P RASAD C HALASANI Carnegie Mellon University chal@cs.cmu.edu S OMESH J HA Carnegie Mellon University sjha@cs.cmu.edu
October 6, 1997
Contents
1 Introduction to Probability Theory 1.1 1.2 1.3 1.4 1.5 The Binomial Asset Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . . Finite Probability Spaces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lebesgue Measure and the Lebesgue Integral . . . . . . . . . . . . . . . . . . . . General Probability Spaces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5.1 1.5.2 1.5.3 1.5.4 1.5.5 1.5.6 1.5.7 Independence of sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Independence of algebras . . . . . . . . . . . . . . . . . . . . . . . . . Independence of random variables . . . . . . . . . . . . . . . . . . . . . . Correlation and independence . . . . . . . . . . . . . . . . . . . . . . . . Independence and conditional expectation. . . . . . . . . . . . . . . . . . Law of Large Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . Central Limit Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 11 16 22 30 40 40 41 42 44 45 46 47 49 49 50 52 52 53 54 55 57 58
2 Conditional Expectation 2.1 2.2 2.3 A Binomial Model for Stock Price Dynamics . . . . . . . . . . . . . . . . . . . . Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conditional Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 2.3.2 2.3.3 2.3.4 2.3.5 2.4 An example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Denition of Conditional Expectation . . . . . . . . . . . . . . . . . . . . Further discussion of Partial Averaging . . . . . . . . . . . . . . . . . . . Properties of Conditional Expectation . . . . . . . . . . . . . . . . . . . . Examples from the Binomial Model . . . . . . . . . . . . . . . . . . . . .
Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2 3 Arbitrage Pricing 3.1 3.2 3.3 Binomial Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General onestep APT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . RiskNeutral Probability Measure . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 3.3.2 3.4 3.5 Portfolio Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selfnancing Value of a Portfolio Process . . . . . . . . . . . . . . . . 59 59 60 61 62 62 63 64 67 67 69 70 70 73 74 77 77 79 81 85 85 86 88 89 91 91 92 94 97 97
4 The Markov Property 4.1 4.2 4.3 4.4 4.5 Binomial Model Pricing and Hedging . . . . . . . . . . . . . . . . . . . . . . . . Computational Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Markov Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.1 Different ways to write the Markov property . . . . . . . . . . . . . . . . Showing that a process is Markov . . . . . . . . . . . . . . . . . . . . . . . . . . Application to Exotic Options . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5 Stopping Times and American Options 5.1 5.2 5.3 American Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Value of Portfolio Hedging an American Option . . . . . . . . . . . . . . . . . . . Information up to a Stopping Time . . . . . . . . . . . . . . . . . . . . . . . . . .
6 Properties of American Derivative Securities 6.1 6.2 6.3 6.4 The properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proofs of the Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compound European Derivative Securities . . . . . . . . . . . . . . . . . . . . . . Optimal Exercise of American Derivative Security . . . . . . . . . . . . . . . . . .
7 Jensens Inequality 7.1 7.2 7.3 Jensens Inequality for Conditional Expectations . . . . . . . . . . . . . . . . . . . Optimal Exercise of an American Call . . . . . . . . . . . . . . . . . . . . . . . . Stopped Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Strong Markov Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 General First Passage Times . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Example: Perpetual American Put . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Difference Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Distribution of First Passage Times . . . . . . . . . . . . . . . . . . . . . . . . . . 107
8.10 The Reection Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 9 Pricing in terms of Market Probabilities: The RadonNikodym Theorem. 9.1 9.2 9.3 9.4 9.5 111
RadonNikodym Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 RadonNikodym Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 The State Price Density Process . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Stochastic Volatility Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . 116 Another Applicaton of the RadonNikodym Theorem . . . . . . . . . . . . . . . . 118 119
11.1 Law of a Random Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 11.2 Density of a Random Variable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 11.3 Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 11.4 Two random variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 11.5 Marginal Density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 11.6 Conditional Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 11.7 Conditional Density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 11.8 Multivariate Normal Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . 129 11.9 Bivariate normal distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130 11.10MGF of jointly normal random variables . . . . . . . . . . . . . . . . . . . . . . . 130 12 SemiContinuous Models 131
8.4
Expectation of
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
8.3
8.2
97 99
4 12.2 The Stock Price Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132 12.3 Remainder of the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 12.4 RiskNeutral Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 12.5 RiskNeutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 12.6 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 12.7 Stalking the RiskNeutral Measure . . . . . . . . . . . . . . . . . . . . . . . . . . 135 12.8 Pricing a European Call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 13 Brownian Motion 139
13.1 Symmetric Random Walk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 13.2 The Law of Large Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 13.3 Central Limit Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 13.4 Brownian Motion as a Limit of Random Walks . . . . . . . . . . . . . . . . . . . 141 13.5 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 13.6 Covariance of Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 13.7 FiniteDimensional Distributions of Brownian Motion . . . . . . . . . . . . . . . . 144 13.8 Filtration generated by a Brownian Motion . . . . . . . . . . . . . . . . . . . . . . 144 13.9 Martingale Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 13.10The Limit of a Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 13.11Starting at Points Other Than 0 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 13.12Markov Property for Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . 147 13.13Transition Density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 13.14First Passage Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 14 The It Integral o 153
14.1 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 14.2 First Variation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 14.3 Quadratic Variation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 14.4 Quadratic Variation as Absolute Volatility . . . . . . . . . . . . . . . . . . . . . . 157 14.5 Construction of the It Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 o 14.6 It integral of an elementary integrand . . . . . . . . . . . . . . . . . . . . . . . . 158 o 14.7 Properties of the It integral of an elementary process . . . . . . . . . . . . . . . . 159 o 14.8 It integral of a general integrand . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 o
5 14.9 Properties of the (general) It integral . . . . . . . . . . . . . . . . . . . . . . . . 163 o 14.10Quadratic variation of an It integral . . . . . . . . . . . . . . . . . . . . . . . . . 165 o 15 It s Formula o 167
15.1 It s formula for one Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . 167 o 15.2 Derivation of It s formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168 o 15.3 Geometric Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 15.4 Quadratic variation of geometric Brownian motion . . . . . . . . . . . . . . . . . 170 15.5 Volatility of Geometric Brownian motion . . . . . . . . . . . . . . . . . . . . . . 170 15.6 First derivation of the BlackScholes formula . . . . . . . . . . . . . . . . . . . . 170 15.7 Mean and variance of the CoxIngersollRoss process . . . . . . . . . . . . . . . . 172 15.8 Multidimensional Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . 173 15.9 Crossvariations of Brownian motions . . . . . . . . . . . . . . . . . . . . . . . . 174 15.10Multidimensional It formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175 o 16 Markov processes and the Kolmogorov equations 177
16.1 Stochastic Differential Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 16.2 Markov Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 16.3 Transition density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 16.4 The Kolmogorov Backward Equation . . . . . . . . . . . . . . . . . . . . . . . . 180 16.5 Connection between stochastic calculus and KBE . . . . . . . . . . . . . . . . . . 181 16.6 BlackScholes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 16.7 BlackScholes with pricedependent volatility . . . . . . . . . . . . . . . . . . . . 186 17 Girsanovs theorem and the riskneutral measure 189
18.1 Martingale Representation Theorem . . . . . . . . . . . . . . . . . . . . . . . . . 197 18.2 A hedging application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 18.4 18.3 dimensional Girsanov Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . 199
. . . . . . . . . . . . . . . . . . . . . . . . . . 191
20.1 Reection principle for Brownian motion . . . . . . . . . . . . . . . . . . . . . . 209 20.2 Up and out European call. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212 20.3 A practical issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218 21 Asian Options 219
21.1 FeynmanKac Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 21.2 Constructing the hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 21.3 Partial average payoff Asian option . . . . . . . . . . . . . . . . . . . . . . . . . . 221 22 Summary of Arbitrage Pricing Theory 223
22.1 Binomial model, Hedging Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . 223 22.2 Setting up the continuous model . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 22.3 Riskneutral pricing and hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 22.4 Implementation of riskneutral pricing and hedging . . . . . . . . . . . . . . . . . 229 23 Recognizing a Brownian Motion 233
23.1 Identifying volatility and correlation . . . . . . . . . . . . . . . . . . . . . . . . . 235 23.2 Reversing the process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236 24 An outside barrier option 239
24.1 Computing the option value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 24.2 The PDE for the outside barrier option . . . . . . . . . . . . . . . . . . . . . . . . 243 24.3 The hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 25 American Options 247
25.1 Preview of perpetual American put . . . . . . . . . . . . . . . . . . . . . . . . . . 247 25.2 First passage times for Brownian motion: rst method . . . . . . . . . . . . . . . . 247 25.3 Drift adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249 25.4 Driftadjusted Laplace transform . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 25.5 First passage times: Second method . . . . . . . . . . . . . . . . . . . . . . . . . 251
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 209
7 25.6 Perpetual American put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252 25.7 Value of the perpetual American put . . . . . . . . . . . . . . . . . . . . . . . . . 256 25.8 Hedging the put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257 25.9 Perpetual American contingent claim . . . . . . . . . . . . . . . . . . . . . . . . . 259 25.10Perpetual American call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259 25.11Put with expiration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260 25.12American contingent claim with expiration . . . . . . . . . . . . . . . . . . . . . 261 26 Options on dividendpaying stocks 263
26.1 American option with convex payoff function . . . . . . . . . . . . . . . . . . . . 263 26.2 Dividend paying stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264 26.3 Hedging at time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266 267
27.1 Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 27.2 Hedging a forward contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 27.3 Future contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270 27.4 Cash ow from a future contract . . . . . . . . . . . . . . . . . . . . . . . . . . . 272 27.5 Forwardfuture spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272 27.6 Backwardation and contango . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273 28 Termstructure models 275
28.1 Computing arbitragefree bond prices: rst method . . . . . . . . . . . . . . . . . 276 28.2 Some interestrate dependent assets . . . . . . . . . . . . . . . . . . . . . . . . . 276 28.3 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 28.4 Forward rate agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 28.6 Computing arbitragefree bond prices: HeathJarrowMorton method . . . . . . . . 279 28.7 Checking for absence of arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . 280 28.8 Implementation of the HeathJarrowMorton model . . . . . . . . . . . . . . . . . 281 29 Gaussian processes 285 28.5 Recovering the interest from the forward rate . . . . . . . . . . . . . . . . . . 278
29.1 An example: Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286 30 Hull and White model 293
' $ (&%#
! "
8 30.1 Fiddling with the formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295 30.2 Dynamics of the bond price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296 30.3 Calibration of the Hull & White model . . . . . . . . . . . . . . . . . . . . . . . . 297 30.4 Option on a bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299 31 CoxIngersollRoss model 303 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
31.2 Kolmogorov forward equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 31.3 CoxIngersollRoss equilibrium density . . . . . . . . . . . . . . . . . . . . . . . 309 31.4 Bond prices in the CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310 31.5 Option on a bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313 31.6 Deterministic time change of CIR model . . . . . . . . . . . . . . . . . . . . . . . 313 31.7 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315 31.8 Tracking down in the time change of the CIR model . . . . . . . . . . . . . 316 319
32.2 Zerocoupon bond prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321 32.3 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323 33 Change of num raire e 325
33.1 Bond price as num raire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 e 33.2 Stock price as num raire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328 e 33.3 Merton option pricing formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 34 BraceGatarekMusiela model 335 . . . . . . . . . . . . . . . . . . . . . . . . . 335
34.2 BraceGatarekMusiela model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336 34.3 LIBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337 34.4 Forward LIBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338 34.6 Implementation of BGM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 34.7 Bond prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342 34.8 Forward LIBOR under more forward measure . . . . . . . . . . . . . . . . . . . . 343 34.5 The dynamics of . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
' A $ )BB&@9
32.1 Nonnegativity of
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
' $ 10)#
9 34.9 Pricing an interest rate caplet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343 34.10Pricing an interest rate cap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 34.11Calibration of BGM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 34.12Long rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346 34.13Pricing a swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346 35 Notes and References 349
35.1 Probability theory and martingales. . . . . . . . . . . . . . . . . . . . . . . . . . . 349 35.2 Binomial asset pricing model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349 35.3 Brownian motion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 35.4 Stochastic integrals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350 35.5 Stochastic calculus and nancial markets. . . . . . . . . . . . . . . . . . . . . . . 350 35.6 Markov processes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351 35.7 Girsanovs theorem, the martingale representation theorem, and riskneutral measures.351 35.8 Exotic options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 35.9 American options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 35.10Forward and futures contracts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 35.11Term structure models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 35.12Change of num raire. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 e 35.13Foreign exchange models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 35.14REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
10
Chapter 1
such that at the next period, the stock price will be either or . Typically, we take and to satisfy , so change of the stock price from to represents a downward movement, and change of the stock price from to represents an upward movement. It is common to also have , and this will be the case in many of our examples. However, strictly speaking, for what we are about to do we need to assume only (1.1) and (1.2) below. Of course, stock price movements are much more complicated than indicated by the binomial asset pricing model. We consider this simple model for three reasons. First of all, within this model the concept of arbitrage pricing and its relation to riskneutral pricing is clearly illuminated. Secondly, the model is used in practice because with a sufcient number of steps, it provides a good, computationally tractable approximation to continuoustime models. Thirdly, within the binomial model we can develop the theory of conditional expectations and martingales which lies at the heart of continuoustime models. With this third motivation in mind, we develop notation for the binomial model which is a bit different from that normally found in practice. Let us imagine that we are tossing a coin, and when we get a Head, the stock price moves up, but when we get a Tail, the price moves down. We denote the price at time by if the toss results in head (H), and by if it 11
D C ' e$ ! EX4@0b4C
DC EX
DC ESF
D EC
DC RQ
C D YF
D EC
(1.1)
12
S2 (HH) = 16
S2 (TT) = 1
results in tail (T). After the second toss, the price will be one of:
After three tosses, there are eight possible coin sequences, although not all of them result in different stock prices at time . For the moment, let us assume that the third toss is the last one and denote by
the set of all possible outcomes of the three tosses. The set of all possible outcomes of a random experiment is called the sample space for the experiment, and the elements of are called sample points. In this case, each sample point is a sequence of length three. We denote the th component of by . For example, when , we have , and . at time depends on the coin tosses. To emphasize this, we often write . The stock price Actually, this notation does not quite tell the whole story, for while depends on all of , depends on only the rst two components of , depends on only the rst component of , and does not depend on at all. Sometimes we will use notation such just to record more explicitly how depends on . Example 1.1 Set , and . We have then the binomial tree of possible stock prices shown in Fig. 1.1. Each sample point represents a path through the tree. Thus, we can think of the sample space as either the set of all possible outcomes from three coin tosses or as the set of all possible paths through the tree. To complete our binomial asset pricing model, we introduce a money market with interest rate ; $1 invested in the money market becomes in the next period. We take to be the interest
q PC ' d$ C c @r
e e eA c e eA e c eA c c eA e e cA c e cA e c cA c c c 1w@1w@1wd1@Bww"wdBwdu
D ' e$ ! C ' e e$ q A D C F ' e$ ! C F ' c e$ q 7EC q t@0s4Qt@07PC uEXSt@&b4S4d@07PC A D C F ' c$ ! C ' e c$ q C A D F ' c$ ! C F ' c c$ q bRSXtd5yxQ4@w57PvuEC q td5s4Yrdd57PC ' A ireAuqx1l!d$k p f vWF g D C !q j ' Aq A! $ sresxeihdg q fC c e c @w '# n $ uHh1Sm ! xC t C DC
13
rate for both borrowing and lending. (This is not as ridiculous as it rst seems, because in a many applications of the model, an agent is either borrowing or lending (not both) and knows in advance which she will be doing; in such an application, she should take to be the rate of interest for her activity.) We assume that
The model would not make sense if we did not have this condition. For example, if , then the rate of return on the money market is always at least as great as and sometimes greater than the return on the stock, and no one would invest in the stock. The inequality cannot happen unless either is negative (which never happens, except maybe once upon a time in Switzerland) or . In the latter case, the stock does not really go down if we get a tail; it just goes up less than if we had gotten a head. One should borrow money at interest rate and invest in the stock, since even in the worst case, the stock price rises at least as fast as the debt used to buy it. With the stock as the underlying asset, let us consider a European call option with strike price and expiration time . This option confers the right to buy the stock at time for dollars, and so is worth at time if is positive and is otherwise worth zero. We denote by
the value (payoff) of this option at expiration. Of course, actually depends only on , and we can and do sometimes write rather than . Our rst task is to compute the arbitrage price of this option at time zero. Suppose at time zero you sell the call for dollars, where is still to be determined. You now have an obligation to pay off if and to pay off if . At the time you sell the option, you dont yet know which value will take. You hedge your short shares of stock, where is still to be determined. You can use position in the option by buying the proceeds of the sale of the option for this purpose, and then borrow if necessary at interest rate to complete the purchase. If is more than necessary to buy the shares of stock, you dollars invested invest the residual money at interest rate . In either case, you will have in the money market, where this quantity might be negative. You will also own shares of stock. If the stock goes up, the value of your portfolio (excluding the short position in the option) is
and
so that (1.3)
and
! h
e ! ~
F r # n Hpq4 s
# n r I`
DG D C D D D G u
llDEsDGWD u suT1Ed5b4lGtd5s! u ' C $ ' # n $ n ' c$ ! C D ' c$ D Du ' c$ d5s! u A l' D C D W D u suHt1E$ ! C D $'# n $ n ' c
lsDElDGD u suHt10b4lGt@0s! u ' C $ ' # n $ n ' e$ ! C D ' e$ ' e @0$ ! u D Du A ' D C D $ ' # n $ n ' e$ ! C D llEsGWD u suT1E@&b4sG
(1.2)
14 These are two equations in two unknowns, and we solve them below Subtracting (1.4) from (1.3), we obtain
so that
This is a discretetime version of the famous deltahedging formula for derivative securities, according to which the number of shares of an underlying asset a hedge should hold is the derivative (in the sense of calculus) of the value of the derivative security with respect to the price of the underlying asset. This formula is so pervasive the when a practitioner says delta, she means the derivative (in the sense of calculus) just described. Note, however, that my denition of is the number of shares of stock one holds at time zero, and (1.6) is a consequence of this denition, not the denition of itself. Depending on how uncertainty enters the model, there can be cases in which the number of shares of stock a hedge should hold is not the (calculus) derivative of the derivative security with respect to the price of the underlying asset. To complete the solution of (1.3) and (1.4), we substitute (1.6) into either (1.3) or (1.4) and solve for . After some simplication, this leads to the formula
This is the arbitrage price for the European call option with payoff formula, we dene
Because we have taken , both and are dened,i.e., the denominator in (1.8) is not zero. , and because they sum to , we can regard Because of (1.2), both and are in the interval them as probabilities of and , respectively. They are the riskneutral probabilites. They appeared when we solved the two equations (1.3) and (1.4), and have nothing to do with the actual probabilities of getting or on the coin tosses. In fact, at this point, they are nothing more than a convenient tool for writing (1.7) as (1.9). We now consider a European call which pays off dollars at time . At expiration, the payoff of this option is , where and depend on and , the rst and second coin tosses. We want to determine the arbitrage price for this option at time zero. Suppose an agent sells the option at time zero for dollars, where is still to be determined. She then buys shares
D G
e c 'A6 ss)$ F gW ' e$ (0y! u Ed5s! u r I t D u n ' c$ # n A uTWeoF F x A WqHF x ' # H n $ # n ! u # n '@0b! ' # q oF n ' c $ W# F n T e$ u uHt1F Ed5y! u WH D u n $
A'' e C ' c C ' e l"@0$ ! Wrd5$ ! 5$ D t@0$ ! u rd5$ ! u ' c p ! ' C 4d5$ ' c @0&$ee y!! q4d5s!! C G ' @$ u ' c$ u D s qC Du qu Du v ' s q 5Vx q u C$ e c D Du
(1.5)
(1.6)
(1.7)
(1.8)
(1.9)
15
dollars in the money market to nance this. At time , the agent has of stock, investing a portfolio (excluding the short position in the option) valued at
After the rst coin toss, the agent has dollars and can readjust her hedge. Suppose she decides to now hold shares of stock, where is allowed to depend on because the agent knows what value has taken. She invests the remainder of her wealth, in the money market. In the next period, her wealth will be given by the righthand side of the following equation, and she wants it to be . Therefore, she wants to have
Although we do not indicate it in the notation, and depend on and , the outcomes of the rst two coin tosses. Considering all four possible outcomes, we can write (1.11) as four equations:
We now have six equations, the two represented by (1.10) and the four represented by (1.11), in the six unknowns , , , , , and . To solve these equations, and thereby determine the arbitrage price at time zero of the option and the hedging portfolio , and , we begin with the last two
Subtracting one of these from the other and solving for mula
'' e$ ! C' e$ ! ' e$ $ ' # n $ n ' e e$ q C' e$ ! l"@&i4"@&b`Wt@0l! suHt1E@0uP"@&y` A '' e$ ! C' e$ ! ' e$ $ ' # n $ n ' c e$ q C' e$ ! lw@0s4"@0s`r0y! suT1Ed@0uP"@&y` A'' c$ ! C' c$ ! ' c$ $ ' # n $ n ' e c$ q C' c$ ! lwy4wy`4i! suTebPwy` A'' c C' c ' c $'# n $ n ' c c C' c l"d5$ ! "d5$ ! W4d5$ ! suHt1Yd$ q w$ !
' e$ @&y!` ' e$ C' $ ! e$ l"'@0s!4"e0b`Wt'@&i! ' # n ' e e $ q C ' e $ ! ' e e$ $suTne$P@0iP"@0b @&bq u A ' e ! C e$ ' e $ ' n $ y'"@0$s4"'@&y!`4@0$i! su#Ht1nE'd@0iP"@0b 0bq u c e$ q C' e$ ! ' c e$ ' e @&$ ! d5$ ! D ' c
and therefore depend on Although we do not indicate it in the notation, the rst coin toss. Thus, there are really two equations implicit in (1.10):
, the outcome of
q x
! C! 4"`T! ! ! ! 'D CD lsEsGWD $ ' # n $ n ' e $ ! C D x ' e $ u suTt1E@0bxiG @0s! A ' D C D $ ' # n $ n ' c$ ! C D yiEsWD u suTed5bxiG d5y! x ' c $
# n ' e ('@e0$ q u Ed@0$ q u H 4@0$ ! e n' c e e $ q C ' c e$ q A '@0ee 7PW4'dc@e0$7fC ' e $ ! ' e $ 0uq u 4d@07q u t@0s`
Du
D CD ElGD u
(1.10)
qu
(1.11)
(1.12)
(1.13)
16 Equation (1.13), gives the value the hedging portfolio should have at time if the stock goes down between times and . We dene this quantity to be the arbitrage value of the option at time if , and we denote it by . We have just shown that (1.14)
The hedger should choose her portfolio so that her wealth if agrees with dened by (1.14). This formula is analgous to formula (1.9), but postponed by one step. The rst two equations implicit in (1.11) lead in a similar way to the formulas
and
, where
, dened by (1.16)
This is again analgous to formula (1.9), postponed by one step. Finally, we plug the values and into the two equations implicit in (1.10). The solution of these equations for and is the same as the solution of (1.3) and (1.4), and results again in (1.6) and (1.9). denotes the value at The pattern emerging here persists, regardless of the number of periods. If time of a derivative security, and this depends on the rst coin tosses , then at time , after the rst tosses are known, the portfolio to hedge a short position shares of stock, where should hold
of all possible outcomes of three coin tosses. Let be the set of all subsets of . Some sets in are , , , and itself. How many sets are there in ?
' e @0$ ! u
(1.15)
' c td5$ !
(1.17)
(1.18)
e ! AA! $ '"AsElt1"issldX u SdBsEyx1wssiihdQ u 4T tByxe"sisldbEl u n ' cA! AA! $ # n '! AA! $! ! AA! Eyx11isssh o eA! AA! $ C ' cA! AA! $ A '@wsElxe1ssisdXPqf'cAs!ElxeA"sisAs!}$QPC ! A ! ' eA! AA! $ @"sEyx1"isii}Q u fsElxe"siss}7 u t' Ey 1wssiA ! d$ Ey
x1"isiAs A ! u
e e e e e cA c e cA e c cA c c c s w"w@jwddb e e eA c e eA e c eA c c eA e e cA c e cA e c cA c c c 1w@1w@1wd1@Bww"wdBwdu
('ebq u Ed5uq u fH d5s! u c$ n ' c c $ # n x ' c $ c! ' c$ y! u '@w5uPqfd7PC ' c $ ! e c$ q C ' c c$ q ' e c$ ' c c$ bq u fd7q u 4b`
! AA! Elt1"isssh
' y e"sisA ! d$ Ey ! A ! `
e ! g `
17
(i)
Probability measures have the following interpretation. Let be a subset of . Imagine that is the set of all possible outcomes of some random experiment. There is a certain probability, between and , that when that experiment is performed, the outcome will lie in the set . We think of as this probability.
For example,
As in the above example, it is generally the case that we specify a probability measure on only some of the subsets of and then use property (ii) of Denition 1.1 to determine for the remaining sets . In the above example, we specied the probability measure only for the sets containing a single element, and then used Denition 1.1(ii) in the form (2.2) (see Problem 1.4(ii)) to determine for all the other sets in .
wG
(i)
Denition 1.2 Let be a nonempty set. A algebra is a collection following three properties:
c ! Y E E Y p E e e c A c e c A e c c A c c c A q p Un p q In Vw"w@j"dddbp
of subsets of
' $ 5
b Qlp ' $ 5
For
, we dene
A b qq A bq q A 7q
for
and
for
(2.2)
with the
! P ! fB ' $ lu5 l g
(ii) If
, then
A i)6
is a function mapping
into
ssiAsBs q A! $ t'
' $ 5
18
in Example 1.2:
so that
We interpret algebras as a record of information. Suppose the coin is tossed three times, and you are not told the outcome, but you are told, for every set in whether or not the outcome is in that set. For example, you would be told that the outcome is not in and is in . Moreover, you might be told that the outcome is not in but is in . In effect, you have been told that the rst toss was a , and nothing more. The algebra is said to contain the information of the rst toss, which is usually called the information up to time . Similarly, contains the information of
Q S BA S BA A A S A S BA Y w BA Y w BA BA A A A A A xYSBrBBA )b
A Q
AQ A Q
A Q
!
A A A ! Q4@BA )b
so that
A e e eA c e eA e c eA c c eA e e cA c e cA e c cA c c c A Q1w@lyQww@sQw"w@jbXjd"wdbyA t
A 11www@sQw"w@jjd"wdbyA t e e eA c e eA e c eA c c eA e e cA c e cA e c cA c c c A
and all sets which can be built by taking unions of these The set of all subsets of
A Q
A X
e e e e A c e e A e c e A c c e x s"w1@w@wd@iq c e e c A c e c A e c c A c c c x bjw"wddb
! @ P
(iii) If
!
w@
A t A
issAuBAiq@i A! g q @ D ! q @
(ii) If
, is also in .
19
contains full the rst two tosses, which is the information up to time . The algebra information about the outcome of all three tosses. The socalled trivial algebra contains no information. Knowing whether the outcome of the three tosses is in (it is not) and whether it is in (it is) tells you nothing about
Example 1.3 Let be given by (2.1) and consider the binomial asset pricing Example 1.1, where , and . Then , , and are all random variables. For example, . The random variable is really not random, since for all . Nonetheless, it is a function mapping into , and thus technically a random variable, albeit a degenerate one. A random variable maps into , and we can look at the preimage under the random variable of sets in . Consider, for example, the random variable of Example 1.1. We have
and sets which can be built by taking unions of these. This collection of sets is a algebra, called the algebra generated by the random variable , and is denoted by . The information content of this algebra is exactly the information learned by observing . More specically, suppose the coin is tossed three times and you do not know the outcome , but someone is willing , whether is in the set. You might be told, for example, that is to tell you, for each set in not in , is in , and is not in . Then you know that in the rst two tosses, there was a head and a tail, and you know nothing more. This information is the same you would have gotten by being told that the value of is . Note that dened earlier contains all the sets which are in , and even more. This means that the information in the rst two tosses is greater than the information in . In particular, if you see the rst two tosses, you can distinguish from , but you cannot make this distinction from knowing the value of alone.
q PC 'q C$ BP
qC
'q C$ "P5
q PC
q PC
' $q dbfC
pA i7Sf
is:
f ' $D }EC
RC
q PC
Denition 1.4 Let be a nonempty nite set and let random variable is a function mapping into .
AAq A! AD w"sisi@"B"7
Denition 1.3 Let be a nonempty nite set. A ltration is a sequence of algebras such that each algebra in the sequence contains all the sets contained by the previous algebra.
@
DEC q ! D PC 4C EC
S j 'q C$ "P5h
q PC
q @
. A
20 Denition 1.5 Let be a nonemtpy nite set and let be the algebra of all subsets of . Let be a random variable on . The algebra generated by is dened to be the collection of all sets of the form , where is a subset of . Let be a sub algebra of . We say that is measurable if every set in is also in . Note: We normally write simply rather than .
Denition 1.6 Let be a nonempty, nite set, let be the algebra of all subsets of , let be , and let be a random variable on . Given any set , we a probabilty measure on dene the induced measure of to be
In other words, the induced measure of a set tells us the probability that takes a value in . In the case of above with the probability measure of Example 1.2, some sets in and their induced measures are:
at the number , and a mass of size at the number . A common way to record this information is to give the cumulative distribution function of , dened by
if if if if
By the distribution of a random variable , we mean any of the several ways of characterizing . If is discrete, as in the case of above, we can either tell where the masses are and how large they are, or tell what the cumulative distribution function is. (Later we will consider random variables which have densities, in which case the induced measure of a set is the integral of the density over the set .) Important Note. In order to work through the concept of a riskneutral measure, we set up the denitions to make a clear distinction between random variables and their distributions. A random variable is a mapping from to , nothing more. It has an existence quite apart from discussion of probabilities. For example, in the discussion above, , regardless of whether the probability for is or .
at the number
, a mass of size
(2.3)
q fC fHGs 7 A A )sjIf A ' q C $ x ' Af STjI A tYHP S$ A 7w ) 6 A l qPC 'Y5$ 7 l q q qC ! q ! Vt'rY$ ~uPup SiB)6 q C A q p A7' 4TB)6 $ ' A A7' t $ $ ' A 6 ' $ ' )t5 t7$
' wtd$ y
Q p x @$ '
' $ ' h $ !q
q PC
on , i.e., a way of assigning probabilities The distribution of a random variable is a measure to sets in . It depends on the random variable and the probability measure we use in . If we set the probability of to be , then assigns mass to the number . If we set the probability assigns mass to the number . The distribution of has changed, but of to be , then the random variable has not. It is still dened by
Thus, a random variable can have more than one distribution (a market or objective distribution, and a riskneutral distribution). In a similar vein, two different random variables can have the same distribution. Suppose in the binomial model of Example 1.1, the probability of and the probability of is . Consider a European call with strike price expiring at time . The payoff of the call at time is the random , which takes the value if or , and takes the value in variable every other case. The probability the payoff is is , and the probability it is zero is . Consider also a European put with strike price expiring at time . The payoff of the put at time is , or . Like the payoff of the call, the payoff of the which takes the value if put is with probability and with probability . The payoffs of the call and the put are different random variables having the same distribution.
(2.4)
Notice that the expected value in (2.4) is dened to be a sum over the sample space . Since nite set, can take only nitely many values, which we label . We can partition the subsets , and then rewrite (2.4) as
Denition 1.7 Let be a nonempty, nite set, let be the algebra of all subsets of , let a probabilty measure on , and let be a random variable on . The expected value of dened to be
v BP5$ 'q C
is a into
!q
q PC
AA! )"sislE
e c c wd
e e e g p p c c c ! d p p
s !
21
b) x
l !
6 c e e @g ! p
f l
' wA $
c l
v XlH q 5$ 'f C
!q
be is
22 Thus, although the expected value is dened as a sum over the sample space , we can also write it as a sum over .
Denition 1.8 Let be a nonempty, nite set, let be the algebra of all subsets of , let be a probabilty measure on , and let be a random variable on . The variance of is dened to be the expected value of , i.e., Var
' lsY5$
Var
Q f f f f ~n f Tn s uQ s XsQ s n f f n uPbp sPbp s XiPbyp ss q C n y )f q C l n q C f 'rY lESj5 sTP@5 ss $ n ' $ f n ' $ e e e ' e e e$ q C n c e e ' c e e$ q C sp w@07fTx@sp "d@07Pn sp "@w@&$ q Irsp "dd@0$ q n e c e ' e c e C n c c e ' c c e C ewbp "@bPIr@wbp "d@w57Pn e c ' e e c$ q C n c e c ' c e c$ q C e c c ' e c c$ q C n c c c ' c c c$ q dbp "@wd57PTrdup "dd7PC
q PC
To make the above set of equations absolutely clear, we consider (2.3). The denition of is
qC PG
qC PG A B"isiA !
(2.5)
23
, is the smallest algebra containing all open Denition 1.9 The Borel algebra, denoted intervals in . The sets in are called Borel sets.
is in , where and are real numbers. Since is By denition, every open interval a algebra, every union of open intervals is also in . For example, for every real number , the open halfline
is a Borel set, as is
This shows that every closed interval is Borel. In addition, the closed halflines
and
are Borel. Halfopen and halfclosed intervals are also Borel, since they can be written as intersections of open halflines and closed halflines. For example,
"sisA q A ! b A
This means that every set containing nitely many real numbers is Borel; if then
Every set which contains only one real number is Borel. Indeed, if
' $ 5
! fb BA pQ @b n
' A $ A $ A lTS5WQw1gSwBY5$
! fb A B4Wp Be$ A
XuXb
!f H
' $ ~
is Borel. Since
contains
' $ 5~
' $ 5
Every set which can be written down and just about every set imaginable is in discussion of this fact uses the algebra properties developed in Problem 1.3.
' $ 5
' $ 5
' $ ~
'A lBY5$
' $ 5
. The following
24
This means that the set of rational numbers is Borel, as is its complement, the set of irrational numbers. There are, however, sets which are not Borel. We have just seen that any nonBorel set must have uncountably many points. Example 1.4 (The Cantor set.) This example gives a hint of how complicated a Borel set can be. We use it later when we discuss the sample space for an innite sequence of coin tosses.
has two pieces. From each of these pieces, remove the middle half, i.e., remove the open set
has four pieces. Continue this process, so at stage , the set length . The Cantor set
is dened to be the set of points not removed at any stage of this nonterminating process. Note that the length of , the rst set removed, is . The length of , the second set removed, . The length of the next set removed is , and in general, the length of the is th set removed is . Thus, the total length removed is
and so the Cantor set, the set of points not removed, has zero length. Despite the fact that the Cantor set has no length, there are lots of points in this set. In particular, none of the endpoints of the pieces of the sets is ever removed. Thus, the points
are all in . This is a countably innite set of points. We shall see eventually that the Cantor set has uncountably many points.
! P x p f s s A s f iA s s s A A )6 q s s s A s s A s x q
q @
s s issA uf A s A s ssiA q
! !q f q !
! fB A p
A s A i 7iA f A f )6 A A A!
fA )6 !
iA f Pf A f
x !
A i)6
, and remove the middle half, i.e., remove the open interval
has
Aq A! 1sisiQib
, then
!f XuXb H
! ! n !
25
Lebesgue measure is dened to be the measure on which assigns the measure of each interval to be its length. Following Williamss book, we denote Lebesgue measure by . A measure has all the properties of a probability measure given in Problem 1.4, except that the total measure of the space is not necessarily (in fact, ), one no longer has the equation
in Problem 1.4(iii), and property (v) in Problem 1.4 needs to be modied to say:
We specify that the Lebesgue measure of each interval is its length, and that determines the Lebesgue measure of all other Borel sets. For example, the Lebesgue measure of the Cantor set in Example 1.4 must be zero, because of the length computation given at the end of that example. The Lebesgue measure of a set containing only one point must be zero. In fact, since
6 D @)uu
Letting
, we obtain
p BA G ETbuETG6 n D D
n BA p b
! P
Then
, so
, but
'! $ HB5
tQQ boy ' $ D 6 ' ! $ D tu P 5QE A' 1issyTBA) lTB)p t@lTB A' A q A' A ! '! $ HB5 ! fB ' l)$ yb ' $ 5~
q ! si@H
Aq A! sisi@s
(v) If
is a sequence of sets in
with
and
!P ! fB $ l'i@5 ' $ 5~
(ii) If
(i)
, then
A )6
' $ 5~
. A measure on
is a
26 The Lebesgue measure of a set containing countably many points must also be zero. Indeed, if , then
The Lebesgue measure of a set containing uncountably many points can be either zero, positive and nite, or innite. We may not compute the Lebesgue measure of an uncountable set by adding up the Lebesgue measure of its individual members, because there is no way to add up uncountably many numbers. The integral was invented to get around this problem. In order to think about Lebesgue integrals, we must rst consider the functions to be integrated.
Denition 3.4 is purely technical and has nothing to do with keeping track of information. It is difcult to conceive of a function which is not Borelmeasurable, and we shall pretend such functions dont exist. Hencefore, function mapping to will mean Borelmeasurable function mapping to and subset of will mean Borel subset of .
to be
is simple and
and each
AX h A Xw
where each
is of the form
if if
A ' $ lY5QQi
A simple function
from
to
to be
at some points. We
for every
from
to
' $ 5
be a function from to . We say that is Borelmeasurable if the set is in whenever . In the language of Section 2, we want the algebra generated by to be contained in .
' $ Sx qb
1sisA q A ! b
27 is integrable.
Finally, let be a function dened on , possibly taking the value at some points and the value at other points. We dene the positive and negative parts of to be
provided the righthand side is not of the form , since (or equivalently,
Let be a function dened on , possibly taking the value other points. Let be a subset of . We dene
The Lebesgue integral just dened is related to the Riemann integral in one very important way: if the Riemann integral is dened, then the Lebesgue integral agrees with the Riemann integral. The Lebesgue integral has two important advantages over the Riemann integral. The rst is that the Lebesgue integral is dened for more functions, as we show in the following examples. Example 1.5 Let be the set of rational numbers in , and consider set, has Lebesgue measure zero, and so the Lebesgue integral of over
To compute the Riemann integral , we choose partition points and divide the interval into subintervals . In each subinterval there is a rational point , where , and there is also an irrational point , where . We approximate the Riemann integral from above by the upper sum
A s)6
x
6 '! $ )tBEySqS5X@6
Ap h A pw
A s6
6 D )E ! D
where
' $ X"S5t
)
are nite at
. Being a countable is
28 , the upper sum is always and the lower sum is No matter how ne we take the partition of always . Since these two do not converge to a common value as the partition becomes ner, the Riemann integral is not dened. Example 1.6 Consider the function
It follows that
Now consider the Riemann integral , which for this function is the same as the . When we partition into subintervals, one of these will contain Riemann integral the point , and when we compute the upper approximating sum for , this point will contribute times the length of the subinterval containing it. Thus the upper approximating sum is . On the other hand, the lower approximating sum is , and again the Riemann integral does not exist. The Lebesgue integral has all linearity and comparison properties one would expect of an integral. In particular, for any two functions and and any real constant ,
D 7 ! E n D
D ! E "
Finally, if
and
and whenever
for all
, we have
6
' $ ! QYS5t E!
A D 7 A7DE7 n D E@ 7
is simple and
6 6D D )@XbuE E7
A s
' $ XSY5t
E7 D
' $ ! QYS5t E!
)BE7 D
' A TB)6
for some
A) 6 A6 )`
if if
for every
This is not a simple function because simple function cannot take the value function which lies between and is of the form
) 6 A6 )
if if
. Every simple
A )6 x ' $ A S5t
A s)6
29
There are three convergence theorems satised by the Lebesgue integral. In each of these the situation is that there is a sequence of functions converging pointwise to a limiting function . Pointwise convergence just means that
There are no such theorems for the Riemann integral, because the Riemann integral of the limiting function is too often not dened. Before we state the theorems, we given two examples of pointwise convergence which arise in probability theory.
Example 1.8 Consider a sequence of normal densities, each with mean and the th having variance :
We have again for every , so , but . The function is not the Dirac delta; the Lebesgue integral of this function was already seen in Example 1.6 to be zero.
D 7Ei
A D 7Ei
D yb E7
y b
D E7s
bo y
If
D 7i
A pA A lssB7dBEi
6 D d
if if
6 6 D @E@
9 D "87Tby TE7
D dE7)i
D @E7Xs
We have
for every , so
, but
for every
Example 1.7 Consider a sequence of normal densities, each with variance mean :
G w
and the th having
A pA lsi)B BA
for every
30 . We could modify either Example 1.7 or 1.8 by setting if is even, if is odd. Now if is even, but if is odd. The has two cluster points, and . By denition, the smaller one, , is and the larger one, , is . Fatous Lemma guarantees that even the smaller cluster point will be greater than or equal to the integral of the limiting function. The key assumption in Fatous Lemma is that all the functions take only nonnegative values. Fatous Lemma does not assume much but it is is not very satisfying because it does not conclude that
There are two sets of assumptions which permit this stronger conclusion.
Then
Theorem 3.3 (Dominated Convergence Theorem) Let be a sequence of functions, which may take either positive or negative values, converging pointwise to a function . Assume that there is a nonnegative integrable function (i.e., ) such that
Then
, a nonempty set, called the sample space, which contains all possible outcomes of some random experiment; , a algebra of subsets of ; , a probability measure on , i.e., a function which assigns to each set a number , which represents the probability that the outcome of the random experiment lies in the set .
j
for every
for every
4 w D HE7
A pA A isi)B7 dBSi
Theorem 3.2 (Monotone Convergence Theorem) Let converging pointwise to a function . Assume that
be a sequence of functions
for every
U D p igj
We have already seen some examples of nite probability spaces. We repeat these and give some examples of innite probability spaces as well. Example 1.9 Finite coin toss space. Toss a coin times, so that is the set of all sequences of and which have components. We will use this space quite a bit, and so give it a name: . Let be the collection of all subsets of . Suppose the probability of on each toss is , a number between zero and one. Then the probability of is . For each in , we dene
We can dene this way because has only nitely many elements, and so only nitely many terms appear in the sum on the righthand side of (4.1).
b x 5 Qlp ' $
' $ 5
For each
, we dene
is q H !
is a sequence of sets in
with
q ! ss@H
is a sequence of sets in
@
(d) If
and
are sets in
and
, then
with
isiA q BA !
6 ' $ t75
(a)
Remark 1.1 We recall from Homework Problem 1.4 that a probability measure properties:
, then
, then
, then
(4.1)
32 Example 1.10 Innite coin toss space. Toss a coin repeatedly without stopping, so that is the set of all nonterminating sequences of and . We call this space . This is an uncountably innite space, and we need to exercise some care in the construction of the algebra we will use here.
, where ranges over the positive In the algebra , we put every set in every algebra integers. We also put in every other set which is required to make be a algebra. For example, the set containing the single sequence
is not in any of the algebras, because it depends on all the components of the sequence and not just the rst components. However, for each positive integer , the set
We next construct the probability measure on which corresponds to probability for and probability for . Let be given. If there is a positive integer such that , then the description of depends on only the rst tosses, and it is clear how to dene . For example, suppose , where these sets were dened earlier. Then is in . We set and , and then we have
c ' n $g n q t@ST5 h@ ' $ ' $ ' $ ' $ q @ tS5 5 ' $ 5 Y G q j
Wv '`"A $
@
is also in
on every toss
! fb c u
c b
is in
and hence in
. Therefore,
on the rst
on the rst
tosses
tosses
on every toss
c c c c c c b~essdddu
c b
q @
Because sets.
e @e
A c @e
A e c
A c wc
For each positive integer , we dene example, contains four basic sets,
tosses. For
x
x Y x S x
A i)6
33
for which there is no positive integer such that . Such Let us now consider a set is the case for the set on every toss . To determine the probability of these sets, we write them in terms of sets which are in for positive integers , and then use the properties of probability measures listed in Remark 1.1. For example,
and
A similar argument shows that if so that , then every set in which contains and ) has probability zero, and hence very set only one element (nonterminating sequence of which contains countably many elements also has probabiliy zero. We are in a case very similar to Lebesgue measure: every point has measure zero, but sets can have positive measure. Of course, are those which contain uncountably many the only sets which can have positive probabilty in elements.
is either zero or one, takes values in the interval . Indeed, , and the other values of lie in between. We dene a dyadic rational number to be a number of the form , where and are integers. For example, is a dyadic . For example, rational. Every dyadic rational in (0,1) corresponds to two sequences
The numbers in (0,1) which are not dyadic rationals correspond to a single have a unique binary expansion.
A is)6
d(isdd5$ ' c c c c E8
Since each
6 ' e e e e t(isd&$
A e @x A c
if if
Aq 8A! issiwsP8
6 x ' $ dQE8
c bp
If
, then
on every toss
; otherwise,
on every toss
e c G6 G6 c bp @ c up y u @
on every toss
on the rst
tosses
6 @ y b@
c b
on the rst
tosses
on every toss
AYss cb c b
by
; these numbers
! fu c b
c u c u
c up
First two tosses are First two tosses are First two tosses are
Continuing this process, we can verify that for any positive integers
we have
In other words, the measure of all intervals in whose endpoints are dyadic rationals is the same as the Lebesgue measure of these intervals. The only way this can be is for to be Lebesgue measure.
We conclude this example with another look at the Cantor set of Example 3.2. Let be the subset of in which every evennumbered toss is the same as the oddnumbered toss immediately preceding it. For example, is the beginning of a sequence in , but is not. Consider now the set of real numbers
The numbers between can be written as , but the sequence must begin with either or . Therefore, none of these numbers is in . Similarly, the numbers between can be written as , but the sequence must begin with or , so none of these numbers is in . Continuing this process, we see that will not contain any of the numbers which were removed in the construction of the Cantor set in Example 3.2. In other words, . With a bit more work, one can convince onself that in fact , i.e., by requiring consecutive coin tosses to be paired, we are removing exactly those points in which were removed in the Cantor set construction of Example 3.2.
3 ' ed ! A e!d ! $
abI T ` Y
e wc
a Y bI T c
other than
!q
A i)6 p p Xp A I vX p A Xp H vX G6
q ' "A $ !
p ~sA f p f p A p p f A p f A 6 p ~sA p p p A 6
h h h h h
A s6 e wc
c @e
on , we have a corresponding induced measure in the construction of this example, then we have
satisfying
when we
35
In addition to tossing a coin, another common random experiment is to pick a number, perhaps using a random number generator. Here are some probability spaces which correspond to different ways of picking a number at random. Example 1.11 Suppose we choose a number from in such a way that we are sure to get either , or . Furthermore, we construct the experiment so that the probability of getting is , the probability of getting is and the probability of getting is . We describe this random experiment by taking to be , to be , and setting up the probability measure so that
The probability measure described in this example is , the measure induced by the stock price , when the initial stock price and the probability of is . This distribution was discussed immediately following Denition 2.8. Example 1.12 Uniform distribution on . Let and let , the collection of all Borel subsets containined in . For each Borel set , we dene to be the Lebesgue measure of the set. Because , this gives us a probability measure. This probability space corresponds to the random experiment of choosing a number from so that every number is equally likely to be chosen. Since there are innitely mean numbers in , this requires that every number have probabilty zero of being chosen. Nonetheless, we can speak of the probability that the number chosen lies in a particular set, and if the set has uncountably many points, then this probability can be positive. I know of no way to design a physical experiment which corresponds to choosing a number at random from so that each number is equally likely to be chosen, just as I know of no way to toss a coin innitely many times. Nonetheless, both Examples 1.10 and 1.12 provide probability spaces which are often useful approximations to reality. Example 1.13 Standard normal distribution. Dene the standard normal density
uDE7o2 @ x ' $ H
Let
, dene (4.2)
A 6 bB)5$
This determines for every set . For example, the probability of the interval is , because this interval contains the numbers and , but not the number .
A s6 A i)6
A is)6
& $ f"p
x ' $ # S52
' $ ~d
A i)6
f D gRC
' $ 5
' $ 5~gg
' $ 5
A s6
q PC
36
