Girsanov’s Theorem

Change of Measure and Numeraire — Girsanov’s Theorem

Theorem 13 (Girsanov’s Theorem)
Let Wt be a Brownian motion on a space (⌦, F, P) with information set
Ft . Let
⇢Z t Z t
1
⌘t = exp ✓(s)dWs ✓2 (s)ds , t  T,
0 2 0

where ✓(t) is a stochastic process satisfying

Rt
P ✓ 2 (s)ds
E [e 0 ] < 1.

Then,
1 ⌘t is a positive P-martingale.
2 If dQ = ⌘t dP, E Q (X) = E P (⌘t X).
Rt
c
Wt = Wt 0 ✓(s)ds is a Q-Brownian motion.
3

H.Y. WONG (CUHK) RMSC4007 Chapter 2 September 7, 2011 33 / 45

 Girsanov’s Theorem Girsanov’s Theorem — Applications

Application IV: Call on a zero-coupon bond I

Consider the risk-neutral process of zero-coupon bonds (zeros):

dP (t, T )
= rt dt + (t, T )dWt , (4)
P (t, T )

where the interest rate rt is stochastic and (t, T ) is deterministic with

(T, T ) = 0. Applying Itô’s Lemma on ln P (t, T ), yields
Z t Z t
2
P (t, T ) = P (0, T ) exp (rs (s, T )/2)ds + (s, T )dWs .
0 0

We are looking for the pricing formula for the option with payo↵:
max(P (T, S) K, 0), where S > T . Thus,
h RT i
V (P (0, S), T ) = EQ e 0 rs ds max(P (T, S) K, 0) .

H.Y. WONG (CUHK) RMSC4007 Chapter 2 September 7, 2011 41 / 45

 Girsanov’s Theorem Girsanov’s Theorem — Applications

Application IV: Call on a zero-coupon bond II

As P (T, T ) = 1, we can alternatively write the formula as
 R ✓ ◆
Q T
rs ds P (T, S)
V (P (0, S), T ) = E e 0 P (T, T ) max K, 0 .
P (T, T )
B(t)/P (t,T )
Let ⌘T = B(T )/P (T,T ) and dQT = ⌘T dQ. Then,
 ✓ ◆
QT P (T, S)
V (P (0, S), T ) = P (0, T )E max K, 0 .
P (T, T )

The remaining job is to identify the process of PP (t,T

(t,S)
) under Q T . From the

process of P (t, T ), we know that

✓ Z t Z t ◆
1 2
⌘t = exp (s, T )ds + (s, T )dWs .
2 0 0

H.Y. WONG (CUHK) RMSC4007 Chapter 2 September 7, 2011 42 / 45

 Girsanov’s Theorem Girsanov’s Theorem — Applications

Application IV: Call on a zero-coupon bond III

By the Girsanov Theorem, the Brownian motion under QT is
ct = dWt
dW (t, T )dt.

Under Q, we have
P (t, S) P (0, S) 1
Rt 2 (s,S)
R
2 (s,T )]ds+ t [
= e 2 0[ 0 (s,S) (s,T )]dWs
.
P (t, T ) P (0, T )

Therefore, under QT ,
P (t, S) P (0, S) Rt Rt
1 2 cs
= e 2 0[ (s,S) (s,T )] ds+ 0 [ (s,S) (s,T )]dW
.
P (t, T ) P (0, T )
2
R
1 T
Let ⌃ (T ) = T 0 [ (s, S) (s, T )]2 ds.
✓ ◆
P (0, S)
V (P (0, S), T ) = P (0, T )Call S = ; = ⌃(T ), r = 0 .
P (0, T )

H.Y. WONG (CUHK) RMSC4007 Chapter 2 September 7, 2011 43 / 45