Introduction to
I.
Stochastic Calculus
Applied to Finance
Damien Loolberton
L'Universite ffSfarne la Vallee
France
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
LG
~jj(5~3
L3(;/3
'996
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for such copying.
Introduction
Options
Arbitrage and put/call parity
BlackScholes model and its extensions
Contents of the book
Acknowledgements
1
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, and are
used only for identification and explanation, without intent to .infringe,
Discretetime models
1.1 Discretetime 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 supermartingales
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 continuoustime processes
3.2 Brownian motion
3.3 Continuoustime martingales
3.4 Stochastic integral and Ito calculus
3.5 Stochastic differential equations
3.6 Exercises
vii
Vll
Vlll
IX
X
X
1
1
4
8
12
17
17
18
21
22
23
25
29
29
31
32
35
49
56
Contents
vi
63
4.1
4.2
4.3
4.4
4.5
63
65
67
72
77
ModeIling principles
Some classical models
Exercises
Poisson process
Dynamics of the risky asset
Pricing and hedging options
Exercises
Appendix
Al Normal random variables
A2 Conditional expectation
A3 Separation of convex sets
Introduction
95
95
103
110
118
121
121
127
136
161
161 ,
168
170
173'
Options
141
141
143
150
159
173,
174
178
References
179
Index
183
Our presentation concentrates on options, because they have been the main motivation in the construction of the theory and stilI are the most spectacular example of
the relevance of applying stochastic calculus to finance. An option gives its holder
the right, but not the obligation, to buy or seIl a certain amount of a financial asset,
by a certain date, for a certain strike price.
The writer of the option needs to specify:
the type of option: the option to buy is caIled a call while the option to seIl is a
put;
the underlying asset: typicaIly, it can be a stock, a bond, a currency and so on.
viii
Introduction
(ST  K)+
= 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.
Introduction
ix
= St 
K er(Tt).
To understand the notion of arbitrage, let us show how we could make a riskless
profit if, for instance,
c, .; Pt > S,
 K er(Tt).
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.
Introduction
Introduction
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 setup, 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 BlackScholes 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 BlackScholes model and seem to be closer to reality. However, their
mathematical treatment is still a matter of research, in the framework of socalled
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. Theorganisation of this lecture series would not have
Xl
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 jead 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. El Karoui, T. Jeulin, J.E Le Gall and D. Talay.
"
Discretetime models
The objective of this chapter is to present the main ideas related to option theory
within the very simple mathematical framework of discretetime 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 Discretetime formalism
1.1.1 Assets
Discretetime models
if>b is Fomeasurable
ViE{O,I, ... ,d}
Discretetime formalism
Vn(if
{ and, for n ~ 1:
= Vo(if + L
if>~ is F n_ 1measurable.
This assumption means that the positions in the portfolio at time n (if>~, if>~, ... , if>~)
,are decided with respect to the information available at time (n 1) and kept until
time n when new quotations are available.
if>j . !::J.Sj,
j=1
where !::J.Sj is the vector Sj  Sjl = {JjSj  {Jj 1Sjl.
Proof. The equivalence between (i) and (ii) results from Remark 1.1.1. The
equivalence between (i) and (iii) follows from the fact that if>n,Sn = if>n+l,Sn if
and only if
= if>n+l.Sn.
0
s;
Vn(~) =
;s: =
Lif>~S~.
;=0
Vn(if
s:
with'{Jn = 1/ S~ and
= (1, (JnS;, ... , (JnS~) is the v~tor of disco~nted
prices.
A strategy is called selffinancing if the following equation is satisfied for all
nE {O,I, ... ,NI}
if>n,Sn
= if>n+l' S;".
!::J.SJ
Proposition 1.1.3 For any predictable process (( if>~, . . . , if>~))O<n<N and for
any Fomeasurable variable Yo, there exists a unique predictable pr~ce~s (if>~) O<n'<N
such that the strategy ) =' (if>o, if>1, ... , if>d) is selffinancing and its initial valueis Yo.
"
,
Proof. The selffinancing condition implies
The interpretation is the following: at time ~, once the new prices S~~, are
quoted, the investor readjusts his positions from if>n to if>n+l without bringing Q!
consuming any wealth.
~~..:..
Vn(if
if>~+if>~S~+"'+if>~S~~
(1 1 + .... + if>j!::J.S
d d)j .
Vo + ~
L.J if>j!::J.Sj
j=1
which defines if>~. We just have to check that if>0 is predictable, but this is obvious
ITw~"~Ifeequation
or to
Vn+l(if  Vn(if
= if>n+dSn+l
Sn).
At time n +'1, the portfolio is worth if>n+l,Sn+l a~d
,Sn+l  if>n+l,Sn is
the net gain caused by the price changes between times nand n + I:Hence;tI1e
profit or loss realised by following a selffinancing strategy is only due to the price
moves.
The following proposition makes this clear in tenns of discounted prices.
+L
j=1
We did not make any assumption on the sign of the quantities if>~. If if>~ : 0, we
have borrowed the amount 1if>~1 in the riskless asset. If if>~ < for i ~ 1, we say
that we are short a number if>~ of asset i. Shortselling and borrowing is allowed
but the value of our portfolio must be' positive at all times.
Vn(if = Vo(if
II' '
if>j . !::J.Sj,
Discretetime models
The investor must be able to pay back his debts (in riskless or risky asset) at any
time..
The notion of arbitrage (possibility of riskless profit) can be formalised as
follows:
Definition 1.1.5 An arbitrage strategy is an admissible strategy with zero initial
value and nonzero final value.
Definition 1.2.2 An adapted sequence (Hn)05,n5,N of random variables is predictable if, for all n ~ 1, n; is Fn~1 measurable.
Proposition 1.2;3 Let (Mn)05,n5,N be a martingale and (Hn)O<n<N a predictable sequence with respect to the filtration (Fn)O<n<N' Denote 6.Mn =
M n  M n 1. The sequence (Xn)05,n5,N defined by
Xo
Most models exclude any arbitrage opportunity and the objective of the next
section is to characterise these models with the notion of martingale.
Xn
HoMo
HoMo
for n ~ 1
(Xn) is sometimes called the martingale transform of (Mn) by (Hn). A consequence of this proposition and Proposition 1.1.2 is that if the discounted prices of
the assets are martingales, the expected value of the wealth generated by following
a selffinancing strategy is equal to the initial wealth.
Proof. Clearly, (Xn ) is an adapted sequence. Moreover, for n > 0
E (Xn+l  XnlFn)
, E (Hn+lUv/n+l  Mn)IFn)
= Hn+lE (Mn+1  MnlFn) since Hn+l is Fnmeasurable
.;.'
= O.
In this section, we consider a finite probability space (D, F, P), with F = P(D)
and Vw E D, P ({w}) > 0, equipped with a filtration (Fnh~n::;N (without
necessarily assuming that F N = F, nor F o = {0, D}). A sequence '(Xn)O::;n::;N
ofrandom variables is adapted to the filtration!f for any n, X!, is Fnmeasurable.
Definition 1.2.1 An adapted sequence
(Mn)O::;n~N
:S N  1;
:S Mnforallri:S
N 1;
u;
Vj ~ 0
= X n.
o
E (Mn+jIFn) ==
Hence
.,
6. u;) = O.
(t. n;
i~ a ~ar
Therefore E (!'v!j+ 11 F j
u;
~O.
0
Discretetime models
If.the.strategy is
ti.!!J1!l{I
that
n ~ N  1,
() <
P (Gn()
G m()
()) = 0,
2: O.
C!n
if j ~
if j > n
<
(V
(bI) To any admissible process (;" ... , ~) we associate the process defined by
Proof. Let us assume thatG N() E r. First, ifG n() 2: 0 for all n E {O,... , N}
the market is obviously not viable. Second, if the Gn () are not all nonnegative,
{kiP (G
Let us get back to the discretetime models introduced in the first section.
Definition 1.2.5 The market is viable if there is no arbitrage opp0'!!!:Eity.
Lemma'1.2.6 jf the market is viable, any ~ble process (i , ... , d) satis "
fies
we define n = sup
admissi~le and
n
if j > n
if j
0,
thus, G ('ljJ) 2: 0 for all j E {O,... , N} and G N ('ljJ) > 0 on A. That contradicts
j
0
the assumption of market viability and completes the proof of the lemma.
 _/
~:_YYiY.q.le~~he:diSt;ounteJpric.:s._(fl!S~e..~~_P* 
Theorem
1.2.7 .The
market is viable if and onl)' if there existsaprobabil.ity .
.
...."
There~ore.it?oesnoti~tersecttheconvexcompactsetK = {X E fI Ew X(w):::
I} WhICh IS included m r. As a result of the convex sets separation theorem (see
I,
vx
E K,
L oX(w)X(w) > O.
w
martingales.
Vn() =
Vo() +
L j.f:::.Sj.
j=l
(Vn ())
t Recall
that two probability measures P I and P2 are equivalent if and only if for any event
A. PI (A) =
} P2 (A) = 0, Here, P" equivalent to P means that. for any wEn.
p({w}o,
'
oX(w)
Ew' EO oX(w')
is equivalent to P. ,
Moreover, if we denote by E* the expectation under measure P*, Property 2.
means that, for any predictable process (n) in IRd,
Discretetime models
It follows that for all i E {I, ... ,d} and any predictable sequence (~) in JR, we
have
E*
(t ;6.8;)
Theore.~ 1.3.4 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 mar.
tingales.
= O.
The probability P* will appear to be the computing tool whereby we can derive
closedform pricing formulae and hedging strategies.
Proof. (a) Let us assume that the market is viable and complete. Then, any
nonneg~tlve, F N~~asurable random variable h can be written as h
VN (),
where IS an admissible strategy that replicates the contingent claim h. Since
is selffinancing, we know that
J=I
h
SO
+.
(V
=2

assumed to be
(b) Let us assume that the market is viable and incomplete. Then, there exists
a random variable h ~ 0 which is not attainable. We call V the set of random
variables of the form
= E*
(VN()IFn).
Uo +
L n.6.8n,
(1.1)
n=I
claim.
j.6.8j.
j=I
Thus, if PI and P: are two probability measures under which discounted prices
are martingales,
that, for i
1 or i
= VN () = Vo () + L
':
((~'''''~))o<n<N
is an JRdvalued pre
 
It follows fr,?m Proposition 1.1.3 and Remark 1.3.2 that the variable hiSf}y does
not belong to V. Hence, V is a strict subset of the set of all random variables on
(0, F). Therefore, if P* is a probability equivalent to P under which discounted
prices are riJ.~ngales and if we define the following scalar product on the set
of random ~ariables (X, Y) t+ E: (XY), we notice that there exists a nonzero
random vanable X orthogonal to V. We also write
P** ({w})
==
(1 + 211Xlloo
X(w)) P*({w})
.
Discretetime models
10
with II XII"" = sUPwEn IX(w)l. Because E* (X) = 0, that defines a new probability measure equivalent to P and different from P*. Moreover
E**
(t, n.~Sn) =
for any predictable process (( ~, ... , ~)) O::;n::;N It follows from Proposition
0
The sequence
(V
n)
O::;n::;N
model will show how we can compute the option price and the hedging strategy
in practice.
Since an American option can be exercised at any time between 0 and N, we shall
define it as a positive sequence (Zn) adapted to (.1'n), 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, Zn
(S~  K) +; in the case of the put,
Zn = (K  S~) t' In order to define the price of the option associated with
(Zn)O::;n::;N, we shall think in terms of a backward induction starting at time N.
Indeed, the value of the option at maturity is obviously equal to UN = Z N. At
what price should we sell the option at time N ., I? If the holder exercises straight
away he will earn Z N 1, or he might exercise at time N in which case the writer
must be ready to pay the amount ZN. Therefore, at time N  1, the writer has
to earn the maximum between Z N 1' and the amount necessary at time N  1 to
generate ZN at time N. In other words, the writer wants the maximum between
Z N 1 and the value at time N  1 of an admissible strategy paying off Z N at time
UN I
that is Vo()
= S~E* ( ;
.
_ Un I =
l.1'n ) ,
S~ =
At any time, the value of an admissible strategy replicating h is completely determined by h. 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 . If, at
time 0, an investor sells the option for'
and
E.* (:~),
let
1) )
If we assume that the interest rate over one period is constant and equal to r,
to
''
Vn ( )
11
Un I
ii;
(1 + r)"
is a P* supermartingale. It is the
.
O<n<N
smallest P* supermartingale that domin~te~ the sequence (Zn)
'.:
.
O<n<N
We should note that, as opposed to the European case, the discounted price of
the American option is generally not a martingale underP".
Proof. From the equality
.,
Un I
= max ( ZnI, E*
(Un l.1'nl ) ) ,
12
Discretetime models
13
3. Give examples of arbitrage strategies if the noarbitrage condition derived in
Question (2.) is not satisfied.
'
Assume for instance that r :S a. By borrowingan amount So at time 0, we can purchase
one share of the risky asset. At time N, we pay the loan back and sell the risky
asset. We realised a profit equal to SN  So(1 + r)N which is always positive, since
SN 2: So(1 + a)N. Moreover, it is strictly positive with nonzero probability. There is
arbitrage opportunity. If r 2: b w,e can make a riskless profit by shortselling the risky
asset.
= UnI'
o
Sn(l+a)
Sn+l = { Sn(1 + b).
n=
The initial stock price So is given. The set of possible states is then
{I +
a, 1 + b}N, Each N tuple represents the successive values of the ratio Sn+d Sn,
n
0,1,
, N  1. We also assume that.1'o
{0, n} and .1' pen). For
n
1,
, N, the aalgebra .1'n is equal to a(SI"'" Sn) generated by the
random variables SI ,... ,Sn. The assumption that each singleton in has a strictly
positive probability implies that P is defined uniquely up to equivalence. We now
,N. If (XI, ... ,XN) is
introduce the variables Tn = Sn/SnI, for n = 1,
one element of n, P{(XI, ... , XN)}
P(TI Xl,
,TN XN). As a result,
knowing P is equivalent to knowing the law of the N tuple (T I, T2 ;' ... , TN). We'
also remark that for n 2: 1,.1'n = a(TI, ... ,Tn).
=
=
1. Show that the discounted price (Sn) is a martingale under P if and only if
s:
E*(Tn+IIFn)
=1+r
+ a)E (1{T n + 1 = l+ a } IF n )
Then, the following equality
E(1{Tn+
n)
1=l+a}IF
+E
(1{Tn+ 1=1+b}IFn)
= 1,:
= =
x;,)
1. p. By
= II Pi
i=l
C;  Pn
= Sn 
K(1
+ r)(Nn),
len 
Pn
=
=
=
"
14
Discretetime models
the last equality comes from the fact that (Sn) is a P" martingale.
(b), Show that we can write en = c(n, Sn) where c is a function of K, a; b, r
andp.
When we write SN = S n::n+l Ti, we get
c; = (1 + r)(Nn)E"
((Sn
,IT K) :
t: 
.=n+l
and their mean is equal to J.LN, with limN400(N J.LN) = J.L. Show that the
sequence (YN ) converges in law towards a Gaussian variable with mean J.L
and variance a 2
Fn).
Wejust need to study the con,:ergenceof the characteristic function tPYN of YN. We
obtain
= E(exp(iuYN =
tPYN(U)
(x
Nn
""'
= (E (exP(iuXf)t
IT K)
,r
t: 
i=n+l
(N  n).! .
L.J (NnJ)!J!
"
rl (1 _ p)Nn i
(x(I
+ a)i (1 + b)Nn i
K) .
i=O
H~(I
'Since H~ and H; are Fn_1measurable, they are functions of Sv,. . . ,Snl only and,
since
is equal to Snl (l + a) or Snl (1 + b), the previous equality implies
s:
H~(l
and
+ b.
pJN)
(a) Let
(YN )N~l
YN=xi'+xf+'''+x~
(1 + RT/N)N'E"
E",((l
(K':'" ~o IT Tn)
+ RT/N)N K
 So exp(YN) +
Xf"
E"(XiN ) = (1 _ 2p)~ =
trlVN
trlVN
 e
 e
~.
VN
etrl VN  e trl VN VN
Therefore, the sequence (YN) satisfies the conditions of Question 7.(a), with J1.
2
_a /2. If we write 'Ij;(y) = (Ke R T  Soe Y)+, we are able to write
IPJN)
E" ('Ij;(YN
< K
RT
I'
n=l
c(n,x(I+bc(n,x(I+a
x(b _ a)
:
, 7. We can now use the model to price a call or a put with maturity T on a single
stock. In order to do that, we study the asymptotic case when N converges
RT/N, log((l + a)j(l + r))
ajVN and log((l +
to 'infinity, and r
b)j(l + r)) ajVN. The real number R is interpreted as the instantaneous
rate at al1 times between 0 and T, because e RT
limN4oo(1 + r)N. a 2 can
be seen as the limit variance, under measure P", of the variable log(SN), when
N converges to infinity.
, '
(1 + iUJ1.N  a 2 u 2 / 2N + a(I/N) N.
= exp (iuJ1.  a 2 u 2 /2), which proves the convergence
(b) Give explicitly the asymptotic prices of the put and the call at time O.
For a certain N, the put price at time 0 is given by
IIE (exp(iuXf")
i=l
c(n, x)
(l +r)(Nn)
E"
{ajVN, ajVN},
Since under the probability P", the random variable n::n+l T, is independent of
F and since S is Fnmeasurable, Proposition A.2.5 in the Appendix allows us to
write: C = c( n, Sn), where c is the function defined by
15
So exp(YN) +
Soexp(yN)+)1
1(1 + RT/N)N _
eRTI.
Since 'Ij; is a bounded t, continuous function and because the sequence (YN) converges in law, we conclude that
I'm p'(N)
N~oo
N .....oo
t It is precisely to be able to work with a bounded function that we studied the put first.
Discretetime models
16
_1_1+
.j21i
00
(KeRT _ Soeu2/2+UY)+ey2/2dy .
00
F(d)
_1_1
.j21i
e,,2/ 2dx .
00
= SoF(d
1) 
Remark 1.4.1 We note that the only nondirectly observable parameter is .a .. Its
interpretation as a variance suggests that it should be estimated by statistical
methods. However, we shall tackle this question in Chapter 4.
Notes: We have assumed throughout this chapter that the risky assets were not
offering any dividend. Actually, Huang and Litzenbe~ger (19~8) a~p.ly the same
ideas to answer the same questions when the stock IS carrying dIvId.en~s. 1?e
theorem of characterisation of complete markets can also be proved WIth infinite
probability spaces (cf. Da1ang, Morton and Willinger (1990) and ~orton (1989)).
In continuous time, the problem is much more tricky (cf. Hamson and Kreps
(1979), Stricker (1990) and Delbaen and Schachermayer (~994)). Th~ theory of
complete markets in continuoustime was developed by H~rns~n and Ph~ka .( 198.1,
1983). An elementary presentation of the CoxRossRubmstem model IS given m
the book by I.e. Cox and M. Rubinstein (1985).
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. To do so, we will need to define the notion of optimal stopping time,
which will enable us to model exercise strategies for American options. We will
also define the Snell envelope", which is the fundamental concept used to solve. the
optimal stopping problem. The application of these concepts to American options
will be described in Section 2.5.
2.1 Stopping time
The buyer of an American option can exercise its right at any time until maturity.
The decision to exercise or not at time n will be made according to the information available at time n. In a discretetime model built on a finite filtered space
(S1, F, (Fn)O:::;n:::;N , P), the exercise date is described by a random variable called
stopping time.
Definition 2.1.1 A random variable IJ taking values in {O,1,2, ... , N} i~'a stopping time if, for any nE {O, 1", . ,N},
{IJ = n} E
(
F~.
Remark 2.'1.3 The reader can verify, as an exercise; that IJ is a stopping time if
and only if, for any n E {O, 1, ... ,Nt
{IJ :::; n} E F n .
We will use this equivalent definition to generalise the concept of stopping time
to the continuoustime setting.
.
18
Let us introduce now the concept of a 'sequence stopped at a stopping time'. Let
(Xn)O<n<N be a sequence adapted to the filtration (Fn)O<n<N and let v be a
stopping time. The sequence stopped at time v is defined as X~
if j
if j
and for k
r;
U:;o = Un/\vo ==
1, we have
= x, + L
IS
Xv/\n
n/\vo O<n<N
> n.
(2.1)
. l
a martmga e.
Proof. Since UN = ZN, Vo is a welldefined element of {O 1
N} and
have
' , ... , .
we
Vo
.
19
X
X~ = { X
>j
ix, 
X j 1),
u
n+l  u = . .>n+l (Un+. 1  Un)
= l{n+l5.vo} (Un+l  Un).
j=1
U vo
n+l 
uvo
n =
+ 1 ~ VO}, U; >
1
.
{n+l5.vo} (Un+l  E (Un+lIFn))
n}).
U~o)
+ 1 ~ vol
IFn)
0 
Hence
{n, n + 1.'... , N}. Nonce that Tn,N is a finite set since f! is assumed to be finite.
ZN
max (Zn, E'(Un+lIFn))
= 0,
"In ~ N:"1.
The study of this sequence is motivated by our first approachof American options
(Section 1.3.3 of Chapter 1). We already know, by Proposition 1.3.6 of Chapter
1, that (Un)O<n<N is the smallest supermartingale that dominates the sequence
(Zn)O<n<N. W;call it the Snell envelope of the sequence (Zn)O<n<N.
By definition, Ui; is greater than Zn (with equality for n =,N) a;din the case of
a strict inequality, Un = E(Un+lIFn). It suggests that, by stopping adequately the
sequence (Un), it is possible to obtain a martingale, as the following proposition
shows.
The martingale property of the sequence U' gives the following result which
relates the concept of Snell envelope to the optimal stopping problem.
Corollary 2.2.2 The stopping time Vo satisfies
vETo.N
If we. think ~f Zn as the total winnings of a gambler after n games, we see that
stopping ~t tlmevvo. maximises the expected gain given F o.
Proof. Since U IS a martingale, we have
20
Uo
which yields the result.
u;
sup E (ZIII.rn)
liE/noN
E (ZlIn
l.rn) ,
Proof. If the stopped sequence U" is a martingale, Uo = E(UIII.ro) and consequently, if (2.2) holds, Uo = E(ZIII.ro). Optimality of 1/ is then ensured by
Corollary 2.2.2.
Conversely, if 1/ is optimal, we have
Uo
= E (ZIII.ro)
= E (Un+ll.rn) 
Un
and
S E (UIII.ro) .
_{Ninf in,. A
1/_ 
n+1 =I O}
if AN = 0
if AN =I O.
Proof. It is straightforward to see that I/m", is a stopping time using the fact that
\A n)o5,n5,N is predictable. From Un = M n  An and because Aj = 0, for
J S ~, we deduce that U"fn", = M"fnu and conclude that U"fn", is a martingale. To
show the optimality of !{n'"" it is sufficient to prove
Therefore
E (UIII.ro) = E (ZIII.ro)
and since UII ~ ZII' UII = ZII'
Since E (UIII.ro) = Uo and from the following inequalities
U"fn'" =Z"fn""
Uo ~ E (UlIl\nl.fo) ~ E (U1I1l"0)
We note that
.
,
(based on the supermartingale property of (U~) we get
Nl
= E (UIII.ro) = E (E (UIII.rn)l.ro).
 (A n+1  An)
E (UlIl\nl.ro)
= 0 is M o = Uo and A o = O.
~A..
Io,N
ZII = UII
{ and (UlIl\n)05,n5,N is a martingale.
21
1{"fn",";N}UN
j=O
Nl
L: 1{"fnu
j=O
=j}
1{"fnu=N}ZN,
22
I
I,
of the sequence (Zn) is given by Un = u(n, X n), where the function u is defined
by
u(N, x) = 'ljJ(N, x) '<Ix E E
and,for n :s N  I,
u(n,')
E(Uv)
= E(Mv) 
E(A v)
= E(Uo) 
23
From now on, we will work in a viable complete market. The modelling will be
(fl,
, UN
{ Un
P(Xn+l
does not depend on n. The matrix P = (P(x, y))(X,Y)EEXE' Indexed byE x .E,
is then called the transition matrix of the chain. The matrix P has nonnegative
, entries and satisfies: LYEE P(x, y) = 1 for all x E' E; itis said to be a stochastic
matrix. On a filtered probability space ( n, F, (F";)O:::;n~N ,P), we can define tlie
notion of a Markov chain with respect to the filtration:
column indexed by E, then P f is indeed the product of the two matrices P and
f. It can also be easily seen that a Markov chain, as defined at the beginning
of the section, is a Markov chain with respect to.its natural filtration, definedby
F n = a(Xo, ... ,Xn ) . '
. C
The following proposition is an immediate consequence of the latter definition
and the definition of a Snell envelope.
'
Proposition 2.4.2 Let (Zn) be an adapted sequence defined by Zn = 'ljJ(n, X n),
where (X n) is a homogeneous Markov chain with transition matrix P, taking
values in E, and ib is afunctionfrom N x E to JR. Then, the Snell envelope (Un)
ZN
'<In:S N1.
Thus, the sequence CUn) 'defined by ii; = Un/ S~ (discounted price of the option)
is,the Snell envelope, under P*, of the sequence (Zn). We deduce from the above
Section 2.2 that .
'
ii; = sup' E* ( ZvlFn)
vETn.N
and consequently
u; = S~
=
=
sup E*
vETn.N
(SZ~v IFn) .
ii; = Mn 
An,
VN
() =
()) is a P* martingale,
E* (VN()!Fn )
E* (MNIFn )
w~ have
24
Therefore
Un = Vn(cP)  An,
where An = S~ An. From the previous equality, it is obvious that the writer of the
option can hedge himself perfectly: once he receives the premium Uo = Vo(cP),
he can generate a wealth equal to Vn(cP) at time n which is bigger than Un and a
fortiori Zn.
What is the optimal date to exercise the option? The date of exercise is to be
chosen among all the stopping times. For the buyer of the option, there is no point
in exercising at time n when U > Zn, because he would trade an asset worth Un
(the option) for an amount Zn, (by exercising the option). Thus an optimal date T
of exercise is such that UT ~ ZT' On the other hand, there is no point in exercising
after the time
/I"", = inf {j, A j +! i O}
(which is equal to inf
{j,
Aj +! i 0})
eF
'
Proposition 2.5.1 Let Cn be the value at time n ofan American option described
by an adapted sequence (Zn)O<n<N and let Cn be the value at time n of the European option defined by the F Nmeasurable random variable h = Z N. Then,
we have Cn ~ Cn.
Moreover, if Cn ~ Zn for any n, then
Cn
=C n
The inequality Cn ~ Cn makes sense since the American option entitles the holder
'.
to more rights than its European counterpart. c..
Proof. For the discounted value
Cn
(C
n)
Cn~C;'
o
Remark 2.5.2 One checks readily that if the relationships of Proposition 2.5.1
did not hold, there would be some arbitrage opportunities by trading the options.
To illustrate the last proposition, let us consider the case of a market with a
single risky asset, with price Sn at time n and a constant riskless interest rate,
equal to r ~ 0 on each period, so that S~ = (I + r)". Then, with notations of
Proposition 2.5.1, if we take Zn = (Sn  K)+, Cn 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. We have
cn
provides the holder with a wealth UJ.iruu = VJ.iruu (cP) and, following the strategy
cP from that time, he creates a portfolio whose value is strictly bigger than the
.option's at times /1m.. + I, /1max + 2, ... , N. Therefore we set; as a second condition,
T :::; /I""" which allows us to say that
is a martingale. As..a result, optimal dates
of exercise are optimal stopping times for the sequence (Zn), under probability
p ". To make this point clear, let us considerthe writer's point of view. If he hedges
himself using the strategy cP as defined above and if the buyer exercises at time T
which is not optimal, then UT > ZT or AT > O. In both cases, the writer makes a
profit VT(cP)  ZT = UT + AT  Zro which is positive.
c, ~ Cn.
25
If Cn ~ Zn for any n then the sequence (cn), which is a martingale under P",
appears to be a supermartingale (under P") and an upper bound of the sequence
(Zn) and consequently
and consequently
Hence
Exercises
N
SnK(I+r)
,
s; 
E(XIFv) =
L
j=O
l{v=j}E(XIFj).
26
2: v, Show that:Fv
Fr.
= N.)
Exercise 2 Let (Un) be the Snell envelope of an adapted sequence (Zn). Without
assuming that :Fo is trivial, show that
E (Uo) = sup E (Zv) ,
vETo,N
vETn,N
Exercise 4 The purpose of this exercise is to study the American put in the model
of CoxRossRubinstein. Notations are those of Chapter 1.
1. Show that the price P n, at time n, of an American put on a share with maturity
N and strike price K can be written as
P n= Pam(n, Sn)
= (K 
27
6. Show that the hedging strategy of the American put is determined by a quantity
H n = ~(n, Snd of the risky asset to be held at time n, where ~ can be
written as a function of Pam.
n+1,Sn
Exercises
= n,Sn 
1'n+l.
(2.3)
s;:
f(n+1,x))
1+r , '
(K  x)+.
5. An agent holds the American put at time 0. For which values of the spot So
would he rather exercise his option immediately?
Vn ( ) = Vo() + L
j=l
j.~Sj  L 1'j.
j=l
j=l
2. In the remainder, 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. Show that if the pair (, 1') defines a trading strategy with
consumption, then (V~()) is a supermartingale under P".
3. Let (Un) be an adapted sequence such that (Un) is a supermartingale under
P". Using the Doob decomposition, show that there is a trading strategy with
consumption (,1') such that Vn ( ) = Un for any n E {O,... , N}.
4. Let (Zn) be an adapted sequence. We say that a trading strategy with consumption (, 1') hedges the American option defined by (Zn) if Vn () 2: Zn for
any n E {O,1, .. '. , N}. Show that there is at least one trading strategy with
consumption that hedges (Zn), whose value is precisely the value (Un) of the
American option. Also, prove that any trading strategy with consumption (, 1')
hedging (Zn) satisfies Vn() 2: Un, for any n E {O,1, ... , N}. '
28
equations
The first two chapters of this book were dealing with discretetime models. We
had the opportunity to see the importance of the concepts of martingales, selffinancing strategy and Snell envelope. We are going to elaborate on these ideas in
a continuoustime framework. In particular, we shall introduce the mathematical
tools needed to model financial assets and to price options. In continuoustime,
the technical aspects are more advanced and more difficult to handle than in
discretetime, but the main ideas are fundamentally the same.
Why do we consider continuoustime models? The primary motivation comes
from the nature of the processes that we want to model. In practice, the price
changes in the market are actually so frequent that a discretetime model can
barely follow the moves. On the other hand, continuoustime models lead to more
explicit computations, even if numerical methods are sometimes required. Indeed,
the most widely used model is the continuoustime BlackScholes model which
leads to an extremely simple formula. As we mentioned in the Introduction, the
connections between stochastic processes and finance are not recent. Bachelier
(1900), in his dissertation called Theorie de la speculation, is not only among
the first to look at the properties of Brownian motion, but he also derived optjon
pricing formulae.
We will be giving a few mathematical definitions in order to understand
continuoustime models. In particular, we shall define the Brownian motion since
it is the core concept orthe BlackScholes model and appears in most financial
asset models. Then we shall state the concept of martingale in a continuoustime
setup and, finally, we shall construct the stochastic integral and introduce the
differential calculus associated with it, namely the Ito calculus.
It is advisable that, upon first reading, the reader passes over the proofs in small
print. as theyare very technical.
3.1 General comments on continuoustime processes
What do we exactly mean by continuoustime processes?
30
31
Brownian motion
Remark 3.1.2
This r7algebra represents the information available before the random time r. One
can prove that (refer to Exercises 8, 9, 10, 11 and 14):
F = {A
T
A, for any t
~ 0 ,A
n {r
t} E Ftl .
Proposition 3.1.6
E.
We will only work with processes that are indexed on a finite time interval
[O,T].
~ T
Definition 3.1.3 Consider the probability space (n, A, P), a filtration (Ft)t>o is
an increasing family of aalgebras included in A
The oalgebra F t represents the information available at time t. We say that a
process (Xtk:~o is adapted to (Ftk~o, if for any t, X, is Ftmeasurable.
Remark 3.1.4 From now on, we will be working with filtrations which have the
following property
If A E A and if P(A)
In other words F t contains all the Pnull sets of A. The importance of this technical
assumption is that if X = Y P a.s. and Y is Ftmeasurable then we can show
that X is also Ftmeasurable.
We can build a filtration generated by a process (Xt)t>o and we write F t =
r7(X s , S ~ t). In general, this filtration does not satisfy the previous condition.
However, if we replace F t by :Ft which is the oalgebra generated by both F t
and N (the oalgebra generated by all the Pnull sets of A), we obtain a proper
filtration satisfying the desired condition. We call it the natural filtration of the
process (Xth~o. When we talk about a filtration without mentioning anything, it
is assumed that we are dealing with the natural filtration of the process that we are
considering. Obviously, a process is adapted to its natural filtration.
As in discretetime, the concept of stopping time will be useful. A stopping time
. is a random time that depends on the underlying process in a non anticipative
way. In other words, at a 'given time t, we know if the stopping time is smaller than
t. Formally, the definition is the following:
.
X, (w) is continuous.
independent increments: If S ~ t, X,  X s is independent ofF s = r7(Xu , U ~
S It
s).
stationary increments: if'S ~ t, X,  X; and X t  s  X o have the same
probability law.
This definition induces the distribution of the process X t , but the result is difficult
to prove and the reader ought to consult the book by Gihman and Skorohod (1980)
for a proof of the following theorem.
'
E(Xd
= 0,
(Xi) = t.
(X
2)
1
exp

