MH4514

Financial Mathematics
Nicolas Privault

January 25, 2024 https://personal.ntu.edu.sg/nprivault/indext.html

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This course is an introduction to the pricing and hedging of financial derivatives using stochastic
calculus and partial differential equations. The presentation is done both in discrete and continuous-
time financial models, with an emphasis on the complementarity between algebraic and probabilistic
methods.
The descriptions of the asset model, self-financing portfolios, arbitrage and market com-
pleteness, are first given in Chapter 2 in a simple two time-step setting. These notions are then
reformulated in discrete time in Chapter 3. The pricing and hedging of options in discrete time,
particularly in the fundamental example of the Cox-Ross-Rubinstein model, are considered in
Chapter 4, with a description of the passage from discrete to continuous time that prepares the
transition to the subsequent chapters.
A presentation of Brownian motion, stochastic integrals and the associated Itô formula, is given
in Chapter 5, with application to stochastic asset price modeling in Chapter 6. The Black-Scholes
model is presented from the angle of partial differential equation (PDE) methods in Chapter 7,
with the derivation of the Black-Scholes formula by transforming the Black-Scholes PDE into the
standard heat equation, which is then solved by a heat kernel argument. The martingale approach
to pricing and hedging is then presented in Chapter 8, and complements the PDE approach of
Chapter 7 by recovering the Black-Scholes formula via a probabilistic argument. An introduction
to stochastic volatility is given in Chapter 9, including by a presentation of volatility estimation
tools including historical, local, and implied volatilities.
Chapter 10 contains an elementary introduction to finite difference methods for the numerical
solution of PDEs and stochastic differential equations, dealing with the explicit and implicit finite
difference schemes for the heat equations and the Black-Scholes PDE, as well as the Euler and
Milshtein schemes for SDEs. The text is completed with an appendix containing the needed
probabilistic background.
The document contains 130 solved exercises and 17 problems with solutions, and includes
25 Python codes e.g. on pages 78, 94, 97, 100, 145, 145, 205 and 281, and 44 codes on
pages 143, 145, 147, 150, 192, 189, 205, 208, 219, 212, 227, 239, 281, 283, 295, 295, 322, and 324.
Supplementary exercises, problems and solutions are available from the textbook Introduction to
Stochastic Finance with Market Examples, Chapman & Hall/CRC Financial Mathematics Series,
2022.
This text also contains external links and 200 figures, including 33 animated figures, e.g.
Figures 4.8, 4.10, 5.6, 5.7, 5.10, 5.11, 5.16, 6.5, 7.5 and S.5, 2 embedded videos in Figures 2 and
9.3, and 2 interacting 3D graphs in Figures 7.4 and 7.11, that may require using Acrobat Reader
for viewing on the complete pdf file. The cover graph represents the time evolution of the HSBC
stock price from January to September 2009, plotted on the price surface of a European put option
on that asset, expiring on October 05, 2009, cf. § 7.1.

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 Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1 Discrete-Time Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1.1 Filtrations and Conditional Expectations 17
1.2 Martingales - Definition and Properties 19
1.3 Stopping Times 21
1.4 Ruin Probabilities 24
1.5 Mean Game Duration 27
Exercises 30

2 Assets, Portfolios, and Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

2.1 Portfolio Allocation and Short Selling 37
2.2 Arbitrage 39
2.3 Risk-Neutral Probability Measures 43
2.4 Hedging of Contingent Claims 47
2.5 Market Completeness 48
2.6 Example: Binary Market 49
Exercises 55

3 Discrete-Time Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
3.1 Discrete-Time Compounding 61
3.2 Arbitrage and Self-Financing Portfolios 64
3.3 Contingent Claims 69

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3.4 Martingales and Conditional Expectations 72

3.5 Market Completeness and Risk-Neutral Measures 76
3.6 The Cox-Ross-Rubinstein (CRR) Market Model 78
Exercises 81

4 Pricing and Hedging in Discrete Time . . . . . . . . . . . . . . . . . . . . . . . . . . 89

4.1 Pricing Contingent Claims 89
4.2 Pricing Vanilla Options in the CRR Model 94
4.3 Hedging Contingent Claims 98
4.4 Hedging Vanilla Options 100
4.5 Hedging Exotic Options 107
4.6 Convergence of the CRR Model 113
Exercises 118

5 Brownian Motion and Stochastic Calculus . . . . . . . . . . . . . . . . . . . . . 137

5.1 Brownian Motion 137
5.2 Three Constructions of Brownian Motion 141
5.3 Wiener Stochastic Integral 146
5.4 Itô Stochastic Integral 153
5.5 Stochastic Calculus 161
Exercises 172

6 Continuous-Time Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

6.1 Asset Price Modeling 181
6.2 Arbitrage and Risk-Neutral Measures 183
6.3 Self-Financing Portfolio Strategies 185
6.4 Two-Asset Portfolio Model 187
6.5 Geometric Brownian Motion 192
Exercises 195

7 Black-Scholes Pricing and Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . 199

7.1 The Black-Scholes PDE 199
7.2 European Call Options 204
7.3 European Put Options 211
7.4 Market Terms and Data 215
7.5 The Heat Equation 219
7.6 Solution of the Black-Scholes PDE 223
Exercises 226

8 Martingale Approach to Pricing and Hedging . . . . . . . . . . . . . . . . . 233

8.1 Martingale Property of the Itô Integral 233
8.2 Risk-Neutral Probability Measures 237

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8.3 Change of Measure and the Girsanov Theorem 241

8.4 Pricing by the Martingale Method 243
8.5 Hedging by the Martingale Method 249
Exercises 254

9 Volatility Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277

9.1 Historical Volatility 277
9.2 Implied Volatility 280
9.3 Local Volatility 287
9.4 The VIX® Index 292
Exercises 297

10 Basic Numerical Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299

10.1 Euler Discretization 299
10.2 Milshtein Discretization 300
10.3 Discretized Heat Equation 301
10.4 Discretized Black-Scholes PDE 304
Exercises 306

Appendix: Background on Probability Theory . . . . . . . . . . . . . . . . . 307

11.1 Probability Sample Space and Events 307
11.2 Probability Measures 310
11.3 Conditional Probabilities and Independence 312
11.4 Random Variables 313
11.5 Probability Distributions 315
11.6 Expectation of Random Variables 321
11.7 Conditional Expectation 330
Exercises 335

Some Useful Identities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

Exercise Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341

Chapter 1 341
Chapter 2 351
Chapter 3 358
Chapter 4 367
Chapter 5 400
Chapter 6 423
Chapter 7 434
Chapter 8 446
Chapter 9 488
Chapter 10 493

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Background on Probability Theory 494

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
Articles 497
Books 499

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503

Author index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 List of Figures

1 Two sample paths of one-dimensional Brownian motion . . . . . . . . . . . . . . . . 2

2 “As if a whole new world was laid out before me.”* . . . . . . . . . . . . . . . . . . . . 3
3 Comparison of WTI vs. Keppel price graphs . . . . . . . . . . . . . . . . . . . . . . . . . 4
4 Hang Seng index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
5 Two put option scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
6 Payoff function of a put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
7 Two call option scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
8 Payoff function of a call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
9 “Infogrames” stock price curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
10 Brent and WTI price graphs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
11 Price map of a four-way collar option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
12 Payoff function of a four-way call collar option . . . . . . . . . . . . . . . . . . . . . 10
13 Four-way call collar payoff as a combination of call and put options* . . . 11
14 Implied probabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
15 Implied probabilities according to bookmakers . . . . . . . . . . . . . . . . . . . . . 15
16 Implied probabilities according to polling . . . . . . . . . . . . . . . . . . . . . . . . . 15
17 Fifty sample price paths used for the Monte Carlo method . . . . . . . . . . . 16
18 Course plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

1.1 Sample path of the random walk (Sn )n∈N . . . . . . . . . . . . . . . . . . . . . . . . . 18

1.2 Updated weather forecast . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.3 Stopped process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1.4 Sample paths of the random walk (Sn )n⩾0 . . . . . . . . . . . . . . . . . . . . . . . . . 24
1.5 Possible paths of the process (Mn )n⩾0 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
1.6 Possible paths of the stopped process (Mτ∧n )n⩾0 . . . . . . . . . . . . . . . . . . . . 32
1.7 Convex function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
1.8 Random walk supremum* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

2.1 Triangular arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

2.2 Arbitrage: Retail prices around the world . . . . . . . . . . . . . . . . . . . . . . . . . 41

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2.3 Separation of convex sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

3.1 Illustration of the self-financing condition (3.2.3) . . . . . . . . . . . . . . . . . . . . 66

3.2 Why apply discounting? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
3.3 Oil price graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
3.4 Take the quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
3.5 Discrete-time asset price tree in the CRR model . . . . . . . . . . . . . . . . . . . . 79
3.6 Discrete-time asset price graphs in the CRR model . . . . . . . . . . . . . . . . . 80
3.7 Function x 7→ ((1 + x)21 − (1 + x)10 )/x . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
3.8 Graph of the function r 7→ (1 − (1 + r )−12 )/r . . . . . . . . . . . . . . . . . . . . . . . . 84
3.9 Transition probabilities in the recovery theorem . . . . . . . . . . . . . . . . . . . . 86

4.1 Graph of 120 = (107 ) paths with n = 5 and k = 2

* ............. . . . . . . . 96
4.2 Discrete-time call option pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
4.3 Discrete-time call option hedging strategy (risky component) . . . . . . . 101
4.4 Discrete-time call option hedging strategy (riskless component) . . . . . . 102
4.5 Tree of asset prices in the CRR model . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
4.6 Tree of option prices in the CRR model . . . . . . . . . . . . . . . . . . . . . . . . . . 106
4.7 Tree of hedging portfolio allocations in the CRR model . . . . . . . . . . . . . 107
4.8 Galton board simulation* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
4.9 A real-life Galton board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.10 Multiplicative Galton board simulation* . . . . . . . . . . . . . . . . . . . . . . . . 116
4.11 Put spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
4.12 Call spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
4.13 Tree of market prices with N = 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
4.14 Trees of bid and ask prices with N = 2 . . . . . . . . . . . . . . . . . . . . . . . . . . 126
4.15 BTC/USD order book example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
4.16 Dividend detachment graph on Z74.SI . . . . . . . . . . . . . . . . . . . . . . . . . 129

5.1 Sample paths of a one-dimensional Brownian motion . . . . . . . . . . . . . . 138

5.2 Evolution of the fortune of a poker player vs. number of games played 139
5.3 Web traffic ranking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
5.4 Two sample paths of a two-dimensional Brownian motion . . . . . . . . . . . 140
5.5 Sample path of a three-dimensional Brownian motion . . . . . . . . . . . . . . 140
5.6 Scaling property of Brownian motion* . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
5.7 Brownian motion as a random walk* . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
5.8 Statistics of one-dimensional Brownian paths vs. Gaussian distribution . . 143
5.9 Statistics of S&P 500 yearly return graphs from 1950 to 2022 . . . . . . . . . . 144
5.10 Lévy’s construction of Brownian motion* . . . . . . . . . . . . . . . . . . . . . . . . 145
5.11 Construction of Brownian motion by series expansions* . . . . . . . . . . . . 146
5.12 Step function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
5.13 Area under the step function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
5.14 Infinite vs. finite area under a curve . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
5.15 Squared step function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
5.16 Step function approximation* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
5.17 Adapted pair trading portfolio strategy . . . . . . . . . . . . . . . . . . . . . . . . 155
5.18 Step function approximation of Brownian motion* . . . . . . . . . . . . . . . . 156
5.19 Squared simple predictable process . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
5.20 NGram Viewer output for the term "stochastic calculus" . . . . . . . . . . . 161
5.21 Wrong application of Itô’s formula (sample) . . . . . . . . . . . . . . . . . . . . . 168
5.22 Simulated path of (5.5.16) with α = 10, σ = 0.2 and X0 = 0.5 . . . . . . . . . . 170
5.23 Simulated path of (5.5.20) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

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5.24 Simulated path of (5.5.21) with α = −5 and σ = 1 . . . . . . . . . . . . . . . . . . 172

6.1 Why apply discounting? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

6.2 Illustration of the self-financing condition (6.3.2) . . . . . . . . . . . . . . . . . . . 185
6.3 Illustration of the self-financing condition (6.4.1) . . . . . . . . . . . . . . . . . . . 187
6.4 Ten sample paths of geometric Brownian motion . . . . . . . . . . . . . . . . . . 189
6.5 Geometric Brownian motion started at S0 = 1* . . . . . . . . . . . . . . . . . . . . 192
6.6 Statistics of geometric Brownian paths vs. lognormal distribution . . . . . . 195

7.1 Underlying market prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

7.2 Simulated geometric Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . 201
7.3 Graph of the Gaussian Cumulative Distribution Function (CDF) . . . . . . . 205
7.4 Black-Scholes call price map* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
7.5 Time-dependent solution of the Black-Scholes PDE (call option)* . . . . . 206
7.6 Delta of a European call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
7.7 Gamma of European call and put options . . . . . . . . . . . . . . . . . . . . . . . 209
7.8 HSBC Holdings stock price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
7.9 Path of the Black-Scholes price for a call option on HSBC . . . . . . . . . . . 210
7.10 Time evolution of a hedging portfolio for a call option on HSBC . . . . . . 210
7.11 Black-Scholes put price function* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
7.12 Time-dependent solution of the Black-Scholes PDE (put option)* . . . . . 212
7.13 Delta of a European put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
7.14 Path of the Black-Scholes price for a put option on HSBC . . . . . . . . . . . 214
7.15 Time evolution of the hedging portfolio for a put option on HSBC . . . . 215
7.16 Time-dependent solutions of the Black-Scholes PDE* . . . . . . . . . . . . . . 216
7.17 Time-dependent solutions of the Black-Scholes PDE* . . . . . . . . . . . . . . 217
7.18 Time-dependent solutions of the Black-Scholes PDE* . . . . . . . . . . . . . . 217
7.19 Warrant terms and data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
7.20 Time-dependent solution of the heat equation* . . . . . . . . . . . . . . . . . . 220
7.21 Time-dependent solution of the heat equation* . . . . . . . . . . . . . . . . . . 222
7.22 Short rate t 7→ rt in the CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
7.23 Option price as a function of the volatility σ . . . . . . . . . . . . . . . . . . . . . 229

8.1 Drifted Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238

8.2 Drifted Brownian paths under a shifted Girsanov measure . . . . . . . . . . . 240
8.3 Payoff functions of bull spread and bear spread options . . . . . . . . . . . . 255
8.4 Graphs of call/put payoff functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
8.5 Long call butterfly payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
8.6 Option price as a function of underlying asset price and time to maturity 272
8.7 Delta as a function of underlying asset price and time to maturity . . . . 272
8.8 Gamma as a function of underlying asset price and time to maturity . . 273
8.9 Option price as a function of underlying asset price and time to maturity 274
8.10 Delta as a function of underlying asset price and time to maturity . . . 274
8.11 Gamma as a function of underlying asset price and time to maturity . 275

9.1 Underlying asset price vs. log-returns . . . . . . . . . . . . . . . . . . . . . . . . . . . 279

9.2 Historical volatility graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
9.3 The fugazi: it’s a wazy, it’s a woozie. It’s fairy dust* . . . . . . . . . . . . . . . . . 280
9.4 Option price as a function of the volatility σ . . . . . . . . . . . . . . . . . . . . . . 281
9.5 Implied volatility of Asian options on light sweet crude oil futures . . . . . . 283
9.6 S&P500 option prices plotted against strike prices . . . . . . . . . . . . . . . . . 284
9.7 Market stock price of Cheung Kong Holdings . . . . . . . . . . . . . . . . . . . . . 284

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 x LIST OF FIGURES

9.8 Comparison of market option prices vs. calibrated Black-Scholes prices 285
9.9 Market stock price of HSBC Holdings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
9.10 Comparison of market option prices vs. calibrated Black-Scholes prices 286
9.11 Comparison of market option prices vs. calibrated Black-Scholes prices 286
9.12 Call option price vs. underlying asset price . . . . . . . . . . . . . . . . . . . . . . 287
9.13 Simulated path of (9.3.2) with r = 0.5 and σ = 1.2 . . . . . . . . . . . . . . . . . . 288
9.14 Local volatility estimated from Boeing Co. option price data . . . . . . . 291
9.15 VIX® Index vs. S&P 500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
9.16 VIX® Index vs. historical volatility for the year 2011 . . . . . . . . . . . . . . . . 296
9.17 Correlation estimates between GSPC and the VIX® . . . . . . . . . . . . . . . 296
9.18 VIX® Index vs. 30 day historical volatility for the S&P 500 . . . . . . . . . . . . 297

10.1 Divergence of the explicit finite difference method . . . . . . . . . . . . . . . 305

10.2 Stability of the implicit finite difference method . . . . . . . . . . . . . . . . . . 306

11.1 Probability density function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315

11.2 Exponential CDF and PDF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
11.3 Probability computed as a volume integral . . . . . . . . . . . . . . . . . . . . . 318

S.2 Sample path of the random walk (Sn )n∈N . . . . . . . . . . . . . . . . . . . . . . . . 342

S.3 Asian option price vs. European option price* . . . . . . . . . . . . . . . . . . . . 346
S.4 Supremum deviation probability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
S.5 Martingale supremum as a function of time* . . . . . . . . . . . . . . . . . . . . . 351
S.6 Strike price as a function of risk-free rate . . . . . . . . . . . . . . . . . . . . . . . . . 358
S.7 Investment graph (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
S.8 Investment graph (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
S.9 Histogram of replies to Question c). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
S.10 Range forward contract payoff as a combination of call and put option
payoffs* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
S.11 Put spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378
S.12 Put spread collar payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
S.13 Put spread collar payoff as a combination of call and put payoffs* . . . 379
S.14 Call spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
S.15 Call spread collar payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
S.16 Call spread collar payoff as a combination of call and put payoffs* . . 381
S.17 Tree of market prices with N = 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388
S.18 Put option prices in the trinomial model . . . . . . . . . . . . . . . . . . . . . . . . 400
S.19 Function x 7→ fε (x) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
S.20 Derivative x 7→ fε′ (x) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
S.21 Samples of linear interpolations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
S.22 Brownian crossings of level 1* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431
S.23 Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
S.24 Risk-neutral pricing of a foreign exchange option . . . . . . . . . . . . . . . . . 433
S.25 Delta hedging of a foreign exchange option . . . . . . . . . . . . . . . . . . . . 433
S.26 Bitcoin XBT/USD order book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
S.27 Time spent by Brownian motion within a given range . . . . . . . . . . . . . . 434
S.28 Market data for the warrant #01897 on the MTR Corporation . . . . . . . . 440
S.29 Lower bound vs. Black-Scholes call price . . . . . . . . . . . . . . . . . . . . . . . 449
S.30 Lower bound vs. Black-Scholes put option price . . . . . . . . . . . . . . . . . . 450
S.31 Bull spread option as a combination of call and put options* . . . . . . . 450
S.32 Bear spread option as a combination of call and put options* . . . . . . 451
S.33 Butterfly option as a combination of call options* . . . . . . . . . . . . . . . . . 453

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

LIST OF FIGURES xi

S.34 Delta of a butterfly option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454

S.35 Gaussian approximation of spread probability density function . . . . . . 462
S.36 Gaussian approximation of spread option prices . . . . . . . . . . . . . . . . . 462
S.37 Price of a binary call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
S.38 Risky hedging portfolio value for a binary call option . . . . . . . . . . . . . . 466
S.39 Risk-free hedging portfolio value for a binary call option . . . . . . . . . . . 466
S.40 Black-Scholes price of the maximum chooser option . . . . . . . . . . . . . . 468
S.41 Delta of the maximum chooser option . . . . . . . . . . . . . . . . . . . . . . . . . 468
S.42 Black-Scholes price of the minimum chooser option . . . . . . . . . . . . . . . 469
S.43 Delta of the minimum chooser option . . . . . . . . . . . . . . . . . . . . . . . . . . 470
√
S.44 Sample path of dSt = St dBt / 1 − t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
S.45 Sample path of dSt = St2 dBt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
S.46 Sample path of dSt = St2 dBt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481
S.47 “Infogrames” stock price curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
S.48 Butterfly option payoff as a combination of call and put options* . . . . 489

*Animated figures (work in Acrobat reader).

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 List of Tables

1.1 List of martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

2.1 Mark Six “Investment Table” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

3.1 Self-financing portfolio value process . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

3.2 NTRC Input investment plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.3 Avenda Insurance investment plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

5.1 Itô multiplication table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

7.1 Black-Scholes Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

7.2 Variations of Black-Scholes prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216

8.1 Call and put options on the Hang Seng Index (HSI) . . . . . . . . . . . . . . . . 257
8.2 Contract summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257

13.1 CRR pricing and hedging table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369

13.2 CRR pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
13.3 CRR pricing and hedging tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
13.4 CRR pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
13.5 CRR pricing and hedging tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
13.6 CRR pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
13.7 CRR pricing and hedging tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
13.8 Call and put options on the Hang Seng Index (HSI) . . . . . . . . . . . . . . . 452
13.9 Original call/put options on the Hang Seng Index (HSI) . . . . . . . . . . . . 453

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

MH4514 Financial Mathematics 1

Introduction (soft opening)

Modern quantitative finance requires a strong background in fields such as stochastic calculus, opti-
mization, partial differential equations (PDEs) and numerical methods, or even infinite dimensional
analysis. In addition, the emergence of new complex financial instruments on the markets makes
it necessary to rely on increasingly sophisticated mathematical tools. Not all readers of this book
will eventually work in quantitative financial analysis, nevertheless they may have to interact with
quantitative analysts, and becoming familiar with the tools they employ could be an advantage. In
addition, despite the availability of ready made financial calculators it still makes sense to be able
oneself to understand, design and implement such financial algorithms. This can be particularly
useful under different types of conditions, including an eventual lack of trust in financial indicators,
possible unreliability of expert advice such as buy/sell recommendations, or other factors such as
market manipulation. Instead of relying on predictions of stock price movements based on various
tools (e.g. technical analysis, charting, “cup & handle” figures), we acknowledge that predicting
the future is a difficult task and we rely on the Efficient Market Hypothesis. In this framework,
the time evolution of the prices of risky assets will be modeled by random walks and stochastic
processes.

Historical sketch

We start with a description of some of the main steps, ideas and individuals that played an important
role in the development of the field over the last century.

Robert Brown, botanist, 1828

Brown, 1828 observed the movement of pollen particles as described in “A brief account of
microscopical observations made in the months of June, July and August, 1827, on the particles
contained in the pollen of plants; and on the general existence of active molecules in organic and
inorganic bodies.” Phil. Mag. 4, 161-173, 1828.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 2 Introduction

0.8

0.6

0.4

0.2

-0.2

-0.4
0 0.2 0.4 0.6 0.8 1

Figure 1: Two sample paths of one-dimensional Brownian motion.

Philosophical Magazine, first published in 1798, is a journal that “publishes articles in the field of
condensed matter describing original results, theories and concepts relating to the structure and
properties of crystalline materials, ceramics, polymers, glasses, amorphous films, composites and
soft matter.”

Albert Einstein, physicist

Einstein received his 1921 Nobel Prize in part for investigations on the theory of Brownian motion:
“... in 1905 Einstein founded a kinetic theory to account for this movement”, presentation speech by
S. Arrhenius, Chairman of the Nobel Committee, Dec. 10, 1922.
Einstein, 1905 “Über die von der molekularkinetischen Theorie der Wärme geforderte Bewegung
von in ruhenden Flüssigkeiten suspendierten Teilchen”, Annalen der Physik 17.

Louis Bachelier, mathematician, PhD 1900

Bachelier, 1900 used Brownian motion for the modeling of stock prices in his PhD thesis “Théorie
de la spéculation”, Annales Scientifiques de l’Ecole Normale Supérieure 3 (17): 21-86, 1900.

Norbert Wiener, mathematician, founder of cybernetics

Wiener is credited, among other fundamental contributions, for the mathematical foundation of
Brownian motion, published in 1923. In particular he constructed the Wiener space and Wiener
measure on C0 ([0, 1]) (the space of continuous functions from [0, 1] to R vanishing at 0).
Wiener, 1923 “Differential space”, Journal of Mathematics and Physics of the Massachusetts
Institute of Technology, 2, 131-174, 1923.
Kiyoshi Itô (mathematician, C.F. Gauss Prize 2006
Itô, 1944 constructed the Itô integral with respect to Brownian motion, and the stochastic calculus
with respect to Brownian motion, which laid the foundation for the development of calculus for
random processes, see Itô, 1951 “On stochastic differential equations”, in Memoirs of the American
Mathematical Society.
“Renowned math wiz Itô, 93, dies.” (The Japan Times, Saturday, Nov. 15, 2008)
Kiyoshi Itô, an internationally renowned mathematician and professor emeritus at Kyoto
University died Monday of respiratory failure at a Kyoto hospital, the university said Friday.
He was 93. Itô was once dubbed “the most famous Japanese in Wall Street” thanks to his
contribution to the founding of financial derivatives theory. He is known for his work on

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 3

stochastic differential equations and the “Itô Formula”, which laid the foundation for the
Black and Scholes, 1973 model, a key tool for financial engineering. His theory is also
widely used in fields like physics and biology.

Paul Samuelson, economist, Nobel Prize 1970

Samuelson, 1965 rediscovered Bachelier’s ideas and proposed geometric Brownian motion as a
model for stock prices. In an interview he stated “In the early 1950s I was able to locate by chance
this unknown Bachelier, 1900 book, rotting in the library of the University of Paris, and when I
opened it up it was as if a whole new world was laid out before me.” We refer to “Rational theory
of warrant pricing” by Paul Samuelson, Industrial Management Review, p. 13-32, 1965.

Figure 2: Clark, 2000 “As if a whole new world was laid out before me.”*

In recognition of Bachelier’s contribution, the Bachelier Finance Society was started in 1996 and
now holds the World Bachelier Finance Congress every two years.

Robert Merton, Myron Scholes, economists

Robert Merton and Myron Scholes shared the 1997 Nobel Prize in economics: “In collaboration
with Fisher Black, developed a pioneering formula for the valuation of stock options ... paved the
way for economic valuations in many areas ... generated new types of financial instruments and
facilitated more efficient risk management in society.Ӡ
Black and Scholes, 1973 “The Pricing of Options and Corporate Liabilities”. Journal of Political
Economy 81 (3): 637-654.
The development of options pricing tools contributed greatly to the expansion of option markets
and led to development several ventures such as the “Long Term Capital Management” (LTCM),
founded in 1994. The fund yielded annualized returns of over 40% in its first years, but registered
* Click on the figure to play the video (works in Acrobat Reader on the entire pdf file).
† This has to be put in relation with the modern development of risk societies; “societies increasingly preoccupied
with the future (and also with safety), which generates the notion of risk” (Wikipedia).

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 4 Introduction

a loss of US$4.6 billion in less than four months in 1998, which resulted into its closure in early
2000.

Oldřich Vašíček, economist, 1977

Interest rates behave differently from stock prices, notably due to the phenomenon of mean
reversion, and for this reason they are difficult to model using geometric Brownian motion. Vašíček,
1977 was the first to suggest a mean-reverting model for stochastic interest rates, based on the
Ornstein-Uhlenbeck process, in “An equilibrium characterization of the term structure”, Journal of
Financial Economics 5: 177-188.

David Heath, Robert Jarrow, Andrew Morton

These authors proposed in 1987 a general framework to model the evolution of (forward)
interest rates, known as the Heath-Jarrow-Morton (HJM) model, see Heath, R. Jarrow, and Morton,
1992 “Bond pricing and the term structure of interest rates: a new methodology for contingent
claims valuation”, Econometrica, (January 1992), Vol. 60, No. 1, pp 77-105.

Alan Brace, Dariusz Gatarek, Marek Musiela (BGM)

The Brace, Gatarek, and Musiela, 1997 model is actually based on geometric Brownian
motion, and it is especially useful for the pricing of interest rate derivatives such as interest rate
caps and swaptions on the LIBOR market, see “The Market Model of Interest Rate Dynamics”.
Mathematical Finance Vol. 7, page 127. Blackwell 1997, by Alan Brace, Dariusz Gatarek, Marek
Musiela. Although LIBOR rates are being phased out, we will still use this terminology when
referring to simple or linear compounded forward rates.

Financial derivatives
The following graphs exhibit a correlation between commodity (oil) prices and an oil-related asset
price.

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(a) WTI price graph. (b) Graph of Keppel Corp. stock price

Figure 3: Comparison of WTI vs. Keppel price graphs.

The study of financial derivatives aims at finding functional relationships between the price of
an underlying asset (a company stock price, a commodity price, etc.) and the price of a related
financial contract (an option, a financial derivative, etc.).

Option contracts
Early accounts of option contracts can also be found in The Politics Aristotle, 350 BCE by Aristotle
(384-322 BCE). Referring to the philosopher Thales of Miletus (c. 624 - c. 546 BCE), Aristotle
writes:
“He (Thales) knew by his skill in the stars while it was yet winter that there would be a great
harvest of olives in the coming year; so, having a little money, he gave deposits for the use

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 5

of all the olive-presses in Chios and Miletus, which he hired at a low price because no one
bid against him. When the harvest-time came, and many were wanted all at once and of a
sudden, he let them out at any rate which he pleased, and made a quantity of money”.

In the above example, olive oil can be regarded as the underlying asset, while the oil press stands
for the financial derivative. Option credit contracts appear to have been used as early as the 10th
century by traders in the Mediterranean.

Next, we move to a description of (European) call and put options, which are at the basis of
risk management.

European put option contracts

As previously mentioned, an important concern for the buyer of a stock at time t is whether its price
ST can decline at some future date T . The buyer of the stock may seek protection from a market
crash by purchasing a contract that allows him to sell his asset at time T at a guaranteed price K
fixed at time t. This contract is called a put option with strike price K and exercise date T .

Figure 4: Graph of the Hang Seng index - holding a put option might be useful here.

Definition 1 A (European) put option is a contract that gives its holder the right (but not the
obligation) to sell a quantity of assets at a predefined price K called the strike price (or exercise
price) and at a predefined date T called the maturity.

In case the price ST falls down below the level K, exercising the contract will give the holder of the
option a gain equal to K − ST in comparison to those who did not subscribe the option contract and
have to sell the asset at the market price ST . In turn, the issuer of the option contract will register a
loss also equal to K − ST (in the absence of transaction costs and other fees).

If ST is above K, then the holder of the option contract will not exercise the option as he may
choose to sell at the price ST . In this case the profit derived from the option contract is 0. Two
possible scenarios (ST finishing above K or below K) are illustrated in Figure 5.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 6 Introduction

10
(K-ST)+=0
9
8 ST

7
Strike price
K=6 K

St 5 K-ST>0
4
3 ST

2
S0.1
1
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 T=1

Figure 5: Two put option scenarios.

In general, the payoff of a (so-called European) put option contract can be written as

 K − ST if ST ⩽ K,
+
φ (ST ) = (K − ST ) :=
0, if ST ⩾ K.


20
Put option payoff (K-x)+

15

(K-x)+

10

0
80 85 90 95 100 105 110 115 120
K

Figure 6: Payoff function of a put option with strike price K = 100.

See e.g. https://optioncreator.com/stwwxvz.

Examples of put options: The buy back guarantee* in currency exchange and the price drop protection
in online ticket booking are common examples of European put options.
Cash settlement vs. physical delivery
Physical delivery. In the case of physical delivery, the put option contract issuer will pay the strike
price $K to the option contract holder in exchange for one unit of the risky asset priced ST .
Cash settlement. In the case of a cash settlement, the put option issuer will satisfy the contract by
transferring the amount C = (K − ST )+ to the option contract holder.
* Right-click to open or save the attachment.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 7

The derivatives market

As of year 2015, the size of the financial derivatives market is estimated at over $1.2 quadrillion*
USD, which is more than 10 times the Gross World Product (GWP). See here or here for up-to-date
data on notional amounts outstanding and gross market value from the Bank for International
Settlements (BIS).

European call option contracts

On the other hand, if the trader aims at buying some stock or commodity, his interest will be in
prices not going up and he might want to purchase a call option, which is a contract allowing him
to buy the considered asset at time T at a price not higher than a level K fixed at time t.
Definition 2 A (European) call option is a contract that gives its holder the right (but not the
obligation) to purchase a quantity of assets at a predefined price K called the strike price, and at a
predefined date T called the maturity.
Here, in the event that ST goes above K, the buyer of the option contract will register a potential
gain equal to ST − K in comparison to an agent who did not subscribe to the call option.

Two possible scenarios (ST finishing above K or below K) are illustrated in Figure 7.

10
ST-K>0
9
8 ST

7
Strike price
K=6 K

St 5 (ST-K)+=0
4
3 ST

2
S0.1
1
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 T=1

Figure 7: Two call option scenarios.

In general, the payoff of a (so-called European) call option contract can be written as


 ST − K if ST ⩾ K,
+
φ (ST ) = (ST − K ) :=
0, if ST ⩽ K.


* One thousand trillion, or one million billion, or 1015 .

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 8 Introduction

20
Call option payoff (x-K)+

15

(x-K)+

10

0
80 85 90 95 100 105 110 115 120
K

Figure 8: Payoff function of a call option with strike price K = 100.

See e.g. https://optioncreator.com/stqhbgn.

Example of call option: The price lock guarantee* in online ticket booking is a common example
of a European call option.

According to market practice, options are often divided into a certain number n of warrants, the
(possibly fractional) quantity n being called the entitlement ratio.

Cash settlement vs. physical delivery

Physical delivery. In the case of physical delivery, the call option contract issuer will transfer one
unit of the risky asset priced ST to the option contract holder in exchange for the strike price $K.
Physical delivery may include physical goods, commodities or assets such as coffee, airline fuel or
live cattle, see Schroeder and Coffey, 2018.

Cash settlement. In the case of a cash settlement, the call option issuer will fulfill the contract by
transferring the amount C = (ST − K )+ to the option contract holder.

Option pricing

In order for an option contract to be fair, the buyer of the option contract should pay a fee (similar
to an insurance fee) at the signature of the contract. The computation of this fee is an important
issue, and is known as option pricing.

Option hedging

The second important issue is that of hedging, i.e. how to manage a given portfolio in such a way
that it contains the required random payoff (K − ST )+ (for a put option) or (ST − K )+ (for a call
option) at the maturity date T .

The next Figure 9 illustrates a sharp increase and sharp drop in asset price, making it valuable to
hold a call option contract during the first half of the graph, whereas holding a put option contract
would be recommended during the second half.

* Right-click to open or save the attachment.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 9

Figure 9: “Infogrames” stock price curve.

Example: Fuel hedging and the four-way zero-collar option

install.packages("Quandl")
library(Quandl);library(quantmod)
getSymbols("DCOILBRENTEU", src="FRED")
chartSeries(DCOILBRENTEU,up.col="blue",theme="white",name = "BRENT Oil Prices",lwd=5)
BRENT = Quandl("FRED/DCOILBRENTEU",start_date="2010-01-01",
end_date="2015-11-30",type="xts")
chartSeries(BRENT,up.col="blue",theme="white",name = "BRENT Oil Prices",lwd=5)
getSymbols("WTI", from="2010-01-01", to="2015-11-30")
WTI <- Ad(`WTI`)
chartSeries(WTI,up.col="blue",theme="white",name = "WTI Oil Prices",lwd=5)

WTI Oil Prices [2010−01−04/2015−11−27] BRENT Oil Prices [2010−01−04/2015−11−30]

25
Last 3.52 Last 43.73

120

20

100

15

80

10

60

40

Jan 04 Jan 03 Jan 03 Jan 02 Jan 02 Jan 02 Jan 04 Jan 03 Jan 03 Jan 02 Jan 02 Jan 02
2010 2011 2012 2013 2014 2015 2010 2011 2012 2013 2014 2015

(a) WTI price graph. (b) Brent price graph

Figure 10: Brent and WTI price graphs.

(April 2011)
Fuel hedge promises Kenya Airways smooth ride in volatile oil market.*

(November 2015)
A close look at the role of fuel hedging in Kenya Airways $259 million loss.∗
The four-way call collar call option requires its holder to purchase the underlying asset (here,
airline fuel) at a price specified by the blue curve in Figure 11, when the underlying asset price is
represented by the red line.

* Right-click to open or save the attachment.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 10 Introduction

160
Four-way collar
150 y=x

140

130

120

110

100

90

80

70
70 80 90 100 110 120 130 140 150
x

Figure 11: Price map of a four-way collar option.

The four-way call collar option contract will result into a positive or negative payoff depending on
current fuel prices, as illustrated in Figure 12.

20
four-way collar payoff
15

10

-5

-10

-15

-20
70 80 90 100 110 120 130 140 150
K1 K2 ST K3 K4

Figure 12: Payoff function of a four-way call collar option.

The four-way call collar payoff can be written as a linear combination

φ (ST ) = (K1 − ST )+ − (K2 − ST )+ + (ST − K3 )+ − (ST − K4 )+

of call and put option payoffs with respective strike prices

K1 = 90, K2 = 100, K3 = 120, K4 = 130,

see e.g. https://optioncreator.com/st5rf51.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 11

20
(K1-x)+-(K2-x)++(x-K3)+
15 -(x-K4)+

10

-5

-10

-15

-20
70 80 90 100 110 120 130 140 150
K1 K2 ST K3 K4

Figure 13: Four-way call collar payoff as a combination of call and put options.*

Therefore, the four-way call collar option contract can be synthesized by:
1. purchasing a put option with strike price K1 = $90, and
2. selling (or issuing) a put option with strike price K2 = $100, and
3. purchasing a call option with strike price K3 = $120, and
4. selling (or issuing) a call option with strike price K4 = $130.
Moreover, the call collar option contract can be made costless by adjusting the boundaries K1 , K2 ,
K3 , K4 , in which case it becomes a zero-collar option.

Example - The one-step 4-5-2 model

We close this introduction with a simplified example of the pricing and hedging technique in a
binary model. Consider:
i) A risky underlying stock valued S0 = $4 at time t = 0, and taking only two possible values

 $5
S1 =
$2


at time t = 1.
ii) An option contract that promises a claim payoff C whose values are defined contingent to the
market data of S1 as: 
 $3 if S1 = $5
C :=
$0 if S1 = $2.


Exercise: Does C represent the payoff of a put option contract? Of a call option contract? If yes,
with which strike price K?
Quiz: Using this form, submit your own intuitive estimate for the price of the claim C.
At time t = 0 the option contract issuer (or writer) chooses to invest ξ units in the risky asset S,
while keeping $η on our bank account, meaning that we invest a total amount

ξ S0 + $η at time t = 0.
* The animation works in Acrobat Reader on the entire pdf file.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 12 Introduction

Here, the amount $η may be positive or negative, depending on whether it is corresponds to savings
or to debt, and is interpreted as a liability.
The following issues can be addressed:
a) Hedging: How to choose the portfolio allocation (ξ , $η ) so that the value

ξ S1 + $η

of the portfolio matches the future payoff C at time t = 1?

b) Pricing: How to determine the amount ξ S0 + $η to be invested by the option contract issuer
in such a portfolio at time t = 0?
S1 = 5 and C = 3
S1 = 5 and C = 3
S0 = 4 S0 = 4
S1 = 2 and C = 0
S1 = 2 and C = 0

Hedging or replicating the contract means that at time t = 1 the portfolio value matches the future
payoff C, i.e.
ξ S1 + $η = C.
Hedge, then price. This condition can be rewritten as

 $3 = ξ × $5 + $η if S1 = $5,
C=
$0 = ξ × $2 + $η if S1 = $2,


i.e.  
 5ξ + η = 3,  ξ = 1 stock,
which yields
2ξ + η = 0, $η = −$2.
 

In other words, the option contract issuer purchases 1 (one) unit of the stock S at the price S0 = $4,
and borrows $2 from the bank. The price of the option contract is then given by the portfolio value

ξ S0 + $η = 1 × $4 − $2 = $2.

at time t = 0.
The above computation is implemented in the attached IPython notebook* that can be run here or
here. This algorithm is scalable and can be extended to recombining binary trees over multiple
time steps.
Definition 3 The arbitrage-free price of the option contract is defined as the initial cost ξ S0 + $η
of the portfolio hedging the claim payoff C. 
 $3 if S1 = $5
Conclusion: in order to deliver the random payoff C = to the option contract
$0 if S1 = $2.

holder at time t = 1, the option contract issuer (or writer) will:
1. charge ξ S0 + $η = $2 (the option contract price) at time t = 0,

* Right-click to save as attachment (may not work on .

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 13

2. borrow −$η = $2 from the bank,

3. invest those $2 + $2 = $4 into the purchase of ξ = 1 unit of stock valued at S0 = $4 at time

t = 0,

4. wait until time t = 1 to find that the portfolio value has evolved into

 ξ × $5 + $η = 1 × $5 − $2 = $3 if S1 = $5,
C=
ξ × $2 + $η = 1 × $2 − $2 = 0 if S1 = $2,


so that the option contract and the equality C = ξ S1 + $η can be fulfilled, allowing the option
issuer to break even whatever the evolution of the risky asset price S.
In a cash settlement, the stock is sold at the price S1 = $5 or S1 = $2, the payoff C =
(S1 − K )+ = $3 or $0 is issued to the option contract holder, and the loan is refunded with
the remaining $2.
In the case of physical delivery, ξ = 1 share of stock is handed in to the option holder in
exchange for the strike price K = $2 which is used to refund the initial $2 loan subscribed
by the issuer.
Here, the option contract price ξ S0 + $η = $2 is interpreted as the cost of hedging the option. In
Chapters 3 and 4 we will see that this model is scalable and extends to discrete time.
We note that the initial option contract price of $2 can be turned to C = $3 (%50 profit) ... or into
C = $0 (total ruin).

Thinking further
1) The expected claim payoff at time t = 1 is

IE[C ] = $3 × P(C = $3) + $0 × P(C = $0)

= $3 × P(S1 = $5).
In absence of arbitrage opportunities (“fair market”), this expected payoff IE[C ] should equal the
initial amount $2 invested in the option. In that case we should have

 IE[C ] = $3 × P(S1 = $5) = $2



P(S1 = $5) + P(S1 = $2) = 1.



from which we can infer the probabilities


2
 P(S1 = $5) = 3



(1)
 1
 P(S1 = $2) = ,


3
which are called risk-neutral probabilities. We see that under the risk-neutral probabilities, the
stock S has twice more chances to go up than to go down in a “fair” market.
2) Based on the probabilities (1) we can also compute the expected value IE[S1 ] of the stock at time
t = 1. We find

IE[S1 ] = $5 × P(S1 = $5) + $2 × P(S1 = $2)

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 14 Introduction
2 1
= $5 × + $2 ×
3 3
= $4
= S0 .

Here, this means that, on average, no extra profit or loss can be made from an investment on the risky
stock, and the probabilities (2/3, 1/3) are termed risk-neutral probabilities. In a more realistic
model we can assume that the riskless bank account yields an interest rate equal to r, in which case
the above analysis is modified by letting $η become $(1 + r )η at time t = 1, nevertheless the main
conclusions remain unchanged.

Market-implied probabilities

By matching the theoretical price IE[C ] to an actual market price data $M as

$M = IE[C ] = $3 × P(C = $3) + $0 × P(C = $0) = $3 × P(S1 = $5)

we can infer the probabilities


$M
 P(S1 = $5) = 3



(2)
 P(S1 = $2) = 3 − $M ,



3

which are implied probabilities estimated from market data, as illustrated in Figure 14. We note
that the conditions
0 < P(S1 = $5) < 1, 0 < P(S1 = $2) < 1

are equivalent to 0 < $M < 3, which is consistent with financial intuition in a non-deterministic
market. Figure 14 shows the time evolution of probabilities p(t ), q(t ) of two opposite outcomes.

Figure 14: Implied probabilities.

Note that implied probabilities should also be used with caution, as shown in Figures 15-16.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 15

Figure 15: Implied probabilities according to bookmakers.

Figure 16: Implied probabilities according to polling.

Implied probabilities can be estimated using e.g. binary options, see for example Exercise 4.11.
The Practitioner expects a good model to be:
• Robust with respect to missing, spurious or noisy data,
• Fast - prices have to be delivered daily in the morning,
• Easy to calibrate - parameter estimation,
• Stable with respect to re-calibration and the use of new data sets.
Typically, a medium size bank manages 5,000 options and 10,000 deals daily over 1,000 possible
scenarios and dozens of time steps. This can mean a hundred million computations of IE[C ] daily,
or close to a billion such computations for a large bank.
The mathematician tends to focus on more theoretical features, such as:
• Elegance,
• Sophistication,
• Existence of analytical (closed-form) solutions / error bounds,
• Significance to mathematical finance.
This includes:
• Creating new payoff functions and structured products,

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 16 Introduction

• Defining new models for underlying asset prices,

• Finding new ways to compute expectations IE[C ] and hedging strategies.
The methods involved include:
• Monte Carlo methods (60%),

10

0.0 0.2 0.4 0.6 0.8 1.0

Time

Figure 17: Fifty sample price paths used for the Monte Carlo method.

• PDEs and finite differences methods (30%),

• Other analytic methods and approximation methods (10%),
+ AI and Machine Learning techniques.
Course plan
The course plan from Chapter 2 to Chapter 8 is structured in layers that repeat the main concepts
(arbitrage, pricing, hedging, risk-neutral measures) in different time scale settings (one-step,
discrete-time, continuous-time).

utral measur
k -ne es
is model
R
ime Multis
t te p
s-

p model
C o n t i n uo u

Arb
m

te
od e
One-s

itrage

4-5-2
l
ing

Example
Pric

H
ed
ing g

Figure 18: Course plan.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 17

1. Discrete-Time Martingales

As mentioned in the introduction, stochastic processes can be classified into two main families,
namely Markov processes on the one hand, and martingales on the other hand. Markov processes
have been our main focus of attention so far, and in this chapter we turn to the notion of martingale.
We will give a precise mathematical meaning to the description of martingales, which says that
when (Xn )n⩾0 is a martingale, the best possible estimate at time n ∈ N of the future value Xm at
time m > n is Xn itself. In this chapter, the main application of martingales will be to recover in an
elegant way the existing results on gambling processes. The concept of martingale has also many
applications in stochastic modeling, for example in financial mathematics, where martingales are
used to characterize the fairness and equilibrium in a market model.

1.1 Filtrations and Conditional Expectations 17

1.2 Martingales - Definition and Properties 18
1.3 Stopping Times 20
1.4 Ruin Probabilities 23
1.5 Mean Game Duration 27
Exercises 29

1.1 Filtrations and Conditional Expectations

Before dealing with martingales we need to introduce the important notion of filtration generated
by a discrete-time stochastic process (Sn )n⩾0 .
Definition 1.1 The filtration (Fn )n⩾0 generated by a stochastic process (Sn )n⩾0 taking its

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 18 Chapter 1. Discrete-Time Martingales

values in a state space S, is the family of σ -algebras

Fn := σ (S0 , S1 , . . . , Sn ), n ⩾ 0,

which denote the collections of events generated by S0 , S1 , . . . , Sn .

Examples of events in Fn include:

{S0 ⩽ a0 , S1 ⩽ a1 , . . . , Sn ⩽ an }

for a0 , a1 , . . . , an a given fixed sequence of real numbers. Note that we have the inclusion Fn ⊂
Fn+1 , n ⩾ 0, i.e. (Fn )n⩾0 is non-decreasing.
One refers to Fn as the information generated by (Sk )k∈N up to time n, and to (Fn )n∈N as the
information flow generated by (Sn )n⩾0 . We say that a random variable is Fn -measurable whenever
F can be written as a function F = f (S0 , S1 , . . . , Sn ) of (S0 , S1 , . . . , Sn ).
Example
1. Consider the simple random walk

Sn := X1 + X2 + · · · + Xn , n ⩾ 0,

where (Xk )k⩾1 is a sequence of independent, identically distributed {−1, 1}-valued random
variables, and S0 := 0.

S0 = 0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 n
-1

-2

Figure 1.1: Sample path of the random walk (Sn )n∈N .

The filtration (or information flow) (Fn )n⩾0 generated by (Sn )n⩾0 satisfies

F0 = {S0 ̸= 0}, {S0 = 0} = 0, / Ω , F1 = 0, / {X1 = 1}, {X1 = −1}, Ω ,

  

and

F2 = σ

/ {X1 = 1, X2 = 1}, {X1 = 1, X2 = −1}, {X1 = −1, X2 = 1},
0,
{X1 = −1, X2 = −1}, Ω .

The notation Fn is useful to represent a quantity of information available at time n, and various sub
σ -algebras of Fn can be defined. For example, the σ -algebra G generated by S2 satisfies

G =σ 0, / {S2 = −2}, {S2 = 2}, {S2 = 0}, Ω




=σ 0, / {X1 = −1, X2 = −1}, {X1 = 1, X2 = 1}
{X1 = 1, X2 = −1} ∪ {X1 = −1, X2 = 1}, Ω ,

which contains less information than F2 , as it only tells whether the increments X1 , X2 are both
equal to 1 or to −1.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 1.2 Martingales - Definition and Properties 19

Definition 1.2 A stochastic process (Zn )n⩾0 is said to be (Fn )n⩾0 -adapted if the value of Zn
depends on no more than the information available up to time n in Fn .

In other words, the value of an (Fn )n⩾0 -adapted process Zn is determined by a function of
X0 , X1 , . . . , Xn for all n ⩾ 0.
We now review the definition of conditional expectation, see Sections 11.6 and 11.7 for details.
Given F a random variable with finite mean, the conditional expectation IE[F | Fn ] refers to

IE[F | X0 , X1 , . . . , Xn ] = IE[F | X0 = k0 , . . . , Xn = kn ]k0 =X0 ,...,kn =Xn ,

given that X0 , X1 , . . . , Xn are respectively equal to k0 , k1 , . . . , kn ∈ S.

The conditional expectation IE[F | Fn ] is itself a random variable that depends only on the values
of X0 , X1 , . . . , Xn , i.e. on the history of the process up to time n ∈ N. It can also be interpreted
as the best possible estimate of F in mean-square sense, given the values of X0 , X1 , . . . , Xn , see
Proposition 11.17.
By point (ii)) page 333, any integrable Fn -adapted process (Zn )n⩾0 satisfies

IE[Zn | Fn ] = Zn , n ⩾ 0.

1.2 Martingales - Definition and Properties

We now turn to the definition of martingale.
Definition 1.3 An integrable,a discrete-time stochastic process (Mn )n⩾0 is a martingale with
respect to (Fn )n⩾0 if (Mn )n⩾0 is (Fn )n⩾0 -adapted and satisfies the property

IE[Mn+1 | Fn ] = Mn , n ⩾ 0. (1.2.1)
a Integrable means IE[|Mn |] < ∞ for all n ⩾ 0.

The process (Mn )n⩾0 is a martingale with respect to (Fn )n⩾0 if, given the information Fn known
up to time n, the best possible estimate of Mn+1 is simply Mn .

R Definition 1.3 can be equivalently stated by saying that

IE[Mn | Fk ] = Mk , k = 0, 1, . . . , n.

Proof. Let k ⩾ 0. We prove the statement by induction on n ⩾ k. For n = k we have Mk = IE[Mk |

Fk ]. Next, assuming that Mk = IE[Mn | Fk ] for some n ⩾ k, by the tower property of conditional
expectations, we have

IE[Mn+1 | Fk ] = IE[IE[Mn+1 | Fn ] | Fk ] = IE[Mn | Fk ] = Mk .

□
A particular property of martingales is that their expectation is constant over time.

Proposition 1.4 Let (Mn )n⩾0 be a martingale. We have

IE[Mn ] = IE[M0 ], n ⩾ 0.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 20 Chapter 1. Discrete-Time Martingales

Proof. By the tower property of conditional expectations, we have

IE[Mn+1 ] = IE[IE[Mn+1 | Fn ] | F0 ] = IE[Mn | F0 ] = IE[Mn ], n ⩾ 0.

Hence, by induction on n ⩾ 0, we have

IE[Mn+1 ] = IE[Mn ] = IE[Mn−1 ] = · · · = IE[M1 ] = IE[M0 ], n ⩾ 0.

Examples of martingales
1. Any centered* integrable process (Sn )n⩾0 with mutually independent increments is a martin-
gale with respect to the filtration (Fn )n⩾0 generated by (Sn )n⩾0 .

Indeed, in this case we have

IE[Sn+1 | Fn ] = IE[Sn + Sn+1 − Sn | Fn ]
= IE[Sn | Fn ] + IE[Sn+1 − Sn | Fn ]
= IE[Sn | Fn ] + IE[Sn+1 − Sn ]
| {z }
=0
= IE[Sn | Fn ] = Sn , n ⩾ 0.
In addition to being a martingale, a stochastic process (Sn )n⩾0 with centered independent
increments is also a Markov process.

However, not all martingales have the Markov property, and not all Markov processes are
martingales. In addition, there are martingales and Markov processes which do not have
independent increments.

2. Given F ∈ L2 (Ω) a square-integrable random variable and (Fn )n⩾0 a filtration, the process
(Xn )n∈N defined by

Xn := IE[F | Fn ], n ⩾ 0,

is an (Fn )n⩾0 -martingale under the probability measure P, as follows from the tower property
(11.6.8):

IE[Xn+1 | Fn ] = IE[IE[F | Fn+1 ] | Fn ] = IE[F | Fn ] = Xn , n ⩾ 0. (1.2.2)

The following Figure 1.2 illustrates various estimates Xn = IE[F | Fn ] at time n =“Wed”, “Thu”,
“Fri”, “Sat”, for a random outcome F =“Saturday temperature” known at time “Sat”, i.e. XWed = 26,
XThu = 28, XFri = 26, XSat = 24.

*A process (Sn )n⩾0 is said to be centered if IE[Sn ] = 0 for all n ⩾ 0.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 1.3 Stopping Times 21
London, UK
Wednesday 9:00 AM
Clear

19
°C | °F Precipitation: 10%
Humidity: 73%
Wind: 14 km/h
London, UK
Thursday 10:00 AM Temperature Precipitation Wind
Mostly Cloudy
27 27

20
23 °C | °F 23 Precipitation: 0%
19
Humidity:
21 78%
18 18
London, UK Wind: 13 km/h
9 AM 12 PM Friday
3 PM 2:00 AM
6 PM 9 PM 12 AM 3 AM 6 AM
Temperature Precipitation Wind
Clear
Wed Thu Fri Sat Sun Mon Tue Wed

18
25 °C
25 | °F Precipitation: 10%
23
20
21 Humidity: 77%
27° 18° 27° 18° 27° 18° 26° 19° 27° 18° 26° 19° 26°
18 19° 29°
1820° 18
Wind: 8 km/h
London, UK
10 AM 1 PM 4 PM
Saturday 7 PM
11:00 AM 10 PM 1 AM 4 AM 7 AM
The Weather Channel ­ Weather Underground ­ Acc uWeather Temperature Precipitation Wind
Clear
Thu Fri Sat Sun Mon Tue Wed Thu
27

24
25 26
°C
23 | °F Precipitation: 20% 23

18 18 19 Humidity: 47%
26° 17° 27° 18° 28° 18° 25° 18° 26° 19° 27° 19° 29° 20° 29° 19°
Wind: 6 km/h
2 AM 5 AM 8 AM 11 AM 2 PM 5 PM 8 PM 11 PM
The Weather Channel ­ Weather Underground ­ Acc uWeather
Temperature Precipitation Wind
Fri Sat Sun Mon Tue Wed Thu Fri

24
22 23 22 22
19
28° 18° 26° 18° 25° 18° 24° 18° 25° 19° 28° 20° 29° 20° 1819°
29° 18

11 AM 2 PM 5 PM 8 PM 11 PM 2 AM 5 AM 8 AM
The Weather Channel ­ Weather Underground ­ Acc uWeather

Sat Sun Mon Tue Wed Thu Fri Sat

24° 18° 25° 17° 22° 16° 25° 18° 24° 18° 28° 20° 26° 18° 28° 19°

Figure 1.2: Updated weather forecast.

1.3 Stopping Times

Next, we turn to the definition of stopping time. If an event occurs at a (random) stopping time, it
should be possible, at any time n ∈ N, to determine whether the event has already occured, based on
the information available up to time n. This idea is formalized in the next definition.
Definition 1.5 A random variable τ : Ω −→ N ∪ {+∞} is a stopping time with respect to
(Fn )n⩾0 if

{τ > n} ∈ Fn , n ⩾ 0. (1.3.1)

The meaning of Relation (1.3.1) is that the knowledge of {τ > n} depends only on the information
present in Fn up to time n, i.e. on the knowledge of X0 , X1 , . . . , Xn .
Note that condition (1.3.1) is equivalent to the condition

{τ ⩽ n} ∈ Fn , n ⩾ 0,

since {τ ⩽ n} = {τ > n}c and Fn is stable by complement.

Not every N-valued random variable is a stopping time, however, hitting times provide natural
examples of stopping times.

Proposition 1.6 The first hitting time

τx := inf{k ⩾ 0 : Xk = x}

of x ∈ S is a stopping time.

Proof. We have

{τx > n} = {X0 ̸= x, X1 ̸= x, . . . , Xn ̸= x}

= {X0 ̸= x} ∩ {X1 ̸= x} ∩ · · · ∩ {Xn ̸= x} ∈ Fn , n ⩾ 0,

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 22 Chapter 1. Discrete-Time Martingales

since
{X0 ̸= x} ∈ F0 ⊂ Fn , {X1 ̸= x} ∈ F1 ⊂ Fn , . . . , {Xn ̸= x} ∈ Fn , n ⩾ 0.
□
Hitting times can be used to trigger “buy limit” or “sell stop” orders in finance. On the other hand,
the first time  
τ := inf k ⩾ 0 : Xk = Max Xl
l =0,1,...,N

the process (Xk )k∈N reaches its maximum over {0, 1, . . . , N} is not a stopping time. Indeed, it is
not possible to decide whether {τ ⩽ n}, i.e. the maximum has been reached before time n, based
on the information available up to time n.
Exercise: Show from Definition 1.5 that the minimum τ ∧ ν := min(τ, ν ) and the maximum
τ ∨ ν := Max(τ, ν ) of two stopping times are themselves stopping times.

Definition 1.7 Given (Zn )n⩾0 a stochastic process and τ : Ω −→ N a stopping time, the stopped
process
(Zτ∧n )n⩾0 = (Zmin(τ,n) )n⩾0
is defined as 
 Zn if n < τ,
Zτ∧n = Zmin(τ,n) =
Zτ if n ⩾ τ,


Using indicator functions we may also write

Zτ∧n = Zn 1{n<τ} + Zτ 1{n⩾τ} , n ⩾ 0.

The following Figure 1.3 is an illustration of the path of a stopped process.

0.065

0.06

0.055

0.05

0.045

0.04

0.035

0.03

0.025
0 2 4 6 τ8 10 12 14 16 18 20
t

Figure 1.3: Stopped process.

The following Theorem 1.8 is called the Stopping Time Theorem, and is due to J.L. Doob (1910-
2004).

Theorem 1.8 Assume that (Mn )n⩾0 is a martingale with respect to (Fn )n⩾0 and that τ : Ω −→

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

1.3 Stopping Times 23

N ∪ {+∞} is a stopping time with respect to (Fn )n⩾0 . Then the stopped process (Mτ∧n )n⩾0 is
also a martingale with respect to (Fn )n⩾0 .

Proof. Writing
n
Mn = M0 + ∑ (Ml − Ml−1 ) = M0 + ∑ 1{l⩽n} (Ml − Ml−1 ),
l =1 l⩾1

we have
τ∧n n
Mτ∧n = M0 + ∑ (Ml − Ml−1 ) = M0 + ∑ 1{l⩽τ} (Ml − Ml−1 ),
l =1 l =1

and for k ⩽ n we find

" #
n
IE[Mτ∧n | Fk ] = IE M0 + ∑ 1{l⩽τ} (Ml − Ml−1 ) Fk
l =1
n
= M0 + ∑ IE 1{l⩽τ} (Ml − Ml−1 ) Fk
 
l =1
k n
= M0 + ∑ IE 1{l⩽τ} (Ml − Ml−1 ) Fk + 1{l⩽τ} (Ml − Ml−1 ) Fk
   
∑ IE
l =1 l =k +1
k
= M0 + ∑ (Ml − Ml−1 ) IE 1{τ>l−1} Fk
 
l =1
n
IE IE (Ml − Ml−1 )1{l−1<τ} Fl−1 Fk
   
+ ∑
l =k +1
k
= M0 + ∑ (Ml − Ml−1 )1{l⩽τ}
l =1
n h i
1{l−1<τ} IE (Ml − Ml−1 ) Fl−1 Fk
 
+ ∑ IE
l =k +1 | {z }
=0
τ∧k
= M0 + ∑ (Ml − Ml−1 )
l =1
= Mτ∧k ,

k = 0, 1, . . . , n, where we used the tower property (11.6.8), the martingale property

IE (Ml − Ml−1 ) Fl−1 = IE Ml Fl−1 − IE Ml−1 Fl−1

     

= Ml−1 − Ml−1 = 0

of (Ml )l⩾0 , and the fact that

{τ ⩾ l} = {τ > l − 1} ∈ Fl−1 ⊃ Fk , l ⩾ k + 1.

□
By the Stopping Time Theorem 1.8 we know that the stopped process (Mτ∧n )n∈N is a martingale,
hence its expectation is constant over time by Proposition 1.4.
i) If τ is a stopping time bounded by a constant N ⩾ 1, i.e. τ ⩽ N, by Proposition 1.4 we have

IE[Mτ ] = IE[Mτ∧N ] = IE[Mτ∧0 ] = IE[M0 ]. (1.3.2)

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 24 Chapter 1. Discrete-Time Martingales

ii) As a consequence of (1.3.2), if (Mn )n⩾0 is a martingale and τ ⩽ N and ν ⩽ N are two
bounded stopping times bounded by a constant N ⩾ 1, we have

IE[Mτ ] = IE[Mν ] = IE[M0 ]. (1.3.3)

iii) In case τ is only a.s. finite, i.e. P(τ < ∞) = 1, we may also write
h i
IE[Mτ ] = IE lim Mτ∧n = lim IE[Mτ∧n ] = IE[M0 ],
n→∞ n→∞

provided that the limit and expectation signs can be exchanged, however this may not be
always the case.
In some situations the exchange of limit and expectation signs may not be valid.* Nevertheless,
the exchange is possible when the stopped process (Mτ∧n )n⩾0 is bounded in absolute value, i.e.
|Mτ∧n | ⩽ K a.s., n ∈ N, for some constant K > 0, as a consequence of the dominated convergence
theorem.
Analog statements can be proved for submartingales, see e.g. Exercise 1.6 for this notion.

1.4 Ruin Probabilities

In the sequel we will show that, as an application of the Stopping Time Theorem 1.8, the ruin
probabilities computed for random walks can be recovered in a simple and elegant way.
Consider the standard random walk (or gambling process) (Sn )n⩾0 on {0, 1, . . . , B} with inde-
pendent {−1, 1}-valued increments, and

P(Sn+1 − Sn = +1) = p and P(Sn+1 − Sn = −1) = q, n ⩾ 0.

Let
τ0,B : Ω −→ N
be the first hitting time of the boundary {0, B}, defined by

τ = τ0,B := inf{n ⩾ 0 : Sn = B or Sn = 0}. (1.4.1)

Sn
B =6

S0 = 3

0 n
0 1 2 3 4 5 6 7 8 τ90,6 10 τ11 12 13
0,6

Figure 1.4: Sample paths of the random walk (Sn )n⩾0 .

One can easily check that the event {τ > n} depends only on the history of (Sk )k∈N up to time n
since
{τ > n} = {0 < S0 < B} ∩ {0 < S1 < B} ∩ · · · ∩ {0 < Sn < B} ⊂ Fn ,
* Consider for example the sequence Mn : = n1
{U<1/n} , n ⩾ 1, where U ≃ U (0, 1] is a uniformly distributed random
variable on (0, 1], see also Exercise 1.5.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

1.4 Ruin Probabilities 25

hence τ is a stopping time.

We will recover the ruin probabilities

P(Sτ = 0 | S0 = k), k = 0, 1, . . . , B,

in three steps, first in the unbiased case p = q = 1/2 (note that the hitting time τ can be shown to
be a.s. finite, i.e. P(τ < ∞) = 1.

Unbiased case p = q = 1/2

Step 1. The process (Sn )n⩾0 is a martingale.

We note that the process (Sn )n⩾0 has independent increments, and in the unbiased case p = q = 1/2
those increments are centered:

1 1
IE[Sn+1 − Sn ] = 1 × p + (−1) × q = 1 × + (−1) × = 0, (1.4.2)
2 2

hence (Sn )n⩾0 is a martingale by Point 1 page 20.

Step 2. The stopped process (Sτ∧n )n⩾0 is also a martingale, as a consequence of the Stopping Time
Theorem 1.8.

Step 3. Since the stopped process (Sτ∧n )n⩾0 is a martingale by the Stopping Time Theorem 1.8, we
find that its expectation IE[Sτ∧n | S0 = k] is constant in n ⩾ 0 by Proposition 1.4, which gives

k = IE[S0 | S0 = k] = IE[Sτ∧n | S0 = k], k = 0, 1, . . . , B.

Letting n go to infinity and noting that |Sn | ⩽ B, n ∈ N, we get

 
IE[Sτ | S0 = k] = IE lim Sτ∧n S0 = k
n→∞
= lim IE[Sτ∧n | S0 = k]
n→∞
= lim IE[Sτ∧0 | S0 = k]
n→∞
= lim IE[S0 | S0 = k]
n→∞
= k,

provided that P(τ < ∞) = 1, see Exercise 1.1, where the exchange between limit and expectation
is justified by the boundedness |Sτ∧n | ⩽ B a.s., n ∈ N. Hence we have

 0 × P(Sτ = 0 | S0 = k) + B × P(Sτ = B | S0 = k) = IE[Sτ | S0 = k] = k



P(Sτ = 0 | S0 = k) + P(Sτ = B | S0 = k) = P(τ < ∞) = 1,



which shows that

k k
P(Sτ = B | S0 = k) = and P(Sτ = 0 | S0 = k) = 1 − ,
B B

k = 0, 1, . . . , B. Namely, the solution has been obtained in a simple way without solving any finite
difference equation, demonstrating the power of the martingale approach.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 26 Chapter 1. Discrete-Time Martingales

Biased case p ̸= q
Next, we turn to the biased case where p ̸= q. In this case the process (Sn )n⩾0 is no longer a
martingale because its increments are not centered:
IE[Sn+1 − Sn ] = 1 × p + (−1) × q = p − q ̸= 0. (1.4.3)
In order to apply the Stopping Time Theorem 1.8, we need to construct a martingale of a different
type. Here, we note that the process
 Sn
q
Mn := , n ⩾ 0,
p
is a martingale with respect to (Fn )n⩾0 .
Step 1. The process (Mn )n⩾0 is a martingale.
Indeed, we have
"  # "  #
q Sn+1 q Sn+1 −Sn q Sn
 
IE[Mn+1 | Fn ] = IE Fn = IE Fn
p p p
 Sn " Sn+1 −Sn #
q q
= IE Fn
p p
 Sn " Sn+1 −Sn #
q q
= IE
p p
 Sn  −1 !
q q q
= P ( Sn + 1 − Sn = 1 ) + P(Sn+1 − Sn = −1)
p p p
 Sn  −1 !
q q q
= p +q
p p p
 Sn  2
pq + p2 q

q
=
p pq
 Sn  Sn
q q
= (q + p) = = Mn , n ⩾ 0.
p p
In particular, the expectation of (Mn )n⩾0 is constant over time by Proposition 1.4 since it is a
martingale, i.e. we have
 k
q
= IE[M0 | S0 = k] = IE[Mn | S0 = k], k = 0, 1, . . . , B, n ⩾ 0.
p
Step 2. The stopped process (Mτ∧n )n⩾0 is also a martingale, as a consequence of the Stopping
Time Theorem 1.8.
Step 3. Since the stopped process (Mτ∧n )n⩾0 remains a martingale by the Stopping Time The-
orem 1.8, its expected value IE[Mτ∧n | S0 = k] is constant in n ⩾ 0 by Proposition 1.4. This
gives
 k
q
= IE[M0 | S0 = k] = IE[Mτ∧n | S0 = k].
p
Next, letting n go to infinity we find*
h i
IE[Mτ | S0 = k] = IE lim Mτ∧n S0 = k
n→∞
* Provided that P(τ < ∞) = 1.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 1.5 Mean Game Duration 27

= lim IE[Mτ∧n | S0 = k]
n→∞
= IE[M0 | S0 = k]
 k
q
= ,
p
hence
 k
q
= IE[Mτ | S0 = k]
p
!   !
q 0
 B  B  0
q q q
= P Mτ = S0 = k + P Mτ = S0 = k
p p p p
 B  B !
q q
= P Mτ = S0 = k + P(Mτ = 1 | S0 = k).
p p

Solving the system of equations

   !
k  B  B
q q q
P Mτ = S0 = k + P(Mτ = 1 | S0 = k)

=


 p p p




  B !
 q
 P Mτ = p S0 = k + P(Mτ = 1 | S0 = k) = 1,





gives
 B !
q
P(Sτ = B | S0 = k) = P Mτ = S0 = k (1.4.4)
p
(q/p)k − 1
= , k = 0, 1, . . . , B,
(q/p)B − 1
and

P(Sτ = 0 | S0 = k) = P(Mτ = 1 | S0 = k)
(q/p)k − 1
= 1− ,
(q/p)B − 1
(q/p)B − (q/p)k
= ,
(q/p)B − 1
k = 0, 1, . . . , B.

1.5 Mean Game Duration

In this section we show that the mean game durations IE[τ | S0 = k] can also be recovered as a
second application of the Stopping Time Theorem 1.8.

Unbiased case p = q = 1/2

case of a fair game with p = q = 1/2, the martingale method can be used by noting
In the unbiased
that Sn2 − n n⩾0 is also a martingale.

Step 1. The process Sn2 − n n⩾0 is a martingale.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 28 Chapter 1. Discrete-Time Martingales

We have

IE[Sn2+1 − (n + 1) | Fn ] = IE[(Sn+1 − Sn + Sn )2 − (n + 1) | Fn ]
= IE[Sn2 + (Sn+1 − Sn )2 + 2Sn (Sn+1 − Sn ) − (n + 1) | Fn ]
= IE[Sn2 − n − 1 | Fn ] + IE[(Sn+1 − Sn )2 | Fn ] + 2 IE[Sn (Sn+1 − Sn ) | Fn ]
= Sn2 − n − 1 + IE[(Sn+1 − Sn )2 | Fn ] + 2Sn IE[Sn+1 − Sn | Fn ]
= Sn2 − n − 1 + IE[(Sn+1 − Sn )2 ] +2Sn IE[Sn+1 − Sn ]
| {z } | {z }
=1 =0
= Sn2 − n − 1 + IE[(Sn+1 − Sn )2 ]
= Sn2 − n, n ⩾ 0,

since IE[Sn+1 − Sn ] = 0 and IE[(Sn+1 − Sn )2 ] = 1.

2 −τ ∧n


Step 2. The stopped process Sτ∧n n⩾0
is also a martingale, as a consequence of the
Stopping Time Theorem 1.8.
2 −τ ∧n


Step 3. Since the stopped process Sτ∧n n⩾0
is also a martingale by the Stopping Time
2
Theorem 1.8, its expectation IE[Sτ∧n − τ ∧ n | S0 = k] is constant in n ⩾ 0 by Proposition 1.4, hence
we have
k2 = IE[S02 − 0 | S0 = k] = IE Sτ∧n
 2 
− τ ∧ n S0 = k ,

and since P(τ < ∞) = 1, after taking the limit as n tends to infinity and using dominated conver-
gence, we find

IE Sτ2 − τ | S0 = k = IE lim Sτ∧n

2
   
− lim τ ∧ n S0 = k
n→∞ n→∞
h i h i
2
= IE lim Sτ∧n | S0 = k − IE lim τ ∧ n | S0 = k
n→∞ n→∞
 2 
= lim IE Sτ∧n | S0 = k − lim IE[τ ∧ n | S0 = k]
n→∞ n→∞
 2 
= lim IE Sτ∧n − τ ∧ n S0 = k
n→∞
= k2 ,
2
since Sτ∧n ∈ [0, B2 ] for all n ⩾ 0 and the mapping n 7→ τ ∧ n is non-decreasing in n ⩾ 0, and this
gives*

k2 = IE Sτ2 − τ | S0 = k
 

= IE Sτ2 | S0 = k − IE[τ | S0 = k]
 

= B2 P(Sτ = B | S0 = k) + 02 × P(Sτ = 0 | S0 = k) − IE[τ | S0 = k],

i.e.

IE[τ | S0 = k] = B2 P(Sτ = B | S0 = k) − k2
k
= B2 − k 2
B
= k (B − k ),

k = 0, 1, . . . , B.
* By application of the dominated and monotone convergence theorems.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

1.5 Mean Game Duration 29

Biased case p ̸= q
Finally, we show how to recover the value of the mean game duration, i.e. the mean hitting time of
the boundaries {0, B}, in the biased non-symmetric case p ̸= q.

Step 1. The process Sn − ( p − q)n is a martingale.

In this case we note that although (Sn )n⩾0 does not have centered increments and is not a martingale,
the compensated process
Sn − ( p − q)n, n ⩾ 0,

is a martingale because, in addition to being independent, its increments are centered random
variables:
IE[Sn+1 − Sn − ( p − q)] = IE[Sn+1 − Sn ] − ( p − q) = 0, n ⩾ 0,

by (1.4.3).

Step 2. The stopped process (Sτ∧n − ( p − q)(τ ∧ n))n⩾0 is also a martingale, as a consequence of
the Stopping Time Theorem 1.8.

Step 3. The expectation IE[Sτ∧n − ( p − q)(τ ∧ n) | S0 = k] is constant in n ⩾ 0.

Step 4. Since the stopped process (Sτ∧n − ( p − q)(τ ∧ n))n⩾0 is a martingale by the Stopping Time
Theorem 1.8, we have

k = IE[S0 − 0 | S0 = k] = IE[Sτ∧n − ( p − q)(τ ∧ n) | S0 = k],

and, since P(τ < ∞) = 1, after taking the limit as n goes to infinity we find

IE[Sτ − ( p − q)τ | S0 = k] = lim IE[Sτ∧n − ( p − q)(τ ∧ n) | S0 = k]

n→∞
 
= IE lim Sτ∧n − ( p − q) lim τ ∧ n S0 = k
n→∞ n→∞
= k,

which gives

k = IE[Sτ − ( p − q)τ | S0 = k]
= IE[Sτ | S0 = k] − ( p − q) IE[τ | S0 = k]
= B × P(Sτ = B | S0 = k) + 0 × P(Sτ = 0 | S0 = k) − ( p − q) IE[τ | S0 = k],

i.e.

( p − q) IE[τ | S0 = k] = B × P(Sτ = B | S0 = k) − k
(q/p)k − 1
= B − k,
(q/p)B − 1

from (1.4.4), hence

(q/p)k − 1
 
1
IE[τ | S0 = k] = B −k , k = 0, 1, . . . , B.
p−q (q/p)B − 1

In Table 1.1, we summarize the family of martingales used to treat the above problems.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 30 Chapter 1. Discrete-Time Martingales

Probabilities
Unbiased Biased
Problem
 Sn
q
Ruin probability Sn
p

Mean game duration Sn2 − n Sn − ( p − q ) n

Table 1.1: List of martingales.

Exercises

Exercise 1.1 Show that for all k = 0, 1, . . . , B we have P(τ0,B < ∞ | S0 = k) = 1, i.e. the stopping
time τ0,B defined in (1.4.1) is finite almost surely.

Exercise 1.2 Doubling down. Consider a sequence (Xn )n⩾1 of independent Bernoulli random
variables, with

1
P(Xn = 1) = P(Xn = −1) = , n ⩾ 1,
2

and the process (Mn )n⩾0 defined by M0 := 0 and

n
Mn := ∑ 2k−1 Xk , n ⩾ 1,
k =1

with in particular



 M1 = X1 ,
 M2 = X1 + 2X2 ,


 M3 = X1 + 2X2 + 4X3 ,
 .
 .

.

see Figure 1.5.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

1.5 Mean Game Duration 31

Mn
7
6
5
4
3
2
1
0 n
-1 1 2 3
-2
-3
-4
-5
-6
-7

Figure 1.5: Possible paths of the process (Mn )n⩾0 .

Note that when X1 = X2 = · · · = Xn−1 = −1 and Xn = 1, we have

n−1
1 − 2n−1
Mn = − ∑ 2k−1 + 2n−1 = − + 2n−1 = 1, n ⩾ 1,
k =1 1−2

while when X1 = X2 = · · · = Xn−1 = Xn = −1, we have

n
1 − 2n
Mn = − ∑ 2k−1 = − = 1 − 2n , n ⩾ 1.
k =1 1−2

a) Show that the process (Mn )n⩾0 is a martingale.

b) Is the random time

τ := inf{n ⩾ 1 : Mn = 1}

a stopping time?
c) Consider the stopped process

 Mn = 1 − 2n

if n < τ,
Mτ∧n := Mn 1{n<τ} + 1{τ⩽n} =
Mτ = 1 if n ⩾ τ,


n ⩾ 0, see Figure 1.6. Give an interpretation of (Mn∧τ )n⩾0 in terms of betting strategy for a
gambler starting a game at M0 = 0.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 32 Chapter 1. Discrete-Time Martingales

Mτ∧n
1
0 n
-1 1 2 3 4 5
-2
-3
-4
-5
-6
-7
-8
-9
-10
-11
-12
-13
-14
-15

Figure 1.6: Possible paths of the stopped process (Mτ∧n )n⩾0 .

d) Determine the two possible values of Mτ∧n and the probability distribution of Mτ∧n at any
time n ⩾ 1.
e) Show, using the result of Question (d)), that we have

IE[Mτ∧n ] = 0, n ⩾ 0.

f) Show that the result of Question (e)) can be recovered using the Stopping Time Theorem 1.8.

Exercise 1.3 Let (Sn )n⩾0 be the random walk defined by S0 := 0 and
n
Sn := ∑ Xk = X1 + · · · + Xn , n ⩾ 1,
k =1

where (Xn )n⩾1 is an i.i.d. Bernoulli sequence of {−1, 1}-valued random variables with P(Xn =
1) = P(Xn = −1) = 1/2, n ⩾ 1. We consider the random time

τ := inf{n ⩾ 1 : Sn − Sn−1 = −1}

at which (Sn )n⩾0 drops for the first time, and decide to use τ as an exit strategy.
a) Show that τ is a stopping time.
b) Find the range of possible values of Sτ .
c) Give the value of IE[Sτ ] according to the stopping time theorem.
d) Find the probability distribution of Sτ , i.e. find P(Sτ = k) for all k ∈ Z.
e) Compute
IE[Sτ ] = ∑ kP(Sτ = k),
k∈Z

and recover the conclusion of part (c)).

Exercise 1.4 Show that, as the discrete-time filtration (Fn )n⩾0 satisfies Fn−1 ⊂ Fn , n ⩾ 1,
Condition (1.3.1) is equivalent to

{τ = n} ∈ Fn , n ⩾ 0. (1.5.1)

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

1.5 Mean Game Duration 33

Exercise 1.5 Give an example of an a.s. converging and unbounded sequence (Xn )n⩾0 of random
variables for which expectation and limit cannot be exchanged, i.e.

lim IE[Xn ] ̸= IE[ lim Xn ].

n→∞ n→∞

Exercise 1.6 Let (Mn )n⩾0 be a discrete-time submartingale with respect to a filtration (Fn )n⩾0 ,
with F0 = {0,
/ Ω}, i.e. we have

Mn ⩽ IE[Mn+1 | Fn ], n ⩾ 0.

a) Show that for all n ⩾ 0, we have IE[Mn ] ⩽ IE[Mn+1 ], i.e. submartingales have a non-decreasing
expected value.
b) Show that independent increment processes whose increments have nonnegative expectation
are examples of submartingales.
c) (Doob-Meyer decomposition). Show that there exists two processes (Nn )n⩾0 and (An )n⩾0
such that
i) (Nn )n⩾0 is a martingale with respect to (Fn )n⩾0 ,
ii) (An )n⩾0 is non-decreasing, i.e. An ⩽ An+1 , a.s., n ⩾ 0,
iii) (An )n⩾0 is predictable in the sense that An is Fn−1 -measurable, n ⩾ 1, and
iv) Mn = Nn + An , n ∈ N.
Hint: Let A0 := 0, A1 := A0 + IE[M1 − M0 | F0 ], and

An+1 := An + IE[Mn+1 − Mn | Fn ], n ⩾ 0,

and define (Nn )n⩾0 in such a way that it satisfies the four required properties.
d) Show that for all bounded stopping times σ and τ such that σ ⩽ τ a.s., we have

IE[Mσ ] ⩽ IE[Mτ ].

Hint: Use the Doob Stopping Time Theorem 1.8 for martingales and (1.3.3).

Exercise 1.7 We say that a function φ : R → R is convex if

φ ( px + qy) ⩽ pφ (x) + qφ (y), x, y ∈ R,

for all p, q ∈ [0, 1] such that p + q = 1.

φ(px + qy)
pφ(x) + qφ(y)

φ(x)

x px + qy y

Figure 1.7: Convex function.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 34 Chapter 1. Discrete-Time Martingales

a) Show that for any convex function φ : R → R we have the inequality

x1 + x2 + · · · + xn φ ( x1 ) + φ ( x2 ) + · · · + φ ( xn )
 
φ ⩽ , (1.5.2)
n n

x1 , . . . , xn ∈ R, n ⩾ 1.
b) Consider a martingale (Sn )n=0,1,...,N under the probability measure P, with respect to the
filtration (Fn )n⩾0 , and let φ be a convex function. Show the inequality

S1 + S2 + · · · + SN
  
IE φ ⩽ IE[φ (SN )].
N

Hint: Use in the following order:

(i) the convexity inequality (1.5.2),
(ii) the martingale property of (Sk )k∈N ,
(iii) the conditional Jensen inequality φ (IE[F | G ]) ⩽ IE[φ (F ) | G ],
(iv) the tower property of conditional expectations.
c) Given the (convex) function φ (x) := (x − K )+ , show that the price
" + #
S1 + S2 + · · · + SN
IE −K
N

of a discrete-time arithmetic average option with payoff

+
S1 + S2 + · · · + SN

−K
N

is upper bounded by the price of the European call option with payoff (SN −K )+ and maturity
N.

Exercise 1.8 A stochastic process (Mn )n⩾0 is a submartingale if it satisfies

Mk ⩽ IE[Mn | Fk ], k = 0, 1, . . . , n.

a) Show that the expected value IE[Mn ] of the submartingale (Mn )n⩾0 is non-decreasing in time
n ∈ N.
b) Consider the random walk given by S0 := 0 and
n
Sn : = ∑ Xk = X1 + X2 + · · · + Xn , n ⩾ 1,
k =1

where (Xn )n⩾1 is an i.i.d. Bernoulli sequence of {0, 1}-valued random variables with P(Xn =
1) = p, n ⩾ 1. Under which condition on α ∈ R is the process (Sn −αn)n⩾0 a submartingale?

Exercise 1.9 Recall that a discrete-time stochastic process (Mn )n⩾0 is a submartingale with respect
to a filtration (Fn )n⩾0 if it satisfies

Mk ⩽ IE[Mn | Fk ], k = 0, 1, . . . , n.

a) Show that any convex function (φ (Mn ))n∈N of a martingale (Mn )n⩾0 is itself a submartingale.
Hint: Use Jensen’s inequality.
b) Show that any convex non-decreasing function φ (Mn ) of a submartingale (Mn )n⩾0 remains a
submartingale.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

1.5 Mean Game Duration 35

Problem 1.10
a) Consider (Mn )n⩾0 a nonnegative martingale generating the filtration (Fn )n⩾0 . For any x > 0,
let
τx := inf{n ⩾ 0 : Mn ⩾ x}.

Show that the random time τx is a stopping time.

b) Show that for all n ⩾ 0, we have
  IE[M ]
n
P Max Mk ⩾ x ⩽ , x > 0. (1.5.3)
k=0,1,...,n x

Hint: Proceed as in the proof of the classical Markov inequality and use the Doob Stopping
Time Theorem 1.8 for the stopping time τx .
c) Show that (1.5.3) remains valid for a nonnegative submartingale.
Hint: Use the Doob Stopping Time Theorem 1.8 for submartingales as in Exercise 1.6-(d)).
d) Show that for any n ⩾ 0 we have
  IE[(M )2 ]
n
P Max Mk ⩾ x ⩽ , x > 0.
k=0,1,...,n x2

e) Show that more generally we have

  IE[(M ) p ]
n
P Max Mk ⩾ x ⩽ p
, x > 0,
k=0,1,...,n x

for all n ⩾ 0 and p ⩾ 1.

f) Given (Yn )n⩾1 a sequence of centered independent random variables with same mean IE[Yn ] =
0 and variance σ 2 = Var[Yn ], n ⩾ 1, consider the random walk Sn = Y1 + Y2 + · · · + Yn , n ⩾ 1,
with S0 = 0.
Show that for all n ⩾ 0, we have
  nσ 2
P Max |Sk | ⩾ x ⩽ 2 , x > 0.
k=0,1,...,n x

g) Show that for any (not necessarily nonnegative) submartingale, we have

  IE[M + ]
P Max Mk ⩾ x ⩽ n
, x > 0,
k=0,1,...,n x

where z+ = Max(z, 0), z ∈ R.

h) A stochastic process (Mn )n⩾0 is a supermartingale* if it satisfies

IE[Mn | Fk ] ⩽ Mk , k = 0, 1, . . . , n.

Show that for any nonnegative supermartingale we have

  IE[M ]
0
P Max Mk ⩾ x ⩽ , x > 0.
k=0,1,...,n x
*“This obviously inappropriate nomenclature was chosen under the malign influence of the noise level of radio’s
SUPERman program, a favorite supper-time program of Doob’s son during the writing of Doob, 1953”, cf. Doob, 1984,
historical notes, page 808.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 36 Chapter 1. Discrete-Time Martingales

i) Show that for any nonnegative submartingale (Mn )n⩾0 and any convex non-decreasing
nonnegative function φ we have
  IE[φ (M )]
n
P Max φ (Mk ) ⩾ x ⩽ , x > 0.
k=0,1,...,n x
Hint: Consider the stopping time

τxφ := inf{n ⩾ 0 : φ (Mn ) ⩾ x},

and use the result of Exercise 1.9-(b)).

j) Give an example of a nonnegative supermartingale which is not a martingale.

Exercise 1.11 Consider the random walk (Sn )n⩾0 on {0, 1, . . . , B} with S0 := 0 and independent
{−1, 1}-valued increments (Sn+1 − Sn )n⩾0 such that

P(Sn+1 − Sn = +1) = p and P(Sn+1 − Sn = −1) = q, n ⩾ 0,

and the martingale (Mn )n⩾0 defined as

 Sn
q
Mn := , n ⩾ 0,
p

where p, q ∈ (0, 1) are such that p + q = 1. Show that for all n ⩾ 0 and r ⩾ 1, we have
  ( p(q/p)r + q( p/q)r )n
P Max Mk ⩾ x ⩽ , x > 0.
k=0,1,...,n xr
11

10

8 x= 1.5 , 45530 / 80000 = 0.5691

7

2
xx
1

0
0 1 2 3 Time 4 5 6 7

Figure 1.8: Random walk supremum.*

* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 37

2. Assets, Portfolios, and Arbitrage

In this chapter, the concepts of portfolio, arbitrage, market completeness, pricing, and hedging, are
introduced in a simplified single-step financial model with only two time instants t = 0 and t = 1.
A binary asset price model is considered as an example in Section 2.6.

2.1 Portfolio Allocation and Short Selling 35

2.2 Arbitrage 37
2.3 Risk-Neutral Probability Measures 40
2.4 Hedging of Contingent Claims 44
2.5 Market Completeness 46
2.6 Example: Binary Market 46
Exercises 53

2.1 Portfolio Allocation and Short Selling

We will use the following notation. An element x of Rd +1 is a vector

x = x (0) , x (1) , . . . , x (d )

made of d + 1 components. The scalar product x • y of two vectors x, y ∈ Rd +1 is defined by

x • y : = x (0) y(0) + x (1) y(1) + · · · + x (d ) y(d ) .

The vector
(0) (1) (d )

S0 = S0 , S0 , . . . , S0
(i)
denotes the prices at time t = 0 of d + 1 assets. Namely, S0 > 0 is the price at time t = 0 of asset
no i = 0, 1, . . . , d.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 38 Chapter 2. Assets, Portfolios, and Arbitrage
(i)
The asset values S1 > 0 of assets No i = 0, 1, . . . , d at time t = 1 are represented by the vector
(0) (1) (d )

S 1 = S1 , S1 , . . . , S1 ,

(1) (d )

whose components S1 , . . . , S1 are random variables defined on a probability space (Ω, F , P).
In addition we will assume that asset no 0 is a riskless asset (of savings account type) that yields
an interest rate r > 0, i.e. we have
(0) (0)
S1 = (1 + r )S0 .

Definition 2.1 A portfolio based on the assets 0, 1, . . . , d is a vector

ξ = ξ (0) , ξ (1) , . . . , ξ (d ) ∈ Rd +1 ,

in which ξ (i) represents the (possibly fractional) quantity of asset no i owned by an investor,
i = 0, 1, . . . , d.

The price of such a portfolio, or the cost of the corresponding investment, is given by
d
(i) (0) (1) (d )
ξ • S0 = ∑ ξ ( i ) S0 = ξ (0) S0 + ξ (1) S0 + · · · + ξ (d ) S0
i=0

at time t = 0. At time t = 1 ,the value of the portfolio has evolved into

d
(i) (0) (1) (d )
ξ • S1 = ∑ ξ (i) S1 = ξ (0) S1 + ξ (1) S1 + · · · + ξ (d ) S1 .
i=0

There are various ways to construct a portfolio allocation ξ (i)

i=0,1,...,d
.
(0)
i) If ξ (0) > 0, the investor puts the amount ξ (0) S0 > 0 on a savings account with interest rate r.
(0)
ii) If ξ (0) < 0, the investor borrows the amount −ξ (0) S0 > 0 with the same interest rate r.

iii) For i = 1, 2, . . . , d, if ξ (i) > 0 then the investor purchases a (possibly fractional) quantity
ξ (i) > 0 of the asset no i.

iv) If ξ (i) < 0, the investor borrows a quantity −ξ (i) > 0 of asset i and sells it to obtain the
(i)
amount −ξ (i) S0 > 0.
In the latter case one says that the investor short sells a quantity −ξ (i) > 0 of the asset no i, which
lowers the cost of the portfolio.
Definition 2.2 The short selling ratio, or percentage of daily turnover activity related to short
selling, is defined as as the ratio of the number of daily short sold shares divided by daily volume.

Profits are usually made by first buying at a low price and then selling at a high price. Short sellers
apply the same rule but in the reverse time order: first sell high, and then buy low if possible, by
applying the following procedure.
1. Borrow the asset no i.
(i) (i)
2. At time t = 0, sell the asset no i on the market at the price S0 and invest the amount S0 at
the interest rate r > 0.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 2.2 Arbitrage 39
(i) (i) (i)
3. Buy back the asset no i at time t = 1 at the price S1 , with hopefully S1 < (1 + r )S0 .
4. Return the asset to its owner, with possibly a (small) fee p > 0.*
At the end of the operation the profit made on share no i equals
(i) (i)
(1 + r )S0 − S1 − p > 0,
(i) (i)
which is positive provided that S1 < (1 + r )S0 and p > 0 is sufficiently small.

2.2 Arbitrage
Arbitrage can be described as: .
“the purchase of currencies, securities, or commodities in one market for immediate resale in
others in order to profit from unequal prices”.† eur to usd
In other words, an arbitrage opportunity is the possibility to make a strictly positive amount of
money starting from zero, or even from a negative amount. In a sense, the existence of an arbitrage
opportunity can be seen as a way to “beat” the market. All News Shopping Maps Books More Settings
For example, triangular arbitrage is a way to realize arbitrage opportunities based on discrepan-
cies in the cross exchange rates of foreign currencies, as seen in Figure 2.1.‡
About 18,900,000 results (1.32 seconds)

XE Live Exchange Rates

USD EUR GBP

1.00000 0.89347 0.76988

1.11923 1.00000 0.86167

1 day ago
1.29891 1.16054 1.00000

0.01548 0.01384 0.01192

(b) Cross exchange rates.
(a) (Wikipedia). 1 more row
Figure 2.1: Examples of triangular arbitrage.
XE: Convert EUR/USD. Euro Member Countries to United States Dollar
As an attempt to realize triangular arbitrage based on thewww.xe.com/currencyconverter/convert/?From=EUR&To=USD
data of Figure 2.1b, one could:
1. Change US$1.00 into €0.89347,
2. Change €0.89347 into 0.89347 × 0.86167 = 0.769876295, About this result F
3. Change back 0.769876295 into US$0.769876295 × 1.2981 = US$0.999376418,
which would actually result into a small loss. Alternatively, one could:
1. Change US$1.00 into 0.76988, XE: Convert EUR/USD. Euro Member Countries to United States Dollar
www.xe.com › XE Currency Converter - Live Rates
2. Change 0.76988 into €1.16054 × 0.76988 =€0.893476535,
3. Change back €0.893476535 into US$0.893476535 EUR×to1.11923
USD currency=converter. Get live exchange rates for Euro Member Countries to United Sta
US$1.000005742,
which would result into a small gain, assuming the absenceDollar.of
Usetransaction
XE's free calculator to convert foreign ...
costs.
Next, we state a mathematical formulation of the concept of arbitrage.
XE: EUR / USD Currency Chart. Euro to US Dollar Rates
* The cost p of short selling will not be taken into account in later calculations.
† https://www.collinsdictionary.com/dictionary/english/arbitrage
‡ https://en.wikipedia.org/wiki/Triangular_arbitrage.
www.xe.com › XE Currency Charts
For an example of forex arbitrage, refer to the kimchi
EUR to USD currency chart. XE's free live currency conversion chart for Euro to US Dollar allows y
premium.
pair exchange rate history for up to 10 years.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

EUR to USD Exchange Rate - Bloomberg Markets
https://www.bloomberg.com/quote/EURUSD:CUR
Current exchange rate EURO (EUR) to US DOLLAR (USD) including currency converter, buying & s
 40 Chapter 2. Assets, Portfolios, and Arbitrage

Definition 2.3 A portfolio allocation ξ ∈ Rd +1 constitutes an arbitrage opportunity if the three

following conditions are satisfied:
i) ξ • S0 ⩽ 0 at time t = 0, [Start from a zero-cost portfolio, or with a debt.]

ii) ξ • S1 ⩾ 0 at time t = 1, [Finish with a nonnegative amount.]

iii) P ξ • S1 > 0 > 0 at time t = 1.

[Profit is made with nonzero probability.]

Note that there exist multiple ways to break the assumptions of Definition 2.3 in order to achieve
absence of arbitrage. For example, under absence of arbitrage, satisfying Condition (i) means
that either ξ •
S1 cannot be almost surely* nonnegative (i.e., potential losses cannot be avoided), or
P ξ • S1 > 0 = 0, (i.e., no strictly positive profit can be made).

Realizing arbitrage

In the example below, we realize arbitrage by buying and holding an asset.

(0)
1. Borrow the amount −ξ (0) S0 > 0 on the riskless asset no 0.

(0) (0) (i)

2. Use the amount −ξ (0) S0 > 0 to purchase a quantity ξ (i) = −ξ (0) S0 /S0 , of the risky
(i)
asset no i ⩾ 1 at time t = 0 and price S0 so that the initial portfolio cost is

(0) (i)
ξ (0) S0 + ξ (i) S0 = 0.

(i) (i) (i)

3. At time t = 1, sell the risky asset no i at the price S1 , with hopefully S1 > (1 + r )S0 .

(0)
4. Refund the amount −(1 + r )ξ (0) S0 > 0 with interest rate r > 0.

At the end of the operation the profit made is

(i) (0)
(i) (0)

ξ (i) S1 − − (1 + r )ξ (0) S0 = ξ ( i ) S1 + ( 1 + r ) ξ ( 0 ) S0
(0)
(0) S0 (i) (0)
= −ξ S + ( 1 + r ) ξ ( 0 ) S0
(i) 1
S0
(0)
S (i) (i)

= −ξ (0) 0(i) S1 − (1 + r )S0
S0
( i) (i)

= ξ (i) S1 − (1 + r )S0
> 0,

(i) (i) (i) (i)

or S1 − (1 + r )S0 per unit of stock invested, which is positive provided that S1 > S0 and r is
(i) (i)

sufficiently small. Therefore, arbitrage has been realized if P S1 > S0 > 0.

Arbitrage opportunities can be similarly realized using the short selling procedure described in
Section 2.1.

*“Almost surely”, or “a.s.”, means “with probability one”.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

2.2 Arbitrage 41

City Currency US$

Tokyo JPY 38,800 $346
Hong Kong HK$2,956.67 $381
Seoul KRW 378,533 $400
Taipei NT$12,980 $404
New York US$433 $433
Sydney A$633.28 $483
Frankfurt €399 $513
Paris €399 $513
Rome €399 $513
Brussels €399.66 $514
London £279.99 $527
Manila PhP 29,500 $563
Jakarta Rp 5,754,1676 $627

Figure 2.2: Arbitrage: Retail prices around the world for the Xbox 360 in 2006.

There are many real-life examples of situations where arbitrage opportunities can occur, such as:
- assets with different returns (finance),
- servers with different speeds (queueing, networking, computing),
- highway lanes with different speeds (driving).
In the latter two examples, the absence of arbitrage is consequence of the fact that switching to a
faster lane or server may result into congestion, thus annihilating the potential benefit of the shift.

Table 2.1: Absence of arbitrage - the Mark Six “Investment Table”.

In the table of Figure 2.1 the absence of arbitrage opportunities is materialized by the fact that
the price of each combination is found to be proportional to its probability, thus making the game
fair and disallowing any opportunity or arbitrage that would result of betting on a more profitable
combination.
In what follows, we will work under the assumption that arbitrage opportunities do not occur, and

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 42 Chapter 2. Assets, Portfolios, and Arbitrage

we will rely on this hypothesis for the pricing of financial instruments.

Example: share rights
Let us give a market example of pricing by absence of arbitrage.
From March 24 to 31, 2009, HSBC issued rights to buy shares at the price of $28. This right
behaves similarly to an option in the sense that it gives the right (with no obligation) to buy the
stock at the discount price K = $28. On March 24, the HSBC stock price closed at $41.70.
The question is: how to value the price $R of the right to buy one share? This question can be
answered by looking for arbitrage opportunities. Indeed, the underlying stock can be purchased in
two different ways:
1. Buy the stock directly on the market at the price of $41.70. Cost: $41.70,
or:
2. First, purchase the right at price $R, and then the stock at price $28. Total cost: $R+$28.
a) In case

$R + $28 < $41.70, (2.2.1)

arbitrage would be possible for an investor who owns no stock and no rights, by
i) Buying the right at a price $R, and then
ii) Buying the stock at price $28, and
iii) Reselling the stock at the market price of $41.70.
The profit made by this investor would equal

$41.70 − ($R + $28) > 0.

b) On the other hand, in case

$R + $28 > $41.70, (2.2.2)

arbitrage would be possible for an investor who owns the rights, by:
i) Buying the stock on the market at $41.70,
ii) Selling the right by contract at the price $R, and then
iii) Selling the stock at $28 to that other investor.
In this case, the profit made would equal

$R + $28 − $41.70 > 0.

In the absence of arbitrage opportunities, the combination of (2.2.1) and (2.2.2) implies that
$R should satisfy
$R + $28 − $41.70 = 0,
i.e. the arbitrage-free price of the right is given by the equation

$R = $41.70 − $28 = $13.70. (2.2.3)

Interestingly, the market price of the right was $13.20 at the close of the session on March 24. The
difference of $0.50 can be explained by the presence of various market factors such as transaction
costs, the time value of money, or simply by the fact that asset prices are constantly fluctuating
over time. It may also represent a small arbitrage opportunity, which cannot be at all excluded.
Nevertheless, the absence of arbitrage argument (2.2.3) prices the right at $13.70, which is quite
close to its market value. Thus the absence of arbitrage hypothesis appears as an accurate tool for
pricing.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 2.3 Risk-Neutral Probability Measures 43

2.3 Risk-Neutral Probability Measures

In order to use absence of arbitrage in the general context of pricing financial derivatives, we will
need the notion of risk-neutral probability measure.
The next definition says that under a risk-neutral probability measure, the risky assets no
1, 2, . . . , d have same average rate of return as the riskless asset no 0.
Definition 2.4 A probability measure P∗ on Ω is called a risk-neutral measure if
 (i)  (i)
IE∗ S1 = (1 + r )S0 , i = 1, 2, . . . , d. (2.3.1)

Here, IE∗ denotes the expectation under the probability measure P∗ . Note that for i = 0, we have
 (0)  (0) (0)
IE∗ S1 = S1 = (1 + r )S0 by definition.
(i)
In other words, P∗ is called risk-neutral because taking risks under P∗ by buying a stock S1
has a neutral effect: on average the expected yield of the risky asset equals the risk-free interest rate
obtained by investing on the savings account with interest rate r, i.e., we have
(i) (i)
" #
S1 − S0
IE∗ (i)
= r.
S0

On the other hand, under a “risk premium” probability measure P# , the expected return (or net
(i)
discounted gain) of the risky asset S1 would be higher than r, i.e., we would have

(i) (i)
" #
S1 − S0
IE# (i)
> r,
S0
or
 (i)  (i)
IE# S1 > (1 + r )S0 , i = 1, 2, . . . , d,
(i)
whereas under a “negative premium” measure P♭ , the expected return of the risky asset S1 would
be lower than r, i.e., we would have
" (i) (i)
#
♭ S1 − S0
IE (i)
< r,
S0
or
 (i)  (i)
IE♭ S1 < (1 + r )S0 , i = 1, 2, . . . , d.
In the sequel we will only consider probability measures P∗ that are equivalent to P, in the sense
that they share the same events of zero probability.
Definition 2.5 A probability measure P∗ on (Ω, F ) is said to be equivalent to another proba-
bility measure P when

P∗ (A) = 0 if and only if P(A) = 0, for all A ∈ F. (2.3.2)

The following Theorem 2.6 can be used to check for the existence of arbitrage opportunities, and is
known as the first fundamental theorem of asset pricing.

Theorem 2.6 A market is without arbitrage opportunity if and only if it admits at least one
risk-neutral probability measure P∗ equivalent to P.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 44 Chapter 2. Assets, Portfolios, and Arbitrage

Proof. (i) Sufficiency. Assume that there exists a risk-neutral probability measure P∗ equivalent to
P. Since P∗ is risk-neutral, we have

d
(i) 1 d (i) ∗  (i)  1
∑ ξ (i) S0 = IE∗ ξ • S1 .
 
ξ • S0 = ∑ ξ IE S1 = (2.3.3)
i=0 1 + r i=0 1+r

We proceed by contradiction, and suppose that the market admits an arbitrage opportunity ξ
according to Definition 2.3.

In this case, Definition
(ii) shows that ξ S1 ⩾ 0, and Definition
2.3- 2.3-
•

(iii) implies P ξ • S1 > 0 > 0, hence P ξ • S1 > 0 > 0 because P is equivalent to P∗ . Since by
∗

Relation (11.2.5) we have

0 < P∗ ξ • S1 > 0


[ 
= P∗ ξ • S1 > 1/n
n⩾1

lim P∗ ξ • S1 > 1/n

=
n→∞
= lim P∗ ξ • S1 > ε ,


ε↘0

there exists ε > 0 such that P∗ ξ • S1 ⩾ ε > 0, hence

IE∗ ξ • S1 ⩾ IE∗ ξ • S1 1{ξ S1 ⩾ε}

   
•

⩾ ε IE∗ 1{ξ S1 ⩾ε}

 
•

= εP∗ ξ • S1 ⩾ ε

> 0,
and by (2.3.3) we conclude that
1
IE∗ ξ • S1 > 0,
 
ξ • S0 =
1+r
which contradicts Definition 2.3-(i). We conclude that the market is without arbitrage opportunities.
(ii) The proof of necessity, see Theorem 1.6 in Föllmer and Schied, 2004, relies on the theorem
of separation of convex sets by hyperplanes Proposition 2.7 below. It can be briefly sketched as
(1) (2)

follows in the case d = 2 of a portfolio including two risky assets priced Si , Si i=0,1 with
discounted market returns
(1) (1) (2) (2)
S1 − S0 S1 − S0
R(1) : = (1)
− r, R(2) : = (2)
− r.
S0 S0
Assume that the relation

IEQ R(2) = IEQ R(1) = 0

   
(2.3.4)

does not hold for any Q in the family P of probability measures Q on Ω equivalent to P. We now
apply the convex separation theorem Proposition 2.7 below to the convex subset

C := IEQ R(1) , IEQ R(2) : Q ∈ P

    

of R2 . If (2.3.4) does not hold under any P∗ ∈ P then (0, 0) ∈

/ C , and Proposition 2.7 applied to
the convex sets C and {(0, 0)} shows the existence of c ∈ R such that

IEQ R(1) + cR(2) = IEQ R(1) + c IEQ R(2) ⩾ 0 for all Q ∈ P,

     
(2.3.5)

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

2.3 Risk-Neutral Probability Measures 45

and the existence of P∗ ∈ P such that

IEP∗ R(1) + cR(2) = IEP∗ R(1) + c IEP∗ R(2) > 0,

     
(2.3.6)

up to a change of direction in both inequalities. As it holds for all Q ∈ P, the inequality (2.3.5)
shows that*
R(1) + cR(2) ⩾ 0, P∗ -almost surely,
while (2.3.6) implies

P∗ R(1) + cR(2) > 0 > 0.

(2.3.7)

Next, choosing a ∈ R such that

(0) (1) (2)
aS0 + S0 + cS0 = 0,
the portfolio allocation
(1)
!
(0) (1) (2)

S0
ξ := ξ ,ξ ,ξ = a, 1, c (2)
,
S0
(0) (1) (2)

on the assets S0 , S0 , S0 satisfies ξ • S0 = 0 and
(0) (1) (2)
ξ • S1 = ξ (0) S1 + ξ (1) S1 + ξ (2) S1
(1)
(0)
(1) S
(2)
= (1 + r )aS0 + 1 + r + R(1) S0 + c 0(2) 1 + r + R(2) S0
S0
( 1 )
= R(1) + cR(2) S0

⩾ 0, P − a.s.,

hence Definition 2.3-(i)-(ii) is satisfied, and (2.3.7) shows that

P∗ ξ • S1 = P∗ R(1) + cR(2) > 0 > 0,

hence Definition 2.3-(iii) is satisfied and ξ would be an arbitrage opportunity, which contradicts
our hypothesis. Therefore, there exists P∗ ∈ P such that (2.3.4) is satisfied, i.e.
 (1) 
(1)  (1)
IEP∗ S1 = IEP∗ 1 + r + R(1) S0 = (1 + r )S0


and  (2) 
(2)  (2)

IEP∗ S1 = IEP∗ 1 + r + R(2) S0 = (1 + r )S0 ,


and P∗ is a risk-neutral probability measure. □

Next is a version of the separation theorem for convex sets, used in the above proof, which relies on
the more general Theorem 2.8 below.

Proposition 2.7 Let C be a convex set in R2 such that (0, 0) ∈

/ C . Then, there exists c ∈ R such
that, e.g.,
x + cy ⩾ 0,
for all (x, y) ∈ C , and there exists (x∗ , y∗ ) ∈ C such that

x∗ + cy∗ > 0,

*“Almost surely”, or “a.s.”, means “with probability one”.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 46 Chapter 2. Assets, Portfolios, and Arbitrage

up to a change of direction in both inequalities “⩾” and “>”.

Proof. Theorem 2.8 below applied to C1 := {(0, 0)} and to C2 := C shows that for some numbers
a, c we have, e.g.,

0 + 0 × c = 0 ⩽ a ⩽ x + cy

for all (x, y) ∈ C .

x + cy = a y
x + cy ⩾ a

x + cy ⩽ a
C
x
(0, 0)

This allows us to conclude when a > 0. When a = 0, if x + cy = 0 for all (x, y) ∈ C then the convex
set C is an interval part of a straight line crossing (0, 0), for which there exists c̃ ∈ R such that
x + c̃y ⩾ 0 for all (x, y) ∈ C and x∗ + c̃y∗ > 0 for some (x∗ , y∗ ) ∈ C , because (0, 0) ∈
/ C.

x + cy = 0 y

x + c̃y = 0 C

x
(0, 0)

The proof of Proposition 2.7 relies on the following result, see e.g. Theorem 4.14 in Hiriart-Urruty
and Lemaréchal, 2001.

Theorem 2.8 Let C1 and C2 be two disjoint convex sets in R2 . Then there exists a, c ∈ R such
that

x + cy ⩽ a (x, y) ∈ C1 ,
and

a ⩽ x + cy, (x, y) ∈ C2 ,
up to exchange of C1 and C2 .

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 2.4 Hedging of Contingent Claims 47

x + cy = a

x + cy ⩽ a

x + cy ⩾ a
C1

C2

Figure 2.3: Separation of convex sets by the linear equation x + cy = a.

2.4 Hedging of Contingent Claims

In this section we consider the notion of contingent claim. The adjective “contingent” means:
1. Subject to chance.
2. Occurring or existing only if (certain circumstances) are the case; dependent on.
More generally, we will work according to the following broad definition which covers contingent
claims such as options, forward contracts etc.
Definition 2.9 A contingent claim is a financial derivative whose payoff C : Ω −→ R is a
random variable depending on the realization(s) of uncertain event(s).

In practice, the random variable C will represent the payoff of an (option) contract at time t = 1.
Referring to Definition 2, the European call option with maturity t = 1 on the asset no i is a
contingent claim whose payoff C is given by

(i) (i)

+  S1 − K if S1 ⩾ K,

(i)
C = S1 − K : =
 (i)
0 if S1 < K,


where K is called the strike price. The claim payoff C is called “contingent” because its value may
(i)
depend on various market conditions, such as S1 > K. A contingent claim is also called a financial
“derivative” for the same reason.
Similarly, referring to Definition 1, the European put option with maturity t = 1 on the asset no
i is a contingent claim with payoff

(i) (i)
 K − S1
 if S1 ⩽ K,
(i) +


C = K − S1 :=
 (i)
0 if S1 > K,


Definition 2.10 A contingent claim with payoff C is
said to be attainable at time t = 1 if there
exists a portfolio allocation ξ = ξ (0) , ξ (1) , . . . , ξ (d ) such that

d
(i) (0) (1) (d )
C = ξ • S1 = ∑ ξ ( i ) S1 = ξ (0) S1 + ξ (1) S1 + · · · + ξ (d ) S1 ,
i=0

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 48 Chapter 2. Assets, Portfolios, and Arbitrage

with P-probability one.

When a contingent claim with payoff C is attainable, a trader will be able to:
1. at time t = 0, build a portfolio allocation ξ = ξ (0) , ξ (1) , . . . , ξ (d ) ∈ Rd +1 ,

2. invest the amount

d
(i)
ξ • S0 = ∑ ξ (i) S0
i=0

in this portfolio at time t = 0,

3. at time t = 1, obtain the equality
d
(i)
C= ∑ ξ ( i ) S1
i=0

and pay the claim amount C using the portfolio value

d
(i) (0) (1) (d )
ξ • S1 = ∑ ξ ( i ) S1 = ξ (0) S1 + ξ (1) S1 + · · · + ξ (d ) S1 .
i=0

We note that in order to attain the claim payoff C, an initial investment ξ • S0 is needed at time t = 0.
This amount, to be paid by the buyer to the issuer of the option (the option writer), is also called the
arbitrage-free price, or option premium, of the contingent claim, and is denoted by
d
(i)
π0 (C ) := ξ • S0 = ∑ ξ ( i ) S0 . (2.4.1)
i=0

The action of allocating a portfolio allocation ξ such that

d
(i)
C = ξ • S1 = ∑ ξ ( i ) S1 (2.4.2)
i=0

is called hedging, or replication, of the contingent claim with payoff C.

Definition 2.11 In case the portfolio value ξ • S1 at time t = 1 exceeds the amount of the claim,
i.e. when
ξ • S1 ⩾ C,
we say that the portfolio allocation ξ = ξ (0) , ξ (1) , . . . , ξ (d ) is super-hedging the claim C.

In this document we only focus on hedging, i.e. on replication of the contingent claim with payoff
C, and we will not consider super-hedging.
As a simplified illustration of the principle of hedging, one may purchase an oil-related asset in
order to hedge oneself against a potential price rise of gasoline. In this case, any increase in the
price of gasoline that would result in a higher value of the financial derivative C would be correlated
to an increase in the underlying asset value, so that the equality (2.4.2) would be maintained.

2.5 Market Completeness

Market completeness is a strong property, stating that any contingent claim available on the market
can be perfectly hedged.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 2.6 Example: Binary Market 49
Definition 2.12 A market model is said to be complete if every contingent claim is attainable.

The next result is the second fundamental theorem of asset pricing.

Theorem 2.13 A market model without arbitrage opportunities is complete if and only if it
admits only one equivalent risk-neutral probability measure P∗ .
Proof. See the proof of Theorem 1.40 in Föllmer and Schied, 2004. □
Theorem 2.13 will give us a concrete way to verify market completeness by searching for a unique
solution P∗ to Equation (2.3.1).

2.6 Example: Binary Market

In this section we work out a simple example that allows us to apply Theorem 2.6 and Theorem 2.13.
We take d = 1, i.e. the portfolio is made of
(0)
- a riskless asset with interest rate r and priced (1 + r )S0 at time t = 1,
(1)
- and a risky asset priced S1 at time t = 1.
We use the probability space
Ω = {ω − , ω + },
which is the simplest possible nontrivial choice of probability space, made of only two possible
outcomes with
P({ω − }) > 0 and P({ω + }) > 0,
in order for the setting to be nontrivial. In other words the behavior of the market is subject to
only two possible outcomes, for example, one is expecting an important binary decision of “yes/no”
type, which can lead to two distinct scenarios called ω − and ω + .
(1)
In this context, the asset price S1 is given by a random variable
(1)
S1 : Ω −→ R
whose value depends on whether the scenario ω − , resp. ω + , occurs.
Precisely, we set
(1) (1)
S1 (ω − ) = a, and S1 (ω + ) = b,
(1)
i.e., the value of S1 becomes equal a under the scenario ω − , and equal to b under the scenario
ω + , where 0 < a < b. *
Arbitrage
The first natural question is:
- Arbitrage: Does the market allow for arbitrage opportunities?
We will answer this question using Theorem 2.6, by searching for a risk-neutral probability measure
P∗ satisfying the relation
 (1)  (1)
IE∗ S1 = (1 + r )S0 , (2.6.1)
where r > 0 denotes the risk-free interest rate, cf. Definition 2.4.
In this simple framework, any measure P∗ on Ω = {ω − , ω + } is characterized by the data of two
numbers P∗ ({ω − }) ∈ [0, 1] and P∗ ({ω + }) ∈ [0, 1], such that
P∗ (Ω) = P∗ ({ω − }) + P∗ ({ω + }) = 1. (2.6.2)
* The case a = b leads to a trivial, constant market.

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 50 Chapter 2. Assets, Portfolios, and Arbitrage

Here, saying that P∗ is equivalent to P simply means that

P∗ ({ω − }) > 0 and P∗ ({ω + }) > 0.

Although we should solve (2.6.1) for P∗ , at this stage it is not yet clear how P∗ is involved in the
equation. In order to make (2.6.1) more explicit we write the expected value as
 (1)  (1) (1)
IE∗ S1 = aP∗ S1 = a + bP∗ S1 = b ,

hence Condition (2.6.1) for the existence of a risk-neutral probability measure P∗ reads
(1) (1) (1)
aP∗ S1 = a + bP∗ S1 = b = (1 + r )S0 .

Using the Condition (2.6.2) we obtain the system of two equations

(1)

 aP∗ ({ω − }) + bP∗ ({ω + }) = (1 + r )S0
(2.6.3)
P∗ ({ω − }) + P∗ ({ω + })

= 1,

with unique risk-neutral solution

(1 + r )S0(1) − a

∗ ∗ ∗ (1)
 p := P ({ω }) = P S1 = b =


 +
b−a
(2.6.4)
(1)
 q∗ := P∗ ({ω − }) = P∗ S(1) = a = b − (1 + r )S0 .




1
b−a

In order for a solution P∗ to exist as a probability measure, the numbers P∗ ({ω − }) and P∗ ({ω + })
must be nonnegative. In addition, for P∗ to be equivalent to P they should be strictly positive from
(2.3.2).
We deduce that if a, b and r satisfy the condition

(1)
a < (1 + r )S0 < b, (2.6.5)

then there exists a risk-neutral equivalent probability measure P∗ which is unique, hence by
Theorems 2.6 and 2.13 the market is without arbitrage and complete.

R
(1) (1)
i) If a = (1 + r )S0 , resp. b = (1 + r )S0 , then P∗ ({ω + }) = 0, resp. P∗ ({ω − }) = 0,
and P∗ is not equivalent to P in the sense of Definition 2.5.
Therefore, we check from (2.6.4) that the condition
(1) (1)
a < b ⩽ (1 + r )S0 or (1 + r )S0 ⩽ a < b, (2.6.6)

do not imply existence of an equivalent risk-neutral probability measure and absence of

arbitrage opportunities in general.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

2.6 Example: Binary Market 51
(1)
ii) If a = b = (1 + r )S0 then (2.3.1) admits an infinity of solutions, hence the market is
without arbitrage, but it is not complete. More precisely, in this case both the riskless
and risky assets yield a deterministic return rate r and the portfolio value becomes

ξ • S1 = ( 1 + r ) ξ • S0 ,

at time t = 1, hence the terminal value ξ • S1 is deterministic and this single value
can not always match the value of a contingent claim with (random) payoff C, that
could be allowed to take two distinct values C (ω − ) and C (ω + ). Therefore, market
(1)
completeness does not hold when a = b = (1 + r )S0 .

Let us give a financial interpretation of Condition (2.6.6).

(1)
1. If (1 + r )S0 ⩽ a < b, let ξ (1) := 1 and choose ξ (0) such that
(0) (1)
ξ (0) S0 + ξ (1) S0 = 0

according to Definition 2.3-(i), i.e.

(1)
S0
ξ (0) = −ξ (1) (0)
< 0.
S0

a
(1)
S0
(1) ( 1 + r ) S0

In particular, Condition (i)) of Definition 2.3 is satisfied, and the investor borrows the amount
(0)
−ξ (0) S0 > 0 on the riskless asset and uses it to buy one unit ξ (1) = 1 of the risky asset. At
(1)
time t = 1 he sells the risky asset S1 at a price at least equal to a and refunds the amount
(0)
−(1 + r )ξ (0) S0 > 0 that he borrowed, with interest. The profit of the operation is
(0) (1)
ξ • S1 = (1 + r )ξ (0) S0 + ξ (1) S1
(0)
⩾ ( 1 + r ) ξ ( 0 ) S0 + ξ ( 1 ) a
(1)
= −(1 + r )ξ (1) S0 + ξ (1) a
(1)
= ξ ( 1 ) − ( 1 + r ) S0 + a

⩾ 0,
which satisfies Condition (ii)) of Definition 2.3. In addition, Condition (iii)) of Definition 2.3
is also satisfied because
(1)
P ξ • S1 > 0 = P S1 = b = P({ω + }) > 0.

(1)
2. If a < b ⩽ (1 + r )S0 , let ξ (0) > 0 and choose ξ (1) such that
(0) (1)
ξ (0) S0 + ξ (1) S0 = 0,

according to Definition 2.3-(i), i.e.

(0)
(1) ( 0 ) S0
ξ = −ξ (1)
< 0.
S0

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 52 Chapter 2. Assets, Portfolios, and Arbitrage

(1)
(1 + r )S0
b
(1)
S0 a

This means that the investor borrows a (possibly fractional) quantity −ξ (1) > 0 of the risky
(1)
asset, sells it for the amount −ξ (1) S0 , and invests this money on the riskless account for
(0)
the amount ξ (0) S0 > 0. As mentioned in Section 2.1, in this case one says that the investor
(0)
shortsells the risky asset. At time t = 1 she obtains (1 + r )ξ (0) S0 > 0 from the riskless
asset, spends at most b to buy back the risky asset, and returns it to its original owner. The
profit of the operation is
(0) (1)
ξ • S1 = (1 + r )ξ (0) S0 + ξ (1) S1
(0)
⩾ ( 1 + r ) ξ ( 0 ) S0 + ξ ( 1 ) b
(1)
= −(1 + r )ξ (1) S0 + ξ (1) b
(1)
= ξ ( 1 ) − ( 1 + r ) S0 + b

⩾ 0,
(1)
since ξ (1) < 0. Note that here, a ⩽ S1 ⩽ b became

(1)
ξ (1) b ⩽ ξ (1) S1 ⩽ ξ (1) a

because ξ (1) < 0. We can check as in Part 1 above that Conditions (i))-(iii)) of Definition 2.3
are satisfied.
(1)
3. Finally if a = b ̸= (1 + r )S0 , then (2.3.1) admits no solution as a probability measure P∗
hence arbitrage opportunities exist and can be constructed by the same method as above.
Under Condition (2.6.5) there is absence of arbitrage and Theorem 2.6 shows that no portfolio
(0) (1)
strategy can yield both ξ • S1 ⩾ 0 and P ξ • S1 > 0 > 0 starting from ξ (0) S0 + ξ (1) S0 ⩽ 0,

however, this is less simple to show directly.

Market completeness
The second natural question is:
- Completeness: Is the market complete, i.e., are all contingent claims attainable?
In what follows we work under the condition

(1)
a < (1 + r )S0 < b,

under which Theorems 2.6 and 2.13 show that the market is without arbitrage and complete since
the risk-neutral probability measure P∗ exists and is unique.

(1)
S0
(1) ( 1 + r ) S0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

2.6 Example: Binary Market 53

Let us recover this fact by elementary calculations. For any contingent claim with payoff C we
( 0 ) ( 1 )


need to show that there exists a portfolio allocation ξ = ξ , ξ such that C = ξ • S1 , i.e.

(0)
 (1 + r )ξ (0) S0 + ξ (1) b = C (ω + )

(2.6.7)
 ( 0 ) (0) ( 1 ) −
(1 + r )ξ S0 + ξ a = C (ω ).


These equations can be solved as

bC (ω − ) − aC (ω + ) C (ω + ) −C (ω − )
ξ (0) = and ξ (1) = . (2.6.8)
(0)
S0 (1 + r )(b − a) b−a

In this case, we say that the portfolio allocation ξ (0) , ξ (1) hedges the contingent claim with payoff

C. In other words, any contingent claim is attainable, and the market is indeed complete. Here, the
quantity
(0) bC (ω − ) − aC (ω + )
ξ ( 0 ) S0 =
(1 + r )(b − a)
represents the amount invested on the riskless asset. Note that if C (ω + ) ⩾ C (ω − ), then ξ (1) ⩾ 0
and there is not short selling.
(1)

When C has the form C = h S1 , we have
C (ω + ) −C (ω − )
ξ (1) =
b−a
(1) (1)
h S1 (ω + ) − h S1 (ω − )



=
b−a
h(b) − h(a)
= .
b−a
Hence when x 7−→ h(x) is a non-decreasing function we have ξ (1) ⩾ 0 and there is no short selling.
This applies in particular to European call options with strike price K, for which the function
h(x) = (x − K )+ is non-decreasing.
In case h is a non-increasing function, which is the case in particular for European put options
with payoff function h(x) = (K − x)+ , we will similarly find that ξ (1) ⩽ 0, i.e. short selling always
occurs in this case.
Arbitrage-free price
Definition 2.14 The arbitrage-free price π0 (C ) of the contingent claim with payoff C is defined
in (2.4.1) as the initial value at time t = 0 of the portfolio hedging C, i.e.
d
(i)
π0 (C ) = ξ • S0 = ∑ ξ (i) S0 , (2.6.9)
i=0

where ξ (0) , ξ (1) are given by (2.6.8).

Arbitrage-free prices can be used to ensure that financial derivatives are “marked” at their fair value
(mark to market).* Note that π0 (C ) cannot be 0 since this would entail the existence of an arbitrage
opportunity according to Definition 2.3.
The next proposition shows that the arbitrage-free price π0 (C ) of the claim can be computed as
the expected value of its payoff C under the risk-neutral probability measure, after discounting by
the factor 1 + r in order to account for the time value of money.
* Not to be confused with “market making”.

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 54 Chapter 2. Assets, Portfolios, and Arbitrage

Proposition 2.15 The arbitrage-free price π0 (C ) = ξ • S0 of the contingent claim with payoff C
is given by
1
π0 (C ) = IE∗ [C ]. (2.6.10)
1+r

Proof. Using the expressions (2.6.4) for the risk-neutral probabilities P∗ ({ω − }), P∗ ({ω + }), and
( 0 ) ( 1 )


(2.6.8) for the portfolio allocation ξ , ξ , we have

π0 (C ) = ξ • S0
(0) (1)
= ξ (0) S0 + ξ (1) S0
bC (ω − ) − aC (ω + ) + −
(1) C (ω ) −C (ω )
= + S0
(1 + r )(b − a) b−a
(1) (1)
!
1 b − S0 (1 + r ) ( 1 + r ) S0 − a
= C (ω − ) + C (ω + )
1+r b−a b−a
1 
(1) (1)

C (ω − )P∗ S1 = a + C (ω + )P∗ S1 = b


=
1+r
1
= IE∗ [C ].
1+r
□
(1)
+
In the case of a European call option with strike price K ∈ [a, b], we have C = S1 − K and
(1)
+
1  (1)
+ 
π0 S1 − K = IE∗ S1 − K
1+r
1 (1)
(b − K )P∗ S1 = b


=
1+r
(1)
1 (1 + r )S0 − a
= (b − K ) .
1+r  b− a
b−K (1) a
= S0 − .
b−a 1+r
(1)
+
In the case of a European put option, we have C = K − S1 and
(1)
+
1 (1)
+ 
IE∗ K − S1

π0 K − S1 =
1+r
1 (1)
(K − a)P∗ S1 = a


=
1+r
(1)
1 b − (1 + r )S0
(K − a)
= .
1+r  b− a
K −a b (1)
= − S0 .
b−a 1+r
(1)
+ (1)
+
Here, S0 − K , resp. K − S0 is called the intrinsic value at time 0 of the call, resp. put
option.
The simple setting described in this chapter raises several questions and remarks.

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2.6 Example: Binary Market 55

Remarks
1. The fact that π0 (C ) can be obtained by two different methods, i.e. an algebraic method via
(2.6.8) and (2.6.9) and a probabilistic method from (2.6.10), is not a simple coincidence.
It is actually a simple example of the deep connection that exists between probability and
analysis.
In a continuous-time setting, (2.6.8) will be replaced with a partial differential equation
(PDE), and (2.6.10) will be computed via the Monte Carlo method. In practice, the quan-
titative analysis departments of major financial institutions may be split into a “PDE team”
and a “Monte Carlo team”, often trying to determine the same option prices by two different
methods.
(1)
2. What if we have three possible scenarios, i.e. Ω = {ω − , ω o , ω + } and the random asset S1
(1)
is allowed to take more than two values, e.g. S1 ∈ {a, b, c} according to each scenario? In
this case the system (2.6.3) would be rewritten as
(1)

 aP∗ ({ω − }) + bP∗ ({ω o }) + cP∗ ({ω + }) = (1 + r )S0

P∗ ({ω − }) + P∗ ({ω o }) + P∗ ({ω + }) = 1,



and this system of two equations with three unknowns does not admit a unique solution,
hence the market can be without arbitrage but it cannot be complete, cf. Exercise 2.5.
Market completeness can be reached by adding a second risky asset to the portfolio, i.e. by
taking d := 2, in which case we will get three equations and three unknowns. More generally,
when Ω contains n ⩾ 2 market scenarios, completeness of the market can be reached provided
that we consider d risky assets with d + 1 ⩾ n. This is related to the Meta-Theorem 8.3.1 of
Björk, 2004, in which the number d of traded risky underlying assets is linked to the number
of random sources through arbitrage and market completeness.

Exercises

Exercise 2.1 Consider a risky asset valued S0 = $3 at time t = 0 and taking only two possible
values S1 ∈ {$1, $5} at time t = 1, and a financial claim given at time t = 1 by

 $0 if S1 = $5
C :=
$2 if S1 = $1.


Is C the payoff of a call option or of a put option? Give the strike price of the option.

Exercise 2.2 Consider a risky asset valued S0 = $4 at time t = 0, and taking only two possible
values S1 ∈ {$2, $5} at time t = 1. Find the portfolio allocation (ξ , η ) hedging the claim payoff

 $0 if S1 = $5
C=
$6 if S1 = $2


at time t = 1, compute its price V0 = ξ S0 + $η at time t = 0, and determine the corresponding

risk-neutral probability measure P∗ .

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 56 Chapter 2. Assets, Portfolios, and Arbitrage

Exercise 2.3 Consider a risky asset valued S0 = $4 at time t = 0, and taking only two possible
values S1 ∈ {$5, $2} at time t = 1, and the claim payoff

 $3 if S1 = $5
C= at time t = 1.
$0 if S1 = $2.


We assume that the issuer charges $1 for the option contract at time t = 0.
a) Compute the portfolio allocation (ξ , η ) made of ξ stocks and $η in cash, so that:
i) the full $1 option price is invested into the portfolio at time t = 0,
and
ii) the portfolio reaches the C = $3 target if S1 = $5 at time t = 1.
b) Compute the loss incurred by the option issuer if S1 = $2 at time t = 1.

Exercise 2.4
a) Consider the following market model:
b

a
(1)
(1)
S0
(1 + r )S0

i) Does this model allow for arbitrage?

Yes | No |
ii) If this model allows for arbitrage opportunities, how can they be realized?
By shortselling | By borrowing on savings | N.A. |
b) Consider the following market model:
b
(1)
( 1 + r ) S0
(1)
S0 a

i) Does this model allow for arbitrage?

Yes | No |
ii) If this model allows for arbitrage opportunities, how can they be realized?
By shortselling | By borrowing on savings | N.A. |
c) Consider the following market model:
(1)
( 1 + r ) S0
b
(1)
S0 a

i) Does this model allow for arbitrage?

Yes | No |

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2.6 Example: Binary Market 57

ii) If this model allows for arbitrage opportunities, how can they be realized?
By shortselling | By borrowing on savings | N.A. |

Exercise 2.5 In a market model with two time instants t = 0 and t = 1 and risk-free interest rate r,
consider
(0) (0) (0)
- a riskless asset valued S0 at time t = 0, and value S1 = (1 + r )S0 at time t = 1.
(1)
- a risky asset with price S0 at time t = 0, and three possible values at time t = 1, with a < b < c,
i.e.:
 (1)

 S0 (1 + a),




(1) (1)
S1 = S0 (1 + b),




 (1)

S0 ( 1 + c ) .
a) Show that this market is without arbitrage but not complete.
b) In general, is it possible to hedge (or replicate) a claim with three distinct claim payoff values
Ca ,Cb ,Cc in this market?

(0) (0)
Exercise 2.6 We consider a riskless asset valued S1 = S0 , at times k = 0, 1, with risk-free interest
(1) (1)
(1)
rate is r = 0, and a risky asset S(1) whose return R1 := S1 − S0 /S0 can take three values
(−b, 0, b) at each time step, with b > 0 and

p∗ := P∗ (R1 = b) > 0, θ ∗ := P∗ (R1 = 0) > 0, q∗ := P∗ (R1 = −b) > 0,

a) Determine all possible risk-neutral probability measures P∗ equivalent to P in the sense of

∗ ∗
" (1)θ ∈(1()0,
Definition 2.5 in terms of the parameter # 1), from the condition IE [R1 ] = 0.
S −S
b) We assume that the variance Var∗ 1 (1) 0 = σ 2 > 0 of the asset return is known to
S0
be equal to σ 2 . Show that this condition provides a way to select a unique risk-neutral
probability measure P∗σ under a certain condition on b and σ .

Exercise 2.7
a) Consider the following binary one-step model (St )t =0,1,2 with interest rate r = 0 and P(S1 =
2) = 1/3.

S1 = 2

S0 = 1 S1 = 1

i) Is the model without arbitrage?

Yes | No |

ii) Does there exist a risk-neutral measure P∗ equivalent to P in the sense of Definition 2.5?
Yes | No |
b) Consider the following ternary one-step model with r = 0, P(S1 = 2) = 1/4 and P(S1 =
1) = 1/9.

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 58 Chapter 2. Assets, Portfolios, and Arbitrage

S1 = 2

S0 = 1 S1 = 1

S1 = 0

i) Does there exist a risk-neutral measure P∗ equivalent to P in the sense of Definition 2.5?
Yes | No |

ii) Is the model without arbitrage?

Yes | No |

iii) Is the market complete?

Yes | No |

iv) Does there exist a unique risk-neutral measure P∗ equivalent to P in the sense of
Definition 2.5?
Yes | No |

Exercise 2.8 The S. Ross, 2015 Recovery Theorem allows for estimates of the real-world transition
probabilities of an underlying asset from option prices in a Markovian state model. We consider a
one-step asset price model with two possible states {s1 , s2 }, and let Xt ∈ {s1 , s2 } denote the state
of the market at times t = 0, 1. Let B1 , B2 denote two binary options maturing at t = 1, with
respective payoffs
1{X1 =s1 } and 1{X1 =s2 } ,
i.e. Bl pays $1 at t = 1 if and only if X1 = sl , l = 1, 2. For k, l = 1, 2 we denote by bk,l > 0 the
known market price of the binary option Bl given that X0 = sk .
a) In this question, we aim at recovering the risk-neutral probabilities
s1 s2
s1 p1,1 p∗1,2
 ∗ 
∗
P =
s2 p∗2,1 p∗2,2
s1 s2
P∗ (X1 P∗ (X1
 
s1 = s1 | X0 = s1 ) = s2 | X0 = s1 )
=
s2 P∗ (X1 = s1 | X0 = s2 ) P∗ (X1 = s2 | X0 = s2 )
using risk-neutral pricing.
1) From Proposition 2.15, express bk,l using:
i) the price dk of the bond paying $1 at t = 1 when the market starts from state sk at
t = 0, and
ii) the risk-neutral probability p∗k,l that the market switches from state sk at t = 0 to
state sl at t = 1.
2) Write the price dk of the bond paying $1 at t = 1 in terms of the prices bk,1 > 0 and
bk,2 > 0 of B1 and B2 when the market starts from state sk at t = 0, k = 1, 2.
3) For k = 1, 2, show that the risk-neutral probabilities p∗k,1 , p∗k,2 can be recovered in terms
of the known prices bk,1 > 0, bk,2 > 0, and provide their expressions.
b) In this question, we aim at recovering the real-world probabilities
s s2
 1 
s1 p1,1 p1,2
P =
s2 p2,1 p2,2

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2.6 Example: Binary Market 59

s1 s2
s1 P(X1 = s1 | X0 = s1 ) P(X2 = s2 | X0 = s1 )
 
=
s2 P(X1 = s1 | X0 = s2 ) P(X1 = s2 | X0 = s2 )
using marginal utility pricing. For this, we price the binary option Bl by the relation

ul bk,l = δ uk pk,l , k, l = 1, 2, (2.6.11)

where δ > 0 is an unknown time discount factor and u1 > 0, u2 > 0 represent unknown
marginal utilities in states s1 , s2 .
1) How many unknowns do we have? How many equations do we have?
2) Show that the following matrix equation holds:
     
b1,1 b1,2 u1 u1
× =δ .
b2,1 b2,2 u2 u2

3) Prove that there is a unique set of strictly positive values δ , u1 , u2 that satisfy the pricing
equation (2.6.11), provide their expressions in terms of bk,l , k, l = 1, 2, and justify your
choice.
Hint. Diagonalize the matrix B.
4) Show that the real-world transition probabilities pk,l and the time discount factor δ > 0
can be recovered from the known binary option prices bk,l > 0 for k, l = 1, 2, and
provide their expressions.

Exercise 2.9 Consider a one-step market model with two time instants t = 0 and t = 1 and two
assets:
- a riskless asset π with price π0 at time t = 0 and value π1 = π0 (1 + r ) at time t = 1,
- a risky asset S with price S0 at time t = 0 and random value S1 at time t = 1.
We assume that S1 can take only the values S0 (1 + a) and S0 (1 + b), where −1 < a < r < b. The
return of the risky asset is defined as
S1 − S0
R= .
S0
a) What are the possible values of R?
b) Show that under the probability measure P∗ defined by

b−r r−a
P∗ (R = a) = , P∗ (R = b) = ,
b−a b−a
the expected return IE∗ [R] of S is equal to the return r of the riskless asset.
c) Does there exist arbitrage opportunities in this model? Explain why.
d) Is this market model complete? Explain why.
e) Consider a contingent claim with payoff C given by

 ξ if R = a,
C=
if R = b.

η

Show that the portfolio allocation (η, ξ ) defined* by

ξ (1 + b) − η (1 + a) η −ξ
η= and ξ= ,
π0 (1 + r )(b − a) S0 ( b − a )
* Here, η is the (possibly fractional) quantity of asset π and ξ is the quantity held of asset S.

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 60 Chapter 2. Assets, Portfolios, and Arbitrage

hedges the contingent claim with payoff C, i.e. show that at time t = 1, we have

ηπ1 + ξ S1 = C.

Hint: Distinguish two cases R = a and R = b.

f) Compute the arbitrage-free price π0 (C ) of the contingent claim payoff C using η, π0 , ξ , and
S0 .
g) Compute IE∗ [C ] in terms of a, b, r, ξ , η.
h) Show that the arbitrage-free price π0 (C ) of the contingent claim with payoff C satisfies

1
π0 (C ) = IE∗ [C ]. (2.6.12)
1+r
i) What is the interpretation of Relation (2.6.12) above?
j) Let C denote the payoff at time t = 1 of a put option with strike price K=$11 on the risky
asset. Give the expression of C as a function of S1 and K.
k) Letting π0 = S0 = 1, r = 5% and a = 8, b = 11, ξ = 2, η = 0, compute the portfolio
allocation (ξ , η ) hedging the contingent claim with payoff C.
l) Compute the arbitrage-free price π0 (C ) of the claim payoff C.

Exercise 2.10 A company issues share rights, so that ten rights allow one to purchase three shares
at the price of €6.35. Knowing that the stock is currently valued at €8, estimate the price of the
right by absence of arbitrage.

Exercise 2.11 Consider a stock valued S0 = $180 at the beginning of the year. At the end of the
year, its value S1 can be either $152 or $203, and the risk-free interest rate is r = 3% per year.
Given a put option with strike price K on this underlying asset, find the value of K for which the
price of the option at the beginning of the year is equal to the intrinsic option payoff. This value of
K is called the break-even strike price. In other words, the break-even price is the value of K for
which immediate exercise of the option is equivalent to holding the option until maturity.
How would a decrease in the interest rate r affect this break-even strike price?

