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P RASAD C HALASANI Carnegie Mellon University chal@cs.cmu.edu S OMESH J HA Carnegie Mellon University sjha@cs.cmu.edu

THIS IS A DRAFT: PLEASE DO NOT DISTRIBUTE c Copyright; Steven E. Shreve, 1996 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deﬁnition 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 one-step APT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-Neutral Probability Measure . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 3.3.2 3.4 3.5 Portfolio Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Self-ﬁnancing 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

Simple European Derivative Securities . . . . . . . . . . . . . . . . . . . . . . . . The Binomial Model is Complete . . . . . . . . . . . . . . . . . . . . . . . . . . .

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 Jensen’s Inequality 7.1 7.2 7.3 Jensen’s Inequality for Conditional Expectations . . . . . . . . . . . . . . . . . . . Optimal Exercise of an American Call . . . . . . . . . . . . . . . . . . . . . . . . Stopped Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8 Random Walks 8.1 First Passage Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 is almost surely ﬁnite . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The moment generating function for Expectation of . . . . . . . . . . . . . . . . . . . . . . . . 97 99

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

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 Reﬂection Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 9 Pricing in terms of Market Probabilities: The Radon-Nikodym Theorem. 9.1 9.2 9.3 9.4 9.5 111

Radon-Nikodym Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 Radon-Nikodym Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 The State Price Density Process . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Stochastic Volatility Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . 116 Another Applicaton of the Radon-Nikodym Theorem . . . . . . . . . . . . . . . . 118 119

10 Capital Asset Pricing

10.1 An Optimization Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 11 General Random Variables 123

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 Semi-Continuous Models 131

12.1 Discrete-time Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

4 12.2 The Stock Price Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132 12.3 Remainder of the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 12.4 Risk-Neutral Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 12.5 Risk-Neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 12.6 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 12.7 Stalking the Risk-Neutral 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 Finite-Dimensional 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 Itˆ 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 Itˆ Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 o 14.6 Itˆ integral of an elementary integrand . . . . . . . . . . . . . . . . . . . . . . . . 158 o 14.7 Properties of the Itˆ integral of an elementary process . . . . . . . . . . . . . . . . 159 o 14.8 Itˆ integral of a general integrand . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 o

5 14.9 Properties of the (general) Itˆ integral . . . . . . . . . . . . . . . . . . . . . . . . 163 o 14.10Quadratic variation of an Itˆ integral . . . . . . . . . . . . . . . . . . . . . . . . . 165 o 15 Itˆ ’s Formula o 167

15.1 Itˆ ’s formula for one Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . 167 o 15.2 Derivation of Itˆ ’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 Black-Scholes formula . . . . . . . . . . . . . . . . . . . . 170 15.7 Mean and variance of the Cox-Ingersoll-Ross process . . . . . . . . . . . . . . . . 172 15.8 Multidimensional Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . 173 15.9 Cross-variations of Brownian motions . . . . . . . . . . . . . . . . . . . . . . . . 174 15.10Multi-dimensional Itˆ 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 Black-Scholes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 16.7 Black-Scholes with price-dependent volatility . . . . . . . . . . . . . . . . . . . . 186 17 Girsanov’s theorem and the risk-neutral measure 17.1 Conditional expectations under

f IP

189

. . . . . . . . . . . . . . . . . . . . . . . . . . 191

17.2 Risk-neutral measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 18 Martingale Representation Theorem 197

18.1 Martingale Representation Theorem . . . . . . . . . . . . . . . . . . . . . . . . . 197 18.2 A hedging application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 18.3 18.4

d-dimensional Girsanov Theorem . . . . . . . . . . . d-dimensional Martingale Representation Theorem . .

. . . . . . . . . . . . . . . 199 . . . . . . . . . . . . . . . 200

18.5 Multi-dimensional market model . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

6 19 A two-dimensional market model 19.1 Hedging when ;1 < 19.2 Hedging when 203 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

=1

<1 .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 209

20 Pricing Exotic Options

20.1 Reﬂection 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 Feynman-Kac 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 Risk-neutral pricing and hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 22.4 Implementation of risk-neutral 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: ﬁrst method . . . . . . . . . . . . . . . . 247 25.3 Drift adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249 25.4 Drift-adjusted Laplace transform . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 25.5 First passage times: Second method . . . . . . . . . . . . . . . . . . . . . . . . . 251

. . . . . . . . . . . . . . . . . . . . . .7 25. . . . . . . . . . . . . . . . . . . . . .12American contingent claim with expiration . . . . . . . . . . . . . . . . .9 Perpetual American contingent claim . . . .4 Cash ﬂow from a future contract . . . . . . . . . . . . 270 27. 281 29 Gaussian processes 285 29. . .1 American option with convex payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266 267 27 Bonds. . . . . . . . .1 Forward contracts . . . . . . . . 256 25. . . . . . . . .8 Hedging the put . . . . . . . . . . . .1 An example: Brownian Motion .6 Computing arbitrage-free bond prices: Heath-Jarrow-Morton method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263 26. . . . . . . . . . . . . . . . . . . . . . .2 Dividend paying stock . . . . . . . . . . . . . . . 257 25. . . . . . 278 28. . . . 259 25. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Implementation of the Heath-Jarrow-Morton model . . . . . . . . . 261 26 Options on dividend-paying stocks 263 26. . . . . . . . . . .5 Recovering the interest r(t) from the forward rate . .6 Backwardation and contango . . .3 Future contracts . . . 279 28. . . . . . . . . . . . . . forward contracts and futures 27. . . . . . . . . . . . .6 Perpetual American put . . . . . . . 273 28 Term-structure models 275 28. . . 252 25. . . . . . . . . . . . . 280 28. . . . . . . . . . 272 27. . 259 25. . . . . .3 Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Forward-future spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286 30 Hull and White model 293 . . . . . 272 27. . . . . . . . . 260 25. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 27. . . . . . . . . . . . . . . . . . . . . . . . 276 28. . . . . . . . . . .3 Hedging at time t1 . . . . . . . . . .7 Value of the perpetual American put . . . . . . . . . . . . . . . . . 276 28. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Computing arbitrage-free bond prices: ﬁrst method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Perpetual American call . . . . . . . . . . . . . . . . . . .2 Hedging a forward contract . . . . . . . . . . . . . . . . . . . . . 277 28. .11Put with expiration . . . . . . . . . . . . . 264 26. . . . . . . . . .7 Checking for absence of arbitrage . .4 Forward rate agreement . . . . . . . . . .2 Some interest-rate dependent assets . . . . . . . . . . . 269 27. . . . . 277 28. . . . .

. . .5 Option on a bond . . . . . . . . . . . . . . . . . . . . .6 Implementation of BGM . .3 Calibration . . . . . . . . . . . . . . 327 e 33. . . . . . . . . . . . . . . . . .8 Tracking down '0(0) in the time change of the CIR model . . . . . . . . . . . . .5 The dynamics of L(t ) . . . . . . . . 328 e 33. . 321 32. . . .1 Bond price as num´ raire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 34. 299 31 Cox-Ingersoll-Ross model 303 31.1 Equilibrium distribution of r(t) . . . . . . . . . . . . . . . . . . . . . . . . . 297 30. . . . . . . . . .3 Merton option pricing formula . . 313 31. . . . . . .3 Cox-Ingersoll-Ross equilibrium density . . . . . . . . . . . . . . . . . 295 30. . 320 32. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309 31. . . . . . . .1 Fiddling with the formulas . . . . . . . . . . .2 Brace-Gatarek-Musiela model . . . . . . . . . . . . . . . . . .3 Calibration of the Hull & White model . . . . . . . . . . . . . . . .8 30. 335 34. . . . . . . . . . . . . . . .7 Bond prices . . . . . . . . . . . .6 Deterministic time change of CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 LIBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343 . . . . . . . . . . . . . . . . . . . . . . .4 Bond prices in the CIR model . .1 Non-negativity of Y . . . . . . . . . . . . 338 34. . . . . . . . . . . . . . .2 Kolmogorov forward equation . . . . . . . . . . . . 313 31. . . . . . . . . .7 Calibration . . . . . . . . . . . 336 34. . . . . . . . . . . . . . . . . . . . . . . .2 Dynamics of the bond price . . . . . . . . . . . . . . . . . . 338 34. . . . 337 34.1 Review of HJM under risk-neutral IP . . . . . . . . . . . . . . . . . . . . . . . 306 31. . . . . . . . . . . . . . . . 315 31. . . . . . . . . . . . . . . . 310 31. . . . . .4 Option on a bond . . . . . . 323 33 Change of num´ raire e 325 33. . . . . . . . . . . . . . 329 34 Brace-Gatarek-Musiela model 335 34. . . . . . . . . . . . . . . . . . . . 316 32 A two-factor model (Dufﬁe & Kan) 319 32. 342 34. . . . . . . . . . 306 31. . . . . . .2 Zero-coupon bond prices . . . . . . .2 Stock price as num´ raire . . . . . 296 30. . . . . . . .4 Forward LIBOR . . . . . . . . . . . . . . . . . . . . . . . .8 Forward LIBOR under more forward measure . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .13Foreign exchange models. . . . . . . . . . . . . . . . . . . . . . . .9 Pricing an interest rate caplet . . . . . . . . . . 349 35. . . . . . . . . . . . . . . . .6 Markov processes. . . . . . . . . . . . . . . . . 346 34. . . .4 Stochastic integrals. . . . . . . . . . . . . . . . . . . . . . . . . 345 34. . . . . . . . . . . .11Term structure models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 35. . . . . . . . . . . . . 350 35. . . .2 Binomial asset pricing model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . and risk-neutral measures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . the martingale representation theorem. . . . . . . . 346 35 Notes and References 349 35. . . . . . .9 34.10Pricing an interest rate cap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Girsanov’s theorem. 350 35. .13Pricing a swap . . . . . . . . . . . . . . . 353 e 35. . . . . . . . . . 352 35. . . . . . 353 35. . . 354 . . . . . . . . . . . 350 35. . . . .12Long rates . . . . . . . . . . . . . . . . . .5 Stochastic calculus and ﬁnancial markets. . . . . . . . . . . . . . . . . . . . . . . . . . 353 35. . . . . . . . . . . . . .3 Brownian motion. . . . . . . . . . .8 Exotic options. . . . . . . .12Change of num´ raire.10Forward and futures contracts. . .1 Probability theory and martingales. . . . . . . 349 35. . . .9 American options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343 34. . . . . . . . . . . . . . . . . . 352 35. .351 35. . . . . . . . . . . . . .11Calibration of BGM . . . . . . . . . . . . . . . . . .14REFERENCES . . . . . . . . . . . . . . . . . . . . . . 351 35. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 34. . .

10 .

First of all. In this course. within the binomial model we can develop the theory of conditional expectations and martingales which lies at the heart of continuous-time models. and this will be the case in many of our examples. strictly speaking. We denote the price at time 1 by S1 (H ) = uS0 if the toss results in head (H). for what we are about to do we need to assume only (1.Chapter 1 Introduction to Probability Theory 1. We consider this simple model for three reasons. There are two positive numbers. and change of the stock price from S0 to uS0 represents an upward movement. assuming that at each step. and when we get a “Head.1) such that at the next period. we model stock prices in discrete time. It is 1 common to also have d = u .” the stock price moves up. Secondly. the model is used in practice because with a sufﬁcient number of steps. within this model the concept of arbitrage pricing and its relation to risk-neutral pricing is clearly illuminated. In the binomial asset pricing model. computationally tractable approximation to continuous-time models. However.1 The Binomial Asset Pricing Model The binomial asset pricing model provides a powerful tool to understand arbitrage pricing theory and probability theory. Let us imagine that we are tossing a coin. so change of the stock price from S0 to dS0 represents a downward movement. we shall use it for both these purposes. Of course. Thirdly. but when we get a “Tail. Typically. d and u.2) below.1) and (1. the stock price will be either dS 0 or uS0. Let us begin with an initial positive stock price S0. stock price movements are much more complicated than indicated by the binomial asset pricing model. we develop notation for the binomial model which is a bit different from that normally found in practice. we take d and u to satisfy 0 < d < 1 < u. it provides a good. With this third motivation in mind. and by S 1 (T ) = dS0 if it 11 . the stock price will change to one of two possible values.” the price moves down. with 0<d<u (1.

For example. The stock price Sk at time k depends on the coin tosses. For the moment.1: Binomial tree of stock prices with S 0 results in tail (T).1 Set S0 = 4. Sometimes we will use notation such S 2(!1 !2) just to record more explicitly how S 2 depends on ! = (!1 !2 !3 ). To complete our binomial asset pricing model. We take r to be the interest . although not all of them result in different stock prices at time 3. each sample point ! is a sequence of length three. The set of all possible outcomes of a random experiment is called the sample space for the experiment. Each sample point ! = (! 1 !2 !3) represents a path through the tree. when ! = HTH . S 1 depends on only the ﬁrst component of ! . !2 = T and !3 = H . for while S 3 depends on all of ! . Thus. u = 2 and d = 2 . and the elements ! of are called sample points.12 S2 (HH) = 16 S (H) = 8 1 S2 (HT) = 4 S =4 0 S1 (T) = 2 S2 (TH) = 4 S2 (TT) = 1 Figure 1.1. We denote the k-th component of ! by !k . u = 1=d = 2. S2 (HH ) = uS1(H ) = u2 S0 S2(HT ) = dS1(H ) = duS0 S2 (TH ) = uS1(T ) = udS0 S2(TT ) = dS1(T ) = d2S0: After three tosses. 1 Example 1. S2 depends on only the ﬁrst two components of ! . and S0 does not depend on ! at all. 1. we often write S k (! ). In this case. 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 emphasize this. After the second toss. the price will be one of: = 4. let us assume that the third toss is the last one and denote by = fHHH HHT HTH HTT THH THT TTH TTT g the set of all possible outcomes of the three tosses. we have !1 = H . we introduce a money market with interest rate r. there are eight possible coin sequences. $1 invested in the money market becomes $(1 + r) in the next period. this notation does not quite tell the whole story. We have then the binomial “tree” of possible stock prices shown in Fig. Actually.

Of course. and then borrow if necessary at interest rate r to complete the purchase. This option confers the right to buy the stock at time 1 for K dollars. V 1(! ) actually depends only on ! 1 . If the stock goes up. 0 S0) and you need to have V1(T ). you want to choose V 0 and 0 so that (1. you don’t yet know which value ! 1 will take. the stock does not really go “down” if we get a tail. One should borrow money at interest rate r and invest in the stock.2) The model would not make sense if we did not have this condition.3) V1(H ) = 0S1 (H ) + (1 + r)(V0 . 0S0 dollars invested in the money market. At the time you sell the option. you invest the residual money at interest rate r. K at time 1 if S1 . You can use the proceeds V0 of the sale of the option for this purpose. an agent is either borrowing or lending (not both) and knows in advance which she will be doing. You hedge your short position in the option by buying 0 shares of stock. You will also own 0 shares of stock. it just goes up less than if we had gotten a head. K )+ if !1 = T . except maybe once upon a time in Switzerland) or d 1. in such an application. where this quantity might be negative. the value of your portfolio (excluding the short position in the option) is With the stock as the underlying asset. and so is worth S 1 . K )+ = maxfS1(!) . (This is not as ridiculous as it ﬁrst seems. because in a many applications of the model. the stock price rises at least as fast as the debt used to buy it. you want to choose V 0 and 0 to also have (1. We denote by V1(!) = (S1(! ) . You now have an obligation to pay off (uS 0 . In either case.CHAPTER 1. In the latter case. she should take r to be the rate of interest for her activity. Introduction to Probability Theory 13 rate for both borrowing and lending. For example. Our ﬁrst task is to compute the arbitrage price of this option at time zero. 0S0 ): . If V0 is more than necessary to buy the 0 shares of stock. K )+ if !1 = H and to pay off (dS0 . the value of your portfolio is 0 S1 (T ) + (1 + r)(V0 . where 0 is still to be determined. where V0 is still to be determined. Suppose at time zero you sell the call for V0 dollars. if 1 + r u. let us consider a European call option with strike price 0 S1(H ) + (1 + r)(V0 . you will have V 0 .) We assume that d < 1 + r < u: (1. 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. Thus. The inequality d 1 + r cannot happen unless either r is negative (which never happens. Thus.4) V 1 (T ) = 0S1 (T ) + (1 + r)(V0 . K is positive and is otherwise worth zero. and we can and do sometimes write V1 (!1) rather than V1(! ). K 0g the value (payoff) of this option at expiration. 0 S0): If the stock goes down. 0 S0 ) and you need to have V1(H ). since even in the worst case. K > 0 and expiration time 1. and no one would invest in the stock.

4).2). 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. K )+ .14 These are two equations in two unknowns. V1(T ) = so that 0 (S1(H ) .7) as (1. They are the risk-neutral probabilites. (1 + r) V1 (T ) : u d u. and have nothing to do with the actual probabilities of getting H or T on the coin tosses. We now consider a European call which pays off K dollars at time 2. p ~ ~ u.9).3) and (1. this leads to the formula 1 r V0 = 1 + r 1 + . S1(T ) : (1. ~ ~ Because of (1.6) into either (1. we substitute (1. At expiration. d ~ u d so that (1. both p and q are in the interval (0 1). the denominator in (1.. To complete the solution of (1. that my deﬁnition of 0 is the number of shares of stock one holds at time zero.7) To simplify this r p = 1 + .8) 1 ~ V0 = 1 + r pV1(H ) + qV1(T )]: ~ (1.6) This is a discrete-time version of the famous “delta-hedging” formula for derivative securities. She then buys 0 shares .9) Because we have taken d < u. 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. They appeared when we solved the two equations (1. This formula is so pervasive the when a practitioner says “delta”.d This is the arbitrage price for the European call option with payoff V 1 at time 1.4) and solve for V0 . formula. Depending on how uncertainty enters the model. S1 (T )) (1. respectively. she means the derivative (in the sense of calculus) just described. V1(T ) S1(H ) .6) is a consequence of this deﬁnition. and we solve them below Subtracting (1. both p and q are deﬁned. and (1. where V2 and S2 depend on !1 and !2 . the ﬁrst and second coin tosses. After some simpliﬁcation. In fact.e.i. however.3) or (1.7) becomes q = u . we obtain V1 (H ) .d (1. they are nothing more than a convenient tool for writing (1.5) 0= V1(H ) . . Suppose an agent sells the option at time zero for V0 dollars.8) is not zero. we deﬁne (1. Note. (1 + r) = 1 .4) from (1. at this point. not the deﬁnition of 0 itself.4). and because they sum to 1. we can regard ~ ~ them as probabilities of H and T . We want to determine the arbitrage price for this option at time zero..3).3) and (1. where V0 is still to be determined. d V1(H ) + u . the payoff of this option is V 2 = (S2 .

there are really two equations implicit in (1. investing V 0 . where 1 is allowed to depend on ! 1 because the agent knows what value !1 has taken.CHAPTER 1.10) Although we do not indicate it in the notation. Introduction to Probability Theory 15 of stock. and X1 (T ). the outcome of the ﬁrst coin toss.13) . X1 . Considering all four possible outcomes. 1S1 in the money market. V2(TT ) S2(TH ) . 0 S0) 0S1 (T ) + (1 + r)(V0 . 1(H ) and 1 (T ). At time 1. 1 S1): (1. the outcomes of the ﬁrst two coin tosses.10): X1(H ) = X1(T ) = 0S1 (H ) + (1 + r)(V0 . Thus. her wealth will be given by the right-hand side of the following equation. 0 S0 ): After the ﬁrst coin toss.12) Subtracting one of these from the other and solving for mula” 1(T ) = V2 (TH ) . V2(TH ) = V2(TT ) = 1 (T )S2(TH ) + (1 + r)(X1(T ) . 0 S0): (1. 1 (T ). S2(TT ) and substituting this into either equation. S 1 and therefore X1 depend on !1 . and she wants it to be V 2. we can solve for 1 ~ X1 (T ) = 1 + r pV2(TH ) + qV2 (TT )]: ~ (1. Suppose she decides to now hold 1 shares of stock. 1 (T )S1(T )): 1(T ). 0 . we can write (1. we obtain the “delta-hedging for(1. S 2 and V2 depend on !1 and !2 . the agent has X 1 dollars and can readjust her hedge. In the next period. She invests the remainder of her wealth.11) Although we do not indicate it in the notation. we begin with the last two We now have six equations. the agent has a portfolio (excluding the short position in the option) valued at X1 = 0 S1 + (1 + r)(V0 . 1(H ). the two represented by (1.10) and the four represented by (1. 0S0 dollars in the money market to ﬁnance this. 1(H )S1(H )) 1(T )S2(TH ) + (1 + r)(X1(T ) .11) as four equations: V2(HH ) V2 (HT ) V2 (TH ) V2(TT ) = = = = 1(H )S2(HH ) + (1 + r)(X1(H ) . in the six unknowns V 0 . X1 (H ). and thereby determine the arbitrage price V 0 at time zero of the option and the hedging portfolio 0 . 1(T )S1(T )) 1 (T )S2(TT ) + (1 + r)(X1(T ) . she wants to have V2 = 1 S2 + (1 + r)(X1 .11). Therefore. 1 (T )S1(T )): To solve these equations. 1(T )S1(T )) 1(T )S2(TT ) + (1 + r)(X1(T ) . 1 (H )S1(H )) 1(H )S2(HT ) + (1 + r)(X1(H ) .