V2ii
dx
2t'
32
The following theorem emphasises the Gaussian property of the Brownian motion.
We have just seen that for any t, X, is a normal random variable. A stronger result
is the following:
Theorem 3.2.4 If (Xdt?o is a Brownian motion and if 0 ~
(Xt1, ... , X t n ) is a Gaussian vector.
then
The reader ought to consult the Appendix, page 173, to recall some properties of
Gaussian vectors.
Proof. Consider 0 ~ tl < ... < t. then the random vector (X t1, X t2 X t1, ... , X t n  X tn_1) is composed of normal, independent random variables
(by Theorem 3.2.2 and by definition of the Brownian motion). Therefore, this
vector is Gaussian and so is (Xt1, ... ,Xt n ) .
0
We shall also need a definition of a Brownian motion with respect to a filtration
(Ft ) .
Definition 3.2.5 A realvalued continuous stochastic process is an (Ft)Brownian
motion if it satisfies: '
For any t
2:
33
Continuoustime martingales
E ((X t  X s)2
+ 2X s(Xt 
E ((X t  Xs)2IFs)
Xs)IFs)
+ 2X sE (Xt 
XsIFs) ,
Because the Brownian motion has independent and stationary increments, it follows that
E ((X t  X s)2JFs ) = E (X'ts)
t  s.
The last equality is due to the fact that X, has a normal distribution with mean
zero and variance t. That yields E (Xl  tlFs ) = X;  s, if s < t.
Finally, let us recall that if 9 is a standard normal random variable, we know
0, X, is Ftmeasurable.
Ifs ~ t, X t  Xs.isindependimtoftheaalgebraFs.
If s ~ t, X t  X; and X t s  X o have the same law.
that
Remark 3.2.6 The first point of this definition shows that a(X u , u ~ t) eFt.
Moreover, it is easy to check that an FtBrownianmotion is also a Brownian
motion with respect to its natural filtration.
E (eX9)
On the other hand, if s
<t
E (eO'(X'X')IFs)
E (e0'9vr=s)
exp
u;
2: Ms.
Remark 3.3.2 It follows from this definition that, if (Mt)t>o is a martingale, then
E(Md = E(Mo) for any t.
.Here are some examples of martingales.
Proposition 3.3.3 If(Xt}t?o is a standard FrBrownian motion:
I. X, is an Ftmartingale.
2.
Xl 
t is an Fimartingale.
E (eO'(X'X'))
E (eO'x,,)
(~a2(t  S))
o
34
Theorem 3.3.4 (optional sampling theorem) If (M t )r2.o is a continuous martingale with respect to the filtration (Ft)t>o, and if 71 and 72 are two stopping
times such that 71 ~ 72 ~ K, where K is a finite real number, then M T 2 is
integrable and
By letting a converge to 0, we show that P(Ta < +00) = 1 (which means that
the Brownian motion reaches the level a almost surely). Also
The case a
Remark 3.3.5
Ta
This result implies that if 7 is a bounded stopping time then E(MT ) = E(Mo )
(apply the theorem with 71 = 0,72 = 7 and take the expectation on both sides).
If M, is a submartingale, the same theorem is true if we replace the previous
equality by
.
We shall now apply that result to study the properties of the hitting time of a point
by a Brownian motion.
Proposition 3.3.6 Once again, we consider (Xt)t>o an FtBrownian motion. If
a is a real number, we call T a = inf {s 2: 0, X, = ~} or +00 if that set is empty.
Then, T a is a stopping time, finite almost surely, and its distribution ischaracterised by its Laplace transform
o
The optional sampling theorem is also very useful to compute expectations
involving the running maximum of a martingale. If M, is a square integrable
martingale, we can show that the secondorder moment of sUPo9:S: T IMti can be
bounded. This is known as the Doob inequality.
Theorem 3.3.7 (Doob inequality) If(M t)o9:S:T is a continuous martingale, we
have
E ( sup IMtl2)
~ 4E(IMT I2).
9:S:T
The proof of this theorem is the purpose of Exercise 13.
,.'l
35
Ito calculus
s>
That last set belongs to F t , and therefore the result is'proved. In the following, we
write x 1\ y = inf(x, y).
Let us apply the sampling theorem to the martingale M; = exp (aX t  (a 2 / 2)t ).
We cannot apply the theorem to T a which is not necessarily bounded; however, if
n is a positive integer, T a 1\ n is a bounded stopping time (see Proposition 3.1.6),
and from the optional sampling theorem
E (MTa/\n) = 1.
On the one hand MTa/\n = exp (aXTa/\n  a 2 (Ta 1\ n)/2) ~ exp (aa). On
the other hand, if T a < +00, limnHoo MTa/\n = M Ta and if T a = +00,
X, ~ a at any t, therefore limnHoo MTai\n = O. Lebesgue theorem implies that
E(I{Ta<+oo}MTJ = 1, i.e. since X Ta = a when T~< +00
E (I{Ta<+oo} exp ( 
~2 T a ) ) =e: u a .
YO +
L H (5
j
j 
5j 
1) .
j=l
r
t
r
t
dX
io f(s)dX. = io f(s) ds' ds.
Nevertheless, we are able to define this type of integral with respect to a Brownian
36
motion, and we shall call them stochastic integrals. That is the whole purpose of
this section.
37
if it can be written as
Ht(w) = ~::>t>i(w)lJt'_l,t.j(t)
i=l
where 0 = to < t 1 < ... < t p = T and r/>i is F t._ 1 measurableand bounded.
Then, by definition, the stochastic integral of a simple process H is the continuous
process (I(H)t)O~t~T defined for any t E '~k, tk+d as
c
I(H)t
r/>i(Wt  Wt._J
+ r/>k+dWt 
Also, if io
W tk)
r/>i(Wt.f\t  Wt._1f\t),
l~i~p
which proves the continuity oft t+ I(Hk We shall write f~ HsdWs for I(Hk
The following proposition is fundamental.
Proposition 3.4.2
(f~ HsdWs)
E ( ([
If(Ht)o~t~T
09~T
(3.1)
Xid(Xj  Xjd)
i=l j=l
1~i9
I(H)t
E(r/>:(XiXiiY)
is a simple process:
is a continuous Ftmartingale.
E(E(r/>:(Xi:Xid
219iI))
E (r/>:E((X i  Xi.d219i~I))
as a result
E ( (Xi ~ X i  i) 219iI) = E ((Wt  Wti_l )2) = t;  ti1.
(3.2)
(I
1;
t~O
IJ\
38
iT H.dW.
HsdWs
I
39
A proof of this result can be found in Karatzas and Shreve (1988) (page 134,
problem 2.5).
If H E Hand (Hn)n?o is a sequence of simple processes converging to H in
the previous sense, we have
rI
t
HsdWs
Now that we have defined the stochastic integral for simple processes and stated
some of its properties, we are going to extend the concept to a larger class of
adapted processes H
H = { (H t)05,t5,T,
(Ft}~?o 
adapted process, E
(I
T
H;dS)
< +00} .
thus, the series whose general term is I(HcP(n+l))  I(HcP(n)) is uniformly convergent, almost surely. Consequently I(HcP(n))t converges towards a continuous
function which will be, by definition, the map t t+ J(H}t. Taking the limit in
(3.6), we obtain
s T, E (J(H);) = E (I
a~ t
. (3.7)
if both
That implies that (J(H)t}O<t<T does not depend on the approximating sequence.
On the other hand, (J(H)SO~t5,T is a martingale, indeed
.
P a.s.
t
T, J(H)t = I(Hk
H;dS).
We denote,for HE H,
H.dW.
Moreover, for any t, lim n + + oo I(Hn)t = J(H}t in L 2(HiP) norm and, because
the conditional expectation is continuous in L 2 (n, P), we can conclude.
= J(H}t.
From (3.7) and from the fact that E(I(Hnm = E (JoT IH';I. dS} it follows that E(J(H);)
E(SUPt5,T I(Hnm
r]
HsdWs =
T
l{s5,T}HsdWs'
Proof.
(3.5)
We shall use the fact that if (H s)s5,T is in,H, there. exists a sequence
(H';) s5,T of simple processes such that '
,
lim E (iT IHs
n++oo
H';1 dS) = O.
= E (JoT IHs l2 dS). In the same way, from (3.7) arid since
~ 4E
(JOT
The uniqueness of the extension results from the fact that the set of simple
processes is dense in H. :
We now prove (3.5). First of all, we notice that (3.3) is still true if H E H.
This is justified by the fact that the simple processes are dense in H and by
(3.7). We first consider stopping times of the form T = L:1<i<n ti1A" where
o < tl < ... < t n = T and the Ai'S are disjoint and F t ; measurable, and we
prove (3.5) in that case. First
40
JoT l{s>T}HsdWs
L
lA;
l:Si:Sn
1 u.sw, 1
T
HsdWs,
t,
41
O<t<T
 
