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# MSc Financial Mathematics - SMM302 1

**5 The change of measure for Brownian motions
**

Recent methods of derivative asset pricing rest on converting prices of such assets into

martingales. This is done through transforming the underlying probability distribution

using the tools provided by Girsanov’s Theorem, which we present in the following section,

and which hinge upon considering the basic “density process” of

ˆ

P with respect to P.

The change of measure technique relates to a wide class of processes; in this module,

though, we have focussed speciﬁcally on Brownian motions, and therefore the illustration

we oﬀer of this topic is limited to Wiener processes only. For further extensions to a

wider class of processes, with discussion of the implication on valuation and pricing of

contingent claim, we refer to the term 2 module “Advanced Stochastic Modelling Methods

in Finance”.

A widely used alternative pricing method is based on the construction of the self-

ﬁnancing replicating portfolio; this technique leads to the governing partial diﬀerential

equation (PDE) satisﬁed by the price process of any contingent claim. In the setting of the

binomial model, it is straightforward to show that this valuation method is equivalent to

Risk Neutral Valuation, i.e. to change the measure via the Girsanov’s theorem and then

look for martingales. In the general setting of continuous time models, the link between

the two methods though is not so obvious. For sake of completeness, the discussion of this

link is provided in section 5.3, in which we introduce the Feynman-Kac representation.

We conclude this Unit and this module with the discussion of the Martingale Repre-

sentation theorem and the related issue of the existence of a hedging strategy.

5.1 Change of probability measure: the martingale problem

As discussed in Unit 2, a process which is a martingale with respect to one probability

measure may not be a martingale with respect to another. For example, consider the

simple random walk

S

n

= S

0

+

n

¸

i=1

X

i

,

where the X

i

are independent and take only the values +1 or −1. If P[X

i

= +1] =

P[X

i

= −1] =

1

2

then S

n

is a P-martingale. But if

ˆ

P[X

i

= +1] =

1

3

and

ˆ

P[X

i

= −1] =

2

3

then S

n

is not a

ˆ

P-martingale.

The aim of this section is to analyze the tools required for solving the so-called Martin-

gale problem: how to look for all the probability measures on a given ﬁltered probability

space under which all members of a given family of processes are martingales. The key

result is presented in the following.

5.1.1 Girsanov Theorem for Brownian motions

As we are going to work with Brownian motions, it is worth recalling that in Unit 1

we have already met the change of probability measure for a standard Normal random

0

c Laura Ballotta - Do not reproduce without permission.

2 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

variable. In this case, the “bridge” between the two equivalent probability measures is

given by the random variable

Z = e

−λX−

λ

2

2

, λ ∈ R.

The variable Z goes under the name of Radon-Nikodym derivative. For the case of chang-

ing measure to an entire process, we need to generalize a little this “bridge”; speciﬁcally,

we deﬁne the Radon-Nikodym derivative process (or density process)

Z

t

= E[ Z| F

t

] , 0 ≤ t ≤ T.

You can show that the process Z is a P-martingale with E[Z

t

] = 1 ∀0 ≤ t ≤ T. The

density process Z is then used as described in the following.

Theorem 1 (Girsanov) Let W be a P-Brownian motion and g an adapted process with

E

t

0

g

2

s

ds < ∞ for all 0 ≤ t ≤ T. Deﬁne the processes

ˆ

W

t

, Z

t

by

ˆ

W

t

= W

t

+

t

0

g

s

ds

Z

t

= e

(−

1

2

t

0

g

2

s

ds−

t

0

gs dWs)

for all 0 ≤ t ≤ T, and deﬁne a probability measure

ˆ

P by

d

ˆ

P

dP

F

T

= Z

T

.

Then

ˆ

W is a

ˆ

P-Brownian motion.

Proof. We need to check if

ˆ

W is a Brownian motion. To this purpose we use the L´evy

characterization of Brownian motions

1

. Hence we need to check if

ˆ

W is a

ˆ

P-martingale

and if its quadratic variation is t. To this purpose, set M

t

= Z

t

ˆ

W

t

. Applying Itˆo’s formula

we get

dM

t

=

ˆ

W

t

dZ

t

+ Z

t

d

ˆ

W

t

+ dZ

t

d

ˆ

W

t

= −

ˆ

W

t

(Z

t

g

t

dW

t

) + Z

t

dW

t

= Z

t

α

t

dW

t

,

where α

t

= 1 −g

t

ˆ

W

t

. Hence Z

t

ˆ

W

t

is a P-martingale. If

ˆ

E denotes the expectation under

ˆ

P, and bearing in mind that Z is a P-martingale, it follows that

ˆ

E

ˆ

W

t

| F

s

=

E

Z

t

ˆ

W

t

| F

s

Z

s

=

ˆ

W

s

.

Hence

ˆ

W is a

ˆ

P-martingale. Since

ˆ

W,

ˆ

W

t

= [W, W]

t

= t, by the L´evy characterization

of Brownian motion we conclude that

ˆ

W is a standard Brownian motion.

1

The L´evy characterization states as follows: a stochastic process {W

t

: t ≥ 0} is a standard Brownian

motion if and only if it is a continuous martingale with [W, W]

t

= t.

5.1 Change of probability measure: the martingale problem 3

Example 1 (Risk-neutral measures) If the risk-free rate of interest at time t is r(t),

then the value at time 0 of one unit paid at time t is β(t)

−1

, where β(t) = exp

t

0

r(u) du

.

