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Springer Finance
Textbooks
Robert A. Jarrow
Continuous-Time
Asset Pricing
Theory
A Martingale-Based Approach
Springer Finance
Textbooks
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Mark Davis
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Walter Schachermayer
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derivatives, and financial economics.
This subseries of Springer Finance consists of graduate textbooks.
More information about this series at http://www.springer.com/series/11355

Robert A. Jarrow
Continuous-Time
Asset Pricing Theory
A Martingale-Based Approach
123
Robert A. Jarrow
Samuel Curtis Johnson Graduate School
Cornell University
Ithaca
New York, USA
ISSN 1616-0533 ISSN 2195-0687 (electronic)

Springer Finance
Springer Finance Textbooks
ISBN 978-3-319-77820-4 ISBN 978-3-319-77821-1 (eBook)
https://doi.org/10.1007/978-3-319-77821-1
Library of Congress Control Number: 2018939163
Mathematics Subject Classification (2010): 90C99, 60G99, 49K99, 91B25
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The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland
This book is dedicated to my wife, Gail.
Preface
The fundamental paradox of mathematics is that abstraction leads to both simplicity and
generality. It is a paradox because generality is often thought of as requiring complexity,
but this is not true. This insight explains both the beauty and power of mathematics.
Philosophy
My philosophy in creating models for practice and for understanding is based on

two simple principles:
1. always impose the least restrictive set of assumptions possible to achieve
maximum generality, and
2. when choosing among assumptions, it is better to impose an assumption that is
observable and directly testable versus an assumption that is unobservable and
only indirectly testable.
This philosophy affects the content of this book.
The Key Topics
Finance’s asset pricing theory has three topics that uniquely identify it.
1. Arbitrage pricing theory, including derivative valuation/hedging and multiple-
factor beta models.
2. Portfolio theory, including equilibrium pricing.
3. Market informational efficiency.
These three topics are listed in order of increasing structure (set of assumptions),
from the general to the specific. In some sense, topic 3 requires less structure than
vii
viii Preface
topic 2 because market efficiency only requires the existence of an equilibrium, not
a characterization of the equilibrium.
The more assumptions imposed, the less likely the structure depicts reality. Of
course, this depends crucially on whether the assumptions are true or false. If
the assumptions are true, then no additional structure is being imposed when an
assumption is added. But in reality, all assumptions are approximations, therefore
all assumptions are in some sense “false.” This means, of course, that the less
assumptions imposed, the more likely the model is to be “true.”
The Key Insights
There are at least nine important insights from asset pricing theory that need to be
understood. These insights are obtained from the three fundamental theorems of
asset pricing. The insights are enriched by the use of preferences, characterizing an
investor’s optimal portfolio decision, and the notion of an equilibrium. These nine
insights are listed below.
1. The existence of a state price density or an equivalent local martingale measure
(First Fundamental Theorem).
2. Hedging and exact replication (Second Fundamental Theorem).
3. The risk-neutral valuation of derivatives (Third Fundamental Theorem).
4. Asset price bubbles (Third Fundamental Theorem).
5. Spanning portfolios (mutual fund theorems) (Third Fundamental Theorem).
6. The meaning of Arrow–Debreu security prices (Third Fundamental Theorem).
7. The meaning of systematic versus idiosyncratic risk (Third Fundamental Theo-
rem).
8. The meaning of diversification (Third Fundamental Theorem and the Law of
Large Numbers).
9. The importance of the market portfolio (Portfolio Optimization and Equilib-
rium).
Insight 1 requires the first fundamental theorem. Insight 2 requires the second
fundamental theorem. Insights 3–8 require the first and third fundamental theorems
of asset pricing. Insight 8 also requires the law of large numbers. Insight 9
requires the notion of an equilibrium with heterogeneous traders. There are three
important aspects of insights 1–9 that need to be emphasized. The first is that all
of these insights are derived in incomplete markets, including markets with trading
constraints. The second is that all of these insights are derived for discontinuous
sample path processes, i.e. asset price processes that contain jumps. The third is that
all of these insights are derived in models where traders have heterogeneous beliefs,
and in certain subcases, differential information as well. As such, these insights are
very robust and relevant to financial practice. All of these insights are explained in
detail in this book.
Preface ix
The Martingale Approach
The key topics of asset pricing theory have been studied, refined, and extended for
over 40 years, starting in the 1970s with the capital asset pricing model (CAPM), the
notion of market efficiency, and option pricing theory. Much knowledge has been
accumulated and there are many different approaches that can be used to present this
material. Consistent with my philosophy, I choose the most abstract, yet the simplest
and most general approach for explaining this topic. This is the martingale approach
to asset pricing theory—the unifying theme is the notion of an equivalent local
martingale probability measure (and all of its extensions). This theme can be used
to understand and to present the known results from arbitrage pricing theory up to,
and including, portfolio optimization and equilibrium pricing. The more restrictive
historical and traditional approach based on dynamic programming and Markov
processes is left to the classical literature.
Discrete Versus Continuous Time
There are three model structures that can be used to teach asset pricing.
1. A static (single period) model,
2. discrete-time and multiple periods, or
3. continuous-time.
Static models are really only useful for pedagogical purposes. The math is simple
and the intuition easy to understand. They do not apply in practice/reality. Consistent
with my philosophy, this reduces the model structure choice to two for this book,
between discrete-time multiple periods and continuous-time models. We focus on
continuous-time models in this book because they are the better model structure for
matching reality (see Jarrow and Protter [103]).
Trading in continuous time better matches reality for three reasons. One, a
discrete-time model implies that one can only trade on the grid represented by
the discrete time points. This is not true in practice because one can trade at any
time during the day. Second, trading times are best modeled as a finite (albeit very
large) sequence of random times on a continuous time interval. It is a very large
finite sequence because with computer trading, the time between two successive
trades is very small (milli- and even microseconds). This implies that the limit
of a sequence of random times on a continuous time interval should provide a
reasonable approximation. This is, of course, continuous trading. Three, continuous-
time has a number of phenomena that are not present in discrete-time models—the
most important of which are strict local martingales. Strict local martingales will be
shown to be important in understanding asset price bubbles.
x Preface
Mean-Variance Efficiency and the Static CAPM
As an epilogue to Part III of this book, its last chapter studies the static CAPM. The
static CAPM is studied after the dynamic continuous-time model to emphasize the
omissions of a static model and the important insights obtained in dynamic models.
This is done because the static model is not a good approximation to actual security
markets. This book only briefly discusses the mean-variance efficient frontier.
Consequently, an in depth study of this material is left to independent reading (see
Back [5], Duffie [52], Skiadas [171]). Generalizations of this model in continuous
time—the intertemporal CAPM due to Merton [137] and the consumption CAPM
due to Breeden [22]—are included as special cases of the models presented in this
book.
Stochastic Calculus
Finance is an application of stochastic process and optimization theory. Stochastic

processes because asset prices evolve randomly across time. Optimization because
investors trade to maximize their preferences. Hence, this mathematics is essential
to developing the theory. This book is not a mathematics book, but an economics
book. The math is not emphasized, but used to obtain results. The emphasis of the
book is on the economic meaning and implications of assumptions and results.
The proofs of most results are included within the text, except those that require
a knowledge of functional analysis. Most of the excluded proofs are related to
“existence results,” examples include the first fundamental theorem of asset pricing
and the existence of a saddle point in convex optimization. For those proofs not
included, references are provided. The mathematics assumed is that obtained from
a first level graduate course in real analysis and probability theory. Sources of
this knowledge include Ash [3], Billingsley [13], Jacod and Protter [75], and
Klenke [123]. Excellent references for stochastic calculus include Karatzas and
Shreve [117], Medvegyev [136], Protter [151], Roger and Williams [157], Shreve
[169], while those for optimization include Borwein and Lewis [19], Guler [66],
Leunberger [134], Ruszczynski [162], and Pham [149].
Preface xi
ASSET PRICING THEORY: TRADITIONAL VERSUS MARKET

MICROSTRUCTURE
Asset Pricing Theory

1. continuous/discrete-time
2. frictionless/frictions
3. equal/differential beliefs
4. equal/differential information
(Traditional)
competitive markets ⇐⇒Walrasian equilibrium

(Market Microstructure)
competitive markets ⇐⇒Nash equilibrium or zero expected profit
Traditional Asset Pricing Theory versus Market

Microstructure
Although the distinction between traditional asset pricing theory and market
microstructure is not “black and white,” one useful classification of the difference
between these two fields is provided in the previous Table. In this classification,
traditional asset pricing theory and market microstructure have common the struc-
tures (1)–(4). They differ in the meaning of a competitive market, in particular, the
notion of an equilibrium. Traditional asset pricing uses the concept of a Walrasian
equilibrium (supply equals demand, price-takers) whereas market microstructure
uses Nash equilibrium or a zero expected profit condition (strategic traders, non-
price-takers). This difference is motivated by the questions that each literature
addresses.
Asset pricing abstracts from the mechanism under which trades are executed.
Consequently, it assumes that investors are price-takers whose trades have no
quantity impact on the price. This literature focuses on characterizing the price
process, optimal trading strategies, and risk premium. In contrast, the market
microstructure literature seeks to understand the trade execution mechanism itself,
and its impact on market welfare. This alternative perspective requires a different
equilibrium notion, one that explicitly incorporates strategic trading. This book
presents asset pricing theory using the traditional representation of market clearing.
For a book that reviews the market microstructure literature, see O’Hara [147].
xii Preface
Themes
The themes in this book differ from those contained in most other asset pricing
books in four notable ways. First, the emphasis is on price processes that include
jumps, not just continuous diffusions. Second, stochastic optimization is based on
martingale methods using convex analysis and duality, and not diffusion processes
with stochastic dynamic programming. Third, asset price bubbles are an important
consideration in every result presented herein. Fourth, the existence and characteri-
zation of economic equilibrium is based on the use of a representative trader. Other
excellent books on asset pricing theory, using the more traditional approach to the
topic, include Back [5], Bjork [14], Dana and Jeanblanc [42], Duffie [52], Follmer
and Schied [63], Huang and Litzenberger [72], Ingersoll [74], Karatzas and Shreve
[118], Merton [140], Pliska [150], and Skiadas [171].
Acknowledgements I am grateful for a lifetime of help and inspiration from family, colleagues,
and students.
Ithaca, NY, USA Robert A. Jarrow