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 61

3. Discrete-Time Model

The single-step model considered in Chapter 2 is extended to a discrete-time model with N + 1 time
instants t = 0, 1, . . . , N. A basic limitation of the one-step model is that it does not allow for trading
until the end of the first time period is reached, while the multistep model allows for multiple
portfolio re-allocations over time. The Cox-Ross-Rubinstein (CRR) model, or binomial model, is
considered as an example whose importance also lies with its computer implementability.

3.1 Discrete-Time Compounding 55

3.2 Arbitrage and Self-Financing Portfolios 58
3.3 Contingent Claims 62
3.4 Martingales and Conditional Expectations 65
3.5 Market Completeness and Risk-Neutral Measures 70
3.6 The Cox-Ross-Rubinstein (CRR) Market Model 72
Exercises 75

3.1 Discrete-Time Compounding

In this chapter, we work in a finite horizon discrete-time model indexed by {0, 1, . . . , N}.

0 1 2 3 N

Investment plan
We invest an amount m each year in an investment plan that carries a constant interest rate r. At the
end of the N-th year, the value of the amount m invested at the beginning of year k = 1, 2, . . . , N

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 62 Chapter 3. Discrete-Time Model

has turned into (1 + r )N−k+1 m, and the value of the plan at the end of the N-th year becomes
N
AN : = m ∑ (1 + r )N−k+1 (3.1.1)
k =1
N
= m ∑ (1 + r )k
k =1
(1 + r )N − 1
= m(1 + r ) ,
r
hence the duration N of the plan satisfies
 
1 rAN
N +1 = log 1 + r + .
log(1 + r ) m

Loan repayment
At time t = 0 one borrows an amount A1 := A over a period of N years at the constant interest rate
r per year.

Proposition 3.1 Constant repayments. Assuming that the loan is completely repaid at the
beginning of year N + 1, the amount m refunded every year is given by

r (1 + r )N A r
m= = A. (3.1.2)
(1 + r ) − 1 1 − (1 + r )−N
N

Proof. Denoting by Ak the amount owed by the borrower at the beginning of year no k = 1, 2, . . . , N
with A1 = A, the amount m refunded at the end of the first year can be decomposed as

m = rA1 + (m − rA1 ),

into rA1 paid in interest and m − rA1 in principal repayment, i.e. there remains

A2 = A1 − (m − rA1 )
= (1 + r )A1 − m,

to be refunded. Similarly, the amount m refunded at the end of the second year can be decomposed
as
m = rA2 + (m − rA2 ),
into rA2 paid in interest and m − rA2 in principal repayment, i.e. there remains

A3 = A2 − (m − rA2 )
= ( 1 + r ) A2 − m
= (1 + r )((1 + r )A1 − m) − m
= ( 1 + r ) 2 A1 − m − ( 1 + r ) m

to be refunded. After repeating the argument we find that at the beginning of year k there remains

Ak = (1 + r )k−1 A1 − m − (1 + r )m − · · · − (1 + r )k−2 m
k−2
= (1 + r )k−1 A1 − m ∑ (1 + r )i
i=0

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3.1 Discrete-Time Compounding 63

1 − (1 + r )k−1
= (1 + r )k−1 A1 + m
r
to be refunded, i.e.

m − (1 + r )k−1 (m − rA)
Ak = , k = 1, 2, . . . , N. (3.1.3)
r
In other words, the repayment at the end of year k can be decomposed as

m = rAk + (m − rAk ),

with

rAk = m + (1 + r )k−1 (rA1 − m)

in interest repayment, and

m − rAk = (1 + r )k−1 (m − rA1 )
in principal repayment. At the beginning of year N + 1, the loan should be completely repaid,
hence AN +1 = 0, which reads

1 − (1 + r )N
(1 + r )N A + m = 0,
r
and yields (3.1.2). □
We also have

A 1 − (1 + r )−N
= . (3.1.4)
m r
and
1 m log(1 − rA/m)
N= log =− .
log(1 + r ) m − rA log(1 + r )

Remark: One needs m > rA in order for N to be finite.

The next proposition is a direct consequence of (3.1.2) and (3.1.3).

Proposition 3.2 The k-th interest repayment can be written as

  N−k+1
1
rAk = m 1 − = mr ∑ (1 + r )−l ,
(1 + r )N−k+1 l =1
and
the k-th principal repayment is
m
m − rAk = , k = 1, 2, . . . , N.
(1 + r )N−k+1

Note that the sum of discounted payments at the rate r is

N
m 1 − (1 + r )−N
∑ l
= m = A.
l =1 (1 + r ) r

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 64 Chapter 3. Discrete-Time Model

In particular, the first interest repayment satisfies

N
1
= m 1 − (1 + r )−N ,


rA = rA1 = mr ∑ l
l =1 (1 + r )

and the first principal repayment is

m
m − rA = .
(1 + r )N

3.2 Arbitrage and Self-Financing Portfolios

Stochastic processes
A stochastic process on a probability space (Ω, F , P) is a family (Xt )t∈T of random variables
Xt : Ω −→ R indexed by a set T. Examples include:
• the one-step (or two-instant) model: T = {0, 1},
• the discrete-time model with finite horizon: T = {0, 1, . . . , N},
• the discrete-time model with infinite horizon: T = N,
• the continuous-time model: T = R+ .
For real-world examples of stochastic processes, one can mention:
• the time evolution of a risky asset, e.g. Xt represents the price of the asset at time t ∈ T.
• the time evolution of a physical parameter - for example, Xt represents a temperature observed
at time t ∈ T.
In this chapter, we focus on the finite horizon discrete-time model with T = {0, 1, . . . , N}.

0 1 2 3 N

Asset price modeling

The prices at time t = 0 of d + 1 assets numbered 0, 1, . . . , d are denoted by the random vector
(0) (1) (d )

S0 = S0 , S0 , . . . , S0

in Rd +1 . Similarly, the values at time t = 1, 2, . . . , N of assets no 0, 1, . . . , d are denoted by the

random vector
(0) (1) (d )

St = St , St , . . . , St

on Ω, which forms a stochastic process St t =0,1,...,N .

In what follows we assume that asset no 0 is a riskless asset (of savings account type) yielding an
interest rate r, i.e. we have
(0) (0)
St = (1 + r )t S0 , t = 0, 1, . . . , N.

Portfolio strategies
(k )
Definition 3.3 A portfolio strategy is a stochastic process ξ t t =1,2,...,N ⊂ Rd +1 where ξt

denotes the (possibly fractional) quantity of asset no k held in the portfolio over the time interval
(t − 1,t ], t = 1, 2, . . . , N.

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3.2 Arbitrage and Self-Financing Portfolios 65

Note that the portfolio allocation

(0) (1) (d )

ξ t = ξt , ξt , . . . , ξt

is decided at time t − 1 and remains constant over the interval (t − 1,t ] while the stock price
(k ) (k )
changes from St−1 to St over this time interval.

ξ1 ξ2 ξ3 ξN

0 1 2 3 N

In other words, the quantity

(k ) (k )
ξt St−1
represents the amount invested in asset no k at the beginning of the time interval (t − 1,t ], and
(k ) (k )
ξt St

represents the value of this investment at the end of the time interval (t − 1,t ], t = 1, 2, . . . , N.
Self-financing portfolio strategies
The opening price of the portfolio at the beginning of the time interval (t − 1,t ] is
d
(k ) (k )
ξ t • St−1 = ∑ ξt St−1 ,
k =0

when the market “opens” at time t − 1. When the market “closes”at the end of the time interval
(t − 1,t ], it takes the closing value
d
(k ) (k )
ξ t • St = ∑ ξt St , (3.2.1)
k =0

t = 1, 2, . . . , N. After the new portfolio allocation ξ t +1 is designed we get the new portfolio opening
price
d
(k ) (k )
ξ t +1 • St = ∑ ξt +1 St , (3.2.2)
k =0

at the beginning of the next trading session (t,t + 1], t = 0, 1, . . . , N − 1.

Note that here, the stock price St is assumed to remain constant “overnight”, i.e. from the end
of (t − 1,t ] to the beginning of (t,t + 1], t = 1, 2, . . . , N − 1.
In case

(3.2.1) coincides with (3.2.2) for t = 0, 1, . . . , N − 1 we say that the portfolio strategy
ξ t t =1,2,...,N is self-financing. A non self-financing portfolio could be either bleeding money, or
burning cash, for no good reason.


Definition 3.4 A portfolio strategy ξ t t =1,2,...,N is said to be self-financing if

ξ t • St = ξ t +1 • St , t = 1, 2, . . . , N − 1, (3.2.3)

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 66 Chapter 3. Discrete-Time Model

i.e.
d d
(k ) (k ) (k ) (k )
∑ ξt St = ∑ ξt +1 St , t = 1, 2, . . . , N − 1.
k =0 k =0
| {z } | {z }
Closing value Opening price

The meaning of the self-financing condition (3.2.3) is simply that one cannot take any money in
or out of the portfolio during the “overnight” transition period at time t. In other words, at the
beginning of the new trading session (t,t + 1] one should re-invest the totality of the portfolio value
obtained at the end of the interval (t − 1,t ].
The next figure is an illustration of the self-financing condition.

Portfolio value ξ t St−1 ξ t St = ξ t +1 St ξ t +1 St +1

Asset value St−1 St St St +1

Time scale t −1 t t t +1
Portfolio allocation ξt ξt ξt +1 ξt +1

“Morning” “Evening” “Next morning” “Next evening”

(Opening) (Closing) (Opening) (Closing)

Figure 3.1: Illustration of the self-financing condition (3.2.3).

By (3.2.1) and (3.2.2) the self-financing condition (3.2.3) can be rewritten as

d d
(k ) (k ) (k ) (k )
∑ ξt St = ∑ ξt +1 St , t = 0, 1, . . . , N − 1,
k =0 k =0

or
d
(k ) (k )
(k )
∑ ξt +1 − ξt St = 0, t = 0, 1, . . . , N − 1.
k =0


Note that any portfolio strategy ξ t t =1,2,...,N which is constant over time, i.e. ξ t = ξ t +1 , t =
1, 2, . . . , N − 1, is self-financing by construction.
Here, portfolio re-allocation happens “overnight”, during which time the global portfolio value
remains the same due to the self-financing condition. The portfolio allocation ξt remains the same
throughout the day, however, the portfolio value changes from morning to evening due to a change
in the stock price. Also, ξ 0 is not defined and its value is actually not needed in this framework.
(0) (1)

In case d = 1 we are only trading d + 1 = 2 assets with prices St = St , St and the portfolio
(0) (1)

allocation reads ξ t = ξt , ξt . In this case, the self-financing condition means that:
(1)
• In the event of an increase in the stock position ξt , the corresponding cost of purchase
(1) (1)
(1) (0) (0)
ξt +1 − ξt St > 0 has to be deducted from the savings account value ξt St , which
becomes updated as
(0) (0) (0) (0) (1) (1)
(1)
ξt +1 St = ξt St − ξt +1 − ξt St ,
recovering (3.2.3).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

3.2 Arbitrage and Self-Financing Portfolios 67
(1) (1)
• In the event of a decrease in the stock position ξt , the corresponding sale profit ξt −
(1)
(1) (0) (0)
ξt +1 St > 0 has to be added to the savings account value ξt St , which becomes updated
as
(0) (0) (0) (0) (1) (1)
(1)
ξt +1 St = ξt St + ξt − ξt +1 St ,
recovering (3.2.3).
Clearly, the chosen unit of time may not be the day and it can be replaced by weeks, hours, minutes,
or fractions of seconds in high-frequency trading.
Portfolio value
Definition 3.5 The portfolio opening prices at times t = 0, 1, . . . , N − 1 are defined as

d
(k ) (k )
Vt := ξ t +1 • St = ∑ ξt +1 St , t = 0, 1, . . . , N − 1.
k =0

Under the self-financing condition (3.2.3), the portfolio closing values Vt at times t = 1, 2, . . . , N
rewrite as
d
(k ) (k )
Vt = ξ t • St = ∑ ξt St , t = 1, 2, . . . , N, (3.2.4)
k =0

as summarized in Table 3.1.

V0 V1 V2 ······ VN−1 VN
Opening price ξ 1 • S0 ξ 2 • S1 ξ 3 • S2 ······ ξ N • SN−1 N.A.
Closing value N.A. ξ 1 • S1 ξ 2 • S2 ······ ξ N−1 • SN−1 ξ N • SN

Table 3.1: Self-financing portfolio value process.

Discounting
Summing the prices of assets considered at different times requires discounting with respect to a
common date in order to compensate for possible monetary inflation. Assuming a yearly risk-free
interest rate r, one dollar of year N can be added to one dollar of year N + 1 either as (1 + r )$1 + $1
if pricing occurs as of year N + 1, or as $1 + (1 + r )−1 $1 if pricing occurs as of year N.

My portfolio St grew by b = 5% this year.

My portfolio St grew by b = 5% this year.
The risk-free or inflation rate is r = 10%.
Q: Did I achieve a positive return?
Q: Did I achieve a positive return?
A:
A:

(a) Scenario A. (b) Scenario B.

Figure 3.2: Why apply discounting?

Definition 3.6 Let

(0) (1) (d )
X t := Set , Set , . . . , Set )

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 68 Chapter 3. Discrete-Time Model

denote the vector of discounted asset prices, defined as:

(i) 1 (i)
Set = S , i = 0, 1, . . . , d, t = 0, 1, . . . , N.
(1 + r )t t

(a) Without inflation adjustment. (b) With inflation adjustment.

Figure 3.3: Are oil prices higher in 2019 compared to 2005?

We can also write

1
X t := St , t = 0, 1, . . . , N.
(1 + r )t
The discounted value at time 0 of the portfolio is defined by
1
Vet = Vt , t = 0, 1, . . . , N.
(1 + r )t
For t = 1, 2, . . . , N we have
1
Vet = ξ t • St
(1 + r )t
d
1 (k ) (k )
= ∑ ξt St
(1 + r )t k =0
d
(k) e(k)
= ∑ ξt St
k =0
= ξ t • Xt,
while for t = 0 we get
Ve0 = ξ 1 • X 0 = ξ 1 • S0 .
The effect of discounting from time t to time 0 is to divide prices by (1 + r )t , making all prices
comparable at time 0.
Arbitrage
The definition of arbitrage in discrete time follows the lines of its analog in the one-step model.

Definition 3.7 A portfolio strategy ξ t t =1,2,...,N constitutes an arbitrage opportunity if all three
following conditions are satisfied:
i) V0 ⩽ 0 at time t = 0, [Start from a zero-cost portfolio, or with a debt.]

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 3.3 Contingent Claims 69

ii) VN ⩾ 0 at time t = N, [Finish with a nonnegative amount.]

iii) P(VN > 0) > 0 at time t = N. [Profit is made with nonzero probability.]

3.3 Contingent Claims

Recall that a contingent claim is given by the nonnegative random payoff C of an option contract
at maturity time t = N. For example, in the case of the European call option of Definition 2, the
(i)
+
payoff C is given by C = SN − K where K is called the strike (or exercise) price of the option,
(i)
+
while in the case of the European put option of Definition 1 we have C = K − SN .

The list given below is somewhat restrictive and there exists many more option types, with new
ones appearing constantly on the markets.

Physical delivery vs. cash settlement

(i)
+
The cash settlement realized through the payoff C = SN − K can be replaced by the physical
delivery of the underlying asset in exchange for the strike price K. Physical delivery occurs only
(i) (i)
when SN > K, in which case the underlying asset can be sold at the price SN by the option holder,
(i) (i)
for a payoff SN − K. When SN > K, no delivery occurs and the payoff is 0, which is consistent
(i)
+
with the expression C = SN − K . A similar procedure can be applied to other option contracts.

Vanilla options - examples

Vanilla options are options whose claim payoff depends only on the terminal value ST of the
underlying risky asset price at maturity time T .
i) European options.
The payoff of the European call option on the underlying asset no i with maturity N and strike
price K is

 (i) (i)
(i)
+  SN − K if SN ⩾ K,
C = SN − K =
 (i)
0 if SN < K.


The moneyness at time t = 0, 1, . . . , N of the European call option with strike price K on the
asset no i is the ratio
(i)
(i) S −K
Mt := t (i) , t = 0, 1, . . . , N.
St
(i)
The option is said to be “out of the money” (OTM) when Mt < 0, “in the money” (ITM)
(i) (i)
when Mt > 0, and “at the money” (ATM) when Mt = 0.
The payoff of the European put option on the underlying asset no i with exercise date N and
strike price K is

(i) (i)
 K − SN
 if SN ⩽ K,
(i) +


C = K − SN =
 (i)
0 if SN > K.


The moneyness at time t = 0, 1, . . . , N of the European put option with strike price K on the
asset no i is the ratio
(i)
(i) K − St
Mt := (i)
, t = 0, 1, . . . , N.
St

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 70 Chapter 3. Discrete-Time Model

ii) Binary options.

Binary (or digital) options, also called cash-or-nothing options, are options whose payoffs
are of the form 
(i)
 $1 if SN ⩾ K,

C = 1[K,∞) SN =
(i)

 (i)
0 if SN < K,


for binary call options, and


(i)
 $1
 if SN ⩽ K,
1(−∞,K ] SN(i)


C= =
 (i)
0 if SN > K,


for binary put options.

iii) Collar and spread options.
Collar and spread options provide other examples of vanilla options, whose payoffs can be
constructed using call and put option payoffs, see, e.g., Exercises 4.12 and 4.13.

Exotic options - examples

i) Asian options.
The payoff of an Asian call option (also called option on average) on the underlying asset no
i with exercise date N and strike price K is
!+
1 N (i)
C= St − K .
N + 1 t∑
=0

The payoff of an Asian put option on the underlying asset no i with exercise date N and
strike price K is
!+
1 N (i)
C = K− St .
N + 1 t∑
=0

It can be shown, see Exercise 4.14, that Asian call option prices can be upper bounded by
European call option prices.
Other examples of such options include weather derivatives (based on averaged temperatures)
and volatility derivatives (based on averaged volatilities).

ii) Barrier options.

The payoff of a down-an-out (or knock-out) barrier call option on the underlying asset no i
with exercise date N, strike price K and barrier level B is
C = SN − K 1n
(i)
+
o
(i)
min St > B
t =0,1,...,N
 (i)
+ (i)
S −K if min St > B,
 N

t =0,1,...,N

=
 (i)
 0 if min St ⩽ B.

t =0,1,...,N
This option is also called a Callable Bull Contract with no residual value, or turbo warrant
with no rebate, in which B denotes the call price B ⩾ K.

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3.3 Contingent Claims 71

The payoff of an up-and-out barrier put option on the underlying asset no i with exercise date
N, strike price K and barrier level B is
C = K − SN 1
(i)
+ n
(i)
o
Max St < B
t =0,1,...,N
 (i)
+ (i)
 K − SN if Max St < B,
t =0,1,...,N


=
 (i)
 0 if Max St ⩾ B.

t =0,1,...,N
This option is also called a Callable Bear Contract with no residual value, in which the call
price B usually satisfies B ⩽ K. See J. Eriksson and Persson, 2006 and Wong and Chan, 2008
for the pricing of type R Callable Bull/Bear Contracts, or CBBCs, also called turbo warrants,
which involve a rebate or residual value computed as the payoff of a down-and-in lookback
option.
iii) Lookback options.
The payoff of a floating strike lookback call option on the underlying asset no i with exercise
date N is
(i) (i)
C = SN − min St .
t =0,1,...,N
The payoff of a floating strike lookback put option on the underlying asset no i with exercise
date N is  
(i) (i)
C= Max St − SN .
t =0,1,...,N

Options in insurance and investment

Such options are involved in the statements of Exercises 3.1 and 3.2.
Vanilla vs. exotic options
(i)
Vanilla options such as European or binary options, have a payoff φ (SN ) that depends only on
(i)
the terminal value SN of the underlying asset at maturity, as opposed to exotic or path-dependent
options such as Asian, barrier, or lookback options, whose payoff may depend on the whole path of
the underlying asset price until expiration time.

Exotic vs Vanilla Options

Vanilla options are called that way because:
(A) They were first used for the trading of vanilla by the
Maya beginning around the 14th century.

(B) “Plain vanilla” is the most standard and common of all

ice cream flavors.

(C) To meet FDA standards, pure vanilla extract must

contain 13.35 ounces of vanilla beans per gallon.

(D) Sir Charles C. Vanilla, FLS, was the early discoverer of

the properties of Brownian motion in asset pricing.

Figure 3.4: Take the Quiz.

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 72 Chapter 3. Discrete-Time Model

3.4 Martingales and Conditional Expectations

Before proceeding to the definition of risk-neutral probability measures in discrete time we need to
introduce more mathematical tools such as conditional expectations, filtrations, and martingales.

Conditional expectations
Clearly, the expected value of any risky asset or random variable is dependent on the amount
of available information. For example, the expected return on a real estate investment typically
depends on the location of this investment.
In the probabilistic framework the available information is formalized as a collection G of events,
which may be smaller than the collection F of all available events, i.e. G ⊂ F .*
The notation IE[F | G ] represents the expected value of a random variable F given (or conditionally
to) the information contained in G , and it is read “the conditional expectation of F given G ”. In a
certain sense, IE[F | G ] represents the best possible estimate of F in the mean-square sense, given
the information contained in G .
The conditional expectation satisfies the following five properties, cf. Section 11.7 for details and
proofs.
i) IE[FG | G ] = G IE[F | G ] if G depends only on the information contained in G .
ii) IE[G | G ] = G when G depends only on the information contained in G .
iii) IE[IE[F | H ] | G ] = IE[F | G ] if G ⊂ H , called the tower property, cf. also Relation (11.6.8).
iv) IE[F | G ] = IE[F ] when F “does not depend” on the information contained in G or, more
precisely stated, when the random variable F is independent of the σ -algebra G .
v) If G depends only on G and F is independent of G , then

IE[h(F, G) | G ] = IE[h(F, x)]x=G .

When H = {0,
/ Ω} is the trivial σ -algebra we have

IE[F | H ] = IE[F ], F ∈ L1 ( Ω ) .

See (11.6.8) and (11.6.14) for illustrations of the tower property by conditioning with respect to
discrete and continuous random variables.

Filtrations
The total amount of “information” available on the market at times t = 0, 1, . . . , N is denoted by Ft .
We assume that
Ft ⊂ Ft +1 , t = 0, 1, . . . , N − 1,
which means that the amount of information available on the market increases over time.
(i) (i) (i)
Usually, Ft corresponds to the knowledge of the values S0 , S1 , . . . , St , i = 1, 2, . . . , d, of the
(i) (i) (i)
risky assets up to time t. In mathematical notation we say that Ft is generated by S0 , S1 , . . . , St ,
i = 1, 2, . . . , d, and we usually write
(i) (i) (i)
Ft = σ S0 , S1 , . . . , St , i = 1, 2, . . . , d ,


t = 1, 2, . . . , N,

with F0 = {0,
/ Ω}.
* The collection G is also called a σ -algebra, cf. Section 11.1.

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3.4 Martingales and Conditional Expectations 73

Example: Consider the simple random walk

Zt := X1 + X2 + · · · + Xt , t ⩾ 0,

where (Xt )t⩾1 is a sequence of independent, identically distributed {−1, 1} valued random variables.
The filtration (or information flow) (Ft )t⩾0 generated by (Zt )t⩾0 is given by F0 = 0, / Ω , F1 =


/ {X1 = 1}, {X1 = −1}, Ω , and


0,

F2 = σ 0,

/ {X1 = 1, X2 = 1}, {X1 = 1, X2 = −1}, {X1 = −1, X2 = 1},
{X1 = −1, X2 = −1}, Ω .

The notation Ft is useful to represent a quantity of information available at time t. Note that
different agents or traders may work with different filtrations. For example, an insider may have
access to a filtration (Gt )t =0,1,...,N which is larger than the ordinary filtration (Ft )t =0,1,...,N available
to an ordinary agent, in the sense that

Ft ⊂ Gt , t = 0, 1, . . . , N.

The notation IE[F | Ft ] represents the expected value of a random variable F given (or conditionally
to) the information contained in Ft . Again, IE[F | Ft ] denotes the best possible estimate of F in
mean-square sense, given the information known up to time t.
We will assume that no information is available at time t = 0, which translates as

IE[F | F0 ] = IE[F ]

for any integrable random variable F. As above, the conditional expectation with respect to Ft
satisfies the following five properties:
i) IE[FG | Ft ] = F IE[G | Ft ] if F depends only on the information contained in Ft .
ii) IE[F | Ft ] = F when F depends only on the information known at time t and contained in
Ft .
iii) IE[IE[F | Ft +1 ] | Ft ] = IE[F | Ft ] if Ft ⊂ Ft +1 (by the tower property, cf. also Rela-
tion (8.1.1) below).
iv) IE[F | Ft ] = IE[F ] when F does not depend on the information contained in Ft .
v) If F depends only on Ft and G is independent of Ft , then

IE[h(F, G) | Ft ] = IE[h(x, G)]x=F .

Note that by the tower property (iii) the process t 7→ IE[F | Ft ] is a martingale, cf. e.g. Rela-
tion (8.1.1) for details.
Martingales
A martingale is a stochastic process whose value at time t + 1 can be estimated using conditional
expectation given its value at time t. Recall that a stochastic process (Mt )t =0,1,...,N is said to be
(Ft )t =0,1,...,N -adapted if the value of Mt depends only on the information available at time t in Ft ,
t = 0, 1, . . . , N.
Definition 3.8 A stochastic process (Mt )t =0,1,...,N is called a discrete-time martingale with
respect to the filtration (Ft )t =0,1,...,N if (Mt )t =0,1,...,N is (Ft )t =0,1,...,N -adapted and satisfies the
property
IE[Mt +1 | Ft ] = Mt , t = 0, 1, . . . , N − 1.

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 74 Chapter 3. Discrete-Time Model

Note that the above definition implies that Mt ∈ Ft , t = 0, 1, . . . , N. In other words, a random
process (Mt )t =0,1,...,N is a martingale if the best possible prediction of Mt +1 in the mean-square
sense given Ft is simply Mt .
In discrete-time finance, the martingale property can be used to characterize risk-neutral probability
measures, and for the computation of conditional expectations.
Exercise. Using the tower property (11.6.8) of conditional expectation, show that Definition 3.8
can be equivalently stated by saying that

IE[Mn | Fk ] = Mk , 0 ⩽ k < n.

A particular property of martingales is that their expectation is constant over time.

Proposition 3.9 Let (Zn )n∈N be a martingale. We have

IE[Zn ] = IE[Z0 ], n ⩾ 0.

Proof. From the tower property (11.6.8) of conditional expectation, we have:

IE[Zn+1 ] = IE[IE[Zn+1 | Fn ]] = IE[Zn ], n ⩾ 0,

hence by induction on n ⩾ 0 we have

IE[Zn+1 ] = IE[Zn ] = IE[Zn−1 ] = · · · = IE[Z1 ] = IE[Z0 ], n ⩾ 0.

□
Weather forecasting can be seen as an example of application of martingales. If Mt denotes the
random temperature observed at time t, this process is a martingale when the best possible forecast
of tomorrow’s temperature Mt +1 given the information known up to time t is simply today’s
temperature Mt , t = 0, 1, . . . , N − 1.
Definition 3.10 A stochastic process (ξk )k⩾1 is said to be predictable if ξk depends only on the
information in Fk−1 , k ⩾ 1.

When F0 simply takes the form F0 = {0, / Ω} we find that ξ1 is a constant when (ξt )t =1,2,...,N is
(i)
(i)
a predictable process. Recall that on the other hand, the process St t =0,1,...,N is adapted as St
depends only on the information in Ft , t = 0, 1, . . . , N, i = 1, 2, . . . , d.
The discrete-time stochastic integral (3.4.1) will be interpreted as the sum of discounted profits and
(1) (1)

losses ξk Sek − Sek−1 , k = 1, 2, . . . ,t, in a portfolio holding a quantity ξk of a risky asset whose
(1) (1)
price variation is Se − Se at time k = 1, 2, . . . ,t.
k k−1

An important property of martingales is that the discrete-time stochastic integral (3.4.1) of a

predictable process is itself a martingale, see also Proposition 8.1 for the continuous-time analog of
the following proposition, which will be used in the proof of Theorem 4.3 below.*
In what follows, the martingale (3.4.1) will be interpreted as a discounted portfolio value, in which
(1) (1)
Sek − Sek−1 represents the increment in the discounted asset price and ξk is the amount invested in
that asset, k = 1, 2 . . . , N.

* See here for a related discussion of martingale strategies in a particular case.

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3.4 Martingales and Conditional Expectations 75

Theorem 3.11 Martingale transform. Given (Xk )k=0,1,...,N a martingale and (ξk )k=1,2,...,N a
(bounded) predictable process, the discrete-time process (Mt )t =0,1,...,N defined by
t
Mt = − Xk−1 ),
∑ ξ|k (Xk {z t = 0, 1, . . . , N, (3.4.1)
k =1 }
Profit/loss

is a martingale.

Proof. Given n > t ⩾ 0, we have

" #
n
IE[Mn | Ft ] = IE ∑ ξk (Xk − Xk−1 ) Ft
k =1
n
ξk (Xk − Xk−1 ) Ft
 
= ∑ IE
k =1
t n
= ∑ IE [ξk (Xk − Xk−1 ) | Ft ] + ∑ IE [ξk (Xk − Xk−1 ) | Ft ]
k =1 k=t +1
t n
= ∑ ξk (Xk − Xk−1 ) + ∑ IE [ξk (Xk − Xk−1 ) | Ft ]
k =1 k=t +1
n
= Mt + ∑ IE [ξk (Xk − Xk−1 ) | Ft ] .
k=t +1

In order to conclude to IE [Mn | Ft ] = Mt it suffices to show that

IE [ξk (Xk − Xk−1 ) | Ft ] = 0, t + 1 ⩽ k ⩽ n.

First, we note that when 0 ⩽ t ⩽ k − 1 we have Ft ⊂ Fk−1 , hence by the tower property (11.6.8)
of conditional expectations, we get

IE [ξk (Xk − Xk−1 ) | Ft ] = IE [IE [ξk (Xk − Xk−1 ) | Fk−1 ] | Ft ] .

Next, since the process (ξk )k⩾1 is predictable, ξk depends only on the information in Fk−1 , and
using Property (ii) of conditional expectations we may pull out ξk out of the expectation since it
behaves as a constant parameter given Fk−1 , k = 1, 2, . . . , n. This yields

IE [ξk (Xk − Xk−1 ) | Fk−1 ] = ξk IE [Xk − Xk−1 | Fk−1 ] = 0 (3.4.2)

since

IE [Xk − Xk−1 | Fk−1 ] = IE [Xk | Fk−1 ] − IE [Xk−1 | Fk−1 ]

= IE [Xk | Fk−1 ] − Xk−1
= 0, k = 1, 2, . . . , N,

because (Xk )k=0,1,...,N is a martingale. By (3.4.2), it follows that

IE [ξk (Xk − Xk−1 ) | Ft ] = IE [IE [ξk (Xk − Xk−1 ) | Fk−1 ] | Ft ]

= IE [ξk IE [Xk − Xk−1 | Fk−1 ] | Ft ]
= 0,
for k = t + 1, . . . , n. □

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 76 Chapter 3. Discrete-Time Model

3.5 Market Completeness and Risk-Neutral Measures

As in the two time step model, the concept of risk-neutral probability measure (or martingale mea-
sure) will be used to price financial claims under the absence of arbitrage hypothesis.*
Definition 3.12 A probability measure P∗ on Ω is called a risk-neutral probability measure if
under P∗ , the expected return of each risky asset equals the return r of the riskless asset, that is
 (i) (i)
IE∗ St +1 Ft = (1 + r )St ,

t = 0, 1, . . . , N − 1, (3.5.1)

i = 0, 1, . . . , d. Here, IE∗ denotes the expectation under P∗ .

(i)
Since St ∈ Ft , denoting by
(i) (i)
(i) St +1 − St
Rt +1 := (i)
St
the return of asset no i over the time interval (t,t + 1], t = 0, 1, . . . , N − 1, Relation (3.5.1) can be
rewritten as
" (i) (i)
#
( i ) S − St
IE∗ Rt +1 Ft = IE∗ t +1 (i) Ft
 
St
" (i) #
∗ St +1
= IE (i)
Ft − 1
St
= r, t = 0, 1, . . . , N − 1,
(i) (i) (i)
which means that the average of the return (St +1 − St )/St of asset no i under the risk-neutral
probability measure P∗ is equal to the risk-free interest rate r.
In other words, taking risks under P∗ by buying the risky asset no i has a neutral effect, as the
expected return is that of the riskless asset. The measure P♯ would yield a positive risk premium if
we had  (i) (i)
IE♯ St +1 Ft = (1 + r̃ )St ,

t = 0, 1, . . . , N − 1,
with r̃ > r, and a negative risk premium if r̃ < r.
In the next proposition we reformulate the definition of risk-neutral probability measure using
the notion of martingale.

Proposition 3.13 A probability measure P∗ on Ω is a risk-neutral measure if and only if the

discounted price process
(i)
(i) St
Set := , t = 0, 1, . . . , N,
(1 + r )t
is a martingale under P∗ , i.e.
 (i) (i)
IE∗ Set +1 Ft = Set ,

t = 0, 1, . . . , N − 1, (3.5.2)

i = 0, 1, . . . , d.
(i) (i)
Proof. It suffices to check that by the relation St = (1 + r )t Set , Condition (3.5.1) can be rewritten
as  (i) (i)
(1 + r )t +1 IE∗ Set +1 Ft = (1 + r )(1 + r )t Set ,


* See also the Efficient Market Hypothesis.

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3.5 Market Completeness and Risk-Neutral Measures 77

i = 1, 2, . . . , d, which is clearly equivalent to (3.5.2) after division by (1 + r )t , t = 0, 1, . . . , N − 1.

□
(i)
Note that, as a consequence of Propositions 3.9 and 3.13, the discounted price process Set :=
(i)
St /(1 + r )t , t = 0, 1, . . . , n, has constant expectation under the risk-neutral probability measure
P∗ , i.e.
 (i)  (i)
IE∗ Set = Se0 , t = 1, 2, . . . , N,
for i = 0, 1, . . . , d.
In the sequel we will only consider probability measures P∗ that are equivalent to P, in the sense
that they share the same events of zero probability.
Definition 3.14 A probability measure P∗ on (Ω, F ) is said to be equivalent to another
probability measure P when

P∗ (A) = 0 if and only if P(A) = 0, for all A ∈ F. (3.5.3)

Next, we restate in discrete time the first fundamental theorem of asset pricing, which can be used
to check for the existence of arbitrage opportunities.

Theorem 3.15 A market is without arbitrage opportunity if and only if it admits at least one
equivalent risk-neutral probability measure.

Proof. See Harrison and Kreps, 1979 and Theorem 5.17 of Föllmer and Schied, 2004. □
Next, we turn to the notion of market completeness, starting with the definition of attainability for a
contingent claim.
Definition 3.16 A contingent claim with payoff C is said

to be attainable (at time N) if there
exists a (predictable) self-financing portfolio strategy ξ t t =1,2,...,N
such that

d
(k ) (k )
C = ξ N • SN = ∑ ξN SN , P − a.s. (3.5.4)
k =0


In case ξ t t =1,2,...,N

is a portfolio that attains the claim payoff C at time N, i.e. if (3.5.4) is satisfied,
we also say that ξ t t =1,2,...,N
hedges the claim payoff C. In case (3.5.4) is replaced by the condition

ξ N • SN ⩾ C,

we talk of super-hedging.


When a self-financing portfolio ξ t t =1,2,...,N hedges a claim payoff C, the arbitrage-free price
πt (C ) of the claim at time t is given by the value

πt (C ) = ξ t • St

of the portfolio at time t = 0, 1, . . . , N. Recall that arbitrage-free prices can be used to ensure that
financial derivatives are “marked” at their fair value (mark to market). Note that at time t = N we
have
πN (C ) = ξ N • SN = C,
i.e. since exercise of the claim occurs at time N, the price πN (C ) of the claim equals the value C of
the payoff.

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 78 Chapter 3. Discrete-Time Model
Definition 3.17 A market model is said to be complete if every contingent claim is attainable.

The next result can be viewed as the second fundamental theorem of asset pricing in discrete
time.
Theorem 3.18 A market model without arbitrage opportunities is complete if and only if it
admits only one equivalent risk-neutral probability measure.
Proof. See Harrison and Kreps, 1979 and Theorem 5.38 of Föllmer and Schied, 2004. □

3.6 The Cox-Ross-Rubinstein (CRR) Market Model

We consider the discrete-time Cox-Ross-Rubinstein (J. Cox, S.A. Ross, and Rubinstein, 1979)
model, also called the binomial model, with N + 1 time instants t = 0, 1, . . . , N and d = 1 risky
(0)
asset, see Sharpe, 1978. In this setting, the price St of the riskless asset evolves as
(0) (0)
St = S0 (1 + r )t , t = 0, 1, . . . , N.
Let the return of the risky asset S(1) be defined as
(1) (1)
St − St−1
Rt := (1)
, t = 1, 2, . . . , N.
St−1
In the CRR (or binomial) model, the return Rt is random and allowed to take only two values a and
b at each time step, i.e.
Rt ∈ {a, b}, t = 1, 2, . . . , N,
with −1 < a < b and
P(Rt = a) > 0, P(Rt = b) > 0, t = 1, 2, . . . , N.
(1) (1)
That means, the evolution of St−1 to St is random and given by
 
(1)
 (1 + b)St−1 if Rt = b 
 
(1) (1)
St = = (1 + Rt )St−1 , t = 1, . . . , N,
 (1) 
(1 + a)St−1 if Rt = a
 

and
t
(1) (1)
St = S0 ∏ ( 1 + Rk ) , t = 0, 1, . . . , N.
k =1
(1)

Note that the price process St t =0,1,...,N
evolves on a binary recombining (or binomial) tree of
the following type:*

S2 = S0 (1 + b)2

S1 = S0 (1 + b)

S0 S2 = S0 (1 + a)(1 + b)

S1 = S0 (1 + a)

S2 = S0 ( 1 + a ) 2 .

* Download the corresponding IPython notebook1 and IPython notebook2 that can be run here or here.

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3.6 The Cox-Ross-Rubinstein (CRR) Market Model 79

The discounted asset price is

(1)
(1) St
Set = , t = 0, 1, . . . , N,
(1 + r )t

with
1 + b e(1)
 
 1 + r St−1


 if Rt = b 


(1)
 1 + Rt e(1)
Set = = S , t = 1, 2, . . . , N,

 1 + a e(1) 
 1 + r t−1

 S if Rt = a 

1 + r t−1

and
(1) t t
(1) S0 (1) 1 + Rk
Set = ∏ (1 + Rk ) = Se0 ∏ .
(1 + r )t k =1 k =1 1 + r

23.84
19.07
15.26 9.54
12.21 7.63
9.77 6.1 3.81
7.81 4.88 3.05
6.25 3.91 2.44 1.53
5.0 3.12 1.95 1.22
4.0 2.5 1.56 0.98 0.61
2.0 1.25 0.78 0.49
1.0 0.62 0.39 0.24
0.5 0.31 0.2
0.25 0.16 0.1
0.12 0.08
0.06 0.04
0.03
0.02

Figure 3.5: Discrete-time asset price tree in the CRR model.

In this model, the discounted value at times t = 1, 2, . . . , N of the portfolio is given by

(0) (0) (1) (1)

ξ t • X t = ξt Se0 + ξt Set .

(1) (1) (1)

The information Ft known in the market up to time t is given by the knowledge of S1 , S2 , . . . , St ,
(1) (1) (1)
which is equivalent to the knowledge of Se , Se , . . . , Set or R1 , R2 , . . . , Rt , i.e. we write
1 2

(1) (1) (1)
(1) (1) (1)

Ft = σ S1 , S2 , . . . , St = σ Se1 , Se2 , . . . , Set = σ (R1 , R2 , . . . , Rt ),

t = 0, 1, . . . , N, where, as a convention, S0 is a constant and F0 = {0,

/ Ω} contains no information.

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 80 Chapter 3. Discrete-Time Model

Figure 3.6: Discrete-time asset price graphs in the CRR model.

Theorem 3.19 The CRR model is without arbitrage opportunities if and only if a < r < b. In
this case the market is complete and the equivalent risk-neutral probability measure P∗ is given
by

r−a b−r
P∗ (Rt +1 = b | Ft ) = and P∗ (Rt +1 = a | Ft ) = , (3.6.1)
b−a b−a
t = 0, 1, . . . , N −1. In particular, (R1 , R2 , . . . , RN ) forms a sequence of independent and identically
distributed (i.i.d.) random variables under P∗ , with
r−a b−r
p∗ := P∗ (Rt = b) = and q∗ := P∗ (Rt = a) = , (3.6.2)
b−a b−a
t = 1, 2, . . . , N.
Proof. In order to check for arbitrage opportunities we may use Theorem 3.15 and look for a
risk-neutral probability measure P∗ . According to the definition of a risk-neutral measure this
probability P∗ should satisfy Condition (3.5.1), i.e.
 (1) (1)
IE∗ St +1 Ft = (1 + r )St ,

t = 0, 1, . . . , N − 1.
 (1)
Rewriting IE∗ St +1 Ft as


 (1)  (1) (1) 

IE∗ St +1 Ft = IE∗ St +1 St


(1) (1)
= (1 + a)St P∗ (Rt +1 = a | Ft ) + (1 + b)St P∗ (Rt +1 = b | Ft ),
it follows that any risk-neutral probability measure P∗ should satisfy the equations
(1) (1) (1)

 (1 + b)St P∗ (Rt +1 = b | Ft ) + (1 + a)St P∗ (Rt +1 = a | Ft ) = (1 + r )St

P∗ (Rt +1 = b | Ft ) + P∗ (Rt +1 = a | Ft ) = 1,


i.e.
 bP∗ (Rt +1 = b | Ft ) + aP∗ (Rt +1 = a | Ft ) = r


P∗ (Rt +1 = b | Ft ) + P∗ (Rt +1 = a | Ft ) = 1,


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3.6 The Cox-Ross-Rubinstein (CRR) Market Model 81

with solution
r−a b−r
P∗ (Rt +1 = b | Ft ) = and P∗ (Rt +1 = a | Ft ) = ,
b−a b−a

t = 0, 1, . . . , N − 1. Since the values of P∗ (Rt +1 = b | Ft ) and P∗ (Rt +1 = a | Ft ) computed in

(3.6.1) are non random, they are independent* of the information contained in Ft up to time t.
As a consequence, under P∗ , the random variable Rt +1 is independent of R1 , R2 , . . . , Rt , hence the
sequence of random variables (Rt )t =0,1,...,N is made of mutually independent random variables
under P∗ , and by (3.6.1) we have

r−a b−r
P∗ (Rt +1 = b) = and P∗ (Rt +1 = a) = .
b−a b−a
Clearly, P∗ can be equivalent to P only if r − a > 0 and b − r > 0. In this case the solution P∗ of
the problem is unique by construction, hence the market is complete by Theorem 3.18. □
As a consequence of Proposition 3.13, letting p∗ := (r − a)/(b − a), when (ε1 , ε2 , . . . , εn ) ∈ {a, b}N
we have
P∗ (R1 = ε1 , R2 = ε2 , . . . , RN = εn ) = ( p∗ )l (1 − p∗ )N−l ,
where l, resp. N − l, denotes the number of times the term “b”, resp. “a”, appears in the sequence
(ε1 , ε2 , . . . , εN ) ∈ {a, b}N .

Exercises

Exercise 3.1 Today I went to Furong Peak Mall. After exiting the Poon Way MTR station, I was
met by a friendly investment consultant from NTRC Input, who recommended that I subscribe to
the following investment plan. The plan requires to invest $2,550 per year over the first 10 years,
with no contribution required from year 11 until year 20. The total projected surrender value is
$30,835 at maturity N = 20. The plan also includes a death benefit which is not considered here.

Surrender Value
Total Premiums Guaranteed ($S) Projected at 3.25%
Year Paid To-date ($S) Non-Guaranteed ($S) Total ($S)
1 2,550 0 0 0
2 5,100 2,460 140 2,600
3 7,650 4,240 240 4,480
4 10,200 6,040 366 6,406
5 12,750 8,500 518 9,018
10 25,499 19,440 1,735 21,175
15 25,499 22,240 3,787 26,027
20 25,499 24,000 6,835 30,835

Table 3.2: NTRC Input investment plan.

a) Compute the constant interest rate over 20 years corresponding to this investment plan.
b) Compute the projected value of the plan at the end of year 20, if the annual interest rate is
r = 3.25% over 20 years.
* The relation P(A | B) = P(A) is equivalent to the independence relation P(A ∩ B) = P(A)P(B) of the events A
and B.

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 82 Chapter 3. Discrete-Time Model

c) Compute the projected value of the plan at the end of year 20, if the annual interest rate
r = 3.25% is paid only over the first 10 years. Does this recover the total projected value
$30, 835?

Exercise 3.2 Today I went to East Mall. After exiting the Bukit Kecil MTR station, I was
approached by a friendly investment consultant from Avenda Insurance, who recommended me to
subscribe to the following investment plan. The plan requires me to invest $3,581 per year over
the first 10 years, with no contribution required from year 11 until year 20. The total projected
surrender value is $50,862 at maturity N = 20. The plan also includes a death benefit which is not
considered here.

Surrender Value
Total Premiums Guaranteed ($S) Projected at 3.25%
Year Paid To-date ($S) Non-Guaranteed ($S) Total ($S)
1 3,581 0 0 0
2 7,161 1,562 132 1,694
3 10,741 3,427 271 3,698
4 14,321 5,406 417 5,823
5 17,901 6,992 535 7,527
10 35,801 19,111 1,482 20,593
15 35,801 29,046 3,444 32,490
20 35,801 43,500 7,362 50,862

Table 3.3: Avenda Insurance investment plan.

a) Using the following graph, compute the constant interest rate over 20 years corresponding to
this investment.

16

15.5

15

14.5

14

13.5

13

12.5

12

11.5
1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3
x in %

Figure 3.7: Graph of the function x 7→ ((1 + x)21 − (1 + x)11 )/x.

b) Compute the projected value of the plan at the end of year 20, if the annual interest rate is
r = 3.25% over 20 years.
c) Compute the projected value of the plan at the end of year 20, if the annual interest rate
r = 3.25% is paid only over the first 10 years. Does this recover the total projected value
$50, 862?

Exercise 3.3 A lump sum of $100,000 is to be released through N identical yearly installment
payments m at the beginning of every year, over N = 10 years.

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3.6 The Cox-Ross-Rubinstein (CRR) Market Model 83

a) Find the value of m.

b) Assume that interests are due at the rate r = 2% on the amount remaining at the beginning of
every year. How does this affect the value of the constant yearly payment m?
c) Assume that the amount remaining at the beginning of every year is invested at the interest
rate r = 2%, and that m is as in Question (a)). In this case, how much is left at the end of
year N after the N payments have been completed?

Exercise 3.4
Today I received an SMS from Jack, and I
opted for the 3K loan over 12 months.
a) Compute the monthly interest rate
earned by Jack using the below
graph of the function
r 7→ (1 − (1 + r )−12 )/r.
b) Compute the yearly interest rate
earned by Jack.
c) Should I:
i) Block him,
ii) Report him,
iii) Sue him,
iv) All of the above.
12

11

10

0 1 2 3 4
r in %

Exercise 3.5 We consider the following two scenarios:

i) In Scenario (i) we borrow the amount $A at the rate rloan to purchase a house. By renting
out the house we receive investment income compounded every month at the rate rrent , and
we refund the loan by paying $m at the end of every month.
ii) In Scenario (ii) at the end of every month we only invest an amount $m on an account paying
the rate rinv , for the same duration as in Scenario (i).
a) How much remains on our account in Scenario (i) after the loan has been completely repaid?
Hint: Refunding $A over N identical payments of $m at the rate rloan > 0 imposes the relation
A/m = (1 − (1 + rloan )−N )/rloan .
b) How much remains on our account in Scenario (ii) at the end of the investment duration?
Hint: Reaching a target of $B by investing N identical payments of $m at the rate rinv > 0
imposes the relation B/m = ((1 + rinv )N − 1)/rinv .
c) Taking N = 12 months and assuming rrent = rinv = 2% and rloan = 5%, which of Scenario (i)
and Scenario (ii) is more profitable?

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 84 Chapter 3. Discrete-Time Model

Hint: Use the graph of Figure 3.8.

12
11.5
11
10.5
10
9.5
9
8.5
0 1 2 3 4 5
r in %
Figure 3.8: Graph of the function r 7→ (1 − (1 + r )−12 )/r.

Exercise 3.6 Consider a two-step trinomial (or ternary) market model (St )t =0,1,2 with r = 0 and
three possible return rates Rt ∈ {−1, 0, 1}. Show that the probability measure P∗ given by
1 1 1
P∗ (Rt = −1) := , P∗ (Rt = 0) := , P∗ (Rt = 1) :=
4 2 4
is risk-neutral.
(0) (0)
Exercise 3.7 We consider a riskless asset valued Sk = S0 , k = 0, 1, . . . , N, where the risk-free
(1) (1)
Sk − Sk−1
interest rate is r = 0, and a risky asset S(1) whose returns Rk := (1)
, k = 1, 2, . . . , N, form a
Sk−1
sequence of independent identically distributed random variables taking three values {−b < 0 < b}
at each time step, with

p∗ := P∗ (Rk = b) > 0, θ ∗ := P∗ (Rk = 0) > 0, q∗ := P∗ (Rk = −b) > 0,

k = 1, 2, . . . , N. The information known to the market up to time k is denoted by Fk .

a) Determine all possible risk-neutral probability measures P∗ equivalent to P in terms of the
parameter θ ∗ ∈ (0, 1).
b) Assume that the conditional variance
" (1) (1)
#
S − S
Var∗ k+1 (1) k Fk = σ 2 > 0, k = 0, 1, . . . , N − 1, (3.6.3)
Sk

of the asset return is constant and equal to σ 2 . Show that this condition defines a unique
risk-neutral probability measure P∗σ under a certain condition on b and σ , and determine P∗σ
explicitly.

Exercise 3.8 The S. Ross, 2015 Recovery Theorem allows for estimates of the real-world transition
probabilities of an underlying asset from option prices in a Markovian state model. We consider
a one-step asset price model with N possible states {s1 , . . . , sN } at time t = 0 and at time t = 1,
and let Xt ∈ {s1 , . . . , sN } denote the state of the market at times t = 0, 1. We also consider N binary
options B1 , . . . , BN maturing at t = 1, with respective payoffs

1{X1 =sk } , k = 1, . . . , N,

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3.6 The Cox-Ross-Rubinstein (CRR) Market Model 85

i.e. Bk pays $1 if and only if X1 = sk , k = 1, . . . , N. For k, l ∈ {1, . . . , N} we denote by bk,l the

known price of the binary option Bl given that X0 = sk .

a) In this question, we aim at recovering the risk-neutral probabilities

P∗ = ( p∗k,l )k,l =1,...,N = (P∗ (X1 = sl | X0 = sk ))k,l =1,...,N

using risk-neutral pricing.

1) From Proposition 2.15, express bk,l using:
i) the price dk of the bond paying $1 at t = 1 when the market starts from state sk at
t = 0, and
ii) the risk-neutral probability p∗k,l , k, l = 1, . . . , N.
2) Write the price dk of a bond paying $1 at t = 1 in terms of the binary option prices bk,l
of Bl when the market starts from state sk at t = 0, k, l = 1, . . . , N.
3) For k = 1, . . . , N, express the risk-neutral probabilities p∗k,l and the bond prices dk in
terms of the known binary option prices bk,l , k, l = 1, . . . , N.
b) In this question, we aim at recovering the real-world probabilities

P = ( pk,l )k,l =1,...,N = (P(X1 = sl | X0 = sk ))k,l =1,...,N

using marginal utility pricing. For this, we price the binary option Bl by the relation

ul bk,l = δ uk pk,l , k, l = 1, . . . , N,

where δ > 0 is an unknown time discount factor and uk > 0 represents an unknown marginal
utility in state sk , k = 1, . . . , N.
1) How many equations do we have? How many unknowns do we have?
2) Show that the matrix equation Bu⊤ = δ u⊤ holds, where u := [u1 , . . . , uN ] and B :=
(bk,l )k,l =1,...,N .
3) Prove that the equation of Question (2)) admits a unique solution δ , u1 , . . . , uN made of
strictly positive numbers.

Hint. Apply the Perron-Frobenius theorem for positive matrices.

4) Show that the transition probabilities pk,l can be recovered from the known binary
option prices bk,l , k, l = 1, . . . , N.
5) Assume that X1 does not depend on the initial state X0 = k, k = 1, . . . , N. Find the
relation between δ and the bond prices dk , and the relation between the real-world and
risk-neutral probabilities pk,l , p∗k,l , k, l = 1, . . . , N.
Figure 3.9 gives an example of estimation of transition probabilities on AMZN option chain
data downloaded on March 31, 2022.

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 86 Chapter 3. Discrete-Time Model

Figure 3.9: Transition probabilities in the recovery theorem.

Exercise 3.9 We consider the discrete-time Cox-Ross-Rubinstein model with N + 1 time instants
t = 0, 1, . . . , N, with a riskless asset whose price At evolves as At = A0 (1 + r )t , t = 0, 1, . . . , N. The
evolution of St−1 to St is given by

 (1 + b)St−1
St =
(1 + a)St−1


with −1 < a < r < b. The return of the risky asset S is defined as

St − St−1
Rt := , t = 1, 2, . . . , N,
St−1

and Ft is generated by R1 , R2 , . . . , Rt , t = 1, 2, . . . , N.
a) What are the possible values of Rt ?
b) Show that, under the probability measure P∗ defined by

r−a b−r
p∗ = P∗ (Rt +1 = b | Ft ) = , q∗ = P∗ (Rt +1 = a | Ft ) = ,
b−a b−a

t = 0, 1, . . . , N − 1, the expected return IE∗ [Rt +1 | Ft ] of S is equal to the return r of the

riskless asset.
c) Show that under P∗ the process (St )t =0,1,...,N satisfies

IE∗ [St +k | Ft ] = (1 + r )k St , t = 0, 1, . . . , N − k, k = 0, 1, . . . , N.

Exercise 3.10 We consider the discrete-time Cox-Ross-Rubinstein model on N + 1 time instants

t = 0, 1, . . . , N, with a riskless asset whose price At evolves as At = A0 (1 + r )t with r ⩾ 0, and a
risky asset whose price St is given by
t
St = S0 ∏ (1 + Rk ), t = 0, 1, . . . , N,
k =1

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3.6 The Cox-Ross-Rubinstein (CRR) Market Model 87

where the asset returns Rk are independent random variables taking two possible values a and b
with −1 < a < r < b, and P∗ is the probability measure defined by

r−a b−r
p∗ = P∗ (Rt +1 = b | Ft ) = , q∗ = P∗ (Rt +1 = a | Ft ) = ,
b−a b−a
t = 0, 1, . . . , N − 1, where (Ft )t =0,1,...,N is the filtration generated by (Rt )t =1,2,...,N .
a) Compute the conditional expected return IE∗ [Rt +1 | Ft ] under P∗ , t = 0, 1, . . . , N − 1.
b) Show that the discounted asset price process
 

St
St t =0,1,...,N :=
e
At t =0,1,...,N

is a (nonnegative) (Ft )-martingale under P∗ .

Hint: Use the independence of asset returns (Rt )t =1,2,...,N under P∗ .
c) Compute the moment IE∗ [(SN )β ] for all β > 0.
Hint: Use the independence of asset returns (Rt )t =1,2,...,N under P∗ .
d) For any α > 0, find an upper bound for the probability

P∗ St ⩾ αAt for some t ∈ {0, 1, . . . , N} .

Hint: Use the fact that when (Mt )t =0,1,...,N is a nonnegative martingale, we have
  IE∗ [(M )β ]
N
P∗ Max Mt ⩾ x ⩽ , x > 0, β ⩾ 1. (3.6.4)
t =0,1,...,N x β

e) For any x > 0, find an upper bound for the probability

 
P∗ Max St ⩾ x .
t =0,1,...,N

Hint: Note that (3.6.4) remains valid for any nonnegative submartingale.

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 89

4. Pricing and Hedging in Discrete Time

We consider the pricing and hedging of financial derivatives in the N-step Cox-Ross-Rubinstein
(CRR) model with N + 1 time instants t = 0, 1, . . . , N. Vanilla options are priced and hedged
using backward induction, and exotic options with arbitrary claim payoffs are dealt with using the
Clark-Ocone formula in discrete time.

4.1 Pricing Contingent Claims 79

4.2 Pricing Vanilla Options in the CRR Model 83
4.3 Hedging Contingent Claims 88
4.4 Hedging Vanilla Options 89
4.5 Hedging Exotic Options 96
4.6 Convergence of the CRR Model 102
Exercises 108

4.1 Pricing Contingent Claims

Let us consider an attainable contingent claim with (random) claim payoff C ⩾ 0 and maturity N.
Recall that by the Definition 3.16 of attainability there exists a (predictable) self-financing portfolio
strategy (ξt )t =1,2,...,N that hedges the claim with payoff C, in the sense that
d
(k ) (k )
ξ N • SN = ∑ ξN SN =C (4.1.1)
k =0

at time N. If (4.1.1) holds at time N, then investing the amount

d
(k ) (k )
V0 = ξ 1 • S0 = ∑ ξ1 S0 (4.1.2)
k =0

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 90 Chapter 4. Pricing and Hedging in Discrete Time

at time t = 0, resp.
d
(k ) (k )
Vt = ξ t • St = ∑ ξt St (4.1.3)
k =0


at times t = 1, 2, . . . , N into a self-financing hedging portfolio ξ t t =1,2,...,N will allow one to hedge
the option and to reach the perfect replication equality (4.1.1) at time t = N.
Definition 4.1 The value (4.1.2)-(4.1.3) at time t of a (predictable) self-financing portfolio
strategy (ξt )t =1,2,...,N hedging an attainable claim payoff C will be called an arbitrage-free price
of the claim payoff C at time t and denoted by πt (C ), t = 0, 1, . . . , N.

Recall that arbitrage-free prices can be used to ensure that financial derivatives are “marked” at
their fair value (mark to market).
Next we develop a second approach to the pricing of contingent claims, based on conditional
expectations and martingale arguments. We will need the following lemma, in which Vet :=
Vt /(1 + r )t denotes the discounted portfolio value, t = 0, 1, . . . , N.
Relation (4.1.4) in the following lemma has a natural interpretation by saying that when a portfolio
is self-financing the value Vet of the (discounted) portfolio at time t is given by summing up the
(discounted) trading profits and losses registered over all trading time periods from time 0 to time t.
Note that in (4.1.4), the use of the vector of discounted asset prices
(0) (1) (d )
X t := Set , Set , . . . , Set ), t = 0, 1, . . . , N,


allows us to add up the discounted trading profits and losses ξ t • X t − X t−1 since they are
expressed in units of currency “at time 0”. Indeed, in general, $1 at time t = 0 cannot be added to
$1 at time t = 1 without proper discounting.
Lemma 4.2 The following statements

are equivalent:
(i) The portfolio strategy ξ t t =1,2,...,N
is self-financing, i.e.

ξ t • St = ξ t +1 • St , t = 1, 2, . . . , N − 1.

(ii) Under discounting, we have ξ t • X t = ξ t +1 • X t for all t = 1, 2, . . . , N − 1.

(iii) The discounted portfolio value Vet can be written as the stochastic summation
t

Vet = Ve0 + ∑ ξ k • X k − X k−1 , t = 0, 1, . . . , N, (4.1.4)
k =1
| {z }
Sum of profits and losses

of discounted trading profits and losses.

Proof. First, the self-financing condition (i), i.e.

ξ t • St = ξ t +1 • St , t = 1, 2, . . . , N − 1,

is clearly equivalent to (ii) by division of both sides by (1 + r )t−1 .

Assuming now that (ii) holds, by (3.2.4) we have
d
(k ) (k )
V0 = ξ 1 • S0 and Vt = ξ t • St = ∑ ξt St , t = 1, 2, . . . , N.
k =0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.1 Pricing Contingent Claims 91

which shows that (4.1.4) is satisfied for t = 1, in addition to being satisfied for t = 0. Next, for
t = 2, 3, . . . , N we have the telescoping identity
t

Vet = Ve1 + ∑ Vek − Vek−1
k =2
t

= Ve1 + ∑ ξ k • X k − ξ k−1 • X k−1
k =2
t

= Ve1 + ∑ ξ k • X k − ξ k • X k−1
k =2
t

= Ve1 + ∑ ξ k • X k − X k−1 , t = 2, 3, . . . , N.
k =2

Finally, assuming that (iii) holds, we get

Vet − Vet−1 = ξ t • X t − X t−1 , t = 1, 2, . . . , N,

which rewrites as


ξ t • X t − ξ t−1 • X t−1 = ξ t • X t − X t−1 , t = 2, 3, . . . , N,

or
ξ t−1 • X t−1 = ξ t • X t−1 , t = 2, 3, . . . , N,
which implies (ii). □


In Relation (4.1.4), the term ξ t • X t − X t−1 represents the (discounted) trading profit and loss


Vet − Vet−1 = ξ t • X t − X t−1 ,


of the self-financing portfolio strategy ξ j j=1,2,...,N over the time interval (t − 1,t ], computed by
multiplication of the portfolio allocation ξ t with the change of price X t − X t−1 , t = 1, 2, . . . , N.

R As a consequence of Lemma 4.2, if a contingent
claim with payoff C is attainable by a

(predictable) self-financing portfolio strategy ξ t t =1,2,...,N , then the discounted claim payoff

C
Ce :=
(1 + r )N
rewrites as the sum of discounted trading profits and losses
N

Ce = VeN = ξ N • X N = Ve0 + ∑ ξ t • X t − X t−1 . (4.1.5)
t =1

The
sum (4.1.4) is also referred to as a discrete-time
stochastic integral of the portfolio strategy
ξ t t =1,2,...,N with respect to the random process X t t =0,1,...,N .

R By Proposition 3.13, the process X t t =0,1,...,N is a martingale under the risk-neutral prob-
ability measure P∗ , hence by the martingale transform Theorem 3.11
and Lemma 4.2,
(Vet )t =0,1,...,N in (4.1.4) is also martingale under P∗ , provided that ξ t t =1,2,...,N is a self-
financing and predictable process.

The above remarks will be used in the proof of the next Theorem 4.3.

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 92 Chapter 4. Pricing and Hedging in Discrete Time

Theorem 4.3 The arbitrage-free price πt (C ) of any (integrable) attainable contingent with claim
payoff C is given by
1
πt (C ) = IE∗ [C | Ft ], t = 0, 1, . . . , N, (4.1.6)
(1 + r )N−t
where P∗ denotes any risk-neutral probability measure.

Proof. a) Short proof. Since the claim payoff C is attainable, there exists a self-financing portfolio
strategy (ξt )t =1,2,...,N such that C = VN , i.e. Ce = VeN . In addition, by Theorem 3.11 Lemma 4.2 the
process (Vet )t =0,1,...,N is a martingale under P∗ , hence we have

Vet = IE∗ VeN Ft = IE∗ Ce Ft ,

   
t = 0, 1, . . . , N, (4.1.7)

which shows (4.1.8). To conclude, we note that by Definition 4.1 the arbitrage-free price πt (C ) of
the claim at time t is equal to the value Vt of the self-financing hedging C.
b) Long proof. For completeness, we include a self-contained, step-by-step derivation of (4.1.7) by
following the argument of Theorem 3.11, as follows. By Remark 4.1 we have

IE∗ Ce Ft = IE∗ VeN Ft

   
" #
N
= IE∗ Ve0 + ∑ ξ k • X k − X k−1 Ft


k =1
N
= IE∗ Ve0 Ft + ∑ IE∗ ξ k • X k − X k−1 Ft
  

k =1
t N
= Ve0 + ∑ IE∗ ξ k • X k − X k−1 Ft + IE∗ ξ k • X k − X k−1 Ft

 

∑
k =1 k=t +1
t N
IE∗ ξ k • X k − X k−1 Ft



= Ve0 + ∑ ξ k • X k − X k−1 + ∑
k =1 k=t +1
N
IE∗ ξ k • X k − X k−1 Ft ,


= Vet + ∑
k=t +1

where we used Relation (4.1.4) of Lemma 4.2. In order to obtain (4.1.8) we need to show that
N
IE∗ ξ k • X k − X k−1 Ft = 0,


∑
k=t +1

or
IE∗ ξ j • X j − X j−1 Ft = 0,



for all j = t + 1, . . . , N. Since 0 ⩽ t ⩽ j − 1 we have Ft ⊂ F j−1 , hence by the tower property

(11.6.8) of conditional expectations we get

IE∗ ξ j • X j − X j−1 Ft = IE∗ IE∗ ξ j • X j − X j−1 F j−1 | Ft ,


  
 

therefore it suffices to show that

IE∗ ξ j • X j − X j−1 F j−1 = 0,



j = 1, 2, . . . , N.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.1 Pricing Contingent Claims 93

We note that the portfolio allocation ξ j over the time period [ j − 1, j ] is predictable, i.e. it is
decided at time j − 1, and it thus depends only on the information F j−1 known up to time j − 1,
hence
IE∗ ξ j • X j − X j−1 F j−1 = ξ j • IE∗ X j − X j−1 F j−1 .

  

Finally we note that

IE∗ X j − X j−1 F j−1 = IE∗ X j F j−1 − IE∗ X j−1 F j−1

     

= IE∗ X j F j−1 − X j−1

 

= 0, j = 1, 2, . . . , N,

because X t t =0,1,...,N is a martingale under the risk-neutral probability measure P∗ , and this

concludes the proof of (4.1.7). Let

C
Ce =
(1 + r )N
denote the discounted payoff of the claim C. We will show that under any risk-neutral probability
measure P∗ the discounted value of any self-financing portfolio hedging C is given by

Vet = IE∗ Ce Ft ,
 
t = 0, 1, . . . , N, (4.1.8)

which shows that

1
Vt = IE∗ [C | Ft ]
(1 + r )N−t
after multiplication of both sides by (1 + r )t . Next, we note that (4.1.8) follows from the martingale
transform result of Theorem 3.11. □
Note that (4.1.6) admits an interpretation in an insurance framework, in which πt (C ) represents an
insurance premium and C represents the random value of an insurance claim made by a subscriber.
In this context, the premium of the insurance contract reads as the average of the values (4.1.6) of
the random claims after discounting for the time value of money.

R By Remark 4.1 the self-financing discounted portfolio value process

Vet t =0,1,...,N = ((1 + r )−t πt (C ))t =0,1,...,N

hedging the claim C is a martingale under the risk-neutral probability measure P∗ . This fact
can be recovered from Theorem 4.3 as in Remark 4.1, since from the tower property (11.6.8)
of conditional expectation we have

= IE∗ Ce Ft
 
Vet
= IE∗ IE∗ Ce Ft +1 Ft
   

= IE∗ Vet +1 Ft ,
 
t = 0, 1, . . . , N − 1. (4.1.9)

This will also allow us to compute Vt by backward induction on t = 0, 1, . . . , N − 1, starting

from VN = C, see (4.2.4) below.

In particular, for t = 0 we obtain the price at time 0 of the contingent claim with payoff C, i.e.
1
π0 (C ) = IE∗ Ce F0 = IE∗ Ce = IE∗ [C ].
   
(1 + r )N

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 94 Chapter 4. Pricing and Hedging in Discrete Time

4.2 Pricing Vanilla Options in the CRR Model

In this section we consider the pricing of contingent claims in the discrete-time Cox-Ross-Rubinstein
(J. Cox, S.A. Ross, and Rubinstein, 1979) model of Section 3.6, with d = 1 and
(0) (0)
St = S0 (1 + r )t , t = 0, 1, . . . , N,

and  
(1)
t  (1 + b)St−1
 if Rt = b 

(1) (1) (1)
St = S0 ∏ (1 + Rk ) =  = (1 + Rt )St−1 ,
k =1 (1) 
(1 + a)St−1 if Rt = a
 

t = 1, . . . , N. More precisely we are concerned with vanilla options whose payoffs depend on the
terminal value of the underlying asset, as opposed to exotic options whose payoffs may depend on
the whole path of the underlying asset price until expiration time.
Recall that the portfolio value process (Vt )t =0,1,...N and the discounted portfolio value process
(Vet )t =0,1,...N respectively satisfy
1 1
Vt = ξ t • St and Vet = t
Vt = ξ t • St = ξ t • X t , t = 0, 1, . . . , N.
(1 + r ) (1 + r )t
Here we will be concerned with the pricing of vanilla options with payoffs of the form
(1)

C = h SN ,

e.g. h(x) = (x − K )+ in the case of a European call option. Equivalently, the discounted claim
payoff
C
Ce =
(1 + r )N
(1)

satisfies Ce = e
h SN with e h(x) = h(x)/(1 + r )N . For example in the case of the European call
option with strike price K we have
1
h(x ) =
e (x − K ) + .
(1 + r )N
From Theorem 4.3, the discounted value of a portfolio hedging the attainable (discounted) claim
payoff Ce is given by
 (1)

Vet = IE∗ e Ft ,

h SN t = 0, 1, . . . , N,
under the risk-neutral probability measure P∗ . As a consequence of Theorem 4.3, we have the
following proposition.

Proposition 4.4 The arbitrage-free price πt (C ) at time t = 0, 1, . . . , N of the contingent claim

(1)

with payoff C = h SN is given by

1  (1)

IE∗ h SN Ft ,

πt (C ) = N−t
t = 0, 1, . . . , N. (4.2.1)
(1 + r )

In the next proposition we implement the calculation of (4.2.1) in the CRR model.*

* Download the corresponding (non-recursive) IPython notebook that can be run here or here.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.2 Pricing Vanilla Options in the CRR Model 95

(1)

Proposition 4.5 The price πt (C ) of the contingent claim with payoff C = h SN satisfies

(1)

πt (C ) = v t, St , t = 0, 1, . . . , N,

where the function v(t, x) is given by

" !#
N
1 ∗
v(t, x) = IE h x ∏ (1 + R j ) (4.2.2)
(1 + r )N−t j =t +1
N−t
N −t
 
1 ∗ k ∗ N−t−k k N−t−k


= ∑ ( p ) ( q ) h x ( 1 + b ) ( 1 + a ) ,
(1 + r )N−t k=0 k

where the risk-neutral probabilities p∗ , q∗ are defined as

r−a b−r
p∗ : = and q∗ : = 1 − p∗ = . (4.2.3)
b−a b−a

Proof. From the relations

N
(1) (1)
SN = St ∏ (1 + R j ),
j =t +1

and (4.2.1) we have, using Property (v)) of the conditional expectation, see page 72, and the
independence of the asset returns {R1 , . . . , Rt } and {Rt +1 , . . . , RN },

1 ∗
 (1)

F

πt (C ) = IE h SN t
(1 + r )N−t
" ! #
N
1 (1) (1)
= IE∗ h St ∏ (1 + R j ) St
(1 + r )N−t j =t +1
" !#
N
1
= IE∗ h x ∏ (1 + R j ) ,
(1 + r )N−t j =t +1 (1)
x=St

where we used Property (v)) of the conditional expectation, see page 72, and the independence of
asset returns. Next, we note that the number of times R j is equal to b for j ∈ {t + 1, . . . , N}, has a
binomial distribution with parameter (N − t,p∗ ) since
 the set of paths from time t + 1 to time N
N −t
containing j times “(1 + b)” has cardinality and each such path has probability
j

( p∗ ) j (q∗ )N−t− j , j = 0, . . . , N − t.

   
10 10
In Figure 4.1 we enumerate the 120 = = possible paths corresponding to n = 5 and
7 3
k = 2.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 96 Chapter 4. Pricing and Hedging in Discrete Time

7
Path number 19 out of 120
6
5
4
3
2
1
0
-1
-2
-3
0 1 2 3 4 5 6 7 8 9 10

   
10 10
Figure 4.1: Graph of 120 = = paths with n = 5 and k = 2.*
7 3

Hence we have
1  (1)

IE∗ h SN Ft

πt (C ) = N−t
(1 + r )
N−t 
N −t

1 (1)
( p∗ )k (q∗ )N−t−k h St (1 + b)k (1 + a)N−t−k .


= N−t ∑
(1 + r ) k =0 k
□
In the above proof we have also shown that πt (C ) is given by the conditional expected value
1  (1)
1  (1)
(1) 
IE∗ h SN Ft = IE∗ h SN

πt (C ) = N−t N−t
St
(1 + r ) (1 + r )
(1) (1)

given the value of St at time t = 0, 1, . . . , N, due to the Markov property of St t =0,1,...,N . In
particular, the price of the claim with payoff C is written as the average (path integral) of the values
(1)
of the contingent claim over all possible paths starting from St .
Market terms and data
(1)

Intrinsic value. The intrinsic value at time t = 0, 1, . . . , N of the option with payoff C = h SN
(1)

is given by the immediate exercise payoff h St . The extrinsic value at time t = 0, 1, . . . , N
(1)

of the option is the remaining difference πt (C ) − h St between the option price πt (C ) and
(1)

the immediate exercise payoff h St . In general, the option price πt (C ) decomposes as
(1)
(1)

πt (C ) = h St + πt (C ) − h St , t = 0, 1, . . . , N.
| {z } | {z }
Intrinsic value Extrinsic value

(1)

Gearing. The gearing at time t = 0, 1, . . . , N of the option with payoff C = h SN is defined as
the ratio
(1) (1)
St St
Gt := = (1)

,
πt (C ) v t, St
(1)
(1)
telling how many time the option price v t, St is “contained” in the stock price St at
time t = 0, 1, . . . , N.
*Animated figure (works in Acrobat Reader).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.2 Pricing Vanilla Options in the CRR Model 97

Break-even price. The break-even price BEPt of the underlying asset at time t = 0, 1, . . . , N, see
(1)

also Exercise 2.11, is the value of S for which the intrinsic option value h St equals the
option price πt (C ). In other words, BEPt represents the price of the underlying asset for
which we would break even if the option was exercised immediately. For European call
options with payoff function h(x) = (x − K )+ , it is given by
(1)

BEPt := K + πt (C ) = K + v t, St , t = 0, 1, . . . , N,

whereas for European put options with payoff function h(x) = (K − x)+ , it is given by
(1)

BEPt := K − πt (C ) = K − v t, St , t = 0, 1, . . . , N.

Premium. The option premium OPt can be defined as the variation required from the underlying
asset price in order to reach the break-even price for which the intrinsic option payoff equals
the current option price, i.e. we have

(1) (1) (1)

BEPt − St K + v t, St ) − St
OPt := (1)
= (1)
, t = 0, 1, . . . , N,
St St

for European call options, and

(1) (1) (1)

St − BEPt St + v t, St −K
OPt := (1)
= (1)
, t = 0, 1, . . . , N,
St St

for European put options. The term “premium” is sometimes also used to denote the
(1)

arbitrage-free price v t, St of the option.

Pricing by backward induction in the CRR model

In the Cox-Ross-Rubinstein (J. Cox, S.A. Ross, and Rubinstein, 1979) model of Section 3.6, the
discounted portfolio value Vet can be computed by solving the backward induction relation (4.1.9),
using the martingale property of the discounted portfolio value process (Vet )t =0,1,...,N under the
risk-neutral probability measure P∗ .

Proposition 4.6 The function v(t, x) defined from the arbitrage-free prices of the contingent
(1)

claim with payoff C = h SN at times t = 0, 1, . . . , N by

(1)
1 ∗
 (1)

F

v t, St = Vt = I
E h S N t
(1 + r )N−t
satisfies the backward recursiona
q∗
p∗

v(t, x) = v t + 1, x(1 + a) + v t + 1, x(1 + b) , (4.2.4)
1+r 1+r
with the terminal condition
v(N, x) = h(x), x > 0.
a Download the corresponding (backward recursive) IPython notebook that can be run here or here.

Proof. Namely, by the tower property of conditional expectations, letting

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 98 Chapter 4. Pricing and Hedging in Discrete Time

(1)
1 (1)

ve t, St := v t, St , t = 0, 1, . . . , N,
(1 + r )t
we have
(1)

ve t, St = Vet
 (1)

IE∗ e Ft

= h SN
  (1)

IE∗ IE∗ e Ft +1 Ft
 
= h SN
IE∗ Vet +1 Ft
 
=
(1)

IE∗ ve t + 1, St +1 St
 
=
(1)
(1)

= ve t + 1, (1 + a)St P∗ (Rt +1 = a) + ve t + 1, (1 + b)St P∗ (Rt +1 = b)
(1)
(1)

= q∗ ve t + 1, (1 + a)St + p∗ ve t + 1, (1 + b)St ,
which shows that ve(t, x) satisfies

ve(t, x) = q∗ ve t + 1, x(1 + a) + p∗ ve t + 1, x(1 + b) ,

(4.2.5)
(1)

while the terminal condition VeN = e
h SN implies

ve(N, x) = e
h(x ), x > 0.

□
The next Figure 4.2 presents a tree-based implementation of the pricing recursion (4.2.4).

1.14
1.04
0.95 0.75
0.86 0.69
0.78 0.62 0.43
0.71 0.57 0.4
0.65 0.51 0.36 0.17
0.59 0.47 0.33 0.16
0.53 0.43 0.3 0.14 0.0
0.39 0.27 0.13 0.0
0.25 0.12 0.0 0.0
0.11 0.0 0.0
0.0 0.0 0.0
0.0 0.0
0.0 0.0
0.0
0.0

Figure 4.2: Discrete-time call option pricing tree.

Note that the discrete-time recursion (4.2.4) can be connected to the continuous-time Black-Scholes
PDE (7.1.2), cf. Exercises 7.15.

4.3 Hedging Contingent Claims

The basic idea of hedging is to allocate assets in a portfolio in order to protect oneself from a given
risk. For example, a risk of increasing oil prices can be hedged by buying oil-related stocks, whose
value should be positively correlated with the oil price. In this way, a loss connected to increasing
oil prices could be compensated by an increase in the value of the corresponding portfolio.

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4.3 Hedging Contingent Claims 99

In the setting of this chapter, hedging an

attainable contingent claim with payoff C means computing
a self-financing portfolio strategy ξ t t =1,2,...,N such that

ξ N • SN = C, i.e. ξ N • X N = C.
e (4.3.1)
Price, then hedge.
The portfolio allocation ξ N can be computed by first solving (4.3.1) for ξ N from the payoff values
C, based on the fact
that the allocation ξ N depends only on information up to time N − 1, by the
predictability of ξ k 1⩽k⩽N .
If the self-financing portfolio value Vt is known, for example from (4.1.6), i.e.
1
Vt = IE∗ [C | Ft ], t = 0, 1, . . . , N, (4.3.2)
(1 + r )N−t

we may similarly compute ξ t by solving ξ t • St = Vt for all t = 1, 2, . . . , N − 1.

Hedge, then price.
If Vt = πt (C ) has not been computed, we can use backward induction to compute a self-financing
portfolio strategy. Starting from the values of ξ N obtained by solving

ξ N • SN = C,

we use the self-financing condition to solve for ξ N−1 , ξ N−2 , . . ., ξ 4 , down to ξ 3 , ξ 2 , and finally
ξ 1.
In order to implement this algorithm we can use the N − 1 self-financing equations

ξ t • X t = ξ t +1 • X t , t = 1, 2, . . . , N − 1, (4.3.3)


allowing us in principle to compute the portfolio strategy ξ t t =1,2,...,N
.

Based on the values of ξ N we can solve

ξ N−1 • SN−1 = ξ N • SN−1

for ξ N−1 , then

ξ N−2 • SN−2 = ξ N−1 • SN−2
for ξ N−2 , and successively ξ 2 down to ξ 1 . In Section 4.3 the backward induction (4.3.3) will be
implemented in the CRR model, see the proof of Proposition 4.7, and Exercises 4.17 and 4.4 for an
application in a two-step model.
The discounted value Vet at time t of the portfolio claim can then be obtained from

Ve0 = ξ 1 • X 0 and Vet = ξ t • X t , t = 1, 2, . . . , N. (4.3.4)

In addition we have shown in the proof of Theorem 4.3 that the price πt (C ) of the claim payoff C
at time t coincides with the value Vt of any self-financing portfolio hedging the claim payoff C, i.e.

πt (C ) = Vt , t = 0, 1, . . . , N,

as given by (4.3.4). Hence the price of the claim can be computed either algebraically by solving
(4.3.1) and (4.3.3) using backward induction and then using (4.3.4), or by a probabilistic method
by a direct evaluation of the discounted expected value (4.3.2).
The development of hedging algorithms has increased credit exposure and counterparty risk
when one party is unable to deliver the option payoff stated in the contract.

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 100 Chapter 4. Pricing and Hedging in Discrete Time

4.4 Hedging Vanilla Options

In this section we implement the backward induction (4.3.3) of Section 4.3 for the hedging of
contingent claims in the discrete-time Cox-Ross-Rubinstein model. Our aim is to compute a
(predictable) self-financing portfolio strategy hedging a vanilla option with payoff of the form
(1)

C = h SN .

(0)
Since the discounted price Set of the riskless asset satisfies
(0) (0) (0)
Set = (1 + r )−t St = S0 ,

(0) (0)
we may sometimes write S0 in place of Set . In Propositions 4.7 and 4.8 we present two different
(1)

approaches to hedging and to the computation of the predictable process ξt t =1,2,...,N , which is
also called the Delta.
Proposition 4.7 Price, then hedge.a The self-financing replicating portfolio strategy

(0) (1)
(0) (1)
(1) (1)

ξt , ξt t =1,2,...,N
= ξt St−1 , ξt St−1 t =1,2,...,N

(1)

hedging the contingent claim with payoff C = h SN is given by

(1)
(1)

(1) (1)
v t, (1 + b)St−1 − v t, (1 + a)St−1
ξt St−1 = (1)
(b − a)St−1
(1)
(1)

ve t, (1 + b)St−1 − ve t, (1 + a)St−1
= (1)
, (4.4.1)
(b − a)Se /(1 + r )
t−1

where the function v(t, x) is given by (4.2.2), and

(1)
(1)

(0) (1)
(1 + b)v t, (1 + a)St−1 − (1 + a)v t, (1 + b)St−1
ξt St−1 = (0)
(b − a)St
(1)
(1)

(1 + b)ve t, (1 + a)St−1 − (1 + a)ve t, (1 + b)St−1
= (0)
, (4.4.2)
( b − a ) S0
t = 1, 2, . . . , N, where the function ve(t, x) = (1 + r )−t v(t, x) is given by (4.2.2).
a Download the corresponding “price, then hedge” IPython notebook that can be run here or here.

Proof. We first compute the self-financing hedging strategy ξ t t =1,2,...,N
by solving

ξ t • X t = Vet , t = 1, 2, . . . , N,

from which we deduce the two equations

(1) (1)
1 + a e(1)


(0) (1)
(0) (1)

 ξ St−1 S0 + ξt St−1 St−1 = ve t, (1 + a)St−1
 t

 1+r

(1) (1)
1 + b e(1)


 ξt(0) St−1
(1)
(0) (1)


 S0 + ξt St−1 St−1 = ve t, (1 + b)St−1 ,
1+r

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.4 Hedging Vanilla Options 101

which can be solved as


(1)
(1)


 ( 0 ) ( 1 )
( 1 + b ) v
e t, ( 1 + a ) St−1 − ( 1 + a ) v
e t, ( 1 + b ) St−1


 ξt St−1 = (0)
( b − a ) S


 0

 (1)
(1)

ve t, (1 + b)St−1 − ve t, (1 + a)St−1

(1) (1)


St−1 =

 ξ ,
 t

 (1)
(b − a)Se /(1 + r ) t−1

(1)
t = 1, 2, . . . , N, which only depends on St−1 , as expected, see also (2.6.8). This is consistent with
(1)
the fact that ξt represents the (possibly fractional) quantity of the risky asset to be present in
the portfolio over the time period [t − 1,t ] in order to hedge the claim payoff C at time N, and is
decided at time t − 1. □

By applying (4.4.1) to the function v(t, x) in (4.2.2), we find

N−t 
N −t

(1) (1)
1
ξt St−1 =
(1 + r )N−t∑ k ( p∗ )k (q∗ )N−t−k
k =0
(1) (1)
h St−1 (1 + b) (1 + a)N−t−k − h St−1 (1 + b)k (1 + a)N−t−k+1
k + 1



× (1)
,
(b − a)St

t = 0, 1, . . . , N.

The next Figure 4.3 presents a tree-based implementation of the risky hedging component (4.4.1).

1.0
1.0
1.0 1.0
0.99 1.0
0.96 0.98 1.0
0.91 0.91 0.93
0.84 0.81 0.79 0.82
0.75 0.7 0.63 0.53
0.58 0.49 0.34 0.0
0.37 0.22 0.0
0.14 0.0 0.0
0.0 0.0
0.0 0.0
0.0
0.0

Figure 4.3: Discrete-time call option hedging strategy (risky component).

The next Figure 4.4 presents a tree-based implementation of the riskless hedging component (4.4.2).

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 102 Chapter 4. Pricing and Hedging in Discrete Time

-0.85
-0.85
-0.85 -0.85
-0.84 -0.85
-0.8 -0.82 -0.85
-0.74 -0.75 -0.78
-0.65 -0.64 -0.63 -0.67
-0.55 -0.52 -0.47 -0.4
-0.41 -0.34 -0.24 0.0
-0.24 -0.14 0.0
-0.09 0.0 0.0
0.0 0.0
0.0 0.0
0.0
0.0

Figure 4.4: Discrete-time call option hedging strategy (riskless component).

We can also check that the portfolio strategy

(0) (1)
(0) (1)
(1) (1)


ξ t t =1,2,...,N = ξt , ξt t =1,2,...,N = ξt St−1 , ξt St−1 t =1,2,...,N

given by (4.4.1)-(4.4.2) is self-financing, as follows:

(0) (1)
(0) (1) (1)
(1)
ξ t +1 • X t = ξt +1 St S0 + ξt +1 St Set
(1)
(1)

(0) ( 1 + b ) ve t + 1, (1 + a)St − (1 + a)ve t + 1, (1 + b)St
= S0 (0)
( b − a ) S0
(1)
(1)

(1) ve t + 1, (1 + b)St − ve t + 1, (1 + a)St
+Ste
(1)
(b − a)Set /(1 + r )
(1)
(1)

(1 + b)ve t + 1, (1 + a)St − (1 + a)ve t + 1, (1 + b)St
=
b−a
(1)
(1)

ve t + 1, (1 + b)St − ve t + 1, (1 + a)St
+
(b − a) / (1 + r )
r−a (1)
b−r (1)

= ve t + 1, (1 + b)St + ve t + 1, (1 + a)St
b−a b−a
∗ (1)
∗ (1)

= p ve t + 1, (1 + b)St + q ve t + 1, (1 + a)St
(1)

= ve t, St
(0) (1)
(0) (1) (1)
(1)
= ξt St S + ξt St Set 0
= ξ t • Xt, t = 0, 1, . . . , N − 1,
where we used (4.2.5) or the martingale property of the discounted portfolio value process
(1)


ṽ t, St t =0,1,...,N
, see Lemma 4.2.

Market terms and data

(1)
Delta. The Delta represents the quantity of underlying risky asset St held in the portfolio over
(1) (1)

the time interval [t − 1,t ]. Here, it is denoted by ξt St−1 for t = 1, 2, . . . , N.

Effective gearing. The effective gearing at time t = 1, 2, . . . , N of the option with payoff C =
(1)

h SN is defined as the ratio
(1)
EGt := Gt ξt

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.4 Hedging Vanilla Options 103
(1)
St (1)
= ξ
πt (C ) t
(1) (1)
(1)


St v t, (1 + b)St−1 − v t, (1 + a)St−1
= (1) (1)

St−1 v t, St (b − a)
(1)
(1)

(1)

v t, (1 + b)St−1 − v t, (1 + a)St−1 /v t, St
= (1) (1)
, t = 1, 2, . . . , N.
St−1 (b − a)/St
(1)
The effective gearing EGt = ξt St /πt (C ) can be interpreted as the hedge ratio, i.e. the
percentage of the portfolio which is invested on the risky asset. It also allows one to
represent the percentage change in the option price in terms of the potential percentage
(1) (1)
change St−1 (b − a)/St in the underlying asset price when the asset return switches from a
to b, as
(1)
(1)

(1)
v t, (1 + b)St−1 − v t, (1 + a)St−1 St−1 (b − a)
(1)

= EGt × (1)
.
v t, St St
By Proposition 4.5 we have the following remark.

R
i) If the function x 7→ h(x) is non-decreasing, e.g. in the case of European call options,
then the function x 7→ ve(t, x) is also non-decreasing for all fixed t = 0, 1, . . . , N, hence
(0) (1)
(1)
the portfolio strategy ξt , ξt t =1,2,...,N defined by (4.2.2) or (4.4.1) satisfies ξt ⩾ 0,
t = 1, 2, . . . , N and there is not short selling.
ii) Similarly, we can show that when x 7→ h(x) is a non-increasing function, e.g. in the case
(1)
of European put options, the portfolio allocation ξt ⩽ 0 is negative, t = 1, 2, . . . , N,
i.e. short selling always occurs.

(0) (0) (1) (1)

As a consequence of (4.4.2), the discounted amounts ξt S0 and ξt Set respectively invested on
the riskless and risky assets are given by
(1)
(1)

(0) (0) (1)
(1 + b)ve t, (1 + a)St−1 − (1 + a)ve t, (1 + b)St−1
S0 ξt St−1 = (4.4.3)
b−a
and
(1)
(1)

(1) (1) (1)
ve t, (1 + b)St−1 − ve t, (1 + a)St−1
St ξt St−1 = (1 + Rt )
e ,
b−a
t = 1, 2, . . . , N.
(0)
Regarding the quantity ξt of the riskless asset in the portfolio at time t, from the relation
(0) (0) (1) (1)
Vet = ξ t • X t = ξt Set + ξt Set , t = 1, 2, . . . , N,

we also obtain
(1) (1)
(0) Vet − ξt Set
ξt = (0)
Set
(1) (1)
Vet − ξt Set
= (0)
S0
(1)
(1) (1)
ve t, St − ξt Set
= (0)
, t = 1, 2, . . . , N.
S0

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 104 Chapter 4. Pricing and Hedging in Discrete Time

In the next proposition we compute the hedging strategy by backward induction, starting from the
relation
(1)
(1)

(1) (1)
h (1 + b)SN−1 − h (1 + a)SN−1
ξN SN−1 = (1)
,
(b − a)SN−1
and
(1)
(1)

(0) (1)
(1 + b)h (1 + a)SN−1 − (1 + a)h (1 + b)SN−1
ξN SN−1 = (0)
,
(b − a)S0 (1 + r )N
that follow from (4.4.1)-(4.4.2) applied to the claim payoff function h(·).

Proposition 4.8 Hedge, then price.a The self-financing replicating portfolio strategy

(0) (1)
(0) (1)
(1) (1)

ξt , ξt t =1,2,...,N
= ξt St−1 , ξt St−1 t =1,2,...,N

(1)

hedging the contingent claim with payoff C = h SN is given from (4.4.1) at time t = N by

(1)
(1)

(1) (1)
h (1 + b)SN−1 − h (1 + a)SN−1
ξN SN−1 = (1)
, (4.4.4)
(b − a)SN−1

and
(1)
(1)

(0) (1)
(1 + b)h (1 + a)SN−1 − (1 + a)h (1 + b)SN−1
ξN SN−1 = (0)
, (4.4.5)
(b − a)SN
and then inductively by
(1) (1) (1) (1)
(1) (1)
(1 + b)ξt +1 ((1 + b)St−1 ) − (1 + a)ξt +1 ((1 + a)St−1 )
ξt St−1 =
b−a
(0) (1) (0) (1)
(0) ξt +1 ((1 + b)St−1 ) − ξt +1 ((1 + a)St−1 )
+S0 (1)
, (4.4.6)
(b − a)Se /(1 + r ) t−1

and
(1) (1) (1)
(1) (1)


(0) (1)
(1 + a)(1 + b)Set−1 ξt +1 (1 + a)St−1 − ξt +1 (1 + b)St−1
ξt St−1 = (0)
(b − a)(1 + r )S0
(0) (1)
(0) (1)

(1 + b)ξt +1 (1 + a)St−1 − (1 + a)ξt +1 (1 + b)St−1
+ , (4.4.7)
b−a
t = 1, 2, . . . , N − 1.
The pricing function ve(t, x) = (1 + r )−t v(t, x) is then given by
(1)
(0) (0) (1)
(1) (1) (1)

ve t, St = S0 ξt St−1 + Set ξt St−1 , t = 1, 2, . . . , N.
a Download the corresponding “hedge, then price” IPython notebook that can be run here or here.

Proof. Relations (4.4.4)-(4.4.5) follow from (4.4.1)-(4.4.2) stated at time t = N. Next, by the

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.4 Hedging Vanilla Options 105

self-financing condition (4.3.3), we have

ξ t • X t = ξ t +1 • X t , t = 0, 1, . . . , N − 1,

i.e.
(1) (1) (1)
1 + b

(0) (0) (1)


 S0 ξt St−1 + Set−1 ξt St−1

 1+r
(1)
e(1) 1 + b


 (0) (1)
(0) (1)
 = ξt +1 (1 + b)St−1 S0 + ξt +1 (1 + b)St−1 St−1 1 + r




(1) (1) (1)
1 + a


 (0) (0) (1)


 S0 ξt St−1 + Set−1 ξt St−1
1+r



(1)
e(1) 1 + a


 =ξ ( 0 ) ( 1 )
(0) ( 1 )
t +1 (1 + a)St−1 S0 + ξt +1 (1 + a)St−1 St−1 ,

1+r
which can be solved as
(1) (1)
(1) (1)

(1) (1)
(1 + b)ξt +1 (1 + b)St−1 − (1 + a)ξt +1 (1 + a)St−1
ξt St−1 =
b−a
(0) (1)
(0) (1)

(0) ξt +1 (1 + b)St−1 − ξt +1 (1 + a)St−1
+(1 + r )S0 (1)
,
(b − a)Se t−1

and
(1) (1) (1)
(1) (1)


(0) (1)
(1 + a)(1 + b)Set−1 ξt +1 (1 + a)St−1 − ξt +1 (1 + b)St−1
ξt St−1 = (0)
(b − a)(1 + r )S0
(0) (1)
(0) (1)

(1 + b)ξt +1 (1 + a)St−1 − (1 + a)ξt +1 (1 + b)St−1
+ ,
b−a
t = 1, 2, . . . , N − 1. □
By (4.4.6)-(4.4.7), we can check that the corresponding discounted portfolio value process


(Vet )t =1,2,...,N = ξ t • X t t =1,2,...,N
is a martingale under P∗ :
Vet = ξ t • Xt
(0) (0) (1)
(1) (1) (1)

= S0 ξt St−1 + Set ξt St−1
(1) (1) (1)
(1) (1)


(1 + a)(1 + b)Set−1 ξt +1 (1 + a)St−1 − ξt +1 (1 + b)St−1
=
(b − a)(1 + r )
(0) (1)
(0) (1)

(0) (1 + b)ξt +1 (1 + a)St−1 − (1 + a)ξt +1 (1 + b)St−1
+ S0
(b − a)
(1) (1)
(1) (1)

( 1 ) (1 + b)ξt +1 (1 + b)St−1 − (1 + a)ξt +1 (1 + a)St−1
+Set
b−a
(0) (1)
(0) (1)

(1) (0) ξt +1 (1 + b)St−1 − ξt +1 (1 + a)St−1
+(1 + r )St S0
e
(1)
(b − a)Set−1
r − a (0) (0) (1)
b − r (0) (0) (1)

= S ξ S + S ξ S
b − a 0 t +1 t b − a 0 t +1 t
(r − a)(1 + b) e(1) (1) (1)
(b − r )(1 + a) e(1) (1) (1)

+ S ξ S + S ξ S
(b − a)(1 + r ) t t +1 t (b − a)(1 + r ) t t +1 t

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 106 Chapter 4. Pricing and Hedging in Discrete Time
(0) (0) (1)
(0) (0) (1)

= p∗ S0 ξt +1 St + q∗ S0 ξt +1 St
1 + b e(1) (1) (1)
1 + a e(1) (1) (1)

+ p∗ St ξt +1 St + q∗ S ξ S
1+r 1 + r t t +1 t
(0) (0) (1) (1) (1) (1)
= IE∗ S0 ξt +1 St + Set +1 ξt +1 St Ft




∗ e
= IE Vt +1 Ft ,
 

t = 1, 2, . . . , N − 1, as in Remark 4.1.

The next Figure 4.5 presents a tree-based implementation of the riskless hedging component
(4.4.2).*

Figure 4.5: Tree of asset prices in the CRR model.

The next Figure 4.6 presents a tree-based implementation of call option prices in the CRR model.

Figure 4.6: Tree of option prices in the CRR model.

The next Figure 4.7 presents a tree-based implementation of risky hedging portfolio allocation in
the CRR model.

* Download the corresponding pricing and hedging IPython (call) or IPython (put) notebook that can be run here
or here.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 4.5 Hedging Exotic Options 107

Figure 4.7: Tree of hedging portfolio allocations in the CRR model.

4.5 Hedging Exotic Options

In this section we take p = p∗ given by (4.2.3) and we consider the hedging of path-dependent
options. Here we choose to use the finite difference gradient and the discrete Clark-Ocone formula
of stochastic analysis, see also §15-1 of Williams, 1991, Lamberton and Lapeyre, 1996, Ruiz
de Chávez, 2001, Föllmer and Schied, 2004, Privault, 2008, or Chapter 1 of Privault, 2009. See
Di Nunno, Øksendal, and Proske, 2009 and Section 8.2 of Privault, 2009 for a similar approach in
continuous time. Given

ω = (ω1 , ω2 , . . . , ωN ) ∈ Ω = {−1, 1}N ,

and r = 1, 2, . . . , N, let
t
ω+ := (ω1 , ω2 , . . . , ωt−1 , +1, ωt +1 , . . . , ωN )
and
t
ω− := (ω1 , ω2 , . . . , ωt−1 , −1, ωt +1 , . . . , ωN ).
We also assume that the return Rt (ω ) takes only two possible values
t
Rt (ω+ ) = b and t
Rt (ω− ) = a, t = 1, 2, . . . , N, ω ∈ Ω.

Definition 4.9 The operator Dt is defined on any random variable F by

t
Dt F (ω ) = F (ω+ ) − F (ω−t ), t = 1, 2, . . . , N. (4.5.1)

We define the centered and normalized return Yt by

b−r


 = q∗ , ωt = +1,
b−a

Rt − r 
Yt := = t = 1, 2, . . . , N.
b−a  a−r
= −p∗ , ωt = −1,



b−a
Note that under the risk-neutral probability measure P∗ we have
Rt − r
 
IE∗ [Yt ] = IE∗
b−a

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 108 Chapter 4. Pricing and Hedging in Discrete Time
a−r ∗ b−r ∗
= P (Rt = a) + P (Rt = b)
b−a b−a
a−r b−r b−r r−a
= × + ×
b−a b−a b−a b−a
= 0,
and
Var [Yt ] = p∗ (q∗ )2 + q∗ ( p∗ )2 = p∗ q∗ , t = 1, 2, . . . , N.
In addition, the discounted asset price increment reads
(1) (1) (1) 1 + Rt (1)
Set − Set−1 = Set−1 − Set−1
1+r
Rt − r e(1)
= S
1 + r t−1
b − a e(1)
= Yt S , t = 1, 2, . . . , N.
1 + r t−1
We also have
b−r a−r
 
Dt Yt = − = 1, t = 1, 2, . . . , N,
b−a b−a
and
N N
(1) (1) (1)
Dt SN = S0 ( 1 + b ) ∏ ( 1 + Rk ) − S0 ( 1 + a ) ∏ ( 1 + Rk )
k =1 k =1
k̸=t k̸=t

N
(1)
= (b − a)S0 ∏(1 + Rk )
k =1
k̸=t

N
(1) b−a
= S0 ∏ ( 1 + Rk )
1 + Rt k =1
b − a (1)
= S , t = 1, 2, . . . , N.
1 + Rt N
The following stochastic integral decomposition formula for the functionals of the binomial process
is known as the Clark-Ocone formula in discrete time, cf. e.g. Privault, 2009, Proposition 1.7.1.

Proposition 4.10 For any square-integrable random variables F on Ω, we have

F = IE∗ [F ] + ∑ Yk IE∗ [Dk F | Fk−1 ]. (4.5.2)

k⩾1

The Clark-Ocone formula (4.5.2) has the following consequence.

Corollary 4.11 Assume that (Mk )k∈N is a square-integrable (Fk )k∈N -martingale. Then, we
have
N
MN = IE∗ [MN ] + ∑ Yk Dk Mk , N ⩾ 0.
k =1

Proof. We have
MN = IE∗ [MN ] + ∑ Yk IE∗ [Dk MN | Fk−1 ]
k⩾1
= IE [MN ] + ∑ Yk Dk IE∗ [MN | Fk ]
∗
k⩾1

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.5 Hedging Exotic Options 109

= IE∗ [MN ] + ∑ Yk Dk Mk
k⩾1
N
= IE∗ [MN ] + ∑ Yk Dk Mk .
k =1

□
In addition to the Clark-Ocone formula we also state a discrete-time analog of Itô’s change of
variable formula, which can be useful for option hedging. The next result extends Proposition 1.13.1
of Privault, 2009 by removing the unnecessary martingale requirement on (Mt )n∈N .

Proposition 4.12 Let (Zn )n∈N be an (Fn )n∈N -adapted process and let f : R × N −→ R be a
given function. We have
t
f (Zt ,t ) = f (Z0 , 0) + ∑ Dk f (Zk , k)Yk
k =1
t
+ ∑ IE∗ [ f (Zk , k) | Fk−1 ] − f (Zk−1 , k − 1) ,


t ⩾ 0. (4.5.3)
k =1

Proof. First, we note that the process

t
Mt := f (Zt ,t ) − ∑ IE∗ [ f (Zk , k) | Fk−1 ] − f (Zk−1 , k − 1) ,


k =1

t = 0, 1, . . . , N, is a martingale under P∗ . Indeed, we have

" #
t
IE∗ f (Zt ,t ) − ∑ IE∗ [ f (Zk , k) | Fk−1 ] − f (Zk−1 , k − 1) Ft−1


k =1
= IE∗ [ f (Zt ,t ) | Ft−1 ]
t
− ∑ IE∗ [IE∗ [ f (Zk , k) | Fk−1 ] | Ft−1 ] − IE∗ [IE∗ [ f (Zk−1 , k − 1) | Fk−1 ] | Ft−1 ]


k =1
t
= IE∗ [ f (Zt ,t ) | Ft−1 ] − ∑ IE∗ [ f (Zk , k) | Fk−1 ] − f (Zk−1 , k − 1)


k =1
t−1
f (Zt−1 ,t − 1) − ∑ IE∗ [ f (Zk , k) | Fk−1 ] − f (Zk−1 , k − 1) ,


= t ⩾ 1.
k =1

Next, applying Corollary 4.11 to the martingale (Mt )t =0,1,...,N , we have

t
f (Zt ,t ) = Mt + ∑ IE∗ [ f (Zk , k) | Fk−1 ] − f (Zk−1 , k − 1)


k =1
t t
= IE∗ [Mt ] + ∑ Yk Dk Mk + ∑ IE∗ [ f (Zk , k) | Fk−1 ] − f (Zk−1 , k − 1)


k =1 k =1
t t
f (Z0 , 0) + ∑ Yk Dk f (Zk , k) + ∑ IE∗ [ f (Zk , k) | Fk−1 ] − f (Zk−1 , k − 1) ,


=
k =1 k =1

t ⩾ 0, as
Dk IE∗ [ f (Zk , k) | Fk−1 ] − f (Zk−1 , k − 1) = 0,


k ⩾ 1.
□

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 110 Chapter 4. Pricing and Hedging in Discrete Time

Note that if (Zt )t∈N is a discrete-time (Ft )t∈N -martingale in L2 (Ω) written as
t
Zt = Z0 + ∑ ukYk , t ⩾ 0,
k =1

where (ut )t∈N is an (Ft )t∈N -predictable process locally* in L2 (Ω × N), then we have



Dt f (Zt ,t ) = f Zt−1 + qut ,t − f Zt−1 − put ,t , (4.5.4)

t = 1, 2, . . . , N. On the other hand, the term

IE[ f (Zt ,t ) − f (Zt−1 ,t − 1) | Ft−1 ]

is analog to the finite variation part in the continuous-time Itô formula, and can be written as




p f Zt−1 + qut ,t + q f Zt−1 − put ,t − f Zt−1 ,t − 1 .

When ( f (Zt ,t ))t∈N is a martingale, Proposition 4.12 naturally recovers the decomposition
f (Zt ,t ) = f (Z0 , 0)
t



+ ∑ f Zk−1 + quk , k − f Zk−1 − puk , k Yk
k =1
t
= f (Z0 , 0) + ∑ Yk Dk f (Zk , k), (4.5.5)
k =1

that follows from Corollary 4.11 as well as from Proposition 4.10. In this case, the Clark-Ocone
formula (4.5.2) and the change of variable formula (4.5.5) both coincide and we have in particular

Dk f (Zk , k) = IE[Dk f (ZN , N ) | Fk−1 ],

k = 1, 2, . . . , N. For example, this recovers the martingale representation

t
(1) (1) (1)
Set = S0 + ∑ Yk Dk Sek
k =1

(1) b − a t e(1)
= S0 + Sk−1Yk
1 + r k∑
=1
t
(1) (1) R − r
= S0 + ∑ Sek−1 k
k =1 1+r
t
(1) (1) (1)

= S0 + ∑ Sek − Sek−1 ,
k =1

of the discounted asset price.

Our goal is to hedge an arbitrary claim payoff C on Ω, i.e. given an FN -measurable random
(0) (1)

variable C we search for a portfolio strategy ξt , ξt t =1,2,...,N such that the equality
(0) (0) (1) (1)
C = VN = ξN SN + ξN SN (4.5.6)
(0) (0)
holds, where SN = S0 (1 + r )N denotes the value of the riskless asset at time N ⩾ 0.
The next proposition is the main result of this section, and provides a solution to the hedging
problem under the constraint (4.5.6).

* i.e. u(·)1[0,N ] (·) ∈ L2 (Ω × N) for all N > 0.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.5 Hedging Exotic Options 111

(1)
Proposition 4.13 Hedge, then price. Given a contingent claim with payoff C, let ξ0 = 0,

(1) (1 + r )−(N−t )
ξt = (1)
IE∗ [Dt C | Ft−1 ], t = 1, 2, . . . , N, (4.5.7)
(b − a)St−1

and
(0) 1 (1) (1)

ξt = (0)
(1 + r )−(N−t ) IE∗ [C | Ft ] − ξt St , (4.5.8)
St
(0) (1)

t = 0, 1, . . . , N. Then the portfolio strategy ξt , ξt t =1,2,...,N
is self financing and we have

(0) (0) (1) (1)

Vt = ξt St + ξt St = (1 + r )−(N−t ) IE∗ [C | Ft ], t = 0, 1, . . . , N.
(0) (1)

In particular we have VN = C, hence ξt , ξt t =1,2,...,N
is a hedging strategy leading to C.

(1)
(0)

Proof. Let ξt t =1,2,...,N
be defined by (4.5.7), and consider the process ξt t =0,1,...,N
recur-
sively defined by
(1) (1)
(1)
(0) IE∗ [C ] (0) (0) ξt +1 − ξt St
ξ0 = (1 + r )−N (1) and ξt +1 = ξt − (0)
,
S0 St

(0) (1)

t = 0, 1, . . . , N − 1. Then ξt , ξt t =1,2,...,N
satisfies the self-financing condition

(0) (0) (0)
(1) (1) (1)

St ξt +1 − ξt + St ξt +1 − ξt = 0, t = 1, 2, . . . , N − 1.

Let now
1 (0) (0) (1) (1)
V0 := IE∗ [C ], Vt := ξt St + ξt St , t = 1, 2, . . . , N,
(1 + r )N
and
Vt
Vet = t = 0, 1, . . . , N.
(1 + r )t
(0) (1)

Since ξt , ξt t =1,2,...,N
is self-financing, by Lemma 4.2 we have

t
1 (1) (1)
Vet = Ve0 + (b − a) ∑ Y ξ Sk−1 ,
k k k
(4.5.9)
k =1 ( 1 + r )

t = 1, 2, . . . , N. On the other hand, from the Clark-Ocone formula (4.5.2) and the definition of
(1)

ξt t =1,2,...,N we have

1
IE∗ [C | Ft ]
(1 + r )N
" #
N
1 ∗ ∗ ∗
= IE IE [C ] + ∑ Yk IE [DkC | Fk−1 ] Ft
(1 + r )N k =0
t
1 1
= N
IE∗ [C ] + ∑ IE∗ [DkC | Fk−1 ]Yk
(1 + r ) (1 + r )N k =0

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 112 Chapter 4. Pricing and Hedging in Discrete Time
t
1 ∗ 1 (1) (1)
= N
IE [C ] + ( b − a ) ∑ ξ Sk−1Yk
k k
(1 + r ) k =0 ( 1 + r )
= Vet
from (4.5.9). Hence
1
Vet = IE∗ [C | Ft ], t = 0, 1, . . . , N,
(1 + r )N
and

Vt = (1 + r )−(N−t ) IE∗ [C | Ft ], t = 0, 1, . . . , N. (4.5.10)

In particular, (4.5.10) shows that we have VN = C. To conclude the proof we note that from
(0) (0) (1) (1) (0)

the relation Vt = ξt St + ξt St , t = 1, 2, . . . , N, the process ξt t =1,2,...,N coincides with
(0)

ξt t =1,2,...,N defined by (4.5.8). □

Example - Vanilla options

(1)

From Proposition 4.5, the price πt (C ) of the contingent claim with payoff C = h SN is given by
(1)

πt (C ) = v t, St ,

where the function v(t, x) is given by

(1)
1
v t, St = IE∗ [C | Ft ]
(1 + r )N−t
" !#
N
1
= IE∗ h x ∏ (1 + R j ) .
(1 + r )N−t j =t +1 (1)
x=St

(1)

Note that in this case we have C = v N, SN , IE[C ] = v(0, M0 ), and the discounted claim payoff
(1)

Ce = C/(1 + r )N = ve N, S satisfies
N

  N (1)

Ft−1
 
Ce = IE Ce + ∑ Yt IE Dt ve N, SN
t =1
N
  (1)

= IE Ce + ∑ Yt Dt ve t, St
t =1
N
  1 (1)

= IE Ce + ∑ t
Yt Dt v t, St
t =1 (1 + r )
  N (1)

Ft
 
= IE Ce + ∑ Yt Dt IE ve N, SN
t =1
N
1
Yt Dt IE[C | Ft ],
 
= IE Ce +
(1 + r )N t∑
=1

hence we have
(1)
(1)

Ft−1 = (1 + r )N−t Dt v t, St ,
 
IE Dt v N, SN t = 1, 2, . . . , N,
(1)

and by Proposition 4.13 the hedging strategy for C = h SN is given by

(1) (1 + r )−(N−t ) (1)

Ft−1
 
ξt = (1)
IE Dt h SN
(b − a)St−1

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 4.6 Convergence of the CRR Model 113

(1 + r )−(N−t ) (1)

Ft−1
 
= (1)
IE Dt v N, SN
(b − a)St−1
1 (1)

= (1)
Dt v t, St
(b − a)St−1
1 (1)
(1)


= (1)
v t, St−1 (1 + b) − v t, St−1 (1 + a)
(b − a)St−1
1 (1)
(1)


= (1)
ve t, St−1 (1 + b) − ve t, St−1 (1 + a) ,
(b − a)Set−1 /(1 + r )
(1)
t = 1, 2, . . . , N, which recovers Proposition 4.7 as a particular case. Note that ξt is nonnegative
(i.e. there is no short selling) when f is a non-decreasing function, because a < b. This is in
particular true in the case of the European call option, for which we have f (x) = (x − K )+ .

4.6 Convergence of the CRR Model

As the pricing formulas (4.2.2) in the CRR model can be difficult to implement for large values on
N, in this section we consider the convergence of the discrete-time model to the continuous-time
Black Scholes model.

Continuous compounding - riskless asset

Consider the discretization
(N − 1)T
 
T 2T
0, , ,..., ,T
N N N
of the time interval [0, T ] into N time steps.

0 T 2T T
N N

Note that
lim (1 + r )N = ∞,
N→∞

when r > 0, thus we need to renormalize r so that the interest rate on each time interval becomes
rN , with limN→∞ rN = 0. It turns out that the correct renormalization is
T
rN : = r , (4.6.1)
N
so that for T ⩾ 0,

T N
 
N
lim (1 + rN ) = lim 1 + r
N→∞ N→∞ N
  
T
= lim exp N log 1 + r
N→∞ N
= e rT . (4.6.2)
(0)
Hence the price St of the riskless asset is given by
(0) (0)
St = S0 e rt , t ⩾ 0, (4.6.3)

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 114 Chapter 4. Pricing and Hedging in Discrete Time

which solves the differential equation

(0)
dSt (0) (0)
= rSt , S0 = 1, t ⩾ 0. (4.6.4)
dt
We can also write
(0)
(0) (0) dSt
dSt = rSt dt, or (0)
= rdt, (4.6.5)
St
(0) (0) (0)
and using dSt ≃ St +dt − St we can discretize this equation by saying that the infinitesimal return
(0) (0) (0)
(St +dt − St )/St of the riskless asset equals rdt on the small time interval [t,t + dt ], i.e.
(0) (0)
St +dt − St
(0)
= rdt.
St
In this sense, the rate r is the instantaneous interest rate per unit of time.
The same equation rewrites in integral form as
wT wT
(0) (0) (0) (0)
ST − S0 = dSt = r St dt.
0 0
Continuous compounding - risky asset
We recall the central limit theorem.
Theorem 4.14 Let (Xn )n⩾1 be a sequence of independent and identically distributed random
variables with finite mean µ = IE[X1 ] and variance Var[X1 ] < ∞. We have the convergence in
distribution
X1 + · · · + Xn − nµ
lim √ = N (0, σ 2 ),
n→∞ n
or equivalently
X1 + · · · + Xn − nµ
lim √ = N (0, 1).
n→∞ σ n

The convergence in distribution of Theorem 4.14 is illustrated by the Galton board simulation of
Figure 4.8, which shows the convergence of the binomial random walk to a Gaussian distribution in
large time.

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Figure 4.8: Galton board simulation.*

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.6 Convergence of the CRR Model 115

Figure 4.9 pictures a real-life Galton board.

Figure 4.9: A real-life Galton board at Jurong Point # 03-01.

In the CRR model we need to replace the standard Galton board by its multiplicative version, which
(1)
shows that as N tends to infinity the distribution of SN converges to the lognormal distribution
with probability density function of the form

 
2 /2 T + log x/S(1)


2 
1 − r − σ 0
x 7−→ f (x) = √ exp − ,
 
2
2σ T
xσ 2πT

(1) √
x > 0, with location parameter (r − σ 2 /2)T + log S0 and scale parameter σ T , or log-variance
σ 2 T , as illustrated in the modified Galton board of Figure 4.10 below, see also Figure 6.6 and
Exercise 6.1.

* The animation works in Acrobat Reader on the entire pdf file.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 116 Chapter 4. Pricing and Hedging in Discrete Time

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Figure 4.10: Multiplicative Galton board simulation.*

2 /2)T
Exercise: Check that f is the probability density function of e σ X +(r−σ where X ≃ N (0, T )
is a centered Gaussian random variable with variance T > 0.
In addition to the renormalization (4.6.1) for the interest rate rN := rT /N, we need to apply a
similar renormalization to the coefficients a and b of the CRR model. Let σ > 0 denote a positive
parameter called the volatility, which quantifies the range of random fluctuations, and let aN , bN be
defined from r r
1 + aN T 1 + bN T
= 1−σ and = 1+σ
1 + rN N 1 + rN N
i.e.
r ! r !
T T
aN = ( 1 + rN ) 1 − σ − 1 and bN = (1 + rN ) 1 + σ − 1. (4.6.6)
N N
(N )
Consider the random return Rk ∈ {aN , bN } and the price process defined as
t
(1) (1) (N )
St,N = S0 ∏ (1 + Rk ), t = 1, 2, . . . , N. (4.6.7)
k =1

Note that the risk-neutral probabilities are given by

(N ) bN − rN
P∗ Rt = aN =


(4.6.8)
bN − aN
√

(1 + rN ) 1 + σ T /N − 1 − rN
= √
√

(1 + rN ) 1 + σ T /N − (1 + rN ) 1 − σ T /N
1
= , t = 1, 2, . . . , N,
2
and
(N ) rN − aN
P∗ Rt = bN =


(4.6.9)
bN − aN
√

rN − (1 + rN ) 1 − σ T /N + 1
= √
√

(1 + rN ) 1 + σ T /N − (1 + rN ) 1 − σ T /N
1
= , t = 1, 2, . . . , N.
2
* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.6 Convergence of the CRR Model 117

Continuous-time limit in distribution

We have the following convergence result.

Proposition 4.15 Let h be a continuous and bounded function on R. The price at time t = 0 of a
(1)

contingent claim with payoff C = h SN,N converges as follows:

1  (1)
  (1) 2
IE∗ h SN,N = e −rT IE h S0 e σ X +rT −σ T /2


lim N
(4.6.10)
N→∞ (1 + rT /N )

where X ≃ N (0, T ) is a centered Gaussian random variable with variance T > 0.

Proof. This result is a consequence of the weak convergence in distribution of the sequence
(1)

SN,N N⩾1 to a lognormal distribution, see e.g. Theorem 5.53 page 261 of Föllmer and Schied,
2004. Informally, using the Taylor expansion of the log function and (4.6.6), by (4.6.7) we have

N
(1) (1) (N )

log SN,N = log S0 + ∑ log 1 + Rk
k =1
N N (N )
(1) 1 + Rk
= log S0 + ∑ log(1 + rN ) + ∑ log
k =1 k =1 1 + rN
N   N
r !
(1) rT T
= log S0 + ∑ log 1 + + ∑ log 1 ± σ
k =1 N k =1 N
N N
r  !
(1) rT T σ 2T T
= log S0 + ∑ + ∑ ±σ − +o
k =1 N k =1 N 2N N

(1) σ 2T 1 N √
= log S0 + rT − + √ ∑ ± σ 2 T + o(1).
2 N k =1
Next, we note that by the Central Limit Theorem (CLT), the normalized sum

1 N √
√ ∑ ± σ 2T
N k =1
of independent Bernoulli random variables, with variance obtained from (4.6.8)-(4.6.9) as
" #
1 N √ 2 σ 2T N (N ) (N )
1 − P∗ Rt = bN P∗ Rt = aN




Var √ ∑ ± σ T = 4 ∑
N k =1 N k =1
≃ σ 2T , [N → ∞],
converges in distribution to a centered N (0, σ 2 T ) Gaussian random variable with variance σ 2 T .
Finally, the convergence of the discount factor (1 + rT /N )N to e −rT follows from (4.6.2). □
Note that the expectation (4.6.10) can be written as the Gaussian integral
w∞ √
e −x2 /2
(1) 2 (1) 2
e −rT IE f S0 e σ X +rT −σ T /2 = e −rT f S0 e σ T x+rT −σ T /2 √


dx,
−∞ 2π
see also Lemma 8.7 in Chapter 8, hence we have

1 w∞ √ 2
−x /2
∗
 (1)
 −rT (1) σ x T +rT −σ 2 T /2
e
lim IE h S N,N = e f S0 e √ dx.
N→∞ (1 + rT /N )N −∞ 2π

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 118 Chapter 4. Pricing and Hedging in Discrete Time

It is a remarkable fact that in case h(x) = (x − K )+ , i.e. when

(1)
+
C = ST − K

is the payoff of the European call option with strike price K, the above integral can be computed
according to the Black-Scholes formula, as
 (1) 2
+  (1)
e −rT IE S0 e σ X +rT −σ T /2 − K = S0 Φ(d+ ) − K e −rT Φ(d− ),

where
(1)
(r − σ 2 /2)T + log S0 /K √


d− = √ , d+ = d− + σ T ,
σ T
and
1 w x −y2 /2
Φ (x ) : = √ e dy, x ∈ R,
2π −∞
is the Gaussian cumulative distribution function, see Proposition 7.3.
The Black-Scholes formula will be derived explicitly in the subsequent chapters using both
PDE and probabilistic methods, cf. Propositions 7.11 and 8.6. It can be regarded as a building
block for the pricing of financial derivatives, and its importance is not restricted to the pricing of
options on stocks. Indeed, the complexity of the interest rate models makes it in general difficult
to obtain closed-form expressions, and in many situations one has to rely on the Black-Scholes
framework in order to find pricing formulas, for example in the case of interest rate derivatives as
in the Black caplet formula of the BGM model.
Our aim later on will be to price and hedge options directly in continuous-time using stochastic
calculus, instead of applying the limit procedure described in the previous section. In addition to the
construction of the riskless asset price (At )t∈R+ via (4.6.3) and (4.6.4) we now need to construct a
mathematical model for the price of the risky asset in continuous time.
(0)
In addition to modeling the return of the riskless asset St as in (4.6.5), the return of the risky
(1)
asset St over the time interval [t, d + dt ] will be modeled as
(1)
dSt
(1)
= µdt + σ dBt ,
St
where in comparison with (4.6.5), we add a “small” Gaussian random fluctuation σ dBt which
accounts for market volatility. Here, the Brownian increment dBt is multiplied by the volatility
parameter σ > 0. In the next Chapter 5 we will turn to the formal definition of the stochastic
process (Bt )t∈R+ which will be used for the modeling of risky assets in continuous time.

Exercises

(1)

Exercise 4.1 (Exercise 3.6 continued). Consider a two-step trinomial market model St t =0,1,2
with r = 0 and three possible return rates Rt = −1, 0, 1, and the risk-neutral probability measure
P∗ given by

P∗ (Rt = −1) := p∗ , P∗ (Rt = 0) := 1 − 2p∗ , P∗ (Rt = 1) := p∗ .

(1)
Taking S0 = 1 and using Proposition 4.4, price the European put option with strike price K = 1
and maturity N = 2 at times t = 0 and t = 1.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.6 Convergence of the CRR Model 119

Exercise 4.2 Consider a two-step binomial market model (St )t =0,1,2 with S0 = 1 and stock return
rates a = 0, b = 1, and a riskless account priced At = (1 + r )t at times t = 0, 1, 2, where r = 0.5.
Price and hedge the tunnel option whose payoff C at time t = 2 is given by


 3 if S2 = 4,



C= 1 if S2 = 2,




3 if S2 = 1.


Exercise 4.3 In a two-step trinomial market model (St )t =0,1,2 with interest rate r = 0 and three
return rates Rt = −0.5, 0, 1, we consider a down-an-out barrier call option with exercise date N = 2,
strike price K and barrier level B, whose payoff C is given by

+
 S N − K if min St > B,
t =1,2,...,N


C = SN − K 1

+
n o=

 0
 if min St ⩽ B.
t =1,2,...,N
min St > B
t =1,2,...,N

a) Show that P∗ given by r∗ = P∗ (Rt = −0.5) := 1/2, q∗ = P∗ (Rt = 0) := 1/4, p∗ = P∗ (Rt =

1) := 1/4 is a risk-neutral probability measure.
b) Taking S0 = 1, compute the possible values of the down-an-out barrier call option payoff C
with strike price K = 1.5 and barrier level B = 1, at maturity N = 2.
c) Price the down-an-out barrier call option with exercise date N = 2, strike price K = 1.5 and
barrier level B = 1, at time t = 0 and t = 1.
Hint: Use the formula
1
πt (C ) = IE∗ [C | St ], t = 0, 1, . . . , N,
(1 + r )N−t
where N denotes maturity time and C is the option payoff.
d) Is this market complete? Is every contingent claim attainable?

Exercise 4.4 Consider a two-step binomial random asset model (Sk )k=0,1,2 with possible returns
a = 0 and b = 200%, and a riskless asset Ak = A0 (1 + r )k , k = 0, 1, 2 with interest rate r = 100%,
and S0 = A0 = 1, under the risk-neutral probabilities p∗ = (r − a)/(b − a) = 1/2 and q∗ =
(b − r )/(b − a) = 1/2.
a) Draw a binomial tree for the possible values of (Sk )k=0,1,2 , and compute the values Vk at
times k = 0, 1, 2 of the portfolio hedging the European call option on SN with strike price
K = 8 and maturity N = 2.
Hint: Consider three cases when k = 2, and two cases when k = 1.
b) Price, then hedge. Compute the self-financing hedging portfolio strategy (ξk , ηk )k=1,2 with
values

V0 = ξ1 S0 + η1 A0 , V1 = ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1 , and V2 = ξ2 S2 + η2 A2 ,

hedging the European call option with strike price K = 8 and maturity N = 2.
Hint: Consider two separate cases for k = 2 and one case for k = 1.

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 120 Chapter 4. Pricing and Hedging in Discrete Time

c) Hedge, then price. Compute the hedging portfolio strategy (ξk , ηk )k=1,2 from the self-
financing condition, and use it to recover the result of part (a)).

Exercise 4.5 We consider a two-step binomial market model (St )t =0,1,2 with S0 = 1 and return
rates Rt = (St − St−1 )/St−1 , t = 1, 2, taking the values a = 0, b = 1, and assume that

p := P(Rt = 1) > 0, q := P(Rt = 0) > 0, t = 1, 2.

S2 = 4, C = 0

S1 = 2

S0 = 1 S2 = 2, C = 1

S1 = 1

S2 = 1, C = 0.

The riskless account is At = $1 and the risk-free interest rate is r = 0. We consider the tunnel
option whose payoff C at time t = 2 is given by


 0 if S2 = 4,



C= $1 if S2 = 2,




0 if S2 = 1.


a) Build a hedging portfolio for the claim C at time t = 1 depending on the value of S1 .
b) Price the claim C at time t = 1 depending on the value of S1 .
c) Build a hedging portfolio for the claim C at time t = 0.
d) Price the claim C at time t = 0.
e) Does this model admit an equivalent risk-neutral measure in the sense of Definitions 3.12-
3.14?
f) Is the model without arbitrage according to Theorem 3.15?

Exercise 4.6 Consider a discrete-time market model made of a riskless asset priced Ak = (1 + r )k
and a risky asset with price Sk , k ⩾ 0, such that the discounted asset price process ((1 + r )−k Sk )k⩾0
is a martingale under a risk-neutral probability measure P∗ . Using Theorem 4.3, compute the
arbitrage-free price πk (C ) at time k = 0, 1, . . . , N of the claim C with maturity time N and affine
payoff function
C = h ( SN ) = α + β SN
where α, β ∈ R are constants, in a discrete-time market with risk free rate r.

Exercise 4.7 Call-put parity.

a) Show that the relation (x − K )+ = x − K + (K − x)+ holds for any K, x ∈ R.
b) From part (a)), find a relation between the prices of call and put options with strike price
K > 0 and maturity N ⩾ 1 in a market with risk-free rate r > 0.
Hints:

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.6 Convergence of the CRR Model 121

i) Recall that an option with payoff  φ (SN ) and

 maturity N ⩾ 1 is priced at times k=
0, 1, . . . , N as (1 + r ) − ( N−k ) IE φ (SN ) Fk under the risk-neutral measure P .
∗ ∗

ii) The payoff at maturity of a European call (resp. put) option with strike price K is
(SN − K )+ , resp. (K − SN )+ .

Exercise 4.8 We consider a range forward contract having the payoff

ST − F + (K1 − ST )+ − (ST − K2 )+ ,

on an underlying asset priced ST at maturity T , where 0 < K1 < F < K2 .

a) Show that this range forward contract can be realized as a portfolio containing ST , a call
option, a put option, and a certain (positive or negative) amount in cash. Specify the quantity
of every asset held in the portfolio.
b) Draw the graph of the payoff function of the range forward contract by taking K1 := $80,
F := $100, and K2 := $110.

Exercise 4.9 Consider a two-step binomial random asset model (Sk )k=0,1,2 with possible returns
a = −50% and b = 150%, and a riskless asset Ak = A0 (1 + r )k , k = 0, 1, 2 with interest rate
r = 100%, and S0 = A0 = 1, under the risk-neutral probabilities p∗ = (r − a)/(b − a) = 3/4 and
q∗ = (b − r )/(b − a) = 1/4.
a) Draw a binomial tree for the values of (Sk )k=0,1,2 .
b) Compute the values Vk at times k = 0, 1, 2 of the hedging portfolio of the European put option
with strike price K = 5/4 and maturity N = 2 on SN .
c) Compute the self-financing hedging portfolio strategy (ξk , ηk )k=1,2 with values

V0 = ξ1 S0 + η1 A0 , V1 = ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1 , and V2 = ξ2 S2 + η2 A2 ,

hedging the European put option on SN with strike price K := 5/4 and maturity N := 2.

Exercise 4.10 Consider a two-step binomial random asset model (Sk )k=0,1,2 with possible returns
a := −50% and b := 200%, and a riskless asset Ak := A0 (1 + r )k , k = 0, 1, 2 with interest rate
r := 100%, S0 := $4, and A0 := $1.
Price and hedge the European put option on SN with strike price K := $11 and maturity N = 2.
Write your answers using simplified fractions only. For example, write 7/4 instead of 14/8 or 1.75.

Exercise 4.11 Analysis of a binary option trading website.

a) In a one-step model with risky asset prices S0 , S1 at times t = 0 and t = 1, compute the price
at time t = 0 of the binary call option with payoff


 $1 if S1 ⩾ K,
C = 1[K,∞) S1 =
0 if S1 < K,


in terms of the probability p∗ = P∗ (S1 ⩾ K ) and of the risk-free interest rate r.

b) Compute the two potential net returns obtained by purchasing one binary call option.
c) Compute the corresponding expected (net) return.
d) A website proposes to pay a return of 86% in case the binary call option matures “in the
money”, i.e. when S1 ⩾ K. Compute the corresponding expected (net) return. What do you
conclude?

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 122 Chapter 4. Pricing and Hedging in Discrete Time

Exercise 4.12 A put spread collar option requires its holder to sell an asset at the price f (S) when
its market price is at the level S, where f (S) is the function plotted in Figure 4.11, with K1 := 80,
K2 := 90, and K3 := 110.

130
Put spread collar price map f(S)
y=S
120

110

100

90

80

70
60 70 80 90 100 110 120 130
SN
K1 K2 K3

Figure 4.11: Put spread collar price map.

a) Draw the payoff function of the put spread collar as a function of the underlying asset price
at maturity. See e.g. https://optioncreator.com/.
b) Show that this put spread collar option can be realized by purchasing and/or issuing standard
European call and put options with strike prices to be specified.
Hints: Recall that an option with payoff φ (SN ) is priced (1 + r )−N IE∗ φ (SN ) at time 0.
 

The payoff of the European call (resp. put) option with strike price K is (SN − K )+ , resp.
(K − SN )+ .
Exercise 4.13 A call spread collar option requires its holder to buy an asset at the price f (S) when
its market price is at the level S, where f (S) is the function plotted in Figure 4.11, with K1 := 80,
K2 := 100, and K3 := 110.

140
Call spread collar price map f(S)
130 y=S

120

110

100

90

80

70

60
60 70 80 90 100 110 120 130
SN
K1 K2 K3

Figure 4.12: Call spread collar price map.

a) Draw the payoff function of the call spread collar as a function of the underlying asset price
at maturity. See e.g. https://optioncreator.com/.
b) Show that this call spread collar option can be realized by purchasing and/or issuing standard
European call and put options with strike prices to be specified.

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4.6 Convergence of the CRR Model 123

Hints: Recall that an option with payoff φ (SN ) is priced (1 + r )−N IE∗ φ (SN ) at time 0.
 

The payoff of the European call (resp. put) option with strike price K is (SN − K )+ , resp.
(K − SN )+ .

Exercise 4.14 Consider an asset price (Sn )n=0,1,...,N which is a martingale under the risk-neutral
probability measure P∗ , with respect to the filtration (Fn )n=0,1,...,N . Given the (convex) function
φ (x) := (x − K )+ , show that the price of an Asian option with payoff
S1 + · · · + SN
 
φ
N
and maturity N ⩾ 1 is always lower than the price of the corresponding European call option, i.e.
show that
S1 + S2 + · · · + SN
  
∗
IE φ ⩽ IE∗ [φ (SN )].
N
Hint: Use in the following order:
(i) the convexity inequality φ (x1 /N + · · · + xN /N ) ⩽ φ (x1 )/N + · · · + φ (xN )/N,
(ii) the martingale property Sk = IE∗ [SN | Fk ], k = 1, 2, . . . , N.
(iii) The Jensen, 1906 inequality

φ (IE∗ [SN | Fk ]) ⩽ IE∗ [φ (SN ) | Fk ], k = 1, 2, . . . , N,

(iv) the tower property IE∗ [IE∗ [φ (SN ) | Fk ]] = IE∗ [φ (SN )] of conditional expectations, k =
1, 2, . . . , N.

Exercise 4.15 (Exercise 3.9 continued).

a) We consider a forward contract on SN with strike price K and payoff

C := SN − K.

Find a portfolio allocation (ηN , ξN ) with value

VN = ηN πN + ξN SN

at time N, such that

VN = C, (4.6.11)

by writing Condition (4.6.11) as a 2 × 2 system of equations.

b) Find a portfolio allocation (ηN−1 , ξN−1 ) with value

VN−1 = ηN−1 πN−1 + ξN−1 SN−1

at time N − 1, and verifying the self-financing condition

VN−1 = ηN πN−1 + ξN SN−1 .

Next, at all times t = 1, 2, . . . , N − 1, find a portfolio allocation (ηt , ξt ) with value Vt =

ηt πt + ξt St verifying (4.6.11) and the self-financing condition

Vt = ηt +1 πt + ξt +1 St ,

where ηt , resp. ξt , represents the quantity of the riskless, resp. risky, asset in the portfolio
over the time period [t − 1,t ], t = 1, 2, . . . , N − 1.

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 124 Chapter 4. Pricing and Hedging in Discrete Time

c) Compute the arbitrage-free price πt (C ) = Vt of the forward contract C, at time t = 0, 1, . . . , N.

d) Check that the arbitrage-free price πt (C ) satisfies the relation
1
πt (C ) = IE∗ [C | Ft ], t = 0, 1, . . . , N.
(1 + r )N−t

Exercise 4.16 Power option. Let (Sn )n∈N denote a binomial price process with returns −50%
and +50%, and let the riskless asset be valued Ak = $1, k ∈ N. We consider a power option with
payoff C := (SN )2 , and a predictable self-financing portfolio strategy (ξk , ηk )k=1,2,...,N with value

Vk = ξk Sk + ηk A0 , k = 1, 2, . . . , N.

a) Find the portfolio allocation (ξN , ηN ) that matches the payoff C = (SN )2 at time N, i.e. that
satisfies

VN = (SN )2 .

Hint: We have ηN = −3(SN−1 )2 /4.

b) In the following questions we use the risk-neutral probability p∗ = 1/2 of a +50% return.
i) Compute the portfolio value

VN−1 = IE∗ [C | FN−1 ].

ii) Find the portfolio allocation (ηN−1 , ξN−1 ) at time N − 1 from the relation

VN−1 = ξN−1 SN−1 + ηN−1 A0 .

Hint: We have ηN−1 = −15(SN−2 )2 /16.

iii) Check that the portfolio satisfies the self-financing condition

VN−1 = ξN−1 SN−1 + ηN−1 A0 = ξN SN−1 + ηN A0 .

Exercise 4.17 Consider the discrete-time Cox-Ross-Rubinstein model with N + 1 time instants
t = 0, 1, . . . , N. The price St0 of the riskless asset evolves as St0 = π 0 (1 + r )t , t = 0, 1, . . . , N. The
return of the risky asset, defined as
St − St−1
Rt := , t = 1, 2, . . . , N,
St−1
is random and allowed to take only two values a and b, with −1 < a < r < b.
The discounted asset price is given by Set := St /(1 + r )t , t = 0, 1, . . . , N.
a) Show that this model admits a unique risk-neutral probability measure P∗ and explicitly
compute P∗ (Rt = a) and P(Rt = b) for all t = 1, 2, . . . , N, with a = 2%, b = 7%, r = 5%.
b) Does there exist arbitrage opportunities in this model? Explain why.
c) Is this market model complete? Explain why.
d) Consider a contingent claim with payoff*

C = (SN )2 .

Compute the discounted arbitrage-free price Vet , t = 0, 1, . . . , N, of a self-financing portfolio

hedging the claim payoff C, i.e. such that
( SN ) 2
VN = C = (SN )2 , or VeN = Ce = .
(1 + r )N
* This is the payoff of a power call option with strike price K = 0.

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4.6 Convergence of the CRR Model 125

e) Compute the portfolio strategy

= ξt0 , ξt1



ξt t =1,2,...,N t =1,2,...,N

associated to Vet , i.e. such that

Vet = ξ t • X t = ξt0 Xt0 + ξt1 Xt1 , t = 1, 2, . . . , N.

f) Check that the above portfolio strategy is self-financing, i.e.

ξ t • St = ξ t +1 • St , t = 1, 2, . . . , N − 1.

Exercise 4.18 We consider the discrete-time Cox-Ross-Rubinstein model with N + 1 time instants
t = 0, 1, . . . , N.
The price πt of the riskless asset evolves as πt = π0 (1 + r )t , t = 0, 1, . . . , N. The evolution of St−1
to St is given by 
 (1 + b)St−1 if Rt = b,
St =
(1 + a)St−1 if Rt = a,


with −1 < a < r < b. The return of the risky asset is defined as
St − St−1
Rt := , t = 1, 2, . . . , N.
St−1

Let ξt , resp. ηt , denote the (possibly fractional) quantities of the risky, resp. riskless, asset held
over the time period [t − 1,t ] in the portfolio with value

Vt = ξt St + ηt πt , t = 0, 1, . . . , N. (4.6.12)

a) Show that

Vt = (1 + Rt )ξt St−1 + (1 + r )ηt πt−1 , t = 1, 2, . . . , N. (4.6.13)

b) Show that under the probability P∗ defined by

b−r r−a
P∗ (Rt = a | Ft−1 ) = , P∗ (Rt = b | Ft−1 ) = ,
b−a b−a
where Ft−1 represents the information generated by {R1 , R2 , . . . , Rt−1 }, we have

IE∗ [Rt | Ft−1 ] = r.

c) Under the self-financing condition

Vt−1 = ξt St−1 + ηt πt−1 , t = 1, 2, . . . , N, (4.6.14)

recover the martingale property

1
Vt−1 = IE∗ [Vt | Ft−1 ],
1+r
using the result of Question (a)).
d) Let a = 5%, b = 25% and r = 15%. Assume that the value Vt at time t of the portfolio is $3
if Rt = a and $8 if Rt = b, and compute the value Vt−1 of the portfolio at time t − 1.

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 126 Chapter 4. Pricing and Hedging in Discrete Time

Problem 4.19 CRR model with transaction costs. Stock broker income is generated by commissions
or transaction costs representing the difference between ask prices (at which they are willing to sell
an asset to their client), and bid prices (at which they are willing to buy an asset from their client).
We consider a discrete-time Cox-Ross-Rubinstein model with one risky asset priced St at time
t = 0, 1, . . . , N. The price At of the riskless asset evolves as

At = ρ t , t = 0, 1, . . . , N,

with A0 := 1 and ρ > 0, and the random evolution of St−1 to St is given by two possible returns α,
β as 
 β St−1
St =

αSt−1
t = 1, . . . , N, with 0 < α < β .

