves. adapted to the filtration '(Ftk~o and such that P a. In other words.x) -b(t. can be written as f(s)dWs where f(·) is a deterministicfunction of time and J~P(s)ds < +00 (~ee Exercise 12).2ct e2c < +00 then.52 Brownian motion and stochastic differential equations Stochastic differential equations that if AI. Indeed.

9 Let (Xt)t>o be a solution of(3. We are only going to sketch the proof of this lemma. It is a Markov process with respect to the Brownian filtration (Ftk~o.Ws.x.3.7 Let (Xtk~o be a solution of (3. for any bounded Borel function f we have P a. =X:+ 1 s b (u. Yet again.Y) dWu.5 in the Appendix to Xs.y and also X. If we apply the result of Proposition A. <I>_and s.s. Remark 3. X~) du The uniqueness of the solution to this equation implies that X~..X) du u + _1 t s a (u . s. In particular. the reader ought to refer to Friedman (1975). it will allow us to show that the price of an option on an underlying asset whose price is Markovian depends only on the price of this underlying asset at time t. if t ::.5. X. u. u. is defined for any (t.. E (f (Xt) IFs) = ¢(Xs).5.X. For any x. x. X!.1O) and r(s. 10).::: 0))1 Fs) + ~s s b. If we use this result for fixed sand t we obtain xt.(u. The previous result can be extended to the case when we consider a function of the whole path of a diffusionafter time s.:::t.10).)dWu.::: O)))lx=x.s. For instance. We shall denote by (X. u.X. t.Ws+u - w. X[ Xt' '.3. a + J/ (u. Furthermore. (Ws+u Ws)u~o. s) which is almost surely continuous with respect to these variables and is a solution of the previous equation.s. and is not influenced by the history of the process before t..X~. X~.X <I>(x. but they can be proved rigorously by using the continuity of H We can also notice that is also a solution of the previous equation.X) dW u U· = E (f(xt. s . xt. b (u. an Fradapted process (Xt)t>o satisfies the Markov property if.::: ) and thus W 0 = x: Proof.x = X..::: 0) (this result is natural but it is quite tricky to justify (see Friedman (1975)). Ws+u ( - P a. The Markov property is a consequence of the flow property of a solution of a stochastic differential equation which is itself an extension of the flow property of solutions of ordinary differential equations. with ¢(x) 1 t s "b (u xt.X satisfies Xt.X))lx=x~ -0 1 s b(u. X~) dWu' for 0 X[ b (u. if s ::. the following theorem is useful when we do computations involving interest rate models.Ws)u~o is independent of Fs.X~. we have = <I>(X:.Ws. the Markov property can be stated as follows: s = We are going to state this property for a solution of equation (3.2. =y w. This result is difficult to prove and the interested reader should refer to Rogers and Williams (1987) for the proof. we shall only sketch the proof of.'x = x + It follows that.8 The previous equality is often written as A priori.X)).X~'Y) du +l a (u. for any y E JR.4 The Markov property of the solution of a stochastic differential equation The intuitive meaning of the Markov property is that the future behaviour of the process (Xtk~o after t depends only on the value X. t ::. x) be a non-negative y x».5. it turns out that F E (f (<I>X: . s x' The-flow property shows that. These results are intuitive. This is a crucial property of the Markovian model and it will have great consequences in the pricing of options. U .x = x ~ s Theorem 3. Lemma 3.'X. For a full proof.5. we can build a process depending on (t. we can prove that xt. s+u . X~.X) dWu. W = E (f (X:. xs= x + J. X: . .X) du + 1 s s a (u. U . . X~) dWu a (u. we have E (f (Xt) IFs) E (f (Xt) IXs) . x= if s .::: 0). On the other hand. under the assumptions of Theorem 3.5. x. For s .X~.s 55 3. However.6 Under the assumptions of Theorem 3. Mathematically speaking. E (f (<I>(x.this theorem.54 Brownian motion and stochastic differential equations Stochastic differential equations Indeed.'x. In this case. P a..x the solution starting from x at time O.:::t Proof. x) almost surely. where X: is Fs-measurable and (Ws+u.:::-) the solution of equation (3. X~) + J/ du + J. Theorem 3.5. for any bounded Borel function f and for any ~ and t such that s t.)dU~ 1 a(u.10) starting from x at time t t and by X" = Xo. s+u ~ w.X is a measurable function of x and the Brownian increments (Ws+u .5.

Conclude that if S ~ measurable. E ((Mt _ Ms)2IFs) = E (Mt2 -'M.t.56 measurable function. t s: s: r(X~'X)du I(X~'X)) . Prove that if (Xn)n>O is a sequence of normal random variables 'with zeromean which converge to X in L2(0.IFs) . In that case.(X:.t is the same as the one of X~. Prove that.F.' Remark 3. r(X~.}.B(lR)) Xs(w) and thus that Xs is Fs- E(¢.. and 0 = to ~ t1 ~ 1= Il/il£2 = (Io+oo j2(s)ds) 1/2.. andE(I(f)2) = 11111£2. with ai E lR.t)) = E (J(X~'X)).s.+d· 3. x. A n {T ~ t} E Ft} 2.' r(u.f. In particular. t]) x Ft) (s.P). Prove thatFs eFT. one can prove a more general result. Prove thatE (Xt) = ct and that Var(Xt) = c't. (k+1)/n[(S)Xk/n(w). O:Si:SN-1 L +00. w) is measurable.)du 1(Xt) IFs) = ¢(Xs) Exercise 10 Let Sand T be two stopping times such that S ~ T P a. 3. = {A E A.. and (Xt)t>o adapted process almost surely continuous.)du 1(Xt) IFs) = E (e- fo -.X.ncept of stochastic integration. Remark 3. . a.5. (f) is a normal random variable and compute its mean and variance. the Theorem 3. P a.X. This type of integral is called Wiener integral and it is a particular case of Ito integral which is studied in Section 3.s.' r(u. ~ tN is dense in the space £2(lR+." r(X:"X)du 1(X:. E lR. Prove that the mapping "1[k/n ~ k~O .when 1belongs to 11. be a process with independent stationary increments and zero initial value such that for any t.)du 1 (Xt) IFs) = E (e.f.1'.. B([O.X)du I(X~:_~)) Ix=x.+ 1 _ Xt.f. for any 1 in L2(lR+). We want to build an integral of the form l(s)dXs.suchthatI(f) = Ie(f). then X is also a normal random . show that is a stopping time. the following stronger result is still true: Pa.. where (Xt)t>o is an Ft-Brownian'motion and I(s) is a measurable function from (lR+.9 becomes E (e. We define Ie(f) = L O:Si:SN-1 ai(Xt.x. dx) endowed with the norm l.' r(u. . Consider E (e. P). B(lR+)) into (lR.. FT is a a-algebra. Without getting into the technicalities. which implies that if 1 is a bounded measurable function. prove that Sis Fs-measurable. t~s))lx=x. and to = 0 ~ t1 ~ . Exercise 8 Prove that.5. 57 >s P a. where c and c' are two constants. We~recall that the set 11. ~rom ~his. tj x 0. E(Ml) < Prove that if s ~ t .t) ) =E (e.X:"X)du I(Xt"")) Ix=x. t.+d.. 3. Exercise 7 Let X.11 When' b and a are independent of x (the diffusion is said to be homogeneous).'X. for all t ~ 0 . We shall also assume that the map t r-t E (Xl) is continuous. and call ai1jt. B(lR)) such that j2 (s )ds < +00. --+ f---+ (lR. if T Prove that I. We can extend this result and show that if r is a function of x only then Exercise 12 This exerciseis an introduction to the co. then E (J(X:.5.f. l. of functionsof the form LO<i<N-1 ai1jt. after time s.s.10 Actually. ~ i».I. E (Xl) < +00..4. be an Exercise 11 Let S be a stopping time almost surely finite. for any s It is also written as E (e. let us just mention that if ¢ is a function of the whole path of X.' r(X. ([0. we can show that the law of X:. Xs is Fcmeasurable.o be a martingale such that for any t..6 Exercises Exercise 6 Let (Mtk:~. For t Brownian motion and stochastic differential equations Exercises Exercise 9 Let S be a stopping time. t~s)IFs)= E(¢(X. = n-t+oo lim 2.. dx) mtoL (O. show that there exists a unique linear mapping I from L2(lR+.s.t. E (ewith f.

M. By applying the sampling theorem to the stopping time 5 ~ (Ms l{s>s}IFs) 3. n---t+oc> (Mtn . SUP050t50TIMtl. to +00). a. Moreover. Z.MJ = E (JoTMn H. 1-1 ) 2) = O. inf{t ~ 0 If. M. exp(Zt . for 0 ~ t < 1 and x E JR. and we define z. Let 59 variable with zero-mean. Prove that E(M*) is finite and E ( sup Exercise 14 E((M* 1.2.s. Prove that P a. Prove that if we /\ A)2) ~ 2E((M* /\ A)IMTI). = u. fo IKslds for 0 ~ i ~n. E (fo H.s. Prove that fol H. H. equal to f. H. x) = O. a. MOI\A (Use the fact that (M* /\ A)P = fo pxp-1dx for p = 1. show that t --t MSl\t is an Ft- t. = < 00. = O.) 3. if M* . Remembering martingale.f.tJ(s)f(s)dXs.~ T. p(t. that MSl\s is Fs-measurable. Show that. 4. V s prove that Conc1ud~ that MT = 0 P a.x) = 1/\l"f=texp(-x2/2(1t)). AP (M* ~ A) ~ E (IMTII{Mo~>. Wd· and E (J. . .58 Brownian motion and stochastic differential equations Exercises Exercise 15 1. ~ n} = .s. Prove that if 5 and 5' are two Ft -stopping times then 5 /\ 5~ = inf (5.e« < +00 P a. = inf{O ~ s . Hint: introduce the sequence ~f ~topping times Tn = prove that Zt is adapted to Ft. Prove that the processes Zt. We assume that E(Mj. IKslds is Ft-m~asurable. then T IJo.s. HsdWs.~ f. fo IKslds is now assumid to be finite'almost surely as opposed to bounded. 1. and that Zt . (Hint: apply the optional sampling theorem to the submartingale IMtl between T /\ T and T where T inf {t ~ T. prove that ~ 1.Z.s.s. a . Under the same assumptions. Considering the sequence of martingales (MtI\TJt~O' prove that 'P a. dx).s. Deduce that if f E £2 (JR+ .) is finite.l{s>s}' = Msl{s>s}. we assume that write ti = Ti/n ~C < +00. 5') and 5 V 5' = sup(S. dx) then /(f) is a normal random variable with zero mean and a variance equal to f2 (s )ds. Define M. Let Mt = f. 'Vt ~ T. Wt).. Deduce that for s ~ t E (Msl\tl{s>s}IFs) 4. then lim E (~' ~ T be a continuous Ft-martingale tc. and p(l. = fat f(s)dXs = J (Ht)o50t50T be an adapted measurable process such that foT H'fdt < 00. Letp(t. 2. .5') are also two Ft-stopping times. j2(s)ds.) 4. dt) < 00. 5. where (Wt)O<t<1 is standard Brownian motion. We consider s: f E £2 (JR+ .dt 2.and thus 3.Mt~ 1. Show that Tn defined by T P a. (b) Let H. is independent of F. f2(s)ds) are 2. Prove that be a continuous (IMtI)0950T is a submartingale. (hint: begin with the case f E H). -(a) Prove that Exercise 13 Let T be a positive real number and (Mt)0950T Ft-martingale.s. From the previous result. 'Vt ~ T. IMti ~ A} (if this set is empty T is equal ap = ax (t.ds). limn-Hex> Tn T. 2.ds = n} = andsho~thatE(Mj. i=1 0950T IMtI2) ~ 4E(IMTI2). We shall accept the fact that the random variable f.}). Frmartingales. deduce that for positive A Exercise 16 Let (Mt)0950T where (Kt)0950T " T is an Ft-adapted process such that fo IKslds P a.dt) = +00. Show that if E (sUPO<t<T Ml) < 00. 10 t IKslds = O.(or T if this set is empty) is stopping time.

. and A Mt be a martingale of the form +00 P a. Let (Yi)t>o be a continuous stochastic process independent of the a-algebra B such that-E(suPO<s<K IY. the solution of the following stochastic differential equation ax.. where o < tl < .rA)) . wt 2: A) u = 2P(Wt - 2: A) .). then v s = E (exp (iz(Wv+s .')dt + (oXt + a')dWt { Xo = O. P(Wt :::. Wt 2: A) A Conclude that wt = P(Wt 2: A.J~ H. P a.u)/2) . Prove that = exp ((fJ. Apply the optional sampling theorem to the martingale M. Finally.. Let T be a non-negative B-measurable random variable bounded from above by K: Show that E (YTIB) = E (Yi)lt=T' We shall start by assuming that T can be written as I:l<i<n ti1A..s. Derive the stochastic differential equation satisfied by St-1 d(XtS.s.s. wt 2: A) ~ P(Wt 2: A). sUPs9 Ws). + J~ Ksds with J~ H. where z is a real number to prove that if 0 u :::. 5.fi.ds < 2: 2: 0. (fJ'xt + fJ.aa')dt + a'dWt). in order to prove that K.sw. 3. 2: 0 Exercise 17 Let us call X.). wt 2: A) = P(Wt 2: 2A u and if A :::. = J~IKslds < +00 J~ n. Ws > A}.a /2)t 2 + aWt). Show that if we write Wt = sUPs9 Ws and if A 2: 0 P(Wt :::.. Deduce that W! = Wu+s . = 4. .Wt) 1{T>'~t}) .' . Define the sequence of stopping = 0 dt x P(Wt :::. motion independent 2.I) < +00.rt3 exp ((2Y -X)2) 2t dxdy. = 7. If A 61 fJ. +A)) E (i(Wt)l{T>'~t}) where ¢(u) = E(f(Wu and prove that + A)). < t« K.. . Wt) is given by We write St 2. and IWtl have the same probability law. . 1 l{o~y} l{x~y} 2(2y-x) . Obtain the explicit representation of Xt. . The purpose of this exercise is to compute the law of (Wt. fJ. 1. prove that if f is a bounded Borel = E (l{T>'~t}¢(t . and times Tn P a. Exercise 18 Let (Wt k:~obe an Ft. and the Ai are disjoint B-measurable sets.Wu+s)) IFu+s) = exp (_Z2(V .60 4.ds 2: n}.Ws is an 'Fs+u-Brownian of the a-algebra Fs- 3.fJ. Consider 5 a bounded stopping time. We denote by rA the inf {s function we have 2: 0. . . inf{t :::. Let Brownian motion and stochastic differential equations Exercises 6.l) = St- ((fJ. prove that fJ. T. 1.P(Wt 2: fJ. check that the law of (Wt. exp(izWt + z2t/2).Brownian motion. Notice thatE(f(Wu T>'91}) = E(f( -Wu +A)) E (f(Wt)l{ = E (i(2A . and A wt 2: A) = P(Wt 2: 2A .

1lhe behaviour of prices The model suggested by Black and Scholes to describe the behaviour of prices is a continuous-time model with one risky asset (a share with price St at time t) and a riskless asset (with price Sp at time t). leads to some formulae frequently used by practitioners. which is based on similar ideas to those developed in discrete-time in Chapter 1 of this book. We assume that the behaviour of the stock price is determined by the following stochastic differential equation: dSt = St . s.t and a are two constants and (Bt) is a standardBrownian motion.4 The Black-Scholes model I· I I Black and Scholes (1973) tackled the problem of pricing and hedging a European option (call or put) on a non-dividend paying stock. = So exp (J. Note that r is an instantaneous interest rate and should not be confused with the one-period rate in discrete-time models.1 Description of the model 4. . we give an up-to-date presentation of their work. (J.3).4. The case of the American option is investigated and some extensions of the model are exposed. (4. We suppose the behaviour of Sp to be encapsulated by the following (ordinary) differential equation: (4.2) where J.tt - ~2 t + a Bt) . Section 3. . The model is valid on the interval [0.1.1) where r is a non-negative constant.tdt + adBt) . In this chapter. As we saw (Chapter 3. We set sg = 1. Their method. despite the simplifying character of the model. so that Sp = eft for t ~ o. T] where T is the maturity of the option. 4. equation (4.2) has a closed-form solution ~ .

64

The Black-Scholes model

Change of probability. Representation of martingales 1. loT IH~ldt 2. H~S~

65

where So is the spot price observed at time 0. One particular result from this model is that the law of St is lognormal (i.e. its logarithm follows a normal law). More precisely, we see that the process (St) is a solution of an equation of type (4.2) if and only if the process (log(St)) is a Brownian motion (not necessarily standard). According to Definition 3.2.1 of Chapter 3, the process (Sd has the following properties: • continuity of the sample paths;' _ • independence of the relative increments: if u t, Stl S« or (equivalently), the relative increment (St - Su) 1Su is independent of the (T-algebra (T(Sv, v u); • stationarity of the relative increments: if u identical to the law of (St-u - So)1 So·

+ loT H;dt < +00 a.s.
H~dS~

+

u.s, = HgSg + tt-s; + lot

+ lot

n.as; a.s.

:s

:s t, the law of, (St

:s

for all t E [0, T]. We denote by St =- e-rt S, the discounted price of the risky asset. The following proposition is the counterpart of Proposition 1.1.2 of Chapter 1. Proposition 4.1.2 Let ¢ ((H?, HtY)09:ST be an adapted process with vdlues inIR?, satisfying JoT IH?ldH JoT Hldt < +ooa.s. We set: Vi(¢) and Vt (¢) e":rtVi (¢). Then, ¢ defines a self-financing strategy

=

- Su)1 Su is

=

= H?S?+HtSt
if and onlyif

These three properties express in concrete terms the hypotheses of Black and Scholes on the behaviour of the share price. 4.1.2 Self-financing strategies A strategy will be defined as it process ¢ (¢t)09:ST=( (H?, Ht)) with values in IR?, adapted to the natural filtration (Ft) of the Brownian motion; the components H? and H, are the quantities of riskless asset and risky asset respectively, held in the portfolio at time t. The value of the portfolio at time t is then given by Vi (¢)

Vt(¢) = Vo(¢)

+ lot

HudSu a.s.

(4.3)

for all t E [0, T]. Proof. Let us consider the self-financing strategy ¢. From equality: dVt(¢)

= -rVt(¢)dt + e-rtdVi(¢)

=

which results from the differentiation of the product of the processes (e~rt) arid (Vi (¢)) (the cross-variation term d{e-r., (¢) kis null), we deduce

v:

dVt(¢)

'--

= H?S~ .+ HtSt· .

(H~ert + HtSt) dt rt Stdt + e-rtdS ) H, (_ret -re-rt HtdSt,

+ e-rtH~d(ert)

+

«<n.as,

In the discrete-time models, we have characterised self-financing strategies by the equality: Vn+1 (¢) - Vn(¢) ¢n+dSn+l - Sn) (see Chapter I, Remark 1.1.1). This equality is extended to give the self-financing condition in the continuous-

=

which yields equality (4.3). The converse is justified similarly.

o

time case dVi (¢)

= H~dS~ + HviS«.
and loT H;dt

To give a meaning to this equality, we set the condition loT IH~ldt Then the integral loT H~dS~ = loT H~rertdt is well-defined, as is the stochastic integral loT Htd;t since the map t
I-t

< +00

a.s.

< +00

a.s.

Remark 4.1.3 We have not imposed any condition of predictability on strategies unlike in Chapter 1. Actually, it is still possible to define a predictable process in continuous-time but, in the case of the filtration of a Brownian motion, it-does not restrict the class of adapted processes significantly (because of the continuity of sample paths of Brownian motion). In our study of complete discrete models, we had to consider at some stage a probability measure equivalent to the initial probability and under which discounted prices of assets are martingales. We were then able to design self-financing strategies replicating the option. The following section provides the tools which allow us to apply these methods in continuous time. 4.2 Change of probability. Representation of martingales

= loT (H~St1L) dt

+ loT

(THtStr/Bt,

4.2.1 Equivalent probabilities Let (S1,A, P) be a probability space. A probability measure Q on (S1,A) absolutely continuous relative to P if -VA E A P (A)
IS

S, is continuous, th~s bounded on [0, T] almost surely.
and (Ht)09:ST
s

Definition 4.1.1 A self-financing strategy is defined by a pair ¢ of adapted processes (H?)09:ST satisfying: -

=

°~

Q (A) =0.

66

The Black-Scholes model

Pricing and hedging options in the Black-Scholes model

67

Theorem 4.2.1 Q is absolutely continuous relative to P if and only a non-negative random variable Z on (fl, A) such that VA E A Q(A) =

if there exists

l

Z(w)dP(w).

Theorem 4.2.4 Let (Mt)09~T be a square-integrable martingale, with respect to the filtration (Ft)09~T. There exists an adapted process (Ht)O<t<T such that E (JOT H;ds) < +00 and --

Z is called density ofQ relative to P and sometimes denoted dQ/dP. The sufficiency of the proposition is obvious, the converse is a version of the Radon-Nikodym theorem (cf. for example Dacunha-Castelle and Dufto (1986), Volume 1, or Williams (1991) Section 5.14). The probabilities P and Q are equivalent if each one is absolutely continuous relative to the other. Note that if Q is absolutely continuous relative to P, with density Z, then P and Q are equivalent if and only if P (Z > 0) 1.

vt E [0, T]

u, = Mo + lot n.s»,

a.s.

(4.4)

=

Note that this representation only applies to martingales relative to the natural filtration of the Brownian motion (cf. Exercise 26). From this theorem, it follows that if U is an FT-measurable, square-integrable random variable, it can be written as U = E (U)

+

4.2.2 The Girsanov theorem Let (fl, F, (Ft)o~t~~

iT n.s»,

a.s., Hlds)

,p) be a probability

space equipped with the natural fil-

where (Ht) is an adapted process such that E (fo

T

<

+00.

To prove it~

tration of a standard Brownianmotion (Bt)O<t<T' indexed on the time interval [0, T]. The following theorem, which we admit. is known as the Girsanov theorem (cf. Karatzas and Shreve (1988), Dacunha-Castelle and Dufto (1986), Chapter 8). T Theorem 4.2.2 Let ((h)09~T be an adapted process satisfying fo O;ds < 00 a.s. and such that the process (Lt)09~T defined by

consider the martingale M; = E (UIFt). It can also be shown (see, for example, Karatzas and Shreve (1988» that if (Mt)O~t~T is a martingale (not necessarily square-integrable) there is a representation similar to (4.4) with a process satisfying T only fo Hl ds < 00, a.s. We will use this result in Chapter 6.

c, = exp

(

-1 e.s», - ~ 1t
t

O;ds)

4.3 Pricing and hedging options in the Black-Scholes 4.3.1 A probability under which (St) is a martingale

model

is a martingale. Then, under the probability p(L) with density LT relative to P, the process (Wt)o~t~T,defined by Wt Bt + f~ Osds, is a standard Brownian motion.

=

Remark 4.2.3 A sufficient condition for (Lt)O<t<T to be a martingale is:

We now consider the model introduced in Section 4.1. We will prove that there exists a probability equivalent to P, under which the discounted share price St = e-rtSt is a martingale. From the stochastic differential equation satisfied by (St), we have dSt

(see Karatzas and Shreve (1988), Dac~nha-Castelle and Dufto (1'986». The proof of Girsanov theorem when (Ot) is constant is the purpose of Exercise 19: 4.2.3 Representation of Brownian martingales Let (Bt)O<t<T be a standard Brownian motion built on a probability space (fl, F, P) -;'n-d let (Ft)O~t~T be its natural filtration. Let us recall (see Chapter 3, Proposition 3.4.4) that if (Ht}O<t<T is an adapted process such that E (JoT Hldt) <' 00, the process (J~ lIs-dBs) is a square-integrable martingale, null at O.The following theorem shows that any Brownian martingale can be represented in terms of a stochasticintegral.

= =

-re-rt

Stdt

+ «=ss,
+ adBt).

St ((/L - r)dt r)t/a,

Consequently, if we set Wt

= 13t + (/L -

dSt = StadWt.

(4.5)

From Theorem 4.2.2, with Ot (/L- r)/a, there exists a probability P" equivalent to P under which (Wt)O<:t'<T is a standard Brownianmotion. We will admit that the definition of the stochastic integral is invariant by change of equivalent probability (cf. Exercise 25). Then, under the probability P", we deduce from equality (4.5) that (St) is a martingale and that St = So exp(aWt - a2t/2).

=

68
4.3.2 Pricing

The Black-Scholes model

Pricing and hedging options in the Black-Scholes model and consequently Vt

69
(4.6)

In this section, we will focus on European options. A European option will be defined by a non-negative, FT-measurable, random variable h. Quite often, h can be written as f(ST), (f(x) (x-K)+ inthecaseofacaIl,f(x) (K-:z:)+ in the case of a put). As in the discrete-time setting, we will define the option value by a replication argument. FOf technical reasons, we will limit our study to

= E*

(e-r(T-:-t)hIFt)

.

=

=

So we have proved that if a portfolio (HO, H) replicates the option defined by h, its value is given by equality (4.6). To complete the proof of the theorem, it remains to show that the option is indeed replicable. i.e. to find some processes (H2) and (Ht) defining an admissible strategy, such that H~ S~

the following admissible strategies: Definition 4.3.1 A strategy l/J (m, Ht) OStS:T is admissible ifit is self-financing

=

+ u.s, = E*

(e-r(T-t)

hlFt) .

and if the discounted value "Ct(l/J) H2 + HtSt_ofthe corresponding portfolio is, for all t, non-negative and such that SUPtE[O,Tj t is sguare-integrable under P*. V An option is said to be replicable if its payoff at maturity is equal to the final value of an admissible strategy. It is clear that, for the 'option defined by h to be replicable, it is necessary that h should be square-integrable under P* . In the case of a call (h (ST - K)+), this property indeed holds since E*(S}) < 00; note

=

Under the probability P*, the process defined by M; = E*(e-rThIFt) is a square-integrable martingale. The filtration (Ft), which is the natural filtration of (Bt). is also the natural filtration of (Wt) and. from the theorem of representation of Brownian martingales, there exists an adapted process (Kt)O<t<T such that E* (JoT K~ds)

=

< +00

and

--

that in the case of a put, h is even bounded. Theorem 4.3.2 In the Black-Scholes model, any option defined Hy a non-negative, :F -measurable random variable h, which is square-integrable under the probabi~ty P*, is replicable and the value at time t of any replicating portfolio is given by Vt = E* (e-r(T-t)hIFt) .'

Vt E [0, T]

u, = Mo + lot

KsdWs

a.s.

The strategy l/J (HO ,H), with H, Kt/(aSt) and H2 M, - HtSt, is then, from Proposition 4.1.2 and equality (4.5), a self-financing strategy; its value at time t is given by Vt(l/JY

=

=

=

Thus, the option value at time t can be. naturally defined by the expression E* (e-r(T-t)hIFt). ..' . o. . Proof. First, let us assume that there ISan admissible strategy (H ,H), replicating the option. The value at time t of the portfolio (H2, Ht) is given by

= ertMt = E*

(e-r(T-t)hIFt).

This expression clearly shows that Vt (l/J) is a non-negative random variable, with sUPO<t<TVt(l/J) square-integrable under P* and that VT(l/J) = h. We have found an admissible strategy replicating h. 0

== H~S~ + HtSt, rt and, by hypothesis, we haveVr = h. Let "Ct = Vtebe the discounted value
Vt

Remark4.3.3
" Vt

Vt =
(4.5)

_

u; + u.s;
+ lot + lot

0

_

When the random variable hces: be written as h f(ST), we can express the option value Vt at time t as a function oft and St. We have indeed E* (e-r(T-t) f(ST )IFt) 1Ft) .

=

Since the strategy is self-financing, we get from, Proposition 4.1.2 and equality

=
b

E* (e':"r(T:"t) f (Ster(T-t)e<1(WT-Wt)~(<12/2)(T-t))

"Ct

Vo

HudSu HuaSudWu.

The random variable St is .r.t-measurable and, under P*. WT - Wt is independent of Ft. Therefore, from Proposition A.2.5 of the Appendix. we deduce

=

Vo

Vt
where F(t, x) = E* (e-r(T-t)

= F(t,

St), ). (4.7)

Under the probability p;' , SUPtE[O,T] t is square-integrable. by definition of adV missible strategies. Furthermore, the preceding equality shows that the pro.c~ss (lit) is a stochastic integral r~la~ve to (Wt): Itfollows (cf ..Chapter 3, PrO!,osIllon 3.4.4 and Exercise 15) that (Vt) ISa square-mtegrablemartmgale under P . Hence Vt = E* (VTIFt) ,

f

2 (xer(T-t)e<1(WT-Wt)-(<1 /2)(T-t))

I I'

Since, under P*, WT - Wt is a zero-mean normal variable with variance T - t F(t,x)

= e-r(T-:t)

. 1+~'
-~

r(:z:e(r-<12/2)(T-t)+<1YVT-t)

e -~~d y.