Contents
Part I Arbitrage Pricing Theory

1 Stochastic Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3
1.1 Stochastic Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 3
1.2 Stochastic Integration .. . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 10
1.3 Quadratic Variation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 12
1.4 Integration by Parts . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 14
1.5 Ito’s Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 14
1.6 Girsanov’s Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 14
1.7 Essential Supremum . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 15
1.8 Optional Decomposition .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 15
1.9 Martingale Representation.. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 15
1.10 Equivalent Probability Measures .. . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 16
1.11 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 16
2 The Fundamental Theorems . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 19
2.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 19
2.2 Change of Numeraire . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 26
2.3 Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 28
2.3.1 Reinvest in the MMA . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 29
2.3.2 Reinvest in the Risky Asset . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 30
2.4 The First Fundamental Theorem . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 31
2.4.1 No Arbitrage (NA) . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 31
2.4.2 No Unbounded Profits with Bounded
Risk (NUPBR) . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 34
2.4.3 Properties of Dl . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 36
2.4.4 No Free Lunch with Vanishing Risk (NFLVR) . . . . . . . . . . 39
2.4.5 The First Fundamental Theorem . . . . .. . . . . . . . . . . . . . . . . . . . 41
2.4.6 Equivalent Local Martingale Measures . . . . . . . . . . . . . . . . . . 42
2.4.7 The State Price Density . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 43
2.5 The Second Fundamental Theorem . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 44
xiii
xiv Contents
2.6 The Third Fundamental Theorem . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 51

2.6.1 Complete Markets .. . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 55
2.6.2 Risk Neutral Valuation .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 56
2.6.3 Synthetic Derivative Construction .. . .. . . . . . . . . . . . . . . . . . . . 57
2.7 Finite-Dimension Brownian Motion Market . .. . . . . . . . . . . . . . . . . . . . 58
2.7.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 59
2.7.2 NFLVR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 60
2.7.4 ND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 66
2.8 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 67
3 Asset Price Bubbles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 69
3.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 69
3.2 The Market Price and Fundamental Value .. . . .. . . . . . . . . . . . . . . . . . . . 70
3.3 The Asset Price Bubble .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 71
3.4 Theorems Under NFLVR and ND . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 76
3.5 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 78
4 Spanning Portfolios, Multiple-Factor Beta Models,
and Systematic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 79
4.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 79
4.2 Spanning Portfolios .. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 81
4.3 The Multiple-Factor Beta Model .. . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 83
4.4 Positive Alphas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 86
4.5 The State Price Density .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 87
4.6 Arrow–Debreu Securities .. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 88
4.7 Systematic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 88
4.7.1 Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 89
4.7.2 The Beta Model . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 90
4.8 Diversification .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 92
4.9 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 96
5 The Black–Scholes–Merton Model . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 97
5.1 NFLVR, Complete Markets, and ND . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 97
5.2 The BSM Call Option Formula . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 99
5.3 The Synthetic Call Option .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 101
5.4 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 103
6 The Heath–Jarrow–Morton Model . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 105
6.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 105
6.2 Term Structure Evolution .. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 106
6.3 Arbitrage-Free Conditions .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 110
6.4 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 115
6.4.1 The Ho and Lee Model . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 116
6.4.2 Lognormally Distributed Forward Rates . . . . . . . . . . . . . . . . . 117
6.4.3 The Vasicek Model .. . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 117
6.4.4 The Cox–Ingersoll–Ross Model .. . . . .. . . . . . . . . . . . . . . . . . . . 118
6.4.5 The Affine Model . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 119
Contents xv
6.5 Forward and Futures Contracts .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 120

6.5.1 Forward Contracts . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 120
6.5.2 Futures Contracts .. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 124
6.6 The Libor Model .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 126
6.7 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 131
7 Reduced Form Credit Risk Models . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 133
7.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 133
7.2 The Risky Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 134
7.3 Existence of an Equivalent Martingale Measure . . . . . . . . . . . . . . . . . . 136
7.4 Risk Neutral Valuation.. . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 139
7.4.1 Cash Flow 1 . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 140
7.4.2 Cash Flow 2 . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 140
7.4.3 Cash Flow 3 . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 141
7.4.4 Cash Flow 4 . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 142
7.5 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 144
7.5.1 Coupon Bonds .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 144
7.5.2 Credit Default Swaps (CDS). . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 145
7.5.3 First-to-Default Swaps . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 147
7.6 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 149
8 Incomplete Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 151
8.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 151
8.2 The Super-Replication Cost . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 152
8.3 The Super-Replication Trading Strategy .. . . . . .. . . . . . . . . . . . . . . . . . . . 154
8.4 The Sub-Replication Cost . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 155
8.5 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 156
Part II Portfolio Optimization

9 Utility Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 159
9.1 Preference Relations . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 159
9.2 State Dependent EU Representation . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 162
9.3 Measures of Risk Aversion . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 168
9.4 State Dependent Utility Functions . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 172
9.5 Conjugate Duality .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 174
9.6 Reasonable Asymptotic Elasticity . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 175
9.7 Differential Beliefs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 179
9.8 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 180
10 Complete Markets (Utility over Terminal Wealth) .. . . . . . . . . . . . . . . . . . . . 181
10.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 181
10.2 Problem Statement .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 182
10.3 Existence of a Solution . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 187
10.4 Characterization of the Solution.. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 188
10.4.1 The Characterization . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 188
10.4.2 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 191
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10.5 The Shadow Price .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 191

10.6 The State Price Density .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 192
10.7 The Optimal Trading Strategy .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 193
10.8 An Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 194
10.8.1 The Market . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 195
10.8.2 The Utility Function . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 195
10.8.3 The Optimal Wealth Process. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 196
10.8.4 The Optimal Trading Strategy .. . . . . . .. . . . . . . . . . . . . . . . . . . . 196
10.8.5 The Value Function . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 197
10.9 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 198
11 Incomplete Markets (Utility over Terminal Wealth) . . . . . . . . . . . . . . . . . . . 203
11.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 203
11.4.1 The Characterization . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 215
11.4.2 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 218
11.5 The Shadow Price .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 219
11.6 The Supermartingale Deflator .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 219
11.7 The Optimal Trading Strategy .. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 221
11.8 An Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 222
11.8.1 The Market . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 222
11.8.2 The Utility Function . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 224
11.8.3 The Optimal Supermartingale Deflator . . . . . . . . . . . . . . . . . . 224
11.8.4 The Optimal Wealth Process. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 225
11.8.6 The Value Function . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 227
11.9 Differential Beliefs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 228
11.10 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 230
12 Incomplete Markets (Utility over Intermediate Consumption
and Terminal Wealth) .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 235
12.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 235
12.4.1 Utility of Consumption (U2 ≡ 0) . . . . .. . . . . . . . . . . . . . . . . . . . 248
12.4.2 Utility of Terminal Wealth (U1 ≡ 0) .. . . . . . . . . . . . . . . . . . . . 256
12.4.3 Utility of Consumption and Terminal Wealth . . . . . . . . . . . . 257
12.5 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 260
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Part III Equilibrium

13 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 263
13.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 263
13.1.1 Supply of Shares . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 264
13.1.2 Traders in the Economy .. . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 264
13.1.3 Aggregate Market Wealth . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 265
13.1.4 Trading Strategies . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 266
13.1.5 An Economy.. . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 267
13.2 Equilibrium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 267
13.3 Theorems .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 268
13.4 Intermediate Consumption . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 272
13.4.1 Supply of the Consumption Good .. . .. . . . . . . . . . . . . . . . . . . . 272
13.4.2 Demand for the Consumption Good .. . . . . . . . . . . . . . . . . . . . 272
13.4.3 An Economy.. . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 273
13.5 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 273
14 A Representative Trader Economy . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 275
14.1 The Aggregate Utility Function . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 275
14.2 The Portfolio Optimization Problem .. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 281
14.3 Representative Trader Economy Equilibrium .. . . . . . . . . . . . . . . . . . . . 285
14.4 Pareto Optimality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 292
14.5 Existence of an Equilibrium .. . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 295
14.6 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 301
14.6.1 Identical Traders.. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 301
14.6.2 Logarithmic Preferences . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 302
14.8 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 306
15 Characterizing the Equilibrium . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 307
15.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 307
15.3 Asset Price Bubbles .. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 311
15.3.2 Incomplete Markets . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 311
15.4 Systematic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 312
15.5 Consumption CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 313
15.6 Intertemporal CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 315
15.7.1 Systematic Risk . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 317
15.7.2 Consumption CAPM . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 317
15.7.3 Intertemporal CAPM . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 318
15.8 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 318
16 Market Informational Efficiency . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 319
16.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 319
16.2 The Definition .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 320
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16.3 The Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 322

16.4 Information Sets and Efficiency .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 324
16.5 Testing for Market Efficiency . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 324
16.5.1 Profitable Trading Strategies.. . . . . . . . .. . . . . . . . . . . . . . . . . . . . 325
16.5.2 Positive Alphas . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 325
16.5.3 Asset Price Evolutions . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 326
16.6 Random Walks and Efficiency . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 326
16.6.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 326
16.6.2 Random Walk . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 327
16.6.3 Market Efficiency Random Walk .. . . . . . . . . . . . . . . . . . . . 327
16.6.4 Random Walk Market Efficiency .. . . . . . . . . . . . . . . . . . . . 329
16.7 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 330
17 Epilogue (The Static CAPM) .. . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 331
17.1 The Fundamental Theorems .. . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 331
17.2 Systematic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 338
17.3 Utility Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 342
17.4 Portfolio Optimization .. . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 343
17.4.1 The Dual Problem .. . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 348
17.4.2 The Primal Problem .. . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 350
17.5 Beta Model (Revisited) . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 354
17.6 The Efficient Frontier .. . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 355
17.6.1 The Solution (Revisited) .. . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 355
17.6.2 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 356
17.6.3 The Risky Asset Frontier and Efficient Frontier .. . . . . . . . 357
17.7 Equilibrium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 358
17.8 Notes.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 362
Part IV Trading Constraints