S2 = β 2 S0

S1 = β S0

S0 S2 = αβ S0

S1 = αS0

S2 = α 2 S0 .

Figure 4.13: Tree of market prices with N = 2.

The ask and bid prices of the risky asset quoted St on the market are respectively given by (1 + λ )St ,
and (1 − λ )St for some λ ∈ [0, 1), such that

↑
 α := α (1 + λ ) < β (1 − λ ) =: β↓ ,

α↓ := α (1 − λ ) < β (1 − λ ) := β↓ ,

 ↑
α : = α (1 + λ ) < β (1 + λ ) = : β ↑ ,

i.e., transaction costs are charged at the rate λ ∈ [0, 1), proportionally to the traded amount.

β ↑ β S0 = β ↑ S1 β↓ β S0 = β↓ S1

β ↑ S0 β↓ S0

α ↑ β S0 = α ↑ S1 α↓ β S0 = α↓ S1

S0 S0

β ↑ αS0 = β ↑ S1 β↓ αS0 = β↓ S1

α ↑ S0 α↓ S0

α ↑ αS0 = α ↑ S1 . α↓ αS0 = α↓ S1 .
(a) Tree of ask prices. (b) Tree of bid prices.

Figure 4.14: Trees of bid and ask prices with N = 2.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.6 Convergence of the CRR Model 127

The riskless asset is not subject to transaction costs or bid/ask prices, and is priced At at time
t = 0, 1, . . . , N. We consider a predictable, self-financing replicating portfolio strategy
(ηt (St−1 ), ξt (St−1 ))t =1,2,...,N .
made of ηt (St−1 ) of the riskless asset At and of ξt (St−1 ) units of the risky asset St at time
t = 1, 2, . . . , N.
Our goal is to derive a backward recursion giving ξt (St−1 ), ηt (St−1 ) from ξt +1 (St ), ηt +1 (St )
for t = N − 1, N − 2 . . . , 1. The following questions are interdependent and should be treated in
sequence.
a) We consider a portfolio reallocation (ηt (St−1 ), ξt (St−1 )) → (ηt +1 (St ), ξt +1 (St )) at time
t ∈ {1, . . . , N − 1}. Write down the self-financing condition in the event of:
i) an increase in the stock position from ξt (St−1 ) to ξt +1 (St ),
ii) a decrease in the stock position from ξt (St−1 ) to ξt +1 (St ).
The conditions are written using ηt (St−1 ), ηt +1 (St ), ξt (St−1 ), ξt +1 (St ), At , St and λ .
b) From Questions i))-ii)), deduce two self-financing equations in case St = αSt−1 , and two
self-financing equations in case St = β St−1 .
c) Using the functions
 ↑  ↑
 α if x ⩽ y,  β if x ⩽ y,
gα (x, y) := and gβ (x, y) :=
α↓ if x > y, β↓ if x > y,
 

rewrite the equations of Question (b)) into a single equation in case St = αSt−1 , and a single
equation in case St = β St−1 .
d) From the result of Question (c)), derive an equation satisfied by ξt (St−1 ), and show that it
admits a unique solution ξt (St−1 ).
Hint: Show that the piecewise affine function

x 7→ f (x, St−1 ) := gβ (x, ξt +1 (β St−1 )) x − ξt +1 (β St−1 )


ηt +1 (β St−1 ) − ηt +1 (αSt−1 )
−gα (x, ξt +1 (αSt−1 ) x − ξt +1 (αSt−1 ) − ρ
Set−1
is strictly increasing in x ∈ R.
e) Find the expressions of ξt (St−1 ) and ηt (St−1 ) by solving the 2 × 2 system of equations of
Question (c)).
Hint: The expressions have to use the quantities
gα (ξt (St−1 ), ξt +1 (αSt−1 )), gβ (ξt (St−1 ), ξt +1 (β St−1 )),
and they should be consistent with Proposition 4.8 when λ = 0, i.e. when α ↑ = α↓ = 1 + a
and β ↑ = β↓ = 1 + b, with ρ = 1 + r.
f) Find the value of gα (ξt (St−1 ), ξt +1 (αSt−1 )) in the following two cases:
i) f (ξt +1 (αSt−1 ), St−1 ) ⩾ 0,
ii) f (ξt +1 (αSt−1 ), St−1 ) < 0,
and the value of gβ (ξt (St−1 ), ξt +1 (β St−1 )) in the following two cases:
i) f (ξt +1 (β St−1 ), St−1 ) ⩾ 0,
ii) f (ξt +1 (β St−1 ), St−1 ) < 0.
g) Hedge and price the call option with strike price K = $2 and N = 2 when S0 = 8, ρ = 1,
α = 0.5, β = 2, and the transaction cost rate is λ = 12.5%. Provide sufficient details of hand
calculations.
Remark: The evaluation of the terminal payoff uses the value of S2 only, and is not affected
by bid/ask prices.

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 128 Chapter 4. Pricing and Hedging in Discrete Time

h) Modify the attached IPython notebook in order to include the treatment of transaction costs.

Figure 4.15: BTC/USD order book example.*

In the above figure, ask prices are marked in red and bid prices are marked in green. The center
column gives the quantity of the asset available at that row’s bid or ask price, and the right column
represents the cumulative volume of orders from the last-traded price until the current bid/ask price
level. The large number in the center shows the last-traded price.

Problem 4.20 CRR model with dividends (1). Consider a two-step binomial model for a stock
paying a dividend at the rate α ∈ (0, 1) at times k = 1 and k = 2, and the following recombining
tree represents the ex-dividend† prices Sk at times k = 1, 2, starting from S0 = $1.

* The animation works in Acrobat Reader on the entire pdf file.

†“Ex-dividend” means after dividend payment.

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4.6 Convergence of the CRR Model 129

S2 = 9
p∗

S1 = 3
p∗
q∗
S0 = 1 S2 = 3
p∗
q∗
S1 = 1

q∗
S2 = 1

install.packages("quantmod");library(quantmod)
getDividends("Z74.SI",from="2018-01-01",to="2018-12-31",src="yahoo")
getSymbols("Z74.SI",from="2018-11-16",to="2018-12-19",src="yahoo")
dev.new(width=16,height=7)
myPars <- chart_pars();myPars$cex<-1.8
myTheme <- chart_theme();myTheme$col$line.col <- "purple"
myTheme$rylab <- FALSE
chart_Series(Op(`Z74.SI`),name="Opening prices (purple) - Closing prices
(blue)",lty=4,lwd=6,pars=myPars,theme=myTheme)
add_TA(Cl(`Z74.SI`),lwd=3,lty=5,legend='Difference',col="blue",on = 1)

Z74.SI.div
2018-07-26 0.107
2018-12-17 0.068
2018-12-18 0.068

Opening prices (purple) − Closing prices (blue) 2018−11−16 / 2018−12−18

3.12

3.10 3.10

3.08

3.06
3.05
3.04

3.02

3.00 3.00

2.98

Nov 16 Nov 20 Nov 22 Nov 26 Nov 28 Nov 30 Dec 04 Dec 06 Dec 10 Dec 12 Dec 14 Dec 18
2018 2018 2018 2018 2018 2018 2018 2018 2018 2018 2018 2018

Figure 4.16: SGD0.068 dividend detached on 18 Dec 2018 on Z74.SI.

The difference between the closing price on Dec 17 ($3.06) and the opening price on Dec 18 ($2.99)
is $3.06 − $2.99 = $0.07. The adjusted price on Dec 17 ($2.992) is the closing price ($3.06) minus
the dividend ($0.068).

Z74.SI Open High Low Close Volume Adjusted (ex-dividend)

2018-12-17 3.05 3.08 3.05 3.06 17441000 2.992
2018-12-18 2.99 2.99 2.96 2.96 28456400 2.960

The dividend rate α is given by α = 0.068/3.06 = 2.22%.

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 130 Chapter 4. Pricing and Hedging in Discrete Time

We consider a riskless asset Ak = A0 (1 + r )k , k = 0, 1, 2 with interest rate r = 100% and A0 = 1,

and two portfolio allocations (ξ1 , η1 ) at time k = 0 and (ξ2 , η2 ) at time k = 1, with the values

V1 = ξ2 S1 + η2 A1 (4.6.15)

and

V0 = ξ1 S0 + η1 A0 . (4.6.16)

We make the following three assumptions:

[A] All dividends are reinvested.
[B] The portfolio strategies are self-financing.
[C] The portfolio value V2 at time k = 2 hedges the European call option with payoff C =
(ST − K )+ , strike price K = 8, and maturity T = 2.
a) Using (4.6.15) and [A], express V2 in terms of ξ2 , η2 , S2 , A2 and α.
b) Using (4.6.16) and [A]-[B], express V1 in terms of ξ1 , η1 , S1 , A1 and α.
c) Using Assumption [C] and the result of Question (a)), compute the portfolio allocation
(ξ2 , η2 ) in cases S1 = 1 and S1 = 3.
d) Using (4.6.15) and the portfolio allocation (ξ2 , η2 ) obtained in Question (c)), compute the
portfolio value V1 in cases S1 = 1 and S1 = 3.
e) From the results of Questions (b)) and (d)), compute the initial portfolio allocation (ξ1 , η1 ).
f) Compute the initial portfolio value V0 from the result of Question (e)).
g) Knowing that the dividend rate is α = 25%, draw the tree of asset prices (Sk )k=1,2 before
(i.e. without) dividend payments.

S2 = ?
p∗

S1 = ?
p∗
q∗
S 0 = S0 = 1 S2 = ?
p∗
q∗
S1 = ?

q∗
S2 = ?

h) Compute the risk-neutral probabilities p∗ and q∗ under which the conditional expected return
of (Sk )k=0,1,2 is the risk-free interest rate r = 100%.
i) ✓ Check that the portfolio value V1 found in Question (d)) satisfies
1
V1 = IE∗ [(S2 − K )+ | S1 ].
1+r
j) ✓ Check that the portfolio value V0 found in Question (f)) satisfies
1 1
IE∗ (S2 − K )+ ] IE∗ V1 ].
 
V0 = 2
and V0 =
(1 + r ) 1+r

Problem 4.21 CRR model with dividends (2). We consider a riskless asset priced as
(0) (0)
Sk = S0 ( 1 + r ) k , k = 0, 1, . . . , N,

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4.6 Convergence of the CRR Model 131

with r > −1, and a risky asset S(1) whose return is given by
(1) (1)
Sk − Sk−1
Rk : = (1)
, k = 1, 2, . . . , N,
Sk−1

with N + 1 time instants k = 0, 1, . . . , N and d = 1. In the CRR model the return Rk is random and
allowed to take two values a and b at each time step, i.e.

Rk ∈ {a, b}, k = 1, 2, . . . , N,
(1) (1)
with −1 < a < 0 < b, and the random evolution of Sk−1 to Sk is given by
 
(1)
 (1 + b)Sk−1 if Rk = b 
 
(1) (1)
Sk = = (1 + Rk )Sk−1 , k = 1, 2, . . . , N, (4.6.17)
 (1) 
(1 + a)Sk−1 if Rk = a
 

according to the tree

(1)
(1 + b)Sk−1
(1)
Sk−1
(1)
(1 + a)Sk−1

and we have
k
(1) (1)
Sk = S0 ∏(1 + Ri ), k = 0, 1, . . . , N.
i=1
(1) (1) (1)
The information Fk known to the market up to time k is given by the knowledge of S1 , S2 , . . . , Sk ,
i.e. we write
(1) (1) (1)

Fk = σ S1 , S2 , . . . , Sk = σ (R1 , R2 , . . . , Rk ),
(1)
k = 0, 1, . . . , N, where S0 is a constant and F0 = {0,
/ Ω} contains no information.
Under the risk-neutral probability measure P∗ defined by
r−a b−r
p∗ := P∗ (Rk = b) = > 0, q∗ := P∗ (Rk = a) = > 0,
b−a b−a
k = 1, 2, . . . , N, the asset returns (Rk )k=1,2,...,N form a sequence of independent identically dis-
tributed random variables.
In what follows we assume that the stock Sk pays a dividend rate α > 0 at times k = 1, 2, . . . , N.
At the beginning of every time step k = 1, 2, . . . , N, the price Sk is immediately adjusted to its
ex-dividend level by losing α% of its value. The following ten questions are interdependent and
should be treated in sequence.
(1) (1)
a) Rewrite the evolution (4.6.17) of Sk−1 to Sk in the presence of a daily dividend rate α > 0.
(1)
b) Express the dividend amount as a percentage of the ex-dividend price Sk , and show that
under the risk-neutral probability measure the return of the risky asset satisfies
" (1) #
∗ Sk+1 (1)
IE Fk = (1 + r )Sk , k = 0, 1, . . . , N − 1.
1−α

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 132 Chapter 4. Pricing and Hedging in Discrete Time

c) We consider a (predictable) portfolio strategy (ξk , ηk )k=1,2,...,N with value process

(1) (0)
Vk = ξk+1 Sk + ηk+1 Sk

at time k = 0, 1, . . . , N − 1. Write down the self-financing condition for the portfolio value
process (Vk )k=0,1,...,N by taking into account the reinvested dividends, and give the expression
of VN .
d) Show that under the self-financing condition, the discounted portfolio value process
Vk
Vek := (0) , k = 0, 1, . . . , N,
Sk
is a martingale under the risk-neutral probability measure P∗ .
e) Show that the price at time k = 0, 1, . . . , N of a claim with random payoff C can be written as
1
Vk = IE∗ [C | Fk ], k = 0, 1, . . . , N,
(1 + r )N−k
assuming that the claim C is attained at time N by the portfolio strategy (ξk , ηk )k=1,2,...,N .
(1)

f) Compute the price at time t = 0, 1, . . . , N of a vanilla option with payoff h SN using the
pricing function

C0 k, x, N, a, b, r
N−k 
N −k

1
( p∗ )l (q∗ )N−k−l h x(1 + b)l (1 + a)N−k−l


:= N−k ∑
(1 + r ) l =0 l
(1)

of a vanilla claim with payoff h SN .
(1)

g) Show that the price at time t = 0, 1, . . . , N of a vanilla option with payoff function h SN
can be rewritten as
(1) (1)
Vk = Cα k, Sk , N, aα , bα , rα := (1 − α )N−kC0 k, Sk , N, aα , bα , rα ,

k = 0, 1, . . . , N, where the coefficients aα , bα , rα will be determined
explicitly.

h) Find a recurrence relation between the functions Cα k, x, N, aα , bα , rα and Cα k + 1, x, N, aα , bα , rα
using the martingale property of the discounted portfolio value process (Vek )k=0,1,...,N under
the risk-neutral probability measure P∗ .

(1)
i) Using the function C0 k, x, N, aα , bα , rα , compute the quantity ξk of risky asset Sk allocated
(1)

on the time interval [k − 1, k) in a self-financing portfolio hedging the claim C = h SN .
j) How are the dividends reinvested in the self-financing hedging portfolio?

Problem 4.22 We consider a ternary tree (or trinomial) model with N + 1 time instants k =
(0)
0, 1, . . . , N and d = 1 risky asset. The price Sk of the riskless asset evolves as
(0) (0)
Sk = S0 (1 + r )k , k = 0, 1, . . . , N,

with r > −1. Let the return of the risky asset S(1) be defined as
(1) (1)
Sk − Sk−1
Rk := (1)
, k = 1, 2, . . . , N.
Sk−1
In this ternary tree model, the return Rk is random and allowed to take only three values a, 0 and b
at each time step, i.e.
Rk ∈ {a, 0, b}, k = 1, 2, . . . , N,

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.6 Convergence of the CRR Model 133
(1) (1)
with −1 < a < 0 < b. That means, the evolution of Sk−1 to Sk is random and given by
(1)
 

 ( 1 + b ) Sk−1 if Rk = b 


 


 

(1) (1) (1)
Sk = Sk−1 if Rk = 0 = (1 + Rk )Sk−1 , k = 1, 2, . . . , N,

 


 

(1)

 

(1 + a)Sk−1 if Rk = a
and
k
(1) (1)
Sk = S0 ∏ ( 1 + Ri ) , k = 0, 1, . . . , N.
i=1
(1)

The price process Sk k=0,1,...,N
evolves on a ternary tree of the form:

(1)
( 1 + b ) S0
(1) (1)
S0 S0

(1)
( 1 + a ) S0

(1) (1) (1)

The information Fk known to the market up to time k is given by the knowledge of S1 , S2 , . . . , Sk ,
i.e. we write
(1) (1) (1)

Fk = σ S1 , S2 , . . . , Sk = σ (R1 , R2 , . . . , Rk ),
(1)
k = 0, 1, . . . , N, where, as a convention, S0 is a constant and F0 = {0, / Ω} contains no information.
In what follows we will consider that (Rk )k=1,2,...,N is a sequence of independent identically
distributed random variables under any risk-neutral probability measure P∗ , and we denote
 ∗

 p := P∗ (Rk = b) > 0,



θ ∗ := P∗ (Rk = 0) > 0,



 ∗
q := P∗ (Rk = a) > 0, k = 1, 2, . . . , N.


a) Determine all possible risk-neutral probability measures P∗ equivalent to P in terms of the

parameter θ ∗ ∈ (0, 1).
b) Give a necessary and sufficient condition for absence of arbitrage in this ternary tree model.
Hint: Use your intuition of the market to find what the condition should be, and then prove
that it is necessary and sufficient. Note that we have a < 0 and b > 0, and the condition
should only depend on the model parameters a, b and r.
c) When the model parameters allow for arbitrage opportunities, explain how you would exploit
them if you joined the market with zero money to invest.
d) Is this ternary tree market model complete?
e) In this question we assume that the conditional variance
" (1) (1)
#
∗ Sk+1 − Sk
Var (1)
Fk = σ 2 > 0
Sk
(1) (1) (1)
of the asset return (Sk+1 −Sk )/Sk given Fk is constant and equal to σ 2 , k = 0, 1, . . . , N −1.
Show that this condition determines a unique value of θ ∗ and a unique risk-neutral probability
measure P∗σ to be written explicitly, under a certain condition on a, b, r and σ .

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 134 Chapter 4. Pricing and Hedging in Discrete Time

f) In this question and in the following we impose the condition (1 + a)(1 + b) = 1, i.e. we let
a := −b/(b + 1). What does this imply on this ternary tree model and on the risk-neutral
probability measure P∗ ?
g) We consider a vanilla financial claim with payoff C = h(SN ) and maturity N, priced as time
k as
(1)
1
IE∗θ h(SN ) Fk
 
f k, Sk = N−k
(1 + r )
1 ∗
 (1) 
= IE θ h ( S N ) S k ,
(1 + r )N−k
k = 0, 1, . . . , N, under the risk-neutral probability measure P∗θ . Find a recurrence equation
between the functions f (k, ·) and f (k + 1, ·), k = 0, . . . , N − 1.

Hint: Use the tower property of conditional expectations.

h) Assuming that C is the payoff of the European put option with strike price K, give the
expression of f (N, x).
i) Modify the attached binomial Python code in order to make it deal with the trinomial model.
(1)
j) Taking S0 = 1, r = 0.1, b = 1, (1 + a)(1 + b) = 1, compute the price at time k = 0 of
the European put option with strike price K = 1 and maturity N = 2 using the code of
Question (i)) with θ = 0.5.

Download* and install the Anaconda distribution from https://www.anaconda.com/

distribution/ or try it online at https://jupyter.org/try.

%matplotlib inline
import networkx as nx
import numpy as np
import matplotlib
import matplotlib.pyplot as plt
N=2;S0=1
r = 0.1;a=-0.5;b=1; # change
# add definition of theta
p = (r-a)/(b-a) # change
q = (b-r)/(b-a) # change
def plot_tree(g):
plt.figure(figsize=(20,10))
pos={};lab={}
for n in g.nodes():
pos[n]=(n[0],n[1])
if g.nodes[n]['value'] is not None: lab[n]=float("{0:.2f}".format(g.nodes[n]['value']))
elarge=g.edges(data=True)
nx.draw_networkx_labels(g,pos,lab,font_size=15)
nx.draw_networkx_nodes(g,pos,node_color='lightblue',alpha=0.4,node_size=1000)
nx.draw_networkx_edges(g,pos,edge_color='blue',alpha=0.7,width=3,edgelist=elarge)
plt.ylim(-N-0.5,N+0.5)
plt.xlim(-0.5,N+0.5)
plt.show()

* Download the corresponding IPython notebook that can be run here or here.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

4.6 Convergence of the CRR Model 135

def graph_stock():
S=nx.Graph()
for k in range(0,N):
for l in range(-k,k+2,2): # change range and step size
S.add_edge((k,l),(k+1,l+1)) # add edge
S.add_edge((k,l),(k+1,l-1))
for n in S.nodes():
k=n[0]
l=n[1]
S.nodes[n]['value']=S0*((1.0+b)**((k+l)/2))*((1.0+a)**((k-l)/2))
return S
plot_tree(graph_stock())

def European_call_price(K):
price = nx.Graph()
hedge = nx.Graph()
S = graph_stock()
for k in range(0,N):
for l in range(-k,k+2,2): # change range and step size
price.add_edge((k,l),(k+1,l+1)) # add edge
price.add_edge((k,l),(k+1,l-1))
for l in range(-N,N+2,2): # change range and step size
price.nodes[(N,l)]['value'] = np.maximum(S.nodes[(N,l)]['value']-K,0)

for k in reversed(range(0,N)):
for l in range(-k,k+2,2): # change range and step size
price.nodes[(k,l)]['value'] = (price.nodes[(k+1,l+1)]['value']*p
+price.nodes[(k+1,l-1)]['value']*q)/(1+r) # add theta
return price

K = input("Strike K=")
call_price = European_call_price(float(K))
print('Underlying asset prices:')
plot_tree(graph_stock())
print('European call option prices:')
plot_tree(call_price)
print('Price at time 0 of the European call option:',
float("{0:.4f}".format(call_price.nodes[(0,0)]['value'])))

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 137

5. Brownian Motion and Stochastic Calculus

Brownian motion is a continuous-time stochastic process having stationary and independent Gaus-
sian distributed increments, and continuous paths. This chapter presents the constructions of
Brownian motion and its associated Itô stochastic integral, which will be used for the random
modeling of asset and portfolio prices in continuous time.

5.1 Brownian Motion 111

5.2 Three Constructions of Brownian Motion 115
5.3 Wiener Stochastic Integral 119
5.4 Itô Stochastic Integral 127
5.5 Stochastic Calculus 134
Exercises 145

5.1 Brownian Motion

We start by recalling the definition of Brownian motion, which is a fundamental example of a
stochastic process. The underlying probability space (Ω, F , P) of Brownian motion can be con-
structed on the space Ω = C0 (R+ ) of continuous real-valued functions on R+ started at 0.

Definition 5.1 The standard Brownian motion is a stochastic process (Bt )t∈R+ such that
1. B0 = 0,

2. The sample trajectories t 7→ Bt are continuous, with probability one.

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 138 Chapter 5. Brownian Motion and Stochastic Calculus

3. For any finite sequence of times t0 < t1 < · · · < tn , the increments

Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1

are mutually independent random variables.

4. For any given times 0 ⩽ s < t, Bt − Bs has the Gaussian distribution N (0,t − s) with
mean zero and variance t − s.
In particular, for t ∈ R+ , the random variable Bt ≃ N (0,t ) has a Gaussian distribution with mean
zero and variance t > 0. Existence of a stochastic process satisfying the conditions of Definition 5.1
will be covered in Section 5.2.
In Figure 5.1 we draw three sample paths of a standard Brownian motion obtained by computer
simulation using (5.2.1). Note that there is no point in “computing” the value of Bt as it is a random
variable for all t > 0. However, we can generate samples of Bt , which are distributed according to
the centered Gaussian distribution with variance t > 0 as in Figure 5.1.

Bt3
Bt2

Bt1
0 t1 t2 t3

-1
0 0.2 0.4 0.6 0.8 1

Figure 5.1: Sample paths of a one-dimensional Brownian motion.

In particular, Property 4 in Definition 5.1 implies

IE[Bt − Bs ] = 0 and Var[Bt − Bs ] = t − s, 0 ⩽ s ⩽ t,

and we have

Cov(Bs , Bt ) = IE[Bs Bt ]
= IE[Bs (Bt − Bs + Bs )]
= IE Bs (Bt − Bs ) + (Bs )2
 

= IE[Bs (Bt − Bs )] + IE (Bs )2

 

= IE[Bs ] IE[Bt − Bs ] + IE (Bs )2

 

= Var[Bs ]
= s, 0 ⩽ s ⩽ t,

hence

Cov(Bs , Bt ) = IE[Bs Bt ] = min(s,t ), s,t ⩾ 0, (5.1.1)

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.1 Brownian Motion 139

cf. also Exercise 5.2-(5.1). The following graphs present two examples of possible modeling of
random data using Brownian motion.

Figure 5.2: Evolution of the fortune of a poker player vs. number of games played.

Figure 5.3: Web traffic ranking.

In what follows, we denote by (Ft )t∈R+ the filtration generated by the Brownian paths up to time
t, defined as
Ft := σ (Bs : 0 ⩽ s ⩽ t ), t ⩾ 0. (5.1.2)
Property 3 in Definition 5.1 shows that Bt − Bs is independent of all Brownian increments taken
before time s, i.e.
(Bt − Bs ) ⊥
⊥ (Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1 ),
0 ⩽ t0 ⩽ t1 ⩽ · · · ⩽ tn ⩽ s ⩽ t, hence Bt − Bs is also independent of the whole Brownian history up
to time s, hence Bt − Bs is in fact independent of Fs , s ⩾ 0.
Definition 5.2 A continuous-time process (Zt )t∈R+ of integrable random variables is a martin-
gale under P and with respect to the filtration (Ft )t∈R+ if

IE[Zt | Fs ] = Zs , 0 ⩽ s ⩽ t.

Note that when (Zt )t∈R+ is a martingale, Zt is in particular Ft -measurable at all times t ⩾ 0. As in
Example 2 on page 234, we have the following result.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 140 Chapter 5. Brownian Motion and Stochastic Calculus

Proposition 5.3 Brownian motion (Bt )t∈R+ is a continuous-time martingale.

Proof. We have

IE[Bt | Fs ] = IE[Bt − Bs + Bs | Fs ]
= IE[Bt − Bs | Fs ] + IE[Bs | Fs ]
= IE[Bt − Bs ] + Bs
= Bs , 0 ⩽ s ⩽ t,

because it has centered and independent increments, cf. Section 8.1. □

(1) (2) (n)
(1)

The n-dimensional Brownian motion can be constructed as Bt , Bt , . . . , Bt t∈R where Bt t∈R ,
+ +
(2)
(n)

Bt t∈R , . . ., Bt t∈R are independent copies of (Bt )t∈R+ . Next, we turn to simulations of 2
+ +
dimensional and 3 dimensional Brownian motions in Figures 5.4 and 5.5. Recall that the movement
of pollen particles originally observed by Brown, 1828 was indeed 2-dimensional.
2

1.5

0.5

-0.5

-1

-1.5

-2
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5

Figure 5.4: Two sample paths of a two-dimensional Brownian motion.

-1

-2
-1
0
1 2
1
0
2 -1
-2

Figure 5.5: Sample path of a three-dimensional Brownian motion.

Figure 5.6 presents an illustration of the scaling property of Brownian motion.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 5.2 Three Constructions of Brownian Motion 141

Figure 5.6: Scaling property of Brownian motion.*

5.2 Three Constructions of Brownian Motion

We refer the reader to Chapter 1 of Revuz and Yor, 1994 and to Theorem 10.28 in Folland,
1999 for proofs of existence of Brownian motion as a stochastic process (Bt )t∈R+ satisfying the
Conditions 1-4 of Definition 5.1.

Brownian motion as a random walk

We start with an informal description of Brownian motion as a random walk over infinitesimal time
intervals of length ∆t, whose increments

∆Bt := Bt +∆t − Bt ≃ N (0, ∆t )

over the time interval [t,t + ∆t ] will be approximated by the Bernoulli random variable

√
∆Bt = ± ∆t (5.2.1)

with equal probabilities (1/2, 1/2). According to this representation, the paths of Brownian motion
are not differentiable, although they are continuous by Property 2, as we have

√
dBt ± dt 1
≃ = ± √ ≃ ±∞. (5.2.2)
dt dt dt

Figure 5.7 presents a simulation of Brownian motion as a random walk with ∆t = 0.1.

* The animation works in Acrobat Reader on the entire pdf file.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 142 Chapter 5. Brownian Motion and Stochastic Calculus
3

2.5

1.5
Bt
1

0.5

-0.5

-1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
t

Figure 5.7: Construction of Brownian motion as a random walk with B0 = 1.*

Note that we have

1√ 1√
IE[∆Bt ] = ∆t − ∆t = 0,
2 2
and
 1 √ 1 √ 1 1
Var[∆Bt ] = IE (∆Bt )2 = (+ ∆t )2 + (− ∆t )2 = ∆t + ∆t = ∆t.

2 2 2 2
In order to recover the Gaussian distribution property of the random variable BT , we can split the
time interval [0, T ] into N subintervals

k−1 k
 
T, T , k = 1, 2, . . . , N,
N N

of same length ∆t = T /N, with N “large”.

0 T 2T T
N N

Defining the Bernoulli random variable Xk as

√
Xk := ± T

with equal probabilities (1/2, 1/2), we have Var(Xk ) = T and

Xk √
∆Bt := √ = ± ∆t
N
is the increment of Bt over ((k − 1)∆t, k∆t ], and we get
X1 + X2 + · · · + XN
BT ≃ ∑ ∆Bt ≃ √ .
0<t<T N

Hence by the central limit theorem we recover the fact that BT has the centered Gaussian distribution
N (0, T ) with variance T , cf. point 4 of the above Definition 5.1 of Brownian motion, and the
illustration given in Figure 5.8. Indeed, the central limit theorem states that given any sequence
* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.2 Three Constructions of Brownian Motion 143

(Xk )k⩾1 of independent identically distributed centered random variables with variance σ 2 =
Var[Xk ] = T , the normalized sum

X1 + X2 + · · · + XN
√
N

converges (in distribution) to the centered Gaussian random variable N (0, σ 2 ) with variance σ 2
as N goes to infinity. As a consequence, ∆Bt could in fact be replaced by any centered random
variable with variance ∆t in the above description.

N=1000; t <- 0:N; dt <- 1.0/N; dev.new(width=16,height=7); # Using Bernoulli samples

nsim=100;X <- matrix((dt)^0.5*(rbinom( nsim * N, 1, 0.5)-0.5)*2, nsim, N)
X <- cbind(rep(0, nsim), t(apply(X, 1, cumsum))); H<-hist(X[,N],plot=FALSE);
layout(matrix(c(1,2), nrow =1, byrow = TRUE));par(mar=c(2,2,2,0), oma = c(2, 2, 2, 2))
plot(t*dt, X[1, ], xlab = "", ylab = "", type = "l", ylim = c(-2, 2), col = 0,xaxs='i',las=1, cex.axis=1.6)
for (i in 1:nsim){lines(t*dt, X[i, ], type = "l", ylim = c(-2, 2), col = i)}
lines(t*dt,sqrt(t*dt),lty=1,col="red",lwd=3);lines(t*dt,-sqrt(t*dt), lty=1, col="red",lwd=3)
lines(t*dt,0*t, lty=1, col="black",lwd=2)
for (i in 1:nsim){points(0.999, X[i,N], pch=1, lwd = 5, col = i)}
x <- seq(-2,2, length=100); px <- dnorm(x);par(mar = c(2,2,2,2))
plot(NULL , xlab="", ylab="", xlim = c(0, max(px,H$density)), ylim = c(-2,2),axes=F)
rect(0, H$breaks[1:(length(H$breaks) - 1)], col=rainbow(20,start=0.08,end=0.6), H$density,
H$breaks[2:length(H$breaks)]); lines(px,x, lty=1, col="black",lwd=2)

−1

−2
0.0 0.2 0.4 0.6 0.8 1.0

Figure 5.8: Statistics of one-dimensional Brownian paths vs. Gaussian distribution.

R The choice of the square root in (5.2.1) is in fact not fortuitous. Indeed, any choice of ±(∆t )α
with a power α > 1/2 would lead to explosion of the process as dt tends to zero, whereas a
power α ∈ (0, 1/2) would lead to a vanishing process, as can be checked from the following
code.

The following code plots the yearly returns of the S&P 500 index from 1950 to 2022 together
with their distribution, see Figure 5.9, for comparison with the path properties and statistics of
Brownian motion.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 144 Chapter 5. Brownian Motion and Stochastic Calculus

library(quantmod); getSymbols("^GSPC",from="1950-01-01",to="2022-12-31",src="yahoo")
stock<-Cl(`GSPC`); s=0;y=0;j=0;count=0;N=240;nsim=72; X = matrix(0, nsim, N)
for (i in 1:nrow(GSPC)){if (s==0 && grepl('-01-0',index(stock[i]))) {if (count==0 || X[y,N]>0)
{y=y+1;j=1;s=1;count=count+1;}}
if (j<=N) {X[y,j]=as.numeric(stock[i]);};if (grepl('-02-0',index(stock[i]))) {s=0;};j=j+1;}
t <- 0:(N-1); dt <- 1.0/N; dev.new(width=16,height=7);
layout(matrix(c(1,2), nrow =1, byrow = TRUE));par(mar=c(2,2,2,0), oma = c(2, 2, 2, 2))
m=mean(X[,N]/X[,1]-1);sigma=sd(X[,N]/X[,1]-1)
plot(t*dt, X[1,]/X[1,1]-1-m*t*dt, xlab = "", ylab = "", type = "l", ylim = c(-0.5, 0.5), col = 0,
xaxs='i',las=1, cex.axis=1.6)
for (i in 1:nsim){lines(t*dt, X[i,]/X[i,1]-1-m*t*dt, type = "l", col = i)}
lines(t*dt,sigma*sqrt(t*dt),lty=1,col="red",lwd=3);lines(t*dt,-sigma*sqrt(t*dt), lty=1, col="red",lwd=3)
lines(t*dt,0*t, lty=1, col="black",lwd=2)
for (i in 1:nsim){points(0.999, X[i,N]/X[i,1]-1-m*N*dt, pch=1, lwd = 5, col = i)}
x <- seq(-0.5,0.5, length=100); px <- dnorm(x,0,sigma);par(mar = c(2,2,2,2))
H<-hist(X[,N]/X[,1]-1-m*N*dt,plot=FALSE);
plot(NULL , xlab="", ylab="", xlim = c(0, max(px,H$density)), ylim = c(-0.5,0.5),axes=F)
rect(0, H$breaks[1:(length(H$breaks) - 1)], col=rainbow(20,start=0.08,end=0.6), H$density,
H$breaks[2:length(H$breaks)]); lines(px,x, lty=1, col="black",lwd=2)

0.4

0.2

0.0

−0.2

−0.4

0.0 0.2 0.4 0.6 0.8

Figure 5.9: Statistics of 72 S&P 500 yearly return graphs from 1950 to 2022.

Lévy’s construction of Brownian motion

Figure 5.10 represents the construction of Brownian motion by successive linear interpolations, see
Problem 5.20 for a proof of existence of Brownian motion based on this construction.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.2 Three Constructions of Brownian Motion 145

0.4

0.2

0.0

−0.2

−0.4

−0.6

0.0 0.2 0.4 0.6 0.8 1.0

Figure 5.10: Lévy’s construction of Brownian motion.*

The following code is used to generate Figure 5.10.†

dev.new(width=16,height=7); alpha=1/2;t <- 0:1;dt <- 1; z=rnorm(1,mean=0,sd=dt^alpha)

plot(t*dt,c(0,z),xlab = "t",ylab = "",col = "blue",main = "",type = "l", xaxs="i", las = 1)
k=0;while (k<12) {readline("Press <return> to continue")
k=k+1;m <- (z+c(0,head(z,-1)))/2;y <- rnorm(length(t)-1,mean=0,sd=(dt/4)^alpha)
x <- m+y;x <- c(matrix(c(x,z), 2, byrow = T));n=2*length(t)-2;t <- 0:n
plot(t*dt/2, c(0, x), xlab = "t", ylab = "", col = "blue", main = "", type = "l", xaxs="i", las =
1);z=x;dt=dt/2}

Construction by series expansions

Brownian motion on [0, T ] can also be constructed by Fourier synthesis via the Paley-Wiener series
expansion

√
2T sin((n − 1/2)πt/T )
Bt = ∑ Xn fn (t ) = ∑ Xn , 0 ⩽ t ⩽ T,
n⩾1 π n⩾1 n − 1/2

where (Xn )n⩾1 is a sequence of independent N (0, 1) standard Gaussian random variables, as
illustrated in Figure 5.11.‡

* The animation works in Acrobat Reader on the entire pdf file.

† Download the corresponding code or the IPython notebook that can be run here or here.
‡ Download the corresponding IPython notebook that can be run here or here.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 146 Chapter 5. Brownian Motion and Stochastic Calculus
2

2
n=35
4

10

0 200 400 600 800

Figure 5.11: Construction of Brownian motion by series expansions.*

5.3 Wiener Stochastic Integral

In this section, we construct the Wiener stochastic integral of square-integrable deterministic
functions of time with respect to Brownian motion.

Recall that the price St of risky assets was originally modeled in Bachelier, 1900 as St := σ Bt ,
where σ is a volatility parameter. The stochastic integral

wT wT
f (t )dSt = σ f (t )dBt
0 0

can be used to represent the value of a portfolio as a sum of profits and losses f (t )dSt where dSt
represents the stock price variation and f (t ) is the quantity invested in the asset St over the short
time interval [t,t + dt ].

A naive definition of the stochastic integral with respect to Brownian motion would consist in
letting
wT wT dBt
f (t )dBt := f (t ) dt,
0 0 dt

and evaluating the above integral with respect to dt. However, this definition fails because the paths
of Brownian motion are not differentiable, cf. (5.2.2). Next we present Itô’s construction of the
stochastic integral with respect to Brownian motion. Stochastic integrals will be first constructed as
integrals of simple step functions of the form

n
f (t ) = ∑ ai 1(t i−1 ,ti ]
(t ), 0 ⩽ t ⩽ T, (5.3.1)
i=1

i.e. the function f takes the value ai on the interval (ti−1 ,ti ], i = 1, 2, . . . , n, with 0 ⩽ t0 < · · · < tn ⩽ T ,
as illustrated in Figure 5.12.

* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.3 Wiener Stochastic Integral 147

f (t )
a2
a1
a4

t0 t1 t2 t3 t4 t

Figure 5.12: Step function t 7→ f (t ).

ti<-c(0,2,4.5,7,9)
ai<-c(0,3,1,2,1,0)
plot(stepfun(ti,ai),xlim = c(0,10),do.points = F,main="", col = "blue")

Recall that the classical integral of f given in (5.3.1) is interpreted as the area under the curve
represented by f , and computed as
wT n

0
f (t )dt = ∑ ai (ti − ti−1 ).
i=1

f (t)
6
a2 b r
b r b r
a1
a4 b r
-
t0 t1 t2 t3 t4 t

Figure 5.13: Area under the step function t 7→ f (t ).

In the next Definition 5.4 we use such step functions for the construction of the stochastic integral
with respect to Brownian motion. The stochastic integral (5.3.2) for step functions will be interpreted
as the sum of profits and losses ai (Bti − Bti−1 ), i = 1, 2, . . . , n, in a portfolio holding a quantity ai of
a risky asset whose price variation is Bti − Bti−1 at time i = 1, 2, . . . , n.
Definition 5.4 The stochastic integral with respect to Brownian motion (Bt )t∈[0,T ] of the simple
step function f of the form (5.3.1) is defined by
wT n

0
f (t )dBt := ∑ ai (Bt − Bti i−1 ). (5.3.2)
i=1

In what follows, we will make a repeated use of the space L2 ([0, T ]) of square-integrable func-
tions.
Definition 5.5 Let L2 ([0, T ]) denote the space of (measurable) functions f : [0, T ] −→ R such
that
rw
T
∥ f ∥L2 ([0,T ]) := | f (t )|2 dt < ∞, f ∈ L2 ([0, T ]). (5.3.3)
0

In the above definition, ∥ f ∥L2 ([0,T ]) represents the norm of the function f ∈ L2 ([0, T ]).

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 148 Chapter 5. Brownian Motion and Stochastic Calculus

For example, the function f (t ) := t α , t ∈ (0, T ], belongs to L2 ([0, T ]) if and only if α > −1/2,
as we have

+∞ if α ⩽ −1/2,

wT wT



f 2 (t )dt = t 2α dt =  1+2α t =T
0 0 t T 1+2α
< ∞ if α > −1/2,


 =
1 + 2α t =0 1 + 2α

see Figure 5.14 for an illustration.

20 20

15 15

10 10

5 5

0 0
0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0

(a) Infinite area, α = −1 < −1/2. (b) Finite area, α = −1/4 > −1/2.

Figure 5.14: Infinite vs. finite area under the curve t 7→ t 2α .

wT
In the next Lemma 5.6 we determine the probability distribution of f (t )dBt and we show that it
0
is independent of the particular representation (5.3.1) chosen for f (t ).
Lemma 5.6 Let f be a simple step function f of the form (5.3.1). The stochastic integral
wT
f (t )dBt defined in (5.3.2) has the centered Gaussian distribution
0
wT  wT 
f (t )dBt ≃ N 0, | f (t )|2 dt
0 0
hw T i
with mean IE f (t )dBt = 0 and variance given by the Itô isometry
0

hw T i h w T 2 i w T
Var f (t )dBt = IE f (t )dBt = | f (t )|2 dt. (5.3.4)
0 0 0

Proof. Recall that if X1 , X2 , . . . , Xn are independent Gaussian random variables with probability
distributions N (m1 , σ12 ),. . .,N (mn , σn2 ), then the sum X1 + · · · + Xn is a Gaussian random variable
with distribution

N m1 + · · · + mn , σ12 + · · · + σn2 .

As a consequence, the stochastic integral

wT n
f (t )dBt = ∑ ak (Bt k
− Btk−1 )
0
k =1

of the step function

n
f (t ) = ∑ ak 1(t k−1 ,tk ]
(t ), 0 ⩽ t ⩽ T,
k =1

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.3 Wiener Stochastic Integral 149

has the centered Gaussian distribution with mean 0 and variance

hw T
" #
i n
Var f (t )dBt = Var ∑ ak (Btk − Btk−1 )
0
k =1
n
= ∑ Var[ak (Bt k
− Btk−1 )]
k =1
n
= ∑ |ak |2 Var[Bt k
− Btk−1 ]
k =1
n
= ∑ (tk − tk−1 )|ak |2
k =1
n w tk
= ∑ |ak |2 tk−1
dt
k =1
n wT
= ∑ |ak |2 1(tk−1 ,tk ] (t )dt
0
k =1
wT n
=
0
∑ |ak |2 1(t k−1 ,tk ]
(t )dt
k =1
wT
= | f (t )|2 dt,
0

since the simple function

n
f 2 (t ) = ∑ a2i 1(t i−1 ,ti ]
(t ), 0 ⩽ t ⩽ T,
i=1

takes the value a2i on the interval (ti−1 ,ti ], i = 1, 2, . . . , n, as can be checked from the following
Figure 5.15.

f2
6
a22 b r
b r b r
a21
a24 b r
-
t0 t1 t2 t3 t4 t

Figure 5.15: Squared step function t 7→ f 2 (t ).

□
The norm ∥ · ∥L2 ([0,T ]) on L2 ([0, T ]) induces a distance between any two functions f and g in
L2 ([0, T ]), defined as
rw
T
∥ f − g∥L2 ([0,T ]) := | f (t ) − g(t )|2 dt < ∞,
0

cf. e.g. Chapter 3 of Rudin, 1974 for details.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 150 Chapter 5. Brownian Motion and Stochastic Calculus

Definition 5.7 Convergence in L2 ([0, T ]). We say that a sequence ( fn )n⩾0 of functions in
L2 ([0, T ]) converges in L2 ([0, T ]) to another function f ∈ L2 ([0, T ]) if
rw
T
lim ∥ f − fn ∥L2 ([0,T ]) = lim | f (t ) − fn (t )|2 dt = 0.
n→∞ n→∞ 0

dev.new(width=16,height=7)
f = function(x){exp(sin(x*1.8*pi))}
for (i in 3:9){n=2^i;x<-cumsum(c(0,rep(1,n)))/n;
z<-c(NA,head(x,-1))
y<-c(f(x)-pmax(f(x)-f(z),0),f(1))
t=seq(0,1,0.01);
plot(f,from=0,to=1,ylim=c(0.3,2.9),type="l",lwd=3,col="red",main="",xaxs="i",yaxs="i", las=1)
lines(stepfun(x,y),do.points=F,lwd=2,col="blue",main="");
readline("Press <return> to continue");}

2.5

2.0
f

1.5

1.0

0.5

0.0 0.2 0.4 0.6 0.8 1.0

Figure 5.16: Step function approximation.*

By e.g. Theorem 3.13 in Rudin, 1974 or Proposition 2.4 page 63 of Hirsch and Lacombe, 1999, we
have the following result which states that the set of simple step functions f of the form (5.3.1) is
a linear space which is dense in L2 ([0, T ]) for the norm (5.3.3), as stated in the next proposition.

Proposition 5.8 For any function f ∈ L2 ([0, T ]) satisfying (5.3.3), there exists a sequence
( fn )n⩾0 of simple step functions of the form (5.3.1), converging to f in L2 ([0, T ]) in the sense
that
rw
T
lim ∥ f − fn ∥L2 ([0,T ]) = lim | f (t ) − fn (t )|2 dt = 0.
n→∞ n→∞ 0

wT
In order to extend the definition (5.3.2) of the stochastic integral f (t )dBt to any function
0
f∈ L2 ([0, T ]), i.e. to f : [0, T ] −→ R measurable such that
wT
| f (t )|2 dt < ∞, (5.3.5)
0

we will make use of the space L2 (Ω) of square-integrable random variables.

* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.3 Wiener Stochastic Integral 151

Definition 5.9 Let L2 (Ω) denote the space of random variables F : Ω −→ R such that
q  
∥F∥L2 (Ω) := IE F 2 < ∞.

The norm ∥ · ∥L2 (Ω) on L2 (Ω) induces the distance

q  
∥F − G∥L2 (Ω) := IE (F − G)2 < ∞,
between the square-integrable random variables F and G in L2 (Ω).
Definition 5.10 Convergence in L2 (Ω). We say that a sequence (Fn )n⩾0 of random variables in
L2 (Ω) converges in L2 (Ω) to another random variable F ∈ L2 (Ω) if
q  
lim ∥F − Fn ∥L2 (Ω) = lim IE (F − Fn )2 = 0.
n→∞ n→∞

The next proposition allows us to extend Lemma 5.6 from simple step functions to square-integrable
functions in L2 ([0, T ]).
wT
Proposition 5.11 The definition (5.3.2) of the stochastic integral f (t )dBt can be extended to
wT 0
any function f ∈ L2 ([0, T ]). In this case, f (t )dBt has the centered Gaussian distribution
0

wT  w
T

f (t )dBt ≃ N 0, 2
| f (t )| dt
0 0

w 
T
with mean IE f (t )dBt = 0 and variance given by the Itô isometry
0

w  "
wT 2 # wT
T
Var f (t )dBt = IE f (t )dBt = | f (t )|2 dt. (5.3.6)
0 0 0

Proof. The extension of the stochastic integral to all functions satisfying (5.3.5) is obtained by a
denseness and Cauchy* sequence argument, based on the isometry relation (5.3.6).
i) Given f a function satisfying (5.3.5), consider a sequence ( fn )n⩾0 of simple functions
converging to f in L2 ([0, T ]), i.e.
rw
T
lim ∥ f − fn ∥L2 ([0,T ]) = lim | f (t ) − fn (t )|2 dt = 0
n→∞ n→∞ 0
as in Proposition 5.8.
ii) By the isometry relation (5.3.4) or (5.3.6) and the triangle inequality† we have
wT wT
fk (t )dBt − fn (t )dBt
0 0
L2 ( Ω )
v "
u w wT 2 #
u T
= tIE fk (t )dBt − fn (t )dBt
0 0
v "
u w 2 #
u T
= tIE ( fk (t ) − fn (t ))dBt
0

* See MH3100 Real Analysis I.

† The triangle inequality ∥ f − f ∥ ⩽ ∥ fk − f ∥L2 ([0,T ]) + ∥ f − fn ∥L2 ([0,T ]) follows from the Minkowski in-
k n L2 ([0,T ])
equality.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 152 Chapter 5. Brownian Motion and Stochastic Calculus
rw
T
= | fk (t ) − fn (t )|2 dt
0
= ∥ fk − fn ∥L2 ([0,T ])
⩽ ∥ fk − f ∥L2 ([0,T ]) + ∥ f − fn ∥L2 ([0,T ]) ,
r 
T
which tends to 0 as k and n tend to infinity, hence 0 fn (t )dBt is a Cauchy sequence
n⩾0
in L2 (Ω) for the L2 (Ω
r)-norm. 
T
iii) Since the sequence 0 fn (t )dBt is Cauchy and the space L2 (Ω) is complete, cf.
n⩾0
w Theorem 3.11 in Rudin, 1974 or Chapter 4 of Dudley, 2002, we conclude that
e.g.
T
fn (t )dBt converges for the L2 -norm to a limit in L2 (Ω). In this case we let
0
n⩾0
wT wT
f (t )dBt := lim fn (t )dBt ,
0 n→∞ 0

which also satisfies (5.3.6) from (5.3.4). From (5.3.6) we can check that the limit is
independent of the approximating sequence ( fn )n⩾0 .
iv) Finally, from the convergence of Gaussian characteristic functions and a dominated conver-
gence argument,  we have
 wT    w
T

IE exp iα f (t )dBt = IE lim exp iα fn (t )dBt
0 n→∞ 0
  w 
T
= lim IE exp iα fn (t )dBt
n→∞ 0

α2 w T
 
2
= lim exp − | fn (t )| dt
n→∞ 2 0
α2 w T
 
2
= exp − | f (t )| dt ,
2 0
wT
f ∈ L2 ([0, T ]), α ∈ R, we check that f (t )dBt has the centered Gaussian distribution
0
wT  w
T

f (t )dBt ≃ N 0, 2
| f (t )| dt ,
0 0

see Theorem 11.10.

□
The next corollary is obtained by bilinearity from the Itô isometry (5.3.6).

Corollary 5.12 The stochastic integral with respect to Brownian motion (Bt )t∈R+ satisfies the
isometry w
T wT  wT
IE f (t )dBt g(t )dBt = f (t )g(t )dt,
0 0 0

for all square-integrable deterministic functions f , g ∈ L2 ([0, T ]).

Proof. Applying the Itô isometry (5.3.6) to the processes f + g and f − g and the relation
xy = (x + y)2 /4 − (x − y)2 /4, we have
w wT 
T
IE f (t )dBt g(t )dBt
0 0
wT wT 2 w wT
" 2 #
1 T
= IE f (t )dBt + g(t )dBt − f (t )dBt − g(t )dBt
4 0 0 0 0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 5.4 Itô Stochastic Integral 153
wT wT
" 2 # " 2 #
1 1
= IE ( f (t ) + g(t ))dBt − IE ( f (t ) − g(t ))dBt
4 0 4 0

1wT 1wT
= ( f (t ) + g(t ))2 dt − ( f (t ) − g(t ))2 dt
4 0 4 0
1wT
( f (t ) + g(t ))2 − ( f (t ) − g(t ))2 dt


=
4 0
wT
= f (t )g(t )dt.
0

□
wT
For example, the Wiener stochastic integral e −t dBt is a random variable having centered
0
Gaussian distribution with variance
wT wT
" 2 #
IE e −t dBt = e −2t dt
0 0

1 −2t t =T
 
= − e
2 t =0
1 −2T


= 1− e ,
2
as follows from the Itô isometry (5.3.4).

wT
R The Wiener stochastic integral f (s)dBs is a Gaussian random variable that cannot be
0
“computed” in the way standard integrals are computed via the use of primitives. However,
when f ∈ L2 ([0, T ]) is in C 1 ([0, T ]),* we have the integration by parts relation
wT wT wT
f (t )dBt = f (T )BT − Bt d f (t ) = f (T )BT − Bt f ′ (t )dt. (5.3.7)
0 0 0

When f ∈ L2 (R+ ) is in C 1 (R+ ) we also have following formula

w∞ w∞
f (t )dBt = − Bt f ′ (t )dt, (5.3.8)
0 0

provided that limt→∞ t| f (t )|2 = 0 and f ∈ L2 (R+ ), cf. e.g. Exercise 5.5 and Remark 2.5.9
in Privault, 2009.

For example, applying Relation (5.3.7) to the function f (t ) = t shows that

wT wT wT wT
tdBt = T BT − Bt dt = T dBt − Bt dt,
0 0 0 0

hence wT wT
(T − t )dBt = Bt dt.
0 0

5.4 Itô Stochastic Integral

In this section we extend the Wiener stochastic integral from deterministic functions in L2 ([0, T ])
to random square-integrable (random) adapted processes. For this, we will need the notion of
measurability.
* This means that the function f is continuously differentiable on [0, T ].

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 154 Chapter 5. Brownian Motion and Stochastic Calculus

The extension of the stochastic integral to adapted random processes is actually necessary in
order to compute a portfolio value when the portfolio process is no longer deterministic. This
happens in particular when one needs to update the portfolio allocation based on random events
occurring on the market.

A random variable F is said to be Ft -measurable if the knowledge of F depends only on the

information known up to time t. As an example, if t =today,
• the date of the past course exam is Ft -measurable, because it belongs to the past.

• the date of the next lunar new year, although it refers to a future event, is also Ft -measurable
because it is known at time t.

• the date of the next typhoon is not Ft -measurable since it is not known at time t.

• the maturity date T of the European option is Ft -measurable for all t ∈ [0, T ], because it has
been determined at time 0.

• the exercise date τ of an American option after time t is not Ft -measurable because it refers
to a future random event.

In the next definition, (Ft )t∈[0,T ] denotes the information flow defined in (5.1.2), i.e.

Ft := σ (Bs : 0 ⩽ s ⩽ t ), t ⩾ 0.

Definition 5.13 A stochastic process (Xt )t∈[0,T ] is said to be (Ft )t∈[0,T ] -adapted if Xt is Ft -
measurable for all t ∈ [0, T ].

For example,
- (Bt )t∈R+ is an (Ft )t∈R+ -adapted process,

- (Bt +1 )t∈R+ is not an (Ft )t∈R+ -adapted process,

- (Bt/2 )t∈R+ is an (Ft )t∈R+ -adapted process,

- B√t t∈R is not an (Ft )t∈R+ -adapted process,

+

- Maxs∈[0,t ] Bs )t∈R+ is an (Ft )t∈R+ -adapted process,

w t 
- Bs ds is an (Ft )t∈R+ -adapted process,
0 t∈R+
w t 
- f (s)dBs is an (Ft )t∈[0,T ] -adapted process when f ∈ L2 ([0, T ]).
0 t∈[0,T ]

In other words, a stochastic process (Xt )t∈R+ is (Ft )t∈[0,T ] -adapted if the value of Xt at time t
depends only on information known up to time t. Note that the value of Xt may still depend on
“known” future data, for example a fixed future date in the calendar, such as a maturity time T > t,
as long as its value is known at time t.

The next Figure 5.17 shows an adapted portfolio strategy on two assets, constructed from a
sign-switching signal based on spread data, see § 2.5 in Privault, 2021 and this code.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 5.4 Itô Stochastic Integral 155

350
Pair trading

0.2

300

0.1

250

Performance
Spread

0.0

200

−0.1

150

−0.2

100

−0.3
2017 2018 2019 2020 2017 2018 2019 2020

Figure 5.17: Adapted pair trading portfolio strategy.

The stochastic integral of adapted processes is first constructed as integrals of simple predictable
processes.
Definition 5.14 A simple predictable processes is a stochastic process (ut )t∈R+ of the form

n
ut := ∑ Fi 1(t i−1 ,ti ]
(t ), t ⩾ 0, (5.4.1)
i=1

where Fi is an Fti−1 -measurable random variable for i = 1, 2, . . . , n, and 0 = t0 < t1 < · · · <
tn−1 < tn = T .

For example, a natural approximation of (Bt )t∈R+ by a simple predictable process can be con-
structed as

n n
ut = ∑ Fi 1(ti−1 ,ti ] (t ) := ∑ Bt 1(t
i−1 i−1 ,ti ]
(t ), t ⩾ 0, (5.4.2)
i=1 i=1

since Fi := Bti−1 is Fti−1 -measurable for i = 1, 2, . . . , n, as in Figure 5.18.

N=10000; t <- 0:(N-1); dt <- 1.0/N;

dB <- rnorm(N,mean=0,sd=sqrt(dt));X <- rep(0,N);X[1]=0
for (j in 2:N){X[j]=X[j-1]+dB[j]}; for (j in 1:10) {m=2**j;
plot(t/(N-1), X, xlab = "t", ylab = "", type = "l", ylim = c(1.05*min(X),1.05*max(X)), xaxs="i", yaxs="i",
col = "blue", las = 1, cex.axis=1.6, cex.lab=1.8)
abline(h=0); t1=seq(1.0/m,1,1.0/m); Bt=c(0)
for (i in 1:m) {Bt=c(Bt,X[t1[i]*N])}
lines(stepfun(t1,Bt),xlim =c(0,T),xlab="t",ylab=expression('N'[t]),pch=1, cex=0.8, col='black', lwd=2,
main=""); Sys.sleep(1)}

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 156 Chapter 5. Brownian Motion and Stochastic Calculus

1.0

0.8

0.6

0.4

0.2

0.0

−0.2

0.0 0.2 0.4 0.6 0.8 1.0

t

Figure 5.18: Step function approximation of Brownian motion.*

The notion of simple predictable process makes full sense in the context of portfolio investment, in
which Fi will represent an investment allocation decided at time ti−1 and to remain unchanged over
the time interval (ti−1 ,ti ].
By convention, u : Ω × R+ −→ R is denoted in what follows by ut (ω ), t ∈ R+ , ω ∈ Ω, and the
random outcome ω is often dropped for convenience of notation.
Definition 5.15 The stochastic integral with respect to Brownian motion (Bt )t∈R+ of any simple
predictable process (ut )t∈R+ of the form (5.4.1) is defined by
wT n

0
ut dBt := ∑ (Bt − Bt
i i−1 )Fi , (5.4.3)
i=1

with 0 = t0 < t1 < · · · < tn−1 < tn = T .

The use of predictability in the definition (5.4.3) is essential from a financial point of view, as Fi
will represent a portfolio allocation made at time ti−1 and kept constant over the trading interval
[ti−1 ,ti ], while Bti − Bti−1 represents a change in the underlying asset price over [ti−1 ,ti ]. See also
the related discussion on self-financing portfolios in Section 6.3 and Lemma 6.14 on the use of
stochastic integrals to represent the value of a portfolio.
Definition 5.16 Let L2 (Ω × [0, T ]) denote the space of stochastic processes

u : Ω × [0, T ] −→ R
(ω,t ) 7−→ ut (ω )

such that
s 
wT 
∥u∥L2 (Ω×[0,T ]) := IE 2
|ut | dt < ∞, u ∈ L2 (Ω × [0, T ]).
0

The norm ∥ · ∥L2 (Ω×[0,T ]) on L2 (Ω × [0, T ]) induces a distance between two stochastic processes u
and v in L2 (Ω × [0, T ]), defined as
s 
wT 
∥u − v∥L2 (Ω×[0,T ]) = IE 2
|ut − vt | dt .
0

* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.4 Itô Stochastic Integral 157

Definition 5.17 Convergence in L2 (Ω × [0, T ]). We say that a sequence u(n) n⩾0 of processes

in L2 (Ω × [0, T ]) converges in L2 (Ω × [0, T ]) to another process u ∈ L2 (Ω × [0, T ]) if

s 
wT 
(n) (n) 2
lim u − u L2 (Ω×[0,T ])
= lim IE ut − ut dt = 0.
n→∞ n→∞ 0

By Lemma 1.1 of Ikeda and Watanabe, 1989, pages 22 and 46, or Proposition 2.5.3 in Privault,
2009, the set of simple predictable processes forms a linear space which is dense in the subspace
2 ( Ω × R ) made of square-integrable adapted processes in L2 ( Ω × R ), as stated in the next
Lad + +
proposition.
2 ( Ω × R ) a square-integrable adapted process there exists a
Proposition 5.18 Given u ∈ Lad +
sequence (u(n) )n⩾0 of simple predictable processes converging to u in L2 (Ω × R+ ), i.e.
s 
wT 
(n) 2
lim u − u(n) L2 (Ω×[0,T ]) = lim IE ut − ut dt = 0.
n→∞ n→∞ 0

The next Proposition 5.19 extends the construction of the stochastic integral from simple predictable
processes to square-integrable (Ft )t∈[0,T ] -adapted processes (ut )t∈R+ for which the value of ut at
time t can only depend on information contained in the Brownian path up to time t.
This restriction means that the Itô integrand ut cannot depend on future information, for example
a portfolio strategy that would allow the trader to “buy at the lowest” and “sell at the highest” is
excluded as it would require knowledge of future market data. Note that the difference between
Relation (5.4.4) below and Relation (5.3.6) is the presence of an expectation on the right-hand side.

Proposition 5.19 The stochastic integral with respect to Brownian motion (Bt )t∈R+ extends to
all adapted processes (ut )t∈R+ such that
w 
T
∥u∥2L2 (Ω×[0,T ]) := IE 2
|ut | dt < ∞,
0

with the Itô isometry

w  "
wT 2 # wT 2 w 
T T
Var ut dBt = IE ut dBt = ut dBt = IE |ut |2 dt . (5.4.4)
0 0 0 0
L2 ( Ω )

In addition, the Itô integral of an adapted process (ut )t∈R+ is always a centered random variable:

w 
T
IE ut dBt = 0. (5.4.5)
0

Proof. We start by showing that the Itô isometry (5.4.4) holds for the simple predictable process u
of the form (5.4.1). We have

 !2 
wT
" 2 # n
IE ut dBt = IE  ∑ (Bti − Bti−1 )Fi 
0
i=1

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 158 Chapter 5. Brownian Motion and Stochastic Calculus
" ! !#
n n
= IE ∑ (Bt − Bti i−1 )Fi ∑ (Bt j − Bt j−1 )Fj
i=1 j =1
" #
n
= IE ∑ (Bt − Bti i−1 )(Bt j − Bt j−1 )Fi Fj
i, j =1
" #
n
= IE ∑ |Fi |2 (Bt − Bt i i−1 )2
i=1
" #
+2 IE ∑ (Bti − Bti−1 )(Bt j − Bt j−1 )Fi Fj
1⩽i< j⩽n
n  2
|Fi | (Bti − Bti−1 )2

= ∑ IE
i=1
 
+2 ∑ IE (Bti − Bti−1 )(Bt j − Bt j−1 )Fi Fj
1⩽i< j⩽n
n
= ∑ IE[IE[|Fi |2 (Bt − Bt i i−1 )2 |Fti−1 ]]
i=1
+2 ∑ IE[IE[(Bti − Bti−1 )(Bt j − Bt j−1 )Fi Fj |Ft j−1 ]]
1⩽i< j⩽n
n
= ∑ IE[|Fi |2 IE[(Bt − Bt i i−1 )2 |Fti−1 ]]
i=1
IE (Bti − Bti−1 )Fi Fj IE[Bt j − Bt j−1 | Ft j−1 ]
 
+2 ∑
1⩽i< j⩽n | {z }
=0
n
∑ IE |Fi |2 IE (Bti − Bti−1 )2
  
=
i=1
+2 ∑ IE[(Bti − Bti−1 )Fi Fj IE[Bt j − Bt j−1 ]]
1⩽i< j⩽n | {z }
=0
n
= ∑ IE[|Fi |2 (ti − ti−1 )]
i=1
" #
n
2
= IE ∑ |Fi | (ti − ti−1 )
i=1
hw T i
= IE |ut |2 dt ,
0

where we applied the tower property (11.6.8) of conditional expectations and the facts that Bti −Bti−1
is independent of Fti−1 , with

IE (Bti − Bti−1 )2 = ti − ti−1 ,

 
IE[Bti − Bti−1 ] = 0, i = 1, 2, . . . , n.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.4 Itô Stochastic Integral 159

u2
6
F22 b r
b r b r
F12
F42 b r
-
t0 t1 t2 t3 t4 t

Figure 5.19: Squared simple predictable process t 7→ ut2 .

The extension of the stochastic integral to square-integrable adapted processes (ut )t∈R+ is obtained
by a denseness and Cauchy sequence argument using the isometry (5.4.4), in the same way as in
the proof of Proposition 5.11.
i) By Proposition 5.18 given u ∈ L2 (Ω × [0, T ]) a square-integrable adapted process there exists
a sequence (u(n) )n⩾0 of simple predictable processes such that
r hw i T (n) 2
lim ∥u − u(n) ∥L2 (Ω×[0,T ]) = lim IE ut − ut dt = 0.
n→∞ n→∞ 0

ii) Since the sequence (u(n) )n⩾0 converges,it is a Cauchy sequence in L2 (Ω × R+ ), hence
r T (n) 
by the Itô isometry (5.4.4), the sequence 0 ut dBt is a Cauchy sequence in L2 (Ω),
n⩾0
therefore it admits a limit in the complete space L2 (Ω). In this case we let
wT wT
(n)
ut dBt := lim ut dBt
0 n→∞ 0

and the limit is unique from (5.4.4) wand satisfies (5.4.4).

T
iii) The fact that the random variable ut dBt is centered can be proved first for a simple
0
predictable process u(n) of the form (5.4.1), as #
w  "
n
T (n)
IE ut dBt = IE ∑ (Bti − Bti−1 )Fi
0
i=1
n
= ∑ IE[IE[(Bt − Bt i i−1 )Fi | Fti−1 ]]
i=1
n
= ∑ IE[Fi IE[Bt − Bt i i−1 | Fti−1 ]]
i=1
n
= ∑ IE[Fi IE[Bt − Bt i i−1 ]]
i=1
= 0,
and this identity extends as above from simple predictable processes to adapted processes
(ut )t∈R+ in L2 (Ω × R+ ) by taking the limit as n tends to infinity in the following equality:
hw T i hw T i hw T i hw T i
(n) (n) (n)
IE ut dt = IE ut dt + IE ut − ut dt = IE ut − ut dt ,
0 0 0 0

since
hw T i hw T i r hw T i
(n)
(n) (n) 2
IE ut − ut dt ⩽ IE ut − ut dt ⩽ T IE ut − ut dt .
0 0 0

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 160 Chapter 5. Brownian Motion and Stochastic Calculus

The Itô isometry (5.4.4) can be similarly extended from simple predictable processes to
adapted processes (ut )t∈R+ in L2 (Ω × R+ ).

□
As an application of the Itô isometry (5.4.4), we note in particular the identity
wT w  w wT
" 2 #
T
2
T T2
IE |Bt |2 dt =
 
IE Bt dBt = IE |Bt | dt = tdt = ,
0 0 0 0 2

with
wT L2 ( Ω )
n

Bt dBt = lim ∑ Bt i−1 Bti − Bti−1
0 n→∞
i=1
from (5.4.2).
The next corollary is obtained by bilinearity from the Itô isometry (5.4.4) by the same argument as
in Corollary 5.12.

Corollary 5.20 The stochastic integral with respect to Brownian motion (Bt )t∈R+ satisfies the
isometry w
T wT  w
T

IE ut dBt vt dBt = IE ut vt dt ,
0 0 0

for all square-integrable adapted processes (ut )t∈R+ , (vt )t∈R+ .

Proof. Applying the Itô isometry (5.4.4) to the processes u + v and u − v, we have
w wT 
T
IE ut dBt vt dBt
0 0
wT wT 2 w wT
" 2 #!
1 T
= IE ut dBt + vt dBt − ut dBt − vt dBt
4 0 0 0 0

wT wT
" 2 # " 2 #!
1
= IE (ut + vt )dBt − IE (ut − vt )dBt
4 0 0
 w  w 
1 T
2
T
2
= IE (ut + vt ) dt − IE (ut − vt ) dt
4 0 0
w 
1 T
2 2


= IE (ut + vt ) − (ut − vt ) dt
4 0
w 
T
= IE ut vt dt .
0

□
In addition, when the integrand (ut )t∈R+ is not a deterministic function of time, the random variable
wT
ut dBt no longer has a Gaussian distribution, except in some exceptional cases.
0

Definite stochastic integral

The definite stochastic integral of an adapted process u ∈ Lad 2 ( Ω × R ) over an interval [a, b] ⊂
+
[0, T ] is defined as
wb wT
ut dBt := 1[a,b] (t )ut dBt ,
a 0
with in particular
wb wT
dBt = 1[a,b] (t )dBt = Bb − Ba , 0 ⩽ a ⩽ b,
a 0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 5.5 Stochastic Calculus 161

We also have the Chasles relation

wc wb wc
ut dBt = ut dBt + ut dBt , 0 ⩽ a ⩽ b ⩽ c,
a a b

and the stochastic integral has the following linearity property:

wT wT wT
(ut + vt )dBt = ut dBt + vt dBt , u, v ∈ L2 (R+ ).
0 0 0

5.5 Stochastic Calculus

Figure 5.20: NGram Viewer output for the term "stochastic calculus".
Stochastic modeling of asset returns
In the sequel, we consider the return at time t ∈ R+ of the risky asset price process (St )t∈R+ ,
defined as
dSt
= µdt + σ dBt , or dSt = µSt dt + σ St dBt . (5.5.1)
St
with µ ∈ R and σ > 0. Using the relation
wT
XT = X0 + dXt , T > 0,
0

which holds for any process (Xt )t∈R+ , Equation (5.5.1) can be rewritten in integral form as
wT wT wT
ST = S0 + dSt = S0 + µ St dt + σ St dBt , (5.5.2)
0 0 0

hence the need to define an integral with respect to dBt , in addition to the usual integral with respect
to dt. Note that in view of the definition (5.4.3), this is a continuous-time extension of the notion
portfolio value based on a predictable portfolio strategy.
In Proposition 5.19 we have defined the stochastic integral of square-integrable processes with
respect to Brownian motion, thus we have made sense of the equation (5.5.2), where (St )t∈R+ is an
(Ft )t∈[0,T ] -adapted process, which can be rewritten in differential notation as in (5.5.1).
This model will be used to represent the random price St of a risky asset at time t. Here the
return dSt /St of the asset is made of two components: a constant return µdt and a random return
σ dBt parametrized by the coefficient σ , called the volatility.
Our goal is now to solve Equation (5.5.1), and for this we will need to introduce Itô’s calculus in
Section 5.5 after a review of classical deterministic calculus.

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 162 Chapter 5. Brownian Motion and Stochastic Calculus

Deterministic calculus
The fundamental theorem of calculus states that for any continuously differentiable (deterministic)
function f we have the integral relation
wx
f (x ) = f (0) + f ′ (y)dy.
0

In differential notation this relation is written as the first-order expansion

d f (x) = f ′ (x)dx, (5.5.3)

where dx is “infinitesimally small”. Higher-order expansions can be obtained from Taylor’s formula,
which, letting
∆ f (x) := f (x + ∆x) − f (x),
states that
1 ′′ 1 1
∆ f (x) = f ′ (x)∆x + f (x)(∆x)2 + f ′′′ (x)(∆x)3 + f (4) (x)(∆x)4 + · · · .
2 3! 4!
Note that Relation (5.5.3), i.e. d f (x) = f ′ (x)dx, can be obtained by neglecting all terms of order
higher than one in Taylor’s formula, since (∆x)n << ∆x, n ⩾ 2, as ∆x becomes “infinitesimally
small”.

Stochastic calculus
Let us now apply Taylor’s formula to Brownian motion, taking
√
∆Bt = Bt +∆t − Bt ≃ ± ∆t,

and letting
∆ f (Bt ) := f (Bt +∆t ) − f (Bt ),
we have

∆ f (Bt )
1 1 1
= f ′ (Bt )∆Bt + f ′′ (Bt )(∆Bt )2 + f ′′′ (Bt )(∆Bt )3 + f (4) (Bt )(∆Bt )4 + · · · .
2 3! 4!
√
From the construction of Brownian motion by its small increments ∆Bt = ± ∆t, it turns out that
the terms in (∆t )2 and ∆t∆Bt ≃ ±(∆t )3/2 can be neglected in Taylor’s formula at the first order of
approximation in ∆t. However, the term of order two
√
(∆Bt )2 = (± ∆t )2 = ∆t

can no longer be neglected in front of ∆t itself.

Basic Itô formula

For f ∈ C 2 (R),* Taylor’s formula written at the second order for Brownian motion reads

1 ′′
d f (Bt ) = f ′ (Bt )dBt + f (Bt )dt, (5.5.4)
2

* This means that f is twice continuously differentiable on [0, T ].

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.5 Stochastic Calculus 163

for “infinitesimally small” dt. Note that writing this formula as

d f (Bt ) dBt 1 ′′
= f ′ (Bt ) + f (Bt )
dt dt 2
does not make sense because the pathwise derivative
√
dBt dt 1
≃± ≃ ± √ ≃ ±∞
dt dt dt
of Bt with respect to t does not exist. Integrating (5.5.4) on both sides and using the relation
wt
f (Bt ) − f (B0 ) = d f (Bs )
0

together with (5.5.4), we get the integral form of Itô’s formula for Brownian motion, i.e.
wt 1 w t ′′
f (Bt ) = f (B0 ) + f ′ (Bs )dBs + f (Bs )ds.
0 2 0

Itô processes
We now turn to the general expression of Itô’s formula, which is stated for Itô processes.
Definition 5.21 An Itô process is a stochastic process (Xt )t∈R+ that can be written as
wt wt
Xt = X0 + vs ds + us dBs , t ⩾ 0, (5.5.5)
0 0

or in differential notation
dXt = vt dt + ut dBt ,
where (ut )t∈R+ and (vt )t∈R+ are square-integrable adapted processes.
∂f
Given (t, x) 7→ f (t, x) a smooth function of two variables on R+ × R, from now on we let
∂t
∂f
denote partial differentiation with respect to the first (time) variable in f (t, x), while denotes
∂x
partial differentiation with respect to the second (price) variable in f (t, x).

Theorem 5.22 (Itô formula for Itô processes). For any Itô process (Xt )t∈R+ of the form (5.5.5)
and any f ∈ Cb1,2 (R+ × R),a we have

f (t, Xt )
wt ∂ f wt ∂ f wt ∂ f
= f (0, X0 ) + (s, Xs )ds + vs (s, Xs )ds + us (s, Xs )dBs
0 ∂s 0 ∂x 0 ∂x
1wt ∂ 2f
+ |us |2 2 (s, Xs )ds. (5.5.6)
2 0 ∂x

a This means that f is continuously differentiable on t ∈ [0, T ] and twice differentiable in x ∈ R, with bounded

derivatives.

Proof. The proof of the Itô formula can be outlined as follows in the case where (Xt )t∈R+ =
(Bt )t∈R+ is a standard Brownian motion and f (x) does not depend on time t. We refer to Theorem II-
32, page 79 of Protter, 2004 for the general case.

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 164 Chapter 5. Brownian Motion and Stochastic Calculus

Let {0 = t0n ⩽ t1n ⩽ · · · ⩽ tnn = t}, n ⩾ 1, be a refining sequence of partitions of [0,t ] tending to
the identity. We have the telescoping identity
n

f (Bt ) − f (B0 ) = ∑ f (Btin ) − f (Bti−1
n ) ,

k =1

and from Taylor’s formula

∂f 1 ∂2 f
f (y) − f (x ) = (y − x ) (x) + (y − x)2 2 (x) + R(x, y),
∂x 2 ∂x
where the remainder R(x, y) satisfies R(x, y) ⩽ o(|y − x|2 ), we get
n
∂f 1 n 2
2∂ f
f (Bt ) − f (B0 ) = ∑ (Bt n − Bti−1
n ) (Bti−1
n )+
∑ |Btin − Bti−1
n | (Bt n )
k =1
i
∂x 2 k =1 ∂ x2 i−1
n
+ ∑ R(Btin , Bti−1
n ).

k =1
It remains to show that as n tends to infinity the above converges to
wt ∂ f 1 w t ∂2 f
f (Bt ) − f (B0 ) = (Bs )dBs + (Bs )ds.
0 ∂x 2 0 ∂ x2
□
From the relation wt
d f (s, Xs ) = f (t, Xt ) − f (0, X0 ),
0
we can rewrite (5.5.6) as
wt wt ∂ f wt ∂ f wt ∂ f
d f (s, Xs ) = (s, Xs )ds + vs (s, Xs )ds + us (s, Xs )dBs
0 0 ∂s 0 ∂x 0 ∂x
1 w t 2
∂ f
+ |us |2 2 (s, Xs )ds,
2 0 ∂x
which allows us to rewrite (5.5.6) in differential notation, as

d f (t, Xt ) (5.5.7)
∂f ∂f ∂f 1 ∂2 f
= (t, Xt )dt + vt (t, Xt )dt + ut (t, Xt )dBt + |ut |2 2 (t, Xt )dt.
∂t ∂x ∂x 2 ∂x

In case the function x 7→ f (x) does not depend on the time variable t we get

∂f ∂f 1 ∂2 f
d f (Xt ) = vt (Xt )dt + ut (Xt )dBt + |ut |2 2 (Xt )dt.
∂x ∂x 2 ∂x

Taking ut = 1, vt = 0 and X0 = 0 in (5.5.5) yields Xt = Bt , in which case the Itô formula (5.5.6)-
(5.5.7) reads
wt ∂ f wt ∂ f 1 w t ∂2 f
f (t, Bt ) = f (0, B0 ) + (s, Bs )ds + (s, Bs )dBs + (s, Bs )ds,
0 ∂s 0 ∂x 2 0 ∂ x2
i.e. in differential notation:
∂f ∂f 1 ∂2 f
d f (t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt. (5.5.8)
∂t ∂x 2 ∂ x2

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.5 Stochastic Calculus 165

Bivariate Itô formula

Next, consider two Itô processes (Xt )t∈R+ and (Yt )t∈R+ written in integral form as
wt wt
Xt = X0 + vs ds + us dBs , t ⩾ 0,
0 0

and wt wt
Yt = Y0 + bs ds + as dBs , t ⩾ 0,
0 0
or in differential notation as

dXt = vt dt + ut dBt , and dYt = bt dt + at dBt , t ⩾ 0.

The Itô formula can also be written for functions f ∈ C 1,2,2 (R+ × R2 ) of two state variables as

∂f ∂f 1 ∂2 f
d f (t, Xt ,Yt ) = (t, Xt ,Yt )dt + (t, Xt ,Yt )dXt + |ut |2 2 (t, Xt ,Yt )dt
∂t ∂x 2 ∂x
∂f 1 2∂2 f ∂2 f
+ (t, Xt ,Yt )dYt + |at | (t, Xt ,Yt )dt + ut at (t, Xt ,Yt )dt. (5.5.9)
∂y 2 ∂ y2 ∂ x∂ y

Itô multiplication table

Applying the bivariate Itô formula (5.5.9) to the function f (x, y) := xy shows that

d (Xt Yt ) = Xt dYt + Yt dXt + at ut dt = Xt dYt + Yt dXt + dXt • dYt (5.5.10)

where the product

dXt • dYt = (vt dt + ut dBt ) • (bt dt + at dBt )

= bt vt dt • dt + bt ut dt • dBt + at vt dt • dBt + at ut dBt • dBt
= at ut dt

can be computed according to the Itô rule

dt • dt = 0, dt • dBt = 0, dBt • dBt = dt, (5.5.11)

which can be encoded in the following Itô multiplication table:

• dt dBt
dt 0 0
dBt 0 dt

Table 5.1: Itô multiplication table.

It follows similarly from the Itô Table 5.1 that

(dXt )2 = (vt dt + ut dBt ) • (vt dt + ut dBt )

= (vt )2 dt • dt + (ut )2 dBt • dBt + 2ut vt dt • dBt
= (ut )2 dt.

Consequently, (5.5.7) can be rewritten as

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 166 Chapter 5. Brownian Motion and Stochastic Calculus

∂f ∂f 1 ∂2 f
d f (t, Xt ) = (t, Xt )dt + (t, Xt )dXt + (t, Xt )dXt • dXt , (5.5.12)
∂t ∂x 2 ∂ x2

and the Itô formula for functions f ∈ C 1,2,2 (R+ × R2 ) of two state variables can be similarly
rewritten as

∂f ∂f 1 ∂2 f
d f (t, Xt ,Yt ) = (t, Xt ,Yt )dt + (t, Xt ,Yt )dXt + (t, Xt ,Yt )(dXt )2
∂t ∂x 2 ∂ x2
∂f 1 ∂2 f 2 ∂2 f
+ (t, Xt ,Yt )dYt + (t, Xt ,Yt )( dYt ) + (t, Xt ,Yt )(dXt • dYt ).
∂y 2 ∂ y2 ∂ x∂ y

Examples
Applying Itô’s formula (5.5.8) to (Bt )2 with

(Bt )2 = f (t, Bt ) and f (t, x) = x2 ,

and
∂f ∂f 1 ∂2 f
(t, x) = 0, (t, x) = 2x, (t, x) = 1,
∂t ∂x 2 ∂ x2
we find

d ((Bt )2 ) = d f (Bt )
∂f ∂f 1 ∂2 f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂ x2
= 2Bt dBt + dt.

Note that from the Itô Table 5.1 we could also write directly

d ((Bt )2 ) = Bt dBt + Bt dBt + (dBt )2 = 2Bt dBt + dt.

Next, by integration in t ∈ [0, T ] we find

wT wT wT
B2T = B20 + 2 Bs dBs + dt = 2 Bs dBs + T , (5.5.13)
0 0 0

hence the relation

wT 1 2

Bs dBs = BT − T , (5.5.14)
0 2
wT
see Exercise 5.13 for the probability distribution of Bs dBs .
0
Similarly, we have
i) d (Bt )3 = 3(Bt )2 dBt + 3Bt dt.

Letting f (x) := x3 with f ′ (x) = 3x2 and f ′′ (x) = 6x, we have

1 ′′
d ((Bt )3 ) = d f (Bt ) = f ′ (Bt )dBt + f (Bt )dt = 3(Bt )2 dBt + 3Bt dt.
2

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5.5 Stochastic Calculus 167
1
ii) d (sin Bt ) = cos(Bt )dBt − sin(Bt )dt.
2
Letting f (x) := sin(x) with f ′ (x) = cos(x), f ′′ (x) = − sin(x), we have
d sin(Bt ) = d f (Bt )
1
= f ′ (Bt )dBt + f ′′ (Bt )dt
2
1
= cos(Bt )dBt − sin(Bt )dt.
2
Bt Bt 1 Bt
iii) d e = e dBt + e dt.
2
Letting f (x) := e x with f ′ (x) = e x , f ′′ (x) = e x , we have
d e Bt = d f (Bt )
1
= f ′ (Bt )dBt + f ′′ (Bt )dt
2
Bt 1 Bt
= e dBt + e dt.
2
1 1
iv) d log Bt = dBt − dt.
Bt 2(Bt )2
Letting f (x) := log x with f ′ (x) = 1/x and f ′′ (x) = −1/x2 , we have

1 ′′ dBt dt
d log Bt = d f (Bt ) = f ′ (Bt )dBt + f (Bt )dt = − .
2 Bt 2(Bt )2

t 2 tBt
v) d e tBt = Bt e tBt dt + e dt + t e tBt dBt .
2
Letting f (t, x) := e xt with

∂f ∂f ∂2 f
(t, x) = x e xt , (t, x) = t e xt , (t, x) = t 2 e xt ,
∂t ∂x ∂ x2

we have
d e tBt = d f (t, Bt )
∂f ∂f 1 ∂2 f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂ x2
t2
= Bt e tBt dt + t e tBt dBt + e tBt dt.
2
1
vi) d cos(2t + Bt ) = −2 sin(2t + Bt )dt − sin(2t + Bt )dBt − cos(2t + Bt )dt.
2
Letting f (t, x) := cos(2t + x) with

∂f ∂f ∂2 f
(t, x) = −2 sin(2t + x), (t, x) = − sin(2t + x), (t, x) = − cos(2t + x),
∂t ∂x ∂ x2

we have
d cos(2t + Bt ) = d f (t, Bt )
∂f ∂f 1 ∂2 f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂ x2
1
= −2 sin(2t + Bt )dt − sin(2t + Bt )dBt − cos(2t + Bt )dt.
2

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 168 Chapter 5. Brownian Motion and Stochastic Calculus

Notation
We close this section with some comments on the practice of Itô’s calculus. In certain finance
textbooks, Itô’s formula for e.g. geometric Brownian motion (St )t∈R+ given by

dSt = µSt dt + σ St dBt

can be found written in the notation

wT ∂f wT ∂f
f (T , ST ) = f (0, S0 ) + σ St (t, St )dBt + µ St (t, St )dt
0 ∂ St 0 ∂ St
wT ∂f 1 w T 2∂2 f
+ (t, St )dt + σ 2 St (t, St )dt,
0 ∂t 2 0 ∂ St2
or
∂f ∂f 1 ∂2 f
d f (St ) = σ St (St )dBt + µSt (St )dt + σ 2 St2 2 (St )dt.
∂ St ∂ St 2 ∂ St
∂f
The notation (St ) can in fact be easily misused in combination with the fundamental theorem
∂ St
of classical calculus, and potentially leads to the wrong identity
∂f 
d f (S)
t = (St )dSt ,
 ∂ St
as in the following actual example:

Figure 5.21: Wrong application of Itô’s formula (sample).

Similarly, writing
∂f 1 ∂2 f
d f (Bt ) = (Bt )dBt + (Bt )dt
∂x 2 ∂ x2
is consistent, while writing

∂ f (Bt ) 1 ∂ 2 f (Bt )
d f (Bt ) = dBt + dt
∂ Bt 2 ∂ Bt2
is a potential source of confusion. Note also that the right-hand side of the Itô formula uses partial
derivatives while its left-hand side is a total derivative.
Stochastic differential equations
In addition to geometric Brownian motion there exists a large family of stochastic differential
equations that can be studied, although most of the time they cannot be explicitly solved. Let now

σ : R+ × Rn −→ Rd ⊗ Rn

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5.5 Stochastic Calculus 169

where Rd ⊗ Rn denotes the space of d × n matrices, and

b : R+ × Rn −→ R

satisfy the global Lipschitz condition

∥σ (t, x) − σ (t, y)∥2 + ∥b(t, x) − b(t, y)∥2 ⩽ K 2 ∥x − y∥2 ,

t ∈ R+ , x, y ∈ Rn . Then there exists a unique “strong” solution to the stochastic differential

equation

wt wt
Xt = X0 + b(s, Xs )ds + σ (s, Xs )dBs , t ⩾ 0, (5.5.15)
0 0

i.e., in differential notation

dXt = b(t, Xt )dt + σ (t, Xt )dBt , t ⩾ 0,

where (Bt )t∈R+ is a d-dimensional Brownian motion, see e.g. Theorem V-7 in Protter, 2004. In
addition, the solution process (Xt )t∈R+ of (5.5.15) has the Markov property, see § V-6 of Protter,
2004.

The term σ (s, Xs ) in (5.5.15) will be interpreted later on in Chapter 9 as a local volatility component.

Stochastic differential equations can be used to model the behaviour of a variety of quantities, such
as
• stock prices,
• interest rates,
• exchange rates,
• weather factors,
• electricity/energy demand,
• commodity (e.g. oil) prices, etc.
Next, we consider several examples of stochastic differential equations that can be solved explicitly
using Itô’s calculus, in addition to geometric Brownian motion. See e.g. § II-4.4 of Kloeden and
Platen, 1999 for more examples of explicitly solvable stochastic differential equations.

Examples of stochastic differential equations

1. Consider the mean-reverting stochastic differential equation

dXt = −αXt dt + σ dBt , X0 = x0 , (5.5.16)

with α > 0 and σ > 0.

N=10000; t <- 0:(N-1); dt <- 1.0/N;alpha=5; sigma=0.4;

dB <- rnorm(N,mean=0,sd=sqrt(dt));X <- rep(0,N);X[1]=0.5
for (j in 2:N){X[j]=X[j-1]-alpha*X[j-1]*dt+sigma*dB[j]}
plot(t*dt, X, xlab = "t", ylab = "", type = "l", ylim = c(-0.5,1), col = "blue")
abline(h=0)

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 170 Chapter 5. Brownian Motion and Stochastic Calculus
0.6

0.5

0.4

0.3
Xt
0.2

0.1

-0.1

-0.2
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t

Figure 5.22: Simulated path of (5.5.16) with α = 10, σ = 0.2 and X0 = 0.5.

We look for a solution of the form

 wt 
Xt = a(t )Yt = a(t ) x0 + b(s)dBs ,
0

where wt
Yt := x0 + b(s)dBs ,
0
and a(·), b(·r) are deterministic functions of time. After applying Theorem 5.22 to the Itô
t
process x0 + 0 b(s)dBs of the form (5.5.5) with ut = b(t ) and v(t ) = 0, and to the function
f (t, x) = a(t )x, we find
dXt = d (a(t )Yt )
= Yt a′ (t )dt + a(t )dYt
= Yt a′ (t )dt + a(t )b(t )dBt . (5.5.17)
By identification of (5.5.16) with (5.5.17), we get
 ′
 a (t ) = −αa(t )

a(t )b(t ) = σ ,


hence a(t ) = a(0) e −αt = e −αt and b(t ) = σ /a(t ) = σ e αt , which shows that
wt
Xt = x0 e −αt + σ e −(t−s)α dBs , t ⩾ 0, (5.5.18)
0

Using integration by parts, we can also write

wt
Xt = x0 e −αt + σ Bt − σ α e −(t−s)α Bs ds, t ⩾ 0, (5.5.19)
0

Remark: the solution of the equation (5.5.16) cannot be written as a function f (t, Bt ) of t
and Bt as in the proof of Proposition 6.15.
2. Consider the stochastic differential equation
2 /2
dXt = tXt dt + e t dBt , X0 = x0 . (5.5.20)

N=10000; T<-2.0; t <- 0:(N-1); dt <- T/N;

dB <- rnorm(N,mean=0,sd= sqrt(dt));X <- rep(0,N);X[1]=0.5
for (j in 2:N){X[j]=X[j-1]+j*X[j-1]*dt*dt+exp(j*dt*j*dt/2)*dB[j]}
plot(t*dt, X, xlab = "t", ylab = "", type = "l", ylim = c(-0.5,10), col = "blue")
abline(h=0)

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5.5 Stochastic Calculus 171
 rt 
Looking for a solution of the form Xt = a(t ) X0 + 0 b(s)dBs , where a(·) and b(·) are
2 /2
deterministic functions of time, we get a′ (t )/a(t ) = t and a(t )b(t ) = e t , hence a(t ) =
2 2
e t /2 and b(t ) = 1, which yields Xt = e t /2 (X0 + Bt ), t ⩾ 0.
7

4
Xt
3

-1
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
t

Figure 5.23: Simulated path of (5.5.20).

3. Consider the stochastic differential equation

√
dYt = (σ 2 − 2αYt )dt + 2σ Yt dBt , (5.5.21)

where Y0 > 0, α ∈ R, and σ > 0.

N=10000; t <- 0:(N-1); dt <- 1.0/N;mu=-5;sigma=1;

dB <- rnorm(N,mean=0,sd=sqrt(dt));Y <- rep(0,N);Y[1]=0.5
for (j in 2:N){Y[j]=max(0,Y[j-1] +(2*mu*Y[j-1]+sigma*sigma)*dt +2*sigma*sqrt(Y[j-1])*dB[j])}
plot(t*dt, Y, xlab = "t", ylab = "", type = "l", ylim = c(-0.1,1), col = "blue")
abline(h=0)

Letting
√ wt
Xt := e −αt Y0 + σ e −(t−s)α dBs , t ⩾ 0,
0

denote the solution of dXt = −αXt dt + σ dBt , see (5.5.18), by the Itô formula the process
Yt := (Xt )2 satisfies the stochastic differential equation
dYt = 2Xt dXt + σ 2 dt
= −2αXt2 dt + 2σ Xt dBt + σ 2 dt
= (σ 2 − 2αXt2 )dt + 2σ |Xt |sign (Xt )dBt
√
= (σ 2 − 2αYt )dt + 2σ Yt dWt ,
where the process
wt
Wt := sign (Xτ )dBτ , t ⩾ 0,
0

is a standard Brownian motion by the Lévy characterization theorem, see e.g. Theorem IV.3.6
in Revuz and Yor, 1994. Therefore, Yt = (Xt )2 is a (weak) solution of (5.5.21).

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 172 Chapter 5. Brownian Motion and Stochastic Calculus
0.7

0.6

0.5

0.4
Yt
0.3

0.2

0.1

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t

Figure 5.24: Simulated path of (5.5.21) with α = −5 and σ = 1.

See Proposition 2.1 in Hefter and Herzwurm, 2017 for the representation of the strong
solution of (5.5.21).

Exercises
Exercise 5.1 Compute IE[Bs Bt ] in terms of s,t ⩾ 0.

Exercise 5.2 Let (Bt )t∈R+ denote a standard Brownian motion. Let c > 0. Among the following
processes, tell which is a standard

Brownian motion and which is not. Justify your answer.
a) (Xt )t∈R+ := Bc+t − Bc t∈R ,

+
b) (Xt )t∈R+ := Bct 2 t∈R ,

+
c) (Xt )t∈R+ := cBt/c2 t∈R ,

+
d) (Xt )t∈R+ := Bt + Bt/2 t∈R .
+

Exercise 5.3 Let (Bt )t∈R+ denote a standard Brownian motion. Compute the stochastic integrals
wT wT
2 × 1[0,T /2] (t ) + 1(T /2,T ] (t ) dBt


2dBt and
0 0

and determine their probability distributions (including mean and variance).

Exercise 5.4 Determine the probability distribution (including mean and variance) of the stochastic
w 2π
integral sin(t ) dBt .
0

Exercise 5.5 Let T > 0. Show that for f : [0, T ] 7→ R a differentiable function such that f (T ) = 0,
we have wT wT
f (t )dBt = − f ′ (t )Bt dt.
0 0

Hint: Apply Itô’s calculus to t 7→ f (t )Bt .

Exercise 5.6 Let (Bt )t∈R+ denote a standard Brownian motion.

r1
a) Find the probability distribution of the stochastic integral 0 t 2 dBt .
r1
b) Find the probability distribution of the stochastic integral 0 t −1/2 dBt .
wT
c) Find the mean and variance of the stochastic integral Bt dBt .
0

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5.5 Stochastic Calculus 173

Exercise 5.7 Given (Bt )t∈R+ a standard Brownian motion and n ⩾ 1, let the random variable Xn
be defined as w 2π
Xn := sin(nt )dBt , n ⩾ 1.
0
a) Give the probability distribution of Xn for all n ⩾ 1.
b) Show that (Xn )n⩾1 is a sequence of identically distributed and pairwise independent random
variables.
1
cos(a − b) − cos(a + b) , a, b ∈ R.


Hint: We have sin a sin b =
2

Exercise 5.8 Apply the Itô formula to the process Xt := sin2 (Bt ), t ⩾ 0.

Exercise 5.9 Let (Bt )t∈R+ denote a standard Brownian motion.

a) Using the Itô isometry and the known relations
wT wT
BT = dBt and B2T = T + 2 Bt dBt ,
0 0

compute the third and fourth moments IE[B3T ] and IE[B4T ].

b) Give the third and fourth moments of the centered normal distribution with variance σ 2 .

Exercise 5.10 Let (Bt )t∈R+ denote a standard Brownian motion. Given T > 0, find the stochastic
integral decomposition of (BT )3 as
wT
( BT ) 3 = C + ζt,T dBt (5.5.22)
0

where C ∈ R is a constant and (ζt,T )t∈[0,T ] is an adapted process to be determined.

Exercise 5.11 Let f ∈ L2 ([0, T ]), and consider a standard Brownian motion (Bt )t∈[0,T ] .
a) Compute the conditional expectation
h rT i
IE e 0 f (s)dBs Ft , 0 ⩽ t ⩽ T,

where (Ft )t∈[0,T ] denotes the filtration generated by (Bt )t∈[0,T ] .

b) Using the result of Question (a)), show that the process
w
1wt 2

t
t 7−→ exp f (s)dBs − f (s)ds , 0 ⩽ t ⩽ T,
0 2 0
is an (Ft )t∈[0,T ] -martingale, where (Ft )t∈[0,T ] denotes the filtration generated by (Bt )t∈[0,T ] .
c) By applying the result of Question (b)) to the function f (t ) := σ 1[0,T ] (t ), show that the
2
geometric Brownian motion process e σ Bt −σt /2 t∈[0,T ] is an (Ft )t∈[0,T ] -martingale for any

σ ∈ R.
(1) (2)
Exercise 5.12 Consider two assets whose prices St , St follow the Bachelier dynamics
(1) (1) (1) (2) (2) (2)
dSt = µSt dt + σ1 dWt , dSt = µSt dt + σ2 dWt , t ∈ [0, T ],
(1)
(2)

where Wt t∈[0,T ]
, Wt t∈[0,T ] are two Brownian motions with correlation ρ ∈ [−1, 1], i.e. we
(1) (2) (2) (1)
have dWt • dWt = ρdt. Show that the spread St := St − St also satisfies an equation of the
form
dSt = µSt dt + σ dWt ,

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 174 Chapter 5. Brownian Motion and Stochastic Calculus

where µ ∈ R, (Wt )t∈R+ is a standard Brownian motion, and σ > 0 should be given in terms of σ1 ,
σ2 and ρ.
Hint: By the Lévy characterization theorem, see e.g. Theorem IV.3.6 in Revuz and Yor, 1994,
Brownian motion (Wt )t∈R+ is the only continuous martingale such that dWt • dWt = dt.

Exercise 5.13
a) Compute the moment generating function
  w 
T
IE exp β Bt dBt
0

for all β < 1/T .

Hint: Expand (BT )2 using the Itô formula as in (5.5.13).
wT
b) Find the probability distribution of the stochastic integral Bt dBt .
0

Exercise 5.14
a) Solve the stochastic differential equation

dXt = −bXt dt + σ e −bt dBt , t ⩾ 0, (5.5.23)

where (Bt )t∈R+ is a standard Brownian motion and σ , b ∈ R.

b) Solve the stochastic differential equation

dXt = −bXt dt + σ e −at dBt , t ⩾ 0, (5.5.24)

where (Bt )t∈R+ is a standard Brownian motion and a, b, σ > 0 are positive constants.
c) Find the probability distribution of Xt , t > 0.

Exercise 5.15 Given T > 0, let (Xt )t∈[0,T ) denote the solution of the stochastic differential equation

Xt
dXt = σ dBt − dt, t ∈ [0, T ), (5.5.25)
T −t
under the initial condition X0 = 0 and σ > 0.
a) Show that wt σ
Xt = (T − t ) dBs , 0 ⩽ t < T.
0 T −s

Hint: Start by computing d (Xt /(T − t )) using the Itô formula.

b) Show that IE[Xt ] = 0 for all t ∈ [0, T ).
c) Show that Var[Xt ] = σ 2t (T − t )/T for all t ∈ [0, T ).
d) Show that limt→T Xt = 0 in L2 (Ω). The process (Xt )t∈[0,T ] is called a Brownian bridge.

Exercise 5.16 Exponential Vašíček, 1977 model (1). Consider a Vasicek process (rt )t∈R+ solving
of the stochastic differential equation

drt = (a − brt )dt + σ dBt , t ⩾ 0,

where (Bt )t∈R+ is a standard Brownian motion and σ , a, b > 0 are positive constants. Show that
the exponential Xt := e rt satisfies a stochastic differential equation of the form


dXt = Xt ae − eb f (Xt ) dt + σ g(Xt )dBt ,

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5.5 Stochastic Calculus 175

b and the functions f (x) and g(x) are to be determined.

where the coefficients ae and e

Exercise 5.17 Exponential Vasicek model (2). Consider a short-term rate interest rate process
(rt )t∈R+ in the exponential Vasicek model:

drt = (η − a log rt )rt dt + σ rt dBt , (5.5.26)

where η, a, σ are positive parameters and (Bt )t∈R+ is a standard Brownian motion.
a) Find the solution (Zt )t∈R+ of the stochastic differential equation

dZt = −aZt dt + σ dBt

as a function of the initial condition Z0 , where a and σ are positive parameters.

b) Find the solution (Yt )t∈R+ of the stochastic differential equation

dYt = (θ − aYt )dt + σ dBt (5.5.27)

as a function of the initial condition Y0 . Hint: Let Zt := Yt − θ /a.

c) Let Xt = eYt , t ∈ R+ . Determine the stochastic differential equation satisfied by (Xt )t∈R+ .
d) Find the solution (rt )t∈R+ of (5.5.26) in terms of the initial condition r0 .
e) Compute the conditional mean* IE[rt |Fu ].
f) Compute the conditional variance

Var[rt |Fu ] := IE[rt2 |Fu ] − (IE[rt |Fu ])2

of rt , 0 ⩽ u ⩽ t, where (Fu )u∈R+ denotes the filtration generated by the Brownian motion
(Bt )t∈R+ .
g) Compute the asymptotic mean and variance limt→∞ IE[rt ] and limt→∞ Var[rt ].

Exercise 5.18 Cox-Ingersoll-Ross (CIR) model. Consider the equation

√
drt = (α − β rt )dt + σ rt dBt (5.5.28)

modeling the variations of a short-term interest rate process rt , where α, β , σ and r0 are positive
parameters and (Bt )t∈R+ is a standard Brownian motion.
a) Write down the equation (5.5.28) in integral form.
b) Let u(t ) = IE[rt ]. Show, using the integral form of (5.5.28), that u(t ) satisfies the differential
equation
u′ (t ) = α − β u(t ),
and compute IE[rt ] for all t ⩾ 0.
c) By an application of Itô’s formula to rt2 , show that

drt2 = rt (2α + σ 2 − 2β rt )dt + 2σ rt3/2 dBt . (5.5.29)

d) Using the integral form of (5.5.29), find a differential equation satisfied by v(t ) := IE[rt2 ] and
compute IE[rt2 ] for all t ⩾ 0.
e) Show that
σ 2 −βt
ασ 2
2
Var[rt ] = r0 e − e −2βt + 2
1 − e −βt , t ⩾ 0.
β 2β

Problem 5.19 Itô-Tanaka formula. Let (Bt )t∈R+ be a standard Brownian motion started at B0 ∈ R.
2
* One may use the Gaussian moment generating function IE[ e X ] = e α /2 for X ≃ N (0, α 2 ).

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 176 Chapter 5. Brownian Motion and Stochastic Calculus

a) Does the Itô formula apply to the European call option payoff function f (x) := (x − K )+ ?
Why?
b) For every ε > 0, consider the approximation fε (x) of f (x) := (x − K )+ defined by
x−K if x > K + ε,






1

f ε (x ) : = (x − K + ε )2 if K − ε < x < K + ε,


 4ε



0 if x < K − ε.
Plot the graph of the function x 7→ fε (x) for ε = 1 and K = 10.
c) Using the Itô formula, show that
w T
fε (BT ) = f ε ( B0 ) + fε′ (Bt )dBt (5.5.30)
0
1 

+ ℓ t ∈ [0, T ] : K − ε < Bt < K + ε ,
4ε
where ℓ denotes the measure of time length (Lebesgue measure) in R.
d) Show that limε→0 ∥1[K,∞) (·) − fε′ (·)∥L2 (R+ ) = 0.
e) Show, using the Itô isometry,* that the limit
1
L[K0,T ] := lim ℓ({t ∈ [0, T ] : K − ε < Bt < K + ε})
ε→0 2ε

exists in L2 (Ω), and prove the Itô-Tanaka formula

wT 1
(BT − K )+ = (B0 − K )+ + 1[K,∞) (Bt )dBt + L[K0,T ] . (5.5.31)
0 2
The quantity L[K0,T ] is called the local time spent by Brownian motion at the level K.

Problem 5.20 Lévy’s construction of Brownian motion. The goal of this problem is to prove
the existence of standard Brownian motion (Bt )t∈[0,1] as a stochastic process satisfying the four
properties of Definition 5.1, i.e.:
1. B0 = 0 almost surely,

2. The sample trajectories t 7→ Bt are continuous, with probability 1.

3. For any finite sequence of times t0 < t1 < · · · < tn , the increments
Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1
are independent.

4. For any given times 0 ⩽ s < t, Bt − Bs has the Gaussian distribution N (0,t − s) with mean
zero and variance t − s.
The construction will proceed by the linear interpolation scheme illustrated in Figure 5.10. We
work on the space C0 ([0, 1]) of continuous functions on [0, 1] started at 0, with the norm
∥ f ∥∞ := Max | f (t )|
t∈[0,1]

and the distance

∥ f − g∥∞ := Max | f (t ) − g(t )|.
t∈[0,1]
The following ten questions are interdependent.
hw T
1[K,∞) (Bt ) − fε′ (Bt ) 2 dt = 0.

i
* Hint: Show that lim IE
ε→0 0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.5 Stochastic Calculus 177

a) Show that for any Gaussian random variable X ≃ N (0, σ 2 ), we have

σ 2 2
P(|X| ⩾ ε ) ⩽ √ e −ε /(2σ ) , ε > 0.
ε π/2

Hint: Start from the inequality IE[(X − ε )+ ] ⩾ 0 and compute the left-hand side.

b) Let X and Y be two independent centered Gaussian random variables with variances α 2 and
β 2 . Show that the conditional distribution

P(X ∈ dx | X + Y = z)

of X given X + Y = z is Gaussian with mean α 2 z/(α 2 + β 2 ) and variance α 2 β 2 /(α 2 + β 2 ).

Hint: Use the definition

P(X ∈ dx and X + Y ∈ dz)
P(X ∈ dx | X + Y = z) :=
P(X + Y ∈ dz)

and the formulas

1 2 2 1 2 2
dP(X ⩽ x) := √ e −x /(2α ) dx, dP(Y ⩽ x) := p e −x /(2β ) dx,
2πα 2 2πβ 2

where dx (resp. dy) represents a “small” interval [x, x + dx] (resp. [y, y + dy]).
c) Let (Bt )t∈R+ denote a standard Brownian motion and let 0 < u < v. Give the distribution of
B(u+v)/2 given that Bu = x and Bv = y.

Hint: Note that given that Bu = x, the random variable Bv can be written as

Bv = (Bv − B(u+v)/2 ) + (B(u+v)/2 − Bu ) + x, (5.5.32)

and apply the result of Question (b)) after identifying X and Y in the above decomposition
(5.5.32).
d) Consider the random sequences
(0)

Z (0)


 = 0, Z1




 (1) (0)

Z (1) = 0, Z1/2 , Z1








(2) (1) (2) (0)


Z (2)





= 0, Z1/4 , Z1/2 , Z3/4 , Z1




(3) (2) (3) (1) (3) (2) (3) (0)

Z (3) = 0, Z1/8 , Z1/4 , Z3/8 , Z1/2 , Z5/8 , Z3/4 , Z7/8 , Z1





 .. ..
. .








(n) (n) (n) (n) (n)

Z (n)

= 0, Z1/2n , Z2/2n , Z3/2n , Z4/2n , . . . , Z1








(n+1) (n) (n+1) (n+1) (n+1) (n+1) (n+1)


 (n+1)
Z = 0, Z1/2n+1 , Z1/2n , Z3/2n+1 , Z2/2n , Z5/2n+1 , Z3/2n , . . . , Z1

(n)
with Z0 = 0, n ⩾ 0, defined recursively as

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 178 Chapter 5. Brownian Motion and Stochastic Calculus
(0)
i) Z1 ≃ N (0, 1),
(0) (0)
(1) Z + Z1
ii) Z1/2 ≃ 0 + N (0, 1/4),
2
(1) (1) (1) (0)
(2) Z0 + Z1/2 (2) Z1/2 + Z1
iii) Z1/4 ≃ + N (0, 1/8), Z3/4 ≃ + N (0, 1/8),
2 2
and more generally
(n) (n)
(n+1)
Zk/2n + Z(k+1)/2n
Z(2k+1)/2n+1 = + N (0, 1/2n+2 ), k = 0, 1, . . . , 2n − 1,
2
where N (0, 1/2n+2 ) is an independent centered Gaussian sample with variance 1/2n+2 ,
(n+1) (n)
and Zk/2n := Zk/2n , k = 0, 1, . . . , 2n .
(n)

In what follows we denote by Zt the continuous-time random path obtained by
t∈[0,1]
(n)

linear interpolation of the sequence points in Zk/2n k=0,1,...,2n .
(0)
(1)
(2)

Draw a sample of the first four linear interpolations Zt t∈[0,1] , Zt t∈[0,1] , Zt t∈[0,1] ,
(3)
(n)
Zt t∈[0,1] , and label the values of Zk/2n on the graphs for k = 0, 1, . . . , 2n and n = 0, 1, 2, 3.
e) Using an induction argument, explain why for all n ⩾ 0 the sequence
(n) (n) (n) (n) (n)

Z (n) = 0, Z1/2n , Z2/2n , Z3/2n , Z4/2n , . . . , Z1

has same distribution as the sequence

B(n) := B0 , B1/2n , B2/2n , B3/2n , B4/2n , . . . , B1 .

Hint: Compare the constructions of Questions (c)) and (d)) and note that under the above
linear interpolation, we have
(n) (n)
(n)
Zk/2n + Z(k+1)/2n
Z(2k+1)/2n+1 = , k = 0, 1, . . . , 2n − 1.
2
f) Show that for any εn > 0 we have
(n+1) (n)
P Z (n+1) − Z (n) ⩾ εn ⩽ 2n P |Z1/2n+1 − Z1/2n+1 | ⩾ εn .



∞

Hint: Use the inequality

n −1
!
2[ 2n −1
P Ak ⩽ ∑ P(Ak )
k =0 k =0

for a suitable choice of events (Ak )k=0,1,...,2n −1 .

g) Use the results of Questions (a)) and (f)) to show that for any εn > 0 we have
  2n/2 −εn2 2n+1
P Z (n+1) − Z (n) ∞
⩾ εn ⩽ √ e .
εn 2π

h) Taking εn = 2−n/4 , show that

!
P ∑ Z (n+1) − Z (n) ∞
<∞ = 1.
n⩾0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

5.5 Stochastic Calculus 179

Hint: Show first that

 
−n/4
∑P Z (n+1) − Z (n) ∞
⩾ 2 < ∞,
n⩾0

and apply the Borel-Cantelli lemma. n o

(n)

i) Show that with probability one, the sequence Zt t∈[0,1] , n ⩾ 1 converges uniformly on
[0, 1] to a continuous (random) function (Zt )t∈[0,1] .

Hint: Use the fact that C0 ([0, 1]) is a complete space for the ∥ · ∥∞ norm.
j) Argue that the limit (Zt )t∈[0,1] is a standard Brownian motion on [0, 1] by checking the four
relevant properties.

Problem 5.21 Consider (Bt )t∈R+ a standard Brownian motion, and for any n ⩾ 1 and T > 0, define
the discretized quadratic variation
n
(n)
QT : = ∑ (BkT /n − B(k−1)T /n )2 , n ⩾ 1.
k =1
h i
(n)
a) Compute IE QT , n ⩾ 1.
(n)
b) Compute Var[QT ], n ⩾ 1.
c) Show that
(n)
lim QT = T ,
n→∞

where the limit is taken in L2 (Ω), that is, show that

(n)
lim ∥QT − T ∥L2 (Ω) = 0,
n→∞

where q
(n)  (n)
2 
QT − T L2 ( Ω )
:= IE QT − T , n ⩾ 1.

d) By the result of Question (c)), show that the limit

wT n

0
Bt dBt := lim
n→∞
∑ (BkT /n − B(k−1)T /n )B(k−1)T /n
k =1

exists in L2 (Ω), and compute it.

Hint: Use the identity

1
( x − y ) y = ( x 2 − y2 − ( x − y ) 2 ) , x, y ∈ R.
2
e) Consider the modified quadratic variation defined by
n
e(n) :=
Q ∑ (B(k−1/2)T /n − B(k−1)T /n )2 , n ⩾ 1.
T
k =1

e(n) in L2 (Ω) by repeating the steps of Questions (a))-(c)).

Compute the limit limn→∞ QT

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 180 Chapter 5. Brownian Motion and Stochastic Calculus

f) By the result of Question (e)), show that the limit

wT n
Bt ◦ dBt := lim ∑ (BkT /n − B(k−1)T /n )B(k−1/2)T /n
0 n→∞
k =1

exists in L2 (Ω), and compute it.

Hint: Use the identities

1
(x − y)y = (x2 − y2 − (x − y)2 ),
2
and
1
( x − y ) x = ( x 2 − y2 + ( x − y ) 2 ) , x, y ∈ R.
2
g) More generally, by repeating the steps of Questions (e)) and (f)), show that for any α ∈ [0, 1]
the limit
w T n
Bt ◦ d α Bt := lim ∑ (BkT /n − B(k−1)T /n )B(k−α )T /n
0 n→∞
k =1

exists in L2 (Ω), and compute it.

h) Comparison with deterministic calculus. Compute the limit
n  
T T T
lim ∑ (k − α ) k − (k − 1)
n→∞
k =1 n n n

for all values of α in [0, 1].

Exercise 5.22 Let (Bt )t∈R+ be a standard Brownian motion generating the information flow
(Ft )t∈R+ .
a) Let 0 ⩽ t ⩽ T . What is the probability distribution of BT − Bt ?
b) From the answer to Exercise A.4-(b)), show that
r
T − t −(Bt )2 /(2(T −t ))
 
Bt
IE[(BT ) | Ft ] =
+
e + Bt Φ √ ,
2π T −t
0 ⩽ t ⩽ T , where Φ denotes the standard Gaussian cumulative distribution function. Hint:
Use the time splitting decomposition BT = BT − Bt + Bt .
c) Let σ > 0, ν ∈ R, and Xt := σ Bt + νt, t ⩾ 0. Compute e Xt by applying the Itô formula
wt ∂f wt ∂ f 1 w t 2∂2 f
f (Xt ) = f (X0 ) + us(Xs )dBs + vs (Xs )ds + u (Xs )ds
0 ∂x 0 ∂x 2 0 s ∂ x2
wt wt
to f (x) = e x , where Xt is written as Xt = X0 + us dBs + vs ds, t ⩾ 0.
0 0
d) Let St = e Xt , t ⩾ 0, and r > 0. For which value of ν does (St )t∈R+ satisfy the stochastic
differential equation
dSt = rSt dt + σ St dBt ?

Exercise 5.23 From the answer to Exercise A.4-(b)), show that for any β ∈ R we have
r
T − t −(β −Bt )2 /(2(T −t )) β − Bt
 
IE[(β − BT ) | Ft ] =
+
e + (β − Bt )Φ √ ,
2π T −t
0 ⩽ t ⩽ T.

Hint: Use the time splitting decomposition BT = BT − Bt + Bt .

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 181

6. Continuous-Time Market Model

The continuous-time market model allows for the incorporation of portfolio re-allocation algorithms
in a stochastic dynamic programming setting. This chapter starts with a review of the concepts of
assets, self-financing portfolios, risk-neutral probability measures, and arbitrage in continuous time.
We also state and solve the equation satisfied by geometric Brownian motion, which will be used
for the modeling of continuous asset price processes.

6.1 Asset Price Modeling 147

6.2 Arbitrage and Risk-Neutral Measures 148
6.3 Self-Financing Portfolio Strategies 150
6.4 Two-Asset Portfolio Model 152
6.5 Geometric Brownian Motion 157
Exercises 160

6.1 Asset Price Modeling

The prices at time t ⩾ 0 of d + 1 assets numbered no 0, 1, . . . , d is denoted by the random vector
(0) (1) (d )

St = St , St , . . . , St

which forms a stochastic process (St )t∈R+ . As in discrete time, the asset no 0 is a riskless asset (of
savings account type) yielding an interest rate r, i.e. we have
(0) (0)
St = S0 e rt , t ⩾ 0.

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 182 Chapter 6. Continuous-Time Market Model
Definition 6.1 Discounting. Let

(0) (1) (d )
X t := Set , Set , . . . , Set ), t ∈ R,

denote the vector of discounted asset prices, defined as:

(k ) (k )
Set = e −rt St , t ⩾ 0, k = 0, 1, . . . , d.

We can also write

X t := e −rt St , t ⩾ 0.
The concept of discounting is illustrated in the following figures.

My portfolio St grew by b = 5% this year.

My portfolio St grew by b = 5% this year.
The risk-free or inflation rate is r = 10%.
Q: Did I achieve a positive return?
Q: Did I achieve a positive return?
A:
A:

(a) Scenario A. (b) Scenario B.

(a) Without inflation adjustment. (b) With inflation adjustment.

Figure 6.1: Why apply discounting?

(k )
Definition 6.2 A portfolio strategy is a stochastic process (ξ t )t∈R+ ⊂ Rd +1 , where ξt denotes
the (possibly fractional) quantity of asset no k held at time t ⩾ 0.

The value at time t ⩾ 0 of the portfolio strategy (ξ t )t∈R+ ⊂ Rd +1 is defined by

d
(k ) (k )
Vt := ξ t • St = ∑ ξt St , t ⩾ 0.
k =0

The discounted value of the portfolio is defined by

Vet := e −rt Vt
= e −rt ξ t • St
d
(k ) (k )
= e −rt ∑ ξt St
k =0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 6.2 Arbitrage and Risk-Neutral Measures 183
d
(k) e(k)
= ∑ ξt St
k =0
= ξ t • Xt, t ⩾ 0.

The effect of discounting from time t to time 0 is to divide prices by e rt , making all prices
comparable at time 0.

6.2 Arbitrage and Risk-Neutral Measures

In continuous-time, the definition of arbitrage follows the lines of its analogs in the one-step and
discrete-time models. In what follows we will only consider admissible portfolio strategies whose
total value Vt remains nonnegative for all times t ∈ [0, T ].
(k )

Definition 6.3 A portfolio strategy ξt t∈[0,T ],k=0,1,...,d
with value

d
(k ) (k )
Vt = ξ t • St = ∑ ξt St , t ∈ [0, T ],
k =0

constitutes an arbitrage opportunity if all three following conditions are satisfied:

i) V0 ⩽ 0 at time t = 0, [Start from a zero-cost portfolio, or with a debt.]
ii) VT ⩾ 0 at time t = T , [Finish with a nonnegative amount.]
iii) P(VT > 0) > 0 at time t = T . [Profit is made with nonzero probability.]

Roughly speaking, (ii) means that the investor wants no loss, (iii) means that he wishes to
sometimes make a strictly positive gain, and (i) means that he starts with zero capital or even with
a debt.
Next, we turn to the definition of risk-neutral probability measures (or martingale measures) in
continuous time, which states that under a risk-neutral probability measure P∗ , the return of the
risky asset over the time interval [u,t ] equals the return of the riskless asset given by

(0) (0)
St = e (t−u)r Su , 0 ⩽ u ⩽ t.

Recall that the filtration (Ft )t∈R+ is generated by Brownian motion (Bt )t∈R+ , i.e.

Ft = σ (Bu : 0 ⩽ u ⩽ t ), t ⩾ 0.

Definition 6.4 A probability measure P∗ on Ω is called a risk-neutral measure if it satisfies

 (k ) (k )
IE∗ St Fu = e (t−u)r Su ,

0 ⩽ u ⩽ t, k = 1, 2, . . . , d. (6.2.1)

where IE∗ denotes the expectation under P∗ .

As in the discrete-time case, P♯ would be called a risk premium measure if it satisfied

 (k )
IE♯ St Fu > e (t−u)r Su ,

0 ⩽ u ⩽ t, k = 1, 2, . . . , d,

(i)
meaning that by taking risks in buying St , one could make an expected return higher than that of
the riskless asset
(0) (0)
St = e (t−u)r Su , 0 ⩽ u ⩽ t.

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 184 Chapter 6. Continuous-Time Market Model

Similarly, a negative risk premium measure P♭ satisfies

 (k ) (k )
IE♭ St Fu < e (t−u)r Su ,

0 ⩽ u ⩽ t, k = 1, 2, . . . , d.
From the relation
(0) (0)
St = e (t−u)r Su , 0 ⩽ u ⩽ t,
(k )
we interpret (6.2.1) by saying that the expected return of the risky asset St under P∗ equals the
(0) (k )
return of the riskless asset St , k = 1, 2, . . . , d. Recall that the discounted (in $ at time 0) price Set
of the risky asset no k is defined by
(k )
(k ) (k ) St
Set := e −rt St = (0) (0)
, t ⩾ 0, k = 0, 1, . . . , d,
St /S0
(0) (0)
i.e. St /S0 plays the role of a numéraire process.
As in the discrete-time case, see Proposition 3.13, the martingale property in continuous
time, see Definition 5.2, can be used to characterize risk-neutral probability measures, for the
derivation of pricing partial differential equations (PDEs), and for the computation of conditional
expectations.

Proposition 6.5 The probability measure P∗ is risk-neutral if and only if the discounted risky
(k )
asset price process (Set )t∈R+ is a martingale under P∗ , k = 1, 2, . . . , d.

Proof. If P∗ is a risk-neutral probability measure, we have

 (k ) (k )
IE∗ Set Fu = IE∗ e −rt St Fu
  
 (k )
= e −rt IE∗ St Fu


(k )
= e −rt e (t−u)r Su
(k )
= e −ru Su
(k )
= Seu , 0 ⩽ u ⩽ t,
(k ) (k )

hence Set t∈R is a martingale under P∗ , k = 1, 2, . . . , d. Conversely, if Set t∈R is a martingale


+ +
under P∗ , then
 (k ) (k )
IE∗ St Fu = IE∗ e rt Set Fu
  
 (k )
= e rt IE∗ Set Fu


(k )
= e rt Seu
(k )
= e (t−u)r Su , 0 ⩽ u ⩽ t, k = 1, 2, . . . , d,
hence the probability measure P∗ is risk-neutral according to Definition 6.4. □
In what follows we will only consider probability measures P∗ that are equivalent to P, in the sense
that they share the same events of zero probability.
Definition 6.6 A probability measure P∗ on (Ω, F ) is said to be equivalent to another proba-
bility measure P when

P∗ (A) = 0 if and only if P(A) = 0, for all A ∈ F. (6.2.2)

Next, we note that the first fundamental theorem of asset pricing also holds in continuous time, and
can be used to check for the existence of arbitrage opportunities.

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 6.3 Self-Financing Portfolio Strategies 185

Theorem 6.7 A market is without arbitrage opportunity if and only if it admits at least one
equivalent risk-neutral probability measure P∗ .

Proof. See Harrison and Pliska, 1981 and Chapter VII-4a of Shiryaev, 1999. □

6.3 Self-Financing Portfolio Strategies

(i)
Let ξt denote the (possibly fractional) quantity invested at time t over the time interval [t,t + dt ),
(k )
in the asset St , k = 0, 1, . . . , d, and let
(k )
(k )

ξ t = ξt k=0,1,...,d
, St = St k=0,1,...,d
, t ⩾ 0,

denote the associated portfolio value and asset price processes. The portfolio value Vt at time t ⩾ 0
is given by
d
(k ) (k )
Vt = ξ t • St = ∑ ξt St , t ⩾ 0. (6.3.1)
k =0

Our description of portfolio strategies proceeds in four equivalent formulations (6.3.2), (6.3.4)
(6.3.5) and (6.3.6), which correspond to different interpretations of the self-financing condition.

Self-financing portfolio update

The portfolio strategy (ξ t )t∈R+ is self-financing if the portfolio value remains constant after
updating the portfolio from ξ t to ξ t +dt , i.e.

d d
(k ) (k ) (k ) (k )
ξ t • St +dt = ∑ ξt St +dt = ∑ ξt +dt St +dt = ξ t +dt • St +dt , (6.3.2)
k =0 k =0

which is the continuous-time analog of the self-financing condition already encountered in the
discrete setting of Chapter 3, see Definition 3.4. A major difference with the discrete-time case of
Definition 3.4, however, is that the continuous-time differentials dSt and dξt do not make pathwise
sense as continuous-time stochastic integrals are defined by L2 limits, cf. Proposition 5.19, or by
convergence in probability.

Portfolio value ξ t • St ξ t • St +dt = ξ t +dt • St +dt ξ t +dt • St +2dt

Asset value St St +dt St +dt St +2dt

Time scale t t + dt t + dt t + 2dt

Portfolio allocation ξt ξt ξt +dt ξt +dt
Figure 6.2: Illustration of the self-financing condition (6.3.2).

Equivalently, Condition (6.3.2) can be rewritten as

d
(k ) (k ) (k )
∑ St +dt (ξt +dt − ξt ) = 0, (6.3.3)
k =0

or, letting
(k ) (k ) (k )
dξt := ξt +dt − ξt , k = 0, 1, . . . , d,

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 186 Chapter 6. Continuous-Time Market Model

denote the respective variations in portfolio allocations, as

d
(k ) (k )
∑ St +dt dξt = 0. (6.3.4)
k =0

Condition (6.3.3) can be rewritten as

d d
(k ) (k ) (k )
(k ) (k )
(k ) (k )

∑ St ξt +dt − ξt + ∑ St +dt − St ξt +dt − ξt = 0,
k =0 k =0

which shows that (6.3.2) and (6.3.4) are equivalent to

d d
(k ) (k ) (k ) (k )
St • dξ t + dSt • dξ t = ∑ St dξt + ∑ dSt • dξt =0 (6.3.5)
k =0 k =0

in differential notation.
Self-financing portfolio differential
In practice, the self-financing portfolio property will be characterized by the following proposition,
which states that the value of a self-financing portfolio can be written as the sum of its trading
Profits and Losses (P/L).

(k )

Proposition 6.8 A portfolio strategy ξt t∈[0,T ],k=0,1,...,d
with value

d
(k ) (k )
Vt = ξ t • St = ∑ ξt St , t ⩾ 0,
k =0

is self-financing according to (6.3.2) if and only if the relation

d
(k ) (k )
dVt = ∑ ξ dS (6.3.6)
k =0
| t {z t }
P/L for asset no k

holds.
Proof. By Itô’s calculus, using (5.5.10) we have
d d d
(k ) (k ) (k ) (k ) (k ) (k )
dVt = ∑ ξt dSt + ∑ St dξt + ∑ dSt • dξt ,
k =0 k =0 k =0

which shows that (6.3.5) is equivalent to (6.3.6). □

Market Completeness
We refer to Definition 2.9 for the definition of contingent claim.
Definition 6.9 A contingent claim with payoff C is said to be attainable if there exists a (self-
(k )

financing) portfolio strategy ξt t∈[0,T ],k=0,1,...,d
such that at the maturity time T the equality
d
(k ) (k )
VT = ξ T • ST = ∑ ξT ST =C
k =0

holds (almost surely) between random variables.

When a claim with payoff C is attainable, its price at time t will be given by the value Vt of a
self-financing portfolio hedging C.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 6.4 Two-Asset Portfolio Model 187
Definition 6.10 A market model is said to be complete if every contingent claim is attainable.

The next result is the continuous-time statement of the second fundamental theorem of asset pricing.

Theorem 6.11 A market model without arbitrage opportunities is complete if and only if it
admits only one equivalent risk-neutral probability measure P∗ .

Proof. See Harrison and Pliska, 1981 and Chapter VII-4a of Shiryaev, 1999. □

6.4 Two-Asset Portfolio Model

In the Black and Scholes, 1973 model, one can show the existence of a unique risk-neutral
probability measure, hence the model is without arbitrage and complete. From now on we work
with d = 1, i.e. with a market based on a riskless asset with price (At )t∈R+ and a risky asset with
price (St )t∈R+ .

Self-financing portfolio strategies

Let ξt and ηt denote the (possibly fractional) quantities respectively invested at time t over the time
interval [t,t + dt ), into the risky asset St and riskless asset At , and let

ξ t = (ηt , ξt ), St = (At , St ), t ⩾ 0,

denote the associated portfolio value and asset price processes. The portfolio value Vt at time t is
given by
Vt = ξ t • St = ηt At + ξt St , t ⩾ 0.
Our description of portfolio strategies proceeds in four equivalent formulations presented below in
Equations (6.4.1), (6.4.2), (6.4.4) and (6.4.5), which correspond to different interpretations of the
self-financing condition.

Self-financing portfolio update

The portfolio strategy (ηt , ξt )t∈R+ is self-financing if the portfolio value remains constant after
updating the portfolio from (ηt , ξt ) to (ηt +dt , ξt +dt ), i.e.

ξ t • St +dt = ηt At +dt + ξt St +dt = ηt +dt At +dt + ξt +dt St +dt = ξ t +dt • St +dt . (6.4.1)

Portfolio value ξ t • St ξ t • St +dt = ξ t +dt • St +dt ξ t +dt • St +2dt

Asset value St St +dt St +dt St +2dt

Time scale t t + dt t + dt t + 2dt

Portfolio allocation ξt ξt ξt +dt ξt +dt
Figure 6.3: Illustration of the self-financing condition (6.4.1).

Equivalently, Condition (6.4.1) can be rewritten as

At +dt dηt + St +dt dξt = 0, (6.4.2)

where
dηt := ηt +dt − ηt and dξt := ξt +dt − ξt

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 188 Chapter 6. Continuous-Time Market Model

denote the respective changes in portfolio allocations, hence we have

At +dt (ηt − ηt +dt ) = St +dt (ξt +dt − ξt ). (6.4.3)
In other words, when one sells a (possibly fractional) quantity ηt − ηt +dt > 0 of the riskless asset
valued At +dt at the end of the time interval [t,t + dt ] for the total amount At +dt (ηt − ηt +dt ), one
should entirely spend this income to buy the corresponding quantity ξt +dt − ξt > 0 of the risky
asset for the same amount St +dt (ξt +dt − ξt ) > 0.
Similarly, if one sells a quantity −dξt > 0 of the risky asset St +dt between the time intervals
[t,t + dt ] and [t + dt,t + 2dt ] for a total amount −St +dt dξt , one should entirely use this income to
buy a quantity dηt > 0 of the riskless asset for an amount At +dt dηt > 0, i.e.
At +dt dηt = −St +dt dξt .
Condition (6.4.3) can also be rewritten as
St (ξt +dt − ξt ) + At (ηt +dt − ηt ) + (St +dt − St )(ξt +dt − ξt )
+ (At +dt − At ) • (ηt +dt − ηt ) = 0,
which shows that (6.4.1) and (6.4.2) are equivalent to
St dξt + At dηt + dSt • dξt + dAt • dηt = 0 (6.4.4)
in differential notation, with
dAt • dηt ≃ (At +dt − At ) • (ηt +dt − ηt ) = rAt (dt • dηt ) = 0
in the sense of Itô’s calculus, by the Itô multiplication Table 5.1. This yields the following
proposition, which is also consequence of Proposition 6.8.

Proposition 6.12 A portfolio allocation (ξt , ηt )t∈R+ with value

Vt = ηt At + ξt St , t ⩾ 0,
is self-financing according to (6.4.1) if and only if the relation

dVt = η dA + ξt dSt (6.4.5)

| t{z t} | {z }
Risk−free P/L Risky P/L

holds.

Proof. By the Itô formula (5.5.10), we have

dVt = [ηt dAt + ξt dSt ] + [St dξt + At dηt + dSt • dξt + dAt • dηt ],
which shows that (6.4.4) is equivalent to (6.4.5). Equivalently, we can also check the equality
dVt = Vt +dt −Vt
= ηt +dt At +dt + ξt +dt St +dt − (ηt At + ξt St )
= ηt (At +dt − At ) + ξt (St +dt − St ) + St (ξt +dt − ξt ) + At (ηt +dt − ηt )
+(St +dt − St )(ξt +dt − ξt ) + (At +dt − At )(ηt +dt − ηt ).
□
Let
Vet := e −rt Vt and Set := e −rt St , t ⩾ 0,
respectively denote the discounted portfolio value and discounted risky asset price at time t ⩾ 0.

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6.4 Two-Asset Portfolio Model 189

Geometric Brownian motion

Recall that the riskless asset price process (At )t∈R+ admits the following equivalent constructions:
At +dt − At dAt
= rdt, = rdt, At′ = rAt , t ⩾ 0,
At At
with the solution
At = A0 e rt , t ⩾ 0, (6.4.6)
where r > 0 is the risk-free interest rate.* The risky asset price process (St )t∈R+ will be modeled
using a geometric Brownian motion defined from the equation
St +dt − St dSt
= = µdt + σ dBt , t ⩾ 0, (6.4.7)
St St
see Section 6.5, which can be solved numerically, according to the following code, see also
Sections 10.1-10.2.
N=2000; t <- 0:N; dt <- 1.0/N;mu=0.5; sigma=0.2; nsim <- 10; S <- matrix(0, nsim, N+1)
dB <- matrix(rnorm(nsim*N,mean=0,sd=sqrt(dt)), nsim, N+1)
for (i in 1:nsim){S[i,1]=1.0;
for (j in 1:N+1){S[i,j]=S[i,j-1]+mu*S[i,j-1]*dt+sigma*S[i,j-1]*dB[i,j]}}
plot(t*dt, rep(0, N+1), xlab = "Time", ylab = "Geometric Brownian motion", lwd=2, ylim =
c(min(S),max(S)), type = "l", col = 0,las=1, cex.axis=1.5,cex.lab=1.5, xaxs='i', yaxs='i')
for (i in 1:nsim){lines(t*dt, S[i, ], lwd=2, type = "l", col = i)}

Note that by Proposition 6.15 below, we also have

   
1 2
St = S0 exp σ Bt + µ − σ t , t ⩾ 0,
2
which can be simulated by the following code.
N=2000; t <- 0:N; dt <- 1.0/N; mu=1.5;sigma=0.3; nsim <- 20; par(oma=c(0,1,0,0))
S <- matrix(rnorm(nsim*N,mean=0,sd=sqrt(dt)), nsim, N)
S <- cbind(rep(0, nsim), t(apply(S, 1, cumsum)))
for (i in 1:nsim){S[i,] <- exp(mu*t*dt+sigma*S[i,]-sigma*sigma*t*dt/2)}
plot(t*dt, rep(0, N+1), xlab = "Time", ylab = "Geometric Brownian motion", lwd=2, ylim = c(0.8,6), type
= "l", col = 0,las=1,cex.axis=1.5,cex.lab=1.5, xaxs='i', yaxs='i')
for (i in 1:nsim){lines(t*dt, S[i, ], lwd=2, type = "l", col = i)}
lines(t*dt, exp(mu*t*dt),xlab = "",type = "l", col = 1, lwd=5)

The next Figure 6.4 presents sample paths of geometric Brownian motion.

5
Geometric Brownian motion

1
0.0 0.2 0.4 0.6 0.8 1.0
Time

Figure 6.4: Ten sample paths of geometric Brownian motion (St )t∈R+ .
*“Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist”,
K. E. Boulding, 1973, page 248.

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 190 Chapter 6. Continuous-Time Market Model

Lemma 6.13 Discounting lemma. Consider an asset price process (St )t∈R+ be as in (6.4.7), i.e.

dSt = µSt dt + σ St dBt , t ⩾ 0.

Then, the discounted asset price process Set t∈R = ( e −rt St )t∈R+ satisfies the equation


+

d Set = ( µ − r )Set dt + σ Set dBt .

Proof. By (5.5.10) and the Itô multiplication Table 5.1, we have

d Set = d ( e −rt St )
= St d ( e −rt ) + e −rt dSt + (d e −rt ) • dSt
= −r e −rt St dt + e −rt dSt + (−r e −rt dt ) • dSt
= −r e −rt St dt + µ e −rt St dt + σ e −rt St dBt
= ( µ − r )Set dt + σ Set dBt .
□
In the next Lemma 6.14, which is the continuous-time analog of Lemma 4.2, we show that when
a portfolio is self-financing, its discounted value is a gain process given by the sum over time of
discounted trading profits and losses (number of risky assets ξt times discounted price variation
d Set ).
Note that in Equation (6.4.8) below, no profit or loss arises from trading the discounted riskless
et := e −rt At = A0 , because its price remains constant over time.
asset A
Lemma 6.14 Let (ηt , ξt )t∈R+ be a portfolio strategy with value

Vt = ηt At + ξt St , t ⩾ 0.
The following statements are equivalent:
(i) the portfolio strategy (ηt , ξt )t∈R+ is self-financing,

(ii) the discounted portfolio value Vet can be written as the stochastic integral sum
wt
Vet = Ve0 + ξu d Seu , t ⩾ 0, (6.4.8)
0 | {z }
Discounted P/L

of discounted profits and losses.

Proof. Assuming that (i) holds, the self-financing condition and (6.4.6)-(6.4.7) show that

dVt = ηt dAt + ξt dSt

= rηt At dt + µξt St dt + σ ξt St dBt
= rVt dt + ( µ − r )ξt St dt + σ ξt St dBt , t ⩾ 0,

where we used Vt = ηt At + ξt St , hence

e −rt dVt = r e −rt Vt dt + ( µ − r ) e −rt ξt St dt + σ e −rt ξt St dBt , t ⩾ 0,

and

= d e −rt Vt


dVet

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

6.4 Two-Asset Portfolio Model 191

= −r e −rt Vt dt + e −rt dVt

= ( µ − r )ξt e −rt St dt + σ ξt e −rt St dBt
= ( µ − r )ξt Set dt + σ ξt Set dBt
= ξt d Set , t ⩾ 0,

i.e. (6.4.8) holds by integrating on both sides as

wt wt
Vet − Ve0 = dVeu = ξu d Seu , t ⩾ 0.
0 0

(ii) Conversely, if (6.4.8) is satisfied we have

dVt = d ( e rt Vet )
= r e rt Vet dt + e rt dVet
= r e rt Vet dt + e rt ξt d Set
= rVt dt + e rt ξt d Set
= rVt dt + e rt ξt Set (( µ − r )dt + σ dBt )
= rVt dt + ξt St (( µ − r )dt + σ dBt )
= rηt At dt + µξt St dt + σ ξt St dBt
= ηt dAt + ξt dSt ,

hence the portfolio is self-financing according to Definition 6.8. □

As a consequence of Relation (6.4.8), the problem of hedging a claim payoff C with maturity T also
reduces to that of finding the process (ξt )t∈[0,T ] appearing in the decomposition of the discounted
claim payoff Ce = e −rT C as a stochastic integral:
wT
Ce = VeT = Ve0 + ξt d Set ,
0

see Section 8.5 on hedging by the martingale method.

Example. Power options in the Bachelier model.
In the Bachelier, 1900 model with interest rate r = 0, the underlying asset price can be modeled
by Brownian motion (Bt )t∈R+ , and may therefore become negative.* The claim payoff C =
(BT )2 of a power option with at maturity T > 0 admits the stochastic integral decomposition
wT
( BT ) 2 = T + 2 Bt dBt
0

which shows that the claim can be hedged using ξt = 2Bt units of the underlying asset at
time t ∈ [0, T ], see Exercise 7.1.
Similarly, in the case of power claim payoff C = (BT )3 we have
wT
(BT )3 = 3 T − t + (Bt )2 dBt ,


0

cf. Exercise 5.10.

