Discrete-time Stochastic Process

Group Work Project

Caio Aranha Vinchi,
Francisco Costa,
Marina Duma,
Addo Sarkodie Opoku

1
1 Introduction 2

1 Introduction
This group work project is an essential assignment regarding the Discrete-
time Stochastic Processes course of the WorldQuant University Master’s de-
gree in Financial Engineering.
This mini-project consists of a three-part submission report over the his-
tory of measure-theoretic probability and martingales, used as an underlying
understanding for the further development of a trinomial tree model in the
discrete-time for a given risky stock price as a way to describe its evolution,
arbitrage-free conditions, and its set of attainable claims.
Subsequently, this report will also evaluate why there are no benefits for
early exercise for a fixed interest rate American call option also considering a
discrete-time market when compared to a European option, and how does it
translate to an American put option, -further described in a binomial model.

2 Komogorov and his axioms of probability

The history of measure theory in mathematics has its official origin on what
is now known as a branch of its realm, the probability theory back in the 17th
century thanks to the exchanging of correspondences between Blaise Pascal,
Pierre de Fermat, and Christian Huygens. Arising from the necessity to
comprehend the profitability of counterintuitive games of chance’ questions
better, towards what rapidly became the genesis of a whole new field in
mathematics, their work led to the development of the first fundamental
concepts of the area, such as the random variable, the expected value, and
the probability of a stochastic event. (Apostol, 2007).
During this stage, significant contributions were made by Jacob Bernoulli’s
geometric constructions on decision theory and the utility function, still, ob-
ject of debate to this date in the ergodicity perspective. Later the works
of Rev. Thomas Bayes, Marquis Pierre Simon Laplace, Johann Friedrich
Carl Gauss, and Siméon Denis Poisson widely complemented the probability
theory throughout various scientific and practical fields such as psychology,
economics, genetics, and engineering (Aleksandrov et al., 1999).
Although it became a widely applicable tool among practitioner, the lack
of a rigorous framework based on a deductive reasoning as commonly required
by hard sciences, led to more than three centuries of debate, including notable
mentions such as Emile Borel, towards an axiomatic definition to replace
the inductive ”measure of belief” in the 20th century mainly attributed to
Andrei Nikolaevich Kolmogorov and Paul Lévy by defining an intersection
to the theory and mathematical definitions within the set theory and real
3 Markov and Markov processes 3

analysis.
From the set theory, those axioms were laid out under basic constructions
like sets containing generalized elements with properties in common (num-
bers, letters, or real-world events -regardless of it’s object size) and other
sets within a given space that could be illustrated by diagrams with spe-
cific notations addressing the viable fundamental operations and notations
within the resources available in theory. With a sense of belonging and its re-
strictiveness, the set operations are represented by unions and intersections,
mutually exclusive sets, partitions, complements, and the De Morgan’s Law.
The probability theory then is elaborated considering a specific space
taking values ranging from 0 to 1, known as ”odds” from which previously
defined elements draw from experimental activities (or trials) were assigned,
and clearly defined -a distinction and restriction imposed by the randomness
in the practical world (Papoulis and Pillai, 2002).
Let S be the representation of a space, and ∅ the representation of an
empty set or -impossible event, then to each event X, a number P(X) denoted
as the probability of the event X, is chosen to satisfy the following conditions:
Probability is a non-negative real number for every event X:
P(X) ≥ 0, and P(X) ∈ R ∀ X ∈ F (1)
Unit measure:
P(Ω) = 1 (2)
Closed under countable additivity for any finite or countably infinite,
pairwise disjoint collection of events Xi : i ∈ I
X
P(∪i∈I Xi ) = P(Xi ) (3)
i∈I

Those are therefore the axioms of the probability theory from which all
outcomes are referred and from which consequences are generated such as
P(X) ≤ P(Y ) for every X ⊂ Y and P(∅) = 0, therefore, 0 ≤ P ≤ 1 ∀ X ∈ F.