This corresponds to choosing a point at random on the real line, and every single point has probability zero of being chosen, but if a set is given, then the probability the point is in that set is given by (4.2). The construction of the integral in a general probability space follows the same steps as the construction of Lebesgue integral. We repeat this construction below. Denition 1.14 Let i.e., a mapping from If be a probability space, and let , possibly also taking the values
to
is an indicator, i.e,
If
If
is simple and
for every
for every
and
for every
A A pA A lssB7jSS8
' }$ d8 ' $
x QS8 yb X ' $ dRY8 uy tdj8 ' $ ' $8 ' $q8 ' $! 8 sidQYTd7dbPTo6
8 XT8 )B x Q
where each
, we dene
is a set in
A@w A w
if if
, we dene
such that
& $ fQ p %p # xwBY x A q
g
A wBY
' A "A $
If
in (4.2) is an interval
37
The above integral has all the linearity and comparison properties one would expect. In particular, if and are random variables and is a real constant, then
If
for every
, then
In fact, we dont need to have for every in order to reach this conclusion; it is has probability one. When a condition holds with enough if the set of for which probability one, we say it holds almost surely. Finally, if and are disjoint subsets of and is a random variable, then
We restate the Lebesgue integral convergence theorem in this more general context. We acknowledge in these statements that conditions dont need to hold for every ; almost surely is enough. Theorem 4.4 (Fatous Lemma) Let be a sequence of almost surely nonnegative random variables converging almost surely to a random variable . Then
or equivalently,
A X A X8 T X n
S 9 b "87 y T A X "87Tby T Q 9
Q x Q x Q
is dened to be
A pA A lis)7S
If
is a set in
and
If
is integrable, i.e,
38 Theorem 4.5 (Monotone Convergence Theorem) Let variables converging almost surely to a random variable
Then
or equivalently,
Theorem 4.6 (Dominated Convergence Theorem) Let be a sequence of random variables, converging almost surely to a random variable . Assume that there exists a random variable such that almost surely for every Then
or equivalently,
In Example 1.13, we constructed a probability measure on by integrating the standard normal density. In fact, whenever is a nonnegative function dened on satisfying , we call a density and we can dene an associated probability measure by
We shall often have a situation in which two measure are related by an equation like (4.3). In fact, the market measure and the riskneutral measures in nancial markets are related this way. We say with respect to , and we write that in (4.3) is the RadonNikodym derivative of
The probability measure weights different parts of the real line according to the density . Now suppose is a function on . Denition 1.14 gives us a value for the abstract integral
which is an integral with respec to Lebesgue measure over the real line. We want to show that
AD 2 uE7E
AD 2 uE7o
X
D E
' $ l 5~j
for every
D 2
p A lssABA7vdB Y b S y A QX y u Q is q
almost surely
A pA A lsi)B BY
be a sequence of random
. Assume that
D E X W2 X
X
D E2 5 x ' $
! G6 7
(4.3)
(4.4)
(4.5)
for in (4.5) and an equation which is suggested by the notation introduced in (4.4) (substitute cancel the ). We include a proof of this because it allows us to illustrate the concept of the standard machine explained in Williamss book in Section 5.12, page 5. The standard machine argument proceeds in four steps.
Step 3. Now that we know that (4.5) holds when is a simple function, we consider a general nonnegative function . We can always construct a sequence of nonnegative simple functions such that
and
for every
D 2 uE
X
We let get
and use the Monotone Convergence Theorem on both sides of this equality to
for every
A G
D 2 E7)i Qi 7 X wj ' $ ' $ Y5Ps uy tY5t ' $ ' $ q ' $ ! isY5QiHS7bIS5bT6
A pA issB7`BA
where each
for every
Step 2. Now that we know that (4.5) holds when is an indicator function, assume that simple function, i.e., a linear combination of indicator functions. In other words,
D bE2
'5$ ' $ 5
Step 1. Assume that is an indicator function, i.e., that case, (4.5) becomes
sr bpp
q
' S$ Sx ' $
39
. In
is a
40 Step 4. In the last step, we consider an integrable function , which can take both positive and negative values. By integrable, we mean that
1.5 Independence
In this section, we dene and discuss the notion of independence in a general probability space , although most of the examples we give will be for coin toss space.
Suppose a random experiment is conducted, and is the outcome. The probability that is . Suppose you are not told , but you are told that . Conditional on this information, the probability that is
The sets and are independent if and only if this conditional probability is the uncondidtional probability , i.e., knowing that does not change the probability you assign to . This discussion is symmetric with respect to and ; if and are independent and you know that , the conditional probability you assign to is still the unconditional probability . Whether two sets are independent depends on the probability measure . For example, suppose we toss a coin twice, with probability for and probability for on each toss. To avoid trivialities, we assume that . Then
' $ A
v
and
are independent if
Q Q v
g
c
X
' $ 5
(5.1)
41
If , then , the probability of one head and one tail, is . If you are told that the coin tosses resulted in a head on the rst toss, the probability of , which is now the probability of a on the second toss, is still . Suppose however that . By far the most likely outcome of the two coin tosses is , and . However, if you the probability of one head and one tail is quite small; in fact, are told that the rst toss resulted in , it becomes very likely that the two tosses result in one head and one tail. In fact, conditioned on getting a on the rst toss, the probability of one and one is the probability of a on the second toss, which is .
No matter which set we choose in and which set we choose in the probabilties is the probability of the intersection.
e cA c c wBwdb
These two algebras are independent. For example, if we choose the set the set from , then we have
e eA e cA c eA c c A Q1wbQd1dbyA )
c eA c c @wdb
Let
from
!
Example 1.14 Toss a coin twice, and let be given by (5.1). Let determined by the rst toss: contains the sets
A wf
for every
e eA c eA e cA c c A Q1sQw"dbyA )
Denition 1.16 Let and be sub algebras of set in is independent of every set in , i.e,
. We say that
and
be the algebra
and
e e
!q
)6 )vpA 6 ' $
!q
S q p S hfT5 ' $ A p ' $ ' $ q A w@5 A p ' $ Y A A S n q h@5 ' $
7 )6
ewbw c c eA e c @"u
)6 6 !q
' $ A
e c e cA c c wBwu
is the
!q
42 Example 1.14 illustrates the general principle that when the probability for a sequence of tosses is dened to be the product of the probabilities for the individual tosses of the sequence, then every set depending on a particular toss will be independent of every set depending on a different toss. We say that the different tosses are independent when we construct probabilities this way. It is also possible to construct probabilities such that the different tosses are not independent, as shown by the following example. Example 1.15 Dene
and for every set , dene to be the sum of the probabilities of the elements in . Then , so is a probability measure. Note that the sets on rst toss and on second toss have probabilities and , so the product of the probabilities is . On the other hand, the intersection of and contains the single element , which has probability . These sets are not independent.
The set in this last equation is a subset of the plane . In particular, i.e, a set of the form , where and . In this case,
AQGsw ' 8 $ 8 Gw"A % Hg H q q H X G"A %p t' $ A ' 8 $ ' 8 "A $ q A 8 x ' G HvQwUsp x$
8Q
A G HQ p @5$ x '
Suppose and on to be
is
could be a rectangle,
e e cA c e c D C F q C wBw@wbiEXSPb
and
ce1Acdc"Awc@ewBAwcdcdcb e e c F qPC l G 8
Denition 1.17 says that for independent random variables and is independent of every set dened in terms of . In the case of
of the stock at time In the probability space of three independent coin tosses, the price independent of . This is because depends on only the rst two coin tosses, whereas either or , depending on whether the third coin toss is or .
l G
q PC
Denition 1.17 We say that two random variables and are independent. generate
c c db c eA c c @"wdb ! bq e A c wcBwdcb c@"wcdbp eA c e cA c c wBwdbp c eA c c @wdb c b e A c wcdcb ! c b $ g' ' $ @ c e e c A ~sp A @Wsp A p @up @A @dbp e e c c e eA c eA e cA c c 1w@1@wBwdb
for the individual elements of to be
and
q PC
' 8$ &
l G
' $
is is
43
In other words, for independent random variables and , the joint distribution represented by the measure factors into the product of the marginal distributions represented by the measures and . A joint density for
is a nonnegative function
Not every pair of random variables has a joint density, but if a pair does, then the random variables and have marginal densities dened by
Suppose and have a joint density. Then and are independent variables if and only if the joint density is the product of the marginal densities. This follows from the fact that (5.2) is and , write (5.1) in terms equivalent to independence of and . Take of densities, and differentiate with respect to both and .
which is dened in terms of the random variable . Therefore, this set is in . (In general, we have that every set in is also in , which means that contains at least as much information as . In fact, can contain strictly more information than , which means that will contain all the sets in and others besides; this is the case, for example, if .) In the same way that we just argued that every set in is also in , we can show that every set in is also in . Since every set in is independent of every set in , we conclude that every set in is independent of every set in .
' h q $
' 8$ 0
' d$ A
' $
' $ x
' $
' d$ @Ah
' $ ' $ A
' 8$ 04d
Theorem 5.7 Suppose and are independent random variables. Let to . Then and are also independent random variables.
1g A $
A $ X1gH
' fg $
8 G Iv`A Y' $ ! A$ ' A A' G HPXSY5$ 5$ ' SY' $ ' $ SS)P5$ A A ' A ' 8 wA $ @XS' f5$ ! hw5$ A ' ' P5$ A 8 ' ' lpA$ 5$ 8 h Gwvsp uc p Gs iw 8
such that
"A $ ' 8
' tY5$
' $ A
' f $
' d$ A
and
and
(5.2)
and
be functions from
and
. But
44 be a sequence of random variables. We say that these random Denition 1.18 Let variables are independent if for every sequence of sets and for every positive integer ,
provided all the expectations are dened. P ROOF : Let trying to prove becomes
and
is dened to be
Var
and
is dened to be
Cov Var
Var
For independent random variables, the correlation coefcient is zero. Unfortunately, two random variables can have zero correlation and still not be independent. Consider the following example.
and
and
, but in fact,
q 8
d 8 d
Example 1.16 Let be a standard normal random variable, let the distribution . Dene standard normal random variable, and are uncorrelated, but
be independent of and have . We show that is also a and are not independent.
According to Theorem 5.8, for independent random variables, the covariance is zero. If both have positive variances, we dene their correlation coefcient
and
are independent. Now use the standard machine to get the result for
8 8 6 uk kp ju Ukp d d
' $ $ ! ' 4
x ' 8 $ j "A P
and
A $ sisl' q w q Bl' ! w ! A $
A A ssisq l!
8 q q
45
Since is standard normal, which shows that is also standard normal. Being standard normal, both Cov and
Where in
We conclude this section with the observation that for independent random variables, the variance , of their sum is the sum of their variances. Indeed, if and are independent and then
This argument extends to any nite number of random variables. If we are given independent random variables , then Var Var Var Var
The point of this statement is that if is independent of , then the best estimate of based on the information in is , the same as the best estimate of based on no information.
SG
' 8 wA $ q 6 6 d l l q d q 8 twA $ ' 8 8 8 p ~ ip 8 p @ p Q Qp p p p n u p b Qp Ikp b p d n d n ud p Qp Hud Usp Tnud Usp Usp ud 8 8 8 8 w
and and and and , and we have have expected value zero. Therefore, does the measure put its mass, i.e., what is the distribution of ? Var Var is independent of a algebra
' 8 l0$ n S' p n ' G80$ n 8 )p W8 & q HS' $ $p i q '8p W80nP'G8p W08$s' W STn q ' W ' 8 i q 8p W n
, then
' lX $
n n ' BsiPq $
n' "! $
$ $ $ g
x ' d A$
Var
Var
Var
8 In gd
(5.3)
46
The partial averaging equation holds because and are independent. The partial averaging equation for general independent of follows by the standard machine.
We are not going to give the proof of this theorem, but here is an argument which makes it plausible. We will use this argument later when developing stochastic calculus. The argument proceeds in two for every . We next check that Var as . In steps. We rst check that other words, the random variables are increasingly tightly distributed around as . For the rst step, we simply compute
times
For the second step, we rst recall from (5.3) that the variance of the sum of independent random variables is the sum of their variances. Therefore, Var Var
As
, we have Var
j 6 q ' &$ 6 8
! f q q q
S8 8
Then
converges to
almost surely as
If is an indicator of some set , which by assumption must be independent of averaging equation we must check is
f
, then the partial
To show this equality, we observe rst that also check the partial averaging property
Q X
is
for every
47
As , the distributions of all the random variables have the same degree of tightness, as measured by their variance, around their expected value . The Central Limit Theorem asserts that as , the distribution of approaches that of a normal random variable with mean (expected value) zero and variance . In other words, for every set ,
then each
Var
Y8
# S8
48
Chapter 2
Conditional Expectation
Please see Hulls book (Section 9.6.)
Note that we are not specifying the probability of heads here. Consider a sequence of 3 tosses of the coin (See Fig. 2.1) The collection of all possible outcomes (i.e. sequences of tosses of length 3) is
A typical sequence of will be denoted , and will denote the th element in the sequence . to denote the stock price at time (i.e. after tosses) under the outcome . Note We write depends only on . Thus in the 3cointoss example we write for instance, that
Each is a random variable dened on the set . More precisely, let . Then is a algebra and is a measurable space. Each is an measurable function , that is, is a function where is the Borel algebra on I . We will see later that R is in fact 49
PC H
' vV $ u
down by a factor of
D EC
' wA $
h h
! E C
50
= 3 2 S2 (HH) =u S0 = 2 S (H) = uS0 1 1= S0 1 = S (T) = dS0 1 = 2 2 S2 (TT) = d S0 3 = S3 (TTT) = d 3 S 0 = 3 = 2 = 2 S2 (HT) = ud S 0 S2 (TH) = ud S 0 = 3 = 3 = 3 S3 (HHT) = u2 d S0 S3 (HTH) = u2 d S0 S3 (THH) = u2 d S0 3 S3 (HHH) = u S 0
Figure 2.1: A three coin period binomial model. measurable under a sub algebra of . Recall that the Borel algebra is the algebra generated by the open intervals of I . In this course we will always deal with subsets of I that belong to . R R For any random variable dened on a sample space and any , we will use the notation:
Assumption 2.1
2.2 Information
Denition 2.1 (Sets determined by the rst tosses.) We say that a set is determined by the rst coin tosses if, knowing only the outcome of the rst tosses, we can decide whether the outcome of all tosses is in . In general we denote the collection of sets determined by the rst tosses by . It is easy to check that is a algebra.
z {y
AA pA BXsis)7G
PC
is
of
q
6 t t F yQ r lQ A A
51
,
The collection 1. 2. 3.
Denition 2.2 (Information carried by a random variable.) Let be a random variable . is determined by the random variable if, knowing only the value We say that a set of the random variable, we can decide whether or not . Another way of saying this is that for every , either or . The collection of susbets of determined by is a algebra, which we call the algebra generated by , and denote by .
these sets are called the atoms of the algebra In general, if is a random variable
, then
1. 2. 3.
$ r' h H
! $ E
is given by
'd$ T
' t $
' t $
! rwP' $
q' $ !E q r
52
is the probability of ,
If
then
and
We can think of
Let us estimate , given . Denote the estimate by . From elementary probability, is a random variable whose value at is dened by
D EC q
D EC q
C ' c e e$ ' q ! C$ ' e e e$ ' q ! C$ 7DEX td@0llPC 4 t@&sBfC x5j DC ' $! EX tdbxC ' q }$bPC D ' $q RC q gduPC c e e H bEYF4'@ewccsBfC x5j Pddd5sPC 45j DC $ 'q ! C$ ' c c c$ 'q ! C$ DRCStdbxC F ' $! Ft'duPC $q D F ' $q RC q td7fC e c c w ' q ! C$ lPC 45j
cddq c c q PC
If the value of
e e e
where
. Properties of
should depend on , i.e., it is a random variable. should also be known. In particular, , then
'q ! C$ BPC 4
2.3.1 An example
as a partial average of
A q t@w ' e c c$
is the probability of
q ' $ t ' $ r d u 5 h
q PC
! 4C
h h
etc.
if if
, then
$ $
A '' $ q C$ ' $ 'q ! C$ lwdsP5rIhdiBPC 4 ! X"4C X1lPC x5j ' q ! C$ ' $ ' $ ' q ! C $ D C' n F bEwQTp5$ !q QB54G dsPC 45j ! C D C' n F E"XT$ Y DC n DC EQ q S tEX q ESF q S tEYF q n DC n DC XB4C !
If
, then or
' $q d7fC
For
where
XB4C X"PC 45j ! 'q ! C$ 'q C$ P5j h ' q 5 ' q C ! 5j h C$ C$ 'q ! C$ PC 45j A ' $ ' q ! C$ lY5f tSPC 45j qPC 'q ! C$ PC 45j D EC DC EQ C q F C' n F ' $ D QY D "XT5$ !q 4Sf D F EC q DC ESF
For every set is measurable. is random only through dependence on , has two fundamental properties: if if if
In other words,
Let on
Then
Furthermore,
be a probability space, and let be a sub algebra of . Let be a random variable . Then is dened to be any random variable that satises:
'P j $
(a)
54
Existence. There is always a random variable satisfying the above properties (provided that ), i.e., conditional expectations always exist.
A random experiment is performed, i.e., an element of is selected. The value of is partially but not fully revealed to us, and thus we cannot compute the exact value of . . Because this estimate Based on what we know about , we compute an estimate of depends on the partial information we have about , it depends on , i.e., is a function of , although the dependence on is often not shown explicitly. If the algebra contains nitely many sets, there will be a smallest set in containing , which is the intersection of all sets in containing . The way is partially revealed to us is that we are told it is in , but not told which element of it is. We then dene to be the average (with respect to ) value of over this set . Thus, for all in this set , will be the same.
( ' $ u E u
Lemma 3.10 If
H E $ ' j u
Note that
' $ 1 E j
'd$e8 'de8 $
' d$
7@'}$ 3 8'd$j8 8 lp
Uniqueness. There can be more than one random variable is another one, then almost surely, i.e.,
' }$
A X ' $ Q"E j
8 "A
8 3 g8
' $ d"8
H
3 8
(3.1)
(3.2)
, (3.3)
55
Proof: To see this, rst use (3.2) and linearity of expectations to prove (3.3) when is a simple measurable random variable, i.e., is of the form , where each is in and each is constant. Next consider the case that is a nonnegative measurable random variable, can be written as the limit of an increasing sequence but is not necessarily simple. Such a of simple random variables ; we write (3.3) for each and then pass to the limit, using the Monotone Convergence Theorem (See Williams), to obtain (3.3) for . Finally, the general measurable random variable can be written as the difference of two nonnegative randomvariables , and since (3.3) holds for and it must hold for as well. Williams calls this argument the standard machine (p. 56). Based on this lemma, we can replace the second condition in the denition of a conditional expectation (Section 2.3.2) by:
in the partial averaging property to be . is thus an unbiased estimator of the random variable
Proof: The partial averaging property holds trivially when is replaced by . And since is measurable, satises the requirement (a) of a conditional expectation as well.
(c) (Linearity)
Proof: Take . This set is in since is measurable. Partial averaging implies . The righthand side is greater than or equal to zero, and the lefthand side is strictly negative, unless . Therefore, .
6 ' $ `@
'P j $
6 r ' $ HP j
(d) (Positivity) If
is sufcient to determine
based
tP j ' $
6 Hr
6 ' $ 5
(b) If
is measurable, then
(a)
( u ( j u ' $
, we have (3.4)
! i f u u
v u
u v u u
is a sub algebra of means that contains more information than . If we estimate based on the information in , and then estimate the estimator based on the smaller amount of information in , then we get the same result as if we had estimated directly based on the information in .
((b) with
If of
is independent of and , then nothing is gained by including the information content in the estimation of .
In particular, if
is independent of
is independent of
, then
, then
d u
Take measurable).
(a) (b)
is measurable;
. Then satises (a) (a product of measurable random variables is also satises property (b), as we can check below:
is
'f Aj d$
' $ d ' y P Aj d$
is measurable, then
if and
' $ $ r $ y"' j 5tfh' x '' $ $ r ' lw 5tfP ' tAj $ $ H ' $ e TXw t
is convex and
, then
nF nF $
$ $
! ' q 5j C$
X(' ! q 5j C$
A q QlPC
must be constant on and
Recall that
'! q C$ B` P5j
A' $ ! C' n $ ' $'! q C$ )lds4"X F tdlB P A ' $ ! C' n $ ' $ '! q C$ w)ldyx"Q F ghdiB P5j H)Slds4"X pF $ A' $! C' n D C F' EY"X n pF $ C ' $ C$ D QYF n D C q F dl' ! q GH)bEXSF n D AD C ' $ '! q C$ EC q F tdlB` P5j uDECXSF q i n D S EC q F q XlPC
This nal expression is Similarly, We can also write Therefore, We compute Now since
'! C$ " E
We leave the verication of this equality as an exercise. We can verify the Tower Property, for instance, from the previous equations we have
. (linearity) . 57
58
2.4 Martingales
The ingredients are: A probability space
Conditions for a martingale: is measurable. If you know the information in , then you know the value of 1. Each . We say that the process is adapted to the ltration .
For , we set , the trivial algebra. This algebra contains no information, and any measurable random variable must be constant (nonrandom). Therefore, by denition, is that constant which satises the averaging property
, and so we have
In conclusion,
If If If
' bG ! v Aj $
A supermartingale tends to go down, i.e. the second condition above is replaced by ; a submartingale tends to go up, i.e. .
y z
2. For each ,
q q q ! q D wGis`xG
A sequence of algebras , with the property that . Such a sequence of algebras is called a ltration.
i
k z
kG y U z SU@
G y z G z
r $ f' ! v Aj
z h e y U
' qtuG ! v Aj $
Gw Gw fiGw
h h h
Chapter 3
Arbitrage Pricing
3.1 Binomial Pricing
Return to the binomial pricing model Please see:
Example 3.1 (Pricing a Call Option) Suppose (interest rate), . (In this and all examples, the interest rate quoted is per unit time, and the stock prices are indexed by the same time periods). We know that
Find the value at time zero of a call option to buy one share of stock at time 1 for $50 (i.e. the strike price is $50). The value of the call at time 1 is
Suppose the option sells for $20 at time 0. Let us construct a portfolio: 1. Sell 3 options for $20 each. Cash outlay is
2. Buy 2 shares of stock for $50 each. Cash outlay is $100. 3. Borrow $40. Cash outlay is
59
V h V
if if
if if
W S%
C i
C G U
Cox, Ross and Rubinstein, J. Financial Economics, 7(1979), 229263, and Cox and Rubinstein (1985), Options Markets, PrenticeHall.
60
This portfolio thus requires no initial investment. For this portfolio, the cash outlay at time 1 is: Pay off option Sell stock Pay off debt
Unlimited borrowing.
No transaction costs.
Agent is a small investor, i.e., his/her trading does not move the market.
We want to choose
and
so that
GGib@uVAVbQS UiyQAU@U
iGC
Invest negative).
iu
Buy
at time 0. (
Important Observation: The APT value of the option does not depend on the probabilities of and .
V Q
ww U%Q h
61
The last condition above can be expressed by two equations (which is fortunate since there are two unknowns):
Note that this is where we use the fact that the derivative security value is a function of , is known for a given , is known (and therefore nonrandom) at that as well. i.e., when Subtracting the second equation above from the rst gives (2.3)
% $#
G #$
Then and . Since , we have and . Thus, probabilities. We will return to this later. Thus the price of the call at time 0 is given by
@Q
W iA @ V
P f c I
G $#
Q
into (2.1):
are like
(2.4)
on
. Equa
(2.1) (2.2)
% $#
8 ( T Sk@VSQ R
% #$
W 6
UU A
8 ( U Sk%SQ T R
62
, where
and
Ci
( h
G #$
% $#
Each
is
Then each
Dene recursively
is
is a martingale.
(3.2) (3.1)
63
for each
When , the equation (4.2) follows directly from the martingale property. For we use the tower property to write
& R w
w A
Theorem 4.13 (Corollary to Theorem 3.12) If a simple European security , the APT value at time of is for each
%v G
9 `
&
w hD `
%&
G #$
i
G #$
G #$
h 6 ` w
&
v
G #$
v G
G #$
v
GU
v
, we call
! w
w h
U A
Denition 3.2 () A simple European derivative security a constant and a portfolio process given by (3.2) satises process
x y
of
"
(requirement (b) of conditional exp.) (taking out what is known) (property (b))
Q w `
U
UU
w A
(4.2) ,
If the simple European security is hedgeable, then there is a portfolio process whose selfnancing value process satises . By denition, is the APT value at time of . Theorem 3.12 says that
Therefore,
Proof: Let and be dened by (5.1) and (5.2). Set and dene the selfnancing value of the portfolio process by the recursive formula 3.2:
We proceed by induction. For , (5.3) holds by denition of some value of , i.e., for each xed , we have
` w UV U Q6 A
Theorem 5.14 The binomial model is complete. In particular, let tive security, and set
w R 6
w 1
VS G #$ QS U Qi
U
w A
(5.1)
(5.2)
(5.3)
W GAkdi kdi iAk6 bk6iyAkdi W W W W kdi iAkWdi I W W W y H bk6iyAkdi W k6i Ak6i W bQSf kikdi d A W W W 6 A 6 W W Gb@uAkdx 3dAk6i W kWW6iAkW6 ibfVSrGb@uAkWd' U@iA Wd W Akd W W i5kdi iAkdi Q
Since will be xed for the rest of the proof, we simplify notation by suppressing these symbols. For example, we write the last equation as
` W X W V R D6i e6 c6VS
G #$
In other words,
We prove the rst equality; the second can be shown similarly. Note rst that
is a martingale under
% $#
We compute
. In particular,
65
66
v z o o
w vx
w u
C0 { xu } x u0 { u0 } { } U u0 } o n ~ o d c  {
{ 
t u t vt s r p o bhq
%fv G %@
Recall that is the given simple European derivative security, and the value and portfolio processes are given by:
Example 4.1 (Lookback Option) Consider a simple European derivative security with expiration 2, with payoff given by (See Fig. 4.1):
j i V 6 0m kkhlf d n j ig e i GU v
Notice that
V x Q x o o y w o o
Chapter 4
67
oo a
a e o o vd S o W"
V Q z V o Q oo
o
Example 4.2 (European Call) Let with expiration time 2 and payoff function
Note that
hG { o ~ G o } G { h o o ~ o o } o e u h U o { o } x o { o } { o cU o } x V o g Q o o U o
Dene etc.
u 6
68
S (H) = 8 1
S1 (T) = 2
when
. Then
S2 (TT) = 1
S2 (TH) = 4
S2 (HT) = 4
S2 (HH) = 16
69
has
For example, a threemonth option has 66 trading days. If each day is taken to be one period, then and . There are three possible ways to deal with this problem: 1. Simulation. We have, for example, that
( 1 f vyhPU
and so we could compute by simulation. More specically, we could simulate coin tosses under the riskneutral probability measure. We could store the . We could repeat this several times and take the average value of as an value of approximation to . 2. Approximate a manyperiod model by a continuoustime model. Then we can use calculus and partial differential equations. Well get to that.
" ( A
3. Look for Markov structure. Example 4.2 has this. In period 2, the option in Example 4.2 has three possible values , rather than four possible values If there were 66 periods, then in period 66 there would be 67 possible stock price values (since the nal price depends only on the number of upticks of the stock price i.e., heads so far) and hence only 67 possible option values, rather than .
f hh P
W W V U Qk6i UU QUdi Q U UU Q W
hG St GSu u e u e
{G $# ( R kcS
( AG $# ( ` A ( U Q
Let
when
. Then
"
70
(If we x and dene , then the equations in (b) and (c) are the same. However in (b) we have a condition which holds for every function , and in (c) we assume this condition only for functions of the form . A main result in the theory of Laplace transforms is that if the equation holds for every of this special form, then it holds for every , i.e., (c) implies (b).)
~` b G $ `
` 3P
` b `
where .)
. (Since
` 6 W
, we have
hG $
W 6 A6
bG $
G $
for which
, we have
m $ $
e w
(b) (Agreement of expectations of all functions). For every (Borelmeasurable) function for which , we have
W d
W v6 ` W
G$
` W U h6 % $
` W Sx 6
S 16 W
, we have
W d
aQ T
W d f" G
ckbY`
G $
G $
G$
T U
hv `
, and
conditioned
Denition 4.1 () Let be a probability space. Let be a ltration under be a stochastic process on . This process is said to be Markov if:
f h $ $
8 ( aUQ T
!
P
W ` 6 G $
xC
!
8 ( a T
R c
. Let
appears, we could just as Remark 4.1 In every case of the Markov properties where well write for some function . For example, form (a) of the Markov property can be restated as:
where is a function that depends on the set . Conditions (a)(d) are equivalent. The Markov property as stated in (a)(d) involves the process at a current time and one future time . Conditions (a)(d) are also equivalent to conditions involving the process at time and multiple future times. We write these apparently stronger but actually equivalent conditions below. Consequences of the Markov property. Let be a positive integer.
$ 4 d W W 6 W W U d 6 U d $ W
for which
, we have
Remark. All these Markov properties have analogues for vectorvalued processes.
Once again, every expression of the form can also be written as function depends on the random variable represented by in this expression.
Y X 7
7 Y hY W W
hY V
` dUSfG $
G$
S ` X 7 e
u 4 d $ W
7 Y hY hY V W W
G$
we have
mh`
WS
7 Y 7 Y
7 e
7 Y hY hY W W
` hY)fhY G $
G$
S `
7 Y 7 Y W W hY
u 4 d $ W
U 6 W
hY
G$
for which
WS
S 4 6 U 6 G $ Sx 4 6 U d G $ ` W W ` W W h ` 4 6 UU 6 G $ m t W W ` $ $ e 4 W U 6 % $ S 4 6 UU 6 ` W W
` h 4 6 W
W W
U 6 W
, we have
, where the
W6
` 4 6 W
4 6 W
W W U 66
,
%$
` W G d % $
W S ` 4 6
ri
For every
, we have
dU `
71
%$
72
6$ c
Example 4.3 It is intuitively clear that the stock price process in the binomial model is a Markov process. We will formally prove this later. If we want to estimate the distribution of based on the information in , the only relevant piece of information is the value of . For example,
is a function of . Note however that form (b) of the Markov property is stronger then (3.2); the Markov property requires that for any function ,
u
Consider a model with 66 periods and a simple European derivative security whose payoff at time 66 is
w Ya
is a function of
are equal to the RHS of (3.1)), they are equal to each other, and this is property (A) with
G Q
Now take conditional expectation on both sides of the above equation, conditioned on use the tower property on the left, to obtain
` W W W S W6 G6 d
6 S6 ` W W W G6 d $ G $ & W 9Yd ` W ` & W F6 cd $ G $G6 d $ G $ W W cd 9 6 F6 ` W ` & W & W $ G $G 6 d $ G $ W W c6 W b `96x Gcd W ` & W & W 6 d $ G $ G $ $ W c6 d `v F6 & W P 6 W $ G $ $ W & W `&W &W W W tcd cd d 6
(Denition of conditional probability) (Tower property) (Taking out what is known) (Markov property, form (a).) (Remark 4.1) (Markov property, form (b).)
e bu
e u n {
`&W x hF6
` & W F6
S6 G6 d ` W W W
& W F6
& W F6
u
G$
eu bh }
W 6
W 6
` & W cd
d W
6 W
bu
& W cd
bu e
%$
%$
G$
W d
d W
(A). (with
%$
u h
).
, and (3.1)
%$ u
(3.2)
73
because the stock price process is Markov. (We are using form (B) of the Markov property here). In other words, the measurable random variable can be written as
e 6d 66
The following lemma will be very useful in showing that a process is Markov:
Lemma 4.15 (Independence Lemma) Let and . Let be a sub algebra of . Assume
Note that
and
or
is , then
m d d td { d b hd n n
d d td n
d r o S o o
from
and
Q C
d o Gm V G Q G
e e
!
Let
c F
i V Q) Gf
Example 4.4 Consider the twoperiod binomial model. Recall that by the rst toss, i.e., contains the four sets
is independent of a algebra
if
Denition 4.2 (Independence) Let be a probability space, and let algebras of . We say that and are independent if for every and
Ya
$ G% P % $ f% $
Y } i e { e } e { {
i
P
!
is measurable.
Then
G$
Remark. In this lemma and the following discussion, capital letters denote random variables and lower case letters denote nonrandom variables.
Example 4.5 (Showing the stock price process is Markov) Consider an period binomial model. Fix a
uhy e fQbu @ u
. Then
Not only have we shown that the stock price process is Markov, but we have also obtained a formula for as a function of . This is a special case of Remark 4.1.
u
Examples:
( ( cA
( v
"
4 4 a h
bu
e bu
bu
e bu
6u
e bSu
Thus
}
and
of
u h
This shows the stock price is Markov. Indeed, if we condition both sides of the above equation on use the tower property on the left and the fact that the right hand side is measurable, we obtain
u h
and
st toss,
uh u { n A h d 6 } u h } 6u I u e bu H
{ 1
{ ~ u
6u dbu e
bu
e bbu
time
and dene
and
. Then
if
and
is independent of . Dene
, so that
bu e
G c ` VhG $
d
Y z e { u h e bu
d
Let
74
is independent of ;
if
. Since
is measurable. Let
R ( R (
( ( v
G $#
( c ` ( (
@ @
( A
( ( ( ( 3 cA A %" G i
% $# i S
` W 6i
is Markov. (Here we are working under Lemma 5.16 The twodimensional process the riskneutral measure I , although that does not matter). P
the second equality being a consequence of the fact that . Since the RHS is a function of , we have proved the Markov property (form (b)) for this twodimensional process.
ib G5
d
ib1 6 A d d bA d AG $#
8 ( 6Uh AQ T
Continuing with the exotic option of the previous Lemma... Let denote the value of the derivative security at time . Since is a martingale under , we have
Q i R fVS
` W A 6
d
Gh A
W 6 A
G $#
Dene Proof: Fix . We have
i
where
and
is independent of
. Let
(Lookback option);
b W W y 36kgUhU %6
and the value of the option at time is . Since this is a simple European option, the hedging portfolio is given by the usual formula, which in this case is
t
d
y x i W W k6 A A36 f c
R (
d
( c
A3
R
( A
6
6
( v
i 1 A
( v
fV
%
R
( v
Chapter 5
Now consider an American option. Again a function is specied. In any period , the holder of the derivative security can exercise and receive payment . Thus, the hedging portfolio should create a wealth process which satises almost surely. , and the wealth process
i
American algorithm.
UA
Then
W W b 36 1k6 f Q
77
GA
This is because the value of the derivative security at time is at least value at that time must equal the value of the derivative security.
i
%@" GU
GA
b 6 zV 6 W W
i Y x
GA
( i
Then
is the value of the option at time , and the hedging portfolio is given by
W k6 iA36k Q W W
( cA A (
( i
"
v w
{ o
vd S o W" Q
Let us now construct the hedging portfolio for this option. Begin with initial wealth as follows:
e
78
Figure 5.1: Stock price and nal value of an American put option with strike price 5.
S =4 0
S (H) = 8 1
S (T) = 2 1
S2 (TT) = 1
S2 (TH) = 4
S2 (HT) = 4
S2 (HH) = 16 v2 (16) = 0
v (4) = 1 2
v (1) = 4 2
. Set
. Compute .
U $ o #
A v 6 A 6 c G $# ` W W
G
i
W 6
w x
Using
Here,
"
i
GA
or, equivalently,
results in
(Recall that
! If we had
):
. 79
80 and the holder of the American option does not exercise, then the seller of the option can consume to close the gap. By doing this, he can ensure that for all , where is the value dened by the American algorithm in Section 5.1.
and
. Therefore,
so there is a gap of size 1. If the owner of the option does not exercise it at time one in the state , then the seller can consume 1 at time 1. Thereafter, he uses the usual hedging portfolio
Denition 5.1 (Stopping Time) Let tion. A stopping time is a random variable
Example 5.2 Consider the binomial model with , so be the value functions dened for the American put with strike price 5. Dene
D e u u h h u 6Y~bt
The stopping time corresponds to stopping the rst time the value of the option agrees with its intrinsic value. It is an optimal exercise time. We note that
We verify that
Example 5.3 (A random time which is not a stopping time) In the same binomial model as in the previous example, dene
o n d S o S% " f C " GU i 3 fhAi Q6Q T 4 ! x TmD5" GG Dmuf4 Q T Q ! e 8 ( TaQ P ! x A bGA bUAk" b W W U k6kxU36k
. It is optimal for the owner of the American option agrees with its intrinsic value . be a probability space and let be a ltrawith the property that:
if if
1 b A 3 & 3 ` & & fV V8 & 3 Y GAU G #$ & & & & 1 b%AkU bAU 2 bxk% D 8 p o E %u W~bA@ C
o
A B
B) B )
az
A@9 7 8
. Let
81
if if if
The atoms of
are
Notation 5.1 (Value of Stochastic Process at a Stopping Time) If is a probability space, is a ltration under , is a stochastic process adapted to this ltration, and is a stopping time with respect to the same ltration, then is an measurable random variable whose value at is given by
!
DV Qf G yB QfQ 7 Q
but
B B
G` X V R '`R R 8 ( U T
The set
is not. Indeed,
if if
i.e.,
R "
8 p e ku ku %u Y~bA@ 7
B) B )
7 7 Ux 7 Q 7
x T 4 Q ii Y fAi Gx
! m
B V o yB Q
y B
Ux
V Q) B
is determined by time provided
H I V
PQ
F G A@ D F 8
t t b
p
stops when the stock price reaches its minimum value. This
8 ( UUQ T
i h q S eS i h p S
H
I o
c H g
V o
I o
G { o 0 o { H o A Q o I H o o
e o S
o o I
o
I o I o
e S c e c S
o H o I o H o I
c eS d
o H u
B )
` D
G$
R `X G` YfG $
R W
"
"
"
8 ( ax iQ T
(or Theorem 3.17 (Optional Sampling) Suppose that gale. Let and be bounded stopping times, i.e., there is a nonrandom number
8 Ux T T
If
82
almost surely.
) is a submartinsuch that
. If
8 GT T
G$
G$
Example 5.5 In the example 5.4 considered earlier, we dene probability measure, the discounted stock price process
hi u
H c
,
B f
G G
8 T U T
V 4
and for
Q
The atoms of
are
and
. Therefore,
83
(4/5) S (H) = 6.40 1 (16/25) S2 (HT) = 2.56 S =4 0 (16/25) S2 (TH) = 2.56 (4/5) S (T) = 1.60 1
84
Chapter 6
almost surely.
85
%" U
i
U Q36 U Q%6 W W U d U 6 U Q W W
T U
R 9r R fVS
r icDA iQ
G #$
f4
which satises
t4
satisfying
6
` R R 1r R 6QS G $# Q U i R
i 9 ui x r 8 ( a R fVSQ T
is
8 ( UsQ T r
almost surely.
"
U GU
i
if`i r u`
8 ( i 6VSQ T R
Q
"
i
8 ( a T
8 ( T SkcSQ R
i i
G #$ E
` R r R 6QS R xr
"
w GR @ 4
8 ( UxvQ T r
W ` 6 G $# f V V xr Qi
. Then the owner of the derivative security (e) Suppose for some and , we have should exercise it. If he does not, then the seller of the security can immediately consume
Let Dene
86
be a sequence of nonnegative random variables such that each is measurable. to be the set of all stopping times satisfying almost surely. Dene also
Lemma 2.18
r ui
Proof: Take
f4
Proof: Let
x '4
Because
is also in
` W 6i eW6 VcR6@ X
G $#
x '4
and
Lemma 2.20 If
to be the constant .
a.s.
b U d U 6 @ V W W ` W G U QS D6i G $# @ V U )V U (
We prove the rst equality; the proof of the second is similar. Note rst that
W W G UU QUdi U Qk6 W U 6 W UU d UU UU G UU c T U" UG Ui Q i i ii x i ( W GU' UQSVd 6 W W UU c 36 W V U Q3d UU ckdi UV U Q W U Q k6i W 8 ( Ui R k@VSQ ( T 6i eW6 VcR fVS G $#i R QS q QS ` W X ` W x D6i G #$ @ Q i
(
Lemma 2.21 Dene
% kVS
kVS kVS
i
G $#
`R 1W R R Q
We proceed by induction on . The induction hypothesis is that , i.e., for each xed we have and dene recursively is a supermartingale,
implies
for some 87
88 will be xed for the rest of the proof, we will suppress these symbols. For Since example, the last equation can be written simply as
We compute
Hedging a short position (all payments). Superpose the hedges for the individual payments. In other words, start with wealth . At each time , rst make the payment and then use the portfolio
T U
% UU
W GAk6 k6 AUdi 5kdiAkdiA W W W W W W k6i iAkdi W W GbfVSC kdi5yA k6 ( U)'iAk@QS W W kW6iAkWd UbQSfAkdx kdA%6i W ( W kU' UQSiAkd Ak6 W W W 5kdi iAkdi Q ) ( " G
U
GU
X U(
8 4 T 4
Q Di
fUUC
( v
6
"
` 4 ( 4 R fVS G $# Q X 4 V
X & W Pcd
X W V f Y6 V
X 4
8 4 (
G UU Q (
UQ
8 U T ( 8 4 T 4 (
( s
Q
89 , we
and the hedging portfolio is . You can borrow and consume it immediately. This leaves you with wealth . In each period , receive the payment and then use the portfolio . At the nal time , after receiving the last payment , your wealth will reach zero, i.e., you will no longer have a debt.
The owner of the American derivative security can borrow this amount of money immediately, if he chooses, and invest in the market so as to exaclty pay off his debt as the payments are
Lemma 4.22
 `
which maximizes
pe} am ip l sj sw
f ge
$ ( fVS
4 4 R
l k dj { Gf 2 f 6G`t'n
$pe p
( s
Q
. Compute
corresponding to all future payments. At the nal time , after making the nal payment will have exactly zero wealth.
8 4 T 4 ( "
i e
{p x us p Uzk yp m 0wvtrqe
8 4
G #$
8 T R ( akQ "
8 4
f k
a
"
}  sw
m l k a6fi Gf vj
f h
f k f m l afi Gf f Guy j
, the
It follows that also attains the maximum in (4.1), and is therefore an optimal exercise time for the American derivative security.
Gu0 Gu0 { t w k sw ~ s w k w ~ s
# # #
w 2 w k
#
Gq0 sGGw vw k w ~ s bt
attains the maximum in the formula
# # #
w w w { A w k sw Gpy
Let be a stopping time which maximizes , i.e., Because is a supermartingale, we have from the optional sampling theorem and the inequality following:
~ s
#
Therefore,
qA w k w
Gpy
~ s w w
#
w k2 w Gq0
~s
#
Y n n
then
and
90
{ ~ s ~ s Gb ~ s
This implies
is linear
W W G b
is linear
Jensens Inequality
Chapter 7
Lemma 1.23 If
{ 9~ s 9~ s a W j l Gd { ~ s ~ s v ~ s h s se
is convex and :
Proof: Since
Now let
For instance, if
u ~ s s u ~ ~ s ~ s
91
u9
W%
, then
92
Proof:
Proof: Because
"
bn
where the LHS is the European value and the RHS is the American value. In particular optimal exercise time.
is an
% Uq0 w w ~ s Gt i w % i
{ f f f ~ s f 6f ~ s a ytYa { { 0t W { d 6 rC s e
#
Theorem 1.24 If
is a martingale and
is convex then
m a6fi l f Uj
Guy
~ s
m l a6fi f sj
#
is a submartingale.
Therefore,
and this last expression is the value of the European derivative security. Of course, the LHS cannot be strictly less than the RHS above, since stopping at time is always allowed, and we conclude that
# # #
f f f
Gu0 Gq0 { i i 2~ s w w w ~ s Gb Gu0 Gq0 i i 2~ s w w w ~ s Gb Gq0 { i G q0 ~ s Uu0 i ~ s g~ s w w ~ s vw i i Gq0 Gpy { vw i i ~ s w w m a6fi l f f Uuq0 j Gq0 n f f p Gq0 6f ~ s t f p Gq0 6f ~ s f % u Gq0 % Gu0 6f ~ s f f 6f } 6f  ~s % u 6f $f
# # # P # # #
and
( x, g( x))
( x, g(x))
"
Therefore, the value of the American derivative security is Taking expectations, we obtain
(x,g(x))
. The 93
94
S2 (HH) = 16
S2 (TT) = 1
Example 7.1 (Stopped Process) Figure 7.3 shows our familiar 3period binomial example. Dene if if
Then
Theorem 3.26 A stopped martingale (or submartingale, or supermartingale) is still a martingale (or submartingale, or supermartingale respectively).
l vv{ U {{ j
m afi l w f sj
m l a6fi Gf vj
the
95
96
Chapter 8
Random Walks
8.1 First Passage Time
Toss a coin innitely many times. Then the sample space is the set of all innite sequences of and . Assume the tosses are independent, and on each toss, the probability of is , as is the probability of . Dene
is a symmetric random walk (see Fig. 8.1) Its analogue in continuous time is
If never gets to 1 (e.g., ), then . The random variable is called the rst passage time to 1. It is the rst time the number of heads exceeds by one the number of tails.
8.2
97
p p
if if
ml Wff j
{{ vs{ f
98
Mk k
e e + 2 1
Figure 8.2: Illustrating two functions of
for every xed (See Fig. 8.2 for an illustration of the various functions involved). We want in (2.1), but we have to worry a bit that for some sequences , . to let
Furthermore,
n 2 n
( &
w f
( &
&
( &
w 6f
'
As
We consider xed
, so
if if
are martingales. (Take in part (i) of the Homework Problem and take (v).) Since and a stopped martingale is a martingale, we have
7 8
w f
f
2 e e + 1
in part (2.1)
&
( &
w f
( &
5 6
~ s w f 4~ s
bf
9 2
'
99
In addition,
For all
i.e.,
We know there are paths of the symmetric random walk which never reach level 1. We have just shown that these paths collectively have no probability. (In our innite sample space , in each path individually has zero probability). We therefore do not need the indicator (2.2), and we rewrite that equation as (2.3)
Solution:
&
( &
s X
Let
be given. We want to nd
so that
n l Uj s
m l af Gf j nj { l U9W s n l Uj s ~ s
so we can let
U V
'
Letting
, we have
( & ( & & x Tyu s ( & S w w ( & ( & S { " x Tw0u s ( & ~ s w
w f
{ n 2 n
{(& w
if if
A EC @
A@
w 6f
and
( ( )& (
&
&
( &
( &
w f
w f
(
Q I G F RPHB( &
&
( &
5 6
( &
~s w 6f
( &
A f
` { XX ` X 0 X ` $ X X d X X w n d ~ s w 4~ s
X
X
`
w 2~ s X
w 2~ s X
X (
( & ( & X X `
&
9 2
{
9 2
{
X
X
`
(&
X ` X X X b X bc X 0 0 X X (& X (& {
X
` Y a
8.4 Expectation of
9 2
We want
With
100
, so we must have
and
s X
We have computed the moment generating function for the rst passage time to 1. related by . Now , so (3.1)
to obtain
Thus in summary:
In discrete time, this Markov property implies the Strong Markov property: random variable depending only on same random variable
Then is the number of periods between the rst arrival at level 1 and the rst arrival at level 2. The distribution of is the same as the distribution of (see Fig. 8.3), i.e.,
{f {{ f sv{ f f
{ vw {{ sw ss{ w w
n {{ vs{ i h l
v { EX
X X
{ "~ s n ` X w n ~ s X
` X h c
f ' Uj ` n g
w qpw 2~ s X
~ s ~ s m l Wf f j ~ s
r s
~ s n
vn
f f '
0 g X
s { X 0
X 0 X
X
`
Dw 2~ s X
In general,
X
`
X
`
For
102
Mk
, and thus
2 1
not random
. The risk
v EX
103 . Suppose
Because the random walk is symmetric under , has the same distribution under as the stopping time in the previous section. This observation leads to the following computations of value. Value of Rule 1:
W#
Value of Rule 2:
This suggests that the optimal rule is Rule 1, i.e., stop (exercise the put) as soon as the stock price falls to 2, and the value of the put is if . Suppose instead we start with , and stop the rst time the price falls to 2. This requires 2 down steps, so the value of this rule with this initial stock price is
We dene
In general, if for some , and we stop when the stock price falls to 2, then steps will be required and the value of the option is
#
{ { r C w G~ u 0 s u ~s r Cw r Cw g n Ws j { l f U` n
{l
{ { p C w ~ s s $p C w  }
j f U` g n
$ w  g n } g
#
}r C w
where
is a symmetric random walk under the riskneutral measure, denoted by . Here are some possible exercise rules:
down
104 for some , then the initial price is at or below 2. In this case, we exercise If immediately, and the value of the put is
Proposed exercise rule: Exercise the put whenever the stock price is at or below 2. The value of as we just dened it. Since the put is perpetual, the initial time is no this rule is given by different from any other time. This leads us to make the following:
How do we recognize the value of an American derivative security when we see it? There are three parts to the proof of the conjecture. We must show: (a) (b) (c)
is a supermartingale,
for
This is straightforward.
By assumption,
h
If
, then
and
{ o o
for
Note: To simplify matters, we shall only consider initial stock prices of the form always of the form , with a possibly different .
{ p h { { p { { p { { p {{ p Y p p h h { g p Y p { p p p h h oh p gf { f h { f % h { f 6f ~ s f
p p
{{ vv{ ' o p
is
h
h h
m a6fl f j m l af m f h k f j f h f i h
o p
p u
, so
is
105 and
There is a gap of size 1. This concludes the proof of (b). Proof: (c). Suppose (a) (b)
is a supermartingale.
provided we let in (7.2) be any number of the form . With appropriate (but messy) conditioning , the proof we give of (7.2) can be modied to prove (7.1). on
for some
j {l o f U` l f U` n j o p { p W h
so if
for some
, i.e.,
. Let
For
{ p p vt p p h p p p p
p h % { f 9f
ml aff j f i f f m l afi Gf sj
p q
If
, then
and
g n n # h o v0 { { { Y h ph p
(7.1)
o f
If
, then
106 Then
Because
is a supermartingale
Comment on the proof of (c): If the candidate value process is the actual value of a particular exercise rule, then (c) will be automatically satised. In this case, we constructed so that is and if we exercise the put the rst time the value of the put at time if the stock price at time is ( , or later) that the stock price is 2 or less. In such a situation, we need only verify properties (a) and (b).
(c) At each , either (a) or (b) holds with equality. In the example we worked out, we have For
for every
W { a w u v { p p he o s p t p { g p e o h
a W w h W h p a h i
(b)
a i
W r D q ah
(a)
For
except for
{ w h
{ w w ~ s p { g p h 6 f
w ~ s w w ~ s 9
m f f al Y f j o
W a h
107
v(x) 5
(3,2)
If or , then both (a) and (b) are strict. This is an artifact of the discreteness of the binomial model. This artifact will disappear in the continuous model, in which an analogue of (a) or (b) holds with equality at every point.
we recall that
We will use this moment generating function to obtain the distribution of . We rst obtain the Taylor series expasion of as follows:
Let
, with
s y
l f U` n j
s Ya
w 2~ s X
X w 2~ s
ml afGf j
If
If
W%
x x x
. Dening
{
0
m { l o G9W s p X p w 2~ s nj X s o o m p $ X o p X X X z w 2~ s X
X
{p
v o o m p $ p o 8s o o m p p m o p $ o am p p } p  z ` W%
W
z
is given by
109
Therefore,
To count how many paths reach level 1 by time , count all those for which double count all those for which . (See Figures 8.5, 8.6.)
{{ vv{ ' o
s o $ o l o U9W s nj o p l U9W s nj
and
g p
{ l q l p j9W s p 9W s l l j l ag p 9W s l j
For 110
In other words,
Chapter 9
Remark 9.2 If is absolutely continuous with respect to I , and I is absolutely continuous with P P respect to , we say that I and are equivalent. I and are equivalent if and only if P P
(Let
and
111
If I and P are equivalent and is the RadonNikodym derivative of RadonNikodym derivative of I w.r.t. , i.e., P
w.r.t. I , then P
{ i ~ s 9~ s {
~ s
exactly when
Ws { d i W s
W#
~s
W#
W#
for which
~ s ~ s ~ s
W#
W#
W#
and
with respect to I . P
$z
W#
t d i W s
Tg
W#
W#
W#
112
Example 9.1 (RadonNikodym Theorem) Let of length 2. Let correspond to probability for
and
for . Then
, so
Proof:
{ W s f
Ws
or equivalently,
f d
s f t~ s
s~ s
is
{ f ~ s { f t~ s)~ s f ~ s~ s ~ s
~s
Lemma 2.28 If
is
is indeed a martingale:
measurable, then
f ~ s ~ s {f f t~ s f f t~ s~ s f 6f t~ s { {vv{ f ~ s f { { WW ss
W#
W#
so that I and P
with respect to I is P
q vb v`
9
#
i W s W s
and
q b q`0bbv
b p pA
W#
113
2/3
(Lemma 2.28)
W
(Partial averaging)
(Lemma 2.28)
Example 9.2 (RadonNikodym Theorem, continued) We show in Fig. 9.1 the values of the martingale We always have , since
p t
{ vs{ f f {{
{ p f~ s pp p ~ s o
d
Ws W s f d d s p f ~ s T W s p f ~ s pp
Uq0
f p p ~ s p
Lemma 2.29 If
is
measurable and
, then
is
, we have
o i pk6p p p am ip l p p j
{ p w k w ~ s e GiG w p Gq0 Gq0 ~ s pp e GG w p p w k w w Gu0 Gq0 p ~ s e GG w p p w k w o { vw k w ~ s s GiG w Gq0 sGGw ~ s i vw k w w Gq0 sGiG w ~ s vw k w m l k afi Gf sj {pp p f e f ~ s p p f e f ~ s ~ s p p p ~ s am fp l p p j p f e f ~ s p Gu0 Gq0 p p f e f f ~ s p Gu0 p Gq0 p f e f p ~s p o Guf e 0f ~ s { ~ s f Gu0 ~s
is a martingale under I , as we can check below: P
f ef f
ef
We then have the following pricing formulas: For a Simple European derivative security with payoff at time ,
f ge
(a) 114
Remark 9.3
(b)
115
(c)
Example 9.3 (RadonNikodymTheorem, continued) We illustrate the use of the valuation formulas for European and American derivative securities in terms of market probabilities. Recall that , . The state price values are shown in Fig. 9.2.
Now consider an American put with strike price 5 and expiration time 2. Fig. 9.3 shows the values of . We compute the value of the put under various stopping times :
4 q 'Eb' `'b '
9 v b v qv v T v 6 b v b 6 b T bb v v s bb bb q b ` i s s b bb v b
, the value is
W#
Ws f
am ip l p p j
q
116
(5  S (HH))+= 0 2 2 (HH) (5  S2(HH))+= 0
+ (5  S (H)) = 0 1 += 0 (H) (5  S (H)) 1 1 1/3 (5S 0)+=1 + 0 (5S 0) =1 2/3 + (5  S1(T)) = 3 (T) (5  S (T))+ = 1.80 1 1
1/3
2/3 1/3
2/3
v8 2 fi 2 #
~
cf #
aa
and for
c8 #
H82 #
Let
8Va'D
Let are
rs
. Then I and P
are
117
As before the portfolio process is . The selfnancing value process (wealth process) , the nonrandom initial wealth, and consists of
i V) c28V))V)cfif)c )T
and
at time :
d a
#
#
and
V)
o)
Note that
is
measurable.
)V
8V
#2T8
sm)'D
118
if for some , this is just the denition of , and the rest follows from the standard machine. If and , then , so . In other words, the measure is absolutely continuous with respect to the measure . The RadonNikodym theorem implies that there exists a measurable random variable such that
# c'58 # 1 5 @v9 # 5 c'8%0
i.e.,
This shows that has the partial averaging property, and since is measurable, it is the conditional expectation (under the probability measure ) of given . The existence of conditional expectations is a consequence of the RadonNikodym theorem.
1 5 @v9
A 0 G4
c F
E C %D
E C B8 # R 5
0 E 4%C
5 c6
1 P5
1 Qv5
Whenever
A 1 5 B@v9
1 5 @v9
0 E C 5 42%D'8 #
5 8
0 5 76
0 4
0 4s~
H IF
Chapter 10
Here, (BC) stands for Budget Constraint. Remark 10.2 If is any random variable satisfying (BC), i.e.,
c
then there is a portfolio which starts with initial wealth and produces at time . To see this, just regard as a simple European derivative security paying off at time . Then is its value at time 0, and starting from this value, there is a hedging portfolio which produces .
Remarks 10.1 and 10.2 show that the optimal obtained by solving the following Constrained Optimization Problem: Find a random variable which solves:
Equivalently, we wish to
119
c W US srpXVi
$ h
Maximize
Subject to
c W US g4fe
Maximize
c d
c 7
a 4b8
Y `E8
W US XVT
is a martingale under I , so P
')
sr
x t
Equation (1.1) implies
w D V)
T V x t
) D
Ti
o8V sV
))
x t
x t
and
))
V)
#2m x t
f x t
)V t I' t x t x t '
t
)V
t
V)
t 
x yt
x yt
fi
cwGv ) ) ) t fi
sr
) s) W US t XVi
sr
s r c s #vdvr
)V
r c m8pdr )) r Tp)
c t 8iu t
120
Subject to
c Pq
$ h
There are
sequences
in . Call them
sr p
Maximize
Subject to
Maxmize
Subject to
g'
))
sr
I'T x t
such that
(1.2) (1.1)
c W US c W US x eXVT eXVe
c W US XVe
#a
c W US x eXVT oc %
W US QXVd
c c W U PpXVS
From (1.5) we have
x c
%
'oc
f
W US t o XV7' x t '
W U t t XVS x t
The function
t fa r t ' t
'
t qy
W US t t XV7' t ' x c x c
x c
'dc
V)
#'
x c
x t
Therefore,
Maximize Subject to
c W US pXVT
Theorem 1.31 If
Proof: Fix
We maximize
then
over
and so Taking expectations, we have and let Let be any random variable satisfying is maximized at and dene is given by (1.4), then : , i.e., solves the problem (1.3). (1.5) (1.4) (1.3) 121
#s#'D
V) ))
REfif
ioD
)) V)
REf
m & oD k
m k h j if )( nl %'D
V)
h j if Rf
' D
)V
m4
gm
W US XVT
In summary, capital asset pricing works as follows: Consider an agent who has initial wealth and wants to invest in the stock and money market so as to maximize
The optimal
122
is
h f ig
Since
Chapter 11
P I is a probability measure on
123
v a H Q9
t ' t
%C
a 6
The density of
such that
a %8
where the probabiliy on the right is dened since in Williams book this is denoted by .
v sH pv2
8H
v Q
a 9
{ a 8
z a sI c8
induces a measure
H p
n'p r
i.e., 11.1)
is a function from
to
v u
a %22@
A function is a random variable if and only if for every Borel subsets of I ), the set R
A Px8vR 8 a a R 2w )
q r p
, i.e.,
nu r p
t t
. (the algebra of
124
R B
.
{X B}
We then write where the integral is with respect to the Lebesgue measure on I . R is the RadonNikodym derivative of with respect to the Lebesgue measure. Thus has a density if and only if is absolutely continuous with respect to Lebesgue measure, which means that whenever has Lebesgue measure zero, then
H p
11.3 Expectation
~ #w r p
) Let
be given. Then
which are true by denition. Now use the standard machine to get the equations for general .
t ' t
a @
a 8
aa
Proof: (Sketch). If
for some
'sa
t ' t
t s t
y X' t XC
g 2w a
v t C
D' t
y X
H t I' t
125
(X,Y)
C y { (X,Y) C} x
F
induce a
that satises
f t t k v t yC C
F 's8a
d)
k f 4 C y C y t t
F
k f y
HQ v
)tcr
f t ' t k
#p
k f
C yC
F
'4i
F
k f y
is a function
p Q v
F v
F Qv
cR 2i
n r
k f y
p v
F
k f
v a H p~9
f t t k t 4G%C C
'8
vd6f C
F fd'F ) a~ g r p F k f
F 2 B2i) F 4
k f XC R 8 t t
where
'd6
f t t k C C f aI k y 2aPI 2v F a F @
a 8
y
Suppose
F v
126
. Let
ga
k f
Therefore,
Suppose
has joint density . Let be given. Recall that depends on through , i.e., there is a function ( depending on ) such that
R F )
How do we determine ?
We can characterize using partial averaging: Recall that . Then the following are equivalent characterizations of :
be given. Then
for some
8H
v Q
a 9
k f 4' v8 H C C y t t
d8 q8 y
H XC
mH
a 9
v4 F
'i F
F qi
F 2 5 8i'@v9
E C
fbE F
C
v H Qa
a F 5 F 2 ovi'P5
n i Gi ( %vp nX"Xn
. Let

