# Continuous-Time Finance

Sessions 1–4
Jyotirmoy Bhattacharya
ICRIER
IIM Kozhikode, January 2011
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 1 / 50
Sets and Functions
Set-theoretic terminology
Membership x ∈ A.
Subset A ⊂ B iff x ∈ A =⇒ x ∈ B. Also B ⊃ A.
Equality A = B iff A ⊂ B and B ⊂ A.
Null set ∅ is the set with no elements.
Real numbers R.
Rational numbers Q. Numbers of the form m/n where m and n are
integers and n = 0
Natural numbers N = {1, 2, 3, . . .}
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 2 / 50
Sets and Functions
Set-theoretic terminology (contd.)
Union If x ∈ A or x ∈ B then x ∈ A ∪ B.
Intersection If x ∈ A and x ∈ B then xinA ∩ B.
Complement x ∈ A
c
iff x ∈ A.
De Morgan’s Laws (A ∪ B)
c
= A
c
∩ B
c
. (A ∩ B)
c
= A
c
∪ B
c
. (Prove!)
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 3 / 50
Sets and Functions
Some subsets of R
Intervals
[a, b] = {x ∈ R|a ≤ x ≤ b}
(a, b) = {x ∈ R|a < x < b}
[a, b) = {x ∈ R|a ≤ x < b}
[a, ∞) = {x ∈ R|x ≥ a}
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 4 / 50
Sets and Functions
Useful properties of R
Archimedian property If x ∈ R, y ∈ R and x > 0, then there is a
positive integer n such that
nx > y.
Density of rationals If x ∈ R, y ∈ R, and x < y then there exists a
p ∈ Q such that x < p < y.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 5 / 50
Sets and Functions
Inﬁnite unions and intersections
Deﬁnition
Let A
1
, A
2
, . . . be an inﬁnite sequence of sets. Then,

_
i =1
A
i
= {x| x ∈ A
n
for some n ∈ N}

i =1
A
i
= {x| x ∈ A
n
for all n ∈ N}
Exercise
Compute

i =1
(−1 −1/n, 1 + 1/n)

i =1
[−1 + 1/n, 1 −1/n]
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 6 / 50
Sets and Functions
Cartesian Products and Functions
Cartesian Product
A ×B = {(a, b)| a ∈ A and b ∈ B}
Function
A function f from a set X to a set Y, written f : X →Y, is a subset
of X ×Y such that for any two elements (x
1
, y
1
) ∈ f and
(x
2
, y
2
) ∈ f , if x
1
= x
2
then y
1
= y
2
.
If (x, y) ∈ f , we write it commonly as y = f (x).
The set X is the domain of f and the set Y its codomain
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 7 / 50
Sets and Functions
Images and pre-images of sets
Let f : X →Y be a function.
Image
For any A ⊂ X, we deﬁne
f (A) = {y ∈ Y| there is some x ∈ A for which y = f (x)}
Pre-Image
For any B ⊂ Y, we deﬁne
f
−1
(B) = {x ∈ X| there is some y ∈ B for which y = f (x)}
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 8 / 50
Sets and Functions
Exercise
Let f (x) = x
2
. Find
1
f ({0, 1})
2
f
−1
({−4})
3
f ([0, 2])
4
f
−1
([−1, 4])
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 9 / 50
Sets and Functions
Exercise
Prove the following:
1
f
−1
(A
c
) = [f
−1
(A)]
c
2
f (A ∪ B) = f (A) ∪ f (B)
3
f (A ∩ B) ⊂ f (A) ∩ f (B). Why not equality?
4
f
−1
(A ∪ B) = f
−1
(A) ∪ f
−1
(B)
5
f
−1
(A ∩ B) = f
−1
(A) ∩ f
−1
(B)
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 10 / 50
Sets and Functions
Varieties of function
Let f : X →Y be a function.
Onto
If f (X) = Y then f is said to be onto.
One-to-one
If for every y ∈ Y, f
−1
({y}) consists of at most one element then f is
said to be 1-1.
Inverse
If f is 1-1 and onto, then we deﬁne a new function f
−1
: Y →X which
assigns to every y ∈ Y then unique element x ∈ X for which f (x) = y.
f
−1
is called the inverse function of f .
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 11 / 50
Sets and Functions
Exercise
Which of the following functions are 1-1, onto, or both:
1
f : R →R, where f (x) = x + 1
2
f : R →R, where f (x) = x
2
3
f : R →[0, ∞), where f (x) = x
2
4
f : [0, ∞) →R, where f (x) = x
2
5
f : N →N, where f (n) = 2n
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 12 / 50
Sets and Functions
Cardinality
Deﬁnition
If there exists a 1-1 mapping of A onto B, we say that A and B can be
put in 1-1 correspondence, or that A and B have the same cardinal
number, or, brieﬂy, that A and B are equivalent, and we write A ∼ B.
Exercise
Show that the set of natural numbers and the set of even natural
numbers have the same cardinal number.
Show that the set of natural number and the set of integers have
the same cardinal number.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 13 / 50
Sets and Functions
Countable and uncountable inﬁnite sets
Deﬁnition
For any positive integer n, let J
n
be the set whose elements are the
integers 1, 2, . . . , n; let J be the set consisting of all positive integers.
For any set A, we say:
A is ﬁnite if A ∼ J
n
for some n.
A is inﬁnite is A is not ﬁnite.
A is countable if A ∼ J.
A is uncountable if A is neither ﬁnite nor countable.
A is at most countable if A is ﬁnite or countable.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 14 / 50
Sets and Functions
Some countable and uncountable sets
N is countable.
Q is countable.
R is uncountable.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 15 / 50
Sets and Functions
Sequences and series
Sequence
A (real-valued) sequence is a function from N to R.
Inﬁnite series
For a sequence a
1
, a
2
, . . ., we write