18 The Trading Constrained Market . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 375
18.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 375
18.2 Trading Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 376
18.3 Support Functions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 378
18.4 Examples (Trading Constraints and Their Support Functions) . . . 380
18.4.1 No Trading Constraints . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 381
18.4.2 Prohibited Short Sales . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 381
18.4.3 No Borrowing . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 382
18.4.4 Margin Requirements . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 382
18.5 Wealth Processes .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 384
19 Arbitrage Pricing Theory .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 389
19.1 No Unbounded Profits with Bounded Risk (NUPBRC ).. . . . . . . . . . 389
19.2 No Free Lunch with Vanishing Risk (NFLVRC ) . . . . . . . . . . . . . . . . . . 390
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19.4 Systematic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 392
20 The Auxiliary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 393
20.1 The Auxiliary Markets.. . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 394
20.2 The Normalized Auxiliary Markets . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 395
21 Super- and Sub-replication .. . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 399
21.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 399
21.1.1 Auxiliary Market (0, 0) . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 399
21.1.2 Auxiliary Markets (ν0 , ν) . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 400
21.2 Local Martingale Deflators . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 400
21.3 Wealth Processes Revisited . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 402
21.4 Super-Replication .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 404
21.5 Sub-replication .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 406
22 Portfolio Optimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 409
22.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 409
22.2 Wealth Processes (Revisited) .. . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 411
22.3 The Optimization Problem . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 412
22.6 The Shadow Price of the Budget Constraint .. .. . . . . . . . . . . . . . . . . . . . 416
22.8 The Shadow Prices of the Trading Constraints .. . . . . . . . . . . . . . . . . . . 417
22.10 Systematic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 419
23 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 425
23.1 The Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 425
23.2 Representative Trader .. . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 426
23.2.1 The Solution .. . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 427
23.2.2 Buy and Hold Trading Strategies .. . . .. . . . . . . . . . . . . . . . . . . . 428
23.3 Existence of Equilibrium . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 429
23.4 Characterization of Equilibrium.. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 430
References .. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 435
Index . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 443
List of Notation
For easy reference, this section contains the notation used consistently throughout
the book. Notation that is used only in isolated chapters is omitted from this list, but
complete definitions are included within the text.
x = (x1 , . . . , xn ) ∈ Rn , where the prime denotes transpose, is a column vector.
n×1
t ∈ [0, T ] represents time in a finite horizon and continuous-time model.
(Ω, F , (Ft ), P) is a filtered probability space on [0, T ] with F = FT , where Ω is
the state space, F is a σ -algebra, (Ft ) is a filtration, and P is a probability measure
on Ω.
E [·] is expectation under the probability measure P.
E Q [·] is expectation under the probability measure Q given (Ω, F , Q), where Q =
P.
Q ∼ P means that the probability measure Q is equivalent to P.
rt is the default-free spot rate of interest.
t
Bt = e 0 rs ds , B0 = 1 is the value of a money market account.
St = (S1 (t), . . . , Sn (t)) ≥ 0 represents the prices of n of risky assets (stocks),
semimartingales, adapted to Ft .
Bt ≡ B Bt = 1 for all t represents the normalized value of the money market account.
t
St = (S1 (t), . . . , Sn (t)) ≥ 0 represents prices when normalized by the value of the
money market account, i.e. Si (t) = SB(t i (t )
).
(S, (Ft ), P) is a market.
B(0, ∞) is the Borel σ -algebra on (0, ∞).
L0 ≡ L0 (Ω, F , P) is the space of all FT -measurable random variables.
L0+ ≡ L0+ (Ω, F , P) is the space of all nonnegative FT -measurable random
variables.
L1+ (P) ≡ L1+ (Ω, F , P) is the space of all nonnegative FT -measurable random
variables X such that E [X] < ∞.
O is the set of optional stochastic processes.
L (S) is the set of predictable processes integrable with respect to S.
L(B) is the set of optional processes that are integrable with respect to B.
xxi
xxii List of Notation
L 0 is the set of adapted, right continuous with left limit existing (cadlag) stochastic
processes.
L+0 is the set of adapted, right continuous with left limit existing (cadlag) stochastic
processes that are nonnegative.
A (x) = {(α t0 , α) ∈ (O, L (S)) : Xt = α0 (t) + αt · St , ∃c ≤ 0,
Xt = x + 0 αu · dSu ≥ c, ∀t ∈ [0, T ]}
is the set of admissible, self-financing trading strategies.
M = {Q ∼ P : S is a Q-martingale}
is the set of martingale measures.
Ml = {Q ∼ P : S is a Q-local martingale}
= {Q ∼ P : X is a Q-local martingale, X = 1 + α · dS, (α0 , α) ∈ A (1)}
is the set of local martingale measures.
Ms = {Q ∼ P : S is a Q-supermartingale}
is the set
of supermartingale measures.
Dl = Y ∈ L
+ 0
0
: Y = 1, XY is a P-local
martingale,
X = 1 + α · dS, (α0 , α) ∈ A (1)
is the set of local martingale deflator processes.
Dl = {YT ∈ L0+ : ∃Z ∈ Dl , YT = ZT }
is the set
of local martingale deflators.
Ml = Y ∈ Dl : ∃Q ∼ P, YT = dQ dP
is the set of local martingale deflator processes generated by a probability density
with respect
to P.
Ml = YT ∈ L0+ : ∃Z ∈ Ml , YT = ZT
is the set of local martingale deflators that are probability densities with respect to
P.
M = {Y ∈ L+0 : YT = dQ dP , Yt = E [YT |Ft ] , Q ∈ M}
= {Y ∈ L+ : Y ∈ Ml , YT = dQ
0
dP , Q ∈ M}
is the set of martingale deflator processes generated by martingale measures.
M = {YT ∈ L0+ : YT = dQ dP , Q ∈ M}
= {Y ∈ L0+ : ∃Z ∈ M , YT = ZT }
is the set of martingale deflators generated by martingale measures.
N (x) = {(α0 , α) ∈ (O, L (S)) : Xt =α0 (t) + αt · St ,
t
Xt = x + 0 αu · dSu ≥ 0, ∀t ∈ [0, T ]
is the set
of nonnegative wealth, self-financing trading strategies.
Ds = Y ∈ L+ : Y0 = 1, XY is a P-supermartingale,
0

X = 1 + α · dS, (α0 , α) ∈ N (1)
is the set of supermartingale deflator processes.
Ds = {YT ∈ L0+ : ∃Z ∈ Ds , YT = ZT }
= {YT ∈ L0+ : Y0 = 1, ∃(Zn (T ))n≥1 ∈ Ml , YT ≤ lim Zn (T ) a.s.}
n→∞
is the set of
supermartingale deflators.
t
X (x) = X ∈ L+0 : ∃(α0 , α) ∈ N (x), Xt = x + 0 αu · dSu , ∀t ∈ [0, T ]
is the set of nonnegative wealth processes generated by self-financing trading
strategies.
List of Notation xxiii
t
X (x) = X ∈ L+0 : ∃(α0 , α) ∈ N (x), x + 0 αu · dSu ≥ Xt , ∀t ∈ [0, T ]
is the set of nonnegative wealth processes dominated by the value process of a self-
financing trading strategy.
T
C (x) = {XT ∈ L0+ : ∃(α0 , α) ∈ N (x), x + 0 αt · dSt = XT }
= {XT ∈ L0+ : ∃Z ∈ X (x), XT = ZT }
is the set of nonnegative random variables generated by self-financing trading
strategies.

T
C (x) = XT ∈ L0+ : ∃(α0 , α) ∈ N (x), x + 0 αt · dSt ≥ XT
is the set of nonnegative random variables dominated by the value process of a self-
financing trading strategy.
βt = St − E Q [ST |Ft ]
is an asset’s price bubble with respect to the equivalent local martingale measure Q.
p(t, T ) is the time t price of a default-free zero-coupon bond paying $1 at time T
with t ≤ T .
f (t, T ) = − ∂ log(p(t,T
∂T
))
is the time t default-free (continuously compounded) forward rate for date T with
t ≤ T.
p(t,T )
L(t, T ) = 1δ p(t,T +δ) − 1
is the time t default-free discrete forward rate for the time interval [T , T + δ] with
t ≤ T.
D(t, T ) is the time t price of a risky zero-coupon bond paying $1 at time T with
t ≤ T.
Ui (x, ω) : (0, ∞) × Ω → R
is for investor i = 1, . . . , I .
the state dependent utility function of wealth
I
((Ft ), P) , (N0 , N) , Pi , Ui , e0 , e i=1 is an economy.
i i
U (x, ω) : (0, ∞) × Ω → R is the aggregate utility function of wealth for a

representative trader.
Part I
Arbitrage Pricing Theory
Overview
The key results of finance that are successfully used in practice are based on the
three fundamental theorems of asset pricing. Part I presents the three theorems.
The applications of these three theorems are also discussed, including state price
densities (Arrow–Debreu prices), systematic risk, multiple-factor beta models,
derivatives pricing, derivatives hedging, and asset price bubbles. All of these
implications are based on the existence of an equivalent local martingale measure.
The three fundamental theorems of asset pricing relate to the existence of an
equivalent local martingale measure, its uniqueness, and its extensions. Roughly
speaking, the first fundamental theorem of asset pricing equates no arbitrage with
the existence of an equivalent local martingale measure. The second fundamental
theorem relates market completeness to the uniqueness of the equivalent local
martingale measure. The third fundamental theorem states that there exists an
equivalent martingale measure, without the prefix “local,” if and only if there is
no arbitrage and no dominated assets in the economy.
There are three major models used in derivatives pricing: the Black–Scholes–
Merton (BSM) model, the Heath–Jarrow–Morton (HJM) model, and the reduced
form credit risk model. These models are discussed in this part. Other extensions
and refinements of these models exist in the literature. However, if you understand
these three classes of models, then their extensions and refinements are easy
to understand. These models are divided into three cases: complete markets,
“extended” complete markets, and incomplete markets.
In complete markets, there is unique pricing of derivatives and exact hedging
is possible. The two model classes falling into this category are the BSM and the
HJM model. There are two models for studying credit risk: structural and reduced
form models. Structural models assume that the markets are complete. Reduced
form models, depending upon the structure imposed, usually (implicitly) assume
that the markets are incomplete.
2 I Arbitrage Pricing Theory
In reduced form models, market incompleteness is due to the use of inaccessible

stopping times to model default (jump processes). “Extended” complete markets
contain the reduced form class of models. This class of models is called “extended”
complete because to obtain unique pricing in such a model, one assumes that
the market studied is embedded in a larger market that is complete and therefore
the equivalent local martingale measure is unique. This extended complete market
usually includes the trading of derivatives (e.g. call and put options with different
strikes and maturities) on the primary traded assets (e.g. stocks, zero-coupon bonds).
In this case the local martingale measure never needs to be explicitly identified for
pricing. It is important to note that in this circumstance, however, exact hedging of
credit risk is impossible without the use of traded derivatives. The primary use of
these models is for pricing and static hedging using derivatives, and not dynamic
hedging using the primary traded assets (risky and default-free zero-coupon bonds).
In incomplete markets, which are not “extended” complete, exact pricing and
hedging of assets is (usually) impossible. In this case upper and lower bounds for
derivative prices are obtained by super- and sub-replication.
Chapter 1
Stochastic Processes
We need a basic understanding of stochastic processes to study asset pricing