i) xq
f v EF V t C t t
DTcF V
f C t t k v t XG%C
8H p
F 82i
dF )a
'8
~f v C t t t
~ #@ r p ~f p r #Bd t
given
tr
and
depends on , but
~f
Theorem 7.33 If
v Q
Example 11.1 (Jointly normal random variables) Given parameters: have the joint density
s
F fd'F )
and then replace the dummy variable
~f v XC t t t
c8f
The function
F 4fdF )
'd6
m Vj 'd f v XG%C C t t t
8 k f t
~f t
F
k f
In conclusion, to determine
is often written as
does not.)
'8
F )
9i g
PC " % `
X
. Therefore,
PC )
~ g
In the variable,
q Qi
o e q
{ z q
y
i
o i)
(i 6
Qi
{ z "
{ z V8 B
P ~ PC % Gi PC
using the substitution
Gi
"% i i
" Gi i
The exponent is
128
as follows
o )
we have
Thus
and variance
Gi o o ) i)
9i e
129
Based on , the best estimator of is . This estimator is unbiased (has expected error zero) and the expected square error is . No other estimator based on can have a smaller expected square error (Homework problem 2.1).
Here,
where
is the variance of
2 )
V)
r 2 8W 2 r
y ~
y ~%
&
T8 T
8g c
y r P % c r 2
qs8
and
is an
nonsingular matrix.
T
&
&
q Gi
q Gi %
)V
))
r s
T8 r
`
n `
"%
(7.3)
&
&
y
V)
))
)r ) t t
y iR
(7.4)
(7.5)
(7.6)
are independent
5 24
i
y 2 r h r r
)V )
) 01 #!
5 4 3 2
) 01 #!
cR
(&$! '%"
&
r y rr 2 r 8Tr t
Let denote a column vector with components in , and let have a and mean vector . Then the moment multivariate normal distribution with covariance matrix generating function is given by
If any random variables have this moment generating function, then they are jointly normal, and we can read out the means and covariances. The random variables are jointly normal and independent if and only if for any real column vector
P )) r 8GP)%
))
t '
V)
Vr
t R t
( r 5 Y & )V Y ! Y C Y C
&
! "
&
))
r )yi8
r y VPr
r 2 v2 y t )iT t
" D r r 2 y r iT' t
!
r 2 2 r ( " vX
'ir
fk t 8 t
and we have the formula from Example 11.1, adjusted to account for the possibly nonzero expectations:
r r " 92 2
("
m P j s j r r 2 r 2 vf2
r 2 f2
m s j m s j
r 2 2
r y r y 8e)iPj%
Take
c%
Thus,
a d F a d F a
V)
o m)a
V)
r a 2 F )a )~8'V
))
r F F T9Rfi2
6 B DC
)V
5 24
) 01 A!
5 4 2
i V)
) 01 A!
9&$! @'%"
f
Let be a collection of independent, standard normal random variables dened on where I is the market measure. As before we denote the column vector P by therefore have for any real colum vector ,
s PH
76
&
F
)V
F )
&
SemiContinuous Models
Chapter 12
, then we know
)V
r a Vx))Ha
Theorem 1.34
a T`
Proof:
is a martingale (under I ). P
131
a a
, . We
F
)V
2 r r
g
y F fy2
( !
cf
s 2 r r
y a %ic2
( !
a 8V8
a dR )Td fi F Y
r H8G8 ! E
E F
F fi c8 f
7E
a 4 )Td F
a cR )ifi8
Theorem 1.35
which is a function of
Given parameters:
a a
y t t
a `
Note that
Then
132
2 t
B k
is a Markov process.
1 Y1
k 2 Y2 Y 3 3 4 Y 4
g fi fi
V)
V)
#)g4'
U! VT
2 {  2 r r
y %iv fi
fif
r
133
P %! 82
P ! ! r P ! 2 r Q I! V F fy2
F y2 z
XV7 W US
R mft
W US XV7y
Thus
m )fi
and
S ' R
fif
W US XVX
S @ R
Portfolio process:
Each
is
Wealth process:
Each
given, nonrandom.
is
measurable.
measurable.
be a probability measure on
76
is a martingale under
, we say that
t t
t t
134
Proof:
Let
may be pathdependent.
Receive
at time 0.
i V)
Remark 12.1 Hedging in this semicontinuous model is usually not possible because there are not enough trading dates. This difculty will disappear when we go to the fully continuous model.
12.6 Arbitrage
c
Theorem 6.37 (Fundamental Theorem of Asset Pricing: Easy part) If there is a riskneutral measure, then there is no arbitrage.
#a
, then
satisfying
f g Y ~ f f ~ Y f
` a
f fi
g Y
a martingale under
Theorem 4.36 If
is
t t t t
2 r
y o !
(v
2 r
y
( !
2 r
f (v
U P!
F 2 8 Vfi%
! F 2
fi
fif
2 r r
y ic fi
(v
f f
fif
)HV 2 r r
( 2 r fy2 y F r ~! ( y F a Rfd62 !
s r 2 r
y %ic
a 2
( ! F v
s v%s V) r F )v)F
76
t t t
co
9H#a
'#c
'#c
'#
c'#a
c'#a
h fb Y iT # Y
, and let be the nal wealth corresponding Proof: Let be a riskneutral measure, let to any portfolio process. Since is a martingale under ,
Suppose
` a 9'# ` c
'#
If
Therefore,
Recall that
d Wy
cy
. We have
g'
76 Y
5 j9
E C 5 %'8 Y
( ! F g %hD
g
h ) 01
( ! ! (
(v !
5 24
gr
F g ohD
( !
2 r d
( !
(v (v 2 r d 2 r r ! !
F ` 2 ! F
)V
fi
P F U ffi7fF fiF
2 r
r r (
2 r
'
P U e'F 2
2 r
y F %i'fi2
under which We want a probability measure dom variables. Then we would have
fF
U P
! ! x!
(v (v (v
f f f
fi f
The quantity
where
136
Then
Dene
Properties of :
for all
j5
In other words,
5 8
t t
{ 
g
r
#
r r z
p
f f
! ! ( ( !
! (
h h
gr
(v
! (v
g X
F i
gr g
F g #X
f f
F g ohD
h TF g
5 %%v9
g F
F 7
V)
g W
F 7 F
We show that
Verication:
g W
F 7
almost surely.
under
))
: 137
% cyH
E C
5 '8
Y
r
F g %hD f
V)
pi
!
(
F f7
t
F
g W
t t
F v
V)
r F )v)F
E s
{
s
q Xis r
r 2 r
2 r
E y2
( (
b! !
z
r
i U!
vxwqu 24 5
2 ) 01
rt s U !
5 24
2 r
F F i F
h 2 h 2
) 01 A! ) 01
!
5 24
2 r
y y %isT%ia'
f f
P U e
y %ic
5 24
2 r
h 2 a 2
) 01 A!
!
P 2 r r
Payoff at time
138
is
is
since
q X
q X
Chapter 13
Brownian Motion
13.1 Symmetric Random Walk
Toss a fair coin innitely many times. Dene
Set
139
r d"
almost surely, as
if if
H f
c
'
r a
! r
! r
z ( !
c'
r
! r r r S !
z W U XVS
! rr ! t r r ! !
{ X
! r
{ 4
5 24
We use the method of moment generating functions to prove the Central Limit Theorem.
! r
! r
( ! h
c '
W U XVS
Y r
z W U 4fS c'
W U XVS
which implies,
! r
z
f
) 01
! !
c c'
Proof:
Therefore,
Let
140
. Then
r d"
! T'
Y r
Proof:
(Independence of the
m
a
m j
a
'D
m j
r !
(LH pitals Rule) o
! r
! r T'
Y r
r !
r S V!
r
r r r
S
r r
S S
'rd
! ! r ! r ! r S r ! { ! r ! r z t r r ! ! r t { ! r ! r XVS z WU
W U XVS
! r
z W U 4fS c'
W U XVS
so that,
Therefore,
Y r
Let
Let
be a positive integer. If
If
j a
f s s )
cs#p m c#
m m
s s s
a 8 j S ' a j
j a
p Bo m
#) s) m )D
j a a j 8
S' R
h h
f s f s
) )
S ' R
m m
a j
)D
j a
p BVD m
j a
m j
a
142
Properties of
Properties of
is a continuous function of .
` dmy m j
a j T'o m
j a
and
k/n
in
(k+1)/n
8)
T' a a
))
r ~
S e A' F '
F v
c V)
r F )v)F
F R t t t
T'RPF a a
WPW A
y a
(, F,P)
1.
g'#a
2.
is a continuous function of ;
D a
3.
Let
then
and
are independent,
are independent, so
B(t) = B(t,)
and
D a
) a
7f
f h
7f
a a a ) dsV 'y 8 c
7f
7f f g g
143
7q D)
V) r 88V88)88V888)8 V)
) a W
))
a r a 8 8 WPW2
V)
r ~
144
(not necessarily
mklfTD)7fa a Wf
Required properties:
` f
be given. Then
Let
For each ,
is
This
are independent of
contains exactly the information learned by observing the Brownian motion upto time . is called the ltration generated by the Brownian motion. . measurable, . First x . Let , the Brownian motion increments ), we have and and . Then put in every other set be given. Put the set
D ) D
7q
t t
2r 2
r s s c
) V
7f
) j )
f h
f f G)Xs r g r
a a a 's) d) TD 8 d
f h
r g r
a y %
h g
( !
2g
a V D
a V d B) D g a a
a a a a y) )V dfs) y 8 gp) Vy
7f
7f
7f
7f
f h
7f
7f
Proof: Let
f WG
Proof: Let
is a martingale.
7f
g h
Up factor. (
f cBV7 )y
f WG
t s t
t t t t t
m j
r )
v r ) 2 Pd
}~ r x %s w
r 2
2 r 2 r
w r
r
2 r
z
2
}~ %s 2  w rx r
W U XVS
2 r 2
z {c
W U D4fS
2
W US D4f
2
'
W U DXVS
W U DXVS
2 r
W US 'DXV"
y
m j
W U XVS
x w yt W
r r 2
r t
'
W U t DXVS
ds
m j
m j
2p Hp
r r
'dP ' p
u u
' g'dP s
uu u F
u u
Let rst
146
in the rst
which implies,
. Let
v m Ds b j
'
2
v m Ds b j
m j
m j
Theorem 10.42 As
2 r
a 2 D `
dP
Under
, the distribution of
r d9
As so
, the distribution of
is a martingale.
2 r
a D 2
W U 4fS
r
. in the
147
B(t) = B(t,) x t
(, F, Px)
Figure 13.3: Continuoustime Brownian Motion, starting at
For a Brownian motion that starts at , denote the corresponding probability measure by (See Fig. 13.3), and for such a Brownian motion we have:
Independent of
measurable
I%7
~aW
Q7a
l l Q7aX~ W7a@ %h
The distribution of
under
under I . P
' a7
@e T ah
H~sl7a7
m7 HQ7ah hQ7
Then
148
sl7m7
Then we have:
B(s)
restart
and dene
s+t
'e yw ya
3
is a martingale, and
y ymC 3 a "T
"
Let be the probability that the Brownian motion changes value from let be dened as in the previous section.
D
Fix
Fix
. Then . Dene
restart +t
149
D
' F m Fm Fm F m lF m m F
H F m
C
3
6 7
y s
m ' G y
( )
& '
'e
0
$ # %
We have
150
if if
yw ywa y y m y
l
A '
6 7
8 9 3 4 5
( )
& '
1 2
y
! "
Let
Let
to get
$ #
Letting
Let
, we obtain
, so
yields
with probability 1. The expected time to reach level (14.4) (14.3) (14.2) (14.1)
1 B3
6 7
@H
4 @ U
4 @
Laplace transform formula:
d V V d eV b ` E T E c a
X Y
V W
E G
6 E
6 F H PI
then Density:
we get
t shadow path
151
Brownian motion
152
Chapter 14
The It Integral o
The following chapters deal with Stochastic Differential Equations in Finance. References: 1. B. Oksendal, Stochastic Differential Equations, SpringerVerlag,1995 2. J. Hull, Options, Futures and other Derivative Securities, Prentice Hall, 1993.
2.
is a continuous function of ,
y Y G f
3. If
153
Quadratic variation is a measure of volatility. First we will consider rst variation, function .
)`
e au a m yT h au a m
y Y
p P
p 7
1.
Technically,
g wvu t
r s
p q
h i
aX a %Q aX a Q%T e j y a yj W m
,
is given, always in the background, even when not explicitly mentioned. , has the following properties:
~a a
U
, of a
154
f(t)
t2 t 1
U
Thus, rst variation measures the total amount of up and down motion of the path. The general denition of rst variation is as follows:
i y f
be a partition of
Suppose is differentiable. Then the Mean Value Theorem implies that in each subinterval there is a point such that
X %
ee e gf e
d 7f
)`
We then dene
For the function pictured in Fig. 14.1, the rst variation over the interval
U U U U U U 5 7f B)`
@ ' ~ @~ ' y
U
@U
. is given by:
Q%T y%Q%
G
c7f
, i.e.,
i
'e
X
i U
e e
i f h y U i U
m oU l
f U U
i U
e
P i U
m
p q m l
p q7 p
m l
yT
f
@
U f j f y h
ee e gf e
eegf e e
eegf e e
m eU l
j h f h y
y U U
f y h
eenf e e
m eU l
@
U f f y h
kf
ee e gf e
U 5 7f )` h y
f j h
Then
y U U
155
f f
u u
yj
{ z
j h
% e
y