is not
L i l A . l{s>qHsdWs
l<i<n a
 
T '
.
T
11{s:ST}HSdW. 11{s:STn}HsdWs
2)
= E
(T
)
11{T<s:STn}H;dS .
Proof. It is easy to deduce from the extension property and from the continuity
property that if H E 1t then P a.s. Vt ~ T, J(H)t = J(Hk
Let H E ic. and define t; = inf {O ~ s ~ T, J; H~du 2: n} (+00 if that set
is empty), and H;' = H, l{s:STn}'
Firstly, we show that Tn is a stopping time. Since {Tn ~ t} =
H~du 2: n},
U6
it
H;'dWs
it
l{s:STn}H;,+ldWs,
l:
il
= {(Hs)o:SS:ST
(Fth~o 
< +00 P
Vt ~ T
(SUPt:STIJ(H)tl2:~) <
J(H)t = J(Hnk
a.s. } .
liN}
).
42
(~~~ IJ(H)tl ~ E)
< P
(iT H;ds
+4/E 2E
< P
(iT
H~ds ~ ~ )
W?
= 2 f~ W. dW
s
is a martingale (because E
TN
}ds)
= 2 f~ f (s )j(s )ds =
~ ~)
(1: H; I {.5:.
43
4
N E2 '
f~ W. dW.
where
X o is Fomeasurable.
(Kt)05,t5,T and (Ht)095,T are Feadapted processes.
f: IK.lds
T
2ds
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.
fo IH.1
We can prove the following proposition (see Exercise 16) which underlines the
of the
previous decomposition.
uniqueness
;J
,
Summary:
Proposition 3.4.9
< +00
(SUp
05,t5:.T
(t
Jo
T
M t = i t K..ds, with P a.s.i IK.lds
< +00,
then
P a.s. 'lit
T,
u,
= O.
H.dW.)
2) < +00.
x,
then
= X o + i t K.ds
0:
'
X o = x;
dP a.s.
H.
H.dW. =' Xb
Jo
= ti;
rK~ds + rH~dW.
Jo
ds x dP a.e.
K.
Jo
= K;
ds x dPa.e.
+ f~ H.dW.,
then
We shall state Ito formula for continuous martingales. The interested reader should
refer to Bouleau (1988) for an elementary proof in the Brownian case, i.e. when
(Wd is a standard Brownian motion, or to Karatzas and Shreve (1988) for a
complete proof.
44
x,
= X o + i t Ksds
+ i t HsdWs,
P a.s.
,
It
+ i t f'(Xs)dX s + ~ i t j"(Xs)d(X,X)s
f(X t) = f(X o)
,~
I
it
Ii
it
log(St) = log(So)
Wt
Since E
(J; W
2
s ds )
..:..
r
+ '2
'1
a WsdW s
+ it
1)
2
Ss
a 2S;ds .
+ i t adWt,
+ (J.L 2/2)
a 2/2) t
+ aWt.
+ aWt)
f(t,x)=xoexp((J.La 2/2)t+ax).
St
f(t, Wd
f(O, W o)
it
f:(s, Ws)ds
io 2ds.
t
t = 2 i WsdWs'
t is a martingale.
(3.8)
+ adWt),
So
= xo
.
it.
St = Xo + a SsJ.Lds
it
+ a
SsadWs"
Remark 3.4.11 We could have obtained the same result (exercise) by applying
Ito formula to St = (Zd, with Zt = (J.La 2 /2)t+aWt (which is an Ito process)
and (x) =nxo exp(x).
2 a
(J.L  a 2/2) dt
as,
+ l i t
dS
_s
=2
a Ss
Yt = log(St) = log(So)
Taking that into account, it seems that
roJ
St = Xo exp ((J.L  a
+ i t f~(s,Xs)dXs + ~ i t f~lx(S:Xs)d(X.,X)s.
Wt
and finally
+ i t f:(s, Xs)ds
+ i t J.LSsds + i t aSsdWs.
Xo
II
f(O, X o)
s, =
tf
= iat H;ds,.
'it
45
(3.9)
We are actually looking for an adapted process (St)t~O such that the integrals
We have just proved the existence of a solution to equation (3.8). We are about to
prove its uniqueness. To do that, we shall use the integration by parts formula.
46
Proposition 3.4.12 (integration by parts formula) Let X, and Yi be two Ito processes, x, = X o + J; K.ds + J; H.dW. and Yi = Yo + J; K~ds + J; H~dW.
Then
XtYi = XoYo +
X.dY.
(X, Z)t =
Y.dX.
+ (X, Y)t
Therefore
d(XtZt)
I H.H~ds.
(X, Y)t
Proof. By
(X t + Yi)2 =
(Xo + YO)2
+2J;(X.
+ J;(H.
+ Y.)d(X. + Y.)
+ H~)2ds'
Theorem 3.4.13 If we consider two real numbers a, J.L and a Brownian motion
(Wth>o and a strictly positive constant T, there exists a unique Ito process
(SdO;:::;T which satisfies,for any t ~ T,
xg + 2 J; X.dX. + J; H;ds
Yo
r
rt ,2
+ 2 Jo
Y.dY. + Jo H. ds.
t
s, =
By subtracting equalities 2 and 3 from the first one, it turns out that
XtYi = XoYo +
t
X.dY.
t
Y"dX.
I H.H~ds.
+ aW t)
~~
+ a 2 and a'
Zt
=1+
+ a'Wt)
t
S. (J.Lds
+ adW.).
'0
We now have the tools to show that equation (3.8) has a unique solution. Recall
th~
,
Xo
X tZt{(J.L+a 2)dtadWt)
XtZt (J.Ldt + adWd  X tZta 2dt = o.
Ito formula
, Zt =
47
and the
Remark 3.4.14
The process St that we just studied will model the evolution of a stock price in
the BlackScholes model.
When J.L = 0, St is actually a martingale (see Proposition 3.3.3) called the
exponential martingale of Brownian motion.
Remark 3.4.15 Let e be an open set in IR and (Xt)O:::;t:::;T an Ito process which
stays in e at all times. If we consider a function f from e to lR which is twice
continuously differentiable, we can derive an extension of Ito formula in that case
f(Xt).~ f(;o) + I
This result allows us to apply
positive process.
t
!'(X.)dX.
+~
t
!"(X.)H;ds.
From the integration by parts formula, we can compute the differential of X;Zt
48
49
version will prove to be very useful when we model complex interest rate structures
for instance.
Definition 3.4.16 We call standard pdimensional FrBrownian motion an lRP valued process (Wt = (Wl, . . . , Wi) k:~o adapted to F t, where all the (Wnt~O
are independent standard FrBrownian motions.
Definition 3.4.17
(Xt)09~T
is an Ito process
if
x, = x +
it
Xs(/Lds
+ adWs)'
x, = Z +
where:
K t and all the processes (Hi) are adapted to (Ft).
JoT IKslds
b(s,Xs)ds
it
(3.10)
a(s,Xs)dWs.
These equations are called stochastic differential equations and a solution of (3.10)
is called a diffusion. These equations are useful to model most financial assets,
whether we are speaking about stocks or interest rate processes. Let us first study
some properties of the solutions to these equations.
it
Kids
s
+ '"
L..J
it ,
Hi,idWi
s
s
j:=l
+tit
i=l
+~2 ..t
it ~~ (s,X~,;
.. ,X:)ds'
it
',J=l
d(X i , Xi) s =
,",P
L...,,J==l
,",P
L...,,m=l
llb(s,Xs),ds
21
88
xixi
Hi,idWj
5
5'
Hi,m
Hi,mds
5
s
.
Remark3.4.19 If (Xs)O<t<T and (Y.)O<t<T are two Ito processes, we can define formally the crossvari~tion of X and Y (denoted by (X, Y)s) through the
following properties:
with:
ax: = Kids +
Definition 3.5:1 We consider a probability space (n, A,.P) equipped with a filtratioh (Ft)t~o, We also have functions b : lR+ x lR + IR., a : lR+ x lR + IR., a
Fomeasurable randomvariable Z and finally an FtBrownian motion (Wdt~o.
1 solution to equation (3./0) is an Fiadapted stochastic process (Xt)t~O that
satisfies:
For any t ~ 0, the integrals J~ b(s, Xs)ds and J~ a(s, Xs)dWs exist
_.
'It
~0
P a.s.
.'
.x,t = Z +
1
t
b (s,Xs) ds
"'
a (s, X s ) dWs'
.{ ex.
Xo
b (t, X t) dt
Z
+ a (t, X t) dWt
Theorem3.5.3 Ifb and a are continuous functions and if there exists a constant
K < +00 such that
50
51
2.
< +00
The uniqueness of the solution means that if (Xt)09~T and (Yi)09~T are two
solutions oj(3.1O), then P a.s. '10 ::; t ::; T, X, = Yi,
Proof. We define the set
<
+oo} .
Together with the norm IIXII = (E (sUPO<s<T IX sJ2)) 1/2 E is a complete normed
vector space. In order to show the existence of a solution, we are going to use
the theorem of existence of a fixed point for a contracting mapping. Let ~ be the
function that maps a process (Xs)O~s~T into a process (~(X)s)O~s~T defined
by
.
(suPO~u~tIlTn IX
uI
1~(X)t  ~(Y)tI2
+sUPO~t~T If~(oo(s,~s) 
sr
1~(X)t  ~(Y)tI2)
< 3 ( E(Z2) + E
E (sup
oo(s, Ys))dWsI2)
2)
0::; t
+ ebT).
= e bt f; f(s)ds. Then,
By firstorder integration we obtain u(T) ::; alb and f(T) ::; a(1 + ebT).
52
In our case, we have t" (T) < K < +00, where K is a function ofT independent
of n. It follows from Fatou lemma that, for any T,
E(
sup IXsI2)
O$;s$;T
, An are real numbers and if 0 ::; t l < ... < t: the random variable
To convince ourselves, we just notice that
that if AI,
Al Xtl +
+ AnXtn is normal.
Therefore X belongs to [; andthat completes the proof for small T. For an arbitrary
T, we consider a large enough integer n and think successively on the intervals
[0, Tin), [Tin, 2TIn), ...,[(n  l)TIn, T).
0
53
1+
00
l{s$;t;}eCSdWs
= mi +
it
Ji(s)dWs.
Then AIXtt + '" + AnXtn = E7=I Aimi + J~ (E7=1 Adi(S)) dWs which is
indeed a normal random variable (since it is a stochastic integral of a deterministic
function of time).
ax,
{ Xo
=
=
cXtdt
x
+ O'dWt
x,
X;
= xe ct + ae ct
it
o
e cSdWs
The analysis of stochastic differential equations can be extended to the case when
. processes evolve in lR n . This generalisation proves to be useful in finance when
we want to model baskets of stocks or currencies. We consider
W = (WI, ... , W1') an lR1' valued FtBrownian motion.
= (O'i,j(s,x)h$;i$;n ,I$;j$;1"
"
(3.11)
E ((X t E(Xt))2)
.'E
,.O'2~2ctE
=
0'2
(lte2csdi) '
1  e 2ct_
2c
We can also prove that X, is a normal random variable, since X; can be written as
J~ j(s)dWs where j(.) is a deterministic function oftim~ and J~ !2(s)d~ < +00
(see Exercise 12). More precisely, the process (Xtk~o IS GaUSSIan. ThIS means
The theorem of existence and uniqueness of a solution of (3.11) can be stated as:
if
E(
54
3.5.4 The Markov property of the solution ofa 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; and is not influenced by the
history of the process before t. This is a crucial property of the Markovian model
and it will have great consequences in the pricing of options. For instance, 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.
Mathematically speaking, an Fradapted process (Xt)t>o satisfies the Markov
property if, for any bounded Borel function f and for any ~ and t such that s t,
we have
E (f (X t) IFs) = E (f (X t) IX s) .
We are going to state this property for a solution of equation (3.10). We shall
denote by (X;'X, s ;::: t) the solution of equation (3.10) starting from x at time t
and by X" = Xo,x the solution starting from x at time O. For s ;::: t, X;'x satisfies
s
s
b
(u
a (u 'Xt,X)
Xt,x
=
x
Xt,X)
du
+
dWu
s
"
u
u
~1
_1
A priori, X.t,x is defined for any (t, x) almost surely. However, under the assumptions of Theorem 3.5.3, we can build a process depending on (t, x, s) which is
almost surely continuous with respect to these variables and is a solution of the
previous equation. This result is difficult to prove and the interested reader should
refer to Rogers and Williams (1987) for the proof.
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.
if s ;::: t
55
Indeed, if t ::; s
X~x
Theorem 3.5.7 Let (Xtk~o be a solution of (3. 10). It is a Markov process with
respect to the Brownian filtration (Ftk~o. Furthermore, for any bounded Borel
function f we have
P a.s. E (f (X t) IFs) = (Xs),
with (x)
= E (f(X;X)).
Proof. Yet again, we shall only sketch the proof of.this theorem. For a full proof,
the reader ought to refer to Friedman (1975).
x'
Theflow property shows that, if s ::; t, Xf = X:' '. On the other hand, we
can prove that X;,x is a measurable function of x and the Brownian increments
(Ws +u  W s , u ;::: 0) (this result is natural but it is quite tricky to justify (see
Friedman (1975)). If we use this result for fixed sand t we obtain X;x
<I>(x, W s+u ~ w., u ;::: 0) and thus
x: = <I>(X:, W s+u Proof. We are only going to sketch the proof of this lemma. For any x, we have
s
s
P a.s. X;'x = x +
b (u,
du +
dWu.
a (u,
X~,X)
X~X)
+ ~s b.(u,X~'Y) du + l
u;::: 0),
w.,
w.,
u;::: 0))1 F s )
(u,X~;Y) dWu,
E (f (X:X))lx=x~ .
0
and also
1b(u,X~'X;)dU~ 1a(u,X~X;)dWu.
s
X;x; =X:+
These results are intuitive, 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.
y x,
X:
The previous result can be extended to the case when we consider a function of
the whole path of a diffusionafter time s. In particular, the following theorem is
useful when we do computations involving interest rate models.
56
with
(x)
=E
Exercises
57
= (Xs)
T P a.s. Prove
It is also written as
(e f.'
r(u,X,,)du
1 (Xt) IFs) = E
Remark 3.5.10 Actually, one can prove a more general result. Without getting
into the technicalities, let us just mention that if is a function of the whole path
of X, after time s, the following stronger result is still true:
Pa.s. E(.(X:, t~s)IFs)= E((Xt'X, t~s))lx=x.'
E (J(X:;t)) = E
(J(X~'X)).
(ef.'
r(X,,)du
1 (Xt) IFs) = E
lim
nt+oo
+
(lR,B(lR))
f+
Xs(w)
s:
ai 1 j ti,t.+d
0:Si:SN1
3.6 Exercises
Exercise 6 Let (Mtk:~.o be a martingale such that for any t, E(Ml) <
Prove that if s ~ t
.
E ((Mt  M s)2IFs)
+00.
= E (M t2 'M;IFs) .
Fr
is a aalgebra.
'L..J
" l[k/n' (k+1)/n[(S)X k/n (w).
k~O
s:
We can extend this result and show that if r is a function of x only then
is measurable.
x,
is a stopping time,
= {A E A,
for all t ~ 0 , A
n {T ~ t} E F t }
We define
Ie(f) =
ai(Xt .+1
XL;).
0:Si:SN 1
Prove that I, (f) is a normal random variable and compute its mean and variance. In particular, show that
2. ~rom ~his, show that there exists a unique linear mapping I from L 2(lR+, dx)
into Z (fl,F,P),suchthatI(f) = Ie(f),when 1 belongs to 11. andE(I(f)2) =
11f1l2, for any 1 in L 2(lR+).
3. Prove that if (Xn)n>O is a sequence of normal random variables 'with zeromean which converge to X in L 2(fl, .1',P), then X is also a normal random
58
L 2(IR+,
s:
z, =
i t f(s)dX s =
I]O,tJ(s)f(s)dX s,
Exercises
59
Exercise 15
1. Let (H t)05,t5,T be an adapted measurable process such that fo H'fdt < 00,
a.s. Let u, = f; HsdWs. Show that if E (sUPO<t<T Ml) < 00, then
E (fo
95,T
~ 4E(IMT I2 ) .
H, =
l
Prove that fo Hldt
op
ox (t, Wd
(fol Hldt)
=+00.
tc,e
T
where (Kt)O.::;t5,T is an Ftadapted process such that fo IKslds < +00 P a.s,
'.
nt+oc>
< +00.
Prove that if we
(~'
L....J (Mtn  Mt~ ) 2) = O.
11
1.
i=1
Exercise 14
1. Prove that if 5 and 5' are two Frstopping times then 5 /\ 5~ = inf(5, 5') and
5 V 5' = sup(5, 5') are also two Ftstopping times.
2. By applying the sampling theorem to the stopping time 5 V s prove that
~ (Ms l{s>s}IFs)
3. Deduce that for s
= u, l{s>s}'
t
E (Msl\t1{s>s}IFs) = Msl{s>s}'
Conclud~ that
MT =
P a.s. 'Vt ~ T, M, = O.
T
3. fo IKslds is now assumid to be finite'almost surely as opposed to bounded.
We shall accept the fact that the random variable f; IKslds is Ftm~asurable.
Show that Tn defined by
t;
= inf{O
~ s ~ T, i t IKslds ~ n}
,(or T if this set is empty) is stopping time. Prove that P a.s. limnHex> Tn =
T. Considering the sequence of martingales (MtI\TJt~O' prove that
P a.s. 'Vt ~ T, M t
= O.
60
Ksds
= 0 dt
ax,
{ Xo
=
2
+ aWt).
d(XtS;l)
= St 1 ((fJ.' 
aa')dt + a'dWd
E (YTIB)
= E (Yi)lt=T'
> A},
prove that if
is a bounded Borel
where(u)
and prove that
E (f(Wt)l{ T>'9
1} )
= E (i(2A 
Wt) l{ T>'9}) .
Exercises
61
2(2yx)
((2 Y
...,fi;i3 exp 
 X)2) dxdy.
2t
Black and Scholes (1973) tackled the problem of pricing and hedging a European
option (call or put) on a nondividend paying stock. Their method, which is based
on similar ideas to those developed in discretetime in Chapter 1 of this book,
leads to some formulae frequently used by practitioners, despite the simplifying
character of the model. In this chapter, we give an uptodate presentation of their
work. The case of the American option is investigated and some extensions of the
model are exposed.
dSP = rSpdt,
(4.1)
dS t
= St (J.tdt + adBt) ,
(4.2)
s, = So exp (J.tt 
~2 t + aB t) ,
64
where So is the spot price observed at time O. 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 :s t, StlS or (equivalently), the
relative increment (St  Su) / Su is independent of the O"algebra O"(Sv, v :s u);
:s
These three properties express in concrete terms the hypotheses of Black and
Scholes on the behaviour of the share price.
= Hf S?+tt.s;
This equality is extended to give the selffinancing condition in the continuoustime case
dVi ()
= HfdSf + HtdSt
and
iT H;dt
1T . iT
1 1 (H~St/L) + 1
HfdSf =
Hfrertdt
I H~dS~ I n.as;
t
2. Hfsf +
u.s, =
HgSg
+ tts; +
65
a.s.
it
HudSu a.s.
(4.3)
+ ertdVi()
which results from the differentiation of the product of the processes (e~rt) arid
(Vi ()) (the crossvariation term d{e r . , () kis null), we deduce
dfrt() . _re rt (Hfe rt + HtSt) dt + ertHfd(e rt) + <n.as,
H, (_re rt St dt + ertdSt)
v:
HtdSt,
dVt() = rfrt()dt
iT IHfldt
.T
O"HtStr/B t,
Definition 4.1.1 A selffinancing sstrategy is defined by a pair of adapted processes (Hf)o::;t::;T and (Ht)09::;T satisfying:
P (A) = 0 ~
Q (A) =0.
Q on (fl, A)
' .
IS
66
Q(A) =
Z(w)dP(w).
u, = M o +
Vt E [0, T]
it n.s,
iT u.s,
t;
= exp
l{ O;ds < 00
<"
00,
the process
(J~ lIsdB s)
is a squareintegrable martin
gale, null at o. The following theorem shows that any Brownian martingale can be
represented in terms of a stochastic" integral.
<
+00.
To prove it,
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
squareintegrable) there is a representation similar to (4.4) with a process satisfying
only fo Hlds
Consequently, if we set W t
=
=
re rt St dt
+ r'as,
St ((J.L  r)dt
= 13t + (J.L 
+ adBt).
r)t/a,
dSt = StadWt.
4.2.3 Representation ofBrownian martingales
(4.4)
a.s.,
dSt
(see Karatzas and Shreve (1988), Dac~nhaCastelle and Duflo (1986. The proof
of Girsanov theorem when (Ot) is constant is the purpose of Exercise 19:
a.s.
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 FTmeasurable, squareintegrable
random variable, it can be written as
U = E (U)
Let
67
(4.5)
St = So exp(aWt  a 2t/2).
68
69
4.3.2 Pricing
In this section, we will focus on European options. A European option will be
defined by a nonnegative, FTmeasurable, random variable h. Quite often, h can
be written as f(ST)' (f(x)
(xK)+ inthecaseofacall,f(x)
(K:z)+
in the case of a put). As in the discretetime setting, we will define the option
value by a replication argument. FOf technical reasons, we will limit our study to
the following admissible strategies:
Definition 4.3.1 A strategy </J = (m, H t) 09 ~T is admissible if it is selffinancing
\It
(JoT K~ds)
<
+ u.s;
Vt =
n;0 + u.s;
I
+I
Vo
u,
= Mo +
I

t
KsdWs a.s.
0
f(ST)' we can
express the option value V t at time t as a function oft and St. We have indeed
',\It
E*
=
b
Vo +
"Ct
 