3 Markov and Markov processes

Andrei Markov was a Russian mathematician who published more than 120
scientific papers regarding several subjects such as probability theory, number
theory, statistics, among others. He is mostly known for his work on the
creation of a new field of research that nowadays is called Markov chains
(Basharin et al., 2004).
Markov defined a simple chain as an infinite sequence x1 , x2 , . . . , xk , xk+1
of variables connected in such a way that xk+1 for any k is independent of
4 J. L. Doob and the development of martingales 4

x1 , x2 , . . . , xk−1 in case xk is known (Markov, 1906; Basharin et al., 2004).

The chain is homogenous if the conditional distributions of xk+1 given xk are
independent of k. He also defined a complex chain in which every number is
directly connected with several preceding numbers (Markov, 1908; Basharin
et al., 2004).
If we consider that the state of the system in a later time is determined by
the state of the system at current time and apply this concept to a stochastic
process, it means that the probability distribution for Xn+1 is completely
determined by Xn and independent of any Xl with l < n (Washington).
Thus, as Markov process is defined as:

P r{Xn+1 ≤ xn+1 |Xl = xl , 1 ≤ l ≤ n} = P r{Xn+1 ≤ xn+1 |Xn = xn } (4)

The solution of a Markov process is completely determined after an initial

condition at one time. Consider Xn discrete random variables. The joint
probability of a Markov process is:

P r{X0 = x0 , X1 = x1 , X2 = x2 , . . . } = P r{X0 = x0 } ×
P r{X1 = x1 |X0 = x0 } × P r{X2 = x2 |X1 = x1 } × . . .

Therefore, this means that a Markov process is determined by an initial

condition (P r{X0 = x0 }), and the transition probability:

P r{Xn+1 = xn+1 |Xn = xn }

.
As in the differential equation, if the transition probability is autonomous,
meaning P r{Xn+1 = xn+1 |Xn = xn } = P r{X1 = xn+1 |X0 = xn }, then the
Markov process is time-homogeneous, otherwise it is time-inhomogeneous
(Washington).

4 J. L. Doob and the development of martingales

Joseph Leo Doob is another mathematician who’s contribution into the de-
velopment of modern probability theory cannot be overestimated. He was
born in Cincinnati, Ohio in February 27, 1910. His yearly interests were po-
tential theory and complex analysis, but during the Great Depression in early
thirties he struggled to find a job and, following the advise of B.O. Koop-
man, Doob approached Harold Hotelling, professor of statistic at Columbia
4 J. L. Doob and the development of martingales 5

University, and got a grant to work in probability and statistics (Bingham,

2005).
In the early 1930’s there was no established theory of probability and
it was not clear whether it should be a part of mathematics or physical
science. In 1933 Kolmogorov proposed an axiomatic framework based on
measure theory for the mathematical probability. Paul Levy was the first
person to introduce the concept of martingale in probability theory without
naming it in 1934. The term itself was introduced by Jean Ville in 1939,
but it was Doob who fully explored martingales in his works and influenced
the further development and widespread of the theory. Giving Ville full
credit for inventing the concept of a martingale, Doob developed the study
of martingales within measure-theoretic probability (Bienvenu et al., 2009).
The definition of Martingale given by Doob is the following: consider a se-
quence of random variables X = X1 , X2 , .., Xn and function A = f (X1 ..Xn ).
Then the sequence of conditional expectations defined as Bi = E(A|X1 ..Xn )
is a martingale - called Doob martingale of A (Bingham, 2005).
After publication of a series of papers on the foundation of probability and
stochastic processes, Doob wrote a book “Stochastic processes” which was
published in 1953 and appeared to be one of the most influential books on the
modern probability theory. In this book Doob showed that the martingale
theory plays a crucial role in a wide variety of stochastic processes in the
information theory, mathematical statistics, mathematical physics and other
parts of science. Doob noticed the connection between Ville’s martingales
and harmonic functions and introduced the martingale based probabilistic
potential theory. In his another famous book “Classical Potential Theory
and Its Probabilistic Counterpart”, Doob shows that the martingales and
potential theory can be studied using the same mathematical tools.
During his career Doob developed a number of important theorems in the
probability theory, among which are:

1. Optional Stopping theorem which shows that the constant expectation

property of martingale for all times t remains valid if t is replaced by
any bounded stopping time T .(Yor et al., 2009). If X is a martingale
then
E(XT ) = E(X0 ) (5)

2. Doob decomposition theorem stating that in discrete time the stochas-

tic process X = {Xn : n ∈ N } adapted to a filtration F with E(|Xn |) <
∞ can be uniquely decomposed to:

Xn = X0 + An + Mn (6)
5 Trinomial trees 6

where A = (An , Fn−1 ) is a predictable process and M = (Mn , Fn ) is a

martingale.

3. Doob martingale convergence theorems and many others.

5 Trinomial trees
We describe a special market, ((Ω, F, F, P), X) with trading times occurring
at times t = 0, 1, . . . , T , where T is a positive integer equal to 2.
We will assume that there is only one risky asset X; therefore the pri-
mary tradeable assets can be represented as the vector (1, X), where 1 is the
constant risk-free asset. We also shall define a filtered probability space for
this financial market as follows:

• let Ω := {ω = (ω1 , ω2 ) : ωi ∈ 0, 1} = {(1, 1), (1), (1, 0), (0, 1), (0), (0, 0)}
or equivalently, Ω = {(u, u), (u), (u, d), (d, u), (d), (d, d)}

• let F := 2Ω

• let P({ω}) > 0∀ω ∈ Ω, F → [0, 1]

• let F = (Ft ), ∀t ≥ 0, F0 := {∅, Ω}, Ft := σ({Z1 , Z2 }), t ≥ 1)

• let X = {Xt : t = 0, 1, 2}∀t ∈ Z+

• let Z = {Zt : t = 0, 1, 2} be Zt (ω := ωt , ω ∈ Ω, 1 ≥ t ≥ 2)

Furthermore, following the concepts presented in Björefeldt et al. (2016)

to create the jumps and the probabilities attached to the model, we define
the trinomial tree model with u and d as positive real numbers 0 < d < u as:

Xt u,
 with probability pu
Xt+1 = Xt with probability p0 = 1 − pu − pd

Xt d with probability pd


According to Hull (2003), trinomial trees can be seen as alternatives to

binomial trees, and, thus their calculations are similar to the ones for a
binomial tree. They assume a more complex form compared to binomial
trees. At each time t, the price of X at the next time step (t + 1) can take on
three values. If we consider pu , pm , and pd are the probabilities of up, middle
and down movements respectively, pu , pd ∈ (0; 1), p0 = 1 − pu − pd > 0.
Assuming that the volatility of the underlying asset σ is constant and
the asset price follows a Brownian motion, considering also that there are no
5 Trinomial trees 7

Fig. 1: Evolution of stock prices in the trinomial model when u = d.

dividends and the risk-free rate is r, one can match the first two moments of
the models distribution according to the no arbitrage condition (Björefeldt
et al., 2016):

E[X(ti+1 )|X(ti )] = er∆t X(ti ) (7)

Var[X(ti+1 )|X(ti )] = ∆tX(ti )2 σ 2 + O(∆t) (8)

Given the two moments defined above, and the additional constraint im-
posed by the jumps being reciprocal (i.e. ud = 1), the condition of no
arbitrage (equation 7) establishes that the expected return from the asset is
equal to the risk-free return, thus:

1 − pu − pd + pu u + pd d = er∆t
Imposing this three constraints on the parameters u, d, pu , pm , we get a
family of trinomial tree models. We will consider the following trinomial tree
model:
√ √
u = eσ 2∆t
, d = e−σ 2∆t
5 Trinomial trees 8

r∆t
√ ∆t !2
e 2 − e−σ 2
pu = √ ∆t √ ∆t
eσ 2 − e−σ 2
√ !2
σ ∆t r∆t
2 − e 2
e
pd = √ ∆t √ ∆t
eσ 2 − e−σ 2