~

3.7). we deduce d(S.So}+ 10 t . . the model is considered as a reference by practitioners. Since p(t. Important differences between historical volatility and implied volatility are observed. In practice.2. In practice.3. cf. called 'volatility' by practitioners (the drift parameter J.L disappears by change of probability). T[xIR. St) is a martingale under P". a2T is the variance oflog(ST) and the variables 10g(ST/So). we see that the function F is of class Coo on [0.t. in the case of calls and puts where we have the closed-form solutions of Remark 4. Vi = fi'(t.K)+) E (xeUY6g-u21i /2 _ K e-rli) + 2.3 Hedging calls and puts In the proof of Theorem 4. x) where = xN(d l) - Ke-rli N(d2). 4. from the Ito formula (4. If we choose the case of the call. If we set .3.S)u 2- . we have. St). Vi = e-rt F(t.) .9) + 1 at t - 0. Let us set - dl = log (x/ K) a +VO + a2/2) (r 0 0 and d2 = dl - avO.. In those problems concerning volatility. . Under large hypothesis on f (and. we show that it is possible to find an explicit hedging portfolio.4 One of the main features of the Black-Scholes model (and one of the reasons for its success) is the fact that the pricing formulae. Chapter 5). P -(t. in particular.. where f(x) = (x . the process K. we can associate an 'implied' volatility to each quoted option.K)+. When the option is defined by a random variable h = f (ST ). by inversion of the Black-Scholes formula. we referred to the theorem of representation of Brownianmartingales to show the existence of a rep. we have F'(~.Su d(S.licating portfolio. Exercise 21). for tcT. -. from equality (4.3. I e- X 2 /2dx .3). as well as the hedging formulae we will give later. In spite of these incoherences. The 'implied' method: some options are quoted on organised markets. F(t. it can be used to elaborate hedging schemes. 8F ( w. the price of the put is equal to The reader will find efficient methods to compute N(d) in Chapter 8. St) ca~ be written as P(t.St)'=p(o.8) N(d) == -. xert) . (4.x) = = E· (e-r(T-t) (xe(r-u2/2)(T-t)~U(WT-W.7) F(t.KudU. one is soon confronted with the imperfections of the Black-Scholes model. log(S2T/ST). a can be estimated by statisti~al means using the asset prices observed in the past (for example ~y calculating empirical variances. we obtain . 10g(SNT/S(N-I)T) are independent and identically distributed. a theorem of existence is not satisfactory and it is essential to be able to build a real replicating portfolio to hedge an option. The historical method: in the present model. two methods are used to evaluate a: 1. .. is necessarily null (cf. the price of options (calls and puts) being an increasing function of a (cf. St) and. Once the model is identified. Remark 4. From equality dSt = aStdWt.70 The Black-Scholes model Pricing and hedging options in the Black-Scholes model 71 F can be calculated explicitly for calls and puts. Therefore. we have Writing this expression as the difference of two integrals and in the first one using the change of variable z = y + aVO.u 1 jd -00 where F is the function defined by equality (4. S)u so that - - =a - 2 -2 ~udu. I./ t a~~ (u.S« -) du+ 11 2 t 0 8 F ( -) -8x2 U. a discounted value equal to where 9 is a standard Gaussian variable and 0 = T .x) = e-rt F (t. at any time t. . the latter seeming to depend upon the strike -price and the maturity. . A replicating portfolio must have. Dacunha-Castelle and Duflo (1986). In Using these notations. Using identical notations and through similar calculations. depend on only one non-o?servable parameter: a.~u)SudWu+ Io.

where (Ct )05:t5:T is an adapted.1 Pricing American options We have seen in Chapter 2 how the pricing of American options and the optimal stopping problem are related in discrete-time setting. where'lj. It i~ ~atural t~ ~onsider u(t. satisfying: 'lj.s. St = 8F 8x (t.(St). . for any strategy ¢> E <1>"'. smce.(x) ~ A + Bx. Ht))095:T.(St)).x) = -N(-d.(St). T]. St)) ISt~e Snell env~lope of the process (e-rt'lj. Ct corresponds to the cumulative consumption up to time t. we have to use a theorem of decomposition of supermartingales similar to Proposition 2. for all = s: -) t.x)+.6 In the' case of the call.lt IS the minimal value of a strategy hedging the option. + loT Htdt < +00 a. we give only the outlines of the proof (see ~aratzas and Shreve (1988)Jor details).St).(x) = (x . T] x IR+ to IR defined by u(t. St).4. H?sf I + u.4 American options in the Black-Scholes model 4. More generally. If we set Hf -( -) + r 8P ( «. when the value at time t of a portfolio can be expressed as ll1(t.forallt E [O. the smallest supermartingale which bounds It from above under p". T].4. Remark 4. (Hf. There exists a strategy ¢> E <1>'" such that Vt (if» = u(t.3.s. An American option is naturally defined by an adapted non-negative process (ht)o5:t5:-r:. he or she p~ssesses a~an~ time t. 'gamma' refers to the second-order derivative (82 III/ 8x2) (t. using the same notations as in Remark 4. This is left as an exercise (the easiest way is to differentiate under the expectation). St).. As it can be proved that the discounted value of a ~ading ~trategy 'with consumption is a supermartingale under P".(St) if. Hence The Black-Scholes model American options in the Black-Scholes model 73 P (t. To show the existence of a strategy. with values in IR?.T] Vt(¢» 2': 'lj. 4. we have. it is possible to associate any American option to a hedging scheme with consumption. 'theta' to the derivative with respect to time and 'vega' to the derivative of IIIwith respect to the volatility a. we wil. based on an induction argument. . ~on-decreasing process null at t = 0. Remark 4.s. cannot be used directly to price American options. The following theorem introduces the minimal value of a hedging scheme for an American option: Theorem 4. is called the 'delta' of the portfolio.. the portfolio discounted value is indeed Vi = P (t.x) = sup TET. which is precisely the payoff If the opuon IS exercised at time t. St) - tt.3. If the writer of the option follows a strategy ¢> E <1>"'.72 Chapter 3. setting Vt (¢» = Hf Sf + HtSt. in a discrete model.s. the quantity (81l1 / 8x) (t. Exercise 5 in Chapter 2 shows that.T E··[e-r(T-t)'lj. SO) + lot O.1 A trading strategy with consumption is defined as an adapted pro_cess ¢> = ((Hf. we have: 'lj. continuous.(xexp((r_ (a2/2))(T-t)+a(WT -Wt)))] wh~re Ti. For a call. To sim?lify.1 of Chapter 2 as well as a theorem of representation of Brownian martingales.4.2 Let u be the map from [0.for all t E [0.= HgSg + HoSo + io H~dS~ + rt in rt HudSu - c. The tra~ing str~tegy with consumption ¢> = ((Hf. satisfying thefollowing properties: 1. for some non-negative constants A and B. To overcome technical difficulties. we have: Vt(¢» 2': u(t. -) 8P ( es. = '<ItE [O. we have .3. which measures the sensitivity of the portfolio with respect to the variations of the asset price at time t.e.. T]. This quantity is often called the 'delta' of the option by practitioners. is then 2. St). a wealth at least equal to 'lj. '<Ix E IR . loT IHfldt = H. i.T]. St). Moreover. St) as a price for the American option at time t. St) = P F (0.5 The preceding argument shows that it is not absolutely necessary to use the theorem of representation of Brownian martingales to deal with options of the fomi f (ST). for anystrategy¢> E <1>"'.K)+ and for a put: 'lj. St). 1). . First. we show that the process (e-rtu( t.3. The natural candidate for the hedging process H. Ht) is self-financing and its t E [0. we de~uce the inequality: ~(¢» 2': u(t.l only study processes of the form ht 'lj. Exercise 16).¢> such that Vt(if» = u(t. De~ote by <1>'" the set of tradi~g strategies with consumption hedging the American option defined by ht = 'lj.T represents the set of stopping times taking values in [t.(St} a. = P (t. and in the case of the put 8F -8 x (t. S~ ) SudWu 8x Definition 4.(x) = (K .3. Ht) )05:t5:T is said to hedge the American option defined by ht = 'lj. IS a _. The theory of optimal stopping in continuous-time is based on the same ideas as in discrete-time but is far more complex technically speaking.So io a ~~ (u. St).ontInuous function from IR+ to IR+.s.3 of Chapter 1. .3.(St). St). St) . The approach we proposed in Section 1.

which implies: Uoo(x) > O.xexp (O'BT . 4. . and let (Bt}o<t<oo be a standard Brownian motion defined on this space and IR+.T (e-rT 'l/J(ST)) E* is the initial wealth that hedges the whole range of possible exercises.e-rTK)+IFT) ~ (ST .(0'2T/2)))+.t)/2 ' .z") ( X x* )-"1 for for x ::." (4. El Karoui (1981). To make our point clearer.":rTz .T Remark 4. In fact. Proof. the process 0IX: ::. Uoo(x) > (K .x (Sd is a martingale under P*.T the set of all elements of To. log(x* /x)} . Then it is E*(e-rT(ST . One has to use numerical methods.S) corresponding call price.4. .x)= TE7Q. it follows that "Ix::.14) 4. We assume here that t 0 (the proof is the same for t sufficient to show that. F. we get u(O.e.2 Perpetual puts. we present some of·them in Chapter 5. it is always possible to come down to this case by replacing Twith = ij I I l inf{t ~ 01 e-rtuoo(Xf) (Xi') being defined by: Xf = x exp ((r . aswell as Chapter 5)enables us to show u~(x) = E [(Ke.x and "Ix >x* = K'Y/(l + "I) and "I = 2r/0'2. the American option price is not equal to the European one and there is no closed-form solution for the function u. So) sUPTE7Q.1 with value 'l/J(ST) at time T is given by E* (e-rT 'l/J(ST)). From the properties of uoo we have just stated. x) = sup E* (K~-r(T-t) TEl.oo with values in [0.xexp (:-0'2(T . for all x ~ O.x}. Equation (4. From formula (4.xexp (O'BT .0'2/2)t + 0'Bt).0'2/2}t + O'Bt ::. Hence.10) to deduce some properties of the function u. On ~e other hand. for any T > O. The following proposition gives an explicit expression for the upper bound in (4.x)+ and. T + O'(WT . T].K)+.K)+) = E*(ST . (4. noting To. It follows from (4. for all < sup E [(KeTE7Q. Proposition 4.74 The Black-Scholes model American options in the Black-Scholes model T . x) = TE7Q.2. z" Uoo(x) = K . we assume t O.e-rT K) + . E* ((ST . x) = F(t. (4.4.e-rTK)+.12) (x . the Spell envelope theory in continuous time (cf.ia. for any stopping time T.Xi') +} (with inf 0 = 00).10) becomes u(O. since the discounted value of any admissible strategy is a martingale under P*. T].e-rTK)+IFT) since ~ E* ((ST . Now we note z" = sup{x ~ Oluoo(x) = K .4.3. The value at time 0 of an admissible strategy in the sense of Definition 4.[(Ke- . 'l/J 'is given by 'l/J(x) then we have u(t.4.14) that : e=.4 If in Theorem 4. we notice that the American call price (on a non-dividend paying stock) is equal to the European call price: Proposition Let us consider a probability space (0.(0'2T/2)))+ I{T<oo}] (4. Thus the quantity u(O. (4. 75 = sup E*(Ke-rT-xexp(O'WT-(0'2T/2)))+.xexp (O'BT%.T sup E(Ke-rT-xexp(O'BT-(0'2T/2)))+ rT .4. Kushner (1977).oo rT sup E.t.oo[ and satisfies: Uoo(x) ~ (K .x)+. P). to the European = > 0).e'-rT K)+ 1FT) .xexp (O'BT . x* x> z" since r ~ 0 and by non-negativity ofthe left-hand term. 0 We obtain the desired inequality by computing the expectation of both s~des. E* ((ST .ST ~ -:»: Uoo(x) = TE7Q. decreasing on [O.oo the set of all stopping times of the filtration of (Btk~o and To. The right-hand term in inequality (4.~ s. Then.13) is given by the formulae Uoo(x) = K . The stopping time Tx is therefore an optimal stopping time (note the analogy with the results in Chapter 2). E*(e-rT(ST .») + I.(0'2T/2)))+ I{T<oo}] .12). In this section we will only use the formula .K)+) ::. .oo where F is the function defined by equation.11 ) As in discrete models.12) can be interpreted naturally as the value of a 'perpetual' put (i. " Proof..x) real z.3 Let T be a stopping time taking values in [0.5 The function On the other hand.z"} = inf where Tx is the stopping time defined by Tx = Tx = inf{t ~ {t ~ Ol(r . we have E* ((ST . critical price In the case of the put.13) we deduce that the function uoo is convex.(0'2Tx/2)))+ Ih<oo}] u(t. it can be exercised at any time).e-rTK)IFT) ::. ~ e-rT K with z" Uoo(x) = (K .. Uoo(x) ~ E(Ke-rT . - w.« .

1. for 0 ~ t. we With. ¢(z) = ¢ (K. x] formula (proved in Exercise 24) . .t 1.12) into account. is inspired by Harrison and Pliska (1981) (also refer to Bensoussan (1984) and Section 5. bounded random.z = inf{t ~OIX: = z} (K .15) = Tx. in the opposite case. Lt ./b+ 1).z)+E (e- rTz . We set.- b + l)z).4. = log(Z/X)} {t ~ Ol/.maxz ¢(z) = ¢(x) = K -xandifx > K. the stopping time Tx.tt + e. the buyer of the option should exercise his or her option immediately.<oo}) Taking inequality (4. 3. . Using the following .• ) +). we obtain s(t) ~ z". = t The maximum of ¢ is attained on the interval [0. K].x) =K .z)E (exp o (-rT1og(z/x)/u)) n [0. E'(LT)(ZIFt) = E (ZLTIFt). Thus. 4. T z'Y-1 x'Y . for z ~ x.L2+ 2a) z) Vz E [O.x)+. 77 defined by = 2r / a2.76 Introduce. The real number s(t) is interpreted as the 'critical price' at time t: if the price of the underlying asset at time t is less than s( t). 2. T x./(.6 Let us come back to the American put with finite maturity T. we see that. We note p(L.z Tx. .. Notes: The presentation we have used. = exp (. .2.a /2.4.K] ¢(z) = (K- (~)'Y.x] we get (K .z 0 and ¢ z x +. for all E [0. (4. x] if z E [O. -roo _ 0 Using the expression of Xt in terms of Bt.) the density probability Lt with respect to the initial probability P.. under the probability p(LT). and consequently ¢(z) = (K .x' • We fix x It results that if x ~ K.z)+E (e-rTx.+oo[. max. d . It is based on an arbitrage argument and the Ito formula. for any z The Black-Scholes model E IR+..5 Exercises Exercise 19 The objective of this exercise is to prove the Girsanov theorem 4. Show that the probabilities p(LT) and p(L. The initial approach of Black-Scholes (1973) and Merton (1973) consisted in deriving a partial differential equation satisfied by the the call price as a function of time and spot price. K] n [K. for any real b. (K. Tb =inf{t = b}. Tx.)· . it is obvious that Tx. Tx . then we will maximise It to etermme x UOO(x) = ¢(x*). I'S'optimal the function ¢ attains its maximum at point z x": We S mce Tx x·. .x] n [O. Let (Bt)o9~T be a standard Brownian motion with respect to the filtration (Ft)O<t<T and let J. given F«. Sh6w that (Lt)O<t<T ~s a martingale ~elative to the filtration (Ft) and that E(Lt) 1.~ T. 0 Remark 4.J. it can be seen that E n [0. .. e -.a. /b + 1)).+I).' iven by With these notations. ( ) _ (K _ ) If z < x we have If z > x. T[.) coincide on the a-algebra Ft..<OO } (K - x: .5. = ~ IOg(Z/X)} ~ OIJ. . * and are going to calculate ¢ explicitly. Show that theconditional expectation of Z.) t + «».x) > (K .LBt . is (e-aT&) = exp (~b- IbJv!J.variable.x and "Ix> s(t) u(t. by convention.·lh. based on Girsanov theorem. there exists a real s(t) satisfying "Ix ~ s(t) . For more information on statistical estimation of the models' parameters. and we recognise the required expressions. -rTz " '1{Tx. Let Z be an FT-measurable. the optimal stoppmg time IS gi and we note ¢ the function of z defined by 'I' Z x = .L a real-valued be 2 /2)t).z = inf inf {t ~ 01 (r .. i. see that.x)+ ~(z) = { (K .Lt+ B. he should keep it.: with J. The derivative of this function is given by ¢'(z) = - = inf{t ~ 0IX: ~ z}. for all t E [0.2 in the special case where the process (Ot}is constant. T[.8 in Karatzas and Shreve (1988».z Exercises where.( ) = E ( e . (i. the reader should refer to Dacunha-Castelle and Duflo (1986) and Dacunha-Castelle and Duflo (1986) and to the references inthese books. T]. Following the same arguments as in the beginning of the proof of Proposition 4. if we note. for any t E [0. -' . by the continuity of the paths of (Xnt~O' = u(t. . if z > x if z E [0.L = r/a . number.

T]. > 0 E (e-a(T'. 2. . for all t E [0. Show that if a sequence (Xn) of random variables converges in probability under P. .1].0 and a non-decreasing function of a many ecreasmg fJ . is well-defined under the probability P. Use the Girsanov theorem to show the following equality: = e-A(I-t)l{T>t} tE [0.1]. under the process Yt = lot HsdWs.LBT~M - ~2 T~ t\ t) 1{t<Tn ) e <-at 3. function of t if r . . Let (Ht)O<t<T . 1.T -- Conclude using Proposition A. it is advised to consider first the case of simple processes. the gamma.') 2 ds Exercise 22 Calculate under the initial probability P. = b} Exercise 26 Let (Bt)O<t<1 be a standard Brownian motion defined on the time interval [0. M)) 2. we set Mt = E (1{T>I}19t).For with the convention: inf 0 00. and we decreasing function (resp. Prove that Fe(t. f(x) = (K _ x)+). we note 9t the a-algebra generated by.d . we set = inf {t 2: 0 I J.rl.2. ' T: 1..Lt+ B.1]. T].<oo} ) = exp (J. The stochastic integral of (Ht) relative to B. . = f. it converges in probability under Q to the same limit. we have p(L). independent of . . the probability that a European call is exercised. Fp) the function F obtained when f(x) (x ~ K)+ (resp. Show that if be an adapted process such that fo H.1 (remark that we would necessarily have P ('Vt E [0.) in the neighbourhood of 0 and +00. Remark 4. . fo (H s H. ality· case. 1.2.J. Study the functions Fe(t. a.) are non-negative for t < T. Notations and hypothesis are those of Theorem 4.) We note Fe (resp. F(t.s.) and Fp(t. . 3. can define. non-increasing). P{Mt = Xt) =.7». where Bl V B2 represents the o-algebragenerated by Bl and B2. Since p(L) = lot n.2.9) and calculate for a call and a put the delta. Let P and Q be two equivalent probabilities on a measurable space (0.non-increasing) of x.x) is a convex function ~f x. Show that (9t)O<t<1 is a filtration and that (Bt)O<t<1 is a Brownian motion with respect to (OS.ds < 00 p(L)_a. x) is a non- and P are equivalent. Exercise 21 We consider an option described by ~ f. + lot Hi}sds.L t t::::O E xeretse "and b. Calculate P (T: 1{T'. A). Let (Wt)t::::o be an .2 of the Appendix.. We set W The Black-Scholes model Exercises Exercise 25 79 all sand tin E [0.7) and make us~ 0 ensen ~ mequ . Exercise 27 The reader use the results of Exercise '18 of Chapter 3.1].L2) .TH.3. H. > 0 E (e-a(T~M)exp t (J. f. a .(ST) and w~ note F the function of time and spot corresponding to the opuon pnce (cf. ' Exercise 23 Justify formulae (4.. and to use the fact that if (Ht)O~t~T is an adapted process satisfying there is a sequence (Hn) of elementary processes such that converges to 0 in probability.L.-w. 4. ~(E(X)) ~ E (~(X)).8) and (4.s». f is non-decreasing (resp. is equal to 'Va. We set = x. We note CFt}099 its natural filtration and we consider T an exponentially distributed random variable with parameter A.Lt+ Bi.6). 2 We assume that f is convex.. = 'Va.s. Showthat there exists· no path-continuous process (Xt) such that for all t E [0. Exercise 20 Show that the portfolio replicating a European option in the BlackScholes model is unique (in a sense to be specified).1] M. Show that F(t. 3.LBT~M . 1.6 that 'Va> 0 E (e-aT'. Prove the inequality' t = E (e-a(T~M) exp (J. To do so.ds < - 00 a. we have E(LT) t = J. then E (-:rIBl V B2) E (..rt-Brownian motion.r s) = e- u2 (t-s)/2. (Hint: first consider equation (4. = Xt) = 1). -2.s. Deduce that the martingale (Mt) cannot be represented as a stochastic integral with respect to (Bd.) and Fp(t. The following property can be used: if Bl and B2 are two sub-a-algebras and X a non-negative random variable such that the aalgebra generated by B2 and X are independent of the a-algebra Bl.fIB2). Show that for all real-valued u and for (eiU(w. equation (4.T~ t\ t) ) .ds < 00 P-a. m~y < 00). Deduce from above and proposition 3. with s ~ t.s. where ~ is a convex function and X IS a random variable such that X and ~(X) are integrable.) l.3. Show that M.Lb-lbIJ2a + J. 24 Let (B ) be a standard Brownian motion. For t E [0.78 4. the theta and the vega (cf. For any real-valued J. The question is to prove the equality of the two processes X and Y.rt and the random variable T t\ t.

2. _- 2 + 2a). = 1/ St be the exchange rate of the franc' against the dollar. t S dS t. at time T. Problem 1 Black-Scholes model with time~dependent parameters ~e consider once again the Black-Scholes model.T u(.ables converging to X in mean-square. with value \It at time t. the number of francs-per dollar. where r(t).. then = 'TIt E [0.?n to this value and give an expression for the probability p that makes Wt (r / (7 . Give its density with respect to P.+ aT) N JL vT 1m . To clarify.::. Prove that Problem 2 Garman-Kohlhagen model The Garman-Kohlhagen model (1983) is the most commonly used model to price and hedge foreign-exchange options. (c) Construct a hedging strategy for the call (find Hpand financing condition).The Black-Scholes model Exercises 81 3. Write C as the expectation under P of a random variable function only ofWT and sUP~::. )dW.Tj the filtration generated by (WdtE[O.::.J. Prove that there exists a probability P" equivalent to P. I 1. is anormal 0 u.T X. (a T 2 . For example. ) (2). = x exp ((r - (J. Let U. one dollar for K francs. we will tackle the problem of pricing and hedging a call with maturity T and strike price K. zero-mean normal random vari. i. Express S. the process (St)tE[O. - JL)dt .A -exp . where X. The behaviour of S. show that random variable and calculate ItS varIance. (b) Give an expression for the function F and compare it to the Black-Scholes formula. (b) By approximating (7 by simple . St). under which the discounted stock price is a martingale. _ 3. Deduce that if E (e aWT1 x ::. . It derives directly from the Black-Scholes model. we shall concentrate on 'dollar-franc' options. . J Zt= Stexp-=.e. we assume that inftE[o..s::.functi?ns. through time is modelled by the following stochastic differential equation: . assuming that ~e ass~t p~ces are described by the following equations (we keep the same notations as In this ch~~ter) J . where (Wt}tE[O. (a) Let (H?. s. = So exp (lot JL(~)ds + lot (7(s)dBs .::. .~ lot You may consider the process (72 (s)ds ). = JLdt + (7dWt. Ht. JL(t}. P). 2. we are looking for an analytic formula for C = E (e-rT(XT '(72/2) . .l .' (7dWt.Tj and assume that Ft represents the accumulated information up to time t ·( . In the remainder. Show that if JL > 0. 3.. Show that Uc satisfies the following. is the right to buy. with (7 > O. Show that if (\It/ SP) is a martingale under P" and if VT (ST . F(t.F. JL -.stochastic differential equation dU . the price of the dollar at time t.inf. .(7/2) t + Wt ~ standard Brownian motion.Let (Xn) be a sequence of real-valued.Tj is a standard Brownian motion on a probability space (f!. check the self- 4. We will note S. JL and (7 are real-valued. .TW.K. T) where F is the function defined by Vi = F(t. Calculate the expectation of St. Give a finan~iaUnterpretati. a European call on the dollar.T U'U)d') -: K e. T). 1. with maturity T and strike price K. We note (Ft)tE[O.~ J.T '('ld') + and (Wd is a standard Brownian motion under p". t and Wt. .Tj (7(t) > 0: .K)+. 2. (7(t) are detenninistic functions of time. . Deduce an analytic formula for C. 4.}) {WT~~.T Ws. dSp { dS t = r(t)Spdt = St(JL(t)dt + (7(t)dBt) . (a) .K)+1{inf. Furthermore.(fat JL(s)ds + lot (7(s)dBs:- ~ lot (72 (s)dS) . as a function of So.t = (2 (7 J~(7(s )dBs • . continuous on [0. x) = E" (x exp t+ (7Wt) .~H}) . Let H ::.Tj is asubmartingale. Hl) be a self-financing strategy. Show that X is a normal random variable.

. _ t- (F is the = e-rotVt portfolio aF sc. = F( t. + . = Hte-rotSt(J.) 83 We would like to price and hedge a European call on one dollar. at tlI~e t and a riskless asset with price S? ert at ~me t ~~hdynti. (c) renlicati that the c.Tj and (Ut)tE[O. = -(t ' St)ae-rotStdW: ax t- . which represents his initial wealth. 7. Show that if an admissible strategy replicates the call.T] are two independent standard Brownian mo nons efined on a probability space (0 F P). with . 1. for sSt.T] t tE[O. In what sense does it seem to be paradoxical? II Exercises (The symbol E stands for the expectation under the probability 5. Derive the equality r«.17) makes sense? 2. d t tE O. (a) Show that there exists a probability process P._~Jo). Sd. I / 4. equivalent to P.x) = E(xexP(-(Tl.(T-t)xN(dd log(x/K) log (x/ K) .Tj(~) under is square-integrable under ! I' Proble~ 3 Option to exchange one asset for another . a wealth equal to (ST .- J. . an d d1 d2 + (TO + (TO - a.d~ 3. said to be admissible if its discounted value ~ is non-negative for all t and if SUPtE[O.TOt + w:t is a standard Brownian motion.x) = e-r. We set c.. We note!t the a-algebra generated by the random vari~ • and B. (b) A self-financing strategy is. W~ t:ons~der a fin2anci~1 market in which there are two risky assets with res ective pnces St a~d s. l and a2 are real numbers a ables 0 and ~2 > O. . Which integrability' conditions must be imposed on the processes (H?) and (Ht) so that the differential equality (4.Ll.+(a2/2»(T-t)+a(WT-Wt}) _Ke-~o(T-t)) where (Bl) [ and (B2) . «=c. Write down a put-call parity relationship.all is replicable and give an explicit expression for the rep icatmg portfoho (( H?. Let ~ be the discounted value of the (self-financing) (H?.Ke-ro(T-t)N(d2) where N is the distribution function of the standard nonnallaw .L < a2. dollars is obviously (4.K)+ at time T. Show that the discounted value of an admissible strategy is a martingale P.. = aStdWt.K)+ (in francs).17) where Vt is defined by equation (4. t . using a Black-Scholes-type method.16) We suppose that French francs are invested or borrowed at the domestic rate TO and US dollars are invested or borrowed at the foreign rate Tl' A self-financing strategy will thus be defined by an adapted-process ((H?. Prove the equality F(t. The next step is to show that the option is effectively replicable.(a2 /2»(T 6. .t) aV'I'=t Tl . (b) Let ~ be the function defined by x) e-rot F(t. with maturity T and strike price K. Then the processes (Bl) and (B2) ~e (Ft}-Brownian motions and..Tj. similar to the relations~ip we ave or f stoCksh'and grve an example of arbitrage opportunity when this relation~hip d oes not old. Derive the equality ss.Ji'=t Tl + (a2/2»(T . Vt F(t. Ht». Ht»tE[O. (a) We set St = eh -ro)t St.t) . both processes (St)tE[O.82 The Black-Scholes model Deduce that if 0 < J.~] mdependent of F. • IS a1. the writer of the option elaborates a strategy. . Show (through detailed calculation) that P.L2dt + a2r1Bl) = where F(t. in other words it is worth VT (ST . Sl and Slover time are modelled by the following' as c irrerentia equations = P. for t 2:: s. the value in francs of a portfolio made of H? francs and H. From his premium. then for any t ::. At time t. at time T.J. in order to create. xe(ro-rtlt) f~ncti_ondefi~ed in Question 4).16). St} = {= dS~ f Sl (J.L + Tl - T'o)dt + Hte-rotStadWt.L2.L+ Tl . the vecto/ (~t~']Bl B2 . defining at any time t a portfolio made of H? francs and Ht dollars.:. such that (4. Ht).Tj are submartingales. J. under which the a w:t.' . t • . T the value of the strategy at time t is given by . = c. St} and = F(t.amd~~of t~elpnces.