s i P
 ts
X X e e T C e % X A
f h } ~ y f h y P s f h
{ z
m
y y s
yj X
P P
j h
y P
This has expectation 0, so
s
C X A C as a X A
T
P P
f h y
ee e gf e
e F
s f
. To simplify notation, set
ts
f u
aX a
y
yQ%Q f
y f
Then
A
f
For
156
, the terms
and
e F
y y
are independent, so
(if
, then
Thus we have )
u
{ z
w x
157
As we increase the number of sample points, this approximation becomes exact. In other words, Brownian motion has absolute volatility 1. Furthermore, consider the equation
This says that quadratic variation for Brownian motion accumulates at rate 1 at all times along almost every path.
'e
H aX a7
Q%T
' ~a ~a
G
'
When
is small,
e H mu m7 % X C e F ~' aX a7
yj e F H mX a7 a
T
P
ee e gf e P P
{ z
As
, so
158
This wont work when the integrator is Brownian motion, because the paths of Brownian motion are not differentiable.
Let
be a partition of
f
Think of
m m
The functions
and
y y
, i.e.,
Q%T y
y Y
m y
S
G
@~
y%Q%
~y
2.
is squareintegrable:
1.
is
The integrand is
measurable
, the increments .
mu m y%Q% mu a au m
3 ~ %%j ~a
2.
is
measurable,
Q7
1.
every set in
is also in
~a
, and the
an
a
c c f
e c c
a
c c
m y
c
~
Linearity If Adaptedness For each is
t
0=t0
( t ) = ( t ) 0
Think of
f f
y y
In general, if
then ,
y
f
can be interpreted as the gain from trading at time ; this gain is given by:
t1
( t ) = ( t 1 )
measurable.
( t ) = ( t 2 )
t2
( t )= ( t 3 )
t3
t4 = T
3 3 Q7 %7
h
H
y
mX m7% y as a7Q y
h
aX~a y aX m y D mX m y aX m y ~
h y y y y f y h c
160
and
mH y
c c f
Proof: Let be given. We treat the more difcult case that and and subintervals, i.e., there are partition points and such that Fig. 14.3).
aX~a C y mX m y
y y f y h
r
.....
k+1
e % C ~ as a7
y y y y f y h
m
y s y f & y h s y s s y f
y h
~ "
y
y y
y
jy
as a y "
f y h f
y y
s
H aX~a7QC y
P
~ mu m7% y
y
Q7
Each
, so
162
path of
path of
0=t0
t1
t2
t3
t4 = T
i
Fix
is
measurable,
~a ~
such that
, over
yT ' 3 y
m~
~a 3
y
f
S
@~ ~ 3
f
163
The only difculty with this approach is that we need to make sure the above limit exists. Suppose and are large positive integers. Then
Linearity. If
and
Martingale. Continuity.
is a martingale.
It Isometry. o
a
mH y
then
a
e c c
m y
is
a y
measurable.
@ y ~ H @ ~y ' y y @ ~ ~a ~ H
has a limit.
f c f y y y f f
(It Isometry:) o
"
~ " ~ ~
{ z
h @
h
7 h
@ h
@ j
h @
h
7 h @ 7 h @
h @
pp
nr
gr
7 h @
pp
u7u
y
164
a
c
T/4
2T/4
if if
uvD
if
D
u
so
3T/4
with
, over
a y
c f
mH a
c c
c U U
T
U
) s h
T m m
c c f
c U U f c
c U U U
7 h @
7 h
Therefore,
@
gr
7 h
Let
or equivalently
but
Then
~
m l
comes from the nonzero quadratic variation of Brownian motion. It has to be term) If is differentiable with , then 165
j h
j h
yyy e %
y m l P P T
yy X %Q 7aX ha % h 7 I
y y h m l m l y y P
7 7
y f
Q
m l m l m l
h y
~y
'~
y
c
This holds even if is not an elementary process. The quadratic variation formula says that at each time , the instantaneous absolute volatility of is . This is the absolute volatility of the Brownian motion scaled by the size of the position (i.e. ) in the Brownian motion. Informally, we can write the quadratic variation formula in differential form as follows:
~ ~
166
It follows that
P
Q y
be a partition
Chapter 15
It s Formula o
15.1 It s formula for one Brownian motion o
We want a rule to differentiate expressions of the form , where is a differentiable were also differentiable, then the ordinary chain rule would give function. If
However, is not differentiable, and in particular has nonzero quadratic variation, so the correct formula has an extra term, namely,
This is It s formula in differential form. Integrating this, we obtain It s formula in integral form: o o
Remark 15.1 (Differential vs. Integral Forms) The mathematically meaningful form of It s foro mula is It s formula in integral form: o
167
H m7
H m7
h
U c c H U U
m7
H
HHa7
f a H a7 D H m 7 H~a7
f a H a7 H m7 H~a7
U c c U U c c U U
@ m7
U U
H~ah
Ha7
~a
~a
168 This is because we have solid denitions for both integrals appearing on the righthand side. The rst,
is a Riemann integral, the type used in freshman calculus. For paper and pencil computations, the more convenient form of It s rule is It s formula in differo o ential form:
U U U
There is an intuitive meaning but no solid denition for the terms and appearing in this formula. This formula becomes mathematically respectable only after we integrate it.
is a quadratic function.
C ah
mX
C aX
y Y
Fix
and let
be a partition of
In the general case, the above equation is only approximate, and the error is of the order of . The total error will have limit zero in the last step of the following argument.
% 7
Q s h f% 7 X h 7 7
U @
a @C as m m m H m7 mX m C ah H m7 H m7 H m7 y %%Q
Let
' 7
Consider
, so that
~a m7 @H~a7 ~a H~a7
mH a7
c T @U f
H a7
Hm7
7
a
c
T
~a
'
U
~a @H~ A @ G ' Hm
U U U U U U
U U
~ay
7
G c f
m 7 f a H m7 fy m m
U c c m l
We let
f f
H m7 H m7
U U
where
Dene
@H~
H~a
U
are constant.
169
170
on
is
As , the above approximation becomes exact. In other words, the instantaneous relative volatility of is . This is usually called simply the volatility of .
@H
y Y
9
Fix volatility of
. Let
be a partition of
Hm
a
@H
y Q%Q
is differentiable with
~
f
a
c
G c
. In differential notation,
9v 1
171
can be random, but must be adapted. The investor nances his investing by borrowing or lending at interest rate .
If an investor starts with and uses the hedge for all , and in particular, .
F H~ ~ H y 7
C
'
'
H F
(where
and
) which simplies to
'
2
'
Equating the
coefcients, we obtain:
H~
for all , we equate coefcients in their differentials. Equating the hedging rule:
H F @ w F
A hedging portfolio starts with some initial wealth time tracks . We saw above that
2
' @ @ f3 f
Value of an option. Consider an European option which pays the value of this option at time if the stock price is option at each time is
~ H
H~
@ @ H
2
F
Let
at each
y
a
y
a
jb
jb
y ~y y y y y y @ ~y 3 ~y
jb
jb
jb
@
!
y
d T
l H~y l y '
d c d c c f d
H y
c f G
y ~y
c f d
d
n
n
@U
U U
h a 3
c U
H y
G c c u
a y
@HH3 l ~y
G
where
172
and
. This is
Hy
c
~
T
3 y
If
We solve for
Integration yields
Differentiation yields
Taking expectations and remembering that the expectation of an It integral is zero, we obtain o
The mean of
, then
for every . If
, then
, where
~ mu m Q%Q mu a %QT
is
b b
~y @
d
y
d
yy
G c
d
T
y
a
c
c @
G c
Variance of
~
T
y
G c
jb
y
b
H~ y%Q% ~ h ~a
H
jb
jb d
y y A y
jb
T ~ ~y
d
d 7
{ z
d 7
@
which implies that
Differentiation yields
Each
y
C
If
and
For each
T
are independent of
is
h y
{ z
T e C X e Q X s Q X u
y y
{ z
% X % X u X u s
y y
yT
f
f h
The increments appearing on the righthand side of the above equation are all independent of one another and all have mean zero. Therefore,
X Q X
y
i f
%Q%
to be
y v
y e
y T ~
. For
v i y
' ~
is a onedimensional Brownian motion, we have the informal equation
174
However, we have:
Theorem 9.49 If
We compute
h y j h y { z
But expectation
All the increments appearing in the sum of cross terms are independent of one another and have mean zero. Therefore,
&
As
, we have
be a partition of
, so
{ z
Uf
F iF U
'e f H H f H " F
U U
F H H F
c c U U
F F U
a@
D H
i
~ @ @ % H 'w @ @ @ H H 'w
and and
c 3 c c c H 3 c
' @e
3 3
To keep the notation as simple as possible, we write the It formula for two processes driven by a o twodimensional Brownian motion. The formula generalizes to any number of processes driven by a Brownian motion of any number (not necessarily the same number) of dimensions.
Such processes, consisting of a nonrandom initial condition, plus a Riemann integral, plus one or more It integrals, are called semimartingales. The integrands o and can be any adapted processes. The adaptedness of the integrands guarantees that and are also adapted. In differential notation, we write
l
c c c f f
c ~ H F F
c
Let
Let be a function of three variables, and let have the corresponding It formula: o
and
and
where
U U
, for
as decribed earlier and with all the variables lled in, this equation
, and
be semimartingales. Then we
175
176
Chapter 16
Here and are given functions, usually assumed to be continuous in chitz continuous in ,i.e., there is a constant such that
for all
f
The solution process will be adapted to the ltration generated by the Brownian motion. If you know the path of the Brownian motion up to time , then you can evaluate .
be a constant and
, so
177
If
Wl
is a process
y F
mF 'H F
D
D
c f d
d
F
178
then
In other words, if you observe the path of the driving Brownian motion from time 0 to time , and based on this information, you want to estimate , the only relevant information is the value of . You imagine starting the at time at value , and compute the expected value of .
f
F H H F p H F
, given that
. Now let
F H F
H F
H F F
Let
be a function. Denote by
and
as constants:
V y
the solution is
3V
3V y
and
as constants:
be constants. Consider
V
2'u n
f I Q h v s eQ f IG
Q h I v s IG r kRTeQ f
i Ff s
v jG Y ~}wz
i o c
q S VW
z i@D
cwQ h v s eG F I I h Q h xv s PG I I v f z
f r Q h I v s IG tRTPQ f
i f s
v jG Y Q Q h IG b v Q s IG b VqekRe7p0tedG
o i c
Q IG b D Q IG Re7@'RegE
Y I D Q IG E j S Q IG E mXlRPgkuTRPgD
Q q IG RtP(U
h I v s RTI
s I
h Q h gv s eG I I f Q Q I eeCQ h v s edWG IG U Y qG v v
@Q h v s PG I I Q s IG tegE
S Q q s I h I TFR0TtiReG y q S Q h IG rpiRegE
Q h I v s IG U Y tRweu7q
f Q IG b D Y I D U S Q IG E Redca`XWVTRPHFD
A9 ) & 0('(
9 9 9 @
'g 4
$% #
B C
% " $ #
) & 0('
g
Y
Denote by
g
2 31
! "
variable) of
h RI
!6 875
or equivalently,
i f s
v jG ~dv
Fi S z
@D
S z '@D
Example 16.4 (Geometric Brownian motion) Recall that the solution to the SDE
Conditioned on , i.e.,
has density
, conditioned on
or equivalently,
i " i
z @D @D
Q h xv s eG I I
. In other words,
and variance
179
) i(
(
) i
Yg
g
0
Y
(
iYg
& (T
& '
'
j
&
'g
i@f B QRIgvpG f s
v Q I v G j wRxa8@dY i f s
Q IG RegE
e 6
I v a Q IG RegE
Q I v B Rgd8G f
Y Q I v G j qRp@pY
Q I v Ra8G f Q I v i RxdG f i Ff s
i cf s
v Q I v G j 0Rp@Y Y Q I v G j qRa8@aY
D Q q I @FR0WetPG
f "@D
h f
I Q h gv s eQ f IG
i @f s
v jG v
Fe f
Ixvd
g#
S Q G cg
I v p I v xd
S Q v Q G E gCxHHG t
Q h I v s I @ RTPG Q h I v s I kRxTPG v
i S S D Q q s I h I W@wtRPG
v { D x Q s IG cx'egE a tu
Therefore,
where
Using the transition density and a fair amount of calculus, one can compute the expected payoff from a European call:
Therefore,
180
Consider
The variables
and let
and
in
'g
and
(KBE)
(
g
(KBE)
!
'
j
) i
& l
& '
&
k y
f q f Fee
i f s f i i Y
q j iuS y
h f
@CQ f
i@f s
v jG v
i @ y
S Q q TFR0TqG y
f Q IG b D Q IG Re7@'RegE
Y I D Q IG E j S Q IG E mXlRPgkuTRPgD
f f B f Q U v q v e"@HwG Y y v Q U v q v G "@wHU y 6 S
S t y s f Y U y
f S f Y v f Q U v q v ecpgG y y f q q t S Y S f U v q v @Hw U v q v @pHp y y y y q f S S U v q v @wH y y y f f B Y Y v 6 S Q U v q v G "@pHpU Q"@UgqpvG v y @ h v v f CQ"@UHvqpvG feQ"@UgvqpvG @ F h S v S f eQcUgvqpvG (y y @ F S Q q TFR0`G y f h f Q Q U Y qG v Ce"@aWG v Q IG b D Y I D U S Q IG E Re7@d`XWVTRPHFD
Let
Therefore,
Consider
(5.1) 181
& i
&
& & i
&
&
w w
& &
w
&
j
A R
9A 9 9
)i !
A9 9 9 9 B
B 9A 9 9 9
!6 6
!6
9A 9
'
!
B
!6
9A
2 31
B
9 9 9 @
l
(
&
( i
'
) &
! !
# # # # !
'
j
i
j
&
'
j
& ('(
' '
j
& l
0
j
It s formula implies o
# 0
where
2 x1
Let
5
so
182
. Then
, the process
183
Thus by two different arguments, one based on the Kolmogorov backward equation, and the other based on It s formula, we have come to the same conclusion. o Theorem 5.51 (FeynmanKac) Dene
The BlackScholes equation is a special case of this theorem, as we show in the next section. Remark 16.1 (Derivation of KBE) We plunked down the Kolmogorov backward equation without any justication. In fact, one can use It s formula to prove the FeynmanKac Theorem, and use o the FeynmanKac Theorem to derive the Kolmogorov backward equation.
16.6 BlackScholes
) i
the solution is
x
&
&
@'
) i
T0
and
0
7mip'
Then
) i
& l
& '
where
&
2 31
i
We know that is a martingale, so the integral for all . This implies that the integrand is zero; hence
must be zero
(FK)
&
&
) X
& (T
! c
l0
T
) i
j j
9A 9 B
!
!6
) i
j
qi
qi
) i
mip w !
! c
l0
Dene
where
184
is a eld,
is measurable, and
is independent of ,
B
9 9
!6
where
measurable
e
e
1 1
Wqiq Wqiq 2 31
! 3
! 3
'
'
'
, we have
independent of
) i0 0 e 0
j j jg
i
j
j j j
jn
e '
1
e q@
jn
2 31
! c e q@'
) 1 )
! 1
'
T0
2 x1
CW
&
&
9A
) i
9 9 9 @
9A 9 B 9
A9 9 9 9 2 71 B
BC 9A 9 9 9
!6 6
!6
Note that the random variable whose conditional expectation is being computed does not depend on . Because of this, the tower property implies that , is a martingale: For ,
9A
2 g1
9 B C
9 @
!6
) i
j
& l
& '
&
2 2 2 31
l
Because formula,
Along with the above partial differential equation, we have the terminal condition
'
T
Furthermore, if condition
for some
&
j
at time if
Finally, we shall eventually see that the value at time of a contingent claim paying
. Therefore, , then also terms in . This gives us the boundary must be 0. By It s o is 185
2 x1
C
0
j
& '
q l0 &
jg
"e6
) & 0(
jn
B "
6
2 g1
j
Even if is some other function (e.g., satises the BlackScholes PDE (BS) derived above.
7
p#
! e q
qi
cl
e q@
jn
"
'
jn
and
for geometric Brownian motion (See Example 16.4), we have the stochastic representation
Compare this with the earlier derivation of the BlackScholes PDE in Section 15.6.
Plugging these formulas into the partial differential equation for and cancelling the pearing in every term, we obtain the BlackScholes partial differential equation:
186
e q@
0
j
&
, a put),
6
T l0
g
187
An example of such a process is the following from J.C. Cox, Notes on options pricing I: Constant elasticity of variance diffusions, Working Paper, Stanford University, 1975:
2 31
2 31
T0 1 ' i
& 
2 31
&
l 1
c
(&
188
Chapter 17
is a matingale. In fact,
189
&
& (
& (
&
# qi
) i
& (
& (
2 1
Under
, the process
, is a Brownian motion.
&
2 x1
2 1
&
&
2 1
#
&
mi
#