theory. Excellent references are Karatzas and Shreve [117], Medvegyev [136],
Rogers and Williams [157], and Protter [151]. This chapter introduces some
terminology, notation, and key theorems. Few proofs of the theorems are provided,
only references for such. The basics concepts from probability theory are used below
without any detailed explanation (see Ash [3] or Jacod and Protter [75] for this
background material).
1.1 Stochastic Processes
We consider a continuous-time setting with time denoted t ∈ [0, ∞). We are given
a filtered probability space (Ω, F , (Ft )0≤t ≤∞, P) where Ω is the state space with
generic element ω ∈ Ω, F is a σ -algebra representing the set of events, (Ft )0≤t ≤∞
is a filtration, and P is a probability measure defined on F . A filtration is a collection
of σ -algebras which are increasing, i.e. Fs ⊆ Ft for 0 ≤ s ≤ t ≤ ∞.
A random variable is a mapping Y : Ω → R such that Y is F -measurable, i.e.
Y −1 (A) ∈ F for all A ∈ B(R) where B(R) is the Borel σ -algebra on R, i.e. the
smallest σ -algebra containing all open intervals (s, t) with s ≤ t for s, t ∈ R (see
Ash [3, p. 8]).
A stochastic process is a collection of random variables indexed by time, i.e.
a mapping X : [0, ∞) × Ω → R, denoted variously depending on the context,
X(t, ω) = X(t) = Xt . It is adapted if Xt is Ft -measurable for all t ∈ [0, ∞).
A sample path of a stochastic process is the graph of X(t, ω) across time t
keeping ω fixed.
We assume that the filtered probability space satisfies the usual hypotheses. The
usual hypotheses are that F0 contains the P-null sets of F and that the filtration
(Ft )t ≥0 is right continuous. Right continuous means that Ft = ∩u>t Fu for all
© Springer International Publishing AG, part of Springer Nature 2018 3

R. A. Jarrow, Continuous-Time Asset Pricing Theory, Springer Finance,
https://doi.org/10.1007/978-3-319-77821-1_1
4 1 Stochastic Processes
0 ≤ t < ∞. Letting F0 contain the P-null sets of F facilitates the measurability of

various events, random variables, and stochastic processes. Right continuity implies
the important result that given a random variable τ : Ω → [0, ∞], {τ (ω) ≤ t} ∈ Ft
for all t if and only if {τ (ω) < t} ∈ Ft for all t, see Protter [151, p. 3]. This
fact will be important with respect to the mathematics of stopping times, which are
introduced below. One can think of right continuity as implying that the information
at time t + is known at time t, see Medvegyev [136, p. 9].
A stochastic process is said to be cadlag if it has sample paths that are right
continuous with left limits existing a.s. P.
It is said to be caglad if its sample paths are left continuous with right limits
existing a.s. P.
Both of these stochastic processes allow sample paths that contain jumps, i.e. a
sample path which exhibits at most a countable number of discontinuities (jumps)
over any compact interval (see Medvegyev [136, p. 5]). An interval in the real line
is compact if and only if it is closed and bounded.
A stochastic process is said to be predictable if it is measurable with respect
to the predictable σ -algebra. The predictable σ -algebra is the smallest σ -algebra
generated by the processes that are caglad and adapted, see Protter [151, p. 102].
A stochastic process is said to be optional if it is measurable with respect to the
optional σ -algebra. The optional σ -algebra is the smallest σ -algebra generated by
the processes that are cadlag and adapted, see Protter [151, p. 102].
It can be shown that the predictable σ -algebra is always contained in the optional
σ -algebra (see Medvegyev [136, p. 27]). Hence, we get the following relationship
among the three types of stochastic processes,
predictable ⊆ optional ⊆ adapted.
A stochastic process is said to be continuous if its sample paths are continuous

a.s. P, i.e. it is both cadlag and caglad.
Definition 1.1 (Nondecreasing Process) Let X be a cadlag process. X is a non-
decreasing process if the paths Xt (ω) are nondecreasing in t for all ω ∈ Ω a.s.
P.
Definition 1.2 (Finite Variation Process) Let X be a cadlag process. X is a finite
variation process if the paths Xt (ω) are of finite variation on compact intervals for
all ω ∈ Ω a.s. P.
A real-valued function f : R → R being of finite variation on a compact interval
means that the function can be written as the difference of two nondecreasing
(monotone) real-valued functions, see Royden [160, p. 100]. From Royden [160,
Lemma 6, page 101] we get the next lemma.
1.1 Stochastic Processes 5
Lemma 1.1 (Lebesgue Integrals) Let Y be a cadlag and adapted process such
that
t
Xt (ω) = Ys (ω)ds
0
exists for all t ∈ [0, T ] and for all ω ∈ Ω a.s. P.

Then, Xt is a continuous and adapted process of finite variation on [0, T ].
Lemma 1.2 (Increasing Functions of Continuous Finite Variation Processes)
Let Xt be a continuous and adapted process of finite variation on [0, T ].
Let f : R → R be strictly increasing (or strictly decreasing) and differentiable
with f continuous.
Then, f (Xt ) is a continuous and adapted process of finite variation on [0, T ].
Proof The continuity of f (Xt ) follows trivially, and the continuity of f implies
f (Xt ) is adapted. Consider a partition of the time interval [0, T ], denoted t0 , · · · , tn
where max[ti − ti−1 ] → 0 as n → ∞.
Fix ω ∈ Ω. Note that ni=1 f (Xti ) − f (Xti−1 ) = ni=1 f (ξi ) Xti − Xti−1
for some ξi ∈ (Xti , Xti−1 ) by the mean value theorem. Since Xt is continuous,
I ≡ [min{Xt ; t ∈ [0, T ]}, max{Xt ; t ∈ [0, T ]}] is a compact interval on the real
line. Since f is continuous, there exists a ξ ∈ I such that f (ξi ) ≤ f (ξ ) for all
ξi ∈ I .
Hence, ni=1 f (ξi ) Xti − Xti−1 ≤ f (ξ ) ni=1 Xti − Xti−1 .
Since Xt is of finite variation on [0, T ], taking the supremum across all such
partitions of time gives sup ni=1 Xti − Xti−1 < ∞, which implies
n
sup i=1 f (Xti ) − f (Xti−1 ) < ∞. This completes the proof.
Definition 1.3 (Martingales) A stochastic process X is a martingale with respect

to (Ft )0≤t ≤∞ if
(i) X is cadlag and adapted,
(ii) E[|Xt |] < ∞ all t, and
(iii) E[Xt |Fs ] = Xs a.s. for all 0 ≤ s ≤ t < ∞.
It is a submartingale if (iii) is replaced by E[Xt |Fs ] ≥ Xs a.s.
It is a supermartingale if (iii) is replaced by E[Xt |Fs ] ≤ Xs a.s.
For the definition of an expectation and a conditional expectation, see Ash [3,
Chapter 6]. Within the class of martingales, uniformly integrable martingales play
an important role (see Protter [151, Theorem 13, p. 9]).
Definition 1.4 (Uniformly Integrable Martingales) A stochastic process X is a
uniformly integrable martingale with respect to (Ft )0≤t ≤∞ if
(i) X is a martingale,
(ii) Y = lim Xt a.s. P exists, E [|Y |] < ∞, and
t →∞
(iii) E[Y |Ft ] = Xt a.s. for all 0 ≤ t < ∞.
6 1 Stochastic Processes
Remark 1.1 (Uniformly Integrable Martingales) Suppose we are given a filtered

probability space (Ω, F , (Ft )0≤t ≤T , P) for a finite time horizon T < ∞ with
X : [0, T ] × Ω → R, where F = FT . Then, if X is a martingale, we have
E[XT |Fs ] = Xs a.s. P for all s ∈ [0, T ]. This implies that all martingales on a
finite horizon are uniformly integrable. This completes the remark.
Definition 1.5 (Stopping Time) A random variable τ : Ω → [0, ∞] is a stopping
time if {ω ∈ Ω : τ (ω) ≤ t} ∈ Ft for all t ∈ [0, ∞].
Note that +∞ is included in the range of the stopping time.
Definition 1.6 (Stopping Time σ -Algebra) Let τ be a stopping time. The stopping
time σ -algebra is
Fτ ≡ {A ∈ F : A ∩ {τ ≤ t} ∈ Ft for all t} .
Let τ be a stopping time. Then, the stopped process is defined as

Xt if t < τ
Xt ∧τ ≡
Xτ if t ≥ τ.
Definition 1.7 (Local Martingales) A stochastic process X is a local martingale

with respect to (Ft )0≤t ≤∞ if
(i) X is cadlag and adapted,
(ii) there exists a sequence of stopping times (τn ) such that lim τn = ∞ a.s. P,
n→∞
where Xt ∧τn is a martingale for each n, i.e.
Xs∧τn = E[Xt ∧τn |Fs ] a.s. P
for all 0 ≤ s ≤ t < ∞.

Remark 1.2 (Finite Horizon Local Martingales) Suppose we are given a filtered
probability space (Ω, F , (Ft )0≤t ≤T , P) for a finite time horizon T < ∞ with
X : [0, T ] × Ω → R, where F = FT . In the definition of a local martingale,
condition (ii) is modified to the existence of a sequence of stopping times (τn ) such
that lim τn = T a.s. P, where Xt ∧τn is a martingale for each n. This completes the
n→∞
remark.
Remark 1.3 (Local Submartingales and Supermartingales) The notion of a local
process extends to both submartingales and supermartingales. Indeed, in the defini-
tion of a local martingale replace the word “martingale” with either “submartingale”
or “supermartingale.” This completes the remark.
Lemma 1.3 (Sufficient Condition for a Local Martingale to be a Supermartin-
gale) Let X be a local martingale that is bounded below, i.e. there exists a constant
a > −∞ such that Xt ≥ a for all t a.s. P.
Then, X is a supermartingale.
1.1 Stochastic Processes 7
Proof Xt ≥ a for all t implies Zt = Xt − a ≥ 0 a.s. P. Note that Z is a local

martingale. Hence, without loss of generality we can consider only nonnegative
processes.
By definition of a local martingale, let the sequence of stopping times (τn ) ↑ ∞
be such that E[Xt ∧τn |Fs ] = Xs∧τn . Keeping s, t fixed, taking limits of both the
left and right sides gives lim E[Xt ∧τn Fs ] = lim Xs∧τn = Xs . Now, by Fatou’s
n→∞ n→∞
lemma
lim E[Xt ∧τn Fs ] ≥ E[ lim Xt ∧τn |Fs ] = E[Xt |Fs ] .

n→∞ n→∞
Combined these give Xs ≥ E[Xt |Fs ] . This completes the proof.

