# Continuous-Time Finance

Sessions 5–8 Jyotirmoy Bhattacharya
ICRIER

IIM Kozhikode, January 2011

Jyotirmoy Bhattacharya (ICRIER)

Continuous-Time Finance

IIMK Jan ’11

1 / 27

Random variable

Deﬁnition Let (Ω, F, P) be a probability space. A random variable is a real-valued function X deﬁned on Ω with the property that for every Borel subset B of R, the subset of Ω given by {X ∈ B} = {ω ∈ Ω|X (ω) ∈ B} is in the σ-algebra F.

Jyotirmoy Bhattacharya (ICRIER)

Continuous-Time Finance

IIMK Jan ’11

2 / 27

A and B are disjoint and C = A ∪ B. the indicator variable of A is IA (ω) = 1 0 if ω ∈ A. C =A∪B C = Ac Continuous-Time Finance IIMK Jan ’11 3 / 27 Jyotirmoy Bhattacharya (ICRIER) . if ω ∈ A Exercises Express IC in terms of IA and IB in the following cases: 1 2 3 4 C = A ∩ B.Indicator random variable Deﬁnition For any A ∈ F.

Show that the two deﬁnitions are equivalent. Exercise We could also deﬁne a simple random variable as the linear combination of a ﬁnite set of indicator functions of disjoint sets.Simple random variable Deﬁnition A simple random variable is a random variable whose range is a ﬁnite set. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 4 / 27 .

P) Distribution measure For every Borel set B. µX (B) = P{X ∈ B} Cumulative distribution function F (x) = P(X ≤ x) Exercises 1 2 Is µX (·) deﬁned above really a measure? How do you obtain µX (·) from F (·)? Vice versa? Continuous-Time Finance IIMK Jan ’11 5 / 27 Jyotirmoy Bhattacharya (ICRIER) . F.The distribution of a random variable Let X be a random variable on a probability space (Ω.

Label as accurately as possible. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 6 / 27 . n→∞ lim F (xn ) = F (x) Would the same result hold if it had been the case that xn ≤ x for all n? Draw a graph of the cumulative distribution function of IA where A is some set in F. Prove that.Exercise Prove that F (·) is a non-decreasing function. For some point x. let xn be a sequence of numbers such that xn ≥ x for all n and limn→∞ xn = x.

Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 7 / 27 .Expectations Deﬁnition EX = Ω X (ω) dP What does that mean? Indicator Ω IA (ω) dP = P(A) n i=1 αi IAi (ω)) dP Non-negative simple Ω( = n i=1 αi P(Ai ) Non-negative Limit of simple functions.

0) X − (ω) = max(−X (ω). 0) Deﬁnition If either E X + < ∞ or E X − < ∞ we deﬁne E X = E X+ − E X− If both E X + < ∞ and E X − < ∞ we say that X is integrable Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 8 / 27 .Real-valued random variable X + and X − X + (ω) = max(X (ω).

Properties of E Comparison If X ≤ Y a.s. then E(αX + βY ) = α E X + β E Y Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 9 / 27 . non-negative then EX ≤ EY Linearity If α and β are real constants and X and Y are integrable or if α and β are nonnegative constants and X and Y are non-negative.s. and X and Y are integrable or a.

then. real-valued function deﬁned on R and if X is integrable.) Integrability X is integrable if and only if. φ(E X ) ≤ E φ(x) Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 10 / 27 . E |X | < ∞ Jensen’s inequality If φ is a convex.Properties of E (contd.

. be a sequence of random variables converging a.s. . lim E Xn = E X Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 11 / 27 .s. to another random variable X . . If 0 ≤ X1 ≤ X2 ≤ · · · then.Monotone convergence theorem Theorem Let X1 . X2 . n→∞ a.

s.a. then n→∞ lim E Xn = E X Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 12 / 27 .Dominated convergence theorem Theorem Let X1 . for every n. . X2 . . be a sequence of random variables converging a. If there is another random variable Y such that E Y < ∞ and |Xn | ≤ Y a. . to a random variable X .