&
2 31
190
1 1
so
is a probability measure.
in terms of
. Let
. If
but since and , this doesnt really tell us anything useful about we consider subsets of , rather than individual elements of .
Distribution of
. If is constant, then
)i mi
Removal of Drift from . The change of measure from To see this, we compute
C qi
to
(Substitute
&
mi
) &
&
$ %
&
7mi`
mi
"mi` !
qi
"
&
d#
Under , variance :
C

) "
&
#
&
#
, where
. We have
3
&
#
, we have
for every
3
. In particular
. Thus,
and
191
Because
&qi ! G% $ &qi ! $% &qi !
$ %
we have
Means change, variances dont. When we use the Girsanov Theorem to change the probability measure, means change but variances do not. Martingales may be destroyed or created. Volatilities, quadratic variations and cross variations are unaffected. Check:
)
. If
is
A
measurable, then
) RR
Proof:
qC
2 31
because
, is a martingale under
&
"
qC
( ) '
&
C
& 
&
&
Under mean
. Under
) &
) &
qi
"
&
&
is normal with
) X A
C 2
2 31
g
&
&
) i
& (&
& 
& & A
2 x1
C
Although we have proved Lemmas 1.53 and 1.54, we have not proved Girsanovs Theorem. We will not prove it completely, but here is the beginning of the proof.
Lemma 1.55 Using the notation of Girsanovs Theorem, we have the martingale property
&
A & C
8C A 8C
6
B C
A
A ) RC 2
C
192
is
measurable and
2 31
Therefore,
is a martingale under
is
, (Lemma 1.53 again) measurable. We check the partial averaging . Recall (Taking in what is known) (Lemma 1.53) , then (1.1)
193
Denition 17.1 (Equivalent measures) Two measures on the same probability space which have the same measurezero sets are said to be equivalent. The probability measures dened by and
Stock price:
The processes and are adapted to the ltration. The stock price model is completely general, subject only to the condition that the paths of the process are continuous. Wealth of an agent, starting with several ways:
Risk premium
6
@ )9
& l
(&
S3
&
e
u3
&
&
78
(&
Interest earnings
& C
x
k & (
& l
& l
& l
2 31
Interest rate:
. The process
As usual we are given the Brownian motion: , with ltration dened on a probability space . We can then dene the following.
) i
&
2 a1
3 4
&
1 2
(&
S3
If
, then
&

&
&
If of
, then to obtain
Because
& 
#
&
is
W
Denition 17.2 (Riskneutral measure) A riskneutral measure (sometimes called a martingale measure) is any probability measure, equivalent to the market measure , which makes all discounted asset prices martingales.
eeT
ee
) i
' &
S3
&
&
&
S3
) i
&
# 
) C
(&
&
u3
&
5 5 Q
&
(& & l
& 
S3
&
3 u4
(&
& l
&
&
&
j
&
&
B F D D G E
B I F D D R 
) C
B D R I F D
&
5 Q
& C
& l
B D E H F D B D E H F D
B I F D D P E
&
&
&
&
B D G E C F D
Notation:
Discounted processes:
TS
and
are martingales.
195
Look back
This is because
is a martingale under
1
, so
) B s 6
X
) B
6
2 1
l
h v e D Q e G iHg(fl`
Q v Q G `G egH8'aS
Q Q G ` Celbv
Q IG RP'`
# 3dS c
s th r p iqS
G S
l
Example 17.1
Y
W %
u3
&
U e me 3 e V
& (
qi
where
& 
#
eeT
'
196
Chapter 18
then is a martingale. Now we see that if is a martingale adapted to the ltration generated by the Brownian motion , i.e, the Brownian motion is the only source of randomness in , then
Homework Problem 4.5. In the context of Girsanovs Theorem, suppse that the ltration generated by the Brownian motion (under ). Suppose that is a Then there is an adapted process , such that
A ) 2
is martingale.
197
2 g1
l &
2 1
for some
& 
& (
l
'
&
2 31
A 2 2 1 2 31
Theorem 1.56 Let be a Brownian motion on the ltration generated by this Brownian motion. Let relative to this ltration. Then there is an adapted process
2 31
&
l
2 31
) X
g3
5
A9 9
l
) 2
2 g1
l &
2 g1
) i
&
&
A )