A risk-neutral probability measure is a probability measure

ˆ

P such that the price of any

tradeable asset behaves as a martingale with respect to

ˆ

P. If a risk-neutral measure exists,

then the value at time s of a (possibly random) amount v paid at time t (t > s) is

V

s

= β(s)

ˆ

E[β(t)

−1

v|F

s

]

so that β(t)

−1

V

t

is a martingale. To ﬁnd the risk-neutral measure, suppose that the price

S

t

of a non-dividend paying share satisﬁes

dS

t

= µ(t)S

t

dt + σ(t)S

t

dW

t

Deﬁne Y

t

= β(t)

−1

S

t

. Then

dY

t

= −r

t

Y

t

dt + (µ(t) dt + σ(t) dW

t

) Y

t

= σ(t)Y

t

(θ(t) dt + dW

t

) ,

where θ(t) = (µ(t) −r(t)) /σ(t) is the market price of risk. Now we see that

dY

t

= σ(t)Y

t

d

ˆ

W

t

,

where

ˆ

W

t

= W

t

+

t

0

θ(s) ds.

Therefore Y

t

is a

ˆ

P-martingale as long as

ˆ

W is a

ˆ

P-Brownian motion, and the Girsanov

theorem tells us that this is the case when

d

ˆ

P

dP

= exp

¸

−

T

0

θ(u) dW

u

−

1

2

T

0

θ

2

(u) du

.

Exercise 1 A process X

t

is given by X

t

= W

t

+ λt + φ

t

0

W

s

ds. Find a probability

measure

ˆ

P such that X

t

is a

ˆ

P-Brownian motion.

Exercise 2 Suppose that the risk-free rate of interest r(t) is deterministic, with r(t) =

b + (r

0

−b)e

−λt

. One tradeable asset in the market has price S(t) which satisﬁes

dS(t) = (0.04 +r(t))S(t)dt + 0.4S(t)dW

t

a) Write down the risk-neutral measure.

b) Another asset has a higher drift coeﬃcient, µ(t) = 0.06 + r(t) at each time t. What

value would you expect the volatility coeﬃcient σ(t) to take? (Assume that this

asset is driven by the same Brownian motion as S).

4 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

Example 2 (Risk-adjusted measures) Consider the problem of pricing a European

call option via risk-neutral valuation in the market described in the previous example.

Assume that the option expires at time T, the strike price is K, and it is written on the

non-dividend paying share S. Risk-neutral valuation implies that

C

t

= β(t)

ˆ

E

β(T)

−1

(S

T

−K)

+

| F

t

.

If the short rate is stochastic, in order to solve the conditional expectation, you need to

derive the joint distribution of the stock and the short rate, which might be not such an

easy task. One way of making the problem simpler is to reduce the dimensional complexity

by eliminating one source of randomness. Let 1

A

be the indicator function of the set A;

then

C

t

= β(t)

ˆ

E

β(T)

−1

(S

T

−K) 1

(S

T

−K)

| F

t

= β(t)

ˆ

E

β(T)

−1

S

T

1

(S

T

−K)

| F

t

−β(t)K

ˆ

E

β(T)

−1

1

(S

T

−K)

| F

t

. (1)

Let P

t

(τ) be the price at time t of a zero coupon bond expiring at time τ; then set

γ

T

=

d

˜

P

d

ˆ

P

F

T

=

S

T

β(T)S

0

,

and

η

(T)

T

=

dP

(T)

d

ˆ

P

F

T

=

P

T

(T)

β(T)P

0

(T)

.

The Bayes theorem implies that equation (1) can be rewritten as

C

t

= S

t

˜

P(S

T

> K | F

t

) −KP

t

(T)P

(T)

(S

T

> K | F

t

) .

The conditional probabilities can then be calculated once the corresponding changes of

measure for the Brownian motion are determined. To this purpose, assume that the

ˆ

P-dynamic of the bond price is

dP

t

(T) = r(t)P

t

(T)dt + m(t, T)P

t

(T)d

ˆ

Z

t

,

where

ˆ

Z is a

ˆ

P-Brownian motion independent of the Brownian motion driving the asset

share price,

ˆ

W. Then

γ

T

= e

−

T

0

σ

2

(t)

2

dt+

T

0

σ(t)d

ˆ

Wt

η

(T)

T

= e

−

T

0

m

2

(t,T)

2

dt+

T

0

m(t,T)d

ˆ

Zt

.

The Girsanov’s theorem implies that

˜

W

t

=

ˆ

W

t

−

t

0

σ(s)ds

5.1 Change of probability measure: the martingale problem 5

is a

˜

P-Brownian motion and

Z

(T)

t

=

ˆ

Z

t

−

t

0

m(s, T)ds

is a P

(T)

-Brownian motion.

˜

P is the stock-risk-adjusted probability measure and P

(T)

is the forward-risk-adjusted

probability measure.

Example 3 (The Black-Scholes-Merton option pricing formula) Consider again the

problem of pricing a European call option in the same setup as in the previous example.