Note that according to (6.4.8), the (non-discounted) self-financing portfolio value Vt can be written
as
wt wt
Vt = e rt V0 + ( µ − r ) e (t−u)r ξu Su du + σ e (t−u)r ξu Su dBu , t ⩾ 0. (6.4.9)
0 0
* Negative oil prices have been observed in May 2020 when the prices of oil futures contracts fell below zero.

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 192 Chapter 6. Continuous-Time Market Model

6.5 Geometric Brownian Motion

In this section we solve the stochastic differential equation

dSt = µSt dt + σ St dBt

which is used to model the St the risky asset price at time t, where µ ∈ R and σ > 0. This equation
is rewritten in integral form as
wt wt
St = S0 + µ Ss ds + σ Ss dBs , t ⩾ 0. (6.5.1)
0 0

N=1000; t <- 0:N; dt <- 1.0/N; sigma=0.2; mu=0.5

dB <- rnorm(N,mean=0,sd=sqrt(dt));
plot(t*dt, exp(mu*t*dt), xlab = "time", ylab = "Geometric Brownian motion", type = "l", ylim = c(0.75,
2), col = 1,lwd=3)
lines(t*dt, exp(sigma*c(0,cumsum(dB))+mu*t*dt-sigma*sigma*t*dt/2),xlab = "time",type = "l",ylim = c(0,
4), col = 4)

The next Figure 6.5 presents an illustration of the geometric Brownian process of Proposition 6.15.

4
St
3.5
ert
3
St 2.5
2
1.5
S0=1
0.5
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
t

Figure 6.5: Geometric Brownian motion started at S0 = 1, with µ = r = 1 and σ 2 = 0.5.*

Proposition 6.15 The solution of the stochastic differential equation

dSt = µSt dt + σ St dBt (6.5.2)

is given by
   
1 2
St = S0 exp σ Bt + µ − σ t , t ⩾ 0. (6.5.3)
2

Proof. a) Using log-returns. We apply Itô’s formula to the Itô process (St )t∈R+ with vt = µSt and
ut = σ St , by taking
f (St ) = log St , with f (x) := log x.
* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

6.5 Geometric Brownian Motion 193

This yields the log-return dynamics

1 ′′
d log St = f ′ (St )dSt + f (St )dSt • dSt
2
σ 2 2 ′′
= µSt f ′ (St )dt + σ St f ′ (St )dBt + S f (St )dt
2 t
σ2
= µdt + σ dBt − dt,
2
hence
wt
log St − log S0 = d log Ss
0
σ2 w t wt

= µ− ds + σ dBs
2 0 0
2
 
σ
= µ− t + σ Bt ,
2
and
σ2
  
St = S0 exp µ− t + σ Bt , t ⩾ 0.
2
b) Let us provide an alternative proof by searching for a solution of the form

St = f (t, Bt )

where f (t, x) is a function to be determined. By Itô’s formula (5.5.8) we have

∂f ∂f 1 ∂2 f
dSt = d f (t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt.
∂t ∂x 2 ∂ x2
Comparing this expression to (6.5.2) and identifying the terms in dBt we get

∂f


 (t, Bt ) = σ St ,
 ∂x


 2
 ∂ f (t, B ) + 1 ∂ f (t, B ) = µS .


t t t
∂t 2 ∂ x2
Using the relation St = f (t, Bt ), these two equations rewrite as

∂f


 (t, Bt ) = σ f (t, Bt ),
 ∂x


 2
 ∂ f (t, B ) + 1 ∂ f (t, B ) = µ f (t, B ).


t t t
∂t 2 ∂ x2
Since Bt is a Gaussian random variable taking all possible values in R, the equations should hold
for all x ∈ R, as follows:

∂f
(t, x) = σ f (t, x),


 (6.5.4a)
 ∂x




∂f 1 ∂2 f


 (t, x) + (t, x) = µ f (t, x).

 (6.5.4b)
∂t 2 ∂ x2

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 194 Chapter 6. Continuous-Time Market Model

To find the solution f (t, x) = f (t, 0) e σ x of (6.5.4a) we let g(t, x) = log f (t, x) and rewrite (6.5.4a)
as
∂g ∂ 1 ∂f
(t, x) = log f (t, x) = (t, x) = σ ,
∂x ∂x f (t, x) ∂ x
i.e.
∂g
(t, x) = σ ,
∂x
which is solved as
g(t, x) = g(t, 0) + σ x,
hence
f (t, x) = e g(t,0) e σ x = f (t, 0) e σ x .
Plugging back this expression into the second equation (6.5.4b) yields
∂f 1
eσ x (t, 0) + σ 2 e σ x f (t, 0) = µ f (t, 0) e σ x ,
∂t 2
i.e.
σ2
 
∂f
(t, 0) = µ − f (t, 0),
∂t 2
or
∂g σ2
(t, 0) = µ − .
∂t 2
This yields
σ2
 
g(t, 0) = g(0, 0) + µ − t,
2
hence
f (t, x) = e g(t,x) = e g(t,0)+σ x
e g(0,0)+σ x+(µ−σ /2)t
2
=
f (0, 0) e σ x+(µ−σ )t ,
2 /2
= t ⩾ 0.
We conclude that
St = f (t, Bt ) = f (0, 0) e σ Bt +(µ−σ )t ,
2 /2

and the solution to (6.5.2) is given by

2 /2)t
St = S0 e σ Bt +(µ−σ , t ⩾ 0.

□
Conversely, taking St = f (t, Bt ) with f (t, x) = S0 e µt +σ x−σ 2 t/2 , we may apply Itô’s formula to
check that
dSt = d f (t, Bt ) (6.5.5)
∂f ∂f 1 ∂2 f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂ x2
σ2
 
2 2
= µ− S0 e µt +σ Bt −σ t/2 dt + σ S0 e µt +σ Bt −σ t/2 dBt
2
1 2
+ σ 2 S0 e µt +σ Bt −σ t/2 dt
2
2 2
= µS0 e µt +σ Bt −σ t/2 dt + σ S0 e µt +σ Bt −σ t/2 dBt
= µSt dt + σ St dBt .

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

6.5 Geometric Brownian Motion 195

Exercises
2 /2)T
Exercise 6.1 Show that at any time T > 0, the random variable ST := S0 e σ BT +(µ−σ has the
lognormal distribution with probability density function

1 2 2 2
x 7−→ f (x) = √ e −(−(µ−σ /2)T +log(x/S0 )) /(2σ T ) , x > 0,
xσ 2πT

with log-variance σ 2 and log-mean ( µ − σ 2 /2)T + log S0 , see Figures 4.10 and 6.6.

N=1000; t <- 0:N; dt <- 1.0/N; nsim <- 100 # using Bernoulli samples
sigma=0.2;r=0.5;a=(1+r*dt)*(1-sigma*sqrt(dt))-1;b=(1+r*dt)*(1+sigma*sqrt(dt))-1
X <- matrix(a+(b-a)*rbinom( nsim * N, 1, 0.5), nsim, N)
X<-cbind(rep(0,nsim),t(apply((1+X),1,cumprod))); X[,1]=1;H<-hist(X[,N],plot=FALSE);
dev.new(width=16,height=7);
layout(matrix(c(1,2), nrow =1, byrow = TRUE)); par(mar=c(2,2,2,0), oma = c(2, 2, 2, 2))
plot(t*dt,X[1,],xlab="time",ylab="",type="l",ylim=c(0.8,3), col = 0,xaxs='i',las=1, cex.axis=1.6)
for (i in 1:nsim){lines(t*dt, X[i, ], xlab = "time", type = "l", col = i)}
lines((1+r*dt)^t, type="l", lty=1, col="black",lwd=3,xlab="",ylab="", main="")
for (i in 1:nsim){points(0.999, X[i,N], pch=1, lwd = 5, col = i)}; x <- seq(0.01,3, length=100);
px <- exp(-(-(r-sigma^2/2)+log(x))^2/2/sigma^2)/x/sigma/sqrt(2*pi); par(mar = c(2,2,2,2))
plot(NULL , xlab="", ylab="", xlim = c(0, max(px,H$density)),ylim=c(0.8,3),axes=F, las=1)
rect(0, H$breaks[1:(length(H$breaks) - 1)], col=rainbow(20,start=0.08,end=0.6), H$density,
H$breaks[2:length(H$breaks)])
lines(px,x, type="l", lty=1, col="black",lwd=3,xlab="",ylab="", main="")

3.0

2.5

2.0

1.5

1.0

0.0 0.2 0.4 0.6 0.8 1.0

time

Figure 6.6: Statistics of geometric Brownian paths vs. lognormal distribution.

Exercise 6.2
a) Consider the stochastic differential equation

dSt = rSt dt + σ St dBt , t ⩾ 0, (6.5.6)

where r, σ ∈ R are constants and (Bt )t∈R+ is a standard Brownian motion. Compute d log St
using the Itô formula.
b) Solve the ordinary differential equation d f (t ) = c f (t )dt for f (t ), and the stochastic differ-
ential equation (6.5.6) for St .
c) Using the Gaussian moment generating function (MGF) formula (11.6.16), compute the n-th
order moment IE[Stn ] for all n ⩾ 1.

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 196 Chapter 6. Continuous-Time Market Model

d) Compute the lognormal mean and variance

2
IE[St ] = S0 e rt Var[St ] = S02 e 2rt e σ t − 1 ,


and t ⩾ 0.

e) Recover the lognormal mean and variance of Question (d)) by deriving differential equations
for the functions u(t ) := IE[St ] and v(t ) := IE St2 , t ⩾ 0, using stochastic calculus.
 

Exercise 6.3 Assume that (Bt )t∈R+ and (Wt )t∈R+ are standard Brownian motions, correlated
according to the Itô rule dWt • dBt = ρdt for ρ ∈ [−1, 1], and consider the solution (Yt )t∈R+ of
the stochastic differential equation dYt = µYt dt + ηYt dWt , t ⩾ 0, where µ, η ∈ R are constants.
Compute d f (St ,Yt ), for f a C 2 function on R2 using the bivariate Itô formula (5.5.9).

Exercise 6.4 Consider the asset price process (St )t∈R+ given by the stochastic differential equation

dSt = rSt dt + σ St dBt .

Find the stochastic integral decomposition of the random variable ST , i.e., find the constant
C (S0 , r, T ) and the process (ζt,T )t∈[0,T ] such that
wT
ST = C (S0 , r, T ) + ζt,T dBt . (6.5.7)
0

Hint: Use the fact that the discounted price process (Xt )t∈[0,T ] := ( e −rt St )t∈[0,T ] satisfies the relation
dXt = σ Xt dBt .

Exercise 6.5 Consider (Bt )t∈R+ a standard Brownian motion generating the filtration (Ft )t∈R+
and the process (St )t∈R+ defined by
w t wt 
St = S0 exp σs dBs + us ds , t ⩾ 0,
0 0

where (σt )t∈R+ and (ut )t∈R+ are (Ft )t∈[0,T ] -adapted processes.
a) Compute dSt using Itô calculus.
b) Show that St satisfies a stochastic differential equation to be determined.

Exercise 6.6 Consider (Bt )t∈R+ a standard Brownian motion generating the filtration (Ft )t∈R+ ,
and let σ > 0.
a) Compute the mean and variance of the random variable St defined as
wt 2
St := 1 + σ e σ Bs −σ s/2 dBs , t ⩾ 0. (6.5.8)
0

b) Express d log(St ) using (6.5.8) and the Itô formula.

2
c) Show that St = eσ Bt −σ t/2 for t ⩾ 0.

Exercise 6.7 We consider a leveraged fund with factor β : 1 on an index (St )t∈R+ modeled as the
geometric Brownian motion

dSt = rSt dt + σ St dBt , t ⩾ 0,

under the risk-neutral probability measure P∗ . Examples of leveraged funds include ProShares
Ultra S&P500 and ProShares UltraShort S&P500.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

6.5 Geometric Brownian Motion 197

a) Find the portfolio allocation (ξt , ηt ) of the leveraged fund value

Ft = ξt St + ηt At , t ⩾ 0,
where At := A0 e rt represents the risk-free money market account price.
Hint: Leveraging with a factor β : 1 means that the risky component of the portfolio should
represent β times the invested amount Ft at any time t ⩾ 0.
b) Find the stochastic differential equation satisfied by (Ft )t∈R+ under the self-financing condi-
tion dFt = ξt dSt + ηt dAt .
c) Find the relation between the fund value Ft and the index St by solving the stochastic
β
differential equation obtained for Ft in Question (b)). For simplicity we take F0 := S0 .
(1) (2)
Exercise 6.8 Consider two assets whose prices St , St at time t ∈ [0, T ] follow the geometric
Brownian dynamics
(1) (1) (1) (1) (2) (2) (2) (2)
dSt = µSt dt + σ1 St dWt and dSt = µSt dt + σ2 St dWt ,
(1)
(2)

t ∈ [0, T ], where Wt t∈[0,T ] , Wt t∈[0,T ] are two Brownian motions with correlation ρ ∈ [−1, 1],
 (1) (2) 
i.e. we have IE Wt Wt = ρt.
 (i) 
a) Compute IE St , t ∈ [0, T ], i = 1, 2.
 (i) 
b) Compute Var St , t ∈ [0, T ], i = 1, 2.
 (2) (1) 
c) Compute Var St − St , t ∈ [0, T ].

Exercise 6.9 Solve the stochastic differential equation

dXt = h(t )Xt dt + σ Xt dBt ,
where σ > 0 and h(t ) is a deterministic, integrable function of t ⩾ 0.
2 t/2
Hint: Look for a solution of the form Xt = f (t ) e σ Bt −σ , where f (t ) is a function to be deter-
mined, t ⩾ 0.

Exercise 6.10 Let (Bt )t∈R+ denote a standard Brownian motion generating the filtration (Ft )t∈R+ .
a) Letting Xt := σ Bt + νt, σ > 0, ν ∈ R, compute St := e Xt by the Itô formula
wt ∂ f wt ∂ f 1 w t 2∂2 f
f (Xt ) = f (X0 ) + us (Xs )dBs + vs (Xs )ds + u (Xs )ds, (6.5.9)
0 ∂x 0 ∂x 2 0 s ∂ x2
wt wt
applied to f (x) = e x , by writing Xt as Xt = X0 + us dBs + vs ds.
0 0
b) Let r > 0. For which value of ν does (St )t∈R+ satisfy the stochastic differential equation
dSt = rSt dt + σ St dBt ?
c) Given σ > 0, let Xt := (BT − Bt )σ , and compute Var[Xt ], 0 ⩽ t ⩽ T .
d) Let the process (St )t∈R+ be defined by St = S0 e σ Bt +νt , t ⩾ 0. Using the result of Exercise A.2,
show that the conditional probability that ST > K given St = x can be computed as
log(x/K ) + (T − t )ν
 
P(ST > K | St = x) = Φ √ , 0 ⩽ t < T,
σ T −t
where Φ(x) denotes the standard Gaussian Cumulative Distribution Function.
Hint: Use the time splitting decomposition
ST
ST = St = St e (BT −Bt )σ +(T −t )ν , 0 ⩽ t ⩽ T.
St

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 198 Chapter 6. Continuous-Time Market Model

Problem 6.11 Stop-loss/start-gain strategy (Lipton, 2001 § 8.3.3., Exercise 5.19 continued). Let
(Bt )t∈R+ be a standard Brownian motion started at B0 ∈ R.
a) We consider a simplified foreign exchange model in which the AUD is a risky asset and
the AUD/SGD exchange rate at time t is modeled by Bt , i.e. AU$1 equals SG$Bt at time
t. A foreign exchange (FX) European call option gives to its holder the right (but not the
obligation) to receive AU$1 in exchange for K = SG$1 at maturity T . Give the option payoff
at maturity, quoted in SGD.
In what follows, for simplicity we assume no time value of money (r = 0), i.e. the (riskless)
SGD account is priced At = A0 = 1, 0 ⩽ t ⩽ T .
b) Consider the following hedging strategy for the European call option of Question (a)):
i) If B0 > 1, charge the premium B0 − 1 at time 0, and borrow SG$1 to purchase AU$1.
ii) If B0 < 1, issue the option for free.
iii) From time 0 to time T , purchase* AU$1 every time Bt crosses K = 1 from below, and
sell† AU$1 each time Bt crosses K = 1 from above.
Show that this strategy effectively hedges the foreign exchange European call option at
maturity T .
Hint: Note that it suffices to consider four scenarios based on B0 < 1 vs. B0 < 1 and BT > 1
vs. BT < 1.
c) Determine the quantities ηt of SGD cash and ξt of (risky) AUDs to be held in the portfolio
and express the portfolio value
Vt = ηt + ξt Bt
at all times t ∈ [0, T ].
d) Compute the integral summation
wt wt
ηs dAs + ξs dBs
0 0

of portfolio profits and losses at any time t ∈ [0, T ].

Hint: Apply the Itô-Tanaka formula (5.5.31), see Question (e)) in Exercise 5.19.
e) Is the portfolio strategy (ηt , ξt )t∈[0,T ] self-financing? How to interpret the answer in practice?

*We need to borrow SG$1 if this is the first AUD purchase.

†We use the SG$1 product of the sale to refund the loan.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 199

7. Black-Scholes Pricing and Hedging

The Black and Scholes, 1973 PDE is a Partial Differential Equation that is used for the pricing
of vanilla options under the absence of arbitrage and self-financing portfolio assumptions. In this
chapter, we derive the Black-Scholes PDE and present its solution by the heat kernel method, with
application to the pricing and hedging of European call and put options.

7.1 The Black-Scholes PDE 163

7.2 European Call Options 168
7.3 European Put Options 174
7.4 Market Terms and Data 179
7.5 The Heat Equation 183
7.6 Solution of the Black-Scholes PDE 187
Exercises 189

7.1 The Black-Scholes PDE

In this chapter, we work in a market based on a riskless asset with price (At )t∈R+ given by
At +dt − At dAt dAt
= rdt, = rdt, = rAt , t ⩾ 0,
At At dt
with
At = A0 e rt , t ⩾ 0,
and a risky asset with price (St )t∈R+ modeled using a geometric Brownian motion defined from
the equation
dSt
= µdt + σ dBt , t ⩾ 0, (7.1.1)
St

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 200 Chapter 7. Black-Scholes Pricing and Hedging

which admits the solution

 
1 2
St = S0 exp σ Bt + µt − σ t , t ⩾ 0,
2

see Proposition 6.15.

library(quantmod); getSymbols("0005.HK",from="2016-02-15",to="2017-05-11",src="yahoo")
Marketprices<-Ad(`0005.HK`); returns = (Marketprices-lag(Marketprices)) / Marketprices
sigma=sd(as.numeric(returns[-1])); r=mean(as.numeric(returns[-1]))
N=length(Marketprices); t <- 0:N;
a=(1+r)*(1-sigma)-1;b=(1+r)*(1+sigma)-1
X <- matrix((a+b)/2+(b-a)*rnorm( N-1, 0, 1)/2, 1, N-1)
X <- as.numeric(Marketprices[1])*cbind(0,t(apply((1+X),1,cumprod))); X[,1]=1;
x=seq(100,100+N-1); dates <- index(Marketprices)
GBM<-xts(x =X[1,], order.by = dates)
myPars <- chart_pars();myPars$cex<-1.4
myTheme <- chart_theme();myTheme$col$line.col <- "blue"
myTheme$rylab <- FALSE;
chart_Series(Marketprices,pars=myPars, theme = myTheme);
dexp<-as.numeric(Marketprices[1])*exp(r*seq(1,305)); ddexp<-xts(x =dexp, order.by = dates)
dev.new(width=16,height=8); par(mfrow=c(1,2));
add_TA(exp(log(ddexp)), on=1, col="black",layout=NULL, lwd=4 ,legend=NULL)
graph <- chart_Series(GBM,theme=myTheme,pars=myPars); myylim <- graph$get_ylim()
graph <- add_TA(exp(log(ddexp)), on=1, col="black",layout=NULL, lwd=4 ,legend=NULL)
myylim[[2]] <- structure(c(min(Marketprices),max(Marketprices)), fixed=TRUE)
graph$set_ylim(myylim); graph

The adjusted close price Ad() is the closing price after adjustments for applicable splits and dividend
distributions.

The next Figure 7.1 presents a graph of underlying asset price market data, which is compared to
the geometric Brownian motion simulations of Figures 6.4 and 6.5.

2016−02−15 / 2017−05−10 2016−02−15 / 2017−05−10 60

0005.HK 0005.HK
56 58
rt
e
56
54 55
54
52
52
50
50 50
48
48
46
46
44 45
44
42 42
40 40 40
38 38

35
Feb 15 May 03 Aug 01 Nov 01 Feb 01 May 02 Feb 15 May 03 Aug 01 Nov 01 Feb 01 May 02
2016 2016 2016 2016 2017 2017 2016 2016 2016 2016 2017 2017

Figure 7.1: Graph of underlying market prices.

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7.1 The Black-Scholes PDE 201

2016−02−15 / 2017−05−10 2016−02−15 / 2017−05−10

Geometric Brownian Motion Geometric Brownian Motion
60 60 rt
60
e
58 58

56 56
55
54 54

52 52

50 50 50

48 48

46
46 45
44
44
42
42
40 40
40
38

Feb 15 May 03 Aug 01 Nov 01 Feb 01 May 02 Feb 15 May 03 Aug 01 Nov 01 Feb 01 May 35
02
2016 2016 2016 2016 2017 2017 2016 2016 2016 2016 2017 2017

Figure 7.2: Graph of simulated geometric Brownian motion.

The package Sim.DiffProc can be used to estimate the coefficients of a geometric Brownian
motion fitting observed market data.

library("Sim.DiffProc")
fx <- expression( theta[1]*x ); gx <- expression( theta[2]*x )
fitsde(data = as.ts(Marketprices), drift = fx, diffusion = gx, start = list(theta1=0.01,
theta2=0.01),pmle="euler")

In the sequel, we start by deriving the Black and Scholes, 1973 Partial Differential Equation
(PDE) for the value of a self-financing portfolio. Note that the drift parameter µ in (7.1.1) is
absent in the PDE (7.1.2), and it does not appear as well in the Black and Scholes, 1973 for-
mula (7.2.2).

Proposition 7.1 Let (ηt , ξt )t∈R+ be a portfolio strategy such that

(i) the portfolio strategy (ηt , ξt )t∈R+ is self-financing,
(ii) the portfolio value Vt := ηt At + ξt St , takes the form

Vt = g(t, St ), t ⩾ 0,

for some function g ∈ C 1,2 (R+ × R+ ) of t and St .

Then, the function g(t, x) satisfies the Black and Scholes, 1973 PDE

∂g ∂g 1 ∂ 2g
rg(t, x) = (t, x) + rx (t, x) + σ 2 x2 2 (t, x), x > 0, (7.1.2)
∂t ∂x 2 ∂x
and ξt = ξt (St ) is given by the partial derivative

∂g
ξt = ξt (St ) = (t, St ), t ⩾ 0. (7.1.3)
∂x

Proof. (i) First, we note that the self-financing condition (6.3.6) in Proposition 6.8 implies

dVt = ηt dAt + ξt dSt

= rηt At dt + µξt St dt + σ ξt St dBt
= rVt dt + ( µ − r )ξt St dt + σ ξt St dBt
= rg(t, St )dt + ( µ − r )ξt St dt + σ ξt St dBt , (7.1.4)

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 202 Chapter 7. Black-Scholes Pricing and Hedging

t ⩾ 0. We now rewrite (6.5.1) under the form of an Itô process

wt wt
St = S0 + vs ds + us dBs , t ⩾ 0,
0 0

as in (5.5.5), by taking
ut = σ St , and vt = µSt , t ⩾ 0.
(ii) By (5.5.7), the application of Itô’s formula Theorem 5.22 to Vt = g(t, St ) leads to
dVt = dg(t, St )
∂g ∂g 1 ∂ 2g
= (t, St )dt + (t, St )dSt + (dSt )2 2 (t, St )
∂t ∂x 2 ∂x
∂g ∂g ∂g 1 ∂ 2g
= (t, St )dt + vt (t, St )dt + ut (t, St )dBt + |ut |2 2 (t, St )dt
∂t ∂x ∂x 2 ∂x
∂g ∂g 1 2 2 ∂ 2g ∂g
= (t, St )dt + µSt (t, St )dt + σ St 2 (t, St )dt + σ St (t, St )dBt .
∂t ∂x 2 ∂x ∂x
(7.1.5)

By respective identification of components in dBt and dt in (7.1.4) and (7.1.5), we get

∂ 2g

∂g ∂g 1
 rg(t, St )dt + ( µ − r )ξt St dt = (t, St )dt + µSt (t, St )dt + σ 2 St2 2 (t, St )dt,


∂t ∂x 2 ∂x
 ξt St σ dBt = St σ ∂ g (t, St )dBt ,


∂x
hence
∂ 2g

∂g ∂g 1
 rg(t, St ) = (t, St ) + rSt (t, St ) + σ 2 St2 2 (t, St ),


∂t ∂x 2 ∂x (7.1.6)
 ξt = ∂ g (t, St ),

0 ⩽ t ⩽ T,

∂x
which yields (7.1.2) after substituting St with x > 0. □
The derivative giving ξt in (7.1.3) is called the Delta of the option price, see Proposition 7.4 below.
The amount invested on the riskless asset is
∂g
ηt At = Vt − ξt St = g(t, St ) − St (t, St ),
∂x
and ηt is given by
Vt − ξt St
ηt =
A
t 
1 ∂g
= g(t, St ) − St (t, St )
At ∂x
 
1 ∂g
= g(t, St ) − St (t, St ) .
A0 e rt ∂x
In the next Proposition 7.2 we add a terminal condition g(T , x) = f (x) to the Black-Scholes
PDE (7.1.2) in order to price a claim payoff C of the form C = h(ST ). As in the discrete-time case,
the arbitrage-free price πt (C ) at time t ∈ [0, T ] of the claim payoff C is defined to be the value Vt of
the self-financing portfolio hedging C.

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7.1 The Black-Scholes PDE 203

Proposition 7.2 Under the assumptions of Proposition 7.1, the arbitrage-free price πt (C ) at time
t ∈ [0, T ] of the (vanilla) option with claim payoff C = h(ST ) is given by πt (C ) = g(t, St ) and
the hedging allocation ξt is given by the partial derivative (7.1.3), where the function g(t, x) is
solution of the following Black-Scholes PDE:


2
 rg(t, x) = ∂ g (t, x) + rx ∂ g (t, x) + 1 σ 2 x2 ∂ g (t, x),

∂t ∂x 2 ∂ x2 (7.1.7)

 g(T , x) = h(x), x > 0.

Proof. Proposition 7.1 shows that the solution g(t, x) of (7.1.2), g ∈ C 1,2 (R+ × R+ ), represents
the value Vt = ηt At + ξt St = g(t, St ), t ∈ R+ , of a self-financing portfolio strategy (ηt , ξt )t∈R+ .
By Definition 4.1, πt (C ) := Vt = g(t, St ) is the arbitrage-free price at time t ∈ [0, T ] of the vanilla
option with claim payoff C = h(ST ). □
The absence of the drift parameter µ from the PDE (7.1.7) can be understood in the next forward
contract example, in which the claim payoff can be hedged by leveraging on the value St of the
underlying asset, independently of the trend parameter µ.
Example - Forward contracts
The holder of a long forward contract is committed to purchasing an asset at the price K at maturity
time T , while the contract issuer has the obligation to hand in the asset priced ST in exchange for
the amount K at maturity time T .
Clearly, the contract has the claim payoff C = ST −K, and it can be hedged by simply holding ξt = 1
asset in the portfolio at all times t ∈ [0, T ]. Denoting by Vt the option price at time t ∈ [0, T ], the
amount St −Vt has to be borrowed at time t in order to purchase the asset. As the amount K received
at maturity T should be used to refund the loan at time T , we should have (St −Vt ) e (T −t )r = K,
hence

Vt = St − K e −(T −t )r , 0 ⩽ t ⩽ T. (7.1.8)

We note that the riskless allocation ηt = −K e −rT is also constant over time t ∈ [0, T ] due to
self-financing.
More precisely, the forward contract can be realized by the option issuer via the following steps:
a) At time t, receive the option premium Vt := St − e −(T −t )r K from the option buyer.
b) Borrow e −(T −t )r K from the bank, to be refunded at maturity.
c) Buy the risky asset using the amount St − e −(T −t )r K + e −(T −t )r K = St .
d) Hold the risky asset until maturity (do nothing, constant portfolio strategy).
e) At maturity T , hand in the asset to the option holder, who will pay the amount K in return.
f) Use the amount K = e (T −t )r e −(T −t )r K to refund the lender of e −(T −t )r K borrowed at time t.
On the other hand, the payoff C of the long forward contract can be written as C = ST − K = h(ST )
where h is the (affine) payoff function h(x) = x − K, and the Black-Scholes PDE (7.1.7) admits the
easy solution

g(t, x) = x − K e −(T −t )r , x > 0, 0 ⩽ t ⩽ T, (7.1.9)

showing that the price at time t ∈ [0, T ] of the long forward contract is

g(t, St ) = St − K e −(T −t )r , 0 ⩽ t ⩽ T.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 204 Chapter 7. Black-Scholes Pricing and Hedging

In addition, the Delta of the option price is given by

∂g
ξt = (t, St ) = 1, 0 ⩽ t ⩽ T,
∂x
which recovers the static, “hedge and forget” strategy, cf. Exercise 7.7.
Forward contracts can be used for physical delivery, e.g. for live cattle. In the case of European
options, the basic “hedge and forget” constant strategy

ξt = 1, ηt = η0 , 0 ⩽ t ⩽ T,

will hedge the option only if

ST + η0 AT ⩾ (ST − K )+ ,
i.e. if −η0 AT ⩽ K ⩽ ST .
Futures contracts
For a futures contract expiring at time T , we take K = S0 e rT and the contract is usually quoted at
time t in terms of the forward price

e (T −t )r St − K e −(T −t )r = e (T −t )r St − K = e (T −t )r St − S0 e rT ,

discounted at time T , or simply using e (T −t )r St . Futures contracts are non-deliverable forward

contracts which are “marked to market” at each time step via a cash flow exchange between the
two parties, ensuring that the absolute difference e (T −t )r St − K is being credited to the buyer’s
account if e (T −t )r St > K, or to the seller’s account if e (T −t )r St < K.

7.2 European Call Options

Recall that in the case of the European call option with strike price K the payoff function is given
by h(x) = (x − K )+ and the Black-Scholes PDE (7.1.7) reads

2
 rg (t, x) = ∂ gc (t, x) + rx ∂ gc (t, x) + 1 σ 2 x2 ∂ gc (t, x)

c
∂t ∂x 2 ∂ x2 (7.2.1)
 g (T , x ) = (x − K ) + .

c

The next proposition will be proved in Sections 7.5-7.6, see Proposition 7.11.

Proposition 7.3 The solution of the PDE (7.2.1) is given by the Black-Scholes formula for call
options:

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.2 European Call Options 205

gc (t, x) = Bl(x, K, σ , r, T − t ) = xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

(7.2.2)

with
log(x/K ) + (r + σ 2 /2)(T − t )
d+ (T − t ) : = √ (7.2.3)
|σ | T − t

and
log(x/K ) + (r − σ 2 /2)(T − t )
d− ( T − t ) : = √ , (7.2.4)
|σ | T − t

0 ⩽ t < T.

We note the relation

√
d+ (T − t ) = d− (T − t ) + |σ | T − t, 0 ⩽ t < T. (7.2.5)

Here, “log” denotes the natural logarithm “ln”, and

1 w x −y2 /2
Φ (x ) : = P(X ⩽ x ) = √ e dy, x ∈ R,
2π −∞
denotes the standard Gaussian Cumulative Distribution Function (CDF) of a standard normal
random variable X ≃ N (0, 1), with the relation

Φ(−x) = 1 − Φ(x), x ∈ R. (7.2.6)

1.2
1
Gaussian CDF Φ(x)
1

0.8
Φ(x)
0.6

0.4

0.2

0
-4 -3 -2 -1 0 1 2 3 4
x

Figure 7.3: Graph of the Gaussian Cumulative Distribution Function (CDF).

In other words, the European call option with strike price K and maturity T is priced at time
t ∈ [0, T ] as

gc (t, St ) = Bl(St , K, σ , r, T − t )
= St Φ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,



0 ⩽ t ⩽ T.

The following R script implements the Black-Scholes formula for European call options in .*
* Download the corresponding IPython notebook that can be run here or here.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 206 Chapter 7. Black-Scholes Pricing and Hedging

BSCall <- function(S, K, r, T, sigma)

{d1 <- (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T));d2 <- d1 - sigma * sqrt(T)
BSCall = S*pnorm(d1) - K*exp(-r*T)*pnorm(d2)
BSCall}

In comparison with the discrete-time Cox-Ross-Rubinstein (CRR) model of Section 3.6, the interest
in the formula (7.2.2) is to provide an analytical solution that can be evaluated in a single step,
which is computationally much more efficient.

Figure 7.4: Graph of the Black-Scholes call price map with strike price K = 100.*

Figure 7.4 presents an interactive graph of the Black-Scholes call price map, i.e. the solution

(t, x) 7−→ gc (t, x) = xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t )

of the Black-Scholes PDE (7.1.7) for a call option.

70
60
50
40
30
20
10
0
0 40
80
100 120 Time in days
Underlying asset price 60 160

Figure 7.5: Time-dependent solution of the Black-Scholes PDE (call option).†

The next proposition is proved by a direct differentiation of the Black-Scholes function, and will be
recovered later using a probabilistic argument in Proposition 8.13 below.

* Right-click on the figure for interaction and “Full Screen Multimedia” view.
† The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.2 European Call Options 207

Proposition 7.4 The Black-Scholes Delta of the European call option is given by

∂ gc
(t, St ) = Φ d+ (T − t ) ∈ [0, 1],


ξt = ξt (St ) = (7.2.7)
∂x
where
log(x/K ) + (r + σ 2 /2)(T − t )
d+ (T − t ) = √
|σ | T − t
is given by (7.2.3).

Proof. From Relation (7.2.5), we note that the standard normal probability density function
1 2
ϕ (x) = Φ′ (x) = √ e −x /2 , x ∈ R,
2π
satisfies
log(x/K ) + (r + σ 2 /2)(T − t )
 
ϕ (d+ (T − t )) = ϕ √
|σ | T − t
2 !
1 log(x/K ) + (r + σ 2 /2)(T − t )

1
= √ exp − √
2π 2 |σ | T − t
2 !
1 log(x/K ) + (r − σ 2 /2)(T − t ) √

1
= √ exp − √ + |σ | T − t
2π 2 |σ | T − t
 
1 1 x
= √ exp − (d− (T − t ))2 − (T − t )r − log
2π 2 K
 
K 1
= √ e −(T −t )r exp − (d− (T − t ))2
x 2π 2
K −(T −t )r
= e ϕ (d− (T − t )),
x
hence by (7.2.2) we have
log(x/K ) + (r + σ 2 /2)(T − t )
  
∂ gc ∂
(t, x) = xΦ √ (7.2.8)
∂x ∂x |σ | T − t
log(x/K ) + (r − σ 2 /2)(T − t )
  
−(T −t )r ∂
−K e Φ √
∂x |σ | T − t
log(x/K ) + (r + σ 2 /2)(T − t )
 
= Φ √
|σ | T − t
log(x/K ) + (r + σ 2 /2)(T − t )
 
∂
+x Φ √
∂x |σ | T − t
log(x/K ) + (r − σ 2 /2)(T − t )
 
∂
−K e −(T −t )r Φ √
∂x |σ | T − t
2
log(x/K ) + (r + σ /2)(T − t )
 
= Φ √
|σ | T − t
log(x/K ) + (r + σ 2 /2)(T − t )
 
1
+ √ ϕ √
|σ | T − t |σ | T − t
K e −(T −t )r log(x/K ) + (r − σ 2 /2)(T − t )
 
− √ ϕ √
x|σ | T − t |σ | T − t

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 208 Chapter 7. Black-Scholes Pricing and Hedging

1 K e −(T −t )r
= Φ(d+ (T − t )) + √ ϕ (d+ (T − t )) − √ ϕ (d− (T − t ))
|σ | T − t x|σ | T − t
= Φ(d+ (T − t )),
and we conclude from (7.1.3). □
As a consequence
of Proposition 7.4, the Black-Scholes call price splits into a risky component
St Φ d+ (T − t ) and a riskless component −K e − ( T −t ) r Φ d− (T − t ) , as follows:

gc (t, St ) = St Φ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,



0 ⩽ t ⩽ T. (7.2.9)
| {z } | {z }
Risky investment (held) Risk free investment (borrowed)

See Exercise 7.4 for a computation of the boundary values of gc (t, x), t ∈ [0, T ), x > 0. The
following R script is an implementation of the Black-Scholes Delta for European call options.

DeltaCall <- function(S, K, r, T, sigma)

{d1 <- (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T))
DeltaCall = pnorm(d1);DeltaCall}

In Figure 7.6 we plot the Delta of the European call option as a function of the underlying asset
price and of the time remaining until maturity.

0.5

150
100 0
Underlying 5
50 10
15
0 Time to maturity T-t
Figure 7.6: Delta of a European call option with strike price K = 100, r = 3%, σ = 10%.

The Gamma of the European call option is defined as the first derivative or sensitivity of Delta with
respect to the underlying asset price. It also represents the second derivative of the option price
with respect to the underlying asset price. This gives
1
Φ ′ d+ (T − t )


γt = √
St |σ | T − t
2 !
log(St /K ) + (r + σ 2 /2)(T − t )

1 1
= p exp − √
St |σ | 2(T − t )π 2 |σ | T − t
⩾ 0.

In particular, a positive value of γt implies that the Delta ξt = ξt (St ) should increase when the
underlying asset price St increases. In other words, the position ξt in the underlying asset should be
increased by additional purchases if the underlying asset price St increases.
In Figure 7.7 we plot the (truncated) value of the Gamma of a European call option as a function of
the underlying asset price and of time to maturity.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.2 European Call Options 209

Figure 7.7: Gamma of European call and put options with strike price K = 100.

As Gamma is always nonnegative, the Black-Scholes hedging strategy is to keep buying the risky
underlying asset when its price increases, and to sell it when its price decreases, as can be checked
from Figure 7.7.

Numerical example - Hedging a call option

In Figure 7.8 we consider the historical stock price of HSBC Holdings (0005.HK) over one year:

Figure 7.8: Graph of the stock price of HSBC Holdings.

Consider the call option issued by Societe Generale on 31 December 2008 with strike price
K=$63.704, maturity T = October 05, 2009, and an entitlement ratio of 100, meaning that one
option contract is divided into 100 warrants, cf. page 8. The next graph gives the time evolution of
the Black-Scholes portfolio value

t 7−→ gc (t, St )

driven by the market price t 7−→ St of the risky underlying asset as given in Figure 7.8, in which
the number of days is counted from the origin and not from maturity.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 210 Chapter 7. Black-Scholes Pricing and Hedging

40
35
30
25
20
15
10
5
0 0
90 80 100 50
70 60 150 Time
Underlying (HK$) 50 40 200 in days

Figure 7.9: Path of the Black-Scholes price for a call option on HSBC with K = 63.70.

As a consequence of (7.2.9), in the Black-Scholes call option hedging model, the amount invested
in the risky asset is

St ξt = St Φ d+ (T − t )

log(St /K ) + (r + σ 2 /2)(T − t )
 
= St Φ √
|σ | T − t
⩾ 0,

which is always nonnegative, i.e. there is no short selling, and the amount invested on the riskless
asset is

ηt At = −K e −(T −t )r Φ d− (T − t )

log(St /K ) + (r − σ 2 /2)(T − t )
 
−(T −t )r
= −K e Φ √
|σ | T − t
⩽ 0,

which is always nonpositive, i.e. we are constantly borrowing money on the riskless asset, as noted
in Figure 7.10.

Black-Scholes price
Risky investment ξtSt
100 Riskless investment ηtAt
Underlying asset price

80

K
60

40
HK$
20

-20

-40

-60

0 50 100 150 200

Figure 7.10: Time evolution of a hedging portfolio for a call option on HSBC.

A comparison of Figure 7.10 with market data can be found in Figures 9.10a and 9.10b below.
Cash settlement. In the case of a cash settlement, the option issuer will satisfy the option contract

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 7.3 European Put Options 211

by selling ξT = 1 stock at the price ST = $83, refund the K = $63 risk-free investment, and hand
in the remaining amount C = (ST − K )+ = 83 − 63 = $20 to the option holder.

Physical delivery. In the case of physical delivery of the underlying asset, the option issuer will
deliver ξT = 1 stock to the option holder in exchange for K = $63, which will be used together
with the portfolio value to refund the risk-free loan.

7.3 European Put Options

Similarly, in the case of the European put option with strike price K the payoff function is given by
h(x) = (K − x)+ and the Black-Scholes PDE (7.1.7) reads


2
 rg (t, x) = ∂ gp (t, x) + rx ∂ gp (t, x) + 1 σ 2 x2 ∂ gp (t, x),

p
∂t ∂x 2 ∂ x2 (7.3.1)
 g (T , x ) = (K − x ) + ,

p

The next proposition can be proved from the call-put parity of Proposition 7.6 and Proposition 7.11,
see Sections 7.5-7.6.
Proposition 7.5 The solution of the PDE (7.3.1) is given by the Black-Scholes formula for put
options:

gp (t, x) = K e −(T −t )r Φ − d− (T − t ) − xΦ − d+ (T − t ) ,



(7.3.2)

with
log(x/K ) + (r + σ 2 /2)(T − t )
d+ (T − t ) = √ (7.3.3)
|σ | T − t

and
log(x/K ) + (r − σ 2 /2)(T − t )
d− ( T − t ) = √ , (7.3.4)
|σ | T − t

0 ⩽ t < T,

Figure 7.11 presents an interactive graph of the Black-Scholes put price map (t, x) 7→ gp (t, x) given
in (7.3.2).

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 212 Chapter 7. Black-Scholes Pricing and Hedging

Figure 7.11: Graph of the Black-Scholes put price function with strike price K = 100.*

In other words, the European put option with strike price K and maturity T is priced at time
t ∈ [0, T ] as

gp (t, St ) = K e −(T −t )r Φ − d− (T − t ) − St Φ − d+ (T − t ) , 0 ⩽ t ⩽ T .

40

30

20

10

00 60
40 80 100
120 160 Underlying asset price
Time in days

Figure 7.12: Time-dependent solution of the Black-Scholes PDE (put option).†

The following R script is an implementation of the Black-Scholes formula for European put options
in .
BSPut <- function(S, K, r, T, sigma)
{d1 = (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T));d2 = d1 - sigma * sqrt(T);
BSPut = K*exp(-r*T) * pnorm(-d2) - S*pnorm(-d1);BSPut}

Call-put parity

Proposition 7.6 Call-put parity. We have the relation

St − K e −(T −t )r = gc (t, St ) − gp (t, St ), 0 ⩽ t ⩽ T, (7.3.5)

* Right-click on the figure for interaction and “Full Screen Multimedia” view.
† The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.3 European Put Options 213

between the Black-Scholes prices of call and put options, in terms of the forward contract price
St − K e −(T −t )r .
Proof. The call-put parity (7.3.5) is a consequence of the relation

x − K = (x − K ) + − (K − x ) +

satisfied by the terminal call and put payoff functions in the linear Black-Scholes PDE (7.1.7),
which is solved as
x − K e −(T −t )r = gc (t, x) − gp (t, x)

for t ∈ [0, T ], since x − K e −(T −t )r is the pricing function of the long forward contract with payoff
ST − K, see (7.1.8). It can also be verified directly from (7.2.2) and (7.3.2) as

gc (t, x) − gp (t, x) = xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t )

− K e −(T −t )r Φ − d− (T − t ) − xΦ − d+ (T − t )

= xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t )

−K e −(T −t )r 1 − Φ d− (T − t ) + x 1 − Φ d+ (T − t )

= x − K e −(T −t )r .

□
The Delta of the Black-Scholes put option can be obtained by differentiation of the call-put parity
relation (7.3.5) and Proposition 7.4.

Proposition 7.7 The Delta of the Black-Scholes put option is given by

ξt = −(1 − Φ d+ (T − t ) ) = −Φ − d+ (T − t ) ∈ [−1, 0],

0 ⩽ t ⩽ T.

Proof. By differentiating on both sides of the call-put parity relation (7.3.5) and applying
Proposition 7.4, we have

∂ gp ∂ gc
(t, St ) = (t, St ) − 1
∂x ∂x
= Φ(d+ (T − t )) − 1
= −Φ(−d+ (T − t )), 0 ⩽ t ⩽ T,

where we applied (7.2.6). □

As a consequence of
Proposition 7.7, the Black-Scholes put price splits
into a risky component
−St Φ − d+ (T − t ) and a riskless component K e −(T −t )r Φ − d− (T − t ) , as follows:

gp (t, St ) = K e −(T −t )r Φ − d− (T − t ) − St Φ − d+ (T − t ) ,



0 ⩽ t ⩽ T. (7.3.6)
| {z } | {z }
Risk−free investment (savings) Risky investment (short)

DeltaPut <- function(S, K, r, T, sigma)

{d1 <- (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T)); DeltaPut = -pnorm(-d1);DeltaPut}

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 214 Chapter 7. Black-Scholes Pricing and Hedging

In Figure 7.13 we plot the Delta of the European put option as a function of the underlying asset
price and of the time remaining until maturity.

-0.5

-1

150
100 0
Underlying 5
50 10
15
0 Time to maturity T-t

Figure 7.13: Delta of a European put option with strike price K = 100, r = 3%, σ = 10%.

Numerical example - Hedging a put option

For one more example, we consider a put option issued by BNP Paribas on 04 November 2008
with strike price K=$77.667, maturity T = October 05, 2009, and entitlement ratio 92.593, cf. page
8. In the next Figure 7.14, the number of days is counted from the origin, not from maturity.

45
40
35
30
25
20
15
10
5
0
40
0 50 60 50
100 150 80 70
Time in days 200 100 90 Underlying (HK$)

Figure 7.14: Path of the Black-Scholes price for a put option on HSBC.

As a consequence of (7.3.6), the amount invested on the risky asset for the hedging of a put option
is
log(St /K ) + (r + σ 2 /2)(T − t )
 
−St Φ − d+ (T − t ) = −St Φ −


√
|σ | T − t
⩽ 0,

i.e. there is always short selling, and the amount invested on the riskless asset priced At = e rt ,
t ∈ [0, T ], is

ηt At = K e −(T −t )r Φ − d− (T − t )

log(St /K ) + (r − σ 2 /2)(T − t )
 
−(T −t )r
= Ke Φ − √
|σ | T − t

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 7.4 Market Terms and Data 215

⩾ 0,

which is always nonnegative, i.e. we are constantly saving money on the riskless asset, as noted in
Figure 7.15.

Black-Scholes price
Risky investment ξtSt
100 Riskless investment ηtAt
Underlying asset price

80 K

60

40
HK$
20

-20

-40

-60
0 50 100 150 200

Figure 7.15: Time evolution of the hedging portfolio for a put option on HSBC.

In the above example the put option finished out of the money (OTM), so that no cash settlement
or physical delivery occurs. A comparison of Figure 7.10 with market data can be found in
Figures 9.11a and 9.11b below.

7.4 Market Terms and Data

The following Table 7.1 provides a summary of formulas for the computation of Black-Scholes
sensitivities, also called Greeks.*

Call option Put option

Option price g(t, St ) St Φ(d+ (T − t )) − K e −(T −t )r Φ(d− (T − t )) K e −(T −t )r Φ(−d− (T − t )) − St Φ(−d+ (T − t ))

∂g
Delta (∆) (t, St ) Φ(d+ (T − t )) ⩾ 0 −Φ(−d+ (T − t )) ⩽ 0
∂x

∂ 2g Φ′ (d+ (T − t ))
Gamma (Γ) (t, St ) √ ⩾0
∂ x2 St |σ | T − t

∂g √
Vega (t, St ) St T − tΦ′ (d+ (T − t )) ⩾ 0
∂σ

∂g St |σ |Φ′ (d+ (T − t )) St |σ |Φ′ (d+ (T − t ))

Theta (Θ) (t, St ) − √ − rK e −(T −t )r Φ(d− (T − t )) ⩽ 0 − √ + rK e −(T −t )r Φ(d− (T − t ))
∂t 2 T −t 2 T −t

∂g
Rho (ρ) (t, St ) (T − t )K e −(T −t )r Φ(d− (T − t )) −(T − t )K e −(T −t )r Φ(−d− (T − t ))
∂r

Table 7.1: Black-Scholes Greeks (Wikipedia).

From Table 7.1 we can conclude that call option prices are increasing functions of the underlying
asset price St , of the interest rate r, and of the volatility parameter σ . Similarly, put option prices are
decreasing functions of the underlying asset price St , of the interest rate r, and increasing functions
of the volatility parameter σ , see also Exercise 7.14.
*“Every class feels like attending a Greek lesson” (AY2018-2019 student feedback).

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 216 Chapter 7. Black-Scholes Pricing and Hedging

Parameter Variation of call option prices Variation of put option prices

Underlying St Increasing ↗ Decreasing ↘

Volatility σ Increasing ↗ Increasing ↗

Decreasing ↘ if r ⩾ 0 Depends on the underlying price level if r > 0

Time t

Depends on the underlying price level if r < 0 Decreasing ↘ if r ⩽ 0

Interest rate r Increasing ↗ Increasing ↘

Table 7.2: Variations of Black-Scholes prices.

The change of sign in the sensitivity Theta (Θ) with respect to time t can be verified in the following
Figure 7.16 when r > 0.
10 10

T-t=0.00 T-t=0.00

8 8

6 6
gp(x,t)
gc(x,t)

4 4

2 2

0 0
90 95 100 105 110 90 95 100 105 110
x x

(a) Black-Scholes call price maps. (b) Black-Scholes put price maps
Figure 7.16: Time-dependent solutions of the Black-Scholes PDE with r = +3% > 0.*

The next two figures show the variations of call and put option prices as functions of time when
r < 0.

* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.4 Market Terms and Data 217
10 10

T-t=0.00 T-t=0.00

8 8

6 6

gp(x,t)
gc(x,t)

4 4

2 2

0 0
90 95 100 105 110 90 95 100 105 110
x x

(a) Black-Scholes call price maps. (b) Black-Scholes put price maps
Figure 7.17: Time-dependent solutions of the Black-Scholes PDE with r = −3% < 0.*
The next two figures show the variations of call and put option prices as functions of time when
r = 0.
10 10

T-t=0.00 T-t=0.00

8 8

6 6
gp(x,t)
gc(x,t)

4 4

2 2

0 0
90 95 100 105 110 90 95 100 105 110
x x

(a) Black-Scholes call price maps. (b) Black-Scholes put price maps
Figure 7.18: Time-dependent solutions of the Black-Scholes PDE with r = 0.†
(1)

Intrinsic value. The intrinsic value at time t ∈ [0, T ] of the option with claim payoff C = h ST
(1)

is given by the immediate exercise payoff h St . The extrinsic value at time t ∈ [0, T ] of
(1)

the option is the remaining difference πt (C ) − h St between the option price πt (C ) and
(1)

the immediate exercise payoff h St . In general, the option price πt (C ) decomposes as
(1)
(1)

πt (C ) = h St + πt (C ) − h St , 0 ⩽ t ⩽ T.
| {z } | {z }
Intrinsic value Extrinsic value

Break-even price. The break-even price BEPt of the underlying asset is the value of S for which
the intrinsic option value h(S) equals the option price πt (C ) at time t ∈ [0, T ]. For European
call options with payoff function h(x) = (x − K )+ , it is given by

BEPt := K + πt (C ) = K + gc (t, St ), t = 0, 1, . . . , N. (7.4.1)

whereas for European put options with payoff function h(x) = (K − x)+ , it is given by

BEPt := K − πt (C ) = K − gp (t, St ), 0 ⩽ t ⩽ T. (7.4.2)

† The animation works in Acrobat Reader on the entire pdf file.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 218 Chapter 7. Black-Scholes Pricing and Hedging

Premium. The option premium OPt can be defined as the variation required from the underlying
asset price in order to reach the break-even price, i.e. we have

BEPt − St K + g(t, St ) − St
OPt := = , 0 ⩽ t ⩽ T,
St St

for European call options, and

St − BEPt St + g(t, St ) − K
OPt := = , 0 ⩽ t ⩽ T,
St St

for European put options, see Figure 7.19 below. The term “premium” is sometimes also
used to denote the arbitrage-free price g(t, St ) of the option.

Gearing. The gearing at time t ∈ [0, T ] of the option with claim payoff C = h(ST ) is defined as
the ratio
St St
Gt := = , 0 ⩽ t ⩽ T.
πt (C ) g(t, St )

Effective gearing. The effective gearing at time t ∈ [0, T ] of the option with claim payoff C =
h(ST ) is defined as the ratio
EGt := Gt ξt
ξt St
=
πt (C )
St ∂ g
= (t, St )
πt (C ) ∂ x
St ∂ g
= (t, St )
g(t, St ) ∂ x
∂
= St log g(t, St ), 0 ⩽ t ⩽ T.
∂x
The effective gearing

ξt St
EGt =
πt (C )

can be interpreted as the hedge ratio, i.e. the percentage of the portfolio which is invested on
the risky asset. When written as

∆g(t, St ) ∆St
= EGt × ,
g(t, St ) St

the effective gearing gives the relative variation, or percentage change, ∆g(t, St )/g(t, St ) of
the option price g(t, St ) from the relative variation ∆St /St in the underlying asset price.

The ratio EGt = St ∂ log g(t, St )/∂ x can also be interpreted as an elasticity coefficient.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 7.5 The Heat Equation 219

f (t,x,σ)
100
=
+ x2 2
σ2 ∂ 2f
2 ∂x

K= =(x−K )/x
log f ∂f
x ∂ ∂x = ∆= = ∂x (t,x,σ)
∂x
∂f

σ= ∂f
= ∂σ (t,x,σ)
+ rx

∂f K +f (t,x,σ)−x
(t,x,σ)= = x
∂t
T= =K +f (t,x,σ)
∂t
∂f
rf =

x=

Figure 7.19: Warrant terms and data.

The package bizdays (requires to install QuantLib) can be used to compute calendar time vs.
business time to maturity
install.packages("bizdays")
library(bizdays)
load_quantlib_calendars('HongKong', from='2018-01-01', to='2018-12-31')
load_quantlib_calendars('Singapore', from='2018-01-01', to='2018-12-31')
bizdays('2018-03-10', '2018-04-03', 'QuantLib/HongKong')
bizdays('2018-03-10', '2018-04-03', 'QuantLib/Singapore')

7.5 The Heat Equation

In the next proposition we notice that the solution f (t, x) of the Black-Scholes PDE (7.1.7) can be
transformed into a solution g(t, y) of the simpler heat equation by a change of variable and a time
inversion t 7−→ T − t on the interval [0, T ], so that the terminal condition at time T in the Black-
Scholes equation (7.5.1) becomes an initial condition at time t = 0 in the heat equation (7.5.4). See
also here for a related discussion on changes of variables for the Black-Scholes PDE.

Proposition 7.8 Assume that f (t, x) solves the Black-Scholes call pricing PDE

2
 r f (t, x) = ∂ f (t, x) + rx ∂ f (t, x) + 1 σ 2 x2 ∂ f (t, x),

∂t ∂x 2 ∂ x2 (7.5.1)
 f (T , x ) = (x − K ) + ,


" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 220 Chapter 7. Black-Scholes Pricing and Hedging

with terminal condition h(x) = (x − K )+ , x > 0. Then, the function g(t, y) defined by
2 /2−r )t
g(t, y) = e rt f T − t, e |σ |y+(σ


(7.5.2)

solves the heat equation (7.5.4) with initial condition

ψ (y) := h e |σ |y , y ∈ R,


(7.5.3)

i.e. we have
 2
 ∂ g (t, y) = 1 ∂ g (t, y)

∂t 2 ∂ y2 (7.5.4)
g(0, y) = h e |σ |y .



Proposition 7.8 will be proved in Section 7.6. It will allow us to solve the Black-Scholes
PDE (7.5.1)
based on the solution of the heat equation (7.5.4) with initial condition ψ (y) = h e |σ |y , y ∈ R, by
2
inversion of Relation (7.5.2) with s = T − t, x = e |σ |y+(σ /2−r)t , i.e.
−(σ 2 /2 − r )(T − s) + log x
 
−(T −s)r
f (s, x) = e g T − s, .
|σ |
Next, we focus on the heat equation
∂ϕ 1 ∂ 2ϕ
(t, y) = (t, y) (7.5.5)
∂t 2 ∂ y2
which is used to model the diffusion of heat over time through solids. Here, the data of g(x,t )
represents the temperature measured at time t and point x. We refer the reader to Widder, 1975 for
a complete treatment of this topic.
4
t=0.0256
3.5

2.5
φ(y,t)

1.5

0.5

0
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2
y

Figure 7.20: Time-dependent solution of the heat equation.*

Proposition 7.9 The fundamental solution of the heat equation (7.5.5) is given by the Gaussian
probability density function
1 2
ϕ (t, y) := √ e −y /(2t ) , y ∈ R,
2πt

* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.5 The Heat Equation 221

with variance t > 0.

Proof. The proof is done by a direct calculation, as follows:
2
!
∂ϕ ∂ e −y /(2t )
(t, y) = √
∂t ∂t 2πt
2 2
e −y /(2t ) y2 e −y /(2t )
= − 3/2 √ + 2 √
2t 2π 2t 2πt
2
 
1 y
= − + 2 ϕ (t, y),
2t 2t
and
2
!
1 ∂ 2ϕ 1 ∂ y e −y /(2t )
2
(t, y) = − √
2 ∂y 2 ∂y t 2πt
2 2
e −y /(2t ) y2 e −y /(2t )
= − √ + 2 √
2t 2πt 2t 2πt
2
 
1 y
= − + 2 ϕ (t, y), t > 0, y ∈ R.
2t 2t
□
In Section 7.6 the heat equation (7.5.5) will be shown to be equivalent to the Black-Scholes PDE
after a change of variables. In particular this will lead to the explicit solution of the Black-Scholes
PDE.
Proposition 7.10 The heat equation
 2
 ∂ g (t, y) = 1 ∂ g (t, y)

∂t 2 ∂ y2 (7.5.6)

g(0, y) = ψ (y)


with bounded continuous initial condition

g(0, y) = ψ (y)

has the solution

w∞ 2 dz
g(t, y) = ψ (z) e −(y−z) /(2t ) √ , y ∈ R, t > 0. (7.5.7)
−∞ 2πt
Proof. We have

∂g ∂ w∞ 2 dz
(t, y) = ψ (z) e −(y−z) /(2t ) √
∂t ∂t −∞ 2πt
w∞ 2 / (2t )
!
∂ e − ( y−z )
= ψ (z) √ dz
−∞ ∂t 2πt
1w∞ (y − z)2 1
 
2 dz
= ψ (z) 2
− e −(y−z) /(2t ) √
2 −∞ t t 2πt
1 w ∞ ∂ 2 2 dz
= ψ (z) 2 e −(y−z) /(2t ) √
2 −∞ ∂z 2πt

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 222 Chapter 7. Black-Scholes Pricing and Hedging

1w∞ ∂2 2 dz
= ψ (z) 2 e −(y−z) /(2t ) √
2 −∞ ∂y 2πt
1 ∂ 2 w ∞ 2 dz
= ψ (z) e −(y−z) /(2t ) √
2 ∂ y2 −∞ 2πt
1 ∂ 2g
= (t, y).
2 ∂ y2
On the other hand, it can be checked that at time t = 0 we have
w∞ 2 dz w∞ 2 dz
lim ψ (z) e −(y−z) /(2t ) √ = lim ψ (y + z) e −z /(2t ) √
t→0 −∞ 2πt t→0 −∞ 2πt
= ψ (y), y ∈ R,
see also (7.5.8) below. □
The next Figure 7.21 shows the evolution of g(t, x) with initial condition based on the European
call payoff function h(x) = (x − K )+ , i.e.

+
g(0, y) = ψ (y) = h e |σ |y = e |σ |y − K , y ∈ R.

10

t= 0

6
g(x,t)

0
0 50 100 150 200
x

Figure 7.21: Time-dependent solution of the heat equation.*

Let us provide a second proof of Proposition 7.10, this time using Brownian motion and stochastic
calculus.
Proof of Proposition 7.10. First, we note that under the change of variable x = z − y we have
w∞ 2 dz
g(t, y) = ψ (z) e −(y−z) /(2t ) √
−∞ 2πt
w∞ 2 dx
= ψ (y + x) e −x /(2t ) √
−∞ 2πt
= IE[ψ (y + Bt )]
= IE[ψ (y − Bt )],
where (Bt )t∈R+ is a standard Brownian motion with Bt ≃ N (0,t ), t ⩾ 0, under the initial condition

g(0, y) = IE[ψ (y + B0 )] = IE[ψ (y)] = ψ (y). (7.5.8)

* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 7.6 Solution of the Black-Scholes PDE 223

Applying Itô’s formula to ψ (y − Bt ) and using the fact that the expectation of the stochastic integral
with respect to Brownian motion is zero, see Relation (5.4.5) in Proposition 5.19, we find

g(t, y) = IE[ψ (y − Bt )]
 wt 1 w t ′′

′
= IE ψ (y) − ψ (y − Bs )dBs + ψ (y − Bs )ds
0 2 0
hw t i 1 hw t i
= ψ (y) − IE ψ ′ (y − Bs )dBs + IE ψ ′′ (y − Bs )ds
 2
0 0
1 w t
 2
∂ ψ
= ψ (y) + IE (y − Bs ) ds
2 0 ∂ y2
1 w t ∂2
= ψ (y) + IE [ψ (y − Bs )] ds
2 0 ∂ y2
1 w t ∂ 2g
= ψ (y) + (s, y)ds.
2 0 ∂ y2
Hence we have
∂g ∂
(t, y) = IE[ψ (y − Bt )]
∂t ∂t
1 ∂2
= IE [ψ (y − Bt )]
2 ∂ y2
1 ∂ 2g
= (t, y).
2 ∂ y2
Regarding the initial condition, we check that

g(0, y) = IE[ψ (y − B0 )] = IE[ψ (y)] = ψ (y).

□
The expression g(t, y) = IE[ψ (y − Bt )] provides a probabilistic interpretation of the heat diffusion
phenomenon based on Brownian motion. Namely, when ψε (y) := 1[−ε,ε ] (y), we find that

gε (t, y) = IE[ψε (y − Bt )]
= IE[1[−ε,ε ] (y − Bt )]
= P y − Bt ∈ [−ε, ε ]

= P y − ε ⩽ Bt ⩽ y + ε

represents the probability of finding Bt within a neighborhood [y − ε, y + ε ] of the point y ∈ R.

7.6 Solution of the Black-Scholes PDE

In this section we solve the Black-Scholes PDE by the kernel method of Section 7.5 and a change
of variables. This solution method uses the change of variables (7.5.2) of Proposition 7.8 and a
time inversion from which the terminal condition at time T in the Black-Scholes equation becomes
an initial condition at time t = 0 in the heat equation.
Next, we provide the proof Proposition 7.8.
2 /2−r )t
Proof of Proposition 7.8. Letting s = T − t and x = e |σ |y+(σ and using Relation (7.5.2), i.e.
2 /2−r )t
g(t, y) = e rt f T − t, e |σ |y+(σ


,

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 224 Chapter 7. Black-Scholes Pricing and Hedging

we have

∂g 2 ∂f 2
(t, y) = r e rt f T − t, e |σ |y+(σ /2−r)t − e rt T − t, e |σ |y+(σ /2−r)t



∂t ∂s
 2 
σ 2 ∂ f 2
− r e rt e |σ |y+(σ /2−r)t T − t, e |σ |y+(σ /2−r)t


+
2 ∂x
 2 
rt rt ∂ f σ ∂f
= r e f (T − t, x) − e (T − t, x) + − r e rt x (T − t, x)
∂s 2 ∂x
1 rt 2 2 ∂ f 2 2
σ rt ∂ f
= e x σ 2
(T − t, x) + e x (T − t, x), (7.6.1)
2 ∂x 2 ∂x
where on the last step we used the Black-Scholes PDE. On the other hand we have

∂g 2 ∂f 2
(t, y) = |σ | e rt e |σ |y+(σ /2−r)t T − t, e |σ |y+(σ /2−r)t


∂y ∂x

and
1 ∂ g2 σ 2 rt |σ |y+(σ 2 /2−r)t ∂ f 2
T − t, e |σ |y+(σ /2−r)t


(t, y) = e e
2 ∂ y2 2 ∂x
σ 2 rt 2|σ |y+2(σ 2 /2−r)t ∂ 2 f 2
T − t, e |σ |y+(σ /2−r)t


+ e e 2
2 ∂x
σ 2 rt ∂ f σ 2 rt 2 ∂ 2 f
= e x (T − t, x) + e x (T − t, x). (7.6.2)
2 ∂x 2 ∂ x2
We conclude by comparing (7.6.1) with (7.6.2), which shows that g(t, x) solves the heat equation
(7.5.6) with initial condition

g(0, y) = f T , e |σ |y = h e |σ |y .

□
In the next proposition we provide a proof of Proposition 7.3 by deriving the Black-Scholes formula
(7.2.2) from the solution of the PDE (7.5.1). The Black-Scholes formula will also be recovered by a
probabilistic argument via the computation of an expected value in Proposition 8.6.

Proposition 7.11 When h(x) = (x − K )+ , the solution of the Black-Scholes PDE (7.5.1) is
given by
f (t, x) = xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,



x > 0,
where
1 w x −y2 /2
Φ (x ) = √ e dy, x ∈ R,
2π −∞
and
log(x/K ) + (r + σ 2 /2)(T − t )


 d + ( T − t ) : = √ ,
|σ | T − t


 log(x/K ) + (r − σ 2 /2)(T − t )
 d− ( T − t ) : = √ ,


|σ | T − t
x > 0, t ∈ [0, T ).
2 /2−r )t
Proof. By inversion of Relation (7.5.2) with s = T − t and x = e |σ |y+(σ , we get

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.6 Solution of the Black-Scholes PDE 225

−(σ 2 /2 − r )(T − s) + log x

 
−(T −s)r
f (s, x) = e g T − s,
|σ |
and  
log x
ψ (y) = h e |σ |y , y ∈ R.


h(x ) = ψ , x > 0, or
|σ |
Hence, using the solution (7.5.7) and Relation (7.5.3), we get

−(σ 2 /2 − r )(T − t ) + log x

 
−(T −t )r
f (t, x) = e g T − t,
|σ |
w ∞  −(σ 2 /2 − r )(T − t ) + log x 
2 dz
−(T −t )r
= e ψ + z e −z /(2(T −t )) p
−∞ |σ | 2(T − t )π
w∞ 2 2 dz
= e −(T −t )r h x e |σ |z−(σ /2−r)(T −t ) e −z /(2(T −t )) p


−∞ 2(T − t )π
w∞ 2 + 2 dz
= e −(T −t )r x e |σ |z−(σ /2−r)(T −t ) − K e −z /(2(T −t )) p


−∞ 2(T − t )π
= e −(T −t )r
w∞ 2
2 dz
× (−r+σ 2 /2)(T −t )+log(K/x) x e |σ |z−(σ /2−r)(T −t ) − K e −z /(2(T −t )) p
|σ | 2(T − t )π
w∞ 2 2 dz
= x e −(T −t )r √ e |σ |z−(σ /2−r)(T −t ) e −z /(2(T −t )) p
−d− (T −t ) T −t 2(T − t )π
w∞ 2 dz
−K e −(T −t )r √ e −z /(2(T −t )) p
−d− (T −t ) T −t 2(T − t )π
w∞ 2 2 dz
= x √ e |σ |z−(T −t )σ /2−z /(2(T −t )) p
−d− (T −t ) T −t 2(T − t )π
w∞ 2 dz
−K e −(T −t )r √ e −z /(2(T −t )) p
−d− (T −t ) T −t 2(T − t )π
w∞ 2 dz
= x √ e −(z−(T −t )|σ |) /(2(T −t )) p
−d− (T −t ) T −t 2(T − t )π
w∞ 2 dz
−K e −(T −t )r √ e −z /(2(T −t )) p
−d− (T −t ) T −t 2(T − t )π
w∞ 2 dz
= x √ e −z /(2(T −t )) p
−d− (T −t ) T −t−(T −t )|σ | 2(T − t )π
w∞ 2 dz
−K e −(T −t )r √ e −z /(2(T −t )) p
−d− (T −t ) T −t 2(T − t )π
w∞ 2 dz w∞ 2 dz
= x √ e −z /2 √ − K e −(T −t )r e −z /2 √
−d− (T −t )−|σ | T −t 2π −d− (T −t ) 2π
−(T −t )r
x 1 − Φ − d+ (T − t ) − K e 1 − Φ − d− ( T − t )





=
xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,



=

where we used the relation (7.2.6), i.e.

1 − Φ(a) = Φ(−a), a ∈ R.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 226 Chapter 7. Black-Scholes Pricing and Hedging

Exercises

Exercise 7.1 Bachelier, 1900 model. Consider a market made of a riskless asset valued At = A0
with zero interest rate, t ⩾ 0, and a risky asset whose price St is modeled by a standard Brownian
motion as St = Bt , t ⩾ 0.
a) Show that the price g(t, Bt ) of the option with claim payoff C = (BT )2 satisfies the heat
equation
∂g 1 ∂ 2g
− (t, y) = (t, y), (t, y) ∈ [0, T ] × R,
∂t 2 ∂ y2
with terminal condition g(T , x) = x2 .
b) Find the function g(t, x) by solving the PDE of Question (a)).
Hint: Try a solution of the form g(t, x) = x2 + f (t ), t ∈ [0, T ].
c) Find the risky asset allocation ξt hedging the claim payoff C = (BT )2 , and the amount
ηt At = ηt A0 invested in the riskless asset, for t ∈ [0, T ].
See Exercises 7.12 and 8.16-8.17 for extensions to nonzero interest rates.

Exercise 7.2 Consider a risky asset price (St )t∈R modeled in the J. Cox, Ingersoll, and S.A. Ross,
1985 (CIR) model as
p
dSt = β (α − St )dt + σ St dBt , α, β , σ > 0, (7.6.3)

and let (ηt , ξt )t∈R+ be a portfolio strategy whose value Vt := ηt At + ξt St , takes the form Vt = g(t, St ),
t ⩾ 0. Figure 7.22 presents a random simulation of the solution to (7.6.3) with α = 0.025, β = 1,
and σ = 1.3.
8

5
St
4

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t

Figure 7.22: Graph of the CIR short rate t 7→ rt with α = 2.5%, β = 1, and σ = 1.3.

N=10000; t <- 0:(N-1); dt <- 1.0/N;a=0.025; b=2; sigma=0.05;

dB <- rnorm(N,mean=0,sd=sqrt(dt));R <- rep(0,N);R[1]=0.01
for (j in 2:N){R[j]=max(0,R[j-1]+(a-b*R[j-1])*dt+sigma*sqrt(R[j-1])*dB[j])}
plot(t, R, xlab = "t", ylab = "", type = "l", ylim = c(0,0.02), col = "blue")
abline(h=0,col="black",lwd=2)

Based on the self-financing condition written as

dVt = rVt dt − rξt St dt + ξt dSt

p
= rVt dt − rξt St dt + β (α − St )ξt dt + σ ξt St dBt , t ⩾ 0, (7.6.4)

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.6 Solution of the Black-Scholes PDE 227

derive the PDE satisfied by the function g(t, x) using the Itô formula.

Exercise 7.3 Black-Scholes PDE with dividends reinvested. Consider a riskless asset with price
At = A0 e rt , t ⩾ 0, and an underlying asset price process (St )t∈R+ modeled as

dSt = ( µ − δ )St dt + σ St dBt ,

where (Bt )t∈R+ is a standard Brownian motion and δ > 0 is a continuous-time dividend rate.
By absence of arbitrage, the payment of a dividend entails a drop in the stock price by the same
amount occurring generally on the ex-dividend date, on which the purchase of the security no longer
entitles the investor to the dividend amount. The list of investors entitled to dividend payment is
consolidated on the date of record, and payment is made on the payable date.

library(quantmod)
getSymbols("9983.HK",from="2010-01-01",to=Sys.Date(),src="yahoo")
getDividends("9983.HK",from="2010-01-01",to=Sys.Date(),src="yahoo")

a) Assuming that the portfolio with value Vt = ξt St + ηt At at time t is self-financing and that
dividends are continuously reinvested, write down the portfolio variation dVt .
b) Assuming that the portfolio value Vt takes the form Vt = g(t, St ) at time t, derive the Black-
Scholes PDE for the function g(t, x) with its terminal condition.
c) Compute the price at time t ∈ [0, T ] of the European call option with strike price K by solving
the corresponding Black-Scholes PDE.
d) Compute the Delta of the option.

Exercise 7.4
a) Check that the Black-Scholes formula (7.2.2) for European call options

gc (t, x) = xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

satisfies the following boundary conditions:

i) at x = 0, gc (t, 0) = 0,
ii) at maturity t = T , (
x − K, x>K
gc (T , x) = (x − K )+ =
0, x ⩽ K,
and 

 1, x>K

1

lim Φ(d+ (T − t )) = , x=K
t↗T 

 2
0, x < K,

iii) as time to maturity tends to infinity,

lim Bl(x, K, σ , r, T − t ) = x, t ⩾ 0.
T →∞

b) Check that the Black-Scholes formula (7.3.2) for European put options

gp (t, x) = K e −(T −t )r Φ − d− (T − t ) − xΦ − d+ (T − t )

satisfies the following boundary conditions:

i) at x = 0, gp (t, 0) = K e −(T −t )r ,
ii) as x tends to infinity, gp (t, ∞) = 0 for all t ∈ [0, T ),

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 228 Chapter 7. Black-Scholes Pricing and Hedging

iii) at maturity t = T , (
0, x>K
gp ( T , x ) = ( K − x ) + =
K − x, x ⩽ K,
and 
 0,
 x>K

1

− lim Φ(−d+ (T − t )) = − , x=K
t↗T 

 2
−1, x < K,

iv) as time to maturity tends to infinity,

lim Blp (St , K, σ , r, T − t ) = 0, t ⩾ 0.

T →∞

Exercise 7.5 Power options (Exercise 4.16 continued). Power options can be used for the pricing of
realized variance and volatility swaps. Let (St )t∈R+ denote a geometric Brownian motion solution
of
dSt = µSt dt + σ St dBt ,
where (Bt )t∈R+ is a standard Brownian motion, with µ ∈ R and σ > 0.
a) Let r ⩾ 0. Solve the Black-Scholes PDE

∂g ∂g σ 2 ∂ 2g
rg(x,t ) = (x,t ) + rx (x,t ) + x2 2 (x,t ) (7.6.5)
∂t ∂x 2 ∂x
with terminal condition g(x, T ) = x2 , x > 0, t ∈ [0, T ].
Hint: Try a solution of the form g(x,t ) = x2 f (t ), and find f (t ).
b) Find the respective quantities ξt and ηt of the risky asset St and riskless asset At = A0 e rt in
the portfolio with value

Vt = g(St ,t ) = ξt St + ηt At , 0 ⩽ t ⩽ T,

hedging the contract with claim payoff C = (ST )2 at maturity.

Exercise 7.6 On December 18, 2007, a call warrant has been issued by Fortis Bank on the stock
price S of the MTR Corporation with maturity T = 23/12/2008, strike price K = HK$ 36.08 and
entitlement ratio=10, cf. page 8. Recall that in the Black-Scholes model, the price at time t of the
European claim on the underlying asset priced St with strike price K, maturity T , interest rate r and
volatility σ > 0 is given by the Black-Scholes formula as

f (t, St ) = St Φ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

where
(r − σ 2 /2)(T − t ) + log(St /K )


 d− ( T − t ) = √ ,
|σ | T − t


 √ (r + σ 2 /2)(T − t ) + log(St /K )
 d+ (T − t ) = d− (T − t ) + |σ | T − t = √ .


|σ | T − t

Recall that by Proposition 7.4 we have

∂f
(t, St ) = Φ d+ (T − t ) ,


0 ⩽ t ⩽ T.
∂x

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.6 Solution of the Black-Scholes PDE 229

a) Using the values of the Gaussian cumulative distribution function, compute the Black-Scholes
price of the corresponding call option at time t =November 07, 2008 with St = HK$ 17.200,
assuming a volatility σ = 90% = 0.90 and an annual risk-free interest rate r = 4.377% =
0.04377,
b) Still using the Gaussian cumulative distribution function, compute the quantity of the risky
asset required in your portfolio at time t =November 07, 2008 in order to hedge one such
option at maturity T = 23/12/2008.
c) Figure 1 represents the Black-Scholes price of the call option as a function of σ ∈ [0.5, 1.5] =
[50%, 150%].
0.6
Market price

0.5

0.4
Option price

0.3

0.2

0.1

0 σ
0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 imp 1.4 1.5
σ

Figure 7.23: Option price as a function of the volatility σ > 0.

BSCall <- function(S, K, r, T, sigma)
{d1 <- (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T));d2 <- d1 - sigma * sqrt(T)
BSCall = S*pnorm(d1) - K*exp(-r*T)*pnorm(d2);BSCall}
sigma <- seq(0.5,1.5, length=100);
plot(sigma,BSCall(17.2,36.08,0.04377,46/365,sigma) , type="l",lty=1, xlab="Sigma",
ylab="Black-Scholes Call Price", ylim = c(0,0.6),col="blue",lwd=3);grid()
abline(h=0.23,col="red",lwd=3)

Knowing that the closing price of the warrant on November 07, 2008 was HK$ 0.023, which
value can you infer for the implied volatility σ at this date?*

Exercise 7.7 Forward contracts. Recall that the price πt (C ) of a claim payoff C = h(ST ) of
maturity T can be written as πt (C ) = g(t, St ), where the function g(t, x) satisfies the Black-Scholes
PDE 
2
 rg(t, x) = ∂ g (t, x) + rx ∂ g (t, x) + 1 σ 2 x2 ∂ g (t, x),

∂t ∂x 2 ∂ x2

 g(T , x ) = h(x ), (1)
with terminal condition g(T , x) = h(x), x > 0.
a) Assume that C is a forward contract with payoff
C = ST − K,
at time T . Find the function h(x) in (1).
b) Find the solution g(t, x) of the above PDE and compute the price πt (C ) at time t ∈ [0, T ].
Hint: search for a solution of the form g(t, x) = x − α (t ) where α (t ) is a function of t to be
determined.
* Download the corresponding code or the IPython notebook that can be run here or here (right-click to save as


attachment, may not work on .

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 230 Chapter 7. Black-Scholes Pricing and Hedging

c) Compute the quantities

∂g
ξt =
(t, St )
∂x
and ηt of risky and riskless assets in a self-financing portfolio hedging C, assuming A0 = $1.
d) Repeat the above questions with the terminal condition g(T , x) = x.

Exercise 7.8 (Exercise 4.8 continued). We consider a range forward contract having the payoff

ST − F + (K1 − ST )+ − (ST − K2 )+ ,

on an underlying asset priced ST at maturity T , where 0 < K1 < F < K2 , and the price process
(St )t∈R+ is modeled as the geometric Brownian motion
2 t/2
St = S0 e rt +σ Bt −σ , t ⩾ 0,

under the risk-neutral measure P∗ , where (Bt )t∈R+ is a standard Brownian motion generating the
filtration (Ft )t∈R+ .
a) Give the value of IE∗ [ST | Ft ], 0 ⩽ t ⩽ T .
b) Price the range forward contract at time t ∈ [0, T ].
Hint. The Black-Scholes call pricing formula reads

gc (t, x) = Bl(K, x, σ , r, T − t ) = xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

with

2 2
d− (T − t ) log(x/K ) + (r − σ 2 /2)(T − t )

1
= √
2 2 |σ | T − t

2
d+ (T − t ) x
= − (T − t )r − log .
2 K

Exercise 7.9
a) Solve the Black-Scholes PDE

∂g ∂g σ 2 ∂ 2g
rg(t, x) = (t, x) + rx (t, x) + x2 2 (t, x) (7.6.6)
∂t ∂x 2 ∂x
with terminal condition g(T , x) = 1, x > 0.
Hint: Try a solution of the form g(t, x) = f (t ) and find f (t ).
b) Find the respective quantities ξt and ηt of the risky asset St and riskless asset At = A0 e rt in
the portfolio with value
Vt = g(t, St ) = ξt St + ηt At
hedging the contract with claim payoff C = $1 at maturity.

Exercise 7.10 Log contracts can be used for the pricing and hedging of realized variance swaps.
a) Solve the PDE

∂g ∂g σ 2 ∂ 2g
0= (x,t ) + rx (x,t ) + x2 2 (x,t ) (7.6.7)
∂t ∂x 2 ∂x
with the terminal condition g(x, T ) := log x, x > 0.
Hint: Try a solution of the form g(x,t ) = f (t ) + log x, and find f (t ).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

7.6 Solution of the Black-Scholes PDE 231

b) Solve the Black-Scholes PDE

∂h ∂h σ 2 ∂ 2h
rh(x,t ) = (x,t ) + rx (x,t ) + x2 2 (x,t ) (7.6.8)
∂t ∂x 2 ∂x
with the terminal condition h(x, T ) := log x, x > 0.
Hint: Try a solution of the form h(x,t ) = u(t )g(x,t ), and find u(t ).
c) Find the respective quantities ξt and ηt of the risky asset St and riskless asset At = A0 e rt in
the portfolio with value
Vt = g(St ,t ) = ξt St + ηt At
hedging a log contract with claim payoff C = log ST at maturity.

Exercise 7.11 Binary options. Consider a price process (St )t∈R+ given by

dSt
= rdt + σ dBt , S0 = 1,
St
under the risk-neutral probability measure P∗ . The binary (or digital) call option is a contract with
maturity T , strike price K, and payoff
(
$1 if ST ⩾ K,
Cd := 1[K,∞) (ST ) =
0 if ST < K.

a) Derive the Black-Scholes PDE satisfied by the pricing function Cd (t, St ) of the binary call
option, together with its terminal condition.
b) Show that the solution Cd (t, x) of
 the Black-Scholes PDE of Question
 (a)) is given by
( r − σ 2 /2)(T − t ) + log(x/K )
Cd (t, x) = e −(T −t )r Φ √
|σ | T − t
= e −(T −t )r Φ(d− (T − t )),
where
(r − σ 2 /2)(T − t ) + log(St /K )
d− (T − t ) := √ , 0 ⩽ t < T.
|σ | T − t

Exercise 7.12
a) Bachelier, 1900 model. Solve the stochastic differential equation

dSt = αSt dt + σ dBt (7.6.9)

in terms of α, σ ∈ R, and the initial condition S0 .

b) Write down the Bachelier PDE satisfied by the function C (t, x), where C (t, St ) is the price at
time t ∈ [0, T ] of the contingent claim with claim payoff C = φ (ST ) = exp(ST ), and identify
the process Delta (ξt )t∈[0,T ] that hedges this claim.
c) Solve the Black-Scholes PDE of Question (b)) with the terminal condition φ (x) = e x , x ∈ R.
Hint: Search for a solution of the form
σ2 2
 
C (t, x) = exp −(T − t )r + xh(t ) + (h (t ) − 1) , (7.6.10)
4r

where h(t ) is a function to be determined, with h(T ) = 1.

d) Compute the portfolio strategy (ξt , ηt )t∈[0,T ] that hedges the contingent claim with claim
payoff C = exp(ST ).

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 232 Chapter 7. Black-Scholes Pricing and Hedging

Exercise 7.13
a) Show that for every fixed value of S, the function
√

d 7−→ h(S, d ) := SΦ d + |σ | T − K e −rT Φ(d ),

log(S/K ) + (r − σ 2 /2)T
reaches its maximum at d∗ (S) := √ .
|σ | T
∂h
Hint: The maximum is reached when the partial derivative vanishes.
∂d
b) By the differentiation rule
d ∂h ∂h
h(S, d∗ (S)) = (S, d∗ (S)) + d∗′ (S) (S, d∗ (S)),
dS ∂S ∂d
recover the value of the Black-Scholes Delta.

Exercise 7.14
a) Compute the Black-Scholes call and put Vega by differentiation of the Black-Scholes function

gc (t, x) = Bl(x, K, σ , r, T − t ) = xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

with respect to the volatility parameter σ > 0, knowing that

2
1 log(x/K ) + (r − σ 2 /2)(T − t )

1
2
− d− ( T − t ) = − √
2 2 |σ | T − t
1
2 x
= − d+ (T − t ) + (T − t )r + log . (7.6.11)
2 K
How do the Black-Scholes call and put prices behave when subjected an increase in the
volatility parameter σ ?
b) Compute the Black-Scholes Rho by differentiation of the Black-Scholes function gc (t, x).
How do the Black-Scholes call and put prices behave when subjected an increase in the
interest rate parameter r?

Exercise 7.15 Consider the backward induction relation (4.2.5), i.e.

ve(t, x) = (1 − p∗N )ve(t + 1, x(1 + aN )) + p∗N ve(t + 1, x(1 + bN )) ,

using the renormalizations rN := rT /N and

p p
aN := (1 + rN )(1 − |σ | T /N ) − 1, bN := (1 + rN )(1 + |σ | T /N ) − 1,

of Section 4.6, N ⩾ 1, with

rN − aN bN − rN
p∗N = and p∗N = .
bN − aN bN − aN
a) Show that the Black-Scholes PDE (7.1.2) of Proposition 7.1 can be recovered from the
induction relation (4.2.5) when the number N of time steps tends to infinity.
∂ gc
b) Show that the expression of the Delta ξt = (t, St ) can be similarly recovered from the
∂x
finite difference relation (4.4.1), i.e.

(1) v (t, (1 + bN )St−1 ) − v (t, (1 + aN )St−1 )

ξt (St−1 ) =
St−1 (bN − aN )
as N tends to infinity.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 233

8. Martingale Approach to Pricing and Hedging

In the martingale approach to the pricing and hedging of financial derivatives, option prices
are expressed as the expected values of discounted option payoffs. This approach relies on the
construction of risk-neutral probability measures by the Girsanov theorem, and the associated
hedging portfolios are obtained via stochastic integral representations.

8.1 Martingale Property of the Itô Integral 193

8.2 Risk-neutral Probability Measures 197
8.3 Change of Measure and the Girsanov Theorem 200
8.4 Pricing by the Martingale Method 202
8.5 Hedging by the Martingale Method 208
Exercises 213

8.1 Martingale Property of the Itô Integral

Recall (Definition 5.2) that an integrable process (Xt )t∈R+ is said to be a martingale with respect to
the filtration (Ft )t∈R+ if
IE[Xt | Fs ] = Xs , 0 ⩽ s ⩽ t.
In what follows,
L2 (Ω) := {F : Ω → R : IE[|F|2 ] < ∞}
denotes the space of square-integrable random variables.
Examples of martingales (i)
1. Given F ∈ L2 (Ω) a square-integrable random variable and (Ft )t∈R+ a filtration, the process
(Xt )t∈R+ defined by
Xt := IE[F | Ft ], t ⩾ 0,

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 234 Chapter 8. Martingale Approach to Pricing and Hedging

is an (Ft )t∈R+ -martingale under P. Indeed, since Fs ⊂ Ft , 0 ⩽ s ⩽ t, it follows from the

tower property (11.6.8) of conditional expectations that
IE[Xt | Fs ] = IE[IE[F | Ft ] | Fs ] = IE[F | Fs ] = Xs , 0 ⩽ s ⩽ t. (8.1.1)
2. Any integrable stochastic process (Xt )t∈R+ whose increments (Xt1 − Xt0 , . . . , Xtn − Xtn−1 ) are
mutually independent and centered under P (i.e. IE[Xt ] = 0, t ∈ R+ ) is a martingale with
respect to the filtration (Ft )t∈R+ generated by (Xt )t∈R+ , as we have
IE[Xt | Fs ] = IE[Xt − Xs + Xs | Fs ]
= IE[Xt − Xs | Fs ] + IE[Xs | Fs ]
= IE[Xt − Xs ] + Xs
= Xs , 0 ⩽ s ⩽ t. (8.1.2)
In particular, the standard Brownian motion (Bt )t∈R+ is a martingale because it has centered
and independent increments. This fact is also consequence of Proposition 8.1 below as Bt
can be written as wt
Bt = dBs , t ⩾ 0.
0
3. The driftless geometric Brownian motion
2 t/2
Xt := X0 e σ Bt −σ (8.1.3)
is a martingale. Indeed, using the Gaussian moment generating function identity (11.6.16),
we have
2
IE[Xt | Fs ] = IE X0 e σ Bt −σ t/2 | Fs
 
2
= X0 e −σ t/2 IE e σ Bt | Fs
 
2
= X0 e −σ t/2 IE e (Bt −Bs )σ +σ Bs | Fs
 
2
= X0 e −σ t/2+σ Bs IE e (Bt −Bs )σ | Fs
 
2
= X0 e −σ t/2+σ Bs IE e (Bt −Bs )σ
 

2
 1 
= X0 e −σ t/2+σ Bs exp IE[(Bt − Bs )σ ] + Var[(Bt − Bs )σ ]
2
2 2
= X0 e −σ t/2+σ Bs e (t−s)σ /2
2
= X0 e σ Bs −σ s/2
= Xs , 0 ⩽ s ⩽ t.
The following result shows that the Itô integral yields a martingale with respect to the Brownian fil-
tration (Ft )t∈R+ . It is the continuous-time analog of the discrete-time Theorem 3.11.
rt

Proposition 8.1 The stochastic integral process 0 us dBs t∈R+ of a square-integrable adapted
process u ∈ 2 (Ω × R )
Lad is a martingale, i.e.:
+
hw t i ws
IE uτ dBτ Fs = uτ dBτ , 0 ⩽ s ⩽ t. (8.1.4)
0 0
rt
In particular, 0 us dBs is Ft -measurable, t ⩾ 0, and since F0 = {0, / Ω}, Relation (8.1.4) applied
with t = 0 recovers the fact that the Itô integral is a centered random variable:
hw t i hw t i w0
IE us dBs = IE us dBs F0 = us dBs = 0, t ⩾ 0.
0 0 0
Proof. The statement is first proved in case (ut )t∈R+ is a simple predictable process, and then
extended to the general case, cf. e.g. Proposition 2.5.7 in Privault, 2009. For example, for u a
predictable step process of the form

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.1 Martingale Property of the Itô Integral 235


 F if s ∈ [a, b],
us := F 1[a,b] (s) =
0 if s ∈
/ [a, b],


with F an Fa -measurable random variable and t ∈ [a, b], by Definition 5.15 we have
hw ∞ i hw ∞ i
IE us dBs Ft = IE F 1[a,b] (s)dBs Ft
0 0
= IE[(Bb − Ba )F | Ft ]
= F IE[Bb − Ba | Ft ]
= F (Bt − Ba )
wt
= us dBs
wat
= us dBs , a ⩽ t ⩽ b.
0

On the other hand, when t ∈ [0, a] we have

wt
us dBs = 0,
0

and we check that

hw ∞ i hw ∞ i
IE us dBs Ft = IE F 1[a,b] (s)dBs Ft
0 0
= IE[F (Bb − Ba ) | Ft ]
= IE[IE[F (Bb − Ba ) | Fa ] | Ft ]
= IE[F IE[Bb − Ba | Fa ] | Ft ]
= 0, 0 ⩽ t ⩽ a,

where we used the tower property (11.6.8) of conditional expectations and the fact that Brownian
motion (Bt )t∈R+ is a martingale:

IE[Bb − Ba | Fa ] = IE[Bb | Fa ] − Ba = Ba − Ba = 0.

The extension from simple processes to square-integrable 2 ( Ω × R ) can be proved

processes in Lad +
as in Proposition 5.19. Indeed, given u(n) n∈N be a sequence of simple predictable processes

converging to u in L2 (Ω × [0, T ]) cf. Lemma 1.1 of Ikeda and Watanabe, 1989, pages 22 and 46,
by Fatou’s Lemma 11.9, Jensen’s inequality and the Itô isometry (5.4.4), we have:
w i2 
t hw ∞
IE us dBs − IE us dBs Ft
0 0
 w t hw ∞ i2 
(n)
= IE lim us dBs − IE us dBs Ft
n→∞ 0 0
w i2 
t (n) hw ∞
⩽ lim inf IE us dBs − IE us dBs Ft
n→∞ 0 0
 hw
∞ (n) w∞ i2 
= lim inf IE IE us dBs − us dBs Ft
n→∞ 0 0
 w
∞ (n) w ∞ 2 
⩽ lim inf IE IE us dBs − us dBs Ft
n→∞ 0 0
w 2 
∞ (n)
= lim inf IE (us − us )dBs
n→∞ 0

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 236 Chapter 8. Martingale Approach to Pricing and Hedging
hw ∞ i
(n)
= lim inf IE |us − us |2 ds
n→∞ 0
(n)
= lim inf ∥u − u∥2L2 (Ω×[0,T ])
n→∞
= 0,
where we used the Itô isometry (5.4.4). We conclude that
hw ∞ i wt
IE us dBs Ft = us dBs , t ⩾ 0,
0 0

2 ( Ω × R ) a square-integrable adapted process, which leads to (8.1.4) after applying

for u ∈ Lad +
this identity to the process (1[0,t ] us )s∈R+ , i.e.,
hw t i hw ∞ i
IE uτ dBτ Fs = IE 1[0,t ] (τ )uτ dBτ Fs
0
ws 0
= 1[0,t ] (τ )uτ dBτ
w0s
= uτ dBτ , 0 ⩽ s ⩽ t.
0

Examples of martingales (ii)

1. The martingale property of the driftless geometric Brownian motion (8.1.3) can also be
recovered from Proposition 8.1, since by Proposition 6.15, (Xt )t∈R+ satisfies the stochastic
differential equation
dXt = σ Xt dBt ,
which shows that Xt can be written using the Brownian stochastic integral
wt
Xt = X0 + σ Xu dBu , t ⩾ 0.
0

2. Consider an asset price process (St )t∈R+ given by the stochastic differential equation

dSt = µSt dt + σ St dBt , t ⩾ 0, (8.1.5)

with µ ∈ R and σ > 0. By the Discounting Lemma 6.13, the discounted asset price process
Set := e −rt St , t ⩾ 0, satisfies the stochastic differential equation

d Set = ( µ − r )Set dt + σ Set dBt ,

and the discounted asset price

2
Set = e −rt St = S0 e (µ−r)t +σ Bt −σ t/2 , t ⩾ 0,

is a martingale under P when µ = r. The case µ ̸= r will be treated in Section 8.3 using
risk-neutral probability measures, see Definition 6.4, and the Girsanov Theorem 8.3, see
(8.3.6) below.
3. The discounted value
Vet = e −rt Vt , t ⩾ 0,
of a self-financing portfolio is given by
wt
Vet = Ve0 + ξu d Seu , t ⩾ 0,
0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 8.2 Risk-Neutral Probability Measures 237

cf. Lemma 6.14 is a martingale when µ = r by Proposition 8.1 because

wt
Vet = Ve0 + σ ξu Seu dBu , t ⩾ 0, ,
0

since we have
d Set = Set (( µ − r )dt + σ dBt ) = σ Set dBt
by the Discounting Lemma 6.13. Since the Black-Scholes theory is in fact valid for any
value of the parameter µ we will look forward to including the case µ ̸= r in the sequel.

8.2 Risk-Neutral Probability Measures

Recall that by definition, a risk-neutral measure is a probability measure P∗ under which the
discounted asset price process
Set t∈R := ( e −rt St )t∈R+


+

is a martingale, see Definition 6.4 and Proposition 6.5.

Consider an asset price process (St )t∈R+ given by the stochastic differential equation (8.1.5). Note
2
that when µ = r, the discounted asset price process Set t∈R = (S0 e σ Bt −σ t/2 )t∈R+ is a martingale


+
under P∗ = P, which is a risk-neutral probability measure.
In this section, we address the construction of a risk-neutral probability measure P∗ in the
general case µ ̸= r using the Girsanov Theorem 8.3 below. For this, we note that by the Discounting
Lemma 6.13, the relation
d Set = ( µ − r )Set dt + σ Set dBt
where µ − r is the risk premium, can be rewritten as

d Set = σ Set d Bbt , (8.2.1)

where Bbt t∈R+
is a drifted Brownian motion given by

µ −r
Bbt := t + Bt , t ⩾ 0,
σ

where the drift coefficient ν := ( µ − r )/σ is the “Market Price of Risk” (MPoR). The MPoR
represents the difference between the return µ expected when investing in the risky asset St , and
the risk-free interest rate r, measured in units of volatility σ .
From (8.2.1) and Propositions 6.5 and 8.1 we note that the risk-neutral probability measure can be
constructed as a probability measure P∗ under which (Bbt )t∈R+ is a standard Brownian motion.
Let us come back to the informal approximation of Brownian motion via its infinitesimal increments:
√
∆Bt = ± ∆t,

with
√
√
1
P ∆Bt = + ∆t = P ∆Bt = − ∆t = ,
2
and
1√ 1√
IE[∆Bt ] = ∆t − ∆t = 0.
2 2

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 238 Chapter 8. Martingale Approach to Pricing and Hedging
14
^
12 Drifted Brownian path Bt
Drift νt
10
8

^ 6
Bt
4
2
0
-2
-4
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t

Figure 8.1: Drifted Brownian path (Bbt )t∈R+ with ν > 0.

Clearly, given ν ∈ R, the drifted process

Bbt := νt + Bt , t ⩾ 0,

is no longer a standard Brownian motion because it is not centered:

 
IE Bbt = IE[νt + Bt ] = νt + IE[Bt ] = νt ̸= 0,

cf. Figure 8.1. This identity can be formulated in terms of infinitesimal increments as
1 √ 1 √
IE[ν∆t + ∆Bt ] = (ν∆t + ∆t ) + (ν∆t − ∆t ) = ν∆t ̸= 0.
2 2
In order to make νt + Bt a centered process (i.e. a standard Brownian motion, since νt + Bt
conserves all the other properties (i)-(iii) in the definition of Brownian motion, one may change
the probabilities of ups and downs, which have been fixed so far equal to 1/2.

That is, the problem is now to find two numbers p∗ , q∗ ∈ [0, 1] such that
√ √
 p (ν∆t + ∆t ) + q∗ (ν∆t − ∆t ) = 0
 ∗

p∗ + q∗ = 1.


The solution to this problem is given by

1 √ 1 √
p∗ := (1 − ν ∆t ) and q∗ := (1 + ν ∆t ). (8.2.2)
2 2

Definition 8.2 We say that a probability measure Q is absolutely continuous with respect to
another probability measure P if there exists a nonnegative random variable F : Ω −→ R+ such
that IE[F ] = 1, and

dQ
= F, i.e. dQ = FdP. (8.2.3)
dP
In this case, F is called the Radon-Nikodym density of Q with respect to P.

Relation (8.2.3) is equivalent to the relation

w
IEQ [G] = G(ω )dQ(ω )
Ω

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.2 Risk-Neutral Probability Measures 239
w dQ
= G(ω )
(ω )dP(ω )
Ω
dP
w
= G(ω )F (ω )dP(ω )
Ω
= IE [FG] ,

for any random variable G integrable under Q.

Coming √ back to Brownian motion considered as a discrete random walk with independent incre-
ments ± ∆t, we try to construct a new probability measure denoted P∗ , under which the drifted
process Bbt := νt + Bt will be a standard Brownian motion. This probability measure will be defined
through its Radon-Nikodym density

√ √
dP∗ P∗ (∆Bt1 = ε1 ∆t, . . . , ∆BtN = εN ∆t )
:= √ √
dP P(∆Bt1 = ε1 ∆t, . . . , ∆BtN = εN ∆t )
√ √
P∗ (∆Bt1 = ε1 ∆t ) · · · P∗ (∆BtN = εN ∆t )
= √ √
P(∆Bt1 = ε1 ∆t ) · · · P(∆BtN = εN ∆t )
1 √ √
= N
P∗ (∆Bt1 = ε1 ∆t ) · · · P∗ (∆BtN = εN ∆t ), (8.2.4)
(1/2)

ε1 , ε2 , . . . , εN ∈ {−1, 1}, with respect to the historical probability measure P, obtained by taking
the product of the above probabilities divided by the reference probability 1/2N corresponding to
the symmetric random walk.

Interpreting N = T /∆t as an (infinitely large) number of discrete time steps and under the identi-
fication [0, T ] ≃ {0 = t0 ,t1 , . . . ,tN = T }, this Radon-Nikodym density (8.2.4) can be rewritten as

dP∗ 1 1 √
 
1
≃ ∏ ∓ ν ∆t (8.2.5)
dP (1/2)N 0<t<T 2 2

where 2N becomes a normalization factor.

The following code is rescaling probabilities as in (8.2.2) based on the value of the drift µ.

nsim <- 100; N=12; t <- 0:N; T<-1.0; dt <- T/N; nu=3; p=0.5*(1-nu*(dt)^0.5);
dB <- matrix((dt)^0.5*(rbinom( nsim * N, 1, p)-0.5)*2, nsim, N)
X <- cbind(rep(0, nsim), t(apply(dB, 1, cumsum)))
plot(t, X[1, ], xlab = "Time", ylab = "", type = "l", ylim = c(-2*N*dt,2*N*dt), col =
0,cex.axis=1.4,cex.lab=1.4,xaxs="i", mgp = c(1, 2, 0), las=1)
for (i in 1:nsim){if (N<20) {points(t,t*nu*dt+X[i,],pch=20,cex=0.6, col=i+1,lwd=2)}
lines(t,t*nu*dt+X[i,],type="l",col=i+1,lwd=2)}

The discretized illustration in Figure 8.2 displays the drifted Brownian motion Bbt := νt + Bt
under the shifted probability measure P∗ in (8.2.5) using the above code with N = 100. The
code makes big transitions less frequent than small transitions, resulting into a standard, centered
Brownian motion under P∗ .

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 240 Chapter 8. Martingale Approach to Pricing and Hedging

1.0

0.5

0.0

−0.5

−1.0
0 20 40 Time 60 80 100

Figure 8.2: Drifted Brownian motion paths under a shifted Girsanov measure.

Next, using the expansion

√
√ 1 √
log 1 ± ν ∆t = ±ν ∆t − (±ν ∆t )2 + o(∆t )
2
√ ν2
= ±ν ∆t − ∆t + o(∆t ),
2
for small values of ∆t, this Radon-Nikodym density can be informally shown to converge as follows
as N tends to infinity, i.e. as the time step ∆t = T /N tends to zero:
dP∗ 1 1 √
 
= 2 ∏ N
∓ ν ∆t
dP 0<t<T 2 2
 √ 
= ∏ 1 ∓ ν ∆t
0<t<T
!
 √ 
= exp log ∏ 1 ∓ ν ∆t
0<t<T
!
 √ 
= exp ∑ log 1 ∓ ν ∆t
0<t<T
!
√ 1 √
≃ exp ν ∑ ∓ ∆t − ∑ (∓ν ∆t )2
0<t<T 2 0<t<T
!
√ ν2
= exp −ν ∑ ± ∆t − ∑ ∆t
0<t<T 2 0<t<T
!
ν2
= exp −ν ∑ ∆Bt − ∑ ∆t
0<t<T 2 0<t<T
ν2
 
= exp −νBT − T ,
2
based on the identifications
√
BT ≃ ∑ ± ∆t and T ≃ ∑ ∆t.
0<t<T 0<t<T

Informally, the drifted process Bbt )t∈[0,T ] = (νt + Bt )t∈[0,T ] is a standard Brownian motion under

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 8.3 Change of Measure and the Girsanov Theorem 241

the probability measure P∗ defined by its Radon-Nikodym density

dP∗ ν2
 
= exp −νBT − T .
dP 2

8.3 Change of Measure and the Girsanov Theorem

In this section we restate the Girsanov Theorem in a more rigorous way, using changes of proba-
bility measures. The Girsanov Theorem can actually be extended to shifts by adapted processes
(ψt )t∈[0,T ] as follows, cf. e.g. Theorem III-42, page 141 of Protter, 2004. Recall also that here,
Ω := C0 ([0, T ]) is the Wiener space and ω ∈ Ω is a continuous function on [0, T ] starting at 0
in t = 0. The Girsanov Theorem 8.3 will be used in Section 8.4 for the construction of a unique
risk-neutral probability measure P∗ , showing absence of arbitrage and completeness in the Black-
Scholes market, see Theorems 6.7 and 6.11.

Theorem 8.3 Let (ψt )t∈[0,T ] be an adapted process satisfying the Novikov integrability condition

  w 
1 T 2
IE exp |ψt | dt < ∞, (8.3.1)
2 0

and let Q denote the probability measure defined by the Radon-Nikodym density
 w
1wT

dQ T
2
= exp − ψs dBs − |ψs | ds .
dP 0 2 0

Then wt
Bbt := Bt + ψs ds, 0 ⩽ t ⩽ T,
0
is a standard Brownian motion under Q.

In the case of the simple shift

Bbt := Bt + νt,0 ⩽ t ⩽ T,

by a drift νt with constant ψs = ν ∈ R, the process Bbt t∈R is a standard (centered) Brownian


+
motion under the probability measure Q defined by

ν2
 
dQ(ω ) = exp −νBT − T dP(ω ).
2

For example, the fact that BbT has a centered Gaussian distribution under Q can be recovered as
follows:


IEQ f BbT = IEQ [ f (νT + BT )]
w
= f (νT + BT )dQ
Ω
w 
1 2

= f (νT + BT ) exp −νBT − ν T dP
Ω 2
w∞ 
1 2

2 dx
= f (νT + x) exp −νx − ν T e −x /(2T ) √
−∞ 2 2πT
w∞ 2 dx
= f (νT + x) e −(νT +x) /(2T ) √
−∞ 2πT

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 242 Chapter 8. Martingale Approach to Pricing and Hedging
w∞ 2 / (2T ) dy
= f (y) e −y √
−∞ 2πT
= IEP [ f (BT )],

i.e.
w
IEQ [ f (νT + BT )] = f (νT + BT )dQ (8.3.2)
wΩ
= f (BT )dP
Ω
= IEP [ f (BT )],

showing that, under Q, νT + BT has the centered N (0, T ) Gaussian distribution with variance
T . For example, taking f (x) = x, Relation (8.3.2) recovers the fact that BbT is a centered random
variable under Q, i.e.
 
IEQ BbT = IEQ [νT + BT )] = IEP [BT ] = 0.
The Girsanov Theorem 8.3 also allows us to extend (8.3.2) as
  w·   w
T 1wT

2
IEP [F (·)] = IE F B· + ψs ds exp − ψs dBs − |ψs | ds
0 0 2 0
h  w· i
= IEQ F B· + ψs ds , (8.3.3)
0

for all random variables F ∈ L1 (Ω), see also Exercise 8.25.

When applied to the (constant) market price of risk (or Sharpe ratio)
µ −r
ψt := ,
σ
the Girsanov Theorem 8.3 shows that the process
µ −r
Bbt := t + Bt , 0 ⩽ t ⩽ T, (8.3.4)
σ
is a standard Brownian motion under the probability measure P∗ defined by

dP∗ µ −r ( µ − r )2
 
= exp − BT − T . (8.3.5)
dP σ 2σ 2

Hence by Proposition 8.1 the discounted price process (Set )t∈R+ solution of

d Set = ( µ − r )Set dt + σ Set dBt = σ Set d Bbt , t ⩾ 0, (8.3.6)

is a martingale under P∗ , therefore P∗ is a risk-neutral probability measure. We also check that

P∗ = P when µ = r.
In the sequel, we consider probability measures Q that are equivalent to P in the sense that they
share the same events of zero probability, see Definition 2.5. Precisely, recall that a probability
measure Q on (Ω, F ) is said to be equivalent to another probability measure P when

Q(A) = 0 if and only if P(A) = 0, for all A ∈ F.

Note that when Q is defined by (8.2.3), it is equivalent to P if and only if F > 0 with P-probability
one.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 8.4 Pricing by the Martingale Method 243

8.4 Pricing by the Martingale Method

In this section we give the expression of the Black-Scholes price using expectations of discounted
payoffs.
Recall that according to the first fundamental theorem of asset pricing Theorem 6.7, a continuous
market is without arbitrage opportunities if and only if there exists (at least) an equivalent risk-
neutral probability measure P∗ under which the discounted price process

Set := e −rt St , t ⩾ 0,

is a martingale under P∗ . In addition, when the risk-neutral probability measure is unique, the
market is said to be complete.
The equation
dSt
= µdt + σ dBt , t ⩾ 0,
St
satisfied by the price process (St )t∈R+ can be rewritten using (8.3.4) as
dSt
= rdt + σ d Bbt , t ⩾ 0, (8.4.1)
St
with the solution
2 t/2 2 t/2
St = S0 e µt +σ Bt −σ = S0 e rt +σ Bt −σ , t ⩾ 0. (8.4.2)
b

By the discounting Lemma 6.13, we have

d Set = ( µ − r )Set dt + σ Set dBt
−
 
µ r
= σ Set dt + dBt
σ
= σ Set d Bbt , t ⩾ 0, (8.4.3)
hence the discounted price process
Set := e −rt St
2 t/2
= S0 e (µ−r)t +σ Bt −σ
2 t/2
= S0 e σ Bt −σ , t ⩾ 0,
b

is a martingale under the probability measure P∗ defined by (8.3.5). We note that P∗ is a risk-
neutral probability measure equivalent to P, also called martingale measure, whose existence and
uniqueness ensure absence of arbitrage and completeness according to Theorems 6.7 and 6.11.
Therefore, by Lemma 6.14 the discounted value Vet of a self-financing portfolio can be written
as
wt
Vet = Ve0 + ξu d Seu
0
wt
= Ve0 + σ ξu Seu d Bbu , t ⩾ 0,
0

and by Proposition 8.1 it becomes a martingale under P∗ .

As in Chapter 4, the value Vt at time t of a self-financing portfolio strategy (ξt )t∈[0,T ] hedging an
attainable claim payoff C will be called an arbitrage-free price of the claim payoff C at time t and
denoted by πt (C ), t ∈ [0, T ]. Arbitrage-free prices can be used to ensure that financial derivatives
are “marked” at their fair value (“mark to market”).

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 244 Chapter 8. Martingale Approach to Pricing and Hedging

Theorem 8.4 Let (ξt , ηt )t∈[0,T ] be a portfolio strategy with value

Vt = ηt At + ξt St , 0 ⩽ t ⩽ T,

and let C be a contingent claim payoff, such that

(i) (ξt , ηt )t∈[0,T ] is a self-financing portfolio, and
(ii) (ξt , ηt )t∈[0,T ] hedges the claim payoff C, i.e. we have VT = C.
Then, the arbitrage-free price of the claim payoff C is given by the portfolio value

πt (C ) = Vt = e −(T −t )r IE∗ [C | Ft ], 0 ⩽ t ⩽ T, (8.4.4)

where IE∗ denotes expectation under the risk-neutral probability measure P∗ .

Proof. Since the portfolio strategy (ξt , ηt )t∈R+ is self-financing, by Lemma 6.14 and (8.4.3) the
discounted portfolio value Vet = e −rt Vt satisfies
wt wt
Vet = V0 + ξu d Seu = Ve0 + σ ξu Seu d Bbu , t ⩾ 0,
0 0

which is a martingale under P∗ from Proposition 8.1, hence

Vet = IE∗ VeT Ft

 

= IE∗ [ e −rT VT | Ft ]
= IE∗ [ e −rT C | Ft ]
= e −rT IE∗ [C | Ft ],
which implies
Vt = e rt Vet = e −(T −t )r IE∗ [C | Ft ], 0 ⩽ t ⩽ T.
□

Black-Scholes PDE for vanilla options by the martingale method

The martingale method can be used to recover the Black-Scholes PDE of Proposition 7.1. As the
process (St )t∈R+ has the Markov property, see Section 5.5, § V-6 of Protter, 2004 and Definition 8.14
below, the value

Vt = e −(T −t )r IE∗ [φ (ST ) | Ft ]

= e −(T −t )r IE∗ [φ (ST ) | St ], 0 ⩽ t ⩽ T,

of the portfolio at time t ∈ [0, T ] can be written from (8.4.4) as a function

Vt = g(t, St ) = e −(T −t )r IE∗ [φ (ST ) | St ] (8.4.5)

of t and St , 0 ⩽ t ⩽ T .

Proposition 8.5 Assume that φ is a Lipschitz payoff function, and that (St )t∈R+ is the geometric
Brownian motion
2 /2)t
(St )t∈R+ = S0 e σ Bt +(r−σ
b

t∈R+

where (Bbt )t∈R+ is a standard Brownian motion under P∗ . Then, the function g(t, x) defined in

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.4 Pricing by the Martingale Method 245

(8.4.5) is in C 1,2 ([0, T ) × R+ ) and solves the Black-Scholes PDE


∂g ∂g 1 ∂ 2g
 rg(t, x) = (t, x) + rx (t, x) + x2 σ 2 2 (t, x)


∂t ∂x 2 ∂x


 g(T , x) = φ (x), x > 0.

Proof. It can be checked similarly to the proof of Proposition 7.10 that the function g(t, x) defined
by
g(t, St ) = e −(T −t )r IE∗ [φ (ST ) | St ] = e −(T −t )r IE∗ [φ (xST /St )]|x=St
is in C 1,2 ([0, T ) × R+ ) when φ is a Lipschitz function, by differentiation of the lognormal
distribution of ST /St . We note that by (5.5.7), the application of Itô’s formula Theorem 5.22 to
Vt = g(t, St ) and (8.4.1) with ut = σ St and vt = rSt leads to
d e −rt g(t, St ) = −r e −rt g(t, St )dt + e −rt dg(t, St )

∂g
= −r e −rt g(t, St )dt + e −rt (t, St )dt
∂t
∂ g 1 ∂ 2g
+ e −rt (t, St )dSt + e −rt (dSt )2 2 (t, St )
∂x 2 ∂x
∂ g
= −r e −rt g(t, St )dt + e −rt (t, St )dt
∂t
∂ g ∂g 1 ∂ 2g
+vt e −rt (t, St )dt + ut e −rt (t, St )d Bbt + e −rt |ut |2 2 (t, St )dt
∂x ∂x 2 ∂x
∂ g
= −r e −rt g(t, St )dt + e −rt (t, St )dt (8.4.6)
∂t
∂g 1 ∂ 2g ∂g
+rSt e −rt (t, St )dt + e −rt σ 2 St2 2 (t, St )dt + σ e −rt St (t, St )d Bbt .
∂x 2 ∂x ∂x
By Lemma 6.14 and Proposition 8.1, the discounted price Vet = e −rt g(t, St ) of a self-financing
hedging portfolio is a martingale under the risk-neutral probability measure P∗ , therefore from e.g.
Corollary II-6-1,

page 72 of Protter, 2004, all terms in dt should vanish in the above expression of
−rt
d e g(t, St ) , showing that

∂g ∂g 1 ∂ 2g
−rg(t, St ) + (t, St ) + rSt (t, St ) + σ 2 St2 2 (t, St ) = 0,
∂t ∂x 2 ∂x
and leads to the Black-Scholes PDE
∂g ∂g 1 ∂ 2g
rg(t, x) = (t, x) + rx (t, x) + σ 2 x2 2 (t, x), x > 0.
∂t ∂x 2 ∂x
□
From (8.4.6) in the proof of Proposition 8.5, we also obtain the stochastic integral expression
e −rT φ (ST ) = e −rT g(T , ST )
wT
d e −rt g(t, St )


= g(0, S0 ) +
0
wT ∂g
= g(0, S0 ) + σ e −rt St (t, St )d Bbt ,
0 ∂x
see also Proposition 6.14, and Proposition 8.11 below.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 246 Chapter 8. Martingale Approach to Pricing and Hedging

Forward contracts
The long forward contract with payoff C = ST − K is priced as

Vt = e −(T −t )r IE∗ [ST − K | Ft ]

= e −(T −t )r IE∗ [ST | Ft ] − K e −(T −t )r
= St − K e −(T −t )r , 0 ⩽ t ⩽ T,

which recovers the Black-Scholes PDE solution (7.1.9), i.e.

g(t, x) = x − K e −(T −t )r , x > 0, 0 ⩽ t ⩽ T.

European call options

In the case of European call options with payoff function φ (x) = (x − K )+ we recover the Black-
Scholes formula (7.2.2), cf. Proposition 7.11, by a probabilistic argument.

Proposition 8.6 The price at time t ∈ [0, T ] of the European call option with strike price K and
maturity T is given by

g(t, St ) = e −(T −t )r IE∗ [(ST − K )+ | Ft ] (8.4.7)

= St Φ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,



0 ⩽ t ⩽ T,

with
log(St /K ) + (r + σ 2 /2)(T − t )

d ( T − t ) : = √ ,

+

σ T −t




log(St /K ) + (r − σ 2 /2)(T − t )


 d− (T − t ) := √ 0 ⩽ t < T,

 ,
σ T −t
where “log” denotes the natural logarithm “ln” and Φ is the standard Gaussian Cumulative
Distribution Function.

Proof. The proof of Proposition 8.6 is a consequence of (8.4.4) and Lemma 8.7 below. Using the
relation

2 T /2
ST = S0 e rT +σ BT −σ
b

2 /2
= St e (T −t )r+(BT −Bt )σ −(T −t )σ , 0 ⩽ t ⩽ T,
b b

that follows from (8.4.2), by Theorem 8.4 the value at time t ∈ [0, T ] of the portfolio hedging C is
given by

Vt = e −(T −t )r IE∗ [C | Ft ]
e −(T −t )r IE∗ (ST − K )+ Ft
 
=
2
e −(T −t )r IE∗ (St e (T −t )r+(BT −Bt )σ −(T −t )σ /2 − K )+ Ft
 
=
b b

2
e −(T −t )r IE∗ (x e (T −t )r+(BT −Bt )σ −(T −t )σ /2 − K )+ |x=S
 
=
b b
t

e −(T −t )r IE∗ ( e m(x)+X − K )+ |x=S ,

 
= 0 ⩽ t ⩽ T,
t

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.4 Pricing by the Martingale Method 247

where
σ2
m(x ) : = (T − t )r − (T − t ) + log x
2
and
X := BbT − Bbt σ ≃ N (0, (T − t )σ 2 )

is a centered Gaussian random variable with variance

Var [X ] = Var BbT − Bbt σ = σ 2 Var BbT − Bbt = (T − t )σ 2

  

under P∗ . Hence by Lemma 8.7 below we have

g(t, St ) = Vt

+ 
e −(T −t )r IE∗ e m(x)+X − K

= |x=S
t

m(St ) − log K
 
2
= e −(T −t )r e m(St )+σ (T −t )/2 Φ v +
v
m(St ) − log K
 
−K e −(T −t )r Φ
v
m(St ) − log K m(St ) − log K
   
−(T −t )r
= St Φ v + −K e Φ
v v
= St Φ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

0 ⩽ t ⩽ T. □
Relation (8.4.7) can also be written as
e −(T −t )r IE∗ (ST − K )+ Ft = e −(T −t )r IE∗ (ST − K )+ St
   
(8.4.8)
log(St /K ) + (r + σ 2 /2)(T − t )
 
= St Φ √
σ T −t
log(St /K ) + (r − σ 2 /2)(T − t )
 
−(T −t )r
−K e Φ √ , 0 ⩽ t ⩽ T.
σ T −t
Lemma 8.7 Let X ≃ N (0, v2 ) be a centered Gaussian random variable with variance v2 > 0. We
have
2
IE ( e m+X − K )+ = e m+v /2 Φ(v + (m − log K )/v) − KΦ((m − log K )/v).
 

Proof. We have

1 w ∞ m+x 2 2
IE ( e m+X − K )+ = √ − K )+ e −x /(2v ) dx
 
(e
2πv 2 −∞
1 w∞ 2 2
= √ ( e m+x − K ) e −x /(2v ) dx
2πv 2 −m + log K
em w ∞ 2 2 K w∞ 2 2
= √ e x−x /(2v ) dx − √ e −x /(2v ) dx
2πv2 −m+log K 2πv2 −m+log K
2 /2 w
e m + v ∞ 2 2 2 K w∞ 2
= √ e −(v −x) /(2v ) dx − √ e −y /2 dy
2πv2 −m+log K 2π (−m+log K )/v
m + v 2 /2 w
e ∞ 2 2
= √ 2
e −y /(2v ) dy − KΦ((m − log K )/v)
2πv2 −v −m+log K
m+v2 /2
= e Φ(v + (m − log K )/v) − KΦ((m − log K )/v),

where we used Relation (7.2.6). □

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 248 Chapter 8. Martingale Approach to Pricing and Hedging

Call-put parity
Let
gp (t, St ) := e −(T −t )r IE∗ (K − ST )+ Ft ,
 
0 ⩽ t ⩽ T,

denote the price of the put option with strike price K and maturity T .

Proposition 8.8 Call-put parity. We have the relation

gc (t, St ) − gp (t, St ) = St − e −(T −t )r K (8.4.9)

between the Black-Scholes prices of call and put options, in terms of the forward contract price
St − K e −(T −t )r .

Proof. From the relation

ST − K = ( ST − K ) + − ( K − ST ) + ,

see https://optioncreator.com/stijwns, and Theorem 8.4, we have

gc (t, St ) − gp (t, St )
= e −(T −t )r IE∗ [(ST − K )+ | Ft ] − e −(T −t )r IE∗ [(K − ST )+ | Ft ]
= e −(T −t )r IE∗ [(ST − K )+ − (K − ST )+ | Ft ]
= e −(T −t )r IE∗ [ST − K | Ft ]
= e −(T −t )r IE∗ [ST | Ft ] − K e −(T −t )r
= St − e −(T −t )r K, 0 ⩽ t ⩽ T,

as we have IE∗ [ST | Ft ] = e (T −t )r St , t ∈ [0, T ], under the risk-neutral probability measure P∗ .

□

European put options

Using the call-put parity Relation (8.4.9) we can recover the European put option price (7.2.2)
from the European call option price (7.2.2)-(8.4.7).

Proposition 8.9 The price at time t ∈ [0, T ] of the European put option with strike price K and
maturity T is given by

gp (t, St ) = e −(T −t )r IE∗ [(K − ST )+ | Ft ]

= K e −(T −t )r Φ − d− (T − t ) − St Φ − d+ (T − t ) ,



0 ⩽ t ⩽ T,

with
log(St /K ) + (r + σ 2 /2)(T − t )

d ( T − t ) : = √ ,

+

σ T −t




log(St /K ) + (r − σ 2 /2)(T − t )


 d− (T − t ) := √ 0 ⩽ t < T,

 ,
σ T −t
where “log” denotes the natural logarithm “ln” and Φ is the standard Gaussian Cumulative
Distribution Function.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 8.5 Hedging by the Martingale Method 249

Proof. By Relation (7.2.6) and the call-put parity (8.4.9), we have

gp (t, St ) = gc (t, St ) − St + e −(T −t )r K
= St Φ d+ (T − t ) + e −(T −t )r K − St − e −(T −t )r KΦ d− (T − t )

= −St (1 − Φ d+ (T − t ) ) + e −(T −t )r K (1 − Φ d− (T − t ) )

= −St Φ − d+ (T − t ) + e −(T −t )r KΦ − d− (T − t ) .

8.5 Hedging by the Martingale Method

Hedging exotic options
In the next Proposition 8.10 we compute a self-financing hedging strategy leading to an arbitrary
square-integrable random claim payoff C ∈ L2 (Ω) of an exotic option admitting a stochastic integral
decomposition of the form
wT
C = IE∗ [C ] + ζt d Bbt , (8.5.1)
0

where (ζt )t∈[0,t ] is a square-integrable adapted process, see for example page 191. Consequently,
the mathematical problem of finding the stochastic integral decomposition (8.5.1) of a given random
variable has important applications in finance. The process (ζt )t∈[0,T ] can be computed using the
Malliavin gradient on the Wiener space, see, e.g., Di Nunno, Øksendal, and Proske, 2009 or § 8.2
of Privault, 2009.
Simple examples of stochastic integral decompositions include the relations
wT
(BT )2 = T + 2 Bt dBt ,
0

cf. Exercises 7.1 and 8.1, and

wT
( BT ) 3 = 3 T − t + Bt2 dBt ,


0

see Exercise 5.10. In the sequel, recall that the risky asset follows the equation
dSt
= µdt + σ dBt , t ⩾ 0, S0 > 0,
St
and by (8.3.6), the discounted asset price Set := e −rt St

d Set = σ Set d Bbt , t ⩾ 0, Se0 = S0 > 0, (8.5.2)

where (Bbt )t∈R+ is a standard Brownian motion under the risk-neutral probability measure P∗ . The
following proposition applies to arbitrary square-integrable payoff functions, in particular it covers
exotic and path-dependent options.

Proposition 8.10 Consider a random claim payoff C ∈ L2 (Ω) and the process (ζt )t∈[0,T ] given
by (8.5.1), and let

e −(T −t )r
ξt = ζt , (8.5.3)
σ St
e −(T −t )r IE∗ [C | Ft ] − ξt St
ηt = , 0 ⩽ t ⩽ T. (8.5.4)
At

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 250 Chapter 8. Martingale Approach to Pricing and Hedging

Then the portfolio allocation (ξt , ηt )t∈[0,T ] is self-financing, and letting

Vt = ηt At + ξt St , 0 ⩽ t ⩽ T, (8.5.5)

we have

Vt = e −(T −t )r IE∗ [C | Ft ], 0 ⩽ t ⩽ T. (8.5.6)

In particular we have

VT = C, (8.5.7)

i.e. the portfolio allocation (ξt , ηt )t∈[0,T ] yields a hedging strategy leading to the claim payoff C
at maturity, after starting from the initial value

V0 = e −rT IE∗ [C ].
Proof. Relation (8.5.6) follows from (8.5.4) and (8.5.5), and it implies

V0 = e −rT IE∗ [C ] = η0 A0 + ξ0 S0
at t = 0, and (8.5.7) at t = T . It remains to show that the portfolio strategy (ξt , ηt )t∈[0,T ] is
self-financing. By (8.5.1) and Proposition 8.1 we have
Vt = ηt At + ξt St
= e −(T −t )r IE∗ [C | Ft ]
 wT 
−(T −t )r ∗ ∗
= e IE IE [C ] + ζu d Bu Ft
b
0
 wt 
= e −(T −t )r IE∗ [C ] + ζu d Bbu
0
wt
= e rt V0 + e −(T −t )r ζu d Bbu
0
wt
= e rt V0 + σ ξu Su e (t−u)r d Bbu
0
wt
= e rt V0 + σ e rt ξu Seu d Bbu .
0
By (8.5.2) this shows that the portfolio strategy (ξt , ηt )t∈[0,T ] given by (8.5.3)-(8.5.4) and its
discounted portfolio value Vet := e −rt Vt satisfy
wt
Vet = V0 + ξu d Seu , 0 ⩽ t ⩽ T,
0

which implies that (ξt , ηt )t∈[0,T ] is self-financing by Lemma 6.14. □

The above proposition shows that there always exists a hedging strategy starting from
V0 = IE∗ [C ] e −rT .
In addition, since there exists a hedging strategy leading to
VeT = e −rT C,
then (Vet )t∈[0,T ] is necessarily a martingale, with

Vet = IE∗ VeT Ft = e −rT IE∗ [C | Ft ],

 
0 ⩽ t ⩽ T,
and initial value
Ve0 = IE∗ VeT = e −rT IE∗ [C ].
 

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.5 Hedging by the Martingale Method 251

Hedging vanilla options

In practice, the hedging problem can now be reduced to the computation of the process (ζt )t∈[0,T ]
appearing in (8.5.1). This computation, called Delta hedging, can be performed by the application
of the Itô formula and the Markov property, see e.g. Protter, 2001. The next lemma allows us to
compute the process (ζt )t∈[0,T ] in case the payoff C is of the form C = φ (ST ) for some function
φ.

Proposition 8.11 Assume that φ is a Lipschitz payoff function. Then, the function C (t, x)
defined from the Markov property of (St )t∈[0,T ] by

C (t, St ) := IE∗ [φ (ST ) | Ft ] = IE∗ [φ (ST ) | St ]

is in C 1,2 ([0, T ) × R), and the stochastic integral decomposition

 wT
φ (ST ) = IE∗ φ (ST ) +

ζt d Bbt (8.5.8)
0

is given by

∂C
ζt = σ St (t, St ), 0 ⩽ t ⩽ T. (8.5.9)
∂x
In addition, the self-financing hedging strategy (ξt )t∈[0,T ] satisfies

∂C
ξt = e −(T −t )r (t, St ), 0 ⩽ t ⩽ T. (8.5.10)
∂x

Proof. It can be checked as in the proof of Proposition 8.5 that the function C (t, x) is in
C 1,2 ([0, T ) × R). Therefore, we can apply the Itô formula to the process

t 7→ C (t, St ) = IE∗ [φ (ST ) | Ft ],

which is a martingale from the tower property (11.6.8) of conditional expectations as in (8.5.17) or
Example (1) page 233. From the fact that the finite variation term in the Itô formula vanishes when
(C (t, St ))t∈[0,T ] is a martingale, (see e.g. Corollary II-6-1 page 72 of Protter, 2004), we obtain:
wt ∂C
C (t, St ) = C (0, S0 ) + σ Su (u, Su )d Bbu , 0 ⩽ t ⩽ T, (8.5.11)
0 ∂x
with C (0, S0 ) = IE∗ [φ (ST )]. Letting t := T , we have

∂C wT
φ (ST ) = C (T , ST ) = C (0, S0 ) + σ (t, St )d Bbt
St
0 ∂x
which yields (8.5.9) by uniqueness of the stochastic integral decomposition (8.5.8) of C = φ (ST ).
Finally, (8.5.10) follows from (8.5.3) and (8.5.9) by applying Proposition 8.10. □
In the case of European options, the process ζ can be computed via the next proposition which
recovers the formula (7.1.3) for the Delta of a vanilla option, and follows from Proposition 8.11
and the relation
C (t, x) = IE∗ f (St,T
x
 
) , 0 ⩽ t ⩽ T , x > 0.
In particular, we have ξt ⩾ 0 and there is no short selling when the payoff function φ is non-
decreasing.

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 252 Chapter 8. Martingale Approach to Pricing and Hedging

Corollary 8.12 Assume that C = (ST − K )+ . Then, for 0 ⩽ t ⩽ T we have

  
ST ST
ζt = σ St IE ∗
1 x , 0 ⩽ t ⩽ T, (8.5.12)
St [K,∞) St |x=St

and
  
ST ST
ξt = e −(T −t )r
IE∗
1 x , 0 ⩽ t ⩽ T. (8.5.13)
St [K,∞) St |x=St

Proof. By (8.5.9) and the relation

2 T /2 2 /2
ST = S0 e σ BT +µT −σ = St e (BT −Bt )σ +(T −t )µ−(T −t )σ ,

we have
 
∂ ∗
ζt = σ St IE [φ (ST ) | St = x]
∂x x=St
   
∂ ∗ ST
= σ St IE φ x , 0 ⩽ t ⩽ T,
∂x St x=St

as in Relation (11.7.8), hence by (8.5.3) we have

1 −(T −t )r
ξt = e ζt (8.5.14)
σ St
   
−(T −t )r ∂ ∗ ST
= e IE φ x
∂x St x=St
  
S T ′ S T
= e −(T −t )r IE∗ φ x , 0 ⩽ t ⩽ T.
St St x=St

The above derivation can be checked for φ (x) = (x − K )+ and φ ′ (x) = 1[K,∞) (x) e.g. by writing
expected values as integrals. □
By evaluating the expectation (8.5.12) in Corollary 8.12 we can recover the formula (7.2.7) in
Proposition 7.4 for the Delta of the European call option in the Black-Scholes model. In that sense,
the next proposition provides another proof of the result of Proposition 7.4.

Proposition 8.13 The Delta of the European call option with payoff function φ (x) = (x − K )+
is given by

log(St /K ) + (r + σ 2 /2)(T − t )
 
ξt = Φ d+ (T − t ) = Φ


√ , 0 ⩽ t ⩽ T.
σ T −t

Proof. By Proposition 8.10 and Corollary 8.12, we have

1 −(T −t )r
ξt = e ζt
σ St

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8.5 Hedging by the Martingale Method 253
  
−(T −t )r ∗ ST ST
=e IE 1 x
St [K,∞) St |x=St

= e −(T −t )r
h i
× IE∗ e (BT −Bt )σ −(T −t )σ /2+(T −t )r 1[K,∞) (x e (BT −Bt )σ −(T −t )σ /2+(T −t )r )
b b 2 b b 2

|x=St
1 w∞ 2 2
=p e σ y−(T −t )σ /2−y /(2(T −t )) dy
2(T − t )π (T −t )σ /2−(T −t )r/σ +σ −1 log(K/St )
1 w∞ 2
=p √ e −(y−(T −t )σ ) /(2(T −t )) dy
2(T − t )π −d − ( T −t ) / T −t

1 w∞ 2
=√ e −(y−(T −t )σ ) /2 dy
2π −d− (T −t )
1 w∞ 2
=√ e −y /2 dy
2π −d + ( T −t )
1 w d+ (T −t ) −y2 /2
=√ e dy
2π −∞
= Φ d+ (T − t ) .

□
The Delta of the Black-Scholes put option can be obtained as in Proposition 7.7 from (7.1.3), by
differentiation of the call-put parity relation (8.8), and application of Proposition 8.13.
Proposition 8.13, combined with Proposition 8.6, shows that the Black-Scholes self-financing
hedging strategy is to hold a (possibly fractional) quantity
log(St /K ) + (r + σ 2 /2)(T − t )
 
ξt = Φ d+ (T − t ) = Φ


√ ⩾0 (8.5.15)
σ T −t
of the risky asset, and to borrow a quantity
log(St /K ) + (r − σt2 /2)(T − t )
 
−rT
−ηt = K e Φ √ ⩾0 (8.5.16)
σ T −t
of the riskless (savings) account.
As noted above, the result of Proposition 8.13 recovers (7.2.8) which is obtained by a direct
differentiation of the Black-Scholes function as in (7.1.3) or (8.5.14).
Markovian semi-groups
For completeness, we provide the definition of Markovian semi-groups which can be used to
reformulate the proofs of this section.

Definition 8.14 The Markov semi-group (Pt )0⩽t⩽T associated to (St )t∈[0,T ] is the mapping Pt
defined on functions f ∈ Cb2 (R) as

Pt f (x) := IE∗ [ f (St ) | S0 = x], t ⩾ 0.

By the Markov property and time homogeneity of (St )t∈[0,T ] we also have

Pt f (Su ) := IE∗ [ f (St +u ) | Fu ] = IE∗ [ f (St +u ) | Su ], t, u ⩾ 0,

and the semi-group (Pt )0⩽t⩽T satisfies the composition property

Ps Pt = Pt Ps = Ps+t = Pt +s , s,t ⩾ 0,

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 254 Chapter 8. Martingale Approach to Pricing and Hedging

as we have, using the Markov property and the tower property (11.6.8) of conditional expectations
as in (8.5.17),

Ps Pt f (x) = IE∗ [Pt f (Ss ) | S0 = x]

= IE∗ IE∗ [ f (St ) | S0 = y]y=Ss S0 = x
 

= IE∗ IE∗ [ f (St +s ) | Ss = y]y=Ss S0 = x

 

= IE∗ IE∗ [ f (St +s ) | Fs ] S0 = x

 

= IE∗ [ f (St +s ) | S0 = x]
= Pt +s f (x), s,t ⩾ 0.

Similarly, we can show that the process (PT −t f (St ))t∈[0,T ] is an Ft -martingale as in Example (i)
above, see (8.1.1), i.e.:

IE∗ [PT −t f (St ) | Fu ] = IE∗ IE∗ [ f (ST ) | Ft ] Fu

 

= IE∗ [ f (ST ) | Fu ]
= PT −u f (Su ), 0 ⩽ u ⩽ t ⩽ T, (8.5.17)

and we have

  
∗ ∗ St
Pt−u f (x) = IE [ f (St ) | Su = x] = IE f x , 0 ⩽ u ⩽ t. (8.5.18)
Su

Exercises

Exercise 8.1 (Bachelier, 1900 model, Exercise 7.1 continued). Consider a market made of a
riskless asset priced At = A0 with zero interest rate, t ⩾ 0, and a risky asset whose price modeled
by a standard Brownian motion as St = Bt , t ⩾ 0. Price the vanilla option with payoff C = (BT )2 ,
and recover the solution of the Black-Scholes PDE of Exercise 7.1.

Exercise 8.2 Given the price process (St )t∈R+ defined as the geometric Brownian motion
2 /2)t
St := S0 e σ Bt +(r−σ , t ⩾ 0,

price the option with payoff function φ (ST ) by writing e −rT IE∗ [φ (ST )] as an integral with respect
to the lognormal probability density function, see Exercise 6.1.

Exercise 8.3 (See Exercise 8.29). Consider an asset price (St )t∈R+ given by the stochastic
differential equation

dSt = rSt dt + σ St dBt , (8.5.19)

where (Bt )t∈R+ is a standard Brownian motion, with r ∈ R and σ > 0.

a) Find the stochastic differential equation satisfied by the power Stp t∈R of order p ∈ R of
+
(St )t∈R+ .
b) Using the Girsanov Theorem 8.3 and the discounting
Lemma 6.13, construct a probability
measure under which the discounted process e −rt Stp t∈R is a martingale.
+

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8.5 Hedging by the Martingale Method 255

Exercise 8.4 Consider an asset price process (St )t∈R+ which is a martingale under the risk-neutral
probability measure P∗ in a market with interest rate r = 0, and let φ be a convex payoff function.
Show that, for any two maturities T1 < T2 and p, q ∈ [0, 1] such that p + q = 1 we have

IE∗ [φ ( pST1 + qST2 )] ⩽ IE∗ [φ (ST2 )],

i.e. the price of the basket option with payoff φ ( pST1 + qST2 ) is upper bounded by the price of the
option with payoff φ (ST2 ).
Hints:
i) For φ a convex function we have φ ( px + qy) ⩽ pφ (x) + qφ (y) for any x, y ∈ R and p, q ∈
[0, 1] such that p + q = 1.
ii) Any convex function (φ (St ))t∈R+ of a martingale (St )t∈R+ is a submartingale.

Exercise 8.5 Consider an underlying asset price process (St )t∈R+ under a risk-neutral measure P∗
with risk-free interest rate r.
a) Does the European call option price C (K ) := e −rT IE∗ [(ST − K )+ ] increase or decrease with
the strike price K? Justify your answer.
b) Does the European put option price C (K ) := e −rT IE∗ [(K − ST )+ ] increase or decrease with
the strike price K? Justify your answer.

Exercise 8.6 Consider an underlying asset price process (St )t∈R+ under a risk-neutral measure P∗
with risk-free interest rate r.
a) Show that the price at time t of the European call option with strike price K and maturity T is

+
lower bounded by the positive part St − K e −(T −t )r of the corresponding forward contract
price, i.e. we have the model-free bound

+
e −(T −t )r IE∗ [(ST − K )+ | Ft ] ⩾ St − K e −(T −t )r , 0 ⩽ t ⩽ T .

b) Show that the price at time t of the European put option with strike price K and maturity T is
lower bounded by K e −(T −t )r − St , i.e. we have the model-free bound

+
e −(T −t )r IE∗ [(K − ST )+ | Ft ] ⩾ K e −(T −t )r − St , 0 ⩽ t ⩽ T .