&
& 
& # mi
& 

&
mi
&
&
1 2l
3 4
&
Let
Then
198
2 71
2 31
B R
9 9
6
X
) X 2
l
2 1
5
Let be an measurable random variable, representing the payoff of a contingent claim at time . We want to choose and , so that
&
u3
&
5 u
& 2 1
Set i.e.,
Dene the
martingale
and choose
5
vb e T

h &
8 &
8
#
& ) "i
) & # mi
) ) F)
&
#
&
2 1
) ) F)
C
 1 2
A
y
&
) ) )
&
&
qi
A9 2
C
2 x1
9 9
B C
A9 9 9 9
9 X 6 w 6 X A 9 9 9 9 6
X
The Martingale Representation Theorem guarantees the existence of a hedging portfolio, although it does not tell us how to compute it. It also justies the riskneutral pricing formula
) X A9
'
9 9
B
s 6
X
A9 )
2 31
9 9
6
X
2
2 1
18.3
where
so
In particular,
2 1
&
For
2 31
dene the accompanying ltration, perhaps larger than the one generated by , we have ; , dimensional adapted process. ,a 199 ;
, the process
Corollary 4.59 If we have a dimensional adapted process then we can dene and as in Girsanovs Theorem. If , is a martingale under relative to , then there is a dimensional adpated process such that
Let
)
, be a dimensional Brownian motion on some , be the ltration generated by . Then we can dene the
Stocks
Accumulation factor
) h &
C1
Here,
and
) ) F)
) ) F)
) ) F)
2 1
2 x1
2 31
& 
2 31
&
& ) (@i
@i & )
) ) F)
& 

&
qi
1 C
&
2 1
) ) ) F
2 g1
C&
Theorem 4.58 on
21 A )
&
) ) F)
2 1
2 x1
18.4
2 g1
) ) )
&
, then there is a
&
201
Risk Premium
3 C F
Case I: (Unique Solution). For Lebesguealmost every and almost every , (MPR) has a unique solution . Using in the dimensional Girsanov Theorem, we dene a unique riskneutral probability measure . Under , every discounted stock price is a martingale. Consequently, the discounted wealth process corresponding to any portfolio process is a martingale, and this implies that the market admits no arbitrage. Finally, the Martingale Representation Theorem can be used to show that every contingent claim can be hedged; the market is said to be complete. Case II: (No solution.) If (MPR) has no solution, then there is no riskneutral probability measure and the market admits arbitrage. Case III: (Multiple solutions). If (MPR) has multiple solutions, then there are multiple riskneutral probability measures. The market admits no arbitrage, but there are contingent claims which cannot be hedged; the market is said to be incomplete. Theorem 5.60 (Fundamental Theorem of Asset Pricing) Part I. (Harrison and Pliska, Martingales and Stochastic integrals in the theory of continuous trading, Stochastic Proc. and Applications 11 (1981), pp 215260.): If a market has a riskneutral probability measure, then it admits no arbitrage. Part II. (Harrison and Pliska, A stochastic calculus model of continuous trading: complete markets, Stochastic Proc. and Applications 15 (1983), pp 313316): The riskneutral measure is unique if and only if every contingent claim can be hedged.
Market price of risk. The market price of risk is an adapted process satisfying the system of equations (MPR) above. There are three cases to consider:
) ) F)
x
) ) F)
, so that (MPR)
& 
&
e & F
) ) F)
&
&
C1
1 C
&
3
(5.1)
F t
202
4 1 )
3 1 4
&
mi
) & & & & & 3t'e 3 3 3 't & 3 & & & & & & 3 l 3 & (& (& & & 3 j 3 2 2 1 ) ) B &
3
Ql
3 d
(& &
3 T
&
A 2 A
Let
In what follows, all processes can depend on and , but are adapted to simplify notation, we omit the arguments whenever there is no ambiguity.
2 1
2 31
Chapter 19
2 g1
Stocks:
3 w
We assume
In other words,
3 3 e
and
Accumulation factor:
Note that
203
3 e
(MPR) . Let . To
g iS g hS
f S f #S g iS g hS f S f #S
F F F y y
A9 )
2 x1
9 9
6
X

A
X
) B & 3
&
6
5
& @
&
3 &
5
5 5
&
5
& @
(&
&
&
&
&
5
&
&
We have changed the mean rates of return of the stock prices, but not the variances and covariances.
) B & 3
& &
3 e 3 js
) i
&
&
A ) h
&
&
&
& # qi
3 e
@ 3 3 1
3
3
1
provided
204
Suppose
Then
m rqp4l n o n m
Let
be
martingale ; we dene
205
We have
&
3 e
Every
A
The stocks are perfectly correlated. The market price of risk equations are
1
The process
&
&
3 T4
3 4
1
&
& 1 &
&
The case
s uo
. Then
) X
l
2 31
we have
and in particular,
l
and setting
& 3
#
l
3
) &
&
3 l't
#
5
l 3
&
 &
&
(MPR)
X
& @
2 1
1 2
3 g f g 3 U
'3
) q
q
3 1 &
3 3
1 1
6 6
&
&
5
T3
5 g g 3 U f f 3 U
) q
5
g
&
& @
&
& @ &
3
5
&
& @
&
&
f
There is no solution to (MPR), and consequently, there is no riskneutral Case I: measure. This market admits arbitrage. Indeed
) q
W
Case II:
206
3 1
(&
3 &
&
w & @
3 '
1
5 5
&
3
1
Hedging:
Notice that
f U
and
Then
Suppose
or
depend on
Set
depends on
be one of them.
& T &
) &
&
&
&
&

A9 )
2 g1
9 9
B C
6
X

To get so
We can write
to match
208
&
&
qi
"
&
&
mi
{  z
"
c
c }
&
&
h (&
mi
"
&
&
&
{ "
qi
z
$
@!
) i
@wxh u v y
y
Then we have:
Chapter 20
Dene
Without drift.
209
s
210
2mb
shadow path
m b Brownian motion
Figure 20.1: Reection Principle for Brownian motion without drift
b
t
)
G&
&
$ % $
&
&qi) !
&
$
!
&
qi mi !
$ %
&
)
$ &
z
&
z
#
{
#
z
'
!
)
$ &
z
v
&
&qi3 !
z
#
{
t
#
z
$ %
eqiq !
!
'
!
)
&
&
qi
"
$
&
&
t
) i A
y i
w u @~Q
where
2 31
Set
Let
Since
But also,
Under
is arbitrary, we conclude that be a function of two variables. Then is a Brownian motion (without drift), so , is a Brownian motion (without drift) on . Dene 211
(MPR)
Hh
k "e 3
t 3
qiq ! 3
! eqiq
T4 q
eCf e
$ S 3 e e
6 ' q 1 q T
) i
D @w~ u y i
y
G$
t 3
! &qi

) i
T
3

G$
&qi ! 3
A @ @ @ )9
k
3
7
7 3 6
78
qi ! &qi 3
&
& '
@
3 w
e e
S d
' qT
) X
w u @~}
y y h S
e e
Let
where
We compute,
(&
where,
212
& &
The standard method for all these integrals is to complete the square in the exponent and then recognize a cumulative normal distribution. We carry out the details for the rst integral and just
) T& (&
&
"
mi
# 1
mi
z
z
m m m
#
{
mi
z z {
# 1
&
&
mi
q
{
"
"
qi
9 9 9 z
mi qi
! "mi` 3
z
q q 1
&
! qiq 3
#
z {
qi
"
$ 3
! qiq
#
z
#
z
q w
z { z
)
~ m
~ M(T)
~ b
so
2 31
leads to
2 g1
We compute
x=y
x ~ B(T)
. 213
"e 3
"e 3
h h 3 h
c
6
h
3 h
qi
3
c
c
m 1
w
)
h
c
3 g
3 3
c
mi !
g
#
3 {
) X
& $ (&
3
& "
w3
mi
z
#
1
mi
#
z
" q
& &
w3 3 P
w3
3
3 u
03
where
Putting all four integrals together, we have to obtain In the rst integral we make the change of variable give the result for the other three. The exponent in the rst integrand is 214
215
v(t,L) = 0
+ v(T,x) = (x  K)
v(t,0) = 0
If we let
If we replace by and replace by in the formula for , we obtain a formula for , the value of the option at the time if . We have actually derived the formula under the assumption , but a similar albeit longer formula can also be derived for . We consider the function
e E
We show that
PEj
HRe# Qd
fC
" e E
te
de
5 76Q
t I
e
" e E
$tI "
" " 1 "
ea! f! Q
te3feb
(Ee
" e E
t dtI
e#
Qdtefeb)fC
(Ee#
I' eb0% t
(Ee#Q
fCe#Q
tee R
$ t" H
" "
e I
$" " "
E
% f
" e E
te
e
I'fh
I)f
(Re#v
% &
" e E
t dt
"Q
IfCQdt
$" " "
Ib'fh
IbfC
% &f
" #e E
e a!
hte "bfC
Re
dfe&iQx
Let
Let
is a martingale.
216
. If
e#f!
But when
Suppose
1 b2
so we may write
, we have
QI Ct te
itff
udf
tPeCQP
f
V
C D8
Ct
Qtf
e 8
hf
C H8
tff
fI Q
A tff e 9 8
eQ
b'
1 T
"QIt
1 8
5 4e
G F (
C H8
Q RP 5 I Be 1 8 (
G F
5 Be
G 2 F ( E 7 Re
tPeQdeb'feb0% )
C D8
C
e#uBt fCe# @8 A 9
Integrate from to
For
Because
teb'feb)f
E 7
(E
The Hedge
Let
then follows.
The PDE
is a martingale. Therefore,
Then
and
We should take
if if
. Then
. 217
W X U
eb
ueb
218
v(T, x)
v(t, x)
In particular, the hedging portfolio can become very negative near the knockout boundary. The hedger is in an unstable situation. He should take a large short position in the stock. If the stock does not cross the barrier , he covers this short position with funds from the money market, pays off the option, and is left with zero. If the stock moves across the barrier, he is now in a region of near zero. He should cover his short position with the money market. This is more expensive than before, because the stock price has risen, and consequently he is left with no money. However, the option has knocked out, so no money is needed to pay it off. Because a large short position is being taken, a small error in hedging can create a signicant effect. Here is a possible resolution. Rather than using the boundary condition
eQ fC tff Qf
V
2. The value of the portfolio is always sufcient to cover a hedging error of size of the short position.
1.
f
where is a tolerance parameter, say %. At the boundary, short position. The new boundary condition guarantees:
t f
Qdf
f
For
but near ,
e ve4
1
8
s %i
tf
C
e &cd
8 fu
d 8
G F
e
8 f
G F
b c
f
C D8
fC
QP
f 8
Payoff:
f
Stock:
Asian Options
Chapter 21
by specifying
219
it
d
b u #
ut e
C
F
e cd
q p h f rig
1
8
G F
G F
b c
1
8
iP
bQ
31 8
G F
hf#Qf
8
V
U j 8
8
V C D8
U
U
C H8
8 4
H 8
V V
U 8
e Gb eHRe#QHGRef e
"Q
hcCt e b e h
e t
31 8
e v
iw
e ve
iw
e y"
The function
One can solve this equation rather than the equation for .
1 E
eHRe GR e
fC
G F
hf@
e b iGcGRef e
e b hcHGR e h 1
eQ
u ' 1
x j 1 1
1
220
is
of a portfolio
f
P
"
1 8
thf 9 ht f
hPb eIEQPf
iP h
eCQI
e4
eQ
Pthe" e
e## Q
Pthee
E 7
IEe u #
QCGR e
eC
8 f
b c
f I
u u
C H8
CH8 fbt f h 8 h 8 8 8
tffC j 8 8 Q
31 8
because both these processes satisfy the same stochastic differential equation, starting from the same initial condition.
C H8
fbf
8 f
U 8
G F
hfP 8
Take
1 8
G F
hf
Qf
U
If
PthPeQP
tff
Qd
where
The function
x
V
satises the BlackScholes PDE . We compute , we compute next the value of a derivative security which pays off , then (From Eq. 1.1) 221
222 Remark 21.1 While no closedform for the Asian option price is known, the Laplace transform (in the variable ) has been computed. See H. Geman and M. Yor, Bessel processes, Asian options, and perpetuities, Math. Finance 3 (1993), 349375.
)
Chapter 22
so that
(four equations)
223
d e
@V
d
e4
Let Let
be the set of all possible sequences of cointosses. We have no probabilities at this point. be given. (See Fig. 2.1)
and
224
The probabilities of the stock price paths are irrelevant, because we have a hedge which works on every path. From a practical point of view, what matters is that the paths in the model include all the possibilities. We want to nd a description of the paths in the model. They all have the property
If we change , then we change , and the pricing and hedging formulas on the previous page will give different results. We reiterate that the probabilities are only introduced as an aid to understanding and computation. Recall: Dene Then
@V
i.e.,
x U
@V
x U
d
f
x U
@V
xU
x U
The paths of
PE
w R
PE
Let
. Then
p p qo r S E
k n
QRP
% &
UI
U 8
PE
PE
PE
t d
R
1 E
k m l
QRP
PE
UI U
U U It
8 8
8 U 8
j
1 1
It
PE
hi
fh g
d d
G G
V U
V U
 7{ U  7{
j 1 } x 8
x 8
q%
%
$"
"
"
"
x !
x}
y
%
, and compute
 {
~ l
under which
is a martingale, we denote
$"
"
"
"
y a
%$ "
"
"
"
xU
xU
xU G
xU
, where
is some
$ "x "
"
"
"
will also be a
x U
"
U x
z y
226
so that the paths of accumulate quadratic variation at rate per unit time. Surprisingly, the choice of in this denition is irrelevant. Roughly, the reason for this is the following: Choose . Then, for ,
w
Since we are interested in hedging along every path, except possibly for a set of paths which has probability zero, the choice of is irrelevant.
is
i
f
C D8
8 f
df 8
is a martingale under
p h if 7 Pudf
is dened by
f
is dened by
f
In other words, regardless of whether we use or in the denition of paths. The mathematically precise statement is the following:
f
C g
p h 3if
p h if
PQdfe
~d
p h if
Pudf
by
, then
is a different function.
f
G7
p h if
Pudf
PQdf
df
f
f
f
w
Let
. For any
and
Let
which is equivalent to
f f
x
Now suppose is a given measurable random variable, the payoff of a simple European derivative security. We want to nd the portfolio process , and initial portfolio value so that . Because must be a martingale, we must have
i
V
% f
$"
"
"
"
E E Ea E {
is a martingale under
f
C 8
f
f
f 8 f
8 f
tf
E { E
f
f
xU
xU
so
is a martingale under
E
C 8
f
Then
x 8
hf
where
. Set
has the same paths as . We can change to the riskneutral measure Brownian motion, and then proceed as if had been chosen to be equal to
, under which .
fI
C H8 E
Q tP
fC
8
I
8 f
f 8
C C
E E {
is a
(3.1)
(3.2)
(3.3)
228 1.
a
is given,
V
under . We next use the corollary to the Martingale Representation Theorem (Homework Problem 4.5) to show that
f
C 8
for some proecss . Comparing (3.4), which we know, and (3.2), which we want, we decide to dene
fBf f
x
Remark 22.1 Although we have taken and to be constant, the riskneutral pricing formula is still valid when and are processes adapted to the ltration generated by . If they depend on either or on , they are adapted to the ltration generated by . The validity of the riskneutral pricing formula means: 1. If you start with
a C C a
Remark 22.2 In general, when there are multiple assets and/or multiple Brownian motions, the riskneutral pricing formula is valid provided there is a unique riskneutral measure. A probability measure is said to be riskneutral provided
% f
$"
"
"
"
xU
hf
, such that
$"
"
"
"
hf
Then (3.4) implies (3.2), which implies (3.1), which implies that the portfolio process .
hf
V
To carry out step 3, we rst use the tower property to show that
z y
hf
U
3. Construct so that (3.2) (or equivalently, (3.1)) is satised by the dened in step 2.
R { R f
V
f~
df
xU
hf
2. Dene
). ,
(3.4)
229
To see if the riskneutral measure is unique, compute the differential of all discounted asset prices and check if there is more than one way to dene so that all these differentials have only terms.
C 8 C
one uses the Markov property. We need to identify some state variables, the stock price and possibly other variables, so that
% " "
where
0D( F 0y
&y' ( )H
7 g
7B'Bt6
0H
046
46
Take
and
D(
44t
and
"
" y'
"
"
46Bt6
04
Then
y y'
y'``
( H6
0HBt6
$"
"
$"
y x
f f
xU U ( (
C 8
G F
P
xU
C 8
In every case, we get an expression involving to be a martingale. We take the differential and set the term to zero. This gives us a partial differential equation for , and this equation must hold wherever the state processes can be. The term in the differential of the equation is the differential of a martingale, and since the martingale is
&4646Bt6
)0D(&'
4 46
46
" y y'
046
hi h h fh 07Bx4t F I hh W
r S y' p p p p p p qo
6 Q RP )0D(&'
&y(x 4 46 04t'0&46&t646#
46&46&t6)446t4
46 4
46
Then
Take
is a martingale under
and
230
and
46
46
Then
is a martingale under
and
f
46464t
4604&t6) &46&t6'
'&46&4Bt6
)4
46 4&t6)4 4 46&46Bt6
4 46 46 4
D46
7B'Bt6
D3
% 0 t % HD R
3(
##
t #
R
4 46 46
0&46@&46Bt6
4&t6
( S 46&46Bt6
Q RP F I 46 46
0&Hx(
is a martingale under
. We have
4t
is
, and
. We want to choose
4`
4&t6'
to be . We have so that
231
232
Chapter 23
2. 3. Then
is a martingale,
f f
, (i.e., informally
Since the moment generating function characterizes the distribution, this shows that is normal with mean 0 and variance , and conditioning on does not affect this, i.e., is independent of . We compute (this uses the continuity condition (1) of the theorem)
f
C H8 E
so
S Q P RtRI 8 5
uses cond. 3
233
f
if
Proof: (Idea) Let be given. We need to show that mean zero and variance , and is independent of conditional moment generating function of is
$
C H8
1 d
'E
5 u
C H8
5 i
C H8
1 d f
$"
" E E
"
"
C H8
F 2 E
C H8
5 i
5 #i
5 Q
5 8
f
1. the paths of
C
are continuous,
).
be a process on
, adapted to a ltration
d C
if
C
5 Q
$"
5 #
E 'R
5 Qd
5 x
5 ec
5 ecf
1
hf
f
 8
5 Qf
5 Qd
% &
% &
5 Q
% &
5 f
G
E 5 i 1 G F !
Q q
C D8
$ "
" " "
C D8
5 i
1 5 1
G F F
% 4
C H8
C H8
Now
We dene
so that
Plugging in , we get
8
C D8
t t
C D8
C D8
C D8
8 8
8 8
8 8
C D8
C H8
C D8
C D8
t t
C D8
8
C H8
C H8
C D8
8 8
C D8
C H8
t t
C H8
C D8
t
C D8
8 8
C C
C H8
Dene processes
Let
and
Dene
and
Then
and
Therefore,
and similarly
and
and
by
8
A 8
8 9
8 9
C D8
C D8 C D8
8
8
C D8
~ C D8 ~
t ic
C D8
C D8
8 C D8
C D8
8 8
e~
C D8
e~ u
eQ
t t t t
n
8 8
8 8
where
236
and
If
This corresponds to
so that
, then there is no
and
t ic
, we have
237
so both
and
We can now apply an Extension of Levys Theorem that says that Brownian motions with zero are independent Brownians. crossvariation are independent, to conclude that
Qd 8
C D8
C H8
238
Chapter 24
Stock process:
C H8
at time , where
d
Remark 24.1 The option payoff depends on both the and processes. In order to hedge it, we will need the money market and two other assets, which we take to be and . The riskneutral measure must make the discounted value of every traded asset be a martingale, which in this case means the discounted and processes.
239
C H8
C 8
C D8
C 8
We want to nd
and
and dene
ee
f
dB
iG }d
P4x
b2i%e
where
, and
and
C H8
C D8
f f
d
d ~
8 f
$
240 so that
C 8 E ee R
We solve to get
x
We shall see that the formulas for and do not matter. What matters is that (0.1) and (0.2) uniquely determine and . This implies the existence and uniqueness of the riskneutral measure. We dene
We need to work out a density which permits us to compute the righthand side.
and
is .
8
e~
tP
hPe
and
has volatility
has volatility
and
Under , and are independent Brownian motions (Girsanovs Theorem). riskneutral measure.
z y
C 8
C D8
C D8
8
d C 8
z 8
C D8
8 8 8 8
q if p h
(0.2)
is the unique
p h 3if
PQ
q
C
t
C 8
8 8
W
p h 3if
8 d
d
g g
p h if p h if
P P
f if C
iG }d
Set
s R
df
C
gif q p h
P
C 8
d d 8
Then
p h 3if p h 3if
PQ PQ
C 8
d d
C iz
Furthermore, the pair of random variables is independent of are independent under . Therefore, the joint density of the random vector is
ee
%
E
E k
G
p h if
P
y
e ee E R
B H
242
. The density of
is
because
C h
The answer depends on and . It also depends on depend on nor . The parameter appearing in the answer is
Remark 24.3 If we had not regarded as a traded asset, then we would not have tried to set its mean return equal to . We would have had only one equation (see Eqs (0.1),(0.2))
to determine and . The nonuniqueness of the solution alerts us that some options cannot be hedged. Indeed, any option whose payoff depends on cannot be hedged when we are allowed to trade only in the stock.
y C z
p h if
and
. It does not
(1.1)
k
P
8 l y 8 8
p h 3if
W p h 3if
4 4 5 5
p h 3if
P
G F
e#Q heC
C 8
and
C iz
e Q
y
P
hPeC
243 , then
h R
8 8 d
we should set
z
Now we have only Brownian motion, there will be only one , namely,
u u
u i
C 8
C 8
d 4
tf
if e
C 8
is a martingale under
8
. We compute
tf
if e#
P
and
t
iPeC
P
by
, and respectively in the formula for . . Using the Markov property, we can show that the stochastic
E A C A@ FDB
8 6 97
Bt
u #
eIEQGR e
y E
fC
9 He#Q
so with
we have
so
C D8
C D8
C H8
C D8
244
y L v(t, x, L) = 0, x >= 0
x v(t, 0, 0) = 0
"
Setting the
e4
is xed.
~e
eQ
de
u u
"QIPef
u i
Ge
eQH
CGR e
f
e
8
V
U d
8 U V
U 8
Let denote the number of shares of stock held at time , and let denote the number of shares of the barrier process . The value of the portfolio has the differential
f
V
d
8
e
8
tf
if e
8
d 8
f
C 8
f
d
e u
8 f
e u e#u
e
8
% f C 8
f
C 8
f 8 f
f 8
e u
f e
8
d C
d
% u C 8
C 8
C 8
e Q
hffC e E
8
eQ
%
eHRe QHPefC
eQCPefCeQI
ue
u u
xe
eQ
Cte e
e
On the is
On the boundary, the barrier is irrelevant, and the option value is given by the usual BlackScholes formula for a European call.
be
eQIt" e q
efC
where that
, and
tf
d
h f
tf
hff
Therefore,
C
e
245
f
d
hff hff
Qdf Qdf
V
htf
tP
hPeQP
U d U
8 f
V
fe#
8
To get
hffudf
Chapter 25
American Options
This and the following chapters form part of the course Stochastic Differential Equations for Finance II.
Let
, let
The plan is to comute and then maximize over to know the distribution of .
if if
tt
I % Pe
fe4
C e4
iQi
I % 7i Qd
V
iQ
"
`
Let
tf