Now, assume that the risk free rate of interest, r, is constant. If this is the case, we can

rewrite the previous pricing equation as

C

t

= S

t

ˆ

P

S

(S

T

> K | F

t

) −e

−r(T−t)

K

ˆ

P(S

T

> K | F

t

) ,

since the second change of measure does not occur in reality (η

t

= 1). Further

ˆ

P(S

T

> K | F

t

) =

ˆ

P

S

t

e

r−

σ

2

2

(T−t)+σ

ˆ

W

T−t

> K | F

t

=

ˆ

P

S

t

e

r−

σ

2

2

(T−t)+σ

ˆ

W

T−t

> K

**since the Brownian motion has independent increments. Also, the increments of the
**

Brownian motion are Gaussian with mean 0 and variance (T −t). Let y be the standard

Normal random variable, then

ˆ

P(S

T

> K | F

t

) =

ˆ

P

S

t

e

r−

σ

2

2

(T−t)+σ

√

T−ty

> K

=

ˆ

P

¸

y >

ln

K

St

−

r −

σ

2

2

(T −t)

σ

√

T −t

=

ˆ

P

¸

y < −

ln

K

St

−

r −

σ

2

2

(T −t)

σ

√

T −t

= N (d

2

) .

where

d

2

=

ln

St

K

+

r −

σ

2

2

(T −t)

σ

√

T −t

.

As far as

ˆ

P

S

(S

T

> K | F

t

)

is concerned, we need to work out ﬁrst the quantity by which the Brownian motion is

shifted with the change of measure. Consider the Radon-Nikod´ ym derivative

γ

T

=

S

T

B

T

S

0

= e

−

σ

2

2

T+σ

ˆ

W

T

.

6 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

Hence, the Girsanov theorem implies that

˜

W

t

=

ˆ

W

t

−σt

is a

ˆ

P

S

-Brownian motion. This implies

ˆ

P

S

(S

T

> K | F

t

) =

ˆ

P

S

S

t

e

r−

σ

2

2

(T−t)+σ

ˆ

W

T−t

> K | F

t

=

ˆ

P

S

S

t

e

r−

σ

2

2

(T−t)+σ(

˜

W

T−t

−σ(T−t))

> K | F

t

=

ˆ

P

S

S

t

e

r+

σ

2

2

(T−t)+σ

˜

W

T−t

> K

.

This follows by the property of independent increments. Using the same argument as

before,

ˆ

P

S

S

t

e

r+

σ

2

2

(T−t)+σ

˜

W

T−t

> K

=

ˆ

P

S

S

t

e

r+

σ

2

2

(T−t)+σ

√

T−ty

> K

=

ˆ

P

S

¸

y < −

ln

K

St

−

r +

σ

2

2

(T −t)

σ

√

T −t

= N (d

1

)

where

d

1

=

ln

St

K

+

r +

σ

2

2

(T −t)

σ

√

T −t

.

Hence

C

t

= S

t

N (d

1

) −Ke

−r(T−t)

N (d

2

) ,

d

1,2

=

ln

St

K

+

r ±

σ

2

2

(T −t)

σ

√

T −t

.

This is the celebrated Black-Scholes-Merton option pricing formula, for which Myron

Scholes and Robert Merton have been awarded the Nobel prize in Economics in 1997

(Fisher Black died in 1995). Note that in their original paper, Black and Scholes did not

solve the martingale problem, but derived the governing PDE ﬁrst, and then solved it, as

shown in the next section. The two approaches are equivalent, as shown in section 5.3,

and the choice of which one to adopt in the end relies on the nature of the payoﬀ, but

above all on the approach you decide to follow to implement a pricing numerical scheme

(in fact, the majority of the options traded in the market do not have such a nice closed

analytical pricing formula!).

5.1 Change of probability measure: the martingale problem 7

5.1.2 Multidimensional Girsanov Theorem

The results presented above can be extended to the case in which there are more than one

Brownian motion involved, i.e. the case in which you are dealing with a multidimensional

Brownian motion, which is deﬁned as follows.

Deﬁnition 2 A d-dimensional Brownian motion is a process

W

t

=

W

(1)

t

, ..., W

(d)

t

**with the following properties.
**

i) Each W

(i)

t

is a one-dimensional Brownian motion.

ii) If i = j, then the processes W

(i)

t

and W

(j)

t

are independent.

The corresponding generalization of the Girsanov theorem is contained in the following.

Theorem 3 (Multidimensional Girsanov Theorem) Let W be a d-dimensional P-

Brownian motion and g a d-dimensional adapted process with

E

t

0

g

s

2

ds < ∞

for all 0 ≤ t ≤ T. Deﬁne the processes

ˆ

W

t

, Z

t

by

ˆ

W

t

= W

t

+

t

0

g

s

ds

Z

t

= e

(−

1

2

t

0

gs

2

ds−

t

0

gs ·dWs)

for all 0 ≤ t ≤ T, and deﬁne a probability measure

ˆ

P by

d

ˆ

P

dP

F

T

= Z

T

.

Then

ˆ

W is a d-dimensional

ˆ

P-Brownian motion.

Examples of ﬁnancial applications of the above theorem are given in the following.

Example 4 1. Consider a market in which the money market account and 2 risky

stocks are traded. Assume that these securities satisfy the following

dβ (t) = r (t) β (t) dt

dS

t

= µ

S

S

t

dt + σ

S

S

t

dW

t

dA

t

= µ

A

A

t

dt + σ

A

A

t

dX

t

,

8 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

where W and X are two independent Brownian motion under P. In order to deter-

mine the risk neutral martingale measure, you need to consider both asset prices,

discount them at the risk-free rate and transform the resulting processes into mar-

tingales. Since you have two independent Brownian motions, the change of measure

will be diﬀerent for W and X, in the sense that the magic “rescaling” factors will

be diﬀerent for the two Wiener processes. Hence, the discounted price processes are

described by

d

˜

S

t

= (µ

S

−r (t) −σ

S

λ

t

)

˜

S

t

dt + σ

S

˜

S

t

d

ˆ

W

t

d

˜

A

t

= (µ

A

−r (t) −σ

A

θ

t

)

˜

A

t

dt + σ

A

˜

A

t

d

ˆ

X

t

;

these are martingales if

λ

t

=

µ

S

−r (t)

σ

S

θ

t

=

µ

A

−r (t)

σ

A

.