i =1
a
i
as a shorthand for
lim
n→∞
n

i =1
a
i
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 16 / 50
Sets and Functions
Limits of a sequence
Finite limit
We say
lim
n→∞
a
n
= L
if for any > 0 we can ﬁnd a N ∈ N such that for every n > N we have
|a
n
−L| <
Limit to inﬁnity
We say
lim
n→∞
a
n
= ∞
if for any M > 0 we can ﬁnd a N ∈ N such that for every n > N we have
a
n
> M
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 17 / 50
Sets and Functions
Existence of limits
In general a sequence may not have a limit. For eg. 0, 1, 0, 1, . . ..
Bounded monotonic sequence
If there is a number B such that a
n
≤ B for all n and if it is the case that
a
1
≤ a
2
≤ a
3
≤ · · · then the sequence a
n
has a limit.
Cauchy’s criteria
If for any > 0 there exists a N such that for all n > N and for all
m > N it is the case that
|a
n
−a
m
| <
then the sequence a
n
has a limit.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 18 / 50
Sets and Functions
Exercises
For all the exercises below a
n
and b
n
are two sequences such that
lim
n→∞
a
n
= a and lim
n→∞
b
n
= b.
1
If a
n
≤ b
n
for all n prove that a ≤ b.
2
If a
n
< b
n
for all n, can we prove that a < b?
3
If c
n
= a
n
+ b
n
prove that lim
n→∞
c
n
= a + b.
4
If c
n
= a
n
b
n
prove that lim
n→∞
c
n
= ab.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 19 / 50
Sets and Functions
Some useful limits
1
If p > 0, then lim
n→∞
1
n
p
= 0.
2
If p > 0, then lim
n→∞
n

p = 1.
3
lim
n→∞
n

n = 1.
4
If p > 0 and α is real, then lim
n→∞
n
α
(1+p)
n
= 0.
5
If |x| < 1, then lim
n→∞
x
n
= 0.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 20 / 50
Sets and Functions
Limits of functions
Deﬁnition
We say that
lim
x→a
f (x) = L
if for every > 0 we can ﬁnd a δ > 0 such that for every x such that
0 < |x −a| < δ
we have
|f (x) −L| <
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 21 / 50
Sets and Functions
Limit of a function (contd.)
Deﬁnition (equivalent to above)
We say that
lim
x→a
f (x) = L
if for every sequence a
n
such that a
n
= a for all n and lim
n→∞
a
n
= a
we have
lim
n→∞
f (a
n
) = L
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 22 / 50
Sets and Functions
Inﬁnite limits
Deﬁnition
We say that
lim
x→a
f (x) = ∞
if for every M > 0 we can ﬁnd a δ > 0 such that for every x for which
|x −a| < δ
it is the case that
f (x) > M.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 23 / 50
Sets and Functions
Limits at inﬁnity
Deﬁnition
We say that
lim
x→∞
f (x) = L
if for every > 0 we can ﬁnd a M > 0 such that for all x for which
x > M
it is the case that
|f (x) −L| <
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 24 / 50
Sets and Functions
Some useful limits
1
e
x
→+∞as x →+∞, e
x
→0 as x →−∞.
2
lim
x→+∞
x
n
e
−x
= 0, for every n.
3
lim
x→+∞
x
−α
logx = 0 for all α > 0.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 25 / 50
Sets and Functions
References
Smith, A. H. and Albrecht, W. A. Fundamental Concepts of
Analysis, PHI, Rs. 76
Malik, S. C. and Arora S. Mathematical Analysis, New Age
International, Rs. 276
Rudin, W. Principles of Mathematical Analysis, McGraw Hill,
Rs. 332.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 26 / 50
Sets and Functions
Probability
Sample space and events
The sample space Ω is the set of all possible outcomes. Variable
ω if often used to refer to elements of Ω.
Events correspond to subsets of Ω.
The set of events under consideration is required to be a
σ-algebra.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 27 / 50
Sets and Functions
σ-algebra
Deﬁnition
A collection F of subsets of Ω is a σ-algebra if
1
∅ ∈ F.
2
A ∈ F implies A
c
∈ F.
3
A
i
∈ F for i = 1, 2, 3, . . . implies