Lemma 1.4 (Sufficient Condition for a Local Martingale to be a Martingale)
Let X be a local martingale.
Let Y be a martingale such that |Xt | ≤ |Yt | for all t a.s. P.
Then, X is a martingale.
Proof For a fixed T , by Remark 1.1, Yt is a uniformly integrable martingale on
[0, T ].
By Medvegyev [136, Proposition 1.144, p. 107], the set
{Yτ : τ is a finite-valued stopping time}
is of class D. Hence
{Xτ : τ is a finite-valued stopping time}
is of class D.
This follows because lim sup {|Yτ |≥n} |Yτ | dP = 0 implies lim sup {|Xτ |≥n}
n→∞ τ n→∞ τ
|Xτ | dP = 0 (by the definition of uniform integrability Protter [151, p. 8]).
By Medvegyev [136, Proposition 1.144, p. 107], again, X is a uniformly
integrable martingale on [0, T ].
Since this is true for all T , X is a martingale. This completes the proof.
Remark 1.4 (Bounded Local Martingales are Martingales) Let X be a local
martingale that is bounded, i.e. there exists a constant k > 0 such that |Xt | ≤ k for
all t a.s. P. Then, Yt ≡ k for all t is a (uniformly integrable) martingale. Applying
Lemma 1.4 shows that X is a martingale. This completes the remark.
Definition 1.8 (Semimartingales) A stochastic process X is a semimartingale
with respect to (Ft )0≤t ≤∞ if it has a decomposition
Xt = X0 + Mt + At ,
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The same reflection is forced upon us when we observe that the
Λόγος or Divine Word conceived as a cosmic power plays no part in
the earliest Hellenic theology of which we have any cognisance (we
are not here concerned with the later history of the concept): nor can
we find in the earliest Greek period the name of God exalted into the
position of a divine creative force; although, as I have shown
elsewhere, the earliest Hellene, as the later, was fully sensitive to the
magico-divine efficacy of names.179.1
We may also gather something for our present purpose from a
comparison between the cosmogony or cosmic myths of East and
West. Of these it is only the Babylonian and Hebraic that can claim a
great antiquity of record. What is reported of Phoenician belief
concerning these matters is of late authority, Eusebios quoting from
Sanchuniathon or Philo Byblios, and this is too much permeated with
later elements to be useful here. As regards the Hellenic theory of
the origin of the world and of man, putting aside a few scattered hints
in the Homeric poems, we have Hesiod for our first and insufficient
witness. If we can detect Babylonian influence in the Hesiodic
system, we must not hastily conclude that this was already rife in the
second millennium: on the other hand, if Hesiod seems to have
escaped it, it is far less likely that it was strong upon the proto-
Hellenes.
For early Babylonian cosmogony our main evidence is the epic
poem of creation, preserved on tablets found in the library of King
Assurbanipal, which elucidates, and in the main corroborates, the
fragments of the story given by Berosos in the third century B.C. Our
earliest record, then, is actually of the seventh century, but
Assyriologists have given reasons for the view that the epic copied
for Assurbanipal descends from a period as early as B.C. 2000; for
part of it accords with an old Babylonian hymn that has been
discovered.179.2 The document is therefore ancient enough for the
purposes of our comparison. It is well known through various
publications, and can be read conveniently in the detailed exposition
of King in his handbook on Babylonian religion.180.1
When we consider carefully the more significant features in this
cosmogony, we are struck with its almost total unlikeness to anything
that we can discover or surmise in early Hellenic thought. It is true
that the Babylonian theory starts with the dogma that the earliest
cosmic fact was the element of water. Apsu and Tiâmat are the first
powers in an unordered universe, and these seem to be the personal
forms of the upper and lower waters, the fresh and the salt. We find
the parallel thought in Homer, who speaks of Okeanos as “the
source of all things,”180.2 including even the gods. But the value of
such a parallelism is of the slightest, for the vague theory of a watery
origin of created things appears widely diffused in the myths of
remote peoples, for instance, North-American Indians, Aztecs, the
Vedic Aryans, and there is a glimmer of it in the old Norse.180.3 No
conclusion, then, can be drawn from so slight a coincidence. If we
know anything of the cosmogony of the pre-Homeric society we
know it from Hesiod, for Homer himself shows no interest and makes
no revelation on the subject. With certain reservations and after
careful criticism we may be able to regard some parts of the
Hesiodic statement as reflecting the thought of an age anterior to
Homer’s. Therefore it is of some present value to observe how little
of characteristically Babylonian speculation appears in the Hesiodic
Theogony or Works and Days. Both systems agree with each other,
and—it may be said—with all theogonies and religious cosmogonies,
in regarding the primeval creative forces as personal powers who
work either by the method of sexual generation or through
mechanical processes of creation: the first of these methods, which
though mythical in form has more affinity with organic science, is
predominant over the other in the Hesiodic narrative. But the
personal powers are different in the two systems. In the Babylonian
the greatest of the primeval dynasts is Tiâmat, the sea, the mother of
the gods and also of all monsters: in the Hesiodic it is Gaia, the
Earth-mother, who does not appear at all in the Eastern cosmogony,
but who claimed this position in the Hellenic through her deep-
seated influence in the ancient religion. We note also that the
Babylonian Sea is decidedly evil, the aboriginal foe of the gods of
light, a conception alien to ordinary Hellenic thought. Again, the
Babylonian creation of an ordered cosmos is a result of the great
struggle between Marduk and Tiâmat, the power of light and the
sovereign of chaos: it is preceded by hate and terror. In the Hellenic
account the generation of the heavens, the mountains, the sea, and
the early dynasty of Titan-powers is peaceful and is stimulated by the
power of love, Eros, who has his obvious double in the Kāma or
principle of desire in a cosmogonic hymn of the Rig-Veda, but is not
mentioned by the Babylonian poet. (Nor does it concern us for the
moment that this Eros is in respect of mere literary tradition post-
Homeric: we may surmise at least that he was a pre-Homeric power
in Boeotia.) Again, when we come to the theomachy in Hesiod, as an
event it has no cosmogonic value at all: it has the air merely of a
dynastic struggle between elder and younger divinities, and the myth
may really have arisen in part from the religious history of a shifting
of cults corresponding to a shifting of population: nor are the Titans
more representative of evil or of a lower order of things than the
Olympian deities; and cosmic creation, so far as Hesiod treats of it at
all, seems over before the struggle begins. On the other hand, after
Marduk has destroyed Tiâmat he constructs his cosmos out of her
limbs, and then proceeds to assign their various stations to the great
gods, his compeers. Thus the struggle of the god with the principle of
disorder has a cosmic significance which is not expressed in the
Titanomachy. The curious conception also that the universe was
compacted out of the dismembered limbs of a divine personage,
which reminds us of the Vedic story of the giant Purusa182.1 and of
the Norse legend of Ymir, is not clearly discoverable in Hellenic
mythology: for the Hesiodic myth of the forms and growths that
spring from the blood of the mutilated Ouranos is no real parallel.
And there is another trait in the Babylonian theory of a world-conflict
that distinguishes it from the Hellenic myths of a Titanomachy or
Gigantomachy; it was sometimes regarded not as a single event,
finished with once for all, but as a struggle liable to be repeated at
certain periods.182.2 On the other hand, Hesiod’s narrative of the
oppression of Gaia’s children by Ouranos and the outrage inflicted
on him by Kronos has its parallels in Maori and savage legend,182.3
but none in Mesopotamian, so far as our knowledge goes at present.
A different Babylonian mythological text from the library of
Assurbanipal speaks of another battle waged by Marduk against
Labbu, a male monster imagined mainly as a huge snake; and
Marduk is described as descending to the conflict in clouds and
lightning:183.1 the legend has no obvious significance for cosmogony,
for it places the event after the creation of the world and of men and
cities. But it has this interest for us, that it may be the prototype for
the legend of Zeus’ struggle with Typhoeus, which is known to
Homer, and which he places in the country of the Arimoi, regarded
by many of the ancient interpreters, including Pindar, as Cilicia.183.2
Now, the story of this conflict in Hesiod’s theogony has no
connections with the Titanomachy or the Gigantomachy, nor is it
there linked by any device to any known Hellenic myth; nor is it
derived, like the legend of Apollo and Python, from genuine Hellenic
cult-history. It has an alien air and character. Typhoeus is on the
whole regarded as a monstrous dragon, but one of his voices is that
of a lion, another that of a bull. The resemblance of this narrative to
the Babylonian one just mentioned is striking, and becomes all the
more salient when we compare certain Babylonian cylinders which
picture Marduk in combat with a monster, sometimes of serpent
form, sometimes with the body of a lion or a bull.183.3 The Typhoeus-
legend belongs also essentially to the Asia-Minor shores, and if
Cilicia was really the country whence it came to the knowledge of the
Homeric Greeks, it is a significant fact that it was just this corner of
the Asia-Minor coast that felt the arms of the earliest Assyrian
conquerors in the fourteenth century B.C.; and it is just such myths
that travel fast and far.
If the hypothesis of Assyrian origin is reasonable here, many will
regard it as still more reasonable in regard to the Deukalion flood-
story. Certain details in it remind us, no doubt, of the Babylonian
flood-myth; and as this latter was far diffused through Asia Minor, it
was quite easy for it to wander across the Aegean and touch Hellas.
But if it did, we have no indication that it reached the Hellenes in the
early period with which we are here concerned, as Hesiod is our
earliest authority for it.
The last theme of high interest in the cosmogonic theory of ancient
Babylonia is the creation of man. According to Berosos, this
momentous act was attributed to Bel, who, after the victory over
Chaos, commanded one of the gods to cut off his head and to make
men and animals out of earth mixed with his own blood, and this
story is partly corroborated by an old cuneiform text that is derived
from the beginning of the second millennium.184.1 This interesting
theory was not universally accepted, for another and independent
text ascribes the creation of man to Marduk and a goddess called
Aruru, simply as a mechanical act of power.184.2 The idea implicit in
the former account, of the blood-relationship of man to god, is of the
greater potentiality for religious metaphysic, and a similar notion is
found, developed into a high spiritual doctrine, in the later Orphic
Zagreus-mystery. But there is no trace of it in genuine Hellenic
thought or literature. We have no provedly early Greek version of the
origin of man: only, in the Works and Days, we are told that the
Immortals or Zeus made the men of the five ages, the third
generation, out of ash-trees: it may be that the story of Prometheus
forming them out of clay was known to Hesiod, as Lactantius
Placidus attests;185.1 in any case we may judge it to be of great
antiquity on account of its wide vogue in the later period, and its
occurrence in other primitive folklore. But nothing like it has as yet
been found in the ἱερὸς λόγος of Mesopotamia.
Generally we may say that the Hesiodic cosmogony bears no
significant resemblance to the Babylonian, and this negative fact
makes against the theory of Mesopotamian influence upon pre-
Homeric Hellas.
As a divine cosmogony implies some organic theory of the
Universe, so the polytheisms that attempted such speculations
would be confronted also with the problem of finding some principle
of order by which they might regulate the relations of the various
divinities, one to the other. We find such attempts in Mesopotamian
religion. Certain deities are affiliated to others, Marduk to Ea, Nebo
to Marduk, though such divine relationships are less clear and less
insisted on than in Hellenic theology; and the grouping of divinities
shifts according to the political vicissitudes of the peoples and cities.
We may discern a tendency at times to use the triad as a unifying
principle, giving us such trinities as Anu, Bel, Ea, or Sin, Shamash,
Adad;185.2 we have glimpses of a trinitarian cult in early
Carthage,185.3 and slight indications of it in the Minoan-Mycenaean
pillar-ritual.185.4 But I cannot find anything to suggest that among the
cultured or uncultured Semites it was ever in the ancient period a
powerful and constructive idea, able to beget a living dogma that
might capture the popular mind and spread and germinate in
adjacent lands.186.1 We have perhaps as much right to regard the
number seven as a grouping principle of Babylonian polytheism, in
the later period at least, when we find a group of seven high deities
corresponding to the seven planets.186.2 We might discover a Hittite
trinity of Father, Mother, and Son if we concentrated our attention on
the Boghaz-Keui reliefs; but the other Hittite evidence, both literary
and monumental, gives no hint of this as a working idea in the
religion. In fact, in most polytheisms of the Mediterranean type it is
easy to discover trinities and easy to deceive oneself about them.
The human family reflected into the heavens naturally suggests
the divine trio of Father, Mother, Child. And this may be found on the
Asia-Minor shore and in Hellas. It would be more important if we
could discover the worship of this triad in an indissoluble union from
which the mystic idea of a triune godhead might arise. This is not
discernible clearly in the older period on either side of the Aegean.
The cult-complex of Zeus, Semele, and Dionysos does not belong to
ancient Hellas and is rare at any period; that of Hades Demeter Kore
is occasionally found in cults of doubtful antiquity, but usually the
mother and daughter were worshipped without the male deity. The
Homeric triad so often invoked in adjurations of Zeus, Athena, and
Apollo, which misled Mr. Gladstone, is due probably to the
exigencies of hexameter verse, and is not guaranteed by genuine
cult. No divine triad in Hellas can be proved to have descended from
the earliest period of Greek religion, except probably that of the
Charites at Orchomenos.187.1 We have later evidence of a trinity of
Zeus, Poseidon, and Hades, expressing the triad that Nature
presents to us of sky, sea, and earth. But probably one of these
figures is an emanation of Zeus himself; the sky-god having become
“chthonian” in a very early period.187.2 We cannot say, then, that the
earliest period of Hellenic religion shows a trinitarian tendency; and if
it were so, we could not impute it to early Mesopotamian influence,
for the idea of a trinity does not appear in the Eastern religion with
such force and strength as to be likely to travel far.
As for the artificial group of the twelve Olympians, we should
certainly have been tempted to connect this with Babylonian lore, the
number twelve being of importance in astronomical numeration; only
that the divine group of twelve does not happen to occur in
Babylonian religious records at all. Nor does the complex cult of the
Δώδεκα θεοί appear to belong to the earliest period of Greek
religion.187.3 And so far I have been able to discern nothing that
justifies the suggestion187.4 that the principle of unification or divine
grouping in early Mediterranean polytheism came from Babylon.
A severely organised polytheism with one chief divinity, to whom
all the others were in definite degrees subordinated, might evolve a
monotheism. And in Babylonian literature we can mark certain
tendencies making in this direction. One tablet contains an
inscription proclaiming all the high gods to be forms of Marduk,
Nergal the Marduk of war, Nebo the Marduk of land.188.1 That all the
deities were mere forms or emanations of the Eternal might have
been an esoteric doctrine of certain gifted minds, though it was
difficult thus to explain away and to de-individualise the powerful
self-asserting personality of Ishtar, for an attractive goddess-cult is
always a strong obstacle to pure monotheism. A particular king might
wish at times to exalt the cult of a particular god into a monotheistic
ideal; the attempt was seriously made in Egypt and failed. It may
have been seriously intended by King Rammannirari III. (B.C. 811-
782), who introduced the cult of Nebo, always one of the most
spiritual figures of the Pantheon, into Kelach; hence comes a long
inscription on two statues now in the British Museum, set up by a
governor in honour of the king, which is valuable for its ethical
import, and still more interesting for its monotheistic exhortation at
the close:188.2 “Oh man, yet to be born, believe in Nebo, and trust in
no other gods but him.” Here is the seed that might have been
developed by a powerful prophet into pure monotheism. But the
ecstatic Babylonian votary is always falling into contradiction, for in
the earlier part of this hymn he has called Nebo, “The beloved of Bel,
the Lord of Lords.” What, then, must the congregation think of Bel?
In Greek religion the germs of monotheistic thought were still
weaker and still less likely to fructify. The earliest Hellenic tribes had
already certain deities in common, and the leading stocks at least
must have regarded Zeus as the supreme god. They must have also
adopted many indigenous deities that they found powerful in their
new homes, whose cult could not be uprooted even if they wished to
do so. We must therefore imagine the pre-Homeric societies as
maintaining a complex polytheism, with some principle of divine
hierarchy struggling to assert itself. Homer, if it is ever true to speak
of him as preaching, seems certainly the preacher of the supremacy
of Zeus. How far this idea was accepted in the various localities of
cult we have not sufficient material for deciding: much would depend
on the degree to which the individuals were penetrated by the higher
literature, which from Homer onwards proclaimed the same religious
tenet.189.1 We can at the same time be sure that in many localities
the countryfolk would be more under the spell of some ancient deity
of the place than of the sky-father of the Aryan Hellenes. And though
his cult was high placed by the progressive races, and his
personality powerfully pervading in the realm of nature and human
society, so that the higher thinkers entered on a track of speculation
that leads to monotheism, the masses did not and could not follow
them, having, in fact, the contrary bias. The popular polytheism
showed itself most tenacious of divine personalities; and owing partly
to the sacred power of divine names, the various titles of a single
divinity tend occasionally to engender distinct divine entities. I have
also already indicated that art contributed to the same effect through
multiplying idols. So far, then, from displaying monotheistic
potentialities, Greek polytheism, from the pre-Homeric period we
may suspect, and certainly after the Homeric age, tended to become
more polytheistic.
CHAPTER XI.
The Religious Temperament of the
Eastern and Western Peoples.
A more interesting and fruitful ground of comparison is that which