The solution of these equations for 0 and V0 is the same as the solution of (1. where V1(H ) is the value of the option at time 1 if ! 1 = H .9).16) 1 ~ V1(H ) = 1 + r pV2(HH ) + qV2(HT )]: ~ This is again analgous to formula (1. after the ﬁrst k . is given by k 1 (!1 . The ﬁrst two equations implicit in (1.17) H ) . 1.16 Equation (1. but postponed by one step. regardless of the number of periods. fHHH HHT HTH HTT g. gives the value the hedging portfolio should have at time 1 if the stock goes down between times 0 and 1.11) lead in a similar way to the formulas 1 (H ) = V2(HH ) . Some sets in F are . then at time k . The pattern emerging here persists. .14) The hedger should choose her portfolio so that her wealth X 1 (T ) if !1 = T agrees with V1(T ) deﬁned by (1. . V : : : !k 1 ) = Sk (!1 :: :: :: !k !k k (!1 . and itself.15) and X1(H ) = V1(H ).9). and this depends on the ﬁrst k coin tosses ! 1 : : : !k . 1 H ) + q Vk (!1 : : : !k ~ . fTTT g. the portfolio to hedge a short position should hold k. where H ) .1) shares of stock.9). .14).4). .18) 1. If Vk denotes the value at time k of a derivative security. 1 tosses !1 : : : !k. Sk (!1 : : : !k 1 T ) and the value at time k . Finally. 1 of the derivative security. We have just shown that 1 ~ V1(T ) = 1 + r pV2 (TH ) + qV2(TT )]: ~ (1. and we denote it by V1(T ).13). We deﬁne this quantity to be the arbitrage value of the option at time 1 if !1 = T . 1 T )] (1. An example to keep in mind is = fHHH HHT HTH HTT THH THT TTH TTT g (2. This formula is analgous to formula (1. Vk (!1 : : : !k 1 T ) (1.1 (!1 : : : !k.10). S2(HT ) (1. . How many sets are there in F ? . . 1 coin tosses result in the outcomes !1 : : : !k 1 . Let F be the set of all subsets of . when the ﬁrst k . 1 ~ Vk 1 (!1 : : : !k 1) = 1 + r pVk (!1 : : : !k .1 are known. and results again in (1. 1 1 . deﬁned by (1. V2(HT ) S2(HH ) .3) and (1. we plug the values X 1(H ) = V1(H ) and X1(T ) = V1(T ) into the two equations implicit in (1.2 Finite Probability Spaces Let be a set with ﬁnitely many elements. postponed by one step.6) and (1.1) of all possible outcomes of three coin tosses.

deﬁne IP fHHH g = IP fHTH g = IP fTHH g = IP fTTH g = For A 2 F . For the individual elements of 3 3 in (2. We think of IP (A) as this probability. 3 As in the above example.2) 3 IP fHHH HHT HTH HTT g = 1 + 2 1 3 3 2 + 1 3 3 2 3 2 =1 3 which is another way of saying that the probability of H on the ﬁrst toss is 1 .2) (see Problem 1.1). Let A be a subset of F . we deﬁne 1 3 1 3 1 3 1 3 3 2 2 3 2 1 3 2 2 3 IP fHHT g = IP fHTT g = IP fTHT g = IP fTTT g = 1 2 2 3 3 1 2 2 3 3 1 2 2 3 3 2 3: 3 IP (A) = For example. and then used Deﬁnition 1. between 0 and 1.1 A probability measure properties: (i) 17 IP is a function mapping F into 0 1] with the following IP ( ) = 1. Imagine that is the set of all possible outcomes of some random experiment.CHAPTER 1. the outcome will lie in the set A. . Deﬁnition 1. There is a certain probability. that when that experiment is performed. Example 1.2 Let be a nonempty set.4(ii)) to determine IP for all the other sets in F .1 to determine IP (A) for the remaining sets A 2 F . X ! A 2 IP f!g: 2 (2. (ii) If A1 A2 : : : is a sequence of disjoint sets in F . it is generally the case that we specify a probability measure on only some of the subsets of and then use property (ii) of Deﬁnition 1. we speciﬁed the probability measure only for the sets containing a single element.2 Suppose a coin has probability 1 for H and 2 for T . In the above example.1(ii) in the form (2. then IP 1 k=1 Ak = ! X 1 k=1 IP (Ak ): Probability measures have the following interpretation. A -algebra is a collection following three properties: (i) G of subsets of with the 2 G. Introduction to Probability Theory Deﬁnition 1.

Suppose the coin is tossed three times. for every set in F 1 whether or not the outcome is in that set. In effect. you might be told that the outcome is not in A H but is in A T . k=1 Ak is also in G . Similarly. For example. you would be told that the outcome is not in and is in . then its complement Ac (iii) If A1 A2 A3 : : : is a sequence of sets in G . F 2 contains the “information of . you have been told that the ﬁrst toss was a T . 1 Here are some important -algebras of subsets of the set F0 = F1 = F2 = ( ( ) in Example 1. and nothing more. which is usually called the “information up to time 1”.18 (ii) If A 2 G . The -algebra F1 is said to contain the “information of the ﬁrst toss”. and you are not told the outcome. but you are told. let us deﬁne AH = fHHH HHT HTH HTT g = fH on the ﬁrst tossg AT = fTHH THT TTH TTT g = fT on the ﬁrst tossg so that and let us deﬁne F1 = f AH AT g AHH = fHHH HHT g = fHH on the ﬁrst two tossesg AHT = fHTH HTT g = fHT on the ﬁrst two tossesg ATH = fTHH THT g = fTH on the ﬁrst two tossesg ATT = fTTH TTT g = fTT on the ﬁrst two tossesg so that F2 = f AHH AHT ATH ATT AH AT AHH ATH AHH ATT AHT ATH AHT ATT Ac Ac Ac Ac g: HH HT TH TT We interpret -algebras as a record of information. Moreover.2: ( ) fHHH HHT HTH HTT g fTHH THT TTH TTT g fHHH HHT g fHTH HTT g fTHH THT g fTTH TTT g ) and all sets which can be built by taking unions of these F3 = F = The set of all subsets of : To simplify notation a bit. then 2 G.

CHAPTER 1.3 Let be a nonempty ﬁnite set. and thus technically a random variable. for each set in (S 2).1. For example. Knowing whether the outcome ! of the three tosses is in (it is not) and whether it is in (it is) tells you nothing about ! Deﬁnition 1. and is not in A TT . it is a function mapping into IR. In particular. Then you know that in the ﬁrst two tosses. A Example 1. the random variable S2 of Example 1. albeit a degenerate one. where S0 = 4. and we can look at the preimage under the random variable of sets in IR. A ﬁltration is a sequence of -algebras F 0 F1 F2 : : : such that each -algebra in the sequence contains all the sets contained by the previous -algebra. The preimage under S2 of this interval is deﬁned to be we can get as preimages of sets in IR is: f! 2 S2(!) 2 4 27]g = f! 2 4 S2 27g = Ac : TT The complete list of subsets of AHH AHT ATH ATT and sets which can be built by taking unions of these. 2 S2 (HHT ) = u2 S0 = 16. S1. but you cannot make this distinction from knowing the value of S2 alone.” The -algebra F 3 = F contains “full information” about the outcome of all three tosses.” which is the “information up to time 2. suppose the coin is tossed three times and you do not know the outcome ! . Fn F be the -algebra of all subsets of . and even more. Introduction to Probability Theory 19 the ﬁrst two tosses. there was a head and a tail. S2 and S3 are all random variables.1. You might be told. The so-called “trivial” -algebra F 0 contains no information. but someone is willing to tell you. and you know nothing more. Then S0. . and is denoted by (S2). This collection of sets is a -algebra. for example. We have S2(HHH ) = S2(HHT ) = 16 S2(HTH ) = S2(HTT ) = S2(THH ) = S2 (THT ) = 4 S2(TTH ) = S2(TTT ) = 1: Let us consider the interval 4 27]. whether ! is in the set. called the -algebra generated by the random variable S 2. if you see the ﬁrst two tosses. This means that the information in the ﬁrst two tosses is greater than the information in S 2 . Consider. Deﬁnition 1. The information content of this -algebra is exactly the information learned by observing S 2 . Nonetheless. is in AHT ATH .3 Let be given by (2. you can distinguish A HT from ATH . Note that F2 deﬁned earlier contains all the sets which are in (S 2).4 Let be a nonempty ﬁnite set and let random variable is a function mapping into IR. More speciﬁcally. A random variable maps into IR. for example. that ! is not in AHH . The “random variable” S0 is really not random. since S0(!) = 4 for all ! 2 .1) and consider the binomial asset pricing Example 1. This information is the same you would have gotten by being told that the value of S 2(! ) is 4. u = 2 and d = 1 .

We say that X is G -measurable if every set in (X ) is also in G . we mean any of the several ways of characterizing Important Note. A common way to record this 9 3 9 information is to give the cumulative distribution function F S2 (x) of S2 . or tell what the cumulative distribution function is. we can either tell where the masses are and how X .-algebra of F . Note: We normally write simply fX 2 Ag rather than f! 2 X (!) 2 Ag. nothing more. let F be the -algebra of all subsets of . and let X be a random variable on .6 Let be a nonempty. Let G be a sub. as in the case of S2 above. If X is discrete. Given any set A IR. and a mass of size 2 2 = 4 at the number 1. the induced measure of a set A tells us the probability that X takes a value in A. Deﬁnition 1. ﬁnite set.20 Deﬁnition 1.5 Let be a nonemtpy ﬁnite set and let F be the -algebra of all subsets of . in the discussion above. In the case of S2 above with the probability measure of Example 1. S 2 (TTH ) = S2(TTT ) = 1. regardless of whether the probability for H is 1 or 1 . we set up the deﬁnitions to make a clear distinction between random variables and their distributions. It has an existence quite apart from discussion of probabilities. 3 2 .2. the induced measure of S2 places a mass of size 1 3 FS2 (x) = IP (S2 By the distribution of a random variable 8 >0 >4 <9 x) = > 8 >1 :9 if x < 1 if 1 x < 4 if 4 x < 16 if 16 x: (2. In order to work through the concept of a risk-neutral measure. The -algebra (X ) generated by X is deﬁned to be the collection of all sets of the form f! 2 X (! ) 2 Ag. A random variable is a mapping from to IR.) LX . Let X be a random variable on ( F ).3) large they are. in which case the induced measure of a set A IR is the integral of the density over the set A. where A is a subset of IR. deﬁned by 2 In fact. some sets in IR and their induced measures are: LS2 ( ) = IP ( ) = 0 LS2 (IR) = IP ( ) = 1 LS2 0 1) = IP ( ) = 1 2 LS2 0 3] = IP fS2 = 1g = IP (ATT ) = 2 : 3 1 = 9 at the number 16. (Later we will consider random variables X which have densities. let IP be a probabilty measure on ( F ). For example. a mass of size 4 at the number 4. we deﬁne the induced measure of A to be LX (A) = IP fX 2 Ag: In other words.

If we set the probability 3 9 of H to be 1 . let IP be a probabilty measure on ( F ).e. which takes the value 2 if ! = HHH or ! = HHT . and takes the value 0 in every other case. and then rewrite (2. the payoff of the put is 2 with probability 1 and 0 with probability 3 . ﬁnite set.4) is deﬁned to be a sum over the sample space . Suppose in the binomial model of Example 1. which we label x 1 : : : xn . let F be the -algebra of all subsets of .CHAPTER 1.1. 14)+. and a “risk-neutral” distribution). the probability of H and the probability of T is 1 . The distribution of S 2 has changed. and let X be a random variable on . Like the payoff of the call. The payoff of the put at time 2 is (3 . We can partition the subsets fX 1 = x1 g : : : fXn = xn g.7 Let be a nonempty. i. Consider a 2 European call with strike price 14 expiring at time 2.4) as IEX = = = = = X 2 ! n X X (!)IP f!g X 2f g k=1 ! Xk =xk n X X xk IP f!g k=1 ! Xk =xk n X xk IP fXk = xk g k=1 n X xk LX fxk g: k=1 2f g X (!)IP f! g . but 2 4 the random variable has not. The payoff of the call at time 2 is the random variable (S2 . two different random variables can have the same distribution. In a similar vein. The probability the payoff is 2 is 1 .. and the probability it is zero is 3 . a way of assigning probabilities to sets in IR. S 2)+ . then LS2 assigns mass 1 to the number 16. Since ﬁnite set. It is still deﬁned by S2(HHH ) = S2(HHT ) = 16 S2(HTH ) = S2(HTT ) = S2(THH ) = S2 (THT ) = 4 S2(TTH ) = S2(TTT ) = 1: Thus. Deﬁnition 1. The payoffs of the call and the put are different 4 4 random variables having the same distribution. Consider also 4 4 a European put with strike price 3 expiring at time 2. which takes the value 2 if ! = TTH or ! = TTT . X can take only ﬁnitely many values. It depends on the random variable X and the probability measure IP we use in . Introduction to Probability Theory 21 The distribution of a random variable is a measure L X on IR. a random variable can have more than one distribution (a “market” or “objective” distribution. If we set the probability of H to be 1 . then LS2 assigns mass 1 to the number 16.4) is a into Notice that the expected value in (2. The expected value of X is deﬁned to be IEX = X 2 ! X (!)IP f!g: (2.

unlike the Riemann integral. This section concerns the Lebesgue integral on the space IR only. if X takes the values Var(X ) = n X k=1 (xk . IEX )2IP f! g: (2.. it can be deﬁned on abstract spaces. IEX )2. IEX )2LX (xk ): 1. let F be the -algebra of all subsets of . a generalization of the Riemann integral. which is uncountably inﬁnite. is the collection of Borel sets deﬁned below. We use Lebesgue measure to construct the Lebesgue integral. Indeed.3 Lebesgue Measure and the Lebesgue Integral In this section. This deﬁnition and the properties of measure determine the Lebesgue measure of many.8 Let be a nonempty. The collection of subsets of IR we consider. To make the above set of equations absolutely clear. although the expected value is deﬁned as a sum over the sample space . i. let IP be a probabilty measure on ( F ). but not all. . The deﬁnition of IES2 is IES2 = S2 (HHH )IP fHHH g + S2(HHT )IP fHHT g +S2 (HTH )IP fHTH g + S2(HTT )IP fHTT g +S2 (THH )IP fTHH g + S2(THT )IP fTHT g +S2 (TTH )IP fTTH g + S2 (TTT )IP fTTT g = 16 IP (AHH ) + 4 IP (AHT ATH ) + 1 IP (ATT ) = 16 IP fS2 = 16g + 4 IP fS2 = 4g + 1 IP fS2 = 1g = 16 LS2 f16g + 4 LS2 f4g + 1 LS2 f1g = 16 1 + 4 4 + 4 4 9 9 9 48 : = 9 Deﬁnition 1. we can also write it as a sum over IR.22 Thus. we can rewrite (2. we consider S 2 with the distribution given by (2. the generalization to other spaces will be given later. then One again. IEX )2IP fX = xk g = n X k=1 (xk . Var(X ) = X 2 ! (X (! ) .5) x1 : : : xn. subsets of IR. and for which Lebesgue measure is deﬁned. we consider the set of real numbers IR. such as the space of inﬁnite sequences of coin tosses or the space of paths of Brownian motion.3). We need this integral because.5) as a sum over IR rather than over . and let X be a random variable on . The variance of X is deﬁned to be the expected value of (X . ﬁnite set. We deﬁne the Lebesgue measure of intervals in IR to be their length.e.

Every set which can be written down and just about every set imaginable is in B(IR). denoted B(IR). for every real number a.CHAPTER 1. The sets in B(IR) are called Borel sets. so B(IR) contains a b] = (. n This means that every set containing ﬁnitely many real numbers is Borel.3. n a): (. For example. if a is a real number. Since B(IR) is a -algebra. By deﬁnition.1 a) = For real numbers a and b. then fag = \ 1 n=1 1 1 a. every open interval (a b) is in B(IR).9 The Borel -algebra.1 b] \ (a 1): Every set which contains only one real number is Borel. since they can be written as intersections of open half-lines and closed half-lines. is the smallest -algebra containing all open intervals in IR. the open half-line (a 1) = is a Borel set. In addition. every union of open intervals is also in B(IR). For example. where a and b are real numbers. the union n=1 (. the closed half-lines c a 1) = and 1 n=1 1 a a + n] a . (a b] = (. Since B(IR) is a -algebra.1 a) (b 1) : This shows that every closed interval is Borel. n a+ n : = fa 1 a2 : : : an g. Introduction to Probability Theory 23 Deﬁnition 1.1 a) (b 1) is Borel. every complement of a Borel set is Borel. if A then A= k=1 fak g: . n a] (. as is 1 n=1 1 (a a + n) (a . Indeed. The following discussion of this fact uses the -algebra properties developed in Problem 1.1 a] = n=1 are Borel. Half-open and half-closed intervals are also Borel.

Thus.” there are lots of points in this set.. From each of these pieces. Example 1. the points are all in C . as is its complement. remove the middle half. There are. the ﬁrst set removed. none of the endpoints of the pieces of the sets C 1 C2 : : : is ever removed.” Despite the fact that the Cantor set has no “length. This is a countably inﬁnite set of points. the set of irrational numbers. is 1 . The Cantor set k 15 16 1 : has four pieces. We have just seen that any non-Borel set must have uncountably many points. We use it later when we discuss the sample space for an inﬁnite sequence of coin tosses. Thus. the total length removed is k=1 X1 2k = 1 1 and so the Cantor set. however. the length of the 8 8 8 .4 (The Cantor set. every set containing countably inﬁnitely many numbers is Borel. Consider the unit interval 0 1].. and remove the middle half. has zero “length.e. remove the open set The remaining set length 41 . the second set removed. We shall see eventually that the Cantor set has uncountably many points. Continue this process. i. sets which are not Borel. and each piece has 1 C2 = 0 16 3 1 16 4 3 13 4 16 C= \ 1 k=1 Ck is deﬁned to be the set of points not removed at any stage of this nonterminating process. Note that the length of A 1 . and in general.24 In fact. remove the open interval 3 A1 = 1 4 : 4 The remaining set C1 = 0 1 4 1 3 A2 = 16 16 31 4 13 15 : 16 16 has two pieces. if A = fa 1 A= n a2 : : : g. 3 1 3 13 1 0 1 4 1 16 16 16 15 64 : : : 4 16 . the set C k has 2k pieces. The “length” of the next set removed is 4 32 = 1 .k k-th set removed is 2 . i.e. the set of points not removed.) This example gives a hint of how complicated a Borel set can be. so at stage k. 2 1 1 is 1 + 1 = 4 . The “length” of A2 . In particular. then k=1 fak g: This means that the set of rational numbers is Borel.

so 0 (\1 Ak ) = 0. In fact. one no longer has the equation (Ac ) = 1 .4 must be zero. Introduction to Probability Theory Deﬁnition 1. n a+ n 0 0 Letting n ! 1.10 Let B(IR) be the -algebra of Borel subsets of IR. Following Williams’s book. A measure has all the properties of a probability measure given in Problem 1.4(iii). (A) in Problem 1. because of the “length” computation given at the end of that example.4. The Lebesgue measure of a set containing only one point must be zero. k=1 We specify that the Lebesgue measure of each interval is its length. (ii) If A1 A2 : : : is a sequence of disjoint sets in B(IR).4 needs to be modiﬁed to say: (v) If A1 A2 : : : is a sequence of sets in B(IR) with A 1 A2 \ 1 k=1 To see that the additional requirment Ak = nlim (An ): !1 ! and (A1 ) < 1. except that the total measure of the space is not necessarily 1 (in fact. and property (v) in Problem 1. we obtain 0 fag 1 1 2 a . 0 (IR) = 1). we denote Lebesgue measure by 0 . and that determines the Lebesgue measure of all other Borel sets. since fag for every positive integer n. For example. then (A 1 ) < 1 is needed in (v). but limn!1 0 (An ) = 1. then 1 k=1 Ak = ! X 1 k=1 (Ak ): Lebesgue measure is deﬁned to be the measure on (IR B(IR)) which assigns the measure of each interval to be its length. the Lebesgue measure of the Cantor set in Example 1. consider A1 = 1 1) A2 = 2 1) A3 = 3 1) : : :: Then \1 Ak k=1 = . we must have 1 1 a.CHAPTER 1. n a + n = n: 0 fag = 0: . A measure on (IR function mapping B into 0 1] with the following properties: (i) 25 B(IR)) is a ( ) = 0.