i =1
A
i
∈ F.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 28 / 50
Sets and Functions
σ-algebra (contd.)
Examples
The set of all subsets of Ω, called the powerset of Ω, denoted 2

.
The set {Ω, ∅}.
For Ω = {HH, HT, TH, TT}, the set {Ω, ∅, {HH, HT}, {TH, TT}}.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 29 / 50
Sets and Functions
σ-algebra generated by a set of subsets
Deﬁnition
Let A be a set of subsets of Ω. Let S be the set of all σ-algebra which
are supersets of A. S is non-empty since it contains at least 2

.
We deﬁne σ(A), the σ-algebra generated by A to be
σ(A) =

F∈S
F
Exercise
Verify that σ(A) as deﬁned above is indeed a σ-algebra.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 30 / 50
Sets and Functions
Examples of generated σ-algebra
Examples
The Borel σ-algebra on R is the σ-algebra generated by open
intervals.
Let Ω be the set of all possible outcomes of an inﬁnite sequence of
coin tosses. We denote by Ω
0
the set of subsets of Ω that can be
deﬁned using the results of a ﬁnite number of tosses. The
σ-algebra generated by Ω
0
is denoted Ω

.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 31 / 50
Sets and Functions
Exercise
Show that the Borel σ-algebra on R is also the σ-algebra
generated by closed intervals.
If ω denotes the outcome of an inﬁnite sequence of coin tosses,
deﬁne H
n
(ω) to be the number of heads in the ﬁrst n tosses of the
coin. Show that the set
S =
_
ω ∈ Ω
¸
¸
¸
¸
lim
n→∞
H
n
(ω)
n
=
1
2
_
is in Ω

.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 32 / 50
Sets and Functions
Probability measure
Deﬁnition
Let Ω be a nonempty set and let F be a σ-algebra of subsets of Ω. A
probability measure P is a function that, to every set A ∈ F assigns a
number in [0, 1], called the probability of A and written P(A). We
require:
1
P(Ω) = 1.
2
Whenever A
1
, A
2
, . . . is a sequence of disjoint sets in F then
P
_

_
n=1
A
n
_
=

n=1
P(A
n
)
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 33 / 50
Sets and Functions
Exercise
Prove the following:
1
P(∅) = 0.
2
If A and B are disjoint events then P(A ∪ B) = P(A) +P(B).
3
P(A
c
) = 1 −P(A).
4
Let A
1
, A
2
, . . . is a sequence of events in F with the property that
A
1
⊂ A
2
⊂ · · · . Let A =

i =1
A
i
. Then
P(A) = lim
n→∞
P(A
n
)
5
Let A
1
, A
2
, . . . is a sequence of events in F with the property that
A
1
⊃ A
2
⊃ · · · . Let A =

i =1
A
i
. Then
P(A) = lim
n→∞
P(A
n
)
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 34 / 50
Sets and Functions
“Building-up” measures
Extension Theorem
A (countably additive) probability measure on a algebra of sets has a
unique extension to the generated σ-algebra.
Lebesgue measure on (0, 1]
The Lebesgue measure is the unique measure on the Borel σ-algebra
on (0, 1] obtained by assigning the length b −a to the interval (a, b]
and assuming that the length of a ﬁnite union of disjoint intervals is the
sum of the lengths of the component intervals.
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 35 / 50
Sets and Functions
References
Basu, A. K. Measure Theory and Probability, Rs. 175.
Jacod, J. and Protter, P. Probability Essentials, Springer, Rs. 595.
Chung, K. L. Course in Probability Theory, Elsevier India, Rs. 295.
Billingsley, P. Probability and Measure, Wiley, Rs. 807 (advanced).
Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 36 / 50