looks at the inward sentiment or psychic emotion of the different
religions, at the personal emotional relation of the individual towards
the godhead. As I observed before, a clear judgment on this
question is only possible when the religious memorials of a people
are numerous, varied, and personal, so that some of them at least
may be regarded as the expression of the individual spirit. Even if
the priest or the ritual dictates the expression, the pious and frequent
votary may come to feel genuinely what is dictated to him. Hence we
can gather direct testimony concerning the ancient Babylonian as we
can of the ancient Hebrew religious temper and emotion; for though
most of the Mesopotamian documents are concerned with the royal
ceremonial, which does not usually reveal genuine personal feeling,
yet in this case the royal inscriptions, whether religious narrative or
liturgies or prayers, are unusually convincing as revelations of self.
And besides these, we have many private hymns of penance and
formulae of exorcism.
On the other hand, the ancient Western world and even historic
Greece is singularly barren of this kind of religious testimony. We
know much about the State religion, but we have very few ritual
formulae or public or private prayers. Our evidence is mainly the
religious utterances of the higher poetry and literature and a few lyric
hymns composed not for the solitary worshipper, but for common
and tribal ritual-service. But we have also the mythology and the art
and the general manifestations of the Hellenic spirit in other
directions that enable us to conclude something concerning the
religious psychology of the average man in the historic periods, and
if we find this markedly different from that of the oriental, we shall
find it hard to believe that the Babylonian spirit could have worked
with any strong influence on the proto-Hellene.
A sympathetic study of the Babylonian-Assyrian documents
impresses us with certain salient traits of the Mesopotamian religious
spirit, some of which are common to other members of the great
Semitic race. In a certain sense the Babylonian might be described
as “ein Gott-betrunkener Mensch”: as one possessed with the
deepest consciousness of the ineffable greatness of God, of his own
utter dependence, and at the same time of the close personal
association between himself and the divinity. The ecstatic adoration
we have marked in the liturgies is the result of a purely mental
contemplation, will-power, and conviction, not of mystic initiation—for
Babylonia had no mysteries—nor of orgiastic rites that could afford a
physico-psychic stimulus. The individual seems to have regarded
himself at times as the son, more often as the bond-slave, of his own
tutelary divinity, who is angry when he sins and becomes favourable
and a mediator in his behalf with other gods when he repents. In
private letters of the time of Hammurabi we find the greeting, “May
thy protecting god keep thy head well.” A common formula occurs in
the incantations: “I, whose god is so-and-so, whose goddess is so-
and-so.”192.1 In the penance-liturgy the priest speaks thus of the
suppliant sinner, “Thy slave who bears the weight of thy wrath is
covered with dust,… commend him to the god who created him.”192.2
With this we may compare certain phrases in a well-known
penitential psalm, “Oh mighty Lady of the world, Queen of
mankind.… His god and goddess in sorrow with him, cry out unto
thee.… As a dove that moans I abound in sighings.”192.3 Abject
remorse, tears and sighing, casting-down of the countenance, are
part of the ritual that turns away the anger of the deity: hence fear of
God and humility are recognised religious virtues. Merodach-Baladin
of Babylon, in Sargon’s inscription, is described as a fool “who did
not fear the name of the Lord of Lords,”192.4 and the idea is shaped
in a general ethical maxim in another inscription, “He who does not
fear his god is cut down like a reed.”192.5 “I love the fear of God,”
says Nebukadnezar in the record of his life.192.6
Such emotion and mental attitude is consonant with the Hebraic
and with much of the modern religious temper; but entirely out of
harmony with all that we know of the Hellenic. The religious habit of
the Hellene strikes us by comparison as sober, well-tempered, often
genial, never ecstatically abject, but even—we may say—self-
respecting. Tears for sin, lamentations and sighs, the countenance
bowed to the ground, the body cleaving to the pavement, these are
not part of his ritual; the wrath of God was felt as a communal more
often than as an individual misfortune, and in any case was averted,
not by emotional outpourings of the individual heart, but by ritual
acts, solemn choruses, soothing sacrifice and songs, or by special
piacular lustrations that wiped off the taint of sin. Tears are never
mentioned,193.1 except indirectly in the fictitious lamentations for
some buried hero, annually and ceremoniously lamented, such as
Achilles. Nor can we find in earlier Hellenic ethic the clear
recognition of fear and humility among the religious virtues,193.2
while both are paraded in the inscriptions of the later Babylonian
kings, even in those that reveal a monstrous excess of pride.193.3
The Hellenic god might punish the haughty and high-minded, he did
not love the grovelling, but rather the man of moderate life, tone, and
act. Such is God for the civic religion of the free man; while the
Babylonian liturgy reflects the despotic society. The Hellene, for
instance, does not try to win for himself the favour of the divinity by
calling himself his slave. And the common phrase found on the
Greek Christian tombs, ὁ δοῦλος τοῦ Θεοῦ, has passed into
Christianity from Semitic sources.193.4 This single fact illustrates,
perhaps better than any other, the different temper of the old Oriental
and old European religions; and there is a curious example of it in
the bilingual Graeco-Phoenician inscription found in Malta,194.1
commemorating a dedication to Melkarth or to Herakles Ἀρχηγέτης:
the Phoenicians recommend themselves to the god as “thy slaves,”
the Greeks use neither this nor any other title of subservient flattery.
In this connection it is well to note the significance of marking the
body of the worshipper by branding, cutting, or tattooing with some
sign that consecrated him as slave or familiar follower to the divinity.
The practice, which may have been of great antiquity, though the
evidence is not earlier than the sixth century B.C., was in vogue in
Syria, Phrygia, and in early Israel, and was adopted by some
Christian enthusiasts, but no proof of it has yet been adduced from
Mesopotamia. It was essentially un-Hellenic, but was apparently
followed by some of the Dionysiac thiasoi as a Thracian
tradition.194.2
In fact, it is only in the latest periods that we find in Hellas an
individual personal religion approaching the Babylonian in intensity.
The older cult was communal and tribal rather than personal; even
the household gods, such as Zeus Κτήσιος and Ἑρκεῖος, the gods of
the closet and storehouse, the hearth-goddess, were shared by the
householder in common with the nearest circle of kindred. These
cults were partly utilitarian, and the moral emotion that they
quickened was the emotion of kinship: they do not appear to have
inspired a high personal and emotional faith and trust. Nor usually
had the average Hellene of the earlier period the conception of a
personal tutelary divinity who brought him to life, and watched over
his course, preserving, rebuking, and interceding for him. The
Babylonian fancy of the great king sitting in infancy on the lap of the
goddess and drinking milk from her breasts would not commend
itself to the religious sense in Greece.
In Mesopotamia and in the other Semitic communities the fashion
of naming a child after the high god or goddess was very common—
commoner I am inclined to think than in Hellas, though in the latter
country such names as Demetrios, Apollodoros, Zenon, Diogenes,
point to the same religious impulse; but they appear to have arisen
only in the later period. The Hellenic language did not admit, and
Hellenic thought would not have approved of, those mystic divine
names, which express as in a sacred text some quality or action of
the divinity, such as we find in the Bible (“the Lord will provide”), and
in pre-Islamitic inscriptions of Arabia, Ili-kariba, “My God hath
blessed”; Ili-azza, “My God is mighty”; Ili-padaja, “My God hath
redeemed.”195.1 Such names served as spells for the protection of
the child, and are speaking illustrations of the close personal
dependence of the individual upon the god.
This is also illustrated by another fashion, possibly ancient, of
Semitic religious nomenclature: not only was the individual frequently
named after the deity, but the deity might sometimes receive as a
cult-title the name of the individual. Of this practice among the
polytheistic Semites the only examples of which I am aware come
from a late period and from the region of Palmyra: Greek inscriptions
of the late Imperial era give such curious forms as Θεὸς Ἀὐμοῦ,
Θεὸς Οὐασεάθου, Θεὸς Ἀμέρου:196.1 and these descriptive names in
the genitive must designate the principal worshipper or founder of
the cult; they are mostly un-Greek, as the religious custom certainly
is, which is illustrated by such ancient Biblical expressions as “the
God of Abraham,” “the God of Jacob.” We may find an example of
the same point of view in the Phrygian title of Μὴν Φαρνάκου in
Pontus, if we take the most probable explanation, namely, that it is
derived from the Persian Pharnakes, the founder of the cult;196.2 and
again in a Carian dedication to Zeus Panamaros Ἀργύρου, as
Ἄργυρος is found in the same neighbourhood as the name of a living
man.196.3
The only parallel that Hellenic religion offers is the doubtful one,
Athena Αἰαντίς, whose temple is recorded at Megara:196.4 it may be
that the goddess took her title from the hero because his grave was
once associated with the temple. In any case, it is not so striking that
the mythic hero should stand in this intimate relation with the deity as
that the living individual should.
The ecstatic and self-prostrating adoration of divinity which is
characteristic of the Babylonian temper might manifest itself at times
in that excess of sentiment that we call sentimentality: we catch this
tone now and again in the childlike entreaties with which the
supplicator appeals to the deity as his father or mother; in the poetic
pathos of the hymns to Tammuz, which sometimes remind us of the
sentimentality of some of our modern hymns: he is called “Lord of
the tender voice and shining eyes”; “he of the dove-like voice.”197.1
Such language may be called “hypokoristic,” to use a Greek phrase;
it belongs to the feminine sentiment in religion, and we are familiar
with it in our own service. No echo of it is heard in the older Greek
religious literature nor in any record of Greek liturgy. We can, indeed,
scarcely pronounce on the question as to the tone to which primitive
Greek wailing-services were attuned. We have only a few hints of
some simple ancient ritual of sorrow: the pre-Homeric Greek may
have bewailed Linos and Hyakinthos, as we hear that the Elean
women in a later period bewailed Achilles; but if, indeed, the
fragment of a Linos-threnody that the Scholiast on Homer has
preserved for us is really primitive,197.2 it has some pathos, but much
brightness and nothing of the Babylonian sentimentality. The spirit of
the Greek religious lyric strikes us as always virile, and as likely to be
unsympathetic with the violent and romantic expression of sorrow or
with endearing ecstasy of appeal.
The other trait that should be considered here in the religious spirit
of the Mesopotamian Semites is fanaticism, an emotional quality
which often affords a useful basis of comparison between various
religions. This religious phenomenon is best known by its deadly
results; but in itself it is most difficult to define, as are other special
moral terms that imply blame and are highly controversial. It is only
found among those who feel their religion so deeply as to be
relatively indifferent to other functions of life. We impute fanaticism
when the tension of religious feeling destroys the moral equilibrium
or stunts development of other parts of our nature, or prompts to acts
which, but for this morbid influence, would excite moral indignation. It
may display itself in the artistic and intellectual sphere, as by
iconoclasm or the suppression of arts and sciences; or in the
discipline of individual life, as by over-ascetic self-mortification. Its
coarsest and most usual manifestation is in war and the destruction
of peoples of alien creed. A war or a slaughter is called fanatical, if
its leading motive is the extermination of a rival religion, not for the
sake of morality or civilisation, but as an act in itself acceptable to
one’s own jealous god. The ascetic type of fanaticism is specially a
product of the Far East: the murderous type is peculiar to the Semitic
spirit, when unchastened by a high ethical sympathy or a sensitive
humanism; for the chief record of it is in the pages of the history of
Israel, Islam, and Christianity, so far as this last religion has been in
bondage to certain Semitic influence. It is a question of interest
whether we find fanaticism of this type in the Mesopotamian area
and in the ancient polytheistic communities of the Western Semites.
We might expect to find it because of the intensity of the religious
spirit that seems to have been a common inheritance of all these
stocks. The more fervent the worship, the more is the likelihood that
the dangerous idea of a “jealous” god will emerge, especially when
races are living under the illusion of the “fallacy of names.” By a fatal
logic of devotion, the jealous god may be thought to favour or ordain
the destruction of those who worship the deity under other names,
which meant, for the old world, other gods. Only this must be
carefully distinguished from the other more innocent idea, proper to
all tribal religions, that the deity of the tribe, like a good citizen, will
desire victory for his people’s arms.
As regards Mesopotamia, in his History of Ancient Religions Tiele
finds in Assyrian history the same traces of murderous fanaticism as
in Israelitish.199.1 So far as I have been able as yet to collect the
evidence, this statement appears to contain some exaggeration. For
I have not found any record of a war that an Assyrian or Babylonian
ruler undertakes at the command of a “jealous god” against a people
whose only offence is an alien worship. The motives for a war
appear to be of the ordinary human and secular kind; Palestine, for
instance, is attacked, not because Marduk or Asshur personally
hates Jahwé, but because the country holds the key of the route to
Egypt. Such Biblical narratives as the destruction of Jericho, Ai, and
the Amalekites find no real parallel in Mesopotamian chronicles. Yet
in these also the temper of homicidal religion is strong enough to be
dangerous. Neither in the Babylonian nor in the Assyrian divinities is
there any spirit of mercy to the conquered. On that early relief of
Annabanini of the third millennium B.C., the goddess leads to the
king the captives by a hook in their noses to work his will upon
them.199.2 And in the later records of the great Assyrian Empire, the
deities appear prominently as motive forces, and the most cruel
treatment of captives is regarded as acceptable to them. The worst
example that Tiele quotes is the great inscription of Assurbanipal,
who, after speaking of himself as “the Compassionate, the King who
cherishes no grudge,”199.3 naïvely proceeds to narrate how he tore
out the tongues of the rebels of Babylon, hewed their flesh into small
pieces, and flung it to the dogs, swine, and vultures; and “after I had
performed these acts, I softened the hearts of the Great Gods, my
Lords.” But the lines that follow suggest that what “softened their
hearts” was not so much the tortures and massacres, which they
might approve of without directly commanding, but the religious
measures that Assurbanipal immediately undertook for the
purification of Babylon, whose temples had been polluted with
corpses. Again, Tiglath-Pileser III. speaks of himself as the Mighty
One “who in the service of Asshur broke in pieces like a potter’s
vessel all those who were not submissive to the will of his god”;200.1
and a little later, Sargon recounts how “Merodach-Baladin, King of
the Chaldaeans,… who did not fear the name of the Lord of Lords…
broke the statues of the great gods and refused his present to
me.”200.2 Yet it would be a misunderstanding to speak of these, as
Tiele does, as if they were wars of religion, like the Crusades or the
war against the Albigenses. Asshur sends the king to the war
invariably, but rather for the sake of the king’s profit and glory than
for the propagation of Asshur’s religion; for his enemies are very
frequently of the same religion as himself. The above phrases must
be understood probably in a political sense rather than a religious;
the god and the king are so intimately associated that whoever
insults or injures one, insults or injures the other. We may suspect
that Merodach-Baladin’s breach of the divine statutes consisted in
his omitting to send his usual tribute to Sargon. When two men had
spoken scornfully of the gods of Assurbanipal, both the king and the
gods would wish to avenge the insult:200.3 it was natural, therefore,
for Assurbanipal to torture and flay them. In warring against an alien
people, the king is warring against alien gods; therefore if he sacks
the alien city he may capture and take away, or—more rarely—
destroy, the city’s gods. Thus Asarhaddon had taken away the idols
of Hazailu, King of Arabia, and of Laili, King of Iadi; but when these
kings had made submission and won his favour he returned to them
the holy images, having first inscribed them with his own ideogram
and a mark of the might of Asshur:201.1 thus the gods, having the
brandmark of the great king and the imperial deity, become tributary
divinities. Or if he wished to wipe a people out, the Assyrian
conqueror might break their idols to dust. Thus Assurbanipal broke in
pieces the gods of the Elamites—the most deadly foes of Babylon—
and thereby “eased the heart of the Lord of Lords.”201.2 But many of
the Elamite deities he led away; and of one of them he speaks in
terms of reverence, Sašinak, the god of destiny, “who dwells in
hidden places, whose working no one sees.”201.3 It is more difficult to
understand why Sanherib should boast to have destroyed the deities
of Babylon after his capture of the city; for the leading Babylonian
divinities certainly belonged to the Assyrian Pantheon.
The evidence here quoted justifies us in attributing fanaticism to
the religious temper of Babylonia and Assyria; not because the wars
were evangelising, undertaken in the service of religion, but because
the savage cruelty that accompanied them is deemed, as it is in the
early Hebraic view, acceptable to the national gods. The idea of
divine mercy is potent in the liturgies; but neither morality nor religion
would appear to have inculcated any mercy towards the alien foe;
and this lack of moral sympathy may be termed a passive fanaticism.
The same fanatic temper might be traced in the savagery of the
punishments for offences against the State-religion, and was
reflected also at times in the legal code.202.1
From other polytheistic Semitic communities we have no record,
so far as I am aware, that bears on the phenomenon that we are
considering, except the famous Moabite Stone, of which the style is
in this respect strikingly Biblical. Mesha regards himself as sent by
his god Chĕmosh to take Nebo from Israel, and he explains why he
slaughtered all within the walls, man, woman, and child, “for I had
devoted it to Chĕmosh.” Fanaticism does not so naturally belong to
polytheism as to monotheism; yet it seems that at times the
polytheistic Semites could be as prone to this vice of the religious
temper as the monotheistic Israelites.
Speaking generally, and in comparison with the ancient Semitic
and the mediaeval and even later spirit of Europe, we must
pronounce the Hellenic temperament of the earlier and classical
period as wholly innocent of fanaticism. The history of Hellas is not
stained by any “war of religion”; and no religious hierarchy in Hellas
ever possessed the power or displayed the will to suppress art or
persecute science and thought. It might occasionally happen that
individuals were in danger of punishment if they insulted or openly
flouted the civic worship or introduced new deities; but that the State
should protect itself thus is not fanaticism. The least tolerant of cities
was the enlightened Athens. But her record in this matter is a
spotless page compared with the history of any later European
State. Hellas owed this happy immunity to her cooler religious
temper, to the equilibrium of the other life-forces within her, and to
her comparative freedom from dark and cruel superstitious fears.
It is specially in regard to such salient features of the religious
temperament as we have been considering that the early Hellene
asserted his spiritual independence of the East.
CHAPTER XII.
Eschatologic Ideas of East and West.
Religions are often found to differ fundamentally in their