Ws ) IS Independent of Fa. Wl). ill The objective of this section is to find an explicit expression for the function F defined by (4. Find a parity relationship between the value of the option with payoff (Sl _ Sf)+ and the symmetrical option with payoff (Sf . a wealth equal to (St . Let 91 and 92 be two independent standard normal random variables and let A be a real number.) = E (e-rT (S} .19) the ~ymb~l E repres~nting the expectation under P.n?~d Brownian motions and that. Sl. prove the equality + H2e-rtS20't t 2 2dW t .St)+.: f07.A arid 92 are independent standard is a martingale with respect to the filtration (Ft)tE[o. Prove that if a self-financing strategy satisfies the hypothesis of the previous question and has a terminal value equal to VT (St :_ Sf)+ then its value at any time t < T is given by = ac. sf. T].l: do so we use the same method as in the Black-Scholes model. the writer ?f the opt~on builds a strategi' defini~g a~ any time t a portfolio made of Units of the riskless asset and H.2). We set by I) ~ "'-T(T-t) . c. for any t E [0. . for t 2: s. the random variables Wl and wl ar_eindependent normal random variables with zero-mean and variance t under P.Sf)+· A trading strategy will be defined by the three adapted processes HO. Let P be the probability with density MT with respect to P. under the probability P.~] x fl.Y2 -A~) JA~+A~ JA~+A~ . (a) Show that under the probability p(>').r) /0'2. Al and A2. the vector (Wl . similar to :he t put-call parity relationship previously seen and give an example of arbitrage opportunity when this relationship does not hold. Noticing that / : . = e:" F(t. the processes (Wl )o:9~T"and (Wl)O:9~T are {Ft)-indepe~dent st. we have E (exp(Yl + A19d' . e-rtVt is where N is the standard normal distribution function. Show that if the processes (HI )o~t~~ and (Hl)09~T of a self-financing strategy are uniformly bounded (which means that: 3C > 0.SI.financing strategies' and prove that. discounted value of the strategy IS a martirigale under P. We will consider in the remainder that the value of the option (St . S5. 85 X2) = E ( x1eO'I(WI W. under the probability P.S. Sl). S.T]' 2. at time T. dtdP-almost everywhere.)O'Ie-rtSfdw/ u 1 - of -- + ~(t.Sf)+ at time t is given by F(t. we' will admit that. Sl).'-w. 4. Derive.Y2 + A?) _ eY2+>'~/2N (Y1 . with density with respect to P given by " dP(>') 2 e>'gl->' /2 dP ' the random Gaussian variables 91. 2.exp(Y2 + A292))+ .2 _ x2e0'2(W. Y2.Sf)+ 1Ft) .dw. = 0. Show that the process defined (4.!Vl the discounted prices Sl e-rt Sl and Sl = and Wl and show that.19) and to establish a strategy replicating the option. Vet. We introduce the processes WI and W2 defined by Wl = Bf +B1t and Wl = B~ +B2t.2)-=f(T-t) ) +' (h = (ILl - r) /0'1 and (h = (IL2. HI and H2. IHi(w)1 ::. P. The existence of a strategy having this value will be proved later on.84 I The Black-Scholes model Exercises where the function F is defined by F(t.II 1. if the discounted value of a self-financing strategy. Wt . Deduce from the previous question an expression for F using the function N. (b) Deduce that for all real-valued YI. C. In the remainder.)0'2e-rtS. 3. w) E [O. then K.S.HIt e -rtSl tal dWlt Yt - =eYI+>'~/2N'(Yl Vt = . r- We study the pricing and hedging of an option giving the right to exchange one of the risky assets for the other at time T. 1. From hIS initial wealth.dWr uX2 of __ (4. = !lx (t. = . 2. Define precisely th~ self. 1. for i 1. the joint characteristic function of (Wl . we have d1-r .Sl. + f~ Ksds and if it is a martingale under P.Ws1. = 3.18) Hint: use the fact that if (Xt) is an Ito process which can be written as X t t t Xo + fo J1dW. We want to price and hedge a European option. Write Sland Sl as functions of SJ. Deduce that. with maturity T. Xl. We set c. then the. in order to generate. and H. Units of the assets 1 and 2 respectively. the premium.. :0 -- = HP variables. giving to the holder the right to exchange one unit of the asset 2 for cine unit of the as~et. Sf. . 3. = F(t. under == e:" S~ are martingales.

Problem 4 A study of strategies with consumption We consider a financial market in which there is one riskless asset. represent respectively the quantities_ of riskless asset and risky asset held at time t. Hint: introduce the martingale (Mt)O~t~T defined by hold: (i) The processes (H~)09~T' (Ht)O~t~T and (c( t) )09~T are adapted and satisfy Mt = E* (x + foT e-rsc(s)dsl:Ft) and apply the theore~ of martingales representation.s. with respect to P. Let (H~)09~T' (Ht)09~T and (C(t))099~ be three adapted pro~~~ses satisfying condition (i) above.s. Prove that the process (Vi)o<t<T is a supermartingale under probability p. for all t E [0. . P). the process (Wt)09~T' defined by Wt (JL. and furthermore Vo = HgSg + HoSo = x. (c) An investor with initial endowment x wants to consume a wealth corresponding to the sale of p risky assets by unit of time whenever.s. (ii) For all t tt E [0.>K})' What conditions on p and x are necessary for this consumption process to be budget-feasible? !aT (IH~I + H~ + Ic(t)1) dt < oo.86 4. Vi with = Vo + lot HudBu -lot c(u)du. 87 show that condition (ii) is satisfied if and only if we have. s: = «r:s. a. Let (c(t))09~T be an adapted process with non-negative values such that 2~ 00 . Tj. a. Prove that (c(t))O~t~T is a budget-feasible consumption process with an initial endowment x. = HOSo+HtSt = HgSg+HoSo+lt 0' H~ds~+lt 0 HudSu-lt 0. < 00 and E' ({ e:"'C(t)dt) [. i. Tj. with price St at time t. . In the following.' c(u)du.We consider a European call with maturity T and strike price K on one unit of the risky asset.following form: -- II (Ifi ffi + u.a. . Under P*. equipped with a filtration (:Ft)09~T' We assume that (:Ft)09~T is the natural filtr~tion of a standard Brownian motion (Bt)09~T and that the process (St)09~T IS adapted to this filtration. We know . Tj.20) isan adapted process.S. We say that (c(t))09~T is a budget- We want to study strategies in ~hich consmnption is allowed. with (J (JL-r)/a. is a standard Brownian motio.~ x. (iv) For all t E [0. yve note exp P" the probability with density /2) . + 10 rt dSt = St(JLdt c( S)dS) where JLE IR and (a(t))O~t~T I + a(t)dBt). som~ ~arrier K upward (that corresponds to c(t) pSt1{s.s. (. The Black-Scholes model Exercises . We suppose that conditions (i) to (iv) are satisfied and we still note Vi = e-rtVt = e:" (HP Sp + HtSt). dSt I is given by the Black-Scholes'model E· (JoTc(t)dt) and let x > O.n. 2.:F. Tj (0 ~ T < 00). with price S~ = ert at time t (with r ~ 0) and one risky asset. -3. Tj. c(t) ~ 0 a. (4.r)t/a + Be. satisfying is square-integrable under the probability P* . with non-negative values and such E' (t C(t)dt). th~ rand. Then for some constantsrrj and az such that 0 < al < az. (St)09~T is a stochastic process defined on a probability space (O. 'lit E [O.e. Build a hedging scheme for the option. (a) Show that if the process (c(t))O<t<T is budget-feasible endowment x then E* (JoT e-rtc(t)dt) (b) Let (c(t))09~T that from the initial with JL E IR and a > O.Tj + HtSt is non-negative and / We now suppose that the volatility is stochastic. We set Vt = H~St + HtSt and Vt = e Vi.Tj al ~ a(t) ~ 1. and c(u) = e-ruc(u).om variable HP Sp sup tE[O. crosses ~.s. feasible consumption process from the initial endowment x if there exist some processes (H~)O~t~T and (Ht)O~t~T such that conditions (i) to (iv) are satisfied. We say that such a strategy is admissible if the following conditions = = be an adapted process. A strategy with consumption is defined by three stochastic processes: (H~)09~T' (Ht)O<t<T and (c(t))09~T' H~ and H. The model is studied on the time interval [0. The dynamic of (St)09~T = St(JLdt + adBt) (-(JBT (J2T . (iii) For all t E [0. x . and c(t) represents the consumption rate at time t.-2. that the process (St)O<t<T is the solution of a stochastic differential equation of the.

show that «=o. with Il E IR and a (see Chapter 5) that if the process (a(t) )09'~T is constant (with a(t) = a for any t) the price of the call at time tis C(t. 5.~I~O.We wan~ to study an example of compound option. Prove (using the price formulae written as expectations) x I-t C1(t. at time t E [0.. functions =x . S~= e-rtSt. ec a} 0 G(O.x) are convex. (t. x) ~ E [e-'~ ( C ( T" xe('- ". where = log(x/~d + (ra. ) - K. x) = ° x = St(lldt + adBd. equipped with a filtration (:Ft)O~t~T' . Determine a probability P* equivalent to P under which the process defined by Wt = B.t. where the function C(t. 4. 1 2. (b) Show that the equation C(T1'X) i~ a martingale. (log(X/ Kr) and 9> + (r - ~2) (0 + Od) -d}. 3.We assume that (:Fd09~T is Ito (c) Show that if 91 is a standard normal variable independent of 9. Prove that the process defined by M. So).::: 0) and the second security is risky and its price is denoted by S. ec at x) + --2 -a x 2 a2x2 a2c (t. T[ and strike price K. Show that at time t G·IS dfi ne db y e < T1.a».K)+) . e-ru . So) :::. The first traded security is a riskless asset whose price is equal to S~ = ert at time t (with r .. l't . Derive the inequality Co ~ C2(0.. . Explain why the price of the call at time n' . x) .xe(r-u /2)II+UV99) 2 1{9>~d}] _ Kle-rIlN(d).Tl and characterise G by.v. on a call of maturity T and strike pnce K. 3. Prove that ' 6.-.t S) s.88 The Black-Scholes model Exercises the natural filtration generated by a standard Brownian motion (Bdo<t<T that (St)O~t~T follows a Black-Scholes model -d.jO a2/2) 0 is a martingale under probability P* .x) and x I-t C2(t.Ke-r(T-Td is 1. Let (SdO~t~T be a stochastic process defined on a probability space (O. (u. the process (Ldoi:.t~T ° = = h = (C(T1' STl) . = exp U~ . x) + ec =s: (t. given by the Black-Scholes formula. " c .S. . the compound option is' worth G(T . We set G(O. We want to show that the price of the call at time in the model with stochastic volatility belongs to [C1(0. 1. 2. we can write O~/= T . = . We consider a call option w~th matunty Tl E]O. Show that the solution of equation (4. Deduce that C1 (0.20) is given by = K. . Problem 5 Compound option ) We consider a financial market offering two investment opportunities.rC(t. x) is an increasing convex function . on [0. Recall that if (Od09~T is a bounded adapted process. T]. G(9. (Ilt where C(t. o.'). So). Let us denote by' N the standard cumulative normal distribution.. The. T[x]O. G(O. (a) Graph function x I-t C(T1' x). So)].:F.Kd+. Su)a(u)SudWu (b) We now want to compute G explicitly. 7. that the. = So exp + fat a(s)dBs . C2 (0.x) = (x . C 8.x) + Kle-rIlN(d) "22 E [( xeU(V99+v'919t)where the event A is defined by (lI+11d _ K e-r(II+11l ») lA] .were h ° with 9 bei~g a standard normal random variable. St).~ fat a2(s)ds) . Co = E* (e:-rT(ST . > 0. oo[ 'C(T. Show that the line y an asymptote (hint: usethe put/call parity).ds) e.value of this option at time Tl is equal to We note C1 the function C corresponding to the case a a1 and C2 the function C corresponding to the case a a2. Sd is a submartingale under probability.r)/a(s)ds is a standard Brownian motion. I Show that E* (Sn s S6eu~t. x) i..P*. d~fined by t. x) is the price of the underlying call. has a unique solution XI. P).K)+. (a) ~how that x I-t is given by . = E [e-rIiC d (n. x) satisfies 89 and -(t. + I~(1l . Using formula and Questions 1 and 6.

with.t$.. For t E [0. equipped with a filtration (:Ft)O<t<T. 3.r)/a.K r 1. s. We shall denote by P" the probability measure with de. Under P .aKg) + 3.: and that (SdO$.Kag)+ (b) Deduce that lim HT s. The first traded secunty 1Sa nskless asset whose price is equal to Sp = ert at time t (with r ~ 0) and the second security is risky and its price is denoted by S.Y1.dt . x) in terms of Nand dimensional cumulative normal distribution defined by N2(Y.8 T/2) with respect to P. Show that liminf KA) 2. derive a formula for G(8. . be the function pricing the European put with maturity T and strike I Pe(t.K)+] . where 8 = (fL . x) = E( e-r(T-t) 1. i. We also assume thatr > 0. = lim HT .g+ pg1 < yd for Y. We are going to study the option whose payoff is equal to To T-t is the set of stopping times with values in [0. T[. K-s(t) JT-t = +00.t?T be a stochastic process defined on a probability space (f!. (b) Deduce that Vo .x has a unique solution in ]0. > E (liminf K~) - t-+T T- t . T]. (c) For t ~ u. Show that if t E [0. we denote by s( t) the critical ~rice defined as" s(t) we recall that limHT price K = inf{x s(t) = K. We assume that (:F. Explain briefly why the Asian option price at time t (t ~ T) is given by K .x}. E(1/ . Let us call it se(t). x) K . Shq. x) = sup' TE70.. Sudu it Sudu orT ~ KT}.r)t/a + Bt is a standard Brownian motion. (a) Show that for any real number 1/..s«: K we have = r ~J .P) N2 the twoE JR.(St)O$.T follows a Black-Scholes model -- dSt = St(fLdt + adBd. Tt = e-r(T-t) T' + 1~ e-r(T-t) S. Let P.u the value at time t of a European call maturing . . > ° I P(t. the Asian option price. = P(t.IL E JR and a > ~..e.x) > K . We define We shall need Fatou l~mma: for any sequence (Xn)nEN of non-negative random variables. 4. T[. for t E [0. [e-'(T-') (~ { J.K e-r(T-t). E(lim infn-+oo Xn) ~ lim infn-+oo E(Xn).ns1ty exp (-8BT . K[. P). at time t E [0.( Ke -rT -xe O"W~_"'2T)+ 2 ..T-t E .(T-t)) + . when P is defined by We conside~ a ?nan~ial market offering two investment opportunities.. It. = P(g < y. h ~ (~ { where K is a positive constant. Problem 6 Behaviour of the critical price close to maturity We consider an American put maturing at T with strike price K on a share of risky asset S.) O<t<T 1S . (Use conditional expectations given > 1/. (a) Derive the inequality ( E· (St . ~ E' where 9 is a standard normal variable. th~ proce~s (Wt)O$. defined by Wt (fL . Show that we can replicate the compound option payoff by trading the underlying call and the riskless bond. 2. T]. we denote by Ct.t] and (Wt)O$.:F.T. T[.Y1. In the Black-Scholes model. = e:" s. ' S.K)+] . the equation Pe(t. K-se(t) JT-t s E· [e-rT (ST .90 The Black-Scholes model Exercises Problem 7 Asian option 91 (d) From this. its value at time t < T is equal to P(t.T is a standard P·-Brownian' motion.is smaller than its European counterpart. -t t he natura 1 filtration generated by a standard Brownian motion (Bdo<t~. St). Let .Ke-rT) + s E· [e-rT(ST :Fd. xeO"vT-tg. T .. for any t E [0. Show that s(t) ~ se(t).w that on the event { Vi t-+T .t$.P 4.t$.

= exp (r .T the process defined by where 9 is a standard normal variable. (a) Show that v.€) ~ E' (u ~t S~d") ill + 3. the random variable zero mean and a variance equal to T3/3. Show that (et)O::. Vt 0 n We denote by (et)O::.K) iT t e-r(T-u)Ct . The purpose of this section is to suggest an approximation of Vo obtained by considering the geometric average as opposed to the arithmetic one. f.u duo Vo = e-rTE (So exp (r . 3. Show that Vo ~ Vo.T is the solution of the following stochastic differential 2. Give a closed-form formula for terms of the normal distribution function. e-·TE· (exp (~ [In(S. + .92 The Black-Scholes model at time u with strike price K. (erTrT- 1 .exp (rT /2) .t::. with F(t.t) + a(Wu .a2 /2)(u . T[ x IR and we shall use It6 formula. (a) Show that under measure P". Prove the following inequality Exercises (b) Deduce that 93 Vt < e-r(T-t)t T (1.K) + . We define Vn ~ 2. et). in et = ~t (~ lot Sudu equation: Vo -Va ~ Soe-rT . Wtdt is normal with . Find a replicating strategy to hedge the Asian option.K U ) + -1 + T .Wt)) Vi (b) Conclude that = e-r(T-t) StF(t.] .K) + 1.)dt) .t::. ~ >{T-'lS. We shall assume that the function F introduced earlier is of class C2 on [0. 1.a /2)(T 2 /2) + aVT/39) . Prove the inequality .it t 0 S du .E' with S~ [ (E' + ~ t S~d") IF.a2T /12) ) .

5 Option pricing and partial differential equations In the previous chapter.x 0 e(r-0'2/2)T+O'W - T . ' The pricing of American options is rather difficult and we will not attempt to address it in its whole generality. We shall concentrate on the Black-Scholes model and. This link is basedon the concept of the infinitesimal generator of a diffusion. the European option price is given by Vi = E (e-r(T-t) with f(x) f(ST)!.1 European option pricing and diffusions In a Black-Scholes environment. The purpose of this chapter is to give an introduction to some concepts useful for computations. We shall also explain how we can solve this kind of system numerically. we are not able to find such explicit expressions. We shall only use classical numerical methodsand therefore we will just recall the few results that we need.K)+ (for a call). However. we shall underline the natural duality between the Snell envelope and a parabolic system of partial differential inequalities. (K . That is why we will often require numerical methods. we saw how we could derive a closed-form formula for the price of a European 'option in the Black-Scholes environment. an introduction to numerical methods to solve parabolic PDEs can be found in Ciarlet and Lions(1990) or Raiviart and Thomas (1983). we shall show how the problem of European option pricing is related to a parabolic partial differential equation (PDE). We shall also address the problem of solving the PDE numerically.x)+ (for a put) and S T . Firstly.rt) = (x . in particular. . But. i-: 5. if we are working with more complex models or even if we want to price American options.

. is an Ft-lTIfrtingale. (5.X. We assume that b ~nd a satisfy th. In fact. s KT xEIR (1 + E (sup IXs[:i)) < +00.1 can also be extended to the time-dependent case.ru) (t. x) is the of the following partial differential equatiori Remark 5. 5.2) V(t.)ds f(XT Vi = F(t. since the derivatives of f are bounded by a constant K and since f Ib(x)1 + la(x)1 ::. ~nd ther~sult follows from the fact that the stochastic integral f'(Xs)a(Xs )dWs ISa martingale. where (t. x)f'(x).1 that 0 x. I E (J (Xt)) { "Ix E R u(T.1.1. let us explain why the operator At appears naturally when we solve stochastic differential equations. x)'E [0.X. = f(Xt) - + b(x)f'(x).J. the process M.2. according to Theorem 3.3) 5.1) starting from x at time t..1. we should point out that the pricing of a European option is only a particular case of the following problem.T o this result is a consequence of Theorem 3. solution of (5. Infinitesimal generator of a diffusion We assume that b and a are time independent and we denote by (Xt}t>o the solution of . . computation of some regularity unique solution (e. we obtain .1. We generally want to compute Ito formula yields f(Xt) 97 1 + 2' Jt J"(Xs)a2(Xs)ds.)dsJ(XT = f(x) =0 (I t 1f'(Xs)12Ia(Xs)12dS) sup 1f'(xW x) . Xt) f(Xt) )IFt) . x) (au/at + Atu (5.9 in Chapter 3. t = f(Xo) + Jo f'(Xs)dXs = f(Xo) Hence o Vt =E (e. K(1 + Ixl) we can say that E (~~~IAf(X:)I) !heref?re.1) where b and a are real-valued functions satisfying the assumptions of Theorem 3.96 Option pricing and partial differential equations European option pricing and diffusions Proof. Let (Xtk~o be a diffusion in R.)dS) ~ Af(x).5.3 in Chapter 3 and r(t.2 If we denote by Xt the solution of (5. Indeed. J~Af(Xs)ds The ProPositio. this function F( t. The Vt is therefore equivalent to the computation of F(t. Vt can be written as It + it f'(Xs)a(Xs)dWs 2 Ga (xs)JII(Xs) + b(Xs)f'(Xs)] ds where F(t.5. s5.1 =a 2 Moreover. T] x R . E J~ and X!·x is the solution of (5.(x) Then.. -.3 in Chapter 3 which guarantee the existence and unIqueness of a solution of equation (5.J.T r(s.3 and since la(x)1 is dominated by K(1 + Ix!). x) J"(x) + b(t.. Before we prove this result.n 5. E(f(xnLo ~e some ~ i~E G l' . the Lebesgue theorem Af(X.3) such that Xx = it follows from Proposition 5. since x . proper ues 0 e infinitesimal generator of a diffusion J .x):'Under assumptions that we shall specify.T r(s.X.5. x) is a bounded continuous function modelling the riskless interest rate.1). differential operator A is called the infinitesimal generator of the diffusion ( t). x} ~ E Mathematically. x) = f(x) + E (lot Af (x:) dS) .·X)ds f(X~X)) )IX '= t .I----t Af(x) ISapplicable and YIelds s Ki and s I----t (1 + E (~~~ IX:12)) < +00. Intuitively F(t.J.1.5. + In the same way as in the Black-Scholes model.T r(s. X: are continuous.1 Let f bea C2 function with bounded derivatives and A be the differential operator that maps a C2 function f to Af such that Proposition :.• 0 su y (AJ) (x~ = a2~x) J".eassumptions of Theorem 3. f the i .:x) =E (e.. (AtJ)(x) . The reader can refer to Bouleau (1988) or Revuz and Yor (1990) t t d .

0 Vt =E (e.4) where F(t. x) a bounded continuous function. Xt). T) x IRn.1. x) ax' _Proposition 5. Proposition 5.Xu)dv (~~ + Asu . when we denote by the unique solution of (5. )ds u (t . Xt)-l er(v. Xt)-l t «: I: r(v.T) x IRn.1 n.I. Xs)d8 The proof is based on the multidimensional Remark 5. x)oo* (t.2 equations in x and European option pricing and diffusions 99 where 00* is the transpose of oo(t.5 are still satisfied. r( t. = u. x) a2u au (Asu) (x) 2 ax2 + b(8. Xt) .J~! .1. x) u.)dsu(t.4) starting from x at time t. and ijr(t.it r(s. x) is a bounded continuous function defined on IR+ x IR.It (~~ + Asu) (8.X. x) a' '. x) is a real-valued function of class C1. Ifu satisfies with a bounded derivative in x defined . Let us consider (Xt)t>o a solution of system (5. As is the operator defined by .4).x) k=! 0.ru) (8.2 defined on IR+ x IR n with bounded derivatives in x and also. then the proces. x) (OO'j(t.T r(s.5 If(Xt) is a solution of system (5. and r(t..)ds f(Xr) 1Ft) .1: the only difference is that we apply the Ito formula for a function of time and an Ito process (see Theorem 3. x)).7 Let u be a C1 .4) andu(t. x) = f(x).4.1. .x)E [O.98 Proposition Option pricing and partial differential 5. = e. Theorem 5.r r(s. x) = function with bounded derivatives if X. I: is a martingale. is a martingale. Xs)d8 Here. x)) is the matrix of components p a. is a martingale.' L . is a solution of (5.4.2 Conditional expectations Ito formula + At stated page 48.6 The differential operator a/at operator of the diffusion. 'V(t. the process In other words a(t.10). = ait. we can prove that This result is still true in a multidimensional model.3 If u( t.1.1.Xu)dv (~~ + Asu . For any time 2 t we define the following differential operator At which maps a C function from IRn to IR to a function characterised by (At!) (x) 'Vx E IRn and u(T.ru) (8.x) =E (e.I J= 0 n B] ax (x).a a 2 f' XJ x. (x) + Lbj(t. '. the process t M.4 Under the assumptions of Proposition 5. .X. 002(8. Proof.X!.Z)ds f(X~X)). We want to compute .5. The following result characterises the function F as a solution of a partial differential equation. f(x) a function from IRn to IR. 5. J (~~ + ~tU then - ru) (t.j (t.)dsu(t. Ito formula to the process u(t.x) .1. .ction. I).x= We assume that the assumptions of Theorem 3. r(s. In order to deal with discounted quantities. x) is a C1 . X t ) t.x) = ° where (a. a"j(t. we want to emphasise the link between pricing a European option and ~olvmg a parabolic partial differential equation. Xs)d8 The proof is very similar to that of Proposition 5.x) = LOO'k(t. = -2 . er(s.X. x) is a continuous boundedfunction defined on IR + x IR.2 function on [0. as in the scalar case. Let us consider the stochastic differential equation (5.12 in Chapter 3) e and then applying In this se.x)OOjk(t.3.J. = u(t. we state a slightly more general result in the following proposition.1. This proposition can be proved by using the integration by parts formula to differentiate the product (see Proposition 3.X. is sometimes called the Dynkin and partial differential equations = I.1. o In a similar way.j(t.

problem asso~iatedto Ab8~log and the computation of ~e pnce of an option in the Black-Scholes model can be highlighted as follows: . Then we can apply some theorems of existence and uniqueness.u at u(T.~2) (12 dt. = v(t.J. the tnck IS to consider the diffusion X.'. " Ab.1.X!.1.. Problem (5. x) +Ab.3 Application to the Black-Scholes model We are working under probability p".r.T .S t- ex. T] x IR (5. XO'X) t is a martingale.8 Obviously.x) '= E E = sinceu(T.) au + A. x) 5.K)+.5.X?. we shall impose some regularity.Z)ds j(X~~)) . Let us prove the equality u(t.-1ogv(t. X)~i~j ~C (t ~?).JoT (e. .=1 (5. "Ix E]O. =-x 2 -+rx. z) ~~ (~. since S .x) (e. T] x !R" (5. .x) for =E (e.7) "1(6. Id V2i 1 /2dx ' -00 Remark 5.5) is a parabolic equation with afinal condition (as soon as the function is given).e.ru ~ ° : in [0.. it has constant coefficients.X~'Z)ds j(X~'X)) = o N(d) is solution of the equation log(x/ K) + (r + (12/2)(T (1y'T . Theorem 5. ts m mtesimal generator can be written as = 2 ax2 a+ 2 ' (r _ _- (12) ~ 2 ax' It is clearly elliptic because We write Ab. moreover. i.t) with ' )_ 1 r(s. 2 ( '(12 3C >0.t e-X 2 .If we ~ant to compute the price F( t.{ at +A b'u au '' . and if the solution u of (5. 'a (5. Note th~t th~ operato~ A b. However. Q aij(t. which is solution of a given j.7 suggests the following method to price the option. we just ~eed to find u such tha~ { u(T.x)'E [O. V(t.= j(e log(x)). = (r . x) =0 / in [0. For the problem to be well defined.100 Option pricing and partial differential equations Pr~of. +00] r(s. we know that the process Mt-e 0 = F(t.5) = = j(x). x) . Generally speaking.Z)ds u'(t . "Ix E IRn. we need to work in a very specific function space (see Raviart and Thomas (1983».assumptions on the parameters band (1 and the operator At will need to be elliptic.X~'Z)dSU(T. a = ""2 ax + 2' r~ ~ 2) ax .t) = j(X).···. x) at time t and for a spot price x of an option paying off j (ST) at time T.X~'X)) r(s. Therefore the relation E(Mo) u(O. °e(r-0'2/2)t+O'w. { v(T.8) "Ix E IR. [0. X ).5) is srnooth enough to satisfy the assumptions of Proposition 5.x) _ ru ~ ° in .T] x IR E n .The process (Wt}t::::o is a standard Brownian motion and the asset price St satisfies then F(t.6) The ~onnection b~tween the parabolh. z) = (z . +00[. u(T. In order to fompute F(t.6). .JoT = E(MT) yields K e-r(T-t) It is straightforward to check that the call price given by F(t x) = xN(d N(d1 . doe~ not satisfy the ellipticity condition (5. x) at time t = o.-log " I " . = --. By Proposition European option pricing and diffusions The operator At is now time independent and is equal to (12 a A t= Ab.a 2 ax2 ax' 2 101 f r(s. we need to find a regular solution v of 5.1.1. T1 x 10.4 we can conclude that F = u. The proof runs similarly fort > o.1.-log (12 > 0 and.(1vT . ~n) IRn L.+ (1dWt. log (St). The same type of result holds for the put. fini .

