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# ETH Zrich FS 2012

D-MATH Coordinator
Prof. Dr. Martin Schweizer Sebastian Herrmann
Brownian Motion and Stochastic Calculus
Exercise Sheet 11
Please hand in until Monday, May 21, 12:00, in HG G 53-54.
Exercise 11-1
Let W = (W
t
)
t0
be a Brownian motion dened on some ltered probability space (, T, F, P)
satisfying the usual conditions. Moreover, let , > 0.
a) Find a strong solution to the Langevin equation
dX
t
= X
t
dt + dW
t
.
Remark: This SDE describes exponential convergence to zero with noise.
Hint: Consider U
t
= e
t
X
t
.
b) Show that there is a Brownian motion B such that Y := X
2
satises the SDE
dY
t
= (2Y
t
+
2
) dt + 2

Y
t
dB
t
. ()
In other words, show that X
2
is a weak solution of the SDE ().
Exercise 11-2
Let W = (W
t
)
t0
be a Brownian motion dened on some ltered probability space (, T, F, P)
satisfying the usual conditions. Moreover, let > 0 and S = (S
t
)
t0
be the unique strong
solution of the SDE
dS
t
= S
t
dW
t
, S
0
= 1.
The process M = (M
t
)
t0
given by M
t
= sup
0st
S
s
is called running supremum of S. Note
that M is an increasing process whose associated LebesgueStieltjes measure dM() on [0, )
is concentrated on the set D() := t 0 : S
t
() = M
t
(). It can be shown that D() has
Lebesgue measure 0 for P-a.e. . In other words, dM() is singular to the Lebesgue measure
dt for P-a.e. .
Next, for some xed T > 0, we consider the random variable H := M
T
S
T
and dene a
process (V
t
)
t0
by
V
t
= E[H[T
t
].
Using the fact that the pair (S
t
, M
t
)
t0
is a Markov process, one can show that
V
t
= v(t, S
t
, M
t
)
for a suciently smooth function v : R
3
R. The goal of this exercise is to nd a PDE for v,
including domain, terminal and boundary conditions.
a) Apply Its formula to v(t, S
t
, M
t
). Use the dt-term to deduce a PDE for v and argue why
D := (0, T) (x, m) (0, ) (1, ) : x < m is its natural domain.
b) What is the terminal condition for v, i.e., what can you say about v(T, x, m) if x m?
c) What is the boundary condition for v, i.e., what can you say about v(t, x, m) if t (0, T)
and x = m?
Remark: In the language of mathematical nance, S models the discounted price process of some
stock (under a risk-neutral measure), H is the payo of a oating strike lookback put option, and
V is the value process associated to H, i.e., V
t
describes the fair price of the option at time t.
Having deduced a PDE for v with appropriate terminal and boundary conditions, one can use
numerical methods to nd v and thus the fair price V
0
= v(0, 1, 1) of the option at time 0.
Exercise 11-3
Recall that C
0
(R) denotes the space of continuous functions f : R R that vanish at innity.
We call C
2
0
(R) the space of twice continuously dierentiable functions f on R such that f, f

and
f

all belong to C
0
(R). For a, b : R R Lipschitz-continuous, we dene the partial dierential
operator / : C
2
0
(R) C
0
(R) by
/f(x) = a(x)
f
x
(x) +
1
2
b
2
(x)

2
f
x
2
(x), x R.
The goal of this exercise is to link weak solutions of the SDE
dX
t
= a(X
t
) dt +b(X
t
) dW
t
()
to solutions of the martingale problem for (/, C
2
K
(R)) where C
2
K
(R) denotes the subspace of
compactly supported functions in C
2
0
(R).
a) Let X be weak solution to () with initial distribution
{x}
. Show that X is a solution to
the martingale problem for (/, C
2
K
(R)). In other words, show that if (, T, F, Q, W, X)
is a weak solution to () with initial distribution
{x}
, then the process M
f
given by
M
f
t
:= f(X
t
)

t
0
/f(X
s
) ds, t 0, is a (Q, F
X
)-martingale for each f C
2
K
(R).
b) Fix x R and let X, dened on some probability space (, T, P), be a continuous process
which is a solution to the martingale problem for (/, C
2
K
(R)) with X
0
= x. Show that the
process M := X

0
a(X
s
) ds is a continuous local martingale with M =

0
b
2
(X
s
) ds.
Hint: For the rst assertion, use the fact that X is a solution to the martingale problem
for (/, C
2
K
(R)) for sequence of functions in C
2
K
(R) that approximates the identity on R,
and construct a compatible localising sequence (
n
)
nN
for M.
For the second assertion, rst follow the same strategy for the function y y
2
, y R.
Then show that M
2

0
b
2
(X
s
) ds is a continuous local martingale by expressing it as the
sum of continuous local martingales.
c) In the setting of b), assume that b(x) ,= 0 for all x R and construct from X a weak
solution of () with initial distribution
{x}
.
Hint: Consider B :=

0
1
b(X
s
)
dM
s
.
Exercise sheets and further information are also available on:
http://www.math.ethz.ch/education/bachelor/lectures/fs2012/math/bmsc/