Since the strategy is selffinancing, we get from, Proposition 4.1.2 and equality
(4.5)
+00 and
\It E [0, T]
Thus, the option value at time t can be. naturally defined by the expression
\It == H~ S~
(4.6)
h, its value is given by equality (4.6). To complete the proof of the theorem, it
= E* (er(T:t) hlFt) .
HudSu
Vt
HuaSudWu.
Under the probability p:;', SUPtE[O,Tj Vt is squareintegrable, by definition of admissible strategies. Furthermore, the preceding equality shows that the pro.c~ss
(lit) is a stochastic integral r~la~ve to (Wt ): It follows (cf..Chapter 3, ProyoSItlOn
3.4.4 and Exercise 15) that (Vt ) ISa squaremtegrablemartmgale under P . Hence
where
F(t, x) = E* (er(Tt) f (xe r(Tt)e,,(WTW,j_(,,2/2)(Tt)) ) .
(4.7)
V t = E* (VTIFt) ,
= F(t, St),
= er(T:t) 1+~ f
~
(xe(r,,2/ 2)(Tt)+"Yv'Tt) e
~~d
y.
70
F can be calculated explicitly for calls and puts. If we choose the case of the call,
where f(x) = (x  K)+, we have, from equality (4.7)
F(t,x)
(xe(r0'2/2)(Tt)~0'(WTW.)
E (er(Tt)
K)+)
log (xl K)
+ (r + (2/2) 0
aVO
1
and' d 2 = d 1
In
avO.
_
=
I.
00
Writing this expression as the difference of two integrals and in the first one using
,
the change of variable z = y + aVO, we obtain
r6
F(t, x) = xN(d 1 )  Ke N(d 2),
(4.8)
where
jd
1
2
N(d) == ,,
e X /2dx.
~ 00
Using identical notations and through similar calculations, the price of the put is
equal to
F(t, x)
2. The 'implied' method: some options are quoted on organised markets; the price
of options (calls and puts) being an increasing function of a (cf. Exercise 21),
we can associate an 'implied' volatility to each quoted option, by inversion
of the BlackScholes formula. Once the model is identified, it can be used to
elaborate hedging schemes.
F(t,x)
71
In those problems concerning volatility, one is soon confronted with the imperfections of the BlackScholes model. Important differences between historical
volatility and implied volatility are observed, the latter seeming to depend upon
the strike price and the maturity. In spite of these incoherences, the model is
considered as a reference by practitioners.
d 
= tee:" N(d 2) 
xN( dd
(4.9)
Vi = e rt F(t, St),
where F is the function defined by equality (4.7). Under large hypothesis on f
(and, in particular, in the case of calls and puts where we have the closedform
solutions of Remark 4.3.3), we see that the function F is of class Coo on [0, T[xIR..
If we set
F'(~, x) = e rt F (t, xe rt) ,
,
we have
the variables 10g(STISo), log(S2TIST), ... , 10g(SNTIS(Nl)T) are independent and identically distributed. Therefore, a can be estimated by statisti~al
means using the asset prices observed in the past (for example ~y calculating
empirical variances; cf. DacunhaCastelle and Duflo (1986), Chapter 5).
it
1at
0;
12
t
8F ( w.S
) du+
1 8 2 F ( )  8x 2 U,Su d(S,S)u
d(S, S)u
so that
2
= a 2 ~udu,
P(t,St)'=p(o,so}+
, /
udu .
Since p(t, St) is a martingale under P", the process K, is necessarily null (cf.
72
S~ ) SudWu
P (t, St)
P (0, SO) +
it ~~
a
(u,
) es;
= F (O,So) + it aP
ax (,s;
o
The natural candidate for the hedging process H, is then
aP ( t, St)
H, =
s:
= aF
ax (t, St) .
If we set Hf
Remark 4.3.5 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).
. .
Remark 4.3.6 In the' case of the call, we have, using the same notations as in
Remark 4.3.3,
aF
a
x (t,x) = N(d
. 1) .
This is left as an exercise (the easiest way is to differentiate under the expectation).
This quantity is often called the 'delta' of the option by practitioners. More
generally, when the value at time t of a portfolio can be expressed as ll1(t, St),
the quantity (alII/ ax) (t, St), which measures the sensitivity of the portfolio with
respect to the variations of the asset price at time t, is called the 'delta' of the
portfolio. 'gamma' refers to the secondorder derivative (a 2 1l1 / ax 2 ) (t, St), 'theta'
to the derivative with respect to time and 'vega' to the derivative of III with respect
to the volatility a.
73
2. H?sf +
I
u.s; =
HgSg + HoSo +
De~ote by <1>'" the set of tradi~g strategies with consumption hedging the American
option defined by h t = 'lj;(St). If the writer of the option follows a strategy if> E <1>"',
he or she p~ssesses a~ an~ time t, a wealth at least equal to 'lj;( St), which is precisely
the payoff If the opuon IS exercised at time t. The following theorem introduces
the minimal value of a hedging scheme for an American option:
Theorem 4.4.2 Let u be the map from [0, Tj x IR+ to IR defined by
u(t, x) =
rE7't,T
wh~re Ti,T represents the set ofstopping times taking values in [t, Tj. There exists
a strategy if> E <1>'" such that Vt () = u(t, St),for all t E [0, Tj. Moreover; for
any strategy if> E <1>"', we have: Vt(if 2': u(t,St),forallt E [O,Tj.
To overcome technical difficulties, we give only the outlines of the proof (see
~aratzas and Shreve (1988)Jor details). First, we show that the process (ertu( t, St))
IS t~e Snell env~lope of the process (ert'lj;(St)), i.e. the smallest supermartingale
which bounds It from above under p ". As it can be proved that the discounted
value of a ~ading ~trategy 'with consumption is a supermartingale under P", we
de~uce the inequality: ~(if 2': u(t, St), for any strategy if> E <1>"'. To show the
existence of a strategy if> such that Vt() = u(t, St), we have to use a theorem
of decomposition of supermartingales similar to Proposition 2.3.1 of Chapter 2 as
well as a theorem of representation of Brownian martingales.
. It i~ ~atural t~ ~onsider u(t; St) as a price for the American option at time t,
smce.lt IS the minimal value of a strategy hedging the option.
74
Remark 4.4.3 Let 7 be a stopping time taking values in [0, T]. The value at time 0
of an admissible strategy in the sense of Definition 4.3.1 with value 'l/J(Sr) at time 7
is given by E* (e rr 'l/J(Sr)), since the discounted value of any admissible strategy
is a martingale under P*. Thus the quantity u(O, So) = sUPrE70,T E* (e rr'l/J(Sr))
is the initial wealth that hedges the whole range of possible exercises.
As in discrete models, we notice that the American call price (on a nondividend
paying stock) is equal to the European call price:
Proposition 4.4.4 If in Theorem 4.4.2, 'l/J 'is given by 'l/J(x)
real x, then we have
u(t,x)
= (z 
u(O, x)
sup E(Kerrxexp(aBr(a27/2)))+
rE70,T
<
sup E [(KerE70,<X>
= E*(ST
>
0). Then it is
 erTK)+.
~ E* ((ST  erTK)IFr) ~
Uoo(x)
s,  erTK'.,
rr
= rE70.<X>
sup E.[(Ke 
E* ((ST  erTK)+IFr)
Uoo(x) = K  x
s;
~ (Sr  e rr K) + .
Uoo(x) = (K  z")
In the case of the put, the American option price is not equal to the European one
and there is no closedform solution for the function u. One has to use numerical
methods; we present some ofthem in Chapter 5. In this section we will only use
the formula
.
.
(4.10)
to deduce some properties of the function u. To make our point clearer, we assume
t = O. In fact, it is always possible to come down to this case by replacing Twith
(4.13)
X)
x*
"'I
for
x:::; z"
for
x > x"
(K~r(rt)
~ e rr K
u(t, x) = sup E*
rET.,T
noting To,oo the set of all stopping times of the filtration of (Bt)t~o and To,T the
set of all elements of To,oo with values in [0, T]. The righthand term in inequality
(4.12) can be interpreted naturally as the value of a 'perpetual' put (i.e. it can be
exercised at any time). The following proposition gives an explicit expression for
the upper bound in (4.12).
Proposition 4.4.5 The function
rr
(4.12)
(4.11)
Let us consider a probability space (0, F, P), and let (Bt)o<t<oo be a standard
Brownian motion defined on this space and IR+. Then, we get
= F(t,x)
since r
75
E* ((ST  erTK)+!Fr)
Uoo(x) = K  x
and
"Ix >x*
On the other hand, the Spell envelope theory in continuous time (cf. E1 Karoui
(1981)(Kushner (1977), aswell as Chapter 5)enables us to show
Uoo(x) = E [(Ke,,"':'rrz
xexp (aB r
(a 27x/2)))+ 1h<00}]
<; 
= inf {t ~ Ol(r 
76
where,
77
Exercises
= 2r1
a2 .
z'Y 1
'(z) = 
.
..
,IS giiven by T x
With these notations, the optimal
stoppmg
ume
and we note the function of z defined by
..1.( ) =. E ( e  r T "
Z
'I' Z
= T x,x'"We fix x
UOO(x) = (x*).
( ) _ (K _ ) If z < x we have
If z > x, it is obvious that Tx,z = a and z x +.
'
,
by the continuity of the paths of (Xnt"~o'
Tx,z
= inf{t ~OIX: = z}
x'Y
(K, 
b + l)z).
Remark 4.4.6 Let us come back to the American put with finite maturity T.
Following the same arguments as in the beginning of the proof of Proposition
4.4.5, we see that, for any t E [0, T[, there exists a real s(t) satisfying
"Ix ~ s(t) u(t,x) = K  x and "Ix> s(t) u(t,x)
> (K  x)+.
(4.15)
Taking inequality (4.12) into account, we obtain s(t) ~ z", for all t E [0, T[. 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), the buyer of the option should exercise
his or her option immediately; in the opposite case, he should keep it.
and consequently
WIth, by convention, e
see that, for z ~ x,
Tx,z
rTz
(z)
roo _
= ria 
expression of Xt in terms of B t , we
,
inf{t~OI(ra;)t+aBt=IOg(ZIX)}
inf {t
with JL
a Using the
.
~ 0l/.tt + e, = ~ IOg(ZIX)} ,
4.5 Exercises
= b},
we get
~(z)
(K  x)+
(K
z)E
(exp
(rT1og(z/x)/u))
= {
if z > x
.
if Z E [0, x] n [0, K]
if z E [O,x] n [K,+oo[.
The maximum of is attained on the interval [0, x] n [0, K]. Using the following
formula (proved in Exercise 24)
(eaT&)
= exp
= (K z)
(~)'Y,
Exercise 19 The objective of this exercise is to prove the Girsanov theorem 4.2.2
in the special case where the process (Ot)is constant. Let (Bt)o9~T be a standard
Brownian motion with respect to the filtration (Ft)O<t<T and let JL be a realvalued
number, We set, for a ~ t,~ T, i; exp ( JLB t .: 2 12)t).
~elative to
(i.t
2. We note p(L.) the density probability L t with respect to the initial probability
P. Show that the probabilities p(L T ) and p(L.) coincide on the aalgebra Ft.
3. Let Z be an FTmeasurable, bounded random.variable, Show that theconditional expectation of Z, under the probability p(LT), given F, is
E'(LT)(ZIFt)
= E (ZLTIFt).
Lt
Exercises
= e
79
Exercise 25
u 2(ts)/2.
x, =
1. Show that if f is nondecreasing (resp. nonincreasing), F(t, x) is a nondecreasing function (resp. ,nonincreasing) of x.
2 We assume that f is convex. Show that F(t,x) is a convex ~unction ~f z, a
. d
. function of t if r  0 and a nondecreasing function of a many
ecreasmg
fJ
,.
ality:
.
case. (Hint: first consider equation (4.7) and make us~ 0 ensen ~ mequ
cI>(E(X)) ~ E (cI>(X)), where cI> is a convex function and X IS a random
variable such that X and cI>(X) are integrable.)
We note Fe (resp. Fp) the function F obtained when f(x) = (x ~ K)+ (resp.
3. f(x) = (K _ x)+). Prove that Fe(t,.) and Fp(t,.) are nonnegatlvefor t < T.
Study the functions Fe(t,.) and Fp(t, .) in the neighbourhood of 0 and +00.
lit =
.and b, we set
= inf{t 2: 0 I JLt + B; = b}
with the convention: inf 0 = 00.
Tt
'Va,t>O
< 00).
<
00
p(L)a.s. and we
t
HsdWs.
converges to 0 in probability.
Exercise 24 Let (Btk?o be a standard Brownian motion. For any realvalued JL
Hs(}sds.
Exercise 22 Calculate under the initial probability P, the probability that a Eu
I n.e, + I
t
9t
by.rt
t\ t. '
P ('Vt E [0, IJ M,
= X t ) = 1).
Exercises
81
3. Prove that there exists a probability P" equivalent to P, under which the
discounted stock price is a martingale. Give its density with respect to P.
4. In the remainder, we will tackle the problem of pricing and hedging a call with
maturity T and strike price K.
Deduce that if
E (e
aWT1
x ~ JL
. (a
. } ) exp
.
{WT~~,inf.::;TW.~A
2T

1m
vT
(a) Let (H?, Hl) be a selffinancing strategy, with value \It at time t. Show that
if (\It/ SP) is a martingale under P" and if VT (ST  K)+, then
= E (erT(XT 
K)+1{inf.::;T X.~H}) ,
F(!,
'u2
. ,.
Problem 1 BlackScholes model with time~dependent parameters ~e consider once again the BlackScholes model, assuming that ~e ass~t p~ces are
described by the following equations (we keep the same notations as In this
J
ter)
dSP
ch~~.
= r(t)Spdt
{ dS
t = St(JL(t)dt + u(t)dBd
. where ret), JL(t), u(t) are detenninistic functions of time, continuous on [0, T).
Furthermore, we assume that inftE[o,T] u(t) > 0:
.
1. Prove that
s,
= So exp
2(S)dS)
s _
. : JL(s)ds
dS t
= JLdt
t.
+ udWt,
z, = s, exp :
The GarmanKohlhagen model (1983) is the most commonly used model to price
and hedge foreignexchange options. It derives directly from the BlackScholes
model. To clarify, we shall concentrate on 'dollarfranc' options. For example, a
European call on the dollar, with maturity T and strike price K, is the right to buy,
at time T, one dollar for K francs.
We will note S; the price of the dollar at time t, i.e. the number of francsper
dollar. The behaviour of S, through time is modelled by the following stochastic
differential equation:
+ ~t u(s)dB s
:
~ ~t u
2(s)dS)
2.
2. Show that if JL
(a) .Let (X n ) be a sequence of realvalued, zeromean normal random vari.ables
converging to X in meansquare. Show that X is a normal random variable.
(b) By approximating o by simple .functi?ns, show that
random variable and calculate ItS varIance.
0
3. Let U; = 1/ St be the exchange rate of the franc' against the dollar. Show that
Uc satisfies the following stochastic differential equation
dU t
(2
.
= u  JL)dt  udWt.
u,
82
Exercises
83
Deduce that if 0 < J.L < a 2, both processes (St)tE[O,T] and (Ut)tE[O,TJ are
submartingales. In what sense does it seem to be paradoxical?
(The symbol E stands for the expectation under the probability P.)
5. Show (through detailed calcUlation) that
II
We would like to price and hedge a European call on one dollar, with maturity T
and strike price K, using a BlackScholestype method. From his premium, which
represents his initial wealth, the writer of the option elaborates a strategy, defining
at any time t a portfolio made of HP francs and H, dollars, in order to create, at
time T, a wealth equal to (ST  K)+ (in francs).
At time t, the value in francs of a portfolio made of Hp francs and H, dollars
is obviously
Vt = H~ +
(4.16)
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 TI' A selffinancing
strategy will thus be defined by an adaptedprocess ((HP, HttE[O,Tj, such that
n.s;
+ HtdSt
+ (a 2j2(T a..;T=t
dl
10g(xjK) + (TO 
d2
10g(xjK)
es, = aStdWt.
(4.17)
(b) Let
TO t
Vi
P.
4. Show that if an admissible strategy replicates the call, in other words it is worth
VT = (ST  K)+ at time T, then for any t ~ T the value of the strategy at
time t is given by
where
F(t,x)
rotc
t =
+ UT
t't't
t  e
(c) renlicati that the c.all is replicable and give an explicit expression for the
rep icatmg portfolio (( Hp, Ht.
To)dt + HterotStadWt.
J.L + TI
, t
sc,
= aF
( t St)aerotS dW';
ax '
t
t
(a) Show that there exists a probability P, equivalent to P, under which the
process
t't't 
3.
TiT
(a 2j2(T  t)
a..;r=t
Vi
+ TI
TI 
t)
,dVt = HterotSt(J.L
+ (TO 
TI
1
I'
W~ tO~~der a fin2anci~1 market in which there are two risky assets with respective
pnces
= ert at time
dS~
S! (J.Lldt
+ aldB!)
{
/
Sl (J.L2dt + a2a B l)
where (BI) [ . and (B2)
.'
.
d t tE O,T]
t tE[O,Tj are two Independent standard Brownian mo
nons efined on a probability space (0 F P).
with
:> 0 . d
' , ,J.LI,J.L2,al anda2arerealnumbers
abiesa11
an ~2 > O. We note!t the aalgebra generated by the random vari~
and B. for s ~ t. Then the processes (B I)
d (B2)
e (FdBrownian motions and, for t ~ s, the vecto/ (~IO~];~ B2 ~ ~JO)?J
:rrIndependent
of F..
t. , t
. IS
.J'
84
85
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. We set
by
(h = (ILl  r) /0"1
u,
and
= exp (
Exercises
3. Write Sland Sl as functions of SJ, S5,!Vl and Wl and show that, under P,
the discounted prices Sl = e:" Sl and Sl == e:" S; are martingales.
We want to price and hedge a European option, with maturity T, giving to the
holder the right to exchange one unit of the asset 2 for cine unit of the as~et.1:
do so we use the same method as in the BlackScholes model. From hIS initial
wealth, the premium, 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; and H; Units of
the assets 1 and 2 respectively, in order to generate, at time T, a wealth equal to
(St  Sf)+ A trading strategy will be defined by the three adapted processes
HO, HI and H 2.
:0
HP
~
,,2
) +'
F(t, Xl, X2) = E ( x1eO'I (WIr  WI) "'T(Tt)
_ x2e0'2(WfW,2)=f(Tt)
(4.19)
the ~ymb~l E repres~nting the expectation under P. The existence of a strategy
having this value will be proved later on. We will consider in the remainder
that the value of the option (St  Sj)+ at time t is given by F(t, Sf, Sl).
4. Find a parity relationship between the value of the option with payoff (Sl _
sj)+ and the symmetrical option with payoff (Sf  St)+, similar to :the
putcall parity relationship previously seen and give an example of arbitrage
opportunity when this relationship does not hold.
ill
The objective of this section is to find an explicit expression for the function F
defined by (4.19) and to establish a strategy replicating the option.
1. Let 91 and 92 be two independent standard normal random variables and let A
be a real number.
(a) Show that under the probability p(A), with density with respect to P given
._
by
dP(A)
2
__ = eAgIA
rtSl dW l
r d1Yt
t 0"1
t
 HIt e 
= ertVt is
2
+ H t2ertS20"
t 2 dW t .
(4.18)
'
E (exp(Yl
+ A19d' 
exp(Y2
=eYI+A~/2N(Yl 
+ A292))+
Y2 + A?) _
JA~+A~
11
1. Define precisely th~ self financing strategies' and prove that, if Vt
the discounted value of a selffinancing strategy, we have
/2
dP
eY2+A~/2N (Y1 
Y2
A~)
JA~+A~
2. Deduce from the previous question an expression for F using the function N.
3. We set c, = :" F(t, Sf, S;). Noticing that
:
/
c, =
E (e rT (S} 
Sf)+ 1F t ) ,
of
 
of
_ _
uX2
Hint: use the fact that if (Xt ) is an Ito process which can be written as X
t
t
t
X o + f o J1dW; .: f0 7 ; dw ; + f~ Ksds and if it is a martingale under P,
then K, = 0, dtdPalmost everywhere.
86
Exercises
show that condition (ii) is satisfied if and only if we have, for all t E [0, Tj.
t:t = Vo +
We consider a financial market in which there is one riskless asset, with price S~ =
ert at time t (with r ~ 0) and one risky asset, with price St at time t: The model
is studied on the time interval [0, Tj (0 ~ T < 00). In the following, (St)O~t~T
is a stochastic process defined on a probability space (0, F, P), equipped with
a filtration (Ft)o9~T' We assume that (Ft)O~t~T is the natural filtr~tion of a
standard Brownian motion (Bt)o9~T and that the process (St)09~T IS adapted
to this filtration.
.
dS t
with JL E IR and a
= St(JLdt + adBt) ,
with
it
HudBu  i t c(u)du,
a.s.
2. We suppose that conditions (i) to (iv) are satisfied and we still note t:t =
ertVi = e:" (H2 S2 + HtSt). Prove that the process (t:t)O<t<T is a supermartingale under probability p. .
 