The discounted asset prices are

ˆ

P martingales as long as

ˆ

W and

ˆ

X are Brownian

motions; the Girsanov theorem tells us that this is the case provided

d

ˆ

P

dP

= e

−

t

0

λudWu−

t

0

θudXu−

1

2

t

0

(λ

2

u

+θ

2

u)du

;

E

t

0

λ

2

u

+ θ

2

u

du

< ∞.

2. In the previous example it is possible to uniquely identify the change of measure,

in the sense that the function λ and θ are uniquely deﬁned. In this case, the

fundamental theorem of asset pricing tells us that the market is complete, since

the risk neutral martingale measure is unique. This can be checked by “counting”

the number of sources of uncertainty (i.e. the independent Brownian motions) and

the number of independent instruments that you have available in order to hedge

against these risks. You can see that in this case they match. Now, consider the

following market

dβ (t) = r (t) β (t) dt

dS

t

= µS

t

dt + σS

t

dW

t

+ γS

t

dX

t

,

where W and X are two independent Brownian motion under P. If you want to

ﬁnd the risk neutral martingale measure for this market, you need to apply the

multidimensional Girsanov theorem as before. Thus, the discounted asset price

process is given by

d

˜

S

t

= (µ −r (t) −σλ

t

−γθ

t

)

˜

S

t

dt + σ

˜

S

t

d

ˆ

W

t

+ γ

˜

S

t

d

ˆ

X

t

;

5.2 PDE detour 9

then

˜

S is a martingale as long as

µ −r (t) −σλ

t

−γθ

t

= 0 (2)

d

ˆ

P

dP

= e

−

t

0

λudWu−

t

0

θudXu−

1

2

t

0

(λ

2

u

+θ

2

u

)du

; (3)

E

t

0

λ

2

u

+ θ

2

u

du

< ∞. (4)

The Girsanov theorem simply tells us that, if conditions (3) and (4) hold, then

ˆ

P

exists; however, in terms of exactly determining this probability measure, we have

a small problem. As you can see, there are inﬁnitely many solutions to equation

(2); this implies that the market is incomplete. In fact, there are two sources

of uncertainty in the market, but not enough instruments to hedge against this

uncertainty.

5.2 PDE detour

Example 5 (The Black-Scholes governing PDE) Consider a market composed by

a risk free asset, B

t

= e

rt

(the money market account), and a non-dividend paying risky

stock S

t

, which is driven by a geometric Brownian motion under the real probability

measure, i.e.

dS

t

= µS

t

dt + σS

t

dW

t

.

Now, consider a European call option on S, with strike K and maturity T. Diﬀerently

from what done in the previous section, we now want to tackle the problem of determining

the price of this contract using the arbitrage principle. Hence, the idea is to ﬁnd a security

V (or better, a portfolio of primary assets) that perfectly replicates the option at maturity

in every possible state of nature; if we can ﬁnd it, then the price of this portfolio at any

other point in time represents the price of the option as well. In other words, we are

looking for a self-ﬁnancing strategy (φ

t

, ϕ

t

) such that

V

t

= φ

t

S

t

+ ϕ

t

e

rt

.

Choose (φ

t

, ϕ

t

) so that V replicates the call option at any point in time and in any state

of nature, i.e.

V

t

= C

t

dV

t

= dC

t

.

The solution to this part of the problem relies on Ito’s lemma. Let’s start with the

replicating portfolio:

dV

t

=

µφ

t

S

t

+ rϕ

t

e

rt

dt + σφ

t

S

t

dW

t.

(5)

The call option is a function of the underlying asset S; therefore, using Ito’s lemma, it

follows that

dC

t

=

¸

∂C

∂t

+ µS

t

∂C

∂S

+

σ

2

2

S

2

t

∂

2

C

∂S

2

dt + σS

t

∂C

∂S

dW

t.

(6)

10 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

Equating the coeﬃcients of (5) and (6), we get

dW

t

-term ⇒φ

t

S

t

=

∂C

∂S

S

t

or

φ

t

=

∂C

∂S

. (7)

Analogously:

dt-term ⇒µφ

t

S

t

+ rϕ

t

e

rt

=

∂C

∂t

+ µS

t

∂C

∂S

+

σ

2

2

S

2

t

∂

2

C

∂S

2

,

which is equivalent to

µφ

t

S

t

+ r (C

t

−φ

t

S

t

) =

∂C

∂t

+ µS

t

∂C

∂S

+

σ

2

2

S

2

t

∂

2

C

∂S

2

.

Using (7) we can now simplify:

r

C

t

−

∂C

∂S

S

t

=

∂C

∂t

+

σ

2

2

S

2

t

∂

2

C

∂S

2

;

rearranging, we obtain

∂C

∂t

+ rS

t

∂C

∂S

+

σ

2

2

S

2

t

∂

2

C

∂S

2

−rC = 0. (8)

This is the Black-Scholes partial diﬀerential equation governing the price of any European

call option.