conceptions of the fate of the departed spirit of man, and in the
prominence and importance they assign to the posthumous life.
There is, in fact, a group of religions which we might term “other-
worldly,” because certain dogmas concerning the world after death
are made the basis on which their aspirations and ideals of conduct
are constructed; to this group belong Christianity, Buddhism, Islam,
and the old Egyptian creed. There are other religions, also of a
highly developed type, in which eschatologic doctrine plays no
forcible or constructive part either in the theology or in the ethics.
Such were the Mesopotamian, primitive Judaism, and the early
Hellenic.
Our question concerning the evidences in the second millennium
of Mesopotamian influences on the Western Aegean demands, then,
at least a brief comparison of the Sumerian-Babylonian, and Hellenic
eschatology. Our knowledge of the former is derived from certain
epic poems, the Epic of Gilgamesh, “The Descent of Ishtar,” and the
poem dealing with the marriage of Nergal and Erishkigal, the Queen
of the dead; secondly, from a few inscriptions of various periods,
alluding to burial or the status of the dead; thirdly, and this is the
most important source, from the recent excavations of certain
“necropoleis.”205.1 The Hellenic facts have been sufficiently set forth
for the present purpose in a former series of lectures.
In the picture of the lower world presented by the two literatures, a
certain general agreement is discoverable, but none closer than they
reveal with the conceptions of other peoples. Both accept as an
undoubted fact the continued existence of the soul after death, and
both imagine this existence as shadowy, profitless, and gloomy. Both
also vaguely locate the abode of the soul under the earth, with a
downward entrance somewhere in the west.205.2 In both we find the
idea of a nether river to be crossed, or “the waters of death”;205.3 of a
porter at the gates of “hell,” and of a god and goddess as rulers of
the lower world; while the mountain of the Babylonian underworld on
which the gods were supposed to have been born was unknown to
Hellenic mythology.205.4 Such coincidences are no criterion of a
common origin of belief; for these traits recur in the death-lore of
many and widely scattered races.
As against them, we must take into account certain salient
differences. The lot of the departed in the Babylonian epic account
appears drearier even than in the Homeric, just as the Babylonian
religious poetry inclines to the more sombre tones and the more
violent pathos. The dead inhabit “the house wherein he who enters is
excluded from the light, the place where dust is their bread, and mud
their food. They behold not the light, they dwell in darkness, and are
clothed, like birds, in a garment of feathers; and over door and bolt
the dust is scattered.”206.1 This is more hopeless than the Homeric
meadow of Asphodel, where the souls still pursue the shadow of
their former interests, and some tidings of the earth may penetrate to
give them joy. Also, the demoniac terrors of the lower world are more
vividly presented in Babylonian than in Hellenic literature and art.
The demons of disease that perform the bidding of Allatu, the Queen
of Hell, are closely connected with the ghost-world; we learn from the
formulae of exorcism that the haunting demon that destroyed a
man’s vital energies might be a wandering spectre. “O Shamash, a
horrible spectre for many days hath fastened itself on my back, and
will not loose its hold upon me.… he sendeth forth pollution, he
maketh the hair of my head to stand up, he taketh the power from
my body, he maketh my eyes to start out, he plagueth my back, he
poisoneth my flesh, he plagueth my whole body… whether it be the
spectre of my own family and kindred, or the spectre of one who was
murdered, or whether it be the spectre of any other man that
haunteth me.”206.2
Now it is possible that the curse of the demon was powerful both
in the earlier and later periods of ancient, as it is powerful to-day in
modern, Greece; the demon might be a ghost or a revenant. And it
has been the ambition of a small group of scholars in this country to
prove that the higher literature and art of Greece, that reveals so fair
and sane an imagination of the unseen world, is only a thin veil