E (JOTc(t)dtf ~ 00 and let x > O. We say that (c(t))09~T is a budgetfeasible consumption process from the initial endowment x if there exist some
processes (H2)o~t~T and (Ht)O~t~T such that conditions (i) to (iv) are satisfied, and furthermore Vo = HgSg + HoSo = x.
.
(a) Show that if the process (c(t))O<t<T is budgetfeasible from the initial
with respect to P, with (J = (JL r)/a. Under p . the process (Wt)09~T. defined
by W t = (JL  r)t/a + Be, is a standard Brownian motion.
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, represent respectively the quantities. of
riskless asset and risky asset held at time t, and c(t) represents th~ consum?~on
rate at time t. We say that such a strategy is admissible if the followmg conditions
hold:
(i) The processes (H2)09~T. (Ht)O~t~T and (c(t) )09~T are adapted and satisfy
iT
87
.~ x.
'
(b) Let (c(t))09~T be an adapted process. with nonnegative values and such
that
M t = E
representation.
(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, crosses
~.
some. ?arrier K upward (that corresponds to c(t)
pSt1{S,>K}). What
conditions on p and x are necessary for this consumption process to be
budgetfeasible?
HOSo+HtSt = HgSg+HoSo+
t
uc(u)du,
.
10r H~dS~+
. 10r HudS 1r0
a.s.
II
We now suppose that the volatility is stochastic. i.e. that the process (St)O<t<T is
the solution of a stochastic differential equation of the.following form:  
dS t = St(JLdt
sup (Itiffi.+HtSt+ tC(S)dS)
tE[O,T]
10
+ a(t)dBt),
(4.20)
Vt E
[O,Tj
al
a(t)
~ (,2,
for so~e constants.o, and az such that 0 < al < az We consider a European
call With maturity T and strike price K on one unit of the risky asset. We know
88
(see Chapter 5) that if the process (a(t) )O<t'<T is constant (with a(t) = a for any
t) the price of the call at time tis C(t, St), where the function C(t, x) satisfies
ec
at
(t,x)
a 2x2 a2c
'C(T, x) = (x  K)+.
We note C 1 the function C corresponding to the case a = a1 and C 2 the function
C corresponding to the case a = a2. We want to show that the price of the call at
time 0 in the model with stochastic volatility belongs to [C1(0, So), C2(0, So)l.
Recall that if (OdO<t<T is a bounded adapted process, the process (Ldoi;t~T
exp ~.r;
with Il E IR and a
a is given by
. Co = E* (e:rT(ST  K)+) .
5, We set
S~
s 
(Sn s S6elT~t.
G(O, xl
M, =
e
7. Using Ito formula and Questions 1 and 6, show that rc, (t, Sd is a submartingale under probability .P*. Deduce that C 1 (0, So) ~ Co. . ,
8. Derive the inequality Co
s C2(0, So).
_ t S) h
, t,were
i.
= E [erIlC (n,xe(rlT
n'
2/2)lI+lT
V69)
1{9>~d}]
_ K1erIlN(d),
where
(u, Su)a(u)SudWu
G(O,x)
ru
3.
. l't . eca}
> O.
1. Prove (using the price formulae written as expectations) that the, functions
x It C1(t,x) and x It C 2(t,x) are convex.
s, =
89
ec
+ ;:;z(t,x)
+ rx;:)(t,x)
 rC(t,x) = a
2 ox
ox
on [0, T[x10, oo[
d~fined by i, =
Exercises
a../O
. G(O, x)
+ K 1 e r llN(d)
E [( xe lT( V69+V919t) 
"22
(1I+IIt) _
K er(II+II l
) lA] ,
(log(X/ Kr)
and 9
>
d}.
(r _~2) (0 + (1))
90
(d) From this, derive a formula for G(B, x) in terms of Nand N 2 the twodimensional cumulative normal distribution defined by
N 2(Y,Y1,P)
< yd
y,Y1,P E JR.
for
4. Show that we can replicate the compound option payoff by trading the underlying call and the riskless bond.
Exercises
91
P(t,x)
sup'
.(
Ke
rT
 xe
I1W~_.,.2T)+
2
TE70.Tt
To Tt
dS t
standard PBrownian' motion. We also assume thatr > O. For t E [0, T[, we
denote by s( t) the critical ~rice defined as,
= St(/Ldt + adBd,
~ (~ {
S,dt  K
= K.
1. Let P, be the function pricing the European put with maturity T and strike
rrJ
price K
Pe(t, x)
= E( er(Tt) K
where 9 is a standard normal variable. Show that if t E [0, T[, the equation
P; (t, x) = K  x has a unique solution in ]0, K[. Let us call it se(t).
3. Show that
liminf K A ) > E (liminf
t+T . T  t t+T
~ E' [,d
K~)
T  t
n.
Vi
aKg) +
We shall need Fatou l~mma: for any sequence (Xn)nEN of nonnegative random variables, E(lim inf n + oo X n ) ~ lim inf n + oo E(X n ) .
 ')
(~ S.da K
er(Tt) it
1 ~ er(Tt)
T'
Sudu +
S,  K er(Tt).
o
rT
4.
E(St:KerT)+
(a) Show that for any real number 1/,
Vo
t+T
Kse(t)
VT 
~E[erT(STK)+].
lim
.
= hm
t+T
Ks(t)
VT 
= +00.
s E [e rT (ST 
K)+] ,
i.e, the Asian option price.is smaller than its European counterpart.
(c) For t ~ u, we denote by Ct,u the value at time t of a European call maturing
92
)+ +  iT er(Tu)Ct
1
duo
Sudu 
K) .
equation:
2.
(a) Show that
v. ~ ;'(T'IS,E'
Vi
+ (1(Wu
Wt}) .
~E' (u ~ t
'>:'duf
3. Find a replicating strategy to hedge the Asian option. We shall assume that the
function F introduced earlier is of class C 2 on [0, T[ x IR and we shall use Ito
formula.
ill
The purpose of this section is to suggest an approximation of Vo obtained by
considering the geometric average as opposed to the arithmetic one. We define
Vo
 K) + ,
,u
~t = ~t (~ I
93
Exercises
Vo
va, ~ Soe rT (e
rT
In the previous chapter, we saw how we could derive a closedform formula for
the price of a European 'option in the BlackScholes environment. But, if we are
working with more complex models or even if we want to price American options,
we are not able to find such explicit expressions. That is why we will often require
numerical methods. The purpose of this chapter is to give an introduction to some
concepts useful for computations.
Firstly, we shall show how the problem of European option pricing is related to
a parabolic partial differential equation (PDE). This link is basedon the concept
of the infinitesimal generator of a diffusion. We shall also address the problem of
solving the PDE numerically.
'
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 BlackScholes
model and, in particular, we shall underline the natural duality between the Snell
envelope and a parabolic system of partial differential inequalities. We shall also
explain how we can solve this kind of system numerically.
We shall only use classical numerical methods and therefore we will just recall
the few results that we need. However, an introduction to numerical methods to
solve parabolic PDEs can be found in Ciarlet and Lions(1990) or Raiviart and
Thomas (1983).
i:
Vi
= E (er(Tt) I(ST)!.rt)
96
In fact, we should point out that the pricing of a European option is only a particular
case of the following problem. Let (Xtk~o be a diffusion in ffi., solution of
97
(5.1)
where band (1 are realvalued functions satisfying the assumptions of Theorem
3.5.3 in Chapter 3 and ret, x) is a bounded continuous function modelling the
riskless interest rate. We generally want to compute
Vt
=E
Hence
f(Xt)
+it
~nd ther~sult follows from the fact that the stochastic integral J~ f'(X s)(1(Xs )dW
s
IS a martingale, Indeed, ~ccording to Theorem 3.5.3 and since 1(1(x)1 is dominated
by K(1 + Ix!), we obtain
.
Vi = F(t, X t )
where
F(t,:x)
=E
[~(12(Xs)JII(Xs)+ b(Xs)f'(Xs)] ds
F(t, x)
"Ix E ffi.
u(T, x)
o
Remark 5.1.2 If we denote by X{ the solution of (5.3) such that Xx =
.
0
x, It
follows from Proposition 5.1.1 that
= f(x)
(5.2)
(au/at
+ Atu 
E (J (Xt)) = f(x)
where
+ bet, x)f'(x).
.2,
..
Before we prove this result, let us explain why the operator At appears naturally
when we solve stochastic differential equations.
We assume that band (1 are time independent and we denote by (Xtk:~o the
solution of
'
dXt = b (Xt) dt + (1 (.Xt ) dWt.
(5.3)
d"
dt E (f (Xt))lt=o
+ b(x)J'(x).
(1 r Af(X:)dS) = Af(x).
= l~ E t 1
The ProPositio,n 5.1.1 can also be extended to the timedependent case. We assume
that b ~nd (1 satisfy th.e assumptions ofTheorem 3.5.3 in Chapter 3 which guarantee
the existence and unIqueness of a solution of equation (5.1).
98
I (~~
The proof is very similar to that of Proposition 5.1.1: the only difference is that
we apply the Ito formula for a function of time and an Ito process (see Theorem
3.4.10).
.
In order to deal with discounted quantities, we state a slightly more general
result in the following proposition.
Proposition 5.1.4 Under the assumptions of Proposition 5.1.3, and ifr(t, x) is a
bounded continuous function defined on IR+ x IR, the process
t
= e r(s,X.)dsu(t, Xt)l e r(v,Xu)dv
+ Asu  ru) (s, Xs)ds
u,
I;
(~~
I:
is a martingale.
Proof. This proposition can be proved by using the integration by parts formula
to differentiate the product (see Proposition 3.4.12 in Chapter 3)
e  Jof'r(s,X.)ds u (t , X t )i,
This result is still true in a multidimensional modeJ. Let us consider the stochastic
bl (t, X t) dt
bn (t, X t) dt
dXi'
(5.4)
We assume that the assumptions of Theorem 3.5.5 are still satisfied. 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
. 1
(At!) (x)
= 2 ..L
82 f '
a"j(t,x)8' .8 (x)
x,
',J~I
XJ
8f
is a martingale.
The proof is based on the multidimensional Ito formula stated page 48.
In this se,ction, we want to emphasise the link between pricing a European option
and ~olvmg a parabolic partial differential equation. Let us consider (Xt)t>o a
solution of system (5.4), f(x) a function from IRn to IR, and r(t, x) a bounded
continuous function. We want to compute
Vt =E
where
F(t,
z) = E (eI,T
r(s,X;,Z)ds f(X~X)) ,
when we denote by xt,x the unique solution of (5.4) starting from x attime t.
The following result characterises the function F as a solution of a partial
differential equation.
.
Vx E IR
u(T, x) = f(x),
and
(~~ + ~tU 
ru) (t,x) = 0
V(t,x)E [O,T) x IR
then
k=1
(e r
a,j(t,x) = La'k(t,x)ajk(t,x)
+ Lbj(t,x)
8x (x),
. I
J
J=
differential equation
d~: t =
99
0'
V(t, x) E [0, T)
xIR
~(t, x)
= F(t, x) =I E
(er
r(s,X;,Z)ds f(X~X)) .
100
 eMt
=
sinceu(T,x)
101
u(O,x) '= E
= E(MT) yields
K er(Tt) N(dl
N(d)
log(x/ K)
1.

+ (r + (12 /2)(T  t)
(1'1/'T  t
I
V2i
e X 2 /2dx
00
'
Remark 5.1.8 Obviously, Theorem 5.1.7 suggests the following method to price
the option. In order to fompute
F(t,x)
for
a given
=E
au
at + A,u _ ru ~ in_ [0, T]
n
x JR"
(5.5)
ex, =
Problem (5.5) is a parabolic equation with afinal condition (as soon as the function
For the problem to be well defined, we need to work in a very specific function
space (see Raviart and Thomas (1983)). Then we can apply some theorems of
existence and uniqueness, and if the solution u of (5.5) is smooth enough to satisfy
the assumptions of Proposition 5.1.4 we can conclude that F = u. Generally
speaking, we shall impose some regularity.assumptions on the parameters band
(1 and the operator At will need to be elliptic, i.e.
"1(6,..,
Note th~t th~ operato~ A b. doe~ not satisfy the ellipticity condition (5.6). However, the tnck IS to consider the diffusion X, = log (St), which is solution of
u(T,.) is given).
.'
(5.6)
(r  ~2)
.
Ab.log
= (12 a +
2 ax 2
' .
(12
. fini .
ts m mtesimal generator can be written as
"
>
(r _2
(12)
~
ax'
a2 + ( r ~ ~2) ax
'a
= '"2 aX
2'
'(12
Ab.Iog
..
au
'. :
'{ at +Ab,u  ru ~
 r.
(5.7)
The ~onnection b~tween the parabolIc problem asso~iatedtoAb8~log and the computation of ~e pnce of an option in the BlackScholes model can be highlighted
as follows:.lf we ~ant to compute the price F(t, x) at time t and for a spot price
x of an option paying off j (ST) at time T, we need to find a regular solution v of
:~ (~' x) +Ab.1ogv(t, x) =
We are working under probability p ". The process (Wt)t::::o is a standard Brownian
motion and the asset price S; satisfies
(5.8)
v(T, x) ,= j(e
then F(t, z)
in [0, TJ x IR
= v(t, log(x)).
) ,
"Ix E IR,
102
5.1.4
Dnrtial ditterentiai
equationson a boundedopen set and computationof
su:
r u.
expectations
. u hout the rest of this section, we shall assume that there is only one asset
:th:t b(x), u(x) and rex) are all time independent. rex) is the riskless rate and
= Af(x) 
u(O,x)
E (e
u(T,x)
= f(x),
Furthermore, f(x)
,
9)
0
] b[ as opposed to nt, we need to
If we want to solve problem (5. on
a,
.
th
consider boundary conditions at a and b. We are going to concentrat~on e ~~s~
when the function takes the value zero on the boundaries'.These are e soca e
Dirichlet boundary conditions. The problem to be solved IS then
+ Au(t, z)
on
{3s
(5.10)
u r>,
0 on the event
consequently
u(O,x)
[0, T] x 0
au (t x)
at '
X:,xEO}e
{3sE[t,Tj,
(5.9)
"Ix E nt.
s: ':(S'X~'X)dSu("X,X~~X))
E(1 {\lsE[t,Tj,
+E(1
r(x)f(x).
on [O,T] x nt
Xt,x
= I}
s
~~(t,~) + Au(t,x) = 0
103
Xo,Z)ds
,)
= E ( 1{\lsE[t,TJ, X:,xEO}e  J.T r(s'.
f(XT'X).
= O..
= f(x)
= E ( 1{\lsE[t,T],.x:,xEo}e
'
 I,T r(X:,Z)ds f(Xt,X))
 J.'r(XO,X)ds (t Xo,X)
eo'
u, t
i
t
f r(X~,X)dv
(au
at
is a martingale. Moreover
"x
o x d o}
= inf { 0 S s S T , X s''f'
 J.T (X"Z)d
,r
t X
s f(Xi
is called extinguishable. Indeed, as soon as the asset price exits the open set 0, the
option becomes worthless. In the BlackScholes model, if 0 is of the form ]0, l[
or ]1, +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).
Proof. We shaltprove the result for t ~ 0 s~nce the argument is simil~ ~ o~h::
times There exists an extension of the function u from [0, T] x 0 to [.' ]
that is still of class C 1,2 . We shall continue to denote by u such an extension. From
Proposition 5.1.4, we know that
,
1{\lsE[t,T], x:,xEo}e
We saw under which conditions the option price coincided with the solution of the
partial differential equation (5.9); We now want to address the problem of solving
a PDE such as (5.9) numerically and we shall see how we can approximate its
solution using the socalled finite difference method. This method is obviously
useless in the BlackScholes model since we are able to derive a closedform
solution, but it proves to be useful when we are dealing with more general diffusion
models. We shall only state the most important results, but the reader can referto Glowinsky, Lions and Tremolieres (1976) or Raviart and Thomas (1983) for a
detailed analysis.
104
5.2.1 Localisation
Problem (5.9) is set on ffi. In order to discretise, we will have to work on a
bounded open set VI =] I, l[, where I is a constant to be chosen carefully
in order to optimise the' algorithm. We also need to specify the boundary conditions (i.e. at I and I). Typically, we shall impose Dirichlet conditions (i.e,
u(l) u( I) 0 or some more relevant constants) or Neumann conditions (i.e.
(8u/8x)(I), (8u/8x)( "':'l)). If we specify Dirichlet boundary conditions, the PDE
becomes
105
Thus
+ Au(t, x)
= 0 on [0,T] x VI
P (sup
s:S;T
w, 2: a)
= P (Ta
= f(x) if x EVI.
>. yields
w, 2: a) ~ exp (_ a
sr
T
2
P (sup
We are going to show how we can estimate the error that we make if we restrict
our state space to VI. We shall work in a BlackScholes environment and, thus, the
logarithm of the asset price solves the following stochastic differential equation
'
and therefore
P (SUP(x
"
dX t = (r  O' 2/2)dt + O'dWt.
8u(t x)
8;
s:S;T
ja  X I2)
O'2T'
and therefore ,
and
UI'(t,X) =
where X;'x == xexp((r  O' 2/2)(s  t) + O'(Ws  Wt )). We assume that the
function f (hence J) is bounded by a constant M and that r 2: O. Then, it is easy
to show that '
II  Ir'TI X12)
O' 2 T
(5.1l)
e convergence
even um orrn in t and :: as long as x remains in a compact set of ffi.
IS
Remark 5.2.1
If we call r ' = r  0'2/2
{3s E [t,T],
IX;,xl 2: I}
{sUPt:S;s:S;T
106
compulsory. The estimate of the error will give us a hint to choose the domain of
integration of the PDE. It is quite a crucial choice that determines how efficient
. our numerical procedure will be.
(E)
(J
a
0
'Y
(J
a
'Y
(J
'Y
0
0
0
0
0
Once the problem has been localised, we obtain the following system with Dirichlet
boundary conditions:
ou(t, x)
ot
107
following matrix:
+ Au(t, x)
= 0 on [0, T] x 0,
(J
a
0
0
0
'Y
(J
where
2h
(J'2)
'2
(J'2
(J
 h2
'Y
(J'2
2h 2
(J+a
a
0
with
1 (
2h . r 
(J'2)
'2 .
and replace
2h 2
U i;+1 _ U i  1
b(x.)
,
with
1 (
2h r 
(J'2
= f(x) if x EO,.
0
0
0
. 0
'Y
(J
a
'Y
(J
'Y
0
0
0
(5.12)
0
0
a
0
(J
a
'Y
(J+'Y
Remark 5.2.2 In the BlackScholes case (after the usual logarithmic change of
variables)
 b s  log
u (')
x
02u (X)
=.' (J'22 + (r
ox 2
(J'2)
ou(x)
ox
( )
   ru x
if 0
'
is associated with

(J'
u;.(T)
+1
(AhUh)i = 2h 2 (u~
 2ui.
. 1
(
+ u~)+ r
(J'2)
'2
Ah
1 (+1
2h u~
. 1)
 u~
 rui..
stsT
= fh
W~ are now going to discretise this equation using the socalled Oschemes. We
consIder 0 E [0,1], k a timestep such that T = Mk and, we approximate the
108
U;;:k = fh
lim u~ =
(Eh,k)
un+! _ un
. h,k k
if a:::;
2 ([0, T] x 01)
in
2 ([0,T] x 01).
in
h,k
n:::;
109
O)AhU~:t1 =
+ OAhUh,k + (1 
When a:::; 0
< 1/2, as h,
M1.
lim u~
Remark 5.2.3
=U
2 ([0,T] x 01)
in
T= (I  OkAh)
{ b = (I + (1 '0) kA
h)
U~:t1
= 0, we get
2 ([0, T] x 01)
in
Remark 5.2.5
In the case a :::; ~ < 1/2 we say that the scheme is conditionally conver ent
because the algonthm converges only if h, k and k/h 2 tend to 0 Th
gl
.th
her tri
.
. ese a gon ms are rat er tricky to Implement numerically and therefore they are rarely
used except when 0 = O.
where T is a tridiagonal matrix. This is obviously more complex and more time
consuming. However, these schemes are often used in practice because of their
good convergence properties, as we shall seeshortly,
In the ca~e 1/2 :::; 0 :::; 1 we say that the scheme is unconditionally convergent
because It converges as soon as hand k tend to O. '
When 0 = 1/2, the algorithm is called the Crank and Nicholson scheme. It is
often used to solve systems of type (E) when b = a and a is constant.
When 0
We shall now state convergence results of the solution Uh,k of (Eh,k) towards
u(t, x) the solution of (E), assuming the ellipticity condition. The reader ought to
refer to Raviart and Thomas (1983) for proofs. We denote by u~(t, x) the function
M
L L(uh,k)i 1
jx .  h/ 2,x i+h / 2j
l](nI)k,nkj.
(J)(x)
= h1 ((x + h/2) 
' .
1 kOAh.
(x  h/2)).
..
n=1 i=1
.'
= " Uh,k
+ Iu 12(0,))
T=
bi
CI
a2'"
b2
C2
a3
b3
C3
a
a a
a\ a
aNI
a
a
o
bN  I
CNI
aN
bN
The algorithm runs as follows: first, we transform T into a lower triangular matrix
110
(on a stock offering no dividend) is equal to the European call price. Nevertheless,
there is no explicit formula for the put price and we require numerical methods.
The problem to be solved is a particular case of the following general problem:
given a good function I and a diffusion (X t )t>o in IR". solution of system (5.4),
compute the function
= bN
= gN
For 1 ~ i ~ N 
b'rv
g'rv
1,
.
l
'.
decreasmg.
~(t, x)
a2
b~
a3
T'=.
o
o
o
0
0
b'3
Noticethat ~(t, x)
aNI
0
r(s,X;,z)ds I (X;'X)) .
is the smallest martingale that dominates the process I(Xt} at all times.
.,
b'rv_1
aN
0
~
Remark 5.3.1 It can be proved (see Chapter 2 for the analogy with discrete time
models and Chapter 4 foqhe BlackScholes case) that the process
00
0
0
.
0
0
sup E (e 
rETt.T
. I
tem T' X  G'
, where
We have obtained an equiva
en tsys
111
American options
~
bN
To conclude, we just have to compute X starting frorri the top of the matrix.
Downward:
XI
gUb~
c
For 2 ~ i ~N, i increasing
We just stressed the fact that the European option price is the solution of a parabolic
partial differential equation. As far as American options are concerned, we obtain
a similar result in terms of a parabolic system of differential inequalities. The
following theorem, stated in rather loose terms (see Remark 5.3.3), tries to explain
that.
Theorem 5.3.2 Let us assume that u is a regular solution ofthe following system
ofpartial differential inequalities:
au
. at
Xi = (g~  aixi_I)/b~,
+ Atu  ru ~ 0, u ~ I
(~~ + Atu 
sufficiently small h.
u(T, x)
.
Then
= ~(t,x) =
= I(x)
ru) (f  u)
in
=0
in
[0,T] x IRn
in
[0, T] x IRn
(5.13)
IRn
u(t,x)
Proof. We shall only sketch the proof of this result. For a detailed demonstration,
the reader ought to refer to Bensoussan and Lions (1978) (Chapter 3; Section 2)
and Jaillet, Lamberton and Lapeyre (1990) (Section 3). We only consider the case
t = 0 since the proof is, very similar for arbitrary t. Let us denote by Xt the
solution of (5.4) starting at x at time O. Proposition 5.1.3 shows that the process
~e;l:~ts~c~~~;:~:l,
rETt.T
:e
~or(;;~p~\ce)of
M;
where
~(t,x)
r(s,X;'~)ds I
sup E
tl ))
rETt,T
is th
t of
( )
is a standard Brownian motion and !t,T IS e se ,
and, under P , ~t t~O
[ T] W
howed how the American call pnce
stopping times taking values in t, . e s
.
'T
e J;'r(s,X;)dsu(t,
ior '
(X;'X)) .
.
Xn
e J; r(v,X;)dv (au
at
+ A u  ru)
s.
(s XX)ds
's
is a martingale. By applying the optional sampling theorem (3.3.4) to this martingale between times 0 and T, we get E(Mr) = E(Mo ), and since au/at + Asu
112
s0
ru
U(O, x) 2: sup E
(eJOT
rE70,T
r(s,X:lds f(X:))
.
n).
U(O,x)=.E
Because at time
Topt.
av
at (t, x) + Abs1ogv(t, x) $ 0 a.e. in
[0, T] xIR
This
= F(O, x).
X)
_1. TOp' r(s,X:lds U(Topt,Xrop.)
e
American options
id
113
If weconsl er(x) = (K eX) h
"
"
to the price of the American putis t e partial differential inequality corresponding
v(t,x)2:(x)
a.e.in
(v~t, x) 
(x))
[O,T]xIR
= 0 a.e. in
[0, T] x IR
veT, x) = (x).
The following theorem states the results o f existence
.
.
and uniqueness
of a(5.14)
solu~
tiraI mequalttyand
.
.
tion to, this partial diirreren
establi h th
"
Amencan put price.
IS es e connection With the
er,
That proves that u(O,x) $ F(O, z}, and that u(O, x) = F(O,x). We even proved
that Topt is an optimal stopping time (i.e. the supremum is attained for T = Topt).
v(t,log(x))
= ~(t,x) =
IS so ution satisfies
The proof of this theorem can be found in Jaillet , L am b erton and Lapeyre (1990),
Remark 5.3.3 The precise definition of system (5.13) is awkward because, even
2
for a regular function f, the solution U is generally not C . The proper method
consists in adopting a variational formulation of the problem (see Bensoussan and
Lions (1978. 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.
aVe
dS t = St (rdt + O"dWt) .
b
~at t,x)+As1ogv(t,x)$0
We are leaving the general framework to concentrate on the pricing ofthe American
(A) ,
a.e.in
[0 ,T] X
o.
[0, T] x Ot
(V)(:~(t,;r)+A:bSIOgV(t,x))
=0
a.e. in
[0, T]
o,
We saw in Section 5.1.3 how we can get an elliptic operator by introducing the
process
x, =
veT, x) = ~x) ,
(r  0";) t + O"Wt
av
a(t,
l) =
X
2 2 ( 2) a 
0" a + r  .0"
bs Iog __ Abslog  r __ A .
2 ax 2
.
2
ax
r.
o.
114
Mk
= T,
Ih
,I,() where x  I
is the vector given by I h = If' Xi
i
+ 2il/(N
1)
. IRn+we
American options
115
with
and Ah
IS
(Ah,k):
_Ok(~+~(r_02))
2h 2 2h
2
'
and if 0 ~ n ~ M  1
!h
O)AhU~~I)
~0
'
+ (1 .
n+l) ,Uh,k
n 0 )A hUh,k
.
Ir 
I h)  0.
. given
.
by (5 . 12). If we note
. ) is the scalar product in IR an d A h IS
(x,y
were
.
h
.
'.
x:Tx
nl
+ L bx~ + L
L aXilxi
i=2
n
i=I
CXiXi+!
i=1
+ ax~ + cx~
x =
Uh.k
G
F
fh,
Under the coercitivity assumption, we can prove that there exists a unique solution
to the problem (Ah,k) (see Exercise 28).
The following theorem analyses explicitly the nature of the convergence of a
solution of(Ah,k) to the solution of (A). We note
M
(AD)
X
\
u~(t,x)
~ F
(T X  G, X  F) = 0,
a+b
a
0
b
a
0
0
0
0
0
0
'.'
b
. a
0
0
0
C
'b + C
l](nl)k,~k]'
.
T=
= L L(uh,k)il]:Z:ih/2,:Z:i+i/2] x
n=I i=1
lim u~
\
=U
if li and
k converge to 0 and
if
L 2 ([0, T) x (1)
in
.
au
lim aukh = ax
in
L 2 ([0, T) x 01),
116
The reader will find the proof of this result in Glowinsky, Lions and Tremolieres
(1976). See also XL Zhang (19 94).
American options
117
In the American put case, when the step h is sufficiently small, we can solve the
system (AD) very efficiently by modifying slightly the algorithm used to solve
tridiagonal systems of equations. We shall proceed as follows (we denote by b the
vector (a + b, b, . . . ,b + e))
Upward:
,b'tv ~ bN
g'tv = s
~For 1 ~ i ~ N  1, decreasing i
b~
g~
= b, = gi 
ca/b~+l
eg~+db~+l
'American' downward:
= =
Pn
= Pam(n, $n),
'
and that the function Pam (n , x) cou ld be computed by induction. according to the
equation
Xl
gUb~
For 2 ~ i ~ N, increasing i
Xi = (g~  aXkd/bi
Xi
= SUp(Xi, Ii)'
Jaillet, Lamberton and ~apeyre (1990) prove that, under the previous assumptions,
this algorithm does compute a solution of inequality (AD).
Remark 5.3.7 'The algorithm is exactly the same as in the' European case, apart
'
,
from the step Xi = SUp(Xi, Ji). That makes it very effective.
Pam(n, x)
= max ( (K 
+ I, (1+ .)x) + (1 
RT/N
l+a
exp
+b)X)
p)Pom(n + I, (1
l+r
x)+,
PP(
om n
(aVT/N)
(+~VT/N)
l+b
exp
(br)/(ba),
(5.16)
Exercises
118
119
v (t, x) ~ (x)
vex)
.,
(5.17)
+ p(M X 
G), V  Y) ~ O.
(!< 
a.e.in
(5.19)
(x) otherwise.
lalu~(O,x) + 1 + lal
>'xOt if x ~ x"
5. Using the closedform formula for u. (0, x) (see Chapter 4, equation 4.9), prove
. that f(O) > 0, that f(K) < K (hint: use the convexity of the function u.) and
that f(x)  x is nonincreasing. Conclude that there exists a unique solution to
the equation f(x) = x.
[O,T]x]O,+oo[
.
(U_(K_X)+).(~~(t,x)+AbSU(t,X))
u(T, x) =
+oof
a.e. in
]0,
Ku.(O,x)
f(x) =
u (t, x) ~ (K  x)+
a.e. in
Write down the equations satisfied by >. and a so that v is continuous with
continuous derivative at z" . Deduce that if v is continuously differentiable then
z" is a solution of f(x) = x where
~:
aU(t,x)+AbBu(t,x).::;O a.e.in
at
.
=0
]0, +oo[
+ T Absv(x) = O.
vex) =
(M X  G, V ., X) ~ O..
(Y  X
a.e. in
VV > F
x)+  u.(O,x)
(5.18)
3. Find the unique negative value for a such that vex) = x" is a solution of
]0, +oo[
:::G
VV ~
= (K 
a.e. in
[O,T]x]O,+oo[
x)+
where'
"
'
Interest rate models are mainly used to price and hedge bonds and bond options.
Hitherto, there has not been any reference model equivalent to the BlackScholes
model for stock options. In this chapter, we will present the main features of
interest rate modelling (following essentially Artzner and Delbaen (1989, study
three particular models and see how they are used in practice.
F(t, T)
= e(Tt)R(t,T).
If we consider the future as certain, i.e. if we assume that all interest rates
(R(t, T))t<T are known, then, in an arbitragefree world, the function F must
satisfy

