# 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
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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)
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

2
u

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

2
u

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

L
x

e
−c
2
(

L
)
2
t
.
Since the general solution can have any n, then
u (x, t) =

¸
n=0
D
n
sin

L
x

e
−c
2
(

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

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

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

w(x, 0) dy.
The initial condition implies that
w(x, τ) =
1
2

πτ

−∞
e

(x−y)
2

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

−∞

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

e

(
z
2
−z(δ+1)

2t
)
2
dz −e
δ−1
2
x
x

2t
−∞
1

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

−e
δ−1
2
x+
(1+δ)
2
4
τ
Φ

x + (δ −1) τ

.
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

−e
−δτ
Φ

x + (δ −1) τ

;
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

−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
continuous sample paths and such that E[M
2
t
] < ∞. Then, there exist F
t
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
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].