Chapter 4

Discrete-time Martingale

4.1 Definition

Martingale was introduced by Paul Levy, and much of the original

theoretical development was done by Joseph Doob. This chapter fo-
cuses on discrete-time martingales while continuous-time martingales
will be discussed in the next chapter.

Let (⌦, F, P ) be a probability space.

• {Fn} = (Fn, n 0) are sub- -algebras on ⌦, and Fn ⇢ F,

8n 0.
• {Xn, n 0} is a sequence of r.v.s on (⌦, F, P ).

65
Definition 4.1

• {Fn} is a filtration if F0 ⇢ F1 ⇢ ....

• Fn = (X0, ...Xn) is called the natural filtration.
• {Xn, n 0} is adapted w.r.t. {Fn} if Xn 2 Fn for all n.
(Loosely speaking, Xn cannot depend on the future informa-
tion.)
• {Xn, n 0} is previsible or predictable w.r.t. {Fn} if
Xn 2 Fn 1, 8n.
(i.e., Xn only depends on the past information, not on the
present and future.)

66
Definition 4.2 {Xn, n 0} is a martingale (or sub-, super-
martingale) w.r.t. {Fn} if

1. E|Xn| < 1,
2. {Xn} is adapted to {Fn},
3. E (Xn+1|Fn) = Xn (or Xn or  Xn) for all n.

67
Remark 4.1

• For a martingale, Xn is the best prediction of Xn+1 given Fn

(“fair game”).
• {Xn, n 1} is a martingale () it is both a sub- and super-
martingale.
• {Xn, n 1} may be a P -martingale but may not be a Q-
martingale.
• Taking expectation in (iii), EXn+1 = EXn (or EXn, or
 EXn).
Martingales, sub- and super-martingales tend to stay the same,
increase, and decrease, respectively.
• Here are a few ways to help you remember which is which:
(A) Life is a supermartingale; as time advances, expectation
decreases;
(B) Submartingales go up while supermartingales go down.
(C) In “sub”, b points upward while in “sup”, p points down-
ward.

68
Martingale di↵erence

Definition 4.3 {Dn, n 0} is a martingale di↵erence w.r.t.

{Fn, n 0} if

(i) E|Dn| < 1,

(ii) {Dn} is adapted to {Fn},
(iii) E (Dn+1|Fn) = 0 for all n.

Theorem 4.1 {Xn, n 1} is a martingale i↵ {Dn = Xn Xn 1, , n

1} is a martingale di↵erence. Note that
Xn X0 = D1 + D2 + · · · + Dn

It is also easy to prove that, see below

EDn = 0, Cov(Di, Dj ) = 0 (i 6= j).
That is, they have mean 0 and are uncorrelated. They are often used
as “white noise” in the literature, replacing the stronger i.i.d. noise
assumption.

69
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Examples of martingales

Martingales often need to be constructed. In the following, X1, X2, ...

are independent, and Fn = (X1, ..., Xn).

• (Random walks)
Pn
Define Sn = i=1 Xi , with S0 = 0. Assume EXi = 0 for all i 0.
(a) {Sn : n 0} is a martingale.
(b) euSn /EeuSn is a martingale for any u.
Proof. (a) Clearly, E|Sn| < 1 and Sn 2 Fn. Furthermore,
E(Sn+1|Fn) = E(Sn+Xn+1|Fn) = Sn+E(Xn+1|Fn) = Sn+E(Xn+1) =
(b) This can be proved by definition directly. Alternatively, it is a
special case of product martingales given below.
• (Product martingale)
Qn
If Xi 0 with EXi = 1, Tn = i=1 Xi is a martingale.
Q
Proof. Clearly, E|Tn| = ni=1 EXi = 1 < 1, and Tn 2 Fn :=
(X1, ..., Xn). Also, E (Tn+1|Fn) = TnE (Xn+1|Fn) = TnE (Xn+1) =
Tn .

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70
 • (Doob’s martingale) dictZO.info
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Yn = E(Z|Fn) is a martingale.
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1. Clearly, Yn 2 Fn.
2. Apply Jensen’s inequality with (x) = |x| to get |E(Z|Fn)| 
E(|Z||Fn). Then, E|Yn| = E (|E(Z|Fn)|)  E (E(|Z||Fn)|) =
E(|Z|) < 1.
3. By Tower property: E(Yn+1|Fn) = E(E(Z|Fn+1)|Fn) = E(Z|Fn) =
Yn .

Remark 4.2 By Levy Upward Theorem, E(X|Fn) ! E(X|F1)

a.s. In particular, if F1 = F, the limit is simply E(X|F) = X.