Exercise 8.7 The following two graphs describe the payoff functions φ of bull spread and bear
spread options with payoff φ (SN ) on an underlying asset priced SN at maturity time N.

100 100

80 80

60 60

40 40

20 20

0 0
0 50 100 150 200 0 50 100 150 200
K1 x K2 K1 x K2
(i) Bull spread payoff. (ii) Bear spread payoff.
Figure 8.3: Payoff functions of bull spread and bear spread options.

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 256 Chapter 8. Martingale Approach to Pricing and Hedging

a) Show that in each case (i) and (ii) the corresponding option can be realized by purchasing
and/or short selling standard European call and put options with strike prices to be specified.
b) Price the bull spread option in cases (i) and (ii) using the Black-Scholes formula.

Hint: An option with payoff φ (ST ) is priced e −rT IE∗ [φ (ST )] at time 0. The payoff of the European
call (resp. put) option with strike price K is (ST − K )+ , resp. (K − ST )+ .

Exercise 8.8 Given two strike prices K1 < K2 , we consider a long box spread option realized as
the combination of four legs having the same maturity time N ⩾ 1:

• One long call with strike price K1 and payoff function (x − K1 )+ ,

• One short put with strike price K1 and payoff function −(K1 − x)+ ,
• One short call with strike price K2 and payoff function −(x − K2 )+ ,
• One long put with strike price K2 and payoff function (K2 − x)+ .

The risk-free interest rate is denoted by r ⩾ 0.

Short put at K1
Long put at K2
Short call at K2
Long call at K1

K1 x K2
Figure 8.4: Graphs of call/put payoff functions.

a) Find the payoff of the long box spread option in terms of K1 and K2 .
b) Price the long box spread option at times k = 0, 1, . . . , N using K1 , K2 and the interest rate r.
c) From Table 8.1 below, find a choice of strike prices K1 < K2 that can be used to build a long
box spread option on the Hang Seng Index (HSI).
d) Price the option built in part (c)) in index points, and then in HK$.

Hints.
i) The closing prices in Table 8.1 are warrant prices quoted in index points.
ii) Warrant prices are converted to option prices by multiplication by the number given in
the “Entitlement Ratio” column.
iii) The conversion from index points to HK$ is given in Table 8.2.
e) Would you buy the option priced in part (d)) ? Here we can take r = 0 for simplicity.

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8.5 Hedging by the Martingale Method 257

Table 8.1: Call and put options on the Hang Seng Index (HSI).

Table 8.2: Contract summary.

Exercise 8.9 Butterfly options. A long call butterfly option is designed to deliver a limited payoff
when the future volatility of the underlying asset is expected to be low. The payoff function of a
long call butterfly option is plotted in Figure 8.5, with K1 := 50 and K2 := 150.

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 258 Chapter 8. Martingale Approach to Pricing and Hedging

60
50
40
30
20
10
0
0 50 100 150 200
K1 SN K2
Figure 8.5: Long call butterfly payoff function.
a) Show that the long call butterfly option can be realized by purchasing and/or issuing standard
European call or put options with strike prices to be specified.
b) Price the long call butterfly option using the Black-Scholes formula.
c) Does the hedging strategy of the long call butterfly option involve holding or shorting the
underlying stock?
Hints: Recall that an option with payoff φ (SN ) is priced in discrete time as (1 + r )−N IE∗ [φ (SN )] at
time 0. The payoff of the European call (resp. put) option with strike price K is (SN − K )+ , resp.
(K − SN )+ .

Exercise 8.10 Forward contracts revisited. Consider a risky asset whose price St is given by
2
St = S0 e σ Bt +rt−σ t/2 , t ⩾ 0, where (Bt )t∈R+ is a standard Brownian motion. Consider a forward
contract with maturity T and payoff ST − κ.
a) Compute the price Ct of this claim at any time t ∈ [0, T ].

b) Compute a hedging strategy for the option with payoff ST − κ.

Exercise 8.11 Option pricing with dividends (Exercise 7.3 continued). Consider an underlying
asset price process (St )t∈R+ paying dividends at the continuous-time rate δ > 0, and modeled as

dSt = ( µ − δ )St dt + σ St dBt ,

where (Bt )t∈R+ is a standard Brownian motion.

a) Show that as in Lemma 6.14, if (ηt , ξt )t∈R+ is a portfolio strategy with value

Vt = ηt At + ξt St , t ⩾ 0,

where the dividend yield δ St per share is continuously reinvested in the portfolio, then the
discounted portfolio value Vet can be written as the stochastic integral
wt
Vet = Ve0 + ξu d Seu , t ⩾ 0,
0

b) Show that, as in Theorem 8.4, if (ξt , ηt )t∈[0,T ] hedges the claim payoff C, i.e. if VT = C, then
the arbitrage-free price of the claim payoff C is given by

πt (C ) = Vt = e −(T −t )r IE∗ [C | Ft ], 0 ⩽ t ⩽ T,

where IE∗ denotes expectation under a risk-neutral probability measure P∗ .

c) Compute the price at time t ∈ [0, T ] of a European call option in a market with dividend rate
δ by the martingale method.
d) Compute the Delta of the option.

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8.5 Hedging by the Martingale Method 259

Exercise 8.12 Forward start options (Rubinstein, 1991). A forward start European call option is an
option whose holder receives at time T1 (e.g. your birthday) the value of a standard European call
option at the money and with maturity T2 > T1 . Price this birthday present at any time t ∈ [0, T1 ],
i.e. compute the price

e −(T1 −t )r IE∗ e −(T2 −T1 )r IE∗ (ST2 − ST1 )+ FT1 Ft

   

at time t ∈ [0, T1 ], of the forward start European call option using the Black-Scholes formula
log(x/K ) + (r + σ 2 /2)(T − t )
 
Bl(x, K, σ , r, T − t ) = xΦ √
|σ | T − t
log(x/K ) + (r − σ 2 /2)(T − t )
 
−(T −t )r
−K e Φ √ ,
|σ | T − t
0 ⩽ t < T.

Exercise 8.13 Cliquet option. Let 0 = T0 < T1 < · · · < Tn denote a sequence of financial settlement
2
dates, and consider a risky asset priced as the geometric Brownian motion St = S0 e σ Bt +rt−σ t/2 ,
t ⩾ 0, where (Bt )t∈R+ is a standard Brownian motion under the risk-neutral measure P∗ . Compute
the price at time t = 0 of the cliquet option whose payoff consists in the sum of n payments
(STk /STk−1 − K )+ made at times Tk , k = 1, . . . , n. For this, use the Black-Scholes formula
log(S0 /κ ) + (r + σ 2 /2)T
 
−rT ∗
e IE [(ST − κ ) ] = S0 Φ
+
√
|σ | T
log(S0 /κ ) + (r − σ 2 /2)T
 
−rT
−κ e Φ √ , T > 0.
|σ | T

Exercise 8.14 Log contracts. (Exercise 7.10 continued). Consider the price process (St )t∈[0,T ]
given by
dSt
= rdt + σ dBt
St
and a riskless asset valued At = A0 e rt , t ∈ [0, T ], with r > 0. Compute the arbitrage-free price

C (t, St ) = e −(T −t )r IE∗ [log ST | Ft ],

at time t ∈ [0, T ], of the log contract with payoff log ST .

Exercise 8.15 Power option. (Exercise 7.5 continued). Consider the price process (St )t∈[0,T ] given
by
dSt
= rdt + σ dBt
St
and a riskless asset valued At = A0 e rt , t ∈ [0, T ], with r > 0. In this problem, (ηt , ξt )t∈[0,T ] denotes
a portfolio strategy with value

Vt = ηt At + ξt St , 0 ⩽ t ⩽ T.

a) Compute the arbitrage-free price

C (t, St ) = e −(T −t )r IE∗ |ST |2 Ft ,

 

at time t ∈ [0, T ], of the power option with payoff C = |ST |2 .

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 260 Chapter 8. Martingale Approach to Pricing and Hedging

b) Compute a self-financing hedging strategy (ηt , ξt )t∈[0,T ] hedging the claim payoff |ST |2 .

Exercise 8.16 (Bachelier, 1900 model, Exercise 7.12 continued).

a) Consider the solution (St )t∈R+ of the stochastic differential equation

dSt = αSt dt + σ dBt .

For which value αM of α is the discounted price process Set = e −rt St , 0 ⩽ t ⩽ T , a martingale
under P?
b) For each value of α, build a probability measure Pα under which the discounted price process
Set = e −rt St , 0 ⩽ t ⩽ T , is a martingale.
c) Compute the arbitrage-free price

C (t, St ) = e −(T −t )r IEα e ST Ft

 

at time t ∈ [0, T ] of the contingent claim with payoff exp(ST ), and recover the result of
Exercise 7.12.
d) Explicitly compute the portfolio strategy (ηt , ξt )t∈[0,T ] that hedges the contingent claim with
payoff exp(ST ).
e) Check that this strategy is self-financing.

Exercise 8.17 Compute the arbitrage-free price

C (t, St ) = e −(T −t )r IEα (ST )2 Ft

 

at time t ∈ [0, T ] of the power option with payoff (ST )2 in the framework of the Bachelier, 1900
model of Exercise 8.16.

Exercise 8.18 (Exercise 6.8 continued, see Proposition 4.1 in Carmona and Durrleman, 2003).
(1) (2)
Consider two assets whose prices St , St at time t ∈ [0, T ] follow the geometric Brownian
dynamics
(1) (1) (1) (1) (2) (2) (2) (2)
dSt= rSt dt + σ1 St dWt dSt = rSt dt + σ2 St dWt t ∈ [0, T ],
(1)
(2)

where Wt t∈[0,T ] , Wt t∈[0,T ] are two standard Brownian motions with correlation ρ ∈ [−1, 1]
(1) (2)
under a risk-neutral probability measure P∗ , with dWt • dWt = ρdt.
(2) (1)
Estimate the price e −rT IE∗ [(ST − K )+ ] of the spread option on ST := ST − ST with maturity
T > 0 and strike price K > 0 by matching the first two moments of ST to those of a Gaussian
random variable.

Exercise 8.19 (Exercise 7.2 continued). Price the option with vanilla payoff C = φ (ST ) using the
noncentral Chi square probability density function of the J. Cox, Ingersoll, and S.A. Ross, 1985
(CIR) model.

Exercise 8.20 Let (Bt )t∈R+ be a standard Brownian motion generating a filtration (Ft )t∈R+ .
Recall that for f ∈ C 2 (R+ × R), Itô’s formula for (Bt )t∈R+ reads
wt ∂ f
f (t, Bt ) = f (0, B0 ) + (s, Bs )ds
0 ∂s
wt ∂ f 1 w t ∂2 f
+ (s, Bs )dBs + (s, Bs )ds.
0 ∂x 2 0 ∂ x2

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8.5 Hedging by the Martingale Method 261
2
a) Let r ∈ R, σ > 0, f (x,t ) = e rt +σ x−σ t/2 , and St = f (t, Bt ). Compute d f (t, Bt ) by Itô’s
formula, and show that St solves the stochastic differential equation

dSt = rSt dt + σ St dBt ,

where r > 0 and σ > 0.

b) Show that
2
IE e σ BT Ft = e σ Bt +(T −t )σ /2 ,
 
0 ⩽ t ⩽ T.
Hint: Use the independence of increments of (Bt )t∈[0,T ] in the time splitting decomposition

BT = (Bt − B0 ) + (BT − Bt ),
2 2
and the Gaussian moment generating function IE e αX = e α η /2 when X ≃ N (0, η 2 ).
 

c) Show that the process (St )t∈R+ satisfies

IE[ST | Ft ] = e (T −t )r St , 0 ⩽ t ⩽ T.

d) Let C = ST − K denote the payoff of a forward contract with exercise price K and maturity T .
Compute the discounted expected payoff

Vt := e −(T −t )r IE[C | Ft ].

e) Find a self-financing portfolio strategy (ξt , ηt )t∈R+ such that

Vt = ξt St + ηt At , 0 ⩽ t ⩽ T,

where At = A0 e rt is the price of a riskless asset with fixed interest rate r > 0. Show that it
recovers the result of Exercise 7.7-(c)).
f) Show that the portfolio allocation (ξt , ηt )t∈[0,T ] found in Question (e)) hedges the payoff
C = ST − K at time T , i.e. show that VT = C.

Exercise 8.21 Binary options. Consider a price process (St )t∈R+ given by

dSt
= rdt + σ dBt , S0 = 1,
St

under the risk-neutral probability measure P∗ . A binary (or digital) call, resp. put, option is a
contract with maturity T , strike price K, and payoff
 
 $1 if ST ⩾ K,  $1 if ST ⩽ K,
Cd := resp. Pd :=
0 if ST < K, 0 if ST > K.
 

Recall that the prices πt (Cd ) and πt (Pd ) at time t of the binary call and put options are given by
the discounted expected payoffs

πt (Cd ) = e −(T −t )r IE[Cd | Ft ] and πt (Pd ) = e −(T −t )r IE[Pd | Ft ]. (8.5.20)

a) Show that the payoffs Cd and Pd can be rewritten as

Cd = 1[K,∞) (ST ) and Pd = 1[0,K ] (ST ).

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 262 Chapter 8. Martingale Approach to Pricing and Hedging

b) Using Relation (8.5.20), Question (a)), and the relation

IE 1[K,∞) (ST ) St = x = P∗ (ST ⩾ K | St = x),

 

show that the price πt (Cd ) is given by

πt (Cd ) = Cd (t, St ),

where Cd (t, x) is the function defined by

Cd (t, x) := e −(T −t )r P∗ (ST ⩾ K | St = x).

c) Using the results of Exercise 6.10-(d)) and of Question (b)), show that the price πt (Cd ) =
Cd (t, St ) of the binary call option is given by the function
− 2 /2)(T − t ) + log(x/K )

−(T −t )r ( r σ
Cd (t, x) = e Φ √
σ T −t
= e −(T −t )r Φ d− (T − t ) ,

where
(r − σ 2 /2)(T − t ) + log(St /K )
d− (T − t ) = √ .
σ T −t
d) Assume that the binary option holder is entitled to receive a “return amount” α ∈ [0, 1] in
case the underlying asset price ends out of the money at maturity. Compute the price at time
t ∈ [0, T ] of this modified contract.
e) Using Relation (8.5.20) and Question (a)), prove the call-put parity relation

πt (Cd ) + πt (Pd ) = e −(T −t )r , 0 ⩽ t ⩽ T. (8.5.21)

If needed, you may use the fact that P∗ (ST = K ) = 0.

f) Using the results of Questions (e)) and (c)), show that the price πt (Pd ) of the binary put
option is given as
πt (Pd ) = e −(T −t )r Φ − d− (T − t ) .

g) Using the result of Question (c)), compute the Delta

∂Cd
ξt := (t, St )
∂x
of the binary call option. Does the Black-Scholes hedging strategy of such a call option
involve short selling? Why?
h) Using the result of Question (f)), compute the Delta
∂ Pd
ξt := (t, St )
∂x
of the binary put option. Does the Black-Scholes hedging strategy of such a put option
involve short selling? Why?

Exercise 8.22 Computation of Greeks. Consider an underlying asset whose price (St )t∈R+ is
given by a stochastic differential equation of the form

dSt = rSt dt + σ (St )dBt ,

where σ (x) is a Lipschitz coefficient, and an option with payoff function φ and price

C (x, T ) = e −rT IE[φ (ST ) | S0 = x],

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.5 Hedging by the Martingale Method 263

where φ (x) is a twice continuously differentiable (C 2 ) function, with S0 = x. Using the Itô formula,
show that the sensitivity

∂
e −rT IE[φ (ST ) | S0 = x]


ThetaT =
∂T
of the option price with respect to maturity T can be expressed as

ThetaT = −r e −rT IE[φ (ST ) | S0 = x] + r e −rT IE St φ ′ (ST ) S0 = x

 

1
+ e −rT IE φ ′′ (ST )σ 2 (ST ) S0 = x .
 
2

Problem 8.23 Chooser options. In this problem we denote by C (t, St , K, T ), resp. P(t, St , K, T ),
the price at time t of the European call, resp. put, option with strike price K and maturity T , on
2
an underlying asset priced St = S0 e σ Bt +rt−σ t/2 , t ⩾ 0, where (Bt )t∈R+ is a standard Brownian
motion under the risk-neutral probability measure
a) Prove the call-put parity formula

C (t, St , K, T ) − P(t, St , K, T ) = St − K e −(T −t )r , 0 ⩽ t ⩽ T. (8.5.22)

b) Consider an option contract with maturity T , which entitles its holder to receive at time T
the value of the European put option with strike price K and maturity U > T .
Write down the price this contract at time t ∈ [0, T ] using a conditional expectation under the
risk-neutral probability measure P∗ .
c) Consider now an option contract with maturity T , which entitles its holder to receive at time
T either the value of a European call option or a European put option, whichever is higher.
The European call and put options have same strike price K and same maturity U > T .
Show that at maturity T , the payoff of this contract can be written as

P(T , ST , K,U ) + Max 0, ST − K e −(U−T )r .

Hint: Use the call-put parity formula (8.5.22).

d) Price the contract of Question (c)) at any time t ∈ [0, T ] using the call and put option pricing
functions C (t, x, K, T ) and P(t, x, K,U ).
e) Using the Black-Scholes formula, compute the self-financing hedging strategy (ξt , ηt )t∈[0,T ]
with portfolio value
Vt = ξt St + ηt e rt , 0 ⩽ t ⩽ T,
for the option contract of Question (c)).
f) Consider now an option contract with maturity T , which entitles its holder to receive at time
T the value of either a European call or a European put option, whichever is lower. The two
options have same strike price K and same maturity U > T .
Show that the payoff of this contract at maturity T can be written as

C (T , ST , K,U ) − Max 0, ST − K e −(U−T )r .

g) Price the contract of Question (f)) at any time t ∈ [0, T ].

h) Using the Black-Scholes formula, compute the self-financing hedging strategy (ξt , ηt )t∈[0,T ]
with portfolio value
Vt = ξt St + ηt e rt , 0 ⩽ t ⩽ T,
for the option contract of Question (f)).

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 264 Chapter 8. Martingale Approach to Pricing and Hedging

i) Give the price and hedging strategy of the contract that yields the sum of the payoffs of
Questions (c)) and (f)).
j) What happens when U = T ? Give the payoffs of the contracts of Questions (c)), (f)) and (i)).

Problem 8.24 (Peng, 2010). Consider a risky asset priced

2 t/2
St = S0 e σ Bt +µt−σ , i.e. dSt = µSt dt + σ St dBt , t ⩾ 0,

a riskless asset valued At = A0 e rt , and a self-financing portfolio allocation (ηt , ξt )t∈R+ with value

Vt := ηt At + ξt St , t ⩾ 0.

a) Using the portfolio self-financing condition dVt = ηt dAt + ξt dSt , show that we have
wT wT
VT = Vt + (rVs + ( µ − r )ξs Ss )ds + σ ξs Ss dBs .
t t

b) Show that under the risk-neutral probability measure P∗ the portfolio value Vt satisfies the
Backward Stochastic Differential Equation (BSDE)
wT wT
Vt = VT − rVs ds − πs d Bbs , (8.5.23)
t t

where πt := σ ξt St is the risky amount invested on the asset St , multiplied by σ , and (Bbt )t∈R+
is a standard Brownian motion under P∗ .
Hint: the Girsanov Theorem 8.3 states that
( µ − r )t
Bbt := Bt + , t ⩾ 0,
σ
is a standard Brownian motion under P∗ .
c) Show that under the risk-neutral probability measure P∗ , the discounted portfolio value
Vet := e −rt Vt can be rewritten as
wT
VeT = Ve0 + e −rs πs d Bbs . (8.5.24)
0

d) Express dv(t, St ) by the Itô formula, where v(t, x) is a C 2 function of t and x.

e) Consider now a more general BSDE of the form
wT wT
Vt = VT − f (s, Ss ,Vs , πs )ds − πs dBs , (8.5.25)
t t

with terminal condition VT = g(ST ). By matching (8.5.25) to the Itô formula of Question (d)),
find the PDE satisfied by the function v(t, x) defined as Vt = v(t, St ).
f) Show that when
µ −r
f (t, x, v, z) = rv + z,
σ
the PDE of Question (e)) recovers the standard Black-Scholes PDE.
µ −r
g) Assuming again f (t, x, v, z) = rv + z and taking the terminal condition
σ
2 /2)T
VT = (S0 e σ BT +(µ−σ − K )+ ,

give the process (πt )t∈[0,T ] appearing in the stochastic integral representation (8.5.24) of the
2 /2)T
discounted claim payoff e −rT (S0 e σ BT +(µ−σ − K )+ .*
* General Black-Scholes knowledge can be used for this question.

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8.5 Hedging by the Martingale Method 265

h) From now on we assume that short selling is penalized* at a rate γ > 0, i.e. γSt |ξt |dt
is subtracted from the portfolio value change dVt whenever ξt < 0 over the time interval
[t,t + dt ]. Rewrite the self-financing condition using (ξt )− := − min(ξt , 0).
i) Find the BSDE of the form (8.5.25) satisfied by (Vt )t∈R+ , and the corresponding function
f (t, x, v, z).
j) Under the above penalty on short selling, find the PDE satisfied by the function u(t, x) when
the portfolio value Vt is given as Vt = u(t, St ).
k) Differential interest rate. Assume that one can borrow only at a rate R which is higher† than
the risk-free interest rate r > 0, i.e. we have

dVt = Rηt At dt + ξt dSt

when ηt < 0, and

dVt = rηt At dt + ξt dSt

when ηt > 0. Find the PDE satisfied by the function u(t, x) when the portfolio value Vt is
given as Vt = u(t, St ).
l) Assume that the portfolio differential reads

dVt = ηt dAt + ξt dSt − dUt ,

where (Ut )t∈R+ is a non-decreasing process. Show that the corresponding portfolio strategy
(ξt )t∈R+ is superhedging the claim payoff VT = C.

Exercise 8.25 Girsanov Theorem. Assume that the Novikov integrability condition (8.3.1) is not
satisfied. How does this modify the statement (8.3.3) of the Girsanov Theorem 8.3?

Problem 8.26 The Capital Asset Pricing Model (CAPM) of W.F. Sharpe (1990 Nobel Prize in
Economics) is based on a linear decomposition
 
dSt dMt
= (r + α )dt + β × − rdt
St Mt

of stock returns dSt /St into:

• a risk-free interest rate‡ r,
• an excess return α,
• a risk premium given by the difference between a benchmark market index return dMt /Mt
and the risk free rate r.
The coefficient β measures the sensitivity of the stock return dSt /St with respect to the market
index returns dMt /Mt . In other words, β is the relative volatility of dSt /St with respect to dMt /Mt ,
and it measures the risk of (St )t∈R+ in comparison to the market index (Mt )t∈R+ .
If β > 1, resp. β < 1, then the stock price St is more volatile (i.e. more risky), resp. less volatile
(i.e. less risky), than the benchmark market index Mt . For example, if β = 2, then St goes up (or
down) twice as much as the index Mt . Inverse Exchange-Traded Funds (IETFs) have a negative
value of β . On the other hand, a fund which has a β = 1 can track the index Mt .

* SGX started to penalize naked short sales with an interim measure in September 2008.
† Regular savings account usually pays r=0.05% per year. Effective Interest Rates (EIR) for borrowing could be as
high as R=20.61% per year.
‡ The risk-free interest rate r is typically the yield of the 10-year Treasury bond.

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 266 Chapter 8. Martingale Approach to Pricing and Hedging

Vanguard 500 Index Fund (VFINX) has a β = 1 and can be considered as replicating the
variations of the S&P 500 index Mt , while Invesco S&P 500 (SPHB) has a β = 1.42, and Xtrackers
Low Beta High Yield Bond ETF (HYDW) has a β close to 0.36 and α = 6.36.
In what follows, we assume that the benchmark market is represented by an index fund (Mt )t∈R+
whose value is modeled according to
dMt
= µdt + σM dBt , (8.5.26)
Mt
where (Bt )t∈R+ is a standard Brownian motion. The asset price (St )t∈R+ is modeled in a stochastic
version of the CAPM as
 
dSt dMt
= rdt + αdt + β − rdt + σS dWt , (8.5.27)
St Mt

with an additional stock volatility term σS dWt , where (Wt )t∈R+ is a standard Brownian motion
independent of (Bt )t∈R+ , with

Cov(Bt ,Wt ) = 0 and dBt • dWt = 0, t ⩾ 0.

The following 10 questions are interdependent and should be treated in sequence.

a) Show that β coincides with the regression coefficient

Cov(dSt /St , dMt /Mt )

β= .
Var[dMt /Mt ]
Hint: We have

Cov(dWt , dWt ) = dt, Cov(dBt , dBt ) = dt, and Cov(dWt , dBt ) = 0.

b) Show that the evolution of (St )t∈R+ can be written as

q
2 + σ 2 dZ
dSt = (r + α + β ( µ − r ))St dt + St β 2 σM S t

where (Zt )t∈R+ is a standard Brownian motion.

Hint: The standard Brownian motion (Zt )t∈R+ can be characterized as the only continuous
(local) martingale such that (dZt )2 = dt, see e.g. Theorem 7.36 page 203 of Klebaner, 2005.
From now on, we assume that β is allowed to depend locally on the state of the benchmark
market index Mt , as β (Mt ), t ⩾ 0.
c) Rewrite the equations (8.5.26)-(8.5.27) into the system
dMt


 = rdt + σM dBt∗ ,
 M

t

 dSt = rdt + σM β (Mt )dBt∗ + σS dWt∗ ,




St
where (Bt∗ )t∈R+ and (Wt∗ )t∈R+ have to be determined explicitly.
d) Using the Girsanov Theorem 8.3, construct a probability measure P∗ under which (Bt∗ )t∈R+
and (Wt∗ )t∈R+ are independent standard Brownian motions.
Hint: Only the expression of the Radon-Nikodym density dP∗ /dP is needed here.
e) Show that the market based on the assets St and Mt is without arbitrage opportunities.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.5 Hedging by the Martingale Method 267

f) Consider a portfolio strategy (ξt , ζt , ηt )t∈[0,T ] based on the three assets (St , Mt , At )t∈[0,T ] , with
value
Vt = ξt St + ζt Mt + ηt At , t ∈ [0, T ],

where (At )t∈R+ is a riskless asset given by At = A0 e rt . Write down the self-financing
condition for the portfolio strategy (ξt , ζt , ηt )t∈[0,T ] .
g) Consider an option with payoff C = h(ST , MT ), priced as

f (t, St , Mt ) = e −(T −t )r IE∗ [h(ST , MT ) | Ft ], 0 ⩽ t ⩽ T.

Assuming that the portfolio (Vt )t∈[0,T ] replicates the option price process ( f (t, St , Mt ))t∈[0,T ] ,
derive the pricing PDE satisfied by the function f (t, x, y) and its terminal condition.
Hint: The following version of the Itô formula with two variables can be used for the function
f (t, x, y), see (5.5.9):

∂f ∂f 1 ∂2 f
d f (t, St , Mt ) = (t, St , Mt )dt + (t, St , Mt )dSt + (dSt )2 2 (t, St , Mt )
∂t ∂x 2 ∂x
∂f 1 2
∂ f 2
∂ f
+ (t, St , Mt )dMt + (dMt )2 2 (t, St , Mt ) + dSt • dMt (t, St , Mt ).
∂y 2 ∂y ∂ x∂ y

h) Find the self-financing hedging portfolio strategy (ξt , ζt , ηt )t∈[0,T ] replicating the vanilla
payoff h(ST , MT ).
i) Solve the PDE of Question (g)) and compute the replicating portfolio of Question (h)) when
β (Mt ) = β is a constant and C is the European call option payoff on ST with strike price K.
j) Solve the PDE of Question (g)) and compute the replicating portfolio of Question (h)) when
β (Mt ) = β is a constant and C is the European put option payoff on ST with strike price K.

Problem 8.27 Market bubbles occur when a financial asset becomes overvalued for various reasons,
for example in the Dutch tulip bubble (1636-1637), Japan’s stock market bubble (1986), dotcom
bubble (2000), or US housing bubble (2009). Local martingales are used for the modeling of market
bubbles and market crashes, see A. Cox and Hobson, 2005, Heston, Loewenstein, and Willard,
2007, R.A. Jarrow, Protter, and Shimbo, 2007, in which case the option call-put parity does not
hold in general. In what follows we let T > 0 and we consider a filtration (Ft )t∈[0,T ] on [0, T ] with
F0 = {0,/ Ω} and a probability measure P on (Ω, FT ).
1. An (Ft )t∈[0,T ] -adapted process (Mt )t∈[0,T ] is called a (true) martingale on [0, T ] if
i) IE[|Mt |] < ∞ for all t ∈ [0, T ],
ii) IE[Mt | Fs ] = Ms , for all 0 ⩽ s ⩽ t.
2. An (Ft )t∈[0,T ] -adapted process (Mt )t∈[0,T ] is called a supermartingale on [0, T ] if
i) IE[|Mt |] < ∞ for all t ∈ [0, T ],
ii) IE[Mt | Fs ] ⩽ Ms , for all 0 ⩽ s ⩽ t.
3. An (Ft )t∈[0,T ] -adapted process (Mt )t∈[0,T ] is called a local martingale on [0, T ] if there exists
a nondecreasing sequence (τn )n⩾1 of [0, T ]-valued stopping times such that
i) limn→∞ τn = T almost surely,
ii) for all n ⩾ 1 the stopped process (Mτn ∧t )t∈[0,T ] is a (true) martingale under P.
4. A local martingale on [0, T ] which is not a true martingale is called a strict local martingale.
1) a) Show that any martingale (Mt )t∈[0,T ] on [0, T ] is a local martingale in [0, T ].
b) Show that any non-negative local martingale (Mt )t∈[0,T ] is a supermartingale.
Hint: Use Fatou’s lemma.

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 268 Chapter 8. Martingale Approach to Pricing and Hedging

c) Show that if (Mt )t∈[0,T ] is a non-negative and strict local martingale on [0, T ] we have
IE[MT ] < M0 .
Hint: Do the proof by contradiction using the tower property, the answer to Ques-
tion (b)), and the fact that if a random variable X satisfies X ⩽ 0 a.s. and IE[X ] = 0,
then X = 0 a.s..
d) Show that the call-put parity

C (0, M0 ) − P(0, M0 ) = IE[M0 ] − e −rT K

between C (0, M0 ) and P(0, M0 ) fails when the discounted asset price process (Mt )t∈[0,T ]
is a strict local martingale.
Hint: See Relation (8.8) in Proposition 8.4.9.
2) Let (St )t∈[0,T ] be the solution of the stochastic differential equation

St
dSt = √ dBt (8.5.28)
T −t

with S0 > 0.
a) Show that (St )t∈[0,T −ε ] is a martingale on [0, T − ε ] for every ε ∈ (0, T ).
Hint: Solve the stochastic differential equation (8.5.28) by the method of Proposi-
tion 6.16-a), and use Exercise 5.11-b).
b) Find the value of ST by a simple argument.
c) Show that (St )t∈[0,T ] is a strict local martingale on [0, T ].
Hint: Consider the stopping times
  
1
τn := 1− T ∧ inf{t ∈ [0, T ] : |St | ⩾ n}, n ⩾ 1,
n

and use Proposition 8.1.

d) Plot a sample graph of (St )t∈[0,T ] with T = 1, and attach or upload it with your submis-
sion.
3) CEV model. Consider the positive strict local martingale (St )t∈[0,T ] solution of dSt = St2 dBt
with S0 > 0, where St has the probability density function

(1/x − 1/S0 )2 (1/x + 1/S0 )2

    
S0
ϕt (x) = √ exp − − exp − ,
3
x 2πt 2t 2t

x > 0, t ∈ (0, T ], see § 2.1.2 in Jacquier, 2017.

a) Plot a sample graph of (St )t∈[0,T ] with T = 1, and attach or upload it with your submis-
sion.
b) Compute IE[ST ] and check that the condition of Question (c)) is satisfied.
Hint: Use the change of variable y = 1/x and the standard normal CDF Φ.
c) Compute the limit of IE[ST ] as S0 tends to infinity.
d) Compute the price IE[(ST − K )+ ] of a European call option with strike price K > 0 in
this model, assuming a risk-free interest rate r = 0.
Hint: The final answer should be written in terms of the standard normal CDF Φ and
of the normal PDF ϕ.
e) Show that IE[(ST − K )+ ] is bounded uniformly in S0 > 0 and K > 0 by a constant
depending on T > 0.

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8.5 Hedging by the Martingale Method 269

Problem 8.28 Quantile hedging (Föllmer and Leukert, 1999, §6.2 of Mel′ nikov, Volkov, and
Nechaev, 2002). Recall that given two probability measures P and Q, the Radon-Nikodym density
dP/dQ links the expectations of random variables F under P and under Q via the relation
w
IEQ [F ] = F (ω )dQ(ω )
Ω
w dQ
= F (ω ) (ω )dP(ω )
Ω dP
 
dQ
= IEP F .
dP

a) Neyman-Pearson Lemma. Given P and Q two probability measures, consider the event
 
dP
Aα := >α , α ⩾ 0.
dQ

Show that for A any event, Q(A) ⩽ Q(Aα ) implies P(A) ⩽ P(Aα ).
Hint: Start by proving that we always have
   
dP dP
− α (21Aα − 1) ⩾ − α (21A − 1). (8.5.29)
dQ dQ

b) Let C ⩾ 0 denote a nonnegative claim payoff on a financial market with risk-neutral measure
P∗ . Show that the Radon-Nikodym density

dQ∗ C
∗
:= (8.5.30)
dP IEP∗ [C ]

defines a probability measure Q∗ .

Hint: Check first that dQ∗ /dP∗ ⩾ 0, and then that Q∗ (Ω) = 1. In the following questions
we consider a nonnegative contingent claim with payoff C ⩾ 0 and maturity T > 0, priced
e −rT IEP∗ [C ] at time 0 under the risk-neutral measure P∗ .
Budget constraint. In what follows we will assume that no more than a certain fraction β ∈ (0, 1]
of the claim price e −rT IEP∗ [C ] is available to construct the initial hedging portfolio V0 at time 0.
Since a self-financing portfolio process (Vt )t∈R+ started at V0 := β e −rT IEP∗ [C ] may fall short
of hedging the claim C when β < 1, we will attempt to maximize the probability P(VT ⩾ C ) of
successful hedging, or, equivalently, to minimize the shortfall probability P(VT < C ).
For this, given A an event we consider the self-financing portfolio process (VtA )t∈[0,T ] hedging the
claim C1A , priced V0A = e −rT IEP∗ [C1A ] at time 0, and such that VTA = C1A at maturity T .
c) Show that if α satisfies Q∗ (Aα ) = β , the event

dQ∗
     
dP dP dP αC
Aα = >α = >α ∗ = >
dQ∗ dP∗ dP dP∗ IEP∗ [C ]

maximizes P(A) over all possible events A, under the condition

e −rT IEP∗ VTA = e −rT IEP∗ [C1A ] ⩽ β e −rT IEP∗ [C ].

 
(8.5.31)

Hint: Rewrite Condition (8.5.31) using the probability measure Q∗ , and apply the Neyman-
Pearson Lemma of Question (a)) to P and Q∗ .

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 270 Chapter 8. Martingale Approach to Pricing and Hedging

d) Show that P(Aα ) coincides with the successful hedging probability

P VTAα ⩾ C = P(C1Aα ⩾ C ),

i.e. show that

P(Aα ) = P VTAα ⩾ C = P(C1Aα ⩾ C ).

Hint: To prove an equality x = y we can show first that x ⩽ y, and then that x ⩾ y. One
inequality is obvious, and the other one follows from
Question (c)).
e) Check that the self-financing portfolio process VtAα t∈[0,T ] hedging the claim with payoff
C1Aα uses only the initial budget β e −rT IEP∗ [C ], and that P VTAα ⩾ C maximizes the

successful hedging probability.

In the next Questions (f))-(j)) we assume that C = (ST − K )+ is the payoff of a European option in
the Black-Scholes model

dSt = rSt dt + σ St dBt , (8.5.32)

with P = P∗ , dP/dP∗ = 1, and

σ2 1
S0 : = 1 and r= := . (8.5.33)
2 2
f) Solve the stochastic differential equation (8.5.32) with the parameters (8.5.33).
g) Compute the successful hedging probability

P VTAα ⩾ C = P(C1Aα ⩾ C ) = P(Aα )

for the claim C =: (ST − K )+ in terms of K, T , IEP∗ [C ] and the parameter α > 0.
h) From the result of Question (g)), express
the parameter α using K, T , IEP∗ [C ], and the
successful hedging probability P VTAα ⩾ C for the claim C =: (ST − K )+ .
i) Compute the minimal initial budget e −rT IEP∗ [C1Aα ] required to hedge the claim C = (ST −
K )+ in terms of α > 0, K, T and IEP∗ [C ].
j) Taking K := 1, T := 1 and assuming a successful hedging probability of 90%, compute
numerically:
i) The European call price e −rT IEP∗ [(ST − K )+ ] from the Black-Scholes formula.
ii) The value of α > 0 obtained from Question (h)).
iii) The minimal initial budget needed to successfully hedge the European claim C =
(ST − K )+ with probability 90% from Question (i)).
iv) The value of β , i.e. the budget reduction ratio which suffices to successfully hedge the
claim C =: (ST − K )+ with 90% probability.

Problem 8.29 (Leung and Sircar, 2015) ProShares Ultra S&P500 and ProShares UltraShort
S&P500 are leveraged investment funds that seek daily investment results, before fees and expenses,
that correspond to β times (β x) the daily performance of the S&P500,® with respectively β = 2 for
ProShares Ultra and β = −2 for ProShares UltraShort. Here, leveraging with a factor β : 1 aims at
multiplying the potential return of an investment by a factor β . The following ten questions are
interdependent and should be treated in sequence.
a) Consider a risky asset priced S0 := $4 at time t = 0 and taking two possible values S1 = $5
and S1 = $2 at time t = 1. Compute the two possible returns (in %) achieved when investing
$4 in one share of the asset S, and the expected return under the risk-neutral probability
measure, assuming that the risk-free interest rate is zero.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.5 Hedging by the Martingale Method 271

b) Leveraging. Still based on an initial $4 investment, we decide to leverage by a factor β = 3

by borrowing another (β − 1) × $4 = 2 × $4 at rate zero to purchase a total of β = 3 shares of
the asset S. Compute the two returns (in %) possibly achieved in this case, and the expected
return under the risk-neutral probability measure, assuming that the risk-free interest rate is
zero.
c) Denoting by Ft the ProShares value at time t, how much should the fund invest in the
underlying asset priced St , and how much $ should it borrow or save on the risk-free market
at any time t in order to leverage with a factor β : 1?
d) Find the portfolio allocation (ξt , ηt ) for the fund value

Ft = ξt St + ηt At , t ⩾ 0,

according to Question (c)), where At := A0 e rt is the riskless money market account.

e) We choose to model the S&P500 index St as the geometric Brownian motion

dSt = rSt dt + σ St dBt , t ⩾ 0,

under the risk-neutral probability measure P∗ . Find the stochastic differential equation
satisfied by (Ft )t∈R+ under the self-financing condition dFt = ξt dSt + ηt dAt , and show that
the discounted fund value is a martingale.
f) Is the discounted fund value ( e −rt Ft )t∈R+ a martingale under the risk-neutral probability
measure P∗ ?
g) Find the relation between the fund value Ft and the index St by solving the stochastic
β
differential equation obtained for Ft in Question (e)). For simplicity we normalize F0 := S0 .
h) Write the price at time t = 0 of the call option with claim payoff C = (FT − K )+ on the
ProShares index using the Black-Scholes formula.
i) Show that when β > 0, the Delta at time t ∈ [0, T ) of the call option with claim payoff
C = (FT − K )+ on ProShares Ultra is equal to the Delta of the call option with claim
payoff C = (ST − Kβ (t ))+ on the S&P500, for a certain strike price Kβ (t ) to be determined
explicitly.
j) When β < 0, find the relation between the Delta at time t ∈ [0, T ) of the call option with
claim payoff C = (FT − K )+ on ProShares UltraShort and the Delta of the put option with
claim payoff C = (Kβ (t ) − ST )+ on the S&P500.

Problem 8.30 Log options. Log options can be used for the pricing of realized variance swaps.
a) Consider a market model made of a risky asset with price (St )t∈R+ as in Exercise 5.22-(d))
and a riskless asset with price At = $1 × e rt and risk-free interest rate r = σ 2 /2. From the
answer to Exercise 5.22-(b)), show that the arbitrage-free price

Vt = e −(T −t )r IE (log ST )+ Ft
 

at time t ∈ [0, T ] of a log call option with payoff (log ST )+ is equal to

r
T − t −Bt2 /(2(T −t ))
 
−(T −t )r −(T −t )r Bt
Vt = σ e e +σ e Bt Φ √ .
2π T −t
b) Show that Vt can be written as
Vt = g(T − t, St ),
where g(τ, x) = e −rτ f (τ, log x), and
r  
τ −y2 /(2σ 2 τ ) y
f (τ, y) = σ e + yΦ √ .
2π σ τ

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 272 Chapter 8. Martingale Approach to Pricing and Hedging

c) Figure 8.6 represents the graph of (τ, x) 7→ g(τ, x), with r = 0.05 = 5% per year and σ = 0.1.
Assume that the current underlying asset price is $1 and there remains 700 days to maturity.
What is the price of the option?

0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
600
T-t 400
300
0 1.5 2
0.5 1 St

Figure 8.6: Option price as a function of underlying asset price and time to maturity.

∂g
d) Show* that the (possibly fractional) quantity ξt = (T − t, St ) of St at time t in a portfolio
∂x
hedging the payoff (log ST )+ is equal to
 
−(T −t )r 1 log St
ξt = e Φ √ , 0 ⩽ t ⩽ T.
St σ T −t

e) Figure 8.7 represents the graph of (τ, x) 7→ ∂∂ gx (τ, x). Assuming that the current underlying
asset price is $1 and that there remains 700 days to maturity, how much of the risky asset
should you hold in your portfolio in order to hedge one log option?

0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0 0
2 300 200 100
1.8 1.6 1.4 400
1.2 1 0.8 600 500 T-t
0.6 0.4 0.2 700
St

Figure 8.7: Delta as a function of underlying asset price and time to maturity.

f) Based on the framework and answers of Questions (c)) and (e)), should you borrow or lend
the riskless asset At = $1 × e rt , and for what amount?
∂ 2g
g) Show that the Gamma of the portfolio, defined as Γt = 2 (T − t, St ), equals
∂x
 !
1 1 2 2 log St
Γt = e −(T −t )r 2 p e −(log St ) /(2(T −t )σ ) − Φ √ ,
St σ 2(T − t )π σ T −t

0 ⩽ t < T.
∂ 1∂f
* Recall the chain rule of derivation f (τ, log x) = (τ, y)|y=log x .
∂x x ∂y

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.5 Hedging by the Martingale Method 273

h) Figure 8.8 represents the graph of Gamma. Assume that there remains 60 days to maturity
and that St , currently at $1, is expected to increase. Should you buy or (short) sell the
underlying asset in order to hedge the option?

0.8

0.6

0.4

0.2

0
180 200
-0.2 140 160
0.2 0.4 0.6 0.8 1 80 100 120 T-t
1.2 1.4 1.6 1.8 60
St

Figure 8.8: Gamma as a function of underlying asset price and time to maturity.

i) Let now σ = 1. Show that the function f (τ, y) of Question (b)) solves the heat equation

1 ∂2 f

∂f
(τ, y) = (τ, y)


2 ∂ y2

∂τ


f (0, y) = (y)+ .


Problem 8.31 Log put options with a given strike price.

a) Consider a market model made of a risky asset with price (St )t∈R+ as in Exercise 6.10, a
riskless asset valued At = $1 × e rt , risk-free interest rate r = σ 2 /2 and S0 = 1. From the
answer to Exercise A.4-(b)), show that the arbitrage-free price

Vt = e −(T −t )r IE∗ (K − log ST )+ Ft

 

at time t ∈ [0, T ] of a log call option with strike price K and payoff (K − log ST )+ is equal to

r
T − t −(Bt −K/σ )2 /(2(T −t )) K/σ − Bt
 
−(T −t )r −(T −t )r
Vt = σ e e +e (K − σ Bt )Φ √ .
2π T −t

b) Show that Vt can be written as

Vt = g(T − t, St ),

where g(τ, x) = e −rτ f (τ, log x), and

r
K −y
 
τ −(K−y)2 /(2σ 2 τ )
f (τ, y) = σ e + (K − y) Φ √ .
2π σ τ

c) Figure 8.9 represents the graph of (τ, x) 7→ g(τ, x), with r = 0.125 per year and σ = 0.5.
Assume that the current underlying asset price is $3, that K = 1, and that there remains 700
days to maturity. What is the price of the option?

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 274 Chapter 8. Martingale Approach to Pricing and Hedging

0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0 600 700
2.2 400 500
2.4 2.6 2.8 200 300
3 3.2 3.4 100 T-t
3.6 3.8 0
St

Figure 8.9: Option price as a function of underlying asset price and time to maturity.

∂g
d) Show* that the quantity ξt = (T − t, St ) of St at time t in a portfolio hedging the payoff
∂x
(K − log ST )+ is equal to

K − log St
 
−(T −t )r 1
ξt = − e Φ √ , 0 ⩽ t ⩽ T.
St σ T −t

e) Figure 8.10 represents the graph of (τ, x) 7→ ∂∂ gx (τ, x). Assuming that the current underlying
asset price is $3 and that there remains 700 days to maturity, how much of the risky asset
should you hold in your portfolio in order to hedge one log option?

-0.1

-0.2

-0.3

-0.4

-0.5 0
4 300 200 100
3.8 3.6 3.4 400
3.2 3 2.8 600 500 T-t
2.6 2.4 2.2 700
St

Figure 8.10: Delta as a function of underlying asset price and time to maturity.

f) Based on the framework and answers of Questions (c)) and (e)), should you borrow or lend
the riskless asset At = $1 × e rt , and for what amount?
∂ 2g
g) Show that the Gamma of the portfolio, defined as Γt = 2 (T − t, St ), equals
∂x

!
K − log St

1 1 )2 /(2(T −t )σ 2 )
Γt = e −(T −t )r 2 p e −(K−log St +Φ √ ,
St σ 2(T − t )π σ T −t

0 ⩽ t ⩽ T.
h) Figure 8.11 represents the graph of Gamma. Assume that there remains 10 days to maturity
and that St , currently at $3, is expected to increase. Should you buy or (short) sell the
underlying asset in order to hedge the option?

∂ 1∂f
* Recall the chain rule of derivation f (τ, log x) = (τ, y)|y=log x .
∂x x ∂y

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

8.5 Hedging by the Martingale Method 275

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
10 20
30 40 50 60 2.4 2.2
70 3 2.8 2.6
T-t 80 90 100 3.4 3.2
3.8 3.6
St

Figure 8.11: Gamma as a function of underlying asset price and time to maturity.

i) Show that the function f (τ, y) of Question (b)) solves the heat equation

σ2 ∂2 f

∂f
(τ, y) = (τ, y)


2 ∂ y2

∂τ


f (0, y) = (K − y)+ .


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 277

9. Volatility Estimation

Volatility estimation methods include historical, implied and local volatility, and the VIX® volatility
index. This chapter presents such estimation methods, together with examples of how the Black-
Scholes formula can be fitted to market data. While the market parameters r, t, St , T , and K used in
Black-Scholes option pricing can be easily obtained from market terms and data, the estimation of
volatility parameters can be a more complex task.

9.1 Historical Volatility 215

9.2 Implied Volatility 218
9.3 Local Volatility 225

9.4 The VIX® Index 230

Exercises 235

9.1 Historical Volatility

We consider the problem of estimating the parameters µ and σ from market data in the stock price
model

dSt
= µdt + σ dBt . (9.1.1)
St

Historical trend estimation

By discretization of (9.1.1) along a family t0 ,t1 , . . . ,tN of observation times as

Stk+1 − Stk
= (tk+1 − tk ) µ + (Btk+1 − Btk )σ , k = 0, 1, . . . , N − 1, (9.1.2)
Stk

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 278 Chapter 9. Volatility Estimation

a natural estimator for the trend parameter µ can be constructed as

!
1 N−1 1 StMk+1 − StMk
bN := , (9.1.3)
N k∑
µ
=0 tk+1 − tk StMk

where (StMk+1 − StMk )/StMk , k = 0, 1, . . . , N − 1 denotes market returns observed at discrete times
t0 ,t1 , . . . ,tN .

Historical log-return estimation

Alternatively, observe that, replacing* (9.1.3) by the log-returns
Stk+1
log = log Stk+1 − log Stk
Stk
Stk+1 − Stk
 
= log 1 +
Stk
Stk+1 − Stk
≃ ,
Stk

with tk+1 − tk = T /N, k = 0, 1, . . . , N − 1, one can replace (9.1.3) with the simpler telescoping
estimate
1 N−1 1 1 ST
∑ (log Stk+1 − log Stk ) = log .
N k=0 tk+1 − tk T S0

Historical volatility estimation

The volatility parameter σ can be estimated by writing, from (9.1.2),
2
(Btk+1 − Btk )2 N−1
N−1 Stk+1 − Stk

2 1
σ ∑ = ∑ − (tk+1 − tk ) µ ,
k =0 tk+1 − tk k=0 tk+1 − tk Stk

which yields the (unbiased) realized variance estimator

2
1 N−1 Stk+1 − Stk

1
bN2 := − (tk+1 − tk ) µ .
N − 1 k∑
σ bN
= 0 k + 1 − tk
t Stk

library(quantmod)
getSymbols("0005.HK",from="2017-02-15",to=Sys.Date(),src="yahoo")
stock=Ad(`0005.HK`)
chartSeries(stock,up.col="blue",theme="white")

stock=Ad(`0005.HK`);logreturns=diff(log(stock));returns=(stock-lag(stock))/lag(stock)
times=index(returns);returns <- as.vector(returns)
n = sum(is.na(returns))+sum(!is.na(returns))
plot(times,returns,pch=19,cex=0.05,col="blue", ylab="returns", xlab="n", main = '')
segments(x0 = times, x1 = times, cex=0.05,y0 = 0, y1 = returns,col="blue")
abline(seq(1,n),0,FALSE);dt=1.0/365;mu=mean(returns,na.rm=TRUE)/dt
sigma=sd(returns,na.rm=TRUE)/sqrt(dt);mu;sigma

* This approximation does not include the correction term (dSt )2 /(2St2 ) in the Itô formula d log St = dSt /St −
(dSt )2 /(2St2 ).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

9.1 Historical Volatility 279

stock [2017−02−15/2017−03−31]

0.02
●

Last 63.3

67
●
●
●

●
●

● ●

0.00
●

66 ● ● ●

● ● ●

●
●

●
●

● ●

●
●

returns
65 ●

−0.02
64

−0.04
63

Feb 15 Feb 27 Mar 06 Mar 13 Mar 20 Mar 27 Mar 31 ●

2017 2017 2017 2017 2017 2017 2017

Feb 15 Mar 01 Mar 15 Apr 01

n
(a) Underlying asset price. (b) Log-returns.

Figure 9.1: Graph of underlying asset price vs. log-returns.

library(PerformanceAnalytics);
returns <- exp(CalculateReturns(stock,method="compound")) - 1; returns[1,] <- 0
histvol <- rollapply(returns, width = 30, FUN=sd.annualized)
myPars <- chart_pars();myPars$cex<-1.4
myTheme <- chart_theme(); myTheme$col$line.col <- "blue"
dev.new(width=16,height=7)
chart_Series(stock,name="0005.HK",pars=myPars,theme=myTheme)
add_TA(histvol, name="Historical Volatility")

The next Figure 9.2 presents a historical volatility graph with a 30 days rolling window.

0005.HK 2017−02−15 / 2021−05−28

70 70

65 65

60 60

55 55

50 50

45 45

40 40

35 35

30 30
0.5 Historical Volatility 0.2402 0.5
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
2017 2018 2019 2020 2021
0.0 0.0
Feb 15 Aug 01 Feb 01 Aug 01 Feb 01 Aug 01 Feb 03 Aug 03 Jan 29
2017 2017 2018 2018 2019 2019 2020 2020 2021

Figure 9.2: Historical volatility graph.

Parameter estimation based on historical data usually requires a lot of samples and it can only be
valid on a given time interval, or as a moving average. Moreover, it can only rely on past data,
which may not reflect future data.

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 280 Chapter 9. Volatility Estimation

Figure 9.3: “The fugazi: it’s a wazy, it’s a woozie. It’s fairy dust.”*

9.2 Implied Volatility

Recall that when h(x) = (x − K )+ , the solution of the Black-Scholes PDE is given by

Bl(t, x, K, σ , r, T ) = xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

where
1 w x −y2 /2
Φ (x ) = √ e dy, x ∈ R,
2π −∞

and
log(x/K ) + (r + σ 2 /2)(T − t )

d ( T − t ) = √ ,

 +

σ T −t



log(x/K ) + (r − σ 2 /2)(T − t )


 d− ( T − t ) = √

 .
σ T −t

In contrast with the historical volatility, the computation of the implied volatility can be done at a
fixed time and requires much less data. Equating the Black-Scholes formula

Bl(t, St , K, σ , r, T ) = M (9.2.1)

to the observed value M of a given market price allows one to infer a value of σ when t, St , r, T are
known, as in e.g. Figure 7.23.

* Scorsese, 2013 Click on the figure to play the video (works in Acrobat Reader on the entire pdf file).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

9.2 Implied Volatility 281
0.6
Market price

0.5

0.4
Option price

0.3

0.2

0.1

0 σ
0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 imp 1.4 1.5
σ

Figure 9.4: Option price as a function of the volatility σ .

This value of σ is called the implied volatility, and it is denoted here by σimp (K, T ), cf. e.g.
Exercise 7.6. Various algorithms can be implemented to solve (9.2.1) numerically for σimp (K, T ),
such as the bisection method and the Newton-Raphson method.*

BS <- function(S, K, T, r, sig){d1 <- (log(S/K) + (r + sig^2/2)*T) / (sig*sqrt(T))

d2 <- d1 - sig*sqrt(T);return(S*pnorm(d1) - K*exp(-r*T)*pnorm(d2))}
implied.vol <- function(S, K, T, r, market){
sig <- 0.20;sig.up <- 10;sig.down <- 0.0001;count <- 0;err <- BS(S, K, T, r, sig) - market
while(abs(err) > 0.00001 && count<1000){
if(err < 0){sig.down <- sig;sig <- (sig.up + sig)/2} else{sig.up <- sig;sig <- (sig.down + sig)/2}
err <- BS(S, K, T, r, sig) - market;count <- count + 1};if(count==1000){return(NA)}else{return(sig)}}
market = 0.83;K = 62.8;T = 7 / 365.0;S = 63.4;r = 0.02; implied.vol(S, K, T, r, market)
BS(S, K, T, r, implied.vol(S, K, T, r, market))

The implied volatility value can be used as an alternative way to quote the option price, based
on the knowledge of the remaining parameters (such as underlying asset price, time to maturity,
interest rate, and strike price). For example, market option price data provided by the Hong Kong
stock exchange includes implied volatility computed by inverting the Black-Scholes formula, cf.
Figure S.28.

library(devtools); install_github("https://github.com/cran/fOptions")
library(fOptions)
market = 0.83;K = 62.8;T = 7 / 365.0;S = 63.4;r = 0.02
sig=GBSVolatility(market,"c",S,K,T,r,r,1e-4,maxiter = 10000)
BS(S, K, T, r, sig)

* Download the corresponding code or the IPython notebook that can be run here or here.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 282 Chapter 9. Volatility Estimation

Option chain data in

install.packages("quantmod");install.packages("jsonlite");
library(quantmod);library(jsonlite)
getSymbols("^GSPC",src="yahoo",from=as.Date("2018-01-01"), to = as.Date("2018-03-01"))
head(GSPC)
# Only the front-month expiry
SPX.OPT <- getOptionChain("^SPX")
AAPL.OPT <- getOptionChain("AAPL")
# All expiries
SPX.OPTS <- getOptionChain("^SPX", NULL)
AAPL.OPTS <- getOptionChain("AAPL", NULL)
# All 2021 to 2023 expiries
SPX.OPTS <- getOptionChain("^SPX", "2021/2023")
AAPL.OPTS <- getOptionChain("AAPL", "2021/2023")

Exporting option price data

write.table(AAPL.OPT$puts, file = "AAPLputs")

write.csv(AAPL.OPT$puts, file = "AAPLputs.csv")
install.packages("xlsx")
library(xlsx)
write.xlsx(AAPL.OPTS$Jun.19.2020$puts, file = "AAPL.OPTS$Jun.19.2020$puts.xlsx")

Volatility smiles

Given two European call options with strike prices K1 , resp. K2 , maturities T1 , resp. T2 , and prices
C1 , resp. C2 , on the same stock S, this procedure should yield two estimates σimp (K1 , T1 ) and
σimp (K2 , T2 ) of implied volatilities according to the following equations.


Bl(t, St , K1 , σimp (K1 , T1 ), r, T1 ) = M1 ,
 (9.2.2a)


Bl(t, St , K2 , σimp (K2 , T2 ), r, T2 ) = M2 , (9.2.2b)


Clearly, there is no reason a priori for the implied volatilities σimp (K1 , T1 ), σimp (K2 , T2 ) solutions
of (9.2.2a)-(9.2.2b) to coincide across different strike prices and different maturities. However, in
the standard Black-Scholes model the value of the parameter σ should be unique for a given stock
S. This contradiction between a model and market data is motivating the development of more
sophisticated stochastic volatility models.

Figure 9.5 presents an estimation of implied volatility surface for Asian options on light sweet
crude oil futures traded on the New York Mercantile Exchange (NYMEX), based on contract
specifications and market data obtained from the Chicago Mercantile Exchange (CME).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

9.2 Implied Volatility 283

0.6

0.55
Implied volatility

0.5

0.45

0.4

0.35

0.3

0.25
8000
9000
Strike price 10000 10
20
11000 Time to maturity
30

Figure 9.5: Implied volatility surface of Asian options on light sweet crude oil futures.*

As observed in Figure 9.5, the volatility surface can exhibit a smile phenomenon, in which implied
volatility is higher at a given end (or at both ends) of the range of strike price values.

install.packages("jsonlite");install.packages("lubridate")
library(jsonlite);library(lubridate);library(quantmod)
# Maturity to be updated as needed
maturity <- as.Date("2021-08-20", format="%Y-%m-%d")
CHAIN <- getOptionChain("GOOG",maturity)
today <- as.Date(Sys.Date(), format="%Y-%m-%d")
getSymbols("GOOG", src = "yahoo")
lastBusDay=last(row.names(as.data.frame(Ad(GOOG))))
T <- as.numeric(difftime(maturity, lastBusDay, units = "days")/365);r = 0.02;ImpVol<-1:1;
S=as.vector(tail(Ad(GOOG),1))
for (i in 1:length(CHAIN$calls$Strike)){ImpVol[i]<-implied.vol(S,CHAIN$calls$Strike[i],T,r,
CHAIN$calls$Last[i])}
plot(CHAIN$calls$Strike[!is.na(ImpVol)], ImpVol[!is.na(ImpVol)], xlab = "Strike price", ylab = "Implied
volatility", lwd =3, type = "l", col = "blue")
fit4 <- lm(ImpVol[!is.na(ImpVol)]~poly(CHAIN$calls$Strike[!is.na(ImpVol)],4,raw=TRUE))
lines(CHAIN$calls$Strike[!is.na(ImpVol)], predict(fit4, data.frame(x=CHAIN$calls$Strike[!is.na(ImpVol)])),
col="red",lwd=2)

currentyear<-format(Sys.Date(), "%Y")
# Maturity to be updated as needed
maturity <- as.Date("2021-12-17", format="%Y-%m-%d")
CHAIN <- getOptionChain("^SPX",maturity)
# Last trading day (may require update)
today <- as.Date(Sys.Date(), format="%Y-%m-%d")
getSymbols("^SPX", src = "yahoo")
lastBusDay=last(row.names(as.data.frame(Ad(SPX))))
T <- as.numeric(difftime(maturity, lastBusDay, units = "days")/365);r = 0.02;ImpVol<-1:1;
S=as.vector(tail(Ad(SPX),1))
for (i in 1:length(CHAIN$calls$Strike)){ImpVol[i]<-implied.vol(S, CHAIN$calls$Strike[i], T, r,
CHAIN$calls$Last[i])}
plot(CHAIN$calls$Strike[!is.na(ImpVol)], ImpVol[!is.na(ImpVol)], xlab = "Strike price", ylab = "Implied
volatility", lwd =3, type = "l", col = "blue")
fit4 <- lm(ImpVol[!is.na(ImpVol)]~poly(CHAIN$calls$Strike[!is.na(ImpVol)],4,raw=TRUE))
lines(CHAIN$calls$Strike[!is.na(ImpVol)], predict(fit4, data.frame(x=CHAIN$calls$Strike[!is.na(ImpVol)])),
col="red",lwd=3)

*© Tan Yu Jia.

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 284 Chapter 9. Volatility Estimation

0.13
0.12
Implied volatility

0.11
0.10
0.09

2800 3000 3200 3400 3600 3800

Strike price

Figure 9.6: S&P500 option prices plotted against strike prices.

When reading option prices on the volatility scale, the smile phenomenon shows that the Black-
Scholes formula tends to underprice extreme events for which the underlying asset price ST is far
away from the strike price K. In that sense, the Black-Scholes formula, which is modeling asset
returns using Gaussian distribution tails, tends to underestimate the probability of extreme events.
Plotting the different values of the implied volatility σ as a function of K and T will yield a
three-dimensional plot called the volatility surface.*

Black-Scholes Formula vs. Market Data

On July 28, 2009 a call warrant has been issued by Merrill Lynch on the stock price S of Cheung
Kong Holdings (0001.HK) with strike price K=$109.99, Maturity T = December 13, 2010, and
entitlement ratio 100, cf. page 8.

Figure 9.7: Graph of the (market) stock price of Cheung Kong Holdings.

The market price of the option (17838.HK) on September 28 was $12.30, as obtained from
* Download the corresponding IPython notebook that can be run here or here (© Qu Mengyuan).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

9.2 Implied Volatility 285

https://www.hkex.com.hk/eng/dwrc/search/listsearch.asp.

The next graph in Figure 9.8a shows the evolution of the market price of the option over time. One
sees that the option price is much more volatile than the underlying asset price.
0.2
Black-Scholes price

0.18

0.16

HK$
0.14

0.12

0.1
Jul17 Aug06 Aug26 Sep15

(a) Graph of (market) option prices. (b) Graph of Black-Scholes prices.

Figure 9.8: Comparison of market option prices vs. calibrated Black-Scholes prices.

In Figure 9.8b we have fitted the time evolution t 7→ gc (t, St ) of Black-Scholes prices to the data of
Figure 9.8a using the market stock price data of Figure 9.7, by varying the values of the volatility
σ.

Another example

Let us consider the stock price of HSBC Holdings (0005.HK) over one year:

Figure 9.9: Graph of the (market) stock price of HSBC Holdings.

Next, we consider the graph of the price of the call option issued by Societe Generale on 31
December 2008 with strike price K=$63.704, maturity T = October 05, 2009, and entitlement ratio
100, cf. page 8.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 286 Chapter 9. Volatility Estimation
0.3
Black-Scholes price

0.2

HK$
0.1

0
Nov 08 Jan 09 Mar 09 May 09 Jul 09 Sep 09

(a) Graph of (market) option prices. (b) Graph of Black-Scholes prices.

Figure 9.10: Comparison of market option prices vs. calibrated Black-Scholes prices.
As above, in Figure 9.10b we have fitted the path t 7−→ gc (t, St ) of the Black-Scholes option price
to the data of Figure 9.10a using the stock price data of Figure 9.9.
In this case the option is in the money at maturity. We can also check that the option is worth
100 × 0.2650 = $26.650 at that time, which, according to absence of arbitrage, is quite close to the
actual value $90 - $63.703 = $26.296 of its payoff.

For one more example, consider the graph of the price of a put option issued by BNP Paribas on 04
November 2008 on the underlying asset HSBC, with strike price K=$77.667, maturity T = October
05, 2009, and entitlement ratio 92.593, cf. page 8.
0.5
Black-Scholes price

0.4

0.3
HK$

0.2

0.1

0
Nov 08 Jan 09 Mar 09 May 09 Jul 09 Sep 09

(a) Graph of (market) option prices. (b) Graph of Black-Scholes prices.

Figure 9.11: Comparison of market option prices vs. calibrated Black-Scholes prices.
One checks easily that at maturity, the price of the put option is worth $0.01 (a market price
cannot be lower), which almost equals the option payoff $0, by absence of arbitrage opportunities.
Figure 9.11b is a fit of the Black-Scholes put price graph

t 7−→ gp (t, St )

to Figure 9.11a as a function of the stock price data of Figure 9.10b. Note that the Black-Scholes
price at maturity is strictly equal to 0 while the corresponding market price cannot be lower than
one cent.

The normalized market data graph in Figure 9.12 shows how the option price can track the values of
the underlying asset price. Note that the range of values [26.55, 26.90] for the underlying asset price
corresponds to [0.675, 0.715] for the option price, meaning 1.36% vs. 5.9% in percentage. This is a
European call option on the ALSTOM underlying asset with strike price K = €20, maturity March
20, 2015, and entitlement ratio 10, cf. page 8.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

 9.3 Local Volatility 287

Figure 9.12: Call option price vs. underlying asset price.

9.3 Local Volatility

As the constant volatility assumption in the Black-Scholes model does not appear to be satisfactory
due to the existence of volatility smiles, it can make more sense to consider models of the form

dSt
= rdt + σt dBt
St

where σt is a random process. Such models are called stochastic volatility models.

A particular class of stochastic volatility models can be written as

dSt
= rdt + σ (t, St )dBt (9.3.1)
St

where σ (t, x) ⩾ 0 is a deterministic function of time t and of the underlying asset price x. Such
models are called local volatility models.

As an example, consider the stochastic differential equation with local volatility

dYt = rdt + σYt2 dBt , (9.3.2)

where σ > 0, see also Problem 8.27.

dev.new(width=16,height=7)
N=10000; t <- 0:(N-1); dt <- 1.0/N;r=0.5;sigma=1.2;
Z <- rnorm(N,mean=0,sd=sqrt(dt));Y <- rep(0,N);Y[1]=1
for (j in 2:N){ Y[j]=max(0,Y[j-1]+r*Y[j-1]*dt+sigma*Y[j-1]**2*Z[j])}
plot(t*dt, Y, xlab = "t", ylab = "", type = "l", col = "blue", xaxs='i', yaxs='i', cex.lab=2,
cex.axis=1.6,las=1)
abline(h=0)

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 288 Chapter 9. Volatility Estimation

3.0

2.5

2.0

1.5

1.0

0.0 0.2 0.4 0.6 0.8

t

Figure 9.13: Simulated path of (9.3.2) with r = 0.5 and σ = 1.2.

In the general case, the corresponding Black-Scholes PDE for the option prices
g(t, x, K ) := e −(T −t )r IE (ST − K )+ St = x ,
 
(9.3.3)
where (St )t∈R+ is defined by (9.3.1), can be written as

∂g ∂g 1 ∂ 2g
 rg(t, x, K ) = (t, x, K ) + rx (t, x, K ) + x2 σ 2 (t, x) 2 (t, x, K ),


∂t ∂x 2 ∂x (9.3.4)

g(T , x, K ) = (x − K )+ ,



with terminal condition g(T , x, K ) = (x − K )+ , i.e. we consider European call options.

Lemma 9.1 (Relation (1) in Breeden and Litzenberger, 1978). Consider a family (CM (T , K ))T ,K>0
of market call option prices with maturities T and strike prices K given at time 0. Then, the
probability density function ϕT (y) of ST is given by

∂ 2CM
ϕT (K ) = e rT (T , K ), K, T > 0. (9.3.5)
∂ K2

Proof. Assume that the market option prices CM (T , K ) match the Black-Scholes prices e −rT IE[(ST −
K )+ ], K > 0. Letting ϕT (y) denote the probability density function of ST , Condition (9.3.8) can be
written at time t = 0 as

C M (T , K ) = e −rT IE[(ST − K )+ ]
w∞
= e −rT (y − K )+ ϕT (y)dy
0
w∞
= e −rT (y − K )ϕT (y)dy
wK∞ w∞
= e −rT yϕT (y)dy − K e −rT ϕT (y)dy (9.3.6)
wK∞ K

= e −rT yϕT (y)dy − K e −rT P(ST ⩾ K ).

K
By differentiation of (9.3.6) with respect to K, one gets
∂CM w∞
(T , K ) = − e −rT KϕT (K ) − e −rT ϕT (y)dy + e −rT KϕT (K )
∂K w∞ K

= − e −rT ϕT (y)dy,
K
which yields (9.3.5) by twice differentiation of CM (T , K ) with respect to K. □

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

9.3 Local Volatility 289

In order to implement a stochastic volatility model such as (9.3.1), it is important to first calibrate
the local volatility function σ (t, x) to market data.
In principle, the Black-Scholes PDE (9.3.4) could allow one to recover the value of σ (t, x) as a
function of the option price g(t, x, K ), as
v
∂g ∂g
u
u 2rg(t, x, K ) − 2 (t, x, K ) − 2rx (t, x, K )
u
σ (t, x) = u
u ∂t ∂x , x,t > 0,
∂ 2g
2
t
x (t, x, K )
∂ x2
however, this formula requires the knowledge of the option price for different values of the
underlying asset price x, in addition to the knowledge of the strike price K.
The Dupire, 1994 formula brings a solution to the local volatility calibration problem by
providing an estimator of σ (t, x) as a function σ (t, K ) based on the values of the strike price K.

Proposition 9.2 (Dupire, 1994, Derman and Kani, 1994) Consider a family (CM (T , K ))T ,K>0
of market call option prices at time 0 with maturity T and strike price K, and define the volatility
function σ (t, y) by

v s
u ∂CM ∂C M ∂CM ∂CM
u
2 (t, y ) + 2ry (t, y ) (t, y ) + ry (t, y)
u
u ∂t ∂y ∂t ∂y
σ (t, y) := u 2 M
= q , (9.3.7)
2∂ C y e −rT /2
( y ) /2
t
y (t, y) ϕt
∂ y2

where ϕt (y) denotes the probability density function of St , t ∈ [0, T ]. Then, the prices generated
from the Black-Scholes PDE (9.3.4) will be compatible with the market option prices CM (T , K )
in the sense that

CM (T , K ) = e −rT IE[(ST − K )+ ], K > 0. (9.3.8)

Proof. For any sufficiently smooth function f ∈ C0∞ (R), with limx→−∞ f (x) = limx→+∞ f (x) = 0,
using the Itô formula we have
w∞
f (y)ϕT (y)dy = IE[ f (ST )]
−∞
 wT wT
= IE f (S0 ) + r St f ′ (St )dt + St f ′ (St )σ (t, St )dBt
0 0

1 w T 2 ′′

2
+ S f (St )σ (t, St )dt
2 0 t
 w
1 w T 2 ′′

T
′ 2
= f (S0 ) + IE r St f (St )dt + S f (St )σ (t, St )dt
0 2 0 t
wT 1wT
= f ( S0 ) + r IE[St f ′ (St )]dt + IE[St2 f ′′ (St )σ 2 (t, St )]dt
0 2 0
w∞ wT
= f ( S0 ) + r y f ′ (y) ϕt (y)dtdy
−∞ 0
w
1 ∞ 2 ′′ w T
+ y f (y) σ 2 (t, y)ϕt (y)dtdy,
2 −∞ 0

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 290 Chapter 9. Volatility Estimation

hence, after differentiating both sides of the equality with respect to T ,

w∞ ∂ ϕT w∞ 1 w ∞ 2 ′′
f (y) (y)dy = r y f ′ (y)ϕT (y)dy + y f (y)σ 2 (T , y)ϕT (y)dy.
−∞ ∂T −∞ 2 −∞
Integrating by parts in the above relation yields
w ∞ ∂ϕ
T
(y) f (y)dy
−∞ ∂ T
w∞ ∂ 1w∞ ∂2
f (y) 2 y2 σ 2 (T , y)ϕT (y) dy,


= −r f (y) (yϕT (y))dy +
−∞ ∂y 2 −∞ ∂y

for all smooth functions f (y) with compact support in R, hence

∂ ϕT ∂ 1 ∂2 2 2
y ∈ R.


(y) = −r (yϕT (y)) + 2
y σ ( T , y ) ϕT ( y ) ,
∂T ∂y 2 ∂y
From Relation (9.3.5) in Lemma 9.1, we have

∂ ϕT ∂ 2CM ∂ 3CM
(K ) = r e rT 2
(T , K ) + e rT (T , K ),
∂T ∂K ∂ T ∂ K2
hence we get

∂ 2CM ∂ 3CM
−r ( T , y ) − (T , y)
∂ y2 ∂ T ∂ y2
 2 M
1 ∂2 ∂ 2CM
  
∂ ∂ C
=r y (T , y) − 2 2
y σ (T , y) (T , y) , y ∈ R.
∂y ∂ y2 2 ∂ y2 ∂ y2

After a first integration with respect to y under the boundary condition limy→+∞ CM (T , y) = 0, we
obtain
∂CM ∂ ∂CM
−r (T , y) − (T , y)
∂y ∂T ∂y
∂ 2CM ∂ 2CM
 
1 ∂ 2 2
= ry (T , y) − y σ (T , y) (T , y) ,
∂ y2 2 ∂y ∂ y2
i.e.
∂CM ∂ ∂CM
−r (T , y) − (T , y)
∂y ∂T ∂y
∂CM ∂CM ∂ 2CM
   
∂ 1 ∂ 2 2
= r y (T , y) − r (T , y) − y σ (T , y) (T , y) ,
∂y ∂y ∂y 2 ∂y ∂ y2
or
∂ ∂CM ∂CM ∂ 2CM
   
∂ 1 ∂ 2 2
− (T , y) = r y (T , y) − y σ (T , y) (T , y) .
∂y ∂T ∂y ∂y 2 ∂y ∂ y2
Integrating one more time with respect to y yields

∂CM ∂CM 1 ∂ 2CM

− (T , y) = ry (T , y) − y2 σ 2 (T , y) (T , y), y ∈ R, (9.3.9)
∂T ∂y 2 ∂ y2

which conducts to (9.3.7) and is called the Dupire, 1994 PDE. □

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

9.3 Local Volatility 291

Partial derivatives in time can be approximated using forward finite difference approximations as

∂C C (ti+1 , y j ) −C (ti , y j )
(ti , y j ) ≃ , (9.3.10)
∂t ∆t

or, using backward finite difference approximations, as

∂C C (ti , y j ) −C (ti−1 , y j )
(ti , y) ≃ . (9.3.11)
∂t ∆t

First order spatial derivatives can be approximated as

∂C C (ti , y j ) −C (ti , y j−1 ) ∂C C (ti , y j+1 ) −C (ti , y j )

(t, y j ) ≃ , (t, y j+1 ) ≃ . (9.3.12)
∂y ∆y ∂y ∆y

Reusing (9.3.12), second order spatial derivatives can be similarly approximated as

∂ 2C
 
1 ∂C ∂C
(ti , y j ) ≃ (ti , y j+1 ) − (ti , y j ) (9.3.13)
∂ y2 ∆y ∂ y ∂y
C (ti , y j+1 ) + C (ti , y j−1 ) − 2C (ti , y j )
≃ .
(∆y)2

Figure 9.14* presents an estimation of local volatility by the finite differences (9.3.10)-(9.3.13),
based on Boeing (NYSE:BA) option price data.
0.5

0.4

0.3

0.2

0.1

0
0.08
0.07
0.06
Time 0.05
0.04 124 122
128 126
0.03 132 130
136 134
Underlying S or Strike price K

Figure 9.14: Local volatility estimated from Boeing Co. option price data.

See Achdou and Pironneau, 2005 and in particular Figure 8.1 therein for numerical methods applied
to local volatility estimation using spline functions instead of the discretization (9.3.10)-(9.3.13).
See also Ackerer, Tagasovska, and Vatter, 2020, Chataigner et al., 2021 for deep learning approaches
to the estimation of local volatility.

The attached code† plots a local volatility estimate for a given stock.

Based on (9.3.7), the local volatility σ (t, y) can also be estimated by computing CM (T , y) from the
Black-Scholes formula, from a value of the implied volatility σ .

*© Yu Zhi Yu.
†© Abhishek Vijaykumar

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 292 Chapter 9. Volatility Estimation

Local volatility from put option prices

Note that by the call-put parity relation

CM (T , y) = PM (T , y) + x − y e −rT , y, T > 0,

where S0 = y, cf. (7.3.5), we have


∂CM ∂ PM
( T , y) = ry e −rT + (T , y),



 ∂T
 ∂T
 ∂ PM ∂CM
(T , y) = e −rT +

(T , y),



∂y ∂y

and
∂CM ∂CM ∂ PM ∂ PM
(T , y) + ry (T , y) = (T , y) + ry (T , y).
∂T ∂y ∂T ∂y
Consequently, the local volatility in Proposition 9.2 can be rewritten in terms of market put option
prices as
v s
u ∂ PM ∂P M ∂ PM ∂ PM
u2
u
(t, y) + 2ry (t, y) (t, y ) + ry (t, y)
u ∂t ∂y ∂t ∂y
σ (t, y) := u 2 M
= q ,
2∂ P y e −rT /2
( y ) /2
t
y (t, y) ϕt
∂ y2

which is formally identical to (9.3.7) after replacing market call option prices CM (T , K ) with
market put option prices PM (T , K ). In addition, we have the relation

∂ 2CM 2 M
rT ∂ P
ϕT (K ) = e rT ( T , y ) = e (T , y) (9.3.14)
∂ y2 ∂ y2

between the probability density function ϕT of ST and the call/put option pricing functions CM (T , y),
PM ( T , y ) .

9.4 The VIX® Index

Other ways to estimate market volatility include the CBOE Volatility Index® (VIX) for the S&P
500 Index (SPX). Let the asset price process (St )t∈R+ satisfy

dSt = rSt dt + σt St dBt ,

i.e. w
1wt 2

t
St = S0 exp σs dBs + rt − σ ds , t ⩾ 0,
0 2 0 s
where (σt )t∈R+ denotes a stochastic volatility process.
Lemma 9.3 Let φ ∈ C 2 ((0, ∞)). For all y > 0, we have the following version of the Taylor
formula:
wy w∞
φ (x ) = φ (y) + (x − y)φ ′ (y) + (z − x)+ φ ′′ (z)dz + (x − z)+ φ ′′ (z)dz,
0 y

x > 0.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

9.4 The VIX® Index 293

Proof. We use the Taylor formula with integral remainder:

w1
φ (x) = φ (y) + (x − y)φ ′ (y) + |x − y|2 (1 − τ )φ ′′ (τx + (1 − τ )y)dτ, x, y ∈ R.
0

Letting z = τx + (1 − τ )y = y + τ (x − y), if x ⩽ y we have

w1 w x z−y

′′
|x − y|2
(1 − τ )φ (τx + (1 − τ )y)dτ = |x − y| 1− φ ′′ (z)dz
0 y x−y
wx
= (x − z)φ ′′ (z)dz
y
w∞
= (x − z)+ φ ′′ (z)dz.
y

If x ⩾ y, we have
w1 w y y−z

|x − y|2 (1 − τ )φ ′′ (τx + (1 − τ )y)dτ = |y − x| 1− φ ′′ (z)dz
0 x y−x
wy
= (z − x)φ ′′ (z)dz
wxy
= (z − x)+ φ ′′ (z)dz.
0

□
The next Proposition 9.4, cf. Remark 5 in Friz and Gatheral, 2005 and page 4 of the CBOE white
paper, shows that the VIX® Volatility Index defined as
s
2 e rτ w Ft,t +τ P(t,t + τ, K ) w ∞ C (t,t + τ, K ) 

VIXt := dK + dK (9.4.1)
τ 0 K2 Ft,t +τ K2

at time t > 0 can be interpreted as an average of future volatility values, see also § 3.1.1 of
Papanicolaou and Sircar, 2014. Here, τ =30 days,

Ft,t +τ := IE∗ [St +τ | Ft ] = e rτ St

represents the future price on St +τ , and P(t,t + τ, K ), C (t,t + τ, K ) are OTM (Out-Of-the-Money)
call and put option prices with respect to Ft,t +τ , with strike price K and maturity t + τ.

Proposition 9.4 The value of the VIX® Volatility Index at time t ⩾ 0 is given from the averaged
realized variance swap price as
s
1 ∗ w t +τ 2
 
VIXt := IE σu du Ft .
τ t

Proof. We take t = 0 for simplicity. Applying Lemma 9.3 to the function

x x
φ (x ) = − 1 − log
y y

with φ ′ (x) = 1/y − 1/x and φ ′′ (x) = 1/x2 shows that

x x wy 1 w∞ 1
− 1 − log = (z − x)+ 2 dz + (x − z)+ 2 dz, x, y > 0.
y y 0 z y z

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 294 Chapter 9. Volatility Estimation

Alternatively, we can use the following relationships which are obtained by integration by parts:
wy dz wy dz
(z − x ) + = 1{x⩽y} (z − x ) 2
0 z2 w
x z
y dz w y dz 
= 1{x⩽y} −x
x z x z2
 
x y
= 1{x⩽y} − 1 + log ,
y x
and
w∞ dz wx dz
(x − z) + = 1{x⩾y} (x − z) 2
y z2 y
 w z
x dz w x dz 
= 1{x⩾y} x −
y z2 y z
 
x y
= 1{x⩾y} − 1 + log .
y x

Hence, taking y := F0,τ = e rτ S0 and x := Sτ , we have

Sτ F0,τ w F0,τ dK w ∞ dK
− 1 + log = ( K − Sτ ) + 2 + (Sτ − K )+ 2 . (9.4.2)
F0,τ Sτ 0 K F0,τ K

Next, taking expectations under P∗ on both sides of (9.4.2), we find

2 e rτ w F0,τ P(0, τ, K ) w ∞ C (0, τ, K ) 


2
VIX0 = dK + dK
τ 0 K2 F0,τ K2
2 w F0,τ ∗ dK 2 w ∞ ∗ dK
= IE [(K − Sτ )+ ] 2 + IE [(Sτ − K )+ ] 2
τ 0 K τ F0,τ K
w w 
2 ∗ F0,τ dK ∞ dK
= IE (K − Sτ )+ 2 + (Sτ − K )+ 2
τ 0 K F0,τ K
 
2 ∗ Sτ F0,τ
= IE − 1 + log
τ F0,τ Sτ
 ∗   
2 IE [Sτ ] 2 ∗ F0,τ
= − 1 + IE log
τ F0,τ τ Sτ
 
2 ∗ F0,τ
= IE log
τ Sτ
1 ∗ hw τ 2 i
= IE σt dt .
τ 0

□
The following code allows us to estimate the VIX® index based on the discretization of (9.4.1)
and market option prices on the S&P 500 Index (SPX). Here, the OTM put strike prices and call
strike prices are listed as
( p) ( p) ( p) (c) (c) (c)
K1 < · · · < Kn p −1 < Kn p := Ft,t +τ =: K0 < K1 < · · · < Knc ,

and (9.4.1) may for example be discretized as

2 e rτ w Ft,t +τ P(t,t + τ, K ) w ∞ C (t,t + τ, K ) 


VIXt2 = dK + dK
τ 0 K2 Ft,t +τ K2

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

9.4 The VIX® Index 295
n p −1 w ( p) nc w K (c)
!
2 e rτ Ki+1 P(t,t + τ, K ) i C (t,t + τ, K )
= ∑ Ki( p) dK + ∑ (c) dK
τ i=1 K2 i=1
Ki−1 K2
n p −1 w ( p) ( p)
nc w K (c) C t,t + τ, K (c)

!
2 e rτ Ki+1 P t,t + τ, Ki i i
≃ ∑ Ki( p) 2
dK + ∑ (c) 2
dK
τ i=1 K i=1
Ki−1 K
n p −1
!
2 e rτ ( p)
1 1
= ∑ P t,t + τ, Ki ( p)
− ( p)
τ i=1 Ki Ki+1
nc w K (c)
!!
i (c)
1 1
+ ∑ (c) C t,t + τ, Ki (c)
− (c) ,
Ki−1
i=1 Ki−1 Ki
see page 158 of Gatheral, 2006 for the implementation of the discretization of the CBOE white
paper.

library(quantmod)
today <- as.Date(Sys.Date(), format="%Y-%m-%d"); getSymbols("^SPX", src = "yahoo")
lastBusDay=last(row.names(as.data.frame(Ad(SPX))))
S0 = as.vector(tail(Ad(SPX),1)); T = 30/365;r=0.02;F0 = S0*exp(r*T)
maturity <- as.Date("2021-07-07", format="%Y-%m-%d") # Choose a maturity in 30 days
SPX.OPTS <- getOptionChain("^SPX", maturity)
Call <- as.data.frame(SPX.OPTS$calls);Put <- as.data.frame(SPX.OPTS$puts)
Call_OTM <- Call[Call$Strike>F0,];Put_OTM <-Put[Put$Strike<F0,];
Call_OTM$dif = c(1/F0-1/min(Call_OTM$Strike),-diff(1/Call_OTM$Strike))
Put_OTM$dif = c(-diff(1/Put_OTM$Strike),1/max(Put_OTM$Strike)-1/F0)
VIX_imp = 100*sqrt((2*exp(r*T)/T)*(sum(Put_OTM$Last*Put_OTM$dif)
+sum(Call_OTM$Last*Call_OTM$dif)))
getSymbols("^VIX", src = "yahoo", from = lastBusDay);VIX_market = as.vector(Ad(VIX)[1])
c("Estimated VIX"= VIX_imp, "CBOE VIX"=VIX_market)
VIX.OPTS <- getOptionChain("^VIX")

The following code is fetching VIX® index data using the quantmod package.

library(quantmod)
getSymbols("^GSPC",from="2000-01-01",to=Sys.Date(),src="yahoo")
getSymbols("^VIX",from="2000-01-01",to=Sys.Date(),src="yahoo")
dev.new(width=16,height=7); myPars <- chart_pars();myPars$cex<-1.4
myTheme <- chart_theme();myTheme$col$line.col <- "blue"
chart_Series(Ad(`GSPC`),name="S&P500",pars=myPars,theme=myTheme)
add_TA(Ad(`VIX`))

The impact of various world events can be identified on the VIX® index in Figure 9.15.

S&P500 2000−01−03 / 2021−04−30

4000 4000

3500 3500

3000 3000

2500 2500

2000 2000

1500 1500

1000 1000
100 100
VIX 18.61
80 80
60 60
40 40
20 20
0 0
Jan 03 Jul 02 Jan 02 Jul 01 Jan 03 Jul 02 Jan 02 Jul 01 Jan 03 Jul 01 Jan 02 Jul 01 Jan 02 Jul 01 Dec 31
2000 2001 2003 2004 2006 2007 2009 2010 2012 2013 2015 2016 2018 2019 2020

Figure 9.15: VIX® Index vs. S&P 500.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 296 Chapter 9. Volatility Estimation

library(quantmod);library(PerformanceAnalytics)
getSymbols("^GSPC",from="2000-01-01",to=Sys.Date(),src="yahoo")
getSymbols("^VIX",from="2000-01-01",to=Sys.Date(),src="yahoo");SP500=Ad(`GSPC`)
SP500.rtn <- exp(CalculateReturns(SP500,method="compound")) - 1;SP500.rtn[1,] <- 0
histvol <- rollapply(SP500.rtn, width = 30, FUN=sd.annualized)
dev.new(width=16,height=7)
myPars <- chart_pars();myPars$cex<-1.4
myTheme <- chart_theme();myTheme$col$line.col <- "blue"
chart_Series(SP500,name="SP500",theme=myTheme,pars=myPars)
add_TA(histvol, name="Historical Volatility");add_TA(Ad(`VIX`), name="VIX")

Figure 9.16 compares the VIX® index estimate to the historical volatility of Section 9.1.

SP500 2000−01−03 / 2021−04−30

4000 4000

3500 3500

3000 3000

2500 2500

2000 2000

1500 1500

1000 1000
1.0 1.0
Historical Volatility 0.10943
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
100 100
0.0 0.0
80 VIX 18.61 80
60 60
40 40
20 20
0 0

Jan 03 Jul 02 Jan 02 Jul 01 Jan 03 Jul 02 Jan 02 Jul 01 Jan 03 Jul 01 Jan 02 Jul 01 Jan 02 Jul 01 Dec 31
2000 2001 2003 2004 2006 2007 2009 2010 2012 2013 2015 2016 2018 2019 2020

Figure 9.16: VIX® Index vs. historical volatility for the year 2011.

We note that the variations of the stock index are negatively correlated to the variations of the VIX®
index, however the same cannot be said of the correlation to the variations of historical volatility.

−10 0 10 20 −0.05 0.00 0.05 0.10

100

100
GSPC.Adjusted GSPC.Adjusted
*** **
50

50
−0.80
Density

Density

−0.04
0

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20

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−100 −50 0 50 100 −100 −50 0 50 100

x x

(a) Underlying returns vs. the VIX® index. (b) Underlying returns vs. hist. volatility.

Figure 9.17: Correlation estimates between GSPC and the VIX® .

chart.Correlation(cbind(Ad(`GSPC`)-lag(Ad(`GSPC`)),Ad(`VIX`)-lag(Ad(`VIX`))), histogram=TRUE,
pch="+")
colnames(histvol) <- "HistVol"
chart.Correlation(cbind(Ad(`GSPC`)-lag(Ad(`GSPC`)),histvol-lag(histvol)), histogram=TRUE, pch="+")

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

9.4 The VIX® Index 297

The next Figure 9.18 shortens the time range to year 2011 and shows the increased reactivity of the
VIX® index to volatility spikes, in comparison with the moving average of historical volatility.

SP500 2011−01−03 / 2011−12−30

1360 1360
1340 1340
1320 1320
1300 1300
1280 1280
1260 1260
1240 1240
1220 1220
1200 1200
1180 1180
1160 1160
1140 1140
1120 1120
1100 1100
0.45 Historical Volatility 0.24002 0.45
0.40 0.40
0.35 0.35
0.30 0.30
0.25 0.25
0.20 0.20
0.15 0.15
0.10 0.10
50 VIX 23.4
0.05 50
0.05
45 45
40 40
35 35
30 30
25 25
20 20
15 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 15
10 10

Jan 03 Feb 01 Mar 01 Apr 01 May 02 Jun 01 Jul 01 Aug 01 Sep 01 Oct 03 Nov 01 Dec 01 Dec 30
2011 2011 2011 2011 2011 2011 2011 2011 2011 2011 2011 2011 2011

Figure 9.18: VIX® Index vs. 30 day historical volatility for the S&P 500.

Exercises
Exercise 9.1 We consider an entropy swap with discrete-time payoff
N N
1 Stk 1
∑ St k
log − κσ2 = ∑ St (log St k k
− log Stk−1 ) − κσ2 ,
T k =1 Stk−1 T k =1

approximated in continous time as

1 wT
St d log St − κσ2 ,
T 0
where κσ is the volatility level.
a) Show that for any K ∗ > 0 we have
wT wT wT St
St d log St = fK ∗ (ST ) − fK ∗ (S0 ) + dSt + log dSt , (9.4.3)
0 0 0 K∗
where fK ∗ (x) := x − K ∗ − x log(x/K ∗ ).
Hint: Use d log St as well.
b) Show that the payoff fK ∗ (ST ) can be hedged using a portfolio of call and put options.
Hint: Use Lemma 9.3 with y := K ∗ .

Exercise 9.2 Strike arbitrage.

a) Given a set of three strike prices K1 < K2 < K3 with K3 − K2 = K2 − K1 = ∆K > 0, write
down a discretized expression of the second partial derivative

∂ 2C
(T , K )|K =K2 .
∂ K2

∂ 2C
b) Show that if (K, T )|K =K2 < 0, one can construct a portfolio leading to an arbitrage
∂ K2
opportunity.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 298 Chapter 9. Volatility Estimation

Hint: Choose your own values of K1 , K2 , K3 , use https://optioncreator.com/, and your

portfolio design.

Exercise 9.3 Consider the Black-Scholes call pricing formula

 x
C (T − t, x, K ) = K f T − t,
K
written using the function

(r + σ 2 /2)τ + log z (r − σ 2 /2)τ + log z

   
−rτ
f (τ, z) := zΦ √ −e Φ √ .
|σ | τ |σ | τ

∂C ∂C ∂C
a) Compute and using the function f , and find the relation between (T − t, x, K )
∂x ∂K ∂K
∂C
and (T − t, x, K ).
∂x
∂ 2C ∂ 2C ∂C2
b) Compute and using the function f , and find the relation between (T − t, x, K )
∂ x2 ∂ K2 ∂ K2
∂C 2
and (T − t, x, K ).
∂ x2
c) From the Black-Scholes PDE
∂C ∂C
rC (T − t, x, K ) = (T − t, x, K ) + rx (T − t, x, K )
∂t ∂x
σ 2 x2 ∂ 2C
+ (T − t, x, K ),
2 ∂ x2
recover the Dupire, 1994 PDE (9.3.9) for the constant volatility σ .

Exercise 9.4 The prices of call options in a certain local volatility model of the form dSt =
St σ (t, St )dBt with risk-free rate r = 0 are given by
r
K − S0
 
T −(K−S0 )2 /(2T )
C (S0 , K, T ) = e − ( K − S0 ) Φ − √ , K, T > 0.
2π T

Recover the local volatility function σ (t, x) of this model by applying the Dupire formula.

Exercise 9.5 Let σimp (K ) denote the implied volatility of a call option with strike price K, defined
from the relation
MC (K, S, r, τ ) = C (K, S, σimp (K ), r, τ ),
where MC is the market price of the call option, C (K, S, σimp (K ), r, τ ) is the Black-Scholes call
pricing function, S is the underlying asset price, τ is the time remaining until maturity, and r is the
risk-free interest rate.
a) Compute the partial derivative
∂ MC
(K, S, r, τ ).
∂K
using the functions C and σimp .
b) Knowing that market call option prices MC (K, S, r, τ ) are decreasing in the strike prices K,
′ (K ) of the implied volatility curve.
find an upper bound for the slope σimp
c) Similarly, knowing that the market put option prices MP (K, S, r, τ ) are increasing in the strike
′ (K ) of the implied volatility curve.
prices K, find a lower bound for the slope σimp

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 299

10. Basic Numerical Methods

Numerical methods in finance include finite difference methods, and statistical and Monte Carlo
methods for computation of option prices and hedging strategies. This chapter is a basic introduction
to finite difference methods for the resolution of PDEs and stochastic differential equations. We
cover the explicit and implicit finite difference schemes for the heat equations and the Black-Scholes
PDE, as well as the Euler and Milshtein schemes for stochastic differential equations.

10.1 Discretized Heat Equation 237

10.2 Discretized Black-Scholes PDE 240
10.3 Euler Discretization 242
10.4 Milshtein Discretization 243
Exercises 244

10.1 Euler Discretization

In order to apply the Monte Carlo method in option pricing, we need to generate a sequence
(Xb1 , . . . , XbN ) of sample values of a random variable X, such that the empirical mean

φ (Xb1 ) + · · · + φ (XbN )
IE[φ (X )] ≃
N
can be used according to the strong law of large number for the evaluation of the expected value
IE[φ (X )]. Despite its apparent simplicity, the Monte Carlo method can converge slowly. The
optimization of Monte Carlo algorithms and of random number generators have been the object of
numerous studies which are outside the scope of this text, see, e.g., Glasserman, 2004, R. Korn,
E. Korn, and Kroisandt, 2010.

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 300 Chapter 10. Basic Numerical Methods

Random samples for the solution of a stochastic differential equation of the form

dXt = b(Xt )dt + a(Xt )dWt (10.1.1)

where (Wt )t∈R+ is a standard Brownian motion, can be generated by time discretization on
{t0 ,t1 , . . . ,tN }. This can be applied in particular to option pricing with local volatility, see § 9.3.
More precisely, the Euler discretization scheme for the stochastic differential equation (10.1.1)
is given by
w tk + 1 w tk + 1
XbtNk+1 = XbtNk + b(Xs )ds + a(Xs )dWs
tk tk
≃ XbtNk + b(Xbtk )(tk+1 − tk ) + a(XbtNk )(Wtk+1
N
−Wtk ),

where Wtk+1 −Wtk ≃ N (0,tk+1 −Wtk ), k = 0, 1, . . . , N − 1.

The next code presents a numerical solution of the stochastic differential equation

dSt = µSt dt + σ St dBt (10.1.2)

which defines geometric Brownian motion (St )t∈R+ .

N=2000; t <- 0:N; dt <- 1.0/N;mu=0.5; sigma=0.2; nsim <- 10; X <- matrix(0, nsim, N+1)
dB <- matrix(rnorm(nsim*N,mean=0,sd=sqrt(dt)), nsim, N+1)
for (i in 1:nsim){X[i,1]=1.0;
for (j in 1:N+1){X[i,j]=X[i,j-1]+mu*X[i,j-1]*dt+sigma*X[i,j-1]*dB[i,j]}}
plot(t*dt, rep(0, N+1), xlab = "Time", ylab = "Geometric Brownian motion", lwd=2, ylim =
c(min(X),max(X)), type = "l", col = 0,las=1, cex.axis=1.5,cex.lab=1.5, xaxs='i', yaxs='i')
for (i in 1:nsim){lines(t*dt, X[i, ], lwd=2, type = "l", col = i)}

10.2 Milshtein Discretization

In the Milshtein scheme we use (10.1.1) to expand a(Xs ) as

a(Xs ) ≃ a(Xtk ) + a′ (Xtk )(Xs − Xtk )

≃ a(Xtk ) + a′ (Xtk ) b(Xtk )(s − tk ) + a(Xtk )(Ws −Wtk ) ,

0 ⩽ tk < s. As a consequence, we get

w tk + 1 w tk + 1
XbtNk+1 = XbtNk + b(Xs )ds + a(Xs )dWs
t tk
w ktk+1
≃ XbtNk + b(Xs )ds + a(Xtk )(Wtk+1 −Wtk )
tk
w tk+1
+a′ (Xtk )b(Xtk ) (s − tk )dWs
tk
w tk+1
+a′ (Xtk )a(Xtk ) (Ws −Wtk )dWs
tk
w tk + 1
≃ XbtNk + b(Xs )ds + a(Xtk )(Wtk+1 −Wtk )
tk
w tk+1
+a′ (Xtk )a(Xtk ) (Ws −Wtk )dWs .
tk

Next, using Itô’s formula we note that

w tk+1 w tk + 1
(Wtk+1 −Wtk )2 = 2 (Ws −Wtk )dWs + ds,
tk tk

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 10.3 Discretized Heat Equation 301

hence w tk+1 1
(Ws −Wtk )dWs = ((Wtk+1 −Wtk )2 − (tk+1 − tk )),
tk 2
and
w tk+1
XbtNk+1 ≃ XbtNk + b(Xs )ds + a(Xtk )(Wtk+1 −Wtk )
tk
1
+ a′ (Xtk )a(Xtk )((Wtk+1 −Wtk )2 − (tk+1 − tk ))
2
≃ XbtNk + b(Xtk )(tk+1 − tk ) + a(Xtk )(Wtk+1 −Wtk )
1
+ a′ (Xtk )a(Xtk )((Wtk+1 −Wtk )2 − (tk+1 − tk )).
2
As a consequence the Milshtein scheme is written as
XbtNk+1 ≃ XbtNk + b(XbtNk )(tk+1 − tk ) + a(XbtNk )(Wtk+1 −Wtk )
1
+ a′ (XbtNk )a(XbtNk )((Wtk+1 −Wtk )2 − (tk+1 − tk )),
2
i.e. in the Milshtein scheme we take into account the “small” difference

(Wtk+1 −Wtk )2 − (tk+1 − tk )

existing between (∆Wt )2 and ∆t. Taking (∆Wt )2 equal to ∆t brings us back to the Euler scheme.
The next code presents a numerical solution of (10.1.2) using the Milshtein scheme.
N=2000; t <- 0:N; dt <- 1.0/N;mu=0.5; sigma=0.2; nsim <- 10; X <- matrix(0, nsim, N+1)
dB <- matrix(rnorm(nsim*N,mean=0,sd=sqrt(dt)), nsim, N+1)
for (i in 1:nsim){X[i,1]=1.0;
for (j in 1:N+1){X[i,j]=X[i,j-1] +mu*X[i,j-1]*dt +sigma*X[i,j-1]*dB[i,j] +0.5*sigma^2*X[i,j-1]*(dB[i,j]^2-dt)}}
plot(t*dt, rep(0, N+1), xlab = "Time", ylab = "Geometric Brownian motion", lwd=2, ylim =
c(min(X),max(X)), type = "l", col = 0,las=1, cex.axis=1.5,cex.lab=1.5, xaxs='i', yaxs='i')
for (i in 1:nsim){lines(t*dt, X[i, ], lwd=2, type = "l", col = i)}

10.3 Discretized Heat Equation

Consider the heat equation
∂φ ∂ 2φ
(t, x) = 2 (t, x) (10.3.1)
∂t ∂x
with initial condition
φ (0, x) = f (x)
on a compact time-space interval [0, T ] × [0, X ].
The intervals [0, T ] and [0, X ] are respectively discretized according to {t0 = 0,t1 , . . . ,tN = T }
and {x0 = 0, x1 , . . . , xM = X} with ∆t = T /N and ∆x = X /M, from which we construct a grid

(ti , x j ) = (i∆t, j∆x), i = 0, . . . , N, j = 0, . . . , M,

on [0, T ] × [0, X ].
Our goal is to solve the heat equation (10.3.1) with initial condition φ (0, x), x ∈ [0, X ], and
lateral boundary conditions φ (t, 0), φ (t, X ), t ∈ [0, T ], via a discrete approximation

(φ (ti , x j ))0⩽i⩽N, 0⩽ j⩽M

of the solution to (10.3.1), by evaluating derivatives using finite differences.

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 302 Chapter 10. Basic Numerical Methods

Explicit scheme
Using the forward time difference approximation

∂φ φ (ti+1 , x j ) − φ (ti , x j )
(ti , x) ≃
∂t ∆t
of the time derivative, and the related space difference approximations

∂φ φ (t, x j ) − φ (ti , x j−1 ) ∂φ φ (t, x j+1 ) − φ (ti , x j ))

(t, x j ) ≃ , (t, x j+1 ) ≃
∂x ∆x ∂x ∆x
and
∂ 2φ φ (ti , x j+1 ) + φ (ti , x j−1 ) − 2φ (ti , x j )
 
1 ∂φ ∂φ
(t, x j ) ≃ (t, x j+1 ) − (t, x j ) =
∂x 2 ∆x ∂x ∂x (∆x)2
of the time and space derivatives, we discretize (10.3.1) as

φ (ti+1 , x j ) − φ (ti , x j ) φ (ti , x j+1 ) + φ (ti , x j−1 ) − 2φ (ti , x j )

= . (10.3.2)
∆t (∆x)2

Letting ρ = (∆t )/(∆x)2 , this yields

φ (ti+1 , x j ) = ρφ (ti , x j+1 ) + (1 − 2ρ )φ (ti , x j ) + ρφ (ti , x j−1 ),

1 ⩽ j ⩽ M − 1, 1 ⩽ i ⩽ N, i.e.
 
φ (ti , x0 )

 0 

Φi+1 = AΦi + ρ  .. i = 0, 1, . . . , N − 1,
, (10.3.3)
 
 . 
 0 
φ (ti , xM )

with  
φ (ti , x1 )
Φi =  .. i = 0, 1, . . . , N,
,
 
.
φ (ti , xM−1 )
and
1 − 2ρ ···
 
ρ 0 0 0 0

 ρ 1 − 2ρ ρ ··· 0 0 0 


 0 ρ 1 − 2ρ ··· 0 0 0 

A= .. .. .. .. .. .. ..
.
 
 . . . . . . . 

 0 0 0 · · · 1 − 2ρ ρ 0 

 0 0 0 ··· ρ 1 − 2ρ ρ 
0 0 0 ··· 0 ρ 1 − 2ρ
The vector    
φ (ti , x0 ) φ (ti , 0)

 0  
  0 

.. ..
= , i = 0, 1, . . . , N,
   

 .   . 
 0   0 
φ (ti , xM ) φ (ti , X )

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10.3 Discretized Heat Equation 303

in (10.3.3) can be given by the lateral boundary conditions φ (t, 0) and φ (t, X ). From those
boundary conditions and the initial data of
 
φ (0, x0 )
 φ (0, x1 ) 
 
Φ0 = 
 .. 
 . 

 φ (0, xM−1 ) 
φ (0, xM )

we can apply (10.3.3) in order to solve (10.3.2) recursively for Φ1 , Φ2 , Φ3 , . . ., see also Figure 10.1.

Implicit scheme
Using the backward time difference approximation

∂φ φ (ti , x j ) − φ (ti−1 , x j )
(ti , x) ≃
∂t ∆t
of the time derivative, we discretize (10.3.1) as

φ (ti , x j ) − φ (ti−1 , x j ) φ (ti , x j+1 ) + φ (ti , x j−1 ) − 2φ (ti , x j )

= (10.3.4)
∆t (∆x)2

and letting ρ = (∆t )/(∆x)2 we get

φ (ti−1 , x j ) = −ρφ (ti , x j+1 ) + (1 + 2ρ )φ (ti , x j ) − ρφ (ti , x j−1 ),

1 ⩽ j ⩽ M − 1, 1 ⩽ i ⩽ N, i.e.
 
φ (ti , x0 )

 0 

Φi−1 = BΦi + ρ  .. i = 1, 2, . . . , N,
,
 
 . 
 0 
φ (ti , xM )

with
−ρ ···
 
1 + 2ρ 0 0 0 0

 −ρ 1 + 2ρ −ρ ··· 0 0 0 


 0 −ρ 1 + 2ρ ··· 0 0 0 

B= .. .. .. .. .. .. ..
.
 
 . . . . . . . 

 0 0 0 · · · 1 + 2ρ −ρ 0 

 0 0 0 ··· −ρ 1 + 2ρ −ρ 
0 0 0 ··· 0 −ρ 1 + 2ρ
By inversion of the matrix B, Φi is given in terms of Φi−1 as
 
φ (ti , x0 )

 0 

−1
Φi = B Φi−1 − ρB  −1  .
.. i = 1, . . . , N,
,

 
 0 
φ (ti , xM )

which also allows for a recursive solution of (10.3.4), see also Figure 10.2.

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 304 Chapter 10. Basic Numerical Methods

10.4 Discretized Black-Scholes PDE

Consider the Black-Scholes PDE
∂φ ∂φ 1 ∂ 2φ
rφ (t, x) = (t, x) + rx (t, x) + x2 σ 2 2 (t, x), (10.4.1)
∂t ∂x 2 ∂x
under the terminal condition φ (T , x) = (x − K )+ , resp. φ (T , x) = (K − x)+ , for a European call,
resp. put, option. The constant volatility coefficient σ may also be replaced with a function σ (t, x)
of the underlying asset price, in the case local volatility models.
Note that in the solution of the Black-Scholes PDE, time is run backwards as we start from a
terminal condition φ (T , x) at time T . Thus here the explicit scheme uses backward differences
while the implicit scheme uses forward differences.

Explicit scheme
Using here the backward time difference approximation

∂φ φ (ti , x j ) − φ (ti−1 , x j )
(ti , x) ≃
∂t ∆t
of the time derivative, we discretize (10.4.1) as
φ (ti , x j ) − φ (ti−1 , x j ) φ (ti , x j+1 ) − φ (ti , x j−1 )
rφ (ti , x j ) = + rx j
∆t 2∆x
1 2 2 φ (ti , x j+1 ) + φ (ti , x j−1 ) − 2φ (ti , x j )
+ xjσ , (10.4.2)
2 (∆x)2
1 ⩽ j ⩽ M − 1, 0 ⩽ i ⩽ N − 1, i.e.
1 2 2
φ (ti−1 , x j ) = (σ j − r j )φ (ti , x j−1 )∆t + φ (ti , x j )(1 − (σ 2 j2 + r )∆t )
2
1
+ (σ 2 j2 + r j )φ (ti , x j+1 )∆t,
2
1 ⩽ j ⩽ M − 1, where the lateral boundary conditions φ (ti , 0) and φ (ti , xM ) are (approximately)
given as follows.
European call options. We take the lateral boundary conditions

+
φ (ti , x0 ) = 0, and φ (ti , xM ) ≃ xM − K e −r(T −ti ) = xM − K e −r(T −ti ) ,

i = 0, 1, . . . , N, provided that xM is sufficiently large.

European put options. We take the lateral boundary conditions

+
φ (ti , x0 ) ≃ K e −(T −ti )r − x0 = K e −(T −ti )r , and φ (ti , xM ) = 0,

i = 0, 1, . . . , N, with here x0 = 0.
Given a terminal condition of the form

φ (T , x j ) = (x j − K )+ , resp. φ (T , x j ) = (K − x j )+ , j = 1, . . . , M − 1,

this allows us to solve (10.4.2) successively for

φ (tN−1 , x j ), φ (tN−2 , x j ), φ (tN−3 , x j ), . . . , φ (t1 , x j ), φ (t0 , x j ).

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10.4 Discretized Black-Scholes PDE 305

The explicit finite difference method is nevertheless known to have a divergent behaviour as time
is run backwards, as illustrated in Figure 10.1.

100

50

-50

-100
0.1 0.2 180 200
0.3 0.4 120 140 160
0.5 0.6 80 100
0.7 0.8 40 60
Time to maturity 0.9 20 Strike price
10

Figure 10.1: Divergence of the explicit finite difference method.

Implicit scheme
Using the forward time difference approximation
∂φ φ (ti+1 , x j ) − φ (ti , x j )
(ti , x) ≃
∂t ∆t
of the time derivative, we discretize (10.4.1) as
φ (ti+1 , x j ) − φ (ti , x j ) φ (ti , x j+1 ) − φ (ti , x j−1 )
rφ (ti , x j ) = + rx j (10.4.3)
∆t ∆x
1 2 2 φ (ti , x j+1 ) + φ (ti , x j−1 ) − 2φ (ti , x j )
+ xjσ ,
2 (∆x)2
1 ⩽ j ⩽ M − 1, 0 ⩽ i ⩽ N − 1, i.e.
1
φ (ti+1 , x j ) = − (σ 2 j2 − r j )φ (ti , x j−1 )∆t + φ (ti , x j )(1 + (σ 2 j2 + r )∆t )
2
1
− (σ 2 j2 + r j )φ (ti , x j+1 )∆t,
2
1 ⩽ j ⩽ M − 1, i.e.

2 r − σ φ (ti , x0 ) ∆t
1 2



 0 

Φi+1 = BΦi +  ..
, (10.4.4)
 
 . 
 0 
− 2 r (M − 1) + (M − 1) σ φ (ti , xM )∆t
1 2 2

i = 0, 1, . . . , N − 1, with
1
r j − σ 2 j2 ∆t, B j, j = 1 + σ 2 j2 ∆t + r∆t,


B j, j−1 =
2
and
1
r j + σ 2 j2 ∆t,


B j, j+1 = −
2

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 306 Chapter 10. Basic Numerical Methods

for j = 1, 2, . . . , M − 1, and B(i, j ) = 0 otherwise.

By inversion of the matrix B, Φi is given in terms of Φi+1 as

2 r − σ φ (ti , x0 ) ∆t
1 2



 0 

−1
Φ i = B Φ i+1 − B −1  ..
,

 . 
 0 
− 12 r (M − 1) + (M − 1)2 σ 2 φ (ti , xM )∆t

i = 0, 1, . . . , N − 1, where the lateral boundary conditions φ (ti , x0 ) and φ (ti , xM ) can be provided as
in the case of the explicit scheme, allowing us to solve (10.4.3) recursively for φ (tN−1 , x j ), φ (tN−2 , x j ), φ (tN−3 , x j ), . . .
The implicit finite difference method is known to be more stable than the explicit scheme, as
illustrated in Figure 10.2, in which the discretization parameters have been taken to be the same as
in Figure 10.1.

140

120

100

80

60

40

20

0
0 1 180 200
2 3 4 120 140 160
5 80 100
6 7 60
8 9 20 40
Time to maturity 100 Strike price

Figure 10.2: Stability of the implicit finite difference method.

Exercises

Exercise 10.1 Show that when the terminal condition is a constant φ (T , x) = c > 0 the implicit
scheme (10.4.4) recovers the known solution φ (s, x) = c e −r(T −s) , s ∈ [0, T ].

Exercise 10.2 Let Xt be the geometric Brownian motion given by the stochastic differential
equation
dXt = rXt dt + σ Xt dWt .
a) Compute the Euler discretization XbtNk k=0,1,...,N of (Xt )t∈R+ .

b) Compute the Milshtein discretization XbtNk k=0,1,...,N of (Xt )t∈R+ .

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 MH4514 Financial Mathematics 307

Appendix: Background on Probability Theory

In this appendix we review a number of basic probabilistic tools that are needed in option pricing
and hedging. We refer to Jacod and Protter, 2000, Devore, 2003, Pitman, 1999 for more information
on the needed probability background.

10.1 Discretized Heat Equation 237

10.2 Discretized Black-Scholes PDE 240
10.3 Euler Discretization 242
10.4 Milshtein Discretization 243
Exercises 244

11.1 Probability Sample Space and Events

We will need the following notation coming from set theory. Given A and B to abstract sets, “A ⊂ B”
means that A is contained in B, and in this case, B \ A denotes the set of elements of B which do
not belong to A. The property that the element ω belongs to the set A is denoted by “ω ∈ A”, and
given two sets A and Ω such that A ⊂ Ω, we let Ac = Ω \ A denote the complement of A in Ω. The
finite set made of n elements ω1 , . . . , ωn is denoted by {ω1 , . . . , ωn }, and we will usually distinguish
between the element ω and its associated singleton set {ω}.
A probability sample space is an abstract set Ω that contains the possible outcomes of a random
experiment.
Examples
i) Coin tossing: Ω = {H, T }.
ii) Rolling one die: Ω = {1, 2, 3, 4, 5, 6}.

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 308 Background on Probability Theory

iii) Picking one card at random in a pack of 52: Ω = {1, 2, 3, . . . , 52}.

iv) An integer-valued random outcome: Ω = N = {0, 1, 2, . . .}.
In this case the outcome ω ∈ N can be the random number of trials needed until some event
occurs.
v) A nonnegative, real-valued outcome: Ω = R+ .
In this case the outcome ω ∈ R+ may represent the (nonnegative) value of a continuous
random time.
vi) A random continuous parameter (such as time, weather, price or wealth, temperature, ...):
Ω = R.
vii) Random choice of a continuous path in the space Ω = C (R+ ) of all continuous functions
on R+ .
In this case, ω ∈ Ω is a function ω : R+ −→ R and a typical example is the graph t 7−→ ω (t )
of a stock price over time.
Product spaces:
Probability sample spaces can be built as product spaces and used for the modeling of repeated
random experiments.
i) Rolling two dice: Ω = {1, 2, 3, 4, 5, 6} × {1, 2, 3, 4, 5, 6}.
In this case a typical element of Ω is written as ω = (k, l ) with k, l ∈ {1, 2, 3, 4, 5, 6}.
ii) A finite number n of real-valued samples: Ω = Rn .
In this case the outcome ω is a vector ω = (x1 , . . . , xn ) ∈ Rn with n components.
Note that to some extent, the more complex Ω is, the better it fits a practical and useful situation,
e.g. Ω = {H, T } corresponds to a simple coin tossing experiment while Ω = C (R+ ) the space of
continuous functions on R+ can be applied to the modeling of stock markets. On the other hand,
in many cases and especially in the most complex situations, we will not attempt to specify Ω
explicitly.
Events
An event is a collection of outcomes, which is represented by a subset of Ω. In what follows we
consider collections of events, called σ -algebras (or σ -fields), according to the following definition.

Definition 11.1 A collection G of events is a σ -algebra provided that it satisfies the following
conditions:
(i) 0/ ∈ G ,
(ii) For all countable sequences (An )n⩾1 such that An ∈ G , n ⩾ 1, we have An ∈ G ,
[

n⩾1
(iii) A ∈ G =⇒ (Ω \ A) ∈ G ,
where Ω \ A := {ω ∈ Ω : ω ∈/ A}.

Note that Properties (ii) and (iii) above also imply the stability of σ -algebras under intersections,
as
!c
∈G,
\ [
An = Acn (11.1.1)
n⩾1 n⩾1

for all countable sequences An ∈ G , n ⩾ 1.

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11.1 Probability Sample Space and Events 309

The collection of all events in Ω will often be denoted by F . The empty set 0/ and the full
space Ω are considered as events but they are of less importance because Ω corresponds to “any
outcome may occur” while 0/ corresponds to an absence of outcome, or no experiment.
In the context of stochastic processes, two σ -algebras F and G such that F ⊂ G will refer to
two different amounts of information, the amount of information associated to F being here lower
than the one associated to G .
The formalism of σ -algebras helps in describing events in a short and precise way.
Examples
i) Let Ω = {1, 2, 3, 4, 5, 6}.
The event A = {2, 4, 6} corresponds to
“the result of the experiment is an even number”.

ii) Taking again Ω = {1, 2, 3, 4, 5, 6},

F := {Ω, 0,
/ {2, 4, 6}, {1, 3, 5}}

defines a σ -algebra on Ω which corresponds to the knowledge of parity of an integer picked

at random from 1 to 6.
Note that in the set-theoretic notation, an event A is a subset of Ω, i.e. A ⊂ Ω, while
it is an element of F , i.e. A ∈ F . For example, we have Ω ⊃ {2, 4, 6} ∈ F , while
{{2, 4, 6}, {1, 3, 5}} ⊂ F .
iii) Taking

G := {Ω, 0,
/ {2, 4, 6}, {2, 4}, {6}, {1, 2, 3, 4, 5}, {1, 3, 5, 6}, {1, 3, 5}} ⊃ F ,

defines a σ -algebra on Ω which is bigger than F and includes the parity information
contained in F , in addition to information on whether the outcome of the experiment is
equal to 6 or not.
iv) Take
Ω = {H, T } × {H, T } = {(H, H ), (H, T ), (T , H ), (T , T )}.
In this case, the collection F of all possible events is given by
F = {0, / {(H, H )}, {(T , T )}, {(H, T )}, {(T , H )}, (11.1.2)
{(T , T ), (H, H )}, {(H, T ), (T , H )}, {(H, T ), (T , T )},
{(T , H ), (T , T )}, {(H, T ), (H, H )}, {(T , H ), (H, H )},
{(H, H ), (T , T ), (T , H )}, {(H, H ), (T , T ), (H, T )},
{(H, T ), (T , H ), (H, H )}, {(H, T ), (T , H ), (T , T )}, Ω} .
 the set F of all events considered in (11.1.2) above has altogether
Note that
n
1= event of cardinality 0,
0
 
n
4= events of cardinality 1,
1
 
n
6= events of cardinality 2,
2
 
n
4= events of cardinality 3,
3

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 310 Background on Probability Theory
 
n
1= event of cardinality 4,
4
with n = 4, for a total of
  4
n 4
16 = 2 = ∑ = 1+4+6+4+1
k =0 k

events. The collection of events

G := {0,
/ {(T , T ), (H, H )}, {(H, T ), (T , H )}, Ω}

defines a sub σ -algebra of F , which corresponds to the restricted information “the results of two
coin tossings are different”.
Exercise: Write down the set of all events on Ω = {H, T }.
Note also that (H, T ) is different from (T , H ), whereas {(H, T ), (T , H )} is equal to {(T , H ), (H, T )}.
In addition, we will distinguish between the outcome ω ∈ Ω and its associated event {ω} ∈ F ,
which satisfies {ω} ⊂ Ω.

11.2 Probability Measures

Definition 11.2 A probability measure is a mapping P : F −→ [0, 1] that assigns a probability

P(A) ∈ [0, 1] to any event A ∈ F , with the properties
a) P(Ω) = 1, and
!
b) P ∑ P(An ), whenever Ak ∩ Al = 0,/ k ̸= l.
[
An =
n⩾1 n⩾1

Property (b)) above is named the law of total probability. It states in particular that we have

P(A1 ∪ · · · ∪ An ) = P(A1 ) + · · · + P(An )

when the subsets A1 , . . . , An of Ω are disjoint, and

P(A ∪ B) = P(A) + P(B) (11.2.1)

if A ∩ B = 0.
/ We also have the complement rule

P(Ac ) = P(Ω \ A) = P(Ω) − P(A) = 1 − P(A).

When A and B are not necessarily disjoint we can write

P(A ∪ B) = P(A) + P(B) − P(A ∩ B),

which extends to arbitrary families of events (Ai )i∈I indexed by a finite set I as the inclusion-
exclusion principle
! !
P ∑ (−1)|J|+1 P
[ \
Ai = Aj , (11.2.2)
i∈I J⊂I j∈J

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11.2 Probability Measures 311

and
! !
P ∑ (−1)|I|+1 P
\ [
Aj = Ai . (11.2.3)
j∈J I⊂J i∈I

The triple

(Ω, F , P) (11.2.4)

is called a probability space, and was introduced by A.N. Kolmogorov (1903-1987). This setting is
generally referred to as the Kolmogorov framework.

A property or event is said to hold P-almost surely (also written P-a.s.) if it holds with
probability equal to one.

Example
1. Take
Ω = (T , T ), (H, H ), (H, T ), (T , H )


and
F = {0,
/ {(T , T ), (H, H )}, {(H, T ), (T , H )}, Ω} .

The uniform probability measure P on (Ω, F ) is given by setting

1 1
P({(T , T ), (H, H )}) := and P({(H, T ), (T , H )}) := .
2 2

In addition, we have the following convergence properties.

1. Let (An )n∈N be a non-decreasing sequence of events, i.e. An ⊂ An+1 , n ⩾ 0. Then we have
!
P = lim P(An ).
[
An (11.2.5)
n→∞
n∈N

2. Let (An )n∈N be a non-increasing sequence of events, i.e. An+1 ⊂ An , n ⩾ 0. Then we have
!
P = lim P(An ).
\
An (11.2.6)
n→∞
n∈N

Theorem 11.3 Borel-Cantelli Lemma. Let (An )n⩾1 denote a sequence of events on (Ω, F , P),
such that
∑ P(An ) < ∞.
n⩾1

Then we have  
P
\ [
Ak = 0,
n⩾1 k⩾n

i.e. the probability that An occurs infinitely many times occur is zero.

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 312 Background on Probability Theory

11.3 Conditional Probabilities and Independence

We start with examples.
Consider a population Ω = M ∪ W made of a set M of men and a set W of women. Here the
σ -algebra F = {Ω, 0,W/ , M} corresponds to the information given by gender. After polling the
population, e.g. for a market survey, it turns out that a proportion p ∈ [0, 1] of the population
declares to like apples, while a proportion 1 − p declares to dislike apples. Let A ⊂ Ω denote the
subset of individuals who like apples, while Ac ⊂ Ω denotes the subset individuals who dislike
apples, with
p = P(A) and 1 − p = P(Ac ),
e.g. p = 60% of the population likes apples. It may be interesting to get a more precise information
and to determine
P(A ∩W )
- the relative proportion of women who like apples, and
P(W )
P(A ∩ M )
- the relative proportion of men who like apples.
P(M )
Here, P(A ∩W )/P(W ) represents the probability that a randomly chosen woman in W likes
apples, and P(A ∩ M )/P(M ) represents the probability that a randomly chosen man in M likes
apples. Those two ratios are interpreted as conditional probabilities, for example P(A ∩ M )/P(M )
denotes the probability that a given individual likes apples given that he is a man.
For another example, suppose that the population Ω is split as Ω = Y ∪ O into a set Y of “young”
people and another set O of “old” people, and denote by A ⊂ Ω the set of people who voted for
candidate A in an election. Here it can be of interest to find out the relative proportion

P(Y ∩ A)
P(A | Y ) =
P(Y )

of young people who voted for candidate A.

Definition 11.4 Given any two events A, B ⊂ Ω with P(B) ̸= 0, we call

P(A ∩ B)
P(A | B) : =
P(B)

the probability of A given B, or conditionally to B.

R We note that if P(B) = 1 we have P(A ∩ Bc ) ⩽ P(Bc ) = 0, hence P(A ∩ Bc ) = 0, which

implies
P(A) = P(A ∩ B) + P(A ∩ Bc ) = P(A ∩ B),
and P(A | B) = P(A).

We also recall the following property:

! !
P B∩ = P
[ [
An ( B ∩ An )
n⩾1 n⩾1
= ∑ P ( B ∩ An )
n⩾1
= ∑ P(B | An )P(An )
n⩾1

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 11.4 Random Variables 313

= ∑ P(An | B)P(B),
n⩾1

/ i ̸= j, and P(B) > 0, n ⩾ 1. This also

for any family of disjoint events (An )n⩾1 with Ai ∩ A j = 0,
shows that conditional probability measures are probability measures, in the sense that whenever
P(B) > 0, we have
a) P(Ω | B) = 1, and
!
b) P ∑ P(An | B), whenever Ak ∩ Al = 0,/ k ̸= l.
[
An B =
n⩾1 n⩾1

An = Ω, (An )n⩾1 becomes a partition of Ω and we get the law of total probability
[
In particular, if
n⩾1

P(B) = ∑ P(B ∩ An ) = ∑ P(An | B)P(B) = ∑ P(B | An )P(An ), (11.3.1)

n⩾1 n⩾1 n⩾1

/ i ̸= j, and P(B) > 0, n ⩾ 1.

provided that Ai ∩ A j = 0,
Remark. In general we have
!
P A ∑ P(A | Bn ),
[
Bn ̸=
n⩾1 n⩾1

/ k ̸= l. Indeed, taking for example A = Ω = B1 ∪ B2 with B1 ∩ B2 = 0/ and

even when Bk ∩ Bl = 0,
P(B1 ) = P(B2 ) = 1/2, we have
1 = P(Ω | B1 ∪ B2 ) ̸= P(Ω | B1 ) + P(Ω | B2 ) = 2.
Independent events
Definition 11.5 Two events A and B such that P(A), P(B) > 0 are said to be independent if

P(A | B) = P(A). (11.3.2)

We note that the independence condition (11.3.2) is equivalent to

P(A ∩ B) = P(A)P(B).

11.4 Random Variables

A real-valued random variable is a mapping*
X : Ω −→ R
ω 7−→ X (ω )
from a probability sample space Ω into the state space R. Given
X : Ω −→ R
a random variable and a (measurable)† subset A of R, we denote by {X ∈ A} the event
{X ∈ A} := {ω ∈ Ω : X (ω ) ∈ A}.
Examples
* See MOE and UCLES, 2016, page 14 lines 4-5 and MOE and UCLES, 2020, page 19 lines 4-5.
† Measurability of subsets of R refers to Borel measurability, a concept which will not be defined in this text.

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 314 Background on Probability Theory

i) Let Ω := {1, 2, 3, 4, 5, 6} × {1, 2, 3, 4, 5, 6}, and consider the mapping

X : Ω −→ R
(k, l ) 7−→ k + l.
Then X is a random variable giving the sum of the two numbers appearing on each die.
ii) the time needed everyday to travel from home to work or school is a random variable, as the
precise value of this time may change from day to day under unexpected circumstances.
iii) the price of a risky asset can be modeled using a random variable.
In what follows, we will often use the notion of indicator function 1A of an event A ⊂ Ω.

Definition 11.6 For any A ⊂ Ω, the indicator function 1A is the random variable

1A : Ω −→ {0, 1}
ω 7−→ 1A (ω )

defined by 
1 if ω ∈ A,
1A (ω ) =
0 if ω ∈
/ A.

Indicator functions satisfy the property

1A∩B (ω ) = 1A (ω )1B (ω ), (11.4.1)
since
1A∩B (ω ) = 1 ⇐⇒ ω ∈ A ∩ B
⇐⇒ ω ∈ A and ω ∈ B
⇐⇒ 1A (ω ) = 1 and 1B (ω ) = 1
⇐⇒ 1A (ω )1B (ω ) = 1.
We also have
1A∪B = 1A + 1B − 1A∩B = 1A + 1B − 1A 1B ,
and
1A∪B = 1A + 1B , (11.4.2)
if A ∩ B = 0.
/
For example, if Ω = N and A = {k}, for all l ⩾ 0 we have

 1 if k = l,
1{k} (l ) =
0 if k ̸= l.


Given X a random variable, we also let


 1 if X = n,
1{X =n} =
0 if X ̸= n,


and 
 1 if X < n,
1{X<n} =
0 if X ⩾ n.


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 11.5 Probability Distributions 315

11.5 Probability Distributions

The probability distribution of a random variable X : Ω −→ R is the collection

{P(X ∈ A) : A is a measurable subset of R}.

As the collection of measurable subsets of R coincides with the σ -algebra generated by the
intervals in R, the distribution of X can be reduced to the knowledge of the probabilities

{P(a < X ⩽ b) = P(X ⩽ b) − P(X ⩽ a) : a < b ∈ R},

or of the cumulative distribution functions

{P(X ⩽ a) : a ∈ R}, or {P(X ⩾ a) : a ∈ R},

see e.g. Corollary 3.8 in Çınlar, 2011.

Two random variables X and Y are said to be independent under the probability P if their
probability distributions satisfy

P(X ∈ A , Y ∈ B) = P(X ∈ A)P(Y ∈ B)

for all (measurable) subsets A and B of R.

Distributions admitting a density
We say that the distribution of X admits a probability density distribution function ϕX : R −→ R+
if, for all a ⩽ b, the probability P(a ⩽ X ⩽ b) can be written as
wb
P(a ⩽ X ⩽ b) = ϕX (x)dx.
a

0.4
Probability density

0.3

0.2

0.1

0
−4 −3 −2 −1 a 0 1 b 2 3 4

Figure 11.1: Probability density function ϕX .

We also say that the distribution of X is absolutely continuous, or that X is an absolutely continuous
random variable. This, however, does not imply that the density function ϕX : R −→ R+ is
continuous.
In particular, we always have
w∞
ϕX (x)dx = P(−∞ ⩽ X ⩽ ∞) = 1
−∞

for any probability density functions ϕX : R −→ R+ .

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 316 Background on Probability Theory

R Note that if the distribution of X admits a probability density function ϕX , then for all a ∈ R
we have
wa
P(X = a) = ϕX (x)dx = 0, (11.5.1)
a

and this is not a contradiction.

In particular, Remark 11.5 shows that

P(a ⩽ X ⩽ b) = P(X = a) + P(a < X ⩽ b) = P(a < X ⩽ b) = P(a < X < b),

for a ⩽ b. Property (11.5.1) appears for example in the framework of lottery games with a large
number of participants, in which a given number “a” selected in advance has a very low (almost
zero) probability to be chosen.
The probability density function ϕX can be recovered from the Cumulative Distribution Func-
tions (CDFs) wx
x 7−→ FX (x) := P(X ⩽ x) = ϕX (s)ds,
−∞
and w∞
x 7−→ 1 − FX (x) = P(X ⩾ x) = ϕX (s)ds,
x
as
∂ FX ∂ wx ∂ w∞
ϕX (x) = (x ) = ϕX (s)ds = − ϕX (s)ds, x ∈ R.
∂x ∂ x −∞ ∂x x

Examples
i) The uniform distribution on an interval.
The probability density function of the uniform distribution on the interval [a, b], a < b, is
given by
1
ϕ (x ) = 1 (x ), x ∈ R.
b − a [a,b]
ii) The Gaussian distribution.
The probability density function of the standard normal distribution is given by
1 2
ϕ (x) = √ e −x /2 , x ∈ R.
2π
More generally, the probability density function of the Gaussian distribution with mean
µ ∈ R and variance σ 2 > 0 is given by
1 2 2
ϕ (x ) : = √ e −(x−µ ) /(2σ ) , x ∈ R.
2πσ 2

In this case, we write X ≃ N ( µ, σ 2 ).

iii) The exponential distribution.
The probability density function of the exponential distribution with parameter λ > 0 is given
by

 λ e −λ x ,

x⩾0
ϕ (x) := λ 1[0,∞) (x) e −λ x
= (11.5.2)
0, x < 0.


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11.5 Probability Distributions 317

1.0
1
0.9

0.8

Probability density
0.8
0.7
0.6 0.6
0.5
0.4

0.4
0.3
0.2

0.2
0.1
0.0

0
0 1 2 3 4 5 6 0 1 2 3 4 5 6

(b) Exponential PDF.

(a) Exponential CDF.

Figure 11.2: Exponential CDF and PDF.

We also have

P(X > t ) = e −λt , t ⩾ 0. (11.5.3)

iv) The gamma distribution.

The probability density function of the gamma distribution is given by

aλ λ −1 −ax
x e , x⩾0


aλ Γ (λ )

ϕ (x ) : = 1 (x)xλ −1 e −ax =
Γ(λ ) [0,∞) 

0, x < 0,


where a > 0 and λ > 0 are scale and shape parameters, and
w∞
Γ (λ ) : = xλ −1 e −x dx, λ > 0,
0

is the gamma function.

v) The Cauchy distribution.
The probability density function of the Cauchy distribution is given by

1
ϕ (x ) : = , x ∈ R.
π ( 1 + x2 )

vi) The lognormal distribution.

The probability density function of the lognormal distribution is given by

1 2 2

 √ e −(µ−log x) /(2σ ) , x⩾0
1 
xσ 2π
ϕ (x) := 1[0,∞) (x) √ e −(µ−log x) /(2σ ) =
2 2

xσ 2π 

0, x < 0.


Exercise: For each of the above probability density functions ϕ, check that the condition
w∞
ϕ (x)dx = 1
−∞

is satisfied.

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 318 Background on Probability Theory

Joint densities
Given two absolutely continuous random variables X : Ω −→ R and Y : Ω −→ R, we can form the
R2 -valued random variable (X,Y ) defined by
(X,Y ) : Ω −→ R2
ω 7−→ (X (ω ),Y (ω )).
We say that (X,Y ) admits a joint probability density

ϕ(X,Y ) : R2 −→ R+

when w w
P((X,Y ) ∈ A × B) = P(X ∈ A and Y ∈ B) = ϕ(X,Y ) (x, y)dxdy
B A
for all measurable subsets A, B of R, see Figure 11.3.

0.1

0
-1
0
x
1 1 1.5
-0.5 0 0.5
-1 y

Figure 11.3: Probability P((X,Y ) ∈ [−0.5, 1] × [−0.5, 1]) computed as a volume integral.

The probability density function ϕ(X,Y ) can be recovered from the joint cumulative distribution
function
wx wy
(x, y) 7−→ F(X,Y ) (x, y) := P(X ⩽ x and Y ⩽ y) = ϕ(X,Y ) (s,t )dsdt,
−∞ −∞

and w ∞w ∞
(x, y) 7−→ P(X ⩾ x and Y ⩾ y) = ϕ(X,Y ) (s,t )dsdt,
x y
as
∂2
ϕ(X,Y ) (x, y) = F (x, y) (11.5.4)
∂ x∂ y (X,Y )
∂2 w x w y
= ϕ (s,t )dsdt (11.5.5)
∂ x∂ y −∞ −∞ (X,Y )
∂2 w ∞w ∞
= ϕ (s,t )dsdt,
∂ x∂ y x y (X,Y )
x, y ∈ R.
The probability densities ϕX : R −→ R+ and ϕY : R −→ R+ of X : Ω −→ R and Y : Ω −→ R are
called the marginal densities of (X,Y ), and are given by
w∞
ϕX (x) = ϕ(X,Y ) (x, y)dy, x ∈ R, (11.5.6)
−∞

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11.5 Probability Distributions 319

and w∞
ϕY (y) = ϕ(X,Y ) (x, y)dx, y ∈ R.
−∞
The conditional probability density ϕX|Y =y : R −→ R+ of X given Y = y is defined by

ϕ(X,Y ) (x, y)
ϕX|Y =y (x) := , x, y ∈ R, (11.5.7)
ϕY (y)

provided that ϕY (y) > 0. In particular, X and Y are independent if and only if

ϕX|Y =y (x) = ϕX (x), i.e., ϕ(X,Y ) (x, y) = ϕX (x)ϕY (y), x, y ∈ R.

Example
1. If X1 , . . . , Xn are independent exponentially distributed random variables with parameters
λ1 , . . . , λn we have
P(min(X1 , . . . , Xn ) > t ) = P(X1 > t, . . . , Xn > t )
= P(X1 > t ) · · · P(Xn > t )
= e −(λ1 +···+λn )t , t ⩾ 0, (11.5.8)
hence min(X1 , . . . , Xn ) is an exponentially distributed random variable with parameter λ1 +
· · · + λn .
From the joint probability density function of (X1 , X2 ) given by

ϕ(X1 ,X2 ) (x, y) = ϕX1 (x)ϕX2 (y) = λ1 λ2 e −λ1 x−λ2 y , x, y ⩾ 0,

we can write
P(X1 < X2 ) = P(X1 ⩽ X2 )
w∞ wy
= ϕ(X1 ,X2 ) (x, y)dxdy
−∞ −∞
w ∞w y
= λ1 λ2 e −λ1 x−λ2 y dxdy
0 0
λ1
= , (11.5.9)
λ1 + λ2
and we note that
w
P(X1 = X2 ) = λ1 λ2 e −λ1 x−λ2 y dxdy = 0.
{(x,y)∈R2+ : x=y}

Discrete distributions
We only consider integer-valued random variables, i.e. the distribution of X is given by the values
of P(X = k), k ⩾ 0.
Examples
i) The Bernoulli distribution.
We have

P(X = 1) = p and P(X = 0) = 1 − p, (11.5.10)

where p ∈ [0, 1] is a parameter.

Note that any Bernoulli random variable X : Ω −→ {0, 1} can be written as the indicator
function
X = 1A
on Ω with A = {X = 1} = {ω ∈ Ω : X (ω ) = 1}.

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 320 Background on Probability Theory

ii) The binomial distribution.

We have  
n k
P(X = k ) = p (1 − p)n−k , k = 0, 1, . . . , n,
k
where n ⩾ 1 and p ∈ [0, 1] are parameters and (nk) = n!/(k!(n − k)!), 0 ⩽ k ⩽ n.
iii) The geometric distribution.
In this case, we have

P ( X = k ) = ( 1 − p ) pk , k ⩾ 0, (11.5.11)

where p ∈ (0, 1) is a parameter. For example, if (Xk )k∈N is a sequence of independent

Bernoulli random variables with distribution (11.5.10), then the random variable,*

T0 := inf{k ⩾ 0 : Xk = 0}

can denote the duration of a game until the time that the wealth Xk of a player reaches 0. The
random variable T0 has the geometric distribution (11.5.11) with parameter p ∈ (0, 1).
iv) The negative binomial (or Pascal) distribution.
We have
k+r−1
 
P(X = k ) = (1 − p)r pk , k ⩾ 0, (11.5.12)
r−1

where p ∈ (0, 1) and r ⩾ 1 are parameters. Note that the sum of r ⩾ 1 independent geometric
random variables with parameter p has a negative binomial distribution with parameter (r, p).
In particular, the negative binomial distribution recovers the geometric distribution when
r = 1.
v) The Poisson distribution.
We have
λ k −λ
P(X = k ) = e , k ⩾ 0,
k!
where λ > 0 is a parameter.
The probability that a discrete nonnegative random variable X : Ω −→ N ∪ {+∞} is finite is given
by

P(X < ∞) = ∑ P(X = k ), (11.5.13)

k⩾0

and we have
1 = P(X = ∞) + P(X < ∞) = P(X = ∞) + ∑ P(X = k ).
k⩾0

R The distribution of a discrete random variable cannot admit a probability density. If this were
the case, by Remark 11.5 we would have P(X = k) = 0 for all k ⩾ 0 and

1 = P(X ∈ R) = P(X ∈ N) = ∑ P(X = k) = 0,

k⩾0

which is a contradiction.
* The notation “inf” stands for “infimum”, meaning the smallest n ⩾ 0 such that Xn = 0, if such an n exists.