A lot can be said about this PDE, the meaning of the terms in it, why the expected rate

of growth on the stock does not appear in it, and so on... however, this is not the right place

as you have already seen all of these nice things in the SMM301 module. Here, instead

we want to focus on how we solve this PDE. In order to be able to tackle this problem,

we need to do a little detour on PDEs ﬁrst, just to put things in a context. However,

we will focus only on the so called heat equation (like equation 8), since it is the most

relevant for ﬁnancial applications; moreover, as we mentioned above, the most frequently

traded derivatives in the market are hardly so nice to have a closed analytical pricing

formula; therefore the market practice is to set up a powerful software architecture that

numerically approximates these prices. Numerical schemes for PDEs are used essentially

when you need to obtain the price of American contracts; however, given the increasing

complexity of the payoﬀs of these American-style securities, the techniques available for

PDEs become more and more powerless. To the point that major ﬁnancial institutions

are switching to the more ﬂexible Monte Carlo.

5.2 PDE detour 11

5.2.1 Classiﬁcation of PDEs

A Partial Diﬀerential Equation (PDE) is a mathematical relation involving an unknown

function of several independent variables and its partial derivatives with respect to those

variables.

Example 6 Consider the functions u (x, y) solution of

u

x

+ (1 +u

y

) u

yy

= 0 (9)

and c (x, t) solution of

c

t

= c

xx

−5c sin (x −t) . (10)

Partial diﬀerential equations are used to formulate and solve problems that involve

unknown functions of several variables, such as the propagation of sound or heat, elec-

trostatics, electrodynamics, ﬂuid ﬂow, elasticity, or more generally any process that is

distributed in space, or distributed in space and time. Very diﬀerent physical problems

may have identical mathematical formulations.

The order of the highest derivative deﬁnes the order of the equation. In the previous

example, both equations (9) and (10) are 2

nd

order PDEs.

The equation is called linear if the unknown function and its derivatives only appear

in a linear combination, multiplied by known functions of the independent variables. In

the previous example, equation (9) is non linear, whilst equation (10) is.

Finally, the equation is homogeneous if every term involves the unknown function or

its partial derivatives and inhomogeneous if it does not.

We can further classify general 2

nd

order, linear, two dimensional PDEs of the form

Au

xx

+ 2Bu

xy

+ Cu

yy

+ Du

x

+ Eu

y

+ F = 0

based on the discriminant B

2

−4AC. Speciﬁcally

• B

2

−4AC < 0: elliptic equations, like for example the Laplace equation

∂

2

u

∂x

2

+

∂

2

u

∂y

2

= 0,

or the Poisson equation

∂

2

u

∂x

2

+

∂

2

u

∂y

2

= f(x, y).

Generally, this type of equations is associated with equilibrium properties, like for

example the steady ﬂow of an incompressible ﬂuid.

• B

2

−4AC = 0: parabolic equations, like the heat (or diﬀusion

2

) equation

∂u

∂t

= c

2

∂

2

u

∂x

2

where u represent the temperature of a body, if the heat equation describes heat

conduction in a thin rod, or concentration if the heat equation models the diﬀusion

of a chemical substance in water.

2

Diﬀusion is the spontaneous spreading of heat.

12 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

• B

2

−4AC > 0: hyperbolic equations, like the wave equation:

∂

2

u

∂t

2

= c

2

∂

2

u

∂x

2

,

where u represent the displacement of a wave. These equations are in general

associated with vibration problems or shock waves.

All the examples are for homogeneous, linear partial diﬀerential equations, except the

Poisson equation.

The solutions to the above equations are numerous. For example, if one considers the

Laplace equation, then it is easily veriﬁed that all of the functions

u = x

2

−y

2

, u = e

x

cos y, ln(x

2

+ y

2

),

are solutions. So how do we determine the actual solution we are looking for? The answer,

of course, lies in the application of boundary conditions. Once the initial conditions

(conditions at t = 0) and the boundary conditions (conditions at speciﬁc values of x),

where appropriate, are speciﬁed, there will be a unique solution to the linear partial

diﬀerential equation.

5.2.2 The heat equation

The function u (x, t) solves the heat equation if it satisﬁes the following PDE

∂u

∂t

= c

2

∂

2

u

∂x

2

; (11)

the coeﬃcient c

2

represents the thermal diﬀusivity and u is the temperature.

The heat equation can be solved using the method of separation of variables, which

consists of the following steps:

1. obtain 2 ordinary diﬀerential equations, one in time and one in space;

2. determine the solutions that satisfy the boundary conditions;

3. use Fourier series to superimpose the solutions to get the ﬁnal solution that satisﬁes

both the heat equation and the given initial conditions.

If we assume the temperature to be separable in x and t, it can be rewritten in the

form

u (x, t) = X (x) T (t) .

Therefore, the heat equation can be rewritten as

X

˙

T = c

2

X

′′

T.

Let k be the separation constant, then

˙

T

T

= c

2

X

′′

X

= k.

5.2 PDE detour 13

Now, consider ﬁrst the time equation

˙

T

T

= k;

this is a ODE, whose solution is

T (t) = T

0

e

c

2

kt

.

This implies that the temperature u is an increasing function of time if k > 0, and a

decreasing function of time if k < 0; it is obviously unphysical for the temperature to

increase in time without any additional heating mechanism, hence k < 0. To force this,

we set k = −ρ

2

, and therefore

T (t) = T

0

e

−c

2

ρ

2

t

.

Let’s now move to the spatial equation

c

2

X

′′

X

= k;

this is a ODE of the second order, and therefore the solution is given by

X = Acos ρx + Bsin ρx.