Z IR f d 0 = sup Z IR hd 0 h is simple and h(x) f (x) for every x 2 IR : . In order to think about Lebesgue integrals.11 Let fx 2 IR f (x) 2 Ag is in B(IR) whenever A 2 B(IR).. Deﬁnition 3. We deﬁne the Lebesgue integral of g to be Z IR g d 0 = 0 (A): n X A simple function h from IR to IR is a linear combination of indicators. i. We deﬁne the Lebesgue integral of h to be 1 0 Z n X Z R k=1 IR gk d 0 = n X k=1 ck 0 (Ak ): We Let f be a nonnegative function deﬁned on deﬁne the Lebesgue integral of f to be IR.12 An indicator function g from and 1. Deﬁnition 1. possibly taking the value 1 at some points.4 is purely technical and has nothing to do with keeping track of information. In the language of Section 2. because there is no way to add up uncountably many numbers.e. and we shall pretend such functions don’t exist. we must ﬁrst consider the functions to be integrated. positive and ﬁnite. or inﬁnite. It is difﬁcult to conceive of a function which is not Borel-measurable. We say that f is Borel-measurable if the set IR to IR is a function which takes only the values 0 A = fx 2 IR g (x) = 1g the set indicated by g . Hencefore. The integral was invented to get around this problem. Deﬁnition 1.26 The Lebesgue measure of a set containing countably many points must also be zero. “function mapping IR to IR” will mean “Borel-measurable function mapping IR to IR” and “subset of IR” will mean “Borel subset of IR”. if A = fa1 a2 : : : g. We may not compute the Lebesgue measure of an uncountable set by adding up the Lebesgue measure of its individual members. We call f be a function from IR to IR. then 0 (A) = X 1 k=1 0 fak g = X 1 k=1 0 = 0: The Lebesgue measure of a set containing uncountably many points can be either zero. a function of the form h(x) = where each gk is of the form k=1 ck gk (x) if x 2 Ak if x 2 Ak = gk (x) = hd 0 = ck ( and each ck is a real number. we want the -algebra generated by f to be contained in B(IR). Indeed.

1 xn]. Being a countable I 0 1] is 1 To compute the Riemann integral 0 f (x)dx. as we show in the following examples. xk 1 ) = .CHAPTER 1. d 0 are ﬁnite R (or equivalently. ). then the Lebesgue integral a b] f d 0 agrees with the Riemann integral.5 Let Q be the set of rational numbers in 0 1]. 27 Finally.. We approximate the Riemann integral from above by the upper sum R 0 1] f d 0 = 0: n X k=1 n X k=1 f (qk )(xk . In each subinterval xk. where f (qk ) = 1. IR fd 0= Z IR f+ d 0. and we deﬁne the Lebesgue integral of f to be . let f be a function deﬁned on IR. xk 1 ) = . and consider f set. . possibly taking the value 1 at some points and the value . Introduction to Probability Theory It is possible that this integral is inﬁnite. and we also approximate it from below by the lower sum f (rk )(xk . R 0 R Z A where fd 0= Z I l A (x) = is the indicator function of A. Q has Lebesgue measure zero. 1. 0 (xk . The ﬁrst is that the Lebesgue integral is deﬁned for more functions. We deﬁne provided the right-hand side is not of the form 1 . and so the Lebesgue integral of f over Z = l Q .1 at other points. we say that f is integrable. since jf j = f + + f . xk 1 ) = 0: . ( IR I l Af d 0 1 0 if x 2 A if x 2 A = The Lebesgue integralRjust deﬁned is related to the Riemann integral in one very important way: if R b the Riemann integral a f (x)dx is deﬁned. we choose partition points 0 = x 0 < x1 < < xn = 1 and divide the interval 0 1] into subintervals x 0 x1] x1 x2] : : : xn. Z IR f d . Example 1. If it is ﬁnite. IR jf j d 0 < 1. and there is also an irrational point rk . If both IR f + d 0 and IR f . possibly taking the value 1 at some points and the value .f (x) 0g respectively. The Lebesgue integral has two important advantages over the Riemann integral. We deﬁne the positive and negative parts of f to be f + (x) = maxff (x) 0g f (x) = maxf. Z Let f be a function deﬁned on IR. n X k=1 n X k=1 1 (xk . where f (rk ) = 0.1 at other points. xk 1 ) = 1 . Let A be a subset of IR.1 xk ] there is a rational point q k . we say that f is integrable.

and when we compute the upper approximating sum for . R The Lebesgue integral has all linearity and comparison properties one would expect of an integral. and thus has Lebesgue integral Z IR h d 0 = y 0 f0 g = 0 : It follows that Z IR f d 0 = sup Z IR hd 0 h is simple and h(x) f (x) for every x 2 IR = 0: 1 Now consider the Riemann integral . the lower approximating sum is 0. one of these will contain Riemann integral . Every simple h(x) = for some y ( 0 y if x = 0 if x 6= 0 2 0 1). Since these two do not converge to a common value as the partition becomes ﬁner. we have IR cf d = c IR Z fd 0+ fd 0 Z IR gd 0 IR Z Finally. the upper sum is always 1 and the lower sum is always 0. for any two functions f and g and any real constant c. which for this function f is the same as the R 1 f (x) dx. In particular. On the other hand. if A and B are disjoint sets. then IR fd 0 Z IR gd d 0: Z A B fd 0= Z A fd 0+ Z B f d 0: .1 1] into subintervals.1 f (x) dx. the Riemann integral is not deﬁned. Z IR and whenever f (x) (f + g ) d Z 0 0 = Z g (x) for all x 2 IR.1 f (x) dx. When we partition .6 Consider the function f (x) = ( 0 1 if x = 0 if x 6= 0: This is not a simple function because simple function cannot take the value function which lies between 0 and f is of the form 1. Thus the upper approximating sum is 1. and again the Riemann integral does not exist. Example 1.28 No matter how ﬁne we take the partition of 0 1]. this point will contribute 1 times the length of the subinterval containing it.1 R1 the point 0.

each with mean 0 and the n-th having vari1 ance n : r 2 2 fn (x) = n e. 0 IR IR n 0 !1 Example 1. each with variance mean n: 1 . In each of these the situation is that there is a sequence of functions f n n = 1 2 : : : converging pointwise to a limiting function f .7 Consider a sequence of normal densities.8 Consider a sequence of normal densities. The function f is not the Dirac delta. then Fatou’s Lemma has the simpler conclusion R IR fd fd lim inf n !1 Z IR fn d 0 : Z IR 0 nlim Z !1 IR fn d 0: This is the case in Examples 1. Theorem 3. xn : 2 These converge pointwise to the function f (x) = ( We have again IR fn d 0 = 1 for every n. where nlim IR fn d 0 = 1 !1 Z . so limn!1 IR fn d 0 = 1. Introduction to Probability Theory 29 There are three convergence theorems satisﬁed by the Lebesgue integral.8. Example 1. Before we state the theorems. but IR f d 0 = 0.7 and 1. but R f d = 0.CHAPTER 1. Then R 0 1 if x = 0 if x 6= 0: R R n = 1 2 : : : be a sequence of nonnegative functions con0 Z If limn!1 IR fn d 0 is deﬁned. so lim n f (x) = 0 for every x 2 IR: R f d = 1. (x. the Lebesgue integral of this function was already seen in Example 1. Pointwise convergence just means that nlim fn (x) = f (x) for every x 2 IR: !1 There are no such theorems for the Riemann integral.6 to be zero.n)2 1 and the n-th having fn (x) = p e 2 2 : These converge pointwise to the function R We have IR fn d 0 = 1 for every n. because the Riemann integral of the limiting function f is too often not deﬁned.1 (Fatou’s Lemma) Let fn verging pointwise to a function f . we given two examples of pointwise convergence which arise in probability theory.

The sequence f IR gn d 0 g1 has two cluster points. We could modify either Example 1.8 Rby setting g n = fn if n is even.13 A probability space ( (i) (ii) (iii) F IP ) consists of three objects: .. but IR gn d 0 = 2 if n is odd. is n=1 R lim inf n!1 IR gn d 0 and the larger one.4 General Probability Spaces Deﬁnition 1.3 (Dominated Convergence Theorem) Let fn n = 1 2 : : : be a sequence of functions.7 or 1. a probability measure on ( F ). which may take either positive or negative values. which represents the probability that the outcome of the random experiment lies in the set A. is lim supn!1 IR gn d 0 . IR g d 0 < 1) such that Then jfn(x)j g(x) for every x 2 IR for every n: Z Z IR f d 0 = nlim !1 IR fn d 0 and both sides will be ﬁnite. Assume R that there is a nonnegative integrable function g (i. 1 and 2. 1.. Theorem 3. a function which assigns to each set A 2 F a number IP (A) 2 0 1]. The key assumption in Fatou’s Lemma is that all the functions take only nonnegative values. i. F.30 while IR f d 0 = 0. Now IR gn d 0 = 1 if n is even. called the sample space. Assume that 0 f1 (x) f2 (x) f3 (x) Then Z IR where both sides are allowed to be 1. 1. R By deﬁnition. Fatou’s Lemma guarantees that even the smaller cluster point will be greater than or equal to the integral of the limiting function.e. which contains all possible outcomes of some random experiment. converging pointwise to a function f . a -algebra of subsets of . a nonempty set.2 (Monotone Convergence Theorem) Let fn converging pointwise to a function f . R f but gn = 2R n if n is odd.e. Fatou’s Lemma does not assume much but it is is not very satisfying because it does not conclude that R Z IR f d 0 = nlim Z !1 IR fn d 0: n = 1 2 : : : be a sequence of functions for every x 2 IR: There are two sets of assumptions which permit this stronger conclusion. . IP . the smaller one. 2. f d 0 = nlim Z IR !1 fn d 0 Theorem 3.

then (d) (Continuity from above.) If A1 k=1 1 Ak = nlim IP (An ): !1 ! . a number between zero and one. then IP 1 k=1 Ak = ! X 1 k=1 IP (Ak ): (c) (Finite additivity) If n is a positive integer and A 1 IP (A1 (d) If A and B are sets in F and A : : : An are disjoint sets in F . Toss a coin n times. Then the probability of T is q = 1 . For each ! = (!1 !2 : : : !n ) in n . Suppose the probability of H on each toss is p. We repeat these and give some examples of inﬁnite probability spaces as well.1) We can deﬁne IP (A) this way because A has only ﬁnitely many elements. so that is the set of all sequences of H and T which have n components.4 that a probability measure IP has the following properties: (a) IP ( ) = 0. (d) (Continuity from below.1 We recall from Homework Problem 1.9 Finite coin toss space. and so give it a name: n . We will use this space quite a bit. p. (b) (Countable additivity) If A1 A2 : : : is a sequence of disjoint sets in F . then IP (B ) = IP (A) + IP (B n A): IP (B ) IP (A): A2 : : : is a sequence of sets in F with A 1 A2 IP 1 In particular.CHAPTER 1. . we deﬁne IP f! g = pNumber of H in ! q Number of T in ! : IP (A) = X ! A 2 IP f!g: (4. then An ) = IP (A1 ) + + IP (An ): B. Let F be the collection of all subsets of n . Example 1. we deﬁne For each A 2 F . and so only ﬁnitely many terms appear in the sum on the right-hand side of (4.) If A1 A2 : : : is a sequence of sets in F with A 1 A2 IP \ ! . Introduction to Probability Theory 31 Remark 1.1). then k=1 Ak = nlim IP (An ): !1 We have already seen some examples of ﬁnite probability spaces.

we put every set in every -algebra Fn . suppose A = AHH ATH . . for each positive integer n. the probability of a H on the second toss is p. Toss a coin repeatedly without stopping. and then we have IP (A) = IP (AHH ATH ) = p2 + qp = (p + q )p = p: In other words. Then A is in F2. This is an uncountably inﬁnite space. p for T . For example. Therefore. fH on every tossg = is also in F . If there is a positive integer n such that A 2 Fn . and all unions of the four basic fHHHHH g = fH on every tossg is not in any of the F n -algebras. \ 1 n=1 fH on the ﬁrst n tossesg We next construct the probability measure IP on ( 1 F ) which corresponds to probability p 2 0 1] for H and probability q = 1 . . the set containing the single sequence Because sets. because it depends on all the components of the sequence and not just the ﬁrst n components. and it is clear how to deﬁne IP (A). For example. where n ranges over the positive integers.10 Inﬁnite coin toss space. We call this space 1 .32 Example 1. the set fH on the ﬁrst n tossesg is in Fn and hence in F . we deﬁne Fn to be the -algebra determined by the ﬁrst n tosses. and we need to exercise some care in the construction of the -algebra we will use here. We set IP (AHH ) = p2 and IP (ATH ) = qp. AHH = f! = (!1 !2 !3 : : : ) !1 = H !2 = H g = The set of all sequences which begin with HH AHT = f! = (!1 !2 !3 : : : ) !1 = H !2 = T g = The set of all sequences which begin with HT ATH = f! = (!1 !2 !3 : : : ) !1 = T !2 = H g = The set of all sequences which begin with TH ATT = f! = (!1 !2 !3 : : : ) !1 = T !2 = T g = The set of all sequences which begin with TT: In the -algebra F . Let A 2 F be given. where these sets were deﬁned earlier. then the description of A depends on only the ﬁrst n tosses. F2 contains four basic sets. so that is the set of all nonterminating sequences of H and T . For each positive integer n. We also put in every other set which is required to make F be a -algebra. For example. However. we must also put into it the sets . F2 is a -algebra.

these numbers .1) which are not dyadic rationals correspond to a single ! have a unique binary expansion.1. Every dyadic rational in (0. Indeed. then IP fH on every tossg = 1. we write them in terms of sets which are in Fn for positive integers n. X (TTTT ) = 0. X (HHTTTTT ) = X (HTHHHHH ) = 3: 4 The numbers in (0.1(d) (continuity from above). IP fH on every tossg = 0. Of course. To determine the probability of these sets. X (HHHH ) = 1 and the other values of X lie in between. For example. We deﬁne a “dyadic rational m number” to be a number of the form 2k . In the inﬁnite coin toss space. and then use the properties of probability measures listed in Remark 1. Such is the case for the set fH on every tossg. but sets can have positive measure. the only sets which can have positive probabilty in 1 are those which contain uncountably many elements. 2 1 . Yk (!) = and we also deﬁne the random variable ( Y2 : : : by 1 0 if !k if !k =H =T X (! ) = n X Y k (! ) k=1 2k : Since each Yk is either zero or one. For example. IP fH on every tossg = nlim IP fH on the ﬁrst n tossesg = nlim pn : !1 !1 A similar argument shows that if 0 < p < 1 so that 0 < q < 1. X takes values in the interval 0 1]. then every set in 1 which contains only one element (nonterminating sequence of H and T ) has probability zero. We are in a case very similar to Lebesgue measure: every point has measure zero. 3 is a dyadic 4 rational. and hence very set which contains countably many elements also has probabiliy zero. fH on the ﬁrst tossg fH on the ﬁrst two tossesg fH on the ﬁrst three tossesg and \ 1 n=1 fH on the ﬁrst n tossesg = fH on every tossg: According to Remark 1. For example.CHAPTER 1. we deﬁne a sequence of random variables Y1 If p = 1. Introduction to Probability Theory 33 Let us now consider a set A 2 F for which there is no positive integer n such that A 2 F . where k and m are integers. otherwise.1) corresponds to two sequences ! 2 1 .

Continuing this process. none of these numbers is in C 0.34 Whenever we place a probability measure IP on ( F ). For example.1 < m 2k 2k 1 we have In other words. In other words. With a bit more work. Therefore. For example. we see that C 0 will not contain any of the numbers which were removed in the construction of the Cantor set C in Example 3. we are removing exactly those points in 0 1] which were removed in the Cantor set construction of Example 3. but the sequence ! must begin with TTTH or TTHT . then we have 2 1 LX 0 2 = IP fFirst toss is T g = 1 2 1 1 = IP fFirst toss is H g = 1 LX 2 2 1 LX 0 4 = IP fFirst two tosses are TT g = 1 4 1 LX 4 1 = IP fFirst two tosses are TH g = 1 2 4 1 LX 2 3 = IP fFirst two tosses are HT g = 1 4 4 3 LX 4 1 = IP fFirst two tosses are HH g = 1 : 4 0 Continuing this process. i. Consider now the set of real numbers C = fX ( ! ) ! 2 0 pairs g: The numbers between ( 1 1 ) can be written as X (! ).e. The only way this can be is for LX to be Lebesgue measure. m LX m2. we can verify that for any positive integers k and m satisfying m. Let pairs be the subset of in which every even-numbered toss is the same as the odd-numbered toss immediately preceding it. HHTTTTHH is the beginning of a sequence in pairs .2. but the sequence ! must begin with either 4 2 1 3 TH or HT ..2. if we set p = q = 1 in the construction of this example. Similarly. . 1 2k = 21k : k We conclude this example with another look at the Cantor set of Example 3.2. so none of these numbers is in C 0. we have a corresponding induced measure LX on 0 1]. by requiring consecutive coin tosses to be paired. It is interesing to consider what L X would look like if we take a value of p other than 1 when we 2 construct the probability measure IP on . one can convince onself that in fact C 0 = C . the LX -measure of all intervals in 0 1] whose endpoints are dyadic rationals is the same as the Lebesgue measure of these intervals. C 0 C. the numbers between ( 16 16 ) can be written as X (! ). but HT is not.

For example. when the initial stock price S 0 = 4 and the probability of H is 1 . we construct the experiment so that the probability of getting 1 is 4 . this gives us a probability measure. Let = 0 1] and let F = B( 0 1]). we deﬁne IP (A) = 0 (A) to be the Lebesgue measure of the set. F to be B(IR).11 Suppose we choose a number from IR in such a way that we are sure to get either 1. x2 Let = IR. Here are some probability spaces which correspond to different ways of picking a number at random. Nonetheless. Because 0 1] = 1. just as I know of no way to toss a coin inﬁnitely many times. perhaps using a random number generator. Example 1. the probability of the interval (0 is 8 .2) . Example 1. Introduction to Probability Theory 35 In addition to tossing a coin. and setting up the probability measure so that 4 1 IP f1g = 9 IP f4g = 4 IP f16g = 9 : 9 This determines IP (A) for every set A 2 B(IR). the probability of 9 getting 4 is 4 and the probability of getting 16 is 1 . this requires that every number have probabilty zero of being chosen. For each Borel set A 0 1].CHAPTER 1. F = B(IR) and for every Borel set A IR. I know of no way to design a physical experiment which corresponds to choosing a number at random from 0 1] so that each number is equally likely to be chosen. Since there are inﬁnitely mean numbers in 0 1]. another common random experiment is to pick a number. 9 5] The probability measure described in this example is L S2 . 0 This probability space corresponds to the random experiment of choosing a number from 0 1] so that every number is “equally likely” to be chosen. deﬁne IP (A) = Z A ' d 0: (4. the measure induced by the stock price S2 .10 and 1.12 provide probability spaces which are often useful approximations to reality. we can speak of the probability that the number chosen lies in a particular set. Example 1. Nonetheless. because this interval contains the numbers 1 and 4. This distribution was discussed 3 immediately following Deﬁnition 2.8. Deﬁne the standard normal density '(x) = p1 e 2 : 2 . Furthermore. then this probability can be positive. and if the set has uncountably many points. but not the number 16.13 Standard normal distribution. the collection of all Borel subsets containined in 0 1].12 Uniform distribution on 0 1]. both Examples 1. 4 or 16. We describe this random experiment by taking 9 9 to be IR.

we deﬁne If X is a simple function.36 If A in (4.. but if a set A is given. X (! ) = l A (!) = I for some set A 2 F . The construction of the integral in a general probability space follows the same steps as the construction of Lebesgue integral. With this sequence. possibly also taking the values 1. we deﬁne Z X dIP = k=1 ck I l Ak dIP = k=1 ck IP (Ak ): If X is nonnegative but otherwise general. i. i. we can always construct a sequence of simple functions Yn and Y (! ) = limn!1 Yn (! ) for every ! n = 1 2 : : : such that 0 Y1 (! ) Y2 (! ) Y3 (! ) : : : for every ! 2 Z 2 . we can deﬁne X dIP = nlim Z !1 Yn dIP: . and let X be a random variable on this space.14 Let ( F IP ) be a probability space.2) as the less mysterious Riemann integral: Z b 1 x2 IP a b] = p e 2 dx: . Deﬁnition 1. i. then we can write (4.e.e.2) is an interval a b]. a 2 This corresponds to choosing a point at random on the real line. We repeat this construction below. If X is an indicator.2). then the probability the point is in that set is given by (4. a mapping from to IR.e. we deﬁne Z X dIP = sup Z Y dIP Y is simple and Y (! ) X (!) for every ! 2 : In fact. ( 1 0 if ! if ! 2A 2 Ac Z X dIP = IP (A): n X k=1 X (! ) = n X Z ck l Ak (!) I n X where each ck is a real number and each Ak is a set in F . and every single point has probability zero of being chosen.