1\ 103 T: 1\ T where tr = inf I {O < - 8- < T . +oo[ weare able to compute explicit formulae for the option price (see Cox and Rubinstein (1985) and exercise 27 for the pricing of Down and Out options).b) = 0 = f(x) 1 That completes the proof for t o .T (X"Z)d ..X~. but the reader can refer to Glowinsky. ° .x) E [O. f(x) . = E (e- JoT ':(S'X~'Z)d8u(rX. 5.J.X~. if 0 is of the form ]0. We shalt prove the result for t ~ 0 s~nce the argument is simil~ ~ o~h:: times There exists an extension of the function u from [0.1. thus by noticing that if 8 E [0. th consider boundary conditions at a and b.T]..9 .r . ') ° = o. as soon as the asset price exits the open set 0.~) { u(T. consequently au (t x) at ' u(t.10).'r(XO'Z)ds u. t=. From Proposition 5. Af(X~'X)= 0. X~~X) = 0 on the event {38 E [t. x) and u('[x.X)d8' rX = inf { 0 S 8 S T .' ] that is still of class C1. We are going to concentrat~on e ~~s~ when the function takes the value zero on the boundaries '.x) ° = E ( l{'v'sE[t.10 An option on the FT-measurable "Ix E O. Indeed. . Lions and Tremolieres (1976) or Raviart and Thomas (1983) for a detailed analysis. = E ( 1{'v'sE[t.T] x nt (5. = u(T.6. Xt. because r" = T.Z)dv (au ° d ''f' at + Au .x s = l} .5) becomes = ~~(t. u hout the rest of this section.3. we get E(Mo) = E(Mrz). rex) is the riskless rate and A is the differential operator defined by .ZEO}e As we are about to explain.T]. on a. += • = f(x). z) =b on [0.X) t - is a martingale.10) can a~so be expr~ssed in terms of the diffusion which is the solution of (5.r(x)f(x).x:. a regular solution of (5.ZEO}e T Z We denote by A the discount operator such that Af(x) Equation (5.rZ r(s. "It S T Remark 5. Xos' x O} or T if this set is empty . We shall only state the most important results.2 Solving parabolic Proof. .4 Option pricing and partial differential equations Partial differential equations on a bounded open set and computation of expectations Solving parabolic equations numerically is a bounded stopping time. we know that M« = eo' J.. rX]. We then have V(t. 2 f(x) 1 a and indeed T{ is a stopping time according to Proposition 3. random variable • s f(XiX) = u(t.T] x 0.4.ZEO}e .T r(s '.T r(X"Z)ds • equation (5.2 function u(t.T]. 9) 0 ] b[ as opposed to nt.(t Xo. XO'X)) E (1 {'v'sE[t.2. T] x 0 to [. t x= Let u be a C . we shall assume that there is only one asset :°th!t b(x).x~~X)) X!. _ J.x) with bounded derivative in x that satisfies . the option becomes worthless. "Ix E nt. We shall continue to denote by u such an extension. X!.T].J. X!'x Ii O} .X)) T is called extinguishable. it follows that (Af)(x) = "2u(x)2aT + b(x)--ax-' af(x) u(O. 1{'v'sE[t.ru) (8. t. equations numerically . X!. .Z)ds u (T . X~. This method is obviously useless in the Black-Scholes model since we are able to derive a closed-form solution.x) Af(x) . In the Black-Scholes model.102 5.T].XO'Z)dsf(XT'X).( We saw under which conditions the option price coincided with the solution of the partial differential equation (5. but it proves to be useful when we are dealing with more general diffusion models.10) u(O.9) Furthermore.x) + Au(t.9) numerically and we shall see how we can approximate its solution using the so-called finite difference method.3) starting at x at orne. We now want to address the problem of solving a PDE such as (5. Theorem 5.These are e so-ca e Dirichlet boundary conditions. By applying the optional sampling theorem between 0 and r". T] x 0 (5. u(x) and rex) are all time independent. Moreover i ° t- e f r(X~. l[ or ]l.Z)ds u ( x XO'X)) + E (1 X!'Z~o}e ° {3sE[t.x) + Au(t.a) u(T.1.T r(s. The problem to be solved IS then TJ.1.xEo}e' f( xt. we need to If we want to solve problem (5.J.9).1.x) =0 = on [O.

3. IX!''''! 2: I} C C {sUPt:S.) s~O is also a standard Brownian motion p (. -I) = 0 if t u(T.W.1 • :t can be proved ~h~t P(suPs:S. Remark 5.Wt)1 2: I -lr'TI) Ix = MP (suPO::S. the PDE becomes < MP (sUPt:S. we shall impose Dirichlet conditions (i. In order to discretise.T + O'Ws) > a) < exp (_Ia O'2T' _XI2) We want to compute the price of an option whose payoff can be written as feST) f(SoeXT). + O'Wsl 2: a)· la .Wt)1 2: I} {SUPt:S.X12) O'2T + exp + X12) O'2T u. x) . x) = E (1 {v'sE[t.UI(t.T and and therefore . Typically. x).2.UI(t.11) where X.T + O'Wsl 2: I -lr'TI) Ix au(t.) = = ice).. = = < MP (sUPO:S. I) = u(t. l[. dXt = (r .S::S. IX!. the logarithm of the asset price solves the following stochastic differential equation w. T] E x VI By Proposition 3. 2: a) = P (Ta s T) s e~TE >. we adopt Dirichlet boundary conditions. and in that case the numerical approximation is = If we call r' = r . 2: a) - ~ - exp ( .J .r Ix + O'(Ws . x)1 105 Problem (5.9) is set on ffi.O'2/2)dt " + O'dWt. x)1 <M (exp (_II .t) + O'(W.:S.) <: a):5 (-IOa. If we specify Dirichlet boundary conditions.. x) ..} th E(exp(-).T!X + r'(s -. (5.t) + O'(Ws . Minimising with respect to = f(x) if x E VI.Tj.xl2:I).0'2/2 = {3s E [t. we will have to work on a bounded open set VI =].Wd! 2: 1-!r'TI}· .zl<l} e-r(T-t) f(X~X)) lu(t. It infers that f~r any a> 0. T].:S.104 5.S:S. at I and -I). and therefore We are going to show how we can estimate the error that we make if we restrict our state space to VI.T_tx + O'Wsl 2: I -lr'T/) I . We can prove in that case that the solution u of (5.T w. where I is a constant to be chosen carefully in order to optimise the algorithm. u(l) u( -I) 0 or some more relevant constants) or Neumann conditions (i.S::S. (au/ax)( "':'l)). x) at + Au(t. :5-a)~pb(-x ~ exp ( -aW.Wt)). x) u(t.~~(X+UW.e. (au/ax)(l). We write f(x) To simplify.i)1 S MP (3s E[t.for given t and x. .9) and the solutions UI of (5.~) . x) [0.I.s:s. We assume that the function f (hence f) is bounded by a constant M and that r 2: O.J2Xlal).6we know that if we define T. e~T e-av'2).I~.1 Localisation Option pricing and partial differential equations Solving parabolic equationsnumen'cally Thus lu(t. - x) = 0 on [0. We also need to specify the boundary conditions (i. = inf {s > 0 W .X12) .10) are smooth enough to be able to say that Since (.T]. . IX.2. yields P (~~~ (e-~To) < _.T Ws 2: a) 2P(WT 2: a) (see Exercise 18 n Chapter 3). a~d f~r:n~ A en u(t.e. We shall work in a Black-Scholes environment and.x) -uI(t. !his prov~s that.T + O'(Ws .O'2/2)(s .e. The convergence even umform In t and :: as long as x remains in a compact set of ffi. • The ~ndamental advantage of the localisation method is that it can be used for pricing American options.'x == xexp((r . it is easy to show that .. + ex P ( IS II-lr'TI + XI2)) O'2T lu(t.I') exp (_Ia These two results imply that P (sup Ix . T] P (sup s:S. P (SUP(x s:S. This would lead to a slightly better approximation than the one above.Ta)) = exp(-. liml-++<x> UI(t. Then.(t. thus.

-l)= 0 if tE [0. 2h and replace with We obtain an operator Ah defined on IRN. where (E) u(t" l) = u(t..2 Thefinite difference method ((Ah).ru(x) 8x ' '{ dUh(t) + AhUh(t) ~ u.. .12) This discretisation in space transforms (E) into an ordinary differential equation (Eh): _ . 0 a . = !h . h.--2u(x) + ( r (T2 8 . We specify boundary conditions on I».We proceed as follows: we denote by (Xi) the sequence defined by Xi = -l + 2il/(N + 1). = -'..:2 - 2~ (r _ ~2) ' The finite difference method is basically a discretisation in time and space of equation (E). - (3 a (3 . 2h u~ .'2 .2. for 0 ~ i ~ N + 1. we obtain the following system with Dirichlet boundary conditions: 8u(t. x) 8t 15:i5:N.u~. k a time-step such that T = Mk and. x) = 0 on [0. . We consider h = 2l/(N + 1) and Uh = (UUI5:i5:N a vector in IRN. 0 (3 0 .. (3+.) + ( r .' 2 8x2 . The estimate of the error will give us a hint to choose the domain of integration of the PDE. T] a u(T. where!h = (f~h5:i5:N\ is the vector f~ = f(Xi). 0 (3 0 .2u~ (T2) 2 8u(x) -.(T) =0 if 0 st sT . each fi is somehow an approximation of f(Xi).'2 1 (·+1 '1) . 0 a 0 0 0 0 + Au(t. fi'Hl in the Dirichlet case and fo. 5. fN+! in the Neumann case.2 In the Black-Scholes case (after the usual logarithmic change of variables) A bs-Iogu(x) is associated with (AhUh)i (3 = (T2 . - (T2 = 2h2 (+1 u~ ' '1 (T2) + u~. our numerical procedure will be.106 Option pricing and partial differential equations Solving parabolic following matrix: equations numerically 107 compulsory.h2 - r 1( . The discretised version of the operator A is called Ah and the substitution runs as follows: ui.. If we specify null Dirichlet boundary conditions. Remark 5. we approximate the .0 0 0 0 I -~ 0 0 0 (3 a .ru~. 15:j5:N = (3 a 0 0 0 0 (3 a 0 0 . (5.1]. Ah is then represented by the W~ are now going to discretise this equation using the so-called O-schemes.= (3+a a 0 2h2 (T2 + 2h (T2) r .. it has the following form: (3 a 0 0 . We shall start by discretising the differential operator A on 0. In order to do this. T] x 0. It is quite a crucial choice that determines how efficient . We consider 0 E [0. If we specify null Neumann conditions. i». a function (f(X))XEO.tl _ Ui-1 b(x') h h with .) '3 Once the problem has been localised. taking values in an infinite space will be associated to a vector (fihsi5:N.2. x) = f(x) if x EO.

we have to solve at each step a system of the form Remark 5. However. known as the Gauss method sol~es the system with a number of multiplications proportional to N.k -k h. The reader ought to refer to Raviart and Thomas (1983) for proofs. eac time-step n we are looking for a solution of T X G where -: . • In the ca~e 1/2 :::.2. assuming the ellipticity condition.k) towards u(t.x..5 • In the case 0 :::.k of (Eh.k = when 0 = b. (Eh. G (gih'~i~N and = (J¢)(x) 1 = h (¢(x + h/2) .::k = fh n decreasing.r(x)f(x). we shall examine in detail how we can solve problem (E) .h/2)). as we shall seeshortly. ese a gon ms are rat er tricky to Implement numerically and therefore they are rarely used except when 0 O.k = = • When 0 = 1. k and k/h2 tend to 0 Th gl .0 :::.0 :::. with >' 0. We also call J¢ the approximate derivative defined by T is a tridiagonal matrix.(xih~i~N.2. Denot: X . T] x aL) in £2 ([0. bN Then: The algorithm runs as follows: first.k numenc y. O)kAh) un~i h. This is obviously more complex and more time consuming. We shall now state convergence results of the solution Uh. k tend to 0. as h.2.k)i1jx. Remark 5. all At h ti .k solution of 109 U.k L L(uh n=l i=l M N T .108 Option pricing and partial differential equations Solving parabolic equations numerically • When 1/2 :::.k is computed directly from £2 ([0.OkAh) .nkj. as h.1. { b = (I + (1.k) un+! _ un . • When 0 = 1/2. We denote by u~(t.0 < 1/2. . T= bi a2'" CI 0 C2 Theorem 5. the scheme is said to be completely implicit. k tend to 0 lim u~ = U solution Uh of (Eh) at time nk by Uh.+h/2j = x l](n-l)k. lim Ju~ = au/ax .O)AhU~:tl =0 if 0 :::.4 We assumethat b and a are Lipschitz and that r is a non-negative continuous function. T] x aL). It is often used to solve systems of type (E) when b 0 and a is constant. h.·0) kAh ) U~:tl = where T is a tridiagonal matrix. .ut B T~h. ' Finally.' X = " Uh.¢(x . h. we get aL) limu~ = U in £2 ([0.1 we say that the scheme is unconditionally convergent because It converges as soon as hand k tend to O. we solve for each n: in £2 ([0.k + (1 .-h/2.n:::. T = (I . with lim k] h2 = 0. the algorithm is called the Crank and Nicholson scheme. T]x u~tl. Let us recall that Af(x) is equal to 1/2a(x)2(a2 f(x)/ax2)+ b(x)(af(x)/ax) . we transform T into a lower triangular matrix . x) the solution of (E). T] x in ad limJu~ = au/ax 0 the scheme is explicit because Uh.th her tri .~ < 1/2 we say that the scheme is conditionally conver ent because the algonthm converges only if h. these schemes are often used in practice because of their good convergence properties.k + OAhUh. x) the function : G (I + (-1 1. M-1.3 • When 0 • When 0 :::.kOAh. The following algorithm. We assume that the operator A is elliptic b2 a3 0 0 C3 0 0 b3 0 0 0 o o\ 0 0 aN-I 0 bN-I aN CN-I with to > O.

X!'~)ds f (X. x) = f(x).4) starting at x at time O. gi .4) to this martingale between times 0 and T.3 American options au .of and.similar result in terms of a parabolic system of differential inequalities. 0 0 ~(t. hk a II.X. Theorem 5.T sup ) E • ( -r(r-t)f e ( xe (r_u2/2)(r-t)+u(WT-W .. 5. t T r(s "X"z)ds t f ( Xr'X) ) .3 shows that the process M. By applying the optional sampling theorem (3.e. we get E(Mr) E(Mo). \ . Jo' r(s. stated in rather loose terms (see Remark 5.' k I the Black-Scholes case. at + Atu - ru :::.1.notmvertIble. is a martingale. .we bt .T r(s. _. St) where Proof.13) = f(x) rETt. (on a stock offering no dividend) is equal to the European call price.3.T = sup E (e. rican 0 tions in continuous time is not straightforward. ~t t~O • [t T] We showed how the American call pnce stopping times taking values in . Lamberton and Lapeyre (1990) (Section 3).i = gUb~ :::.3.X. under P . However.x) Noticethat = sup E rETt.0.' .+l /b' . ~(t.N.)ds~ (t. we 0 ill . T] x IR n (~~ + Atu u(T. 0 is the smallest martingale that dominates the process f(Xt} at all times. compute the function b'· = bi .x) . Let us denote by Xf the solution of (5. ~ 5.110 Upward: Option pricing and partial differential equations American options 111 using the Gauss method from. ~(t. For a detailed demonstration. The problem to be solved is a particular case of the following general problem: given a good function f and a diffusion (Xth>o in IRn. We just stressed the fact that the European option price is the solution of a parabolic partial differential equation.ru) (f ..ru) (8 XX)d8 . bottom to top. 1 1+1 . XX) t e- J. s is a standard Brownian motion and Tt. The following theorem. the reader ought to refer to Bensoussan and Lions (1978) (Chapter 3.we c~n prove Remark5. As far as American options are concerned. _ C. T] x IRn [0.aixi-d/b~.3. u .. N t .T ( e-' J. we just have to compute X starting frorri the top of the matrix.I < Ibl WheneverTis. We shall only sketch the proof of this result. 1 _ 2/21 < a2/h.x) = •( rETt... very similar for arbitrary t.')ds J~ U (t . G' where . there is no explicit formula for the put price and we require numerical methods.K)-t) or an AmerIcan put (f(x) + = Vt :. x) Then u(t.J. u~f in in [0.:')dv (au at = +A s. r(v. c i increasing Xi = (g~ .ned the following formula for the price of an the Black.. Proposition 5.X)) .6 Th.the th t't' s if for any t we have ai C. Nevertheless. . o a2 b'2 a3 o o Remark 5. tl)) = e . we obtain a. '. decreasmg.3.f"r(s.1 It can be proved (see Chapter 2 for the analogy with discrete time models and Chapter 4 forthe Black-Scholes case) that the process T'= 0 0 b'3 0 0 0 0 e. . it is easy to c ec previous algonthm does not wor . We only consider the case t = 0 since the proof is.3. Downward: Xl For 2 :::. x) ~ f(x) and for =T we obtain ~(T.4).Xt) o o 0 0 aN-I 0 v. b'rv = bN g'rv = gN For 1 :::. and since au/at + Asu- .x) = ~(t.3).1.. . .T is the set.g. Section 2) and Jaillet.2 Let us assume that u is a regular solution of the following system of partial differential inequalities: aN b'rv To conclude.10 ' r .::: ~(t.+1 . In The analysis of Arne del.2. solution of system (5. for that T satisfies the preceding condition as soon as r a sufficiently small h.X.i :::. tries to explain that. e matrix T is not necessarily invertible. n.1 Statement of the problem .u) in IRn =0 (5. en We have obtained an equiva Itt sys em T'X -.. i. .g.Scholes mo e. _ (K _ x) ) American call (f(x) (x .Ciai+! /b~+l ~.

X:)dSf(X:)) rE70. Also. .t L am b erton and Lapeyre (1990).e.14).in [O. I es e connection With the 'Topt. we can write op . + Abs-Iogv(t.Ing th~ finite di~eren~es method. 8 ::. . XX).14) . Because at time . a.¢(x)) (:~ (t. The proper method consists in adopting a variational fonnulation of the problem (see Bensoussan and Lions (1978». Flr~t. (V-¢J(88Vt(t.T]xIR = F(O.x).h~ e dlls~nbutlO. = Abs-Iog _ 8v -8(t.JOT r(s.)ds f(Xn) ° a.).e.!)+AbS-IOgV(t. Numerical solution to this inequality We are going to show how we can numericall I" . T. x) ::..8v /8t. ) The following theorem states the results o f existence and uniqueness of a(5. ttteren tila I inequality and establi sh th " Amencan put price.ru) (8. (v~t.X)) veT. we must Impose boundary I y WI eumann boundary conditions 8v( -b ~8t t.x~ = E (e- JoToP' r(s. zmq~e :ont~nuous bounded solution 82v/8x2 are locally bounded. in J a. in [0.X.3. T] xIR v(t. o Remark 5.. Its infinitesimal generator A is actually time-independent and . in [O.nsense 8v/8x. a.3. the supremum is attained for T Topd. 2 We can now discretise inequalit (A) . thus u(O.3 how we can get an elliptic operator by introducing the x. x) = ¢(x).x)2:¢(x) U(O. X:)) . We are working under the probability measure P* such that the process (Wt is a standard Brownian motion and the stock price St satisfies The proof of this theorem can be found in Jaill e.1.' ( e-oJ. for 8 between and Topt. The proof that we have just sketched turns out to be tricky because we cannot apply the Ito formula to a solution of the previous inequality.in - We recall that u(t.T] x IR Now. .)ds f(X: vet. the solution u is generally not C . = log (St) AbS-log = log (So) + (r + a.JOT r(S. we have (8u/8t + Asu . The optional sampling theorem yields / = ° u(Ox)=E .x) 2: E (e.3. IS Theorem 5. and that u(O. " to the price of the American putis t e partial differential Inequality corresponding = u(O. Esse~tially. T] x O[ We saw in Section 5. . . ) = f(XrX . x) = F(O. X:) = f(X:)}. XX)d Su(~ ( opt opt._ 8x r.)dSU(T. Here is the inequalit ith N' Then.)) • U(O.JOT r(s.x)::. x) ::.2 The American put in the Black-Scholes model We are leaving the general framework to concentrate on the pricing of the American put in the Black-Scholes model.X.) t + aWt· . x) veT.log(x)) = ~(t. U(8.!. T] x O[ dSt = St (rdt process + adWt) .T E* (e-r(r-t)f (xe(r-u2/2)(r-t)+u(W -Wtl)) T . we define Topt = inf{O ::. x) 2: ¢(x) . =0 a. even 2 for a regular function f. The _ n .~2) . x) 2: E (e. solution to this partial diff .4 The inequality (5 14) has a' . U(T~Pt.T . .3 The precise definition of system (5. 5. x) = ¢~x) . er. n particular. M IS the Integer such that . the method is similar to the one used in the ~ so ve InequalIt~ (5. .. x) + A bs-Iogv( t. X:) 0.e. [O.e. x). This 8v 8t (t. F(O.x) 2: sup E (e. M~re~:s I.112 Option pricing and partial differential equations ru s° American options id 113 If weconsl er¢(x) (K -eX) h '. so ution satisfies That proves that u(O.13) is awkward because.x)+As-logv(t. problem to work in the interval O[ =l.x) = sup rETi.e. we localise the conditions at ±l.I l[uropean case. = v(t.O v (t.X.e. x).e. . we can show that Topt is a stopping time. notations are the same as in Sectio y5 2 2U. X ±l) = 0 . r r 2 = ~2 ~ 2 2 8x (-r . Xrx opt TOP' rs.T ] X O[ k~:o [0. x) . in [0. x) such that its partial deri 'at" . We even proved that Topt is an optimal stopping time (i. (A) . Topt. x)) = ° a.x) proves that 2: f(x).

we have to solve.-I + 2il/(N +we .' b . at each time n.X. when 0 = 1. and Ah IS represente~ by rna x . with a > 0). In our case. the convergence is unconditional. T will satisfy this assumption if 2 0'2/21 ~ O' /h and if 0'2/21 k/2h < 1. we can prove that there exists a unique solution to the problem (Ah.F) = 0. F' lly the method is the same as in the . . (.x) = L L(uh. We note M N u~(t.k) to the solution of (A).) x.T X ~ aX. F = th. by using the fact that (a + b)2 ~ 2 (a2 + b2) we show that Ir - Ir - h were . Indeed.a 'b +C C 2. If we note x:Tx = > n n n-l L aXi-lxi i=2 n +L (a/2) L (xLI ~2 i=1 + bx~ +L i=1 CXiXi+1 + ax~ + cx~ xn x= Uh.k)il]:Z:i-h/2.ationin time leads to the finite dimensional inequality European case.' wnte U . the previous convergence is true when hand k converge to 0 without restriction.() 1) Mk = T.3.h IS given by (5 .V I . Under the coercitivity assumption. The following theorem analyses explicitly the nature of the convergence of a solution Of(Ah.:Z:i+i/2] n=1i=1 if li x l](n-l)k. the convergence is conditional: k/h2 converges to 0 then and k converge to 0 and (1) if C 0 C 0 ·0 C b a 0 0 b 0 0 0 lim u~ =U in L2 ([0. an d A.k _ = -Ok (~+ _!_ (r _ 2h2 2h 0'2)) 2 ' (AD) is a finite dimensional inequality. . We know how to solve this type of /h un h.k + (1 - O)AhU~11) ' ~0 inequality both theoretically and numerically if the matrix T is coercive (i. therefore. /h is the vector given b y fih = If' Xi where x • . when 0 < 1. e (Ah. .i.I. th -dl'sc-reti.e.k + E~=1 bx~ + (c/2) E7:/ (x~ + x~+1) + ax~ + cx~ .k ~ n+l uh. this condition implies that a and c are negative and.~k]' Theorem 5. IRn -. 12). 1.y I'S the scalar product '. tri (5 12) If u and v are two vectors In . X.5 Ifu is a solution o!(A). the system of inequalities (AD) where T is the tridiagonal matrix a+b a 0 T= 0 0 0 I TX~G X~F (T X ..k): U~k 114 Option pricing and partial differential equations American options with 115 = /h C and if 0 ~ n ~ M . T) x a 0 '. X .1 Uh.k +k (afhuh .G.k) (see Exercise 28). orma .e.. In IR N . < "['vI < z < n Ui < Vi.

X an P(T = 1 + a) = p = (bn_n:. and that .mencan A' as put pnce In this model could bee written + b. . Lions and Tremolieres (1976).b'N ~ bN 'g'N = gN ~For1 ~ i ~N . as an . the previous algorithm is due to Brennan and Schwartz (1977). at." (5. x) could be computed by induction ' according to the Pam(n. Zhang (1994).3. Let r a at IS Widely used to pri~e the that -1 < a < r < b Let (S) b .9 An implementation offered in Chapter 8. b.p according to i ~ n by induction of (5 15) Itam n. There exist some cases where the result computed by the previous algorithm is not the solution of (AD). . ) >0 is a seq f II 0 .b + cl) Upward: . withthefinalconditionP. See also X. xercise 4 . .. we shall proceed as follow iven some discretisation parameter N we fi th . Section 1.. Some exact methods are described in Jaillet.. exp ( = (b-r)/(b-a). we normally use () unconditional.L.3.6 In practice. Lions and Tremolieres (1976). This suggests G' .1 Wi ' that the " . .k). Lamberton and l:apeyre (1990) prove that.16) and we compute the price pN ( ) h x e values r.('K )+' (5. we can solve the system (AD) very efficiently by modifying slightly the algorithm used to solve tridiagonal systems of equations. we proved . We must emphasise the fact that the previous algorithm only computes the exact solution of system (AD) if the assumptions stated above are satisfi~d. X)we can am 0. were (T..16) Remark 5. pPa'.ca/b~+1 = gi = gi . this algorithm does compute a solution of inequality (AD). when the step h is sufficiently small.3 American put pricing by a binomial method We shall now explain another numerical method th . . of th B e rennan and Schwartz algorithm is 5. In particular. .X . d n+1 n n.3. (1 + b)X)) Remark 5.'(n + 1. under the previous assumptions.x)+. Remark 5. Lamberton and Lapeyre (1990). :' b be three real numbers such S _ S T. hen n n2:0 e the binomial model defined by S. (N x)'.aXk-d/b~ Xi = SUp(Xi' Ii)· Jaillet. (1 + a)x) + (1 l+r p)Pam(n + 1.116 The reader will find the proof of this result in Glowinsky. equation the function Pam (n. it works specifically for the American put. o then the European option price in this model a ' ' computed for a riskless rate equal t R d pproxl~ates the Black-Scholes price that in order to price the Am' 0 an a volatility equal to (7.8 When we plug in () =' 1 in (Ah. ' case.. a. .15) in Chapter 1. increasing i Xi = (g~ .S c hi' es pnce P(O. .1. some iterative methods are exposed in Glowinsky. 0< . 0 . encan put. . seems quite natural to take pN ( approximauon of the American Black . x) = max ( (K .t enodesx{1+a)n-'(I+b)i.:)/(b _ ) uence 0 D random variables such that hn 2E a and P(Tn 1 + b) . apart ' There exist other algorithms to solve inequalities in finite dimensions.3. On the other hand. and we impose Neumann boundary conditions. decreasing i b~ = b. The following example should erase any doubts: -1 1 . e parameters are chosen as follows: ' r = RT/N exp = l+b ~p (-(7/TTN) +~/TTN) (5. . American put in the Black-Scholes model. $n). b.= SUp(Xi' Ii)· That makes it very effective.7 'The algorithm is exactly the same as in rheEuropean from the step Xi .p.x). We shall proceed as follows (we denote by b the vector (a Option pricing and partial differential equations American options The computation gives 117 = 1 because the convergence is which is not a solution of (AD).4 that ifth . Remark 5. Numerical solution of a finite dimensional inequality In the American put case.3.cgi+1/b~+1 'American' downward: Xl = gUb~ For 2 ~ i ~N. Indeed. Pn = Pam(n. saw In C apter .

v . a > O.¢(x)) ( -vex) + T _AbSv(x)) = 0 +oo[ 1. Deduce that if v is continuously differentiable then z" is a solution of f(x) x where = vv >F (Y . Write down the equations satisfied by A and a so that v is continuous with continuous derivative at z" ..x) + 1 + lal K-u. 4. x) (see Chapter 4.(O.1 5.x). = prove. d P . and Y (Yih~i~n' The not~~'.+oo[ . V . [O. in = V (t. = x)jax). d b (X Y)thescalarproductoftwovectorsX (xih~i~n ExerCISe 28 We eno~e y . x) u(T. Conclude that there exists a unique solution to the equation f(x) x. x) satisfies -vex) + T _Absv(x) ::.x). x) . Sp is a coritraction.x)+_AbBu(t.(t.d i th called Cox-Ross-Rubinstein This me 0 IS e sodetails in Cox and Rubinstein (1985).18).17). Using the closed-form formula for u.Letusreca a to a roximate the Black-Scholes American ~ut pnce is a~~lution of the partial differential inequality . Suggest an iterative algorithm (using a dichotomy argument) to compute x" with an arbitrary.e..Y) ~ O..e.17). x) the price of the European put in the Black-Scholes model. x) ~ ¢(x) = (K .(o. (1990» and we will not try to (see Kushner (1977) and Lamberton an ages 118 Exercises = 119 1. method and it is exposed in 2. Prove the uniqueness of a solution of (5. in a. x) )0.x)+). +oo[ )0.x is non-increasing.F) =0. Derive the system of inequalities satisfied by v u .O at u (t. x) = where' + _Absu(t.T]x]O.T]x]O.u. . .(K . prove that f(O) > 0. .X) ~ o. write an algorithm in Pascal to compute the (!< - x)+ The algorithm that we have just studied is a marginally different version of the MacMillan algorithm (see MacMillan (1986) and Barone-Adesi and Whaley (1987». T] X ]0.18) with a continuous derivative at x. ( X . N (0 x) P(O. .(t. vex) ={ AXOt if x ~ x· (5. of this inequality by discretising it in time. '. +oo[ a.x)+ a. (u .19) where z" is the solution of f(x) solution of (5. that f(K) < K(hint: use the convexity of the function u. American put price. equation 4.x)+ . . X) with Xi ~ Yi.e. We look for a continuous solution of (5. Ia Iu~(O. (0. When we use a totally implicit method. (5.9).Option pricing and partial differential equations .tem ~ a. in ]0.x). 'Show that for sufficiently small p. Show that this is equivalent to find X ~ F such that I :::G (5. 4.4 Exercises . show that the approximation v(x) of v(O.u•.( ~~ (t. We are going to approximate the solution v = u .e. x)) =0 a. We denote by u. We are going to study the sys.u. = x is a aU(t.) and that f(x) . This result is quite tricky to JUStl y show that IImN-++oo Pam . +oo[ 7. in [0. Find the unique negative value for a such that vex) = x" is a solution of -vex) + T _Absv(x) = o. using one time-step only. Exercise 29 We arIel I~~ : u(t.. = (v(x) .x) ~ (K .e. (5. 5 Derive the existence of a solution to.G.x) = (au.in [O.. . ffin M satisfies (X MX) ~ a(X. (M~ -G. '. We assume that for am.e. From the previousresults. Prove that vex) defined by (5.X . in a. accuracy. 0 5.17).G).::.18) 3.X + p(M f x) = and u~(t. X > Y means that for all i between 1 and n. it herthe. -l-oo] 8. 6.17) ¢(x) otherwise. if . ~: Show that if M is the identity matrix there exists a unique solution to (5. Let p be positive: we denote b y S p (X) the unique vector Y ~ F such that .19) vv ~ Ii (MX .