The general solution is then

u (x, t) = T

0

e

−c

2

ρ

2

t

(Acos ρx + Bsin ρx) . (12)

If we are given the boundary conditions

u (0, t) = 0

u (L, t) = 0,

then A = 0 and ρ = nπ/L; hence equation (12) becomes

u (x, t)

n

= D

n

sin

nπ

L

x

e

−c

2

(

nπ

L

)

2

t

.

Since the general solution can have any n, then

u (x, t) =

∞

¸

n=0

D

n

sin

nπ

L

x

e

−c

2

(

nπ

L

)

2

t

.

Now, if we are also given an initial condition

u (x, 0) = u

0

(x) ,

we have

u

0

(x) =

∞

¸

n=0

D

n

sin

nπ

L

x

;

14 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

by inverting the Fourier series, we obtain

D

n

=

2

L

L

0

u

0

(x) sin

nπ

L

x

dx.

An alternative method of solving the diﬀusion equation relies on Green functions.

Green functions are, in fact, the solutions of the diﬀusion equation corresponding to the

initial condition of a particle of known position. For another initial condition, the solution

to the diﬀusion equation can be expressed as a decomposition on a set of Green functions.

There exists a full catalogue of Green functions solutions that you can use, however the

most useful to our purposes is the following

∂u

∂t

= c

2 ∂

2

u

∂x

2

−∞< x < ∞; 0 < t < ∞

u (x, 0) = f (x)

u (x, t) =

1

2c

√

πt

∞

−∞

e

−

(x−y)

2

4c

2

t

f (y) dy.

5.2.3 Solving Black-Scholes

Now we know enough to tackle the Black-Scholes PDE. Clearly, the Black-Scholes PDE

is a parabolic equation, since the discriminant is zero; we know how to solve the heat

equation, and for this reason, it would be very helpful to be able to express the Black-

Scholes PDE (8) in the same form as the heat equation. This will require a little patience

and “few” calculations.

To start with, let’s rewrite the price of the call option as C (S (t) , t), in order to

make clear the dependencies. Now, let’s specify the initial condition and the boundary

conditions, so that we can arrive to a unique solution; the full speciﬁcation of the problem

is given below

∂C

∂t

+ rS

t

∂C

∂S

+

σ

2

2

S

2

t

∂

2

C

∂S

2

−rC = 0

C (S (T) , T) = (S (T) −K)

+

C (0, t) = 0 ∀t

lim

S(t)→∞

C (S (t) , t)

S (t)

= 1.

At this stage, we can operate the following transformation in order to reduce the

number of parameters

S (t) = Ke

x

⇒x = ln

S (t)

K

;

τ =

σ

2

2

(T −t) ⇒t = T −

τ

σ

2

/2

;

C (S (t) , t) = Kc (x, τ) = e

−x

Sc (x, τ) .

5.2 PDE detour 15

From this, it follows

∂C

∂t

= K

∂c

∂τ

∂τ

∂t

= −

σ

2

2

K

∂c

∂τ

;

∂C

∂S

= K

∂c

∂x

∂x

∂S

= e

−x

∂c

∂x

;

∂

2

C

∂S

2

= K

∂

∂S

∂c

∂x

∂x

∂S

=

e

−2x

K

∂

2

c

∂x

2

−

∂c

∂x

.

Replacing in the Black-Scholes PDE, we obtain the PDE

∂c

∂τ

=

∂

2

c

∂x

2

+ (δ −1)

∂c

∂x

−δc (13)

δ =

2r

σ

2

,

with initial condition

c (x, 0) = (e

x

−1)

+

,

and boundary conditions

lim

x→−∞

c (x, τ) = 0

lim

x→∞

c (x, τ)

e

x

= 1.

Now that we have only a single parameter δ involved in the PDE, let’s try to reduce

the number of terms involved in it; hence, let’s operate the following transformation

c (x, τ) = e

ax+bτ

w(x, τ)

a =

1 −δ

2

; b = −

(1 +δ)

2

4

.

This implies

∂c

∂τ

= be

ax+bτ

w(x, τ) + e

ax+bτ

∂w

∂τ

;

∂c

∂x

= ae

ax+bτ

w(x, τ) + e

ax+bτ

∂w

∂x

;

∂

2

c

∂x

2

= e

ax+bτ

¸

a

2

w(x, τ) + 2a

∂w

∂x

+ e

ax+bτ

∂

2

w

∂x

2

.

Replacing in the PDE (13), we obtain

∂w

∂τ

=

∂

2

w

∂x

2

+

∂w

∂x

(2a + δ −1) +w

a (δ −1) −δ −b + a

2

;

by using the deﬁnition of the parameters a and b, the above equation can be ﬁnally

reduced to

∂w

∂τ

=

∂

2

w

∂x

2

16 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

with initial condition

w(x, 0) =

e

δ+1

2

x

−e

δ−1

2

x

+

,

and boundary conditions

lim

x→∞

e

−

δ−1

2

x−

(1+δ)

2

4

τ

w(x, τ) = 1

lim

x→−∞

e

−

δ+1

2

x−

(1+δ)

2

4

τ

w(x, τ) = 0.

Using the Green function solution (note that now the domains for space and time coin-

cide), we obtain that the solution to the heat equation is given by

w(x, τ) =

1

2

√

πτ

∞

−∞

e

−

(x−y)

2

4τ

w(x, 0) dy.