'TIt < T
F(t, T)
= exp
(iT
r(S)ds)
Interest
, rate models
122
and consequently
R(t, T)
1
= T'
 t
iT
t
Modelling principles
r(s)ds.
P(t, T)
123
= e J.T r(s)ds.
is a martingale.
This hypothesis has some interesting conse
erty under P* leads to, using the equality p(~~~)e~ I;,deed, the martingale prop
. .
~(t,U) = E* (F(u,u)/Ft)
= E*
(e fa"r(S)ds!Ft)
P(t,u)
(e J."r(S)ds!;:,)
= E*
(6.1)
(6.2)
P(t, u) only depend on the behaviour of th rmula (6.1), shows that the prices
d
he process (r(s))OSsST under the
probability P*. The hypothesis w
e rna e on t e filtration (;:, )
.
11
express the density of the probabilit P* ith
t 09ST a ows us to
S to  e.f0 r(s)ds
where (r(t))oStST is an adapted process satisfying JOT Ir(t)ldt < 00, almost
surely. It might seem strange that we should call such an asset riskless since its
price is random; we will see later why this asset is less 'risky' than the others.
The risky assets here are the zerocoupon bonds with maturity less or equal to the
horizon T. For each instant u ~ T, we define an adapted process (P(t, u))o<t<u,
satisfying P(u, u) = 1 giving the price of the zerocoupon bond with matu~ity u
as a function of time.
In Chapter 1, we have characterised the absence of arbitrage opportunities by
the existence of an equivalent probability under which discounted asset prices
are martingales. The extension of this result to continuoustime models is rather
technical (cf. Harrison and Kreps (1979), Stricker (1990), Delbaen and Schachermayer (1994), Artzner and Delbaen (1989)), but we were able to check in Chapter
4, that such a probability exists in the BlackScholes model. In the light of these
examples, the starting point of the modelling will be based upon the following
hypothesis:
(H) There is a probability P* equivalent to P, under which, for all realvalued
WI respect to P We denot b L hi
.
Y
density,
For any nonnegative random
. bl X
.'
e Y T t IS
and, if X is Ftmeasurable E* (X) _ v;(~~) ,w~ have E* (X) = E(X L T )
the random variable i; is th~ density P*
t.' sedttIn g t; ~ E(LTIFt). Thus
. .
restncte to Ft WIth respect to P.
Proposition 6.1.1 There is an ada d
(
t E [0, T],'
',
.
. pte process q(t ))OStST such'that, for all
;rt.
i;
a.s.
(6.3)
t;
= Lo + i t HsdWs
S'
a.s.
10g('L t)
Jo
o
which leads to equality (6.3) with q(t) = HtiL .
t
a.s.
124
.
>
Corollary 6.1.2 The price at time t of the zerocoupon bond of maturity u 
Modelling principles
riskier. Furthermore, the term r(t)  arq(t) corresponds intuitively to the average
yield (i.e. in expectation) of the bond at time t (because increments of Brownian
motion have zero expectation) and the term a;:q(t) is the difference between
the average yield of the bond and the riskless rate, hence the interpretation of
q(t) as a 'risk premium'. Under probability P*, the process (TVt ) defined by
TVt = W t  f; q(s)ds is a standard Brownian motion (Girsanov theorem), and
we have
can be expressedas
P(t u)
,
(6.4)
E (XIFt ) =
E (XLTI F t )
L
t
125
dP(t, u)
P(t, u)
(65)
= r(t)dt + at dWt.
(6.7)
For this reason the probability P" is often called the 'risk neutral' probability.
To make things clearer, let us first consider a European option with maturity 0
on the zerocoupon bond with maturity equal to the horizon T. If it is a call with
strike price K, the value of the option at time 0 is obviously (P(O, T)  K)+ and
it seems reasonable to hedge this call with a portfolio of riskless asset and zerocoupon bond with maturity T. A strategy is then defined by an adapted process
((HP, H t) )O~t~T with values in rn?, Hp representing the quantity of riskless asset
and H, the number of bonds with maturity T held in the portfolio at time t. The
value of the portfolio at time t is given by
+ afdWt.
(6.6)
Proof. Since the process (F(t, u))o9~u is a martingale under P~, (F()t u)L~09~U
is a martingale under P (see Exercise 31). Moreo~er~ we have: P(t, U .t. > 6 ~.si'
f
ofPr?po~ltI2on >: '
uj Then , using the same rationaleUas In the proof
or aII t E [0, .
h h t t ( OU) dt < 00
we see that there exists an adapted process (Ot )o~t~u SUC t a Jo t
and
F(t, u)Lt
Ie'(O~)2ds
= P(O,u)e Ie'oO"dW._l
'
.
2
+ fat (O~ 
dVi = HPdS~
q(s))d~s
r(t)dt
+ (Of 
q(t))dWt 
~((Of)2  ~(t)2)dt
+ q(t)2 
if it is self
Proposition 6.1.6 We assume sUPO<t<T Ir(t)1 < 00 a.s. and o'[ 1: 0 a.s. for
all t E [0,8]. Let 0 < T and let h bean Focmeasurable random variable such
Ofq(t))dt
= Or 
((HP,Ht))o~t~T is admissible
+~(Of  q(t))2dt
,2
(r(t)
financing and ifthe discounted value Vi () = Hp + H, F( t, T) ofthe corresponding portfolio is, for all t, nonnegative and if SUPtE[O,Tj Vi is squareintegrable
underP*.
.
q(S)2)dS).
+ HtdP(t, T).
Taking into account Proposition 6.1.3, we impose the following integrability conT
T
ditions: fo IHpr(t)ldt < 00 and fo (H ta;:)2dt < 00 a.s. As in Chapter 4, we
define admissible strategies in the following manner:
Definition 6.1.5 A strategy
_~ it ((O~)2 dP(t,u)
P(t,u)
Hence, using the explicit expression of L; and getting rid of the discounting factor
P(t, u)
Vi
+ (Of 
q(t).
q(t))dWt,
.C
Vi
= E*
(e
r(S)dshl Ft) .
126
Vi is
the (discounted) value at time t of an admissible strategy ((HP, H t) )O<t<T, we
obtain, using the selffinancing condition, the integration by parts forffili"la and
Remark 6.1.4 (cf. equation (6.7))
= HtdP(t, T)
= n.i, T)aT dWt .
We deduce, bearing in mind that SUPtE[O,TJ Vi is squareintegrable under P*, that
(Vi) is a martingale under P*. Thus we have
'It 5, 8 Vi = E* ( Vol F t )
dVt
~=
o
such that Io Jt < 00, a.s, and
 