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71
4.2 Basic properties of martingales E ⾺ Xm

Theorem 4.2
t
1. If Xn is a martingale (or super-, sub-martingale), then for
n > m,
E(Xn|Fm) = Xm (or  Xm , Xm).

2. If Xn is a martingale and is convex, then (Xn) is a sub-

martingale.
3. is increasing and convex. If Xn is a submartingale, so is
(Xn).

Proof.

1. By Tower property, E(Xm+k |Fm) = E(E(Xm+k |Fm+k 1)|Fm) =

E(Xm+k 1|Fm) = ... = E(Xm+1|Fm) = Xm.
2. By Jensen’s inequality, E ( (Xn+1)|Fn) (E(Xn+1|Fn)) =
(Xn) .
3. By Jensen’s inequality, E ( (Xn+1)|Fn) (E(Xn+1|Fn))
(Xn) .

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______
Example 4.1

1. Xn is a martingale =) |Xn|p is a submartingale for p 1.

e.g., |Xn| and Xn2 are both submartingales.
2. Give a submartingale Xn, Xn2 may not be a submartingale.
e.g., { 1/n, n 1} is a submartingale, but {( 1/n)2, n 1}
is a supermartingale.
3. Xn is a submartingale =) (Xn a)+ is a submartingale.
Note: (x a)+ is increasing and convex.
4. Xn is a supermartingale =) Xn ^ a is a supermartingale. I

Note: x ^ a is an increasing concave function.

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4.3 Doob’s decomposition theorem

Theorem 4.3 {Yn} is a submartingale, then

Yn = Y0 + Mn + An, n 0,
where

• Mn is a martingale with M0 = 0;
• An is an increasing predictable process with A0 = 0;
• This decomposition is unique.

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74
 Proof. Note that
n
X
Yn = Y0 + (Yk Yk 1 )
k=1
n
X
= Y0 + (Yk E(Yk |Fk 1) + E(Yk |Fk 1) Yk 1 )
k=1
n
X n
X
= Y0 + (Yk E(Yk |Fk 1)) + (E(Yk |Fk 1) Yk 1 ) .
k=1 k=1

So we define M0 = 0, A0 = 0, and
n
X n
X
Mn = (Yk E(Yk |Fk 1)) , An = (E(Yk |Fk 1) Yk 1 ) .
k=1 k=1

And we will show below that M and A satisfy the requirements in the
theorem.

1. Clearly, Mn 2 Fn and E|Mn| < 1. Also

E(Mn+1|Fn) = E{[Mn + (Yn+1 E(Yn+1|Fn)]|Fn)} = Mn.
Hence, Mn is a martingale.
2. Clearly, An 2 Fn 1. Also, An+1 An = E(Yn+1|Fn) Yn 0 as
Yn is a submartingale, so An ".
3. Suppose that Yn = Y0 + Mn0 + A0n is another decomposition. Then
0
Yn+1 Yn = (Mn+1 Mn0 )+(A0n+1 A0n) = (Mn+1 Mn)+(An+1 An).
Take conditional expectation given Fn to obtain
A0n+1 A0n = An+1 An.
However, since A00 = A0, and therefore A0n = An by induction,
implying that Mn0 = Mn. This decomposition is unique.

75
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4.4 Martingale transform

Let {Xn} be adapted and {Cn} predictable w.r.t. Fn. Define

n
X
Y0 = 0, Yn =: (C • X)n = Ci(Xi Xi 1).
i=1

For example, if

• Ci = number of shares holding at day i (decided at the beginning

of day i), and
• (Xi Xi 1) = the change in the stock price per share at day i,
i = 1, ..., n.

Pn
Then, (C • X)n = i=1 Ci (Xi Xi 1) is the total earning at the end
of day n.

76
Theorem 4.4 Assume that E|Yn| < 1. Then

1. If Xn is a martingale, so is Yn,
2. If Xn is a sub-martingale and Ci 0, so is Yn,

Proof. Let us prove (1) only since that of (2) is very similar.

Clearly, Yn 2 Fn, and E|Yn| < 1. Now Cn+1 2 Fn, we have

E(Yn+1|Fn) = E[(Yn + Cn+1(Xn+1 Xn))|Fn]
= Yn + E[(Cn+1(Xn+1 Xn))|Fn]
= Yn + Cn+1E[(Xn+1 Xn)|Fn]
= Yn + Cn+1 ⇥ 0 = Yn.

77
4.5 Are martingales really “fair”?