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 11.6 Expectation of Random Variables 321

Given two discrete random variables X and Y , the conditional distribution of X given Y = k is given
by
P(X = n and Y = k)
P(X = n | Y = k ) = , n ⩾ 0,
P(Y = k)
provided that P(Y = k) > 0, k ⩾ 0.

11.6 Expectation of Random Variables

The expectation, or expected value, of a random variable X is the mean, or average value, of X. In
practice, expectations can be even more useful than probabilities. For example, knowing that a
given equipment (such as a bridge) has a failure probability of 1.78493 out of a billion can be of
less practical use than knowing the expected lifetime (e.g. 200000 years) of that equipment.
For example, the time T (ω ) to travel from home to work/school can be a random variable with
a new outcome and value every day, however we usually refer to its expectation IE[T ] rather than to
its sample values that may change from day to day.
Expected value of a Bernoulli random variable
Any Bernoulli random variable X : Ω −→ {0, 1} can be written as the indicator function X := 1A
where A is the event A = {X = 1}, and the parameter p ∈ [0, 1] of X is given by

p = P(X = 1) = P(A) = IE[1A ] = IE[X ].

The expectation of a Bernoulli random variable with parameter p is defined as

IE[1A ] := 1 × P(A) + 0 × P(Ac ) = P(A). (11.6.1)

Expected value of a discrete random variable

Next, let X : Ω −→ N be a discrete random variable. The expectation IE[X ] of X is defined as the
sum

IE[X ] = ∑ kP(X = k), (11.6.2)

k⩾0

in which the possible values k ⩾ 0 of X are weighted by their probabilities. More generally we have

IE[φ (X )] = ∑ φ (k )P(X = k ),
k⩾0

for all sufficiently summable functions φ : N −→ R.

The expectation of the indicator function X = 1A = 1{X =1} can be recovered from (11.6.2) as

IE[X ] = IE[1A ] = 0 × P(Ω \ A) + 1 × P(A) = 0 + P(A) = P(A).

Note that the expectation is a linear operation, i.e. we have

IE[aX + bY ] = a IE[X ] + b IE[Y ], a, b ∈ R, (11.6.3)

provided that
IE[|X|] + IE[|Y |] < ∞.
Examples

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 322 Background on Probability Theory

i) Expected value of a Poisson random variable with parameter λ > 0:

λk λk
IE[X ] = ∑ kP(X = k) = e −λ ∑ k k! = λ e −λ ∑ = λ. (11.6.4)
k⩾0 k⩾1 k⩾0 k!

ii) Estimating the expected value of a Poisson random variable using R:

Taking λ := 2, we can use the following code:
poisson_samples <- rpois(100000, lambda = 2)
poisson_samples
mean(poisson_samples)

Given X : Ω −→ N ∪ {+∞} a discrete nonnegative random variable X, we have

P(X < ∞) = ∑ P(X = k ),

k⩾0

and
1 = P(X = ∞) + P(X < ∞) = P(X = ∞) + ∑ P(X = k ),
k⩾0

and in general
IE[X ] = +∞ × P(X = ∞) + ∑ kP(X = k).
k⩾0

In particular, P(X = ∞) > 0 implies IE[X ] = ∞, and the finiteness condition IE[X ] < ∞ implies
P(X < ∞) = 1, however the converse is not true. For example, assume that X has the geometric
distribution
1
P(X = k ) : = , k ⩾ 0, (11.6.5)
2k + 1
with parameter p = 1/2, and

k 1 k 1 1
IE[X ] = ∑ 2k+1 = 4 ∑ 2k−1 = 4 (1 − 1/2)2 = 1 < ∞.
k⩾0 k⩾1

Letting φ (X ) := 2X , we have

1
P(φ (X ) < ∞) = P(X < ∞) = ∑ 2k+1 = 1,
k⩾0

and
2k 1
IE[φ (X )] = ∑ φ (k)P(X = k) = ∑ 2k+1 = ∑ 2 = +∞,
k⩾0 k⩾0 k⩾0

hence the expectation IE[φ (X )] is infinite although φ (X ) is finite with probability one.*

Conditional expectation
The notion of expectation takes its full meaning under conditioning. For example, the expected
return of a random asset usually depends on information such as economic data, location, etc. In
this case, replacing the expectation by a conditional expectation will provide a better estimate of
the expected value.
* This is the St. Petersburg paradox.

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11.6 Expectation of Random Variables 323

For instance, life expectancy is a natural example of a conditional expectation since it typically
depends on location, gender, and other parameters.
The conditional expectation of a finite discrete random variable X : Ω −→ N given an event A
is defined by
P(X = k and A)
IE[X | A] = ∑ kP(X = k | A) = ∑ k .
k⩾0 k⩾1 P(A)
Lemma 11.7 Given an event A such that P(A) > 0, we have

1
IE X 1A .
 
IE[X | A] = (11.6.6)
P(A)
Proof. The proof is done only for X : Ω −→ N a discrete random variable, however (11.6.6) is
valid for general real-valued random variables. By Relation (11.4.1) we have
IE[X | A] = ∑ kP(X = k | A)
k⩾0
1 1
k IE 1{X =k}∩A
 
= ∑ kP({X = k} ∩ A) = ∑
P(A) k⩾0 P(A) k⩾0
" #
1 1
∑ k IE 1{X =k} 1A = P(A) IE 1A ∑ k1{X =k}
 
=
P(A) k⩾0 k⩾0
1
IE 1A X ,
 
=
P(A)
where we used the relation
X= ∑ k1{X =k}
k⩾0

which holds since X takes only integer values. □

Example
i) For example, consider Ω = {1, 3, −1, −2, 5, 7} with the non-uniform probability measure
given by
1 2 1
P({−1}) = P({−2}) = P({1}) = P({3}) = , P({5}) = , P({7}) = ,
7 7 7
and the random variable
X : Ω −→ Z
given by
X (k) = k, k = 1, 3, −1, −2, 5, 7.
Here, IE[X | X > 1] denotes the expected value of X given

A = {X > 1} = {3, 5, 7} ⊂ Ω,

i.e. the mean value of X given that X is strictly positive. This conditional expectation can be
computed as
IE[X | X > 1]
= 3 × P(X = 3 | X > 1) + 5 × P(X = 5 | X > 1) + 7 × P(X = 7 | X > 1)
3+2×5+7
=
4
3+5+5+7
=
7 × 4/7

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 324 Background on Probability Theory
1
IE X 1{X>1} ,
 
=
P(X > 1)
where P(X > 1) = 4/7 and the truncated expectation IE X 1{X>1} is given by IE X 1{X>1} =
   

(3 + 2 × 5 + 7)/7.
ii) Estimating a conditional expectation using R:
geo_samples <- rgeom(100000, prob = 1/4)
mean(geo_samples)
mean(geo_samples[geo_samples<10])

Taking p := 3/4, we have

p
IE[X ] = (1 − p) ∑ kpk = = 3,
k⩾1 1− p

and
1
IE X 1{X<10}
 
IE[X | X < 10] =
P(X < 10)
9
1
= ∑ kP(X = k)
P(X < 10) k=0
9
1
= 9 ∑ kpk
k =1
∑ pk
k =0
p(1 − p) ∂ 9 k
= p
1 − p10 ∂ p k∑
=0
p(1 − p) ∂ 1 − p10
 
=
1 − p10 ∂ p 1 − p
p(1 − p10 − 10(1 − p) p9 )
=
(1 − p)(1 − p10 )
≃ 2.4032603455.

If the random variable X : Ω −→ N is independent* of the event A, we have

IE[X 1A ] = IE[X ] IE[1A ] = IE[X ]P(A),

and we naturally find

IE[X | A] = IE[X ]. (11.6.7)

Taking X = 1A with
1A : Ω −→ {0, 1} 
1 if ω ∈ A,
ω 7−→ 1A :=
0 if ω ∈
/ A,
shows that, in particular,

IE[1A | A] = 0 × P(X = 0 | A) + 1 × P(X = 1 | A)

= P(X = 1 | A)
= P(A | A)
* i.e., P({X = k} ∩ A) = P({X = k})P(A) for all k ⩾ 0.

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11.6 Expectation of Random Variables 325

= 1.
One can also define the conditional expectation of X given A = {Y = k}, as

IE[X | Y = k] = ∑ nP(X = n | Y = k),

n⩾0

where Y : Ω −→ N is a discrete random variable.

Proposition 11.8 Given X a discrete random variable such that IE[|X|] < ∞, we have the relation

IE[X ] = IE[IE[X | Y ]], (11.6.8)

which is sometimes referred to as the tower property.

Proof. We have

IE[IE[X | Y ]] = ∑ IE[X | Y = k]P(Y = k)

k⩾0
= ∑ ∑ nP(X = n | Y = k)P(Y = k)
k⩾0 n⩾0
= ∑ n ∑ P(X = n and Y = k)
n⩾0 k⩾0
= ∑ nP(X = n) = IE[X ],
n⩾0

where we used the marginal distribution

P(X = n) = ∑ P(X = n and Y = k), n ⩾ 0,

k⩾0

that follows from the law of total probability (11.3.1) with Ak = {Y = k}, k ⩾ 0. □
Taking
Y= ∑ k1A , k
k⩾0

with Ak := {Y = k}, k ⩾ 0, from (11.6.8) we also get the law of total expectation

IE[X ] = IE[IE[X | Y ]] (11.6.9)

= ∑ IE[X | Y = k]P(Y = k)
k⩾0
= ∑ IE[X | Ak ]P(Ak ).
k⩾0

Example
Life expectancy in Singapore is IE[T ] = 80 years overall, where T denotes the lifetime of a given
individual chosen at random. Let G ∈ {m, w} denote the gender of that individual. The
statistics show that

IE[T | G = m] = 78 and IE[T | G = w] = 81.9,

and we have
80 = IE[T ]

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 326 Background on Probability Theory

= IE[IE[T |G]]
= P(G = w) IE[T | G = w] + P(G = m) IE[T | G = m]
= 81.9 × P(G = w) + 78 × P(G = m)
= 81.9 × (1 − P(G = m)) + 78 × P(G = m),
showing that
80 = 81.9 × (1 − P(G = m)) + 78 × P(G = m),

i.e.
81.9 − 80 1.9
P(G = m) = = = 0.487.
81.9 − 78 3.9
Variance
The variance of a random variable X is defined by

Var[X ] := IE X 2 − (IE[X ])2 ,

 

provided that IE |X|2 < ∞. If (Xk )k=1,...,n is a sequence of independent random variables, we have
 

" #  !2  " #!2

n n n
Var ∑ Xk = IE  ∑ Xk  − IE ∑ Xk
k =1 k =1 k =1
" # " # " #
n n n n
= IE ∑ Xk ∑ Xl − IE ∑ Xk IE ∑ Xl
k =1 l =1 k =1 l =1
" #
n n n n
= IE ∑ ∑ Xk Xl −∑ ∑ IE[Xk ] IE[Xl ]
k =1 l =1 k =1 l =1
n n
∑ IE Xk2 + IE[Xk Xl ] − ∑ (IE[Xk ])2 −
 
= ∑ ∑ IE[Xk ] IE[Xl ]
k =1 1⩽k̸=l⩽n k =1 1⩽k̸=l⩽n
n
IE Xk2 − (IE[Xk ])2
 

= ∑
k =1
n
= ∑ Var [Xk ]. (11.6.10)
k =1

Random sums
In what follows, we consider Y : Ω −→ N an a.s. finite, integer-valued random variable, i.e. we
have P(Y < ∞) = 1 and P(Y = ∞) = 0. Based on the tower property of conditional expectations
Y
(11.6.8) or ordinary conditioning, the expectation of a random sum ∑ Xk , where (Xk )k∈N is a
k =1
sequence of random variables, can be computed from the tower property (11.6.8) or from the law
of total expectation (11.6.9) as
" # " " ##
Y Y
IE ∑ Xk = IE IE ∑ Xk Y
k =1 k =1
" #
Y
= ∑ IE ∑ Xk Y = n P(Y = n)
n⩾0 k =1
" #
n
= ∑ IE ∑ Xk Y = n P(Y = n),
n⩾0 k =1

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11.6 Expectation of Random Variables 327

and if the sequence (Xk )k∈N is (mutually) independent of Y , this yields

" # " #
Y n
IE ∑ Xk = ∑ IE ∑ Xk P(Y = n)
k =1 n⩾0 k =1
n
= ∑ P(Y = n) ∑ IE[Xk ].
n⩾0 k =1

Random products
Similarly, for a random product we will have, using the independence of Y with (Xk )k∈N ,
" # " #
Y n
IE ∏ Xk = ∑ IE ∏ Xk P(Y = n) (11.6.11)
k =1 n⩾0 k =1
n
= ∑ P(Y = n) ∏ IE[Xk ],
n⩾0 k =1

where the last equality requires the (mutual) independence of the random variables in the sequence
(Xk )k⩾1 .
Distributions admitting a density
Given a random variable X whose distribution admits a probability density ϕX : R −→ R+ we have
w∞
IE[X ] = xϕX (x)dx,
−∞

and more generally,

w∞
IE[φ (X )] = φ (x)ϕX (x)dx, (11.6.12)
−∞

for all sufficiently integrable function φ on R. For example, if X has a standard normal distribution
we have w∞ 2 dx
IE[φ (X )] = φ (x) e −x /2 √ .
−∞ 2π
Examples
a) In case X has a Gaussian distribution with mean µ ∈ R and variance σ 2 > 0, we have
1 w∞ 2 2
IE[φ (X )] = √ φ (x) e −(x−µ ) /(2σ ) dx. (11.6.13)
2πσ 2 −∞
b) The uniform random variable U on [0, 1] satisfies IE[U ] = 1/2 < ∞ and

P(1/U < ∞) = P(U > 0) = P(U ∈ (0, 1]) = 1,

however we have w 1 dx
IE[1/U ] = = +∞,
0 x
and P(1/U = +∞) = P(U = 0) = 0.
c) If the random variable X has an exponential distribution with parameter µ > 0 we have
 µ
w∞  µ −λ < ∞
 if µ > λ ,
λ x −µx
 λX
IE e =µ e e dx =
0 

+∞, if µ ⩽ λ .

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 328 Background on Probability Theory

Exercise: In case X ≃ N ( µ, σ 2 ) has a Gaussian distribution with mean µ ∈ R and variance σ 2 > 0,
check that
σ 2 = IE X 2 − (IE[X ])2 .
 
µ = IE[X ] and

When (X,Y ) : Ω −→ R2 is a R2 -valued couple of random variables whose distribution admits a

probability density ϕX,Y : R2 −→ R+ we have
w∞ w∞
IE[φ (X,Y )] = φ (x, y)ϕX,Y (x, y)dxdy,
−∞ −∞

for all sufficiently integrable function φ on R2 .

The expectation of an absolutely continuous random variable satisfies the same linearity property
(11.6.3) as in the discrete case.

The conditional expectation of an absolutely continuous random variable can be defined as

w∞
IE[X | Y = y] = xϕX|Y =y (x)dx
−∞

where the conditional probability density ϕX|Y =y (x) is defined in (11.5.7), with the relation

IE[X ] = IE[IE[X | Y ]] (11.6.14)

which is called the tower property and holds as in the discrete case, since
w∞
IE[IE[X | Y ]] = IE[X | Y = y]ϕY (y)dy
w−∞
∞ w∞
= xϕX|Y =y (x)ϕY (y)dxdy
w−∞
∞
−∞
w ∞
= x ϕ(X,Y ) (x, y)dydx
w−∞
∞
−∞

= xϕX (x)dx = IE[X ],

−∞

where we used Relation (11.5.6) between the probability density of (X,Y ) and its marginal X.

For example, an exponentially distributed random variable X with probability density function
(11.5.2) has the expected value
w∞ 1
IE[X ] = λ x e −λ x dx = .
0 λ

Proposition 11.9 (Fatou’s lemma). Let (Fn )n∈N be a sequence of nonnegative random variable.
Then we have  
IE lim inf Fn ⩽ lim inf IE[Fn ].
n→∞ n→∞

In particular, Fatou’s lemma shows that if in addition the sequence (Fn )n∈N converges with
probability one and the sequence (IE[Fn ])n∈N converges in R then we have
 
IE lim Fn ⩽ lim IE[Fn ].
n→∞ n→∞

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11.6 Expectation of Random Variables 329

Moment Generating Functions

Characteristic functions
The characteristic function of a random variable X is the function

ΨX : R −→ C

defined by
ΨX (t ) = IE e itX , t ∈ R.
 

The characteristic function ΨX of a random variable X with probability density function f : R −→

R+ satisfies
w∞
ΨX (t ) = e ixt ϕ (x)dx, t ∈ R.
−∞

On the other hand, if X : Ω −→ N is a discrete random variable we have

ΨX (t ) = ∑ e itn P(X = n), t ∈ R.

n⩾0

One of the main applications of characteristic functions is to provide a characterization of probabil-

ity distributions, as in the following theorem.

Theorem 11.10 Two random variables X : Ω −→ R and Y : Ω −→ R have same distribution if

and only if
ΨX (t ) = ΨY (t ), t ∈ R.

Theorem 11.10 is used to identify or to determine the probability distribution of a random variable
X, by comparison with the characteristic function ΨY of a random variable Y whose distribution is
known.
The characteristic function of a random vector (X,Y ) is the function ΨX,Y : R2 −→ C defined
by
ΨX,Y (s,t ) = IE e isX +itY , s,t ∈ R.
 

Theorem 11.11 The random variables X : Ω −→ R and Y : Ω −→ R are independent if and

only if
ΨX,Y (s,t ) = ΨX (s)ΨY (t ), s,t ∈ R.

A random variable X has a Gaussian distribution with mean µ and variance σ 2 if and only if its
characteristic function satisfies
2 2
IE e iαX = e iα µ−α σ /2 , α ∈ R.
 
(11.6.15)

From Theorems 11.10 and 11.11 we deduce the following proposition.

Proposition 11.12 Let X ≃ N ( µ, σX2 ) and Y ≃ N (ν, σY2 ) be independent Gaussian random
variables. Then X + Y also has a Gaussian distribution

X + Y ≃ N ( µ + ν, σX2 + σY2 ).

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 330 Background on Probability Theory

Proof. Since X and Y are independent, by Theorem 11.11 the characteristic function ΨX +Y of
X + Y is given by

ΦX +Y (t ) = ΦX (t )ΦY (t )
2 σ 2 /2 2 σ 2 /2
= e itµ−t X e itν−t Y
2 (σ 2 +σ 2 ) /2
= e it (µ +ν )−t X Y , t ∈ R,

where we used (11.6.15). Consequently, the characteristic function of X + Y is that of a Gaussian

random variable with mean µ + ν and variance σX2 + σY2 and we conclude by Theorem 11.10.
□

Moment generating functions

The moment generating function of a random variable X is the function ΦX : R −→ R defined by

ΦX (t ) := IE e tX ,
 

for t in a neighborhood of 0. In particular, we have

∂n
IE[X n ] = ΦX (0), n ⩾ 1,
∂t n

provided that IE[|X|n ] < ∞, and

tn
ΦX (t ) = IE e tX = ∑ n! IE[X n ],
 
n⩾0

provided that IE e t|X| < ∞, t ∈ R, and for this reason the moment generating function GX
 

characterizes the moments IE[X n ] of X : Ω −→ N, n ⩾ 0.

The moment generating function ΦX of a random variable X with probability density function
f : R −→ R+ satisfies w∞
ΦX (t ) = e xt ϕ (x)dx, t ∈ R.
−∞

For example, the moment generating functions (MGF) of a Gaussian random variable X with mean
µ and variance σ 2 is given by
2 2
IE e αX = e α µ +α σ /2 , α ∈ R.
 
(11.6.16)

Note that in probability, the moment generating function is written as a bilateral transform defined
using an integral from −∞ to +∞.

11.7 Conditional Expectation

The construction of conditional expectations of the form IE[X | Y ] given above for discrete and
absolutely continuous random variables can be generalized to σ -algebras.
Definition 11.13 Given F a σ -algebra on Ω, a random variable X : Ω −→ R is said to be
F -measurable if
{X ⩽ x} := {ω ∈ Ω : X (ω ) ⩽ x} ∈ F ,
for all x ∈ R.

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11.7 Conditional Expectation 331

Intuitively, when X is F -measurable, the knowledge of the values of X depends only on the
information[contained in F . For example, when F = σ (A1 , . . . , An ) where (An )n⩾1 is a partition
of Ω with An = Ω, any F -measurable random variable X can be written as
n⩾1

n
X (ω ) = ∑ ck 1A (ω ),
k
ω ∈ Ω,
k =1

for some c1 , . . . , cn ∈ R.

Definition 11.14 Given (Ω, F , P) a probability space we let L2 (Ω, F ) denote the space of
F -measurable and square-integrable random variables, i.e.

L2 (Ω, F ) := X : Ω −→ R : IE |X|2 < ∞ .

  

More generally, for p ⩾ 1 one can define the space L p (Ω, F ) of F -measurable and p-integrable
random variables as
L p (Ω, F ) := X : Ω −→ R : IE[|X| p ] < ∞ .


We define a inner product ⟨·, ·⟩L2 (Ω,F ) between elements of L2 (Ω, F ), as

⟨X,Y ⟩L2 (Ω,F ) := IE[XY ], X,Y ∈ L2 (Ω, F ). (11.7.1)

This inner product is associated to the norm ∥ · ∥L2 (Ω) by the relation
q   q
∥X∥L2 (Ω) = IE X 2 = ⟨X, X⟩L2 (Ω,F ) , X ∈ L2 (Ω, F ).

The norm ∥ · ∥L2 (Ω) also defines the mean-square distance

q  
∥X −Y ∥L2 (Ω) = IE (X −Y )2

between random variables X,Y ∈ L2 (Ω, F ), and it induces a notion of orthogonality, namely X is
orthogonal to Y in L2 (Ω, F ) if and only if

⟨X,Y ⟩L2 (Ω,F ) = 0.

Proposition 11.15 The ordinary expectation IE[X ] achieves the minimum distance

2
X − IE[X ] L2 ( Ω )
= min ∥X − c∥2L2 (Ω) . (11.7.2)
c∈R

Proof. It suffices to differentiate

∂ 
IE (X − c)2 = −2 IE[X − c] = 0,

∂c
showing that the minimum in (11.7.2) is reached when IE[X − c] = 0, i.e. c = IE[X ]. □
Similarly to Proposition 11.15, the conditional expectation will be defined by a distance minimizing
procedure.

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 332 Background on Probability Theory

Definition 11.16 Given G ⊂ F a sub σ -algebra of F and X ∈ L2 (Ω, F ), the conditional

expectation of X given G , and denoted

IE[X | G ],

is defined as the orthogonal projection of X onto L2 (Ω, G ).

X
L2 (Ω, F )

L2 (Ω, G )
0 IE[X | G ]

As a consequence of the uniqueness of the orthogonal projection onto the subspace L2 (Ω, G ) of
L2 (Ω, F ), the conditional expectation IE[X | G ] is characterized by the relation

⟨Y , X − IE[X | G ]⟩L2 (Ω,F ) = 0,

which rewrites as
IE[Y (X − IE[X | G ])] = 0,

i.e.

IE[Y X ] = IE[Y IE[X | G ]],

for all bounded and H -measurable random variables Y , where ⟨·, ·⟩L2 (Ω,F ) denotes the inner
product (11.7.1) in L2 (Ω, F ). The next proposition extends Proposition 11.15 as a consequence of
Definition 11.16. See Theorem 5.1.4 page 197 of Stroock, 2011 for an extension of the construction
of conditional expectation to the space L1 (Ω, F ) of integrable random variable.

Proposition 11.17 The conditional expectation IE[X | G ] realizes the minimum in mean-square
distance between X ∈ L2 (Ω, F ) and L2 (Ω, G ), i.e. we have

∥X − IE[X | G ]∥L2 (Ω) = min ∥X −Y ∥L2 (Ω) . (11.7.3)

Y ∈L2 (Ω,G )

Proof. This is a consequence of the Pythagorean theorem written as

∥X −Y ∥L2 (Ω) = ∥X − IE[X | G ]∥L2 (Ω) + ∥ IE[X | G ] −Y ∥L2 (Ω) ,

for any Y ∈ L2 (Ω, G ). □

The following proposition will often be used as a characterization of IE[X | G ].

Proposition 11.18 Given X ∈ L2 (Ω, F ), Z := IE[X | G ] is the unique random variable Z in

L2 (Ω, G ) that satisfies the relation

IE[Y X ] = IE[Y Z ] (11.7.4)

for all bounded and G -measurable random variables Y .

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11.7 Conditional Expectation 333

We note that taking Y = 1 in (11.7.4) yields

IE[IE[X | G ]] = IE[X ]. (11.7.5)
In particular, when G = {0,
/ Ω} we have IE[X | G ] = IE[X | {0,
/ Ω}] and
/ Ω}] = IE[IE[X | {0,
IE[X | {0, / Ω}]] = IE[X ]
/ Ω}] is in L2 (Ω, {0,
because IE[X | {0, / Ω}) and is a.s. constant. In addition, the conditional
expectation operator has the following properties.
i) IE[XY | G ] = Y IE[X | G ] if Y depends only on the information contained in G .
Proof. By the characterization (11.7.4) it suffices to show that
IE[H (XY )] = IE[H (Y IE[X|G ])], (11.7.6)
for all bounded and G -measurable random variables H, which implies IE[XY | G ] = Y IE[X |
G ].
Relation (11.7.6) holds from (11.7.4) because the product HY is G -measurable hence Y in
(11.7.4) can be replaced with HY .
ii) IE[Y |G ] = Y when Y depends only on the information contained in G .
Proof. This is a consequence of point (i) above by taking X := 1.
iii) IE[IE[X|G ] | H ] = IE[X|H ] if H ⊂ G , called the tower property.
Proof. First, we note that by (11.7.5), (iii) holds when H = {0,
/ Ω}. Next, by the characteri-
zation (11.7.4) it suffices to show that
IE[H IE[X|G ]] = IE[H IE[X|H ]], (11.7.7)
for all bounded and H -measurable random variables H, which will imply (iii) from (11.7.4).
In order to prove (11.7.7) we check that by point (i) above and (11.7.5) we have
IE[H IE[X|G ]] = IE[IE[HX|G ]] = IE[HX ]
= IE[IE[HX|H ]] = IE[H IE[X|H ]],
and we conclude by the characterization (11.7.4).
iv) IE[X|G ] = IE[X ] when X “does not depend” on the information contained in G or, more
precisely stated, when the random variable X is independent of the σ -algebra G .
Proof. It suffices to note that for all bounded G -measurable Y we have
IE[XY ] = IE[X ] IE[Y ] = IE[Y IE[X ]],
and we conclude again by (11.7.4).
v) If Y depends only on G and X is independent of G , then
IE[h(X,Y )|G ] = IE[h(X, x)]x=Y . (11.7.8)
Proof. This relation can be proved using the tower property, by noting that for any bounded
K ∈ L2 (Ω, G ) we have
IE[K IE[h(x, X )]x=Y ] = IE[K IE[h(x, X ) | G ]x=Y ]
= IE[K IE[h(Y , X ) | G ]]
= IE[IE[Kh(Y , X ) | G ]]
= IE[Kh(Y , X )],
which yields (11.7.8) by the characterization (11.7.4).

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 334 Background on Probability Theory
The notion of conditional expectation can be extended from square-integrable random variables in
L2 (Ω, F ) to integrable random variables in L1 (Ω, F ), cf. e.g. Theorem 5.1 in Kallenberg, 2002.

Proposition 11.19 When the σ -algebra G := σ (A1 , A2 , . . . , An ) is generated by n disjoint events

A1 , A2 , . . . , An ∈ F , we have
n n
IE[X 1Ak ]
IE[X | G ] = ∑ 1A k
IE[X | Ak ] = ∑ 1A k
P(Ak )
.
k =1 k =1

Proof. It suffices to note that the G -measurable random variables can be generated by indicators of
the form 1Al , and that

IE[X 1Ak ] IE[X 1Al ]

" #
n  
IE 1Al ∑ 1Ak = IE 1Al
k =1 P(Ak ) P(Al )
IE[X 1Al ]  
= IE 1Al
P(Al )
= IE X 1Al ,
 
l = 1, 2, . . . , n,

showing (11.7.4). The relation

IE[X 1Ak ]
IE[X | Ak ] = , k = 1, 2, . . . , n,
P(Ak )

follows from Lemma 11.7. □

For example, in case Ω = {a, b, c, d} and G = 0,

/ Ω, {a, b}, {c}, {d} , we have


IE[X | G ] = 1{a,b} IE[X | {a, b}] + 1{c} IE[X | {c}] + 1{d} IE[X | {d}]
IE X 1{a,b} IE X 1{c} IE X 1{d}
     
= 1{a,b} + 1{c} + 1{d} .
P({a, b}) P({c}) P({d})

Regarding conditional probabilities we have similarly, for A ⊂ Ω = {a, b, c, d},

P A ∩ {a, b} P A ∩ {c} P A ∩ {d}

P(A | G ) = 1{a,b} + 1{c} + 1{d}
P({a, b}) P({c}) P({d})
= 1{a,b} P(A | {a, b}) + 1{c} P(A | {c}) + 1{d} P(A | {d}).

In particular, if A = {a} ⊂ Ω = {a, b, c, d} we find

P({a} | G ) = 1{a,b} P({a} | {a, b})

P {a} ∩ {a, b}


= 1{a,b}
P({a, b})
P({a})
= 1{a,b} .
P({a, b})

In other words, the probability of getting the outcome a is P({a})/P({a, b}) knowing that the
outcome is either a or b, otherwise it is zero.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

11.7 Conditional Expectation 335

Exercises

Exercise A.1 Compute the expected value IE[X ] of a Poisson random variable X with parameter
λ > 0.

Exercise A.2 Let X denote a centered Gaussian random variable with variance η 2 , η > 0. Show
that the probability P(eX > c) is given by

P(eX > c) = Φ(−(log c)/η ),

where log = ln denotes the natural logarithm and

1 w x −y2 /2
Φ (x ) = √ e dy, x ∈ R,
2π −∞
denotes the Gaussian cumulative distribution function.

Exercise A.3 Let X ≃ N ( µ, σ 2 ) be a Gaussian random variable with parameters µ > 0 and σ 2 > 0,
and density function
1 (x−µ )2
−
f (x ) = √ e 2σ 2 , x ∈ R.
2πσ 2
a) Write down IE[X ] as an integral and show that

µ = IE[X ].

b) Write down IE[X 2 ] as an integral and show that

σ 2 = IE[(X − IE[X ])2 ].

c) Consider the function x 7→ (x − K )+ from R to R+ , defined as


 x − K if x ⩾ K,
(x − K ) + =
0 if x ⩽ K,


where K ∈ R be a fixed real number. Write down IE[(X − K )+ ] as an integral and compute
this integral.

Hints: (x − K )+ is zero when x < K, and when µ = 0 and σ = 1 the result is

1 K2
IE[(X − K )+ ] = √ e− 2 − KΦ(−K ),
2π
where wx y2 dy
Φ (x ) : = e− 2 √ , x ∈ R.
−∞ 2π
d) Write down IE[eX ] as an integral, and compute IE[eX ].

Exercise A.4 Let X be a centered Gaussian random variable with variance α 2 > 0 and density
2 2
x 7→ √ 1 2 e−x /(2α ) and let β ∈ R.
2πα
a) Write down IE[(β − X )+ ] as an integral. Hint: (β − x)+ is zero when x > β .

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 336 Some Useful Identities

b) Compute this integral to show that

α − β2
IE[(β − X )+ ] = √ e 2α 2 + β Φ(β /α ),
2π
where wx y2 dy
Φ (x ) = e− 2 √ , x ∈ R.
−∞ 2π

Exercise A.5 Let X be a centered Gaussian random variable with variance v2 .

a) Compute
h i 1 w∞ 2 2
IE eσ X 1[K,∞[ (xeσ X ) = √ 1 K
eσ y−y /(2v ) dy.
2
2πv σ log x
Hint: use the decomposition

y2 v2 σ 2  y vσ 2
σy− = − − .
v2 4 v 2
b) Compute
1 w ∞ m+x 2 2
IE[(em+X − K )+ ] = √ (e − K )+ e−x /(2v ) dx.
2πv2 −∞

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 337

Some Useful Identities

Here we present a summary of algebraic identities that are used in this text.

Indicator functions
 
 1 if x ∈ A,  1 if a ⩽ x ⩽ b,
1A (x) = 1[a,b] (x) =
0 if x ∈
/ A. 0 otherwise.
 

Binomial coefficients
 
n n!
:= , k = 0, 1, . . . , n.
k (n − k)!k!

Exponential series
∞
xn
ex = ∑ , x ∈ R. (12.9)
n=0 n!

Geometric sum
n
1 − r n+1
∑ rk = 1−r
, r ̸= 1. (12.10)
k =0

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 338 Some Useful Identities

Geometric series
∞
1
∑ rk = 1 − r , −1 < r < 1. (12.11)
k =0

Differentiation of geometric series

∞
∂ ∞ k ∂ 1 1
∑ krk−1 = ∑
∂ r k =0
r =
∂r 1−r
=
(1 − r )2
, −1 < r < 1. (12.12)
k =1

Binomial identities
n  
n
∑ k ak bn−k = (a + b)n .
k =0

n  
n
∑ k = 2n . (12.13)
k =0

n  
n
∑ k k = n2n−1 .
k =1

n   n
n n!
∑ k k ak bn−k = ∑ (n − k)!(k − 1)! ak bn−k
k =0 k =1
n−1
n!
= ∑ (n − 1 − k)!k! ak+1 bn−1−k
k =0
n−1 
n − 1 k+1 n−1−k

=n∑ a b
k =0 k
= na(a + b)n−1 , n ⩾ 1,

n
∂ n n k n−k
   
n k n−k
∑ k k a b = a∂a ∑ k a b
k =0 k =0
∂
=a (a + b)n
∂a
= na(a + b)n−1 , n ⩾ 1.

Sums of integers
n
n(n + 1)
∑k= 2
. (12.14)
k =1

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MH4514 Financial Mathematics 339
n
n(n + 1)(2n + 1)
∑ k2 = 6
. (12.15)
k =1

Taylor expansion
∞
xk
(1 + x )α = ∑ k! α (α − 1) × · · · × (α − (k − 1)). (12.16)
k =0

Differential equation

The solution of f ′ (t ) = c f (t ) is given by f (t ) = f (0) e ct , t ∈ R+ . (12.17)

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MH4514 Financial Mathematics 341

Exercise Solutions

Chapter 1 - Discrete-Time Martingales

Exercise 1.1 (Steele, 2001, page 3). For all k = 0, 1, . . . , B and n ⩾ 1 we have
P(τ0,B = ∞ | S0 = k) ⩽ P(τ0,B > nB | S0 = k)
!
n−1
⩽ P
\
{XkB+1 = 1, . . . , X(k+1)B = 1}c
k =0
k n
= (1 − p ) ,
from which we obtain P(τ0,B = ∞ | S0 = k) = 0 after letting n tend to infinity when p ∈ [0, 1),
hence P(τ0,B < ∞ | S0 = k) = 1. In case p = 1, we clearly have P(τ0,B < ∞ | S0 = k) = 1.

Exercise 1.2
a) We have " #
n+1
IE [Mn+1 | Fn ] = IE ∑2 k−1
Xk Fn
k =1
" #
n
= IE ∑ 2k−1 Xk Fn + IE [2n Xn+1 | Fn ]
k =1
n
= ∑ 2k−1 Xk + 2n IE[Xn+1 ]
k =1
= Mn , n ⩾ 0.
b) This random time is a hitting time, so it is a stopping time.
c) The strategy of the gambler is to double the stakes each time he loses (double down strategy),
and to quit the game as soon as his gains reach $1.
d) The two possible values of Mτ∧n are 1 and
n
1 − 2n
− ∑ 2k−1 = − = 1 − 2n , n ⩾ 1.
k =1 1−2

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 342 Exercise Solutions

We have

P(Mn∧τ = 1 − 2n ) = 2−n and P(Mn∧τ = 1) = 1 − 2−n , n ⩾ 1.

e) We have
IE[Mn∧τ ] = (1 − 2n )P(Mn∧τ = 1 − 2n ) + P(Mn∧τ = 1)
= (1 − 2n )2−n + (1 − 2−n )
= 0, n ⩾ 1.
f) The Stopping Time Theorem 1.8 directly states that

IE[Mn∧τ ] = IE[M0 ] = 0.

Exercise 1.3
a) The random time τ is a stopping time because for every n ⩾ 0, the validity of the event
{τ > n} can be decided
6 by studying the path of the process (Sk )k⩾0 until time n.
b) The range of possible values of Sτ is {−1, 0, 1, 2, 3, 4, . . .}.
5

Sτ = 3

S0 = 0
0 1 2 3 4 5 6 7 n
τ

Figure S.2: Sample path of the random walk (Sn )n∈N .

c) According to the stopping time theorem, the stopped process (Sn∧τ )n⩾0 is a martingale, and
therefore we have
 
IE[Sτ ] = IE lim Sn∧τ = lim IE[Sn∧τ ] = lim IE[S0 ] = 0.
n→∞ n→∞ n→∞

The exchange between between limit and expected value can be justified from the dominated
convergence theorem, see the next question.
d) We have P(Sτ = −1) = 1/2 and P(Sτ = k) = 1/2k+1 , k ⩾ 0. In particular, we have
Sn∧τ ⩽ 1 + Sτ , and Sτ is integrable according to the next question.
e) We have
IE[Sτ ] = ∑ kP(Sτ = k)
k∈Z
1
= − + ∑ kP(Sτ = k)
2 k⩾0
1
= − + ∑ k2k+2
2 k⩾0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 343
1 1 k
= − + ∑ k−1
2 8 k⩾0 2
1 1 1
= − +
2 8 (1 − 1/2)2
= 0.

Exercise 1.4 We note that for all n ⩾ 1 we have

{τ = n} = {τ ⩾ n} \ {τ > n} = {τ > n − 1} ∩ {τ > n}c ∈ Fn ,

since {τ > n} ∈ Fn and {τ > n − 1} ∈ Fn−1 ⊂ Fn . In case n = 0, we have

{τ = 0} = {τ > 0}c ∈ F0 .

Conversely, assuming that (1.5.1) holds, we have

!c
n n
{τ = k}c ∈ Fn ,
[ \
c
{τ > n} = {τ ⩽ n} = {τ = k} =
k =0 k =0

since
{τ = k} ∈ Fk ⊂ Fn , k = 0, 1, . . . , n.

Exercise 1.5 We consider several examples.

i) Consider the stopped martingale (Xn )n⩾0 := (Mτ∧n )n∈N of Exercise 1.2, for which by
Question (e)) therein we have IE[Xn ] = IE[Mτ∧n ] = 0, n ⩾ 0, hence

lim IE[Xn ] = lim IE[Mτ∧n ] = 0,

n→∞ n→∞

while
lim Xn = lim Mτ∧n = 1,
n→∞ n→∞

sequence of events ({Xn = 1})n⩾1 satisfies

a.s.. Indeed, by (11.2.5), the non-decreasing !

P lim Xn = 1 = P

[
{Xn = 1}
n→∞
n⩾1
= lim P(Xn = 1)
n→∞
 
1
= lim 1 − n
n→∞ 2
= 1.
Note that here the sequence (Mn )n⩾0 is unbounded, as

inf Mn = −∞ and Sup |Mn | = +∞.

n∈N n∈N

ii) Consider the random sequence Xn := n1{U<1/n} , n ⩾ 1, where U ≃ U (0, 1] is a uniformly

distributed random variable on (0, 1]. More formally, (Xn )n⩾1 can be constructed by e.g.
taking Ω = (0, 1) with the probability measure P defined by P([a, b]) = b−a, 0 < a ⩽ b < 1,
and defining the random variable Xn (ω ) = n1{0<ω<1/n} , ω ∈ (0, 1), in which case we
have Supn⩾1 |Xn | = +∞, IE[Xn ] = n × (1/n − 0) = 1, n ⩾ 1, and limn→∞ Xn (ω ) = 0 for all
ω ∈ (0, 1).

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 344 Exercise Solutions

iii) Consider the random sequence Xn := n2 1{Un <1/n2 } , n ⩾ 1, where (Un )n⩾1 ≃ U (0, 1] is a
sequence of uniformly distributed random variables on (0, 1]. On the one hand, we have

IE[Xn ] = n2 IE[1{Un <1/n2 } ] = n2 P(1{Un <1/n2 } ) = 1, n ⩾ 1.

On the other hand, we have

∞ ∞
1
∑ P(Xn > 0) = ∑ n2 < ∞,
n=1 n=1

hence by the Borel-Cantelli Lemma, the probability that Xn > 0 infinitely many times is
zero, which yields limn→∞ Xn = 0 almost surely, i.e. with probability one.

Exercise 1.6
a) From the tower property of conditional expectations (11.6.8), we have:

IE[Mn+1 ] = IE[IE[Mn+1 | Fn ]] ⩾ IE[Mn ], n ⩾ 0.

b) If (Zn )n∈N is a stochastic process with independent increments having nonnegative expecta-
tions, we have
IE[Zn+1 | Fn ] = IE[Zn | Fn ] + IE [Zn+1 − Zn | Fn ]
= IE[Zn | Fn ] + IE[Zn+1 − Zn ]
⩾ IE[Zn | Fn ] = Zn , n ⩾ 0.
c) We define (An )n⩾0 by induction with A0 := 0 and

An+1 := An + IE[Mn+1 − Mn | Fn ], n ⩾ 0,

and let

Nn := Mn − An , n ⩾ 0. (S.1)

(i) For all n ⩾ 0, we have

IE[Nn+1 | Fn ] = IE[Mn+1 − An+1 | Fn ]
= IE[Mn+1 − An − IE[Mn+1 − Mn | Fn ] | Fn ]
= IE[Mn+1 − An | Fn ] − IE[IE[Mn+1 − Mn | Fn ] | Fn ]
= IE[Mn+1 − An | Fn ] − IE[Mn+1 − Mn | Fn ]
= − IE[An | Fn ] + IE[Mn | Fn ]
= Mn − An
= Nn ,
hence (Nn )n⩾0 is a martingale with respect to (Fn )n⩾0 .
(ii) For all n ⩾ 0, we have
An+1 − An = IE[Mn+1 − Mn | Fn ]
= IE[Mn+1 | Fn ] − IE[Mn | Fn ]
= IE[Mn+1 | Fn ] − Mn ⩾ 0,
since (Mn )n⩾0 is a submartingale.
(iii) By induction we have An+1 = An + IE[Mn+1 − Mn | Fn ], n ⩾ 0, which is Fn -measurable
if An is Fn−1 -measurable, n ⩾ 1.
(iv) This property is obtained by construction in (S.1).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 345

d) For all bounded stopping times σ and τ such that σ ⩽ τ a.s., we have IE[Aσ ] ⩽ IE[Aτ ], and
IE[Nσ ] = IE[Nτ ] by (1.3.3), hence
IE[Mσ ] = IE[Nσ ] + IE[Aσ ]
= IE[Nτ ] + IE[Aσ ]
⩽ IE[Nτ ] + IE[Aτ ]
= IE[Mτ ],
by (1.3.3), since (Nn )n⩾0 is a martingale and (An )n⩾0 is non-decreasing.

Exercise 1.7
a) We will show more generally that

φ ( p1 x1 + p2 x2 + · · · + pn xn ) ⩽ p1 φ (x1 ) + p2 φ (x2 ) + · · · + pn φ (xn ), (S.2)

x1 , . . . , xn ∈ R, for any sequence of coefficients p1 , p2 , . . . , pn ⩾ 0 such that p1 + p2 + · · · +

pn = 1. The inequality (S.2) clearly holds for n = 1, and for n = 2 it coincides with the
convexity property of φ , i.e.

φ ( p1 x1 + p2 x2 ) ⩽ p1 φ (x1 ) + p2 φ (x2 ), x1 , x2 ∈ R.

Assuming that (S.2) holds for some n ⩾ 1 and taking p1 , p2 , . . . , pn+1 ⩾ 0 such that p1 +
p2 + · · · + pn+1 = 1 and 0 < pn+1 < 1 and applying (1.5.2) at the second order, we have
φ ( p1 x1 + p2 x2 + · · · + pn+1 xn+1 )
p1 x1 + p2 x2 + · · · + pn xn
 
= φ (1 − pn+1 ) + pn+1 xn+1
1 − pn + 1
p1 x1 + p2 x2 + · · · + pn xn
 
⩽ ( 1 − pn + 1 ) φ + pn + 1 φ ( xn + 1 )
1 − pn + 1
p1 φ ( x1 ) + p2 φ ( x2 ) + · · · + pn φ ( xn )
 
⩽ ( 1 − pn + 1 ) + pn+1 φ (xn+1 )
1 − pn + 1
= p1 φ (x1 ) + p2 φ (x2 ) + · · · + pn+1 φ (xn+1 ),
and we conclude by induction.
b) Taking p1 = p1 = · · · = pN = 1/N, we have

S1 + · · · + SN φ (S1 ) + · · · + φ (SN )
    
IE∗ φ ⩽ IE∗ since φ is convex,
N N
∗ ∗
IE [φ (S1 )] + · · · + IE [φ (SN )]
=
N
IE∗ [φ (IE∗ [SN | F1 ])] + · · · + IE∗ [φ (IE∗ [SN | FN ])]
= because (Sn )n⩾0 is a martingale,
N
IE∗ [IE∗ [φ (SN ) | F1 ]] + · · · + IE∗ [IE∗ [φ (SN ) | FN ]]
⩽ by Jensen’s inequality,
N
IE∗ [φ (SN )] + · · · + IE∗ [φ (SN )]
= by the tower property,
N
= IE∗ [φ (SN )].

c) This is an application of the above bound to the convex payoff function x 7→ (x − K )+ , see
Figure S.3 and the code below for an illustration.

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 346 Exercise Solutions

nSim=99999;p=0.4;q=1-p;n=7;a=q/p;r=1;european=0;asian=0;K=1.5
dev.new(width=16,height=7)
for (j in 1:nSim){S<-a^cumsum(2*rbinom(n,1,p)-1);color="blue"
A<-sum(c(1,S))/(n+1);if (S[n]>=K) {european=european+S[n]-K}
if (A>=K) {asian=asian+A-K};if (S[n]>A) {color="darkred"} else {color="darkgreen"}
plot(seq(0,n),c(1,S), xlab = "Time", xlim=c(0,n), type='o',ylim = c(0,a^(n-2)), lwd = 3, ylab = "", col =
color,main=paste("Asian Price=",format(round(asian,2)),"/", j,"=",format(round(asian/j,2)),"European
Price=",format(round(european,2)), "/",j,"=",format(round(european/j,2))), xaxs='i',xaxt='n',yaxt='n',
yaxs='i', yaxp = c(0,10,10))
text(3,6,paste("A-Payoff=",format(round(max(A-K,0),2))," E-Payoff=", format(round(max(S[n]-K,0),2))),
col=color,cex=2)
axis(1, at=seq(0,n), labels=seq(0,n), las=1)
axis(2, at=c(0,K,A,1,2,3,4,5,6,7,8,9,10), labels=c(0,"K","Average",1,2,3,4,5,6,7,8,9,10), las=2)
lines(seq(0,n),rep(K,n+1),col = "red",lty = 1, lwd = 4);
lines(seq(0,n),rep(A,n+1),col = "darkgreen",lty = 2, lwd = 4); Sys.sleep(0.1)
if (S[n]>K || A>K) {readline(prompt = "Pause. Press <Enter> to continue...")}}

Asian
Price= 6.12 / 36 = 0.17 European
Price= 17.46 / 36 = 0.49

6
A−Payoff= 1.27 ,
E−Payoff= 1.87
●
5

● ● ●

3
Average
● ●
2

K ● K

1 ●

0
0 1 2 3 4 5 6 7

Time

Figure S.3: Asian option price vs. European option price.*

Exercise 1.8
a) We have
IE[Mn ] ⩽ IE[IE[Mn+1 | Fn ]] = IE[Mn+1 ], n ⩾ 0.
b) We write
n
Sn − αn = ∑ (Xk − p) + n( p − α )
k =1
= (X1 + X2 + · · · + Xn − np) +n( p − α )
| {z }
martingale
= Sn − np + ( p − α )n
as the sum of a martingale (a stochastic process with centered independent increments) and
( p − α )n. As in the Doob-Meyer decomposition of Exercise 1.6-(c)), we conclude that
(Sn )n⩾0 is a submartingale if and only if p ⩾ α. Indeed, we have
IE[Sn − αn | Fk ] = IE[X1 + X2 + · · · + Xn − np | Fk ] + ( p − α )n
= X1 + X2 + · · · + Xk − kp + ( p − α )n
* The animation works in Acrobat Reader.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 347

= X1 + X2 + · · · + Xk − kα + (n − k)( p − α )
⩾ Sk − kα, k = 0, 1, . . . , n,
if and only if p ⩾ α.

Exercise 1.9
a) We have
φ (Mk ) = φ (IE[Mn | Fk ]) ⩽ IE[φ (Mn ) | Fk ], k = 0, 1, . . . , n
b) We have
φ (Mk ) ⩽ φ (IE[Mn | Fk ]) ⩽ IE[φ (Mn ) | Fk ], k = 0, 1, . . . , n.

Problem 1.10
a) We have
n
\
{τx > n} = {Mk < x}.
k =0

On the other hand, for all k = 0, 1, . . . , n we have {Mk < x} ∈ Fk ⊂ Fn , hence {τx > n} ∈ Fn
by stability of σ -algebras by intersection, cf. (11.1.1).
b) We have  
xP Max Mk ⩾ x = xP(τx ⩽ n)
k=0,1,...,n
= x IE[1{τx ⩽n} ]
⩽ IE Mτx 1{τx ⩽n}
 

= IE Mτx ∧n 1{τx ⩽n}

 
(S.3)
⩽ IE[Mτx ∧n ] (S.4)
⩽ IE[Mτx ∧0 ]
⩽ IE[M0 ]
= IE[Mn ], (S.5)
where we used the condition Mτx ∧n ⩾ 0 from (S.3) to (S.4), hence
  IE[M ]
n
P Max Mk ⩾ x ⩽ , x > 0. (S.6)
k=0,1,...,n x

Remark. The nonnegativity of (Mn )n⩾0 is used to reach (S.4), and the Doob Stopping Time
Theorem 1.8 is used to derive (S.5).
c) When (Mn )n⩾0 is a submartingale, by the Doob Stopping Time Theorem 1.8 for submartingales
we have
IE[Mτx ∧n ] ⩽ IE[Mn ],
see Exercise 1.6-(d)), showing that (S.5) and (S.6) above still hold in this case.
d) Since x 7→ x2 is a convex function, ((Mn )2 )n∈N is a submartingale by Question (a)), hence
by Question (c)) we have
    IE[(M )2 ]
n
P Max Mk ⩾ x = P Max (Mk )2 ⩾ x2 ⩽ , x > 0.
k=0,1,...,n k=0,1,...,n x2

e) Similarly to Question (d)), x 7→ x p is a convex function for all p ⩾ 1 hence ((Mn ) p )n∈N is a
submartingale by Question (a)), and by Question (c)) we find
    IE[(M ) p ]
n
P Max Mk ⩾ x = P Max (Mk ) p ⩾ x p ⩽ p
, x > 0.
k=0,1,...,n k=0,1,...,n x

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 348 Exercise Solutions

f) We note that (Sn )n⩾0 is a martingale because it has centered and independent increments,
with
IE[(Sn )2 ] = Var[Sn ] = n Var[Y1 ] = nσ 2 ,

hence by Question (d)) we have

  IE[(S )2 ] nσ 2
n
P Max Sk ⩾ x ⩽ = , x > 0.
k=0,1,...,n x2 x2

g) When (Mn )n⩾0 is a (not necessarily nonnegative) submartingale we can modify the an-
swer to Question (b)) using the Doob Stopping Time Theorem 1.8 for submartingales, see
Exercise 1.6-(d)),
 as follows:

xP Max Mk ⩾ x = x IE[1{τx ⩽n} ]
k=0,1,...,n
⩽ IE Mτx ∧n 1{τx ⩽n}
 

⩽ IE[(Mτx ∧n )+ ]
⩽ IE[(Mn )+ ],
since ((Mk )+ )k∈N is a submartingale because x 7→ x+ is a non-decreasing convex function,
cf. Exercise 1.9-(b)), hence
  IE[(M )+ ]
n
P Max Mk ⩾ x ⩽ , x > 0.
k=0,1,...,n x

h) We have  
xP Max Mk ⩾ x = xP(τx ⩽ n)
k=0,1,...,n
= x IE[1{τx ⩽n} ]
IE Mτx ∧n 1{τx ⩽n}
 
⩽
⩽ IE[Mτx ∧n ]
⩽ IE[M0 ].
i) We have   h i
xP Max φ (Mk ) ⩾ x = x IE 1{Maxk=0,1,...,n φ (Mk )⩾x}
k=0,1,...,n
h i
= x IE 1{τxφ ⩽n}
h   i
= IE φ Mτxφ ∧n 1{τxφ ⩽n}


= IE φ Mτ φ ∧n x

⩽ IE[φ (Mn )],

φ
where the last inequality follows from Exercise 1.6-(d)), since both τx ∧ n and n are stopping
times.
j) Consider for example any nonnegative martingale such as Mn = ( p/q)Sn where Sn = X1 +
· · · + Xn and (Xk )k⩾1 is a sequence of independent identically distributed Bernoulli random
variables with p = P(Xk = 1) and q = 1 − p = P(Xk = −1), k ⩾ 1. Then Zn := e −n Mn will
be a supermartingale, since
IE[Zn | Fk ] = e −n IE[Mn | Fk ]
= e −n Mk
⩽ e −k Mk
= Zk , k = 0, 1, . . . , n.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 349

Exercise 1.11 We have

"  #
q rSn
IE[(Mn )r ] = IE
p
"   #
n
q r(Sk −Sk−1 )
= IE ∏
k =1 p
"  #
n
q r(Sk −Sk−1 )
= ∏ IE p
k =1
n  r  −r !
q q
= ∏ p p +q p
k =1
  r  r n
q p
= p +q
p q
 2r 2r
n
pq + qp
=
( pq)r

n
= IE[(M1 )r ] .

We note that by Jensen’s inequality we have

r
IE[(M1 )r ] ⩾ IE[M1 ] = 1,

and IE[(Mn )r ] is non-decreasing in n ⩾ 0 as ((Mn )r )n∈N is a submartingale. By Problem 1.10-(e)),

for all n ⩾ 0 and r ⩾ 1 we have

  IE[(Mn )r ]
P Max Mk ⩾ x ⩽
k=0,1,...,n xr
( p(q/p)r + q( p/q)r )n
= , x > 0. (S.7)
xr

We also check that

"  #
r q rS2n
IE[(M2n ) ] = IE
p
n
q 2kr
 
= ∑ P(S2n = 2k)
k=−n p
n    2kr
2n q
= ∑ n + k p pn+k qn−k
k=−n
2n    2(k−n)r
2n q
= ∑ k p pk q2n−k
k =0
 −2nr !k
2n    2r−1
q 2n 2n q
= q ∑
p k =0 k p
  r  r 2n
q p
= p +q .
p q

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 350 Exercise Solutions

1.0

Upper bound
0.8 Monte Carlo Estimate
Probability

0.6

0.4

0.2

0.0
0 5 10 15 20 25
x
Figure S.4: Supremum deviation probability with n = 7 and p = 0.4.

Note also that when r = 1 we find

  IE[M ] 1
1
P Max Mk ⩾ x ⩽ = , x > 0.
k=0,1,...,n x x

The following code together with Figures S.4-S.5 provide a numerical confirmation of the upper
bound (S.7) when r = 1.

nSim=99999;p=0.4;q=1-p;n=7;a=q/p;r=1;prob=rep(0,2*n+2)
par(mar=c(2,3,2,2));par(mgp=c(1,1,0)); for (i in (-n):(n+1)){for (j in 1:nSim){
M<-a^cumsum(2*rbinom(n,1,p)-1);color="blue"
if (max(c(1,M))>=a^i) {prob[n+1+i]=prob[n+1+i]+1;color="darkred"}
if ((j%%10000)==0){
plot(seq(0,n),c(1,M), xlab = "Time", xlim=c(0,n), type='o',ylim = c(0,a^(n-1)), lwd = 3, ylab
= "", col = color, main='',xaxs='i',yaxs='i',yaxp = c(0, 11, 11), las =1)
text(3,8,paste("x=",format(round(a^i,2)),",
",prob[n+1+i],"/",j,"=",format(prob[n+1+i]/j,digits=4)),col=color,cex=2)
axis(2, at=c(a^i), labels=c("x"), las=1)
lines(seq(0,n),rep(a^i,n+1),col = "black",lty = 2, lwd = 2); text(-0.1,a^i,
paste("x"));Sys.sleep(0.9)}}
prob[n+1+i]=prob[n+1+i]/nSim};x=a^seq(-n,n+1); par(mar=c(2,3,2,2));par(mgp=c(1,1,0))
plot(x,prob,type="o",pch=19,lwd=3,col="red",xlab="x",ylim=c(0,1),
ylab="Probability",main="",axes=FALSE,cex.axis=1.5, cex.lab=1.5)
lines(x,(p*a^r+q*(p/q)^r)^n/x^r,type="o",pch=19,lwd=3,col="blue",main="")
axis(1, pos=0,las =1);axis(2, pos=0,las =1);
legend(4, 1, legend=c("Upper bound", "Monte Carlo estimate"), col=c("blue","red"), lty=1,
lwd=6,cex=2)
for (i in 0:(n+1)){segments(x0=a^i, y0=prob[n+1+i],x1=a^i,
(p*a^r+q*a^(-r))^n/a^(i*r),col="black")}

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 351

11

10

8 x= 1.5 , 45530 / 80000 = 0.5691

7

2
xx
1

0
0 1 2 3 Time 4 5 6 7

Figure S.5: Martingale supremum as a function of time.*

Chapter 2
Exercise 2.1 The payoff C is that of a put option, whose strike price K = $3 can be determined by
trial and error.

Exercise 2.2 Each of the two possible scenarios yields one equation:
 
 5α + β = 0  α = −2
with solution
2α + β = 6, β = +10.
 

The hedging strategy at t = 0 is to shortsell −α = +2 units of the asset S priced S0 = 4, and to

put β = $10 on the savings account. The price V0 = αS0 + β of the initial portfolio at time t = 0 is

V0 = αS0 + β = −2 × 4 + 10 = $2,

which yields the price of the claim at time t = 0. In order to hedge then option, one should:
i) At time t = 0,
(a) Charge the $2 option price.
(b) Shortsell −α = +2 units of the stock priced S0 = 4, which yields $8.
(c) Put β = $8 + $2 = $10 on the savings account.
ii) At time t = 1,
(a) If S1 = $5, spend $10 from savings to buy back −α = +2 stocks.
(b) If S1 = $2, spend $4 from savings to buy back −α = +2 stocks, and deliver a $10 - $4
= $6 payoff.
Pricing the option by the expected value IE∗ [C ] yields the equality

$2 = IE∗ [C ]
= 0 × P∗ (C = 0) + 6 × P∗ (C = 6)
* The animation works in Acrobat Reader.

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 352 Exercise Solutions

= 0 × P∗ (S1 = 2) + 6 × P∗ (S1 = 5)
= 6 × q∗ ,

hence the risk-neutral probability measure P∗ is given by

2 1
p∗ = P∗ (S1 = 5) = and q∗ = P∗ (S1 = 2) = .
3 3

Exercise 2.3
a) Each of the stated conditions yields one equation, i.e.
 
 4α + β = 1  α =2
with solution
5α + β = 3, β = −7.
 

Therefore, the portfolio allocation at t = 0 consists to purchase α = 2 unit of the asset S

priced S0 = 4, and to borrow −β = $7 in cash.

We can check that the price V0 = αS0 + β of the initial portfolio at time t = 0 is

V0 = αS0 + β = 2 × 4 − 7 = $1.

b) This loss is expressed as

α × $2 + β = 2 × 2 − 7 = −$3.

Note that the $1 received when selling the option is not counted here because it has already
been fully invested into the portfolio.

Exercise 2.4
a) i) Does this model allow for arbitrage? Yes | ✓ No |

ii) If this model allows for arbitrage opportunities, how can they be realized? By shortselling |

By borrowing on savings | ✓ N.A. |

b) i) Does this model allow for arbitrage? Yes | No | ✓

ii) If this model allows for arbitrage opportunities, how can they be realized? By shortselling |

By borrowing on savings | N.A. | ✓

c) i) Does this model allow for arbitrage? Yes | ✓ No |

ii) If this model allows for arbitrage opportunities, how can they be realized? By shortselling | ✓

By borrowing on savings | N.A. |

Exercise 2.5

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 353
 (1) 
a) We need to search for possible risk-neutral probability measure(s) P∗ such that IE∗ S1 =
(1)
(1 + r )S0 . Letting
(1) (1)
 !
( 1 ) ( 1 ) S − S
p∗ = P∗ S1 = S0 (1 + a) = P∗ 1 0




 (1)
=a ,



 S 0




(1) (1)
 !
∗ S1 − S0

∗ ∗ (1) (1)
θ = P S1 = S0 (1 + b) = P


(1)
=b ,


 S0




(1) (1)
 !
S1 − S0

(1) (1)


∗ ∗ ∗
 q = P S1 = ( 1 + c ) S0 = P



(1)
=c ,
S0

We have
(1) (1) (1) (1)
 (1 + a) p∗ S0 + (1 + b)θ ∗ S0 + (1 + c)q∗ S0 = (1 + r )S0


p∗ + θ ∗ + q∗ = 1,


from which we obtain

(1 − θ ∗ )c + θ ∗ b − r

∗
 ∗ ∗ ∗
 p a + θ b + q c = r,

 p = ∈ (0, 1),

 c−a
=⇒
∗ ∗ ∗ ∗ ∗
p + θ + q = 1.  q∗ = r − (1 − θ )a − θ b ∈ (0, 1).
 


c−a
In order for p∗ and q∗ to belong to the interval (0, 1), we should have
∗ ∗

 0 < (1 − θ )c + θ b − r < c − a,

0 < r − (1 − θ ∗ )a − θ ∗ b < c − a,


i.e.
r−c r−a

∗
 b−c < θ < b−c,




 r−c r−a
< θ∗ <


 .
b−a b−a
Therefore, there exists an infinity of risk-neutral probability measures depending on the
value of
r−c r−c r−a r−a
    
∗
θ ∈ Max , , min , ,
b−c b−a b−c b−a
in which case the market is without arbitrage but not complete. This is the case when
a < r < c.
b) Hedging a claim with possible payoff values Ca ,Cb ,Cc would require to solve
(1) (0)


 (1 + a)ξ (1) S0 + (1 + r )ξ (0) S0 = Ca




(1) (0)
(1 + b)ξ (1) S0 + (1 + r )ξ (0) S0 = Cb




(1) (0)

(1 + c)ξ (1) S0 + (1 + r )ξ (0) S0 = Cc ,


" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 354 Exercise Solutions

for ξ (0) and ξ (1) , which is not possible in general due to the existence of three conditions
with only two unknowns.

Exercise 2.6
a) The risk-neutral condition IE∗ [R1 ] = 0 reads

bP∗ (R1 = b) + 0 × P∗ (R1 = 0) + (−b) × (R1 = −b) = bp∗ − bq∗ = 0,

hence
1−θ∗
p∗ = q∗ = ,
2
since p∗ + q∗ + θ ∗ = 1.
b) We have
" (1) (1)
#
∗ S1 − S0 ∗
R1 − (IE∗ [R1 ])2
 2
Var (1)
= IE
S0
= IE∗ R21
 

= b2 P∗ (R1 = b) + 02 × P∗ (R1 = 0) + (−b)2 × (R1 = −b)

= b2 ( p∗ + q∗ )
= b2 ( 1 − θ ∗ )
= σ 2,
hence θ ∗ = 1 − σ 2 /b2 , and therefore
1−θ∗ σ2
p∗ = q∗ = = 2,
2 2b
provided that σ 2 ⩽ 2b2 .

Exercise 2.7
a) We denote the risk-neutral measure by p∗ = P∗ (S1 = 2), q∗ = P∗ (S1 = 1).
i) Yes | No | ✓ Comment: No loss is possible, while a 100% profit is possible
with non-zero probability 1/3.
ii) Yes | No | ✓ Comment: The (unique) risk-neutral measure ( p∗ , q∗ ) = (0, 1) is
given by

$2 × p∗ + $1 × q∗ = $1 × (1 + r ) = $1 and p∗ + q∗ = 1,

and is not equivalent to P given by ( p, q) = (1/3, 2/3).

b) We denote the risk-neutral measure by p∗ = P∗ (S1 = 2), θ ∗ = P∗ (S1 = 1), q∗ = P∗ (S1 = 0).
i) Yes | ✓ No | Comment: The risk-neutral measure ( p∗ , θ ∗ , q∗ ) is given by the
equations

$2 × p∗ + $1 × θ ∗ + $0 × q∗ = $1 × (1 + r ) = $1 and p∗ + θ ∗ + q∗ = 1, (S.8)

which clearly admit solutions, see (iv)) below.

ii) Yes | ✓ No | Comment: Realizing arbitrage would mean building a portfolio
achieving no strictly negative return with probability one, which is impossible since the
probability of 100% loss is P(S1 = 0) = 1 − 1/4 − 1/9 = 23/36 > 0.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 355

iii) Yes | No | ✓ Comment: Examples of claims that cannot be attained can be

easily constructed in this market. For example, the claim 1{S1 >0} cannot be attained
since there is no portfolio allocation (α, β ) satisfying

 $2 × α + β = $1

$1 × α + β = $1

$0 × α + β = $0.


iv) Yes | No | ✓ Comment: The risk-neutral measure is clearly not unique, as for
example

( p∗ , θ ∗ , q∗ ) = (1/4, 1/2, 1/4) and ( p∗ , θ ∗ , q∗ ) = (1/3, 1/3, 1/3)

are both solutions of (S.8).

Exercise 2.8
a) 1) We have bk,l = dk p∗k,l , k, l = 1, 2.
2) We have
dk = dk ( p∗k,1 + p∗k,2 ) = bk,1 + bk,2 , k = 1, 2.
3) We have
bk,l bk,l
p∗k,l = = , k, l = 1, 2.
dk bk,1 + bk,2
b) 1) There are 7 unknowns δ , u1 , u2 , p∗1,1 , p∗1,2 , p∗2,1 , p∗2,2 and 4 + 2 = 6 equations.
2) We have
bk,1 u1 + bk,2 u2 = δ uk pk,1 + δ uk pk,2 = δ uk , k = 1, 2.
3) Diagonalization shows that, up to a multiplicative constant, we have either
i)  p 
(b1,1 − b1,2 )2 + 4b1,2 b2,1 − (b1,1 − b2,2 )
 − <0 
 
u1
= 2b2,1
u2

1
and p
b1,1 + b2,2 − (b1,1 − b2,2 )2 + 4b1,2 b2,1
δ= ,
2
ii) or  p 
b1,1 − b2,2 + (b1,1 − b2,2 )2 + 4b1,2 b2,1
>0 
 
u1
=
 2b2,1
u2

1
and p
(b1,1 − b2,2 )2 + 4b1,2 b2,1
b1,1 + b2,2 +
δ= > 0,
2
and we check that only the second choice (ii) yields positive values.
4) We find
1 2b1,1
p1,1 = b1,1 = p ,
δ b1,1 + b2,2 + (b1,1 − b2,2 )2 + 4b1,2 b2,1
1 u2
p1,2 = b1,2
δ u1

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 356 Exercise Solutions
4b1,2 b2,1
= p
p
,
b1,1 − b2,2 + (b1,1 − b2,2 )2 + 4b
1,2 b2,1 b1,1 + b2,2 + (b1,1 − b2,2 )2 + 4b1,2 b2,1
p
1 u1 b1,1 − b2,2 + (b1,1 − b2,2 )2 + 4b1,2 b2,1
p2,1 = b2,1 = p ,
δ u2 b1,1 + b2,2 + (b1,1 − b2,2 )2 + 4b1,2 b2,1
1 2b2,2
p2,2 = b2,2 = p .
δ b1,1 + b2,2 + (b1,1 − b2,2 )2 + 4b1,2 b2,1

Exercise 2.9
a) The possible values of R are a and b.
b) We have
IE∗ [R] = aP∗ (R = a) + bP∗ (R = b)
b−r r−a
= a +b
b−a b−a
= r.
c) By Theorem 2.6, there do not exist arbitrage opportunities in this market since from Ques-
tion (b)) there exists a risk-neutral probability measure P∗ whenever a < r < b.
d) The risk-neutral probability measure is unique hence the market model is complete by
Theorem 2.13.
e) Taking
α (1 + b) − β (1 + a) β −α
η= and ξ = ,
π1 (b − a) S0 ( b − a )
we check that 
 ηπ1 + ξ S0 (1 + a) = α if R = a,

ηπ1 + ξ S0 (1 + b) = β if R = b,


which shows that

ηπ1 + ξ S1 = C
in both cases R = a and R = b.
f) We have
π0 (C ) = ηπ0 + ξ S0
α (1 + b) − β (1 + a) β − α
= +
(1 + r )(b − a) b−a
α (1 + b) − β (1 + a) − (1 + r )(α − β )
=
(1 + r )(b − a)
αb − β a − r (α − β )
= . (S.9)
(1 + r )(b − a)
g) We have
IE∗ [C ] = αP∗ (R = a) + β P∗ (R = b)
b−r r−a
= α +β . (S.10)
b−a b−a
h) Comparing (S.9) and (S.10) above, we do obtain
1
π0 (C ) = IE∗ [C ]
1+r
i) The initial value π0 (C ) of the portfolio is interpreted as the arbitrage-free price of the option
contract and it equals the expected value of the discounted payoff.
j) We have 
 11 − S1 if K > S1 ,
+ +
C = (K − S1 ) = (11 − S1 ) =
0 if K ⩽ S1 .


January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 357

k) We have S0 = 1, a = 8, b = 11, α = 2, β = 0, hence

β −α 0−2 2
ξ= = =− ,
S0 (b − a) 11 − 8 3

and
α (1 + b) − β (1 + a) 24
η= = .
π1 (b − a) 3 × 1.05
l) The arbitrage-free price π0 (C ) of the contingent claim with payoff C is

π0 (C ) = ηπ0 + ξ S0 = 6.952.

Exercise 2.10 Letting R denote the price of one right, it will require 10R/3 to purchase one stock
at €6.35, hence absence of arbitrage tells us that

10
R + 6.35 = 8,
3
from which it follows that
3
R= (8 − 6.35) = €0.495.
10
Note that the actual share right was quoted at €0.465 according to market data.

Exercise 2.11 Let a := (152 − 180)/180 = −7/45 and b := (203 − 180)/180 = 23/180 denote
the potential market returns, with r = 0.03. From the strike price K and the risk-neutral probabilities

r−a b−r
p∗r = = 0.6549 and q∗r = = 0.3451,
b−a b−a
the price of the option at the beginning of the year is given from Proposition 2.15 as the discounted
expected value

1 1
IE∗ [(K − S1 )+ ] = p∗r (K − 203)+ + q∗r (K − 152)+ .


1+r 1+r

Equating this price with the intrinsic value (K − 180)+ of the put option yields the equation

1
(K − 180)+ = p∗r (K − 203)+ + q∗r (K − 152)+


1+r
which requires K > 180 (the case K ⩽ 152 is not considered because both the option price and
option payoff vanish in this case). Hence we consider the equation

1
p∗r (K − 203)+ + q∗r (K − 152)+ ,


K − 180 =
1+r
with the following cases.
i) If K ∈ [180, 203] we get

(1 + r )(K − 180) = q∗r (K − 152),

hence
(1 + r )180 − q∗r 152 (1 + r )180 − q∗r 152
K= = = 194.11.
1 + r − q∗r p∗r + r

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 358 Exercise Solutions

ii) If K ⩾ 203 we find

180(1 + r ) − 203p∗r − 152q∗r
K= < 203,
r
which is out of range and leads to a contradiction.
We note that the above formula
(1 + r )180 − q∗r 152 28b − 180a + r (180(b − a) + 152)
K= =
p∗r + r (b + 1 − a)r − a
yields a decreasing function K (r ) of r in the interval [0, 100%], although the function is not
monotone over R+ .

150

140

130

120

110
K(r)

100

90

80

70

60
0 0.5 1 1.5 2
r

Figure S.6: Strike price as a function of risk-free rate r.

Chapter 3
Exercise 3.1 Let m := $2, 550 denote the amount invested each year.
a) By (3.1.1), the value of the plan after N = 10 years becomes
N
(1 + r )N − 1
m ∑ (1 + r )k = m(1 + r ) ,
k =1 r

which in turns becomes

N
(1 + r )N − 1
(1 + r )N m ∑ (1 + r )k = m (1 + r )N +1 ,
k =1 r

after N additional years without further contributions to the plan. Equating

(1 + r )N − 1
A = 30835 = m(1 + r )N +1
r
shows that
(1 + r )2N +1 − (1 + r )N +1 A
= ,
r m
with m = 2550, or
(1 + r )21 − (1 + r )11 30835
= ≃ 12.09215,
r 2550
hence r ≃ 1.23% according to Figure S.7, which is typical of an annual fixed deposit interest
rate.

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MH4514 Financial Mathematics 359

14

13.5

13

12.5

12

11.5

11

10.5

10
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2
r in %

Figure S.7: Graph of r 7−→ ((1 + r )21 − (1 + r )11 )/r.

In the hypothesis r = 3.25% we would find

(1 + r )N − 1
A = m (1 + r )N +1 = 42040.42.
r
b) Taking N = 10, m = 2, 550 and r = 0.0325, we find
N
A2N : = m(1 + r )N ∑ (1 + r)N−k+1
k =1
N
= m(1 + r )N ∑ (1 + r )k
k =1
(1 + r )N − 1
= m (1 + r )N +1
r
= $42, 040.42.
c) In this case, with N = 10, m = 2, 550 and r = 0.0325, we find
N
(1 + r )N − 1
A2N = AN = m ∑ (1 + r )N−k+1 = m(1 + r ) = $30, 532.79.
k =1 r

Exercise 3.2
a) Let m := $3, 581 denote the amount invested each year. After multiplying (3.1.1) by (1 + r )N
in order to account for the compounded interest from year 11 until year 20, we get the
equality
(1 + r )N − 1
A = m (1 + r )N +1
r
shows that
50862
(1 + r )21 − (1 + r )11 = r ≃ 14.2033r,
3581
showing that r ≃ 2.28% according to Figure S.8.

b) Taking N = 10, m = 3, 581 and r = 0.0325, we find

N
A2N : = m(1 + r )N ∑ (1 + r)N−k+1
k =1
N
= m(1 + r )N ∑ (1 + r )k
k =1

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 360 Exercise Solutions

16

15.5

15

14.5

14

13.5

13

12.5

12

11.5
1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3
r in %

Figure S.8: Graph of r 7−→ ((1 + r )21 − (1 + r )11 )/r.

(1 + r )N − 1
= m (1 + r )N +1
r
= $59, 037.94.
c) In this case, we find
N
(1 + r )N − 1
A2N = m ∑ (1 + r )N−k+1 = m(1 + r ) = $42, 877.61.
k =1 r

Exercise 3.3
a) We find m = $10, 000.
b) Denoting by Ak the amount owed by the borrower at the beginning of year no k = 1, 2, . . . , N,
the amount A1 = A can be decomposed at the beginning of the first year as
A1 = m + (A1 − m),
where A1 − m is subject to interests at the rate r = 2% i.e. at the end of the first year there
remains A2 = (A1 − m)(1 + r ) to be refunded. Similarly, the amount A2 due at the beginning
of the second year can be decomposed as A2 = m − (A2 − m), i.e. at the end of the second
year there remains
(A2 − m)(1 + r ) = ((A1 − m)(1 + r ) − m)(1 + r )
= A1 (1 + r )2 − m(1 + r )2 − m(1 + r )
to be refunded. After repeating the argument, we find that at the end of year k there remains
k
1 − (1 + r )k
(1 + r )k A1 − m ∑ (1 + r )l = (1 + r )k A1 − m(1 + r )
l =1 1 − (1 + r )
1 − (1 + r )k
= (1 + r )k A1 + m(1 + r )
r
to be refunded. At the end of year N, the loan will be completely repaid if hence AN = 0,
which reads
1 − (1 + r )N
(1 + r )N−1 A + m = 0,
r
and yields
(1 + r )N−1 rA rA
m= = .
N
(1 + r ) − 1 (1 + r )(1 − (1 + r )−N )
Taking N = 10, A = 100, 000 and r = 0.02, we find
rA 0.02 × 100, 000
m= = = $10, 914.36.
(1 + r )(1 − (1 + r )−N ) 1.02 × (1 − 1.02−10 )

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MH4514 Financial Mathematics 361

c) In this case, amount remaining on the account at the end of the first year is (A − m)(1 + r ),
and at the end of the second year it becomes ((A − m)(1 + r ) − m)(1 + r ). After repeating
the argument, we find that at the end!of year k there remains
k−1
(1 + r )k − 1
(1 + r )k−1 A − m ∑ (1 + r )l (1 + r ) = (1 + r )k A − m(1 + r )
l =0 r
on the account. Therefore, what is left at the end of year N is

(1 + r )N − 1
(1 + r )N A − m(1 + r ) .
r

Taking N = 10, A = 100, 000 and r = 0.02, we find

1.0210 − 1
1.0210 × 100, 000 − 10, 000 × 1.02 × = $10, 212.29.
0.02

Exercise 3.4
a) The discounted value of the loan after N months is

N−1
1 − (1 + r )N 1 − (1 + r )−N
m(1 + r )−N ∑ (1 + r)k = m(1 + r)−N =m ,
k =0 1 − (1 + r ) r

which should match A = $3, 000 with m = $275 and N = 12, hence

1 − (1 + r )−12 A
= = 10.909090909,
r m

see also Equation (3.1.2) in Proposition 3.1, hence

r ≃ 1.49767% per month.

b) The yearly interest rate is given by

(1 + r )N − 1 = (1 + r )12 − 1 = 1.014976712 − 1 ≃ 19.529% per year.

Remark: Computing the interest rate as

12 × $275
− 1 = 0.1 = 10%
$3000

is not correct because this implicitly means that the 12 × $275 = $3, 300 are repaid as one
lump sum at the end of the 12th month, which is not the case.
c) The analysis of replies to Question (c) shows that “All of the above” was the most popular
answer, followed by “Block”.

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 362 Exercise Solutions

Figure S.9: Histogram of replies to Question c).

Exercise 3.5
a) We start by borrowing $A. After the first month we receive rrent A, meaning that the account is
at A + rrent A = (1 + rrent )A. After the second month we then receive an additional Arrent (1 +
rrent )A, meaning that the account is at

(1 + rrent )A + rrent A(1 + rrent )A = (1 + rrent )2 A.

Proceeding similarly, after N months the account will be at A(1 + rrent )N , according to
interest rate compounding. However, what we actually ’received’ is A(1 + rrent )N − A. On the
other hand, we also have to refund the amount $A initially borrowed by paying an identical
amount $m every month, and this occurs at the rate rloan . Refunding the amount $A at the
rate rloan over N months imposes the relation
A 1 − (1 + rloan )−N
=
m rloan
as seen recalled in the hint. Given the values of m, rloan and N, this relation actually imposes
a condition on the amount A that we are allowed to borrow. After refunding the loan we have
no debt left, but we still own the amount A(1 + rrent )N obtained from renting out the property.
Therefore, after the loan is refunded, the account contains A(1 + rr ent )N , which also equals

1 − (1 + rloan )−N
(1 + rrent )N A = m(1 + rrent )N ,
rloan
where N is the number of refund payments. If we want to deduct the loan repayments, which
add up to mN, we can write
1 − (1 + rloan )−N
A(1 + rrent )N − mN = m(1 + rrent )N − mN.
rloan
b) This is the amount accumulated on the investment account, which is
(1 + rinv )N − 1 1 − (1 + rinv )−N
m = m(1 + rinv )N .
rinv rinv
c) According to the graph of Figure 3.7, Scenario (ii) is more profitable.

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MH4514 Financial Mathematics 363

Exercise 3.6 We check that for any P∗ of the form

P∗ (Rt = −1) := p∗ , P∗ (Rt = 0) := 1 − 2p∗ , P∗ (Rt = 1) := p∗ ,

we have
IE∗ [S1 ] = S0 (2p∗ + 1 − 2p∗ ) = S0 ,
and similarly
IE∗ [S2 | S1 ] = S1 (2p∗ + (1 − 2p∗ )) = S1 ,
hence the probability measure P∗ is risk-neutral.

Exercise 3.7
a) In order to check for arbitrage opportunities we look for a risk-neutral probability measure
P∗ which should satisfy
 (1) (1)
IE∗ Sk+1 | Fk = (1 + r )Sk ,

k = 0, 1, . . . , N − 1,
 (1)
with r = 0. Rewriting IE∗ Sk+1 | Fk as


 (1)
IE∗ Sk+1 | Fk


(1) (1)
= (1 − b)Sk P∗ (Rk+1 = a | Fk ) + Sk P∗ (Rk+1 = 0 | Fk )
(1)
+ (1 + b)Sk P∗ (Rk+1 = b | Fk )
(1) (1) (1)
= (1 − b)Sk P∗ (Rk+1 = a) + Sk P∗ (Rk+1 = 0) + (1 + b)Sk P∗ (Rk+1 = b),

k = 0, 1, . . . , N − 1, it follows that any risk-neutral probability measure P∗ should satisfy the

equations
(1) (1) (1) (1)

 (1 + b)Sk P∗ (Rk+1 = b) + Sk P∗ (Rk+1 = 0) + (1 − b)Sk P∗ (Rk+1 = a) = Sk

P∗ (Rk+1 = b) + P∗ (Rk+1 = 0) + P∗ (Rk+1 = −b) = 1,



k = 0, 1, . . . , N − 1, i.e.

 bP∗ (Rk = b) − bP∗ (Rk = −b) = 0,



P∗ (Rk = b) + P∗ (Rk = −b) = 1 − P∗ (Rk = 0),



k = 1, 2, . . . , N, with solution
1−θ∗
P∗ (Rk = b) = P∗ (Rk = −b) = ,
2
k = 1, 2, . . . , N.
b) We have "
(1) (1)
#
S − S 1  (1) (1)
IE∗ k+1 (1) k Fk IE∗ Sk+1 − Sk | Fk

= (1)
Sk Sk
1  (1)  (1)
IE∗ Sk+1 | Fk − IE∗ Sk | Fk
 

= (1)
Sk
1  (1) (1)

IE∗ Sk+1 | Fk − Sk

= (1)
Sk

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 364 Exercise Solutions

= 0,
and
(1) (1)
" #
∗ Sk+1 − Sk
Var (1)
Fk
S
k !2  #!2
(1) (1) (1) (1)
"
∗ Sk+1 − Sk ∗ Sk+1 − Sk
= IE (1)
Fk  − IE (1)
Fk
Sk Sk

(1) (1)
!2 
Sk+1 − Sk
= IE∗  (1)
Fk 
Sk
= b2 P∗σ (Rk+1 = −b | Fk ) + b2 P∗σ (Rk+1 = b | Fk )
1 − P∗σ (Rk+1 = 0) 1 − P∗σ (Rk+1 = 0)
= b2 + b2
2 2
= b2 ( 1 − θ ∗ )
= σ 2,
k = 0, 1, . . . , N − 1, hence
σ2
P∗σ (Rk = 0) = θ ∗ = 1 − 2 ,
b
and therefore
1 − P∗σ (Rk = 0) σ2
P∗σ (Rk = b) = P∗σ (Rk = −b) = = 2,
2 2b
k = 0, 1, . . . , N − 1, under the condition 0 < σ 2 < b2 .

Exercise 3.8
a) 1) We have bk,l = dk p∗k,l , k, l = 1, . . . , N.
2) We have
N N
dk = dk ∑ p∗k,l = ∑ bk,l , k = 1, . . . , N.
l =1 l =1
3) We have
bk,l bk,l
p∗k,l = = , k, l = 1, . . . , N,
dk bk,1 + · · · + bk,N
which yields the equation Bu⊤ = δ u⊤ .
b) 1) There are N 2 + N + 1 unknowns δ , u1 , . . . , uN , p∗k,l , k, l = 1, . . . , N, and N 2 + N equations.
2) We have
N N
∑ bk,l ul = δ uk ∑ pk,l = δ uk , k = 1, . . . , N.
l =1 l =1
3) We note that B is a positive matrix, in the sense that bk,l > 0, k, l = 1, . . . , N. Conse-
quently, by the Perron-Frobenius theorem there exists a choice of eigenvalue δ and
eigenvector (u1 , . . . , uN ) such that δ > 0 and uk > 0, k = 1, . . . , N. Moreover, this choice
is unique.
4) Once the unique set of parameters δ > 0 and uk > 0, k = 1, . . . , N has been determined,
we use the relation
ul bk,l
pk,l =
δ uk
to recover the transition probabilities pk,l from the binary option prices bk,l , k, l =
1, . . . , N.

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MH4514 Financial Mathematics 365

5) In this case, the probabilities pk,l = pk and p∗k,l = p∗k do not depend on l ∈ {1, . . . , N}
and we have bk,l = dk p∗k,l = dk p∗l and ul bk,l = δ uk pk,l = δ uk pl hence the relation
ul dk p∗l = δ uk pl , k, l = 1, . . . , N.
By summation over l, this gives dk ∑Nl=1 ul p∗l = δ uk , hence
δ uk
dk = , k = 1, . . . , N.
u1 p1 + · · · + uN p∗N
∗

If in addition dk = d does not depend on k = 1, . . . , N, we find that

δ uk
d= ,
u1 p∗1 + · · · + uN p∗N
hence u = uk does not depend on k = 1, . . . , N, and
δ uk δu
d= = ∗ = δ,
u1 p∗1 + · · · + uN p∗N up1 + · · · + up∗N
and therefore p∗l = pl , l = 1, . . . , N.

Exercise 3.9
a) The possible values of Rt are a and b.
b) We have
IE∗ [Rt +1 | Ft ] = aP∗ (Rt +1 = a | Ft ) + bP∗ (Rt +1 = b | Ft )
b−r r−a
= a +b = r.
b−a b−a
∗ ∗
c) Letting p = (r − a)/(b − a) and q = (b − r )/(b − a) we have
k  
∗ ∗ i ∗ k−i k
IE [St +k | Ft ] = ∑ ( p ) (q ) (1 + b)i (1 + a)k−i St
i=0 i
k  
k
= St ∑ ( p∗ (1 + b))i (q∗ (1 + a))k−i
i=0 i
= St ( p∗ (1 + b) + q∗ (1 + a))k
k
r−a b−r

= St (1 + b) + (1 + a)
b−a b−a
k
= (1 + r ) St .
Assuming that the formula holds for k = 1, its extension to k ⩾ 2 can also be proved
recursively from the tower property (11.6.8) of conditional expectations, as follows:
IE∗ [St +k | Ft ] = IE∗ [IE∗ [St +k | Ft +k−1 ] | Ft ]
= (1 + r ) IE∗ [St +k−1 | Ft ]
= (1 + r ) IE∗ [IE∗ [St +k−1 | Ft +k−2 ] | Ft ]
= (1 + r )2 IE∗ [St +k−2 | Ft ]
= (1 + r )2 IE∗ [IE∗ [St +k−2 | Ft +k−3 ] | Ft ]
= (1 + r )3 IE∗ [St +k−3 | Ft ]
= ···
= (1 + r )k−2 IE∗ [St +2 | Ft ]
= (1 + r )k−2 IE∗ [IE∗ [St +2 | Ft +1 ] | Ft ]
= (1 + r )k−1 IE∗ [St +1 | Ft ]
= (1 + r )k St .

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 366 Exercise Solutions

Exercise 3.10
a) We check that
IE∗ [Rt +1 | Ft ] = aP∗ (Rt +1 = a | Ft ) + bP∗ (Rt +1 = b | Ft )
b−r r−a
= a +b = r.
b−a b−a
b) We have
1
IE∗ Set +1 Ft = E∗ [St +1 | Ft ]
 
A0 (1 + r )t +1
1 ∗ ∗
P F P F


= ( 1 + a ) St ( Rt + 1 = a | t ) + ( 1 + b ) St ( Rt + 1 = b | t )
A0 (1 + r )t +1
b−r r−a
 
1
= (1 + a)St + (1 + b)St
A0 (1 + r )t +1 b−a b−a
b − a + (b − a)r
= Set
(1 + r )(b − a)
= St ,
e t = 0, 1, . . . , N − 1.
c) We have  !β 
N
IE∗ (SN )β = S0 IE∗  ∏ (1 + Rk ) 
 
k =1
" #
N
= S0 IE∗ ∏ (1 + Rk )β
k =1
N
= S0 ∏ IE∗ (1 + Rk )β ,
 
k =1
after using the independence of the returns (Rk )k=1,2,...,N , with

b−r r−a
IE∗ (1 + Rk )β = (1 + a)β
 
+ (1 + b)β , k = 0, 1, . . . , N,
b−a b−a
hence we find
N
b−r r−a

∗ β
 β
 β
IE (SN ) = S0 (1 + a) + (1 + b)β .
b−a b−a

d) We have  
∗ ∗ St
P St ⩾ αAt for some t ∈ {0, 1, . . . , N} = P


Max ⩾α
t =0,1,...,n At
 
IE (MN )β
⩽
αβ
β  N
β b−r β r−a

S0
= ( 1 + a ) + ( 1 + b ) ,
(1 + r )N αA0 b−a b−a
since the discounted price process
 
St
(Mt )t =0,1,...,N :=
At t =0,1,...,N

is a nonnegative martingale by part (b)).

e) Since (Mt )t =0,1,...,N is a nonnegative martingale, we have
IE[St +1 | Ft ] = IE[Mt +1 At +1 | Ft ]
= At +1 IE[Mt +1 | Ft ]

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MH4514 Financial Mathematics 367

= At +1 Mt
⩾ At Mt
= St , t = 0, 1, . . . , N − 1,
because r ⩾ 0, hence (St )t =0,1,...,N is a nonnegative
 submartingale. Therefore, we have
  IE (MN ) β
P∗ Max St ⩾ x ⩽
t =0,1,...,n xβ
 β  N
S0 β b−r β r−a
⩽ (1 + a) + (1 + b) .
x b−a b−a

Chapter 4
Exercise 4.1 (Exercise 3.6 continued). We consider the following trinomial tree.

S2 = 4, C = 0
p∗
1 − 2p∗
S1 = 2 S2 = 2, C = 0

p∗
∗ S2 = 0, C = 1
p
S2 = 2, C = 0
p∗
1 − 2p∗ 1 − 2p∗
S0 = 1 S1 = 1 S2 = 1, C = 0

p∗
S2 = 0, C = 1
p∗
S2 = 0, C = 1
p∗
1 − 2p∗
S1 = 0 S2 = 0, C = 1

p∗
S2 = 0, C = 1

At time t = 0, we find
1
π0 (C ) = IE∗ [(K − S2 )+ ]
(1 + r )2
= p∗ ( p∗ + (1 − 2p∗ ) + p∗ ) + (1 − 2p∗ ) p∗ + ( p∗ )2
= p∗ + (1 − 2p∗ ) p∗ + ( p∗ )2
= 2p∗ − ( p∗ )2 .
At time t = 1, we find
1
π1 (C ) = IE∗ [(K − S2 )+ | S1 ]
1+r
 ∗
 p
 if S1 = 2S0 ,



= p∗ if S1 = S0 ,




1 if S1 = 0.


Exercise 4.2 We have p∗ = (r − a)/(b − a) = 1/2 and q∗ = (b − r )/(b − a) = 1/2, and the
following underlying asset price tree:

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 368 Exercise Solutions

S2 = 4, C = 3
p∗
S1 = 2
p∗
q∗
S0 = 1 S2 = 2, C = 1
p∗
q∗
S1 = 1
q∗
S2 = 1, C = 3.

We first price, and then hedge. At time t = 1, by Theorem 4.3 we have

3p∗ + q∗ 4

 1 + r = 3 if S1 = 2


4 p∗ + q∗

8
π1 (C ) = V1 = and π0 (C ) = V0 = = .
∗ ∗ 3 1+r 9
 p + 3q = 4 if S1 = 1,



1+r 3
This leads to the following option pricing tree:

S2 = 4, V2 = 3
p∗
V1 = 4/3
∗ S1 = 2
p
q∗
V0 = 8/9
S2 = 2 V2 = 1
S0 = 1 ∗
p
q∗
V1 = 4/3
S1 = 1
q∗
S2 = 1 V2 = 3.

Regarding hedging, if S1 = 2 the condition ξ 2 · S2 = ξ2 S2 + η2 A2 = V2 reads

2

 4ξ2 + η2 (1 + r ) = 3
S1 = 2 =⇒
2ξ2 + η2 (1 + r )2 = 1,


hence (ξ2 , η2 ) = (1, −4/9). On the other hand, if S1 = 1 we have

2

 2ξ2 + η2 (1 + r ) = 1
S1 = 1 =⇒
ξ2 + η2 (1 + r )2 = 3,


hence (ξ2 , η2 ) = (−2, 20/9). Finally, at time t = 0 with S0 = 1 the condition ξ 1 · S1 = ξ1 S1 +

η1 A1 = V1 yields 
 2ξ1 + η1 (1 + r ) = 4

3



 4
 ξ1 + η1 (1 + r ) = ,

3

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 369

hence (ξ1 , η1 ) = (0, 8/9). The results can be summarized in the following table:

S1 = 2, V1 = 4/3 S2 = 4
S0 = 1 ξ2 = 1, η2 = −4/9 V2 = 3
V0 = 8/9 S2 = 1
ξ1 = 0 V2 = 3
η1 = 8/9 S1 = 1, V1 = 4/3 S2 = 1
ξ2 = −2, η2 = 20/9 V2 = 3

Table 13.1: CRR pricing and hedging table.

In addition, it can be checked that the portfolio strategy (ξk , ηk )k=1,2 is self-financing, as we have

8 3
ξ1 S1 + η1 A1 = ×
9 2

4 3
 2− 9 × 2



=

 20 3
 −2 +
 ×
9 2
= ξ2 S1 + η2 A1 .

Exercise 4.3
a) We have
IE∗ [St +1 | Ft ] = IE∗ [St +1 | St ]
St ∗
= P (Rt = −0.5) + St P∗ (Rt = 0) + 2St P∗ (Rt = 1)
2
 ∗ 
r ∗ ∗
= + q + 2p St
2
= St , t = 0, 1,
with r = 0.
b) We have the following graph:

S2 = 4, C = 2.5
/4
p∗ = 1
q∗ = 1/4
S1 = 2 S2 = 2, C = 0.5

r∗ = 1/2
4 S2 = 1, C = 0
1/
∗ =
p
S2 = 2, C = 0
/4
p∗ = 1
q∗ = 1/4 q∗ = 1/4
S0 = 1 S1 = 1 S2 = 1, C = 0

r∗ = 1
/2
S2 = 0.5, C = 0
r∗
=
1/
2 S2 = 1, C = 0
/4
p∗ = 1
q∗ = 1/4
S1 = 0.5 S2 = 0.5, C = 0

r∗ = 1/2
S2 = 0.25, C = 0

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 370 Exercise Solutions

c) The down-an-out barrier call option is priced at time t = 0 as

3
V0 = IE∗ [C ] = 2.5 × ( p∗ )2 + 0.5 × p∗ q∗ = .
16

At time t = 1 we have

1 1 3
V1 = 2.5 × p∗ + 0.5 × q∗ = 2.5 × + 0.5 × =
4 4 4

if S1 = 2, and V1 = 0 in both cases S1 = 1 and S1 = 0.5.

d) This market is not complete, and not every contingent claim is attainable, because the risk-
neutral probability measure P∗ is not unique, for example (r∗ , q∗ , p∗ ) = (1/4, 5/8, 1/8) and
(r∗ , q∗ , p∗ ) = (1/2, 1/4, 1/4) are both risk-neutral probability measures.

Exercise 4.4 The CRR model can be described by the following binomial tree.

(1 + b)2 S0
p∗

(1 + b)S0
p∗
q∗
S0 = 1 (1 + a)(1 + b)S0
p∗
q∗
(1 + a)S0

q∗
(1 + a)2 S0

a) By the formulas
1 1
V1 = IE∗ [V2 | F1 ] = IE∗ [V2 | S1 ]
1+r 1+r
S0 (1 + b)2 − 8 ∗
= P (S2 = S0 (1 + b)2 | S1 )
1+r
(S0 (1 + b)2 − 8)
= p∗ 1{S1 =S0 (1+b)} ,
1+r
and
1
V0 = IE∗ [V1 | F0 ]
1+r
2
∗ ( S0 ( 1 + b ) − 8 )
 
1 ∗ ∗
= p × P (S1 = S0 (1 + b)) + 0 × P (S1 = S0 (1 + a))
1+r 1+r
( S0 ( 1 + b ) 2 − 8 )
= ( p∗ )2 ,
(1 + r )2
we find the table

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MH4514 Financial Mathematics 371

S2 = 9
S1 = 3, V1 = 1/4 V2 = 1
S0 = 1 S2 = 3
V0 = 1/16 V2 = 0
S1 = 1, V1 = 0 S2 = 1
V2 = 0
Table 13.2: CRR pricing tree.

Note that we could also directly compute V0 from

1
V0 = IE∗ [V2 | F0 ].
(1 + r )2
b) When S1 = S0 (1 + b), the equation ξ2 S2 + η2 A2 = V2 reads
2 2 2

 ξ2 S0 (1 + b) + η2 A0 (1 + r ) = S0 (1 + b) − 8

ξ2 S0 (1 + b)(1 + a) + η2 A0 (1 + r )2 = 0,


which yields
S0 (1 + b)2 − 8 (S0 (1 + b)2 − 8)(1 + a)
ξ2 = and η2 = − . (S.11)
S0 (b − a)(1 + b) ( b − a ) A0 ( 1 + r ) 2
When S1 = S0 (1 + a), the equation ξ2 S2 + η2 A2 = V2 reads
2 2

 ξ2 S0 (1 + a) + η2 A0 (1 + r ) = 0

ξ2 S0 (1 + b)2 + η2 A0 (1 + r )2 = 0,


which has the unique solution (ξ2 , η2 ) = (0, 0). Next, the equation ξ1 S1 + η1 A1 = V1 reads
p∗ ( S0 ( 1 + b ) 2 − 8 )

 ξ1 S0 (1 + b) + η1 A0 (1 + r ) = ,


1+r


ξ1 S0 (1 + a) + η1 A0 (1 + r ) = 0,


which yields
S0 (1 + b)2 − 8 (1 + a)(S0 (1 + b)2 − 8)
ξ1 = p∗ and η1 = −p∗ . (S.12)
S0 (b − a)(1 + r ) (b − a)A0 (1 + r )2
This can be summarized in the following table:

S1 = 3, V1 = 1/4 S2 = 9
S0 = 1 V2 = 1
V0 = 1/16 ξ2 = 1/6, η2 = −1/8 S2 = 3
ξ1 = 1/8 S1 = 1, V1 = 0 V2 = 0
η1 = −1/16 S2 = 1
ξ2 = 0, η2 = 0 V2 = 0
Table 13.3: CRR pricing and hedging tree.

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 372 Exercise Solutions

When S1 = S0 (1 + a) at time t = 1 the option price is V1 = 0 and the hedging strategy is to

cut all positions: ξ2 = η2 = 0. On the other hand, if S1 = S0 (1 + b) then there is a chance of
being in the money at maturity and we need to increase our position in the underlying asset
from ξ1 = 1/8 to ξ2 = 1/6.

Note that the self-financing condition

ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1 , (S.13)

is verified. For example when S1 = S0 (1 + a) we have

1 1
× S1 − A1 = 0 × S1 + 0 × A1 = 0,
8 16
while when S1 = S0 (1 + b) we find
1 1 1 1 1
× S1 − A1 = × S1 − × A1 = .
8 16 6 8 4
c) We can also use the self-financing condition (S.13) to recover (S.12) by rewriting the system
of equations as

 ξ1 S0 (1 + b) + η1 A0 (1 + r ) = ξ2 S0 (1 + b) + η2 A0 (1 + r )

ξ1 S0 (1 + a) + η1 A0 (1 + r ) = 0,


with (ξ2 , η2 ) given by (S.11), which recovers


3 2 1
 8 − 16 = 4 if S1 = 3,



V1 = ξ1 S1 + η1 A1 =

 1 2
 −
 =0 if S1 = 1.
8 16

Exercise 4.5
a) We build a portfolio based at times t = 0, 1 on αt +1 units of stock and $βt +1 in cash. When
S1 = 2, we should have 
4α2 + β2 = 0
2α2 + β2 = 1,
hence (α2 , β2 ) = (−1/2, 2). On the other hand, when S1 = 1 we should have

2α1 + β1 = 1
α1 + β1 = 0,

hence (α2 , β2 ) = (1, −1).

b) When S1 = 2, the price of the claim at t = 1 is

α2 S1 + β2 = (−1/2) × 2 + 2 × 1 = 1.

When S1 = 1, the price of the claim at t = 1 is α2 S1 + β2 = 1 × 1 − 1 × 1 = 0.

c) At time t = 1 we build a portfolio using α1 units of stock and $β1 in cash. We should have

2α1 + β1 = 1
α1 + β1 = 0,

hence (α1 , β1 ) = (1, −1).

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MH4514 Financial Mathematics 373

d) The price of the claim C at time t = 0 is α1 S0 + β1 = 1 × 1 + (−1) × 1 = 0.

e) The probabilities ( p∗ , q∗ ) = ((r − a)/(b − a), (b − r )/(b − a)) = (0, 1) are clearly risk-
neutral in the sense of Definition 3.12, as they yield
IE∗ [S2 | S1 ] = S1 and IE∗ [S1 | S0 ] = S0 .
with the risk-free rate r = 0. However, this does not form a risk-neutral probability measure
P∗ equivalent to P in the sense of Definition 3.14 when q = P(R1 = 0) = P(R2 = 0) > 0.

In case ( p, q) = (0, 1), the probabilities ( p∗ , q∗ ) = (0, 1) would yield an equivalent risk-
neutral probability measure.
f) According to Theorem 3.15 this model allows for arbitrage opportunities as the unique avail-
able risk-neutral probability measure P∗ are not be equivalent to the historical probability
measure P when q = P(R1 = 0) = P(R2 = 0) > 0. In this case, arbitrage opportunities
are easily implemented by purchasing the option at the price 0 of part (d)) while receiving
a strictly positive payoff at maturity. More generally, arbitrage opportunities exist when
the underlying price may increase with nonzero probability, without a possibility of strict
decrease.

In case ( p, q) = (0, 1), no arbitrage is possible as prices remain constant.

Exercise 4.6 We have the model-free answer

1
πk (C ) = IE∗ [h(SN ) | Fk ]
(1 + r )N−k
1
= IE∗ [α + β SN | Fk ]
(1 + r )N−k
α β
= + IE∗ [SN | Fk ]
(1 + r )N−k (1 + r )N−k
α
= Ak + β Sk , k = 0, 1, . . . , N.
(1 + r )N
The hedging portfolio strategy is to hold β units of the underlying asset priced Sk and α/(1 + r )N
units of the riskless asset priced Ak = (1 + r )k at time k = 0, 1, . . . , N.

Note that in the particular case of the CRR model, this answer is also compatible with (4.4.1)-
(4.4.2).

Exercise 4.7 Call-put parity.

a) The relation (x − K )+ = x − K + (K − x)+ can be verified by successively checking the cases
x ⩽ K and x ⩾ K.
b) Respectively denoting by C (k) and P(k) the call and put prices at time k = 0, 1, . . . , N, by
part (a)) we have
C (k) = (1 + r )−(N−k) IE∗ (SN − K )+ Fk
 

= (1 + r )−(N−k) IE∗ SN − K + (K − SN )+ Fk
 

= (1 + r )−(N−k) IE∗ [SN | Fk ] − (1 + r )−(N−k) K

+(1 + r )−(N−k) IE∗ (K − SN )+ Fk
 

= Sk − (1 + r )−(N−k) K + (1 + r )−(N−k) IE∗ (K − SN )+ Fk

 

= Sk − (1 + r )−(N−k) K + P(k).

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 374 Exercise Solutions

Exercise 4.8
a) This range forward contract can be realized by
• holding one unit of ST ,
• holding one put option with strike price K1 ,
• shorting one call option with strike price K2 ,
• borrowing $F in cash.
b) The graph of the payoff function of the range forward contract with K1 = $80, F = $100,
K2 = $110 is as follows:

x-F + (K1-x)+ - (x-K2)+

40

20

-20

-40

50 60 70 80 90 100 110 120 130

K1 ST F K2

Figure S.10: Range forward contract payoff as a combination of call and put payoffs.*
See also http://optioncreator.com/st7ulpk.

Exercise 4.9
a) Taking q∗ = 1 − p∗ = 1/4, we find the binary tree

6.25 = (1 + b)2
p∗

2.5 = 1 + b
p∗
q∗
S0 = 1 1.25 = (1 + a)(1 + b)
p∗
q∗
0.5 = 1 + a

q∗
0.25 = (1 + a)2

b) We find the binary tree

* The animation works in Acrobat Reader on the entire pdf file.

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MH4514 Financial Mathematics 375

S2 = 6.25 and V2 = 0
p∗

S1 = 2.5 and V1 = 0
p∗
q∗
S0 = 1 and V0 = 1/64 S2 = 1.25 and V2 = 0
p∗
q∗
S1 = 0.5 and V1 = 1/8

q∗
S2 = 0.25 and V2 = 1

and the table

S2 = 6.25
S1 = 2.5, V1 = 0 V2 = 0
S0 = 1 S2 = 1.25
V0 = 1/64 V2 = 0
S1 = 0.5, V1 = 1/8 S2 = 0.25
V2 = 1
Table 13.4: CRR pricing tree.

c) Here, we compute the hedging strategy from the option prices. When S1 = S0 (1 + b) we
clearly have ξ2 = η2 = 0. When S1 = S0 (1 + a), the equation ξ2 S2 + η2 A2 = V2 reads

2 2 2

 ξ2 S0 (1 + a) + η2 (1 + r ) = (K − S0 (1 + a) )

ξ2 S0 (1 + b)(1 + a) + η2 (1 + r )2 = 0


hence
( K − S0 ( 1 + a ) 2 ) (K − S0 (1 + a)2 )(1 + b)
ξ2 = − and η2 = .
S0 (b − a)(1 + a) S0 (b − a)(1 + r )2

Next, at time t = 1 the equation ξ1 S1 + η1 A1 = V1 reads

q∗ (K − (1 + a)(1 + b))

 ξ1 S0 (1 + a) + η1 (1 + r ) = S0 ,


1+r


 ξ S (1 + b) + η (1 + r ) = 0
1 0 1

which yields

q∗ (K − S0 (1 + a)(1 + b)) q∗ (K − S0 (1 + a)(1 + b))(1 + b)

ξ1 = − and η1 = .
S0 (b − a)(1 + r ) S0 (b − a)(1 + r )2

This can be summarized in the following table:

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 376 Exercise Solutions

S1 = 2.5, V1 = 0 S2 = 6.25
S0 = 1 V2 = 0
V0 = 1/64 ξ2 = 0, η2 = 0 S2 = 1.25
ξ1 = −1/16 S1 = 0.5, V1 = 1/8 V2 = 0
η1 = 5/64 S2 = 0.25
ξ2 = −1, η2 = 5/16 V2 = 1
Table 13.5: CRR pricing and hedging tree.

If S1 = S0 (1 + a) then there is a chance of being in the money at maturity and we need to

short sell further by decreasing ξ1 from ξ1 = −1/16 to ξ2 = −1. Note that the self-financing
condition
ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1
is satisfied.

Exercise 4.10 The risk-neutral measure is given by p∗ = (r − a)/(b − a) = (1 − 0.5)/(2 −

(−0.5)) = 3/5 and q∗ = (b − r )/(b − a) = (2 − 1)/(2 − (−0.5)) = 2/5, and we have the binary
tree

36 = S0 (1 + b)2
p∗

12 = S0 (1 + b)
p∗
q∗
S0 = 4 6 = S0 (1 + a)(1 + b)
p∗
q∗
2 = S0 (1 + a)

q∗
1 = S0 ( 1 + a ) 2

and

S2 = 36 and V2 = 0
p∗

S1 = 12 and V1 = 1
p∗
q∗
S0 = 4 and V0 = 1 S2 = 6 and V2 = 5
p∗
q∗
S1 = 2 and V1 = 7/2

q∗
S2 = 1 and V2 = 10

and the table

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MH4514 Financial Mathematics 377

S2 = 36
S1 = 12, V1 = 1 V2 = 0
S0 = 4 S2 = 6
V0 = 1 V2 = 5
S1 = 2, V1 = 7/2 S2 = 1
V2 = 11
Table 13.6: CRR pricing tree.

This can be summarized in the following table:

S1 = 12, V1 = 1 S2 = 36
S0 = 4 V2 = 0
V0 = 1 ξ2 = −1/6, η2 = 3/2 S2 = 6
ξ1 = −1/4 S1 = 2, V1 = 7/2 V2 = 5
η1 = 2 S2 = 1
ξ2 = −1, η2 = 11/4 V2 = 10
Table 13.7: CRR pricing and hedging tree.

We also check that the self-financing condition

ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1
is satisfied. The attached IPython notebook* can be used to recover the above results.

Exercise 4.11
a) The binary call option can be priced under the risk-neutral probability measure P∗ as
1
π0 (C ) = IE∗ [C ]
1+r
1
= IE∗ [1[K,∞) (SN )]
1+r
1
= P∗ (SN ⩾ K )
1+r
p∗
= ,
1+r
with p∗ := P∗ (SN ⩾ K ).
b) Investing $p∗ by purchasing one binary call option yields a potential net return of
$1 − p∗ $1


 ∗
= ∗ − 1 if SN ⩾ K,

 p p
∗
 $0 − p = −100%


if SN < K.

p∗
c) The corresponding expected return is
 
∗ 1
p × − 1 + (1 − p∗ ) × (−1) = 0.
p∗
d) The corresponding expected return is
p∗ × 0.86 + (1 − p∗ ) × (−1) = p∗ × 1.86 − 1,


* Right-click to save as attachment (may not work on .

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 378 Exercise Solutions

which will be negative if

1
p∗ < ≃ 0.538.
1.86
That means, the expected gain can be negative even if

0.538 > p∗ = P∗ (SN ⩾ K ) > 0.5.

Similarly, the expected gain

(1 − p∗ ) × 0.86 + p∗ × (−1) = 0.86 − p∗ × 1.86,

on binary put options will be negative if 1 − p∗ > 1/1.86, i.e. if

0.86
p∗ > ≃ 0.462.
1.86

That means, the expected gain can be negative even if 1−0.462 > P∗ (SN < K ) > 0.5. In con-
clusion, the average gains of both call and put options will be negative if p∗ ∈ (0.462, 0.538).

Note that the average of call and put option gains will still be negative, as

p∗ × 1.86 − 1 0.86 − p∗ × 1.86 0.86 − 1

+ = < 0.
2 2 2

Exercise 4.12
a) Based on the price map of the put spread collar option:

130
Put spread collar price map f(S)
y=S
120

110

100

90

80

70
60 70 80 90 100 110 120 130
SN
K1 K2 K3

Figure S.11: Put spread collar price map.

we deduce the following payoff function graph of the put spread collar option in the next
Figure S.12.
b) The payoff function can be written as
−(K1 − x)+ + (K2 − x)+ − (x − K3 )+
= −(80 − x)+ + (90 − x)+ − (x − 110)+ ,
see also https://optioncreator.com/stp7xy2.

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MH4514 Financial Mathematics 379

20
Put spread collar payoff function
15

10

-5

-10

-15

-20
60 70 80 90 100 110 120 130
K1 K2 SN K3

Figure S.12: Put spread collar payoff function.

20
-(K1-x)++(K2-x)+
15 -(x-K3)+

10

-5

-10

-15

-20
60 70 80 90 100 110 120 130
K1 K2 SN K3

Figure S.13: Put spread collar payoff as a combination of call and put option payoffs.*

Hence this collar option payoff can be realized by

1. issuing (or shorting/selling) one put option with strike price K1 = 80, and
2. purchasing and holding one put option with strike price K2 = 90, and
3. issuing (or shorting/selling) one call option with strike price K3 = 110.

Exercise 4.13
a) Based on the price map of the call spread collar option:

* The animation works in Acrobat Reader on the entire pdf file.

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 380 Exercise Solutions

140
Call spread collar price map f(S)
130 y=S

120

110

100

90

80

70

60
60 70 80 90 100 110 120 130
SN
K1 K2 K3

Figure S.14: Call spread collar price map.

we deduce the following payoff function graph of the call spread collar option in the next
Figure S.15.

20
Call spread collar payoff function
15

10

-5

-10

-15

-20
60 70 80 90 100 110 120 130
SN
K1 K2 K3

Figure S.15: Call spread collar payoff function.

b) The payoff function can be written as

−(K1 − x)+ + (x − K2 )+ − (x − K3 )+
= −(80 − x)+ + (x − 100)+ − (x − 110)+ ,

see also https://optioncreator.com/st3e4cz.

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MH4514 Financial Mathematics 381

20
-(K1-x)++(x-K2)+
15 -(x-K3)+

10

-5

-10

-15

-20
60 70 80 90 100 110 120 130
K1 SN K2 K3

Figure S.16: Call spread collar payoff as a combination of call and put option payoffs.*

Hence this collar option payoff can be realized by

1. issuing (or shorting/selling) one put option with strike price K1 = 80, and
2. purchasing and holding one call option with strike price K2 = 100, and
3. issuing (or shorting/selling) one call option with strike price K3 = 110.

Exercise 4.14 We have

S1 + · · · + SN ∗ φ ( S1 ) + · · · + φ ( SN )
    
∗
IE φ ⩽ IE since φ is convex,
N N
IE∗ [φ (S1 )] + · · · + IE∗ [φ (SN )]
=
N
IE∗ [φ (IE∗ [SN | F1 ])] + · · · + IE∗ [φ (IE∗ [SN | FN ])]
= because (Sn )n∈N is a martingale,
N
IE∗ [IE∗ [φ (SN ) | F1 ]] + · · · + IE∗ [IE∗ [φ (SN ) | FN ]]
⩽ by Jensen’s inequality,
N
IE∗ [φ (SN )] + · · · + IE∗ [φ (SN )]
= by the tower property.
N
= IE∗ [φ (SN )].

The above argument is implicitly using the fact that a convex function φ (Sn ) of a martingale (Sn )n∈N
is itself a submartingale, as
φ (Sk ) = φ (IE∗ [SN | Fk ]) ⩽ IE∗ [φ (SN ) | Fk ], k = 1, 2, . . . , N.

Exercise 4.15 (Exercise 3.9 continued).

a) The condition VN = C reads

 ηN πN + ξN (1 + a)SN−1 = (1 + a)SN−1 − K

ηN πN + ξN (1 + b)SN−1 = (1 + b)SN−1 − K,


* The animation works in Acrobat Reader on the entire pdf file.

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 382 Exercise Solutions

from which we deduce the (static) hedging strategy ξN = 1 and ηN = −K (1 + r )−N /π0 .
b) We have

 ηN−1 πN−1 + ξN−1 (1 + a)SN−2 = ηN πN−1 + ξN (1 + a)SN−2

ηN−1 πN−1 + ξN−1 (1 + b)SN−2 = ηN πN−1 + ξN (1 + b)SN−2 ,



which yields ξN−1 = ξN = 1 and ηN−1 = ηN = −K (1 + r )−N /π0 . Similarly, solving the
self-financing condition

 ηt πt + ξt (1 + a)St−1 = ηt +1 πt + ξt +1 (1 + a)St−1

ηt πt + ξt (1 + b)St−1 = ηt +1 πt + ξt +1 (1 + b)St−1


at time t yields

K
ξt = 1 and ηt = −(1 + r )−N , t = 1, 2, . . . , N.
π0

c) We have
πt (C ) = Vt
= ηt πt + ξt St
πt
= St − K (1 + r )−N
π0
= St − K (1 + r )−(N−t ) .
d) For all t = 0, 1, . . . , N we have
(1 + r )−(N−t ) IE∗ [C | Ft ] = (1 + r )−(N−t ) IE∗ [SN − K | Ft ],
= (1 + r )−(N−t ) IE∗ [SN | Ft ] − (1 + r )−(N−t ) IE∗ [K | Ft ]
= (1 + r )−(N−t ) (1 + r )N−t St − K (1 + r )−(N−t )
= St − K (1 + r )−(N−t )
= Vt = πt (C ).
For a futures contract expiring at time N we take K = S0 (1 + r )N and the contract is usually
quoted at time t using the forward price (1 + r )N−t (St − K (1 + r )N−t ) = (1 + r )N−t St − K =
(1 + r )N−t St − S0 (1 + r )N , or simply using (1 + r )N−t St . Futures contracts are “marked
to market” at each time step t = 1, 2, . . . , N via a positive or negative cash flow exchange
(1 + r )N−t St − (1 + r )N−t +1 St−1 from the seller to the buyer, ensuring that the absolute
difference |(1 + r )N−t St − K| has been credited to the buyer’s account if it is positive, or to
the seller’s account if it is negative.

Exercise 4.16
a) We write
2

 ξN SN−1 (1 + 1/2) + ηN = (SN−1 (1 + 1/2))
VN =
ξN SN−1 (1 − 1/2) + ηN = (SN−1 (1 − 1/2))2 ,


which yields

 ξN = 2SN−1

ηN = −3(SN−1 )2 /4.


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MH4514 Financial Mathematics 383

b) i) We have
IE∗ [(SN )2 | FN−1 ] = p∗ (SN−1 )2 (1 + 1/2)2 + (1 − p∗ )(SN−1 )2 (1 − 1/2)2
1
(SN−1 )2 (1 + 1/2)2 + (1 − 1/2)2


=
2
= 5(SN−1 )2 /4.
ii) We have 
 ξN−1 SN−2 (1 + 1/2) + ηN−1
ξN−1 SN−1 + ηN−1 A0 =
ξN−1 SN−2 (1 − 1/2) + ηN−1

= VN−1
= 5(SN−1 )2 /4
2

 5(SN−2 (1 + 1/2)) /4
=
5(SN−2 (1 − 1/2))2 /4,

hence 
 ξN−1 = 5SN−2 /2

ηN−1 = −15(SN−2 )2 /16.



iii) We have
ξN−1 SN−1 + ηN−1 A0 = 5SN−2 SN−1 /2 − 15(SN−2 )2 /16
2 2

 5(SN−2 ) (1 + 1/2)/2 − 15(SN−2 ) /16
=
5(SN−2 )2 (1 − 1/2)/2 − 15(SN−2 )2 /16

2 2

 15(SN−2 ) /4 − 15(SN−2 ) /16
=
5(SN−2 )2 − 15(SN−2 )2 /16

2

 45(SN−2 ) /16
=
5(SN−2 )2 /16,

and on the other hand,
ξN SN−1 + ηN A0 = 2(SN−1 )2 − 3(SN−1 )2 /4
2 2 2 2

 2(SN−2 ) (1 + 1/2) − 3(SN−2 ) (1 + 1/2) /4
=
2(SN−2 )2 (1 − 1/2)2 − 3(SN−2 )2 (1 − 1/2)2 /4

2

 45(SN−2 ) /16
=
5(SN−2 )2 /16.

Remark: We could also determine (ξN−1 , ηN−1 ) as in Proposition 4.8, from (ξN , ηN )
and the self-financing condition

ξN−1 SN−1 + ηN−1 A0 = ξN SN−1 + ηN AN−1 ,

as 
 ξN−1 SN−2 (1 + 1/2) + ηN−1
ξN−1 SN−1 + ηN−1 A0 =
ξN−1 SN−2 (1 − 1/2) + ηN−1


= ξN SN−1 + ηN A0
= 2(SN−1 )2 − 3(SN−1 )2 /4

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 384 Exercise Solutions
2 2 2 2

 2(SN−2 ) (1 + 1/2) − 3(SN−2 ) (1 + 1/2) /4
=
2(SN−2 )2 (1 − 1/2)2 − 3(SN−2 )2 (1 − 1/2)2 /4,

which recovers ξN−1 = 5SN−2 /2 and ηN−1 = −15(SN−2 )2 /16.

Exercise 4.17
a) By Theorem 3.19 this model admits a unique risk-neutral probability measure P∗ because
a < r < b, and from (3.6.2) we have
b−r 0.07 − 0.05
P∗ (Rt = a) = = ,
b − a 0.07 − 0.02
and
r−a 0.05 − 0.02
P(Rt = b) = = ,
b − a 0.07 − 0.02
t = 1, 2, . . . , N.
b) There are no arbitrage opportunities in this model, due to the existence of a risk-neutral
probability measure.
c) This market model is complete because the risk-neutral probability measure is unique.
d) We have
C = (SN )2 ,
hence
( SN ) 2
Ce = = h(XN ),
(1 + r )N
with

h ( x ) = x2 ( 1 + r ) N . (S.14)

Now we have
Vet = ṽ(t, Xt ),
where the function v(t, x) is given from Proposition 4.5 as
!
N−t 
N −t 1 + b k 1 + a N−t−k
    
∗ k ∗ N−t−k
ṽ(t, x) = ∑ ( p ) (q ) h x .
k =0 k 1+r 1+r

Using (S.14) and the binomial theorem, we find

N−t 
N −t

2 N
ṽ(t, x) = x (1 + r ) ∑
k =0 k
1 + a 2(N−t−k)
 2k  
∗ k ∗ N−t−k 1 + b
×( p ) (q )
1+r 1+r
N−t 
N −t

= x2 ( 1 + r ) N ∑
k =0 k
k  N−t−k
(r − a)(1 + b)2 (b − r )(1 + a)2

×
(b − a)(1 + r )2 (b − a)(1 + r )2
2
N−t
N (r − a)(1 + b) (b − r )(1 + a)2

2
= x (1 + r ) +
(b − a)(1 + r )2 (b − a)(1 + r )2

N−t
x2 (r − a)(1 + b)2 + (b − r )(1 + a)2
=
(1 + r )N−2t (b − a)N−t

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MH4514 Financial Mathematics 385

N−t
x2 (r − a)(1 + 2b + b2 ) + (b − r )(1 + 2a + a2 )
=
(1 + r )N−2t (b − a)N−t

N−t
x2 r (1 + 2b + b2 ) − a(1 + 2b + b2 ) + b(1 + 2a + a2 ) − r (1 + 2a + a2 )
=
(1 + r )N−2t (b − a)N−t
(1 + r (a + b + 2) − ab)N−t
= x2 .
(1 + r )N−2t
e) We have
1+b 1+a



v t, 1+r X t−1 − v t, 1+r X t−1
ξt1 =
Xt−1 (b − a)/(1 + r )
1+b 2 a 2
− 11+



1+r +r (1 + r (a + b + 2) − ab)N−t
= Xt−1
(b − a) / (1 + r ) (1 + r )N−2t
(1 + r (a + b + 2) − ab)N−t
= St−1 (a + b + 2) , t = 1, 2, . . . , N,
(1 + r )N−t
representing the quantity of the risky asset to be present in the portfolio at time t. On the
other hand we have
Vt − ξt1 Xt
ξt0 =
Xt0
Vt − ξt1 Xt
=
π0
Xt − Xt−1 (a + b + 2)/(1 + r )
= Xt (1 + r (a + b + 2) − ab)N−t
π0 (1 + r )N−2t
St − St−1 (a + b + 2)
= St (1 + r (a + b + 2) − ab)N−t
π0 (1 + r )N
(1 + a)(1 + b)
= −(St−1 )2 (1 + r (a + b + 2) − ab)N−t ,
π0 (1 + r )N
t = 1, 2, . . . , N.
f) Let us check that the portfolio is self-financing. We have
ξ t +1 · St = ξt0+1 St0 + ξt1+1 St1
(1 + a)(1 + b) 0
= −(St )2 (1 + r (a + b + 2) − ab)N−t−1 S
π0 (1 + r )N t
(1 + r (a + b + 2) − ab)N−t−1
+(St )2 (a + b + 2)
(1 + r )N−t−1
(1 + r (a + b + 2) − ab)N−t−1
= (St )2
(1 + r )N−t
× ((a + b + 2)(1 + r ) − (1 + a)(1 + b))
1
= (Xt )2 (1 + r (a + b + 2) − ab)N−t
(1 + r )N−3t
= (1 + r )t Vt
= ξ t · St , t = 1, 2, . . . , N.

Exercise 4.18
a) We have
Vt = ξt St + ηt πt
= ξt (1 + Rt )St−1 + ηt (1 + r )πt−1 .
b) We have
IE∗ [Rt |Ft−1 ] = aP∗ (Rt = a | Ft−1 ) + bP∗ (Rt = b | Ft−1 )

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 386 Exercise Solutions
b−r r−a
= a +b
b−a b−a
r r
= b −a
b−a b−a
= r.
c) By the result of Question (a)), we have
IE∗ [Vt | Ft−1 ] = IE∗ [ξt (1 + Rt )St−1 | Ft−1 ] + IE∗ [ηt (1 + r )πt−1 | Ft−1 ]
= ξt St−1 IE∗ [1 + Rt | Ft−1 ] + (1 + r ) IE∗ [ηt πt−1 | Ft−1 ]
= (1 + r )ξt St−1 + (1 + r )ηt πt−1
= (1 + r )ξt−1 St−1 + (1 + r )ηt−1 πt−1
= (1 + r )Vt−1 ,
where we used the self-financing condition.
d) We have
1
Vt−1 = IE∗ [Vt | Ft−1 ]
1+r
3 8
= P∗ (Rt = a | Ft−1 ) + P∗ (Rt = b | Ft−1 )
1+r 1 + r
0.25 − 0.15 0.15 − 0.05
 
1
= 3 +8
1 + 0.15 0.25 − 0.05 0.25 − 0.05
 
1 3 8
= +
1.15 2 2
= 4.78.

Problem 4.19 CRR model with transaction costs.

a) i) In the event of an increase in the stock position ξt , the corresponding cost of purchase
(1 + λ )(ξt +1 − ξt )St > 0 has to be deducted from the savings account value ηt At , which
becomes updated as

ηt +1 At = ηt At − (1 + λ )(ξt +1 − ξt )St ,

hence we have

ηt +1 At + (1 + λ )ξt +1 St = ηt At + (1 + λ )ξt St .

ii) In the event of a decrease in the stock position ξt , the corresponding sale profit (ξt −
ξt +1 )(1 − λ )St > 0 has to be added to from the savings account value ηt At , which
becomes updated as

ηt +1 At = ηt At + (ξt − ξt +1 )(1 − λ )St ,

hence we have

ηt +1 At + ξt +1 (1 − λ )St = ηt At + ξt (1 − λ )St .

b) We have:
i) If ξt +1 (β St−1 ) > ξt (St−1 ),

(ξt (St−1 ) − ξt +1 (β St−1 ))β ↑ Set−1 = (ηt +1 (β St−1 ) − ηt (St−1 ))ρ.

ii) If ξt +1 (β St−1 ) < ξt (St−1 ),

(ξt (St−1 ) − ξt +1 (β St−1 )) β↓ Set−1 = (ηt +1 (β St−1 ) − ηt (St−1 ))ρ,

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 387

and
iii) If ξt +1 (αSt−1 ) > ξt (St−1 ),

(ξt (St−1 ) − ξt +1 (αSt−1 )) α ↑ Set−1 = ρηt +1 (αSt−1 ) − ρηt (St−1 ).

iv) If ξt +1 (αSt−1 ) < ξt (St−1 ),

(ξt (St−1 ) − ξt +1 (αSt−1 )) α↓ Set−1 = ρηt +1 (αSt−1 ) − ρηt (St−1 ).

c) We find


gβ (ξt (St−1 ), ξt +1 (β St−1 )) ξt (St−1 ) − ξt +1 (β St−1 ) Set−1 = ρηt +1 (β St−1 ) − ρηt (St−1 ).

and


gα (ξt (St−1 ), ξt +1 (αSt−1 )) ξt (St−1 ) − ξt +1 (αSt−1 ) Set−1 = ρηt +1 (αSt−1 ) − ρηt (St−1 ).

d) The equation is

Set−1 gβ (ξt (St−1 ), ξt +1 (β St−1 )) ξt (St−1 ) − ξt +1 (β St−1 )


−Set−1 gα (ξt (St−1 ), ξt +1 (αSt−1 )) ξt (St−1 ) − ξt +1 (αSt−1 )
= ρηt +1 (β St−1 ) − ρηt +1 (αSt−1 ),
which can be rewritten as

f (x, St−1 ) = 0 (S.15)

at x = ξt (St−1 ). The function

x 7→ f (x, St−1 )
is continuous by construction, and its derivative is the function

x 7→ gβ (x, ξt +1 (β St−1 )) − gα (x, ξt +1 (αSt−1 )),

which can only take four values β ↑ − α ↑ , β ↑ − α↓ , β↓ − α ↑ , β↓ − α↓ , which are all strictly
positive due to the conditions

↑
 α := α (1 + λ ) < β (1 − λ ) =: β↓ ,

α↓ := α (1 − λ ) < β (1 − λ ) := β↓ ,

 ↑
α : = α (1 + λ ) < β (1 + λ ) = : β ↑ .

Hence x 7→ f (x, St−1 ) is strictly increasing, and we have

lim f (x, St−1 ) = −∞ and lim f (x, St−1 ) = ∞.

x→−∞ x→∞

Therefore, Equation (S.15) admits a unique solution x = ξt (St−1 ).

e) We have
ηt +1 (β St−1 ) − ηt +1 (αSt−1 )
ξt (St−1 ) = ρ

Set−1 gβ (ξt (St−1 ), ξt +1 (β St−1 )) − gα (ξt (St−1 ), ξt +1 (αSt−1 ))
ξt +1 (β St−1 )gβ (ξt (St−1 ), ξt +1 (β St−1 )) − ξt +1 (αSt−1 )gα (ξt (St−1 ), ξt +1 (αSt−1 ))
+ ,
gβ (ξt (St−1 ), ξt +1 (β St−1 )) − gα (ξt (St−1 ), ξt +1 (αSt−1 ))

and

ηt (St−1 )

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 388 Exercise Solutions

gα (ξt (St−1 ), ξt +1 (αSt−1 ))gβ (ξt (St−1 ), ξt +1 (β St−1 ))ξt +1 (β St−1 )

= Set−1
ρgα (ξt (St−1 ), ξt +1 (αSt−1 )) − ρgβ (ξt (St−1 ), ξt +1 (β St−1 ))
gβ (ξt (St−1 ), ξt +1 (β St−1 ))gα (ξt (St−1 ), ξt +1 (αSt−1 ))ξt +1 (αSt−1 )
− Set−1
ρgα (ξt (St−1 ), ξt +1 (αSt−1 )) − ρgβ (ξt (St−1 ), ξt +1 (β St−1 ))
gα (ξt (St−1 ), ξt +1 (αSt−1 ))ηt +1 (β St−1 ) − gβ (ξt (St−1 ), ξt +1 (β St−1 ))ηt +1 (αSt−1 )
+ .
gα (ξt (St−1 ), ξt +1 (αSt−1 )) − gβ (ξt (St−1 ), ξt +1 (β St−1 ))


f) i) In case f (ξt +1 (αSt−1 ), St−1 ⩾ 0 we have ξt (St−1 ) ⩽ ξt +1 (αSt−1 ) because f is in-
creasing, hence
gα (ξt (St−1 ), ξt +1 (αSt−1 )) = α ↑ (1 + λ )α.


ii) In case f ξt +1 (αSt−1 ), St−1 < 0 we have ξt (St−1 ) > ξt +1 (αSt−1 ) because f is in-
creasing, hence

gα (ξt (St−1 ), ξt +1 (αSt−1 )) = α↓ = (1 − λ )α.

Note that in case f ξt +1 (αSt−1 ), St−1 = 0 we have ξt (St−1 ) = ξt +1 (αSt−1 ) hence there is
no transaction from St−1 to αS
t−1 . Similarly,
iii) If f ξt +1 (β St−1 ), St−1 ⩾ 0 then ξt (St−1 ) ⩽ ξt +1 (β St−1 ), hence

gβ (ξt (St−1 ), ξt +1 (β St−1 )) = β ↑ (1 + λ )β .

iv) If f ξt +1 (β St−1 ), St−1 < 0 then ξt (St−1 ) > ξt +1 (β St−1 ), hence

gβ (ξt (St−1 ), ξt +1 (β St−1 )) = β↓ = (1 − λ )β .

Note that in case f ξt +1 (β St−1 ), St−1 = 0 we have ξt (St−1 ) = ξt +1 (β St−1 ) hence there is
no transaction from St−1 to β St−1 .
g) With the parameters N = 2, K = $2, S0 = 8, ρ = 1, α = 0.5, β = 2, and the transaction cost
rate λ = 12.5%, we find the tree of asset prices

S2 = 32

S1 = 16

S0 = 8 S2 = 8

S1 = 4

S2 = 2.
Figure S.17: Tree of market prices with N = 2.

At maturity time N we use the equations (4.4.4)-(4.4.5) of Proposition 4.11, which read here

h(β SN−1 ) − h(αSN−1 )
ξN SN−1 = , (4.4.4)
(β − α )SN−1
where h(t, x) = (x − K )+ , and
β h(αSN−1 ) − αh(β SN−1 )
ηN (SN−1 ) = , (4.4.5)
( β − α ) AN
as the evaluation of the terminal payoff is not affected by bid/ask prices. This yields

(η2 (16), ξ2 (16)) = (−2, 1) and (η2 (4), ξ2 (4)) = (−2, 1).

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MH4514 Financial Mathematics 389

In this case we check that f (ξ2 (16), S0 ) = f (1, 8) = 0 and f (ξ2 (4), S0 ) = f (1, 8) = 0, which
yields the hedging strategy ξ1 (8) = ξ2 (16) = ξ2 (4) = 1 and η1 (8) = η1 (15) = η1 (4) = −2
as the portfolio is self-financing. This static hedging involves no transaction costs and gives
the initial price V0 = 8 × 1 − 2 × 1 = $6.

Due to the simplicity of the case K = $2, we now consider the case K = $4. In this case,
(4.4.4) and (4.4.5) give

(η2 (16), ξ2 (16)) = (−4, 1) and (η2 (4), ξ2 (4)) = (−4/3, 2/3),

which yields
f (ξ2 (16), S0 ) = f (1, 8)
−4 − (−4/3)
= gβ (1, 1)(1 − 1) − gα (1, 2/3)(1 − 2/3) −
8
1 1
= − α↓ +
3 3
1 1
= − (1 − λ )α +
3 3
1 1 1
= − × 0.875 × +
3 2 3
> 0,
hence
gβ (ξ1 (S0 ), ξ2 (β S0 )) = β↑ = (1 + λ )β .
We also have

f (ξ2 (4), S0 ) = f (2/3, 8)

−4 − (−4/3)
= gβ (2/3, 1)(2/3 − 1) − gα (2/3, 2/3)(2/3 − 2/3) −
8
1 1
= − β↑+
3 3
1 1
= − (1 + λ )β +
3 3
2 1
= − × 1.125 +
3 3
< 0,

hence
gα (ξ1 (S0 ), ξ2 (αS0 )) = α↓ = (1 − λ )α.
Therefore, we find
η2 (β S0 ) − η2 (αS0 )
ξ1 (S0 ) = ρ

Se0 gβ (ξ1 (S0 ), ξ2 (β S0 )) − gα (ξ1 (S0 ), ξ2 (αS0 ))
ξ2 (β S0 )gβ (ξ1 (S0 ), ξ2 (β S0 )) − ξ2 (αS0 )gα (ξ1 (S0 ), ξ2 (αS0 ))
+
gβ (ξ1 (S0 ), ξ2 (β S0 )) − gα (ξ1 (S0 ), ξ2 (αS0 ))
η2 (β S0 ) − η2 (αS0 ) ξ2 (β S0 )(1 + λ )β − ξ2 (αS0 )(1 − λ )α
= ρ
+
S0 ( 1 + λ ) β − ( 1 − λ ) α
e (1 + λ )β − (1 − λ )α
−4 − (−4/3) 1.125 × 2 − (2/3) × 0.875 × 0.5
=
+
8 1.125 × 2 − 0.875 × 0.5 2 × 1.125 − 0.5 × 0.875
= 0.8965,

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 390 Exercise Solutions

and
gα (ξ1 (S0 ), ξ2 (αS0 ))gβ (ξ1 (S0 ), ξ2 (β S0 ))ξ2 (β S0 )
η1 (S0 ) = Se0
ρgα (ξ1 (S0 ), ξ2 (αS0 )) − ρgβ (ξ1 (S0 ), ξ2 (β S0 ))
gβ (ξ1 (S0 ), ξ1 (β S0 ))gα (ξ1 (S0 ), ξ2 (αS0 ))ξ2 (αS0 )
−Se0
ρgα (ξ1 (S0 ), ξ2 (αS0 )) − ρgβ (ξ1 (S0 ), ξ2 (β S0 ))
gα (ξ1 (S0 ), ξ2 (αS0 ))η2 (β S0 ) − gβ (ξ1 (S0 ), ξ2 (β S0 ))η2 (αS0 )
+
gα (ξ1 (S0 ), ξ2 (αS0 )) − gβ (ξ1 (S0 ), ξ2 (β S0 ))
(1 − λ )α (1 + λ )β ξ2 (β S0 ) e (1 + λ )β (1 − λ )αξ2 (αS0 )
= Se0 − S0
ρ (1 − λ )α − ρ (1 + λ )β (1 − λ )αρ − (1 + λ )β ρ
(1 − λ )αη2 (β S0 ) − (1 + λ )β η2 (αS0 )
+
(1 − λ )α − (1 + λ )β
0.875 × 0.5 × 1.125 × 2 − 1.125 × 2 × 0.875 × 0.5 × 2/3
= 8
0.875 × 0.5 − 1.125 × 2
0.875 × 0.5 × (−4) − 1.125 × 2 × (−4/3)
+
0.875 × 0.5 − 1.125 × 2
= −2.1379.
This leads to the initial option price

V0 = 0.8965 × 8 − 2.1379 = 5.0345.