X (!) 0g Z X dIP = Z X + dIP . . X dIP: . it is enough if the set of ! for which X (! ) Y (! ) has probability one.4 (Fatou’s Lemma) Let Xn n = 1 2 : : : be a sequence of almost surely nonnegative random variables converging almost surely to a random variable X . where then we deﬁne 37 Z X + dIP < 1 Z .e. if A and B are disjoint subsets of and X is a random variable. Z If A is a set in F and X is a random variable. X dIP < 1 . In particular. then Z (X + Y ) dIP = Z Z cX dIP = c X dP . i. Then Z X dIP lim inf n !1 !1 Z Xn dIP or equivalently. then Z X dIP + Z Y dIP If X (! ) Y (!) for every ! 2 Z X dIP Z Y dIP: In fact. Finally. almost surely is enough. if X and Y are random variables and c is a real constant. X + (!) = maxfX (!) 0g X (! ) = maxf. Introduction to Probability Theory If X is integrable. We acknowledge in these statements that conditions don’t need to hold for every ! . then Z A B X dIP = Z A X dIP + Z B X dIP: We restate the Lebesgue integral convergence theorem in this more general context. we say it holds almost surely.CHAPTER 1. we deﬁne Z The expectation of a random variable X is deﬁned to be A X dIP = IEX = Z I l A X dIP: X dIP: Z The above integral has all the linearity and comparison properties one would expect. When a condition holds with probability one. Theorem 4. we don’t need to have X (! ) Y (! ) for every ! 2 in order to reach this conclusion. IEX lim inf IEXn: n .

IEX = nlim IEXn : !1 Theorem 4. we constructed a probability measure on (IR B(IR)) by integrating the standard R normal density.3). the market measure and the risk-neutral measures in ﬁnancial markets are related this way. Assume that there exists a random variable Y such that jXnj Y almost surely for every n: Then Z X dIP = nlim Z !1 Xn dIP or equivalently.38 Theorem 4. In fact.3) is the Radon-Nikodym derivative of dIP with respect to 0 . we call ' a density and we can deﬁne an associated probability measure by IP (A) = Z A 'd 0 for every A 2 B(IR): (4. converging almost surely to a random variable X .6 (Dominated Convergence Theorem) Let Xn n = 1 2 : : : be a sequence of random variables.14 gives us a value for the abstract integral Z We can also evaluate Z Z IR IR f dIP: 0 f' d which is an integral with respec to Lebesgue measure over the real line. In fact. Now suppose f is a function on (R B(IR) IP ). We want to show that IR f dIP = Z IR f' d 0 (4.4) The probability measure IP weights different parts of the real line according to the density '.3) We shall often have a situation in which two measure are related by an equation like (4.5) . and we write dIP '= d : 0 (4.5 (Monotone Convergence Theorem) Let Xn n = 1 2 : : : be a sequence of random variables converging almost surely to a random variable X . IEX = nlim IEXn : !1 In Example 1. Deﬁnition 1. Assume that 0 X1 X2 X3 Then almost surely: Z X dIP = nlim Z !1 Xn dIP or equivalently. whenever ' is a nonnegative function deﬁned on R satisfying IR ' d 0 = 1.13. We say that ' in (4.

We include a proof of this because it allows us to illustrate the concept of the standard machine explained in Williams’s book in Section 5. we consider a general nonnegative function f .e.5) holds when f is a simple function. Step 1.5) and “cancel” the d 0 ). Introduction to Probability Theory 39 dIP an equation which is suggested by the notation introduced in (4.12.CHAPTER 1.4) (substitute d 0 for ' in (4. i.. (4. We can always construct a sequence of nonnegative simple functions fn n = 1 2 : : : such that 0 f1 (x) f2 (x) f3 (x) : : : for every x 2 IR and f (x) = limn!1 fn (x) for every x 2 IR. assume that f simple function.5) becomes Z = l A (x) for some Borel set A I IR.. f (x) that case.5) holds when f is an indicator function. Assume that f is an indicator function. Now that we know that (4. We have already proved that Z We let n ! 1 and use the Monotone Convergence Theorem on both sides of this equality to get Z Z IR fn dIP = Z IR fn ' d 0 for every n: IR f dIP = IR f' d 0: . page 5. The standard machine argument proceeds in four steps. i. In other words. Now that we know that (4.e. Then Z IR f dIP = = = = = Z "X n ck hk dIP IR k=1 n X Z ck hk dIP IR k=1 Z n X ck hk ' d 0 k=1 " IR # Z X n ck hk ' d 0 IR k=1 Z IR # f' d 0: Step 3. Step 2. is a f (x) = n X k=1 ck hk (x) where each ck is a real number and each hk is an indicator function. a linear combination of indicator functions. In IP (A) = ' d 0: A This is true because it is the deﬁnition of IP (A).

. The probability that ! 2 A is IP (A). we deﬁne and discuss the notion of independence in a general probability space ( F IP ). we assume that 0 < p < 1. IR Z f dIP . By integrable. we obtain the desired result: Z IR f dIP = = = Z ZIR ZIR R f + dIP . but you are told that ! 2 B . 0 f ' d 0: Subtracting these two equations. This discussion is symmetric with respect to A and B .15 We say that two sets A 2 F and B IP (A \ B) = IP (A)IP (B): 2 F are independent if Suppose a random experiment is conducted. and ! is the outcome. IR f 'd . For example. (A \ IP (AjB) = IP IP (B)B) : Whether two sets are independent depends on the probability measure IP . suppose we toss a coin twice. 1. Z ZIR IR f +' d .1) . i. the probability that ! 2 A is The sets A and B are independent if and only if this conditional probability is the uncondidtional probability IP (A). Suppose you are not told !. f +' d f' d 0 : Z 0. with probability p for H and probability q = 1 . Conditional on this information. which can take both positive and negative values. if A and B are independent and you know that ! 2 A.5. p for T on each toss. Then IP fHH g = p2 IP fHT g = IP fTH g = pq IP fTT g = q2: (5. 0 1.e. Z ZIR IR f + dIP = f dIP = . the conditional probability you assign to B is still the unconditional probability IP (B ).1 Independence of sets Deﬁnition 1. To avoid trivialities. we mean that Z IR ¿From Step 3. we consider an integrable function f . although most of the examples we give will be for coin toss space. we have f + dIP <1 Z IR f dIP < 1: . In the last step. knowing that ! 2 B does not change the probability you assign to A.5 Independence In this section.40 Step 4.

We say that G and H are independent if every set in G is independent of every set in H. However.e. 2 Suppose however that p = 0:01. if you are told that the ﬁrst toss resulted in H . i. If you are told that the coin 2 2 tosses resulted in a head on the ﬁrst toss.1). . if we choose the set fHH the set fHH TH g from H. the probability of one H and one T is the probability of a T on the second toss. In fact. In words. in fact. is still 1 . the probability of one head and one tail. IP (B ) = 0:0198. conditioned on getting a H on the ﬁrst toss. 1. These sets are independent if and only if 2p 2 q = pq . then IP (B ). For example.16 Let G and H be sub. A is the set “H on the ﬁrst toss” and B is the = fHT g. which is the case if and only if p = 1 2. Let determined by the ﬁrst toss: G contains the sets G = F1 be the -algebra fHH HT g fTH TT g: Let H be the -albegra determined by the second toss: H contains the sets fHH TH g fHT TT g: These two -algebras are independent. then we have HT g from G and IP fHH HT gIP fHH TH g = (p2 + pq )(p2 + pq ) = p2 IP fHH HT g\ fHH TH g = IP fHH g = p2: No matter which set we choose in G and which set we choose in H. We compute IP (A) = p2 + pq = p IP (B ) = 2pq IP (A)IP (B ) = 2p2q IP (A \ B) = pq: If p = 1 . we will ﬁnd that the product of the probabilties is the probability of the intersection. Introduction to Probability Theory Let A = fHH HT g and B = fHT set “one H and one T . is 1 . the probability of B .” Then A \ B 41 TH g. it becomes very likely that the two tosses result in one head and one tail.5. IP (A \ B) = IP (A)IP (B) for every A 2 H B 2 G : Example 1.2 Independence of -algebras Deﬁnition 1.CHAPTER 1. and let IP be given by (5. and the probability of one head and one tail is quite small. which is 0:99.-algebras of F . By far the most likely outcome of the two coin tosses is TT .14 Toss a coin twice. which is now the probability of a T on the second toss.

In particular. then every set depending on a particular toss will be independent of every set depending on a different toss. for exS2 ample. depending on whether the third coin toss is H or T . We say that the different tosses are independent when we construct probabilities this way. = fHH HT TH TT g to be 1 1 IP fHH g = 9 IP fHT g = 2 IP fTH g = 1 IP fTT g = 3 9 3 and for every set A . Then IP ( ) = 1. udS0g = fHTH HTT g and n S3 S2 = u = fHHH HTH THH TTH g o Suppose X and Y are independent random variables.17 says that for independent random variables X and Y . Deﬁnition 1. whereas S3 is S2 S2 either u or d.e. the price S 2 of the stock at time 2 is independent of S3 . the measure induced by Y is Now the pair (X pair LX (A) = IP fX 2 Ag A IR: LY (B) = IP fY 2 Bg B IR: Y ) takes values in the plane IR 2. LX Y (C ) = IP f(X Y ) 2 C g C IR2: f(X Y ) 2 A Bg = fX 2 Ag \ fY 2 Bg . and we can deﬁne the measure induced by the The set C in this last equation is a subset of the plane IR 2 . It is also possible to construct probabilities such that the different tosses are not independent. the sets fS2 = are indepedent sets. so the product of the probabilities is 27 . where A IR and B IR.3 Independence of random variables Deﬁnition 1. deﬁne IP (A) to be the sum of the probabilities of the elements in A.42 Example 1. as shown by the following example. the intersection of fHH HT g and fHH TH g contains the single element fHH g. In the case of S2 and S3 just considered. so IP is a probability measure. C could be a “rectangle”. We deﬁned earlier the measure induced by X on IR to be Similarly. which has probability 1 .15 Deﬁne IP for the individual elements of independent. i. a set of the form A B . These sets are not 9 1. every set deﬁned in terms of X is independent of every set deﬁned in terms of Y . Note that the sets fH on ﬁrst tossg = fHH HT g and fH on second tossg = fHH TH g have probabilities IP fHH HT g = 1 and IP fHH TH g = 3 Example 1.5. On the other hand.14 illustrates the general principle that when the probability for a sequence of tosses is deﬁned to be the product of the probabilities for the individual tosses of the sequence. In this case. In the probability space of three independent coin tosses. 4 4 9 . This is because S2 depends on only the ﬁrst two coin tosses.17 We say that two random variables X and Y are independent if the -algebras they generate (X ) and (Y ) are independent.

P ROOF : Let us denote W = g (X ) and Z a typical set in (W ) is of the form = h(Y ). (In general. we have that every set in (W ) is also in (X ). Since every set in (X ) is independent of every set in (Y ). This follows from the fact that (5. which means that X contains at least as much information as W .2) is equivalent to independence of X and Y . we conclude that every set in (W ) is independent of every set in (Z ). this is the case. Take A = (. for independent random variables X and Y . X can contain strictly more information than W . this set is in (X ). which means that (X ) will contain all the sets in (W ) and others besides. Therefore. A joint density for (X Y ) is a nonnegative function f X Y (x y) such that LX Y (A B) = Z Z Z Not every pair of random variables (X Y ) has a joint density. the joint distribution represented by the measure LX Y factors into the product of the marginal distributions represented by the measures LX and LY . Let g and h be functions from IR to IR.7 Suppose X and Y are independent random variables.1) in terms of densities. we can show that every set in (Z ) is also in (Y ). Then X and Y are independent variables if and only if the joint density is the product of the marginal densities. if W = X 2.1 fX Y ( y ) d : LX (A) = LY (B) = Z ZA B fX (x) dx A IR fY (y) dy B IR: Suppose X and Y have a joint density. .2) In other words. Theorem 5. Then g(X ) and h(Y ) are also independent random variables. write (5.) In the same way that we just argued that every set in (W ) is also in (X ).1 x] and B = (. Introduction to Probability Theory and X and Y are independent if and only if 43 LX Y (A B) = IP fX 2 Ag \ fY 2 Bg = IP fX 2 AgIP fY 2 B g = LX (A)LY (B ): (5. In fact. and differentiate with respect to both x and y . for example.CHAPTER 1. But f! W (!) 2 Ag = f! : g(X (!)) 2 Ag which is deﬁned in terms of the random variable X . then the random variables X and Y have marginal densities deﬁned by A B fX Y (x y) dx dy: fX (x) = These have the properties 1 . but if a pair does.1 fX Y (x ) d fY (y) Z 1 .1 y ]. We must consider sets in (W ) and (Z ).

If X 2 = Y 2 almost surely. Example 1. Now use the standard machine to get the result for general functions g and h. so would be X 2 and Y 2 . Deﬁne Y = XZ . I Then the equation we are IP fX 2 Ag \ fY 2 Bg = IP fX 2 AgIP fY 2 Bg which is true because X and Y are independent. Unfortunately. the covariance is zero. IEX )(Y . If both have positive variances.5. the correlation coefﬁcient is zero.4 Correlation and independence Theorem 5. X and Y were independent. .8.18 Let X1 X2 : : : be a sequence of random variables. IP (A1 \ A2 \ An) = IP (A1 )IP (A2 ) IP (An ): 1. X and Y are uncorrelated. The variance of a random variable X is deﬁned to be Var(X ) = IE X . IEX IEY: h i X and Y According to Theorem 5. and if g and h are functions from IR to IR. IEY ) = IE XY ] . Consider the following example. for independent random variables. let Z be independent of X and have the distribution IP fZ = 1g = IP fZ = . but in fact.44 Deﬁnition 1. but X and Y are not independent. IEX ]2: The covariance of two random variables X and Y is deﬁned to be Cov(X Y ) = IE (X . two random variables can have zero correlation and still not be independent.1g = 0. We say that these random variables are independent if for every sequence of sets A1 2 (X1) A2 2 (X2) : : : and for every positive integer n. I P ROOF : Let g (x) = l A (x) and trying to prove becomes h(y) = l B (y ) be indicator functions. we deﬁne their correlation coefﬁcient (X Y ) = p Cov(X Y ) : Var(X )Var(Y ) For independent random variables.8 If two random variables X and Y are independent. We show that Y is also a standard normal random variable. then IE g (X )h(Y )] = IEg (X ) IEh(Y ) provided all the expectations are deﬁned. The last claim is easy to see.16 Let X be a standard normal random variable.

the variance of their sum is the sum of their variances. For y 45 IP fY Being standard normal. Therefore. Indeed. 1995..X y g: 2 . We now return to property (k) for conditional expectations. and we have IP fY yg = IP fX yg. IEX )2 + 2(X . i.1g y gIP fZ = 1g + IP f.3) 1.CHAPTER 1. page 88. both X and Y have expected value zero. if X and Y are independent and Z = X + Y . If we are given independent random variables X1 X2 : : : Xn . The property as stated there is taken from Williams’s book. IEX )(Y . IEY )2 h i = IE (X .1g y g + 1 IP f. Introduction to Probability Theory We next check that Y is standard normal. Y ) = IE XY ] = IE X 2Z ] = IEX 2 IEZ = 1 0 = 0: Y )? Where in IR2 does the measure LX Y put its mass. IEX . IEY )2 = Var(X ) + 2IE X . . Cov(X Since X is standard normal. IEY ) + (Y .1g y and Z = 1g + IP f. then the best estimate of X based on the information in H is IEX . we have y and Z = 1g + IP fY y and Z = . yg = IP fY = IP fX = IP fX 1 = 2 IP fX 2 IR. the same as the best estimate of X based on no information. what is the distribution of (X We conclude this section with the observation that for independent random variables.X y and Z = . IEX ]IE Y . then Var(Z ) = IE (Z . then Var(X1 + X2 + + Xn ) = Var(X1) + Var(X2) + + Var(Xn ): (5. IEY ] + Var(Y ) = Var(X ) + Var(Y ): h i This argument extends to any ﬁnite number of random variables.X y gIP fZ = . we shall need only the second assertion of the property: (k) If a random variable X is independent of a -algebra H. IEZ )2 i = IE X + Y . then IE X jH] = IEX: The point of this statement is that if X is independent of H. IP fX y g = IP fX which shows that Y is also standard normal.5 Independence and conditional expectation. presented in the lecture dated October 19.5.yg.e.

then the partial averaging equation we must check is A IEX dIP = Z A X dIP for every A 2 H: Z The left-hand side of this equation is IP (A)IP (B ). 1.3) that the variance of the sum of independent random variables is the sum of their variances. We will use this argument later when developing stochastic calculus. we simply compute 1 IEYn = n IEX1 + IEX2 + 1 + IEXn] = n | + + + } = : ] {z n times For the second step. we ﬁrst recall from (5.46 To show this equality. For the ﬁrst step. which by assumption must be independent of H. We are not going to give the proof of this theorem. We must also check the partial averaging property Z If X is an indicator of some set B . Therefore. n X k=1 Var n Xk = X 2 = 2 : 2 n n k=1 n . The argument proceeds in two steps. the random variables Yn are increasingly tightly distributed around as n ! 1.6 Law of Large Numbers There are two fundamental theorems about sequences of independent random variables. Deﬁne the sequence of averages Then Yn converges to Yn = X1 + X2 + + Xn n = 1 2 : : :: n almost surely as n ! 1. We next check that Var(Yn ) ! 0 as n ! 0. The partial averaging equation for general X independent of H follows by the standard machine. Var(Yn ) = As n ! 1. In other words. Theorem 5. but here is an argument which makes it plausible. we observe ﬁrst that IEX is H-measurable. we have Var(Yn ) ! 0. We ﬁrst check that IEYn = for every n.9 (Law of Large Numbers) Let X1 X2 : : : be a sequence of independent. Here is the ﬁrst one.5. since it is not random. and the right hand side is A IP (B) dIP = Z A I l B dIP: Z I I l Al B dIP = Z I l A B dIP = IP (A \ B): \ The partial averaging equation holds because A and B are independent. identically distributed random variables. each with expected value and variance 2.

In other words. This is because the denominator in the deﬁnition of Y n is so large that the variance of Yn converges to zero.pn + n X Var + (Xn . the distributions of all the random variables Z n have the same degree of tightness. ) 2 As n ! 1. pn = n X k=1 2 n = : 1 Z e lim IP fZn 2 Ag = p n 2 A !1 . The Central Limit Theorem asserts that as n ! 1. we should divide by n rather than n. x2 2 2 dx: . k=1 Xk .CHAPTER 1. but now we set then each Zn has expected value zero and Var(Zn ) = ) Zn = (X1 . if we again have a sequence of independent. for every set A IR. the distribution of Z n approaches that of a normal random variable with mean (expected value) zero and variance 2. each with expected value and variance 2 .5. around their expected value 0. Introduction to Probability Theory 47 1. as measured by their variance. If we want p to prevent this. ) + (X2 . identically distributed random variables. In particular.7 Central Limit Theorem The Law of Large Numbers is a bit boring because the limit is nonrandom.