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Continuous Time Asset Pricing Theory

Financial Asset Pricing Theory 1st Edition Munk Claus

Asset pricing and portfolio choice theory Second

Empirical Asset Pricing Models Jau-Lian Jeng

Financial Decisions and Markets A Course in Asset

Modeling Fixed Income Securities and Interest Rate

Analytical Corporate Valuation Fundamental Analysis

Environmental Sustainability in a Time of Change Robert

Econophysics and Capital Asset Pricing: Splitting the

This subseries of Springer Finance consists of graduate textbooks.

More information about this series at http://www.springer.com/series/11355

ISSN 1616-0533 ISSN 2195-0687 (electronic)

Library of Congress Control Number: 2018939163

Mathematics Subject Classification (2010): 90C99, 60G99, 49K99, 91B25

© Springer International Publishing AG, part of Springer Nature 2018

Printed on acid-free paper

My philosophy in creating models for practice and for understanding is based on

The Key Topics

The Key Insights

The Martingale Approach

Discrete Versus Continuous Time

Mean-Variance Efficiency and the Static CAPM

Finance is an application of stochastic process and optimization theory. Stochastic

ASSET PRICING THEORY: TRADITIONAL VERSUS MARKET

Asset Pricing Theory

competitive markets ⇐⇒Walrasian equilibrium

Traditional Asset Pricing Theory versus Market

Ithaca, NY, USA Robert A. Jarrow

Part I Arbitrage Pricing Theory

2.6 The Third Fundamental Theorem . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 51

6.5 Forward and Futures Contracts .. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 120

Part II Portfolio Optimization

10.5 The Shadow Price .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 191

Part III Equilibrium

16.3 The Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 322

Part IV Trading Constraints

19.3 Asset Price Bubbles .. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . 391

U (x, ω) : (0, ∞) × Ω → R is the aggregate utility function of wealth for a

In reduced form models, market incompleteness is due to the use of inaccessible

We need a basic understanding of stochastic processes to study asset pricing

1.1 Stochastic Processes

© Springer International Publishing AG, part of Springer Nature 2018 3

0 ≤ t < ∞. Letting F0 contain the P-null sets of F facilitates the measurability of

predictable ⊆ optional ⊆ adapted.

A stochastic process is said to be continuous if its sample paths are continuous

exists for all t ∈ [0, T ] and for all ω ∈ Ω a.s. P.

Definition 1.3 (Martingales) A stochastic process X is a martingale with respect

Remark 1.1 (Uniformly Integrable Martingales) Suppose we are given a filtered

Let τ be a stopping time. Then, the stopped process is defined as

Definition 1.7 (Local Martingales) A stochastic process X is a local martingale

Xs∧τn = E[Xt ∧τn |Fs ] a.s. P

for all 0 ≤ s ≤ t < ∞.

Proof Xt ≥ a for all t implies Zt = Xt − a ≥ 0 a.s. P. Note that Z is a local

lim E[Xt ∧τn Fs ] ≥ E[ lim Xt ∧τn |Fs ] = E[Xt |Fs ] .

Combined these give Xs ≥ E[Xt |Fs ] . This completes the proof.

{Yτ : τ is a finite-valued stopping time}

{Xτ : τ is a finite-valued stopping time}

A more interesting and fruitful ground of comparison is that which

Religions are often found to differ fundamentally in their

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