pm = 1 − pu − pd
Knowing the jump sizes (u, d) and transition probabilities (pu , pd ), we can
now construct a trinomial tree similar to the one shown in figure 1.
Let the number of up, down and middle jumps be defined as Zu , Zd , Zm .
The value of the underlying asset at node j for time i is given by

t
Y
Zu Zd
X0 = const, Xi,j = u d X0 , t ≥ 0 where Zu + Zd + Zm = Z
i=1

For the set of all equivalent martingale measures, given that it should
have at least one element to set an arbitrage-free market, we need to define
a new probability measure whose filtration is the natural filtration of X as
previously identified. This new measure should be equivalent to the current
measurement if the null set is the empty set for both of them, and if X is a
martingale concerning the new measure.
First, we make sure that the trinomial model can hold the martingale
Z (ω) Z (ω) Z (ω)
condition for the probability measure P∗ (ω) = p−1−1 p0 0 p+1+1 given the
stochastic process of the trinomial price on the probability space (ΩZ , P) via
theorem. In this case, we consider the discounted value of the asset e−rt X(t)
as being a martingale given that eu p+1 + p0 + e−u p−1 = er holds and that it
satisfies the following conditions

E[e−rt X(t)] < ∞ (9)

E[e−rt X(t)|X(t − 1)] = e−r(t−1 X(t − 1) (10)

The development of those conditions and the required outcome goes as
follows

t
Y
−rt −rt
E[e X(t)] = X0 e E[xi ] = X0 e−rt (eu p+1 + p0 + e−u p−1 )t
i=1
5 Trinomial trees 9

E[e−rt X(t)|X(t−1)] = X0 e−rt Z(t−1)E[xi ] = X0 e−rt Z(t−1)(eu p+1 +p0 +e−u p−1 )

Now let (q+1 , q0 , q−1 ) be a triple of real numbers defined by

q+1 + q0 + q−1 = 1, q+1 eu + q0 + q−1 e−u = er

Which implies that the following are equivalent

q+1 > 0, q−1 > 0, q+1 + q−1 < 1

eu − er
0 < q0 <
eu − 1
The triple q0 , q+1 , q−1 defines a probability if and only if
eu − er
r < u, 0 < q0 <
eu − 1
This triple can be understood as a probability on the sample space ΩZ ,
thus it is a martingale denoted by the new probability (risk-neutral) measure
Z (ω) Z0 (ω) Z+1 (ω)
P∗ (ω) = q−1−1 q0 q+1
Because there exists infinitely many measures dependent by an arbitrary
value of q0 , it is classified only under the arbitrage-free condition and not
under the complete market condition. Thus the market is arbitrage-free,
however, it is not complete.

5.1 Pricing a contingent claim in trinomial trees

As stated previously, the calculations for trinomial trees are similar to the
ones for binomial trees. In order to price a contingent claim we start from the
end to the beginning using a backward algorithm. At each node we compute
the value of continuing, which is equal to:

e−r∆t (pu fu + pm fm + pd fd ),
where fu , fm , and fd are the values of the contingent claim at the subsequent
up, middle, and down nodes, respectively.
For pricing a contingent claim with trinomial trees we need:
1. The transition probabilities pu , pm , and pd

2. The size of moves up, middle and down (u, m = 1, and d)

5 Trinomial trees 10

3. The payoff of the contingent claim at maturity.

Let the contingent claim H be an European call option with a payoff

H = max(X − K, 0),

where K is the strike price at the maturity. Applying the backward algo-
rithm, the value of H is equal to:

Hn,j = e−r∆t (pu Hn+1,j+1 + pm Hn+1,j + pd Hn+1,j−1 ),

where n represents the time and j represents the node position. This means
that we can compute the option value at interior nodes of the tree by consid-
ering it as a weighting of the option value at future nodes, discounted by one
time step (Björefeldt et al., 2016). Thus the value of the contingent claim H
today (considering today to be time 0), is:

H0 = e−r∆t (pu H1,j+1 + pm H1,j + pd H1,j−1 ).

5 Trinomial trees 11

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