48 .

e. after k tosses) under the outcome !. Note that we are not specifying the probability of heads here. and ! k will denote the kth element in the sequence ! . At each time step. S1 (!) = S1(!1 !2 !3) = S1(! 1) 4 4 S2 (!) = S2(! 1 !2 !3) = S2(!1 !2): 4 4 Each Sk is a random variable deﬁned on the set .1 A Binomial Model for Stock Price Dynamics Stock prices are assumed to follow this simple binomial model: The initial stock price during the period under study is denoted S 0. and say that the stock price moves up by a factor of u if the coin comes out heads (H ). Note that Sk (! ) depends only on ! 1 !2 : : : !k . let F = P ( ).Chapter 2 Conditional Expectation Please see Hull’s book (Section 9. the stock price either goes up by a factor of u or down by a factor of d. . We write Sk (! ) to denote the stock price at “time” k (i.) 2. Then F is a -algebra and ( F ) is a measurable space. and down by a factor of d if it comes out tails (T ). Sk 1 is a function B!F where B is the Borel -algebra on I . We will see later that Sk is in fact R 49 .1) The collection of all possible outcomes (i. More precisely. Each Sk is an F -measurable function !IR. sequences of tosses of length 3) is = fHHH HHT HTH HTT THH THH THT TTH TTT g: A typical sequence of will be denoted ! . It will be useful to visualize tossing a coin at each time step. Thus in the 3-coin-toss example we write for instance.6. that is.e. Consider a sequence of 3 tosses of the coin (See Fig. 2.

are deﬁned similarly.1 (Sets determined by the ﬁrst k tosses. we can decide whether the outcome of all tosses is in A. the collection F 1 of sets determined by the ﬁrst toss consists of: .1 In the 3 coin-toss example. knowing only the outcome of the ﬁrst k tosses.) We say that a set A is determined by the ﬁrst k coin tosses if. we will use the notation: fX yg = f! 2 X (!) yg: The sets fX < y g fX y g fX = y g etc. In general we denote the collection of sets determined by the ﬁrst k tosses by F k . 2. measurable under a sub. Note that the random variable Sk is F k -measurable. It is easy to check that F k is a -algebra. Similarly for any subset B of IR. Recall that the Borel -algebra B is the -algebra generated by the open intervals of I .1 u > d > 0.1: A three coin period binomial model.50 ω = Η 3 S2 (HH) =u 2S0 ω2 = Η S (H) = uS0 1 ω1= Η S0 ω1 = Τ S (T) = dS0 1 ω2 = Τ S2 (TT) = d 2S0 ω3 = Τ S3 (TTT) = d 3 S0 ω = Η 3 ω2 = Η ω2 = Τ S2 (HT) = ud S 0 S2 (TH) = ud S 0 ω = Η 3 ω3 = Τ ω3 = Τ S3 (HHT) = u2 d S0 S3 (HTH) = u2 d S0 S3 (THH) = u2 d S0 3 S3 (HHH) = u S 0 S3 (HTT) = d 2 u S0 S3 (THT) = d 2 u S0 S3 (TTH) = d 2 u S0 Figure 2.2 Information Deﬁnition 2. Example 2. for each k = 1 2 : : : n. In this course we will always deal with subsets of I that belong to B. R R For any random variable X deﬁned on a sample space 4 and any y 2 IR.-algebra of F . we deﬁne fX 2 Bg = f! 2 X (!) 2 Bg: 4 Assumption 2.

and denote by (X ). !IR. = fS2 (!) 2 IRg. 5. then tion of sets (X ) is generated by the collec- fX 1(X (!))j! 2 g . 7. Conditional Expectation 1.1 (y ) \ A = . 6.2 (Sets determined by S2 ) The -algebra generated by S2 consists of the following sets: 1. If the random variable X takes ﬁnitely many different values. either X . Deﬁnition 2. Another way of saying this is that for every y 2 IR. and . . 3. 5. The collection of susbets of determined by X is a -algebra. AT T = fTTH T TT g = fS2 = d2S0 g AHT AT H = fS2 = udS0g 4. = fS2 (!) 2 g. . 6. 3. 2. if X is a random variable (X ). The collection F 2 of sets determined by the ﬁrst two tosses consists of: 1. which we call the -algebra generated by X . 4 AT T = fTTH T TT g. 4. 51 4 AH = fHHH HHT HTH HT T g. 3. these sets are called the atoms of the -algebra In general. Complements of the above sets. knowing only the value X (!) of the random variable. we can decide whether or not ! 2 A. 2.2 (Information carried by a random variable. Any union of the above sets. 4 AHH = fHHH HHT g.) Let X be a random variable !IR. We say that a set A is determined by the random variable X if. 2. Any union of the above sets (including the complements). then (X ) is given by . (X ) = fX 1(B ) B 2 Bg: Example 2.1(y ) A or X . 4. 7. AHH = fHHH HHT g = f! 2 S2 (!) = u2S0 g. 4 AT H = fTHH THT g. 4 AT = fTHH THT TTH TTT g. The complements of the above sets. 4 AHT = fHTH HTT g. .CHAPTER 2.

we know that S 1 (! ) = uS0. i.52 2. We deﬁne IE (S1jS2)(TTT ) = IE (S1jS2 )(TTH ) = dS0 : . q = (1 . we need to introduce a probability measure on our coin-toss sample space . Deﬁnition 2. IP (HHT ) = p2q etc. p) is the probability of T .) IEX = 4 X ! 2 X (!)IP (! ): 1 0 if ! if ! If A then IA (!) = 4 ( and IE (IAX ) = Z A XdIP = 2A 62 A X 2 We can think of IE (IA X ) as a partial average of X over the set A. IE (S1jS2) is a random variable Y whose value at ! is deﬁned by Y (!) = IE (S1jS2 = y ) where y = S2 (!). 4 the coin tosses are independent. so that. then even without knowing ! . then the value of IE (S 1jS2 ) should also be known.g. Let us deﬁne p 2 (0 1) is the probability of H . If we know that S2(! ) = d2S0 . e. 8A 4 2 . ! A X (!)IP (! ): 2. From elementary probability. Properties of IE (S1jS2): IE (S1jS2) should depend on !. – If ! = HHH or ! = HHT ..3.3 Conditional Expectation In order to talk about conditional expectation. then S2(! ) = d2S0 . If we know that S2(! ) = u2 S0 .3 (Expectation. We deﬁne IE (S1jS2)(HHH ) = IE (S1jS2)(HHT ) = uS0: – If ! = TTT or ! = TTH . then S2 (! ) = u2 S0.e. If the value of S2 is known.1 An example Let us estimate S1. In particular.. it is a random variable. we know that S 1 (! ) = dS0. IP (A) = P! A IP (!). given S2. then even without knowing ! . Denote the estimate by IE (S1jS2).

IE (S1jS2) is random only through dependence on S 2 . and let G be a sub. Z A S1 dIP = p2quS0 + pq2uS0 + p2qdS0 + pq 2dS0 = pq (u + d)S0 For ! 2 A we deﬁne R S dIP IE (S1jS2)(!) = A (1A) = 1 (u + d)S0: 2 IP Z A Then IE (S1jS2)dIP = Z A S1dIP: In conclusion. F IP ) be a probability space. p. For every set A 2 (S2).CHAPTER 2. The random variable IE (S1jS2) has two fundamental properties: IE (S1jS2) is (S2)-measurable. .3. then we do not know whether S1 = uS0 or S1 = dS0. We then take a weighted average: 2 A = fHTH HTT THH THT g. Let X be a random variable F IP ). Then IE (X jG) is deﬁned to be any random variable Y that satisﬁes: Y is G -measurable.2 Let ( on ( (a) IE (S1jS2)dIP = Z A S1dIP: Deﬁnition of Conditional Expectation Please see Williams. If we know S2(!) = IP (A) = p2 q + pq2 + p2q + pq 2 = 2pq: Furthermore. We also write 8 > uS0 < g(x) = > 1 (u + d)S0 2 : dS 0 IE (S1jS2)(!) = g (S2(!)) if x = u2 S0 if x = udS0 if x = d2 S0 IE (S1jS2 = x) = g (x) where g is the function deﬁned above.83.-algebra of F . we can write where In other words. then S2(!) = udS0. Z A 2. Conditional Expectation – If ! 53 udS0.

i. i. i. an element ! of is selected. In fact the following holds: Lemma 3.54 (b) For every set A 2 G . There can be more than one random variable Y satisfying the above properties. it depends on !..3) .1) IE IA:IE (X jG)] = IE IA:X ]: Note that IA is a G -measurable random variable.10 If V is any G -measurable random variable. then Y = Y 0 almost surely.e.e. i.2) IE V:IE (X jG)] = IE V:X ]: (3. it is standard notation to write 4 IE (X jY ) = IE (X j (Y )): Here are some useful ways to think about IE (X jG): A random experiment is performed..3 Further discussion of Partial Averaging The partial averaging property is Z A We can rewrite this as IE (X jG)dIP = Z A XdIP 8A 2 G : (3. Based on what we know about ! . If the -algebra G contains ﬁnitely many sets. IE X jY ](!) is a function of ! .e.e. which is the intersection of all sets in G containing ! . Because this estimate depends on the partial information we have about ! . but if Y 0 is another one.. for all ! in this set A. but not told which element of A it is. we compute an estimate of X (!).3. conditional expectations always exist. and thus we cannot compute the exact value of X (!). we have the “partial averaging property” Z A Y dIP = Z A XdIP: Uniqueness. Y . There is always a random variable Y satisfying the above properties (provided that IE jX j < 1). The value of ! is partially but not fully revealed to us. IP f! 2 Y (!) = Y 0 (!)g = 1: Notation 2..1 For random variables X Existence. then provided IE jV:IE (X jG)j < 1. 2. IE X jY ](!) will be the same. although the dependence on ! is often not shown explicitly. there will be a “smallest” set A in G containing ! . (3. The way ! is partially revealed to us is that we are told it is in A. We then deﬁne IE X jY ](!) to be the average (with respect to IP ) value of X over this set A. Thus.

but is not necessarily simple. and the left-hand side is strictly negative. using the Monotone Convergence Theorem (See Williams). unless IP (A) = 0. where each Ak is in G and k each ck is constant. we can replace the second condition in the deﬁnition of a conditional expectation (Section 2. 56). we have IE V:IE (X jG)] = IE V:X ]: 2. The right-hand side is greater than or equal to zero.4) Please see Willams p. .CHAPTER 2. to obtain (3. it must hold for V as well. and since (3. IP (A) = 0. If X is G -measurable. Such a V can be written as the limit of an increasing sequence of simple random variables Vn . V is of the form V = Pn=1 ck IAK . then the best estimate of X based on G is X itself.2) and linearity of expectations to prove (3. (a) (b) IE (IE (X jG)) = IE (X ): Proof: Just take A in the partial averaging property to be . then (c) (Linearity) (d) (Positivity) If X IE (X jG) 0: Proof: Take A = f! 2 R (X jG)(! ) < 0g. X satisﬁes the requirement (a) of a conditional expectation as well.. V . Therefore. i. Williams calls this argument the “standard machine” (p.3) for each Vn and then pass to the limit. If the information content of G is sufﬁcient to determine X .3.2) by: (b’) For every G -measurable random-variable V . Proof sketches of some of the properties are provided below. The conditional expectation of X is thus an unbiased estimator of the random variable X . 88.3) holds for V + and V . ﬁrst use (3. then IE (X jG) = X: Proof: The partial averaging property holds trivially when Y is replaced by X .3) for V . Conditional Expectation 55 Proof: To see this. the general G measurable random variable V can be written as the difference of two nonnegative random-variables V = V + . Finally.e.3. we write (3. IE (a1X1 + a2X2jG) = a1IE (X1jG) + a2IE (X2jG): 0 almost surely. And since X is G -measurable. Based on this lemma. This set is in G since IE (X jG) is G -measurable.3) when V is a simple G -measurable random variable.4 Properties of Conditional Expectation (3. . IE R Partial averaging implies A IE (X jG)dIP = A XdIP . Next consider the case that V is a nonnegative G -measurable random variable.

(j) (Taking out what is known) If Z is G -measurable. the G -measurable random variable Z acts like a constant. then IE (X j (G H)) = IE (X jG): In particular. then nothing is gained by including the information content of H in the estimation of X . . If we estimate X based on the information in G . then IE (X jH) = IE (X ): If H is independent of X and G . Take Y = Z:IE (X jG). then IE ( (X )jG) Recall the usual Jensen’s Inequality: IE (IE (X jG)): (IE (X )): (X ) (i) (Tower Property) If H is a sub. then IE (IE (X jG)jH) = IE (X jH): -algebra of G means that G contains more information than H. R R (b) A Y dIP = A ZXdIP When conditioning on G . if X is independent of H. 8A 2 G . Then Y satisﬁes (a) (a product of G -measurable random variables is G-measurable). and then estimate the estimator based on the smaller amount of information in H. A random variable Y is IE (ZX jG) if and only if (a) Y is G -measurable. as we can check below: Z A Y dIP = IE (IA:Y ) = IE IAZIE (X jG)] = IE IAZ:X ] ((b’) with V = IA Z Z = ZXdIP: A (k) (Role of Independence) If H is independent of ( (X ) G).-algebra of G . then we get the same result as if we had estimated X directly based on the information in H. Y also satisﬁes property (b).56 (h) (Jensen’s Inequality) If : R!R is convex and IE j (X )j < 1. then H is a sub- IE (ZX jG) = Z:IE (X jG): Proof: Let Z be a G -measurable random variable.

for instance.3. Z Z We compute AH AT IE (S2jF 1)dIP = IE (S2jF 1)dIP = Z Z AH AT S2 dIP S2dIP: Z AH IE (S2jF 1 )dIP = IP (AH ):IE (S2jF 1 )(!) = pIE (S2jF 1)(! ) 8! 2 AH : On the other hand.5 Examples from the Binomial Model Recall that F 1 = f AH AT g. IE (S2jF 1 )(!) = (pu + qd)S1(!) 8! 2 AT : IE (S2jF 1)(!) = (pu + qd)S1(!) 8! 2 : Thus in both cases we have A similar argument one time step later shows that IE (S3jF 2)(!) = (pu + qd)S2(! ): We leave the veriﬁcation of this equality as an exercise. Notice that IE (S2jF 1 ) must be constant on AH and AT . Now since IE (S2jF 1 ) must satisfy the partial averaging property.CHAPTER 2. We can also write IE (S2jF 1 )(!) = pu2 S0 + qudS0 8! 2 AH : IE (S2jF 1)(! ) = pu2 S0 + qudS0 = (pu + qd)uS0 = (pu + qd)S1(!) 8! 2 AH Similarly. (linearity) . from the previous equations we have IE IE (S3jF 2)jF 1] = IE (pu + qd)S2jF 2] = (pu + qd)IE (S2jF 1) = (pu + qd)2S1: This ﬁnal expression is IE (S 3jF 1). Z AH S2 dIP = p2u2 S0 + pqudS0: Therefore. Conditional Expectation 57 2. We can verify the Tower Property.

Such a sequence of Conditions for a martingale: F IP ). We say that the process fMk g is adapted to the ﬁltration fF k g. -algebras F 0 F 1 : : : F n .4 Martingales The ingredients are: A probability space ( A sequence of F . the second condition above is replaced by IE (M k+1 jF k ) Mk . a submartingale tends to go up. and so we have IE(S1 jF 0) = (pu + qd)S0 : In conclusion. . F k k = 0 1 2 3g is a supermartingale. with the property that F 0 F 1 : : : F n -algebras is called a ﬁltration. we set F 0 = f g. If you know the information in F k . This -algebra contains no information. i.e. the “trivial -algebra”.e. i. F k k = 0 1 2 3g is a submartingale. Each Mk is F k -measurable. IE (M k+1jF k ) Mk . 1. 2. Martingales tend to go neither up nor down. then you know the value of Mk .) For k = 1 2 we already showed that IE(Sk+1 jF k ) = (pu + qd)Sk : For k = 0. If (pu + qd) = 1 then fSk If (pu + qd) 1 then fSk If (pu + qd) 1 then fSk F k k = 0 1 2 3g is a martingale. A supermartingale tends to go down. by deﬁnition.3 (Example from the binomial model. IE(S1 jF 0 ) is that constant which satisﬁes the averaging property Z IE(S1 jF 0 )dIP = Z S1 dIP: The right hand side is IES1 = (pu + qd)S0 . Example 2. For each k. A sequence of random variables M0 M1 : : : Mn. This is called a stochastic process. IE (Mk+1 jF k ) = Mk .58 2. Therefore. and any F 0 -measurable random variable must be constant (nonrandom).

$60: 2. Prentice-Hall. Borrow $40. Financial Economics. Let us construct a portfolio: 1. 3. and Cox and Rubinstein (1985). J. Cash outlay is . the strike price is $50). (In this and all examples. Cash outlay is $100.e. Example 3. Cash outlay is . and the stock prices S0 S1 : : : are indexed by the same time periods). 50)+ = 50 0 if ! 1 if ! 1 =H =T Suppose the option sells for $20 at time 0. 7(1979).1 Binomial Pricing Return to the binomial pricing model Please see: Cox. 229–263. We know that S1 (!) = 100 25 if ! 1 if ! 1 =H =T Find the value at time zero of a call option to buy one share of stock at time 1 for $50 (i. Ross and Rubinstein. Options Markets.1 (Pricing a Call Option) Suppose u = 2 d = 0:5 r = 25%(interest rate).Chapter 3 Arbitrage Pricing 3. The value of the call at time 1 is V1(!) = (S1 (!) . the interest rate quoted is per unit time. Sell 3 options for $20 each. S0 = 50. Buy 2 shares of stock for $50 each.$40: 59 .

.e. Important Observation: The APT value of the option does not depend on the probabilities of H and T . . (1 + r)S0): We want to choose V0 and 0 so that X1 = V1 regardless of whether the stock goes up or down. (V0 . .. (V0 is to be determined later). where V1 is an F 1 -measurable random variable.. at risk-free interest rate r... negative).60 This portfolio thus requires no initial investment. Buy Then wealth at time 1 is 0S0 might be X1 = 4 = 0 S1 + (1 + r)(V0 ..2 General one-step APT Suppose a derivative security pays off the amount V 1 at time 1. Assumptions underlying APT: Unlimited short selling of stock. the cash outlay at time 1 is: Pay off option Sell stock Pay off debt $0 The arbitrage pricing theory (APT) value of the option at time 0 is V0 = 20... his/her trading does not move the market. No transaction costs.$200 $50 $0 !1 = T $0 .$50 $50 3. Unlimited borrowing. For this portfolio. at least in the straightforward method described below). !1 = H $150 . Sell the security for V0 at time 0. 0S0 ) (1 + r)V0 + 0 (S1 . . 0S0 in the money market. (This measurability condition is important. ( 0 is also to be determined later) Invest V0 .. Agent is a “small investor”. i. 0 shares of stock at time 0. this is why it does not make sense to use some stock unrelated to the derivative security in valuing it.

)S (T ) (u .3 Risk-Neutral Probability Measure Let be the set of possible outcomes from n coin tosses.d r 1 = 1 + .3) 0 into (2.1): (1 + r)V0 = V1 (H ) . d V1(H ) + u . p ~ ~ ~ ~ ~ ~ ~ ~ probabilities. 1 . Subtracting the second equation above from the ﬁrst gives 0= Plug the formula (2. Equation 2. d)V (H ) . r)S0 u. r V1(T ): u d u d We have already assumed u > d > 0..3) for V1(H ) . We will return to this later. r : ~ ~ u d u d 1 ~ ~ V0 = 1 + r pV1(H ) + qV1(T )]: q are like ~ (2. p. V1(T ) : S1(H ) . Thus.CHAPTER 3. (1 + r)S0) = V1 (H ) 0 (S1(T ) . i. . 1 . . S1(T ) (2.1) (2. . V1((H ) .4 says f 1 V0 = IE 1 + r V1 : . Arbitrage Pricing 61 The last condition above can be expressed by two equations (which is fortunate since there are two unknowns): (1 + r)V0 + (1 + r)V0 + 0(S1 (H ) . d q = u .e. 0 (S1(H ) . (1 + r)S0) = V1 (T ) (2. Construct a probability measure by the formula 4 f IP (! 1 !2 : : : !n ) = p#fj !j =H g q #fj !j =T g ~ ~ f IP on f f f IP is called the risk-neutral probability measure. V (T ))(u . Vk is known (and therefore non-random) at that ! as well. We now also assume d be an arbitrage opportunity).2) Note that this is where we use the fact that the derivative security value V k is a function of Sk . r)] 1 1 1 u.d 0 = 1 (u . (V (H ) . We denote by IE the expectation under IP . . Since p + q = 1. we have 0 < p < 1 and q = 1 . ..4) 3. (1 + r)S0) V1 = V1 (H ) . Deﬁne 4 4 1 + r u (otherwise there would Then p > 0 and q > 0. when Sk is known for a given ! . Thus the price of the call at time 0 is given by r 1 p = 1 + .

.d + du = (1 + r) (k+1) u + ur . r) S k u.1) (3. (1 + r) k Sk : . d . (1 + r)Sk ): (3. 3. k f IE (1 + r) = = d(u . . d)(1 + r) Sk u. the discounted self-ﬁnancing portfolio process value f(1 + r) .62 f P Theorem 3.3. . where .2) f P Theorem 3.k Sk Proof: F k gn=0 is a martingale.d u. dr Sk u = (1 + r) (k+1) (u . d) + . (k+1) Sk+1 jF k ] (1 + r) (k+1)(~u + qd)Sk p ~ (1 + r) (k+1) u(1 + r . . . . .12 Under I . (No insider trading).11 Under I . 1 . ud . Deﬁne recursively Xk+1 = = Then each Xk is F k -measurable. the discounted stock price process f(1+ r) . k is the number of shares of stock held between times k and k + 1. . k Sk+1 + (1 + r)(Xk . d . which need not be 0. k Sk ) (1 + r)Xk + k (Sk+1 . Proof: We have F k gn=0 k (1 + r) (k+1)Xk+1 = (1 + r) k Xk + k (1 + r) (k+1) Sk+1 .3. Each k is F k -measurable. 3.1 Portfolio Process The portfolio process is =( 0 1 ::: n 1).d kS : = (1 + r) k .k Xk is a martingale.2 Self-ﬁnancing Value of a Portfolio Process Start with nonrandom initial wealth X 0 .

(1 + r) k k Sk (property (b)) = (1 + r) k Xk (Theorem 3.e. . m is less than or equal to n. we call Xk the APT value at time k of V m . 1: (4. i. fMk F k k = 0 1 : : : mg is a martingale. . 1. 2. .2) When k = m . .13 (Corollary to Theorem 3.2 () A simple European derivative security Vm is said to be hedgeable if there exists a constant X0 and a portfolio process = ( 0 : : : m.1 ) such that the self-ﬁnancing value process X0 X1 : : : Xm given by (3.1) Proof: We ﬁrst observe that if martingale property for each k we use the tower property to write = 0 1 : : : m . . . then we also have f IE Mm jF k ] = Mk k = 0 1 : : : m . . .4 Simple European Derivative Securities Deﬁnition 3. (4. 63 f IE (1 + r) (k+1)Xk+1 jF k ] f = IE (1 + r) k Xk jF k ] f +IE (1 + r) (k+1) k Sk+1 jF k ] f .1 () A simple European derivative security with expiration time m is an F m -measurable random variable Vm . the number of periods/coin-tosses in the model).) f + k IE (1 + r) (k+1) Sk+1 jF k ] (taking out what is known) .2) satisﬁes Xm(!) = Vm(!) 8! 2 : In this case. 3. for k = 0 1 : : : m. . Deﬁnition 3.IE (1 + r) k k Sk jF k ] = (1 + r) k Xk (requirement (b) of conditional exp. . satisﬁes the f IE Mk+1 jF k ] = Mk f ff IE Mm jF m 2 ] = IE IE Mm jF m 1 ]jF m 2 ] f = IE Mm 1 jF m 2 ] = Mm 2 : . ..CHAPTER 3. 1. .11) . (Here. For k = m . Theorem 4.12) If a simple European security Vm is hedgeable. then for each k = 0 1 : : : m. the equation (4. the APT value at time k of V m is f Vk = (1 + r)k IE (1 + r) m VmjF k ]: 4 . . Arbitrage Pricing Therefore.2) follows directly from the martingale property.