The initial condition implies that

w(x, τ) =

1

2

√

πτ

∞

−∞

e

−

(x−y)

2

4τ

e

δ+1

2

x

−e

δ−1

2

x

+

dy;

thus, changing the variable z = (x −y) /

√

2t, we obtain

w(x, τ) =

1

√

2π

∞

−∞

e

δ+1

2

(x−z

√

2t)

−e

δ−1

2

(x−z

√

2t)

+

e

−

z

2

2

dz,

which should remind you of an old friend. No? Really? Are you sure? Ok then! Let’s

look for the domain of exercise of the option

e

δ+1

2

(x−z

√

2t)

−e

δ−1

2

(x−z

√

2t)

> 0 ⇒z <

x

√

2t

;

hence, you can now split the integral in two parts and compact the terms together

w(x, τ) = e

δ+1

2

x

x

√

2t

−∞

1

√

2π

e

−

(

z

2

−z(δ+1)

√

2t

)

2

dz −e

δ−1

2

x

x

√

2t

−∞

1

√

2π

e

−

(

z

2

−z(δ−1)

√

2t

)

2

dz.

Now it rings a bell! This is nothing but some shifted Normal distribution. So what is left

is just standard calculations, like completing the squares and expressing the integrals in

form of the distribution of the standard normal random variable. The ﬁnal result is

w(x, τ) = e

δ+1

2

x+

(1+δ)

2

4

τ

Φ

x + (δ + 1) τ

√

2τ

−e

δ−1

2

x+

(1+δ)

2

4

τ

Φ

x + (δ −1) τ

√

2τ

.

Final (very ﬁnal) step: revert back to the original function and parametrization, so

that (reversing the second transformation)

c (x, t) = e

x

Φ

x + (δ + 1) τ

√

2τ

−e

−δτ

Φ

x + (δ −1) τ

√

2τ

;

5.3 Feynman-Kac Representation 17

(reversing the ﬁrst transformation and using the fact that δ = 2r/σ

2

)

C (S (t) , t) = S (t) Φ

¸

ln

S(t)

K

+

r +

σ

2

2

(T −t)

σ

√

T −t

−e

−δτ

Φ

¸

ln

S(t)

K

+

r −

σ

2

2

(T −t)

σ

√

T −t

.

There! No wonder it took Black and Scholes about 10 minutes to derive the PDE and

about a year to solve it!!... but, they have been awarded the Nobel prize...

5.3 Feynman-Kac Representation

As mentioned above, risk neutral valuation and the replicating portfolio technique lead

to the same price process satisﬁed by any asset in the market (this follows from the

no-arbitrage argument). The link between these two pricing methods is given by the

Feynman-Kac representation for the solution to the Cauchy problem. This result es-

sentially implies that behind any PDE (of the form speciﬁed by the Theorem) lies a

martingale with respect to some probability measure as identiﬁed by the Theorem itself.

Proposition 4 (Feynman-Kac Representation) Assume that f ∈ C

12

satisﬁes

f(T, x) = Φ(x) for all x ∈ R and that, for 0 < t < T, f satisﬁes

∂f

∂t

+ b(t, x)

∂f

∂x

+

1

2

σ

2

(t, x)

∂

2

f

∂x

2

= r(t, x)f(t, x). (14)

Assume also that X

s

= x and that, for t > s,

dX

t

= b(t, X

t

) dt + σ(t, X

t

) dW

t

.

Then f can be represented as

f(s, x) = E

e

−

T

s

r(u,Xu) du

Φ(X

T

)|F

s

. (15)

Proof. Deﬁne

β

t

= e

t

0

r(u,Xu) du

V

t

= β

−1

t

f(t, X

t

)

Then

dV

t

= f(t, X

t

) d(β

−1

t

) + β

−1

t

df

= −r(t, X

t

)β

−1

t

fdt + β

−1

t

df

Now, by Itˆo’s Lemma,

df(t, X

t

) =

∂f

∂t

dt +

∂f

∂x

b(t, X

t

) dt

+

1

2

σ

2

(t, X

t

)

∂

2

f

∂x

2

dt + σ(t, X

t

)

∂f

∂x

dW

t

= r(t, X

t

)f(t, X

t

)dt + σ(t, X

t

)

∂f

∂x

dW

t

18 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

Therefore

dV

t

= β

−1

t

σ(t, X

t

)

∂f

∂x

dW

t

This means that V

t

is a martingale, implying that E[V

t

|F

s

] = V

s

, so that

f(s, X

s

) = β

s

E

β

−1

T

f(T, X

T

)|F

s

= E

e

−

T

s

r(u,Xu) du

Φ(X

T

)|F

s

,

as required.

Hence, the Theorem says that any function satisfying the PDE (14) can be represented

as a martingale, once it has been rescaled by the function r (t, x) appearing on the RHS

of the PDE. The important thing to notice is that this representation works with respect

to the same probability measure under which the process X has a drift function exactly

equal to the function b (t, x), appearing on the LHS of the PDE. No further conditions are

required, though, on the Itˆo term; this is consistent with the fact that, when we change

the measure to a Brownian motion via the Girsanov’s Theorem, we rescale its distribution

(i.e. we shift its mean), but we do not change how the probability mass spreads around

the mean (i.e. we do not touch its variance).

Example 7 1. Black-Scholes PDE. The Black-Scholes PDE for the option price C

returns

∂C

∂t

+ rS

t

∂C

∂S

+

σ

2

2

S

2

t

∂

2

C

∂S

2

= rC(t, S).