Sets and Functions

Set-theoretic terminology

Membership x ∈ A. Subset A ⊂ B iff x ∈ A =⇒ x ∈ B. Also B ⊃ A. Equality A = B iff A ⊂ B and B ⊂ A. Null set ∅ is the set with no elements. Real numbers R. Rational numbers Q. Numbers of the form m/n where m and n are integers and n = 0 Natural numbers N = {1, 2, 3, . . .}

Jyotirmoy Bhattacharya (ICRIER)

Continuous-Time Finance

IIMK Jan ’11

2 / 50

Sets and Functions

Set-theoretic terminology (contd.)

Union If x ∈ A or x ∈ B then x ∈ A ∪ B. Intersection If x ∈ A and x ∈ B then xinA ∩ B. Complement x ∈ Ac iff x ∈ A. De Morgan’s Laws (A ∪ B)c = Ac ∩ B c . (A ∩ B)c = Ac ∪ B c . (Prove!)

Jyotirmoy Bhattacharya (ICRIER)

Continuous-Time Finance

IIMK Jan ’11

3 / 50

∞) = {x ∈ R|x ≥ a} Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 4 / 50 .Sets and Functions Some subsets of R Intervals [a. b] = {x ∈ R|a ≤ x ≤ b} (a. b) = {x ∈ R|a < x < b} [a. b) = {x ∈ R|a ≤ x < b} [a.

Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 5 / 50 .Sets and Functions Useful properties of R Archimedian property If x ∈ R. Density of rationals If x ∈ R. y ∈ R. y ∈ R and x > 0. and x < y then there exists a p ∈ Q such that x < p < y . then there is a positive integer n such that nx > y.

Sets and Functions Inﬁnite unions and intersections Deﬁnition Let A1 . . A2 . Then. be an inﬁnite sequence of sets. ∞ Ai = {x| x ∈ An for some n ∈ N} i=1 ∞ Ai = {x| x ∈ An for all n ∈ N} i=1 Exercise Compute ∞ i=1 (−1 − 1/n. 1 + 1/n) ∞ i=1 [−1 + 1/n. . 1 − 1/n] Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 6 / 50 . .

is a subset of X × Y such that for any two elements (x1 . If (x. y) ∈ f . The set X is the domain of f and the set Y its codomain Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 7 / 50 .Sets and Functions Cartesian Products and Functions Cartesian Product A × B = {(a. if x1 = x2 then y1 = y2 . b)| a ∈ A and b ∈ B} Function A function f from a set X to a set Y . written f : X → Y . we write it commonly as y = f (x). y1 ) ∈ f and (x2 . y2 ) ∈ f .

Sets and Functions Images and pre-images of sets Let f : X → Y be a function. Image For any A ⊂ X . we deﬁne f −1 (B) = {x ∈ X | there is some y ∈ B for which y = f (x)} Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 8 / 50 . we deﬁne f (A) = {y ∈ Y | there is some x ∈ A for which y = f (x)} Pre-Image For any B ⊂ Y .

2]) f −1 ([−1. Find 1 2 3 4 f ({0.Sets and Functions Exercise Let f (x) = x 2 . 4]) Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 9 / 50 . 1}) f −1 ({−4}) f ([0.

Why not equality? f −1 (A ∪ B) = f −1 (A) ∪ f −1 (B) f −1 (A ∩ B) = f −1 (A) ∩ f −1 (B) Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 10 / 50 .Sets and Functions Exercise Prove the following: 1 2 3 4 5 f −1 (Ac ) = [f −1 (A)]c f (A ∪ B) = f (A) ∪ f (B) f (A ∩ B) ⊂ f (A) ∩ f (B).

Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 11 / 50 . Inverse If f is 1-1 and onto. f −1 is called the inverse function of f . then we deﬁne a new function f −1 : Y → X which assigns to every y ∈ Y then unique element x ∈ X for which f (x) = y . One-to-one If for every y ∈ Y . f −1 ({y}) consists of at most one element then f is said to be 1-1.Sets and Functions Varieties of function Let f : X → Y be a function. Onto If f (X ) = Y then f is said to be onto.

or both: 1 2 3 4 5 f : R → R. where f (x) = x 2 f : [0. where f (x) = x 2 f : N → N. ∞) → R. where f (n) = 2n Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 12 / 50 .Sets and Functions Exercise Which of the following functions are 1-1. where f (x) = x + 1 f : R → R. ∞). where f (x) = x 2 f : R → [0. onto.

that A and B are equivalent. Exercise Show that the set of natural numbers and the set of even natural numbers have the same cardinal number. we say that A and B can be put in 1-1 correspondence. Show that the set of natural number and the set of integers have the same cardinal number. or. and we write A ∼ B. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 13 / 50 . or that A and B have the same cardinal number. brieﬂy.Sets and Functions Cardinality Deﬁnition If there exists a 1-1 mapping of A onto B.

A is at most countable if A is ﬁnite or countable. A is uncountable if A is neither ﬁnite nor countable. let Jn be the set whose elements are the integers 1. . Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 14 / 50 . we say: A is ﬁnite if A ∼ Jn for some n.Sets and Functions Countable and uncountable inﬁnite sets Deﬁnition For any positive integer n. . n. For any set A. 2. . A is inﬁnite is A is not ﬁnite. A is countable if A ∼ J. let J be the set consisting of all positive integers. .

Q is countable. R is uncountable. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 15 / 50 .Sets and Functions Some countable and uncountable sets N is countable.

a2 .Sets and Functions Sequences and series Sequence A (real-valued) sequence is a function from N to R. we write ∞ ai i=1 as a shorthand for n→∞ n lim ai i=1 Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 16 / 50 . .. . Inﬁnite series For a sequence a1 . .

Sets and Functions Limits of a sequence Finite limit We say n→∞ lim an = L if for any > 0 we can ﬁnd a N ∈ N such that for every n > N we have |an − L| < Limit to inﬁnity We say n→∞ lim an = ∞ if for any M > 0 we can ﬁnd a N ∈ N such that for every n > N we have an > M Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 17 / 50 .

. 0. Cauchy’s criteria If for any > 0 there exists a N such that for all n > N and for all m > N it is the case that |an − am | < then the sequence an has a limit. . For eg. 1. Bounded monotonic sequence If there is a number B such that an ≤ B for all n and if it is the case that a1 ≤ a2 ≤ a3 ≤ · · · then the sequence an has a limit.Sets and Functions Existence of limits In general a sequence may not have a limit. 1.. 0. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 18 / 50 . .

If cn = an bn prove that limn→∞ cn = ab. can we prove that a < b? If cn = an + bn prove that limn→∞ cn = a + b. If an < bn for all n. 1 2 3 4 If an ≤ bn for all n prove that a ≤ b. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 19 / 50 .Sets and Functions Exercises For all the exercises below an and bn are two sequences such that limn→∞ an = a and limn→∞ bn = b.

then limn→∞ If p > 0. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 20 / 50 . then limn→∞ If |x| < 1. then limn→∞ xn = 0. = 0. then limn→∞ √ limn→∞ n n = 1. 1 n √ n p = 0. p = 1. nα (1+p)n If p > 0 and α is real.Sets and Functions Some useful limits 1 2 3 4 5 If p > 0.

Sets and Functions Limits of functions Deﬁnition We say that x→a lim f (x) = L if for every > 0 we can ﬁnd a δ > 0 such that for every x such that 0 < |x − a| < δ we have |f (x) − L| < Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 21 / 50 .

) Deﬁnition (equivalent to above) We say that x→a lim f (x) = L if for every sequence an such that an = a for all n and limn→∞ an = a we have lim f (an ) = L n→∞ Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 22 / 50 .Sets and Functions Limit of a function (contd.

Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 23 / 50 .Sets and Functions Inﬁnite limits Deﬁnition We say that x→a lim f (x) = ∞ if for every M > 0 we can ﬁnd a δ > 0 such that for every x for which |x − a| < δ it is the case that f (x) > M.

Sets and Functions Limits at inﬁnity Deﬁnition We say that x→∞ lim f (x) = L if for every > 0 we can ﬁnd a M > 0 such that for all x for which x >M it is the case that |f (x) − L| < Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 24 / 50 .

limx→+∞ x n e−x = 0. for every n. ex → 0 as x → −∞. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 25 / 50 .Sets and Functions Some useful limits 1 2 3 ex → +∞ as x → +∞. limx→+∞ x −α log x = 0 for all α > 0.