. the model is called incomplete. the self-ﬁnancing value of the portfolio process 0 1 : : : m. for each ﬁxed (!1 : : : !k ).12 says that X0 (1 + r) 1X1 : : : (1 + r) m Xm is a martingale. the model is said to be complete. If the answer is “yes”. Theorem 5. Assume that (5.1) k (!1 f E Starting with initial wealth V 0 = I (1 + r). Vk+1 (!1 :: :: :: !k T ) : !k H ) . we have Xk (!1 : : : !k ) = Vk (!1 : : : !k ): .e. i. . and set f Vk (!1 : : : !k ) = (1 + r)k IE (1 + r) m Vm jF k ](!1 : : : !k ) . (5.1 by the recursive formula 3. .2). If the simple European security Vm is hedgeable. Theorem 3. In particular. f f (1 + r) k Xk = IE (1 + r) m Xm jF k ] = IE (1 + r) m Vm jF k ]: .3) holds for some value of k.2: V : : : !k ) = Sk+1(!1 :: :: :: !k H ) . Xk is the APT value at time k of Vm . and so for each k. (5.64 We can continue by induction to obtain (4.14 The binomial model is complete. If the answer is “no”. f Xk = (1 + r)k IE (1 + r) m VmjF k ]: . Therefore. Set X0 = V0 and deﬁne the self-ﬁnancing value of the portfolio process 0 : : : m. let V m be a simple European derivative security.1 is the process V0 V1 : : : Vm.5 The Binomial Model is Complete Can a simple European derivative security always be hedged? It depends on the model.1 and 0 : : : m. then there is a portfolio process whose selfﬁnancing value process X0 X1 : : : Xm satisﬁes Xm = Vm . By deﬁnition.3) holds by deﬁnition of X 0. For k = 0..m Vm ].1 be deﬁned by (5.3) We proceed by induction.2).2) Xk+1 = We need to show that k Sk+1 + (1 + r)(Xk . k Sk ): Xk = Vk 8k 2 f0 1 : : : mg: (5. Sk+1 (!1 !k T ) k+1 (!1 (5. 3. .1) and (5. Proof: Let V0 : : : Vm.

(1 + r)Sk ) k+1 k+1 (T ) +~Vk+1 (H ) + q Vk+1 (T ) p ~ (H . f(1 + r). 1 . we simplify notation by suppressing these symbols. (k+1) Vk+1 jF k ] f In other words. we write the last equation as We compute Xk+1 (H ) = k Sk+1 (H ) + (1 + r)(Xk . f Vk (!1 : : : !k ) = IE (1 + r) 1 Vk+1jF k ](!1 : : : !k ) 1 p ~ = 1 + r (~Vk+1 (!1 : : : !k H ) + q Vk+1 (!1 : : : !k T )) : 1 p ~ Vk = 1 + r (~Vk+1 (H ) + qVk+1(T )) : Since (!1 : : : !k ) will be ﬁxed for the rest of the proof.k Vk gn=0 is a martingale under I . V = Sk+1 (H ) . r + pVk+1 (H ) + qVk+1 (T ) ~ ~ u. (1 + r)Sk ) + (1 + r)Vk V (H ) . Note ﬁrst that f IE (1 + r) . P k . Sk+1 (T ) (Sk+1 (H ) . (1 + r)Sk ) k k +~Vk+1 (H ) + q Vk+1 (T ) p ~ = (Vk+1 (H ) . Vk = Vk+1uS ) . k Sk ) = k (Sk+1 (H ) . = = = ff IE IE (1 + r) m VmjF k+1 ]jF k ] f IE (1 + r) mVm jF k ] (1 + r) k Vk . .d = (Vk+1 (H ) . Vk+1 (T )) u . the second can be shown similarly. In particular. Arbitrage Pricing We need to show that 65 Xk+1 (!1 : : : !k H ) = Vk+1(!1 : : : !k H ) Xk+1(!1 : : : !k T ) = Vk+1(!1 : : : !k T ): We prove the ﬁrst equality. .CHAPTER 3. Vk+1 (T )) q + pVk+1 (H ) + q Vk+1 (T ) ~ ~ ~ = Vk+1 (H ): . dS+1 (T ) (uSk . For example.

66 .

5)+ : k Notice that V2 (HH) = 11 V2 (HT) = 3 6= V2 (TH) = 0 V2 (T T ) = 0: 1 ~ V1 (H) = 1 + r pV2 (HH) + qV2 (HT)] = 4 0:5 11 + 0:5 3] = 5:60 ~ 5 V1 (T) = 4 0:5 0 + 0:5 0] = 0 5 4 0:5 5:60 + 0:5 0] = 2:24: V0 = 5 0 The payoff is thus “path dependent”. with payoff given by (See Fig. 1: Vk+1 (!1 : : : !k H ) . p = ~ ur d ~ ~ Consider a simple European derivative security with expiration 2. Working backward in time. S (HT) 67 . 1: k+1 1 k k+1 1 k . 4.1): 0:5: V2 = 0max2(Sk . V1 (T ) = 0:93 (H) S (T ) 1 1 2 2 1 V (H) = S2 (HH) . we have: Using these values.d = 0:5 q = 1 .Chapter 4 The Markov Property 4.. = S1(H) . V2 (HT) = 0:67 (HH) .1 Binomial Model Pricing and Hedging Recall that Vm is the given simple European derivative security.1 (Lookback Option) u = 2 d = 0:5 r = 0:25 S0 = 4 p = 1+. S (! : : : ! T ) k = 0 1 : : : m . and the value and portfolio processes are given by: f Vk = (1 + r)k IE (1 + r) m Vm jF k ] k = 0 1 : : : m . Example 4. we can now compute: V . Vk+1(!1 : : : !k T ) k (!1 : : : !k ) = S (! : : : ! H ) .

and consider a European call Note that V2 (HH) = 11 V2 (HT) = V2 (TH) = 0 V2 (T T ) = 0 1 V1 (H) = 4 2 :11 + 1 :0] = 4:40 2 5 41 V1(T) = 5 2 :0 + 1 :0] = 0 2 41 V0 = 5 2 4:40 + 1 0] = 1:76: 2 Deﬁne vk (x) to be the value of the call at time k when Sk = x. Example 4. 0S0 ) = 5:59 V1 (H) = 5:60 X1 (T ) = 0S1 (T) + (1 + r)(X0 . 1(H)S1 (H)) = 11:01 V1 (HH) = 11 etc.2 (European Call) Let u = 2 with expiration time 2 and payoff function ~ ~ d = 1 r = 1 S0 = 4 p = q = 2 4 V2 = (S2 . 1 V (T) = S2 (TH) . 0S0 ) = 0:01 V1 (T ) = 0 X1 (HH) = 1(H)S1 (HH) + (1 + r)(X1 (H) .1: Stock price underlying the lookback option. 5)+ : 1 2. Then v2 (x) = (x . we can check that X1 (H) = 0S1 (H) + (1 + r)(X0 . S (TT) 2 2 Working forward in time.68 S2 (HH) = 16 S (H) = 8 1 S2 (HT) = 4 S =4 0 S1 (T) = 2 S2 (TH) = 4 S2 (TT) = 1 Figure 4. 5)+ v1(x) = 4 1 v2 (2x) + 1 v2 (x=2)] 2 52 v0(x) = 4 1 v1 (2x) + 1 v1 (x=2)]: 2 52 . V2 (TT ) = 0: (TH) .

. rather than four possible values V 2(HH ) V2(HT ) V2(TH ) If there were 66 periods. Then we can use calculus and partial differential equations. vk+1 (x=2) k = 0 1: 2x . We could store the value of Vn (! ). 2.. There are three possible ways to deal with this problem: 1.CHAPTER 4. for example. Then k (x) = vk+1 (2x) . Simulation. We could repeat this several times and take the average value of Vn as an f EV approximation to I n . 69 Let v2(16) = 11 v2 (4) = 0 v2 (1) = 0 1 v1(8) = 4 2 :11 + 1 :0] = 4:40 2 5 1 v1(2) = 4 1 :0 + 2 :0] = 0 52 1 v0 = 4 2 4:40 + 1 0] = 1:76: 2 5 k (x) be the number of shares in the hedging portfolio at time k when S k = x. then in period 66 there would be 67 possible stock price values (since the ﬁnal price depends only on the number of up-ticks of the stock price – i. equations of the form has 2 n elements. We have. The Markov Property In particular. a three-month option has 66 trading days. V2(TT ). that f V0 = (1 + r) n IEVn . the option in Example 4. then n = 66 and 266 7 1019.e. 3. and so we could compute V0 by simulation.2 has this.2 Computational Issues For a model with n periods (coin tosses). Look for Markov structure. heads – so far) and hence only 67 possible option values. Approximate a many-period model by a continuous-time model. We’ll get to that. If each day is taken to be one period. For period k. Example 4. rather than 2 66 7 1019.2 has three possible values v 2 (16) v2(4) v2(1). we could simulate n coin tosses ! = (!1 : : : !n ) under the risk-neutral probability measure. In period 2. x=2 4. More speciﬁcally. we must solve 2k 1 ~ Vk (!1 : : : !k ) = 1 + r pVk+1(!1 : : : !k H ) + qVk+1 (!1 : : : !k T )]: ~ For example.

i. For each k = 0 1 : : : n . and in (c) we assume this condition only for functions h of the form h(x) = e ux .) (d) (Agreement of characteristic functions) For every u 2 IR.1. i. This process is said to be Markov if: k The stochastic process fXk g is adapted to the ﬁltration fF k g. we have IE euXk+1 F k = IE euXk+1 Xk : (If we ﬁx u and deﬁne h(x) = eux . the distribution of Xk+1 conditioned on F k is the same as the distribution of X k+1 conditioned on X k . then the equations in (b) and (c) are the same. we have 4 IP (Xk+1 2 AjF k ) = IE IA(Xk+1)jF k ] = IE IA(Xk+1 )jXk ] = IP Xk+1 2 AjXk ]: (b) (Agreement of expectations of all functions). However in (b) we have a condition which holds for every function h. Let (The Markov Property). we only consider subsets A of I that are in B and functions g : IR!IR such that g . 1.e.. For every (Borel-measurable) function h : IR!IR for which IE jh(Xk+1 )j < 1.3 Markov Processes Technical condition always present: We consider only functions on I and subsets of I which are R R R Borel-measurable. (Since jeiuxj = j cos x +sin xj 1 we don’t need to assume that IE jeiuxj < IE eiuXk+1 jF k = IE eiuXk+1 jXk h i h i . For every A 2 B = B(IR). we have IE h(Xk+1 )jF k ] = IE h(Xk+1)jXk]: (c) (Agreement of Laplace transforms.70 4..) For every u 2 IR for which IEeuXk+1 < 1. (c) implies (b).1 Different ways to write the Markov property (a) (Agreement of distributions). A main result in the theory of Laplace transforms is that if the equation holds for every h of this special form. 4.1 () Let ( F P) be a probability space.e. then it holds for every h. Let fF k gn=0 be a ﬁltration under k fXk gn=0 be a stochastic process on ( F P). and F.) p. Deﬁnition 4.3.1 is a function B!B. we have where i = 1.

We write these apparently stronger but actually equivalent conditions below. Conditions (a)-(d) are equivalent. Let j be a positive integer. we have IE euk+1 Xk+1+:::+uk+j Xk+j jF k ] = IE euk+1 Xk+1 +:::+uk+j Xk+j jXk ]: (D) For every u = (uk+1 : : : uk+j ) 2 IRj we have IE ei(uk+1Xk+1 +:::+uk+j Xk+j )jF k ] = IE ei(uk+1Xk+1 +:::+uk+j Xk+j )jXk ]: Once again. we have IP (Xk+1 2 AjF k ) = g (Xk ) where g is a function that depends on the set A. Consequences of the Markov property. we could just as well write g (Xk ) for some function g . Remark.1 In every case of the Markov properties where IE : : : jXk ] appears. where the function g depends on the random variable represented by : : : in this expression. IP (Xk+1 : : : Xk+j ) 2 AjF k ] = IP (Xk+1 : : : Xk+j ) 2 AjXk ]: (B) For every function h : IRj !IR for which IE jh(Xk+1 : : : Xk+j )j < 1. The Markov Property 71 Remark 4. All these Markov properties have analogues for vector-valued processes. For example. . Conditions (a)-(d) are also equivalent to conditions involving the process at time k and multiple future times. The Markov property as stated in (a)-(d) involves the process at a “current” time k and one future time k + 1. (A) For every Ak+1 IR : : : Ak+j IR. we have IE h(Xk+1 : : : Xk+j )jF k ] = IE h(Xk+1 : : : Xk+j )jXk ]: (C) For every u = (uk+1 : : : uk+j ) 2 IRj for which IE jeuk+1 Xk+1 +:::+uk+j Xk+j j < 1. every expression of the form IE (: : : jXk ) can also be written as g (Xk ). IP Xk+1 2 Ak+1 : : : Xk+j 2 Ak+j jF k ] = IP Xk+1 2 Ak+1 : : : Xk+j 2 Ak+j jXk ]: (A’) For every A 2 IRj .CHAPTER 4. form (a) of the Markov property can be restated as: For every A 2 B.

IP Xk+1 2 Ak+1 Xk+2 2 Ak+2 jF k ] = IE IAk+1 (Xk+1 )IAk+2 (Xk+2 )jF k ] = IE IE IAk+1 (Xk+1 )IAk+2 (Xk+2 )jF k+1 ]jF k ] = IE IAk+1 (Xk+1 ):IE IAk+2 (Xk+2)jF k+1 ]jF k ] = IE IAk+1 (Xk+1 ):IE IAk+2 (Xk+2)jXk+1 ]jF k ] = IE IAk+1 (Xk+1 ):g (Xk+1)jF k ] = IE IAk+1 (Xk+1 ):g (Xk+1)jXk ] (Markov property.2) is the case of h(x) = x. form (b).1)).1) (Markov property. and (3. e IE h(Sk+1)jF k ] is a function of Sk . Consider a model with 66 periods and a simple European derivative security whose payoff at time 66 is 1 V66 = 3 (S64 + S65 + S66 ): . conditioned on use the tower property on the left.72 Proof that (b) Consider =) (A). and this is property (A) with j Example 4. form (a).2). If we want to estimate the distribution of S k+1 based on the information in F k .) (Taking out what is known) (Tower property) (Deﬁnition of conditional probability) Now take conditional expectation on both sides of the above equation. Note however that form (b) of the Markov property is stronger then (3.2) is a function of Sk . Equation (3. Then (a) also holds (take h = IA ). the Markov property requires that for any function h. to obtain (X k ). the only relevant piece of information is the value of Sk . are equal to the RHS of (3. they are equal to each other. For example. (with j = 2 in (A)) Assume (b).) (Remark 4. We will formally prove this later. e IE Sk+1 jF k ] = (~u + qd)Sk = (1 + r)Sk p ~ (3.3 It is intuitively clear that the stock price process in the binomial model is a Markov process.1) IP Xk+1 2 Ak+1 Xk+2 2 Ak+2jXk ] = IE IAk+1 (Xk+1 ):g (Xk+1)jXk]: Since both and IP Xk+1 2 Ak+1 Xk+2 2 Ak+2 jF k ] IP Xk+1 2 Ak+1 Xk+2 2 Ak+2 jXk ] = 2.

Assume .CHAPTER 4.2 (Independence) Let ( F P) be a probability space. is independent of G . The Markov Property The value of this security at time 50 is 73 e V50 = (1 + r)50IE (1 + r). F 1 contains the four sets 4 4 AH = fHH HT g AT = fTH TT g fHH T H g fHT T T g : Let H be the -algebra of sets determined by the second toss. For example. Let G be a sub.e.15 (Independence Lemma) Let X and Y be random variables on a probability space ( F P).algebras of F . We say that G and H are independent if for every A 2 G and B 2 H. then IP (A \ B) = IP(HH) = p2 and IP (A)IP(B) = (p2 + pq)(p2 + pq) = p2 (p + q)2 = p2: Note that F 1 and S2 are not independent (unless p = 1 or p = 0). For example.e. and let G and H be sub. we have IP (A \ B) = IP (A)IP (B): We say that a random variable X is independent of a -algebra G if by X . if we take A = fHH HT g from F1 and B = fHH T H g from H. one of the sets in (S2 ) is f! S2 (!) = u2S0 g = fHH g. If we take A = fHH HT g from F 1 and B = fHH g from (S2 ).4 Showing that a process is Markov Deﬁnition 4.4 Consider the two-period binomial model. 4. i. the -algebra generated Example 4. then IP(A \ B) = IP(HH) = p2 . which we can determine with a bit of work. the F50-measurable random variable V50 can be written as V50(!1 : : : !50) = g(S50 (! 1 : : : !50)) for some function g. (X ).. i. (We are using form (B) of the Markov property here). In other words.-algebra of F .16IE V66jS50] because the stock price process is Markov. H contains the four sets : Then F 1 and H are independent. Recall that F 1 is the -algebra of sets determined by the ﬁrst toss. but IP(A)IP(B) = (p2 + pq)p2 = p3(p + q) = p3 : The following lemma will be very useful in showing that a process is Markov: Lemma 4.66V66 jF 50 ] e = (1 + r)..

but we have also obtained a formula for 4. if we condition both sides of the above equation on (S k ) and use the tower property on the left and the fact that the right hand side is (S k )-measurable. Fix a 4 k 4 = SS+1 and G = F k . Deﬁne the running maximum of the stock price to be Consider a simple European derivative security with payoff at time n of v n (Sn Examples: Mk = 1maxk Sj : j 4 Mn ) . and deﬁne g (y) = IEf (X y): 4 Then IE f (X Y )jG] = g (Y ): Remark. Let f (x y ) be a function of two variables. Then X = u if !k+1 = H and X = d if !k+1 = T . Since X k 4 depends only on the (k + 1)st toss. Example 4. Indeed. Let h 4 be any function and set f(x y) = h(xy). IE h(Sk+1 )jF k ] as a function of Sk . we obtain IE h(Sk+1 )jSk ] = ph(uSk ) + qh(dSk ): Thus IE h(Sk+1 )jF k ] and IE h(Sk+1 )jXk ] are equal and form (b) of the Markov property is proved.1. capital letters denote random variables and lower case letters denote nonrandom variables.5 (Showing the stock price process is Markov) Consider an n-period binomial model. This is a special case of Remark 4. Deﬁne Y = Sk . X is independent of G .74 X is independent of G . Not only have we shown that the stock price process is Markov. Y is G -measurable. In this lemma and the following discussion. Then 4 g(y) = IEf(X y) = IEh(Xy) = ph(uy) + qh(dy): time k and deﬁne X The Independence Lemma asserts that IE h(Sk+1 )jF k ] = = = = k IE h SS+1 :Sk jF k ] k IE f(X Y )jG ] g(Y ) ph(uSk ) + qh(dSk ): This shows the stock price is Markov. so that Y is G -measurable. .5 Application to Exotic Options Consider an n-period binomial model.

k Vk is a martingale under I . Let V k denote the value of the derivative f security at time k. (Here we are working under k the risk-neutral measure I . P Proof: Fix k.CHAPTER 4. The Markov Property 75 vn(Sn Mn ) = (Mn . 1 = 1 IE v (S M )jF ] f 1+r n n n n 1 1 ~ = 1 + r pvn (uSn 1 uSn 1 _ Mn 1 ) + q vn (dSn ~ . Let h(x k = SS+1 . We have h(Sk+1 Mk+1 ) = h(Sk+1 Mk _ Sk+1 ) = h(ZSk Mk _ (ZSk )): Deﬁne f g (x y) = IEh(Zx y _ (Zx)) = ph(ux y _ (ux)) + q h(dx y _ (dx)): ~ ~ 4 The Independence Lemma implies f IE h(Sk+1 Mk+1 )jF k ] = g(Sk Mk ) = ph(uSk Mk _ (uSk )) + qh(dSk Mk ) ~ ~ the second equality being a consequence of the fact that M k ^ dSk = Mk . we have proved the Markov property (form (b)) for this two-dimensional process. we have Vn = vn (Sn Mn): Stepping back one step. 1 Mn 1)] : . Since (1 + r). although that does not matter). . . . so k y ) be a function of two variables. Continuing with the exotic option of the previous Lemma. Let Z f IP (Z = u) = p IP (Z = d) = q ~ f ~ and Z is independent of F k . Since the RHS is a function of (Sk Mk ). . K )+ (Knock-in Barrier option). . 1: At the ﬁnal time. K )+ (Lookback option).16 The two-dimensional process f(S k Mk )gn=0 is Markov... vn(Sn Mn ) = IMn B (Sn . we have P 1 f Vk = 1 + r IE Vk+1jF k ] k = 0 1 : : : n . Lemma 5. we can compute Vn . We have Mk+1 = Mk _ Sk+1 4 where _ indicates the maximum of two quantities.