G H
or lower. We dene
f
S
8
p h 3if
U V 4 3T
F
" "
p h 3if
4
F
4 5 w R "" 3 wR
p h if
p h 3if
4
F
8 8
4 5 3
8
p h 3if
5 iG @
Dene
8
f
C 8
Now Therefore, From the rst section of Chapter 20 we have 248 Figure 25.1: Intrinsic value of perpetual American put
K
Intrinsic value
Stock price
ji
p h 3if
gz u d
z y
iz
y
hf C
z 8
f C "
CiQx
C C
G G
C
p h 3if
f df C
p h 3if
e Q
gz
X `
G F
I X Y5
p h 3if
p h 3if
F v
S
8
p h 3if
U V 4
W
z gz
W W W
f 8
gz
so
For
Reference: Karatzas and Shreve, Brownian Motion and Stochastic Calculus, pp 9596.
Under
Dene
, the process
, dene
(See Homework)
f
C
Qx
e4
Q 8
p h if
G F
I X Y5
df
C e&iQx
ji
p h 3if
8 8
#
8
p h if
G F
G F
#
W
p h if
#
p h 3if G F
y #
u
y y y y y
% % b
p h if p h if
$ "
" "
d d
"
p h 3if
p h if
I be a I b a I ab I a b
I ab I a be
For
ji
Since
Therefore,
250
C g
p h 3if
df
c V
q
b z
f f c Dc etViQ c T T
e hQ
c V
c !X
et iQ%
c V
I 5#i X e YX
G
4 I a
#
#
I 5 X
e YX
Y
Pq
#
I X Y5
Y
"
'
d
Y
with
replaced by
c dPX
T 4
e Q
G F
c V
p h 3if
c V
G F
p h 3if
p h 3if
G F
I 5 X
If
, then
I 5# X
e YX
I ` X
if
, then
for every
#
Therefore,
I ` X
(Recall that
Letting
e
Y
If
If
we obtain
Let
(Based on martingales) , then , then and using the Monotone Convergence Theorem in the Laplace transform formula ). , so . 251
be given. Then
ggg p
c
f
C p
ih
Q RP
gggi h
I fhh
ggg
g gg
p h f 3in
p qo
p h f 3in
df P 8
C D8
e4
e4
eb0f
p h 3if
e
ef
eh
eb
ef
e)f
I X Y5#i QiX
# #
i Q
4 I
p h 3if
Q Q
deb0f
C #
ebf
deb0f
p h if
C g d
p h if
de0f
C #
eb
C g
p h 3if
deb0f
C #
p h 3if C
eb C g de)f
eb)f
ebg
is a martingale, so
252
for which
p h 3if
p h if d
Q
d
eb0f
d
where we understand
Therefore,
For those
for which
to be zero if
Let
, so
U
y w x
u F u Y
U
v 9
U
w x
v 9
h
V V
s t
s t
p h 3if
c dt
PE
q r
PE
V V
I % 7e
i t
PE PE
f
C
"
Q Q Q
"
df"
tfV
Let
"
Dene
. 253
254
value
Kx K 2 (K  L) (x/L)2r/
Stock price
value
C3 x C2 x C1 x
2r/ 2
2r/ 2 2r/ 2
Stock price
U
'
'
v 9
ec %
V
V
W W
and
Since
Solution to the perpetual American put pricing problem (see Fig. 25.4):
we have 255
f gYq
(7.4)
In other words, solves the linear complementarity problem: (See Fig. 25.5).
k ~x~p d q
t pd q qo o k q p k 51o n
p d xk 5k o p o q q r q
256
Set
If
mQjh l k i
If
mQjh l k i
If
t l k Qi
where , then
L*
Kx
Stock price
2r/ (K  L* )(x/L* )
value
257
and is the boundary between them. If the stock price is in , the owner of the put should not exercise (should continue). If the stock price is in or at , the owner of the put should exercise (should stop).
p o
p o
or equivalently,
p s o
p o
p p o p os p o o q q p Q o pp h o o dn
Let be given. Sell the put at time zero for stock and consuming at rate at time . The value
hQ n k k q n q n k p5k owp51odnk k qr
p o
p os p Q o
p o
p ut h
The halfline
pk o n qv h n k 5k q n q n
gk
sk
(a) (b) (c)
258
We should set
To hedge the put when , short one share of stock and hold in the money market. As long as the owner does not exercise, you can consume the interest from the money market position, i.e.,
3.
, i.e.,
pp h o 1o !n
pp h 1o
z p ho o {Dy 1 q
w1o i p h
Case I:
We have
p o
If is not zero, we can take to be the initial time and adapt the argument below to prove property (8.2).
t l
t Ql
i h
p o p
o 7(~ p s o qr Q
t Ql
i jh
2.
1.
Properties of
f d q
p p o 1n o p m o
p o
p o
lp o p p o !n o qr l Hp o
Remark 25.1 If
, then
(8.1) (8.2) (8.3)
259
where the supremum is over all stopping times. Optimal exercise rule: Any stopping time Characterization of :
Theorem 10.63
k !
p ko 51dn
p ko 51dn
o !n 7(~
3.
t Ql
l jh
p o P(~ p o
o !n 7(~
2.
pp o pp o p p o
o !n 7(~
1.
is a supermartingale; ;
p o x 7~ p o
5Y
(D
p o D
p ko 51dn
Q 1s p ho
Now let
to get
(Since
5Y
o Dp p h o pt o Q 1s Q 1o p h
h u
Case II:
: For
D z  Y(1 y { (
p o p o q r e h
.
p ko 1dn
ki7p o
7~
l Q p
p o 57~ o
p o 7(~ p o e
and dene
k po h k pk1!n o
Let
Then:
260
1.
p1o !n 1 p h o p ho p p o o 7~ p o q Q
2.
t Ql
i jh
Therefore,
to get
, i.e.,
p ko 1!n
.
~ p p o r o (Y ~ f q k p o
Intrinsic value:
Expiration time:
we choose,
stopping time
is a martingale);
n n n
Y 5k dn p o
Let
p h 1o
! h
p k o
p1ox k n h n k n k n n q q q
p p o x1Y (~ o ~
Y(1 (
p o 5k dn
Value of the contingent claim:
pp o x o h e
i k i sQjh k
q r
p k !n o
n k n k n n Yq q h n n h n d q k q r n
k h p k !n o n k n h n k n q k n q r k
1.
q ui
2.
ui
i jh
p o p
Then
Intrinsic value:
Expiration time:
3.
At every point . .
p ut h
Characterization of : Let
p h 1o
be given. Then is a supermartingale; , either (a) or (b) is an equality. ; 261 (b) (c) (a)
2. 3.
If
p o x p o
p p o
d(h o n
bdje
ui
1.
262
p Bo
is a supermartingale; ;
Chapter 26
where and are processes and a.s. This stock pays no dividends. be a convex function of , and assume . (E.g., ). An Let American contingent claim paying if exercised at time does not need to be exercised before expiration, i.e., waiting until expiration to decide whether to exercise entails no loss of value.
263
p o
pp o o
pp o o x
p o
p o p o i po ppo x o p o p o f
at time
p o
p o
p to
and
, so
d i
i h
p 5o
sq
po i jh p o
Let
Proof: For
and
, we have
k 1o
p ko 1x
p o h
(*)
pp o o p ho 1 k h p o i ih h o p o Q p o p o p o
i i d Qjh p ko 51
264
is a martingale)
This shows that the value of the European contingent claim dominates the intrinsic value of the American claim. In fact, except in degenerate cases, the inequality
is strict, i.e., the American claim should not be exercised prior to expiration.
Let and
pp ko k 1x 1o
ui
p o p o p p o o p o p p o po o p o pp o o
i jh
p o
l f d
p o ox p Q p o
l h
p p o f p o p o po p o
p Q o p o o x d p o d p o d p o d p o p o p Q o
p ko 51x p k o 51x p p o x o
.... .... . ..... ......... .. ..... . ..... ....... . . ..... . .... .... .... .... .... .... .... .... .... .... .... .... .... ..... ..... ..... ..... ..... ..... .. . . ...... . . . . . . . . . . . ..... . . . .. .. .. . . . .... .... .... .... .... .... .... .... .... .... .... .... .... ..... ..... ..... ..... ..... ........ . . .... ...... ..... . . ...... . . . . ....... . . . . ........ . . .......... . . . . . . ........... . . ............ . . ..............
Consider an American call on this stock. At times , it is not optimal to exercise, so the value of the call is given by the usual BlackScholes formula
p h o
1.
p p o
Proof: We only need to show that an American contingent claim with payoff need not be exercised before time . According to Theorem 1.64, it sufces to prove
k 85Y 0 p k p
p o o n ui l p p m o f i jh p o o i p % ui jh h h o % i p f o dn p o k 1o p 5k o q d q
( 7 6 &
Y e
(where
i jh
h k %
% 5
% q
i h
where
%
p o p
p 5k o
At time
p p o Y p
o !n o q d
At time
, where
p # $
! "
o Vp
o k
where
at time
ui
l i jh
p ho 1e
266
Since
To prove that is convex in , we need to show that is convex is . Obviously, is convex in , and the maximum of two convex functions is convex. The proof of the convexity of in is left as a homework problem.
is the number of shares of stock held by the hedge immediately after payment of the dividend. The postdividend position can be achieved by reinvesting in stock the dividends received on the stock held in the hedge. Indeed,
Case II: . The owner of the option should exercise before the dividend payment at time and receive . The hedge has been constructed so the seller of the option has before the dividend payment at time . If the option is not exercised, its value drops from to , and the seller of the option can pocket the difference and continue the hedge.
k 1o
pkpY o dn o k q d kq q
p s o
4 A 3 B
p s o
p o m
where
p o Y p po p o q d p s
o o %
k 1olHp5kpY o !n o q d
k o
o p s o q d o sY p s q d o
pkpY o !n o q d p o
p m o
p o s
Let
@ 9
p5kpY d o !n o q 0 phpY h o dn p o h 1o q d q
& Y'e
p h o
o p5kpY d o !n k q
p 5k o
h h !n p o p 5k o %
%
2.
is convex in .
uq
k 1o
Chapter 27
Here, and are adapted processes, and we have already switched to the riskneutral measure, which we call . Assume that every martingale under can be represented as an integral with respect to . Dene the accumulation factor
I ) H
p o
Given
dollars at time , one can construct a portfolio of investment in the stock and money 267
U V
p o
A zerocoupon bond, maturing at time , pays 1 at time to the riskneutral pricing formula, its value at time
3o E
Let be a Brownian motion (Wiener process) on some sider an asset, which we call a stock, whose price satises
p o
Q R
p o p o Q p o p o p o
p o
p 53o
p3o P
q S T e p p o to p o e p o
p o (
p o
p o
ei
i h mp o
H
p o
C
C D
. Con
268
martingale
If is random for all , then is not zero. One generally has three different instruments: the stock, the money market, and the zero coupon bond. Any two of them are sufcient for hedging, and the two which are most convenient can depend on the instrument being hedged.
p t o
i.e., . Then given above is zero. If, at time , you are given invest only in the money market, then at time you will have
f d
p 53o
p o p o p o p o q (
p 3o
p o
p o
p o
If
i umi
f d 3s p o
p o
p o
p o
p s o
We set
o p o p o p s o p Q7p o o o p C om p oQ p o p o p s p o o q
p o
p o p o
p o p o f p o p o
p o
{ p z o
p o
p Q o
p t o
p o
(*)
269
p h o
This suggests the following hedge of a short position in the forward contract. At time 0, short maturity zerocoupon bonds. This generates income
p o
p o W p o
Remark 27.1 (Value vs. Forward price) The forward price the forward contract. The value of the contract at time is zero. time which will be paid for the stock at time .
p o
po p h 1o p o p o 1o pp h
p h 1o
po p o p o
P P
p h o
p o p o p p o
p h o
p f p o p o W aq p o
W X
p o p o p o f q W p p o o p to q W p o p o o
p h 1o p h 1o
W X
o 1o p h W Xq p o ph1o W Xq p o p to po p o
We solve for
ui
i h
p o
p p o
W X
p o p o f p o p o p o e h
p h 1o
p o o
p o p o p o p o p o
p h 1o
p o
d
W
p o
p o
270 Buy one share of stock. This portfolio requires no initial investment. Maintain this position until time , when the portfolio is worth
A short position in the forward could also be hedged using the stock and money market, but the implementation of this hedge would require a termstructure model.
. At time Enter a future contract at time , taking the long position, when the future price is , when the future price is , you receive a payment . (If the price has fallen, you make the payment . ) The mechanism for receiving and making these payments is the margin account held by the broker.
b
at times
of this sequence is
Because it costs nothing to enter the future contract at time , this expression must be zero almost surely.
p ~
p o p o Rp o p o go p p o d u Gc f q c d 3 ~ t c c 3 b P ff Vbf b 9 d i d e p p p o p o o o q q
ff VVf
d i
d e
d i
d e
By time
p o
p o
d e
p o
d e
pp o p o o q p o q d e
d i
d e
b
p o
is
measurable.
Vp o y wxp o q c c c p 53o
Q 1
4 ig h f
dP
u vc t sr p q
I )
p o
d e
On each
, is constant, so
b V
f f bVf
p h 1o
p h o
W X
p to
p o l
W
p h 1o l
P
W X
q h
p o
c 3
c 3
d e
e d
271
satisfying
satises
this implies
p o 3
p 53o
U e
p o
P q p o
p o 5
i jh i f p 53o
p o 5
p o
p 3o
Proof: We rst show that (b) holds if and only if is also a martingale, so
ui jh h i U Vp o p o 5 f po p o ui j9p i h o
is a martingale. If
i jh p o
p o
p o
a.s., and
f
(a) (b) is a martingale, then
i jh
c
U V
p o
p o 5
p o 53
P
pto p o e
p o 53
p p53o 5o P d p 5o
p 3o
h d
p o p o
p 5o
d p 3o
U
p o
p o p o d
S T
p o
p o 5
S T
p o
p o p o
p o
p 3o
p o
S T
p 53o
272
and so
With a future contract, entered at time 0, the buyer receives a cash ow (which may at times be negative) between times 0 and . If he still holds the contract at time , then he pays at time for an asset valued at . The cash ow received between times 0 and sums to
Thus, if the future contract holder takes delivery at time , he has paid a total of
Future price:
p h 1o
p h 1o
p o
If
and
are uncorrelated,
p o p o
pp o o
p o
p h 1o
p o
Forwardfuture spread:
p o
p o
p o
pt o p o
p o
Forward price:
W
pto p o e
p h 1o
p o
p o
p o
p ho 1
p h 1o
With a forward contract, entered at time 0, the buyer agrees to pay The only payment is at time .
p ho 1
p o
p o
p h 1o
pp o
Clearly (a) is satised. By the tower property, is the only martingale satisfying (a).
f
.
ui
i h
p o po p o e
Now dene
term).
p o t
p ho 13o
p o 3
p o
P
p ho 1
273
This is the case that a rise in stock price tends to occur with a fall in the interest rate. The owner of the future tends to receive income when the stock price rises, but invests it at a declining interest rate. If the stock price falls, the owner usually must make payments on the future contract. He withdraws from the money market to do this just as the interest rate rises. In short, the long position and . The buyer of the future is in the future is hurt by positive correlation between compensated by a reduction of the future price below the forward price.
We have
is
f g
p o
Because
is nonrandom,
and
p o p o
p h o f p h p o e o q C d e( H p o p o (~ f e p o p o W p p o p o o p o p h o u p q o C p h ( o u p q o p o C ( 7 p o e
p o
Then
, and
po p to f p H q to q
p o p o p o H p 3o o H p
( p o
(~
Dene
p o
u p o
po
Suppose
p to
f
. Therefore,
p h 1o
i p h H1o
p o
p o
If
and
274
p o
p ho 1
If then
, then
This situation is called normal backwardation (see Hull). If . This is called contango.
p h 1o
p h 1o e
is
po l h p1o
Chapter 28
Termstructure models
C
In a termstructure model, we take the zerocoupon bonds (zeroes) of various maturities to be the primitive assets. We assume these bonds are defaultfree and pay $1 at maturity. For , let price at time of the zerocoupon bond paying $1 at time . Theorem 0.67 (Fundamental Theorem of Asset Pricing) A term structure model is free of arbitrage if and only if there is a probability measure on (a riskneutral measure) with the same probabilityzero sets as (i.e., equivalent to ), such that for each , the process
and
. Therefore
275
p o
p o p o p o 5 i p p o o p o p o d
i jh
p o
p o
p o
p o p o q j p o p o d p o i p p o t
i 5
p o p o p o p o
is a martingale under
i Qi
i h
ho 1e
i h i f ui j9p o i h
ui
i jh
i
H
p5o P
p o p t o
i jp o i h i h 9p o p o
H
is a Brownian motion on some probability space is the ltration generated by . . We dene the accumu
p o
F p h
3o E
276 , the mean rate of return of under , is so is a riskneutral measure if and only if the interest rate . If the mean rate of return of under is not at each time and for each maturity , we should change to a measure under which the mean rate of return is . If such a measure does not exist, then the model admits an arbitrage by trading in zerocoupon bonds.
H
The solution is the factor. If we want to have factors, we let be an dimensional be a function Brownian motion and let be an dimensional process. We let the interest rate of . In the usual onefactor models, we take to be (e.g., CoxIngersollRoss, HullWhite).
under
is a riskneutral measure
ui
i h
p o
p o
at times
. Price at time is
uui i
p o
ff VVf
i jh
p o p t o p o p o p p o p o o
Vp o U
i h p o
p o
p o
n
p o
p o
p o
p Q o
p o p Q o
pt o H p o
n
p o
m 5
p o p Q o
b H
p o
p 3o
f f bVf
sq S ( e po p o p o
p o
k l
p Q o
p o
p o
p Q o
p Q o
277
28.3 Terminology
Denition 28.1 (Termstructure model) Any mathematical model which determines, at least theoretically, the stochastic processes
for all
p o
xo
p o P p t o p
A q
p s
xo
p 5
or equivalently,
p f t o
p r
At time , you receive $1 from the maturity zero. At time effective interest rate on the dollar you receive at time is
3 2 q 3 2 Y
p q
p p5 o
3 2 q 3 2 Y
p o p5
p 5
ui i
p 5 o p p o o q o p
is equivalent to determining
ui i
i jh
i jh
p o o p
p p o p o
Determining
p o
xo
q d
p t o
or equivalently,
p s o
t o p p
ui
is the . The (4.1)
i jh q
t o p i uh t(
p t o
p i p 5
l i
ho 1
i h
p o
p o
t
sq p o
t
p o f p o
t
sq
p o p o o t u p u u q u p o u q p o
.
Up o
p 3o
p o p o f q
q p 3o
yp o q p o
Vp o U
sq
S ( e
x 9 w $"v
p o u u e u p o u e p o
d p o
p o
p t o p 5 o
You can agree at time to receive interest rate at each time . If you invest $ at time and receive interest rate at each time between and , this will grow to
p o
p 5 o
t
sq
p t o
u u
p o p 5 o
xo
p 5 o
u u
xo
xo
p o
This is the instantaneous interest rate, agreed upon at time , for money borrowed at time .
Conclusion: at time .
so
278
p
C
pp o p
q o
~ }
p o p o o p f p pC o o p o t q o p5 o sq ~ } t o 5 o p q q p 5 o t
p 5 o
p o
~ }