McGraw Hill. and Albrecht.Sets and Functions References Smith. Fundamental Concepts of Analysis. C. Mathematical Analysis. W. New Age International. Rs. A. 276 Rudin. 76 Malik. W. Rs. and Arora S. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 26 / 50 . PHI. Principles of Mathematical Analysis. A. S. 332. Rs. H.

Variable ω if often used to refer to elements of Ω. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 27 / 50 . Events correspond to subsets of Ω.Sets and Functions Probability Sample space and events The sample space Ω is the set of all possible outcomes. The set of events under consideration is required to be a σ-algebra.

. Ai ∈ F for i = 1.Sets and Functions σ-algebra Deﬁnition A collection F of subsets of Ω is a σ-algebra if 1 2 3 ∅ ∈ F. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 28 / 50 . 2. 3. . A ∈ F implies Ac ∈ F. . implies ∞ i=1 Ai ∈ F.

denoted 2Ω . TH. HT . TT }}. The set {Ω.Sets and Functions σ-algebra (contd. ∅}. {TH.) Examples The set of all subsets of Ω. HT }. For Ω = {HH. ∅. TT }. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 29 / 50 . the set {Ω. called the powerset of Ω. {HH.

Sets and Functions σ-algebra generated by a set of subsets Deﬁnition Let A be a set of subsets of Ω. We deﬁne σ(A). Let S be the set of all σ-algebra which are supersets of A. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 30 / 50 . S is non-empty since it contains at least 2Ω . the σ-algebra generated by A to be σ(A) = F ∈S F Exercise Verify that σ(A) as deﬁned above is indeed a σ-algebra.

The σ-algebra generated by Ω0 is denoted Ω∞ . Let Ω be the set of all possible outcomes of an inﬁnite sequence of coin tosses. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 31 / 50 . We denote by Ω0 the set of subsets of Ω that can be deﬁned using the results of a ﬁnite number of tosses.Sets and Functions Examples of generated σ-algebra Examples The Borel σ-algebra on R is the σ-algebra generated by open intervals.

Show that the set S= is in Ω∞ . If ω denotes the outcome of an inﬁnite sequence of coin tosses. deﬁne Hn (ω) to be the number of heads in the ﬁrst n tosses of the coin.Sets and Functions Exercise Show that the Borel σ-algebra on R is also the σ-algebra generated by closed intervals. ω ∈ Ω lim Hn (ω) 1 = n→∞ n 2 Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 32 / 50 .

is a sequence of disjoint sets in F then ∞ ∞ P n=1 An = n=1 P(An ) Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 33 / 50 . called the probability of A and written P(A). to every set A ∈ F assigns a number in [0. 1]. Whenever A1 .Sets and Functions Probability measure Deﬁnition Let Ω be a nonempty set and let F be a σ-algebra of subsets of Ω. A2 . . . A probability measure P is a function that. We require: 1 2 P(Ω) = 1. .

P(Ac ) = 1 − P(A). is a sequence of events in F with the property that A1 ⊂ A2 ⊂ · · · . If A and B are disjoint events then P(A ∪ B) = P(A) + P(B). . A2 . . Then i=1 P(A) = lim P(An ) n→∞ 5 Let A1 . Then i=1 P(A) = lim P(An ) n→∞ Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 34 / 50 . . Let A = ∞ Ai . . A2 . Let A = ∞ Ai . . .Sets and Functions Exercise Prove the following: 1 2 3 4 P(∅) = 0. is a sequence of events in F with the property that A1 ⊃ A2 ⊃ · · · . Let A1 .

Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 35 / 50 . Lebesgue measure on (0. 1] obtained by assigning the length b − a to the interval (a. b] and assuming that the length of a ﬁnite union of disjoint intervals is the sum of the lengths of the component intervals. 1] The Lebesgue measure is the unique measure on the Borel σ-algebra on (0.Sets and Functions “Building-up” measures Extension Theorem A (countably additive) probability measure on a algebra of sets has a unique extension to the generated σ-algebra.

Rs. Rs. Jacod. Probability Essentials. Measure Theory and Probability. 595. Springer. Wiley. 295.Sets and Functions References Basu. K. L. and Protter. 807 (advanced). K. Chung. P. 175. Probability and Measure. Rs. Course in Probability Theory. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 36 / 50 . A. Elsevier India. J. P. Rs. (advanced) Billingsley.