1Jsd~s.
0
127
X,
>:
an d
H tO E* (h e
1.
r(S)ds\:F.)
t
dX t
00
ret)
it
asdWt
e:
it is not clear that the risk process (q(t)) is defined without ambiguity. Actually, it
can be shown (cf. Artzner arid Delbaen (1989)) that P* is the unique probability
equivalent to P under which (p(t, T))O<t<T is a martingale if and only if the
process
satisfies
:f:. 0, dtdP almOsteverywhere. This condition, slightly
weaker than the hypothesis of Proposition 6.1.6, is exactly what is needed to hedge
options with bonds of maturity T, which is not surprising when one keeps in mind
the characterisation of complete markets we gave in Chapter 1.
aT
= aXtdt + adWt.
at
(6.10)
= r(O)e at +
Remark 6.1.7 We have not investigated the uniqueness of the probability P* and
(an
b,
i:T
for t 5, 8. We check easily that ((HP,Ht))o<t<o defines an admissible strategy (the hypothesis sUPO<t<T Ir(t)1 < 00 a~s.guarantees that the condition
I~ Ir(s)H~lds <
= ret) 
it is sufficient to set
Jt T
pet, T)a t
(6.9)
where b
b  .\a 1a and W  W
.\
.
according to this model let us g'i t + t. Before calculating the price of bonds
set
.'
ve some consequences of equation (6.8). If we
Note that this property is not a trivial consequence of the theorem of representation
Ht 
+ adWt
r~t)
v:i~blea~i;h:
,.
m~mty,
P(t,T)
E*(eJ.Tr(S)d~IFt)
128
eb(Tt)E* (e
r x;dsl
Ft)
(6.11)
T
X;dS\ Ft) = F(T 
ft
E* ( e 
.
. 0 f equaU' on (6 . 12) which satisfies X
unique
solution
t,r(t)  b*)
(6.13)
s
fo X:dS) , (X"')
t
being the
3.5.11).
)
letel We kn ow (cf, Chapter 3) that
It is possible to calculate F(B, x compe y.
9 '"
h
(X"') is Gaussian with continuous paths. It follow.s that fo X s ds
r X~dS)
GaUSSian(,
E* e o '
( E*
= exp 
(1
X"'dS)
s
~Var (1
2
0 ~
X:dS)).
1X:d~
9
'
(I,' X:d')
0"2 ea(t+ u)
. 1
0" e
a(t+u)
t)R(T  t, r(t))],
where R(T  t, ret)), which can be seen as the average interest rate on the period
[t,T], is given by the formula
with Roo = lim9~oo R(B, r) = b"  0"2/(2a2). The yield Roo can be interpreted
as a longterm rate; note that it does not depend on the 'instantaneous spot rate' r.
This last property is considered as an imperfection of the model by practitioners.
Remark 6.2.1 In practice, parameters must be estimated and a value for r must
be chosen. For r we will choose a short rate (for example, the overnight rate); then
we will fit the parameters b, a, 0" by statistical methods to the historical data of
the instantaneous rate. Finally .x will be determined from market data by inverting
the Vasicek formula. What practitioners really do is to determine the parameters,
including r, by fitting the Vasicek formula on market data.
t l\ u
.
e2asds
o
( e 2a(tI\U) 
2a
1)
= (a  br(t))dt a~dWt
(6.15)
with 0" and a nonnegative, s e JR., and the process (q(t)) being equal to q(t) =
Cov(Xf,X~)
= exp [(T 
dr(t)
COY
Going back to equations (6.11) and (6.13), we obtain the following formula
Cox; Ingersoll and Ross (1985) suggest modelling the behaviour of the instantaneous rate by the following equation:
Var
9
r
X"'dS) = 0"2B _ 0"2 (1 _ e a9) _ z: (1 _ ea9)2 .
Jo
a2
a3
2a3
Remark 6.2.2 In the Vasicek model, the pricing of bond options is easy because
of the Gaussian property of the OrnsteinUhlenbek process (cf. Exercise 33).
,
1 e a9
= x  a
Var (
= xe as ~ we deduce
E*
.t29
pet, T)
= F(T 
t,X;)
(6.12)
(6.14)
aVT(t), with a E JR.. 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. However, from the HOlder property of the
square root function, one can show the following result,
Theorem 6.~.3 We suppose that (Wt ) is a standard Brownian motion defined on
[0,00[. For any real number x 2: 0, there is a unique continuous, adapted process
(X t ), taking values in'JR.+, satisfying X o x and
on
[0,00[.
(6.16)
For a proof of this result, the reader is referred to Ikeda and Watanabe (1981), p.
221. To be able to study the CoxIngersollRoss model, we give some properties
.:="
'lj;'(t)
{
0 = 00.
Proposition 6.2.4
Thi
oposition is proved in Exercise 34.
. .'
f
IS p r .
..
hich enables us to characterise the JOint law 0
The following proposition, w
.
d I
x ft XXdS) is the key to any pricing within the CoxIngersollRoss mo e .
t
'Jo
'
.,
E (e>'X;)
= (
2/4b
=  a2 log
2,e
'lj;(t).
b
) 2a/u
a 2/2A(1  e bt) + b
exp
(2AL
+ 1)2a/u
exp (
with,
'lj;>',I'(t) =
a2A (e1't _ 1) +
= Jb + 2a
2JL.
bt
(6.17)
2 a 2F
aF
_ ='~x2
at. Q . ax
.,
v
+ (a 
F(O,x)=e
aF
.
bx)  JLxF
ax
>.x
Indeed, if F satisfies these equations and has bounded derivatives, the Ito formula
shows that, for any T, the process (Mt)o9~T, defined by .r
, XT.ds
Mt.='e I' 1. ~ F(T 0
t, X t )
2AA~ 1) .
This function is the Laplace transform of the noncentral chisquare law with 8
degrees of freedom and parameter ( (see Exercise 35 for this matter). The density
of this law is given by the function [s.c. defined by
.
i: b + e1'tCT + b)
Abe bt
)
x a2 /2A(1 _ ebt) + b
AL()
2AL + 1
and
with L = a
(1  e ) and ( = 4xb/(a 2 (e bt  1)). With these notations,
the Laplace transform of Xi / L is given by the function 94a/u2,(, where 96,( is
defined by
'(t)
Solving these two differential equations gives the desired expressions for and
'lj;.
0
(x
131
= inf{t ~ 0IX: = O}
T~
(r::;()
(/2
I
() e
J6,(
x  2(6/41/2
e x/2 x 6/41/2I6/21 V zt,
lor x > 0 ,
l'
Iv(x) =
~
(~)v
2
f:
n=O
(x/2)2n
n!r(v + n + 1) .
The reader can find many properties of Bessel functions and some approximations of distribution functions of noncentral chisquared laws in Abramowitz and
Stegun (1970)rChapters 9 and 26.
Let us go back to the CoxIngersollRoss model. From the hypothesis on the
processes (r(t)) and (q'(t)), we get
+ av0'ijdWt,
132
133
denoting by PI and P 2 the probabilities whose densities relative to P" are given
respectively by
by:
P(O,T)
__
dP l
_a<!>(T)r(O).p(T)
th.+ b .
(t) =  a 2 log
r(s)ds P(O,T)
P(O,T)
dP 2
dP
and
 J.9 r(s)ds
0
P(O,O)
(e"Y o  1)
o
1 = 2'" 'Y. (e"Y + 1) + (a 2 'ljJ (T  0) + b) (e"Y o  1)
a2
+ e"Ytb + e)
'Y. _ b.
2'Y e ........,.
e
dP 
(6.18)
where the functions and 'ljJ are given by the following formulae
2
and
a2
(e"Y o 1)
..,.='..,.',,:: 2 'Y. (e"Y o + 1) + b: (e"Y o  1)'
2  
and
.
2(e"Y t  l )
.'ljJ(t) ,= 'Y. _ b + e"Ytb + b)
with b"
= exp (a(T 
t)  r(t)'ljJ(T  t)) .
the law of r(O) / 1 under PI (resp. r(O) / 2 under Ps) is a noncentral chisquared
law with 4a/a 2 degrees of freedom and parameter equal to (I (resp. (2), with
,
8r(Oh 2e"Y O
.
.
(1 = a2 (e"YO  1) b(e"Y o + 1) + (a 2'ljJ (T  0) + b)(e"Y o  1))
and
8r(Oh 2e"Y O
(2 = a2 (e"YO  1) b(e"Y o + 1) + b(e"Y o  1)) .
Let us now price a European call with maturity 0 and exercise pr~ce K, on a ~e~o
coupon bond with maturity ~. We .can sho~ that the hypothesIs of Proposition
6.1.6 holds; the call price at time
Co
ISthus given by
With these notations, introducing the distribution function Fo,( of the noncentral
chisquared law with fJ degrees of freedom and parameter (, we have consequently
Co
J: r(S)dS 1{r(o)<r.})
r"
Notice that
=
a(T  0) + log(K)
'ljJ(T _ 0)
E. ( e
 t r(s)ds
P(O T))
o,
.
(e  J.9 r(S)ds) _
of discounted prices. Similarly, E
0
K P(O,O)F4a/u 2 ' ( 2
(~:)
The main drawback of the Vasicek model and the CoxIngersollRoss 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.
Some authors have resorted to a twodimensional analysis to improve the models
in terms of discrepancies between short and long rates, cf. Brennan and Schwartz
(1979), Schaefer and Schwartz (1984) and Courtadon (1982). These more complex
models do not lead' to explicit formulae and require the solution of partial differential equations.
More
recently, Ho and Lee (1986) have proposed a discretetime
.
\
.model describing the behaviour of the whole yield curve. The continuoustime
model we present now is based on the same' idea and has been introduced by
Heath, Jarrow and Morton (1987) and Morton (1989).
First of all we define the forward interest rates f (t, s), for t ::; s, characterised
,
 , .
Co
134
(l
P(t,u) = exp
f(t,S)dS)
(6.19)
for any maturity u. So f(t, s) represents the instantaneous interest rate at time s
as 'anticipated' by the market at time t. For each u, the process (J(t,u))o~t~u
must then be an adapted process and it is natural to set f(t, t) = ret). Moreover,
we constrain the map (t, s) H f(t, s), defined for t ~ s, to be continuous. Then
the next step of the modelling consists in assuming that, for each maturity u, the
process (J(t, u))o~t~u satisfies an equation of the following form:
it
a(J(v, u))dWv,
dP(t, u)
pet, u)
1
ex, + "2d(X,
x),
If the hypothesis (H) holds, we must have, from Proposition 6.1.3 and equality
f(t, t) = ret),
arq(t)
U
l
l + l {is
+ l (is
= l
+ l (l
+l
=
+ it
(l
a(v, S)dV) ds
(lua(J(v, S))dS) dW v
Xo
i~' (t
1~ a(t,S)dS) dt 
(l
a(J(t, s'))ds
= a(J(t, u))
a(V,S)dS}diJ'
(6.21)
The fact that the integrals commute in equation (6.21) is justified in Exercise 37.
We then have
ex, = (f(t,t)
a(t,u) = a(J(t,u'))
f(S,s)dSi
U
(6.22)
a(v:S)dS}dV
q(t)
f(s,s)ds
2 
The following theorem, by Heath, Jarrow and Morton (1987), gives some sufficient
conditions such that equation (6.22) has a unique solution.
a(J(v, S))dWv) ds
u
a(J(t, S))dS)
~(lU a(J(t,S))ds}2,
df(t, u)
f(s, s)ds
a(t,S)dS) 
a(t, s)ds =
(lU
U
~ (l
X;
(6.20)
the process (a(t, u))o9~u being adapted, the map (t, u) H a(t, u) being continuous and a being a continuous map from IR into IR (a could depend on time as
well, cf. Morton (1989.
Then we have to make sure that this model is compatible with the hypothesis
(H). This gives some conditions on the coefficients a and a of the model. To find
them, we derive the differential dP(t, u)/ pet, u) and we compare it to equation
(6.6).LetussetXt =  f U f(t,s)ds. WehaveP(t,u) = eX. and,fromequation
(6.20),
135
f(t, u)
Some classicalmodels
a(J(t,S))dS) dW t
The striking feature of this model is that the law of forward rates under P" only
depends on t~e function zr. This" is a consequence of equation (6.22), in which
only a a~d (Wd appear. It follows that the price of the options only depends on
the function d. This situation is similar to BlackScholes'. The case where a is a
constant is covered in Exercise 38. Note that the boundedness condition on a is
essential since, for a(x) = x, there is nQ solution (cf. Heath, Jarrow and Morton
(1987) and Morton (1989.
136
Notes: To price options on bonds with coupons, the reader is referred to Jamshidian
(1989) and EI Karoui and Rochet (1989).
Exercises
137
4. Using the previous question, show that under the probabilities whose densities
are respectively exp (  J; r(s)ds) / P(O, ()) andexp (  JoT r(s)ds) / P(O, T)
with respect to P *, the random variable r( ()) is normal. Deduce an expression
for the price of the option in the form Co = P(O, T)PI  K P(O, ())P2' for some
parameters PI and P2 to be calculated.
6.3 Exercises
Exercise'30 Let (Mt)O~t~T be a continuous martingale such that, for any t E
[0, T], P(Mt > 0) = 1. We set
T
s(x)
= E (MT1{T=T}).
/72
~s
 x 2
2 dx
2. For e
Exercise 32 The notations are those of Section 6.1.3. L~t (Mt)O~t~T be a proce~s
adapted to the filtration (Ft ) . We suppose that (Mt ) IS a martingale under P .
Using Exercise 31, show that there exists an adapted process (Ht)o9~T such that
00
]0,oo[ by
Exercise 31 Let (n, F, (Ft)o9~T, P) be a filtered space and let Q be a probability measure absolutely continuous with respect to P. We denote by L, the
density of the restriction of Qto Ft. Let (~t)09~T ~e an adapted process. 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.
> 0,
ds
+ (a  bx)= 0.
dx
Deduce, taking the variance on both sides and using the fact that s' is bounded
from below on the interval [e, M], that E (T:'M) < 00, which implies that T:,M
is finite a.s.
a.s. and
< x <M, s(x) = s(e)P (T: < TM) + s(M)P (T: > TM)'
We assume a 2: /72/2. Then prove that limx..+~ s(x) = 00. Deduce that
P (TO < TM) = for all M > 0, then that P (TO < 00) = 0.
We now assume that ~ a < /72/2 and we set s(O) == limx..+o s(x). Show
that, for all M > x, we have s(x) = s(O)P (TO < TM) + s(M)P (TO> T
M)
and complete the proof of Proposition 6.2.4.
3. Show that if e
for all t
4.
E [0, T].
E~ercise 33
r*
Roo ( 1  1 _
log(K)
ea(T II)
(1 _e~a(TII)
. , 4a2
) .
dP
5.
' e>'x
dP = E (e>'x)"
Show that, under P, Y is normal and give its mean and variance.
138
Exercises
139
f: E (f: H
2(t,
s)dt) ds <
00
(which is sufficient
I. Prove that
ds,
(I: nu;
I: (iT
[T
Jo
=
s) (W ti+1 .WtJ) ds
.=0
.=0
and justify why we can take the limit to obtain the desired equality.
Exercise 38 In the HeathJarrowMorton model, we assume that the function a is
a positive constant. We would like to price a call with maturity' 0 and strike price
K, on a zerocoupon bond with maturity T > O.
1. Show that the hypothesis of Proposition 6.1.6 holds.
2. Show that the solution of equation (6.22) is given by f(t, u)
a 2 t (u  t/2) + aWt . Deduce, that
ll
T)
P( u'.
= P(O,T)
(_ (T' _
P(O,O) exp
a
(e
rJ'
ll)TXT
U
.,
HII
20T(T.
f(O, u)
0))
dP
dP* =
e
JOB r(~)dSp(o, T)
P(O,T)
and
dP
e foB ~(s)ds
2
=
dP*
P(O,O)
In the BlackScholes model, the share price is a continuous function of time and
this property is one of the characteristics of the model. But some rare events
(release of an unexpected economic figure, major political changes or even a
natural disaster in a major economy) can lead to brusque variations in prices.
To model this kind of phenomena, we have to introduce discontinuous stochastic
processes.
Most of these models 'with jumps' have a striking feature that distinguishes
them from the BlackScholes model: they are incomplete market models, and
there is no perfect hedging of options in this case. It is no longer possible to price
options using a replicating portfolio. 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.
In this chapter, we will study the simplest models with jumps. The description
of these models requires a review of the main properties of the Poisson process;
this is the objective of the first section.
7.1 Poisson process
(Tik~l be a sequence of independent, identically exponentially distributed random variables with parameter A, i. e. their density is equal to
l{x>o}Ae>.x. We s~t Tn
L~l t: We call Poisson process with intensity A the
process N, defined by
.
Nt
=L
n~l
l{Tn::;t}
= L nl{T
n::;t<Tn+l}'
n~l
Remark 7.1.2 N; represents the number of points of the sequence (Tn)n~ 1 which
are smaller than or equal to t. We have
Tn
= inf{t ;to,
N,
= n}.
143
142
.
The following proposition gives an explicit expression for the law of N; for a
.,
.
given t.
Proposition 7.1.3 If (Ntk~o is a Poisson process Wlt~ intensity A then, for any
t > 0, the random variable N, follows a Poisson law witn parameter A
P(Nt = n) = e
>.t
(At)n
,.
n.
P(Nt
n.
(Nt)t>o is a process with independent and stationary increments, rightcontin
In particular we have
E(Nt )
Moreover, for s
>
= At,
= n) = e>'.t (At~n.
E (sN.)
= exp {At (s 
I)}.
(AX)nl .
l{x>O}.Ae>'x (n _ I)! dx,
:I.e. a gamma law with parameters
, A and n. Indeed, the Laplace transform of
E
thus the law of Tn
(e
T1
is
ct T 1
)
= T 1 + ... + Tn is
E(e ctr n ) = E(e
= A + 0:'
ct T l
(
= (A ~ 0:) n
We recognise the Laplace transform of the gamma law with parameters A and n
(cf. Bouleau (1986), Chapter VI, Section 7.12). Then we have, for n 2: 1
P(Nt = n)
P(Tn ~ t)  P(Tn+l ~ t)
)nl
{ Ae>'x AX
dx _
Jo
(n  I)!
(Att
>.t
e
.
n!
t (\
it
0
(AX)n
Ae>'x   Idx
n.
t
't"
7 1 4 Let (Nt ) t >0 be a Poisson process with intensity A
d and .F =
Proposl Ion . .
a(N ', s ~ t). The process (Ntk~o is a process with independent an stationary
The objective of this section is to model a financial market in which there is one
= e'", at time t) and one risky asset whose price
riskless asset (with price
jumps in the proportions U1 , ... , Uj, ..., at some times Tl , ... , Tj, ... and which,
between two jumps, folIows the BlackScholes model. Moreover, we will assume
that. the Tj'S correspond to the jump times of a Poisson process.To be more rigorous, let us consider a probability space (11, A, P) on which we define a standard
Brownian motion (Wdt~o, a Poisson process (Nt)t~o with intensity A and a
sequence (Uj)j~1 of independent, identicalIy distributed random variables taking
values in ]1, +00[. We will assume that the aalgebras generated respectively
by. (Wdt~o, (Nt)t~o, (Uj)j~1 are independent.
For all t 2: 0, let us denote by F t the aalgebra generated by the random
variables Ws , N, for s ~ t and tt, 1{j~Nd for j 2: 1. It can be shown that
(Wdt>o is a standard Brownian motion with respect to the filtration (Ft)t>o, that
(Nt)t~o is a process adapted to this filtration and that, for all't > s, N, ~ N, is
independent of the zralgebra F s . Because the random variables UjJ{j~Nd are
Frmeasurable, we deduce that, at timet, the relative amplitudes of the jumps
taking place before t are known. Note as well that the Tj'S are stopping times of
(Fdt~o,.sinc~ {Tj ~ t} = {Nt 2: j} EFt.
_
The dynamics of Xt, price of the risky asset at time t, can nowbe described
in the following manner, The process (Xt)t~O is an adapted, rightcontinuous
process satisfying:
Sr
increments, i.e.
independence:
dX t
if s > 0, N t+ s
h, Tj+l [
= N s
Remark 7.1.5 It is easy to see that the jump times Tn are stopping tim~s. In~eed~
{ Tn < t} = {Nt 2: n} E Ft. A random variable T with .expon~nuallaw sat~sfie
P(T 2: t + siT 2: t) = P(T 2: s). The exponential variables are said to
At time
Tj,
 \ 6,Xr
.
thus X r;
= Xt(jldt + adWt).
= Xr~, (I + Uj ) .
=X
r J, 
XT j
=X
Tj
U
, j
144
145
T \
and
n C n {(U 1, .. . , Ud) E B} n {d $ N s } )
2
X T\ ,= X o(1 + U1)e(/L<T /2)T\ +<TW
T\
00
X,
=
=
=
T\ )
T \ )
x, =Xo
(fl(1
+Uj ) )
e(/L<T2/2)t+<T~',
p=d
P a.s.
= Xo +
x,
1x,
'.
(J.Lds
N,
+ adW s) + L
j=1
XTjU j
(7.1)
0, the aalgebras
We will see that, for this kind of model, it is generally impossible to hedge the
options perfectly. This difficulty is due to the fact that for T < +00, there are
infinitely many probabilities equivalent to P on :FT under which the discounted
price (e rt Xt)O<t<T is a martingale. In the remainder, we will make the following assumption: under P, the process (e rt Xt)O<t<T is a martingale. This
is a stringenthypothesis, but it will allow us to determine simply some hedging
strategies with minimal risk. When this hypothesis does not hold, the hedging of
options is rather tricky (see Schweizer (1989)).
.
To derive E(Xtl:Fs) we will need the following lemma; which means intuitively that the relative amplitudes of the jumps which take place after time s are
independent of the aalgebra :F~.
J=1
= p}).
E(X,J.r.)
X.E (,(.,u',,*,,)+U(w.w.) .
fi
(1 +
U;)j.r.)
J=Ns+l
X\E (e(/L_r<T
.
2/2)(t_ S)+<T(W,_W.)
N
rr'Ns(1
+U
')1)
Ns+J :Fs
j=1
I+U Ns+j )
)
,
j=1
N
s
Xse(/Lr)(t.,s)e),(ts)E(U!l
are
. d
In
d
epen ent of
146
.=r: 
f.L
(I ~8 J
t
v(dZ)<P
Mt
N.
=L
2(:s,
z)) <
ds
(7.2)
setting
8.
'
v(dz)<p(Ys, z), :
j=l
1 JV(~Z)<p2(YSl
' t
M;  A
ds
J=l
z)
~i (y) is thus the expectation of a random sum and, from Exercise 40,
is a martingale.
2:~=1
~i(Y) = A(Si+l 
= 1.
s.)
av(z)<p(y, z).
I<p(y, z)l
sup
(y,z)EHtd xlR
UJ.en we have
N 5)..
c 11
' It 10 ows that the convergence takes place in L 1
Using
7.2.1'and the fact that Y.5,. is F measurabl e, we apply Proposition
..
A
2 5 Lemma
f th A
. . 0
e ppendix to see that
+00.
'It J
<p(YTj, V j)  A
147
AE(V1 )
To deal with the terms due to the jumps in the hedging schemes, we will need two
more lemmas, whose proofs can be omitted at first reading. We will denote by v
the common law of the random variables Vj's.
< t, and
set
E( Z'IF.)
s.)
N.
<p(YTj , Vj).
j=N.+1
To a partition p = (80 =.8
associate
ml
ZP =
N~i+l
L L
<p(Ys"Vj).
i=O j=N+I
The leftcontinuity 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.
,+ 1 .r 5;
We
IF.) .
.. ~
148
Moreover,
E ((Zp  2
p)2I
FS)
E (it ds /
IF.]
Fs)
dv(z)~2(ys, z))
< +00,
for any t, we can introduce the (bounded) functions ~n's defined by ~n(y, z) =
inf(n, sup( n, ~(y, z))), and the martingales (M;')c?o defined by
E ((Zp  2
149
~(Y., Z))2)
tends to 0 as n
(f; A;ds)
=
.',
~
V(y) = Var
Proof. It is sufficient to prove the lemma for ~ bounded (the general case is
proved by approximating ~ by some ~n = inf(n, sup( n, ~ )), as in the proof of
Lemma 7.2.2). Let us fix s < t and denote by p = (so = s < S1 < ... < Sm = t)
a partition of the interval [s, t]. We have
]=1
Jdv(z)~2(y,Z).
Therefore
E ((ZP: 2p)2IFs) = E
(~A(Si+1 
s.)
JdV(Z)~2(YsilZ)IFs),
E ((LSi+! M S i + 1
(Mtk~.o
M,)'iF:j = E [A
l J
du
dv(z)<l"(Y.,
LSiMsJIFs,)
= E ((L Si+
1 
LSi)(MSi+ 1
Whence
Z)IF.] .
(7.3)
with
m1
AI' = L (LSi+ 1
!
I
i=O
Ms.)IFsi) .
j'p=
150
m1
<
L IM',+I 
M., I
i=O
N.)
+ )"C(t
 s)),
N.)
+ )"C(t 
= H?rertdt + HtdXt,
i.e., taking into account equation (7.1), dlit = Hprertdt + HtXt(J.Ldt + O'dWd
between the jump times and at a jump time Tj, lit jumps by an amount ~ Vrj =
dVt
151
We deduce
IAPI
s)).
.~u9
Vo +
it
H?rer'ds
it
H.X.(J.Lds
+ O'dW.)
N,
consequently
+ '"
L.J HrUjXr,.
(7.5)
j=l
For this equation to make sense, it suffices to impose the condition JOT IH~lds
J::
Let us go back to the model introduced at the beginning of the previous section,
assuming that the U/,s are squareintegrable and that.
=r
J.L
which
 )"E(Ud
=r
(.it) t>O =

 )..
zv(dz),
that
H:ds < 00, a.s. (it is easily seen that s H X. is almost surely bounded).
Actually, for a specific reason to be discussed later, we will impose a stronger
condition of integrability on the process (Hdo~t~T, by restricting the class of
admissible strategies as follows:
'
= ((Ht , Ht))O~t~T
(7.4)
~ ais.
rn?,
< +00.
Note that we do' not impose any condition of nonnegativity on the value of
admissible strategies. The following proposition is the counterpart of Proposition
4.1.2 of Chapter 4.
E (X;)
Therefore the process'
(.it)
is a squareintegrable martingale.
t~O
E (iT H;X;dS)
< 00,
and let Vo E nt., There exists a unique process (HP)O~t~T such that the pair
152
((HP, H t))O$t<5,T defines an admissible strategy with initial value Vo. The discounted value at time t ofthis strategy is given by
II,
Proof. If the pair (HP, H t)O$t<5,T defines an admissible strattegy, its value at time t
is given by Vi = yt + Zt, with yt = Vo + f; H~rersds + fo HsX s tude + adWs)
and Zt = EN~1 H; UjX . Differentiating the product ertyt,
J
ertVi = Vo +
1
t
(rers)Ysds +
+ LHrjUjXr:,
j=1
'
1
t
153
rt
ersdYs + e Zt."
(7.6)
It is clear then that if Vo and (H t) are given, the unique process (HP) such that
((HP, H t) )O$t<5,T is an admissible strategy with initial value Vo is given by
H?
=.
Vi 
lftXt
t
u.x, +Vo +
N,
L
j=1
e rrj +
r(_rers)ds
t
n., u.x..
N,
j=1
N,"
in
= ~
 +
L.t errjHr,U1'X
]
r ,
1
t
'0
1=1.
N,
N .
ds(re rs) ~
L HrjUjX
.  t . r:}
j=I'
' .
r .
1(rers)Vs~s 1H~rds +1
N,
+ LHrjUjXr~,
j=1
+ HtX t)
'j
((H~, Ht))O<t<T
00
Nt
J ]
x..
+ LHrjUjX~jVo  i t r
v(dz)z.
= HrD.Xr + HrUjX  = o.
H rJ  H T j
dsl{rj<5,s}( _rerS)HrjU1Xrj
dsHsXs
i
J
From this formula, we see that the process (HP) is adapted, has lefthand limit at
any point and is such that HP = H~_. This last property is straightforward if t is
not a jump time Tj and if t is some Tj, we have
o
0
 .
Nt
LerrjHrjUjXrjj=1
j=1
A
ir, ,
.+ L
1
t
).
Nt
HsXsadWs +LHrjUjXr:o
j=I'
7.3.2 Pricing
,
with
point of view. He sells the option at a price Vo at time 0 and' then follows an
admissible strategy between times 0 and T. From Proposition 7.3.2, this strategy
is completely determined by the process (Ht)os;t5;T representing the amount of
the risky asset. If Vi represents the value of this strategy at time t, the hedging
mismatch at maturity is given by h  VT. If this quantity is nonnegative, the writer
of the option loses money, otherwise he earns some. A way. of measuring the risk
"
is to introduce the quantity
HI = E ((erT(h 
155
154
F( t, x)
If
If
VT))2) .
(1 +
(1 + Uj
Uj)) )
)) )
Since, from Remark 7.3.3, the discounted value (ft) is a martingale, we have
E (erTVT) = Vo. Applying the identity E(Z2) = (E(Z))2 + E ([Z ::: E(Z)]2)
to the random variable Z
erT(h  VT), we obtain
HI = (E(erTh) 
which gives the price of the option for the BlackScholes model, we have
(7.7)
Proposition 7.3.2 shows that the quantity VT'  Vo depends only on (Ht ) (and
he will
not on Vo). If the writer of the option tries to minimise the risk
ask for a premium Vo
E(erTh). So it appears that E(erTh) 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. By a
similar argument, we see that an agent selling the option at time t > 0, who wants
R; = E ( (er(Tt)(h 
Vi = E (er(Tt) hIFt).
Before tackling the problem of hedging, we try to give an explicit expression for
the price of the call or the put with strike price K. We will assume therefore that
h can be written as f(XT), with f(x) = (x  K)+ or f(x) = (K  x)+. As we
saw earlier, the price of the option at time t is given by
(e~(Tt) f(XT)IFt)
E (er(Tt) f (Xte(l'cr2
E (e d T .) I
).
(7.8)
F(t, x)
(1+ Uj ) )
e'(T')
~~(T 
t)"
(1 + Uj ) )
Ft)
]=N,+l
(X .e('u'/2)(T')+U(WT  W,t~r' (1 +
E (er(Tt)!(XT)!Ft)
'.
(1+ Uj ) )
Each term of this series can be computed numerically if we know how to simulate
the law of the Uj's. For some laws, the mathematical expectation in the formula'
can be calculated explicitly (cf. Exercise 42).
If
RJ,
= F(t,Xt),
R6
RJ = E (erTh UN,+
j))
.r}
VT
Now we determine a process (H t )Os;t5;T for the quantities of the risky asset to be
To do so, we need the following proposition.
held in portfolio t? minimise
RJ.
ir==
156
RJ =
R&T
157
E ( Jo
r T (aF
ax (s, X)
s
 2 2 ds
H; ) 2 Xsu
x.n + z)) 
(1 dsX; JV(dz)z2)
t
< +00,
T,
u,
j=1
Al t ds
F(t,x) = ertF(t,xe rt),
so that F(t, X t) = E
the option at timet. We deduce easily (exercise) from fonnula (7.8) that F(t, x)
is C 2 on [0, T[xlR+ and, writing down the Ito formula between the jump times,
we obtain
F(t,
Xt ) =
F(O, X o)+
lit
+
aF
r aF  ior 8;(s,
Xs)ds + io ax (s,Xs)X s(AE(Vdds + udWs)
aF
2
2  2
a
2 (s,Xs)u Xsds
x . ..
.
+ L F(Tj,XrJ  F(Tj,Xr~)
N,
j=1
(7.10)
(F(s,Xs(l+z))F(s,Xs))dv(z)