Remark: Note that with λ = 0 and K = 4 we would find

8 20 44
ξ1 (S0 ) = = 0.88, η1 (S0 ) = − = −2.22, and V0 = = 4.88.
9 9 9
Therefore, the presence of transaction costs increases the price of the option, and requires a
higher stock position and a higher level of debt.
h) Please refer to the attached IPython notebook.*
Remark: Transaction costs in the CRR model were originally introduced in Boyle and Vorst, 1992.
The present solution is based on the method of Mel′ nikov and Petrachenko, 2005, which originally
also takes into account different borrowing and lending rates ρ ↑ = 1 + r↑ and ρ↓ = 1 + r↓ , which
can be regarded as bid/ask prices for the riskless asset, and can also represent transaction costs.

Problem 4.20 CRR model with dividends (1).

a) Denoting Sb2 the asset price at time 2 before the dividend is paid at the rate α, we find that
the ex-dividend asset price S2 after dividend payment is

S2 = Sb2 − α Sb2 ,

hence
V2 = ξ2 S2 + η2 A2 + αξ2 Sb2
S2
= ξ2 S2 + η2 A2 + αξ2
1−α
S2
= ξ2 + η2 A2 .
1−α
b) Denoting Sb1 the asset price at time 1 before the dividend is paid at the rate α, we find that
the ex-dividend asset price S1 after dividend payment is

S1 = Sb1 − α Sb1 ,


* Right-click to save as attachment (may not work on .

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 391

hence
V1 = ξ1 S1 + η1 A1 + αξ1 Sb1
S1
= ξ1 S1 + η1 A1 + αξ1
1−α
S1
= ξ1 + η1 A1 .
1−α
c) If S1 = 3 we have

9ξ2

2
 1 − α + η2 2 = $1 if S2 = 9,



S2
V2 = ξ2 + η2 A2 =
1−α
 3ξ2 + η2 22 = 0


if S2 = 3,

1−α

hence (ξ2 , η2 ) = ((1 − α )/6, −1/8).

If S1 = 1 we have

3ξ2

2
 1 − α + η2 2 = 0 if S2 = 3,



S2
V2 = ξ2 + η2 A2 =
1−α  ξ2
+ η2 22 = 0

if S2 = 1,


1−α

hence (ξ2 , η2 ) = (0, 0).

d) We have

1−α 1 1 − 2α

 V1 = ξ2 S1 + 2η2 = 3 ×
 −2× = if S1 = 3,
6 8 4

V1 = ξ2 S1 + 2η2 = 0 × 1 + 0 × 2 = 0 if S1 = 1.


e) We have

3ξ1 1 − 2α



 1−α + 2η1 = if S1 = 3,
S1
 4
V1 = ξ1 + η1 A1 =
1−α 
 ξ1
+ 2η1 = 0 if S1 = 1,


1−α

hence (ξ1 , η1 ) = ((α − 1)(2α − 1)/8, (2α − 1)/16).

f) At time k = 0 we have

(α − 1)(2α − 1) 2α − 1 (2α − 1)2

V0 = ξ1 S0 + η1 = + = .
8 16 16

g) Multiplying the prices (Sk )k=1,2 of the original tree by

 k  k  k
1 1 4
= = ,
1−α 1 − 1/4 3

we find the prices (Sk )k=1,2 = (Sk /(1 − α )k )k=1,2 as in the following tree:

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 392 Exercise Solutions

S2 = 16
p∗

S1 = 4
p∗
q∗
S0 = 1 S2 = 16/3
p∗
q∗
S1 = 4/3

q∗
S2 = 16/9

h) The market returns found in Question (g)) are a = 1/3 and b = 3, with r = 1%. Therefore
we have
r−a 1 − 1/3 1 3−1 b−r 3
p∗ = = = and q∗ = = = .
b − a 3 − 1/3 4 3 − 1/3 b − a 4
i) If S1 = 3 we have
1 p∗ 1
IE∗ (S2 − K )+ | S1 = 3] = $1 ×

= ,
1+r 2 8
which coincides with
3 2 1
V1 = ξ2 S1 + 2η2 = − = .
8 8 8
If S1 = 1 we have
1
IE∗ (S2 − K )+ | S1 = 1] = 0,

1+r
which coincides with
V1 = ξ2 S1 + 2η2 = 0.
j) At time k = 0 we have
1 ∗
 + ( p∗ )2 1
2
I
E ( S2 − K ) ] = 2
= ,
(1 + r ) (1 + r ) 64
which coincides with
3 1 1
V0 = ξ1 S0 + η1 = − = .
64 32 64
We also have
1 p∗ 1 1 1 1
IE∗ V1 ] =

× = × = .
1+r 1 + r 8 8 8 64

Problem 4.21 CRR model with dividends (2).

a) We have  
(1)
 (1 + b)(1 − α )Sk−1
 if Rk = b 

(1)
Sk =
 (1) 
(1 + a)(1 − α )Sk−1 if Rk = a
 
(1)
= (1 + Rk )(1 − α )Sk−1 , k = 1, 2, . . . , N,
and
k
(1) (1)
Sk = S0 ∏(1 + Ri ), k = 0, 1, . . . , N,
i=1
with the binary tree

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 393

(1)
(1 + b)(1 − α )S0

(1)
S0

(1)
(1 + a)(1 − α )S0
(1)
b) The asset price before dividend payment is Sk /(1 − α ), hence the dividend amount is
(1) (1)
Sk (1) αSk
− Sk = ,
1−α 1−α
therefore, the dividend value represents a percentage α/(1 − α ) of the ex-dividend price
(1)
Sk . Moreover, the return of the risky asset satisfies the following relation
" (1) #
∗ Sk+1 (1)
Fk = IE∗ (1 + Rk )Sk Fk
 
IE
1−α
r−a (1) b−r (1)
= ( 1 + b ) Sk + (1 + a)Sk
b−a b−a
(1)
k = 0, 1, . . . , N − 1.
= (1 + r )Sk ,
α (1)
c) When reinvesting the dividend amount ξk Sk into the new portfolio allocation, we
1−α
have
(1) (0)
Vk = ξk+1 Sk + ηk+1 Sk
(1) (0) α (1)
= ξk Sk + ηk Sk + ξk Sk
1−α
(1)
S (0)
= ξk k + ηk Sk ,
1−α
at times k = 1, 2, . . . , N − 1. Moreover, at time N we will similarly have
(1)
(1) α (1) (0) S (0)
VN = ξN SN + ξN SN + ηN SN = ξN N + ηN SN ,
1−α 1−α
therefore the self-financing condition reads
(1)
Sk (0)
Vk = ξk + ηk Sk , k = 1, 2, . . . , N. (S.16)
1−α
d) By the self-financing condition (S.16) we have
(1) (1)
Sk Sk−1
Vk − Vk−1 = ξk+1 (0) + ηk+1 − ξk (0) − ηk
e e
Sk Sk−1
(1) (1)
ξk Sk Sk−1
= (0)
+ ηk − ξk (0)
− ηk
Sk ( 1 − α ) Sk−1
(1) (1)
!
Sk Sk−1
= ξk (0) (0)
, −
k = 1, 2, . . . , N,
Sk (1 − α ) Sk−1
which allows
 us to conclude from Question (b)) that
∗ e ∗ e
IE Vk | Fk−1 − Vk−1 = IE Vk − Vek−1 | Fk−1
  
e

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 394 Exercise Solutions
(1) (1)
" ! #
∗ Sk Sk−1
= IE ξk × (0)
− (0)
Fk−1
Sk ( 1 − α ) Sk−1
(1) (1)
" #
Sk Sk−1
= ξk IE∗ (0)
− (0) Fk−1
Sk (1 − α ) Sk−1
" (1) # !
ξk ∗ Sk (1)
= IE Fk−1 − (1 + r )Sk−1
Sk
(0) (1 − α )
= 0, k = 1, 2, . . . , N,
therefore Vek k=0,1,...,N−1 is a martingale under P∗ .

attains the claim C∗ we have C = VN and C = VN , hence

e) Assuming that the portfolio strategy e e
by the martingale property of Vk k=0,1,...,N−1 under P , we find
e

Vek = IE∗ VeN Fk = IE∗ Ce Fk ,

   
k = 0, 1, . . . , N,

which shows that

1
Vk = IE∗ [C | Fk ], k = 0, 1, . . . , N,
(1 + r )N−k
f) By a binomial probability computation, we have
1
Vk = IE∗ [h(SN ) | Fk ]
(1 + r )N−k
" ! #
N
1
= IE∗ h x ∏ (1 + Rl ) Fk ,
(1 + r )N−k l =t +1 (1)
x=Sk
1
=
(1 + r )N−k
N−k 
N −k

(1)
( p∗ )l (q∗ )N−k−l h Sk (1 + b)k (1 + a)N−k−l (1 − α )N−k


×∑
l =0 l
(1)
= C0 k, Sk (1 − α )N−k , N, a, b, r .

g) We “absorb” the dividend rate α into new market returns by taking aα , bα , rα such that

1 + aα = (1 + a)(1 − α ), 1 + bα = (1 + b)(1 − α ), 1 + rα = (1 + r )(1 − α ),

i.e.
aα = −α + a(1 − α ), bα = −α + b(1 − α ), rα = −α + r (1 − α ).
As a consequence, we have
1
Vk =
(1 + r )N−k
N−k 
N −k

(1)
( p∗ )l (q∗ )N−k−l h Sk (1 + b)k (1 + a)N−k−l (1 − α )N−k


×∑
l =0 l
(1 − α )N−k N−k N − k
 
∗ k ∗ N−k−l (1) k N−k−l


= ∑ ( p ) ( q ) h S k ( 1 + b α ) ( 1 + aα )
(1 + rα )N−k l =0 l
(1)
= (1 − α )N−kC0 k, Sk , N, aα , bα , rα ,

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 395

where
rα − aα r−a
p∗ := P∗ (Rk = b) = = > 0,
bα − aα b−a
and
bα − rα b−r
q∗ := P∗ (Rk = a) = = > 0,
bα − aα b−a
k = 1, 2, . . . , N.
h) We have
1 (1)

Vek = N
Cα k, Sk , N, aα , bα , rα , k = 0, 1, . . . , N,
(1 + r )
hence by the martingale property we have
1 (1)

Vek = k
Cα k, Sk , N, aα , bα , rα
(1 + r )
= IE∗ Vek+1 | Fk
 

1 (1)
IE∗ Cα k + 1, Sk+1 , N, aα , bα , rα Fk


= k + 1
(1 + r )
1 
∗ (1)

= p C α k + 1, S k ( 1 + b α ) , N, aα , b α , r α
(1 + r )k +1
(1)

+q∗Cα k + 1, Sk (1 + aα ), N, aα , bα , rα .
This yields
(1)

(1 + r )Cα k, Sk , N, aα , bα , rα
(1) (1)
= p∗Cα k + 1, Sk (1 + bα ), N, aα , bα , rα + q∗Cα k + 1, Sk (1 + aα ), N, aα , bα , rα .

i) We find the equations


(0) (1) (1)

 ηk Sk + ξk (1 + aα )Sk−1 = Cα k, (1 + aα )Sk−1 , N, aα , bα , rα


 (0) (1) (1)

ηk Sk + ξk (1 + bα )Sk−1 = Cα k, (1 + bα )Sk−1 , N, aα , bα , rα ,


which imply
(1)
(1)

Cα k, (1 + bα )Sk−1 , N, aα , bα , rα −Cα k, (1 + aα )Sk−1 , N, aα , bα , rα
ξk = (1)
(bα − aα )Sk−1
(1)

N−k C0 k, ( 1 + b α ) Sk−1 , N, aα , b α , rα
= (1 − α ) (1)
(bα − aα )Sk−1
(1)

N−k C0 k, (1 + aα )Sk−1 , N, aα , bα , rα
− (1 − α ) (1)
,
(bα − aα )Sk−1
and
(1)

(1 + bα )Cα k, (1 + bα )Sk−1 , N, aα , bα , rα
ηk = (0)
(bα − aα )Sk−1
(1)

(1 + aα )Cα k, (1 + aα )Sk−1 , N, aα , bα , rα
− (0)
(bα − aα )Sk−1
(1)

N−k (1 + bα )C0 k, (1 + bα )Sk−1 , N, aα , bα , rα
= (1 − α ) (0)
(bα − aα )Sk−1

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 396 Exercise Solutions
(1)

N−k (1 + aα )C0 k, (1 + aα )Sk−1 , N, aα , bα , rα
− (1 − α ) (0)
,
(bα − aα )Sk−1

k = 1, 2, . . . , N.
j) A possible answer: We have
N−k 
N −k

1
ξk = (1) ∑
( p∗ )k (q∗ )N−k−l
(b − a)Sk−1 l =0 l

(1)
× h (1 − α )N−k Sk (1 + b)k+1 (1 + a)N−k−l

(1)

−h (1 − α )N−k Sk (1 + b)k (1 + a)N−k−l +1
and
N−k 
N −k

1
ηk = (1) ∑
( p∗ )k (q∗ )N−k−l
(b − a)Sk−1 l =0 l

(1)
× (1 + b)h (1 − α )N−k Sk (1 + b)k (1 + a)N−k−l +1

(1)

−(1 + a)h (1 − α )N−k Sk (1 + b)k+1 (1 + a)N−k−l ,
k = 1, 2, . . . , N. Differentiation with respect to α of the general term inside the above
summations yields respectively

(1 + a)yh′ ((1 + a)y) − (1 + b)yh′ ((1 + b)y) (S.17)

for ξk , and

(1 + b)yh′ ((1 + b)y) − (1 + a)yh′ ((1 + a)y), (S.18)

(1)
for ηk , with y := (1 − α )N−k Sk (1 + b)k (1 + a)N−k−l and a < b.

We note that the sign of the above quantities (S.17)-(S.18) depends on whether the func-
tion x 7−→ xh′ (x) is non-decreasing, which is the case for example for the payoff functions
h(x) = (x − K )+ and h(x) = (K − x)+ of both European call and put options.

In particular, when the function x 7−→ xh′ (x) is non-decreasing, the amount invested on the
risky (resp. riskless) asset will be lower (resp. higher) in the presence of a higher dividend.

We also note that the expected return

p∗ (1 + b)(1 − α ) + q∗ (1 + a)(1 − α ) = r (1 − α )

and the variance

p∗ (1 + b)2 (1 − α )2 + q∗ (1 + a)2 (1 − α )2 − r2 (1 − α )2
= (1 − α )2 p∗ (1 + b)2 + q∗ (1 + a)2 − r2

of returns are lower in the presence of dividends.

Problem 4.22
a) In order to check for arbitrage opportunities we look for a risk-neutral probability measure
P∗ which should satisfy
 (1) (1)
IE∗ Sk+1 Fk = (1 + r )Sk ,

k = 0, 1, . . . , N − 1.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 397
 (1)
Rewriting IE∗ Sk+1 Fk as

 (1) (1) (1)
IE∗ Sk+1 Fk = (1 + a)Sk P∗ (Rk+1 = a | Fk ) + Sk P∗ (Rk+1 = 0 | Fk )


(1)
+(1 + b)Sk P∗ (Rk+1 = b | Fk )
(1) (1)
= (1 + a)Sk P∗ (Rk+1 = a) + Sk P∗ (Rk+1 = 0)
(1)
+(1 + b)Sk P∗ (Rk+1 = b),
k = 0, 1, . . . , N − 1, it follows that any risk-neutral probability measure P∗ should satisfy the
equations

(1)


 ( 1 + r ) Sk =



(1) (1) (1)
 (1 + b)Sk P∗ (Rk+1 = b) + Sk P∗ (Rk+1 = 0) + (1 + a)Sk P∗ (Rk+1 = a),



P (Rk+1 = b) + P∗ (Rk+1 = 0) + P∗ (Rk+1 = a) = 1,
 ∗


k = 0, 1, . . . , N − 1, i.e.

 bP∗ (Rk = b) + aP∗ (Rk = a) = r,



P∗ (Rk = b) + P∗ (Rk = a) = 1 − P∗ (Rk = 0),



k = 1, 2, . . . , N, with solution

r − (1 − P∗ (Rk = 0))a r − (1 − θ ∗ )a
P∗ (Rk = b) = = ,
b−a b−a

and
(1 − P∗ (Rk = 0))b − r (1 − θ ∗ )b − r
P∗ (Rk = a) = = ,
b−a b−a
k = 1, 2, . . . , N. We check that this ternary tree model is without arbitrage if and only if there
exists θ ∗ := P∗ (Rk = 0) ∈ (0, 1) such that

(1 − θ ∗ )a < r < (1 − θ ∗ )b, (S.19)

or  r
 1− b if r ⩾ 0,


r−a b−r
 
∗
0 < θ < min , =
−a b
 1− r

if r ⩽ 0.

a
Condition (S.19) is necessary in order to have

P∗ (Rk = b) > 0 and P∗ (Rk = a) > 0,

and it is sufficient because it also implies

P∗ (Rk = b) = 1 − θ ∗ − P∗ (Rk = a) ⩽ 1

and
P∗ (Rk = a) = 1 − θ ∗ − P∗ (Rk = b) ⩽ 1.

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 398 Exercise Solutions

b) We will show that this ternary tree model is without arbitrage if and only if a < r < b.

(i) Indeed, if the condition a < r < b is satisfied there always exists θ ∈ (0, 1) such that

a < (1 − θ )a < r < (1 − θ )b < b,

as can be seen by taking

r−a b−r
  
θ ∈ 0, min , ,
−a b
hence there exists a risk-neutral probability measure P∗θ , and the market model is without
arbitrage.

(ii) Conversely, if this ternary tree model is without arbitrage there exists some θ = P∗ (Rt =
0) ∈ (0, 1) such that
(1 − θ )a < r < (1 − θ )b.
c) When r ⩽ a < 0 < b the risky asset overperforms the riskless asset, therefore we can realize
arbitrage by borrowing from the riskless asset to purchase the risky asset. When a < 0 <
b ⩽ r the riskless asset overperforms the risky asset, therefore we can realize arbitrage by
shortselling the risky asset and save the profit of the short sale on the riskless asset.
d) Under the absence of arbitrage condition a < r < b, every value of θ ∈ (0, 1) such that

r−a b−r
 
0 < θ < min ,
−a b

satisfies
(1 − θ )a < r < (1 − θ )b,
and gives rise to a different risk-neutral probability measure, hence the risk-neutral measure
is not unique and by Theorem 6.11 this ternary tree model is not complete.

In particular, every risk-neutral probability measure P∗θ will give rise to a different claim
price
(θ ) 1
IE∗θ C Ft ,
 
πt (C ) = N−t
t = 0, 1, . . . , N.
(1 + r )
e) We have
(1) (1)
" #
∗ Sk+1 − Sk
Var (1)
Fk
S
k !2  #!2
(1) (1) (1) (1)
"
Sk+1 − Sk Sk+1 − Sk
= IE∗  (1)
Fk  − IE∗ (1)
Fk
Sk Sk

(1) (1)
!2 
Sk+1 − Sk
= IE∗  (1)
Fk  − r2
Sk
= a2 P∗σ (Rk+1 = a | Fk ) + b2 P∗σ (Rk+1 = b | Fk ) − r2
(1 − P∗σ (Rk+1 = 0))b − r r − (1 − P∗σ (Rk+1 = 0))a
= a2 + b2 − r2
b−a b−a
= ab(θ − 1) + r (a + b) − r2
= σ 2,

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 399

k = 0, 1, . . . , N − 1, hence
σ 2 + r 2 − r (a + b)
P∗σ (Rk = 0) = θ = 1 + ,
ab
and therefore
r − (1 − P∗σ (Rk = 0))a σ 2 − r (a − r )
P∗σ (Rk = b) = = ,
b−a b(b − a)
and
(1 − P∗σ (Rk = 0))b − r r (b − r ) − σ 2
P∗σ (Rk = a) = = ,
b−a a(b − a)
k = 1, 2, . . . , N, under the condition
σ 2 > Max(−r (r − a), r (b − r )),
in addition to the condition 0 < θ < 1, i.e.
r (b − r ) + rb < σ 2 < (b − r )(r − a).
Finally, we find
−r (r − a) < σ 2 < (b − r )(r − a),
if r ∈ (a, 0], and
r (b − r ) < σ 2 < (b − r )(r − a),
if r ∈ [0, b).
f) In this case the ternary tree becomes a trinomial recombining tree, and the expression of the
risk-neutral probability measure becomes
r (b + 1) + (1 − θ )b
P∗θ (Rk = b) = ,
b2 + 2b
and
(1 − θ )b − r
P∗θ (Rk = a) = (b + 1) ,
b2 + 2b
k = 1, 2, . . . , N. The market model is without arbitrage if and only if there exists θ :=
P∗θ (Rk = 0) ∈ (0, 1) such that
b
−(1 − θ ) < r < (1 − θ )b,
b+1
or
r
0 < θ < 1− .
b
g) Using the tower property (11.6.8) of conditional expectations, we have
(1)
1
f k, Sk = IE∗ [C | Fk ]
(1 + r )N−k
1
= IE∗ [IE∗ [C | Fk+1 ] | Fk ]
(1 + r )N−k
1 ∗ (1)

N−(k+1)
F
 
= IE ( 1 + r ) f k + 1, Sk +1 k
(1 + r )N−k
1 (1)

IE∗ f k + 1, Sk+1 Fk
 
=
1+r
1  (1) (1)

f k + 1, Sk (1 + a) P∗θ (Rk = a) + f k + 1, Sk P∗θ (Rk = 0)


=
1+r 
(1)
+ f k + 1, Sk (1 + b) P∗θ (Rk = b) .

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 400 Exercise Solutions

h) In this case we have f (N, x) = (K − x)+ .

i) See the attached code.* †
j) Taking θ = 0.5 we find the following graph:

4.0 0.0

2.0 2.0 0.24 0.0

1.0 1.0 1.0 0.74 0.82 1.0

0.5 0.5 1.32 1.5

0.25 1.75

(a) Underlying asset prices. (b) Put option prices.

Figure S.18: Put option prices in the trinomial model.

There also exists extensions of the trinomial model to five states (pentanomial model), six states
(hexanomial model), etc.

Chapter 5
Exercise 5.1 If 0 ⩽ s ⩽ t, using the facts that IE[Bt ] = 0 and IE (Bt )2 = 0, t ⩾ 0, we have
 

IE[Bt Bs ] = IE[(Bt − Bs )Bs ] + IE (Bs )2

 

= IE[(Bt − Bs )] IE[Bs ] + IE (Bs )2

 

= 0+s
= s,
and similarly we obtain IE[Bt Bs ] = t when 0 ⩽ t ⩽ s, hence in general we have

IE[Bt Bs ] = min(s,t ), s,t ⩾ 0.

Exercise 5.2 We need to check whether the four properties of the definition of Brownian motion
are satisfied.
a) Checking Conditions 1-2-3 are easily satisfied using the time shift t 7→ c + t. As for
Condition 4, Bc+t − Bc+s clearly has the centered Gaussian distribution with variance
c + t − (c − s) = t − s. We conclude that (Bc+t − Bc )t∈R+ is a standard Brownian motion.
b) We note that Bct 2 is a centered Gaussian random variable with variance ct 2 - not t, hence
(Bct 2 )t∈R+ is not a standard Brownian motion.
c) Similarly, checking Conditions 1-2-3 does not pose any particular problem using the time
change t 7→ t/c2 . As for Condition 4, Bc+t −Bc+s clearly has a centered Gaussian distribution
with
= c2 Var Bt/c2 − Bs/c2




Var c Bt/c2 − Bs/c2
= (t − s)c2 /c2
* Download the modified (trinomial) IPython notebook that can be run here or here.
† Download the corresponding (binomial) IPython notebook. The Anaconda distribution can be installed from
https://www.anaconda.com/distribution/ or tried online at https://jupyter.org/try.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 401

= t − s.


As a consequence, Bt/c2 t∈R is a standard Brownian motion.
+
d) This process does not have independent increments, hence it cannot be a Brownian motion.
For example,
 by (5.1.1) we have



IE Bt + Bt/2 − Bs + Bs/2 Bs + Bs/2
 
= IE Bt Bs + Bt Bs/2 + Bt/2 Bs + Bt/2 Bs/2
 
− IE Bs Bs + Bs Bs/2 + Bs/2 Bs + Bs/2 Bs/2
s s s s s
= s+ +s+ −s− − −
2 2 2 2 2
s
= ,
2
which differs from 0, hence the two increments are not independent. Indeed, independence
of Bt + Bt/2 − Bs + Bs/2 ) and Bs + Bs/2 would yield


IE Bt + Bt/2 − Bs + Bs/2 ) Bs + Bs/2 )
   
= IE Bt + Bt/2 − Bs + Bs/2 ) IE Bs + Bs/2 )
= 0.

Exercise 5.3 By Definition 5.4, we have

wT
2dBt = 2(BT − B0 ) = 2BT ,
0

which has a Gaussian distribution with mean 0 and variance 4T . On the other hand, by Definition 5.4
again, we have
wT
(2 × 1[0,T /2] (t ) + 1(T /2,T ] (t ))dBt = 2(BT /2 − B0 ) + (BT − BT /2 )
0
= BT + BT /2 ,

which has a Gaussian distribution with mean 0 and variance

Var[BT + BT /2 ] = Var[(BT − BT /2 ) + 2BT /2 ]

= Var[BT − BT /2 ] + 4 Var[BT /2 ]
T 4T
= +
2 2
5T
= .
2
Equivalently, using the Itô isometry (5.3.4), we have
w 
T
Var (2 × 1[0,T /2] (t ) + 1(T /2,T ] (t ))dBt
0
wT
" 2 #
= IE (2 × 1[0,T /2] (t ) + 1(T /2,T ] (t ))dBt
0
wT
2 × 1[0,T /2] (t ) + 1(T /2,T ] (t ) dt

2
=
0
w T /2 wT
= 4 dt + dt
0 T /2
5T
= .
2

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 402 Exercise Solutions
w 2π
Exercise 5.4 By Proposition 5.11, the stochastic integral sin(t ) dBt has a Gaussian distribution
0
with mean 0 and variance
w 2π 1 w 2π
sin2 (t )dt = (1 − cos(2t ))dt = π.
0 2 0

Exercise 5.5 By the Itô formula (5.5.11), we have

d ( f (t )Bt ) = f (t )dBt + Bt d f (t ) + d f (t ) • dBt
= f (t )dBt + Bt f ′ (t )dt + f ′ (t )dt • dBt
= f (t )dBt + Bt f ′ (t )dt,
and by integration on both sides we get
wT wT wT
f (t )dBt + Bt f ′ (t )dt = d ( f (t )Bt )
0 0 0
= f (T )BT − f (0)B0
= 0,
since f (T ) = 0 and B0 = 0, hence the conclusion. Note that this result can also be obtained by
integration by parts on the interval [0, T ], see (5.3.7).

Exercise 5.6 r1
a) The stochastic integral 0 t 2 dBt is a centered Gaussian random variable with variance

w1 2 # w
"
1 1
IE t 2 dBt = t 4 dt = .
0 0 5
r1
b) The stochastic integral 0 t −1/2 dBt has the variance

w1 2 # w
"
11
−1/2
IE t dBt = dt = +∞.
0 0 t

r1
In fact, the stochastic integral 0 t −1/2 dBt does not exist as a random variable in L2 (Ω)
because the function t 7→ t −1/2 is not in L2 ([0, 1]).
Remark. Writing Relation (5.3.7) with f (t ) = t −1/2 gives
w1 BT 1 w 1 −3/2
t −1/2 dBt = √ + t Bt dt,
0 T 2 0
however this is only a formal statement as f is not in C 1 ([0, 1]). Informally, we can check
wT
that the term t −3/2 Bt dt has the infinite variance
0
wT w  w
" 2 # 
T T
′
IE Bt f (t )dt = IE Bt f ′ (t )dt Bs f ′ (s)ds
0 0 0
w w 
T T
= IE Bs Bt f ′ (s) f ′ (t )dsdt
0 0
wTwT
= f ′ (s) f ′ (t ) IE[Bs Bt ]dsdt
0 0
1 w T w T −3/2 −3/2
= s t min(s,t )dsdt
4 0 0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 403
1 w T −3/2 w t −5/2 1 w T −5/2 w T −3/2
= t s dsdt + t s dsdt
4 0 0 4 0 t
1 w T −3/2 w t −5/2 1 w T −5/2 w T −3/2
= t s dsdt + t s dsdt
4 0 0 4 0 t
= +∞,
where we used Relationw(5.1.1) or the result of Exercise 5.1
T
c) The stochastic integral Bt dBt has mean 0 and variance
0

wT w wT wT
" 2 #
T2

T
2
IE |Bt |2 dt =
 
IE Bt dBt = IE |Bt | dt = tdt = .
0 0 0 0 2

Exercise 5.7
a) By Proposition 5.11, the probability distribution of Xn is Gaussian with mean zero and
variance
w 2π
" 2 #
Var[Xn ] = IE sin(nt )dBt
0
w 2π
= sin2 (nt )dt
0
1 w 2π 1 w 2π
= cos(0)dt − cos(2nt )dt
2 0 2 0
= π, n ⩾ 1.
b) The random variables (Xn )n⩾1 have same Gaussian distribution, and they are pairwise
independent as from Corollary
w 5.12 we have
2π w 2π 
IE[Xn Xm ] = IE sin(nt )dBt sin(mt )dBt
0 0
w 2π
= sin(nt ) sin(mt )dt
0
w
1 2π 1 w 2π
= cos((n − m)t )dt − cos((n + m)t )dt
2 0 2 0
= 0
and the vector (Xn , Xm ) is jointly Gaussian, for n, m ⩾ 1 such that n ̸= m. Note that this
condition implies independence only when the random variables have a Gaussian distribution.

Exercise 5.8 We have Xt = f (Bt ) with f (x) = sin2 x, f ′ (x) = 2 sin x cos x = sin(2x), and f ′′ (x) =
2 cos(2x), hence

dXt = d sin2 (Bt )

= d f (Bt )
1 ′′
= f ′ (Bt )dBt +
f (Bt )dt
2
= sin(2Bt )dBt + cos(2Bt )dt.

Exercise 5.9
a) Using the Itô isometry(5.4.4), 
we have
 3 wT wT 
IE BT = IE dBt T + 2 Bt dBt
0 0
w  w wT 
T T
= T IE dBt + 2 IE dBt Bt dBt
0 0 0

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 404 Exercise Solutions
w 
T
= 2 IE Bt dt
0
wT
= 2 IE[Bt ]dt
0
= 0.
We also have
wT
" 2 #
 4
IE BT = IE T + 2 Bt dBt
0

wT w
" 2 #
T
= IE T 2 + 4T Bt dBt + 4 Bt dBt
0 0
w  "
wT 2 #
T
= T 2 + 4T IE Bt dBt + 4 IE Bt dBt
0 0
w 
T
= T 2 + 4 IE |Bt |2 dt
0
wT 
= T 2 + 4 IE |Bt |2 dt

0
wT
= T 2 + 4 tdt
0
T2
= T2 +4
2
2
= 3T .
b) If X ≃ N (0, σ 2 ), we have X ≃ BT with σ 2 = T , hence the answer to Question (a)) yields

IE X 3 = 0 and IE X 4 = 3σ 4 .
   

We note that those moments can be recovered directly from the Gaussian probability density
function as w∞
1 2 2
IE X 3 = √ x3 e −x /(2σ ) dx = 0
 
2πσ 2 −∞
and w∞
1 2 2
IE X 4 = √ x4 e −x /(2σ ) dx = 3σ 4 .
 
2πσ 2 −∞

Exercise 5.10 Taking expectation on both sides of (5.5.22) shows that

0 = IE (BT )3
 
 wT 
= IE C + ζt,T dBt
0
w 
T
= C + IE ζt,T dBt
0
= 0

by (5.4.5), hence C = 0. Next, applying Itô’s formula to the function f (x) = x3 shows that

( BT ) 3 = f ( BT )
wT 1 w T ′′
= f ( B0 ) + f ′ (Bt )dBt + f (Bt )dt
0 2 0
wT wT
= 3 (Bt )2 dBt + 3 Bt dt.
0 0

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MH4514 Financial Mathematics 405

By the integration by parts formula (5.3.7) applied to f (t ) = t, we find

wT wT wT
Bt dt = T BT − tdBt = (T − t )dBt ,
0 0 0

hence
wT  wT 
3 2
( BT ) = 3 (Bt ) dBt + 3 T BT − tdBt
0 0
wT
= 3 (T − t + (Bt )2 )dBt ,
0

and we find ζt,T = 3(T − t + (Bt )2 ), t ∈ [0, T ]. This type of stochastic integral decomposition can
be used for option hedging, cf. Section 8.5.

Exercise 5.11
a) We haveh r h rT rt
T
i i
IE e 0 f (s)dBs
Ft = IE e t f (s)dBs Ft
e 0 f (s)dBs

rt h rT i
= e 0 f (s)dBs IE e t f (s)dBs
w
1wT

t
2
= exp f (s)dBs + | f (s)| ds , (S.20)
0 2 t
2
0 ⩽ t ⩽ T , where we used the Gaussian moment generating function IE e X = e σ /2 for
 
wT  wT 
X ≃ N (0, σ 2 ) and the fact that f (s)dBs ≃ N 0, f 2 (s)ds by Proposition 5.11.
t t
b) We have w
1wt 2
 
t
IE exp f (s)dBs − f (s)ds Fu
0 2 0
 w
1 t 2
 h w t  i
= exp − f (s)ds IE exp f (s)dBs Fu
2 0 0

1 w t
 h w u wt  i
= exp − f 2 (s)ds IE exp f (s)dBs + f (s)dBs Fu
2 0 0 u
w w  h
u 1 t 2 w t  i
= exp f (s)dBs − f (s)ds IE exp f (s)dBs Fu
0 2 0 u
w w  h
u 1 t w t i
= exp f (s)dBs − f 2 (s)ds IE exp f (s)dBs
0 2 0 u
w w w 
u 1 t 2 1 t 2
= exp f (s)dBs − f (s)ds + f (s)ds
0 2 0 2 u
w
1wu 2

u
= exp f (s)dBs − f (s)ds , 0 ⩽ u ⩽ t.
0 2 0
This result can also be obtained by directly applying (S.20).
c) We apply the conclusion of Question (b)) to the constant function f (t ) := σ , t ⩾ 0.

Exercise 5.12 We have

(1) (2)

dSt = d St − St
(1) (2)
= dSt − dSt
(1) (1) (2) (2)

= µSt dt + σ1 dWt − µSt dt + σ2 dWt
(1) (2)
(1) (2)
= µ St − µSt dt + σ1 dWt − σ2 dWt .

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 406 Exercise Solutions
(1) (2)
The process Mt := σ1Wt − σ2Wt
is a continuous martingale, with
(1) (2)
(1) (2)

dMt • dMt = σ1 dWt − σ2 dWt • σ dW
1 t − σ2 dWt
(1) (1) (1) (2) (2) (2)
= σ12 dWt • dWt − 2σ1 σ2 dWt • dWt + σ22 dWt • dWt
= (σ12 − 2ρσ1 σ2 + σ22 )dt.

Therefore, letting q
σ := σ12 − 2ρσ1 σ2 + σ22
and
Mt σ1 (1) σ2 (2)
Wt :== Wt − Wt ,
σ σ σ
by the Lévy characterization theorem, see e.g. Theorem IV.3.6 in Revuz and Yor, 1994, the process
(Wt )t∈R+ is a standard Brownian motion with quadratic variation dWt • dWt = dt, with
(1) (2)
(1) (2)
dSt = µ St − St dt + σ1 dWt − σ2 dWt
= µSt dt + σ dWt .

Remark: Since ρ ∈ [−1, 1], we have

σ12 − 2ρσ1 σ2 + σ22 ⩾ σ12 − 2σ1 σ2 + σ22 = (σ1 − σ2 )2 ⩾ 0.

Exercise 5.13
a) Using (5.5.14),
 we have 
 wT 2
= IE e β (BT −T )/2
 
IE exp β Bt dBt
0
h 2
i
= e −β T /2 IE e β (BT ) /2
e −β T /2 w ∞ β x2 /2 −x2 /(2T )
= √ e e dx
2πT −∞
e −β T /2 w ∞ (β −1/T )x2 /2
= √ e dx
2πT −∞
e −β T /2 w ∞ e −x /(2/(1/T −β ))
2

= p p dx
1 − β T −∞ 2π/(1/T − β )
e −β T /2
= p ,
1−βT
2
for all β < 1/T , where we applied Relation (11.6.13) to the function φ (x) = e β x /2 , knowing
that BT ≃ N (0, T ).
b) Due to the relation

T −λ w ∞ β y λ −1 −y/T 1
e y e dy = , β < 1/T ,
Γ (λ ) 0 (1 − β T )λ
p
applied with λ = 1/2, the function β 7→ 1/ 1 − β T can be identified as the moment
generating function of the gamma distribution with shape parameter λ = 1/2, scaling
parameter 1/T , and probability density function

1
y 7→ (yT )−1/2 e −y/T .
Γ(1/2)

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 407
wT
Therefore, T + 2 Bt dBt = B2T has a gamma distribution with shape parameter 1/2 and
0 wT
scaling parameter T . In other words, the square 1 + 2 Bt dBt /T = B2T /T of the normal
√ 0
random variable BT / T ≃ N (0, 1) has a χ 2 distribution with one degree of freedom.

Exercise 5.14
a) Letting Yt := e bt Xt , we have
dYt = d ( e bt Xt )
= b e bt Xt dt + e bt dXt
= b e bt Xt dt + e bt (−bXt dt + σ e −bt dBt )
= σ dBt ,
hence wt wt
Yt = Y0 + dYs = Y0 + σ dBs = Y0 + σ Bt ,
0 0
and
Xt = e −bt Yt = e −bt Y0 + σ e −bt Bt = e −bt X0 + σ e −bt Bt .
Alternatively, we can also search for a solution Xt of the form Xt = f (t, Bt ), with

∂f ∂f 1 ∂2 f
dXt = d f (t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂ x2
from the Itô formula. Matching this expression to the stochastic differential equation (5.5.23)
would yield
∂f 1 ∂2 f
(t, Bt ) + (t, Bt )dt = −bXt = −b f (t, Bt )
∂t 2 ∂ x2
and
∂f
(t, Bt ) = σ e −bt ,
∂x
hence
∂f 1 ∂2 f ∂f
(t, x) + 2
(t, x)dt = −b f (t, x) and (t, x) = σ e −bt ,
∂t 2 ∂x ∂x
x ∈ R, which can be solved as f (t, x) = f (t, 0) + σ x e −bt and
∂f
(t, 0) = −b f (t, 0),
∂t
which gives f (t, 0) = f (0, 0) e −bt , and recovers

Xt = f (t, Bt ) = X0 e −bt + σ e −bt Bt , t ⩾ 0.

Remark. This type of computation appears anywhere discounting by the factor e −bt is
involved.
b) Letting Yt = e bt Xt , we have
dYt = d ( e bt Xt )
= b e bt Xt dt + e bt dXt
= b e bt Xt dt + e bt − bXt dt + σ e −at dBt

= σ e (b−a)t dBt ,
hence we can solve for Yt by integrating on both sides as
wt wt
Yt = Y0 + dYs = Y0 + σ e (b−a)s dBs , t ⩾ 0.
0 0

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 408 Exercise Solutions

This yields the solution

wt
Xt = e −bt Yt = e −bt X0 + σ e −bt e (b−a)s dBs , t ⩾ 0. (S.21)
0

Remark. In part (b)) the solution cannot take the form Xt = f (t, Bt ) when a ̸= b. Indeed,
solving
∂f
(t, x) = σ e −at
∂x
gives f (t, x) = f (t, 0) + σ x e −at , yielding

∂f 1 ∂2 f ∂f
(t, x) + (t, x) = (t, 0) − aσ x e −at ,
∂t 2 ∂ x2 ∂t
which cannot match −bwf (t, x) unless a = b.
t
c) The stochastic integral e (b−a)s dBs cannot be computed in closed form. If r ̸= −a, the
wt 0
stochastic integral e −(a+r)s dBs is a centered Gaussian random variable with variance
0
wt 1 − e −2(a+r)t
e −2(a+r)s ds = .
0 2(a + r )
From (S.21) we conclude that Xt has a Gaussian distribution with mean e rt X0 , and variance
e 2rt − e −2at
σ2 ⩾ 0,
2(a + r )

When a = −r we have Xt = e rt X0 + σ e rt Bt , which has variance σ 2t e 2rt .

Exercise 5.15
a) Note that the stochastic integral
wT 1
dBs
0 T −s
is not defined in L2 (Ω) as the function s 7→ 1/(T − s) is not in L2 ([0, T ]), and by the Itô
isometry (5.3.4) we have
wT 1 2 # w
"
1 ∞
 
T 1
IE dBs = ds = = +∞.
0 T −s 0 (T − s)2 T −s 0

On the 
other hand,
 by (5.5.10) and (5.5.25)
 we have 
 
Xt dXt 1 1
d = + Xt d + dXt d •
T −t T −t T −t T −t
dXt Xt
= + dt
T − t (T − t )2
dBt
= σ ,
T −t
hence, by integration over the time interval [0,t ] and using the initial condition X0 = 0, we
find
X0 w t w t dB
 
Xt Xs s
= + d =σ , 0 ⩽ t < T.
T −t T 0 T −s 0 T −s

b) By (5.4.5), we have
w 
t 1
IE[Xt ] = (T − t )σ IE dBs = 0, 0 ⩽ t < T.
0 T −s

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MH4514 Financial Mathematics 409

c) By the Itô isometry (5.3.4), we have

wt 1 
2 2
Var[Xt ] = (T − t ) σ Var dBs
0 T −s
wt 1
" 2 #
= (T − t )2 σ 2 IE dBs
0 T −s
wt 1
= (T − t )2 σ 2 ds
0 (T − s)2
 
2 2 1 1
= (T − t ) σ −
T −t T
T −t
= σ 2t , 0 ⩽ t < T.
T
d) We have
t2
 
2
lim ∥Xt ∥L2 (Ω) = lim Var[Xt ] = σ lim t − = 0.
t→T t→T t→T T

Exercise 5.16 Exponential Vašíček, 1977 model (1). Applying the Itô formula (5.5.12) to
Xt = e rt = f (rt ) with f (x) = e x , we have
dXt = d e rt
1 ′′
= f ′ (rt )drt + f (rt )drt • drt
2
1
= e rt drt + e rt drt • drt
2
1 rt
= e rt ((a − brt )dt + σ dBt ) + e ((a − brt )dt + σ dBt )2
2
σ 2 rt
= e rt ((a − brt )dt + σ dBt ) + e dt
2
σ2
 
= Xt a + − b log(Xt ) dt + σ Xt dBt
2
= Xt (ae − e
b f (Xt ))dt + σ g(Xt )dBt ,
hence
σ2
ae = a + and b=b
e
2
the functions f (x) and g(x) are given by f (x) = log x and g(x) = x. Note that this stochastic
differential equation is that of the exponential Vasicek model.

Exercise 5.17 Exponential Vasicek

w model (2).
t
a) We have Zt = e −at Z0 + σ e −(t−s)a dBs .
0
θ wt
b) We have Yt = e −at Y0 + 1 − e −at + σ e −(t−s)a dBs .


a 0
σ2
 
c) We have dXt = Xt θ + − a log Xt dt + σ Xt dBt .
2

θ wt 
−at −at −(t−s)a


d) We have rt = exp e log r0 + 1 − e +σ e dBs .
a 0
2
e) Using the Gaussian moment generating function identity IE[ e X ] = e α /2 for X ≃ N (0, α 2 )
and the variance formula (5.3.6), we have
 
θ wt  
IE[rt | Fu ] = IE exp e −at log r0 + 1 − e −at + σ e −(t−s)a dBs Fu


a 0

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 410 Exercise Solutions
−at log r

ru  wt
1− e −at +σ e −(t−s)a dBs
θ
h  i
0+ a
= ee 0 IE exp σ e −(t−s)a dBs Fu
u
−at θ −at

ru
− (t−s ) a
h  wt i
= e e log r0 + a 1− e +σ 0 e dBs
IE exp σ e −(t−s)a dBs
u

θ wu σ 2 w t −2(t−s)a

−at −at −(t−s)a


= exp e log r0 + 1 − e +σ e dBs + e ds
a 0 2 u

θ wu σ2

−at −at −(t−s)a −2(t−u)a



= exp e log r0 + 1 − e +σ e dBs + 1− e
a 0 4a
 
θ wu 
−(t−u)a −au −au −(u−s)a


= exp e e log r0 + 1 − e +σ e dBs
a 0

σ2

θ −(t−u)a −2(t−u)a


+ 1− e + 1− e
a 4a

σ2
 
−(t−u)a θ −(t−u)a −2(t−u)a


= exp e log ru + 1 − e + 1− e
a 4a

σ2
 
e −(t−u)a θ −(t−u)a −2(t−u)a


= ru exp 1− e + 1− e .
a 4a
In particular, for u = 0 we find

σ2
 
−at θ −at −2at
r0e


IE[rt ] = exp + 1 − e + 1− e .
a 4a
f) Similarly, we have
 
2θ wt  
IE[rt2 | Fu ] = IE exp 2 e −at log r0 + 1 − e −at + 2σ e −(t−s)a dBs Fu


a 0
−at 2θ −at

r u −(t−s)a dB
h  w t  i
= e 2 e log r0 + a 1− e +2σ 0 e s
IE exp 2σ e −(t−s)a dBs Fu
u
−at 2θ −at

r u −(t−s)a h  wt i
= e 2 e log r0 + a 1− e +2σ 0 e dBs
IE exp 2σ e −(t−s)a dBs
u

2θ wu wt 
−at −at −(t−s)a 2 −2(t−s)a


= exp 2 e log r0 + 1− e + 2σ e dBs + 2σ e ds
a 0 u

2θ wu σ2

−at −at −(t−s)a −2(t−u)a



= exp 2 e log r0 + 1− e + 2σ e dBs + 1− e
a 0 a
 
2θ wu 
−(t−u)a −au −au −(u−s)a


= exp 2 e 2e log r0 + 1− e + 2σ e dBs
a 0

σ2

2θ −(t−u)a −2(t−u)a


+ 1− e + 1− e
a a

σ2
 
−(t−u)a 2θ −(t−u)a −2(t−u)a


= exp 2 e log ru + 1− e + 1− e
a a

σ2
 
2 e −(t−u)a 2θ −(t−u)a −2(t−u)a


= ru exp 1− e + 1− e ,
a a
hence
Var[rt | Fu ] = IE[rt2 | Fu ] − (IE[rt | Fu ])2

σ2
 
2 e −(t−u)a 2θ −(t−u)a −2(t−u)a


= ru exp 1− e + 1− e
a a

σ2
 
−(t−u)a 2θ
−ru2 e 1 − e −(t−u)a + 1 − e −2(t−u)a


exp
a 2a

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 411

σ2
 
2 e −(t−u)a 2θ −(t−u)a −2(t−u)a


= ru exp 1− e + 1− e
a a
σ2
  
−2(t−u)a


× 1 − exp − 1− e .
 2a 2 
θ σ
g) We find lim IE[rt ] = r0 exp + and
a 4a 2  
t→∞
σ2
 
2θ σ
lim Var[rt ] = exp + 1 − exp −
t→∞ a a 2a
   2 
2θ σ
= exp exp −1 .
a a

Exercise 5.18 Cox-Ingersoll-Ross (CIR) model.

a) We have
wt wt√
rt = r0 + (α − β rs )ds + σ rs dBs , t ⩾ 0. (S.22)
0 0

b) Taking expectations on both sides of (S.22) and using the fact that the expectation of the
stochastic integral with respect to Brownian motion is zero, we find
u(t ) = IE[rt ]
h wt wt√ i
= IE r0 + (α − β rs )ds + σ rs dBs
0 0
h wt i
= IE r0 + (α − β rs )ds
hw0t i
= r0 + IE (α − β rs )ds
0
wt
= r0 + (α − β IE[rs ])ds
w0t
= r0 + (α − β u(s))ds,
0
which yields the differential equation u′ (t ) = α − β u(t ). Letting w(t ) : e βt u(t ), we have

w′ (t ) = β e βt u(t ) + e βt u′ (t ) = α e βt ,

hence
IE[rt ] = u(t )
= e −βt w(t )
 wt 
= e −βt w(0) + α e β s ds
0
 
−βt α βt
= e u(0) + ( e − 1)
β
α
= e −βt r0 + 1 − e −βt ,


t ⩾ 0. (S.23)
β
c) By applying Itô’s formula (5.5.12) to
 wt wt√ 
rt2 = f r0 + (α − β rs )ds + σ rs dBs ,
0 0

with f (x) = x2 , we find

1 ′′
d (rt )2 = f ′ (rt )drt +
f (rt )drt • drt
2
= 2rt drt + drt • drt
= rt (σ 2 + 2α − 2β rt )dt + 2σ rt3/2 dBt

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 412 Exercise Solutions

or, in integral form,

wt wt
rt2 = r02 + rs (σ 2 + 2α − 2β rs )ds + 2σ rs3/2 dBs , t ⩾ 0. (S.24)
0 0

d) Taking again the expectation on both sides of (S.24), we find

v(t ) = IE[rt2 ]
h wt wt i
= IE r02 + rs (σ 2 + 2α − 2β rs )ds + 2σ rs3/2 dBs
hw0t i 0
2 2
= r0 + IE rs (σ + 2α − 2β rs )ds
0
wt
= r02 + (σ 2 IE[rs ] + 2α IE[rs ] − 2β IE[rs2 ])ds
0
wt
= v(0) + (σ 2 u(s) + 2αu(s) − 2β v(s))ds,
0
and after differentiation with respect to t this yields the differential equation

v′ (t ) = (σ 2 + 2α )u(t ) − 2β v(t ), t ⩾ 0.

By (S.23) we find
  
′ 2 α α −βt
v (t ) = (σ + 2α ) + r0 − e − 2β v(t ), t ⩾ 0.
β β
Looking for a solution of the form

v(t ) = c0 + c1 e −βt + c2 e −2βt , t ⩾ 0,

we find
v′ (t ) = −β c1 e −βt − 2β c2 e −2βt
   
α α
= (σ 2 + 2α ) + r0 − e −βt − 2β (c0 + c1 e −βt + c2 e −2βt )
β β
 
α 2 α
= 2
(σ + 2α ) + (σ + 2α ) r0 − e −βt − 2β c0 − 2β c1 e −βt − 2β c2 e −βt ,
β β
t ⩾ 0, hence 
α

 0 = (σ 2 + 2α ) − 2β c0 ,


 β
 

 2 α
 −β c1 = (σ + 2α ) r0 − − 2β c1 ,


β
and
σ 2 + 2α
 
α α
c0 = (σ 2 + 2α ), c1 = r0 − ,
2β 2 β β
with
r02 = v(0) = c0 + c1 + c2 ,
which yields
c2 = r02 − c0 − c1
σ 2 + 2α
 
2 α 2 α
= r0 − 2 (σ + 2α ) − r0 −
2β β β
 
r0 α
= r02 − (σ 2 + 2α ) − 2 ,
β 2β
and
IE[rt2 ] = v(t )

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 413

= c0 + c1 e −βt + c2 e −2βt
σ 2 + 2α
 
α α
= 2
(σ + 2α ) + r0 − e −βt
2β 2 β β
  
r0 α
2 2
+ r0 − (σ + 2α ) − e −2βt , t ⩾ 0.
β 2β 2
e) We have
Var[rt ] = IE[rt2 ] − (IE[rt ])2
σ 2 + 2α
 
α α
= 2
(σ + 2α ) + r0 − e −βt
2β 2 β β
  
r0 α
2 2
+ r0 − (σ + 2α ) − e −2βt
β 2β 2
   2
α α
− + r0 − e −βt
β β
σ 2 + 2α
 
α α
= 2
(σ + 2α ) + r0 − e −βt
2β 2 β β
  
r0 α
2 2
+ r0 − (σ + 2α ) − e −2βt
β 2β 2
 2    2 !
α 2α α α α
− − r0 − e −βt − r02 − 2r0 + e −2βt
β β β β β
σ 2 −βt
ασ 2 ασ 2 −βt ασ 2 −2βt
= r0 e − e −2βt + − 2 e + 2e
β 2β 2 β 2β
σ 2
ασ 2
2
= r0 e −βt − e −2βt + 2
1 − e −βt , t ⩾ 0.
β 2β

Problem 5.19
a) The Itô formula cannot be applied to the function f (x) := (x − K )+ because it is not (twice)
differentiable.
b) The function x 7→ fε (x) can be plotted as follows with K = 1.

1
fε

0
0 K-ε K K+ε
x

Figure S.19: Graph of the function x 7→ fε (x).

We note that fε converges uniformly on R to the function x 7→ (x − K )+ as we have

ε
0 ⩽ f ε (x ) − (x − K ) + ⩽ , x ∈ R. (S.25)
4

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 414 Exercise Solutions

c) Applying the Itô formula to the function fε we find

wT 1 w T ′′
fε (BT ) = fε (B0 ) + fε′ (Bt )dBt + f (Bt )dt
0 2 0 ε
wT 1 wT
= f ε ( B0 ) + fε′ (Bt )dBt + 1 (Bt )dt,
0 4ε 0 (K−ε,K +ε )
and to conclude it suffices to note that

wT
1(K−ε,K +ε ) (Bt )dt.

ℓ t ∈ [0, T ] : K − ε < Bt < K + ε =
0

d) The derivative fε′ (x) of fε (x) is given by

if x > K + ε,

 1




1

′
f ε (x ) : = (x − K + ε ) if K − ε < x < K + ε,


 2ε



0 if x < K − ε.

1
f'ε

0
0 K-ε K K+ε
x

Figure S.20: Graph of the derivative x 7→ fε′ (x).

Hence we have w∞
∥1[K,∞) (·) − fε′ (·)∥2L2 (R+ ) = 1[K,∞) (x) − fε′ (x) 2 dx


0
w K +ε
1 + | fε′ (x)|2 dx


=
K−ε
1 w K +ε
2
⩽ 2ε + 2 x − K + ε dx
4ε K−ε
1 h
3 iK +ε
= 2ε + x − K + ε
12ε 2 K−ε
2ε
= 2ε + .
3
e) i) We
w have  w
T T h
i
1[K,∞) (Bt ) − fε′ (Bt ) 2 dt = IE 1[K,∞) (Bt ) − fε′ (Bt ) 2 dt


IE
0 0
wTw∞ 1
1[K,∞) (x) − fε′ (x) 2 e −x /(2t ) dx √

2
= dt
0 −∞ 2πt
w T w K +ε 1
1[K,∞) (x) − fε′ (x) 2 e −(K−ε ) /(2t ) dx √

2
⩽ dt
0 K−ε 2πt
wT 1
⩽ ∥1[K,∞) (·) − fε′ (·)∥2L2 (R+ )
2 / (2t )
e −(K−ε ) √ dt
0 2πt

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 415

2ε w T −(K−ε )2 /(2t ) 1
 
⩽ 2ε + e √ dt,
3 0 2πt
where wT wT
2 1 2 1
e −(K−ε ) /(2t ) √ dt < e −K /(8t ) √ dt < ∞,
0 2πt 0 2πt
w 
T
1[K,∞) (Bt ) − fε (Bt ) dt = 0, and by the Itô isometry
′

2
for ε < K/2, hence lim IE
ε→0 0

w 
∞
2 hw ∞ i
1[K,∞) (Bt ) − fε (Bt ) dBt 1[K,∞) (Bt ) − fε (Bt ) 2 dt


IE = IE
0 0

we find that
w
∞ w∞ 2 
lim IE 1[K,∞) (Bt )dBt − fε (Bt )dBt = 0,
ε→0 0 0

r∞ w∞
which shows that 0 fε (Bt )dBt converges to 1[K,∞) (Bt )dBt in L2 (Ω) as ε tends to
0
zero.
ii) By (S.25) we have h
2 i ε
IE (BT − K )+ − fε (BT ) ⩽ ,
4
hence fε (BT ) converges to (BT − K )+ in L2 (Ω).
iii) Similarly, fε (B0 ) converges to (B0 − K )+ for any fixed value of B0 .
As a consequence of (i)), (ii)) and (iii)) above, the equation (5.5.30) shows that

1 

ℓ t ∈ [0, T ] : K − ε < Bt < K + ε
2ε

admits a limit in L2 (Ω) as ε tends to zero, and this limit is denoted by L[K0,T ] . The formula
(5.5.31) is known as the Tanaka formula.

Problem 5.20
a) We have
0 ⩽ IE[(X − ε )+ ]
1 w∞ 2 2
= √ (x − ε ) e −x /(2σ ) dx
2πσ 2 ε
1 w∞ 2 2 ε w∞ 2 2
= √ x e −x /(2σ ) dx − √ e −x /(2σ ) dx
2πσ 2 ε 2πσ 2 ε

σ 2 h 2 2
i ∞
= −√ e −x /(2σ ) − εP(X ⩾ ε )
2πσ 2 ε
σ 2 2 2
= √ e −εx /(2σ ) − εP(X ⩾ ε ),
2πσ 2
which leads to the conclusion.
b) We have
P(X ∈ dx and X + Y ∈ dz)
P(X ∈ dx | X + Y = z) =
P(X + Y ∈ dz)
P(X ∈ dx and Y ∈ (dz) − x)
=
P(X + Y ∈ dz)
2 2 2 2
2π (α 2 + β 2 ) e −x /(2α )−(z−x) /(2β )
p
= 2 2 2 dx
2παβ e −z /(2(α +β ))

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 416 Exercise Solutions
p
1/β 2 + 1/α 2 −(x2 (1+β 2 /α 2 )+(x2 +z2 −2xz)(1+α 2 /β 2 )−z2 )/(2(α 2 +β 2 ))
= √ e dx
2π
p
1/β 2 + 1/α 2 −(x2 (2+β 2 /α 2 +α 2 /β 2 )+z2 α 2 /β 2 −2xz(1+α 2 /β 2 ))/(2(α 2 +β 2 ))
= √ e dx
2π
p
1/β 2 + 1/α 2 −(x(β /α +α/β )−zα/β )2 /(2(α 2 +β 2 ))
= √ e dx
2π
p
1/β 2 + 1/α 2 −(x((α 2 +β 2 )/(αβ ))−zα/β )2 /(2(α 2 +β 2 ))
= √ e dx
2π
p
1/β 2 + 1/α 2 −(x−zα 2 /(α 2 +β 2 ))2 /(2/(1/α 2 +1/β 2 )))
= √ e dx.
2π
c) Given that Bu = x we decompose

Bv = (Bv − B(u+v)/2 ) + (B(u+v)/2 − Bu ) + x,

and apply the result of Question (b)) by taking

X = B(u+v)/2 − Bu and Y = Bv − B(u+v)/2 ,

i.e.
v−u
and z = y − x, α2 = β 2 =
2
which shows that the distribution of B(u+v)/2 = x + X given that Bu = x and Bv = y is
x+y v−u
 
Gaussian N , with mean
2 4
α 2z y−x x+y α 2β 2 v−u
x+ 2 2
= x+ = and variance 2 2
= .
α +β 2 2 α +β 4
d) Four linear interpolations are displayed in Figure S.21.

n= 0 n= 1 n= 2 n= 3
2.0

2.0

2.0

2.0
1.5

1.5

1.5

1.5
1.0

1.0

1.0

1.0
0.5

0.5

0.5

0.5
0.0

0.0

0.0

0.0

0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0

t t t t

Figure S.21: Samples of linear interpolations.

(0)
e) Clearly, the statement is true for n = 0 because Z1 and B1 have the same N (0, 1) distri-
bution. Next, assuming that it holds at the rank n, we note that the terms appearing in the
sequence
(n+1) (n+1) (n+1) (n+1) (n+1)

Z (n+1) = 0, Z1/2n+1 , Z2/2n+1 , Z3/2n+1 , Z4/2n+1 , . . . , Z1 .
can bewritten for any k = 0, 1, . . . , 2n − 1 as 
(n+1) (n+1)
Z n+1 + Z (2k+2)/2n+1
. . . , Z (n+1n)+1 , 2k/2

(n+1)
2k/2
+ N 0, 1/2n+2 , Z(2k+2)/2n+1 , . . .
2
 
(n) (n)
(n)
Z 2k/2n+1
+ Z (2k+2)/2n+1
(n)
= . . . , Zk/2n , + N 0, 1/2n+2 , Z(k+1)/2n , . . .
2

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 417
   
(n) (n)
(n)
Z 2k/2n + 1 + Z (2k+2)/2n + 1 1 (n)
= . . . , Zk/2n , N  , n+2  , Z(k+1)/2n , . . . .
2 2
(S.26)
On the other hand, the result of Question (c)) shows that given that B2k/2n+1 = x and
B n+1 = y, the distribution of B(2k +1) /2n+1 is
(2k+2)/2
B2k/2n+1 + B(2k+2)/2n+1 (2k + 2)/2n+1 − (2k + 2)/2n+1

N ,
2 4
B2k/2n+1 + B(2k+2)/2n+1 1
 
= N , n+2 . (S.27)
2 2
Given that Z (n) and B(n) have same distribution, we conclude by comparing (S.26) and (S.27)
that Z (n+1) and B(n+1) also have same distribution.
f) We have !
(n+1) (n)
P Sup |Zt − Zt | ⩾ εn
t∈[0,1]
 
(n+1) (n)
= P Max n |Z(2k+1)/2n+1 − Z(2k+1)/2n+1 | ⩾ εn
k=0,1,...,2 −1
!
n o
(n+1) (n)
⩽ P
[
|Z(2k+1)/2n+1 − Z(2k+1)/2n+1 | ⩾ εn
k=0,1,...,2n −1
2n −1
(n+1) (n)
∑P


⩽ |Z(2k+1)/2n+1 − Z(2k+1)/2n+1 | ⩾ εn
k =0
(n+1) (n)
= 2n P |Z1/2n+1 − Z1/2n+1 | ⩾ εn


 
(n) (n)
(n+1) Z n + Z n
= 2n P  Z1/2n+1 − 0/2 1/2
⩾ εn  .
2
g) Since
(n) (n)
(n+1) Z0 + Z1/2n (n)
Z1/2n+1 = + N (0, 1/2n+2 ) = Z1/2n+1 + N (0, 1/2n+2 ),
2
we have !
(n+1) (n) (n+1) (n)
P ⩽ 2n P |Z1/2n+1 − Z1/2n+1 | ⩾ εn


Sup |Zt − Zt | ⩾ εn
t∈[0,1]
 
(n) (n)
(n+1) Z0/2n + Z1/2n
= 2n P  Z1/2n+1 − ⩾ εn 
2

= 2n P N (0, 1/2n+2 ) ⩾ εn

2n/2 −εn2 2n+1

√ e ⩽
,
εn 2π
where we applied the bound of Question (a)) to the Gaussian random variable

(n) (n)
(n+1) Z0/2n + Z1/2n
Z1/2n+1 − ≃ N (0, 1/2n+2 ).
2

h) We have !
(n+1) (n)
∑ P ∥Z (n+1) − Z (n) ∥∞ ⩾ 2−n/4 = ∑P


Sup |Zt − Zt | ⩾ εn
n⩾0 n⩾0 t∈[0,1]

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 418 Exercise Solutions

2n/2 −εn2 2n+1

⩽ ∑ √ e
n⩾0 εn 2π
1 1+n/2
= √ ∑ 23n/4 e −2 < ∞,
2π n⩾0
since
1+(n+1)/2
23(n+1)/4 e −2 √
1+n/2 ( 2−1)
lim 1 + n/2
= 23/4 lim e −2 = 0.
n→∞ 23n/4 e −2 n→∞

Hence the Borel-Cantelli lemma shows that

P ∥Z (n+1) − Z (n) ∥∞ ⩾ 2−n/4 for infinitely many n = 0,

therefore we have

P ∥Z (n+1) − Z (n) ∥∞ < 2−n/4 except for finitely many n = 1.

i) The result of Question (h)) shows that with probability one we have
p−1
lim ∥Z ( p) − Z (q) ∥∞ = lim ∑ Z (n+1) − Z (n)
p,q→∞ p,q→∞
n=q ∞
p−1
⩽ lim
p,q→∞
∑ ∥Z (n+1) − Z (n) ∥∞
n=q

⩽ lim
p→∞
∑ ∥Z (n+1) − Z (n) ∥∞
n⩾q

= 0,
hence the sequence Z ( n )
n⩾0
is Cauchy in C0 ([0, 1]) for the ∥ · ∥∞ norm. Since C0 ([0, 1]) is
a complete space for the ∥ · ∥∞ norm, this implies that, with probability one, the sequence
(Z (n) )n⩾0 admits a limit in C0 ([0, 1]).
(n) (n)
j) 1. By construction we have Z0 = 0 for all n ∈ N, hence Z0 = limn→∞ Z0 = 0, almost
surely.

2. The sample trajectories t 7→ Zt are continuous, because the limit Z belongs to C0 ([0, 1])
with probability 1.

3. The result of Question (e)) shows that for any fixed m ⩾ 1, the sequences

Zt1 − Zt0 , Zt2 − Zt1 , . . . , Ztm − Ztm−1

and
Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btm − Btm−1
have same distribution when the tk′ s are dyadic rationals of the form tk = in /2n ,
k = 0, 1, . . . , n. This property extends to any sequence t0 ,t1 , . . . ,tm of real numbers by
approximation of each tk > 0 by a sequence (in )n∈N such that tk = limn→∞ in /2n and
taking the limit as n tends to infinity.
4. By a similar argument as in the above point 3, one can show that for any 0 ⩽ s < t,
Zt − Zs has the Gaussian distribution N (0,t − s).

Problem 5.21
a) We have
 (n)  n
(BkT /n − B(k−1)T /n )2
 
IE QT = ∑ IE
k =1

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 419
n  
T T
= ∑ k − (k − 1)
k =1 n n
= T, n ⩾ 1.
b) We have  !2 
n
(n) 2
= IE  ∑ (BkT /n − B(k−1)T /n )2 
 
IE (QT )
k =1
" #
n
2 2
= IE ∑ (BkT /n − B(k−1)T /n ) (BlT /n − B(l−1)T /n )
k,l =1
n h i
4
= ∑ IE ( BkT /n − B (k−1)T /n )
k =1
h i h i
+2 ∑ IE (BkT /n − B(k−1)T /n )2 IE (BlT /n − B(l−1)T /n )2
1⩽k<l⩽n
n
= 3 ∑ (kT /n − (k − 1)T /n)2
k =1
+2 ∑ (kT /n − (k − 1)T /n)(lT /n − (l − 1)T /n)
1⩽k<l⩽n
T 2 n(n − 1)T 2
= 3 +
n n2
2T 2
= T2 + , n ⩾ 1,
n
hence
 (n)   (n)
2   (n) 
2 2T 2
Var QT = IE QT − IE QT = , n ⩾ 1.
n
c) We have
(n)  (n) (n)
∥QT − T ∥2L2 (Ω) = IE (QT − IE[QT ])2

 (n) 
= Var QT
n(n + 2)T 2
= −T2
n2
2T 2
= ,
n
hence
(n) 2T 2
lim ∥QT − T ∥2L2 (Ω) = lim = 0,
n→∞ n→∞ n
showing that
(n)
lim QT = T
n→∞

in L2 (Ω).
d) We have
n
1 n 2
∑ (BkT /n − B(k−1)T /n )B(k−1)T /n = BkT /n − B2(k−1)T /n
k =1 2 k∑
=1
1 n
− (BkT /n − B(k−1)T /n )(BkT /n − B(k−1)T /n )
2 k∑
=1
1
= ((BT )2 − (B0 )2 )
2
1 n
− ∑ (BkT /n − B(k−1)T /n )(BkT /n − B(k−1)T /n )
2 k =1

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 420 Exercise Solutions
1 (n)

= (BT )2 − QT ,
2
which converges to ((BT )2 − T )/2 in L2 (Ω) as n tends to infinity, hence
wT n
Bt dBt = lim ∑ (BkT /n − B(k−1)T /n )B(k−1)T /n
0 n→∞
k =1
(BT )2 − T
= .
2
e) We have
 (n)  n
(B(k−1/2)T /n − B(k−1)T /n )2
 
IE Q
e
T = ∑ IE
k =1
n
= ∑ ((k − 1/2)T /n − (k − 1)T /n)
k =1
T
= , n ⩾ 1.
2
Next, we have  !2 
 (n)
2  n
2
IE Qe
T = IE  ∑ B(k−1/2)T /n − B(k−1)T /n 
k =1
" #
n
2 2
= IE ∑ (B(k−1/2)T /n − B(k−1)T /n ) (BlT /n − B(l−1)T /n )
k,l =1
n
(B(k−1/2)T /n − B(k−1)T /n )4
 
= ∑ IE
k =1
IE (B(k−1/2)T /n − B(k−1)T /n )2 IE (B(l−1/2)T /n − B(l−1)T /n )2
   
+2 ∑
1⩽k<l⩽n
n
= 3 ∑ ((k − 1/2)T /n − (k − 1)T /n)2
k =1
+2 ∑ ((k − 1/2)T /n − (k − 1)T /n)((l − 1/2)T /n − (l − 1)T /n)
1⩽k<l⩽n
T 2 n(n − 1)T 2
= 3 +
4n 4n2
n(n + 2)T 2
= , n ⩾ 1.
4n2
Finally, we find
e(n) − T /2∥2 2
 (n)
e(n) ])2

∥Q T L (Ω) = IE ( e − IE[Q
Q T T
 (n) 
= Var Q e
T
n(n + 2)T 2 T 2
= −
4n2 4
T 2
= ,
2n
hence
e(n) − T /2∥2 2 T2
lim ∥Q T L (Ω) = lim = 0,
n→∞ n→∞ 2n

showing that
e(n) = T
lim QT
n→∞ 2
in L2 (Ω).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 421

f) We have
n

∑ BkT /n − B(k−1)T /n B(k−1/2)T /n
k =1
n

= ∑ BkT /n − B(k−1/2)T /n B(k−1/2)T /n
k =1
n

+ ∑ B(k−1/2)T /n − B(k−1)T /n B(k−1/2)T /n
k =1
n
1
= B2kT /n − B2(k−1/2)T /n
2 k∑
=1
1 n


− ∑ BkT /n − B(k−1/2)T /n BkT /n − B(k−1/2)T /n
2 k =1
1 n 2
+ B(k−1/2)T /n − B2(k−1)T /n
2 k∑
=1
1 n


+ ∑ B(k−1/2)T /n − B(k−1)T /n B(k−1/2)T /n − B(k−1)T /n
2 k =1
1 1 n
(BT )2 − ∑ BkT /n − B(k−1/2)T /n BkT /n − B(k−1/2)T /n



=
2 2 k =1
1 n


∑+ B(k−1/2)T /n − B(k−1)T /n B(k−1/2)T /n − B(k−1)T /n ,
2 k =1
which converges to ((BT )2 − T + T )/2 = (BT )2 /2 in L2 (Ω) as n tends to infinity, hence
wT n
( BT ) 2
Bt ◦ dBt = lim ∑ (BkT /n − B(k−1)T /n )B(k−1/2)T /n = ,
0 n→∞
k =1 2
see Section 2.4 of Mikosch, 1998 for further details on the Stratonovich integral.
g) We have
 (n)  n 
2 
IE Qe
T = ∑ IE B(k−α )T /n − B(k−1)T /n
k =1
n
= ∑ ((k − α )T /n − (k − 1)T /n)
k =1
T
= (1 − α ) , n ⩾ 1.
2
Next, we have  !2 
 (n)
2  n
IE Qe
T = IE  ∑ (B(k−α )T /n − B(k−1)T /n )2 
k =1
" #
n
= IE ∑ (B(k−α )T /n − B(k−1)T /n )2 (BlT /n − B(l−1)T /n )2
k,l =1
n
(B(k−α )T /n − B(k−1)T /n )4
 
= ∑ IE
k =1
IE (B(k−α )T /n − B(k−1)T /n )2 IE (B(l−α )T /n − B(l−1)T /n )2
   
+2 ∑
1⩽k<l⩽n
n
= 3 ∑ ((k − α )T /n − (k − 1)T /n)2
k =1
+2 ∑ ((k − α )T /n − (k − 1)T /n)((l − α )T /n − (l − 1)T /n)
1⩽k<l⩽n

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 422 Exercise Solutions

T2 n(n − 1)T 2
= 3(1 − α )2 + (1 − α )2
n n2
n(n + 2)T 2
= (1 − α )2 , n ⩾ 1.
n2
Finally we find
 (n) 
2 
e(n) − (1 − α )T /2∥2 2
 (n)
∥Q T L (Ω) = IE QT − IE QT
e e
 (n) 
= Var Q e
T
n(n + 2)T 2
= (1 − α )2 − (1 − α )2 T 2
n2
T2
= 2(1 − α )2 ,
n
hence
e(n) − (1 − α )T ∥2 2 2 T2
lim ∥QT L (Ω) = ( 1 − α ) lim = 0.
n→∞ n→∞ n
Next, we have
n
∑ (BkT /n − B(k−1)T /n )B(k−α )T /n
k =1
n n
= ∑ (BkT /n − B(k−α )T /n )B(k−α )T /n + ∑ (B(k−α )T /n − B(k−1)T /n )B(k−α )T /n
k =1 k =1
n
1 1 n
= ∑ B2kT /n − B2(k−α )T /n − ∑ (BkT /n − B(k−α )T /n )(BkT /n − B(k−α )T /n )
2 k =1 2 k =1
1 n 2
+ B(k−α )T /n − B2(k−1)T /n
2 k∑
=1
1 n
+ (B(k−α )T /n − B(k−1)T /n )(B(k−α )T /n − B(k−1)T /n )
2 k∑
=1
1 1 n
= (BT )2 − ∑ (BkT /n − B(k−α )T /n )(BkT /n − B(k−α )T /n )
2 2 k =1
1 n
+ (B(k−α )T /n − B(k−1)T /n )(B(k−α )T /n − B(k−1)T /n ),
2 k∑
=1

which converges to

(BT )2 − αT + (1 − α )T (BT )2 + (1 − 2α )T
=
2 2
in L2 (Ω) as n tends to infinity, hence
wT n
Bt ◦ d α Bt = lim ∑ (BkT /n − B(k−1)T /n )B(k−α )T /n
0 n→∞
k =1
(BT )2 + (1 − 2α )T
= .
2
In particular we find
wT n
(BT )2 + T
Bt ◦ d 0 Bt = lim ∑ (BkT /n − B(k−1)T /n )BkT /n = ,
0 n→∞
k =1 2

and we note that wT 1 wT wT

 
Bt ◦ dBt = Bt dBt + Bt ◦ d 1 Bt .
0 2 0 0

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MH4514 Financial Mathematics 423

h) We have
n  
T T T
lim ∑ (k − α ) k − (k − 1)
n→∞
k =1 n n n
n
T T
= lim
n→∞ n
∑ (k − α ) n
k =1
n n
T T T T
= lim
n→∞ n
∑ k n − α n→∞
lim ∑
n
k =1 k =1 n
n(n + 1) T2
= T 2 lim − α lim
n→∞ 2n2 n→∞ n
T2
= ,
2
which does not depend on α ∈ [0, 1]< hence the stochastic phenomenon of the previous
rT
questions does not occur when approximating the deterministic integral 0 tdt = T 2 /2 by
Riemann sums.

In quantitative finance we choose to use the Itô integral (which corresponds to the choice
α = 1) because it is suitable for the modeling of market returns as

dSt St +∆t − St
≃ = µ∆t + σ ∆Bt = µ∆t + (Bt +∆t − Bt )σ
St St
or
dSt ≃ St +∆t − St = µSt ∆t + σ St ∆Bt , = µSt ∆t + σ St (Bt +∆t − Bt ),
based on the value St at the the left endpoint of the discretized time interval [t,t + ∆t ].

Chapter 6
Exercise 6.1 For all x ∈ R, we have
2
P(ST ⩽ x) = P S0 e σ BT +(µ−σ /2)T ⩽ x

σ2
   
x
= P σ BT + µ − T ⩽ log
2 S0
2
    
1 x σ
= P BT ⩽ log − µ − T
σ S0 2
w (log(x/S0 )−(µ−σ 2 /2)T )/σ 2 dy
= e −y /(2T ) √
−∞ 2πT
w (log(x/S0 )−(µ−σ 2 /2)T )/(σ √T ) 2 dz
= e −z /2 √
−∞ 2π
2
    
1 x σ
= Φ √ log − µ − T ,
σ T S0 2
where wx 2 /2 dy
Φ (x ) : = e −y √ , x ∈ R,
−∞ 2πT
denotes the standard Gaussian cumulative distribution function. After differentiation with respect
to x, we find the lognormal probability density function
dP(ST ⩽ x)
f (x ) =
dx

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 424 Exercise Solutions

∂ w (log(x/S0 )−(µ−σ 2 /2)T )/σ −y2 /(2T ) dy

= e √
∂ x −∞ 2πT
2
    
∂ 1 x σ
= Φ √ log − µ − T
∂x σ T S 0 2
σ2
    
1 1 x
= √ ϕ √ log − µ − T
xσ T σ T S0 2
1 2 2 2
= √ e −(−(µ−σ /2)T +log(x/S0 )) /(2σ T ) , x > 0,
xσ 2πT
where
1 2
ϕ (y) = Φ′ (y) := √ e −y /2 , y ∈ R,
2π
denotes the standard Gaussian probability density function.

Exercise 6.2
a) We have
1 1 σ2
d log St = dSt − 2 (dSt )2 = rdt + σ dBt − dt, t ⩾ 0.
St 2St 2
b) We have f (t ) = f (0) e ct (continuous-time interest rate compounding), and
2 t/2+rt
St = S0 e σ Bt −σ , t ⩾ 0,
which is a geometric Brownian motion.
c) Those quantities can be computed from the expression of Stn as a function of the N (0,t )
random variable Bt for n ⩾ 1. Namely, we have
2
IE[Stn ] = IE S0n e nσ Bt −nσ t/2+nrt
 
2
= S0 e −nσ t/2+nrt IE e nσ Bt
 
2 2 2
= S0 e −nσ t/2+nrt +n σ t/2
2
= S0n e nrt +(n−1)nσ t/2 ,
where we used the Gaussian moment generating function (MGF) identity (11.6.16), i.e.
2 2
IE e nσ Bt = e n σ t/2
 

for the normal random variable Bt ≃ N (0,t ), t > 0.

d) By the result of Question (c)), we have IE[St ] = S0 e rt and
2
IE[St2 ] = IE S02 e 2σ Bt −σ t +2rt
 
2
= S02 e −σ t +2rt IE e 2σ Bt
 
2
= S02 e σ t +2rt , t ⩾ 0.
e) We note that from the stochastic differential equation
wt wt
St = S0 + r Ss ds + σ Ss dBs ,
0 0

the function u(t ) := IE[St ] satisfies the Ordinary Differential Equation (ODE) u′ (t ) = ru(t )
with u(0) = S0 and solution u(t ) = IE[St ] = S0 e rt . On the other hand, by the Itô formula we
have
dSt2 = 2St dSt + (dSt )2 = 2rSt2 dt + σ 2 St2 dt + 2σ St2 dBt ,
hence letting v(t ) = IE St2 and taking expectations on both sides of
 

wt wt wt
St2 = S02 + 2r Su2 du + σ 2 Su2 du + 2σ Su2 dBu ,
0 0 0

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 425

we find
v(t ) = IE St2
 
hw t i hw t i
= S02 + (2r + σ 2 ) IE Su2 du + 2σ IE Su2 dBu
0 0
wt  
2 2 2
= S0 + (2r + σ ) IE Su du
w0t
2 2
= S0 + (2r + σ ) v(u)du,
0
hence v(t ) := IE St2 satisfies the ordinary differential equation
 

v′ (t ) = (σ 2 + 2r )v(t ),

with v(0) = S02 and solution

2
v(t ) = IE St2 = S02 e (σ +2r)t ,
 

which recovers
Var[St ] = IE St2 − (IE[St ])2
 

= v(t ) − u2 (t )
2 +2r )t
= S02 e (σ − S02 e 2rt
2
= S02 e 2rt ( e σ t − 1), t ⩾ 0.

Exercise 6.3 Using the bivariate Itô formula (5.5.9), we find

∂f ∂f
d f (St ,Yt ) = (St ,Yt )dSt + (St ,Yt )dYt
∂x ∂y
1 ∂2 f 2 1 ∂2 f 2 ∂2 f
+ ( S t ,Y t )( dS t ) + ( St ,Y t )( dY t ) + (St ,Yt )dSt • dYt
2 ∂ x2 2 ∂ y2 ∂ x∂ y
∂f ∂f
= (St ,Yt )(rSt dt + σ St dBt ) + (St ,Yt )( µYt dt + ηYt dWt )
∂x ∂y
σ 2 St2 ∂ 2 f η 2Yt2 ∂ 2 f ∂2 f
+ ( S t ,Yt ) dt + ( S t ,Yt ) dt + ρσ ηS t Yt (St ,Yt )dt.
2 ∂ x2 2 ∂ y2 ∂ x∂ y

Exercise 6.4 Taking expectations on both sides of (6.5.7) shows that

w 
T
IE[ST ] = C (S0 , r, T ) + IE ζt,T dBt = C (S0 , r, T ),
0

hence

C (S0 , r, T ) = IE[ST ]
2 T /2
= IE[S0 e rT +σ BT −σ ]
rT −σ 2 T /2
= S0 e IE[ e σ BT ]
rT −σ 2 T /2+σ 2 T /2
= S0 e
= S0 e rT ,

where we used the moment generating function

2 T /2
IE[ e σ BT ] = e σ

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 426 Exercise Solutions

of the Gaussian random variable BT ≃ N (0, T ). On the other hand, the discounted asset price
Xt := e −rt St satisfies dXt = σ Xt dBt , which shows that
wT
XT = X0 + σ Xt dBt .
0

Multiplying both sides by e rT shows that

wT wT
ST = e rT S0 + σ e rT Xt dBt = e rT S0 + σ e (T −t )r St dBt ,
0 0

which recovers the relation C (S0 , r, T ) = S0 e rT , and shows that ζt,T = σ e (T −t )r St , t ∈ [0, T ].

Exercise 6.5
a) We have St = f (Xt ), t ⩾ 0, where f (x) = S0 e x and (Xt )t∈R+ is the Itô process given by
wt wt
Xt := σs dBs + us ds, t ⩾ 0,
0 0

or in differential form
dXt := σt dBt + ut dt, t ⩾ 0,
hence
dSt = d f (Xt )
1 ′′
= f ′ (Xt )dXt + f (Xt )(dXt )2
2
1
= ut f ′ (Xt )dt + σt f ′ (Xt )dBt + σt2 f ′′ (Xt )dt
2
1
= S0 ut e Xt dt + S0 σt e Xt dBt + S0 σt2 e Xt dt
2
1 2
= ut St dt + σt St dBt + σt St dt.
2
b) The process (St )t∈R+ satisfies the stochastic differential equation
 
1 2
dSt = ut + σt St dt + σt St dBt .
2

Exercise 6.6
a) We have IE[St ] = 1 because the expected value of the Itô stochastic integral is zero. Regarding
the variance, using the Itôisometry (5.3.4) we have
w t 2 
2 σ Bs −σ 2 s/2
Var[St ] = σ IE e dBs
0
w  2 
t
2 σ Bs −σ 2 s/2
= σ IE e ds
0
wt   2
2 
= σ 2 IE e σ Bs −σ s/2 ds
0
wt h 2
i
= σ 2 IE e 2σ Bs −σ s ds
0
wt 2
2
e −σ s IE e 2σ Bs ds
 
= σ
w0t 2 2
= σ 2
e −σ s e 2σ s ds
w0t 2
2
= σ e σ s ds
0
2
= e σ t − 1.

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MH4514 Financial Mathematics 427

b) Taking f (x) = log x, we have

d log(St ) = d f (St )
1 ′′
= f ′ (St )dSt +f (St )(dSt )2
2
2 1 2
= σ f ′ (St ) e σ Bt −σ t/2 dBt + σ 2 f ′′ (St ) e 2σ Bt −σ t dt
2
σ σ Bt −σ 2t/2 σ 2 2σ Bt −σ 2t
= e dBt − 2 e dt. (S.28)
St 2St
2
c) We check that when St = eσ Bt −σ t/2 , t ⩾ 0, we have

σ2
log St = σ Bt − σ 2t/2, and d log St = σ dBt − dt.
2
On the other hand, we also find
σ2 σ 2 σ2 2
σ dBt − dt = e σ Bt −σ t/2 dBt − 2 e 2σ Bt −σ t dt,
2 St 2St
showing by (S.28) that the equation

σ σ Bt −σ 2t/2 σ2 2
d log St = e dBt − 2 e 2σ Bt −σ t dt
St 2St
2 t/2
is satisfied. By uniqueness of solutions, we conclude that St := eσ Bt −σ solves
wt 2
St = 1 + σ e σ Bs −σ s/2 dBs , t ⩾ 0.
0

Exercise 6.7
a) Leveraging with a factor β : 1 means that we invest the amount ξt St = β Ft on the risky asset
priced St . In this case, the fund value Ft at time t ⩾ 0 decomposes into the portfolio
Ft Ft
Ft = ξt St + ηt At = β St − (β − 1) At , t ⩾ 0,
St At
with ξt = β Ft /St and ηt = −(β − 1)Ft /At , t ⩾ 0.
b) We have
dFt = ξt dSt + ηt dAt
Ft Ft
= β dSt − (β − 1) dAt
St At
Ft
= β dSt − (β − 1)rFt dt
St
= β Ft (rdt + σ dBt ) − (β − 1)rFt dt
= rFt dt + β σ Ft dBt , t ⩾ 0.
The above equation shows that the volatility β σ of the fund is β times the volatility of the
index. On the other hand, the risk-free rate r remains the same.
c) By Proposition 6.15 we have
2 2
Ft = F0 e β σ Bt +rt−β σ t/2
2
= F0 e σ Bt +rt/β −β σ t/2

β

2 2
= F0 e σ Bt +rt−σ t/2−(1−1/β )rt−(β −1)σ t/2

β

2 2
= F0 e σ Bt +rt−σ t/2 e −(β −1)rt−(β −1)β σ t/2

β

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 428 Exercise Solutions
2 t/2 2 t/2
e −(β −1)rt−(β −1)β σ

β
= S0 e σ Bt +rt−σ
2 t/2
= Stβ e −(β −1)rt−(β −1)β σ , t ⩾ 0.

Exercise 6.8
a) For t ∈ [0, T ] and i = 1, 2 we have
 (i)   (i) (i) 2
= IE S0 e µt +σiWt −σi t/2

IE St
(i) 2 (i) 
= S0 e µt−σi t/2 IE e σiWt


(i) 2 2
= S0 e µt−σi t/2+σi t/2
(i)
= S0 e µt .
b) For all t ∈ [0, T ] and i = 1, 2, we have
 (i)
2   (i)
2 (i) 2 
IE St = IE S0 e 2µt +2σiWt −σi t
(i)
2 2 (i) 
= S0 e 2µt−σi t IE e 2σiWt


(i)
2 2 2
= S0 e 2µt−σi t +2σi t
(i)
2 2
= S0 e 2µt +σi t ,
hence  (i)   (i)
2   (i) 

Var St = IE St − IE St
(i)
2 2 (i)
2
= S0 e 2µt +σi t − S0 e 2µt
(i)
2 2
= S0 e 2µt e σi t − 1 , t ∈ [0, T ], i = 1, 2.

c) We have
 (2) (1)   (1)   (2)  (1) (2)

Var St − St = Var St + Var St − 2 Cov St , St
with
 (1) (2)   (1) (2) (1) 2 (2) 2
= IE S0 S0 e 2µt +σ1Wt −σ1 t/2+σ2Wt −σ2 t/2

IE St St
(1) (2) 2 2 (1) (2) 
= S0 S0 e 2µt−σ1 t/2−σ2 t/2 IE e σ1Wt +σ2Wt

 
(1) (2) 2µt−σ12 t/2−σ22 t/2 1  (1) (2)
2 
= S0 S0 e exp IE σ1Wt + σ2Wt ,
2
with 
(1) (2)
2   (1)
2   (1) (2)   (2)
2 
IE σ1Wt + σ2Wt = IE σ1Wt + 2 IE σ1Wt σ2Wt + IE σ2Wt
= σ12t + 2ρσ1 σ2t + σ22t,
hence  (1) (2)  (1) (2)
IE St St = S0 S0 e 2µt +ρσ1 σ2t ,
and
(1) (2)
 (1) (2)   (1)   (2)  (1) (2)
Cov St , St = IE St St − IE St IE St = S0 S0 e 2µt ( e ρσ1 σ2t − 1),

and therefore
 (2) (1) 
Var St − St
(1)
2 2µt 2 (2)
2 2µt 2 (1) (2)
= S0 e ( e σ1 t − 1) + S0 e ( e σ2 t − 1) − 2S0 S0 e 2µt ( e ρσ1 σ2t − 1)
(1)
2 σ12 t (2)
2 σ22 t (1) (2) (2) (1)
2

= e 2µt S0 e + S0 e − 2S0 S0 e ρσ1 σ2t − S0 − S0 .
2 t/2
Exercise 6.9 Letting Xt := f (t ) e σ Bt −σ and noting the relation
2 t/2 2 t/2
d e σ Bt −σ = σ f (t ) e σ Bt −σ dBt , t ⩾ 0,

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MH4514 Financial Mathematics 429

see Proposition 6.15 and Relation (6.5.5) with µ = 0, we have

2 t/2 2 t/2
dXt = e σ Bt −σ f ′ (t )dt + f (t )d e σ Bt −σ
2 2 t/2
= e σ Bt −σ t/2 f ′ (t )dt + σ f (t ) e σ Bt −σ dBt
f ′ (t )
= Xt dt + σ Xt dBt
f (t )
= h(t )Xt dt + σ Xt dBt ,
hence
d f ′ (t )
log f (t ) = = h(t ),
dt f (t )
which shows that wt
log f (t ) = log f (0) + h(s)ds,
0
and
2
Xt = f (t ) e σ Bt −σ t/2
w
σ2

t
= f (0) exp h(s)ds + σ Bt − t
0 2
w 2

t σ
= X0 exp h(s)ds + σ Bt − t , t ⩾ 0.
0 2

Exercise 6.10
a) We have
St = e Xt
wtwt 1 w t 2 Xs
= e X0 +
us e Xs dBs + vs e Xs ds + u e ds
0 0 2 0 s
wt wt σ 2 w t Xs
= e X0 + σ e Xs dBs + ν e Xs ds + e ds
0 0 2 0
wt wt σ2 w t
= S0 + σ Ss dBs + ν Ss ds + Ss ds.
0 0 2 0
b) Let r > 0. The process (St )t∈R+ satisfies the stochastic differential equation

dSt = rSt dt + σ St dBt

when r = ν + σ 2 /2.
c) We have

Var[Xt ] = Var[(BT − Bt )σ ] = σ 2 Var[BT − Bt ] = (T − t )σ 2 , t ∈ [0, T ].

d) Let the process (St )t∈R+ be defined by St = S0 e σ Bt +νt , t ⩾ 0. Using the time splitting
decomposition
ST
ST = St = St e (BT −Bt )σ +ντ ,
St
we have
P(ST > K | St = x) = P(St e (BT −Bt )σ +(T −t )ν > K | St = x)
= P(x e (BT −Bt )σ +(T −t )ν > K )
= P( e (BT −Bt )σ > K e −(T −t )ν /x)
BT − Bt
 
1
= P √ log K e −(T −t )ν /x


> √
T −t σ T −t

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 430 Exercise Solutions

!
log K e −(T −t )ν /x
= 1−Φ √
σ τ

!
log K e −(T −t )ν /x
= Φ − √
σ τ
 
log(x/K ) + ντ
= Φ √ ,
σ τ
where τ = T − t.

Problem 6.11 (Exercise 5.19 continued).

a) The option payoff is (BT − K )+ at maturity.
b) We can ignore what happens between two crossings as every crossing resets the portfolio to
its state right before the previous crossing. Based on this, It is clear that every of the four
possible scenarios will lead to a portfolio value (BT − K )+ at maturity:
i) If B0 < 1 and BT < 1 we issue the option for free and finish with an empty portfolio
and zero payoff.
ii) If B0 < 1 and BT > 1 we issue the option for free and finish with one AUD and one
SGD to refund, which yields the payoff BT − 1 = (BT − 1)+ .
iii) If B0 > 1 and BT < 1 we purchase one AUD and borrow one SGD at the start, however
the AUD will be sold and the SGD refunded before maturity, resulting into an empty
portfolio and zero payoff.
iv) If B0 > 1 and BT > 1 we purchase one AUD and borrow one SGD right before maturity,
which yields the payoff BT − 1 = (BT − 1)+ .
Therefore we are hedging the option in all cases. Note that P(BT = K ) = 0 so the case
BT = 1 can be ignored with probability one.
c) Since the portfolio strategy is to hold AU$1 when Bt > K and to and borrow SG$1 when
Bt > K, we let

ξt := 1(K,∞) (Bt ) and ηt := −1(K,∞) (Bt ), t ∈ [0, T ],

which is called
w a stop-loss/start-gain strategy.
t
d) Noting that ηs dAs = 0 because At = A0 is constant, t ∈ [0, T ], we find by the Itô-Tanaka
0
formula
w (5.5.31) that
w w
t t T
ηs dAs + ξs dBs = 1[K,∞) (Bt )dBt
0 0 0
1
= (BT − K )+ − (B0 − K )+ − L[K0,T ] .
2
e) Question (d)) shows that

wt wt 1
( BT − K ) + = ( B0 − K ) + + ηs dAs + ξs dBs + L[K0,T ] ,
0 0 2

i.e. the initial premium (B0 − K )+ plus the sum of portfolio profits and losses is not sufficient
to cover the terminal payoff (BT − K )+ , and that we fall short of this by the positive amount
2 L[0,T ] > 0. Therefore the portfolio allocation (ξt , ηt )t∈[0,T ] is not self-financing.
1 K

Additional comments:
The stop-loss/start-gain strategy described here is difficult to implement in practice because it would
require infinitely many transactions when Brownian motion crosses the level K, as illustrated in
Figure S.22.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 431

-1 -0.5 0 0.5 1

Figure S.22: Brownian crossings of level 1.*

The arbitrage-free price of the option can in fact be computed as the expected discounted option
payoff

πt = e −(T −t )r IE∗ [(BT − K )+ | Ft ]

= e −(T −t )r IE∗ [(BT − Bt + x − K )+ | Ft ]x=Bt
= e −(T −t )r IE∗ [(BT − Bt + x − K )+ ]x=Bt
w∞ 2 dy
= e −(T −t )r (y + Bt − K )+ e −y /(2(T −t )) p
−∞ 2π (T − t )
w∞ 2 dy
= e −(T −t )r (y + Bt − K ) e −y /(2(T −t )) p
K−Bt 2π (T − t )
w∞ 2 dy
= e −(T −t )r y e −y /(2(T −t )) p
K−Bt 2π (T − t )
w∞ 2 dy
+(Bt − K ) e −(T −t )r e −y /(2(T −t )) p
K−Bt 2π (T − t )
w∞ 2 dy
= e −(T −t )r √ y e −y /2 √
(K−Bt )/ T −t 2π
w∞ 2 dy
+(Bt − K ) e −(T −t )r √ e −y /2 √
(K−Bt )/ T −t 2π
e − ( T −t ) r h 2
i ∞
= √ − e −y /2 √
2π (K−Bt )/ T −t
Bt − K
 
−(T −t )r
+(Bt − K ) e Φ √
T −t
e − ( T −t ) r 2
= √ e −(K−Bt ) /(2(T −t ))
2π
Bt − K
 
−(T −t )r
+(Bt − K ) e Φ √
T −t
=: g(t, Bt ),

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 432 Exercise Solutions

where the function

e −(T −t )r −(K−x)2 /(2(T −t )) x−K

 
−(T −t )r
g(t, x) := √ e + (x − K ) e Φ √ , t ∈ [0, T ),
2π T −t

solves the Black-Scholes heat equation

∂g ∂g 1 ∂ 2g
(t, x) + r (t, x) + (t, x) = 0
∂t ∂x 2 ∂ 2x

with terminal condition g(T , x) = (x − K )+ . The Delta gives the amount to be invested in AUD at
time t and is given by

∂g
ξt = (t, Bt )
∂x
e −(T −t )r 2
= (K − Bt ) √ e −(K−Bt ) /(2(T −t ))
2π (T − t )
e −(T −t )r Bt − K
 
2
+ (Bt − K ) p e −(Bt −K ) /(2(T −t )) + e −(T −t )r Φ √
2π (T − t ) T −t
!
Bt − K
= e −(T −t )r Φ p
(T − t )
=: h(t, Bt ),

with

x−K
 
−(T −t )r
h(t, x) := e Φ √ , t ∈ [0, T ),
T −t

and h(T , x) = 1[K,∞) (x).

Bt

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Figure S.23: Brownian path started at B0 > 1.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 433

(Bt-K)+
g(t,Bt)

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Figure S.24: Risk-neutral pricing of the FX option by πt (Bt ) = g(t, Bt ) vs. stop-loss/start-gain pricing.

1[K,∞ )(Bt)
h(t,Bt)

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Figure S.25: Delta hedging of the FX option by ξt = h(t, Bt ) vs. the stop-loss/start-gain strategy.

The “one or nothing” stop-loss/start-gain strategy is not self-financing because in practice there
is an impossibility to buy/sell the AUD at exactly SGD1.00 to the existence of an order book that
generates a gap between bid/ask prices as in the sample of Figure S.26 with 383.16964 < 384.07141.

Figure S.26: Bitcoin XBT/USD order book.

The existence of the order book will force buying and selling within a certain range [K − ε, K + ε ],
typically resulting into selling lower than K = 1.00 and buying higher than K = 1.00. This

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 434 Exercise Solutions

potentially results into a trading loss that can be proportional to the time


ℓ t ∈ [0, T ] : K − ε < Bt < K + ε
spent by the exchange rate (Bt )t∈[0,T ] within the range [K − ε, K + ε ].

The Itô-Tanaka formula (5.5.31)

wT 1
(BT − K )+ = (B0 − K )+ + 1[K,∞) (Bt )dBt + L[K0,T ] ,
0 2
precisely shows that the trading loss equals half the local time L[K0,T ] spent by (Bt )t∈[0,T ] at the
level K. When ε is small we have
1 K 1
L ≃ ℓ({t ∈ [0, T ] : K − ε < Bt < K + ε}),
2 [0,T ] 4ε
therefore the trading loss is proportional to the time spent by Brownian motion (Bt )t∈R+ within
the interval (K − ε, K + ε ), with proportionality coefficient 1/(4ε ).

Bt

K+ε

K-ε

0 0.05 0.1 0.15 0.2

Figure S.27: Time spent by Brownian motion within the range (K − ε, K + ε ).

More generally, one could show that there is no self-financing (buy and hold) portfolio that can
remain constant over time intervals, and that the self-financing portfolio has to be constantly
re-adjusted in time as illustrated in Figure S.25. This invalidates the stop-loss/start-gain strategy as
a self-financing portfolio strategy.

Chapter 7
Exercise 7.1
a) By the Itô formula, we have
∂g ∂g 1 ∂ 2g
dVt = dg(t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt. (S.29)
∂t ∂x 2 ∂ x2
Consider a hedging portfolio with value Vt = ηt At + ξt Bt , satisfying the self-financing
condition
dVt = ηt dAt + ξt dBt = ξt dBt , t ⩾ 0. (S.30)
By respective identification of the terms in dBt and dt in (S.29) and (S.30) we get
1 ∂ 2g

∂g
0 = (t, B ) dt + (t, Bt )dt,

t

2 ∂ x2

 ∂t

 ξt dBt = ∂ g (t, Bt )dBt ,




∂x

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 435

hence
1 ∂ 2g

∂g
0 = (t, B ) + (t, Bt ),

t

2 ∂ x2

 ∂t

 ξt = ∂ g (t, Bt ),



∂x
and
1 ∂ 2g

∂g
0 = (t, B ) + (t, Bt ),

t

2 ∂ x2

 ∂t

 ξt = ∂ g (t, Bt ),



∂x
hence the function g(t, x) satisfies the heat equation

∂g 1 ∂ 2g
0= (t, x) + (t, x), x > 0, (S.31)
∂t 2 ∂ x2
with terminal condition g(T , x) = x2 , and ξt is given by the partial derivative

∂g
ξt = (t, Bt ), t ⩾ 0.
∂x
b) In order to solve (S.31) we substitute a solution of the form g(t, x) = x2 + f (t ) in to the
partial differential equation, which yields 1 + f ′ (t ) = 0 with the terminal condition f (T ) = 0.
Therefore we have f (T − t ) = T − t, and

g(t, x) = x2 + f (t ) = x2 + T − t, 0 ⩽ t ⩽ T.

c) By (7.1.3), we have

∂g
ξt = ξt (Bt ) = (t, Bt ) = 2Bt , 0 ⩽ t ⩽ T,
∂x
which recovers the value of ξt found page 191 in the power option example. We also have

ηt At = ηt A0 = g(t, Bt ) − ξt Bt = T − t − Bt2 , 0 ⩽ t ⩽ T.

Exercise 7.2 By the Itô formula, we have

dVt = dg(t, St ) (S.32)

∂g ∂g 1 ∂ 2g p ∂g
= (t, St )dt + β (α − St ) (t, St )dt + σ 2 St 2 (t, St )dt + σ St (t, St )dBt .
∂t ∂x 2 ∂x ∂x
By respective identification of the terms in dBt and dt in (7.6.4) and (S.32) we get

 rg(t, St )dt + β (α − St )ξt dt − rξt St dt
∂ 2g

 ∂g ∂g 1
(t, St )dt + β (α − St ) (t, St )dt + σ 2 St 2 (t, St )dt,

=


∂t ∂x 2 ∂x


 σ ξt St dBt = σ St ∂ g (t, St )dBt ,

 p p

∂x

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 436 Exercise Solutions

hence
1 2 ∂ 2g

∂g ∂g
rg (t, S ) + ( − S ) − rξ S = (t, S ) + ( − S ) (t, S ) + σ St 2 (t, St ),

 t β α t ξt t t t β α t t
∂x 2 ∂x

 ∂t

 ξt = ∂ g (t, St ),



∂x
and
1 2 ∂ 2g

∂g
 rg(t, St ) − rξt St = ∂t (t, St ) + 2 σ St ∂ x2 (t, St ),




 ξt = ∂ g (t, St ),



∂x
hence the function g(t, x) satisfies the PDE

∂g ∂g 1 ∂ 2g
rg(t, x) = (t, x) + rx (t, x) + σ 2 x 2 (t, x), x > 0,
∂t ∂x 2 ∂x
and ξt is given by the partial derivative

∂g
ξt = (t, St ), t ⩾ 0.
∂x

Exercise 7.3
a) Let Vt := ξt St + ηt At denote the hedging portfolio value at time t ∈ [0, T ]. Since the dividend
yield δ St per share is continuously reinvested in the portfolio, the portfolio change dVt
decomposes as
dVt = ηt dAt + ξt dSt + δ ξt St dt
| {z } | {z }
trading profit and loss dividend payout
= rηt At dt + ξt (( µ − δ )St dt + σ St dBt ) + δ ξt St dt
= rηt At dt + ξt ( µSt dt + σ St dBt )
= rVt dt + ( µ − r )ξt St dt + σ ξt St dBt , t ⩾ 0.
b) By Itô’s formula we have
∂g ∂g
dg(t, St ) = (t, St )dt + ( µ − δ )St (t, St )dt
∂t ∂x
1 2 2 ∂ 2g ∂g
+ σ St 2 (t, St )dt + σ St (t, St )dBt ,
2 ∂x ∂x
hence by identification of the terms in dBt and dt in the expressions of dVt and dg(t, St ), we
get
∂g
ξt = (t, St ),
∂x
and we derive the Black-Scholes PDE with dividend
∂g ∂g 1 ∂ 2g
rg(t, x) = (t, x) + (r − δ )x (t, x) + σ 2 x2 2 (t, x). (S.33)
∂t ∂x 2 ∂x
c) In order to solve (S.33) we note that, letting f (t, x) := e (T −t )δ g(t, x) and substituting
g(t, x) = e −(T −t )δ f (t, x) into the PDE (S.33), we have
∂f ∂f 1 ∂2 f
r f (t, x) = δ f (t, x) + (t, x) + (r − δ )x (t, x) + σ 2 x2 2 (t, x),
∂t ∂x 2 ∂x

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 437

hence f (t, x) := e (T −t )δ g(t, x), satisfies the standard Black-Scholes PDE with interest rate
r − δ , i.e. we have

∂f ∂f 1 ∂2 f
(r − δ ) f (t, x) = (t, x) + (r − δ )x (t, x) + σ 2 x2 2 (t, x),
∂t ∂x 2 ∂x
with same terminal condition f (T , x) = g(T , x) = (x − K )+ , hence we have
f (t, x) = Bl(x, K, σ , r − δ , T − t )
(T − t ) − K e −(r−δ )(T −t ) Φ d−δ (T − t ) ,
δ



= xΦ d+
where
log(x/K ) + (r − δ ± σ 2 /2)(T − t )
δ
d± (T − t ) : = √ .
σ T −t
Consequently, the pricing function of the European call option with dividend rate δ is
g(t, x) = e −(T −t )δ f (t, x)
= e −(T −t )δ Bl(x, K, σ , r − δ , T − t )
= x e −(T −t )δ Φ d+ (T − t ) − K e −(T −t )r Φ d−δ (T − t ) ,
δ



0 ⩽ t ⩽ T.
We also have
g(t, x) = Bl x e −(T −t )δ , K, σ , r, T − t

= e −(T −t )δ Bl x, K e (T −t )δ , σ , r, T − t ,


0 ⩽ t ⩽ T.
d) As in Proposition 7.4, we have

∂g
(t, St ) = e −(T −t )δ Φ d+
δ


ξt = (T − t ) , 0 ⩽ t < T.
∂x

Exercise 7.4
a) We check that gc (t, 0) = 0, as when x = 0 we have d+ (T − t ) = d− (T − t ) = −∞ for all
t ∈ [0, T ). On the other hand, we have


 +∞, x > K,



lim d+ (T − t ) = lim d− (T − t ) = 0, x = K,
t↗T t↗T 



−∞, x < K,


which allows us to recover the boundary condition

gc (T , x) = lim gc (t, x)
t↗T

xΦ(+∞) − KΦ(+∞) = x − K,
 
 x>K 

 


 

x K
 
= − = 0, x=K = (x − K ) +


 2 2 



 

xΦ(−∞) − KΦ(−∞) = 0,
 
x<K
at t = T . Regarding the Delta of the European call option, we find
Φ(+∞) = 1,
 
 x>K 

 


 

1
 
lim Φ(d+ (T − t )) = Φ (0) = , x=K
t↗T 

 2 



 

Φ(−∞) = 0,
 
x<K

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 438 Exercise Solutions

see Figure 7.6. Similarly, we can check that

σ2

+∞, r> ,





 2



σ2

lim d− (T − t ) = 0, r= ,
T →∞ 
 2



σ2



 −∞,

r< ,
2
and limT →∞ d+ (T − t ) = +∞, hence
lim Bl(x, K, σ , r, T − t )
T →∞
= x lim Φ(d+ (T − t )) − lim e −(T −t )r Φ(d− (T − t ))


T →∞ T →∞
= x, t ⩾ 0.
b) We check that gp (t, 0) = K e −(T −t )r and gp (t, ∞) = 0 as when x = 0 we have d+ (T − t ) =
d− (T − t ) = −∞ and as x tends to infinity we have d+ (T − t ) = d− (T − t ) = +∞ for all
t ∈ [0, T ). On the other hand, we have
KΦ(+∞) − xΦ(+∞) = K − x,
 
 x<K 

 


 

K x
 
gp ( T , x ) = − = 0, x=K = (K − x ) +


 2 2 



 

KΦ(−∞) − xΦ(−∞) = 0,
 
x>K
at t = T . Regarding the Delta of the European put option, we find
Φ(−∞) = 0,
 
 x>K 

 


 

1
 
− lim Φ(−d+ (T − t )) = −Φ(0) = − , x=K
t↗T 

 2 



 

−Φ(+∞) = −1, x < K
 
see Figure 7.13. Similarly, we can check that
σ2

+ r > ,


 ∞,


 2



σ2

lim d− (T − t ) = 0, r = ,
T →∞ 
 2



σ2



 −∞,

r< ,
2
and limT →∞ d+ (T − t ) = +∞, hence
lim Blp (x, K, σ , r, T − t ) = 0, t ⩾ 0.
T →∞

Exercise 7.5 (Exercise 4.16 continued).

a) Substituting g(x,t ) = x2 f (t ) in (7.6.5), we find f ′ (t ) = −(r + σ 2 ) f (t ), hence
2 )t 2 )(T −t )
f (t ) = f (0) e −(r+σ = f ( T ) e (r +σ ,
2 )(T −t ) 2 )(T −t )
hence g(x,t ) = f (T )x2 e (r+σ = x2 e ( r + σ due to the terminal condition g(x, T ) =
x2 .

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 439

∂g 2
b) We have ξt = g(St ,t ) = 2St e (r+σ )(T −t ) , and
∂x
1
ηt = (g(St ,t ) − ξt St )
At
1 2 (r +σ 2 )(T −t ) 2 (r +σ 2 )(T −t )


= S t e − 2St e
A0 ert
S2 2
= − t e (T −2t )r+(T −t )σ , t ∈ [0, T ].
A0

Exercise 7.6
a) Counting approximately 46 days to maturity, we have
(r − σ 2 /2)(T − t ) + log(St /K )
d− (T − t ) = √
σ T −t
(0.04377 − (0.9)2 /2)(46/365) + log(17.2/36.08)
= √
0.9 46/365
= −2.461179058,
and
p
d+ (T − t ) = d− (T − t ) + 0.9 46/365 = −2.14167602.

From the standard Gaussian cumulative distribution table we get

Φ(d+ (T − t )) = Φ(−2.14) = 0.0161098

and
Φ(d− (T − t )) = Φ(−2.46) = 0.00692406,

hence
f (t, St ) = St Φ(d+ (T − t )) − K e −(T −t )r Φ(d− (T − t ))
= 17.2 × 0.0161098 − 36.08 × e −0.04377×46/365 × 0.00692406
= HK$ 0.028642744.
For comparison, running the corresponding Black-Scholes script of Figure 7.23 yields

BSCall(17.2, 36.08, 0.04377, 46/365, 0.9) = 0.02864235.

b) We have

∂f
ηt = (t, St ) = Φ(d+ (T − t )) = Φ(−2.14) = 0.0161098, (S.34)
∂x

hence one should only hold a fractional quantity equal to 16.10 units in the risky asset in
order to hedge 1000 such call options when σ = 0.90.
c) From the curve it turns out that when f (t, St ) = 10 × 0.023 = HK$ 0.23, the volatility σ is
approximately equal to σ = 122%.

This approximate value of implied volatility can be found under the column “Implied
Volatility (IV.)” on this set of market data from the Hong Kong Stock Exchange:

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 Derivative Warrant Search
440
http://www.hkex.com.hk/dwrc/sea
Exercise Solutions

Updated: 6 November 2008

Basic Data
DW Issuer UL Call DW Listing
Maturity Strike Entitle- Total O/S D
Code /Put Type (D-M-Y)
(D-M-Y) ment Issue (%)
Ratio^ Size
Link to Relevant Exchange Traded Options
01897 FB 00066 Call Standard 18-12-2007 23-12-2008 36.08 10 138,000,000 16.43

04348 BP
00066 Call Standard 18-12-2007 23-02-2009 38.88 10 300,000,000 0.25
Market Data
04984 AA 00066 Call Standard 02-06-2005 22-12-2008 12.88 10 300,000,000 0.36
rity Strike Entitle- Total O/S Delta IV. Day Day Closing T/O UL Base Listing Supp
-Y) ment Issue SB (%)
05931 (%)
00066 Call (%) High
Standard Low
27-03-2008 Price # 27.868
29-12-2008 ('000) Price Document
10 200,000,000 0.04
Ratio^ Size ($) ($) ($) ($) Annou
09133 CT 00066 Call Standard 31-01-2008 08-12-2008 36.88 10 200,000,000 0.15
2008 36.08 10 138,000,000 16.43 0.780 125.375 0.000 0.000 0.023 0 17.200
13436 SG 00066 Call Standard 14-05-2008 30-04-2009 32 10 200,000,000 0.10
2009 38.88 10 300,000,000
Figure0.25 0.767 data
S.28: Market 88.656
for the0.000
warrant0.000 0.024
#01897 on the MTR Corporation.0 17.200
13562
Remark: BP
a typical00066 Call theStandard 26-05-2008 08-12-2008 30 be 10 150,000,000 0.00
2008 12.88 10 300,000,000 0.36 value for 128.202
8.075 volatility
0.000in standard
0.000 market conditions
0.540 would around
0 17.200
20%. The observed volatility value σ = 1.22 per year is actually quite high.
13688 RB 00066 Call Standard 04-06-2008 20-02-2009 26.6 10 200,000,000 7.17
2008 27.868 10 200,000,000
Exercise 7.7 0.04 2.239 126.132 0.000 0.000 0.086 0 17.200
a) We find h(x) = x − K.
13764 SG 00066 Call Standard 13-06-2008 26-02-2009 28 10 300,000,000 0.31
2008 36.88 10b)200,000,000
Letting g(t, x)0.15 0.416
, the PDE 133.443
rewrites as 0.000 0.000 0.010 0 17.200
13785 ML 00066 Call Standard t ))17-06-2008
(x − α (0.000 −α ′ (t ) +19-01-2009
r =0.000 rx, 27.38 10 100,000,000 0.50
2009 32 10 200,000,000 0.10 1.059 61.785 0.031 0 17.200
hence α (JP
13821 (0) e rt and
t ) = α00066 Callg(t,Standard (0) e rt . The final
x) = x − α18-06-2008 condition 28.8
18-12-2008 10 100,000,000 0.81
2008 30 10 150,000,000 0.00 0.987 127.080 0.000 0.000 0.026 0 17.200
g(T , x ) = h(x ) = x − K
14111 UB 00066 Call Standard 09-07-2008 16-02-2009 23.88 10 500,000,000 0.88
2009 26.6 10 200,000,000 7.17 −rT0.706 49.625 0.000−(0.000 0.013 0 17.200
yields α (0) = K e and g(t, x) = x − K e T −t )r .
c) 14264
We have BI 00066 Call Standard 16-07-2008 25-02-2009 26.38 10 200,000,000 0.03
2009 28 10 300,000,000 0.31 0.549 49.880 0.010 ∂ g 0.010 0.010 6 17.200
ξt = (t, St ) = 1,
14305 DB 00066 Call Standard ∂22-07-2008 x 09-03-2009 27 10 300,000,000 0.00
2009 27.38 10 100,000,000 0.50 0.714 63.598 0.000 0.000 0.014 0 17.200
hence
14489 FB = Vt − ξtCall
00066 gStandard St − K e −(T −t )r − St
(t, St ) − St 06-08-2008
= 0.000 29-06-2009 28.08 10 175,000,000 0.15
St
2008 28.8 10 100,000,000 η0.81 t 0.670 = 91.664 0.000 0.014
= −K e −rT0. 17.200
At At At
14512
Note thatMB 00066
we 0.88
could also Call Standard
have 66.247
directly used 08-08-2008 26-02-2009 26 10 300,000,000 0.86
2009 23.88 10 500,000,000 2.288 0.000the0.000identification 0.068 0 17.200
−(T −t )r −rT
14531 = g(St ,tCall
UB Vt00066 t −K e
) = SStandard = St − K e11-05-2009
08-08-2008 At = ξt St + ηt At ,
26.88 10 500,000,000 0.00
2009 26.38 10 200,000,000 0.03 1.250 58.172 0.000 0.000 0.030 0 17.200
which immediately yields ξt = 1 and ηt = −K e −rT .
14548
It sufficesCT 00066 0, Call
whichStandard that12-08-2008 ξ25-05-2009 26.88 10 400,000,000 0.03
2009 27 10d)300,000,000 0.00K =0.000
to take 0.000
shows 0.000 g(t,0.000 99,999,999.000
x) = x, t = 1 and ηt = 0. 0 17.200
14571
Exercise 7.8 CT 00066 Put Standard 15-08-2008 22-06-2009 26 10 240,000,000 0.06 (6
2009 28.08 10 175,000,000 0.15 1.681 52.209 0.000 ∗0.000 0.053 0 17.200
a) Under the risk-neutral probability measure P , we have IE [ST | Ft ] = St , 0 ⩽ t ⩽ T .
∗

b) 14925
The rangeCT 00066 CallcanStandard
forward 18-09-2008 12-10-2009 28.88 10 330,000,000 0.00
2009 26 10 300,000,000 0.86 contract
1.273 56.527 be priced as
0.000 0.000 0.030 0 17.200
IE∗ [ST − F + (K1 − ST )+ − (ST − K2 )+ | Ft ]
15159 =JP IE∗ [00066
ST | F Call Standard − S29-09-2008
IE∗ [(K10.000 +
| Ft ] − I12-10-2009
E∗ [(ST − K2 )+28.08 10
| Ft ] 0 17.200 100,000,000 2.00
2009 26.88 10 500,000,000 0.00 3.261
t] −F + 84.055 T ) 0.000 0.162
K2 e −(Standard
T −t )r
Φ −15-10-2008 St Φ − d+ (T − t22





15257 = RB St −00066
F + + Call d− (T − t ) − 30-07-2009 ) 10 100,000,000 0.41
2009 26.88 10 400,000,000 0.03 2.749 70.622 0.000 0.000
−(T −t )r


0.117 0 17.200
− St Φ d+ (T − t ) − K2 e Φ d− (T − t ) ,


0 ⩽ t ⩽ T.
15339 CT 00066 Call Standard 17-10-2008 19-10-2009 20 10 200,000,000 0.07
2009 26 10 240,000,000 0.06 (6.751) 71.243 0.000 0.000 1.020 0 17.200

2009 28.88 10 330,000,000 0.00 0.000 0.000

January 25, 2024 0.000 MH4514
0.000 99,999,999.000
Financial Mathematics - 0N.17.200
Privault "

2009 28.08 ^ The entitlement

10 100,000,000 2.00ratio in general
3.270 represents
66.344 the number of derivative
0.000 0.000 0.169 warrants required to be exercis ed
0 17.200
necessary to reflect any capitalization, rights issue, distribution or the like).
MH4514 Financial Mathematics 441

Exercise 7.9
a) We develop two approaches.
(i) By financial intuition. We need to replicate a fixed amount of $1 at maturity T , without
risk. For this there is no need to invest in the stock. Simply invest g(t, St ) := e −(T −t )r
at time t ∈ [0, T ] and at maturity T you will have g(T , ST ) = e (T −t )r g(t, St ) = $1.

(ii) By analysis and the Black-Scholes PDE. Given the hint, we try plugging a solution
of the form g(t, x) = f (t ), not depending on the variable x, into the Black-Scholes
PDE (7.6.6). Given that here we have

∂g ∂ 2g ∂g
(t, x) = 0, (t, x) = 0, and (t, x) = f ′ (t ),
∂x ∂ x2 ∂t
we find that the Black-Scholes PDE reduces to r f (t ) = f ′ (t ) with the terminal con-
dition f (T ) = g(T , x) = 1. This equation has for solution f (t ) = e −(T −t )r and this is
also the unique solution g(t, x) = f (t ) = e −(T −t )r of the Black-Scholes PDE (7.6.6)
with terminal condition g(T , x) = 1.
b) We develop two approaches.
(i) By financial intuition. Since the terminal payoff $1 is risk-free we do not need to invest
in the risky asset, hence we should keep ξt = 0. Our portfolio value at time t becomes

Vt = g(t, St ) = e −(T −t )r = ξt St + ηt At = ηt At

with At = e rt , so that we find ηt = e −rT , t ∈ [0, T ]. This portfolio strategy remains

constant over time, hence it is clearly self-financing.

(ii) By analysis. The Black-Scholes theory of Proposition 7.1 tells us that

∂g
ξt = (t, x) = 0,
∂x
and
Vt − ξt St Vt e −(T −t )r
ηt = = = = e −rT .
At At e rt

Exercise 7.10 Log contracts.

a) Substituting the function g(x,t ) := f (t ) + log x in the PDE (7.6.7), we have

σ2
0 = f ′ (t ) + r − ,
2
hence
σ2
 
f (t ) = f (0) − r − t,
2
σ2
 
with f (0) = r − T in order to match the terminal condition g(x, T ) := log x, hence
2
we have
σ2
 
g(x,t ) = r − (T − t ) + log x, x > 0.
2
b) Substituting the function

σ2
  
h(x,t ) := u(t )g(x,t ) = u(t ) r− (T − t ) + log x
2

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 442 Exercise Solutions

in the PDE (7.6.7), we find u′ (t ) = ru(t ), hence u(t ) = u(0) e rt = e −(T −t )r , with u(T ) = 1,
which yields

σ2
  
−(T −t )r
h(x,t ) = u(t )g(x,t ) = e r− (T − t ) + log x ,
2

x > 0, t ∈ [0, T ].
c) We have
∂h e −(T −t )r
ξt = (t, St ) = , 0 ⩽ t ⩽ T,
∂x St
and
1

ηt = h(t, St ) − ξt St
At
e −rT σ2
  
= r− (T − t ) + log x − 1 ,
A0 2
0 ⩽ t ⩽ T.

Exercise 7.11 Binary options.

a) From Proposition 7.1, the function Cd (t, x) solves the Black-Scholes PDE

∂Cd ∂C 1 ∂ 2C
 rCd (t, x) = (t, x) + rx d (t, x) + σ 2 x2 2d (t, x),


∂t ∂x 2 ∂x
 C (T , x ) = 1


d [K,∞) (x).

b) We can check by direct differentiation that the Black-Scholes PDE is satisfied by the function
Cd (t, x), together with the terminal condition Cd (T , x) = 1[K,∞) (x) as t tends to T .

Exercise 7.12
a) By (5.5.18) we have wt
St = S0 e αt + σ e (t−s)α dBs .
0
b) By the self-financing condition (6.3.6) we have
dVt = ηt dAt + ξt dSt
= rηt At dt + αξt St dt + σ ξt dBt
= rVt dt + (α − r )ξt St dt + σ ξt dBt , (S.35)
t ⩾ 0. Rewriting (7.6.9) under the form of an Itô process
wt wt
St = S0 + vs ds + us dBs , t ⩾ 0,
0 0

with
ut = σ , and vt = αSt , t ⩾ 0,
the application of Itô’s formula Theorem 5.22 to Vt = C (t, St ) shows that
∂C ∂C
dC (t, St ) = vt (t, St )dt + ut (t, St )dBt
∂x ∂x
∂C 1 ∂ 2C
+ (t, St )dt + |ut |2 2 (t, St )dt
∂t 2 ∂x
∂C ∂C 1 ∂ 2C ∂C
= (t, St )dt + αSt (t, St )dt + σ 2 2 (t, St )dt + σ (t, St )dBt .
∂t ∂x 2 ∂x ∂x
(S.36)

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 443

Identifying the terms in dBt and dt in (S.35) and (S.36) above, we get

σ 2 ∂ 2C

∂C ∂C
 rC (t, St ) = (t, St ) + rSt (t, St ) + (t, St ),


∂t ∂x 2 ∂ x2
 ξt = ∂C (t, St ),


∂x

hence the function C (t, x) satisfies the usual Black-Scholes PDE

∂C ∂C 1 ∂ 2C
rC (t, x) = (t, x) + rx (t, x) + σ 2 2 (t, x), x > 0, 0 ⩽ t ⩽ T, (S.37)
∂t ∂x 2 ∂x

with the terminal condition C (T , x) = e x , x ⩾ 0.

c) Based on (7.6.10), we compute

σ2
  
∂C ′ ′
(t, x) = r + xh (t ) + h(t )h (t ) C (t, x),





 ∂t 2r


∂C
(t, x) = h(t )C (t, x)


 ∂x
2

 ∂ C (t, x) = (h(t ))2C (t, x),



∂ x2
hence the substitution of (7.6.10) into the Black-Scholes PDE (S.37) yields the ordinary
differential equation

σ2 ′ σ2
xh′ (t ) + h (t )h(t ) + rxh(t ) + (h(t ))2 = 0, x > 0, 0 ⩽ t ⩽ T,
2r 2

which reduces to the ordinary differential equation h′ (t ) + rh(t ) = 0 with terminal condition
h(T ) = 1 and solution h(t ) = e (T −t )r , t ∈ [0, T ], which yields

σ 2 2(T −t )r
 
(T −t )r
C (t, x) = exp −(T − t )r + x e + (e − 1) .
4r

d) We have
σ 2 2(T −t )r
 
∂C (T −t )r
ξt = (t, St ) = exp St e + (e − 1) .
∂x 4r

Exercise 7.13
2
a) Noting that ϕ (x) = Φ′ (x) = (2π )−1/2 e −x /2 , we have the
∂h √

(S, d ) = Sϕ d + σ T − K e −rT ϕ (d )
∂d
S − d +σ √T 2 /2 K


2
= √ e − √ e −rT e −d /2
2π 2π
S −d 2 /2−σ √T d−σ 2 T /2 K 2
= √ e − √ e −rT e −d /2 ,
2π 2π
∂h
hence the vanishing of (S, d∗ (S)) at d = d∗ (S) yields
∂d
S 2
√ 2 K 2
√ e −d∗ (S)/2−σ T d∗ (S)−σ T /2 − √ e −rT e −d∗ (S)/2 = 0,
2π 2π

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 444 Exercise Solutions

log(S/K ) + rT − σ 2 T /2
i.e. d∗ (S) = √ . We can also check that
σ T

∂ 2h S − d∗ (S)+σ √T 2 /2
 
K −rT −d∗2 (S)/2


∂
(S, d∗ (S)) = √ e −√ e e
∂ d2 ∂d 2π 2π
√
S − d (S)+σ √T
2 /2 K 2
= − d∗ (S) + σ T √ e ∗ + √ d∗ (S) e −rT e −d∗ (S)/2
2π 2π
√
K −rT −d 2 (S)/2 K 2
= − d∗ (S) + σ T √ e e ∗ + √ d∗ (S) e −rT e −d∗ (S)/2
2π 2π
√ K −rT −d 2 (S)/2
= −σ T √ e e ∗ < 0,
2π
√

hence the function d 7−→ h(S, d ) := SΦ d + σ T − K e −rT Φ(d ) admits a maximum at
d = d∗ (S), and √

h(S, d∗ (S)) = SΦ d∗ (S) + σ T − K e −rT Φ(d∗ (S))
log(S/K ) + (r + σ 2 /2)T log(S/K ) + (r − σ 2 /2)T
   
−rT
= SΦ √ −K e Φ √
σ T σ T
is the Black-Scholes call option price.
b) Since ∂∂ dh (S, d∗ (S)) = 0, we find
d ∂h ∂h
∆ = h(S, d∗ (S)) = (S, d∗ (S)) + d∗′ (S) (S, d∗ (S))
dS ∂S ∂d
√
log(S/K ) + rT + σ 2 T /2
 
= Φ d∗ (S) + σ T = Φ √ .
σ T
Exercise 7.14
a) When σ > 0 we have
∂ gc
∂
∂
= xΦ′ d+ (T − t ) d+ (T − t ) − K e −(T −t )r Φ′ d− (T − t ) d− ( T − t )
∂σ ∂σ ∂σ

∂
= xΦ′ d+ (T − t ) d+ (T − t )
∂σ
∂
−K e −(T −t )r Φ′ d+ (T − t ) e (T −t )r+log(x/K )


d− ( T − t )
∂σ

∂
= xΦ′ d+ (T − t )


d+ (T − t ) − d− (T − t )
∂σ
∂ √
= xΦ′ d+ (T − t )



σ T −t
√ ∂σ

= x T − tΦ′ d+ (T − t ) ,
where we used the fact that
1 2
Φ′ d− (T − t ) = √ e −(d− (T −t )) /2


2π
1 −(d− (T −t ))2 /2+(T −t )r+log(x/K )
= √ e
2π
= Φ d+ (T − t ) e (T −t )r+log(x/K ) .
′

Relation (7.6.11) can be obtained from the equalities

2
2
d+ (T − t ) − d− (T − t )



= d+ (T − t ) + d− (T − t ) d+ (T − t ) − d− (T − t )
x
= 2r (T − t ) + 2 log .
K
Due to the call-put parity relation (7.3.5), the Black-Scholes call and put Vega are identical,

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 445

i.e.
∂ gp ∂ gc √
= x T − tΦ′ d+ (T − t ) .


=
∂σ ∂σ
The Black-Scholes European call and put prices are increasing functions of the volatility
parameter σ > 0.
b) We have
∂ gc ∂ ∂
= xΦ′ (d+ (T − t )) d+ (T − t ) − K e −(T −t )r Φ′ (d− (T − t )) d− (T − t )
∂r ∂r ∂r
−(T −t )r
+(T − t )K e Φ(d− (T − t ))
∂
= xΦ′ (d+ (T − t )) d+ (T − t )
∂r
∂
−K e −(T −t )r Φ′ (d+ (T − t )) e (T −t )r+log(x/K ) d− (T − t )
∂r
−(T −t )r
+(T − t )K e Φ(d− (T − t ))
∂
= xΦ′ (d+ (T − t )) d+ (T − t ) − d− (T − t ) + (T − t )K e −(T −t )r Φ(d− (T − t ))


∂r
∂ √
= xΦ′ (d+ (T − t )) σ T − t + (T − t )K e −(T −t )r Φ(d− (T − t ))


∂r
−(T −t )r
= (T − t )K e Φ(d− (T − t )),
where we used the fact that
1 2
Φ′ (d− (T − t )) = √ e −(d− (T −t )) /2
2π
1 −(d− (T −t ))2 /2+(T −t )r+log(x/K )
= √ e
2π
= Φ (d+ (T − t )) e (T −t )r+log(x/K ) .
′

The same relationship is used to simplify the formulas of the Black-Scholes Delta and Vega.
We note that the Black-Scholes European call price is an increasing function of the interest
rate parameter r.

Regarding put option prices gp (t, x), the call-put parity relation (7.3.5) yields
∂ gp ∂
gc − (x − K e −r(T −t ) )


=
∂r ∂r
= (T − t )K e −(T −t )r Φ(d− (T − t )) − (T − t )K e −r(T −t )
= (T − t )K e −(T −t )r (Φ(d− (T − t )) − 1)
= −(T − t )K e −(T −t )r Φ(−d− (T − t )),
therefore the Black-Scholes European call price is a decreasing function of the interest rate
parameter r.

Exercise 7.15
a) Given that
rN − aN 1 bN − rN 1
p∗ = = and q∗ = = ,
bN − aN 2 bN − aN 2
Relation (4.2.5) reads
1 p

ve(t, x) = ve t + T /N, x(1 + rT /N )(1 − σ T /N )
2
1 p

+ ve t + T /N, x(1 + rT /N )(1 + σ T /N ) .
2
After letting ∆T := T /N and applying Taylor’s formula at the second order we obtain
1 √


ve t + ∆T , x 1 + r∆T − σ ∆T − ve(t, x)


0 =
2

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 446 Exercise Solutions
1 √


ve t + ∆T , x 1 + r∆T + σ ∆T − ve(t, x) + o ∆T



+
2
√
∂ ve

1 ∂ ve
= ∆T (t, x) + x r∆T − σ ∆T (t, x)
2 ∂t ∂x
x2 √
2 ∂ 2 ve

+ r∆T − σ ∆T (t, x) + o(∆T )
2 ∂ x2
√
∂ ve

1 ∂ ve
+ ∆T (t, x) + x r∆T + σ ∆T (t, x)
2 ∂t ∂x
x2 √
2 ∂ 2 ve

+ r∆T + σ ∆T (t, x) + o(∆T ) + o ∆T


2 ∂x 2

∂ ve ∂ ve x2 √
2 ∂ 2 ve
= ∆T (t, x) + rx∆T (t, x) + σ ∆T (t, x) + o ∆T ,


∂t ∂x 2 ∂x 2
which shows that

o ∆T


∂ ve ∂ ve 2 2e
2σ ∂ v
(t, x) + rx (t, x) + x (t, x) = − ,
∂t ∂x 2 ∂ x2 ∆T
hence as N tends to infinity (or as ∆T tends to 0) we find*

∂ ve ∂ ve σ 2 ∂ 2 ve
0= (t, x) + rx (t, x) + x2 2 (t, x),
∂t ∂x 2 ∂x

showing that the function v(t, x) := e (T −t )r ve(t, x) solves the classical Black-Scholes PDE

∂v ∂v σ 2 ∂ 2v
rv(t, x) = (t, x) + rx (t, x) + x2 2 (t, x).
∂t ∂x 2 ∂x
b) Similarly, we have
(1) v (t, (1 + bN )x) − v (t, (1 + aN )x)
ξt (x) =
x(bN − aN )
√
√

v t, (1 + r/N )(1 + σ T /N )x − v t, (1 + r/N )(1 − σ T /N )x
= √
2x(1 + r/N )σ T /N
∂v
→ (t, x),
∂x
as N tends to infinity.

Chapter 8
Exercise 8.1 (Exercise 7.1 continued). Since r = 0 we have P = P∗ and

g(t, Bt ) = IE∗ B2T | Ft

 

= IE∗ (BT − Bt + Bt )2 | Ft
 

= IE∗ (BT − Bt + x)2 x=B

 
t
∗
= IE (BT − Bt ) + 2x(BT − Bt ) + x2 x=B
2
 
t
∗ 2 ∗ 2
 
= IE (BT − Bt ) + 2x IE [BT − Bt ] + Bt
= Bt2 + T − t, 0 ⩽ t ⩽ T,
* The notation o(∆T ) is used to represent any function of ∆T such that lim∆T →0 o(∆T )/∆T = 0.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 447

hence ξt is given by the partial derivative

∂g
ξt = (t, Bt ) = 2Bt , 0 ⩽ t ⩽ T,
∂x

with
g(t, Bt ) − ξt Bt
ηt =
A0
Bt + (T − t ) − 2Bt2
2
=
A0
(T − t ) − Bt2
= , 0 ⩽ t ⩽ T.
A0

Exercise 8.2 Since BT ≃ N (0, T ), we have

2
IE[φ (ST )] = IE φ S0 e σ BT +(r−σ /2)T



1 w∞ 2 2
= √ φ (S0 e σ y+(r−σ /2)T ) e −y /(2T ) dy
2πT −∞
1 w∞ 2 2 2 dx
= √ φ (x) e −((σ /2−r)T +log x) /(2σ T )
2 −∞ x
w ∞2πσ T
= φ (x)g(x)dx,
−∞

under the change of variable

2 /2)T 2 /2)T
x = S0 e σ y+(r−σ , with dx = σ S0 e σ y+(r−σ dy = σ xdy,

i.e.
(σ 2 /2 − r )T + log(x/S0 ) dx
y= and dy = ,
σ σx
where
1 2 2 2
g(x ) : = √ e −((σ /2−r)T +log(x/S0 )) /(2σ T )
2
x 2πσ T
is the lognormal probability
√ density function with location parameter (r − σ 2 /2)T + log S0 and
scale parameter σ T .

Exercise 8.3
a) By the Itô formula, we have
p( p − 1) p−2
dStp = pStp−1 dSt + St dSt • dSt
2
p( p − 1) p−2
= pStp−1 (rSt dt + σ St dBt ) + St (rSt dt + σ St dBt ) • (rSt dt + σ St dBt )
2
p( p − 1) p
= prStp dt + σ pStp dBt + σ 2 St dt
2
p( p − 1)
 
= pr + σ 2 Stp dt + σ pStp dBt .
2

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 448 Exercise Solutions

b) By the Girsanov Theorem 8.3, letting

2 p( p − 1)
 
1
ν := ( p − 1)r + σ ,
pσ 2

the drifted process

Bbt := Bt + νt, 0 ⩽ t ⩽ T,
is a standard (centered) Brownian motion under the probability measure Q defined by

ν2
 
dQ(ω ) = exp −νBT − T dP(ω ).
2

Therefore, the differential of (Stp )t∈R+ can be written as

−

p p ( p 1 )
dSt = pr + σ 2 Stp dt + σ pStp dBt
2
= (r + pσ ν ) Stp dt + σ pStp dBt
= rStp dt + σ pStp (dBt + νdt )
= rStp dt + σ pStp d Bbt ,
hence the discounted process Set := e −rt Stp satisfies d Set = σ pSet d Bbt , and (Set )t∈R+ is a mar-
tingale under the probability measure Q.

Exercise 8.4 We have

IE∗ [φ ( pST1 + qST2 )] ⩽ IE∗ [ pφ (ST1 ) + qφ (ST2 )] since φ is convex,

∗ ∗
= p IE [φ (ST1 )] + q IE [φ (ST2 )]
= p IE∗ [φ (IE∗ [ST2 | FT1 ])] + q IE∗ [φ (ST2 )] because (St )t∈R+ is a martingale,
⩽ p IE∗ [IE∗ [φ (ST2 ) | FT1 ]] + q IE∗ [φ (ST2 )] by Jensen’s inequality,
= p IE∗ [φ (ST2 )] + q IE∗ [φ (ST2 )] by the tower property,
= IE∗ [φ (ST2 )], because p + q = 1.

Remark: This kind of technique can provide an upper price estimate from Black-Scholes when
the actual option price is difficult to compute: here the closed-form computation would involve a
double integration of the form

h  2 2
i
IE∗ [φ ( pST1 + qST2 )] = IE∗ φ pS0 e σ BT1 −σ T1 /2 + qS0 e σ BT2 −σ T2 /2
h  2
 2
i
= IE∗ φ S0 e σ BT1 −σ T1 /2 p + q e (BT2 −BT1 )σ −(T2 −T1 )σ /2
1 w∞ w∞  2
 2

= φ S0 e σ x−σ T1 /2 p + q e σ y−(T2 −T1 )σ /2
2π −∞ −∞
2 2 dxdy
× e −x /(2T1 )−y (2(T2 −T1 )) p
T1 (T2 − T1 )
1 w∞ w∞  2
 2
 +
= S0 e σ x−σ T1 /2 p + q e σ y−(T2 −T1 )σ /2 − K
2π −∞ −∞
2 2 dxdy
× e −x /(2T1 )−y (2(T2 −T1 )) p
T1 (T2 − T1 )
1 w
=
2π {(x,y)∈R2 : S0 e σ x ( p+q e σ y−(T2 −T1 )σ 2 /2 )⩾K e σ 2 T1 /2 }
2 T /2 2 /2
(S0 e σ x−σ 1
( p + q e σ y−(T2 −T1 )σ ) − K)

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 449
2 / (2T )−y2 (2(T −T )) dxdy
× e −x 1 2 1 p
T1 (T2 − T1 )
= ···

Exercise 8.5
a) The European call option price C (K ) := e −rT IE∗ [(ST − K )+ ] decreases with the strike price
K, because the option payoff (ST − K )+ decreases and the expectation operator preserves
the ordering of random variables.
b) The European put option price C (K ) := e −rT IE∗ [(K − ST )+ ] increases with the strike price
K, because the option payoff (K − ST )+ increases and the expectation operator preserves the
ordering of random variables.

Exercise 8.6
a) Using Jensen’s inequality and the martingale property of the discounted asset price process
( e −rt St )t∈R+ under the risk-neutral probability measure P∗ , we have

+
e −(T −t )r IE∗ [(ST − K )+ | Ft ] ⩾ e −(T −t )r IE∗ [ST − K | Ft ]

+
= e −(T −t )r e (T −t )r St − K

+
= St − K e −(T −t )r , 0 ⩽ t ⩽ T .