C(T, S) = (S

T

−K)

+

In order to use the Feynman-Kac Theorem, the process S has to be driven by the

following SDE

dS

t

= rS

t

dt + σS

t

d

ˆ

W

t

,

which we know to occur only under the risk neutral martingale measure

ˆ

P. There-

fore, the theorem says that the option price can be represented as

C

t

=

ˆ

E

e

−r(T−t)

(S

T

−K)

+

)|F

t

,

which is what risk neutral valuation postulates.

2. Term structure PDE. Zero coupon bond prices of any maturity, P (t, T) =

F

T

(t, r), satisfy the so-called Term Structure Partial Diﬀerential Equation:

∂F

T

∂t

+ (µ

t

−λ

t

σ

t

)

∂F

T

∂r

+

σ

2

t

2

∂

2

F

T

∂r

2

= r

t

F

T

(t, r) .

F

T

(T, r) = 1

Therefore the driving process is

dr

t

= (µ

t

−λ

t

σ

t

) dt + σ

t

d

ˆ

W

t

,

and the bond price can be written as

F

T

(t, r) = P (t, T) =

ˆ

E

e

−

T

t

r(s)ds

|F

t

,

5.4 Martingale Representation Theorem 19

where

ˆ

E is the expectation taken under the probability measure

ˆ

P. It can be shown,

by changing the measure to the dynamic of the bond price process, that this is again

the risk-neutral martingale measure.

Exercise 3 A mathematician is attempting to solve for 0 ≤ t ≤ T the partial diﬀerential

equation

∂f

∂t

+ αx

∂f

∂x

+

1

2

σ

2

x

2

∂

2

f

∂x

2

= γf,

(where α, σ and γ are constants), subject to the terminal condition f(T, x) = (x −δ)

2

.

a) Explain to the mathematician how stochastic processes may be used to assist in the

solution of the problem.

b) Express the problem in terms of the Feynman-Kac representation.

c) Find the solution f.

5.4 Martingale Representation Theorem

The Girsanov’s theorem provides us the tools for implementing risk-neutral valuation; the

Feynman-Kac representation provides us the “bridge” between the price process governing

PDE and its risk-neutral formula, which in general is easier to solve. However, risk-neutral

valuation is fully justiﬁed only when it is accompanied by a hedge for a short/long position

in the security being priced. The conditions for the existence of such a hedge are contained

in the following.

Theorem 5 (Martingale Representation) Let M

t

be an F

t

-adapted P-martingale with

continuous sample paths and such that E[M

2

t

] < ∞. Then, there exist F

t

-adapted processes

g and W, such that W is a Brownian motion,

E

¸

t

0

g

2

s

ds

< ∞,

and

M

t

= M

0

+

t

0

g

s

dW

s

.

Proof. Since M is a continuous martingale, then M

2

is a continuous submartingale. In

particular, we can write

E[dM

2

t

|F

t

] = g

2

t

dt

which implies that

E

¸

t

0

g

2

s

ds

= E[M

2

t

−M

2

0

] < ∞.

Now deﬁne

dW

t

= g

−1

t

dM

t

.

20 5 THE CHANGE OF MEASURE FOR BROWNIAN MOTIONS

In order to prove that W

t

is a Brownian motion, notice that

E[ dW

t

| F

t

] = g

−1

t

E[ dM

t

| F

t

] = 0;

moreover

E(dW

t

)

2

= g

−2

t

E

dM

2

t

.

But (dM

t

)

2

= g

2

t

dt, and therefore

E(dW

t

)

2

= g

−2

t

E

dM

2

t

= dt.

as required.

The Martingale Representation theorem states that every continuous martingale can

be represented by an initial condition (M

0

) plus an Itˆo integral with respect to a Brownian

motion. The relevance of this result in terms of hedging is shown in the following.

Example 8 Let’s use the market introduced in Example 1. By risk-neutral valuation,

we know that the discounted price, C, of some contingent claim written on the underlying

S is a

ˆ

P-martingale, i.e. for t < T

β(t)

−1

C

t

=

ˆ

E

β(T)

−1

C

T

|F

t

.

The Martingale Representation theorem implies that there exists a F

t

-adapted process g

such that

β(t)

−1

C

t

= C

0

+

t

0

g

u

d

ˆ

W

u

∀t ∈ [0, T].

Now, consider the hedging strategy (φ, ϕ)

t

; the dynamic of the discounted portfolio process

under

ˆ

P is

d

˜

V

t

= φ

t

d

˜

S

t

= φ

t

σ(t)

˜

S

t

d

ˆ

W

t

,

which implies

˜

V

t

= V

0

+

t

0

φ

u

σ(u)

˜

S

u

d

ˆ

W

u

.

For the perfect hedge to work we need

V

0

= C

0

g

t

= φ

t

σ(t)

˜

S

t

,

i.e.

φ

t

=

g

t

σ(t)

˜

S

t

.

The Martingale Representation theorem guarantees the existence of the process g and

therefore of the portfolio strategy, provided that σ(t) is non zero, i.e. the stock is an

eﬀective hedging instrument.

Note that the Martingale Representation theorem only tells us that the process g

exists, but it does not provide any method for ﬁnding it.

5.4 Martingale Representation Theorem 21

Exercise 4 Let γ be a positive stochastic process such that Eγ

2

t

< ∞. Suppose that γ

is a martingale with respect to the history of the Wiener process W.

a) Formulate the martingale representation theorem for the process γ.

b) Prove the existence of a process f such that

γ

t

= γ

0

e

t

0

fsdWs−

1

2

t

0

f

2

s

ds

for all t ∈ [0, T].