F(t. ' Interest rate models are mainly used to price and hedge bonds and bond options. which is equivalent to an average interest rate R(t. u)F(u. we will present the main features of interest rate modelling (following essentially Artzner and Delbaen (1989». s). From this relationship and the equality F(t. t) = 1.1 The yield curve In most of the models that we have already studied. Hitherto. if F is smooth. the function F must satisfy - '<It < u < s F(t. T))t<T are known. T) at time T. T) given by the equality. In this chapter. T) = exp (iT r(S)ds) . there exists a functionr(t) such that ! '<It < T F(t. If we consider the future as certain. it is easy to drrive arbitrage schemes when this equality does not hold. there has not been any reference model equivalent to the Black-Scholes model for stock options. Someone borrowing one dollar at time t. Indeed.1 Modelling principles 6.6 Interest rate models . In the real world. it follows that. i. T) = e(T-t)R(t. 6.e. in an arbitrage-free world. until maturity T. if we assume that all interest rates (R(t. then. will have to pay back an amount F(t. s) = F(t.T).1. the interest rate was assumed to be constant. study three particular models and see how they are used in practice. it is observed that the loan interest rate depends both on the date t of the loan emission and on the date T of the end or 'maturity' of the loan.

)d.k that P "It E [0 T] L + rt H dW) . d ensity. for all i. The risky assets here are the zero-coupon bonds with maturity less or equal to the horizon T. u) = 1 giving the price of the zero-coupon bond with matu~ity u as a function of time.u)/:Ft) = E* (e- fa"r(S)d. shows that the prices probability P*. • a.1.122 and consequently Interest rate models .1 There is an ada d ( t E [0. whose price at time t is given by = P(t. .1. J. P(t.) .sp' tynthm~~efgenerallY P(Lt > O} 1 for any .. u) = e . we need to chec.fa' r(s)dsP(t.dWs a.1). setting L = E(L IF. (:Ft}O<t<T) and will assume that the filtration (:FdO<t<T is the natural filtration of a st.s. T vari ' t . it is possible to borrow at the rate r(t) (in practice it corresponds to a short rate. . For each instant u ::. iT -t t r(s)ds.s. . < 00 a. u) only depend on the behaviour of th rmula (6.3) Proof. T]. X d. u) This hypothesis has some interesting conse erty under P* leads to.. using the equality p(~~~)e~ I~. the starting point of the modelling will be based upon the following hypothesis: (H) There is a probability P* equivalent to P. T e). it makes sense to believe that there should be some relationships between the different rates. T) 1 and in a world-where the future is certain . The function r(s) is interpreted as the instantaneous interest rate. forP" is t.3) with q(t) o . Harrison and Kreps (1979). We call 'zero-coupon bond' a security paying 1 dollar at a maturity date T and we note P(t. As in the models we previously studied. P.s. 0 m~e LT is a probability density. almost surely..s.e - . .Lo and. S.art) I~~a\~ relative to (:F_t). T) = e . t t0 ows (cf. is a martingale. la vi g le property and It IS the purpose . under which. the future interest rates R( u. for all real-valued (6. In the light of these examples. this rationale does not hold any more. and = exp (it q(s)dW. filtration of the Brown:a~~~~~~ a(. for example the overnight rate). the martingale prop- . satisfying P(u. restncte to:Ft WIth respect to P. 11 express the density of the probabilit P* ith t 09ST a ows us to .f r(s)ds 0 where (r(t»oStST is an adapted process satisfying JOTIr(t)ldt < 00. 0 Jo • • >0 1 The proof OtIS }act relies in a crucial way on the martin a . T) for T > u > t are not known. This equality. we :p.we have E* (X) . of Exercise 30 Then the ItA e. Section 4.E(XL ).2 Yield curve for an uncertainfuture For an uncertain future. which leads to equality (6. In an uncertain world. we introduce a so-called 'riskless' asset. The process (L ) . t· (6. Lo + H. eliminating the discounting.u) = E* (6. 0 tormu a YIelds = it = = 10g('Lt) .:F.- ~ lot q(S)2dS) a. To make the modelling rigorous. The hypothesis w d he process (r(s»OSsST under the e rna e on t e filtration (:F. Y . pte process q( t) )OStST such' that. Nevertheless. T) = -T 1 . T) the value of this security at time t. we define an adapted process (P(t.U) = E* (F(u. ..d t. Obviously we have P(T. F(t. u»oStSu defined by 123 R(t. we will consider a filtered probability space (n.3 of Chapter 4) ere exists an adapted process (H ) . In Chapter 1.E(XL ) an . T].deed. Modelling principles u E [0. P(t. fvi rT for all t E [0.ndard Brownian motion (Wt)09ST and that J:T. For any non-negative random' WIbl respect to P . u»o<t<u. t.' '. we have characterised the absence of arbitrage opportunities by the existence of an equivalent probability under which discounted asset prices are martingales. the issue is to price bond options. The extension of this result to continuous-time models is rather technical (cf. we have E(L ) _ _ equivalem to P we have L > 0 d T . :F. ~(t. .T.We d eno te b Y L T this .. Artzner and Delbaen (1989».T r(s)ds. that such a probability exists in the Black-Scholes model. Stricker (1990)./:F..Jf . the aim of the modelling is to determine them. = 10• r Ll H. T] t OStST sans ying Jo Hldt. Delbaen and Schachermayer (1994). Proposition 6.1 . . which could be compared to fo Sto . intuitively. To obtain the 'formula (6~~).I X IS :Ft-measurable E* (X) .dW • .:_~ 10r 2_H2ds 2 L2. vana e .. one must think of the instantaneous rate in terms of a random process: between times t and t + dt.2) 6.) . = Hi] Lt.2. we will see later why this asset is less 'risky' than the others. At time t. which is the natural that th .J. f hi ~ ~ . ( e 0 ormula to the log function To do so."r(. Essentially. but we were able to check in Chapter 4.1) (e. It might seem strange that we should call such an asset riskless since its price is random./:Ft) = and. the process (F(t.) Th us th e ran dom variable Ltis the density of P* om .

Ofq(t))dt + (Of - q(t))dWt.Jo r(s).m theX' able _ formula which is easy to derive for any non-negative ran om van _.5 A strategy ¢ The following proposition shows that under some assumptions. ~'Si' Vi = HP Sp + HtP(t. _ 'u 't' 613.~((Of)2 .f. Proof. (6.q(t))2dt . T) of the corresponding portfolio is. the number of bonds with maturity T held in the portfolio at time t.124 Corollary can be expressed as Interest rate models 6. If it is a call with strike price K. as in Chapter-a. o o that he . u) = (r(t) _ _ afq(t))dt + afdWt.1.s. u h h t t (OU) dt < 00 we see that there exists an adapted process (Ot )o~t~u sue t a Jo t and . Proposition 6. Ht) )O~t~T with values in rn?. u) pet. Definition 6. dP(t. Let 0 < T and let h be -an :Fl1cmeasurable random variable such = dP(t. f8 ~ \ which gives the equality (6. u) = r(t)dt + at u dWt. 6. such that. .14 The formula (6. The value of the portfolio at time t is given by The following proposition gives lm ec~nomic interpretation of the process (q( t)) (cf.u) = = r(t)dt +~(Of + (Of + q(t)2 q(t))dWt .1. we define admissible strategies in the following manner: _~ It ((O~)2 .u 09~u isamartingaleunderp·. on [0.K)+ and it seems reasonable to hedge this call with a portfolio of riskless asset and zerocoupon bond with maturity T. 6. Moreo~er~ we have: pet.4) following P roo f. For 'each maturity u.1. Hence. we get ((Hf. the process (TVt) defined by TVt Wt . The value at time t ~ 0 of such a strategy is given by 1 . = E (exp (- l. we impose the following integrability conT ditions: fo IHpr(t)ldt < 00 and foT (Htar)2dt < 00 a. - (6.1.3.s. Furthermore. for all t E [0. Then there exists an admissible strategy whose value at time 0 is equal to h. there is an adapted process (at )o9~u . . (6.1.q(s))d~s Taking into account Proposition 6.u)Lt=P(O. u]._l ' f(I1~)2ds 20 • • = HPdSP + HtdP(t. the value of the option at time 0 is obviously (P(O. P_roposl Ion .1. let us first consider a European option with maturity 0 on the zero-coupon bond with maturity equal to the horizon T. u) pet.e. and we have = E· (XIFt) = E (XLTIFt) L t . Thi s follows immediately from Proposition. dP(t.7) o For this reason the probability P" is often called the 'risk neutral' probability.2 The price at time t of the zero-coupon bond of maturity u - Modelling principles . dW hich satisfied by the so-called riskless asset.u)eo' t _ f l1"dW. A strategy is then defined by an adapted process ((HP. and o'[ i:. I" r(s)ds + I" q(s)dWs Jt -~ l t u q(S)_2dS) \ Ft) .(P(t. .1d and fro.6) . T). SInce the process (P-(t)) . u) P(O.4). the term ret) . > 125 t pet u) . and getting rid of the discounting factor pet. for all t.0].T]lit is square-integrable under P"..q(S)2)dS} Applying the Ito fo~ula with the exponential fun~tion. It IS the term In tw Vi = E* (e- f r(S)dshl :Ft) ..a a. it is possible to hedge all European options with maturity 0 < T. Ht)) O~t~T is admissible if it is selffinancing and if the discounted value lit(¢) = Hf + HtP(t. dVi T) = Hpefo' r(s)ds + HtP(t. using the explicit expression of L.~s is square-integrable under p".6) with af = Of - q(t).u)Lt)o9~u _ is a martingale under P (see Exercise 31). hence the interpretation of -q(t) as a 'risk premium'. HP representing the quantity of riskless asset and H. u) exp (I r(s)ds + it (O~ . .6) is to be related with the equality makes rthe bon d '. dS t . u)~t. As in Chapter 4.s.6 We assume sUPO<t<T Ir(t)1 < 00 a.(t)SOdt t R emar k 6 . non-negative and if SUPtE[O.1. T) and the self-financing condition is written. Under probability P*. in expectation) of the bond at time t (because increments of Brownian motion have zero expectation) and the term -arq(t) is the difference between the average yield of the bond and the riskless rate. T) .: ' lora .. as P(t.u) P(t. > ~ t: II t E [0 u] Then using the same rationale as In the proof ofPr?po~ltI2on .3 Bond options To make things clearer.arq(t) corresponds intuitively to the average yield (i. q(s)ds is a standard Brownian motion (Girsanov theorem). following Remark 6. .~(t)2)dt -2 (r(t) . (65) . riskier.

If we X. is exactly what is needed to hedge options with bonds of maturity T. we see that (Xt) is a soluti~n of the stochastic differential equation dXt = -aXtdt + adW t.t!~n~n~.1.Aa / a and W . ean an variance = r (an aT . the integration by parts formli'la and Remark 6.1.9) Note that this property is not a trivial consequence of the theorem of representation of martingales because we do not know whether he-I: r(s)ds is in the a-algebra generated by the Wt's. using the self-financing condition.3.W A .Ht))o<t<o defines an admissible strategy (the hypothesis sUPO<t<T Ir(t)1 < 00 a~s. is to provide formulae that oniy dep d e ~~ exp am briefly in dynamics of interest rates under P. q(t)) under P. it is sufficient to set = ret) . This condition. a are non-negative t Wi ' a const~nt q(t) -A. T)aT dWt. To do so. Fro~ e~:~i~y " I ~. -- = a. = + adWt (6. if we impose the condition Vo = h.2. We first observe that if Vi is the (discounted) value at time t of an admissible strategy ((Hf.l~t~ under P*. which is not surprising when one keeps in mind the characterisation of complete markets we gave in Chapter 1. 8 (we only know it is in the a-algebra Fo which can be bigger (see Exercise 32 for this particular point). a /2a. dtdP almOst everywhere. 8 Vi = E* Vol Ft) 6.T] We deduce.ynamics of the dynamics of ret) under P by a diffusi e are about to exam me describe the q(t~ should have to get a similar e~u~~~~nu~~~:~~ and determ~ne the form that options depend explicitly on 'risk parameters' which The~ .2). The method is the same as in Chapter 4. t 5.2. 0 Remark 6. 8. Section for t 5.::~: e also assume that the process q(t) is To complete the proof. one proves that there exists a process (Jt)o<t<o Jt < 00.I: r(s)ds hlFt) .10) I~ Ir(s)H~lds < 00 holds) . Before calculating the price of bonds i set " ve some consequences of equation (6. In this model.I: r(S)ds) + 1 0 * dr(t~ = a (b* . equation (6.2~: d we proceed under probability P* P(t.I: r(s)ds = . according to this model let us -g' t + t. We deduce th. Ht) )O<t<T. .Tr(. Artzner arid Delbaen (1989)) that P* is the unique probability equivalent to P under which (p(t. 0 . Chapter 3. or the d.E* (he. T))O<t<T is a martingale if and only if the process satisfies # 0.ret)) dt Jsd~s. ~(~ ~at~i~)) fOl~OWS normal law w~ose mean is given by E(r(t)) ~ r(O)e-at + e an variance by Var(r(t)) .a2/2 (1 -2at) P(r(t) < 0) > 0.b. -e It f~llows that (unless this probability is always very small) Nry r~m a practical point ?f vi. T) = n. we obtain. en on e parameters of the 'It 5. it can be shown (cf.8) where a. SUPtE[O.s.-guarantees that the condition ret) = r(O)e-at + b (1..9). b. with A EC.:Ttt which means that (X) .)e:~~r(~h~ 127 ~how t?at i~ order to calculate the price of bonds. and he. We check easily that ((Hf.(6. paragraph 6. are I cu t to estimate.T)at and H~ = E* (he- I: r(s)dsl Ft) . slightly weaker than the hypothesis of Proposition 6. o such that Io r(s)dsE* (e .hose value at time 8 is indeed equal to h. Actually.2 Some classical models ~!u. n. = _ Jt T P(t. we assume that the process ret) satisfies dr(t) = a (b .6.T) = E*(e-J.8).Proof. which is not very satisfacto .1.1 The Vasicek model and. ri:a:::~~sm~d.4 (cf.~e p~lces o~ bonds and advantage of the Heath-Jarrow Mort d1 .i«.7)) 126 Interest rate models Some classical models 6. bearing in mind that Vi is square-integrable ( under P*.h: t tebndsd m~mty. Thus we have pair (r(t).5. 3.s .7 We have not investigated the uniqueness of the probability P* and it is not clear that the risk process (q(t)) is defined without ambiguity. that (Vi) is a martingale under P*.ew to r~t) converges in }aw to a Gaussian random' v:i~blea~i.ret)) ' dt + adWt .)d~IFt) . Once this property is proved. it is sufficient to find an admissible strategy having the same value at any time. we get Yt = eI. where b b .t rl(t):anr~:t:~~~~l:~beck process (cf. One on mo e which w '11 lai .e-at) ~ ae-at lot easdWt (6. To calculate the price of zero c b and we use equation (6. we dVt = HtdP(t.

where X* . r) = b" . which can be seen as the average interest rate onthe period [t. is given by the formula where F is the function defi~ed by F (8.. x) . including r.a2/(2a2). 221. Exercise 33).3 We suppose that (Wt) is a standard Brownian motion defined on [0. Finally .Zd) s (Xxt) being the 3. From equality E* (X:) 1 9 ~we ') deduce X:d~ =x 1 -a e- a9 6.t.2 In the Vasicek model. 2 -a(t+u} 1tl\u e2asds ~ .r (t) .X. from the expression of the Laplace transform 0 a Gaussian GaUSsian(. satisfying Xo x and = = = ae .2. Chapter 3) that It is possible to calculate F(8.14) with a and a non-negative. (6.) where R(T .= (a -' bXd dt + a#tawt on [0. _J.11) and (6. p. ret)).dsl Ft) = F(T .5 . then we will fit the parameters b. = ae 2 -a(t+u} o (e2a(tl\u) ~dXt. f. x compe y.12) Going back to equations (6.T X. ) letel We kn ow (cf. the overnight rate). 9 x (XX) is Gaussian with continuous paths.dS) = 11 9 9 Cox. 2 dXt = -aXtdt we can write E* (e- + a dW-t. s e JR. 8 x. we obtain the following formula pet.t.t.1 In practice. the reader is referred to Ikeda and Watanabe (1981).11 ) Some classical models and in equality (6. Remark " R(8.8 XZdS) = exp ( .t)R(T .2.16) 1) 2a For a proof of this result. we get Var .129 .15) Cov(Xf. . we give some properties . Since (X*) is a solution of the diffusion equation with tt coefficients independent of time ' (1 o 9 X ds s x ) a a = -a .E* = xeE* ( as (1 o 9 XXdS) s + ~Var 2 (1 9 0~ X:dS)). This last property is considered as an imperfection of the model by practitioners. For any real number x 2: 0. T]. and the process (q(t)) being equal to q(t) -aJr(t}.13) = exp [-(T . For r we will choose a short rate (for example. 12) which satisfies Xo = x (cf.b*) E* (6.- a2 (1 2a3 e -a9 ).11 ).) ~ (l X. we write Var X.x will be determined from market data by inverting the Vasicek formula. It follows that fo Xs ds ~he pro::~ random variable since the integra! is the limit of Riemann sums fof IS a n~ componen.dsl Ft) Interest rate models (6. note that it does not depend on the 'instantaneous spot rate' r.b*. r(t))].~. = F(T . The yield Roo can be interpreted as a long-term rate.2 The Cox-Ingersoll-Ross model For the calculation of the variance. a by statistical methods to the historical data of the instantaneous rate. Remark 6.a 28 2 2 3 (1 - e -a9 ). T) (6.t.X~)dudL (6. the pricing of bond options is easy because of the Gaussian property of the Ornstein-Uhlenbek process (cf. ts Thus' . parameters must be estimated and a value for r must be chosen. E* eo' with Roo = lim9~oo R(8. taking values in'JR+. by fitting the Vasicek formula on market data. with a E JR.r)=Roo- 1 a 8[(Roo-r)(1-e-a9)_ ::2 (1_e-a9)2] 0 f equa tion (6 . However.00[.[ X.14). COy (l d.2. Theorem 6.r(t) . J. a.128 = e-b·(T-t}E* (e- r x.00[. Ingersoll and Ross (1985) suggest modelling the behaviour of the instantaneous rate by the following equation: dr(t) = (a - br(t))dt + aVr(t)dWt (6.d. one can show the following result. To be able to study the Cox-Ingersoll-Ross model. Remark 6.13). Note that we cannot apply the theorem of existence and uniqueness that we gave in' Chapter 3 because the square root function is only defined on JR+ and is not Lipschitz. What practitioners really do is to determine the parameters. adapted process (Xt). there is a unique continuous. from the HOlder property of the square root function. . Chapter 3. unique solution = ( eo.

Xi (x t .(e"' _ 1)2:'~ + .1' and ?j..Jo 8 ' E (e->'X. we h ave P( TO < 00) < 3: If 0 ~ a < a2/2 and b < 0. From the hypothesis on the Indeed. Xt ) x where.2(t) ?j.. xh of this equation.. . p.. hich enables us to characterise the JOint law 0 The following proposition. defined by . ..2AA~ 1) . Ikeda and Watanabe (l?81) .17) I.ethe Laplace transform of defined by and ( 4xb/(a2 (ebt . defined by F(t. x) = e-a</>(t)-xt/J(t).1) ?j. We denote by (Xt) the solution of (6. . Let us go back to the Cox-Ingersoll-Ross processes (r(t)) and (q'(t)). E ]0.5 with JL= 0.a < a2/2 and b ~ 0. at time 0. ) I' e J6. If 0 ..bx). for all x > O.2(6/4-1/2 e -x/2 x 6/4-1/2I 6/2-1 -(/2 and . inf Proposition 6.I'(t) = a2A (e1't . we get model.dr(t) '= (a . where 96.) =( Proposition .e-bt) + b a exp -x a2 /2A(1 _ e-bt) + b E (e->'X.((A) = (2A +11)6/2 exp ( .( ()x . Mt.for all x> O.2.x F(O. we obtain the Laplace transform of Thi oposition is proved in Exercise 34. we have Ph) < 00) ?j. x) defined by = Jb2 + 2a 2 JL.( is = ¢>. . .for all x> x 2.t. 1 [..2. ->. O. 225. dI x ft XXdS) is the key to any pricing within the Cox-Ingersoll-Ross mo e .(x) = (~)" ~2 f: n=O (x/2)2n n!r(v + n it is n~tural t~ look for F as a soiution of the problem .(0) = A and = inf{t ~ 0IX: = O} -?j.(t).4 0 = 00.' (XX) I tive to the parameter a an e uu a additivity property of the process t re a d y.1)). w .dS) = exp (-a¢>'. the process (Mt)o9~T' defined by" Ito formula . Solving these two differential equations gives the desired expressions for ¢ and 0 When applying Proposition 6.2.17).(t)-xt/J(t) (1-. If F can be written as F(t.(b + aa)r(t)) dt + a. the process (Wt)O<t<T is a standard Brownian motion.Jr(ijdWt. Xi / L is given by the function 94a/u2. (6. under probability P".>'.>. ?j. 2 v a2F The reader can find many properties of Bessel functions and some approximations of distribution functions of non-central chi-squared laws in Abramowitz and Stegun (1970)rChapters 9 and 26.2 ?j. (1990)) If condition x (cf. . is due to the Proof The fact that this expectation can be written as e.(.16) starting at x and TO t e stopping time defined by T~ Some classical models 131 is a martingale and the equality E(MT) = Mo leads to (6. This function is the Laplace transform of the non-central chi-square law with 8 degrees of freedom and parameter ( (see Exercise 35 for this matter). where I" is the first-order modified Bessel function with index u.1' given by are with L a /4b (1 .(t) - JL with. A (T + b + e1't(T .1) +. The density of this law is given by the function he. as usual. .5 Forany non-negative A and JL. the shows that.we have 2 b ) 2a/u ( Abe-bt ) 2/2A(1 .dS) .='e -I' J. ax ax { . lor x l' > 0. we consider the function F(t.. ~evuz an or " for A and JLfixed..b + e1't(T + b) with." (t) ~ .JLxF 2 .'(t) { ¢'(t) =. e -I' J: X. 6.e-I'_J: X.b)) + 2JL(e1't .' f IS pr. we have P(T~ = 00) = l. = I If a > a2/2.1.I'(t)) exp (-X1/J>. + b?j.' 0 XT-ds ~ F(T .x):= E (e->.) V zt.X. .Interest rate models 130 . if F satisfies these equations and has bounded derivatives.' . Q . The price of a zero-coupon bond with m'at~rity T is then given. the equations above become ¢(O) = 0. + 1) .:' log ( u' :>. aF ' aF _ ='~x+ (a .1' t)) ( = = 2 (2AL + 1)2a/u2 bt ) 1 exp ( AL() 2AL + 1 where thefunctions'¢~. d th ' iti I • . With these notations."'(7+ b) ) 96.-aq. for any T. at.x)=e .

+ b·) The price at time t is given by == + aa an d 'Y• f(b·)2 -V + 2a2• the law of r(O) / L. (e. prices.(T .(T .f>(S)dSP(O.' • ( e .t)) . With these notations. T) == exp (-a¢(T .a2 log and .t) . _ b· + e'Y·t(')'. Similarly.}) a¢(T . introducing the distribution function Fa.--. Schaefer and Schwartz (1984) and Courtadon (1982)..1) 2 (e'Y·t .----':---::---:. == P(O .1.T) __ E. . 8r(O)'Y .:---'--._~ 9 e..KP(O.K P(O. (e'Y·o + 1) + b· (e'Y·o .(T _ 0) T)) 6. where r" is defined by r· ==Notice that E of discounted .(t) .( of the non-central chi-squared law with 8 degrees of freedom and parameter (.. Exercise 36) that. ==Eeo == 9 r(s)ds ( _a4>(T-O)-r(O).O) where the functions ¢ and 'lj. .0) + 10g(K) 'lj.2. are given by the following formulae We prove (cf. We can then write the price of the option as Co == P(O. r(O) / L2 under P2) is a non-central chi-squared law with Aa] a2 degrees of freedom and parameter equal to (I (resp.2 'Y.:. for t ::.\ . . we have consequently ISthus given by 0 == E· (e. Jarrow and Morton (1987) and Morton (1989).0) a2 + b·) (e'Y·o .1. (e'Y·O .(T .T)l{r(o)<r. O)P2 (r(O) < r·) .0) + b·)(e'Y·o . We . (e'Y·o + 1) + (a2'lj. T)F4a/u2.}) _ KE· (e- f: r(s)ds1{r(o)<r. + ] Co 0 • [ _ 1.f0 r(s)ds (P(O.132 by: Interest rate models Some classical models 133 denoting by PI and P2 the probabilities whose densities relative to P" are given respectively by P(O.p(T-O) e ' = P(O. the call price at time Co ° 8r(Oh·2e'Y·O (2 == a2 (e'Y·O _ 1) (')'·(e'Y·o + 1) + b·(e'Y·o .1) a2 (e'Y·o . cf.18) == e-acp(T)-r(O). _ b.model describing the behaviour of the whole yield curve.K)+] _ K) . More recently.. Ho and Lee (1986) have proposed a discrete-time . with (I = a2 .6 holds. _ P(O 0).r(t)'lj.fo r(S)dS) T dPl (6. T) . These more complex models do not leadto explicit formulae and require the solution of partial differential equations..O)F4a/ u2. T) P(O.3 Other models The main drawback of the Vasicek model and the Cox-Ingersoll-Ross model lies in the fact that prices are explicit functions of the instantaneous 'spot' interest rate so that these models are unable to take the whole yield curve observed on the market into account in the-price structure.n a ~e~ocoupon bond with maturity T. and Let us now price a European call with maturity 0 and exercise pr~ce K .1) (')'·(e'Y·o + 1) + (a2'lj. characterised . The continuous-time model we present now is based on the sameidea and has been introduced by Heath.can sho~ that the hypothesIs of oposiuon 6.1)' 'lj.(-r r(s)dsp(O eo. s)..1)) .(2 (i:) . P(O.--:-. T) and dP2 dP" e Jo _ f9 r(s)ds . Some authors have resorted to a two-dimensional analysis to improve the models in terms of discrepancies between short and long rates. if we set ¢(t) == .~) 9 . from 9 0 the martingale property .. . E· (e. Brennan and Schwartz (1979).1) L2 .1)) P(t. + b·) ) and Ll == (e'Y·o -1) 2"" 'Y. (2). First of all we define the forward interest rates f (t. s. under PI (resp. . T)P1 (r(O) < r·) .p(T) dP· 0 = --~-__. E r(S)ds) -.f r(s)ds P(O. + e'Y·t(')'. 2e'Y·O ._.(1 (i:) . with b" b 2 ( 2'Y·e~ 'Y.== 'Y.

cf. u)) (l O'(f(t. the process (f(t. differentiating with respect to u. We then have ex. The case where 0' is a constant is covered in Exercise 38. x).q(t)) . u))o9~u being adapted. Whence O'(f(t.u')) (6.1. in which only 0' a~d (Wt) appear. we must have.u) eX.forall u. for O'(x) = x. Moreover.dV = O'(f(t. we derive the differential dP(t. gives some sufficient conditions such that equation (6.s)ds u u = Xo -1~' (t + It O'(f(v. Theorem 6. s)ds = ~ (lU U lU a(f(t. u))O~t~u~T such that.S)dS) (6. we constrain the map (t. s).2.q(t)) . u)) (l U O'(f(t.S)dS) - ~(lU 2- O'(f(t. u) 1 ex. This situation is similar to Black-Scholes'. I u)) dWt. s)ds u Equation (6.s))dS f(s.S))ds . -. for each maturity u. So f(t. S))dS) dt + O"(f(t. '))d. Heath.19) dP(t.S)dS}diJ' (6. . s))dS) dWv ~ The fact that the integrals commute in equation (6. Jarrow and Morton (1987). u) a(v.S)dS) dt - (l U O'(f(t. the process (a(t. Morton (1989». s) )ds ). For each u. u) H a(t. This gives some conditions on the coefficients a and 0' of the model. by Heath. t) r(t). We see that.20). to be continuous.6 If the. s) H f(t. t) . u) = ¢(u).21) ~a(t. S)dV) ds ds a(v:S)dS). u) and we compare it to equation (6. S))dS) dWv t f(S. If the hypothesis (H) holds.1ta(v.20): take a solution of (6. s))ds .function 0' is Lipschitz and bounded. Note that the boundedness condition on 0' is essential since. It follows that the price of the options only depends on the function d. O'(f(v.S))dS) dWt The striking feature of this model is that the law of forward rates under P" only depends on t~e function 0'. u) = f(O.s)ds. there is n2 solution (cf.)}t = -(l f(t. S))dS) q(t) u a(t. u)dv + It = r(t). if written in differential form.S)+f(s.s)-f(t.3 and equality f(t. u) being continuous and 0' being a continuous map from IR into IR (0' could depend on time as well. fo~ any continuous process (q(t)).6). from Proposition 6. :- = (lU a(t. Jarrow and Morton (1987) and Morton (1989».134 Interest rate models Some classical models and by the Ito formula 135 by the following equality: P(t. (6. = = l -lu + lu {is + l (1" -lu + lu (l + l (l u (-f(s. u) P(t. s) represents the instantaneous interest rate at time s as 'anticipated' by the market at time t. WehaveP(t.u) = O'(f(t.fromequation l (ft U 0' (f (t. Then the next step of the modelling consists in assuming that.22) has a unique solution. and. with f(O. = (f(t.(f(t. To find them. u) = O'(f(t. O'(f(v. + '2d(X. =- = a(t. (lu'O'(f(t. for any continuous junction ¢from [0.')d') + ~ ([ . u))o<t<u is adapted and satisfies (6. S))dS) dWt . df(t.20) O'rq(t) with O'r =. u))dWv.21) is justified in Exercise 37. S))dWv) U f(s. t) U O'(f(t.22) and set .LetussetXt ftU f(t. This is a consequence of equation (6. defined for t ~ s. s'))ds and. for any maturity u. u)/ P(t. u) + . it is then possible to build a model of the form (6.u))o~t~u must then be an adapted process and it is natural to set f(t.22).20) becomes.t) -1~ 0 a(t. u))o~t~u satisfies an equation of the following form: = (f(t.s)dS-l U (l U a(V.u) = exp (-lU f(t. the map (t. the process (f(t. theprocess (f(t. O'(f(v. T] to IR + there exists a unique continuous process with two indices (f(t. Then we have to make sure that this model is compatible with the hypothesis (H).22). X.S))dS)2.22) The following theorem.([ a(t. (6.