76 This leads us to deﬁne 1 ~ vn 1 (x y) = 1 + r pvn (ux ux _ y ) + qvn(dx y)] ~ 4 . vk+1 (dSk Mk ) ( k . Since this is a simple European option. 1 ~ ~ vk (x y) = 1 + r pvk+1 (ux ux _ y ) + q vk+1(dx y ) and the value of the option at time k is v k (Sk Mk ). the hedging portfolio is given by the usual formula. d))S. . so that The general algorithm is Vn 1 = vn 1 (Sn . 1 Mn 1): . . which in this case is k _ Mk = vk+1 (uSk (uSk ) u .

Thus. 1: k= (u . Let Vn = g (Sn ) be the payoff of a derivative security. This is because the value of the derivative security at time k is at least g (S k ). Again a function g is speciﬁed.1 American Pricing Let us ﬁrst review the European pricing formula in a Markov model. Deﬁne by backward recursion: vn (x) = g (x) 1 ~ vk (x) = 1 + r pvk+1 (ux) + qvk+1(dx)]: ~ Then vk (Sk ) is the value of the option at time k. vn(x) = g (x) 1 p vk (x) = max 1 + r (~vk+1 (ux) + q vk+1 (dx)) g(x) ~ Then vk (Sk ) is the value of the option at time k. vk+1 (dSk ) k = 0 1 2 : : : n . 77 . the hedging portfolio should create a wealth process which satisﬁes Xk g (Sk) 8k almost surely.Chapter 5 Stopping Times and American Options 5. d)Sk Now consider an American option. and the hedging portfolio is given by vk+1 (uSk ) . the holder of the derivative security can “exercise” and receive payment g (Sk ). In any period k. and the wealth process value at that time must equal the value of the derivative security. American algorithm. Consider the Binomial model with n periods.

Set v2 (x) = g(x) = (5 .0:43 v1 (S1 (T)) S1 (T) 0 + (1 + r)(X0 . 0S0 ) 2 0 + 5 (1:36 . x)+ . 2)+ 2 5 2 = maxf2 3g = 3:00 v0 (4) = max 4 1 :(0:4) + 1 :(3:0) (5 . 5. 4)+ 2 5 2 = maxf1:36 1g = 1:36 Let us now construct the hedging portfolio for this option.0:43 .1: Stock price and ﬁnal value of an American put option with strike price 5. 8)+ 2 5 2 = max 2 0 5 = 0:40 v1 (2) = max 4 1 :1 + 1 :4 (5 . 4 0) 4 . Begin with initial wealth X 0 0 as follows: = 1:36. Example 5.3 0 + 1:70 =) 0 = . S0 Then 1 ~ ~ 2 = 4 u = 2 d = 1 r = 4 p = q = 1 n = 2.1 See Fig. 2 v1 (8) = max 4 1 :0 + 1 :1 (5 .1. 0S0 ) 8 0 + 5 (1:36 .78 S2 (HH) = 16 v2 (16) = 0 S (H) = 8 1 S2 (HT) = 4 S =4 0 S1 (T) = 2 S2 (TH) = 4 v (4) = 1 2 S2 (TT) = 1 v (1) = 4 2 Figure 5. 4 0) 4 3 0 + 1:70 =) 0 = . Compute 0:40 = = = = 3:00 = = = = v1 (S1 (H)) S1 (H) 0 + (1 + r)(X0 .

1 (T )S1 (T )) 5 1(T) + (3 . Stopping Times and American Options Using 0 79 = .0:16 (T)! If we had X1 (T ) = 2. The value satisﬁes Xk g(Sk) k = 0 1 : : : n.1 1 (T) = . 2 1(T)) 4 . Ck . The value process is the smallest process with these properties. (1 + r)Sk ) . (1 + r)Ck Here.1 5.1:5 1(T) + 2:5 =) 1 (T) = . . equivalently.0:43 results in X1 (H) = v1(S1 (H)) = 0:40 X1 (T ) = v1 (S1 (T)) = 3:00 (Recall that S1 (T) = 2): Now let us compute 1 1 = = = = 4 = = = = We get different answers for 1 v2 (4) S2 (TH) 1(T) + (1 + r)(X1 (T ) .1:83 v2 (1) S2 (TT ) 1(T ) + (1 + r)(X1 (T) . (k+1) vk+1 (Sk+1 )jF k ] < (1 + r) k vk (Sk ) . Ck is the amount “consumed” at time k. 1(T)S1 (T)) 5 4 1(T ) + 4 (3 . When do you consume? If f IE ((1 + r) or. The discounted value of the portfolio is a supermartingale. f 1 IE( 1 + r vk+1(Sk+1)jF k ] < vk (Sk ) . 2 1(T)) 1:5 1(T ) + 3:75 =) 1(T) = .2 Value of Portfolio Hedging an American Option Xk+1 = = k Sk+1 + (1 + r)(Xk .CHAPTER 5. the value of the European put. we would have 1 = 1:5 1(T ) + 2:5 =) 4 = . k Sk ) (1 + r)Xk + k (Sk+1 .1:5 1(T ) + 3:75 =) 1(T ) = .

where vk is the value deﬁned by the American algorithm in Section 5. 2 Example 5. deﬁne (!) = minfk Sk (!) = m2 (!)g .2 Consider the binomial model with n = 2 S 0 = 4 u = 2 d = 1 r = 1 . We note that (!) = We verify that is indeed a stopping time: 1 2 if ! if ! 2 AT 2 AH f! (!) = 0g = 2 F 0 f! (!) = 1g = AT 2 F 1 f! (!) = 2g = AH 2 F 2 Example 5. Deﬁne Let (!) = minfk vk(Sk ) = (5 . )S+1 (dSk ) ( . Sk )+ g: The stopping time corresponds to “stopping the ﬁrst time the value of the option agrees with its intrinsic value”. 1 f 1 IE 1 + r v2(S2 )jF 1 ](T ) = 4 2 :1 + 1 :4 2 5 h i = = v1 (S1(T )) = 4 5 5 2 2 3 so there is a gap of size 1. Deﬁnition 5.d k In the example.1. v1 (S1(T )) = 3 v2(S2(TH )) = 1 and v2(S2 (TT )) = 4. In the previous example. then the seller of the option can consume to close the gap.1 (Stopping Time) Let ( F tion. By doing this. It is an optimal exercise time. It is optimal for the owner of the American option to exercise whenever its value vk (Sk ) agrees with its intrinsic value g (S k ). Thereafter. he can ensure that X k = vk (Sk ) for all k. A stopping time is a random variable f! 2 P) be a probability space and let fF k gn=0 be a ﬁltrak : !f0 1 2 : : : ng f1g with the property that: (!) = kg 2 F k 8k = 0 1 : : : n 1: q= ~ 1. If the owner of the option does not exercise it at time one in the state ! 1 = T . then the seller can consume 1 at time 1. Therefore. he uses the usual hedging portfolio k k vk = vk+1 (uSu ) . so p = ~ 2 4 v0 v1 v2 be the value functions deﬁned for the American put with strike price 5. we have v1 (S1(T )) = g (S1(T )).3 (A random time which is not a stopping time) In the same binomial model as in the previous example.80 and the holder of the American option does not exercise.

CHAPTER 5. 1 2 if ! if ! 2 AT 2 AH fHT g \ f! (!) = 0g = 2 F 0 fHT g \ f! (!) = 1g = 2 F 1 fHT g \ f! (!) = 2g = fHT g 2 F 2 but The atoms of F are fT H g \ f! (!) = 1g = fTH g 62 F 1 : fHT g fHH g AT = fT H T T g: Notation 5. Sk )+ g i. This if ! if ! if ! 2 AH = TH = TT We verify that is not a stopping time: f! (!) = 0g = AH 62 F 0 f! (!) = 1g = fTH g 62 F 1 f! (!) = 2g = fTT g 2 F 2 5. and is k k a stopping time with respect to the same ﬁltration. (!) = The set fHT g is determined by time .2 Let that be a stopping time.3 Information up to a Stopping Time Deﬁnition 5. let = minfk vk (Sk ) = (5 . but the set fTH g is not.1 (Value of Stochastic Process at a Stopping Time) If ( F P) is a probability space. Stopping Times and American Options where m2 = min0 j 2 Sj . In other words. then X is an F -measurable random variable whose value at ! is given by X (!) = X (!) (!): 4 .. Example 5. fF k gn=0 is a ﬁltration under F . We say that a set A is determined by time provided A \ f! (!) = kg 2 F k 8k: The collection of sets determined by is a -algebra. fXk gn=0 is a stochastic process adapted to this ﬁltration. Indeed. which we denote by F .e. random variable is given by 81 4 80 < (!) = : 1 2 stops when the stock price reaches its minimum value.4 In the binomial model considered earlier.

the discounted stock price process ( 5 ). there is a nonrandom number n such that n If almost surely.5 In the example 5. e IE " 4 5 2 S2 F (!) = # 4 2 S (T H) + 1 4 2 5 5 2 = 1 2:56 + 1 0:64 2 2 = 1:60 1 2 S2 (T T) In every case we have gotten (see Fig. We compute 4 e IE The atoms of F are fHH g " 4 5 2 S2 F : # fHT g e IE e IE and for ! " and AT . Therefore.k Sk is a martingale.82 Theorem 3. 5. implies Y = IE (Y jF ). i.2) e IE " 4 5 2 S2 F (!) = 4 5 # ( ) ! S (! ) (!): .. Y IE (Y jF ): Taking expectations. we obtain IEY IEY . then implies Y IE (Y jF ). Y 0 = IEY0 IEY is a supermartingale. Under the risk-neutral probability measure.e. then n almost surely. If fYk F k gk=0 1 Example 5. we deﬁne (!) = 2 for all ! 2 . and in particular. If fYk F k gk=0 is a martingale.4 considered earlier. Let and be bounded stopping times.17 (Optional Sampling) Suppose that fYk F k g1 (or fYk F k gn=0 ) is a submartink=0 k gale. then 1 . " 4 2 S F (HH) = 5 2 # 4 2 S F (HT) = 5 2 # 4 5 4 5 2 S2 (HH) S2 (HT ) 2 2 2 AT .

.60 1 (16/25) S2 (TT) = 0.40 1 (16/25) S2 (HT) = 2.CHAPTER 5. Stopping Times and American Options 83 (16/25) S (HH) = 10.56 S =4 0 (16/25) S2 (TH) = 2.56 (4/5) S (T) = 1.2: Illustrating the optional sampling theorem.64 Figure 5.24 2 (4/5) S (H) = 6.

84 .

The owner of an American derivative security can k exercise at any time k.k Vk gn=0 is the smallest supermartingale which satisﬁes k Vk Gk 8k almost surely. 1: !k H ) . Sk+1 (!1 !k T ) k+1 !1 85 . and if he does.1 The properties Deﬁnition 6. is an optimal exercise time. he receives the payment Gk .Chapter 6 Properties of American Derivative Securities 6. (c) Any stopping time which satisﬁes f V0 = IE (1 + r) G ] . In particular = minfk Vk = Gk g 4 is an optimal exercise time. where the maximum is over all stopping times satisfying k almost surely. Vk+1(!1 :: :: :: !k T ) k = 0 1 : : : n . (d) The hedging portfolio is given by k (!1 V ( : : : !k ) = Sk+1(!1 :: :: :: !k H ) . (a) The value Vk of the security at time k is f Vk = max (1 + r)k IE (1 + r) G jF k ] .1 An American derivative security is a sequence of non-negative random variables fGk gn=0 such that each Gk is F k -measurable. (b) The discounted value process f(1 + r).

i Because is also in T k . 6. k Deﬁne Tk to be the set of all stopping times satisfying k n almost surely.k Vk gn=0 is a supermartingale. . h i Lemma 2. Deﬁne also f Vk = (1 + r)k max IE (1 + r) G jF k ] : T 4 .. 2 k Lemma 2.s.k Yk gn=0 is a supermartingale. 2 . k Proof: Let fh (1 + r) (k+1) Vk+1 = IE (1 + r) .s. Then the owner of the derivative security should exercise it. 1 + r IE Vk+1jF k ](!) and still maintain the hedge.86 (e) Suppose for some k and ! . then the seller of the security can immediately consume 1 f Vk (!) .20 If fYk gn=0 is another process satisfying k Yk Gk k = 0 1 : : : n and f(1 + r). then k a.18 Proof: Take Vk Gk for every k. Lemma 2. Yk Vk k = 0 1 : : : n a. we have Vk (!) = Gk (!).2 Proofs of the Properties Let fGk gn=0 be a sequence of non-negative random variables such that each Gk is F k -measurable. . attain the maximum in the deﬁnition of V k+1 .19 The process f(1 + r). If he does not. i. . 2 Tk to be the constant k.. we have f IE (1 + r) (k+1) Vk+1jF k ] f f IE IE (1 + r) G jF k+1]jF k f IE (1 + r) G jF k ] f max IE (1 + r) G jF k ] Tk = (1 + r) k Vk : = = .e. G jF k+1 : . .

The induction hypothesis is that X k = Vk k 2 f0 1 : : : n . = Yk : Lemma 2.e. . for each ﬁxed (!1 : : : !k) we have Xk (!1 : : : !k ) = Vk (!1 : : : !k ): Proof: We need to show that Xk+1 (!1 : : : !k H ) = Vk+1(!1 : : : !k H ) Xk+1(!1 : : : !k T ) = Vk+1(!1 : : : !k T ): We prove the ﬁrst equality. 1 + r IE Vk+1 jF k ] n f = (1 + r)k (1 + r) k Vk . C k must be non-negative almost surely. . Vk+1 (!1 :: :: :: !k T ) : !k H ) . k Sk ): V : : : !k ) = Sk+1(!1 :: :: :: !k H ) . f Vk = (1 + r)k max IE (1 + r) G jF k ] T . Therefore. Ck .k Vk gn=0 is a supermartingale. Sk+1 (!1 !k T ) k+1 (!1 Then Xk = Vk 8k: for some We proceed by induction on k. Properties of American Derivative Securities Proof: The optional sampling theorem for the supermartingale f(1 + r) . Ck (!1 : : : !k ) f = 1 IE Vk+1 jF k ](!1 : : : !k ) 1+r 1 p = 1 + r (~Vk+1 (!1 : : : !k H ) + q Vk+1 (!1 : : : !k T )) : ~ . (k+1) Vk+1jF k ] o : Since f(1 + r). 1g. Note ﬁrst that Vk (!1 : : : !k ) .k Yk gn=0 implies k 87 f IE (1 + r) Y jF k ] (1 + r) k Yk 8 2 Tk : . 2 .21 Deﬁne f (1 + r)k max IE (1 + r) Y jF k ] Tk (1 + r) k (1 + r)k Yk .. Deﬁne k k (!1 Set X0 = V0 and deﬁne recursively Xk+1 = k Sk+1 + (1 + r)(Xk . 2 k 1 f Ck = Vk . the proof of the second is similar.CHAPTER 6. i. IE (1 + r) .

k Sk ) Vk+1 (H ) . Skj+1 (!1 : : : !k T ) (j ) (j ) Thus. d)Sk +~Vk+1 (H ) + q Vk+1 (T ) p ~ (Vk+1 (H ) . Superpose the hedges for the individual payments. Vk+1(T ) (uS . Vk+1(T ) (S (H ) . Vk+1 (T ))~ + pVk+1(H ) + q Vk+1 (T ) q ~ ~ Vk+1 (H ): 6. ::: (j ) ). starting with wealth V 0 . 1: () Sk+1 (!1 : : : !k H ) . Vk(+1 (!1 : : : !k T ) : : : !k ) = (j) k = 0 : : : j . and the hedging portfolio for that security is given by (j ) (! k 1 j) j) Vk(+1 (!1 : : : !k H ) . (1 + r)S ) k k (u . At each time k 2 f0 1 : : : n . Ck . we will suppress these symbols. Ck ) Vk+1 (H ) .3 Compound European Derivative Securities In order to derive the optimal stopping time for an American derivative security. ﬁrst make the j payment Ck and then use the portfolio k = k (k+1) + k (k+2) + : : : + k (n) .. which are also interesting in their own right. i. the security that expires at time j has payoff Cj . k Hedging a short position (one payment). we can ensure that at j 1 . the process fCj gn=0 is adapted to the ﬁltration j j fF k gn=0. Here is how we can hedge a short position in the j ’th European derivative security. start with wealth V 0 = n=0 V0 . A compound European derivative security consists of n + 1 different simple European derivative securities (with the same underlying stock) expiring at times 0 1 : : : n. where each Cj is F j -measurable. Sk+1 (T ) k+1 +(1 + r)(Vk . Thus a compound European derivative security is speciﬁed by the process fCj gn=0 . Ck = 1 + r (~Vk+1 (H ) + qVk+1 (T )) : ~ We compute Xk+1 (H ) = = = = = k Sk+1 (H ) + (1 + r)(Xk .e. the last equation can be written simply as 1 p Vk . it will be useful to study compound European derivative securities. Hedging a short position (all payments). For example.88 Since (!1 : : : !k ) will be ﬁxed for the rest of the proof. In P (j) other words. 1g. and using the portfolio ( 0 time j we have wealth Cj . (1 + r)S ) k Sk+1 (H ) . The value of European derivative security j at time k is given by f Vk(j) = (1 + r)k IE (1 + r) j Cj jF k ] k = 0 : : : j .

CHAPTER 6. Properties of American Derivative Securities

89

corresponding to all future payments. At the ﬁnal time n, after making the ﬁnal payment Cn , we will have exactly zero wealth. Suppose you own a compound European derivative securityfC j gn=0 . Compute j

V0 =

n X j =0

2n 3 X f V0(j ) = IE 4 (1 + r) j Cj 5

;

j =0

;1 and the hedging portfolio is f k gn=0 . You can borrow V0 and consume it immediately. This leaves k you with wealth X 0 = ;V0 . In each period k, receive the payment Ck and then use the portfolio ; k . At the ﬁnal time n, after receiving the last payment Cn, your wealth will reach zero, i.e., you will no longer have a debt.

**6.4 Optimal Exercise of American Derivative Security
**

In this section we derive the optimal exercise time for the owner of an American derivative security. Let fGk gn=0 be an American derivative security. Let be the stopping time the owner plans to k use. (We assume that each Gk is non-negative, so we may assume without loss of generality that the owner stops at expiration – time n– if not before). Using the stopping time , in period j the owner will receive the payment

Cj = I

f

=j

g

Gj :

In other words, once he chooses a stopping time, the owner has effectively converted the American derivative security into a compound European derivative security, whose value is

V0( )

2n 3 X f = IE 4 (1 + r) j Cj 5 2j=0 3 n X f = IE 4 (1 + r) j I =j Gj 5

; ;

f = IE (1 + r) G ]:

;

j =0

f

g

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 fC j gn=0 are j received. Thus, his optimal behavior is to use a stopping time Lemma 4.22 which maximizes V 0 .

( )

**V0( ) is maximized by the stopping time
**

= minfk Vk = Gk g:

Proof: Recall the deﬁnition

f V0 = max IE (1 + r) G ] = max V0( T T

4 ; 2

)

0

2

0

90

f Let 0 be a stopping time which maximizes V0 , i.e., V0 = I (1 + r); G 0 : Because f(1 + r);k Vk gn=0 E k is a supermartingale, we have from the optional sampling theorem and the inequality V k Gk , the following:

( )

0

h

i

V0

f IE (1 + r) 0 V 0 jF 0 i fh = IE (1 + r) 0 V 0 i fh IE (1 + r) 0 G 0 = V0:

; ; ; ;

h

i

Therefore, and

f f V0 = IE (1 + r) 0 V 0 = IE (1 + r) 0 G 0

;

h

i

h

i

V 0=G

0

0 a.s.

We have just shown that if

attains the maximum in the formula

f V0 = max IE (1 + r) G ] T

; 2

0

(4.1)

**then But we have deﬁned and so we must have
**

0

V 0=G

0 a.s.

**n almost surely. The optional sampling theorem implies
**

;

= minfk Vk = Gk g

;

(1 + r)

G

= (1 + r) V i fh IE (1 + r) 0 V 0 jF i fh = IE (1 + r) 0 G 0 jF :

; ;

Taking expectations on both sides, we obtain

f IE (1 + r)

h

;

G

i fh i IE (1 + r) 0 G 0 = V0 :

;

It follows that also attains the maximum in (4.1), and is therefore an optimal exercise time for the American derivative security.