F(t, X t)  M,
= F(O, X o) +
i
0
t aF
ax (s, Xs)XsudWs.
(7.11)
ii  VT = M~1) + M),
with
and
N,
IF(t,x) (F(t'Y)1
(
N _,
)
T
< E er(Tt) jxe(rXE(Utl u 2 /2)(Tt)+UWT_t
(1 + V j)
L
(Fh,Xr;) j=1
I !
Fh,Xr~)  HrjVjXr~)
] ]
A
ds
E (MP) M1
2))
= J.!a 1) Ma2) = O.
Whence
Ix yl
It follows that
(ii  VT)
=,
E((M~1))2) + E((M~2))2)
'E
(J:{~~
(s, X.) 
HrX;U'dS) + (M~')'),
E(
158
Notes: The financial models with jumps were introduced by Merton (1976).
The approach used in this chapter is based on Follmer and Sondermann (1986),
CERMA (1988) and Bouleau and Lamberton (1989). The approach we have chosen.relies heavily on the assumption that the discounted stock price is a martingale.
This assumption is rather arbitrary: Moreover, the use of variance as a measure
of risk is questionable. Therefore, the reader is urged to consult the recent literature de.aling with incomplete markets, especially Follmer and Schweizer (1991),
Schweizer (1992,1993,1994), El Karoui and Quenez (1995).
E(( M f2))2)
=
2) .
)2  s a ds
T aF
Jo
ax
(s,
X s) ( (
+ JoT A J v(dz)
F(s, X s)  HszX s)
Hs
159
Exercises
7.4 Exercises
(F(s, X s(l
o
It follows that the minimal risk is obtained when H, satisfies P a.s.
~xercis~ 3~. Let (Vn)n~I be a sequence of nonnegative, independent and identically distributed random variables and let N be a random variable with values
in N, following a Poisson law with parameter A, independent of the sequence
(Vn)n~I. Show that
.
aF .) 2 2
( ax (s, x.)  H, Xsa
(11 vn) ~
e'(E(V,j')
It suffices indeed to minimise the integrand with respect to ds. It yields, since
H,
= 6.(s,.X s  ) ,
with
6.(s,x)
aF
(2
a  (s x )
(12 +A J v(dz)z2
ax'
1
+A
.
j. v (d)z z (F(S,X(l+Z))F(S,X)))
x
(JoT
2. "!'Ie assume N and VI to be squareintegrable. Then show that S is squareIntegrable and that its variance is Var(S) = E(N)Var(Vt) + Var(N) (E(Vt ))2.
3. Deduce that if N follows a Poisson law with parameter A, E(S)
and Var(S) = AE (Vn.
= AE(Vt)
Exercise 41 The hypothesis and notations are those of Exercise 40. We suppose
that the Vi's take values in {a, ,8}, with a, ,8 E IR and we set p = P(VI = a) =
1  P(Vt = ,8). Prove that S has the same law as aNI + ,8N2 , where N I and
N 2 are two independent random variables following a Poisson law with respective
parameters AP and (1  p)A.
.
Exercise 42
1. W,e suppose, with the notations of Section 7.3, that UI takes values in {a, b},
WIth P = P(UI = a) = 1  P(UI = b). Write the price formula (7.8) as a
double series where each term is calculated from the BlackScholes formulae
(hint: use Exercise 41).
2. Now we suypose that UI has the same law as e 9  1, where 9 is a normal
variablewithmean m and variance a 2 Write the price formula (7.8) as a series
of terms calculated from the BlackScholes formulae (for some interest rates
and v?latilities to be given).
P a.s.
 F(s,X s)'
2. Show that the law of X; has (for s > 0) a positive density on ]0, ~[. It
may be worth noticing that if Y has a density 9 and i~ Z is a random vana~le
independent ofY with values in ]0,00[; the random van able Y ~ has the density
JdJL(z)(l/z)g(y/z),whereJL is the lawofZ.
.
3. Under the same assumptions as in the first question, ~ho"w that there eXl~ts
z 1= a such that f~r s E [0,T[ and x E]0, 00[,
aF
ax (s,x)
F(s,x(l+z))F(s,x)
zx
.
Deduce (using the convexity of F with respect to x) that, for s E [0, T], the
function x tt F (s; x) is linear. .
.
"
4. Conclude. It may be noticed that, in the case of the put, the function x tt F(s, x)
is nonnegative and decreasing on ]0, 00[.
lim N
Nt+oo
"
L..J
l~n~N
f(Xn)
f(x)JL(dx).
(8.1)
162
Remark 8.1.1 The function F can depend in some cases (in particular when it
comes to simulate stopping times), on the whole sequence (Un)n;?:I, and not only
on a fixed number of Ui 'so The previous method can still be used if we can simulate
X from an almost surely finite number of Ui 's, this number being possibly random.
This is the case, for example, for the simulation of a Poisson random variable (see
page 163).
8.1.2 Simulation of a uniform law on [0, 1]
We explain how to build random number generators because very often, those
available with a certain compiler are not entirely satisfactory.
The simplest and most common method is to use the linear congruential generator. A sequence (Xn)n;?:O of integers between 0 andm  1 is generated as
follows:
Xo = initial value E {O, 1, ... ,m  I}
{ ~n+I = aXn + b (modulo m),
163
V 2 10g(Ud cos(27rU2 )
follows a standard Gaussian law (i.e. zeromean and with variance 1).
To simulate a Gaussian random variable with mean m and variance a, it suffices
to set X = m + ag, where 9 is a standard Gaussian random variable.
function Gaussian(m, sigma : real) : real;
begin
gaussian := m + sigma" sqrt(2.0 " log(Random
" Random);
end;
31415821
1
108 .
This method enables us to simulate pseudorandom integers between 0 and m  1;
to obtain a random realvalued number between 0 and 1 we divide this random
integer by m.
const
m
ml
b
100000000;
10000;
31415821;
We can simulate X ~oticing ~hat, if U follows a uniform law on [0,1], 10g(U) / f,L
follows an exponential law with parameter u,
var a : integer;
"
P(X
An
= n) = e>'"
n.
ifn 2: O.
164
We have seen in Chapter 7 that if (Ti )i>l iS a sequence of exponential random variables with parameter A, then the law oeNt = L:n>l nl {Tl +..+Tn9<T1++Tn+l}
is a Poisson law with parameter At. Thus Ni has the same law as the variable
X we want to simulate. On the other hand, it is always possible to write exponential variables T, 'as log(Ui)/ A, where the (Ui)i>l 's are independent random
variables following the uniform law on [0, 1). N: can be written as
N:
165
n:2:1
+ AG.
Remark 8.1.3 To derive the square root of I', we may assume that A is uppertriangular; then there is a unique solution to the equation A x t A = r. This method
of calculation of the square root is called Cholesky's method (for a complete
algorithm see Ciarlet (1988)).
8.1.4 Simulation of stochastic processes
For the simulation of laws not mentioned above or for other methods of simulation of the previous laws, one may refer to Rubinstein (1981).
Simulation of Gaussian vectors
Multidimensional models will generally involve Gaussian processes with values
in IR.". The problem in simulating Gaussian vectors (see Section A.l.2 of the
Appendix for the definition of a Gaussian vector) is then essential. We give a
method of simulation for this kind of random variables.
We will suppose that we want to simulate a Gaussian vector (Xl,' .. , X n)
whose law is characterised by the vector of its means m = (mI, ... , m n ) =
(E(X1 ) , ... , E(Xn)) and its variance matrix r = (O'ij h~i~n.1~j~n whererr., =
E(XiX j)  E(Xi)E(Xj). The matrix r is positive definite and we will assume
that it is invertible. We can find the square root of I', in other words a matrix A,
such that A x t A = r. As r is invertible so is A, and we can consider the vector
Z = AI (X  m). It is easily verified that this vector is a Gaussian vector with
zeromean. Moreover, its variance matrix is given by
X;'
= JnS[nt 1
where [x) is the largest integer less than or equal to x. This method of simulation
of the Brownian motion,is partially justified in Exercise 48.
In the second method, we notice that, if (gi)i:2:0 is a sequence of independent
standard normal random variables, if t1t > 0 and if we set
So = 0
,{ Sn+l  Sn = g':'
then the law of (ViSJ,So, ViSJ,Sl,' .. , ViSJ,sn) is identical to the law of
166
167
There are many methods, some of them very sophisticated, to simulate the solution
of a stochastic differential equation; the reader is referred to Pardoux and Talay
(1985) or Kloeden and Platen (1992) for a review of these methods. Here we
present only the basic method, the socalled 'Euler approximation' . The principle
is the following: consider the stochastic differential equation
In the case of the BlackScholes model, we want to simulate the solution of the
equation
Xo
ex.
b(Xt)dt + a(Xt)dWt.
{;;t
Two approaches are available. The first consists in using the Euler approximation.
We set
= x
SO
{ Sn+l
Sn(1 + rb.t + agn.,fl;i) ,
and simulate X; by Xl' = S[t/ ~t). The either method consists in using the explicit
expression of the solution
x, =
So
{ Sn+l  Sn
{b(Sn)b.t
+ a(Sn)
t<S.T
s; = z exp ((, .;
,
x
S~
xexp (rt 
q'
/2)nLlt +
q~t, g,) .
(8.2)
= S[t/~t).
Remark 8.1.6 We can also replace the Gaussian random variables gi by some
Bernouilli variables with values + 1 or 1with probability 1/2 in (8.2); we obtain
a binomialtype model close to the CoxRossRubinstein model used in Section
5.3.3 of Chapter 5.
x, : ;: : x
~2t + awt)
and simulating the Brownian motion by one of the methods presented previously.
In the case where we simulate the Brownian motion by .,fl;i ~:::l gi, we obtain
>0
~t(rdt + adWt).
}1 (i + ~j)
N'
.
(
e(Il
CT2
/
)t+CTW, ,
(8.3)
.x,
Xn~t ~ X
If we noteYk
(X~t/x)
(X2~t/X~t)
x x
(Xn~t/X(nl)~t).
168
(Wdt2:o and (Uj ) j2:l that (Yk h2:l is a sequence of independent random variables
with the same law. Since Xn~t = xYl . , . Yn , the simulation of X at times
169
Cl
n.6.t comes down to the simulation of the sequence (Yk h 2: l . This sequence
C2
C3
C4
, ... ,
'"
00
y 27r
N(x) ::::: 1 
=
,,2
rrceT (bit
y27r
0.196854
0.115194
0.000344
0.019527
'
=
=
=
=
Un'
All these variables are assumedto be independent. Then, from equation (8.3), it
is clear that the law of
>0
opposed to an exponential. If x
1/(I+px)
TYPE
Date = INTEGER;
Amount = REAL;
AmericanPut = RECORD
ContractDate
: Date; (* in days *)
MaturityDate : Date; (* in days *)
StrikePrice : Amount;
END;
vector = ARRAY[l, ,PriceStepNbI OF REAL;
Model = RECORD
r
REAL; (* annual riskless interest rate
sigma
REAL; (* annual volatility *)
xO
i REAL; (* initial value of the SDE *)
END;
*)
(*
prices the 'option' for the 'model'
at time 't' if the price o~th~ underlying at 'this time
is "x ".
*)
VAR
Obst,A,B,C,G : vector;
alpha, beta ;gamina, h , k , VV, temp, r , Y del t a , Time', 1 : REAL;
Index,PriceIndex,TimeIndex : INTEGER;
BEGIN
'""
Time := (option,MaturityDate  ~) / Days InYearNb;
k := Time / TimeStepNb;
r := model.r;
170
vv :=
~odel.sigma
171
I::
* model. sigma;
+ abs(r  vv / 2)
Exercises
f(x)dx. We setF(u) =
f(x)dx. Prove thatifU is a uniform random variable
oo
on [0,1], then the law of Fl (U) is f(x)dx. Deduce a method of simulation of
X.
Exerci.se 46 We model a risky asset S, by the stochastic differential equation
as,
{ So
(2.0 * h;
(2.0 * h;
x,
where (Wt)t>o is a standard Brownian motion, a the volatility and r is the riskless
interest rate. Propose a method of simulation to approximate
END;
B[l]
B[PriceStepNb]
G[PriceIndex]
:=
:=
:=
beta + alpha;
beta + gamma;
0.0;
B[PriceStepNbl := B[PriceStepNb];
FOR PriceIndex:=PriceStepNbl DOWNTO 1 DO
B[PriceIndex] := B[Pri'ceIndex]  C[PriceIndex] * A[PriceIndex+l] /
B[PriceIndex+l] ;
FOR PriceIndex:= i TO PriceStepNb DO A[PriceIndex] := A[PriceIndex] /"
B [PriceIndex] ;
FOR PriceIndex:= 1 TO PriceStepNb  1 DO C[PriceIndex] := C[Pricelndex] /
B[PriceIndex+l] ;
y := In(x);
FOR PriceIndex:=l TO PriceStepNb DO Obst(PriceIndex] := PutObstacle(y  1 +
PriceIndex * h , option );
.
FOR PriceIndex:=l TO PriceStepNb DO G[PriceIndex] := ,0bst[priceIndex];
FOR TimeIndex:=l TO TimeStepNb DO BEGIN
FOR PriceIndex := PriceStepNbl DOWNTO 1 DO
G[PriceIndex) := G[PriceIndex]  '. C[PriceIndex] * G[PriceIndex+1];
G[l] := G[l] / at i i ,
FOR ,PriceIndex:=2 TO PriceStepNb DO BEGIN
G [PriceIndex] : = G [PriceIndexl / B [PriceIndex]  A[Pric'~IndexJ * G [Price
Indexl] ;
temp := Obst[PriceIndex];
IF G[PriceIndex] < temp THEN G[PriceIndex] := temp;
END;
END;
Index := PriceStepNb DIV 2;
delta
:= (G[Indice+l]  G[Index]) / h;
Prix':= G[Index]+ delta*(Index * h  1);
END;
as,
{ So
x,
(Wtk~o represents a standard Brownian motion, a the annual volatility and r the
riskless interest rate. Further on we will fix r = lO%jyear, a = 20%/ Jyear = 0.2
and x = 100.
Being 'delta neutral' means that we compensate the total delta of the portfolio
by trading the adequate amount of underlying asset.
In the following, the options have 3 months to maturity and are contingent on
one unit of asset. 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.
Strangle: short a 90 put and short a 110 call.
Condor: short a 90 call, long a 95 call and a 105 call and finally short a 110
call.
Put ratio backspread: short a 110 put and long 3 90 puts.
8.3 Exercises
..
.:
Exercise 44 Let X and Y be two standard Gaussian random variables; derive! the joint law of (JX2 + Y2,arctg(Y/X)). Deduce that, if U1 and U2
are two independent uniform random variables on [0,1], the random variables
210g(Ul ) cos(27l'U2 ) and 210g(Ud sin(27l'U2 ) are independent and folIowa standard Gaussian law.
.
0
Exercise 45 Let f be a function from JR to JR, such that f(x) > 0 for all x, and
such that
f(x)dx = 1. We want to simulate a random variable X withlaw
r:
We ,90 not hedge: we sell the option, get the premium, we wait for three
months, we take into account the exercise of the option sold and we evaluate
the portfolio.
We hedge immediately after selling the option, then we do nothing.
172
Appendix
2. Let t and s be nonnegative.using the fact that the random variable X?+s  X?
is independent of X?, prove that the pair (X?+s' X?) converges in law to
(Wt+ s, Wt).
3. IfO < tl < ... < t p, show that (X~, . . . ,X~) converges in law to (W t l , .. , Wt p ) .
In this section, we recall the main properties of Gaussian variables. The following
results are proved in Bouleau (1986), Chapter VI, Section 9.
= _1_ exp
.J2;
2)
(_ X
2
If X is a standard normal variable and m and a are two real numbers, then the
variable Y = m + a X is normal with mean m and variance 0'2. Its law is denoted
by N( m, 0'2) (it does not depend on the sign of a since X and  X have the same
law). If a i= .0, the density of Y is
(xm)2)
20'2'
_1_ exp (
J27fO'2
If a = 0, the law of Y is the Dirac measure in m and therefore it does not have a
density. It is sometimes called 'degenerate normal variable'.
If X is a standard normal variable, we can prove that for any complex number
z, we have
.
.
(e z X )
= e4 .
u2
00
e'x
2/2dx
1
_rrc
tv 27f
00
/2
t.J2;
174
Appendix
Finally, one.should know that there exist very good approximations of the cumulative normal distribution (cf. Chapter 8) as well as statistical tables.
E(Xi))(Xj  E(Xj))].
It is well known that if the random variables Xl'... , X d are independent. the
matrix I'(X) is diagonal. but the converse is generally wrong. except in the
Gaussian case:
Theorem A.I.2 Let X
(Xl,' .. , X d) be a Gaussian vector in lRd. The random
variables Xl, ... , X d are independent if and only if the covariance matrix X is
.
,
diagonal.
The reader should consult Bouleau (1986), Chapter VI. p. 155, for a proof ofthis
result.
A.
... :""_..
_~._
B
.,.r:...
175
aij
Conditional expectation
'

~= ~~_.~
.
XI(B) = {X E B}}.
Y = foX,
where fJs a me~~b~~~aP._~~~(E~E) toJF,:F). (cf. Bouleau (1986), p.
101102). In other words, a(X)measurable random variables are the measurable
functions of X.
!heorem A.2.1 For any real integrable random variable X, there exists a real
Integrable Btmeasurable random variable Y such that
VB E B
=L
E(XIB;)/P(Bi)IB;,
E,: (~~
I
= E(ZX).
,'
a.s.
~_
=>
,
176
Appendix
Conditional expectation
Vx E E
(eiUX~)
= E
P(B) , ~
{l(X:~p~~))
(<I>(x, Y))
= cp(X) a.s.
In other words, under the previous assumptions, we can compute E ( <I> (X, Y) IB)
as if X was aconstant. '
..,
.
(A.l)
cp(x) =
E (<I>(X, Y)Z)
=.E (f(X)),
=;: E
This equality means that the characteristic function of X is identical under measure
P and measure Q where thedensity of Q with respectto P is equal to IB /P(B).
The equality of characteristic functions implies the equality of probability laws
,
and consequently
E
cp(x)
Proof. Given the Property 8..above, we just need to prove that (A.l) implies that
X is independent of B.
If E (e iuX IB) = E (e iUX) then, by definition of the conditional expectation,
for all B E B, E (e iuX IB) = E (e iuX) P(B). If P(B) =j:. 0, we can write '
(e iuX)
177
= / /
z)dPy(y)
zdPx,z(x, z)
= / cp(x)zdPx,z(x,z)
= E (cp(X)Z) ,
which completes the proof.
Remark A.2.6 In the Gaussian case, the computation of a conditional expectation is particularly simple. Indeed, if (Y, Xl, X 2 , .. ,Xn ) is a normal vector (in
n I
IR + ) , the conditional expectation Z' == E (YIX I , . . . ,Xn ) has the following
form
" '
Remark A.2.4 We can define E(XIB) for any nonnegative random variable
X (without integrability condition). Then E(X Z) = E (E(XIB)Z), for any Bmeasurable nonnegative random variable Z. The rules are basically the same as
in the integrable case (see DacunhaCastelle and Duflo (1982), Chapter 6).
= Co + LCiXi,
i=l
:J
where c, are real constant numbers. This means that the function of Xi which
approximates.Y in the leastsquare sense is linear. On top of that, we can compute
Z by p~?jecting the random variable Y in L 2 on the linear subspace generated by
I and the X/s (cf. Bouleau (1986), Chapter 8, Section 5).
/'\
Appendix
178
References
Theorem A.3.1 Let C be a closed convex set which does not contain the origin.
Then there exists a real linear functional ( defined on IRn and 0: > 0 such that
'<Ix E C
((x)
2:
0:.
Proof. Let>' be anonnegative real number such that the closed ball B(>') with
centre at the origin and radius>' intersects C. Let Xo be the point where the map
x ~ Ilxll achieves its minimum (where 1111 is the Euclidean norm) on the compact
set C n B(>'). It follows immediately that
.,
'<Ix E C
IIxll 2: II xoll
The vector Xo is nothing but the projection of the origin on the closed convex set
C. If we consider x E C, then for all t E [0,1], Xo + t(x  xo) E C, since Cis
convex. By expanding the following inequality
"
.
Theorem A.3.2 Let us consider a compact convex set K and a vector subspace
Vof IRn . If V and K are disjoint, there exists a linear functional ( defined on
IRn , satisfying the following conditions:
J. '<Ix E K ((x) > O.
2. '<Ix E V ((x) = O.
Therefore, thesubspace V is included in a hyperplane that does not intersect K.
Proof. The set
C=KV={xEIRn 13(y,z)EKxV,x=yz}
is convex, closed (because V is closed and IS is compact) and does, not contain
n
the origin. By Theorem A.3.1" we can find a linearfunctional ( defined on IR
and a certain 0: > 0 such that
'<Ix E C
((x)
2:
0:.
Hence
2:
0:.
(A.2)
= 0,
0
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1970.
Artzner, P. and F. Delbaen, Term structure of interest rates: The martingale approach,
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Bachelier, L., Theorie de la speculation, Ann. Sci. Ecole Norm. Sup., 17 (1900), pp. 2186.
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Bensoussan, A., On the theory of option pricing, Acta Appl. Math., 2 (1984) pp. 139158.
Bensoussan, A. and J.L. Lions, Applications des inequations variationnelles en contriile
.
stochastique, Dunod, 1978.
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Black, F. and M. Scholes, The pricing of options and corporate liabilities, Journal of
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Brennan, MJ. and E.S. Schwartz, The valuation of the American put option, J. of Finance,
32, 1977, pp. 449462.
Brennan, MJ. and E.S. Schwartz, A continuous time approach to the pricing of bonds, J.
of Banking and Finance, 3 (1979), pp. 133155.
Bouleau, N., Probabilites de l'Ingenieur, Hermann, 1986.
Bouleau, N., Processus Stochastiques et Applications, Hermann, 1988.
Bouleau, N. and D.Lamberton, Residual risks and hedging strategies in Markovian markets,
Stoch. Proc. and Appl. , 33 (1989), pp. 131150.
.
CERMA, Sur les risques residuels des strategies de couverture d'actifs conditionnels,
Comptes Rendus de l'Academie des Sciences, 307 (1988), pp. 625630.
Chateau, 0., Quelques remarques sur les processus a accroissements independants et
stationnaires, et la subordination au sens de Bochner, These de l'Universite Paris VI,
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Index'
Adapted,4
Algorithm
Brennan and Schwartz, 116, 169
Cox, Ross and Rubinstein, 117
American call
pricing, 25
American option
price, 11
American put
hedging, 27
pricing, 26
Arbitrage, viii
Asset
'
financial, vii, 1
riskless, 1, 122
risky, 1
underlying, vii
Atom, 174
Attainable, 8
.....
"
Bachelier, vii
Bessel function, 131
Black, vii
BlackScholes formulae, 70
BlackScholes model, ix, 12
Bond
pricing, 124, 129, 132
Bond option
pricing, 125,' 136
Brownian motion, vii, 31
Simulation of process, 165
Call, vii
pricing, 154
CalIon bond
pricing, 133, 138
Complete, 8
Conditional expectation
Gaussian case, 177
of a nonnegative random variable, 176
orthogonal projection, 176
w.r.t. a random variable, 176
Contingent claim, 8
Continuoustime process, 29
CoxRossRubinstein model, 12
CrankNicholson scheme, 108
Critical price, 77
Delta, 72
Diffusion, 49
Doob decomposition, 21
Doob inequality, 35
Dynkin operator, 99
Equivalent probabilities, 66
Equivalent probability, 6
European call
pricing, 70, 74
European option
pricing, 68, 154
European put
pricing, 70
Exercise price, viii
Expectation, 5
Index
184
conditional, 174
Expiration, viii
Exponential martingale, 33
Filtration, I, 30
Forward interest rate, 133
Gamma, 72
Girsanov theorem, 66, 77
Greeks
delta, 72
gamma, 72
theta, 72
vega, 72
Hedging, viii
a can, 14
cans and puts, 71
no replication, 160
of cans and puts, 155159
Infinitesimal generator, 112
Ito calculus, 42
Ito formula, 42
multidimensional, 47
Ito processes, 43
Law
chisquare, 131
exponential, 141, 142
gamma, 142
lognormal, 64
Market
complete, 8
incomplete, 141, 160
Markov Property; 54, 56
Martingale, 4
continuoustime, 32
exponential, 47
optional sampling theorem, 33
Martingale transform, 5
Martingales representation, 66
Merton, vii
Method
168
Index
Portfolio
value, 2
Position
short, 3
Predictable, 5
Premium, viii
Pricing, viii
Process
continuoustime, 29
OmsteinUlhenbeck, 52
Poisson, 141
Put, vii
partial differential inequalities, 113
pricing, 154
Put/Call parity, ix
RadonNikodym, 66
Random number generators, 162
Replicating strategy, 14
Scholes, vii
Separation of convex sets, 178
Short selling, 3
Sigmaalgebra, 174
Simulation of processes, 165
BlackScholes model, 167
Brownian motion, 165
model with jumps, 167
stochastic differential equations, 166
Simulation of random variables, 163
exponential variable, 163
Gaussian, 163
Gaussian vector, 164
. Poisson variable, 163
Snell envelope, 18
Stochastic differential equations, 49, 52, 96
Stopped sequence, 18
'
Stopping time, 17,30
hitting time, 34
optimal,20
Strategy, 1
admissible, 3, 68, 125, 151
consumption, 27,73
selffinancing, 2, 64, 125, 151
Strike price, vii
Submartingale, 4
Supermartingale, 4
185
Theta, 72
Vega, 72
Viable, 6
Volatility, ix, 70
implied,71
Wiener integral, 57
Yield curve, 121, 133
Zero coupon bond, 122
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