2. T].()) ) 4. oo[ by e2by/u2 y-2a/u 2 ° = > 0. . show that under the probabilities whose densities / P{O. that E (T:'M) < 00. we have < x < M. d be independent Gaussian random variables with unit variance and respective means mI. Y) be a Gaussian ~~ctor with values in .J. density Exercise 36 Using Proposition 6. Using the optional sampling theorem. under P. > 0. Using the previous question. m2.1.T] Mt > O}) = 1.s. and Deduce. (Ft)o9~T' P) be a filtered space and let Q be a probability measure absolutely continuous with respect to P.. for all M > x. ())P2. for any t J. °~ = -00. 1. Let s be the function defined on ]0. T) with respect to P*. We now assume that a < /72/2 and we set s{O) that. Deduce that == limx--+o s{x). 2.M is finite a.3. for any t E > 0) 1. Show that if e < x <M. = E (MT1{T=T}). Exercise 31 Let {n.{ Hldt < 00 a. .. We consider a process 'with two indices {H{t. s{x) = s{c)P (T: < TM) + s{M)P (T: > TM). 1. taking the variance on both sides and using the fact that S' is bounded from below on the interval [e.IR? unde~haprobabtiltity :':~ let P be a probability measure absolutely contmuous WIt respec 0 . T]. We set = T = (inf{t E [O.X)" Show that. P) be a filteredspace and let {Wt)O<t<T be a standard Brownian motion-with respect to (Ft). X2.s))O~t. then that P (TO < 00) 2 5. r{s)ds) parameters PI and P2 to be calculated. Show that.5. 3. F.(T-II)) . Prove that s satisfies s{x) = jX ~s dy. show that there exists an adapted process {Ht)o9~T such that -x2 2. For x. the law of r{ ()) uti'der the probabilities PI and P 2 introduced at the end of Section 6. Exercise 34 The aim of this exercise is to prove Proposition 6.e. . T)PI . for the Cox-Ingersoll-Ross model. show that E (MT) Deduce that P ({'It E [O. [0. F. 1.4. s) t-t H{t. . Show the option is exercised if and only if r{ ()) a{T . the random variable r{()) is normal. L~t {Mt)O~t~T be a proce!s adapted to the filtration (Ft). Show that T is a stopping time. the process ' e->. Show + s{M)P (TO> TM) r* Roo < r" .4. the map (t. for some are respectively exp ( . Let (X. Exercise 32 The notations are those of Section 6.1_ e-a(T-II) Exercise 35 Let d be an integer and let Xl.s. the density of the restriction of Qto Ft.1. 2.2.K P{O. for all t E [0. 4a2 . Show that {Mt)09~T is a martingale under Q If and only If the process {LtMt)o~t~T is a martingale under P. Using Exercise 31.JoT r{s)ds) / P{O..3 Exercises Exercise'30 4. E~ercise 33 We would like to price. e~a(T-II) ) 3. Xd. a call with mat~rity () and strike price K on a zero-coupon bond with maturity T > (). . Y is normal and give its mean and variance. Deduce an expression for the price of the option in the form Co = P{O.T] I Mt = = O}) t\ T. 6. = 0. which implies that T:.2. T].2.2. We denote by L. ()) andexp ( . M]. ' Exercise 37 Let {n. md· Show that the random variable X = E~=I Xl follows a non-central chi-squared law with d degrees of freedom and parameter ( -log{K) (1_ dP = E~=I m~.s~T satisfying the following properties: for any w. We assume a P (TO < TM) = 2: ° /7 /2. ( 1.•. Then prove that limx--+~ s{x) for all M > 0. where a _ /72 (1 . For e /7 2 dx 2 + (a- bx)dx ds = 0.6 does hold. Let {~t)09~T ~e an adapted process. we set T:'M = T: t\ TM. . . derive. the reader is referred to Jamshidian (1989) and EI Karoui and Rochet (1989). We suppose that (Mt) IS a martingale under P .X I dP = E (e->. Show that the hypothesis of Proposition 6. M we note TM the stopping time defined by TM inf{t 2: I Xi M}.136 Interest rate models Exercises 137 Notes: To price options on bonds with coupons. we have s{x) = s{O)P (TO < TM) and complete the proof of Proposition 6. P{Mt Let (Mt)O~t~T be a continuous martingale such that. (Ft)O<t<T. s){w) is continuous and for any s E [0. at time 0.in the Vasicek model.

s)dWt) ds exists..O) 4. 2.. 1. = P(O. for A E JR..fO(T .fO(T . we assume that the function a is a positive constant. Show that the solution of equation (6. on a zero-coupon bond with maturity T > O.K P(O. Derive.. Show that the price of a call at time 0 is given by Co = P(O. . -w. 1. We would like to price a call with maturity' 0 and strike price K.O) exp a (1. ds e>' W8 } Deduce the law of WIJ' under probability measures PI and P2 with densities with respect to P* respectively dP _2 dP* and f ~(s)ds = _e_o __ - P(O.~.0) _ log (K P(O.fO(T . .. T)) 2 a. We would like to justify the equality d = a. s) )O$t~T is adapted.0) For simplicity. Exercise 38 In the Heath-Jarrow-Morton model. Show that the .6 holds. Remark that { (~H(t.a.)) ds ~ ~ ({ H(t.+. Let 0 = to < tl < : ._ 0) w.t/2) + aWt.)d.) (W'. the 3.0)) .1. we assume that to justify equality (6. a20T(T-2 . . T]. s)dt) ds < 00 (which is sufficient Deduce that the integral 2. u) a2t (u . T) (_ P(O. Prove that I: E (I: H2(t. given by E* (e -(T I: w.21».W..138 Interest rate models Exercises where N is the standard normal distribution function and 139 (H (t. O)N (d . < t N = T J: U: H(t. Deduce. T)N(d) . .) and justify why we can take the limit to obtain the desired equality.. be a partition of interval [0. 0) / P(O...) (W. IJ . that = 0)) f(O.. u) + P(O T) '. ..hypothesis of Proposition 6.22) is given by f(t.

We s~t Tn L~l T. To model this kind of phenomena.7 Asset models with jumps In the Black-Scholes model. major political changes or even a natural disaster in a major economy) can lead to brusque variations in prices. But some rare events (release of an unexpected economic figure.1. 7. In this chapter.to. A possible approach to pricing and hedging consists in defining a notion of risk and choosing a price and a hedge in order to minimise this risk. = n}. this is the objective of the first section. We have Tn which = inf{t . defined by = Nt = L l{Tn~t} = L nl{Tn~t<Tn+l}' n~l n~l (Tn)n~l Remark 7. the process N. The description of these models requires a review of the main properties of the Poisson process. i. the share price is a continuous function of time and this property is one of the characteristics of the model. represents the number of points of the sequence are smaller than or equal to t.e.2 N. we have to introduce discontinuous stochastic processes.1 Let (Tik~l be a sequence of independent. we will study the simplest models with jumps. Most of these models 'with jumps' have a striking feature that distinguishes them from the Black-Scholes model: they are incomplete market models. and there is no perfect hedging of options in this case. .1. N. It is no longer possible to price options using a replicating portfolio. their density is equal to l{x>o}>'e->'x. We call Poisson process with intensity>.1 Poisson process Definition 7. identically exponentially distributed random variables with parameter >..

expon~nuallaw sat~sfie P(T.Xr· . is characterised by either of the following two properties: • (Ntk~o is a right-continuous limit.r.5 It is easy to see that the jump times Tn are stopping tim~s. at time t) and one risky asset whose price jumps in the proportions UI.. and which. It can be shown that (Wdt>o is a standard Brownian motion with respect to the filtration (Ft)t>o. . t) . is identical to the law of N. n.6 The law of a Poisson process with intensity>. non-decreasing. The exponential variables are said to .. for all·t > s. Proof. the jump of X. .~o:)n We recognise the Laplace transform of the gamma law with parameters>. for n 2: 1 P (Nt = n) = P (Tn::. (Uj)j~1 are independent. The following proposition gives an explicit expression for the law of N. = = thus Xr. follows the Black-Scholes model. - = Xt(jldt + adWt).} are Frmeasurable.Uj. l{x>o}>..e. (1 + U j). . Proposition 7. A.Nd for j 2: 1. E (ethus the law of Tn Sr = aT1 ) x = >. at some times Tl . let us consider a probability space (11.. Bouleau (1988). Note as well that the Tj'S are stopping times of (Fdt~o"sinc~ {Tj ::. price of the risky asset at time t. such that homogeneous Markov process with left-hand P(Nt In particular we have E(Nt) Moreover.I)! (>. the relative amplitudes of the jumps taking place before t are known. the Laplace transform of Tl is I. +00[. P) on which we define a standard Brownian motion (Wdt~o.No • stationarity: the law of Nt+s =N s· • At time Tj. 1U::. is independent of the zr-algebra Fs. . . . N. . and a sequence (Uj)j~1 of independent. . A random variable T with . Moreover. E (sN. Chapter VI. Indeed. . Chapter III. Then we have. i. let us denote by Ft the a-algebra generated by the random variables Ws. . at timet. \ 6. o = Ion d P roposl ·t·· 7. a Poisson process (Nt)t~o with intensity>. Uj. .2: t + siT 2: t) P(T 2: s). identically distributed random variables taking values in ]-1. • independence: if s > 0.. + 0:' = Tl + . In~eed~ {Tn < t} {Nt 2: n} E Ft.1.142 .e->'x AX dx _ Jo (n . N. for any t > 0. right-continuous process satisfying: > ° = >. can nowbe described in the following manner.12).t --e. the Tj'S correspond to the jump times of a Poisson process. + Tn is E(e-arn) =E(e-aT1(= (>.t)n = n) = e -. cf. = Xr~. t) = = )n-l { >. . for a given t. cf. is given by Remark 7. =X r· J N. Asset models with jumps Dynamics of the risky asset 143 be 'memoryless'.t. Nt+s - . .. P(Nt = n) = e->'.1. t).x)n-l . The process (Ntk~o is a process with independent an stationary • On the time intervals h.. The dynamics of Xt. follows a Poisson law witn parameter >. Because the random variables UjJU::. we will assume that. 7.. First we notice rhatthe law of Tn is (>. The independence of the increments is a consequence of this property of exponential laws..To be more rigorous. Remark 7. we deduce that.tt ->. Tj.e. then.. for the second one.4 Let (N t ) t >0 be a Poisson process with intensity x and . the random variable N. for s ~ t and tt. J - XTj =X Tj . t} {Nt 2: j} EFt. the amplitude of the jumps being one. that (Nt)t~o is a process adapted to this filtration and that.) = exp {At (s .3. and n (cf. N.e->'x (n _ I)! dx. between two jumps. for s ->.t (>. • (Nt)t>o is a process with independent and stationary increments. 1. and n. For all t 2: 0.I)}. (Wdt~o. right-continuous.x)n >'e->'x--I -dx n.t (>'t~n. n. Section 6.. s ::.P (Tn+! ::. Dacunha-Castelle and Duflo (1986). = a(Ns·.N. Bouleau (1986). is independent of the a-algebra Ft. ~ N. We will assume that the a-algebras generated respectively by. (Nt)t~o. : a gamma law with parameters>. For the first characterisation.1. n! t (\ it 0 (>. . Section 7.3 If (Ntk~o is a Poisson process Wlt~ intensity >.-. The process (Xt)t~O is an adapted.2 Dynamics of the risky asset The objective of this section is to model a financial market in which there is one riskless asset (with price e'". Tj+l [ dXt increments.

UN. adapted and has only finitely many discontinuities-on each interval [0.+2. +Uj)) e(IL-<T2/2)t+<T~'.Hence's Wand N t- N s are ..H.0 1x.. . it is generally impossible to hedge the options perfectly. . there are infinitely many probabilities equivalent to P on :FT under which the discounted price (e-rt Xt)O<t<T is a martingale. U N. Tl -WT1) 2/2)(t-T!l+<T(W.s an of the a-algebra a(N <) "r.0IIowsthesamelawas(Ul P ({(UN. ) = Xse(lL-r)(t""s)eA(t-s)E(U!l .}. . ... .. we obtain x. i ~ 1) are independent. In the remainder. . the hedging of options is rather tricky (see Schweizer (1989)). . Ud) E B} n {d $ N }) s and Then. for t E [0.+k . . UN. U N.) .. XT1 . the a-algebras a (U N.s. We can also prove that it satisfies.Lds + adWs) N. . it sufficesto provethatthea-algebraa (UN. When this hypothesis does not hold. +k.+l. .= Xo(1 + U )e(IL-<T2 1 /2)Tl +<TWT1. This difficulty is due to the fact that for T < +00. As thea-algebras W = a(W. . . the process (e-rt Xt)O<t<T is a martingale. but it will allow us to determine simply some hedging strategies with minimal risk.-w. " (J. . .. for all t 2: 0. B)}n{d$ P a.. . I1~=1= and B .+k A)P(Cn{(U1.. +2. e have. + L XTjU j• j=1 . we deduce (taking C .+J ')1) :F8 = XsE - (' e IL-r-<T 2 /2)(t-8)+<T(W. with the convention 1.H. From the last equality. UN. This is a stringent-hypothesis. . = Xo + . UN. . s ~ O). X~E (e(lL-r-<T2/2)(t_8)+<T(W.+1 . Whence the independence stated above. Ud) E B)P (Cn {Ns ' = p})._W.Uk) E A) LP p=d «U1. .+1. Proof..«<x t- Th en We will see that.···) using Lemma 7. for t E [71.. . x.U. . U) N.2. N j=1 rr '-N'(l +U N. . 145 consequently.1) < +00 and set X t -. U _ S .+ -N' N j=1 j) .. USIng the independence of U d N d that the Uj 's are independent and identically distributed.JRd) h t at the vector U) and then that k. Suppose now that E(lU11) 0 (7. we will make the following assumption: under P. = P«UN. .. Repeating this scheme. 00 . Ud) E n {d $ Ns}) Ns}).···. an an event u. .1 For all s 2: 0.... The process (Xt)t>o is obviously right-continuous.71 [ Dynamics of the risky asset UjIUSN..-WT1) X -(1 + Ude(IL-<T Tl Xo(l' + U1)e(IL-<T2/2)t+<TW. =Xo (fl(1 J=1 t P «U1..+k) E A} n C n {(U1..72[. s ~ 0) andU = a(U..1 and the fact that Wt the a-algebra :Fs. the left-hand limit at 71 is given by X _ Xoe(IL-<T2 /2)Tl +<TWT1 Tl = is independent of the a-algebra generated by the random variables N < d Let A be a Borel subset of JRk. E B} E n C n {(U1...N = a(N. which means intuitively that the relative amplitudes of the jumps which take place after time s are independent of the a-algebra :F~.+k) E A} =n "".+l.... t). = = = X e(IL-<T2 /2)(t-T!l+<T(W. (uN. for this kind of model. UN. B aBorel subset f JRd u'duC.+1..) - N'rr ) (l+U . an an the fact ° P ({(UN. To derive E(Xtl:Fs) we will need the following lemma.d In d epen ent of and :F8 are independent..2.. Lemma 7...144 Asset models with jumps So we have. .

A 10 is a martingale.(y) is defined by is a square-integrable martingale and M.. We assume first that <P is bounded and we set = Going back to equation (7. 0 e ppendix to see that Then the process M. = L <p(YTj. We will denote by v the common law of the random variables Uj's.) ~ E (~ ~. . So E( Z'IF.z)1 s Ct.(Y. When the mesh of p tends to 0.2). : ' where ~.L Asset models with jumps Dynamics of the risky asset Moreover . Let us fix sand t. A 2 5 Lemma 7. . tj.2) setting To deal with the terms due to the jumps in the hedging schemes. and set Z~ To a partition p associate m-l 12:7::1 <P(YTj. < of the interval [s. C = A(Si+l .) J dv(z)<p(y.+. defined by Mt N..+ 1 IT) .) . Notice that by convention Proof. z). z) is continuous on IR .146 using Exercise 39. Sm = (so =.. from Exercise 40. is F 8.=0 j=N. We have t- 147 N s ) . II:I = t) v(dz)~(Ys. z)) -A > 0.+1 N~i+l ZP = "m-1 L. ~i(Y) 2:~==1= 1.2 Let <p(y. taking values in IR d. Using f th A' .2. whose proofs can be omitted at first reading.=r: - AE(U1)· (7. z)l· and T\len we have M.>z) IF. v(~Z)<p2(ys. Uj).for ~ll t E ~s (lot J v(dZ)<P2(:s. we deduce sup (y. .' " < +00. 2< an d even In L . Lemma 7. .2.) ~ E (~ ). (y) is thus the expectation of a random sum and.. -measura bl e. 't ds J .".Uj)1 s CNt L N. We The left-continuity of (Ydt~o and the continuity of <P with respect to y imply that ZP converges almost surely to Z when the mesh of the partition p tends to O. z) ~. IZPI . we obtain <p(YTj. let us which proves that M. It is now clear that (Xt) is a martingale if and only if f.s.(s.1 and the fact that Y. Uj} j=l 'It J ds 0 ) v(dz)<p(Ys..==o E(Z· <p(Ys"Uj). z). .s. I<p(y.z)EHtd xffi. . It 10 11 c ows th at the convergence takes place in L1 t» .) I dV(z)'I> (Y. is a martingale. We assume that. adapted to the filtration (Ft)Qo.. we apply Proposition . Now set can wnte' ZP = LL . and let (Yt}t>o be a left-continuous process..z) be a measurablefunctionfr~m IRd x IR to IR.C(N..s. we will need two more lemmas. with s < t.J IF.S < S'l < . is square-integrable. such d thatfor any real number z the function y ~ <p(y.r s.

-t: hence:F s. It follows that the sequence (M!')n"21 is Cauchy in L2 and as M.= L (LS'+1 i=O Ls.o is a square-integrable martingale. is bounded. we see that the second sum IS 2. A.-measurable. On the other hand.2(y.2p)21:Fs) = . is a martingale.' tends to .+dF. Z))2) tends to 0 as n Taking the conditional expectation with respect to :Fs. for any t. Whence (7.M. and us~ng the fact that Zi+1 .(y.... Let (At)t>o E (~ E ([Zi+1 .) = E ((LS'+1 .n's defined by q..J]) p z) is a martingale.q.l'iF.M. z 1 IF. where the function V is defined by V(y) and.2. Whence ISJ"Si+1 E ((Zp .Ms)21:Fs] = E (M. M.:Fs.\ lJ du . If we do not assume that q. + M. We have = = dv(z)q.M.2. E ((Zp - Asset models with jumps Dynamics of the risky asset and equality (7. be an adapted process such that E (f. sup( -n.(Ys. Let us fix 8 < t and denote by p ~ (80 8 < 81 < . but instead 149 2 )21:FS) [Z.)(Ms'+t --.3) implies that M? .n(ys.2(yu.)) L E ((Zi+l i<i It is easily seen that E (Jot ds J v(dz) (q.2).2(ys. z) . Using Lemma 7.2.E(Zi+l. E ((ZP:- 2p)21:Fs) = E (~'\(8i+l . z))).148 Moreover.+.].). we can introduce the (bounded) functions q.2. ~ . sup( -n. we obtain E [(Mt . tends to infinity.2MtMsl:Fs) = E (Mt2 .] = V(Ys.))21:Fs.8~) J Proof. z) inf(n. ~ fat AsdWs and. Then the product Li M.E(Zi+ll:FsJ) Irs) . z)) < +00.] = E [.3) with m-l . q.] IF.)). and the martingales (M!')c?o defined by = = E (~[Z'+.\ f. . .2. bounded (the general case is proved by approximating q. as in Lemma 7.2.1 once again E [(Zi+1 - E(Zi+ll:Fs.2(Ysilz)l:Fs).. .E(Zi+ll:Fs.s.(y.s.Ms. as in the proof of Lemma 7. Ms. a.Ms.3 We keep the hypothesis and notations of Lemma 7.) (Zi+l . 'E [(M.J]' .)] I :Fs. < 8 t) m a partition of the interval [8.)l:Fsi). UN ••+i)) V(y) Therefore = '\(8i+1 .2.)l:Fs. is square-integrable and taking the limit. 2 = E [ (~ IF. We set L. the lemma is 0 (Zi+l .E(Zi+l l:Fs.'.))21:Fs) 2 Lemma 7.I:Fs) A" .d8) < +00 for any t.. Since (Mtk~.n = inf(n. t]..Ls. +2 -E(Zi+dF. E (fat ds / dv(z)q.LSi)(Msi+1 dv(z)iI>'(Y.) J dV(Z)q. = Var (N'i~N" ]=1 q. by some q. from Exercise 40.).= E (~1 satisfied for q.n(y. It is sufficient to prove the lemma for q. du f dv(z)q. ! I I .Z).E(Z. . q. since (Lt)t"2o and (Mtk:::o are martingales E ((Ls'+tMs'+1 and so when the mesh of the partition p tends to 0.) l:Fs) .

left-continuous process such and consequently. = H?rertdt + HtdXt. Proposition 3.s. from Exercise 39.I (C(Nt .Ldt + 17dWt} between the jump times and at a jump time Tj. (i}I'(Y". taking into account equation (7. a. we see that AP tends almost surely t~ 0 as the mesh of the partition p tends to O.+I i=O . HrUjX 1 r. We deduce that AP tends to 0 In L . is almost surely bounded). we will impose a stronger condition of integrability on the process (Ht}O~t~T' by restricting the class of admissible strategies as follows: Definition 7. c. . i. Ht} )O<t<T. A trading strategy will be defined. < +00 ~ ais. for all .+1 .. b-ut~to take the jumps into account. Vr. as welCas N. For this equation to make sense.2 of Chapter 4. of' Proposition 4.z)l.e.3.1 An admissible strategy is defined by a process =r .Ht) )09~T adapted.) + )"C(t .3.4) o .tE(Ut)) .Xr· = Hs...) (7. and let Vo E nt. andE (JoT H:X:ds) < +00. we will constrain the processes (HP) and (Ht} to be left-continuous. T] and such that JOTIH~lds with values in rn?. In the following. by an adapted process ¢ ((HP.<u<t ILul is in L2 (from the Doobinequality. f: du f dv(z)liI>(Y" Z)I) .5) o + '"' L. E (loT H.J j=l N.)"E(Ut} = which implie~ that the process that ) JOTH:ds < 00..150 We deduce m-1 IAPI Asset models with jumps Pricing and hedging options 151 < (SUPO<i<m-1 IL'.From the continuity of t f--t Lt.L r . this means.f.L.1 Admissible strategies l + Let us go back to the model introduced at the beginning of the previous section. Notice satisfying equality (7.s)). and consequently Vo + lot H?rersds + lot HsX.C~apter 3.3 Pricing and hedging options 7. Moreover IAPI ~ 2 sup .5) a. intuitively.~u9 = ILul (C(Nt .s.3.+1 . This condition is the counterpart of the condition of predictability which is found in the discrete models (cf. J. There exists a unique process (H?)O~t~T such that the pair . Proposition 7. representing the amounts of assets held over time. (7.(J. t E [0. The following proposition is the counterpart. Vt jumps by an amount 6. ..Ns) + )"C(t with C SUPy z 1<I>(y.1).2 Let (Ht}o9~T that 2 be an adapted. and the strategy is said to be self-financing if = = (SUPO~i~m-1) IL'. dVt = H?rertdt + HtXt(J.1.. I .s)). (X t) t>O = (e-rt:Xtk:~o - is a martingale.M.~ U.LdS + 17dW. left-continuous. Chapter 1) and which is slightly more prickly to define in continuous time. assuming that the Ui'.L. that one can react to the jumps only after their occurrence.-.N. 6. UjXr-. The value at time t of the strategy ¢ is given by Vt Hpert + Hi X. for a specific reason to be discussed later.. I) L IM'. taking values in rn?. the condition of self-financing can be written dVt as 1 1 1 j The random variablesuP. it suffices to impose the condition JOTIH~lds 7.7). (it is easily seen that s f--t X. we fix a finite horizon T. Since the process (Xt} is itself right-continuous.).s are square-integrable and that. ¢ = ((Ht . Note that we do' not impose any condition of non-negativity on the value of admissible strategies.. (X t) t~O is a square-integrable martingale. Precisely.X?dS) < 00. J zv(dz). Actually.3. E (Xl) Therefore the process' = XJ exp ((17 + 2r)t) exp (). as in the Black-Scholes model. = Hs.Ns.)I + >.