Black-Scholes European call price

Lower bound
80
70
60
50
40
30
20
10
0
120
100 5
Underlying (HK$) 80 15 10
60 20
Time to maturity T-t

Figure S.29: Lower bound vs. Black-Scholes call price.

In terms of the break-even price (7.4.1) defined as

BEPt := K + e −(T −t )r IE∗ [(ST − K )+ | Ft ],

we obtain the bound

+
BEPt ⩾ K + St − K e −(T −t )r .

b) Similarly, by Jensen’s inequality and the martingale property, we find

+
e −(T −t )r IE∗ [(K − ST )+ | Ft ] ⩾ e −(T −t )r IE∗ [K − ST | Ft ]

+
= e −(T −t )r K − e (T −t )r St

+
= K e −(T −t )r − St , 0 ⩽ t ⩽ T .

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 450 Exercise Solutions
Black-Scholes European put price
Lower bound
30
25
20
15
10
5
0
120

100

Underlying (HK$)
0
80 5
10
15 Time to maturity T-t
20

Figure S.30: Lower bound vs. Black-Scholes put option price.

We may also use the fact that a convex function of the martingale ( e rt St )t∈R+ under the
risk-neutral probability measure P∗ is a submartingale, showing that
e rt IE∗ [( e −rT K − e −rT ST )+ | Ft ] ⩾ e rt ( e −rT K − e −rt St )+

+
= K e −(T −t )r − St , 0 ⩽ t ⩽ T .
In terms of the break-even price (7.4.2) defined as

BEPt := K − e −(T −t )r IE∗ [(ST − K )+ | Ft ],

we obtain the bound
+

BEPt ⩽ K − K e −(T −t )r − St .

Exercise 8.7
a) (i) The bull spread option can be realized by purchasing one European call option with
strike price K1 and by short selling (or issuing) one European call option with strike
price K2 , because the bull spread payoff function can be written as

x 7−→ (x − K1 )+ − (x − K2 )+ .

see https://optioncreator.com/st3ce7z.

150
(x-K1)+
-(x-K2)+

100

50

-50
0 50 100 150 200
K1 ST K2

Figure S.31: Bull spread option as a combination of call and put options.*

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MH4514 Financial Mathematics 451

(ii) The bear spread option can be realized by purchasing one European put option with
strike price K2 and by short selling (or issuing) one European put option with strike
price K1 , because the bear spread payoff function can be written as

x 7−→ −(K1 − x)+ + (K2 − x)+ ,

see https://optioncreator.com/stmomsb.

150
-(K1-x)+
(K2-x)+

100

50

-50
0 50 100 150 200
K1 ST K2

Figure S.32: Bear spread option as a combination of call and put options.*

b) (i) The bull spread option can be priced at time t ∈ [0, T ) using the Black-Scholes formula
as

Bl(St , K1 , σ , r, T − t ) − Bl(St , K2 , σ , r, T − t ).

(ii) The bear spread option can be priced at time t ∈ [0, T ) using the Black-Scholes formula
as

Bl(St , K2 , σ , r, T − t ) − Bl(St , K1 , σ , r, T − t ).

Exercise 8.8
a) The payoff of the long box spread option is given in terms of K1 and K2 as

(x − K1 )+ − (K1 − x)+ − (x − K2 )+ + (K2 − x)+ = x − K1 − (x − K2 ) = K2 − K1 .

b) By standard absence of arbitrage, the long box spread option payoff is priced (K2 − K1 )/(1 +
r )N−k at times k = 0, 1, . . . , N.
c) From Table 13.8 below, we check that the strike prices suitable for a long box spread option
on the Hang Seng Index (HSI) are K1 = 25, 000 and K2 = 25, 200.

* The animation works in Acrobat Reader on the entire pdf file.

* The animation works in Acrobat Reader on the entire pdf file.

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 452 Exercise Solutions

Table 13.8: Call and put options on the Hang Seng Index (HSI).

d) Based on the data provided, we note that the long box spread can be realized in two ways.
i) Using the put option issued by BI (BOCI Asia Ltd.) at 0.044.
In this case, the box spread option represents a short position priced

| {z } ×7, 500 −0.064

0.540
| {z }
×8, 000 −0.370 ×11, 000 +0.044 ×10, 000 = −92
| {z } | {z }
Long call Short put Short call Long put

index points, or −92 × $50 = −$4, 600 on 02 March 2021.

Note that according to Table 8.2, option prices are quoted in index points (to be
multiplied by the relevant option/warrant entitlement ratio), and every index point is
worth $50.
ii) Using the put option issued by HT (Haitong Securities) at 0.061.
In this case, the box spread option represents a long position priced

| {z } ×7, 500 −0.044

0.540
| {z }
×8, 000 −0.370 ×11, 000 +0.061 ×10, 000 = +78
| {z } | {z }
Long call Short put Short call Long put

index points, or 78 × $50 = $3, 900 on 02 March 2021.

e) As the option built in i)) represents a short position paying $4, 600 today with an additional
$50 × (K2 − K1 ) = 200 = $10, 000 payoff at maturity on June 29, I would definitely enter
this position.
As for the option built in ii)) it is less profitable because it costs $3, 900, however it is still
profitable taking into account the $10, 000 payoff at maturity on June 29.
By the way, the put option at 0.061 has zero turnover (T/O).
In the early 2019 Robinhood incident, a member of the Reddit community /r/WallStreetBets realized
a loss of more than $57,000 on $5,000 principal by attempting a box spread. This was due to the
use of American call and put options that may be exercised by their holders at any time, instead of
European options with fixed maturity time N. Robinhood subsequently announced that investors on
the platform would no longer be able to open box spreads, a policy that remains in place as of early
2021
Remark. Searching for arbitrage opportunities via the existence of profitable long box spreads is
a way to test the efficiency of the market (Billingsley and Chance, 1985). The data used for this
test in Table 8.1 was in fact modified market data. The original 02 March 2021 data is displayed in
Table 13.9, and shows that the call option with strike price K2 = 25, 200 was actually not available
for trading (N/A) at that time, with 0% outstanding quantity and zero turnover (T/O).

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MH4514 Financial Mathematics 453

Table 13.9: Original call/put options on the Hang Seng Index (HSI) as of 02/03/2021.

Exercise 8.9
a) The payoff function can be written as
(x − K1 )+ + (x − K2 )+ − 2(x − (K1 + K2 )/2)+
= (x − 50)+ + (x − 150)+ − 2(x − 100)+ , (S.38)
see also https://optioncreator.com/stnurzg.

150
(x-K1)++(x-K2)+
-2(x-K1/2-K2/2)+

100

50

-50
0 50 100 150 200
K1 ST K2

Figure S.33: Butterfly option as a combination of call options.*

Hence the butterfly option can be realized by:

1. purchasing one call option with strike price K1 = 50, and
2. purchasing one call option with strike price K2 = 150, and
3. issuing (or selling) two call options with strike price (K1 + K2 )/2 = 100.
b) From (S.38), the long call butterfly option can be priced at time t ∈ [0, T ) using the Black-
Scholes call formula as

Bl(St , K1 , σ , r, T − t ) + Bl(St , K2 , σ , r, T − t ) − 2Bl(St , (K1 + K2 )/2, σ , r, T − t ).

* The animation works in Acrobat Reader.

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 454 Exercise Solutions

c) For example, in the discrete-time Cox-Ross-Rubinstein (J. Cox, S.A. Ross, and Rubinstein,
1979) model, denoting by φ (x) the payoff function, the self-financing replicating portfolio
strategy (ξt (St−1 ))t =1,2,...,N hedging the contingent claim with payoff C = φ (SN ) is given as
in Proposition 4.7 by
h    i
IE∗ φ x(1 + b) ∏Nj=t +1 (1 + R j ) − φ x(1 + a) ∏Nj=t +1 (1 + R j )
ξt (x) =
(b − a)(1 + r )N−t St−1
with x = St−1 . Therefore, ξt (x) will be positive (holding) when x = St−1 is sufficiently
below (K1 + K2 )/2, and ξt (x) will be negative (short selling) when x = St−1 is sufficiently
above (K1 + K2 )/2.

1
0.8
0.6
0.4
0.2
0
-0.2
-0.4 15 200
-0.6
-0.8 10 150
-1 Time to maturity T-t 100
5
50
0 0
Underlying price

Figure S.34: Delta of a butterfly option with strike prices K1 = 50 and K2 = 150.

Exercise 8.10
a) We have
Ct = e −(T −t )r IE∗ [ST − K | Ft ]
= e −(T −t )r IE∗ [ST | Ft ] − K e −(T −t )r
e rt IE∗ e −rT ST Ft − K e −(T −t )r
 
=
= e rt e −rt St − K e −(T −t )r
= St − K e −(T −t )r .
We can check that the function g(x,t ) = x − K e −(T −t )r satisfies the Black-Scholes PDE
∂g ∂g σ 2 ∂ 2g
rg(x,t ) = (x,t ) + rx (x,t ) + x2 2 (x,t )
∂t ∂x 2 ∂x
with terminal condition g(x, T ) = x−K, since ∂ g(x,t )/∂t = −rK e −(T −t )r and ∂ g(x,t )/∂ x =
1.
b) We simply take ξt = 1 and ηt = −K e −rT in order to have
Ct = ξt St + ηt e rt = St − K e −(T −t )r , 0 ⩽ t ⩽ T.
Note again that this hedging strategy is constant over time, and the relation ξt = ∂ g(St ,t )/∂ x
for the option Delta, cf. (S.34), is satisfied.

Exercise 8.11 Option pricing with dividends (Exercise 7.3 continued).

a) Let P∗ denote the probability measure under which the process (Bbt )t∈R+ defined by
µ −r
d Bbt = dt + dBt
σ

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 455

is a standard Brownian motion. Under absence of arbitrage the asset price process (St )t∈R+
has the dynamics
dSt = ( µ − δ )St dt + σ St dBt
= (r − δ )St dt + σ St d Bbt ,
and the discounted asset price process (Set )t∈R+ = ( e −rt St )t∈R+ satisfies

d Set = −δ Set dt + σ Set d Bbt .

Assuming that the dividend yield δ St per share is continuously reinvested in the portfolio,
the self-financing portfolio condition
dVt = ηt dAt + ξt dSt + δ ξt St dt
| {z } | {z }
Trading profit and loss Dividend payout

= rηt At dt + ξt ((r − δ )St dt + σ St d Bbt ) + δ ξt St dt

= rηt At dt + ξt (rSt dt + σ St d Bbt )
= rVt dt + σ ξt St d Bbt , t ⩾ 0.
In other words, no arbitrage is induced by the dividend payout. This yields
−rt


dVt = d e Vt
e
= −r e −rt Vt dt + e −rt dVt
= σ ξt e −rt St d Bbt
= σ ξt Set d Bbt
= ξt (d Set + δ Set dt ), t ⩾ 0.
Therefore, we have w
t
Vet − Ve0 = dVeu
0
wt
= σ ξu Seu d Bbu
wt 0 wt
= ξu d Seu + δ Seu du, t ⩾ 0.
0 0
Here, the asset price process ( e δt St )t∈R+ with added dividend yield satisfies the equation


d e δt St = r e δt St dt + σ e δt St d Bbt ,

and after discount, the process ( e −rt e δt St )t∈R+ = ( e −(r−δ )t St )t∈R+ is a martingale under
P∗ .
b) We have wt
Vet = Ve0 + σ ξu Seu d Bbu , t ⩾ 0,
0
which is a martingale under P∗ from Proposition 8.1, hence
Vet = IE∗ VeT Ft
 

= e −rT IE∗ [VT | Ft ]

= e −rT IE∗ [C | Ft ],
which implies
Vt = e rt Vet = e −(T −t )r IE∗ [C | Ft ], 0 ⩽ t ⩽ T.
c) After discounting the payoff (ST − K )+ at the continuously compounded interest rate r, we
obtain
Vt = e −(T −t )r IE∗ (ST − K )+ | Ft
 
2
+
= e −(T −t )r IE∗ S0 e σ BT +(r−δ −σ /2)T − K | Ft
 b 
2
+
= e −(T −t )δ e −(T −t )(r−δ ) IE∗ S0 e σ BT +(r−δ −σ /2)T − K | Ft
 b 

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 456 Exercise Solutions

= e −(T −t )δ Bl(x, K, σ , r − δ , T − t )
e −(T −t )δ St Φ d+ (T − t ) − K e −(T −t )(r−δ ) Φ d−δ (T − t )
δ




=
e −(T −t )δ St Φ d+ (T − t ) − K e −(T −t )r Φ d−δ (T − t ) ,
δ



= 0 ⩽ t < T,
where
log(St /K ) + (r − δ + σ 2 /2)(T − t )
δ
d+ (T − t ) : = √
|σ | T − t
and
log(St /K ) + (r − δ − σ 2 /2)(T − t )
δ
d− (T − t ) : = √ .
|σ | T − t
We also have
g(t, x) = Bl x e −(T −t )δ , K, σ , r, T − t

= e −(T −t )δ Bl x, K e (T −t )δ , σ , r, T − t ,


0 ⩽ t ⩽ T.
d) In view of the pricing formula

Vt = e −(T −t )δ St Φ d+ (T − t ) − K e −(T −t )r Φ d−δ (T − t ) ,

δ

the Delta of the option is identified as

ξt = e −(T −t )δ Φ d+
δ


(T − t ) , 0 ⩽ t < T,

which recovers the result of Exercise 7.3-(d)).

Exercise 8.12 We start by pricing the “inner” at-the-money option with payoff (ST2 − ST1 )+ and
strike price K = ST1 at time T1 as

e −(T2 −T1 )r IE∗ (ST2 − ST1 )+ | FT1

 

(r + σ 2 /2)(T2 − T1 ) + log(ST1 /ST1 )

 
= ST1 Φ √
σ T2 − T1
(r − σ 2 /2)(T2 − T1 ) + log(ST1 /ST1 )
 
−(T2 −T1 )r
−ST1 e Φ √
σ T2 − T1
r + σ 2 /2 √ r − σ 2 /2 √
   
−(T2 −T1 )r
= ST1 Φ T2 − T1 − ST1 e Φ T2 − T1 ,
σ σ
where we applied (8.4.8) with T = T2 , t = T1 , and K = ST1 . As a consequence, the forward start
option can be priced as

e −(T1 −t )r IE∗ e −(T2 −T1 )r IE∗ (ST2 − ST1 )+ | FT1 Ft

   

= e −(T1 −t )r
r + σ 2 /2 √ r − σ 2 /2 √
     
∗ −(T2 −T1 )r
× IE ST1 Φ T2 − T1 − ST1 e Φ T2 − T1 Ft
σ σ
= e −(T1 −t )r
r + σ 2 /2 √ r − σ 2 /2 √
    
× Φ T2 − T1 − e −(T2 −T1 )r Φ T2 − T1 IE∗ [ST1 | Ft ]
σ σ
r + σ 2 /2 √ r − σ 2 /2 √
    
−(T2 −T1 )r
= St Φ T2 − T1 − e Φ T2 − T1 ,
σ σ

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MH4514 Financial Mathematics 457

0 ⩽ t ⩽ T1 .

Exercise 8.13 From the Black-Scholes formula we have

" + #
(r + σ 2 /2)(Tk − Tk−1 ) − log K
 
−(Tk −Tk−1 )r ∗ STk
e IE −K FTk−1 = Φ √
STk−1 σ Tk − Tk−1
(r − σ 2 /2)(Tk − Tk−1 ) − log K
 
−(Tk −Tk−1 )r
−K e Φ √ .
σ Tk − Tk−1
As a consequence, for t = T0 = 0 we have
" + # " " + ##
∗ STk ∗ ∗ STk
IE −K Ft = IE IE −K FTk−1
STk−1 STk−1
(r + σ 2 /2)(Tk − Tk−1 ) − log K
  
∗ (Tk −Tk−1 )r
= IE e Φ √
σ Tk − Tk−1
(r − σ 2 /2)(Tk − Tk−1 ) − log K
 
−KΦ √
σ Tk − Tk−1
(r + σ 2 /2)(Tk − Tk−1 ) − log K
 
(Tk −Tk−1 )r
=e Φ √
σ Tk − Tk−1
(r − σ 2 /2)(Tk − Tk−1 ) − log K
 
− KΦ √ .
σ Tk − Tk−1
Hence, the cliquet option can be priced at time t = T0 = 0 as
" + #
n
S T
∑ e −rTk IE∗ ST k − K
k =1 k−1

n 
(r + σ 2 /2)(Tk − Tk−1 ) − log K
 
−rTk−1
=∑ e Φ √
k =1 σ Tk − Tk−1
(r − σ 2 /2)(Tk − Tk−1 ) − log K
 
−rTk
−K e Φ √ .
σ Tk − Tk−1

Exercise 8.14 (Exercise 7.10 continued). We have

C (t, St ) = e −(T −t )r IE∗ log ST | Ft
 

σ2
   
−(T −t )r ∗
= e IE log St + (BT − Bt )σ + r −
b b (T − t ) | Ft
2
σ2
 
= e −(T −t )r log St + e −(T −t )r r − (T − t ), 0 ⩽ t ⩽ T.
2

Exercise 8.15 (Exercise 7.5 continued).

a) By (6.5.3), for all t ∈ [0, T ], we have
C (t, St ) = e −(T −t )r IE[ST2 | Ft ]
S2
 
= e −(T −t )r IE St2 T2 Ft
St
 2 
S
= e −(T −t )r St2 IE T2 Ft
St

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 458 Exercise Solutions

ST2
 
= e −(T −t )r St2 IE
St2
2
e −(T −t )r St2 IE e 2(BT −Bt )σ −(T −t )σ +2(T −t )r
 
=
2
e −(T −t )r St2 e −(T −t )σ +2(T −t )r IE e 2(BT −Bt )σ
 
=
2
= St2 e (r+σ )(T −t ) ,
where we used the Gaussian moment generating function (MGF) identity (11.6.16), i.e.
2
IE e 2(BT −Bt )σ = e 2(T −t )σ
 

for the normal random variable BT − Bt ≃ N (0, T − t ), 0 ⩽ t < T .

b) For all t ∈ [0, T ], we have

∂C 2
ξt = (t, x)|x=St = 2St e (r+σ )(T −t ) ,
∂x
i.e.
2 )(T −t )
ξt St = 2St2 e (r+σ = 2C (t, St ),
and
C (t, St ) − ξt St e −rt 2 (r+σ 2 )(T −t ) 2
− 2St2 e (r+σ )(T −t )


ηt = = St e
At A0
S2 2
= − t e σ (T −t )+(T −2t )r ,
A0
i.e.
At σ 2 (T −t )+(T −2t )r 2
ηt At = −St2 e = −St2 e σ (T −t )+(T −t )r = −C (t, St ).
A0
As for the self-financing condition, we have
2
dC (t, St ) = d St2 e (r+σ )(T −t )


2 )(T −t ) 2 )(T −t )
= − ( r + σ 2 ) e (r +σ St2 dt + e (r+σ d St2


2 )(T −t ) 2 )(T −t )
= − ( r + σ 2 ) e (r +σ St2 dt + e (r+σ 2St dSt + σ 2 St2 dt


2 )(T −t ) 2 )(T −t )
= −r e (r+σ St2 dt + 2St e (r+σ dSt ,
and
2 )(T −t ) St2 σ 2 (T −t )+(T −2t )r
ξt dSt + ηt dAt = 2St e (r+σ dSt − r e At dt
A0
2 2
= 2St e (r+σ )(T −t ) dSt − rSt2 e σ (T −t )+(T −t )r dt,
which recovers dC (t, St ) = ξt dSt + ηt dAt , i.e. the portfolio strategy is self-financing.

Exercise 8.16 (Exercise 7.12 continued).

a) The discounted process Xt := e −rt St satisfies

dXt = (α − r )Xt dt + σ e −rs dBs ,

which is a martingale when α = r by Proposition 8.1, as in this case it becomes a stochastic

integral with respect to a standard Brownian motion. This fact can be recovered by directly
computing the conditional expectation IE[Xt | Fs ] and showing it is equal to Xs . By (5.5.18),
see Exercise 7.12, we have
wt
St = S0 e αt + σ e (t−s)α dBs ,
0

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MH4514 Financial Mathematics 459

hence wt
Xt = S0 + σ e −rs dBs , t ⩾ 0,
0
and  wt 
−ru
IE[Xt | Fs ] = IE S0 + σ e dBu Fs
0
w 
t
−ru
= IE[S0 ] + σ IE e dBu Fs
0
w  w 
s t
−ru −ru
= S0 + σ IE e dBu Fs + σ IE e dBu Fs
0 s
ws w
t

−ru −ru
= S0 + σ e dBu + σ IE e dBu
0 s
ws
= S0 + σ e −ru dBu
0
= Xs , 0 ⩽ s ⩽ t.
b) We rewrite the stochastic differential equation satisfied by (St )t∈R+ as
dSt = αSt dt + σ dBt = rSt dt + σ d Bbt ,
where
α −r
d Bbt :=St dt + dBt ,
σ
which allows us to rewrite (5.5.18), by taking α := −r therein, as
 wt  wt
St = e rt S0 + σ e −rs d Bbs = S0 e rt + σ e (t−s)r d Bbs . (S.39)
0 0
Taking
α −r
ψt := St , 0 ⩽ t ⩽ T,
σ
in the Girsanov Theorem 8.3, the process (Bbt )t∈R+ is a standard Brownian motion under the
probability measure Pαdefined by
dPα wT 1wT 2

:= exp − ψt dBt − ψ dt
dP 0 2 0 t
α −r w T 1 α −r 2w T 2
  !
= exp − St dBt − St dt ,
σ 0 2 σ 0

and (Xt )t∈R+ is a martingale under Pα .

c) Using (S.39) under the risk-neutral probability measure P∗ , we have
C (t, St ) = e −(T −t )r IEα [exp(ST ) | Ft ]
  wT  
= e −(T −t )r IEα exp e rT S0 + σ e (T −u)r d Bbu Ft
0
  wt wT  
−(T −t )r (T −u)r b (T −u)r b
= e rT
IEα exp e S0 + σ e d Bu + σ e d Bu Ft
0 t
    wT  
= exp − (T − t )r + e (T −t )r St IEα exp σ e (T −u)r d Bbu Ft
t
    wT 
(T −t )r (T −u)r b
= exp − (T − t )r + e St IEα exp σ e d Bu
t
  σ2 w T 
= exp − (T − t )r + e (T −t )r St exp e 2(T −u)r du
2 t
 σ 2 
= exp − (T − t )r + e (T −t )r St + ( e 2(T −t )r − 1) , 0 ⩽ t ⩽ T.
4r

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 460 Exercise Solutions

d) We have
∂C  σ2 
ξt = (t, St ) = exp St e (T −t )r + ( e 2(T −t )r − 1)
∂x 4r
and
C (t, St ) − ξt St
ηt =
At
e − ( T −t )r  σ 2 2(T −t )r 
= exp St e (T −t )r + (e − 1)
At 4r
St  σ 2 
− exp St e (T −t )r + ( e 2(T −t )r − 1) .
At 4r
e) We have
 σ 2 2(T −t )r 
dC (t, St ) = r e −(T −t )r exp St e (T −t )r + (e − 1) dt
4r
 σ 2 
−rSt exp St e (T −t )r + ( e 2(T −t )r − 1) dt
4r
σ 2 (T −t )r  σ 2 2(T −t )r 
− e exp St e (T −t )r + (e − 1) dt
2 4r
 σ 2 
+ exp St e (T −t )r + ( e 2(T −t )r − 1) dSt
4r
1 (T −t )r  σ 2 2(T −t )r 
+ e exp St e (T −t )r + (e − 1) σ 2 dt
2 4r
 σ 2 
= r e −(T −t )r exp St e (T −t )r + ( e 2(T −t )r − 1) dt
4r
 σ 2 
−rSt exp St e (T −t )r + ( e 2(T −t )r − 1) dt + ξt dSt .
4r
On the other hand, we have
ξt dSt + ηt dAt = ξt dSt
 σ2 
+r e −(T −t )r exp St e (T −t )r + ( e 2(T −t )r − 1) dt
4r
 σ 2 
−rSt exp St e (T −t )r + ( e 2(T −t )r − 1) dt,
4r
showing that
dC (t, St ) = ξt dSt + ηt dAt ,

and confirming that the strategy (ξt , ηt )t∈R+ is self-financing.

Exercise 8.17
a) Using (S.39) under the risk-neutral probability measure P∗ , we have
C (t, St ) = e −(T −t )r IEα [ST2 | Ft ]
wT
" 2 #
−(T −t )r (T −u)r b
= e IEα rT
e S0 + σ e d Bu Ft
0

wt wT
" 2 #
−(T −t )r (T −u)r (T −u)r
= e IEα rT
e S0 + σ e d Bbu + σ e d Bbu Ft
0 t
 wt 2 
−(T −t )r (T −u)r
= e IEα rT
e S0 + σ e d Bbu Ft
0
 wt  w
T

+2σ e −(T −t )r e rT S0 + σ e (T −u)r d Bbu IEα e (T −u)r d Bbu Ft
0 t

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MH4514 Financial Mathematics 461
wT
" 2 #
2 −(T −t )r (T −u)r b
+σ e IEα e d Bu Ft
t

wt wT
" 2 #
 2
= e −(T −t )r e rT S0 + σ e (T −u)r d Bbu + σ 2 e −(T −t )r IEα e (T −u)r d Bbu
0 t
 wt 2 wT
= e −(T −t )r e rT S0 + σ e (T −u)r d Bbu + σ 2 e −(T −t )r e 2(T −u)r du
0 t
σ 2 (T −t )r
e (T −t )r St2 + − e −(T −t )r


= e
2r
sinh((T − t )r )
= e (T −t )r St2 + σ 2 , 0 ⩽ t ⩽ T.
r
b) We find
∂C
ξt = (t, St ) = 2 e (T −t )r St , 0 ⩽ t ⩽ T.
∂x

Exercise 8.18 (Exercise 6.8 continued, see Proposition 4.1 in Carmona and Durrleman, 2003).
(2) (1)

Letting α := IE∗ [ST ] = e rt S0 − S0 and
 (2) (1) 
η 2 := Var∗ St − St
(1)
2 σ12 t (2)
2 σ22 t (1) (2) (2) (1)
2

= e 2rt S0 e + S0 e − 2S0 S0 e ρσ1 σ2t − S0 − S0 ,

we approximate

e −rt w ∞ 2 2
e −rt IE∗ [(ST − K )+ ] ≃ p (x − K )+ e −(x−α ) /(2η ) dx
2πη 2 −∞

e −rt w ∞ 2 2
= p (x − K ) e −(x−α ) /(2η ) dx
2πη 2 K

e −rt w ∞ −(x−α )2 /(2η 2 ) K e −rt w ∞ −(x−α )2 /(2η 2 )

= p xe dx − p e dx
2πη 2 K 2πη 2 K
η e −rt w ∞ 2 K e −rt w ∞ 2
= √ (x + α ) e −x /2 dx − √ e −x /2 dx
2π ( K−α ) /η 2π ( K−α ) /η

η e −rt h −x2 /2 i∞ K −α
 
−rt
= −√ e − (K − α ) e Φ −
2π (K−α )/η η
−rt K −α
 
ηe 2 2
= √ e −(K−α ) /(2η ) − (K − α ) e −rt Φ − .
2π η

Remark: We note that the expected value IE∗ [φ (ST − K )] can be exactly computed from
w ∞w ∞
(2) (1)

IE∗ [φ (ST )] = IE∗ φ ST − ST


= φ x − y ϕ1 (x)ϕ2 (y)dxdy,
0 0

where
(−(r − σi2 /2)T + log(x/S0 ))2
 
1
ϕi (x) = √ exp −
xσi 2πT 2σi2 T
(i)
is the lognormal probability density function of ST , i = 1, 2. In particular, we have
w∞
(2) (1)

IE∗ [φ (ST )] = IE∗ φ ST − ST


= φ z ϕ (z)dz,
0

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 462 Exercise Solutions

where
w∞
ϕ (z) = ϕ1 (z + y)ϕ2 (y)dydy
w ∞0 2 2 2 2 2 2
= e −(−(r−σ1 /2)T +log((z+y)/S0 )) /(2σ1 T )−(−(r−σ2 /2)T +log(y/S0 )) /(2σ2 T )
0
dy
×
2πT σ1 σ2 (z + y)y
is the probability density function of ST .

1.6
1.4
1.2
1
0.8
0.6
0.4
0.2 Gaussian PDF
Integral formula
0
-1 -0.5 0 0.5 1
z

Figure S.35: Gaussian approximation of spread probability density function.

0.12
Integral evaluation
0.1 Monte Carlo estimation
Gaussian approximation
0.08

0.06

0.04

0.02

0
0 0.2 0.4 0.6 0.8 1
K

Figure S.36: Gaussian approximation of spread option prices.

Exercise 8.19 (Exercise 7.2 continued). If C is a contingent claim payoff of the form C = φ (ST )
such that (ξt , ηt )t∈[0,T ] hedges the claim payoff C, the arbitrage-free price of the claim payoff C at
time t ∈ [0, T ] is given by

πt (X ) = Vt = e −r(T −t ) IE∗ [φ (ST ) | Ft ], 0 ⩽ t ⩽ T,

where IE∗ denotes expectation under the risk-neutral measure P∗ . Hence, from the noncentral Chi

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MH4514 Financial Mathematics 463

square probability density function

fT −t (x)

! αβ /σ 2 −1/2
2β 2β x + rt e −β (T −t ) x
= 2 exp − 2
σ 1 − e −β (T −t ) σ 1 − e −β (T −t ) rt e −β (T −t )



p !
4β rt x e −β (T −t )
× I2αβ /σ 2 −1
,
σ 2 1 − e −β (T −t )
of ST given St , x > 0, we find
g(t, St ) = e −r(T −t ) IE∗ [φ (ST ) | Ft ]
2β e −r(T −t ) w∞ 
x
αβ /σ 2 −1/2 β (x+S e −β (T −t ) )
−2 2 t −β (T −t )
= 2 φ (x ) e σ (1− e )
σ 1 − e −β (T −t ) 0 St e −β (T −t )


p !
4β xSt e −β (T −t )
× I2αβ /σ 2 −1
dx
σ 2 1 − e −β (T −t )

0 ⩽ t ⩽ T , under the Feller condition 2αβ ⩾ σ 2 .

Exercise 8.20
a) We have
∂f ∂f
(t, x) = (r − σ 2 /2) f (t, x), (t, x) = σ f (t, x),
∂t ∂x
and
∂2 f
(t, x) = σ 2 f (t, x),
∂ x2
hence
dSt = d f (t, Bt )
∂f ∂f 1 ∂2 f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t  ∂x 2 ∂ x2
1 1
= r − σ 2 f (t, Bt )dt + σ f (t, Bt )dBt + σ 2 f (t, Bt )dt
2 2
= r f (t, Bt )dt + σ f (t, Bt )dBt
= rSt dt + σ St dBt .
b) We have
IE e σ BT Ft = IE e (BT −Bt +Bt )σ Ft
  

= e σ Bt IE e (BT −Bt )σ Ft
 

= e σ Bt IE e (BT −Bt )σ
 
2 (T −t ) /2
= e σ Bt +σ .
c) We have
2
IE[ST | Ft ] = IE e σ BT +rT −σ T /2 Ft
 
2
= e rT −σ T /2 IE e σ BT Ft
 
2 T /2 2 (T −t ) /2
= e rT −σ e σ Bt +σ
2 t/2
= e rT +σ Bt −σ
2 t/2
= e (T −t )r+σ Bt +rt−σ
= e (T −t )r St , 0 ⩽ t ⩽ T.

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 464 Exercise Solutions

d) We have
Vt = e −(T −t )r IE[C | Ft ]
= e −(T −t )r IE[ST − K | Ft ]
= e −(T −t )r IE[ST | Ft ] − e −(T −t )r IE[K | Ft ]
= St − e −(T −t )r K, 0 ⩽ t ⩽ T.
−rT
e) We take ξt = 1 and ηt = −K e /A0 , t ∈ [0, T ].
f) We find
VT = IE[C | FT ] = C.

Exercise 8.21 Binary options. (Exercise 7.11 continued).

a) By definition of the indicator (or step) functions 1[K,∞) and 1[0,K ] we have

 
 1 if x ⩾ K,  1 if x ⩽ K,
1[K,∞) (x) = resp. 1[0,K ] (x) =
0 if x < K, 0 if x > K,
 

which shows the claimed result by the definition of Cb and Pb .

b) We have
πt (Cb ) = e −(T −t )r IE[Cb | Ft ]
= e −(T −t )r IE 1[K,∞) (ST ) St
 

= e −(T −t )r P(ST ⩾ K | St )
= Cb (t, St ).
c) We have πt (Cb ) = Cb (t, St ), where
Cb (t, x) = e −(T −t )r P(ST > K | St = x)
(r − σ 2 /2)(T − t ) + log(St /K )
 
−(T −t )r
= e Φ √
σ T −t
= e −(T −t )r Φ (d− (T − t )) ,
with
(r − σ 2 /2)(T − t ) + log(St /K )
d− (T − t ) = √ .
σ T −t

d) The price of this modified contract with payoff

Cα = 1[K,∞) (ST ) + α 1[0,K ) (ST )

is given by
πt (Cα ) = e −(T −t )r IE 1[K,∞) (ST ) + α 1[0,K ) (ST ) St
 

= e −(T −t )r P(ST ⩾ K | St ) + α e −(T −t )r P(ST ⩽ K | St )

= e −(T −t )r P(ST ⩾ K | St ) + α e −(T −t )r (1 − P(ST ⩾ K | St ))
= α e −(T −t )r e −(T −t )r + (1 − α )P(ST ⩾ K | St )
(T − t )r − (T − t )σ 2 /2 + log(St /K )
 
= α e −(T −t )r + (1 − α ) e −(T −t )r Φ √ .
σ T −t

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MH4514 Financial Mathematics 465

1.2
1
0.8
0.6
0.4
0.2
0

15

10 200
150
5 100
Time to maturity T-t 50
0 Underlying (HK$)
0

Figure S.37: Price of a binary call option.

e) We note that

1[K,∞) (ST ) + 1[0,K ] (ST ) = 1[0,∞) (ST ),

almost surely since P(ST = K ) = 0, hence

πt (Cb ) + πt (Pb ) = e −(T −t )r IE[Cb | Ft ] + e −(T −t )r IE[Pb | Ft ]
= e −(T −t )r IE[Cb + Pb | Ft ]
e −(T −t )r IE 1[K,∞) (ST ) + 1[0,K ] (ST ) Ft
 
=
e −(T −t )r IE 1[0,∞) (ST ) Ft
 
=
= e −(T −t )r IE[1 | Ft ]
= e −(T −t )r , 0 ⩽ t ⩽ T.
f) We have
πt (Pb ) = e −(T −t )r − πt (Cb )
(T − t )r − (T − t )σ 2 /2 + log(x/K )
 
= e −(T −t )r − e −(T −t )r Φ √
σ T −t
= e −(T −t )r (1 − Φ(d− (T − t )))
= e −(T −t )r Φ(−d− (T − t )).
g) We have
∂Cb
ξt = (t, St )
∂x
(T − t )r − (T − t )σ 2 /2 + log(x/K )
 
−(T −t )r ∂
= e Φ √
∂x σ T −t x=St
1 2
= e −(T −t )r p e −(d− (T −t )) /2
σ St 2(T − t )π
> 0.
The Black-Scholes hedging strategy of such a call option does not involve short selling
because ξt > 0 at all times t, cf. Figure S.38 which represents the risky investment in the
hedging portfolio of a binary call option.

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 466 Exercise Solutions

Figure S.38: Risky hedging portfolio value for a binary call option.

Figure S.39 presents the risk-free hedging portfolio value for a binary call option.

Figure S.39: Risk-free hedging portfolio value for a binary call option.

h) Here, we have
∂ Pb
ξt = (t, St )
∂x
(T − t )r − (T − t )σ 2 /2 + log(x/K )
 
−(T −t )r ∂
= e Φ − √
∂x σ T −t x=St
1 2
= − e −(T −t )r p e −(d− (T −t )) /2
σ 2(T − t )πSt
< 0.
The Black-Scholes hedging strategy of such a put option does involve short selling because
ξt < 0 for all t.

Exercise 8.22 Applying Itô’s formula to e −rt φ (St ))t∈R+ and using the fact that the expectation of
the stochastic integral with respect to (Bt )t∈R+ is zero, cf. Relation (5.4.5), we have

C (x, T ) = IE e −rT φ (ST ) S0 = x

 
(S.40)
 wT wT
= IE φ (x) − r e −rt φ (St )dt + r e −rt St φ ′ (St )dt
0 0

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MH4514 Financial Mathematics 467
wT 1 w T −rt ′′

−rt ′ 2
+σ e St φ (St )dBt + e φ (St )σ (St )dt S0 = x
0 2 0
w  w 
T T
−rs −rt ′
= φ (x) − r IE e φ (St )dt S0 = x + r IE e St φ (St )dt S0 = x
0 0
w 
1 T
−rt ′′ 2
+ IE e φ (St )σ (St )dt S0 = x
2 0
wT wT
r e −rt IE φ (St ) S0 = x dt + r e −rt IE St φ ′ (St ) S0 = x dt
   
= φ (x ) −
0 0
1 w T −rt  ′′ 2

+ e IE φ (St )σ (St ) S0 = x dt,
2 0
hence, by differentiation with respect to T we find
∂
e −rT IE[φ (ST ) | S0 = x]


ThetaT =
∂T
= −r e −rT IE φ (ST ) S0 = x + r e −rT IE ST φ ′ (ST ) S0 = x
   

1
+ e −rT IE φ ′′ (ST )σ 2 (ST ) S0 = x .
 
2

Problem 8.23 Chooser options.

a) We take conditional expectations in the equality

(ST − K )+ − (K − ST )+ = ST − K
to find
C (t, St , K, T ) − P(t, St , K, T )
= e −(T −t )r IE∗ [(ST − K )+ | Ft ] − e −(T −t )r IE∗ [(K − ST )+ | Ft ]
= e −(T −t )r IE∗ [ST − K | Ft ]
= e −(T −t )r IE∗ [ST | Ft ] − K e −(T −t )r
= St − K e −(T −t )r , 0 ⩽ t ⩽ T.
b) The price this contract at time t ∈ [0, T ] can be written as
e −(T −t )r IE∗ [P(T , ST , K,U ) | Ft ]
h i
= e −(T −t )r IE∗ e −(U−T )r IE∗ (K − SU )+ | FT | Ft
 

= e −(U−t )r IE∗ (K − SU )+ | Ft
 

= P(t, St , K,U ).
c) From the call-put parity (8.5.22) the payoff of this contract can be written as
Max(P(T , ST , K,U ),C (T , ST , K,U ))
= Max(P(T , ST , K,U ), P(T , ST , K,U ) + ST − K e −(U−T )r )
= P(T , ST , K,U ) + Max(ST − K e −(U−T )r , 0).
d) The contract of Question (c)) is priced at any time t ∈ [0, T ] as
e −(T −t )r IE∗ [Max(P(T , ST , K,U ),C (T , ST , K,U )) | Ft ]
= e −(T −t )r IE∗ [P(T , ST , K,U ) | Ft ]
h i
+ e −(T −t )r IE∗ Max(ST − K e −(U−T )r , 0) | Ft
= e −(T −t )r IE∗ [ e −(U−T )r IE∗ [(K − SU )+ | FT ] | Ft ]
+ e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft



= e −(U−t )r IE∗ [(K − SU )+ | Ft ]

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 468 Exercise Solutions

+ e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft




= P(t, St , K,U ) + C t, St , K e −(U−T )r , T .

(S.41)

100
90
80
70
60
50
40
30
20
10
8
6 120 140
4 80 100
Time to maturity T-t 2 40 60
0 0 20
Underlying
Figure S.40: Black-Scholes price of the maximum chooser option.

e) By (S.41) and Relation (7.1.3) in Proposition 7.1 we have

∂C
∂P
ξt = t, St , K e −(U−T )r , T + (t, St , K,U )
∂x ∂x !
log( e (U−T )r St /K ) + (r + σ 2 /2)(T − t )
= Φ √
σ T −t
log(St /K ) + (r + σ 2 /2)(U − t )
 
−Φ − √
σ U −t
log(St /K ) + (U − t )r + (T − t )σ 2 /2
 
= Φ √
σ T −t
log(St /K ) + (r + σ 2 /2)(U − t )
 
−Φ − √ .
σ U −t

0.5

-0.5

-1

2.5
2
1.5 140
Time to maturity T-t 1 120
100
0.5 80
0 60
40 Underlying

Figure S.41: Delta of the maximum chooser option.

f) From the call-put parity (8.5.22) the payoff of this contract can be written as
min(P(T , ST , K,U ),C (T , ST , K,U ))
= min C (T , ST , K,U ) − ST + K e −(U−T )r ,C (T , ST , K,U )

= C (T , ST , K,U ) + min(−ST + K e −(U−T )r , 0)

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 469

= C (T , ST , K,U ) − Max(ST − K e −(U−T )r , 0).

g) The contract of Question (f)) is priced at any time t ∈ [0, T ] as

e −(T −t )r IE∗ min P(T , ST , K,U ),C (T , ST , K,U ) Ft




= e −(T −t )r IE∗ [C (T , ST , K,U ) | Ft ]

− e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft



= e −(T −t )r IE∗ [ e −(U−T )r IE∗ [(SU − K )+ | FT ] | Ft ]

− e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft



= e −(U−t )r IE∗ (SU − K )+ | Ft

 

− e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft




= C (t, St , K,U ) −C t, St , K e −(U−T )r , T .

(S.42)

8
7
6
5
4
3
2
1
0

8
6
4 140
Time to maturity T-t 120
100
2 80
60
40
0 20
0 Underlying

Figure S.42: Black-Scholes price of the minimum chooser option.

h) By (S.42) and Relation (7.1.3) in Proposition 7.1 we have

∂C ∂C
t, St , K e −(U−T )r , T


ξt = (t, St , K,U ) −
∂x ∂x
log(St /K ) + (r + σ 2 /2)(U − t )
 
= Φ √
σ U −t
!
log( e (U−T )r St /K ) + (r + σ 2 /2)(T − t )
−Φ √
σ T −t
log(St /K ) + (r + σ 2 /2)(U − t )
 
= Φ √
σ U −t
log(St /K ) + (U − t )r + (T − t )σ 2 /2
 
−Φ √ .
σ T −t

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 470 Exercise Solutions

0.6
0.4
0.2
0
-0.2
-0.4

8
6
140
4 120
Time to maturity T-t 100
2 80
60
40
0 20 Underlying
0

Figure S.43: Delta of the minimum chooser option.

i) Such a contract is priced as the sum of a European call and a European put option with
maturity U, and is priced at time t ∈ [0, T ] as P(t, St , K,U ) + C (t, St , K,U ). Its hedging
strategy is the sum
 of the hedging strategies of Questions (e)) and (h)), i.e.
log(St /K ) + (r + σ 2 /2)(U − t )

ξt = Φ √
σ T −t
log(St /K ) + (r + σ 2 /2)(U − t )
 
−Φ − √
σ T −t
log(St /K ) + (r + σ 2 /2)(U − t )
 
= 2Φ √ − 1.
σ T −t
j) When U = T , the contracts of Questions (c)), (f)) and (i)) have the respective payoffs
• Max((ST − K )+ , (K − ST )+ ) = |ST − K|,

• min((ST − K )+ , (K − ST )+ ) = 0, and

• (ST − K )+ + (K − ST )+ = |ST − K|,

where |ST − K| is known as the payoff of a straddle option.

Problem 8.24
a) The self-financing condition reads
dVt = ηt dAt + ξt dSt
= rηt At dt + µξt St dt + σ ξt St dBt
= rVt dt + ( µ − r )ξt St dt + σ ξt St dBt ,
hence wT wT
VT = V0 + (rVt + ( µ − r )ξt St )dt + σ ξt St dBt
0 0
wT wT
= Vt + (rVs + ( µ − r )ξs Ss )ds + σ ξs Ss dBs .
t t
b) The portfolio value Vt rewrites as
wT µ −r
 wT
Vt = VT − rVs + πs ds − πs dBs
t σ t
wT wT
= VT − r Vs ds − πs d Bbs .
t t
c) We have wT wT
Vt = VT − r Vs ds − πs d Bbs ,
t t

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 471

hence
dVt = rVt dt + πt d Bbt ,
and after discounting we find
dVet = −r e −rt Vt dt + e −rt dVt
= −r e −rt Vt dt + e −rt (rVt dt + πt d Bbt )
= e −rt πt d Bbt ,
which shows that wT
VeT = V0 + e −rt πt d Bbt ,
0
after integration in t ∈ [0, T ].
d) We have
dVt = du(t, St )
∂u ∂u ∂u
= (t, St )dt + µSt (t, St )dt + σ St (t, St )dBt
∂t ∂x ∂x
1 2 2 ∂ 2u
+ σ St 2 (t, St )dt. (S.43)
2 ∂x
e) By matching the Itô formula (S.43) term by term to the BSDE (8.5.25) we find that Vt =
u(t, St ) satisfies the PDE

1 2 2 ∂ 2u
 
∂u ∂u ∂u
(t, x) + µ (t, x) + σ x (t, x) + f t, x, u(t, x), σ x (t, x) = 0.
∂t ∂x 2 ∂ x2 ∂x
f) In this case we have
∂u ∂u 1 ∂ 2u ∂u
(t, x) + µx (t, x) + σ 2 x2 2 (t, x) − ru(t, x) − ( µ − r )x (t, x) = 0,
∂t ∂x 2 ∂x ∂x
which recovers the Black-Scholes PDE
∂u ∂u 1 ∂ 2u
ru(t, x) = (t, x) + rx (t, x) + σ 2 x2 2 (t, x).
∂t ∂x 2 ∂x
g) In the Black-Scholes model the Delta of the European call option is given by
(r + σ 2 /2)(T − t ) + log(St /K )
 
ξt = Φ √ ,
σ T −t
hence
(r + σ 2 /2)(T − t ) + log(St /K )
 
πt = σ ξt St = σ St Φ √ , 0 ⩽ t ⩽ T.
σ T −t
h) Replacing the self-financing condition with
dVt = ηt dAt + ξt dSt − γSt (ξt )− dt
= rηt At dt + µξt St dt + σ ξt St dBt − γSt (ξt )− dt
= rVt dt + ( µ − r )ξt St dt − γSt (ξt )− dt + σ ξt St dBt ,
we get the BSDE w wT
T
rVs + ( µ − r )πs + γ (πs )− ds −


Vt = VT − πs dBs .
t t
i) In this case we have
µ −r
f (t, x, u, z) = −ru − z − γz−
σ
and the BSDE reads

dVt = ru(t, St )dt + ( µ − r )ξt St dt − γSt (ξt )− dt + σ ξt St dBt .

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 472 Exercise Solutions

j) We find the nonlinear PDE

−
∂ 2u

∂u ∂u 1 ∂u
(t, x) + rx (t, x) + σ 2 x2 2 (t, x) − γσ x (t, x) = ru(t, x), (S.44)
∂t ∂x 2 ∂x ∂x

with the terminal condition u(T , x) = g(x).

k) The self-financing condition reads
dVt = r1{ηt >0} At ηt dt + R1{ηt <0} At ηt dt + ξt dSt
= rAt ηt dt + (R − r )1{ηt <0} At ηt dt + ξt dSt
= rVt dt − rSt ξt dt − (R − r )(ηt At )− dt + ξt dSt
= rVt dt + ( µ − r )St ξt dt − (R − r )(Vt − ξt St )− dt + σ ξt St dBt ,
which yields the BSDE
wT wT
rVs + ( µ − r )πs − (R − r )(Vs − ξs Ss )− ds −


Vt = VT − πs dBs ,
t t
hence we have
(µ − r)  z −
f (t, x, u, z) = −ru − z + (R − r ) u −
σ σ
and the nonlinear PDE
1 2 2 ∂ 2u
 
∂u ∂u ∂u
(t, x) + µ (t, x) + σ x (t, x) + f t, x, u(t, x), σ x (t, x) = 0
∂t ∂x 2 ∂ x2 ∂x

rewrites as
−
1 2 2 ∂ 2u

∂u ∂u ∂u
(t, x) + r (t, x) + σ x (t, x) = ru(t, x) + (r − R) u(t, x) − x (t, x) .
∂t ∂x 2 ∂ x2 ∂x

l) The sum of profits and losses of the portfolio (ξt , ηt )t∈R+ is

wT wT wT wT
V0 + ηt dAt + ξt dSt = V0 + dVt + dUt
0 0 0 0
= VT + UT −U0
> VT = C,
hence the corresponding portfolio strategy superhedging the claim payoff VT = C.

Exercise 8.25 Girsanov Theorem. For all n ⩾ 1, let

:= 1{ψt ∈[−n,n]} ψt ,
(n)
ψt 0 ⩽ t ⩽ T.

(n)
Since (ψt )t∈[0,T ] is a bounded process it satisfies the Novikov integrability condition (8.3.1),
hence for all n ⩾ 1 and random variable F ∈ L1 (Ω) we have
  w·   w
T (n) 1 w T (n) 2

(n)
IE[F ] = IE F B· + ψs ds exp − ψs dBs − (ψs ) ds ,
0 0 2 0

which yields
  w·   w
T (n) 1 w T (n) 2

(n)
IE[F ] = lim IE F B· + ψs ds exp − ψs dBs − (ψs ) ds
n→∞ 0 0 2 0
  w·   w
T (n) 1 w T (n) 2

(n)
⩾ IE lim inf F B· + ψs ds exp − ψs dBs − (ψs ) ds
n→∞ 0 0 2 0
  w·   w
T 1wT

= IE F B· + ψs ds exp − ψs dBs − (ψs )2 ds ,
0 0 2 0

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MH4514 Financial Mathematics 473

where we applied Fatou’s Lemma 11.9.*

Problem 8.26
a) We have
Cov(dSt /St , dMt /Mt )
Var[dMt /Mt ]
Cov((r + α )dt + β (dMt /Mt − rdt ) + σS dWt , µdt + σM dBt )
=
Var[ µdt + σM dBt ]


Cov (r + α )dt + β ( µdt + σM dBt − rdt ) + σS dWt , µdt + σM dBt
=
Var[ µdt + σM dBt ]


Cov β σM dBt + σS dWt , σM dBt
=
Var[σM dBt ]



Cov β σM dBt , σM dBt + Cov σS dWt , σM dBt
=
Var[σM dBt ]


Cov β σM dBt , σM dBt
=
Var[σM dBt ]


Cov σM dBt , σM dBt
= β
Var[σM dBt ]
= β.
b) We have  
dMt
dSt = (r + α )St dt + β − r St dt + σS St dWt
Mt
= (r + α )St dt + β St ( µdt + σM dBt − rdt ) + σS St dWt


= (r + α + β ( µ − r ))St dt + St β σM dBt + σS dWt
β σM dBt + σS dWt
q
= (r + α + β ( µ − r ))St dt + St β 2 σM2 + σS2 q .
2 + σ2
β 2 σM S
Now, we
 have 2
2
2
β σ dB + σ dW β σM dBt + β σM σS dBt • dWt + σS dWt
 qM t S t
= 2 + σ2
β 2 σM
2
β 2 σM + σS 2 S

β 2 σM
2 (dB )2 + σ 2 (dW )2
t S t
= 2 + σ2
β 2 σM S
β 2 σM2 dt + σ 2 dt
S
= 2 + σ2
β 2 σM S
= dt.
By the characterization of Brownian motion as the only continuous martingale whose
quadratic variation is dt, it follows that the process (Zt )t∈R+ defined by
β σM dBt + σS dWt
dZt = q
2 + σ2
β 2 σM S

is a standard Brownian motion, see e.g. Theorem 7.36 page 203 of Klebaner, 2005. Hence,
we have

dSt = (r + α + β ( µ − r ))St dt + St β σM dBt + σS dWt
* IE[limn→∞ Fn ] ⩽ limn→∞ IE[Fn ] for any sequence (Fn )n∈N of nonnegative random variables, provided that the limits
exist, see MH4100 Real Analysis II.

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 474 Exercise Solutions
q
= (r + α + β ( µ − r ))St dt + St β 2 σM2 + σS2 dZt .
In what follows we assume that β is allowed to depend locally on the state of the benchmark
market index on Mt , as β (Mt ), t ∈ R+ .
c) We take
µ −r
dBt∗ = dBt + dt (S.45)
σM
and
α
dWt∗ = dWt + dt (S.46)
σS
in order to have

dMt

 = µdt + σM dBt = rdt + σM dBt∗ ,
M

t





  
dSt dMt (S.47)
= (r + α )dt + β (Mt ) × − rdt + σS dWt
St Mt



= (r + α )dt + σM β (Mt )dBt∗ + σS dWt




= rdt + σM β (Mt )dBt∗ + σS dWt∗ .



d) By the Girsanov theorem, (Bt∗ )t∈[0,T ] is a standard Brownian motion under the probability
measure P∗B defined by its Radon-Nikodym density

dP∗B µ −r ( µ − r )2
 
= exp − BT − 2
T ,
dP σM 2σM

and (Wt∗ )t∈[0,T ] is a standard Brownian motion under the probability measure PW
∗ defined

by its Radon-Nikodym density

∗ α2
 
dPW α
= exp − WT − 2 T .
dP σS 2σS

We conclude that (Bt∗ )t∈[0,T ] and (Wt∗ )t∈[0,T ] are independent standard Brownian motions
under the probability measure P∗ defined by its Radon-Nikodym density

dP∗ dP∗B dPW ∗ µ −r ( µ − r )2 α2

 
α
= × = exp − BT − WT − 2
T − 2T .
dP dP dP σM σS 2σM 2σS

Indeed, for any sequence t0 = 0 < t1 < · · · < tn−1 < tn = T we have
 ∗ 
∗
 ∗ ∗ ∗ ∗

 dP ∗ ∗ ∗ ∗


IE f Bt1 − Bt0 , . . . , Btn − Btn−1 = IE f Bt1 − Bt0 , . . . , Btn − Btn−1
dP
= IE f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1


µ −r ( µ − r )2 α2
 
α
× exp − BT − 2
T − WT − 2 T
σM 2σM σS 2σS
µ −r ( µ − r )2
  
∗ ∗ ∗ ∗


= IE f Bt1 − Bt0 , . . . , Btn − Btn−1 exp − BT − 2
T
σM 2σM
α2
  
α
× IE exp − WT − 2 T
σS 2σS

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MH4514 Financial Mathematics 475

µ −r ( µ − r )2
  
∗ ∗ ∗ ∗


= IE f Bt1 − Bt0 , . . . , Btn − Btn−1 exp − BT − 2
T
σM 2σM


= IE f Bt1 − Bt0 , . . . , Btn − Btn−1 ,

and similarly for (Wt∗ )t∈[0,T ] .

e) By (S.47), the discounted price processes

(Set )t∈R+ := ( e −rt St )t∈R+ and et )t∈R+ := ( e −rt Mt )t∈R+

(M

satisfy
et dBt∗ ,

et = σM M
 dM

d Set = σM β (Mt )Set dBt∗ + σS Set dWt∗ ,



hence
by the Girsanov theorem of Question (d)) the discounted two-dimensional process
Set , M
et
t∈R+
is a martingale under the probability measure P∗ , showing that P∗ is a risk-
neutral probability measure. Therefore, by Theorem 6.8 the market made of St and Mt is
without arbitrage opportunities due to the existence of a risk-neutral probability measure P∗ .
f) The self-financing condition for the portfolio strategy (ξt , ζt , ηt )t∈[0,T ] reads

ηt +dt At +dt + ξt +dt St +dt + ζt +dt Mt +dt , = ηt At +dt + ξt St +dt + ζt Mt +dt

which yields
At +dt dηt + St +dt dξt + Mt +dt ζt = 0,
i.e.
dAt • dηt + dSt • dξt + dMt • dζt + At dηt + St dξt + Mt dζt = 0,
hence
dVt = ηt dAt + ξt dSt + ζt dMt
+At dηt + dηt • dAt + St dξt + dξt • dSt + Mt dζt + dζt • dMt
= ηt dAt + ξt dSt + ζt dMt
= 0.
g) By the self-financing condition we have

dVt = d f (t, St , Mt )
= ξt dSt + ζt dMt + ηt dAt
= ξt (rSt dt + σM β (Mt )St dBt∗ + σS St dWt∗ ) + ζt (rMt dt + σM Mt dBt∗ ) + rηt At dt
= rξt St dt + σM β (Mt )ξt St dBt∗ + σS ξt St dWt∗ + rζt Mt dt + σM ζt Mt dBt∗ + rηt At dt
= rξt St dt + rηt At dt + σS ξt St dWt∗ + rζt Mt dt + (σM β (Mt )ξt St + σM ζt Mt )dBt∗
= rVt dt + σS ξt St dWt∗ + (σM β (Mt )ξt St + σM ζt Mt )dBt∗ . (S.48)

On the other hand, by the Itô formula for two state variables, we have

∂f ∂f 1 ∂2 f
d f (t, St , Mt ) = (t, St , Mt )dt + (t, St , Mt )dSt + (t, St , Mt )(dSt )2
∂t ∂x 2 ∂ x2
∂f 1 ∂2 f 2 ∂2 f
+ (t, St , Mt )dMt + (t, St , M t )( dM t ) + (t, St , Mt )dSt • dMt
∂y 2 ∂ y2 ∂ x∂ y
∂f ∂f
= (t, St , Mt )dt + (t, St , Mt )(rSt dt + σM β (Mt )St dBt∗ + σS St dWt∗ )
∂t ∂x
1 ∂2 f
+ (t, St , Mt )(σM2 β 2 (Mt )St2 + σS2 St2 )dt
2 ∂ x2

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 476 Exercise Solutions

∂f 1 ∂2 f
+ (t, St , Mt )(rMt dt + σM Mt dBt∗ ) + (t, St , Mt )σM2 Mt2 dt
∂y 2 ∂ y2
∂2 f
+ σM2 St Mt β (Mt ) (t, St , Mt )dt
∂ x∂ y
∂f ∂f ∂f
= (t, St , Mt )dt + rSt (t, St , Mt )dt + σM β (Mt )St (t, St , Mt )dBt∗
∂t ∂x ∂x
∂f 1 ∂ 2f
+ σS St (t, St , Mt )dWt∗ + (t, St , Mt )(σM2 β 2 (Mt )St2 dt + σS2 St2 dt )
∂x 2 ∂ x2
∂f ∂f
+ rMt (t, St , Mt )dt + σM Mt (t, St , Mt )dBt∗
∂y ∂y
1 ∂2 f 2 2 2 ∂2 f
+ ( t, St , Mt ) σ M
M t dt + σ S M
M t t β ( Mt ) (t, St , Mt )dt
2 ∂ y2 ∂ x∂ y
∂f ∂f ∂f
= (t, St , Mt )dt + rMt (t, St , Mt )dt + rSt (t, St , Mt )dt
∂t ∂y ∂x
1 ∂ f2 1 ∂2 f
+ σM2 Mt2 2 (t, St , Mt )dt + σM2 β 2 (Mt )St2 2 (t, St , Mt )dt
2 ∂y 2 ∂x
1 2
∂ f ∂2 f
+ σS2 St2 2 (t, St , Mt )dt ) + σM2 St Mt β (Mt ) (t, St , Mt )dt
2 ∂x ∂ x∂ y
 
∂f ∂f
+ σM β (Mt )St (t, St , Mt ) + σM Mt (t, St , Mt ) dBt∗ (S.49)
∂x ∂y
∂f
+ σS St (t, St , Mt )dWt∗ .
∂x
By identification of the terms in dt in (S.48) and (S.49), we find

∂f ∂f
r f (t, St , Mt ) =(t, St , Mt ) + rSt (t, St , Mt )
∂t ∂x
1 2
∂ f
+ (σS2 + σM2 β 2 (Mt ))St2 2 (t, St , Mt )
2 ∂x
∂f 1 2 2∂2 f ∂2 f
+ rMt (t, St , Mt ) + σM Mt 2 (t, St , Mt ) + σM2 St Mt β (Mt ) (t, St , Mt )dt,
∂y 2 ∂y ∂ x∂ y
which yields the PDE
r f (t, x, y) (S.50)
∂f ∂f 1 ∂2 f
= (t, x, y) + rx (t, x, y) + x2 (σS2 + σM2 β 2 (y)) 2 (t, x, y)
∂t ∂x 2 ∂x
∂f 1 2 2∂2 f 2 ∂2 f
+ry (t, x, y) + σM y (t, x, y ) + σM xyβ ( y ) (t, x, y),
∂y 2 ∂ y2 ∂ x∂ y
with the terminal condition

f (T , x, y) = h(x, y), x, y > 0.

h) By identification of terms in dBt∗ and dWt∗ in (S.48) and (S.49), we find

∂f
ξt = (t, St , Mt )
∂x
and
∂f ∂f
σM β (Mt )St (t, St , Mt ) + σM Mt (t, St , Mt ) = σM β (Mt )ξt St + σM ζt Mt ,
∂x ∂y

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 477

hence
∂f
ζt = (t, St , Mt ),
∂y
and by the relation Vt = ξt St + ζt Mt + ηt At we find
Vt − ξt St − ζt Mt
ηt =
At
∂f ∂f
f (t, St , Mt ) − St (t, St , Mt ) − Mt (t, St , Mt )
∂x ∂y
= , 0 ⩽ t ⩽ T.
A0 e rt
i) When the option payoff depends only on ST we can look for a solution of (S.50) of the form
f (t, x), in which case (S.50) simplifies to

∂f ∂f 1 ∂2 f
r f (t, x, y) = (t, x, y) + rx (t, x, y) + x2 (σS2 + σM2 β 2 (y)) 2 (t, x, y), (S.51)
∂t ∂x 2 ∂x
When β (Mt ) = β is a constant, (S.51) becomes the Black-Scholes PDE with squared volatil-
ity parameter
σ 2 := σS2 + σM
2 2
β .
When the option is the European call option with strike price K on ST , its solution is given
by the Black-Scholes function

f (t, x) = Bl(x, K, σ , r, T − t )
= xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

with
log(x/K ) + (r + (σS2 + σM
2 β 2 ) /2)(T − t )
d+ (T − t ) : = √ ,
|σ | T − t

2 β 2 ) /2)(T − t )
log(x/K ) + (r − (σS2 + σM
d− (T − t ) := √ ,
|σ | T − t

and
∂f
(t, St , Mt ) = Φ d+ (T − t ) ,


ξt =
∂x
with
K −(T −t )r K
Φ d− (T − t ) = − e −Tr Φ d− (T − t ) ,



ηt = − e 0 ⩽ t < T.
At A0
j) Similarly to Question (i)), when the option is the European put option with strike price K on
ST , its solution is given by the Black-Scholes put price function

f (t, x) = K e −(T −t )r Φ − d− (T − t ) − xΦ − d+ (T − t ) ,

with
∂f

ζt = (t, St , Mt ) = −Φ − d+ (T − t ) , 0 ⩽ t < T.
∂y

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 478 Exercise Solutions

and
K −Tr
e Φ − d− (T − t ) ,


ηt = 0 ⩽ t < T.
A0
Remark. By the answer to Question (b)) we have
q
dSt = (r + α + β ( µ − r ))St dt + St 2 + σ 2 dZ
β 2 σM S t

where (Zt )t∈R+ is a standard Brownian motion, hence the answers to Questions (i)) and j)
can be recovered from the pricing relation

f (t, St ) = e −(T −t )r IE∗ φ (ST ) | Ft ],


0 ⩽ t ⩽ T.

Problem 8.27
1) a) It suffices to let τn := T , n ⩾ 1. Then, the sequence (τn )n⩾1 clearly satisfies Condi-
tions (v) − (vi), and the process (Mτn ∧t )t∈[0,T ] = (Mt )t∈[0,T ] is a (true) martingale under
P.
b) Applying
i) the local martingale property to a suitable sequence (τn )n⩾1 of stopping times, and
ii) Fatou’s Lemma 11.9 to the non-negative sequence (Mτn ∧t )n⩾1 ,
we have
IE[Mt | Fs ] = IE lim Mτn ∧t Fs
 
n→∞
⩽ lim inf IE[Mτn ∧t | Fs ]
n→∞
= lim inf Mτn ∧s
n→∞
= lim Mτn ∧s
n→∞
= Ms , 0 ⩽ s ⩽ t ⩽ T,
which shows that (Mt )t∈[0,T ] is a supermartingale.
c) Since (Mt )t∈[0,T ] is a supermartingale by Question (b)), for any t ∈ [0, T ] we have
IE[MT | Ft ] − Mt ⩽ 0 a.s., and there exists t ∈ [0, T ] such that IE[IE[MT | Ft ] − Mt ] < 0,
otherwise we would have IE[MT | Ft ] − Mt = 0 a.s. for all t ∈ [0, T ], and (Mt )t∈[0,T ]
would be a martingale by the tower property.* Therefore, using again the tower property,
we find

IE[MT − M0 ] = IE[IE[MT | Ft ] − M0 ] ⩽ IE[IE[MT | Ft ] − Mt ] < 0.

d) We have
C (0, M0 ) − P(0, M0 ) = e −rT IE[( e rT MT − K )+ − (K − e rT MT )+ ]
= IE[(MT − e −rT K )+ − ( e −rT K − MT )+ ]
= IE[MT − e −rT K ]
< IE[M0 ] − e −rT K,
showing that the call-put parity relation C (0, M0 ) − P(0, M0 ) = IE[M0 ] − e −rT K is not
satisfied.
2) a) The√stochastic differential equation can be rewritten as dSt = σ (t, St )dBt where σ (t, x) =
x/ T − t, t ∈ [0, T − ε ], satisfies the global Lipschitz condition

x−y |x − y|
|σ (t, x) − σ (t, y)| = √ ⩽ , x, y ∈ R.
T −t T −ε
* If Mt = IE[MT | Ft ] for all t ∈ [0,t ] then Ms = IE[MT | Fs ] = IE[IE[MT | Ft ] | Fs ] = IE[MT | Fs ], 0 ⩽ s ⩽ t ⩽ T .

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 479

Hence by e.g. Theorem V-7 in Protter, 2004 this stochastic differential equation admits
unique (strong) solution such that

wt S
s
St = S0 + dBs , 0 ⩽ t ⩽ T − ε.
0 T −s

Next, we have w
1 w t ds

dBst
St = S0 exp √ −
0 T −s 2 0 T −s
w 
t dBs 1 T
= S0 exp √ − log
0 T −s 2 T −t
r w 
t t dBs
= S0 1 − exp √ , 0 ⩽ t ⩽ T − ε.
T 0 T −s
b) We have ST = 0, as can be checked from the graphs of Question (d ) below.
c) Consider the stopping times

  
1
τn := 1− T ∧ inf{t ∈ [0, T ] : |St | ⩾ n}, n ⩾ 1.
n

for all n ⩾ 1 the stopped process (Sτn ∧t )t∈[0,T ] is given by

w τn ∧t S wt S
Sτn ∧t = S0 + √ u dBu = S0 + 1[0,τn ] (u) √ u dBu ,
0 T −u 0 T −u

√
0 ⩽ t ⩽ T , and the process (1[0,τn ] (u)Su / T − u)0⩽u⩽τn ∧t is square integrable as

w w
Su2 n2
 
T (1−1/n)T
IE 1[0,τn ] (u) du ⩽ IE 1[0,τn ] (u) du ,
0 T −u 0 T −u

hence by Proposition 8.1 the stopped process (Sτn ∧t )t∈[0,T ] is a (true) martingale under
P for all n ⩾ 1, and therefore (St )t∈[0,T ] is a local martingale on [0, T ]. Finally, we note
that since 0 = IE[ST ] ̸= S0 , the process (St )t∈[0,T ] is not a martingale.
√
d) The following code solves the stochastic differential equation dSt = St dBt / 1 − t by
the Euler scheme.

N=10000; t <- 0:N; dt <- 1.0/N;

dB <- rnorm(N,mean=0,sd=sqrt(dt));S <- rep(0,N+1);S[1]=1.0
for (k in 2:(N-1)){S[k]=S[k-1]+S[k-1]*dB[k]/sqrt(1-k*dt)}
plot(t*dt, S, xlab = "t", ylab = "", type = "l", ylim = c(0,1.05*max(S)), col = "blue", xaxs =
"i", yaxs = "i",cex.axis=1.6,cex.lab=1.8)

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 480 Exercise Solutions

7
6
5
4
3
2
1
0

0.0 0.2 0.4 0.6 0.8 1.0

t
√
Figure S.44: Sample path of dSt = St dBt / 1 − t.

3) a) The following code solves the stochastic differential equation dSt = St2 dBt by the Euler
scheme.

N=10000; t <- 0:N; dt <- 1.0/N;

dB <- rnorm(N+1,mean=0,sd=sqrt(dt));S <- rep(0,N+1);S[1]=1.0
for (k in 2:(N+1)){S[k]=S[k-1]+S[k-1]^2*dB[k]}
plot(t*dt, S, xlab = "t", ylab = "", type = "l", ylim = c(1.05*min(S),1.05*max(S)), col =
"blue", xaxs = "i", yaxs = "i",cex.axis=1.6,cex.lab=1.8)
6
5
4
3
2
1

0.0 0.2 0.4 0.6 0.8 1.0

t

Figure S.45: Sample path of dSt = St2 dBt .

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 481

3.5
3.0
2.5
2.0
1.5
1.0

0.0 0.2 0.4 0.6 0.8 1.0

t

Figure S.46: Sample path of dSt = St2 dBt .

b) With the change of variable y = 1/x and dy = −dx/x2 , we have

w∞
IE[ST ] = xϕT (x)dx
0
w∞ S0
 
(1/x − 1/S0 )2
 
(1/x + 1/S0 )2

= √ exp − − exp − dx
0 x2 2πT 2T 2T
w∞ S 
(y − 1/S0 )2
 w∞ S 
(y + 1/S0 )2

= √ 0 exp − dy − √ 0 exp − dy
0 2πT 2T 0 2πT 2T
w∞ S0
 2
y w∞ S0
 2
y
= √ exp − dy − √ exp − dy
−1/S0 2πT 2t 1/S0 2πT 2T
w∞ S0
 2
y w∞ S0
 2
y
= √ √ exp − dy − √ √ exp − dy
−1/(S0 T ) 2π 2 1/(S0 T ) 2π 2
√ √
= S0 Φ(1/(S0 T )) − S0 Φ(−1/(S0 T ))
√
= S0 (1 − 2Φ(−1/(S0 T ))).
c) We have
   
1 1
IE[ST ] = 2S0 Φ √ −
S0 T 2
w √ w0 
1/(S0 T ) 2 dx 2 dx
= 2S0 e −x /2 √ − e −x /2 √
−∞ 2π −∞ 2π
w 1/(S0 √T ) 2 dx
= 2S0 e −x /2 √
0 2π
w 1/√T 2 dy
= 2 e −(y/S0 ) /2 √ ,
0 2π
hence by the dominated convergence theorem we have
w 1/√T 2 dy
lim IE[ST ] = lim 2 e −(y/S0 ) /2 √
S0 →∞ S0 →∞ 0 2π
w 1/√T 2 dy
= 2 lim e −(y/S0 ) /2 √
0 S0 →∞ 2π
w 1/√T dy
= 2 1√
0 2π

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 482 Exercise Solutions
r
2
= .
πT
d) With the change of variable y = 1/x and dy = −dx/x2 , we have
w∞
IE[(ST − K )+ ] = (x − K )+ ϕT (x)dx
0
w ∞ x−K  
(1/x − 1/S0 )2
 
(1/x + 1/S0 )2

= S0 √ exp − − exp − dx
K x3 2πT 2T 2T
w 1/K S  
(y − 1/S0 )2
 
(y + 1/S0 )2

0
= √ exp − − exp − dy
0 2πT 2T 2T
w 1/K y  
(y − 1/S0 )2
 
(y + 1/S0 )2

−KS0 √ exp − − exp − dy
0 2πT 2T 2T
w 1/K−1/S0 S 
y2
 w 1/K +1/S0 S 
y2

= √ 0 exp − dy − √ 0 exp − dy
−1/S0 2πT 2T 1/S0 2πT 2T
w 1/K−1/S0 y + 1/S  2
y
0
−KS0 √ exp − dy
−1/S0 2πT 2T
w 1/K +1/S0 y − 1/S  2
y
0
+KS0 √ exp − dy
1/S0 2πT 2T
   
1 1 1
= S0 Φ √ − √ − S0 Φ − √
K T S0 T S T
   0 
1 1 1
−S0 Φ √ + √ + S0 Φ √
K T S0 T S0 T
√ √
   
1 1 1 1
+KS0 T ϕ √ − √ − KS0 T ϕ √ + √
K T S0 T K T S0 T
   
1 1 1
−KΦ √ − √ + KΦ − √
K T S0 T S T
   0 
1 1 1
−KΦ √ + √ + KΦ √
K T S0 T S T
   0 
1 1 1
= S0 Φ √ − √ − S0 Φ − √
K T S0 T S T
   0 
1 1 1
−S0 Φ √ + √ + S0 Φ √
K T S0 T S0 T
√ √
   
1 1 1 1
+KS0 T ϕ √ − √ − KS0 T ϕ √ + √
K T S0 T K T S0 T
   
1 1 1 1
−KΦ √ − √ − KΦ √ + √ +1
K T S0 T K T S0 T
   
1 1 1
= S0 Φ √ − √ − S0 Φ − √
K T S0 T S T
   0 
1 1 1
−S0 Φ √ + √ + S0 Φ √
K T S0 T S0 T
√ √
   
1 1 1 1
+KS0 T ϕ √ − √ − KS0 T ϕ √ + √
K T S0 T K T S0 T
   
1 1 1 1
+KΦ √ − √ − KΦ √ + √ ,
S0 T K T K T S0 T
2 √
where ϕ (z) := e −z / 2π is the standard normal probability density function, see
Relation (2.1.2) in Jacquier, 2017.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 483

e) We have
IE[(ST − K )+ ] ⩽ IE[ST ]
w 1/√T 2 dy
= 2 e −(y/S0 ) /2 √
0 2π
w 1/√T dy
⩽ 2 √
0 2π
r
2
⩽ .
πT

Figure S.47: “Infogrames” stock price curve.

Problem 8.28
a) Relation (8.5.29) can be checked to hold first on the event Aα , and then on its complement
Acα . Taking the Q-expectation on both sides of (8.5.29) yields
     
dP dP
IEQ − α (21Aα − 1) ⩾ IEQ − α (21A − 1) ,
dQ dQ
i.e.
   
dP dP
IEQ (21Aα − 1) − α IEQ [21Aα − 1] ⩾ IEQ (21A − 1) − α IEQ [21A − 1],
dQ dQ
i.e.
2P(Aα ) − 1 − α (2Q(Aα ) − 1) ⩾ 2P(A) − 1 − α (2Q(A) − 1),
which shows that
P(Aα ) − P(A) ⩾ α (Q(Aα ) − Q(A)),
allowing us to show that P(Aα ) − P(A) ⩾ 0 since α ⩾ 0.
b) We check that dQ∗ /dP
w
∗ ⩾ 0 since C ⩾ 0, and

Q∗ (Ω) = dQ∗
Ω
w dQ∗
= dP∗
Ω dP∗
w C
= dP∗
Ω IEP∗ [C ]
 
C
= IEP∗
IEP∗ [C ]

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 484 Exercise Solutions

IEP∗ [C ]
=
IEP∗ [C ]
= 1.
In the next questions we consider a nonnegative contingent claim payoff C ⩾ 0 with maturity
T > 0, priced e −rT IEP∗ [C ] at time 0 under the risk-neutral measure P∗ .

Budget constraint. We assume that no more than a certain fraction β ∈ (0, 1] of the claim
price e −rT IEP∗ [C ] is available to construct the initial hedging portfolio V0 at time 0.

Since a self-financing portfolio process (Vt )t∈R+ started at V0 = β e −rT IEP∗ [C ] may not able
to hedge the claim C when β < 1, we will attempt to maximize the probability P(VT ⩾ C )
of successful hedging.

For this, given A an event we consider the portfolio process (VtA )t∈[0,T ] hedging the claim
C1A , priced V0A = e −rT IEP∗ [C1A ] at time 0, and such that VTA = C1A at maturity T .
c) Using the probability measure Q∗ , we rewrite the condition (8.5.31) as

dQ∗ IEP∗ [C1A ]

 
Q (A) = IEQ∗ [1A ] = IEP∗ 1A ∗ =
∗
⩽ β,
dP IEP∗ [C ]

i.e.
Q∗ (A) ⩽ Q∗ (Aα ) = β .
By the Neyman-Pearson Lemma, for any event A, the inequality Q∗ (A) ⩽ Q∗ (Aα ) = β
implies P(A) ⩽ P(Aα ), which shows that the event A = Aα realizes the maximum under the
required condition.
d) The obvious inequality is

P(Aα ) ⩽ P(C1Aα ⩾ C ) = P VTAα ⩾ C .

In the other direction, we note that the event Bα := {C1Aα ⩾ C} = VTAα ⩾ C satisfies


(8.5.31), as
e −rT IEP∗ VTBα = e −rT IEP∗ C1Bα
   

= e −rT IEP∗ C1{C1Aα ⩾C}

 

= e −rT IEP∗ C1Aα

 

=  β e −rT
 IEP∗ [C ],
where the last equality IEP∗ C1Aα = β IEP∗ [C ] follows from Q∗ (Aα ) = β and the definition
(8.5.30) of Q∗ .

Therefore, by the result of Question (c)) we have

P(C1Aα ⩾ C ) = P VTAα ⩾ C = P(Bα ) ⩽ P(Aα ).

e) This hedging strategy starts from the initial amount

V0Aα = e −rT IEP∗ [C1Aα ] = β e −rT IEP∗ [C ],

and it satisfies
P VTAα ⩾ C = P(C1Aα ⩾ C ) = P(Aα )

which is the maximum hedging probability under the constraint (8.5.31).

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 485

f) We have
2 t/2
St = S0 e σ Bt +rt−σ = S0 e σ Bt = S0 e Bt , t ⩾ 0.
g) We have
P VTAα ⩾ C = P(Aα )


 
dP
= P >α
dQ∗
dQ∗
 
dP
= P >α
dP∗ dP∗
 
dP C
= P >α
dP∗ IEP∗ [C ]
= P (αC < IEP∗ [C ])
= P (ST − K )+ < IEP∗ [C ]/α

= P ST − K < IEP∗ [C ]/α

= P ST < K + IEP∗ [C ]/α

= P S0 e BT < K + IEP∗ [C ]/α

= P (BT < log(K + IEP∗ [C ]/α ))

 
log(K + IEP∗ [C ]/α )
= Φ √ .
T
h) We have
IEP∗ [C ]
α= √ .
exp T Φ P VTAα ⩾ C
−1




−K
i) We have
IEP∗ [C1Aα ] = IEP∗ [(ST − K )+ 1Aα ]
h i
= IEP∗ (ST − K )+ 1{BT <log(K +IEP∗ [C]/α )}
h i
= IEP∗ e BT − K 1{BT <log(K +IEP∗ [C]/α )}

+

w log(K +IEP∗ [C]/α )/√T 2 dx

e x − K e −x /2 √


= √
(log K )/ T 2π
w log(K +IEP∗ [C]/α )/√T 2 dx
= √ e x e −x /2 √
(log K )/ T 2π
w log(K +IEP∗ [C]/α )/√T 2 dx
−K √ e −x /2 √
(log K )/ T 2π
w log(K +IEP∗ [C]/α )/√T 2 dx
= √ e 1/2−(x−1) /2 √
(log K )/ T 2π
−K Φ(log(K + IEP∗ [C ]/α )) − Φ(log K )


w −1/√T +log(K +IEP∗ [C]/α )/√T 2 dx
= √ e 1/2−x /2 √
(−1+log K )/ T 2π
−K Φ(log(K + IEP∗ [C ]/α )) − Φ(log K )

√ −1 + log(K + IEP∗ [C ]/α ) −1 + log K

    
= e Φ √ −Φ √
T T
    
log(K + IEP∗ [C ]/α ) log K
−K Φ √ −Φ √ ,
T T
hence
e −rT IEP∗ [C1Aα ]

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 486 Exercise Solutions

−1 + log(K + IEP∗ [C ]/α ) −1 + log K

    
−rT +1/2
= e Φ √ −Φ √
T T
    
log ( K + I
E [C ] /α ) log K
√P
∗
−K e −rT Φ −Φ √ .
T T
j) i) We have d+ (T ) = 1, d− (T ) =√0, hence by the Black-Scholes formula we find
+
IEP∗ [(ST − K ) ] = eS0 Φ(d+ (T )) − KΦ(d− (T ))
= 1.64872 × 0.84134 − 1/2
= 0.88713,
and
e −rT IEP∗ [(ST − K )+ ] = S0 Φ(d+ (T )) − K e −Tr Φ(d− (T ))
= 0.84134 − 0.60653/2
= 0.53807.
ii) By the result of Question (h)), we have
IEP∗ [C ]
α =
exp Φ−1 P VTAα ⩾ C




−K
0.88714
=
exp (Φ−1 (0.9)) − 1
0.88714
= = 0.34165.
e 1.28 − 1
iii) By the result of Question (i)), we find
e −rT IEP∗ [C1Aα ] = Φ(−1 + log(K + IEP∗ [C ]/α )) − Φ(−1 + log K )

−K e −1/2 Φ(log(K + IEP∗ [C ]/α )) − Φ(log K )

= Φ(−1 + log(1 + IEP∗ [C ]/α )) − Φ(−1)

− e −1/2 Φ(log(1 + IEP∗ [C ]/α )) − Φ(0)

= Φ(−1 + log(1 + 0.88713/0.34165)) − Φ(−1)

− e −1/2 Φ(log(3.596604712)) − Φ(0)

= Φ(0.27999) − Φ(−1)

−0.60653 × Φ(1.279990265) − Φ(0)

= (0.61026 − 0.158655) − 0.60653 × (0.899726 − 0.5)

= 0.20915.
In addition, we find

e −rT IEP∗ [C1Aα ] 0.20915

β= −rT
= = 37.53%.
e IEP [C ]
∗ 0.53807

Problem 8.29
a) When the risk-free rate is r = 0 the two possible returns are (5 − 4)/4 = 25% and (2 −
4)/4 = −50%. Under the risk-neutral probability measure given by P∗ (S1 = 5) = (4 −
2)/(5 − 2) = 2/3 and P∗ (S1 = 2) = (5 − 4)/(5 − 2) = 1/3 the expected return is 2 ×
25%/3 − 50%/3 = 0%. In general, the expected return can be shown to be equal to the
risk-free rate r.
b) The two possible returns become (3 × 5 − 4 − 2 × 4)/4 = 75% and (3 × 2 − 4 − 2 × 4)/4 =
−150%. Under the risk-neutral probability measure given by P∗ (S1 = 5) = (4 − 2)/(5 −
2) = 2/3 and P∗ (S1 = 2) = (5 − 4)/(5 − 2) = 1/3 the expected return is 2 × 75%/3 −
150%/3 = 0%. Similarly to Question (a)), the expected return can be shown to be equal to
the risk-free rate r when r ̸= 0.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 487

c) We decompose the amount Ft invested in one unit of the fund as

Ft = βF − (β − 1)Ft ,
| {z t} | {z }
Purchased/sold Borrowed/saved

meaning that we invest the amount β Ft in the risky asset St , and borrow/save the amount
−(β − 1)Ft from/on the saving account.
d) We have
Ft Ft
Ft = ξt St + ηt At = β St − (β − 1) At , t ⩾ 0,
St At
with ξt = β Ft /St and ηt = −(β − 1)Ft /At , t ⩾ 0.
e) We have
dFt = ξt dSt + ηt dAt
Ft Ft
= β dSt − (β − 1) dAt
St At
Ft
= β dSt − (β − 1)rFt dt (S.52)
St
= β Ft (rdt + σ dBt ) − (β − 1)rFt dt
= rFt dt + β σ Ft dBt , t ⩾ 0.
By (S.52), the return of the fund Ft is β times the return of the risky asset St , up to the cost of
borrowing (β − 1)r per unit of time. By the Discounting Lemma 6.13, the discounted fund
value Fet := e −rt Ft , t ⩾ 0, satisfies the stochastic differential equation

d Fet = β σ Fet dBt ,

hence by Proposition 8.1 it is a martingale.

f) The discounted fund value ( e −rt Ft )t∈R+ is a martingale under the risk-neutral probability
measure P∗ as we have

d ( e −rt Ft ) = β σ e −rt Ft dBt , t ⩾ 0.

g) We have
2 σ 2 t/2
Ft = F0 e β σ Bt +rt−β
and  β
2 2
St = S0 e σ Bt +rt−σ t/2 = F0 e β σ Bt +β rt−β σ t/2 ,
β

hence
2 t/2
Ft = St e −(β −1)rt−β (β −1)σ
β
, t ⩾ 0.
Note that when β = 0 we have Ft = e rt , i.e. in this case the fund Ft coincides with the
money market account.
h) We have

e −(T −t )r IE∗ (FT − K )+ | Ft

 

log(Ft /K ) + (r + β 2 σ 2 /2)(T − t )
 
= Ft Φ √
|β |σ T − t
log(Ft /K ) + (r − β 2 σ 2 /2)(T − t )
 
−(T −t )r
−K e Φ √ ,
|β |σ T − t

t ∈ [0, T ).

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 488 Exercise Solutions

i) We have

log(Ft /K ) + (r + β 2 σ 2 /2)(T − t )
 
Φ √
|β |σ T − t
2
!
log(St e −(β −1)rt−β (β −1)σ t/2 /K ) + (r + β 2 σ 2 /2)(T − t )
β
=Φ √
|β |σ T − t
!
β
log(St /K ) − (β − 1)rt − β (β − 1)σ 2t/2 + (r + β 2 σ 2 /2)(T − t )
=Φ √
|β |σ T − t
2
!
log(St /(K e (β −1)rT −(T /2−t )(β −1)β σ )) + (T − t )β r + (T − t )β σ 2 /2
β
=Φ √
|β |σ T − t
!
log(St /Kβ (t )) + (r + σ 2 /2)(T − t )
=Φ √ , 0 ⩽ t < T,
σ T −t
2
if β > 0, with Kβ (t ) := K 1/β e (β −1)(rT /β −(T /2−t )σ ) .
j) When β  < 0 we find that the Delta of the call option on FT with strike price K is
log(Ft /K ) + (r + β 2 σ 2 /2)(T − t )

Φ √
|β |σ T − t
β
!
log(St /Kβ ) + (T − t )β r + (T − t )β σ 2 /2
= Φ √
|β |σ T − t
!
log(St /Kβ (t )) + (r + σ 2 /2)(T − t )
= Φ − √ , 0 ⩽ t < T,
σ T −t
which coincides, up to a negative sign, with the Delta of the put option on ST with strike
2
price Kβ (t ) := K 1/β e (β −1)(rT /β −(T /2−t )σ ) .

Chapter 9
Exercise 9.1
a) We have fK′ ∗ (x) = − log(x/K ∗ ) and fK′′∗ (x) := −1/x, hence

1 ′′ St (dSt )2
d fK ∗ (St ) = fK′ ∗ (St )dSt + fK ∗ (St )(dSt )2 = − log ∗ dSt − .
2 K 2St
On the other hand, we have
dSt (dSt )2
d log St = − ,
St 2St2
hence
(dSt )2
− = St d log St − dSt ,
2St
which yields
St
St d log St = d fK ∗ (St ) + log dSt ,
K∗
and leads to (9.4.3) by integration over [0, T ].
b) We note that fK ∗ (K ∗ ) = fK′ ∗ (K ∗ ) = 0, hence by Lemma 2.3 we have
w K∗
fK ∗ (x) = fK ∗ (K ∗ ) + (x − K ∗ ) fK′ ∗ (K ∗ ) + (z − x)+ fK′′∗ (z)dz
0
w∞
+ ∗ (x − z)+ fK′′∗ (z)dz
K

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 489
w K∗ dK w ∞ dK
= − (K − x ) + − ∗ (x − K ) + .
0 K K K
As a consequence, we have
wT w K∗ dK
St d log St = ((K − S0 )+ − (K − ST )+ )
0 0 K
w∞ wT 
+ + dK St
+ ∗ ((S0 − K ) − (ST − K ) ) + 1 + log ∗ dSt ,
K K 0 K
and the entropy swap payoff can be hedged in a self-financing way by:
• holding (1 + log(St /K ∗ ) units of St ,
w K∗ dK w ∞ dK
• holding ( K − S0 ) + + ∗ ( S0 − K ) + in cash,
0 K K K
• shorting a static portfolio of call options with strike prices K > K ∗ and a static portfolio
of put options with strike prices K < K ∗ .

Exercise 9.2
a) We have
∂C C (T , K2 ) −C (T , K1 ) ∂C C (T , K3 ) −C (T , K2 )
(T , K2 ) ≃ , (T , K3 ) ≃ . (S.53)
∂K ∆K ∂K ∆K
Reusing (S.53), second order  spatial derivatives can be similarly approximated as
∂ 2C

1 ∂C ∂C
(T , K2 ) ≃ (T , K3 ) − (T , K2 )
∂ K2 ∆K ∂ K ∂K
C (T , K3 ) + C (T , K1 ) − 2C (T , K2 )
≃ .
(∆K )2
∂ 2C
b) Under the condition (T , K2 ) < 0, the portfolio with terminal payoff
∂ K2
(ST − K3 )+ + (ST − K1 )+ − 2(ST − K2 )+
has the negative initial price

C (T , K3 ) + C (T , K1 ) − 2C (T , K2 ) < 0,

hence it constitutes an arbitrage opportunity, see https://optioncreator.com/stzrvij with

K1 = $80, K2 = $100, K3 = $120.

150
(x-K1)++(x-K2)+-2(x-(K1+K2)/2)+

100

50

-50
0 50 100 150 200
K1 ST K2

Figure S.48: Butterfly option payoff as a combination of call and put options.*

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 490 Exercise Solutions

See page 30 of Bergomi, 2016 for the construction of arbitrage opportunities based on the
negativity of the numerator in (9.3.7) (maturity arbitrage).

Exercise 9.3
∂C ∂f  x
a) We have (T − t, x, K ) = T − t, and
∂x ∂ z  K
∂C ∂ x 
(T − t, x, K ) = K f T − t,
∂K ∂K K
 x x ∂f  x
= f T − t, − T − t,
K K ∂z K
1 x ∂C
= C (T − t, x, K ) − (T − t, x, K ),
K K ∂x
hence
∂C 1 K ∂C
(T − t, x, K ) = C (T − t, x, K ) − (T − t, x, K ).
∂x x x ∂K
∂ 2C 1 ∂2 f  x
b) We have ( T − t, x, K ) = T − t, and
∂ x2 K ∂ z2 K
∂ 2C
(T − t, x, K )
∂ K2
x ∂f  x x ∂f  x  x2 ∂ f  x
= − 2 T − t, + 2 T − t, + 3 T − t,
K ∂z K K ∂z K K ∂z K
x2 ∂ 2 f  x
= T − t,
K 3 ∂ z2 K
2
x ∂ C 2
= (T − t, x, K ),
K 2 ∂ x2
hence
∂ 2C K 2 ∂ 2C
( T − t, x, K ) = (T − t, x, K ).
∂ x2 x2 ∂ K 2
c) Noting that
∂C ∂C
(T − t, x, K ) = − (T − t, x, K ),
∂t ∂T
we can rewrite the Black-Scholes PDE as
∂C
rC (T − t, x, K ) = − (T − t, x, K )
∂ T 
1 K ∂C
+rx C (T − t, x, K ) − (T − t, x, K )
x x ∂K
σ 2 x2 K 2 ∂ 2C
+ (T − t, x, K ),
2 x2 ∂ K 2
i.e.
∂C ∂C σ 2 x2 K 2 ∂ 2C
(T − t, x, K ) = −rK (T − t, x, K ) + (T − t, x, K ).
∂T ∂K 2 x2 ∂ K 2

Remarks:
1. Using the Black-Scholes Greek Gamma expression
∂ 2C 1
2
(T − t, x, K ) = √ Φ′ (d+ (T − t ))
∂x σx T −t
1 2
= p e −(d+ (T −t )) /2 ,
σ x 2π (T − t )
we can recover the lognormal probability density function ϕT (y) of geometric Brownian
motion ST as follows:
* The animation works in Acrobat Reader on the entire pdf file.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 491

∂ 2C
ϕT (K ) = e (T −t )r (T − t, x, K )
∂ K2
x2 ∂ 2C
= e (T −t )r 2 2 (T − t, x, K )
K ∂x
e −t )r x
( T 2
= p e −(d+ (T −t )) /2
2
σ K 2π (T − t )
1 2
= p e −(d− (T −t )) /2
σ K 2π (T − t )

2 !
1 (r − σ 2 /2)(T − t ) + log(x/K )
= exp − ,
2(T − t )σ 2
p
σ K 2π (T − t )
knowing that
2
1 log(x/K ) + (r − σ 2 /2)(T − t )

1
2
− d− ( T − t ) = − √
2 2 |σ | T − t
2
1 log(x/K ) + (r + σ 2 /2)(T − t )

x
= − √ + (T − t )r + log
2 |σ | T − t K
1
2 x
= − d+ (T − t ) + (T − t )r + log ,
2 K
which can be obtained

2 from the relation
2
d+ (T − t ) − d− (T − t )



= d + ( T − t ) + d− ( T − t ) d + ( T − t ) − d− ( T − t )
x
= 2r (T − t ) + 2 log .
K
2. Using the expressions of the Black-Scholes Greeks Delta and Theta we can also recover
∂C ∂C
(T − t, x, K ) + rK (T − t, x, K )
2 ∂T ∂K
∂ 2C
K 2 2 (T − t, x, K )
∂K  
∂C 1 x ∂C
− (T − t, x, K ) + rK C (T − t, x, K ) − (T − t, x, K )
∂t K K ∂x
= 2
∂ 2C
x2 2 (T − t, x, K )
∂x
√
xσ Φ (d+ (T − t ))/(2 T − t ) + rK e −(T −t )r Φ(d− (T − t ))
′
= 2 √
x2 Φ′ (d+ (T − t ))/(xσ T − t )
rC (T − t, x, K ) − rxΦ(d+ (T − t ))
+2 2 ′ √
x Φ (d+ (T − t ))/(xσ T − t )
= σ 2.

Exercise 9.4 We have

2
∂C e −(K−S0 ) /(2T )
(S0 , K, T ) = −(K − S0 ) √
∂K 2πT
K − S0 K − S0 K − S0
   
−Φ − √ + √ ϕ − √
T T T
K − S0
 
= −Φ − √ ,
T

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 492 Exercise Solutions

and
∂C2 1 2
(S0 , K, T ) = √ e −(K−S0 ) /(2T ) ,
∂ K2 2πT
which is the Gaussian probability density function of ST = S0 + BT . We also have
r
∂C 1 −(K−S0 )2 /(2T ) (K − S0 )2 T −(K−S0 )2 /(2T )
(S0 , K, T ) = √ e − e
∂T 2 2πT 2T 2 2π
( K − S0 ) 2 K − S0
 
+ ϕ − √ .
2T 3/2 T
1 2
= √ e −(K−S0 ) /(2T )
2 2πT
1 ∂C2
= (S0 , K, T ),
2 ∂ K2
hence
v v
u ∂CM ∂CM ∂CM
u
u2 (t, y) + 2ry (t, y) u
u s
u ∂t ∂y
u 2 (t, y ) 1 1
|σ (t, y)| = u =u
u ∂t = = ,
2
∂ C M t 2∂ C2 M y2 |y|
y2
t
2
(t, y) y 2
(t, y)
∂y ∂y
and the equation satisfied by (St )t∈R+ is
St
dSt = St σ (t, St )dBt = dBt = sign (St )dBt = dWt ,
|St |
where dWt := sign (St )dBt is also a standard Brownian motion by the Lévy characterization
theorem, σ (t, y) = 1/y, and St = S0 + Bt . Indeed, as in Quiz 2 of FE8815, the price of the call
option in the Bachelier model is given by
C (S0 , K, T ) = IE[(ST − K )+ ]
= IE[(S0 + BT − K )+ ]
w∞ 2 dx
= (x + S0 − K ) e −x /(2T ) √
K−S0 2πT
w∞ 2 dx w∞ 2 dx
= x e −x /(2T ) √ − (K − S0 ) e −x /(2T ) √
K−S0 2πT K−S 0 2πT
r h
T w
−y2 /2 dy
2
i∞ ∞
= − e −x /(2T ) − (K − S0 ) √ e √
2π K−S0 (K−S0 )/ T 2π
r
K − S0
 
T −(K−S0 )2 /(2T )
= e − (K − S0 )Φ − √ .
2π T
Exercise 9.5
a) We have
∂ MC ∂C ′ ∂C
(K, S, r, τ ) = (K, S, σimp (K ), r, τ ) + σimp (K ) (K, S, σimp (K ), r, τ ).
∂K ∂K ∂σ
b) We have
∂C ′ ∂C
(K, S, σimp (K ), r, τ ) + σimp (K ) (K, S, σimp (K ), r, τ ) ⩽ 0,
∂K ∂σ
which shows that
∂C
(K, S, σimp (K ), r, τ )
σimp (K ) ⩽ − K
′ ∂
∂C
(K, S, σimp (K ), r, τ )
∂σ

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 493

c) We have
∂P ′ ∂P
(K, S, σimp (K ), r, τ ) + σimp (K ) (K, S, σimp (K ), r, τ ) ⩾ 0,
∂K ∂σ
which shows that
∂P
(K, S, σimp (K ), r, τ )
′
σimp (K ) ⩾ − ∂ K
∂P
(K, S, σimp (K ), r, τ )
∂σ

Chapter 10
Exercise 10.1 For all j = 1, 2, . . . , M − 1 we have

B j, j−1 + B j, j + B j, j+1 = 1 + r∆t,

hence when the terminal condition is a constant φ (T , x) = c > 0 we get

T −(N−i)
 
φ (ti , x) = c(1 + r∆t )−(N−i) = c 1 + r , i = 0, . . . , N.
N
In particular, when the number N of discretization steps tends to infinity, denoting by [x] the integer
part of x ∈ R we find


φ (s, x) = lim φ t[Ns/T ] , x
N→∞

T −(N−[Ns/T ])
 
= c lim 1 + r
N→∞ N
T −[N (T −s)/T ]
 
= c lim 1 + r
N→∞ N
T −(T −s)/T
 
= c lim 1 + r
N→∞ N
= c e −r(T −s) ,
for all s ∈ [0, T ], as expected.

Exercise 10.2
a) We have
XbtNk+1 = XbtNk + rXbtNk (tk+1 − tk ) + σ XbtNk (Wtk+1 −Wtk ),
which yields
k
XbtNk = XbtN0 ∏ (1 + r (ti − ti−1 ) + (Wti −Wti−1 )σ ) , k = 0, 1, . . . , N.
i=1

b) We have
XbtN k +1
= XbtNk + (r − σ 2 /2)XbtNk (tk+1 − tk ) + σ XbtNk (Wtk+1 −Wtk )
1
+ σ 2 XbtNk (Wtk+1 −Wtk )2 ,
2
which yields
k  
N N 2 1 2 2
Xtk = Xt0 ∏ 1 + (r − σ /2)(ti − ti−1 ) + (Wti −Wti−1 )σ + (Wti −Wti−1 ) σ .
b b
i=1 2

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 494 Exercise Solutions

Background on Probability Theory

Exercise A.1
a) We have
λk
IE[X ] = ∑ kP(X = k) = e −λ ∑ k k!
k⩾0 k⩾0
λk λk
= e −λ ∑ = λ e −λ ∑ = λ.
k⩾1 (k − 1) ! k⩾0 k!
b) We have
IE[X 2 ] = ∑ k 2 P(X = k )
k⩾0
λk
= e −λ ∑ k2 k!
k⩾1
λk
= e −λ ∑ k (k − 1) !
k⩾1
λk λk
= e −λ ∑ + e −λ
∑
k⩾2 (k − 2) ! k⩾1 (k − 1) !
λk λk
= λ 2 e −λ ∑ + λ e −λ ∑
k⩾0 k! k⩾0 k!

= λ2 +λ,
and
Var[X ] = IE[X 2 ] − (IE[X ])2 = λ = IE[X ].

Exercise A.2 We have

w∞ 2 / (2η 2 ) dy
P( e X > c) = P(X > log c) = e −y p
log c 2πη 2
w∞ 2 /2 dy
= e −y √ = 1 − Φ((log c)/η ) = Φ(−(log c)/η ).
(log c)/η 2π

Exercise A.3
a) Using the change of variable z = (x − µ )/σ , we have
w∞ 1 w∞ 2 2
ϕ (x)dx = √ e −(x−µ ) /(2σ ) dx
−∞ 2πσ 2 −∞
1 w∞ 2 2
= √ e −y /(2σ ) dy
2πσ 2 −∞
1 w ∞ −z2 /2
= √ e dz.
2π −∞
Next, using the polar change of coordinates dxdy = rdrdθ , we find*
1 w ∞ −z2 /2 1 w ∞ −y2 /2 w ∞ −z2 /2
 2
√ e dz = e dy e dz
2π −∞ 2π −∞ −∞
1 w ∞ w ∞ −(y2 +z2 )/2
= e dydz
2π −∞ −∞
2
*“In a discussion with Grothendieck, Messing mentioned the formula expressing the integral of e −x in terms of π,
which is proved in every calculus course. Not only did Grothendieck not know the formula, but he thought that he had
never seen it in his life”. Milne, 2005.

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

MH4514 Financial Mathematics 495
1 w 2π w ∞ −r2 /2
= re drdθ
w2π∞ 0 2 0
= r e −r /2 dr
0
wR 2
= lim r e −r /2 dy
R→+∞ 0
h 2 iR
= − lim e −r /2
R→+∞ 0
−R2 /2
= lim (1 − e )
R→+∞
= 1,
or w∞ √
2 /2
e −z dz = 2π.
−∞

b) We have w∞
IE[X ] = xϕ (x)dx
−∞
1 w∞ 2 2
= √ x e −(x−µ ) /(2σ ) dx
2πσ 2 −∞
1 w∞ 2 2
= √ ( µ + y) e −y /(2σ ) dx
2πσ 2 −∞
µ w ∞ −y2 /2 σ w∞ 2
= √ e dy + √ y e −y /2 dy
2π −∞ 2π −∞
µ w ∞ −y2 /2 σ wA 2
= √ e dy + √ lim y e −y /2 dy
2π −∞ 2π A→+∞ −A
µ w ∞ −y2 /2
= √ e dy
2π −∞
w∞
= µ ϕ (y)dy
−∞
= µP(X ∈ R)
= µ,
2
by symmetry of the function y 7−→ y e −y /2 on R.
c) Similarly, by integration by partsw ∞ twice on R, we find
2
IE[(X − IE[X ]) ] = (x − µ )2 ϕ (x)dx
−∞
1 w∞ 2 2
= √ y2 e −(y−µ ) /(2σ ) dy
2πσ 2 −∞

σ2 w ∞ 2
= √ y × y e −y /2 dy
2π −∞

σ 2 w ∞ −y2 /2
= √ e dy
2π −∞
= σ 2.
d) By a completion ofwsquares argument, we have
∞
IE[ e X ] = e x ϕ (x)dx
−∞
1 w∞ 2 2
= √ e x−(x−µ ) /(2σ ) dx
2πσ −∞ 2
e µ w ∞ y−y2 /(2σ 2 )
= √ e dy
2πσ 2 −∞
e µ w ∞ σ 2 /2+(y−σ 2 )2 /(2σ 2 )
= √ e dy
2πσ 2 −∞

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 496 Exercise Solutions

e µ + σ 2 /2 w ∞ x2 /(2σ 2 )
= √ e dy
2πσ 2 −∞

σ2
= eµ + .
2
Exercise A.4
a) We have
1 w∞ 2 2
IE[X + ] = √ x+ e −x /(2/σ ) dx
2πσ 2 −∞
σ w ∞ −x2 /2
= √ xe dx
2π 0
σ h −x2 /2 ix=∞
= √ −e
2π x=0
σ
= √ .
2π
b) We have
1 w∞ 2 2
IE[(X − K )+ ] = √ (x − K )+ e −x /(2σ ) dx
2πσ 2 −∞
1 w∞ 2 2
= √ (x − K ) e −x /(2σ ) dx
2πσ K2
1 w∞ 2 2 K w ∞ −x2 /(2σ 2 )
= √ x e −x /(2σ ) dx − √ e dx
2πσ 2 K 2πσ 2 K
σ h −x2 /(2σ 2 ) i∞ K w −K/σ −x2 /2
= √ −e −√ e dx
2π x=K 2π −∞
 
σ −K 2 /(2σ )2 K
= √ e − KΦ − .
2π σ
c) Similarly, we have
1 w∞ 2 2
IE[(K − X )+ ] = √ (K − x)+ e −x /(2σ ) dx
2πσ −∞
2
1 wK 2 2
= √ (K − x) e −x /(2σ ) dx
2πσ 2 −∞
K w K −x2 /(2σ 2 ) 1 wK 2 2
= √ e dx − √ x e −x /(2σ ) dx
2πσ 2 −∞ 2πσ 2 −∞
K w K/σ 2 σ h 2 2
ix=K
= √ e −x /2 dx − √ − e −x /(2σ )
2π −∞ 2π −∞
 
σ 2 2 K
= √ e −K /(2σ ) + KΦ .
2π σ

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

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" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 Index

Symbols asset pricing

first theorem . . . . . . . . . . . . . . . . . . . . . . . . 43
σ -algebra . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308 continuous time, 184
σ -field . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308 discrete time, 77
code . 9, 143, 145, 147, 150, 154, 155, 169– second theorem . . . . . . . . . . . . . . . . . . . . . 49
171, 189, 192, 195, 200, 201, 205, continuous time, 187
208, 212, 213, 219, 226, 227, 229, discrete time, 78
239, 281–283, 287, 291, 295, 296, at the money . . . . . . . . . . . . . . . . . . . . . . . 69, 259
300, 301, 322, 324, 479, 480 ATM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69, 259
package attainable . . . . . . . . . . . . . . . . . . . 48, 52, 89, 186
bizdays . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
fOptions . . . . . . . . . . . . . . . . . . . . . . . . . . 281 B
quantmod . . . . . . . . . . . . . . . . . . . . 200, 278
Sim.DiffProc . . . . . . . . . . . . . . . . . . . . . . 201 Bachelier model 173, 191, 226, 231, 254, 260,
492
A backward
induction . . . . . . . . . . . . . . . . . . . . . . . 97, 99
absence of arbitrage . . . . . . . . . . . . . . . . . . . . . 42 stochastic differential equation . . . . . . 264
adapted process . . . . . . . . . . . . . . . . . . . . . . . . 154 Bank for International Settlements . . . . . . . . . 7
adjusted close price . . . . . . . . . . . . . . . . . . . . 200 barrier option . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
admissible portfolio strategy . . . . . . . . . . . . 183 basket option . . . . . . . . . . . . . . . . . . . . . . . . . . 255
arbitrage bear spread option . . . . . . . . . . . . . . . . . 255, 450
absence . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Bernoulli distribution . . . . . . . . . . . . . . . . . . . 319
continuous time . . . . . . . . . . . . . . . . . . . 183 binary
discrete time . . . . . . . . . . . . . . . . . . . . . . . 68 tree . . . . . . . . . . . . . . . . . . . . . . . . . . . 78, 126
forex . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 binary option . . . . . . . . . 70, 121, 231, 261, 377
opportunity . . . . . . . . . . . . . . . . . . . . . . . . . 40 binomial
price . . . . . . . . . . . . . . . . 12, 53, 77, 90, 243 coefficient . . . . . . . . . . . . . . . . . . . . . . . . . 337
strike . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 distribution . . . . . . . . . . . . . . . . . . . . . . . . 320
triangular . . . . . . . . . . . . . . . . . . . . . . . . . . 39 identity . . . . . . . . . . . . . . . . . . . . . . . . . . . 338

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 504 INDEX

model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 sequence . . . . . . . . . . . . . . . . . . . . . . . . . . 418

dividends, 128 CBBC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
transaction costs, 126 CBOE
BIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Volatility Index® . . . . . . . . . . . . . . . . . . . 292
bisection method . . . . . . . . . . . . . . . . . . 229, 281 centered random variable . . . . . . . . . . . . . . . . 20
bizdays ( package) . . . . . . . . . . . . . . . . . . . 219 CEV model . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Black-Scholes change of measure . . . . . . . . . . . . . . . . . . . . . 241
calibration . . . . . . . . . . . . . . . . . . . . . . . . 284 characteristic
formula . . . . . . . . . . . . . . . . . . 224, 228, 246 function . . . . . . . . . . . . . . . . . . . . . . . . . . 329
call options, 204 Chasles relation . . . . . . . . . . . . . . . . . . . . . . . . 161
put options, 211, 212 Chi square distribution . . . . . . . . . . . . . 260, 463
PDE . . . . . . . . . . . . . . . . 203, 223, 229, 304 chooser option . . . . . . . . . . . . . . . . . . . . 263, 467
bond CIR model . . . . . . . . . . . . . . . . . . . 175, 226, 260
convertible . . . . . . . . . . . . . . . . . . . . . . . . 357 Clark-Ocone formula . . . . . . . . . . . . . . . . . . . 108
Borel-Cantelli Lemma . . . . . . . . . . . . . 178, 311 cliquet
boundary condition . . . . . . . . . . . . . . . . . . . . 304 option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
box spread option . . . . . . . . . . . . . . . . . . . . . . 257 closing portfolio value . . . . . . . . . . . . . . . . . . . 65
break-even collar option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
strike price . . . . . . . . . . . . . . . . . . . . . . . . . 60 call spread . . . . . . . . . . . . . . . . . . . . . . . . 122
underlying asset price . . . . . . 97, 217, 449 costless . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Brent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 put spread . . . . . . . . . . . . . . . . . . . . . . . . . 122
Brownian complement rule . . . . . . . . . . . . . . . . . . . . . . . 310
bridge . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 complete market . . . . . . . . . . . . . . . . 48, 52, 243
motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 complete space . . . . . . . . . . . . . . . . . . . . 152, 159
geometric, 234 completeness
Lévy’s construction, 145, 176, 431
continuous time . . . . . . . . . . . . . . . . . . . 186
series construction, 142, 146
discrete time . . . . . . . . . . . . . . . . . . . . . . . . 77
BSDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
conditional
bubble . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
expectation . . . . . . . . . . . . 18, 72, 323, 330
bull spread option . . . . . . . . . . . . . . . . . 255, 450
probability . . . . . . . . . . . . . . . . . . . 311, 312
business time . . . . . . . . . . . . . . . . . . . . . . . . . . 219
conditioning . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
butterfly option . . . . . . . . . . . . . . . . . . . . 258, 453
constant repayment . . . . . . . . . . . . . . . . . . . . . . 62
buy back guarantee . . . . . . . . . . . . . . . . . . . . . . . 6
contingent claim . . . . . . . . . . . . . . 47, 69, 77, 89
buy limit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
attainable . . . . . . . . . . . . . . . . . . 48, 52, 186
continuous-time
C
limit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
calendar time . . . . . . . . . . . . . . . . . . . . . . . . . . 219 convertible bond . . . . . . . . . . . . . . . . . . . . . . . 357
call costless collar option . . . . . . . . . . . . . . . . . . . . 11
option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 counterparty risk . . . . . . . . . . . . . . . . . . . . . . . . 99
spread collar option . . . . . . . . . . . . . . . . 122 Cox-Ingersoll-Ross model . . . . . . . . . . . . . . 175
call-put parity . . . . . . . 120, 212, 248, 263, 292 Cox-Ross-Rubinstein model . . . . . . . . . 78, 206
callable dividends . . . . . . . . . . . . . . . . . . . . . . . . . 128
bear contract . . . . . . . . . . . . . . . . . . . . . . . . 71 transaction costs . . . . . . . . . . . . . . . . . . . 126
Capital Asset Pricing Model (CAPM)265, 473 credit exposure . . . . . . . . . . . . . . . . . . . . . . . . . 99
cash settlement . . . . . . . . . . . . . . . . 6, 8, 69, 211 CRR model . . . . . . . . . . . . . . . . . . . . . . . . 78, 206
cash-or-nothing option . . . . . . . . . . . . . . . . . . . 70 dividends . . . . . . . . . . . . . . . . . . . . . . . . . 128
cattle futures . . . . . . . . . . . . . . . . . . . . . . . . . . 204 transaction costs . . . . . . . . . . . . . . . . . . . 126
Cauchy cumulative distribution function . . . . . . . . . 316
distribution . . . . . . . . . . . . . . . . . . . . . . . . 317 joint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

INDEX 505

cup & handle . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 E

D effective gearing . . . . . . . . . . . . . . . . . . 102, 218

efficient market hypothesis . . . . . . . . 1, 76, 452
date elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
of payment . . . . . . . . . . . . . . . . . . . . . . . . 227 entitlement ratio . . . . . . . 8, 209, 214, 284–286
of record . . . . . . . . . . . . . . . . . . . . . . . . . . 227 entropy swap . . . . . . . . . . . . . . . . . . . . . . . . . . 297
Delta . 100, 102, 202, 207, 208, 214, 215, 228, equivalent probability measure43, 50, 77, 184,
232, 252, 454 242
hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . 251 ETF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265, 294
density Euler discretization . . . . . . . . . . . . . . . . . . . . 299
function . . . . . . . . . . . . . . . . . . . . . . . . . . 315 event . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
marginal . . . . . . . . . . . . . . . . . . . . . . . . . . 318 ex-dividend. . . . . . . . . . . . . . . . . . . . . . . . . . . .227
derivatives exchange-traded fund . . . . . . . . . . . . . . 265, 294
market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 exercise price . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
differential interest rate . . . . . . . . . . . . . . . . . 265 exotic option . . . . . . . . . . . . . . . . . . . 70, 94, 249
digital option . . . . . . . . . 70, 121, 231, 261, 377 discrete time . . . . . . . . . . . . . . . . . . . . . . 107
discounting . . . . . . . . . . . . . . . . . . . . . . . . 67, 181 expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
lemma . . . . . . . . . . . . . . . . . . . . . . . 190, 243 conditional . . . . . . . . . . . . . . . . . . . 323, 330
discrete distribution . . . . . . . . . . . . . . . . . . . . 319 exponential
discrete-time distribution . . . . . . . . . . . . . . . . . . . . . . . . 316
martingale . . . . . . . . . . . . . . . . . . . . . . . . . 19 Vasicek model . . . . . . . . . . . . . . . . 175, 409
distribution exponential series . . . . . . . . . . . . . . . . . . . . . . 337
Bernoulli . . . . . . . . . . . . . . . . . . . . . . . . . 319 extrinsic value . . . . . . . . . . . . . . . . . . . . . . 96, 217
binomial . . . . . . . . . . . . . . . . . . . . . . . . . . 320
F
Cauchy . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
discrete . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 Fatou’s lemma . . . . . . . . . . . . . . . . 235, 328, 473
exponential . . . . . . . . . . . . . . . . . . . . . . . 316 filtration. . . . . . . . . . . . . . . . . . . . . . . . 17, 72, 139
gamma . . . . . . . . . . . . . . . . . . . . . . . . . . . 317 finite differences
Gaussian . . . . . . . . . . . . . . . . . . . . . . . . . . 316 explicit scheme . . . . . . . . . . . . . . . 302, 304
geometric . . . . . . . . . . . . . . . . . . . . . . . . . 320 implicit scheme . . . . . . . . . . . . . . . 303, 305
lognormal . . . . . . . . . . . 115, 195, 317, 447 first theorem of asset pricing . . . . . 43, 77, 184
marginal . . . . . . . . . . . . . . . . . . . . . . . . . . 325 floating
negative binomial . . . . . . . . . . . . . . . . . . 320 strike . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Pascal . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320 fOptions ( package) . . . . . . . . . . . . . . . . . . 281
Poisson . . . . . . . . . . . . . . . . . . . . . . . . . . . 320 foreign exchange option . . . . . . . . . . . . . . . . 198
uniform . . . . . . . . . . . . . . . . . . . . . . . . . . . 316 forex arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . 39
dividend . . . . . . . . . . . . . . . . . 128, 130, 227, 258 formula
date of payment . . . . . . . . . . . . . . . . . . . 227 Tanaka . . . . . . . . . . . . . . 176, 198, 415, 430
date of record. . . . . . . . . . . . . . . . . . . . . .227 Taylor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
ex-date . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 forward
payable date . . . . . . . . . . . . . . . . . . . . . . . 227 contract. . . . . . . . .123, 203, 229, 246, 440
dominated convergence . . . . . . . . . . . . . . . . . . 28 non-deliverable, 204
dominated convergence theorem . . . . . 24, 481 range . . . . . . . . . . . . . . . . . . . . . . . . 121, 230
Doob-Meyer decomposition . . . . . . . . . . . . . . 33 start option . . . . . . . . . . . . . . . . . . . . . . . . 259
double down . . . . . . . . . . . . . . . . . . . . . . . . . . . 341 four-way collar option . . . . . . . . . . . . . . . . . . . . 9
drift estimation . . . . . . . . . . . . . . . . . . . . . . . . 277 Fourier
drifted Brownian motion . . . . . . . . . . . . . . . . 238 synthesis . . . . . . . . . . . . . . . . . . . . . . . . . . 145
Dupire PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . 289 fugazi (the) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 506 INDEX

futures contract . . . . . . . . . . . . . . . . . . . 204, 382 hexanomial model . . . . . . . . . . . . . . . . . . . . . 400

FX option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198 historical
probability measure . . . . . . . . . . . . . . . . 239
G volatility . . . . . . . . . . . . . . . . . . . . . . . . . . 277

gains process . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Galton board . . . . . . . . . . . . . . . . . . . . . . . . . . 114 I
Gamma
implied
Greek . . . . . . . . . . . . . . . . . . . . . . . . 208, 215
probability . . . . . . . . . . . . . . . . . . . . . . . . . 14
gamma
volatility . . . . . . . . . . . . . . . . . . . . . . . . . . 280
distribution . . . . . . . . . . . . . . . . . . . . . . . . 317
in the money . . . . . . . . . . . . . . . . . . 69, 286, 372
function . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
increment
Gaussian
independent . . . . . . . . . . . . . . . . . . . . . 20, 33
cumulative distribution function . . . . . 118
distribution . . . . . . . . . . . . . . . . . . . 205, 316 independence . . . 311, 313, 315, 319, 320, 324,
random variable . . . . . . . . . . . . . . . . . . . 329 329, 333
gearing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96, 218 independent increments . . . . . . . . . . 20, 33, 234
effective . . . . . . . . . . . . . . . . . . . . . . 102, 218 indicator function. . . . . . . . . . . . . . . . . .314, 337
generating function . . . . . . . . . . . . . . . . 175, 329 infimum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
geometric infinitesimal . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Brownian motion . . . . . . . . . . . . . . 192, 234 information flow . . . . . . . . . . . . . . . . . . . . . 18, 73
distribution . . . . . . . . . . . . . . . . . . . . . . . . 320 interest rate
series . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338 differential . . . . . . . . . . . . . . . . . . . . . . . . 265
sum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337 model
Girsanov Theorem . . . . . . . . . . . . . . . . . 241, 265 Cox-Ingersoll-Ross, 226, 260
Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215 exponential Vasicek, 175, 409
Delta . . 202, 207, 208, 214, 215, 228, 232, intrinsic value . . . . . . . . . . . . . . . . . . . 54, 96, 217
252, 454 IPython notebook . . . . . . . . . . . . . . . . 12, 78, 94,
Gamma . . . . . . . . . . . . . . . . . . . . . . 208, 215 97, 100, 104, 106, 128, 134, 145, 205,
Rho . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215 229, 281, 284, 390, 400
Rhod . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 Itô
Theta . . . . . . . . . . . . . . . . . . . . 215, 262, 466 formula . . . . . . . . . . . . . . . . . . . . . . 163, 260
Vega . . . . . . . . . . . . . . . . . . . . . . . . . 215, 232 isometry . . . . . . . . . . . . . . . . . 148, 151, 157
gross market value . . . . . . . . . . . . . . . . . . . . . . . 7 process . . . . . . . . . . . . . . 163, 165, 202, 442
gross world product . . . . . . . . . . . . . . . . . . . . . . 7 stochastic integral . . . . 147, 156, 157, 233
guarantee table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
buy back . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 ITM . . . . . . . . . . . . . . . . . . . . . . . . . . 69, 286, 372
price lock . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
GWP. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
J
H Jensen’s inequality . . . . . . . 123, 235, 381, 449
heat joint
equation . . . . . . . . . . . . . . . . . . . . . . 219, 301 cumulative distribution function . . . . . 318
hedge and forget . . . . . . . . . . . . . . . . . . 203, 382 probability density function . . . . . . . . . 318
hedge ratio . . . . . . . . . . . . . . . . . . . . . . . 103, 218
hedging . . . . . . . . . . . . . . . . 48, 98, 99, 107, 249 K
quantile . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
static . . . . . . . . . . . . . . . . . . . . . . . . . 203, 382 kimchi . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 knock-out option . . . . . . . . . . . . . . . . . . . . . . . . 70

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

INDEX 507

L submartingale . . . . . . . . . . 24, 33, 344, 348

supermartingale . . . . . . . . . . . . . . . . . . . 348
Lévy transform . . . . . . . . . . . . . . . . . . 74, 93, 234
construction of Brownian motion145, 176, maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
431 mean
Lévy characterization . . . . . . . . . . . . . . . . . . 174 game duration . . . . . . . . . . . . . . . . . . . . . . 27
law mean-square distance . . . . . . . . . . . . . . . . . . . 332
of total expectation. . . . . . . . . . . . . . . . .325 measurability . . . . . . . . . . . . . . . . . . . . . . . . . . 153
of total probability . . . . . . . . 310, 313, 325 method
lemma bisection . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Neyman-Pearson . . . . . . . . . . . . . . . . . . 269 Newton-Raphson . . . . . . . . . . . . . . . . . . 281
leverage . . . . . . . . . . . . 196, 266, 270, 473, 486 Milshtein discretization . . . . . . . . . . . . . . . . . 300
liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Minkowski inequality . . . . . . . . . . . . . . 151, 152
local model
time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 Bachelier . . . 191, 226, 231, 254, 260, 492
volatility . . . . . . . . . . . . . . . . . . . . . 287, 304 binomial . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
local martingale . . . . . . . . . . . . . . . . . . . . . . . . 267 dividends, 128
log transaction costs, 126
contract . . . . . . . . . . . . . . . . . . . . . . 230, 259 CEV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271 hexanomial . . . . . . . . . . . . . . . . . . . . . . . 400
return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278 pentanomial . . . . . . . . . . . . . . . . . . . . . . . 400
dynamics, 193 trinomial . . . . . . . . . . . . . . . . . . 84, 118, 132
variance . . . . . . . . . . . . . . . . . . . . . . 115, 195 moment
log variance . . . . . . . . . . . . . . . . . . . . . . . . . . . 195 generating function . . . . . . . . . . . . . . . . 329
lognormal moneyness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
distribution . . . . . . . . . . 115, 195, 317, 447 monotone convergence . . . . . . . . . . . . . . . . . . 28
long box spread option . . . . . . . . . . . . . 257, 452 MPoR . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237, 242

M N
marginal natural logarithm . . . . . . . . . . . . . . . . . . . . . . 205
density . . . . . . . . . . . . . . . . . . . . . . . . . . . 318 negative
distribution . . . . . . . . . . . . . . . . . . . . . . . . 325 binomial distribution . . . . . . . . . . . . . . . 320
mark to market . . . . . 53, 77, 90, 204, 243, 382 premium . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
market risk premium . . . . . . . . . . . . . . . . . . . . . . 184
bubble . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 Newton-Raphson method . . . . . . . . . . . . . . . 281
completeness . . . . . . . . . . . . . . . . 48, 52, 77 Neyman-Pearson Lemma . . . . . . . . . . . . . . . 269
efficiency . . . . . . . . . . . . . . . . . . . . . . . . . 453 non-deliverable forward contract . . . . . . . . 204
making . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 noncentral Chi square . . . . . . . . . . . . . . 260, 463
price of risk . . . . . . . . . . . . . . . . . . 237, 242 notional amount . . . . . . . . . . . . . . . . . . . . . . . . . . 7
market terms and data . . . . . . . . . . . . . . . 96, 215
Markov property . . . . . . . . . . . . . . . . . . . . . . . 169 O
martingale . . . . . . . . . . . . . 30, 72, 140, 233, 341
continuous time . . . . . . . . . . . . . . . 139, 184 opening portfolio price . . . . . . . . . . . . . . . . . . 65
discrete time . . . . . . . . . . . . . . . . . . . . 19, 73 option
local . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 at the money . . . . . . . . . . . . . . . . . . . . . . 259
measure barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
continuous time, 183 basket . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
discrete time, 75 bear spread . . . . . . . . . . . . . . . . . . . 255, 450
method . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 binary . . . . . . . . . . . . . . . . . . . . 70, 121, 377

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 508 INDEX

box spread . . . . . . . . . . . . . . . . . . . . . . . . 257 portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

bull spread . . . . . . . . . . . . . . . . . . . 255, 450 process . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
butterfly . . . . . . . . . . . . . . . . . . . . . . 258, 453 replicating . . . . . . . . . . . . . . . . . . . . 100, 104
cash-or-nothing . . . . . . . . . . . . . . . . . . . . . 70 strategy . . . . . . . . . . . . 48, 64, 89, 185, 187
chooser. . . . . . . . . . . . . . . . . . . . . . .263, 467 admissible, 183, 186
cliquet . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259 update . . . . . . . . . . . . . . . . . . . . . . . . 185, 187
digital . . . . . . . . . . . . . . . . . . . . 70, 121, 377 value . . . . . . . . . . . . . . . . . . . . . . . . . . . 67, 90
effective gearing . . . . . . . . . . . . . . 102, 218 power option . . . . . . . . 124, 191, 228, 259, 382
exotic . . . . . . . . . . . . . . . . . 70, 94, 107, 249 predictable process . . . . . . . . . . . . . . . . . . 74, 93
extrinsic value . . . . . . . . . . . . . . . . . 96, 217 premium
foreign exchange . . . . . . . . . . . . . . . . . . 198 kimchi . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
forward start . . . . . . . . . . . . . . . . . . . . . . 259 negative . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
gearing . . . . . . . . . . . . . . . . . . . . . . . . 96, 218 option . . . . . . . . . . . . . . . . . . . . . . . . . 97, 218
intrinsic value . . . . . . . . . . . . . . . . . . 96, 217 risk . . . . . . . . . . . . . . . . . . . . . . . 43, 183, 237
issuer . . . . . . . . . . . . . . . . . . . . . . . . . . 12, 48 price
knock-out . . . . . . . . . . . . . . . . . . . . . . . . . . 70 graph . . . . . . . . . . . . . 6, 7, 9, 122, 378, 380
long box spread . . . . . . . . . . . . . . . 257, 452 price lock guarantee . . . . . . . . . . . . . . . . . . . . . . 8
on average . . . . . . . . . . . . . . . . . . . . . 70, 255 pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89, 93
out of the money . . . . . . . . . . . . . . . . . . . 262 probability
path-dependent . . . . . . . . . . . . . . . 107, 249 conditional . . . . . . . . . . . . . . . . . . . 311, 312
power . . . . . . . . . . 124, 191, 228, 259, 382 density function . . . . . . . . . . . . . . . . . . . 315
premium . . . . . . . . . . . . . . . . . . . 48, 97, 218 joint, 318
straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . 470 distribution . . . . . . . . . . . . . . . . . . . . . . . . 314
tunnel . . . . . . . . . . . . . . . . . . . . . . . . 119, 120 measure . . . . . . . . . . . . . . . . . . . . . . . . . . 310
vanilla . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202 equivalent, 43, 50, 77, 184, 242
writer . . . . . . . . . . . . . . . . . . . . . . . . . . 12, 48 ruin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
zero-collar . . . . . . . . . . . . . . . . . . . . . . . . . 11 sample space . . . . . . . . . . . . . . . . . . . . . . 307
order book . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433 space . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
OTM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69, 262 process
out of the money . . . . . . . . . . . . . . . . . . . 69, 262 predictable . . . . . . . . . . . . . . . . . . . . . . 74, 93
stopped . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
P put
option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Paley-Wiener series . . . . . . . . . . . . . . . . . . . . 145 spread collar option . . . . . . . . . . . . . . . . 122
parity Python code . . . . . . . . . . . . . . . . . . . . . 12, 78, 94,
call-put . . . . . . . . . 120, 212, 248, 263, 292 97, 100, 104, 106, 128, 134, 145, 205,
partition . . . . . . . . . . . . . . . . . . . . . . . . . . 313, 331 229, 281, 284, 390, 400
Pascal distribution . . . . . . . . . . . . . . . . . . . . . 320 Python package
path yfinance . . . . . . . . . . . . . . . . . . . . . . . . . . 284
integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
path-dependent option . . . . . . . . . . . . . 107, 249 Q
payable date . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
payoff function . . . . . . . . . . . . . . . . . . . . . . . . 6, 7 quantile hedging . . . . . . . . . . . . . . . . . . . . . . . 269
PDE quantmod ( package) . . . . . . . . . . . . 200, 278
Black-Scholes . . . . . . . . . . . . . . . . 203, 223
pentanomial model . . . . . . . . . . . . . . . . . . . . . 400 R
Perron-Frobenius theorem . . . . . . . . . . . . . . . 85
physical delivery . . . . . . . . . . . . . . . 6, 8, 69, 211 Radon-Nikodym . . . . . . . . . . . . . . . . . . . . . . . 238
Poisson random
distribution . . . . . . . . . . . . . . . . . . . . . . . . 320 product . . . . . . . . . . . . . . . . . . . . . . . . . . . 327

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

INDEX 509

sum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326 stopped process . . . . . . . . . . . . . . . . . . . . . . . . . 22

variable . . . . . . . . . . . . . . . . . . . . . . . . . . . 313 stopping time . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
range forward . . . . . . . . . . . . . . . . . . . . . 121, 230 theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
realized variance . . . . . . . . . . . . . . . . . . . . . . . 278 straddle option . . . . . . . . . . . . . . . . . . . . . . . . . 470
recovery theorem . . . . . . . . . . . . . . . . . . . . 58, 84 Stratonovich integral . . . . . . . . . . . . . . . . . . . 421
replicating portfolio . . . . . . . . . . . . . . . 100, 104 strike arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . 297
replication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 strike price . . . . . . . . . . . . . . . . . . . . . . . . . . . 5, 47
return floating . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
log . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278 super-hedging . . . . . . . . . . . . . . . . . . . . . . . 48, 77
Rho . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215, 232 swap
risk entropy . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
counterparty . . . . . . . . . . . . . . . . . . . . . . . . 99
market price . . . . . . . . . . . . . . . . . . 237, 242 T
premium . . . . . . . . . . . . . . . . . . . . . . 43, 183
risk premium . . . . . . . . . . . . . . . . . . . . . . . . . . 237 Tanaka formula . . . . . . . . . . 176, 198, 415, 430
risk-neutral Taylor’s formula . . . . . . . . . . . . . . . . . . . 162, 445
measure . . . . . . . . . . . . . . . . . . . . . . . . 13, 42 terms and data. . . . . . . . . . . . . . . . . . . . . .96, 215
continuous time, 183, 237 ternary tree . . . . . . . . . . . . . . . . . . . . 84, 118, 132
discrete time, 75 theorem
probabilities . . . . . . . . . . . . . . . . . . . . . . . . 14 asset pricing . . . . . 43, 49, 77, 78, 184, 187
riskless asset . . . . . . . . . . . . . . . . . . . . . . 118, 189 Girsanov . . . . . . . . . . . . . . . . . . . . . 241, 265
Robinhood incident . . . . . . . . . . . . . . . . . . . . 453 Perron-Frobenius . . . . . . . . . . . . . . . . . . . 85
ruin probability . . . . . . . . . . . . . . . . . . . . . . . . . 24 recovery . . . . . . . . . . . . . . . . . . . . . . . . 58, 84
Theta . . . . . . . . . . . . . . . . . . . . . . . . 215, 262, 466
S time
business . . . . . . . . . . . . . . . . . . . . . . . . . . 219
second theorem of asset pricing . . . 49, 78, 187 splitting . . . . . . . . . . . . . . . . . 197, 261, 429
self-financing portfolio tower property . . . . . . . . . . . . 19, 20, 73–75, 92,
continuous time . . . . . . . . . . . . . . . 185–188 98, 158, 234, 235, 251, 254, 325, 328,
discrete time . . . . . . . . . . . . . . . . . . . . 65, 90 333, 365, 399
sell stop . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 transaction cost . . . . . . . . . . . . . . . . . . . . . . . . 126
share right . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 transform
Sharpe ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 martingale . . . . . . . . . . . . . . . . . . . . . . 74, 93
short selling . . . . . . . . . . . . . . . . . . . 52, 103, 210 tree
ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 binary . . . . . . . . . . . . . . . . . . . . . . . . . 78, 126
Sim.DiffProc . . . . . . . . . . . . . . . . . . . . . . . . . . 201 ternary . . . . . . . . . . . . . . . . . . . . 84, 118, 132
smile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282 trend estimation . . . . . . . . . . . . . . . . . . . . . . . . 277
spline function . . . . . . . . . . . . . . . . . . . . . . . . . 291 triangle inequality . . . . . . . . . . . . . . . . . . . . . . 152
square-integrable triangular arbitrage . . . . . . . . . . . . . . . . . . . . . . 39
functions . . . . . . . . . . . . . . . . . . . . . . . . . . 147 trinomial model . . . . . . . . . . . . . . . . 84, 118, 132
random variables . . . . . . . . . . . . . . . . . . 150 tunnel option . . . . . . . . . . . . . . . . . . . . . . 119, 120
St. Petersburg paradox . . . . . . . . . . . . . . . . . 322 turbo warrant . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
static hedging . . . . . . . . . . . . . . . . . . . . . 203, 382
stochastic U
calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
uniform distribution . . . . . . . . . . . . . . . . . . . . 316
differential equations . . . . . . . . . . . . . . . 168
integral . . . . . . . . . . . . . . . . . . . 91, 146, 153 V
integral decomposition108, 173, 249, 251
process . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 vanilla option . . . . . . . . . . . . . . . 69, 93, 94, 202
stop-loss/start-gain strategy . . . . . . . . . . . . . 198 variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

 510 INDEX

realized . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
Vega . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215, 232
VIX® . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
volatility
historical . . . . . . . . . . . . . . . . . . . . . . . . . . 277
implied . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
local . . . . . . . . . . . . . . . . . . . . . . . . . 287, 304
smile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
surface . . . . . . . . . . . . . . . . . . . . . . . . . . . 284

warrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8, 209
terms and data . . . . . . . . . . . . . . . . . . . . . 219
turbo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
West Texas Intermediate (WTI) . . . . . . . . . . 4, 9
Wiener space . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

yfinance (Python package) . . . . . . . . . . . . . . 284

zero-
collar option . . . . . . . . . . . . . . . . . . . . . . . . 11

January 25, 2024 MH4514 Financial Mathematics - N. Privault "

INDEX 511

Author index

Achdou, Y. 291 Gatheral, J. 293, 295

Ackerer, D. 291 Glasserman, P. 299
Aristotle 4 Gueye, D. 291

Bachelier, L. 2, 146 Harrison, J.M. 77, 78, 185, 187

Bergomi, L. 490 Heath, D. 4
Billingsley, R.S. 452 Hefter, M. 172
Björk, T. 55 Herzwurm, A. 172
Black, F. 3, 187, 199 Heston, S.L. 267
Boulding, K.E. 189 Hiriart-Urruty, J.-B. 46
Boyle, P.P. 390 Hirsch, F. 150
Brace, A. 4 Hobson, D.G. 267
Breeden, D.T. 288
Brown, R. 1, 140 Ikeda, N. 157, 235
Ingersoll, J.E. 226, 260
Carmona, R. 260 Itô, K. 2
Chan, C.M. 71
Chance, D.M. 452 Jacod, J. 307
Chataigner, M. 291 Jacquier, A. 268, 482
Çınlar, E. 315 Jarrow, R. 4
Coffey, B.K. 8 Jarrow, R.A. 267
Cousin, A. 291 Jensen, J. 123
Cox, A.M.G. 267
Kallenberg, O. 334
Cox, J.C. 78, 226, 260
Kani, I. 289
Crépey, S. 291
Klebaner, F. 266, 473
Derman, E. 289 Kloeden, P.E. 169
Devore, J.L. 307 Korn, E. 299
Di Nunno, G. 107, 249 Korn, R. 299
Dixon, M. 291 Kreps, D.M. 77, 78
Doob, J.L. 22, 33 Kroisandt, G. 299
Dudley, R.M. 152
Lacombe, G. 150
Dupire, B. 289
Lamberton, D. 107
Durrleman, V. 260
Lapeyre, B. 107
Einstein, A. 2 Lemaréchal, C. 46
Eriksson, J. 71 Leukert, P. 269
Leung, T. 270
Feller, W. 463 Lévy, P. 174
Folland, G.B. 141 Lipton, A. 198
Föllmer, H. 107, 269 Litzenberger, R.h. 288
Friz, P. 293 Loewenstein, M. 267

Galton, F. 115 Melnikov, A.V. 269, 390

Gatarek, D. 4 Merton, R.C. 3

" January 25, 2024 MH4514 Financial Mathematics - N. Privault

Meyer, P.A. 33 Samuelson, P.A. 3
Mikosch, T. 421 Schied, A. 44, 49, 77, 78, 107, 117
Milne, J.S. 494 Scholes, M. 3, 187, 199
Morton, A. 4 Schroeder, T.C. 8
Musiela, M. 4 Scorsese, M. 280
Sharpe, W.F. 78
Nechaev, M.L. 269
Shimbo, K. 267
Nikodym, O.M. 238
Shiryaev, A.N. 185, 187
Novikov, A. 241
Sircar, K.R. 270, 293
Øksendal, B. 107, 249 Steele, J. 341
Stroock, D.W. 332
Paley, R. 145
Papanicolaou, A. 293 Tagasovska, N. 291
Peng, S. 264 Thales 4
Persson, J. 71
Petrachenko, Y.G. 390 UCLES, MOE & 313
Pironneau, O. 291
Pitman, J. 307 Vašíček, O. 4
Platen, E. 169 Vatter, T. 291
Pliska, S.R. 185, 187 Volkov, S.N. 269
Proske, F. 107, 249 Vorst, T. 390
Protter, P. 163, 169, 241, 251, 267, 307, 478
Watanabe, S. 157, 235
Radon, J. 238 Widder, D.V. 220
Revuz, D. 141 Wiener, N. 2, 145
Ross, S. 58, 84 Willard, G.A. 267
Ross, S.A. 78, 226, 260 Williams, D. 107
Rubinstein, M. 78 Wong, H.Y. 71
Rudin, W. 149, 150
Ruiz de Chávez, J. 107 Yor, M. 141

January 25, 2024 MH4514 Financial Mathematics - N. Privault "