C
p o
U 
p o
Now
i jh
53o p
C
p 3o P
p o mq ( t p p u t o t o t uisix 3o h p i i h p sj 3H o p 3H P 1o o p h
p o ho t 1
For each
Here
and
In other words,
p o
C
p o p o
~ }
p o
f
and
p 3o
C
p 3o P
pt o P o p h
t
p o
h 3o p ho i ih p 3oH 1r i jh f ui i ui i f
, let for all
i jh
H i h i f p o(Gt o p pp t o pp t o
p o(G o p pp o p o p o t o p p C o o p o p q t o p o p p C o o q p o p
under
o q o p o q o p p o
Then
f p 53o P
Not only does (7.1) imply (7.2), (7.2) also implies (7.1). This will be a homework problem.
uui i
i jh
p 5 o
p o
uui i
i jh
p 5 o
i Y eui
i jh
p o o p
ui
p H o
Differentiating this w.r.t.
p o 5 H
i.e.,
p o
In order for
280
p t o
Differentiation w.r.t.
Theorem 7.68 (HeathJarrowMorton) For each , be adapted processes, and assume , be a deterministic function, and dene
t i jh 1o i p h i i reh 3o p
t
, we obtain
is not a riskneutral measure, but there might still be a riskbe an adapted process, and dene
, we must have
p o(G o p p p t o o
p t o
p o
281
is a family of forward rate processes for a termstructure model Then without arbitrage if and only if there is an adapted process , satisfying (7.3), or equivalently, satisfying (7.4).
and volatility
and when normalized by the volatility, this becomes the market price of risk
The noarbitrage condition is that this market price of risk at time does not depend on the maturity of the bond. We can then set
and (7.3) is satised. (The remainder of this chapter was taught Mar 21) Suppose the market price of risk does not depend on the maturity , so we can solve (7.3) for . Plugging this into the stochastic differential equation for , we obtain for every maturity :
Because (7.4) is equivalent to (7.3), we may plug (7.4) into the stochastic differential equation for to obtain, for every maturity :
p o
p o
p o o u p p o p f p o Q C p (G o u o o p p p
p o p
p o p p p t o o o q
pp o p o t o q p o
ui jh i uf ui jh i i
p o f pp p t o o o q
pp p t o o o q
i sh p o
p o p p q o p o o o
p o o p
p ( o
i o o
o p
i
H
p o
i gh o p
p o
282 These may be stochastic processes, but are usually taken to be deterministic functions. Dene
Because all pricing of interest rate dependent assets will be done under the riskneutral measure , under which is a Brownian motion, we have written (8.1) and (8.3) in terms of rather than . Written this way, it is apparent that neither nor will enter subsequent computations. , and the process The only process which matters is (8.4)
C
i h 1o p h
In conclusion, to implement the HJM model, it sufces to have the initial market data and the volatilities
p o
ueui i
i h
p o
p o
and so as approaches
ueujh i i
p o
obtained from
is the volatility at time of the zero coupon bond maturing at time (8.5) must
i mh 1o i p h
and then the zerocoupon bond prices are determined by the initial conditions , gotten from the market, combined with the stochastic differential equation
p o
p uiei h 5 o i p p o i ueui h o i p p H o
p o
ui
p o p o p o q
i jh
p ( o
p o
p o
p o Q p o t o p
p o
p o
p o
t ui
p o
i h
p o
Then
for
ueujh i i
1o p h
xo
p h 1o
uujh t 1o i i p h
Let
f p 53o P
p p
(8.2) (8.3)
sq I ( p o 5 P o p o
P
p o
p t3o H p o p o C p H o
t t
Remark 28.3 It is customary in the literature to write rather than and rather than , is the symbol used for the riskneutral measure and no reference is ever made to the so that market measure. The only parameter which must be estimated from the market is the bond volatility , and volatility is unaffected by the change of measure.
H
i h o p
We then let be a Brownian motion under a probability measure , be given by (8.3), where is given by (8.2) and initial conditions
C
p o H p 5 o
ueujh i i
pt o u 1o p h
u
p o p p q o o
xo
We require that
p o
u u
p o
p h 1o
p o
be differentiable in
p o
284
d b
f f bVf
p Vo
d e
p Q o
d e
u d t
is the row vector
ff Vbf
Denition 29.1 (Gaussian Process) A Gaussian process the property that for every set of times
Gaussian processes
Chapter 29
p Q p Q o p o o f f bVf b i i i jh i p b Q VVf o f f
Remark 29.1 If
p oQ p o e
where
is
, and
D o p
p o
p Vo
i i i
p o ib f f b p bVf o i p o i
ff VVf
k k
where
285
p n 1o
t
t
j j
t t
f p 3o
p3o
P
p 3o
i
p5 P o p o
C
p Q o
h p o
p o 5
S
S
To prove that a process is Gaussian, one must show that has either a density or a moment generating function of the appropriate form. We shall use the m.g.f., and shall cheat a bit by considering only two times, which we usually call and . We will want to show that
b
ff Vbf
p Q o
pb3o
C
pp V3o
p o
h p o
286
and
. Indeed, if
i jh
p o
C C o
p o o q C p o
C e p 3o Q e i
f
C
p o V3Q
t(
Therefore,
p o b3Q
. a nonran(1.1) ,
te
i h i p1o n
:
I )
b3o p
H
o
V3o p
Vo p pb3o p o t Vo p1o n p t
p n 1o
C
p no 1(
h p n o
C
Vo p
t
C
pn1( P o
p Vo
n p n 1o o p n f ot
pn1( o
p o
Now let
p o p o f
C
n 1o p n o p o p Q7V3Q f n 1o P n 1o P p n p o p n h p Q o p o V3Q 5 e P P 5 U U P f P S S ( P P Qn p n 1o p n p n 1o o I )( Q n p1o n n n1o P p p 3o I )( Qn p n 1o f i 4 f t o I7( d 5s e Q pV3o $ 4 tG t I e Qn n1o 4 p t o I)( V3o 4 p i e p o p Q b3Qo p o
(1.1) 1.2
Vo p
te
t t
p n o
C
p Vo t
t t
pb3o p o p Vo p o
pn o
f f bVf
l i sh
to get
Take
, where
(1.2) 287
288
Remark 29.2 The hard part of the above argument, and the reason we use moment generating functions, is to prove the normality. The computation of means and variances does not require the use of moment generating functions. Indeed,
Therefore,
P n o p n p b3o f o p o p pp o o o p o b3o V3Q q p QBVb3Q p Q7b3Q
However, when is stochastic, is not necessarily a Gaussian process, so its distribution is not determined from its mean and covariance functions. Remark 29.3 When is nonrandom,
C
is also Markov. We proved this before, but note again that the Markov property follows immediately from (1.2). The equation (1.2) says that conditioned on , the distribution of depends only on ; in fact, is normal with mean and variance .
p Q o
n 1o p n f
po n
p 3o
p b3o
p5 P o o p Q
pV3o
i jh
 V3Q p o
V3o Q p
pp o b3Q
{ z b3o p
p o
p QVV3Q o o p o
p n 1o
y p o V
I q
p o V
p b3o
o p o p Q7b3Q
po n
pb3o
p Q o
For xed
h p o p o
p ho 1Q
is a martingale and
, so
p 3o
p5 P o
p Q o
p o V3Q
289
z
z z
s y t (a)
y=
s v (b)
s v y t (c)
Proof: (Partial) Computation of : Let be given. It is shown in a homework problem that is a jointly normal pair of random variables. Here we observe that
n x 3x p o p o f
p o 53Q
p3x P o
i h
p n 1o
p o p o e
p 3o
zi
p 3o
p o p o p V3so
Then
p x o
p5op53o P
p ( o
h p o
p o
5o p
p53( P o
p o
p o
and
n (
be nonrandom functions.
(1.3)
n p3 3x o p o n p o 3x p o
p oxp3 o
p x3 o p o
p n o
p oxp3 o
p o
p n p o 1o G3x
p3 1o Gp o p n o
P
p o
P
p n p o o G3x
px 1o Gp x o p n o
P
p n 1o n n
p x o
p o 3x
p1o n
px p o o
po n
p 3x o p o
We have
290
, the process
p o 3Q
P
p s o
p 53o
p o 3(
P
p Q o
is
p n 1o
P P P
p n 1o p n 1o
P
p n 1o
P
p V3o
b3o p
where we have used the fact that is a martingale. The conditional expectation , nor is it a function of alone. not equal to
p o
p o V3
p o V3
291
is
pV3oQ7p3ox p o b3s
p V3o
p o 3Q
p o 3x p o b3s p o p o 53Q73x l i jh
P
p53oQ7p3x o
p Vo
p s o
292
P V
p3o o p 5o
~ 1
~ p 3o e
i
P p h o
~ p o e
3o p
C
p5o o
53o p
p53o
p 3o
P p h 1o
p o
Integrating, we get
e e
p p o p o u p o 5 o f p o C p o p o f
7p o
Then
p 3o
p o p o p o
where , and
p o
C
Consider
p o p p o o p o u p o p o q p H1o
are nonrandom functions of .
so
p o p o 53H
P p h 1o
~ p o e
The process
Chapter 30
293
p o
n f
p1o n o
p o 3H
~ P
p ho 1r p h t 1o
where
t 1j 1o 1o p ho p h p h q q d( P Q n ~ p n 1o ~ P p5o p h 1o ~ P P q ~ q I ( P p o P pd qo p o pd qo (
x&
p o
p h 1o
n f
p po 3o 7 o p Q1 o
P P P p3oH p h p o 1o ~ o g x p o P P p h 1o w
p o f
p 5o
P p h o
P ~ P p o 9 ~ p o e
p o
3o p
C
P p5o o p Q o p o P
Then
We want to study
294
. To do this, we dene
is (0.3)
p1o n
po
p o
&
p o
p no 1H
n f
P ~ p no 1H p n w 3o ~ P ~ p3oH o p53oH ~ P P
Therefore,
. In fact, 295
p ho r
u = t
p o
C U V
p o p o p o p o bVf f f
p o
p o
o p f p o p o q p p o p o p o p o p o p o t o p q
p h 1o p o p o p 3o uq p 5o
p o p n 1o q
P
p 5o
p n 1o
The reason for these changes is the following. We are now taking the initial time to be rather than should be replaced by Recall that zero, so it is plausible that
n f Vbf ff
VVf P ff
f n
x
p1o n o q
p n 1o
p o p r o
where
296
p ho 1j
p o p 3o
Let
p 3o
S (1T e
p o
q p o C p o q q p o
p o p o p o p o op o p o
q q p o q p o p o
t or o p o p p p t o q q t( p o p t o
and
we have denote the partial derivatives with respect to . From the formula , we
p h 1o
p o p
h o j
po n o q
p o
p o p u p o p o
p o p H o p h 1o p o p o p o q q t ~ p o p n1o p r o o ~ 3o P p p o p o 1o p o q
p o
C
p t o
We leave the verication of this equation to the homework. After this verication, we have the formula
p o p o p o p o p p q o p o o
.
p o
p o
p o p o p o Bx o p t o p o p o o p p o p q q q q
Recall:
from market data (with some interpolation). Can we for all ? Not quite. Here is what we can do.
1.
ueuh 1o i i p h
2.
p h o
3.
uiuijh p o o h p h ui ijh p o p h 1o
; ;
5. 4.
k s!
h h d p k 1o p5khh h do k s! h 51o p k
}
n f
po n o q q p h 1o
1r p ho
P po p 3o f u o u p h
u
q e
p o p o
h e u
u
p h t 1o
u
We can then compute
p h 1o
P ~ p no 1H p ho 1j o ~ p ho t 1j h e 1o p h
From assumption 4 and step 1, we know all the coefcients in this equation. From assumption 3, . We can solve the equation numerically to determine the function we have the initial condition .
We now have
p to
298
Remark 30.1 The derivation of the ordinary differential equation for requires three differentiations. Differentiation is an unstable procedure, i.e., functions which are close can have very different derivatives. Consider, for example,
p o
p ho 1H
i jh p H o
o
u u u u
for all
for all
. Recall that
as follows:
known function of
u u
n f n
~
P 4
p1o n
P 4
p o 3H
P 4
~ 1o p h p 3o
p k o f p
t
p o r p o q q D r p o p q
.
Then
Assumption 5 for the calibration was that we know the volatility at time zero of bonds of all maturities. These volatilities can be implied by the prices of options on bonds. We consider now how the model prices options.
Consider a European call option on a zerocoupon bond with strike price The bond matures at time . The price of the option at time 0 is
h d p5khh o h d k s!
h d
p ko 5
}
p ko 511
t
p k 51o
}
h h d d
i 51o p k
}
p k 5o
t
we have
but because
p 53o
p53o 4 P p o ~ q ( o p o o z o q p p o o x q ut
5~
5~
4
j ~
where
is normal with
U z
p 53o
P 4
S x&
U z
p 53o
P 4
p k 1o
Because of the Markov property, this is random only through a dependence on . To compute this option price, we need the joint distribution of conditioned on . This
p o
p o
p o
p 3o
p o
j p o q
p o
k
S
p i o (i x q d q d q d d r D o p o p
In fact,
7p o
p 53o
where
300
is
(4.2) (4.1)
p o o 4 o q p o p p D q
~ e o o
o
5~
5~
d(
p 3o
U e
p o
p 5o
sq S e
p o
y U V
f p o p
n q
p n 1o p o o
p o
p 5o
p o n
p 3o
p o
p 53o
The variances and covariances are not random. The means are random through a dependence on .
2. Interest rate is normally distributed, and hence can take negative values. Consequently, the bond price
r p o q
p o p o p o q t(
p o p o
i
p o e
can exceed 1.
p o
301
302
Chapter 31
CoxIngersollRoss model
In the Hull & White model, is a Gaussian process. Since, for each , is normally distributed, . The CoxIngersollRoss model is the simplest one which there is a positive probability that avoids negative interest rates.
is called the OrsteinUhlenbeck process. It always has a drift toward the origin. The solution to this stochastic differential equation is
Dene If
, we have
I 'H
for which
Qh p o h Q hQHp o p o d p o H p o Vfbf p o p o p o f f P p 3o i ~ d
53o p
p o
c C
c C
p o
P o p h
p h 1o
p o e
p o q
~ p o e
and let
We begin with a dimensional Brownian motion constants. For , let be given so that
. Let
and
p o
ff Vbf
h l QHp o p h Ho
p o
VVf d ff
be
u t
p 53o
p 53o P p 3o
p o
C
u t
p o
p o p o
p o
u t
p o
u t t
p o q ~ p o u t Q q q u t
u t t
p o
It s formula implies o
88
h f
h k 8 $8 t t k VVf k k ff h Q p o
. Then
ff VVf
h p o
H
If
Let
304
r(t) = X2 (t) 1
Figure 31.1:
x2
can be zero.
for which
if if
p k
k 1o k
Dene
( X (t), X (t) ) 2 1 x 1 t
305
is a martingale,
C
so
If
p ~
o p o q d
For
p h o
p h 1o
p h 1o
h Q
~ p h o
f f bVf
p o
for xed
. Let
be given. Take
With the CIR process, one can derive formulas under the assumption that integer, and they are still correct even when is not an integer.
h Q
for which
h p o
p o d q bf d ff p h 1o h o p h
If
(i.e.,
), then
h u
for which
f d
h p o
to be an integer. If
(i.e.,
p o
h Q
u t
p o
We dene
), then
p o
p o
p o
p o
p Q p o
p o
is a positive
1o p o
u t u t
p o
306
and variance
. Then
p  o { z y
degrees of
p o
p p oo p o p Qo
p o
in Section 15.7.
p o
p o
{ d
p o
p o
p o
t u
As with
, we have , and so the limiting distribution of is times a chisquare degrees of freedom. The chisquare density with degrees of freedom is
is
p o i p o
u t
p o
p o
p o
h up o
As
. We have
x 9 w v
p o
Thus
p h 1o
(0.1)
p o ~
~ { p Do u z y i p o i p o ~ Dt ~u
p o p o i
p o
P ppV3oQo p p o # p p o p p o pp ho o p o o 1Qx p x b3Qo bgQo m V3Qo b3o p pp o pp o Vo b3Qo P C pp o V3Qo V3Q#` VQo m V3Q( P 1Qx p Qx pp o o pp o pp o o pp ho o p o o
p o
C
p p oQo p o p o
p p oQo p o p o p p Qo # p o o m p Qo
which vanishes near
p o o p Qx
p o 3 P p o p o o p x k p Q o h k
p o h p k 1o
We start at at time 0. Then is random with density variable). Since 0 and will not change during the following, we omit them and write than . We have
Because we are going to apply the following analysis to the case for all .
, we assume that
p o
p Q o
p o x
p o 3
p k 1o h
p ho
h p Q o
so The Kolmogorov forward equation (KFE) is a partial differential equation in the forward variables and . We derive it below. and for all large values of (see 307
f
at that and nearby
Uep o
q p
im
u u
u pp p o p o po u q o 3o m o
u pp p 7 o p3o p u q o 3o m o
u p o p o p3o x P u
 p p o o p3o u x P P u f
u u
p o p3o
pp o 3o o p
m
p o p3o 3o # P p
If there were a place where (KFE) did not hold, then we could take points, but take to be zero elsewhere, and we would obtain
u u
h j3x p o
pp o 3o o p
m
u u
{ Dzu p ) o p3o
u  P p3o P sq u u
u P p3o P q
u
p o p3o p3o P
m
p o
p3ox P q
p o 3x P p o
Therefore,
u u
p o 3x q
p o 3x P p o
p o 3x P p o
or equivalently,
or equivalently,
308
(KFE)
p o
p o 3 P
u u
u u
p o
p o p 1o q q p o p q q q
We want to verify the equilibrium Kolmogorov forward equation for the CIR process:
~
f d h
p 3o
p 3o
u u
u p p pp p o 3o 3o o m o u q
p o
p 3o
p o
If the process
p Q o
We compute
p o
Letting
t Q
where
When an equilibrium density exists, it is the unique solution to this equation satisfying
We computed this to be
(EKFE) 309
p p o o
p o q p o p q 1o
q p # o
q o ! p o
p 1o q q d q q p o q q p o ! q p o f
q d q
p o
p o
the tower property implies that this is a martingale. The Markov property implies that is random only through a dependence on . Thus, there is a function of the three dummy variables such that the process is the function evaluated at , i.e.,
p o
p o
p p o o p t o f p o p o p o p 53o
P
Up o
U V
p o
p o
p 53o
sq T e S
p o
p o
C
p o
p Q p o
1o p o
p q
p q p
p o
p q 1o q q q p 1o q q p 1o ! p q q q 1o p q q q q 1o d p q q q t q p o p o p q q
p # o o p f u p o p Q p o o u p o o u p u u p o p p p o p o 17o q
1o d q q 1o p o
1o d 1o 5p q 1o p q
1o p o
as expected.
Now
310
p o
u u
where
p h 1o
Because
p5o P q
I
p t o
p 3o j p o p `h p t o o q d q p t o
p 3o p o q q d q h p o p o q q q q q 7 q p o q q 2
~ 2 (~ p o } e d
Surprisingly, this equation has a closed form solution. Using the Hull & White model as a guide, we look for a solution of the form
ul ijh h f h t o P o p p p 1o p p t o t o q q
Setting the term to zero, we obtain the partial differential equation
7 f p 1o q q
equals
p o o p p o f p o p p o o pt p o o t p
p o p p o Q q p o o R Q
p o o 7 p53o P
p3o P q
q
d
Because pute
p p o o
f
(4.1)
p t o
bVf f f
sq
I
( (
I )
p 3o P
where
p j h o
p o
We rst solve the ordinary differential equation and the partial differential equation becomes The expression in
p p h d h o o p p h 1o o
P
p 5o
p o
p
h h p p o or q p o q t( p t o p j o q p o p o p o p p o 1o p o u q
C
p o o p
U 3
p o
p 53o
T S
Thus in the CIR model, we have
f ~ p p q o o
o j
h p t r o
9 ~ q p p q o o p q (~ $ xo p p o o p o o p p t q q p p o o q p o f p o q
where
where
ul
i jh
j p o
p o
t(
p j o p o
and
so
312
and
and
p o
p o q
p o
where
f 9 p o p j o q xo o p o p o p o
We have
p p h 1o o
Now
h p Qw5o
313
But also, so
and
is strictly inreasing in .
where is the expiration time of the option, is the maturity time of the bond, and . As usual, is a martingale, and this leads to the partial differential equation (where .) The terminal condition is
Other European derivative securities on the bond are priced using the same partial differential equation with the terminal condition appropriate for the particular security.
i ui
i h
Vp o U
p h p o o p !n o f q p !n o n 7 ul ijh h h n p n 1o n n f q q p p o d 53o P o n f p
f h
p p o p o p p o zp o p H o o p o o q f C p o p o p o p p o Q p o q 1o
p o
p3o P sq
R
ptor o p
( p 5o
4
p h o
S ( e
p p o dn o
314
if we set
p p o o o p
p o
p o
p o
p p o o
p o
p t h 1o o p h
p h 1o o p h
p o
With
p o P p h 1o o p h sq f P p o p t h 1o o p h
p o
where
, and
and
3 2
denote the price at real time of a bond with maturity Let is . We want to set things up so
p j o p o p t o ~ 2 1 3 (~ p o p o } e
p o
"
which relates the two time scales (See when the interest rate at time
. . . . . . . . . . . . . . . .
p o
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
"
p o
Process time
Real time
p p o 1oj o 1o h pp h
p o pp o h1o oj o 1o o p pp p h
p1o h p h 1o
p h o o p h
q
or equivalently,
o j o
pp H o p o j o
fgp j o p q p o p q p o p o
i
p o
o p o q d e( p o o q ( p o p o p p o o p o ~
where
31.7 Calibration
Suppose we know
and
only through
for all
The righthand side of this equation is increasing in the having limit at , i.e.,
so the equilibrium distribution of seems reasonable. These values determine . Take (we justify this in the next section). For each , solve the :
p o
p h 1o
p h o o p h
p h o
p o
Since is
so
p o
l p o
. If
. Thus
, then
is a strictly increasing timechangefunction with the right properties. , this solution 315 and (*)
f p o p o p o j q $ Y xo p p t o o p o o p
r o p o p h
where , determined by market data, is strictly increasing in , starts at 1 when and goes to zero as . Therefore, is as shown in Fig. 31.4.
p h 1o o p h
xo
t Q
o j H o o pp o pp
p h 1o
p h 1o d
p h 1o o p h
p h 1o
h 1o o p p h
In the real time scale associated with the calibration of CIR by time change, we write the bond price as
h o o p p h
p h 1o
t 1o p h
u u
u u
p h 1o p h 1o
xo
xo u u
z P
f x ~ o j p ~ o
p 5o
q p h 1o f
Hxo
P
xo
p 53o
q
P
( e 1o p h
u
p h 1o
x w $G)
p h 1o
p h 1o o p h q h
xo
The calibration of CIR by time change requires that we nd a strictly increasing function such that
Here
thereby indicating explicitly the initial interest rate. The above says that
Justication:
316
and
are given by
p o r
p o
(cal) with
p h 1o
317
Strictly increasing
Figure 31.5: Calibration The function is zero at , is strictly increasing in , and goes to as . This is because the interest rate is positive in the CIR model (see last paragraph of Section 31.4). To solve (cal), let us rst consider the related equation
(cal)
t p u o
t Q
p o
l p o
, then . As , . We have thus which has all the right properties, except it satises (cal) rather
p o r o p
p h 1o
p h o o p h
xo
p o
p o
Fix
and dene
to be the unique
pp o oj p o o p
.... .... ..... ..... ..... ..... ..... ..... .... .... .... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
poj to p
p h 1o
p h 1o
p h 1o o p h
p h 1o o p h
p o
ptor o p
xo
xo
q p h 1o
Goes to
p h 1o o p h
t u
xo
h f q p ho 1 q
7p o
p o $
p p h1o q h o 5 7p o p $ p o
p o
U q d S p h o d h o q p o $ d p o S
p o q
p o $
p o
p o
p o
p ho p p ho 11 15h q h o f d d p o p o q p o p o
$
f d
p h 1o
p h 1o d p h 1o 1o p h
u u
xo
p h 1o
p h 1o
Computation of
p h 1o
Computation of
p h 1o
Note that is the initial interest rate, observed in the market, and is striclty positive. Dividing by , we obtain
318
: : ,
p o
p h 1o
p h 1o
(i
p o
p o
C
p o i q d p o i p o f C o C C p o p o p
C C
p o p
q d
p o i o p o p C p o p o p
C
o o
k k
u p u p
m 5
p o m5 p o
p p o o k p p o o k
u
P
Chapter 32
Let us dene:
p o
p o
and
p Y o
p o
h 1 o p ho h p h
where
and
o o
and
Then
319
(SDE2) (SDE1)
p f
i o
hQ o 1o p h p h
will stay strictly positive provided that:
p o i p C p m q
m
k k
k k
p o
C
p D m
p o C p m o m D p (i q C D
k
p o p p 7D k d C o
k
(i (i d p q
p i o o
C
(i o k i p m
7p s ok C D k
o k k
o o
32.1 Nonnegativity of
where
320
p m q m (i o 7
p o
Then
Assumption 2:
p ho 1
o o #
and
Assumption 3:
almost surely,
(SDE2) (SDE1)
p o f p o
C C
p o p o
k k
p u D u p
m 5
p o m5 o p l t i h
p p o o k p p o o k QHp s h o
o o
p o o p k o k r q p 5k q p o k q t(
(PDE)
h f p x
p
m s
4 px k p k o x k k o ( i 4 5 k p k k k o ' k o p ' 5 k o q k q m m k k k k p 5k 1o k 4 u u C C 4 4 4 i 4 P D p o p 5 o q Q 3o sq m I ( k k k k 4 4 4 4 Q 3o P p sq q q I ( p o p o o Q p
is
p53o P sq
p o p o o
p53o P sq
I
f p 5k 1o k
U V
p o
p53o p p oV p o o q q 1S e k k q
Since the pair of processes is Markov, this is random only through a dependence on . Since the coefcients in (SDE1) and (SDE2) do not depend on time, the bond price . Thus, there is a function depends on and only through their difference of the dummy variables and , so that
p o
p Y p o o
U V
p o
is
p 53o
sq
S (1 e
p o
and all
(*)
h k
k k
5k 1o k o k k p q k o k o k k q
p o
m s
p o p oV p o ( p o i p Y m p o m p o p o q q p o o p Y p o ( p o i p o p o p o 5p k q q k k p o p oY p o ( p o i p o p o p o d q q k k p p k o 5 p p k oY p o px k k o (i p o 5 p o s p m k k p k p o k k
k
o k o q p p o
k
k 5k 1o k o q k 5p k h k 1o
(PDE) becomes
k 1o k 4 k 1o k k 1o 4 4 k k 1o k 4 k 1o k k 1o k o p o
We must have
We want to nd
because
322
corresponds to
for
. We have
(IC)
p o q p p o q p o
(h o o b p o i q p o q p 5 p o m m (h p o o (i q p o q p Y p o k (hl k d
k
p ho 1r p o p1o h p o p h 1o p o
p o o q p b p o (i q p o q p o
k
p o
323
We rst solve (1) and (2) simultaneously numerically, and then integrate (3) to obtain the function .
32.3 Calibration
p p oY p p o p o o p o o P oj P p b p o q P q P q
P
and
Y i w b m
h h p o o r P p P f p o p o p j o o p P Y p o p P o p o f P p o P p j o o p p P Y p o p P o p o f P d
o p V p o o
p Po
p o
xo
P q d
h Q
Let
p j o
is
324
Chapter 33
where the interest rate process and the volatility process are adapted to some ltration . is a Brownian motion relative to this ltration, but may be larger than the ltration generated by . This is not a geometric Brownian motion model. We are particularly interested in the case that the interest rate is stochastic, given by a term structure model we have not yet specied. We shall work only under the riskneutral measure, which is reected by the fact that the mean rate . of return for the stock is We dene the accumulation factor
325
U V
p o
p 53o
p o
p o
sq
po p o e
1 e S
p o p o p o
p o
p o p o
is a martingale. Indeed,
i p o h
p o
p o
p o p o u p o
Q R
p3o P
I )
p o (
p o p o p o
p o
C
(0.1)
i h p o
326 so
of the stock is the price set at time for delivery of one share of stock The forward price at time with payment at time . The value of the forward contract at time is zero, so
Denition 33.1 (Num raire) Any asset in the model whose price is always strictly positive can be e taken as the num raire. We then denominate all other assets in units of this num raire. e e
Example 33.1 (Money market as num raire) The money market could be the num raire. At time , the e e stock is worth units of money market and the maturity bond is worth units of money market.
g 3 g
We will say that a probability measure is riskneutral for the num raire if every asset price, e divided by , is a martingale under . The original probability measure is riskneutral for the num raire (Example 33.1). e Theorem 0.71 Let be a num raire, i.e., the price process for some asset whose price is always e strictly positive. Then dened by
H
is riskneutral for
Example 33.2 (Bond as num raire) The maturity bond could be the num raire. At time e e is worth units of maturity bond and the maturity bond is worth 1 unit.
H
p o
p o o p u
p ho 1u
p o p o
H
Therefore,
p o
W a
p o
p o
p o
e p o
H
p o
H
p o p o
e
, the stock
G3
G3
Fix and let
h vh3Xr
H
p o
p o p o ptu o o p p o p o s tu
p o p s o p o p o p o p o
p o
p o
Let be an asset price. Under , is a martingale. We must show that under , is a martingale. For this, we need to recall how to combine conditional expectations with change of measure (Lemma 1.54). If and is measurable, then
d p h 1o o p h p ho 1u d p h o p o p u o f d E p o p h o p E 3o o p u d
#
H
p t3o
H
p o
H
p u o p o
p ho 1u
Proof: Because
Note:
and
are equivalent, i.e., have the same probability zero sets, and
is a probability measure.
H
p o
Therefore,
be the num raire. The riskneutral measure for this num raire is e e
under
po p o ts
328
Because this bond is not dened after time , we change the measure only up to time using and only for .
, i.e.,
G$
8 Y6
@ ' S
G$
8 6 $a
Q `
G sG$T E 1 1 X 2W
(
HI @ S V e
G$
T U
x3
S e
Q R
H I
H P
We write
rather than
G 8 3h$6 @ E 1 1 FD( B
i.e., a differential without a term. The process . We may assume without loss of generality that
1 1 35A
1 1 45352
C @ '
8 6 97G$
)
(
(1.1)
(2.1)
in (1.1). In other
(2.1)
x x x x
0 0 0 0
h3
Wi
d gi
h f e# jgh% H
Wi
d 9' 0
h f e# xgh% H
i $WI
5
d 8 6
Under is a Brownian motion. Under this measure, has volatility and mean rate of return . The change of measure from to makes a martingale, i.e., it changes the mean return to zero, but the change of measure does not affect the volatility. Therefore, in (2.1) must be and must be
G$
8 Y6
#
H P 8 #
G$
r )
G$
e X
Proof: Let
8 6
r8 %6
i V
Q )
c d1b
, so
. Then 329
i r 5h3 x3
is not constant, we still have the explicit
Px
r 3i r8 6 pxhrv i r 3i r8 6 hrv v
r x3 r8 6 i
G3 x3
r r8 6 i r 3 r8 6
r i r8 6 I
r r8 6 v
G3 x3
r i y z r8 6 I
This is a completely general formula which permits computation as soon as we specify we assume that is a constant , we have the following:
G$
8 Y6
0 0
~ } i{ ~ } i{
8 $6 $6 8
r
If is constant, then
g7G 8 Y6 r
~ } !{
8 Y6
x3
) 8 6
where Similarly,
!{ ~ }
8 Y6
G3
H I
)
G
8 6
8 6
where
330
, . If
where
We want to verify that this hedge is selfnancing. Suppose we begin with $ and at each time hold shares of stock. We short bonds as necessary to nance this. Will the position in ? If so, the value of the portfolio will always be the bond always be
3 e
At time , hold shares of stock. If is the value of the portfolio at time , then will be invested in the bond, so the number of bonds owned is and the portfolio value evolves according to
If
, will
for
Formulas (3.1) and (3.2) are difcult to compare, so we simplify them by a change of num raire. e This change is justied by the following theorem. Theorem 3.73 Changes of num raire affect portfolio values in the way you would expect. e Proof: Suppose we have a model with assets with prices . At each time , hold shares of asset , , and invest the remaining wealth in asset . Begin with a nonrandom initial wealth , and let be the value of the portfolio at time . The number of shares of asset held at time is
i 3e
Ge r 5
#
#%! "h #
G$
50
G$
r G$ i
Ge e
0 i he r 5hWGe 5i
Gi 5ae
1 1 5
0 i i WPi i
i Ie
v $e
0 V
i s AXqq
Gi
x3
Pi
8 $6
r 5xi
Ge
r 5 0
e i
(3.1)
(3.2)
0 0 i v 0 0 0 Wi 0 i W e 50 W i
Now Therefore,
0 e 0 e 0 A
v Q
0 0' Q 0 ' A v
Then
i5 e
e5 0 0 e
e5
Let and 332
qXq e
, not
0 ' 0
0 V A 0 0 i 'v ' A
, in advance.
333
We return to the European call hedging problem (comparison of (3.1) and (3.2)), but we now use the zerocoupon bond as num raire. We still hold e shares of stock at each time . In terms of the new num raire, the asset values are e
i
becomes
glGi r 5 re i
Gi r 5 Wi i
Ge
5 $Gi 5 v
Ge
5Gi 5 v
v 5e
and
Gi
e
gGe
r 5re i
r 5G$
iGe
Bond:
he
i Pi
i v e l5i
h 5a e e 0 5ai
Stock:
(3.1)
(3.2)
i s PqX
Gi
) 5pi
This is the formula for the evolution of a portfolio which holds , and all assets and the portfolio are denominated in units of
shares of asset ,
Ge
5a
334
@ '
6 v y$
6 a
1 1 45352 @ '
maturity bond.
e
G$
G$
i P
G$
ah
satisfy
G eG$
@ '
$6 Ph 6
G
6 v 5
G$
BraceGatarekMusiela model
Chapter 34
z
6 G$6
h h
where
where
is the constant volatility of the forward rate. This is not possible because it leads to
volatility of
335
6 G$ r aIG$ aIG$ 6 6
k W6
$
aeh
Ix$
v$G$ P v y$G$ P
e q
i Iq e q i I$
q
x3
$Wi i i i Iq i
x3
v i i f
where
s
ge
i f
The problem with the above equation is that the term grows like the square of the forward rate. To see what problem this causes, consider the similar deterministic ordinary differential equation
and Heath, Jarrow and Morton show that solutions to this equation explode before .
k Fax3
New variables:
336
. We have
Current time
Time to maturity
i y2
Bond prices:
Forward rates:
i a2h
x$
e
@ V @ '
6 i rP
V $
i rx$
i We
v u%h
u%h v
v u9G
v
$
(2.8)
6 a 6
$
where
and
% v h
(2.5),(2.2)
I$
Also,
(2.6),(2.4)
v $ G
6 i WP
v 5he
34.3 LIBOR
(2.1)
I$
Fix time
(say, .
(2.8)
year). $ invested at time in a maturity bond grows to $ 1 at is dened to be the corresponding rate of simple interest:
v y%
z
5 v q2 k
@ V
T 5
. Can do this at time by shorting bonds maturing at time . The value of this portfolio at time is one bond maturing at time
We cannot have a lognormal model for because solutions explode as we saw in Section 34.1. For xed positive , we can have a lognormal model for .
a Dgs v u I  uma v $q
zgs v u P  $q
Connection with forward rates:
w gs I v u i y  $q  $q y $q E
v gDF
v $$
v y5
$ i DvF v v uF5
338
at time
v yP
yvy5 v k `
r
so
xed
i y 25
v au%G$
3'VW
We want to choose
6 h
p @ ' e e m 6 6 i v v V rIy4$ 6 F$ v 6 i v v 6 i v V$WF ev n p r 6 i v r V$ rIy4 6 v @ ' e V$ 6WF$ 6 i v v r r i r Gy4 6h v$DPum v i v n $V$uv zgu4s v s  v P  $q $q zg4 v us P %q $q l Fgs w v u i y
$
$q
e
@ '
6 v 5
G
r w 6 d $ v P
Recall (2.9):
. This is the BGM model, and is a subclass of HJM models, for some corresponding to particular choices of .
G W
and
Therefore,
(4.1), (5.1)
#
339
(5.2) (5.1)
G G (3
e
@ V
Tv v v 6 T v $ $$ r r T
v $ 7F$ 6 v 6 v T
i
@ '
T v $%
v 6 T v y4 $$$ I$
Then
6 i v he WDum 6
V $
uv
Ve
@ '
v %
v y4$ 6 e WF$ 6 V v 6 i v v $
Therefore,
%q
from market data. Choose a forward LIBOR volatility function (usually nonrandom)
G (
w gs v u
But
340
to be given by
6 7
$x
6 i v rIy4$x6
yv
T
Remark 34.3 From (5.3) we have
e
6 6
G G
i T erhU i T erhUIh5
i G
i i iG
i eyh aIG$5
q
uz 1 6 o 1 G yA3
1 G uA3
Because LIBOR gives no rate information on time periods smaller than , we must also choose a partial bond volatility function
for
is
is o
Remark 34.1 BGM is a special case of HJM with HJMs In BGM, is usually taken to be nonrandom; the resulting
Remark 34.2 (5.4) (equivalently, (5.4)) is a stochastic partial differential equation because of the term. This is not as terrible as it rst appears. Returning to the HJM variables and , set
1 G uz
If we let
Then
, then
and so
(6.1) 341
1 1 A
i Whd 6
v 5i
`
G3G G
F
G3
p r
G
i 6 hd d
i n
v u gs
e
Vh
@ '
eX
i h 6
i p S e
G
v %
G$
he
xi
G$
G$5v r euG r q i T
Remark 34.4 Although the term in (6.1) has the term to this equation do not explode because
h5
so
342
involving
i 6 G$a
Let
y
Q `
v u w gs
The solution
. , solutions
h3 G$
he
yvr5a 1 1 W$h5d i
v yr
yv511A k U
Consider a oating rate interest payment settled in arrears. At time , the oating rate interest the LIBOR at time . A caplet protects its owner by payment due is requiring him to pay only the cap if . Thus, the value of the caplet at time is . We determine its value at times .
v ur
gG
(x
h5
a a5
G
i rGd r T
r Ih $ i
@ V
i WrGdT
v u mgs
v u gs
h35
p rGd r T i
r Ih $ i
@ V
i WrGdT
h35
aIG$5
so
Vi
@ '
v $
@ $ V e v i u%Xh 6
G$5 e
We assume that
and mean
r r i
and
Case I:
is nonrandom. Then
i u
T Ui
i 1 1 Xry535A
gGG$5 1 D
v u gs e WxiqB i E qB
G$5
% v yrhD7e $ x %
e e
e
i r v u gs
G$5
i e WG
v r(
yWG Gi v e v yrh
v y
.
A
5
1 1 35A
We have
where
344
and mean
r r i
i Gh r T
a5h5
b v d urG$
T 7e $
a i $
v r
e
Then
(9.2) .
gy h
$ $Xqxg
G3
Y
dr T
z
qq
dr T
X
i F
dr T
x3
x3
9
dr T
i  r T
T dU T
Let us suppose
i WGh r T
gGG35
b v d rh3D7Px $
at time
e
e
s X$a$qXx8a r
a
Rl
Let
at time
i `Xq
2
i rI
v yr
h3
Then depends on
The value at time of the cap is the value of all remaining caplets, i.e.,
dr T
XqXx3 $
x3
X $
where
z zd r T X d r T o o X qX $ o
346 and choose these constants to make the above integrals have the values implied by the caplet prices.
, and
or equivalently, using the recursive procedure outlined at the start of Section 34.6.
The long rate is determined by long maturity bond prices. Let that is 20 or 30 years. Then be a large xed positive integer, so
where the last equality follows from (4.1). The long rate is
X$v
s A$XXqiyv
v
Let
7v
Now is the volatility at time of a zero coupon bond maturing at time , it is reasonable to set Since is small (say year), and
V
dr T
i zd
X
X
1 G yAX
$~i}{ $ ~ } i{ % $ yv
1 G uA3
G G UGs
G G `3
G (
sG(Ph T dr T
l $
G a
1 y
$$
IdT $ 6
for all
hr T
(see (2.6)).
G$
In contrast to the cap formula, which depends on the term structure model and requires estimation of , the swap formula is generic.
which makes the time
v h5vXqU5 G$ i h G$
e
v
i $G$
m
i mhe WIx$
i
at time
i RqX
The forward swap rate at time value of the swap equal to zero:
e
i r5
Px$
For
1 1 5A
Now
Px$
We compute
yv
so
is the value of
G$
347
348
Chapter 35
350
351
The rst derivation of the BlackScholes formula given in this course, using only It s formula, o is similar to that originally given by Black & Scholes (1973). An important companion paper is Merton (1973), which makes good reading even today. (This and many other papers by Merton are collected in Merton (1990).) Even though geometric Brownian motion is a less than perfect model for stock prices, the BlackScholes option hedging formula seems not to be very sensitive to deciencies in the model.
35.7 Girsanovs theorem, the martingale representation theorem, and riskneutral measures.
Girsanovs Theorem in the generality stated here is due to Girsanov (1960), although the result for constant was established much earlier by Cameron & Martin (1944). The theorem requires a technical condition to ensure that , so that is a probability measure; see Karatzas & Shreve (1991), page 198. The form of the martingale representation theorem presented here is from Kunita & Watanabe (1967). It can also be found in Karatzas & Shreve (1991), page 182. The application of the Girsanov Theorem and the martingale representation theorem to riskneutral pricing is due to Harrison & Pliska (1981). This methodology frees the Brownianmotion driven model from the assumption of constant interest rate and volatility; these parameters can be random through dependence on the path of the underlying asset, or even through dependence on the paths of other assets. When both the interest rate and volatility of an asset are allowed to be stochastic, the Brownianmotion driven model is mathematically the most general possible for asset prices without jumps.
352 When asset processes have jumps, riskfree hedging is generally not possible. Some works on hedging and/or optimization in models which allow for jumps are Aase (1993), Back (1991), Bates (1988,1992), Beinert & Trautman (1991), Elliott & Kopp (1990), Jarrow & Madan (1991b,c), Jones (1984), Madan & Seneta (1990), Madan & Milne (1991), Mercurio & Runggaldier (1993), Merton (1976), Naik & Lee (1990), Schweizer (1992a,b), Shirakawa (1990,1991) and Xue (1992). The Fundamental Theorem of Asset Pricing, as stated here, can be found in Harrison & Pliska (1981, 1983). It is tempting to believe the converse of Part I, i.e., that the absence of arbitrage implies the existence of a riskneutral measure. This is true in discretetime models, but in continuoustime models, a slightly stronger condition is needed to guarantee existence of a riskneutral measure. For the continuoustime case, results have been obtained by many authors, including Stricker (1990), Delbaen (1992), Lakner (1993), Delbaen & Schachermayer (1994a,b), and Fritelli & Lakner (1994, 1995). In addition to the fundamental papers of Harrison & Kreps (1979), and Harrison & Pliska (1981, 1983), some other works on the relationship between market completeness and uniqueness of the riskneutral measure are Artzner & Heath (1990), Delbaen (1992), Jacka (1992), Jarrow & Madan (1991a), M ller (1989) and Taqqu & Willinger (1987). u
353
and by Parkinson (1977), Johnson (1983), Geske & Johnson (1984), MacMillan (1986), Omberg (1987), BaroneAdesi & Whalley (1987), BaroneAdesi & Elliott (1991), Bunch & Johnson (1992), Broadie & Detemple (1994), and Carr & Faguet (1994).
354
35.14 REFERENCES
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