L e-rr. the product e-rt Zt can be written as follows: = .UjXr. Differentiating the product e-rtyt. writing Hpert HtXt = ert (Hp + HtXt) and integrating by parts as above we see that ] T + ((H?. X.j=1 value (Vt) of an admissible strategy is a square-integrable martingale. its value at time t yt + Zt. Ht))095. -u. the unique process (HP) such that ((HP. = From this formula. . ]] ] = = N. - = vo + !at Nt HsXs((jl.4).3. This results from the expression in Proposition 7.. we see that the process (HP) is adapted. + i ! t n.. o that the discounted Writing this in (7. Xt-) (note that in the integral with respect to ds. (7.ds + adWs) + LHr. The discounted value at time to/this strategy is given by t V = +1 t Vo 0 HsXsadW. +Vo -A !at dsHsX. Ht) )095.T is an admissible strategy with initial value Vo is given by H? Moreover. we obtain (l{ H.UjX~. Remark 7.UjXr-:j=I' v(dz)z. T.Xr. defined by a random variable h.:_ j=1 'Let us consider'a European option with maturity T.J=I.x.H T j = -Hr/j.)" rs N_. o 0 Hr-] .3 The condition E (-re-rs)Zsds. L. yields and Zt = EN~1 H..ds + adWs) ] ~ which.3. x.2 Pricing .+ Hr-UjX . HrjUjXrj j=1 - + '0 1 r + Jo t ds(-re.T defines an admissible strategy with initial value Vo.r)ds ((HP.3.rT-measurable and square-integrable. "e-rr'Hr_UJ-X L. Ht)095.152 Asset models with jumps Pricing and hedging options 153 . for because there is only finitely many discontinuities). + ~Hr. HsXsadWs o +LHr. Ht) )095.2.ds) < 00 implies Vo + fat (-re-rs)Vs~s Nt + fat H~rds +fat HsXs(jl.2 and Lemma 7. j=1 ' Proof. \ + LHr."s.T defines an admissible strategy with initial value Vo.UjXr-:-. = Vo -It Nt r (H~ + HsXs) ds + fat H~rds + lot HsX~(jl.6) It is clear then that if Vo and (Hd are given. e-rtvt = Vo + fat (-re-rs)Ysds +fat e-rsdYs + e-rt Zt.n.= o. has left-hand limit at any point and is such that HP H?_. To clarify. applied with the continuous process with left-hand limit defined by Yt = (Ht. iet us stand from the writer's I .UjXr-:j~I-_ I It is also obvious that fo IHPldt < 00 almost surely. we have = - .-t ] j=1 n.2. N. Moreover. taking into account equality (7. . + adWs) + LHr.Vt .T is given by vt = defines an admissible strattegy. This last property is straightforward if t is not a jump time 7j and if t is some 7j. UjX J- -. one can substitute x.-t Hr. with yt = Vo + f~ H~rersds + fo HsXs(jl.UjXr.6) and expressing dYs.x. -A it!: 0 dsHsXs v(dz)z. If the pair (HP.ds + adWs) 7.

we have Proposition 7. following a Poisson law with parameter >.e('-" RJ = E (e-rTh (1+ N'+. Exercise 42). Note that if we introduce the function If .t). with f(x) = (x . F( t. x) ~ E (FO (t. otherwise he earns some.7) yields f(XT)IFt) .3. Xo).2.7) which gives the price of the option for the Black-Scholes model. who wants = RJ. .xe -'(T-')E(U.-" ")(T-')+. If this quantity is non-negative.E(e-rTh) . determined by a process (Ht)Os. For some laws.8) Since NT-t is a random variable independent of the U. we need the following proposition. x) = E (e-r(T-t) f (xe(r-cr2 /2)(T-t)+crWT_t) ).K)+ or f(x) (K .r' U F} Now we determine a process (Ht )Os.. .3 Prices of calls and puts.x)+. We will assume therefore that h can be written as f(XT).4 Let Vi be the value at time t of an admissible strategy with initial value Vo = E (e-rTf(XT)) = F(O.t5. we can also write to minimise the quantity premium Vi = E (e-r(T-t)hIFt).tJ. R.If (1 + U. RJ. with f(x) = (x .t)" of the option at time t. By a similar argument. From Proposition 7. xe-'(T-')E(U. Before tackling the problem of hedging. equality (7.WT_ HI = ~ E (e-'(T-') f (xe('->E(U.)) ).(T . = = ~ E (e-r(T-t) . we see that an agent selling the option at time t > O.VT f· /2)(T-')+'(WT-w.(VT .T for the quantities of the risky asset.1 and this equality. x) ~ ~ E (FO ~. A way.)) ) .T for the quantities of the risky asset to be held in portfolio t? minimise To do so. As we saw earlier. He sells the option at a price Vo at time 0 and' then follows an admissible strategy between times 0 and T.2 shows that the quantity Vr' . will ask for a F(t.x)+.) f (xe(. x) ~ E (e -. IT.Xo). = ~ ((e-r(T-t)(h .) We will take this quantity to define the price Q (1+ U.(T -. Propositio~7. For such a strategy.)) . (1 + Uj)) Ft) J=Nt+l E (e-'(T-') f (x. we obtain Fo(t.t5. we have E (e-rTVT) = Vo.)_.4 Hedging of calls and puts Let us examine the hedging problem for an option h= f(XT).')(T-.)) ) (1 + U.. Each term of this series can be computed numerically if we know how to simulate the law of the U. HI = (E(e-rTh) .VT.K)+ or f(x) = (K . F(t. we try to give an explicit expression for the price of the call or the put with strike price K.Xt). the hedging mismatch at maturity is given by h . the writer of the option loses money.Vo depends only on (Ht) (and not on Vo).3.3. From Lemma 7. this strategy is completely determined by the process (Ht)os.3. we deduce that E (e-r(T-t)!(XT)IFt) = F(t. the discounted value (Vt) is a martingale.t5.VT))2IFt). The quadratic risk at maturity . 's. 's. If the writer of the option tries to minimise the risk he will ask for a premium Vo E(e-rTh). Since.T representing the amount of the risky asset. 7.154 Asset models with jumps Pricing and hedging options with 155 point of view. at maturity is given by Vo = E(e-rTh) = F(O. So it appears that E(e-rTh) is the initial value of any strategy designed to minimise the risk at maturity and this is what we will take as a definition of the price of the option associated with h.Vo)'2 +E (e-rTh .' .VT))2) . the price of the option at time t is given by E (e-~(T-t) 7.) If (1+ U.Vo)f· (7.WT_' = E ((e-rT(h .VT). Applying the identity E(Z2) = (E(Z))2 + E ([Z :::-E(Z)]2) to the random variable Z e-rT(h . of measuring the risk is to introduce the quantity . the mathematical expectation in the formula can be calculated explicitly (cf.2.)+. f (Xte(l'-cr2/2)(T-t)+cr~WT-W') . We have seen that the initial value of any admissible strategy aiming at minimising the risk R1.3.3. If Vi represents the value of this strategy at time t. from Remark 7. (7.))) e-'(T-') :~(T.3.

Xs) .x) < -(F(t'Y)1 E e-r(T-t) ( jxe(r->.HszXs)2 dS).2.~s)17 Xsds - . (7. we have. We also know that F(t. we get ii . Xt) = E (iil. t Proof. it can be written as a stochastic integral.)' X. Xs)) 2) V(dz)z2) which. From Exercise 16 of Chapter 3.2.rt).11). for t ~ T. T[xJR+ and.) 1=1 .x) so that = e-rtF(t. Whence E (ii - VT) =. with o. Xo) + l 0 taF ax (s. Xs(1 + z)) . Xt) is a martingale. From Proposition 7. Xs)Xs17dWs. E((M~1))2) ~ 'E = Ix -yl· It follows that (J: (~~ X.F(s. A J v(dz)e-2rs (F(s. x. F(t.F(Tj.) .3. from Lemma 7. +2" llt a F 2 r Xs)ds 2 -2 + Jo N.n + z)) . Xt) . Xt) is the discounted price of J (F(s. + E((M~2))2) + E( (M~'»)').XT-:-) J . r aF (s.F(s. XTj) .11) aF F(O.VT)) 2 Pricing and hedging options 157 RJ is given by the following formula: RJ = E(IoT(~~(s.M.F(Tj. ax2 (S.H. + LF(Tj.10) Gathering equalities (7.F(s. is also a martingale and. Xt) = -- = F(O. From Lemma 7.XT.(s. Whence F(t.172ds + E (it J:. XO)+ Jo a. Xt) .2. emerges that F(t.xert). < +00.XTj-)· Remark that the function F(t.XTj) j=1 -A lot ds ! .3. x) is Lipschitz of order 1 with respect to x.M.rT (f (X T) .) J dv(z) (F(s.Xs))dv(z) r«.E(Ut}-u2 NT_t) /2)(T-t)+UWT_t (1 + Uj) U = Nt L (Fh.Xs)-Hs)2X.10). . J + z)) . XTj-) j=1 AfotdS F(t. from equality (7. We deduce easily (exercise) from formula (7.HTjUjXT-:. implies that the process Mt = Nt L F(Tj.1t the option at time t.VT = M~1) + M~2).8) that F(t.HszXs) .Xs(l+z))-F(s. MP) MP) is a martingale and consequently E (MP) M12)) = fl!a1) Ma2) = O.156 Asset models with jumps = E (e-. since and IF(t. we obtain is a square-integrable martingale. Xs(l (1 dsX. it is an Ito process. x) is C2 on [0. s o ds /v(dz) E (F(s. Xs) .U'ds) (s.9) and (7. writing down the Ito formula between the jump times.Xs)Xs(ax - -A~(Udds - + I7dWs) (7.2.F(Tj. Therefore the process F( t.

Let (Vn)n~I be a sequence of non-negative.2 again Asset models with jumps Exercises 159 E((M?))2) = E ( x J'.8) as a double series where each term is calculated from the Black-Scholes formulae (hint: use Exercise 4 I).P(Vt . H.F(s. In this way.p)A. WIth p P(UI a) 1 .158 and applying Lemma 7. Therefore. 7. b}.z. especially Follmer and Schweizer (1991). from the market data.HszXs) zXs = O. we know that the hedging is perfect. where 9 is a normal variable-withmean m and variance a2• Write the price formula (7.. Note that if there is no jump (A = _0).) - .8) as a series of terms calculated from the Black-Scholes formulae (for some interest rates and v?latilities to be given).3.4 Exercises = o ~xercis~ 3~.X. i. we obtain a process which satisfies E (JoT H. In the second approach. independent and identically distributed random variables and let N be a random variable with values in N. = = = = 2. in other words from the prices of options quoted on an organised market. the use of variance as a measure of risk is questionable.1993. Then show that S is squareintegrable and that its variance is Var(S) E(N)Var(Vt) + Var(N) (E(Vt ))2.8 E IR and we set p P(Vt a) 1 . E1 Karoui and Quenez (1995). Xsa - 22 (ft VB) = e'(E(V.~1 be a sequence of independent. satisfies P a. in this case.¥.F(" X. It yields. It remains to identify parameters and the law of the U. We suppose that the Vi's take values in {a.-).) ') . the models with jump. . m:I V. we recover the hedging formula for the Black-Scholes model and. with a. O.) H. Write the price formula (7.)-.d. Exercise 43 and Chateau (1990».8N2' where NI and N2 are two independent random variables following a Poisson law with respective parameters AP and (1 . from the historical data and (2) an implied approach. integrable random variables and let N be a random variable taking values in N integrable and oindependent of the sequence (V.. = ~(s.X. But. since ~xercise 40 Let (Vn):.H. identically distributed.F(s. Prove that S has the same law as aNI + . 'soAs for the volatility in the Black-Scholes model. with the notations of Section 7. we can distinguish two approaches: (I) a statistical approach. ). the reader is urged to consult the recent literature dealing with incomplete markets. Deduce that if N follows a Poisson law with parameter A.e. give a better 'fit' to the market prices. This assumption IS rather arbitrary: Moreover. = v(dz)z (F(s.X. x.3.s.1994). Remark 7. following a Poisson law with parameter A. The approach we have cho~ se~ relies hea~i1y ?n the assumption that the discounted stock price is a martingale. The approach used in this chapter is based on Follmer and Sondermann (1986) CERMA (1988) and Bouleau and Lamberton (1989). The risk at maturity is then given by m Notes: The financial models with jumps were introduced by Merton (1976). (with the n = (Hdt~iJ must be left-continuous.x(1 . Prove that S is integrable and that E(S) = E(N)E(VjJ = = AE(Vt) 2. E It follows that the minimal risk is obtained when H. the minimal risk is generally positive (cf. ~e suppose. when there are jumps. "'!'Ieassume N and VI to be square-integrable. .2.P(U1 b). .[ v(dz) . (F(" X . ( aF ax (s. that UI takes values in {a. Show that . ~(s. x) = a2 +A +A ! J v(dz)z2 1 3.5 The formulae we obtain indicate that calculations are still possible for models with jump.ds) < +00 and which determines therefore an admissible strategy minimising the risk at maturity.1. with convention En:l = 0).) .) + AJ v(dz) (F(s.Xs) . E(S) and Var(S) AE (V?). Schweizer (1992.(1 + z)) . Now we suypose that U1 has the same law as e9 . independent of the sequence (Vn)n~l. Exercise 41 The hypothesis and notations are those of Exercise 40. It suffices indeed to minimise the integrand with respect to ds. which-involve several parameters. (2aF() s x aax' +~) .8).(1 + z)) .8}. = = = = m= Exercise 42 1.. We set S ""N n L. X))) 1.

up) t-t F( Ul. the function x t-t F (s. . > a and P (Ul 1= 0) > O.1] and we look for a function (UI. (8.1) o To implement this method on a computer. we can apply (8. Monte Carlo methods can be used. Unfortunately these methods are inefficient and are only used if there is no closedform solution for the price of the option. We suppose that we know how to build a sequence of numbers (Un)n>l which is the realisation t. of a sequence of independent.1 The Monte Carlo method The problem of simulation can' be presented as follows.1. see Exercise 46). ZXs~~ (s.Xn. we have 8 P a.s. we proceed as follows. .whereJL is the lawofZ. >. From Proposition 7.. with common distribution JL... uniform random variables on the interval [0. Show that the law of X. the random van able Y ~ has the density JdJL(z)(I/z)g(y/z). . '. s and for v almost every z. .4. Xl. : .Xs(1 + z)) . Deduce (using the convexity of F with respect to x) that. We consider a model in which a > 0...x) zx . Simulation and algorithms for financial models 2. T[ and x E ]0.F(s. x) is linear.Unp) is then a sequence of independent random variables following the required law JL.00[.Xs).3. T]. . For example. When we can write the option price as the expectation of a random variable that can be simulated. already coded. We consider a random variable with law JL(dx) and we would like to generate a sequence of independent trials. . It may be noticed that. has (for s > 0) a positive density on ]0. x) is non-negative and decreasing on ]0. for ds almost every. In this chapter. show that if there is a perfect hedging scheme then.1 Simulation and financial models = F(s.160 Asset models with jumps Exercise 43 The objective of this exercise is to show that there is no perfect hedging of calls and puts for the models with jumps we studied in this chapter. 00[. Conclude. The sequence of random variables (Xn)n~l where Xn = F(U(n-l)p+I. Under the same assumptions as in the first question.. we can assert that if f is a JL-integrable function N--t+= lim N 1 " f(Xn) ~ l~n~N = J f(x)JL(dx).up) such that the random variable FeUI... we describe some methods which can be used to simulate financial models and compute prices. Simulations are also useful to evaluate complex hedging strategies (example: find the impact of hedging a portfolio every ten days instead of every day.. Applying the law of large numbers.1) to the functions f(x) = x and f(x) = x2 to estimate the first and second-order moments of X (provided E(IXI2) is finite).. ..x) 8. . 1. for s E [0. 3. =l It may be worth noticing that if Y has a density 9 and i~ Z is a random varIa~le independent ofY with values in ]0. ~hO"wthat there eXI~ts z 1= a such that f~r s E [0. 00[. 4.. Most languages available on modern computers provide a random' function. . . 8. The sequence (Un)n~I is obtained in practice from successive calls to a pseudorandom number generator. in the case of the put.~s) = F(s. the function x t-t F(s. . Up) has the desired law JL(dx). which returns either a pseudo-random number . aF ax (s. .x(l+z))-F(s. .

:= p div m1. Then it is possible to create random number generators with an arbitrary long period by increasing m.\n ifn 2: o.0 " pi gaussian := m + sigma" " Random). avoiding . ' Simulation ofa Poisson random variable " - o A Poisson random variable is a variable with values in N such that P(X = n) = e->'" n.1. and not only on a fixed number of Ui 'soThe previous method can still be used if we can simulate X from an almost surely finite number of Ui 's.I} { ~n+I = aXn + b (modulo m). .1].?:O}f. q: integer) : integer.pO := p mod m1. 10000.1.2 This method of simulation of the exponential law is a particular case of the so-called 'inverse distribution function' method (for this matter see Exercise 45).. U2) are two independent uniform random variables on [0. for the simulation of a Poisson random variable (see page 163). const m m1 b var 100000000. Remark 8.p l.. Remark 8.1. We can simulate X ~oticing ~hat. " log(Random)) " cos(2. q1. (" Multiplies p by q. = function begin Gaussian(m. A sequence (Xn)n. 1] J-210g(Ut} [0. function Random : real.?:O of integers between 0 andm . . qO : integer. end. b. b) + 1) mod m. To simulate a Gaussian random variable with mean m and variance a. to obtain a random real-valued number between 0 and 1 we divide this random integer by m. begin a := (Mult(a. for example. end. = cos(27rU2) a. on the whole sequence (Un)n.2 Simulation of a uniform law on The previous generator provides reasonable results in common cases. 31415821.?:I. sigma : real) sqrt(-2. function Mult(p.:overflows' ") var pI.q1 :=. 8. end. However it might happen that its period (here m = lOB) is not big enough. pO. follows a standard Gaussian law (i. it suffices to set X m + ag. This is the case. this number being possibly random. begin exponential := .162 Simulation and algorithms for financial models Simulation and financial models 163 between 0 and 1. those available with a certain compiler are not entirely satisfactory. Mult := (((pO"q1 + pI"qO) mod m1)"m1 + pO"qO) mod m.1.0 : real. 1. 8. random in Turbo Pascal).m . function exponential( mu : real) : real. Simulation of a Gaussian law A classical method to simulate Gaussian random variables is based on the observation (see Exercise 44) that if (UI.1 is generated as follows: Xo initial value E {O. 1begin .Le-I""dx. q1 := q div m1. This method enables us to simulate pseudo-random integers between 0 and m . if U follows a uniform law on [0. m being integers to be chosen cautiously in order to obtain satisfactory characteristics for the sequence. . The interested reader will find much information on random number generators and computer procedures in Knuth (1981) and L'Ecuyer (1990). a : integer.log (Random) / mu. . 1] We explain how to build random number generators because very often. Random := aim.e.q mod m1. Simulation of an exponential law We recall that a random variable X follows an exponential law with parameter f.L follows an exponential law with parameter u. We give some methods to simulate each of these laws.1. end. The simplest and most common method is to use the linear congruential generator. 10g(U)/ f. or a random integer in a fixed interval (this function is called rand () in C ANSI. zero-mean and with variance 1). Sedgewick (1987) advocates the following choice: 31415821 1 lOB.L if its law is 1{x.3 Simulation of random variables The probability laws we have used for financial models are mainly Gaussian laws (in the case of continuous models) and exponential and Poisson laws (in the case of models with jumps).1 The function F can depend in some cases (in particular when it comes to simulate stopping times). where 9 is a standard Gaussian random variable.

:isn) is identical to the law of o ~ (Wo. in other words a matrix A. . then the law of (. ..' . • Simulate n independent standard normal variables G = (gl.:iSo. + Xn.+Tn 9<Tl +. it is always possible to write exponential variables T. . W~t.Un+l~e-A<U1U2". . Let (Xi)i>O be a ~equence of independent. = . Thus Ni h-as the same law as the variable X we want to simulate.m).. As r is invertible so is A. We can find the square root of I'. then the law oeNt = L:n>l nl {Tl +. . Simulation of Gaussian vectors Multidimensional models will generally involve Gaussian processes with values in IR". This method of simulation motion. • Compute m Nt = Lnl{U1U2". This method of calculation of the square root is called Cholesky's method (for a complete algorithm see Ciarlet (1988)). We will suppose that we want to simulate a Gaussian vector (Xl.. 'as -log(Ui)/ A. = where [x) is the of the Brownian In the second standard normal JnS[nt] = = largest integer less than or equal to x. n := 0. Poisson := n end.:iS1.4 Simulation of stochastic processes The methods delineated previously enable us to simulate a random variable. + AG. while u > a do begin u := u * Random.l.1. we notice that. The law of the vector X = m + AZ can then be simulated in the following manner: • Derive the square root of the matrix I'. mn) = (E(X1)' . in particular the value of a stochastic process at a given time. where the (Ui)i>l 's are independent random variables following the uniform law on [0. then we can 'approximate' the Brownian motion by the process (X:')t:2:o where For the simulation of laws not mentioned above or for other methods of simulation of the previous laws.3 To derive the square root of I'. 1).-:-~)= = = X:.. say A.. method.. . W2~t. is partially justified in Exercise 48.2 of the Appendix for the definition of a Gaussian vector) is then essential. and we can consider the vector Z A-I (X . identically distributed random walks with law-P (Xi = 1) = 1/2.. .{ Sn+t . . n : integer. Then we have E (Xi) 0 and E (Xl) 1. This section suggests some simple tricks to simulate paths of processes.Jl.:. . u := Random. Remark 8. The first one consists in 'renormalising' a random walk. Xn) whose law is characterised by the vector of its means m = (mt. We set Sn Xl + . if t1t > 0 and if we set So = 0 . The law of the vector Z is the law of n independent standard normal variables. = E(XiXj) .. Wn~t). then there is a unique solution to the equation A x t A = r.1~j~n whererr. its variance matrix is given by = = .164 Simulation and algorithms for financial models Simulation andfinancial models 165 We have seen in Chapter 7 that if (Ti)i>l-iS a sequence of exponential random variables with parameter A. n := n + 1 end. We give a method of simulation for this kind of random variables. . 8.' ..Jl. such that A x t A r.Sn = g. . we may assume that A is uppertriangular.. P (Xi 1/2.Jl. . see Exercise 47). N: can be written as Z is therefore a Gaussian vector with zero-mean and a variance matrix equal to the identity.. On the other hand. The problem in simulating Gaussian vectors (see Section A. function poisson(larnbda var U : real. E(Xn)) and its variance matrix r = (O'ijh~i~n. This leads to the following algorithm to simulate a Poisson random variable.. ..1.:iS[t/ ~t]. Sometimes we need to know how to simulate the whole path of a process (for example.E(Xi)E(Xj). if (gi)i:2:0 is a sequence of independent random variables.. The Brownian motion can be approximated by X:. It is easily verified that this vector is a Gaussian vector with zero-mean. Moreover. one may refer to Rubinstein (1981). Simulation of a Brownian motion We distinguish two methods to simulate a Brownian motion (Wt}t>o.Jl. The matrix r is positive definite and we will assume that it is invertible. when we are studying the dynamics through time of the value of a portfolio of options.+Tn+l} is a Poisson law with parameter At. gn)..Un}· n:2:1 : real) : integer. begin a := exp(-larnbda).

. we substitute gn.3) Remark 8. X..T .. { Xo ex.t.2. the so-called 'Euler approximation'.t If X.1. setting x and simulate X. = (Xk~t/X(k-l)~t). to simulate the solution of a stochastic differential equation.~o a sequence of independent random variables (Ui)i~O.1... There is still a theorem of convergence. . we obtain a binomial-type model close to the Cox-Ross-Rubinstein model used in Section S.t. . To simulate this process at times nb.:k~. W.2) E (SliP IX.o approximates (Xtk:~o in the following >0 sense: and simulating the Brownian motion by one of the methods presented previously. We take the notations and the hypothesis of Chapter 7.. (8. it must be noticed that the convergence is different from that found in Theorem 8. we can prove. = Two approaches are available. we want to simulate the solution of the equation { Xo ex.1.) .with probability 1/2 in (8. identically distributed random variables.3.~2t + aWt) {b(Sn)b.: S[t/~tl' The either method consists in using the explicit expression of the solution = Sn(1 + rb. by X. The process (Xtk. The law of the sequence (W(n+1)~t .2). We always approximate X. such that P(Ui = 1) = P(Ui = -1) = 1/2. (Nt)t>o is a Poisson process with intensity>" and (Uj) j?_l is a sequence of independent.(... The principle is the following: consider the stochastic differential equation In the case of the Black-Scholes model. x.: -.6 We can also replace the Gaussian random variables gi by some BernouiIIi variables with values + 1 or l.t b(S~) + a(S~)gn. we notice that Xn~t ~ If we noteYk XX (X~t/x) (X2~t/X~t) x ···X (Xn~t/X(n-l)~t). The first consists in using the Euler approximation.Wn~t) where (gn)n~O is a sequence of independent standard normal variables. at times nb. but it applies to the laws of the processes. Kushner (1977) and Pardoux and Talay (1985) can be consulted for some explanations on this kind of convergence and many results on discretisation in law for stochastic differential equations. Nevertheless. (Uj)j~l are supposed to be independent. +oo[ and law IJ(dx)..1. = = = x Xt(rdt + adWt).s:t to (W(n+1)~t . The a-algebras generated by (W~)t~O' (Nt)t~o. (X. of the asset is = x S~ + b.)) . Section 7. Xt12) ~ CTb.-.: = S[t/~tl' + a(Sn) (W(n+l)~t "..: g.1. we obtain Theorem 8.4.t. (8. t'5. We set x b(Xt)dt + a(Xt)dWt..3 of Chapter 5. x We discretise time by a fixed mesh b. in this case. The approximating sequence (S~)n~O is in this case defined by Remark 8. '" x (it X (i + U. from the properties of (Nt)t~o.t.'1')'+. by X.t + agn. some of them very sophisticated.166 Simulation and algorithms for financial models Simulation and financial models An application to the Black-Scholes model 167 Simulation of stochastic differential equations There are many methods. In a simulation.Wn~t) n>O is the law of a sequence of independent normal random variables with zero-mean ana variance b.t. In the case where we simulate the Brownian motion by . ~ x exp ((r ~ u' /2)nLlt + UVMt.~o describing the dynamics. A proof of this result (as well as other schemes of discretisation of stochastic differential equations) can be found in Chapter 7 of Gard (1988) . Then we can construct a discrete-time process (Sn)n>O approximating the solution of the stochastic differential equation . = S[t/~tl' = CT being a constant depending only on T. Simulation of models with jumps We have investigated in Chapter 7 an extension of the Black-Scholes model with jumps. = xexp (rt ..5 We can substitute to the sequence of independent Gaussian random variables (gik.Wn~t)} . with values in l-:. the reader is referred to Pardoux and Talay (1985) or Kloeden and Platen (1992) for a review of these methods.s:t) . Here we present only the basic method.4 For any T s.s:t. we describe nowa methodto simulate this process. where (Wt)t~O is a standard Brownian motion.s:t ~~1 gi.

(* in days *) StrikePrice : Amount. CONST PriceStepNb = 200. be independent.6.gamina.t) / Days InYearNb. x : Amount.exp(x). we give two approximation formulae from Abramowitz and Stegun (1970) .2 dx N(x) = P(X :::. END. AmericanPut = RECORD ContractDate : Date. Accuracy = 0. • We simulate a Poisson random variable with parameter )". If x 169 (Wdt2:o and (Uj) j2:1 that (Yk with the same law. 8. the simulation of X at times n. *) t = 70 VAR Obst.231641900 b1 = 0. (* initial value of the SDE *) END. 8.k . it is identical to the law 'of Yl. but it uses the exponential function. Yn.2 Implementation of the Brennan and Schwartz method The following program prices an American put using the method described in Chapter 5. (* prices the 'option' for the 'model' at time 't' if the price of.VV. we have gathered some widely used algorithms for the pricing of options. Time'.01.. del ta..x) = e-:T J7L' where X is standard Gaussian random variable: Due to the importance of this function in the pricing of options. BEGIN .r. Un. TYPE Date = INTEGER. it sufficesto know how to simulate Y1 X~t!x.3 + C4x4)-4.2 Some useful algorlthms In this section.' TimeStepNb = 200. beta .. N(x) :::::1 - J7Le-T y27r 1 2 The second approximation is accurate to 10-3 but it involves only a ratio as . BEGIN u := Opt.330274429 a I -00 '" *) y 27r FUNCTION PutObstacle(x : REAL.PriceStepNb) OF REAL. h Index. temp.t: N.2. = = FUNCTION Price(t : Date.1 : REAL.B..C. (* annual riskless interest rate sigma REAL. Section 5. IF u > 0 THEN PutObstacle := u ELSE PutObstacle := 0.781477937 ·b4 ~ 1.StrikePrice . This sequence being independent and identically distributed. . Ifx>O p _.2(1 1 + CIX + C2x2 + C3X. r .000344 0. The first approximation is accurate to 10-7. underlying at 'this time is "x "._" Time r e (option. 'model : Model) : REAL.PriceIndex. 8. alpha.0.Opt : AmericanPut) :'REAL.y. 0. vector = ARRAY[l . from equation (8.L(dx): U1. . Since Xn~t xY1 .3. (* in days *) MaturityDate : Date. option: AmericanPut. 1/(I+px) (bit 5 + b2t 2 + b3t 3 + b4t 4 + b5tv).. • If N = n.2: we make a logarithmic change of variable. r := model. k := Time / TimeStepNb.' the. we simulate n random variables following the law J. (* annual volatility *) xO : REAL..3).115194 0.2.. DaysInYearNb = 360. END. All these variables are assumedto is clear that the law of .821255978 b5 1.168 Simulation and algorithms for financial models h2:1 is a sequence of independent random variables Some useful algorithms opposed to an exponential.MaturityDate .1 Approximation of the distributionfunction of a Gaussian variable We saw in 'Chapter 4 that the pricing of many classical options requires the calculation of . = = = = ' 0.196854 0.t comes down to the simulation of the sequence (Ykh2:1. . Then.A.TimeIndex : INTEGER.G : vector.6. VAR u : REAL. Amount = REAL. Then' we operate as follows: = >0 Cl C2 C3 C4 = • We simulate a 'standard Gaussian random variable g.019527 N(x) :::::1 . Model = RECORD r REAL.356563782 b3 1.319381530 b2 -0. we discretise the parabolic inequality using a totally implicit method and finally solve the inequality in infinite dimensions using the algorithm described on page 116.