Example 4.2 Let X1, X2, ... be independent with

2
Xn = 1 with probability 1 n
n2 1 with probability n 2.
Define M0 = 0 and Mn = X1 + ... + Xn for n 1. Since EXn =
( 1) ⇥ (1 n 2) + (n2 1) ⇥ n 2 = 0, {Mn} forms a random walk
and hence is a martingale. However, we have
Mn ! 1, a.s.

Proof. P (|Xn ( 1)| > ✏) = P (Xn 6= 1) = 1/n2 ! 0, hence,

P
Xn ! 1 in probability. Furthermore, since 1 2
n=1 1/n < 1, we have
Xn ! 1 a.s. Thus, Mn ! 1 a.s.

78
Remark 4.3 Think of Lotto or Jackpot gambling game, for ex-
ample, which is held independently everyday. Suppose that the
number of players increases like n2 at day n. Everyone places a
bet of one dollar and has the equal chance of winning, and there
is only one winner (one winner takes it all). If you don’t win, you
lose your bet $1; if you win, you collect all the money $ n2 1.
Note that each day, your average net gain is 0, it seems fair, right?
But the last example tells us that if you keep on playing, you are
sure to be broke!!!

# of players (day^n) Net Gain Prob

--------------------------------------------------------
Day 1 1 Loss = -1
Gain = 0

Day 2 4 Loss = -1
Gain = 4-1 = 3

Day 3 9 Loss = -1
Gain = 9-1 = 8

... ... ...

Day n n*2 Loss = -1

Gain = n*2-1

79
 The moral of this example is: even martingales can be
unfair in real life when it appears fair! Martingales are only “fair”
on average, but may be “unfair” in the long term.

In fact, with slight modification, it is not difficult to construct a

sub-martingale (i.e., expectations go up, so is is favorable to the
player on each game). For example, we can choose
2
Xn = 1 with probability 1 n
n2 with probability n 2.
However, he/she will lose everything for sure in the long term. It
does not sound “fair”, does it?

80
4.6 Exercises

1. Let Xi be independent with EXi = 0 and i2 = V ar(Xi) < 1,

P P
and let Sn2 = ni=1 Xi2 and Bn2 = ESn2 = ni=1 i2. Show that
Sn2 Bn2 is a martingale (w.r.t. the natural filtration.)
2. Let {Xn, n 1} be a martingale di↵erence w.r.t. Fn and further
assume EXn2 < 1 for all n. Show that Cov(Xi, Xj ) = 0, if i 6= j.
(Note: Martingale di↵erences are dependent, but uncorrected. In
fact, many results in probability theory which hold for i.i.d. r.v.’s
also hold for martingale di↵erences with little or no changes.
3. It is known that the first entry time into A is a stopping time.
Show that the second entry time is also a stopping time.
4. Let X0, X1, X2, ... be r.v.’s such that
E(Xn+1|Fn) = aXn + bXn 1, for n 1,
where 0 < a, b < 1, a + b = 1 and Fn = (X0, ..., Xn). Find
an appropriate ↵ so that Yn = ↵Xn + Xn 1 forms a martingale
sequence.
5. (Likelihood-ratio testing) Let X1, ..., Xn be i.i.d. We test
H0 : Xi ⇠ f vs H1 : Xi ⇠ g. Show that the “likelihood ratio”
statistic is a martingale under H0, where
n
Y g(Xi)
Yn = .
i=1 f (X i )

6. Let Xi be nonnegative i.i.d. r.v.s with E(Xi) = 1 and P (Xi =

1) < 1. Show that
Qn
(a) Tn = i=1 Xi is a martingale.
(b) (1/n) log(Tn) ! c < 0 a.s.
(c) Tn ! 0 a.s.

81
 P
7. (Abraham de Moivre martingale) Let Sn = ni=1 Xi, with
S0 = 0, and Fn = (X1, ..., Xn). Assume that P (Xi = 1) = p
and P (Xi = 1) = 1 p. Then, Yn = (q/p)Sn is a martingale.
8. Let Y1, Y2, ..., be a sequence of r.v.s with E|Yi| < 1. Let Fn =
(Y1, ..., Yn). Then Zn,m, Fn, n 1 is a martingale di↵erence,
where
Zn,m =: E(Yn+m|Fn) E(Yn+m|Fn 1).
Note: Some special cases include:
1. Zn,0 =: E(Yn|Fn) E(Yn|Fn 1) = Yn E(Yn|Fn 1);
2. Zn,2n =: E(Yn+2n |Fn) E(Yn+2n |Fn 1);
2. Zn,1 =: E(Y1|Fn) E(Y1|Fn 1).

82