F. P) an let g be a Borel measurable function on R. E |g(X )| = R |g(x)| dµX and if this quantity is ﬁnite then E g(X ) = R g(x) dµX Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 13 / 27 .Expectations of functions Theorem Let X be a random variable on a probability space (Ω. Then.

then we deﬁne pi = P(X = xi ). . x2 ..Two special cases Density function f is a density function for the distribution measure µX if for any Borel set B. It follows that µX (B) = i|xi ∈B pi Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 14 / 27 . µX (B) = B f (x)dx Probability mass function If X takes on only a countable set of values x1 . . .

Expectations and density Theorem Let X be a random variable on a probability space (Ω. F. Suppose that X has a density f . ∞ E |g(X )| = −∞ |g(x)|f (x) dx If this quantity is ﬁnite. P). then ∞ Eg(X ) = −∞ g(x)f (x) dx Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 15 / 27 . Then. and let g be a Borel-measurable function on R.

Furthermore.s.Change of measure Theorem Let (Ω. deﬁne P(A) = A Z (ω) dP(ω). Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 16 / 27 . nonnegative random variable with E Z = 1. For A ∈ F. F. if X is a nonnegative random variable then EX = E[XZ ]. Then P is a probability measure. P) be a probability space and let Z be an a.

Radon-Nikod´ m Theorem y Theorem Let P and P be equivalent probability measures deﬁned on (Ω. Then there exists an almost surely positive random variable Z such that E Z = 1 and P(A) = A Z (ω) dP(ω) for every A ∈ F Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 17 / 27 . F).

Let T be a ﬁxed positive number and assume that for each t ∈ [0.Filtration Deﬁnition Let Ω be a nonempty set. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 18 / 27 . Assume further that if s ≤ t. then every set in F(s) is also in F(t). a ﬁltration. T ] there is a σ-algebra F(t). 0 ≤ t ≤ T . Then we call the collection of σ-algebras F(t).

P) be a probability space.B ∈ H Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 19 / 27 . and let G and H be sub-σ-algebras of F.Independence (σ-algebras) Deﬁnition Let (Ω. F. We say these two σ-algebras are independent if P(A ∩ B) = P(A) · P(B) for all A ∈ G.

Independence (random variables) Deﬁnition Let X and Y be random variables on (Ω. P). Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 20 / 27 . We say these two variables are independent if σ(X ) and σ(Y ) are independent. F.

Y (x. E euX +vY = E eux · E evY . Any of this implies E[XY ] = E X · E Y if E |XY | < ∞ Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 21 / 27 . y ) = fX (x) · fY (y ) a. FX .Independence (characterization) The following are equivalent: 1 2 3 4 5 X and Y are independent.Y (A × B) = µx (A) · µY (B). µX .Y (a.e. b) = FX (a) · FY (b). fX .

Partial averaging E[X | G](ω) dP(ω) = A A X (ω) dP(ω) for all A ∈ G Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 22 / 27 . let G be a sub-σ-algebra of F. is any random variable that satisﬁes Measurability E[X | G] is G-measurable. P) be a probability space. F. The conditional expectation of X given G. and let X be a random variable that is either nonnegative or integrable. denoted E[X | G].Conditional Expectation Deﬁnition Let (Ω.

Taking out what is known Deﬁnition If X and Y are integrable random variables. and X is G-measurable. Y and XY are integrable. then E[XY |G] = X E[Y |G] Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 23 / 27 .

Iterated conditioning Deﬁnition If H is a sub-σ-algebra of G and X is an integrable random variable. then E[E[X |G]|H] = E[X |H] Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 24 / 27 .

Independence Deﬁnition If X is integrable and independent of G. then E[X |G] = E X Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 25 / 27 .

. Xn ) is jointly normal if it has the joint density fX (x) = 1 (2π)n det(C) e− 2 (x−µ)C 1 −1 (x−µ) Where µ is a row vector of constants and C is a n × n positive-deﬁnite matrix. .Multivariate normal Deﬁnition A random column vector X = (X1 . . Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 26 / 27 . X2 . .

175. Elsevier India. 807 (advanced). Measure Theory and Probability. A. Springer. 595. P. 295. Jacod. (advanced) Billingsley. Jyotirmoy Bhattacharya (ICRIER) Continuous-Time Finance IIMK Jan ’11 27 / 27 . Rs. and Protter. Probability Essentials. Rs. P. Wiley. Course in Probability Theory.References Basu. L. Chung. Rs. K. Probability and Measure. J. Rs. K.