90 not hedge: we sell the option. the random variables -210g(Ul) cos(27rU2) and -210g(Ud sin(27rU2) are independent and folIowa standard Gaussian law. { So = x. Prove thatifU is a uniform random variable on [0. Exercise 47 The aim of this exercise is to study the influence of the hedging frequency on the variance of a portfolio of options. f(x)dx. sigma.obst[priceIndex].2 and x 100.vv / (2. FOR PriceIndex:=l TO PriceStepNb PriceIndex * h • option ). Index := PriceStepNb DIV 2. Further on we will fix r = 10%/year. Exercise 45 Let f be a function from JR to JR.C[PriceIndex] * A[PriceIndex+l] / B[PriceIndex+l] .0 * h * h) + (r .··· .se 46 We model a risky asset S. . G[PriceIndex] := 0. a the volatility and r is the riskless interest rate.170 vv := ~odel. { So x. h := 2 * 1 / PriceStepNb. FOR FOR TimeIndex:=l TO TimeStepNb DO BEGIN PriceIndex := PriceStepNb-l DOWNTO 1 DO G[PriceIndex] := G[PriceIndex] -" C[PriceIndex] * G[PriceIndex+1].vv / (2.arctg(Y/X)).0) / (2. the options have 3 months to maturity and are contingent on one unit of asset. Exerci. beta := 1 + k * (r + vv / (h * h)). a the annual volatility and r the riskless interest rate. such that f(x) > 0 for all x. END.(r . END. where (Wt)t>o is a standard Brownian motion. ..In(2) :5:3). derive! the joint law of (JX2 + Y2.sigma Simulation and algorithms for financial models * model. • Put ratio backspread: short a 110 put and long 3 90 puts.1]. * sqrt(ln(l/Accuracy)) + abs(r .1]. We setF(u) = f(x)dx. then the law of F-i (U) is f(x)dx. long a 95 call and a 105 call and finally short a 110 call. • Strangle: short a 90 put and short a 110 call.L = r . Deduce that. .vv / 2) * Exercises 171 1 := (model. (Wtk~o represents a standard Brownian motion.. We will choose one of the following combinations of options: = • Bull spread: long a call with strike price 90 (written as 90 call) and short a 110 call with same maturity. B[PriceStepNb] := beta + gamma. Propose a method of simulation to approximate Give an interpretation for the final value in terms of option.0) / (2.1 DO C[PriceIndex] := C[Pricelndex] B[PriceIndex+l] . G[l] := G[l] / B[l]. We want to simulate a random variable X with-law r: = We . FOR PriceIndex:= 1 TO PriceStepNb .3 Exercises . 0 J J . FOR PriceIndex:= i TO PriceStepNb DO A[PriceIndex] := A[PriceIndex] /' B [PriceIndex] . IF G[PriceIndex] < temp THEN G[PriceIndex] := temp. FOR . Prix':= G[Index]+ delta*(Index * h .sigma * sqrt(Temps) Time) . and such that f(x)dx l. Being 'delta neutral' means that we compensate the total delta of the portfolio by trading the adequate amount of underlying asset. we wait for three months. B[PriceStepNb] := B[PriceStepNb]. We hedge immediately after selling the option.G[Index]) / h. Deduce a method of simulation of X. DO G[PriceIndex] := . B[l] := beta + alpha. END. a = 20%/ ~ = 0. B[PriceIndex] := beta. we take into account the exercise of the option sold and we evaluate the portfolio. First we suppose that f. if Ui and U2 are two independent uniform random variables on [0.0 * h * h) . Exercise 44 Let X and Y be two standard Gaussian random variables. C[PriceIndex] := gamma.A[Pric'~Index] * G [Price Index-l] . get the premium.PriceIndex:=2 TO PriceStepNb DO BEGIN G [PriceIndex] := G [PriceIndex] / B [PriceIndex] .0 * h)). then we do nothing. y := In(x). FOR PriceIndex:=PriceStepNb-l DOWNTO 1 DO B[PriceIndex] := B[Pri'ceIndex] . FOR PriceIndex:=l TO PriceStepNb DO BEGIN A[PriceIndex] := alpha.vv / 2. END. by the stochastic differential equation I::oo alpha := k * (.0. FOR PriceIndex:=l TO PriceStepNb as. .0 * h)). Write a program which: • Simulates the asset described previously. In the following. gamma := k * (.1). delta := (G[Indice+l] .1+ as. • Calculates the mean and variance of the discounted final value of the portfolio in the following cases: ( 8. writeln(1:5:3. temp := Obst[PriceIndex]. • Condor: short a 90 call.vv / 2'. The underlying asset of the options is described by the Black-Scholes model / DO Obst[PriceIndex] := PutObstacle(y .

the density of Y is = _1_exp .. We set Sn = Xl + .l Scalar normal variables A real random variable X is a standard normal variable if its probability density function is equal to .6 .I Normal random variables In this section. .. we recall the main properties of Gaussian variables.L bigger and smaller than r).. 1.m)2) 2(72' f· If (7 = 0.)27f(72 (_ (x . then every day. (72) (it does not depend on the sign of (7 since X and .96 .. Are there arbitrage opportunities? Exercise 48 We suppose that (Wtk?o is a standard Brownian motion and that (Ui)i>l is a sequence of independent random variables taking values +1 or -1 with probability 1/2. Let t and s be non-negative.X[' is independent of X['. Now consider the previous simulation assuming that J.L =I r (take values of J. prove that the pair (X[... the law of Y is the Dirac measure in m and therefore it does not have a density. < tj" show that (X~. The following results are proved in Bouleau (1986). Chapter VI.X~) converges in law to (Wt1. _ We hedge immediately after selling the option.. If (7 i= ..· . . __ 1 tV2if 1 t 00 xe-x2/2dx _t = _e__ /2 .+. we can prove that for any complex number z. E (ezX) = e4. 2 tV2if .01. Section 9. Wt). A.X have the same law).l. . Forlarge values of t > 0. 22 ' ¢y(u) elUT1le-u' a /2.05 and P(IXI > 2. IfO < tl < . we have P(IXI > 1. X[' converges in law to Wt. Prove that.. then the variable Y m + (7X is normal with mean m and variance (72 • Its law is denoted by N( m. 3. If X is a standard normal variable. ) = 0. If X is a standard normal variable and m and (7 are two real numbers. _ We hedge immediately after selling the option. we have ' . then every month. ) = 0.. It is sometimes called 'degenerate normal variable'.. 2 o Thus. .. tr>= . . > t) = . 2..(ii.172 Simulation and algorithms for financial models _ We hedge immediately after selling the option.. Investigate the influence of the discretisation frequency. + Xn. if X[' = S[ntJ/.using the fact that the random variable X['+s . the following approximation is handy: = 1 P(X . X[') converges in law to (Wt+s.0. Appendix A. /2 and for Y . then every 10 days . Wtp)' n(x) = -_1 V2if exp -_ (X2) 2 . v 27f 1 t 00 e'-X 2 /2dx ::. the characteristic function of X is given by ¢x (u) = e-u. It is sometimes useful to know that if X is a standard normal variable.

2..I. but the fact that each component of a vector is a normal random variable does not imply that the vector is normal.!lb~a-=algebra of . of the co~dition~l expectation Let (n. It is well known that if the random variables Xl'... I . A.. then E(XIB) 2: 0 a. 2: Y => . Xd) is the matrix I'(X) = (aij h~i. .2 Properties.. There is a one-to-one mappingfrom-tfie ser'OCfinite sub-aalgeoras ofAonto the set of partitions of by elements of A. we can associ~ition B (BI' .. It follows from this property that ~ IE (XIB)I ::.r:---._~~~(E~ £) to (F. a..A.)/P(Bi)IB.~of A: B.. It isolWiouslyiilCliiOea-in A and It IS easy to show that . Chapter 8): !heorem A...Let us consider a ~~Race (P.. As far as the trivial a-algebra is concerned (B = {0. for a proof of this result.I. ..:F) is a(X)-measurable if and only if it can be written as . and more generally. X2. n ~-------~~---.. The random variables X I. independent random variables...bra of A. . . . E). a map from to ]R (and its Borel a-algebra) is B-measurable if and only' if it is constant on each atom of B. .I expectation = Y is another randomvar~able with these properties then Y = Y P a. ~ .1 For any real integrable random variable X.'-- + JLYIB) =AE + JLE (YIB) a.Xd) in]Rd is a Gaussian vector if for any sequence of real numbers at._~ _---.~ n 5. .2 Conditional A. ••• . where we sum on the atoms with strictly positive probability . with n events in A. .s. A. . Definition Ad. The reader ought to refer to Dacunha-Castelle and Dufto (1986) (Chapter 5) for problems of estimation and to Chapter 8 for problems of simulation. Examples of a-algebras .should know that there exist very good approximations of the cumulative normal distribution (cf. A) with values in a m~able ~~~. We can prove that a random variable Y from (n..:F). the scalar random variable 2:~=1aiX is normal. --~. The reader should consult Bouleau (1986). the matrix I'(X) is diagonal.A) and a p~. n}).I A random variable X (XI. where i~.E(Xj))]. However. Xj) = E [(Xi .Xd) is normal.Q'I' B2. Section 4). . Th~ r:.2 Multivariate normal variables Let us now consider a random variable X defined on (n... p. For any bounded! B-measurablerandom 4. The ~omplitations involving conditional expectations are based on the following properties: ~!. If B IS a finite sub-a-algebra. Y = foX.A = X-I(B) = {X E B}}.~ E (E (XIB)) n B __.. .~. ad. Remark-A. Bouleau (1986)....E (ZE(XIB)) .j~d whose coefficients are equal to = -'-'---'-~(X)-:.174 Appendix Conditional expectation 175 Finally.. ---. The components X I. " Conversely.2.E(Xi))(Xj . one.2 Let X (Xl. Bouleau (1986). Xd are real-valued. E(XIB) = L E(XIB. . It is-the a-algebra generated by the sequence of B. on each atom Bi. (cf. Y is th~ cond~tional expectation of X given B and it is denoted by E(XIB).. . to any finite s. In other words. . Chapter VI. then the vector (Xl.. n}.. p. is a finite sub-a-alg.JE. Positivity: if X 2: 0. P) be a probability space and B a a-algebra in~luded in A. we have E(XIB) = E(X). . ..s. a(X)-measurable random variables are the measurable functions of X..s.' .. Linearity:' = E(ZXj. E (IXIIB) a.s.Consequently. = aij = cov(Xi. . X E(XIB) .~I~X isthesmallest a-algebra f~~~~.-. .~--..I.- ' ----- _ .3 The importance of normal random variables in modelling comes partly from the central limit theorem (cf. empty elements ofB which contain onIy-tnemselves and the empty set. normal.~ E(YIB) a.{A E AI3B E £. . there exists a real Integrable Btmeasurable random variable Y such that VB E B If E(XIB) = E(YIB). .... .. . The definition of the conditional expectation is based on the following theorem (refer to Bouleau (1986). E(XIB) is the mean value of X on Bi.. = E (X).Bn) of where is·g~. One should notice that if B is a sub-a-algebra of A.... ... X d are independent if and only if the covariance matrix X is diagonal. A.. . Bn. A) to (F.: (~~ I E(XIB) = X. if Xl. . A.2.-.s..Ich X ~~~~~~~ It IS denoted by a(X).-. .s. E. are the non-. where f is a measu~b~:__~ap. . 101-102). except in the Gaussian case: Theorem A.. Chapter 8) as well as statistical tables. .. f £~~~l![~ble. They are 'called--atoms of B. Chapter VI.I.. . ''_'' ~ (XIB) ~_ 3. .-----.. Xd are independent. . The set B containing the elements of ~ which are ei~pty or that can be written as Bil U Bi2 u··· U Bik. but the converse is generally wrong. ~n. ik E {I.. Xd) be a Gaussian vector in ]Rd.' . variable Z. with atoms BI.!Ierated by theelements B. The covariance matrix of-a random vector X (XI. X d of a Gaussian vector are obviously normal. 155.

Y)Z) {l(X:~p~~)) =. on (E. We have cp(x) = (eiUX~)P(B) -. £ ® F). E (eiuX IB) = E (eiuX) P(B). so is E(XIB). since a(€)measurable random variables are the measurable functions of €.2. .P). E (cI>(X.z(x.2. Notice that by Pythagoras' theorem. then E (E (XIB) IC) = E (XIC) a. we can compute E ( cI> (X. X is independent of the a-algebra B if and only if Vu'E IR E Appendix Conditional expectation 177 Proposition A. I /'\ where c. Vx E E cp(x) = E (cI>(x. Y) IB) as if X was a-constant.s. together with the scalar product (X.S Let us consider a B-measurable random variable X taking values in (E. If E (eiuX IB) = E (eiUX) then.2 Let X be a real random variable. The conditional expectation of X given B is the least-square-best B-measurable predictor of X. ' . Bouleau (1986).1) Proof.Xn) is a normal vector (in nI IR + ). under the previous assumptions. Xl.. X2. we just need to prove that (A. a random variable independent of B with values in (F. (A. Z). Indeed.. cI>(x. If we denote by P X.above. E and the measurability of cp is a consequence of the. if (Y. ••• . In particular. If X is independent of B then E (XIB) = E (X) a.2. The rules are basically the same as in the integrable case (see Dacunha-Castelle and Duflo (1982). If Z is B-measurable and bounded. o Remark A.• . P).z) = E (cp(X)Z). Y)IB) (eiUXIB) ='E (eiuX) a:!. Proof. 176 and therefore IIE(XIB)II£1(fl) ~ IIXII£1(fl)' 6. we know that IIE(XIB)IIL2(fl) ~ IIXII£2(fl)' Remark A. This means that the function of Xi which approximates. Y) H E(XY) (cf.Y)dPy(y)) z)dPy(y) zdPx. A. the computation of a conditional expectation is particularly simple.Z the law of (X. The equality of characteristic functions implies the equality of probability laws and consequently . 7. On top of that. For any Borelfunction cI> non-negative (or bounded) on (E x F.s.6 In the Gaussian case. if B is the a-algebra generated by a random variable €.. for any Bmeasurable non-negative random variable Z. CnapterVIII. Let Z be a non-negative B-measurable random variable (for example Z = IB. B.z(x.2. The following proposition is crucial and is used quite often in this book.Y in the least-square sense is linear.1) implies that X is independent of B. .z(x. which is a closed subspace of L2 (0.E (f(X)).Y)) = cp(X) a.y)dPy(y) .. by definition of the conditional expectation. we can compute Z by p~?jecting the random variable Y in L2 on the linear subspace generated by I and the X/s (cf. £) and Y. it follows from the independence between Y and (X.2. The converse property is not true but we have the following result. Bouleau (1986). are real constant numbers. If P(B) =j:. Xn) has the following form "' i=l A.y)zdPx.s. F).4 We can define E(XIB) for any non-negative random variable X (without integrability condition). . for all B E B. and it is the best approximation of X by a function of €. which completes the proof..3 Computations of conditional expectations . Chapter 6). the function cpdefined by . we can write ' E In other words. This equality means that the characteristic function of X is identical under measure P and measure Q where thedensity of Q with respect to P is equal to IB /P(B). Chapter 8. Then E(X Z) = E (E(XIB)Z).3 If X is square integrable. 0. :J = / cp(x)zdPx. z) for any bo~nded Borel function j. Proposition A. ~ = E (eiuX) i cI>(x.2. hence the independence. Z) that. Fubini theorem. Let us denote by Py the law of Y. Section 2). = // / (/ cI>(x. E (ZXIB) = ZE (XIB) a. and E(XIB) coincides with the orthogonal projection of X on L2 (0. If C is a sub-a-algebra of B. Section 5). the conditional expectation E(XIB) is noted E(XI€). 0 Remark A. is a Borelfunction 8.s. Given the Property 8. £) and we have E (cI>(X. with B E B). the conditional expectation Z' == E (YIX1.

L. 301-329. In this section. Acta Appl. N.2) For a fixed y. Barone-Adesi.z. Probabilites de l'Ingenieur. 133-155.) with centre at the origin and radius>. ((z) thus '<Iy E K. pp.L.z)EKxV. J. Lions. Black.. CERMA.2 Let us consider a compact convex set K and a vector subspace Vof IRn.G. ((y) 2: 0:. 2: 0:. = 0 does not intersect C. Comptes Rendus de l'Academie des Sciences. Masson. 1988. . Xo + t(x . Term structure of interest rates: The martingale approach. Bensoussan. Let Xo be the point where the map. pp.3. 2 (1984) pp. pp. be anon-negative real number such that the closed ball B(>. M.}. 33 (1989)..178 A. 2: 0:. 1986. These de l'Universite Paris VI. P. . the hyperplane ((x) ((x) References 2: 0:.J. Bouleau. '<Ix E V ((x) O. Bensoussan. and E. Journal of Political Economy. Delbaen. 21-86. there exists a linear functional ( defined on n IR . of Finance. intersects C. 42 (1987). thesubspace V is included in a hyperplane that does not intersect K. and Appl. This completes the proof. The set C=K-V={xEIRn 13(y.2) to >. Stoch. Volume I. M. Ciarlet. Theorie de la speculation. M. and R. A. 81 (1973).. Dunod.' 0 Theorem A. 635-654. we can apply (A. Ann. . Scholes. pp. 449-462. A. Then there exists a real linear functional ( defined on IRn and 0: > 0 such that '<Ix E C In particular. Bouleau. 17 (1982).S. A. and D. Advances in Applied Mathematics 10 (1989). J.. By expanding the following inequality . pp. Quelques remarques sur les processus a accroissements independants et stationnaires. Handbook of Mathematical Functions. the diligent reader can refer to Dudley (1989) p. Brennan.G.x denotes the scalar product of Xo and x. 95-129.L. since Cis convex.x=y-z} is convex. G.1 Let C be a closed convex set which does not contain the origin. Brennan.. N. closed (because V is closed and K. Sup.. and LA. of Financial and Quant. x f-t IIxll achieves its minimum (where "·11 is the Euclidean norm) on the compact set C n B(>. and J. Bachelier. where Xo. Proof. The pricing of options on default-free bonds. Courtadon. 9th printing.3. G. Lions.. The pricing of options and corporate liabilities. 131-150. Therefore. Math. of Banking and Finance. then for all t E [0. Lions Applications of VariationalInequalities in Stochastic Control.1]. 1970. Sci. 32. Schwartz. 301-320. 307 (1988). it yields Xo.l. Processus Stochastiques et Applications.. pp. and J. Handbook of Numerical Analysis. Sur les risques residuels des strategies de couverture d'actifs conditionnels. Residual risks and hedging strategiesin Markovian markets. Schwartz. we state the theorem of separation of convex sets that we use in the first chapter. Hermann. J. Whaley. and M. Applications des inequations variationnelles en contriile stochastique. The valuation of the American put option.J. pp.Lamberton. et la subordination au sens de Bochner. 0 Abramowitz. Hermann. 1982. L. By Theorem A. J. It follows immediately that '<Ix E C Ilxll 2: Ilxoll· The vector Xo is nothing but the projection of the origin on the. Une Introduction a I 'analyse numerique matricielle et a I 'optimisation. Bouleau.3. P. Chateau. North-Holland. and E. we can find a linearfunctional ( defined on IR and a certain 0: > 0 such that '<Ix E C Hence '<Iy EX. . Bensoussan. 1990. 152 or Minoux (1983). and J. P. 0. 1977. North Holland. 625-630.x 2: IIxoll2 > 0 for any x E C. Ciarlet. of Finance.. Stegun (eds). N. 3 (1979). Part 1 (1990). Efficient analytic approximation of American option values. Artzner. Anal. (A.. On the theory of option pricing. E IR to obtainxvz E V. '<Ix E K ((x) 2. = 0. If we consider x E C. If V and K are disjoint. 17 (1900). 1978. and F.3 Separation of convex sets Appendix .((z) ((x) = > O. closed convex set C. F. Ecole Norm. 139-158. Proof..S. For more details. '<Iz E V. Ilxo + t(x - xo}112 2: Ilxol12. not contain n the origin. with>. 1988. pp. Theorem A. Proc. is compact) and does.. pp. ((y) .xo} E C. Let>. A continuous time approach to the pricing of bonds. satisfying the following conditions: 1.

Applied Stochastic Analysis. and M. Harrison.I. Schweizer. Masson.Verlag. Proc. Heath. Schachennayer. pp. of International Money and Finance. Gard. Schaefer. Bell 1. Platen. Stochastics and Stochastics Reports. . Tremolieres. North-Holland. and S. 53 (1985).R.H. 231-237.. Ross. pp. N. A.1981. Arbitrage and Martingales. 17 (1988). Security Markets.Wesley. Willinger. of Economic Theory. N. D. andM. . Communications of the ACM. Option hedging for semi-martingales. Kloeden. Huang. and D. 2: Seminumerical algorithms. and G.M. pp. Stochastic Models. Lecture Notes in Mathematics 876. North-Holland. T. Introduction to Stochastic Differential Equations. Simulation and the Monte Carlo Method. Elliott (eds). 215-260. and Appl. EI Karoui. pp. Marcel Dekker..I. E..D. Springer. 1988. Gordon & Breach (1991): pp. and S. Lamberton and B. 1988. . 'Mas-Colell (eds). M. R. J. I. Dunod. 1980. Dacunha-CasteIle.. and J. Dacunha-Castelle. D. P. Annales de l'IHP. 2 vols. J. and D. 33 (10). Introduction ala Theorie des Processus Ateatoires. 3 (1985). Sondermann. Jaillet. Term structure movements and pricing interest rate contingent claims. A theory of the term structure of interest rates. pp. R. 313-3Hi. pp. Discretization and simulation of stochastic differential equations. J. 1986. Williams. 141-183 . MacMillan. M. vol. and J. Springer-Verlag. 413-424.. 22 (1993).E. E. John Wiley & Sons. M. no. N.C. Lapeyre. Probability and Statistics. Random numbers for simulation.171-179. . Theory of rational option pricing.S. 37-60. 4 (1973). (1981). 463-520.V. 29. pp.pp. Stochastic Differential Equation~and Applications. 1983. 1976.G. Revuz. Bond pricing and the term structure of interest rates. Options Markets. A general version of the fundamental theorem of asset pricing. J. 1 (1986).. Jarrow and A. EI Karoui. 11 (1981).180 References References 181 Cox. Schweizer.A. Garman. 8925. of Finance. Analytic approximation for the American put price. Ho. 300 (1994). Springer-Verlag. Acta Applicandae Mathematicae. Academic Press. Stochastic Differential Equations and Diffusion Processes. Shreve. "Hedging of contingent claims under incomplete information".. pp.. R. Rubinstein. . and D. Foundations for Financial Economics. P. 1983. Option pricing when underlying stock returns are discontinuous. Programmation mathematique.J. Elliott (eds). . 205-209. P. 1975. 1986. and M. J \' . L. Breach. 3 (1976). Ann.1989. Analyse numerique des inequations variationnelles. W. R. 389-414. Litzenberger. . L.A. J. 29-66. Schweizer. Rubinstein.R. J. Dynamic programming and pricing of contingent claims in an incomplete market. 1981. Gordon & ..S.Hildebrand and A. Follmer. 23-47. Lions and R.A. and D.. Annals of Probability. Masson.A. Advances in Futures and Options Research. Kohlhagen. Cornell University.E and R. 1989. (2) (1990). Talay. " Fri~dman. Dunod. and M.C. Wadsworth & Brooks/Cole.. 2. Follmer. Morton. North-Holland. 1989. 21 (1990).. and A. Kreps. 19 (1984). pp. Thomas. 1011-1029. Ito Calculus. M. Pliska. S. A. pp. Vol. Martingales and arbitrage in multiperiod securities markets. Springer-Verlag. 263-289. 185-202. 2 (1992). Watanabe. Skorohod. Morton and W. M. 1987. 1992.. Martingales and stochastic integrals in the theory of conti. Prentice-Hall.. H. Cahier de recherche du GREMAQ-CRES.e. Harrison. Introduction a l'analyse numerique des equations aux derivees partielles. Jamshidian. 26 (1990). and S.I. Equivalent martingale measures and no-arbitrage in stochastic securities market models. H.claims under incomplete information. Applied Mathematics and Optimization. and S. pp. Duflo. pp... vol.. 2 (1983). A. Anal.e.L. Academic Press. A stochastic calculusmodel of continuous trading: complete markets. D. Martingales a temps discret.E. 1981. Hedging of contingent. Rochet. 37 (1991). Glowinsky.M. Duflo. Variational inequalities and the pricing of American options. and D.. pp.es and their Applications.. M. Springer-Verlag.H. Quenez.381-408. John Wiley and sons. Probability Methods for Approximations in Stochastic Control and for Elliptic Equations. Continuous Martingale Calculus. thesis. 1987. IngersoIl and S. Lamberton.M.W. J. R. Applied Stochastic Analysis.Y. Karatzas. J. A. M. Raviart.J. E and W. Morton. J.. and E. Econometrica. pp. Math.B. and S.. Les aspectsprobabilistes du controle stochastique. The Art of Computer Programming. Dalang. Stochasti~ Processes and their Applications. On the pricing of American options. of Financial Economics. Mir. 1988. M. Gihman. 1990.. T. 15 (1983). and Management Sci. J. pp. 5. Ikeda. Contributions to Mathematical Economics in Honor df Gerard Debreu. Harrison.. Probability and Statistics. Mean-variance hedging for general claims. and M.331-355.1.H.C. and E.J. P. Davis and R. Schweizer.B. Kushner. J.J. volume I.. Knuth. A two-factor model of the term structure: an approximate analytical solution.C.M. Foreign currency option values. Duffie.C. Numerical Solution of Stochastic Differential Equations. 29 (1979). Stochastic Proces. preprint. 1536-1575. Cox. of Finance and Quant. H. 119-139. of Econ. Acta Applicandae Mathematicae. 1986. Markov Processes and Martingales. pp. pp. Ph. Delbaen. Lee. Sur I'approximation des reduites. EI Karoui.Pliska. R. 1977. Stoch. Real Analysis and Probability. vol. Springer-Verlag. 41 (1986). A pricing formula for options on coupon-bonds. 1972. N. Pardoux. C. Approximating random variables by stochastic integrals. Vol. Addison. Dudley. Academic Press. Annals of Applied Probability. pp.D. 44 (1989). Sondermann. Karatzas. Minoux. Schwartz.'Stochastics Monographs. 1988. A. 339-363. 385-407. Control and Optimization 33 (1995). Pages. Yor. M. H. and M.. and S. Merton.E. 1. An exact bond pricing formula. Brownian Motion and Stochastic Calculus. L'Ecuyer. volume 2. Amsterdam. D. pp. October 1990. Merton. I. 125-144. Davis and R. pp. 72~238. D.. Hedging of non-redundant contingent claims. 1985. 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176 orthogonal projection. Arbitrage et lois de martingales. Williams. 29 Cox-Ross-Rubinstein model.. 8 Conditional expectation Gaussian case. Inst.182 References Schweizer. pp. 108 Critical price. M.. 1978. Cambridge University Press.. 174 Attainable. 169 Cox. vii Bessel function. 74 European option pricing.. 8 Continuous-time process. Optimal Stopping Rules. 154 European put pricing. vii Atom. Sedgewick. 12 Crank-Nicholson scheme. On the minimal martingale measure and the Hillmer-Schweizer decomposition. 49 Doob decomposition. 25 American option price. 165 Equivalent probabilities. 177 of a non-negative random variable. vii. 99 21 . R. Addison-Wesley.. 6 European call pricing. 116. a jump diffusion model. vii. 70. 70 Exercise price. 11 American put hedging. financial. viii Asset . 154 Calion bond pricing. 26 Arbitrage. 66 Equivalent probability. 131 Black.. 5 . ix. 13 (1994).' 136 Brownian motion. vii Black-Scholes formulae. Stochastic Analysis and Applications. I " I Index' Adapted. c. Doob inequality. Algorithms.4 Algorithm Brennan and Schwartz. 1987.N. Springer-Verlag. Ross and Rubinstein. Probability with Martingales. 1994. D. 70 Black-Scholes model. 31 Simulation of process.. 26 (1990). Stricker.. a random variable. Ann. 68.. 129. 451-460. 1. 122 risky. 138 Complete. pp. Zhang. 125. 1 riskless. 77 Delta. 133. 176 w.L. X. Numerical analysis of American option pricing in. 124. vii pricing. Shiryayev. 1991..t. 27 pricing. 176 Contingent claim. 132 Bond option pricing. 573-599. 12 Bond pricing. A. 117 American call pricing. CERMICS. Soc. viii Expectation. Henri Poincarre. 1 underlying. 35 Dynkin operator.r.Gen . " o Bachelier. 72 Diffusion. 8 Call.

109 inequality in finite dimension. 168 finite differences. vii Submartingale. Brennan and Schwartz algorithm. ix Radon-Nikodym. viii a call. 166 Simulation of random variables. 66 Random number generators. 68. 30 Forward interest rate.· 1 ll. 141. 6 Volatility. 5 Premium. 118 partial differential inequality. 72 theta. 106 Gauss method. 169 Cox. 72 Viable. 141. 18 Stochastic differential equations. 71 Wiener integral. 71 no replication. 14 calls and puts. vii partial differential inequalities. 121. 151 consumption. 113 Option American. 34 optimal.184 conditional. Ross and Rubinstein method. 133 Index Index Portfolio value. Market complete. 42 multidimensional. 161 Model Black-Scholes. 47 optional sampling theorem. 160 Markov property. 33 Martingale transform. viii Exponential martingale. 70 implied. 163 Gaussian vector. 2 Position short. 95. viii. 72 vega. 66 Merton. vii Separation of convex sets. 66. 52. 162 Replicating strategy.80 simulation. viii Asian.63. 142 lognormal. 3. 116 algorithm of Brennan and Schwartz. 96 Stopped sequence. I. 163 exponential variable. 72 Hedging. 174 Simulation of processes. 122 Natural filtration. 30 Normal variable. 49. 4 J ~ _/ 185 Theta. 141 . I interest rate. 117 distribution function of a gaussian law. 73 self-financing. 127-129 with jumps. 125. 174 Expiration. 72 Girsanov theorem. 154 Put/Call parity. 14 Scholes. 131 exponential. 173 Numerical methods .47. 102 parabolic. 42 Ito formula. 17.30 hitting time. 2. vii Method Monte Carlo. 72 gamma. 54. 129-133 Cox-Ross-Rubinstein. viii Pricing. 173 standard. 173 degenerate. 8 replicable. 160 of calls and puts. 141 Put. 33 Parity put/call. 77 Greeks delta. 3 Predictable. 5 Martingales representation. 3 Sigma-algebra. 155-159 Infinitesimal generator. 113 Perpetual put. 75 Poisson process. 29 Omstein-Ulhenbeck. 56 Martingale. 72 Vega. 165 model with jumps. 52 Poisson. 151 Strike price. 64 ~. ix. 121-139 Vasicek. 12. 167 Cox-Ingersoll-Ross. 178 Short. 18 ' Stopping time. 13 Partial differential equation numerical solution. 47 Ito processes. 141-160 simulation. 164 Poisson variable. 8 European. 142 gamma. 167 Yield curve. 32 exponential. 20 Strategy. 165 Black-Scholes model. . I admissible. 33 Filtration. 106 on a bounded open set. 133 Zero coupon bond. 116 Mac Millan and Waley. 27. 4 continuous-time. viii Process continuous-time. 75 pricing. 167 Brownian motion. 113 pricing. 43 Law chi -square. 125. 112 Ito calculus. 99 Partial differential inequalities. 163 Gaussian. 167 stochastic differential equations. 8 incomplete. 4 Supermartingale. 12 discrete-time. 68 I Optional sampling theorem. 57 Yield curve. 64. 133 Gamma. 163 Snell envelope.selling.

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