Girsanov theorem

In probability theory, the Girsanov

theorem tells how stochastic processes
change under changes in measure. The
theorem is especially important in the
theory of financial mathematics as it
tells how to convert from the physical
measure which describes the
probability that an underlying
instrument (such as a share price or
interest rate) will take a particular value
or values to the risk-neutral measure
which is a very useful tool for
evaluating the value of derivatives on
the underlying. Visualisation of the Girsanov theorem. The left side shows a Wiener
process with negative drift under a canonical measure P; on the
right side each path of the process is colored according to its
History likelihood under the martingale measure Q. The density
transformation from P to Q is given by the Girsanov theorem.
Results of this type were first proved
by Cameron-Martin in the 1940s and
by Igor Girsanov in 1960. They have been subsequently extended to more general classes of process
culminating in the general form of Lenglart (1977).

Significance
Girsanov's theorem is important in the general theory of stochastic processes since it enables the key result
that if Q is a measure that is absolutely continuous with respect to P then every P-semimartingale is a Q-
semimartingale.

Statement of theorem
We state the theorem first for the special case when the underlying stochastic process is a Wiener process.
This special case is sufficient for risk-neutral pricing in the Black–Scholes model.

Let be a Wiener process on the Wiener probability space . Let be a measurable

process adapted to the natural filtration of the Wiener process ; we assume that the usual conditions
have been satisfied.

Given an adapted process define

where is the stochastic exponential of X with respect to W, i.e.

and denotes the quadratic variation of the process X.

If is a martingale then a probability measure Q can be defined on such that Radon–Nikodym

derivative

Then for each t the measure Q restricted to the unaugmented sigma fields is equivalent to P restricted to

Furthermore if is a local martingale under P then the process

is a Q local martingale on the filtered probability space .

Corollary
If X is a continuous process and W is Brownian motion under measure P then

is Brownian motion under Q.

The fact that is continuous is trivial; by Girsanov's theorem it is a Q local martingale, and by computing

it follows by Levy's characterization of Brownian motion that this is a Q Brownian motion.

Comments

In many common applications, the process X is defined by

For X of this form then a necessary and sufficient condition for X to be a martingale is Novikov's condition
which requires that

The stochastic exponential is the process Z which solves the stochastic differential equation
The measure Q constructed above is not equivalent to P on as this would only be the case if the
Radon–Nikodym derivative were a uniformly integrable martingale, which the exponential martingale
described above is not. On the other hand as long as Novikov's condition is satisfied the measures are
equivalent on .

Additionally, then combining this above observation in this case, we see that the process

for is a Q Brownian motion. This was Igor Girsanov's original formulation of the above
theorem.

Application to finance
This theorem can be used to show in the Black–Scholes model the unique risk-neutral measure, i.e. the
measure in which the fair value of a derivative is the discounted expected value, Q, is specified by

Application to Langevin equations

Another application of this theorem, also given in the original paper of Igor Girsanov, is for stochastic
differential equations. Specifically, let us consider the equation

where denotes a Brownian motion. Here and are fixed deterministic functions. We assume that this
equation has a unique strong solution on . In this case Girsanov's theorem may be used to compute
functionals of directly in terms a related functional for Brownian motion. More specifically, we have for
any bounded functional on continuous functions that

This follows by applying Girsanov's theorem, and the above observation, to the martingale process

In particular, we note that with the notation above, the process

is a Q Brownian motion. Rewriting this in differential form as

we see that the law of under Q solves the equation defining , as is a Q Brownian motion. In
particular, we see that the right-hand side may be written as , where Q is the measure taken with
respect to the process Y, so the result now is just the statement of Girsanov's theorem.

A more general form of this application is that if both

admit unique strong solutions on , then for any bounded functional on , we have that

See also
Cameron–Martin theorem – Theorem of measure theory

References
Liptser, Robert S.; Shiriaev, A. N. (2001). Statistics of Random Processes (2nd, rev. and
exp. ed.). Springer. ISBN 3-540-63929-2.
Dellacherie, C.; Meyer, P.-A. (1982). "Decomposition of Supermartingales, Applications".
Probabilities and Potential. Vol. B. Translated by Wilson, J. P. North-Holland. pp. 183–308.
ISBN 0-444-86526-8.
Lenglart, E. (1977). "Transformation de martingales locales par changement absolue continu
de probabilités". Zeitschrift für Wahrscheinlichkeit (in French). 39: 65–70.
doi:10.1007/BF01844873 (https://doi.org/10.1007%2FBF01844873).

External links
Notes on Stochastic Calculus (http://www.chiark.greenend.org.uk/~alanb/stoc-calc.pdf)
which contain a simple outline proof of Girsanov's theorem.

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