Chapter 7

Jensen’s Inequality

7.1 Jensen’s Inequality for Conditional Expectations

Lemma 1.23 If ' : IR!IR is convex and IE j'(X )j < 1, then

IE '(X )jG] '(IE X jG]):

For instance, if G

=f

g '(x) = x2:

IEX 2 (IEX )2:

Proof: Since ' is convex we can express it as follows (See Fig. 7.1):

'(x) = max h(x): h '

h is linear

Now let h(x) = ax + b lie below '. Then,

IE '(X )jG]

**IE aX + bjG] = aIE X jG] + b = h(IE X jG])
**

max h(IE X jG]) h '

This implies

IE '(X )jG]

= '(IE X jG]):

h is linear

91

92

ϕ

Figure 7.1: Expressing a convex function as a max over linear functions. Theorem 1.24 If fYk gn=0 is a martingale and k Proof: is convex then f'(Y k )gn=0 is a submartingale. k

IE '(Yk+1)jF k ]

'(IE Yk+1jF k ]) = '(Yk ):

**7.2 Optimal Exercise of an American Call
**

This follows from Jensen’s inequality. Corollary 2.25 Given a convex function g : 0 1)!IR where g (0) = 0. For instance, g (x) = (x ; K )+ is the payoff function for an American call. Assume that r 0. Consider the American derivative security with payoff g (S k ) in period k. The value of this security is the same as the value of the simple European derivative security with ﬁnal payoff g (S n), i.e., f f IE (1 + r) n g (Sn)] = max IE (1 + r) g (S )]

; ;

where the LHS is the European value and the RHS is the American value. In particular optimal exercise time. Proof: Because g is convex, for all

= n is an

**2 0 1] we have (see Fig. 7.2): g( x) = g ( x + (1 ; ):0) g (x) + (1 ; ):g (0)
**

=

g (x):

CHAPTER 7. Jensen’s Inequality

93

( λ x, λ g(x))

(x,g(x))

x ( λ x, g( λ x))

Figure 7.2: Proof of Cor. 2.25 Therefore,

1 g 1 + r Sk+1

1 g (S ) 1 + r k+1

;

and

optional sampling theorem implies

1 g (S )jF 1 + r k+1 k 1 f (1 + r) k IE g 1 + r Sk+1 jF k f 1 (1 + r) k g IE 1 + r Sk+1 jF k = (1 + r) k g (Sk ) So f(1 + r) k g (Sk )gn=0 is a submartingale. Let be a stopping time satisfying 0 k

f IE (1 + r)

h

;

(k+1) g (Sk+1)jF k

i

f = (1 + r) k IE

; ;

;

;

n. The

f (1 + r) g (S ) IE (1 + r) n g (Sn)jF ] :

; ; ;

Taking expectations, we obtain

f IE (1 + r) g(S )]

f f IE IE (1 + r) n g(Sn)jF ] f = IE (1 + r) n g (Sn)] :

; ; ;

**Therefore, the value of the American derivative security is
**

;

f f max IE (1 + r) g (S )] IE (1 + r) n g (Sn )] f f max IE (1 + r) g (S )] = IE (1 + r) n g (Sn )] :

; ;

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 n is always allowed, and we conclude that

94

S2 (HH) = 16

S (H) = 8 1 S2 (HT) = 4 S =4 0 S1 (T) = 2 S2 (TH) = 4

S2 (TT) = 1

Figure 7.3: A three period binomial model.

7.3 Stopped Martingales

Let fYk gn=0 be a stochastic process and let k stopped process

^

be a stopping time. We denote by

fY k gn=0 the k

^

Yk (!) (!) k = 0 1 : : : n:

(!) = 1 2

if if

Example 7.1 (Stopped Process) Figure 7.3 shows our familiar 3-period binomial example. Deﬁne

Then

8 S (HH) = 16 > 2 < ) S2^ (! ) (!) = > S2 (HT= = 4 S1 (T ) 2 : S1(T ) = 2

!1 = T !1 = H:

if if if if

! = HH ! = HT ! = TH ! = T T:

Theorem 3.26 A stopped martingale (or submartingale, or supermartingale) is still a martingale (or submartingale, or supermartingale respectively). Proof: Let fYk gn=0 be a martingale, and be a stopping time. Choose some k 2 f0 1 k The set f kg is in F k , so the set f k + 1g = f kgc is also in F k . We compute

: : : ng.

IE Y(k+1) jF k = IE I k Y + I k+1 Yk+1 jF k = I k Y + I k+1 IE Yk+1 jF k ] = I k Y + I k+1 Yk = Yk :

^ f g f g f f g g f f g g ^

h

i

h

i

CHAPTER 7. Jensen’s Inequality

95

96 .

It is the ﬁrst time the number of heads exceeds by one the number of tails. . Deﬁne 2 Yj (!) = Mk = ( . Then the sample space is the set of all inﬁnite sequences ! = (!1 !2 : : : ) of H and T .1) Its analogue in continuous time is k=0 Brownian motion. the probability of H is 1 .1 k X 1 if if !j = H !j = T M0 = 0 The process fMk g1 is a symmetric random walk (see Fig. !) k . and on each toss. then = 1. It is shown in a Homework Problem that fM k g1 and fNk g1 where k=0 k=0 Nk = exp Mk .g.. Deﬁne j =1 Yj k = 1 2 : : : = minfk 0 Mk = 1g: If Mk never gets to 1 (e. Assume the tosses are independent.Chapter 8 Random Walks 8.1 First Passage Time Toss a coin inﬁnitely many times. as is the probability of T . 8. The random variable 8. ! = (TTTT : : : )). k log e + e 2 = e Mk 2 e +e 97 ( .2 is almost surely ﬁnite is called the ﬁrst passage time to 1.

we have =. We want to let k!1 in (2.98 Mk k Figure 8. 8. so e +e 2 e +e k . (! ) = 1. (2.2 for an illustration of the various functions involved). in part 1 = IENk = IE e Mk ^ " ^ 2 e +e k ^ # .1: The random walk process Mk eθ e−θ + 2 1 θ Figure 8.1). < 1: if if ! ( 0 2 e +e. <1 Furthermore.1) for every ﬁxed 2 IR (See Fig.Sk in part (i) of the Homework Problem and take (v). but we have to worry a bit that for some sequences ! 2 . > 0. We consider ﬁxed As k!1. Mk^ 1. ^ 2 . so 0 e Mk ^ =1 e .) Since N0 = 1 and a stopped martingale is a martingale. (Take Mk = . because we stop this martingale when it reaches 1.2: Illustrating two functions of 2 eθ e−θ + 1 θ are martingales.

2) 2 (0 1]. and we rewrite that equation as IE e +e 2 . 2e + = 0 . we have so we can let #0 in (2.3 The moment generating function for Let 2 (0 1) be given. : Solution: e + e . (In our inﬁnite sample space . I f < 1g (2.CHAPTER 8.3) 8.2). . We k=0 have just shown that these paths collectively have no probability.e. =1 = 1: 2 IE e e + e For all . we obtain 2 e +e k ^ # . We want to ﬁnd > 0 so that 2 = e +e . . . ^ 2 e +e . We know there are paths of the symmetric random walk fMk g1 which never reach level 1. Random Walks and 99 0 e Mk lim e Mk k! 1 ^ 2 e +e k ^ k ^ . I f < 1g e i. <1 = 1: Recall Equation (2. each path individually has zero probability). to conclude h i IE If < 1g = 1 IP f < 1g = 1: 2 0 e e +e . and using the Bounded Convergence Theorem. = ( 0 e 2 e +e. (2. We therefore do not need the indicator I f < 1g in (2.2=0 (e )2 .2).. =e : . e: if if In addition. using the Bounded Convergence Theorem again.1): IE e Mk^ " Letting k!1.

8.3): IE With 2 (0 1) and > 0 related by e e +e .1) We have computed the moment generating function for the ﬁrst passage time to 1. 2 : 2 We want > 0. . 1. so . 2 < p 1. 1) p 2 ! p 2 2 : . 1. 1 . d IE d = 1 . p 2 0 < < 1: (3. 2 .100 e =1 . 2 = e +e . 2 < 1 We take the negative square root: p e = 1. 1.p 1 .4 Expectation of Recall that IE so = 1. so we must have e < 1. )2 < (1 . p 2 : > 0: 2 Recall Equation (2. 1. 1. 2 1. p 1. < 1. = 1. = IE ( p 2 0< <1 . =e . 0 < (1 . p this becomes IE = 1. 1. 1. Now 0 < < 1. 2 p 1. = dd 1 . ) < 1 .

Random Walks Using the Monotone Convergence Theorem. 1 = 1.e. 1. i..p 1 . 1 is the number of periods between the ﬁrst arrival at level 1 and the ﬁrst arrival at level 2. 2 1. 1 is the same as the distribution of 1 (see Fig.. i. p "1 in the equation 2 2 IE = 1: = minfk Mk = 1g 4 Thus in summary: IP f < 1g = 1 IE = 1: 8.3). 8.5 The Strong Markov Property The random walk process fMk g1 is a Markov process. p 2 2 (0 1): . this Markov property implies the Strong Markov property: IE random variable depending only on = IE same random variable M +1 M +2 : : : j F ] j M ]: for any almost surely ﬁnite stopping time . 8. we can let 101 IE ( to obtain .CHAPTER 8. 1) = 1 . m = minfk 4 0 Mk = mg m = 1 2 : : : IE 2.e.6 General First Passage Times Deﬁne Then 2 . k=0 IE random variable depending only on = IE same random variable Mk+1 Mk+2 : : : j F k ] jMk ] : In discrete time. The distribution of 2 .

q = 1 . and thus ~ neutral probabilities are p = 2 ~ 2 r= 1 . IE m = 1. S )+ . 1 jM 1 ] IE 2 1 ] (M 1 = 1 not random ) ! p 1 . 1 2. 1 IE IE jF 1 jF 1 ] = = = Take expectations of both sides to get (taking out what is known) 1 2. p ! 2 m 2 (0 1): 8. 1 . 1. 2 : IE 2 = IE 1 : 1 . For τ2 2 (0 1). with u = 2 d = 2 1 . p 2 ! p ! 2 2 In general.3: General ﬁrst passage times. 1. and payoff function (5 .7 Example: Perpetual American Put 1 Consider the binomial model. (strong Markov property) 1 1. 1. The risk k 4 Sk = S0 uMk . IE 2 jF 1 ] = IE = 1 1 2. = 1.102 Mk k τ1 τ 2 − τ1 Figure 8.

1 . at time . 2 In general. S . = 3: 3 = 2: Value of Rule 2: 1 . at time .CHAPTER 8. 2)+ IE ( 5 ) .2g: 4 f f Because the random walk is symmetric under I . stop (exercise the put) as soon as the stock price falls to 2.. = minfk Mk = .(j. This observation leads to the following computations of value.2 = 3:( 1 )2 = 3 : 2 4 h i . i. 1)+IE ( 4 ) .m has the same distribution under I as the P P stopping time m in the previous section. This requires 2 down steps. i.2 1 = 4:( 2 )2 = 1: h i Suppose instead we start with S 0 = 8. ( 4 )2 5 4 5 q f 5 V ( . 1 j = 1 2 3 ::: .1g: 4 Rule 2: Stop as soon as stock price falls to 1. so the value of this rule with this initial stock price is This suggests that the optimal rule is Rule 1.1 (5 . Random Walks 103 Suppose S0 = 4.e.. and stop the ﬁrst time the price falls to 2. = 0 V ( 0 ) = 1. and we stop when the stock price falls to 2. 2)+ IE ( 5 ) .1 . 2 = minfk Mk = . Here are some possible exercise rules: Rule 0: Stop immediately. Value of Rule 1: f V ( .2 ) = (5 . .1) = 3:( 1 )j 1 : 2 We deﬁne v(2j ) = 3:( 1 )j 2 4 . denoted by IP . 2)+IE ( 5 ) . and the value of the put is 3 if S0 = 4. then j . 0 where f Mk is a symmetric random walk under the risk-neutral measure.1) = IE (1 + r) . f 4 (5 . 1 Rule 1: Stop as soon as stock price falls to 2.1 )+ h4 i = (5 . i. 1 down steps will be required and the value of the option is fh 4 i (5 . if S0 = 2j for some j 1.e..e.

Proof: (a). . The value of this rule is given by v (2 j ) as we just deﬁned it. 2j )+ for for j 1 j 1: v(2j ) = 5 . Proof: (b). 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. f 5 IE 4 v (Sk+1)jF k = 4 : 1 v (2Sk ) + 4 : 1 v ( 1 Sk ): 5 2 5 2 2 h i . we exercise If S0 = 2j for some j immediately. 2j (5 . We must show that 2 v(2j ) 5 v (2j +1) + 2 v (2j 1): 5 If j 2. Sk )+ 8k o n (b) ( 4 )k v (Sk ) is a supermartingale. . 2j )+ This is straightforward. . . the initial time is no different from any other time. . Sk = 2j for some j . then v (2j ) = 3:( 1 )j 1 and 2 2 v (2j +1 ) + 2 v (2j 1) 5 5 1 1 = 2 :3:( 2 )j + 2 :3:( 2 )j 2 5 5 2 = 3: 5 : 1 + 2 ( 1 )j 2 4 5 2 = 3: 1 :( 1 )j 2 2 2 = v (2j ): . We must show that v(Sk ) By assumption. we shall only consider initial stock prices of the form S 0 always of the form 2j . Since the put is perpetual. and the value of the put is v (2j ) = 5 . 2j j = 1 0 .104 1. with a possibly different j . 5 k=0 (c) fv (Sk )gk=0 is the smallest process with properties (a) and (b).2 : : : 4 Proposed exercise rule: Exercise the put whenever the stock price is at or below 2. We must show: (a) v (Sk ) (5 . This leads us to make the following: Conjecture 1 The value of the perpetual put at time k is v (S k ). 1 1 Note: To simplify matters. 1 (5 . then the initial price is at or below 2. Just check that = 2j . In this case.1 . so Sk is v(2j ) = 3:( 1 )j 2 4 4 .

so if S0 = 2j for some j 1. . 2j )+ = v (S0): Suppose now that S 0 = 2j for some j 2. 2j +1 ) + 2 (5 . 5 0.1). Suppose fYk gn=0 is some other process satisfying: k (a’) (b’) Yk (5 .1) Actually. S0 4.CHAPTER 8. There is a gap of size 1.2) provided we let S0 in (7. With appropriate (but messy) conditioning on F k .2) be any number of the form 2j . then (a’) implies v (2j ) = 5 . 2j = (5 . This concludes the proof of (b). Let = minfk Sk = 2g = minfk Mk = j .2) can be modiﬁed to prove (7. 1. 1g: . . so it will sufﬁce to show (7.. every time k is like every other time. Random Walks If j 105 = 1. then v (2j ) = 5 . the proof we give of (7. = 3=5 + 8=5 1 = 2 5 < v (2) = 3 If j There is a gap of size 4 .e. 2j : . i. 2j 1 ) 5 5 2 = 4 . Sk )+ 8k f( 4 )k Yk gk=0 is a supermartingale. 2j < v (2j ) = 5 . then v (2j ) = v (2) = 3 and 2 v (2j +1 ) + 2 v (2j 1) 5 5 2 = 5 v (4) + 2 v (1) 5 2 :3: 1 + 2 :4 = 5 2 5 . 5 1 We must show that Yk v (Sk ) 8k: Y0 v(S0) For j (7. 2j )+ Y0 (5 . 2j and 2 v (2j +1 ) + 2 v (2j 1) 5 5 = 2 (5 . Proof: (c). since the put is perpetual. 5 (4 + 1)2j 1 = 4 .

deﬁned for all x > 0.4): (a) (b) ( x 3 5 . then (c) will be automatically satisﬁed. then we can imagine the function v (x). we have For 6 j 1 : v(2j ) = 3:( 1 )j 1 = 2j 2 For j 1 : v (2j ) = 5 . (a) In the example we worked out. either (a) or (b) holds with equality. x)+ 8x.106 Then v(S0) = v (2j ) = 3:( 1 )j 1 h 4 2 +i = IE ( 5 ) (5 . x)+ 8x v (x) 4 1 1 x 5 2 v (2x) + 2 v ( 2 ) for every x except for 2 < x < 4. This function should satisfy the conditions: v (x) (K . 2j : . 8. 8.8 Difference Equation If we imagine stock prices which can fall at any point in (0 1). not just at points of the form 2 j for integers j . S ) : . 4 Because f( 5 )k Yk g1 is a supermartingale k=0 4 Y0 IE ( 5 ) Y h i IE ( 4 ) (5 . h i . In such a situation. This suggests the formula v (x) = We then have (see Fig. In this case. x 0 < x 3: 6 x v (x) (5 . we constructed v so that v (S k ) is the value of the put at time k if the stock price at time k is S k and if we exercise the put the ﬁrst time (k. S )+ = v(S0): 5 h i Comment on the proof of (c): If the candidate value process is the actual value of a particular exercise rule. 1 ~ ~ (b) v (x) 1+r pv (ux) + q v (dx)] 8x (c) At each x. or later) that the stock price is 2 or less. we need only verify properties (a) and (b). which gives the value of the perpetual American put when the stock price is x.

then (b) holds with equality: =4 5 6 = x: If 3 < x < 4 or 4 < x < 6. then both (a) and (b) are strict. then (a) holds with equality. p 2 0 < < 1: We will use this moment generating function to obtain the distribution of . 4 1 v (2x) + 1 v ( x ) 5 2 2 2 1 12 1 6 2 2x + 2 x 6.4: Graph of v (x). with M0 k=0 = 0. We ﬁrst obtain the Taylor series expasion of IE as follows: .9 Distribution of First Passage Times Let fMk g1 be a symetric random walk under a probability measure IP . Random Walks 107 v(x) 5 (3. 8. This is an artifact of the discreteness of the binomial model. Deﬁning = minfk 0 Mk = 1g we recall that IE = 1.2) 5 x Figure 8. Check of condition (c): If 0 < x If x 3. 1. in which an analogue of (a) or (b) holds with equality at every point. This artifact will disappear in the continuous model.CHAPTER 8.

2 xj : j ! So we have IE = 1. 3) : 2 42j :1:(: . 3) (1 . 2) j 1)! 2j 1 (2j . 1g: .(2j . 00 000 . 1 . j =2 1 2 2j 1 IP f . = 1 f ( 2) = 2 + p 2 X 1 2j 1 . (2j 1) 2 . 2j The Taylor series expansion of f (x) is given by f (x) = 1 . 1) 2j . . 1. IE = X j =1 = 2j . x X 1 (j) j = j ! f (0)x 1 p j =0 = X 1 X = x+ 2 1 j =1 1 2j 1 2 . 2)! 1 = 2 (j . 3) 0 . j =2 1 2j 1 1 2 (j .108 f (x) = 1 . 1 . 1)! x . x) 2 f (0) = 2 3 f (x) = 1 (1 . x) 2 f (0) = 1 4 4 3 (1 . 0 00 . (2j . x f (0) = 0 1 1 1 f (x) = 2 (1 . x) f (j)(0) = 1 3 : : : (2j . 000 p . x) 5 f (0) = 3 2 f (x) = 8 8 ::: : f (j)(x) = 1 3 : :2j (2j . (j . 2)! j j !(j . 2 : ! j But also. : = 1 3 : :2j (2j . 1) 1 2j . 1)! .

2 j = 2 3 : : : 2 (j . Random Walks 109 Figure 8. (See Figures 8. 1) j . 8. 8.6: Example with j Therefore.CHAPTER 8. IP f = 1g = IP f = 2j . 1.5.6.10 The Reﬂection Principle To count how many paths reach level 1 by time 2j .) = 1 and .5: Reﬂection principle. 1g = 1 2 ! 1 2j 1 1 2j . = 2.1 double count all those for which M 2j . Figure 8. count all those for which M 2j .1 3.

3)! . 3)! 1 2 j !(j . 1)(2j .3g 2. 1 2j 1 (2j . IP fM2j 1 = . 1)! ! 2j . IP fM2j 1 = . 1)! 2j 1 (2j . . IP fM2j 3 = . 3)! 2j (2j . IP f For j 2j . 1) . . . 1)! 1 2j 3 2 (j . . 1g = IP f = = = = = = = 2j . . 1) j . 2)] 2 j !(j . (2j . . 2)! 1 2 j !(j . 2 : 1 2j 1 1 2 (j . . . 3g 1 . 1g = IP fM2j 1 = 1g + 2IP fM2j 1 3g = IP fM2j 1 = 1g + IP fM2j 1 3g + IP fM2j = 1 . 1)(2j . 1)! 2j 1 (2j . 1g . . IP fM2j 1 = .1g] . IP f 2j . 1 . (2j .1g (2j . 2)] 1 2j 1 (2j . 1)! 4j (j .1g] IP fM2j 3 = . 1 . . . . 1)!(j . 2)! 2 j !(j . .110 In other words. . 2) . IP f = 2j .1g .1g: . .

t. P P f (1. 9.1 Equation (1. I .3) Remark 9. Then we say that P f is absolutely continuous with respect to I . we say that I and IP are equivalent. i. and I is absolutely continuous with P P P f.1 Radon-Nikodym Theorem f P Theorem 1.1) implies the apparently stronger condition A ZdIP 8A 2 F (1.e.. f IEX = IE XZ ] for every random variable X for which IE jXZ j < 1.r.2) and (1. Under this assumption. P f Assume that for every A 2 F satisfying IP (A) = 0.3) are the same.r. I and IP are equivalent if and only if f f respect to I P P P f IP (A) = 0 exactly when IP (A) = 0 8A 2 F : 1 f f If I and I are equivalent and Z is the Radon-Nikodym derivative of I w. then Z is the P P P P f Radon-Nikodym derivative of I w.27 (Radon-Nikodym) Let I and I be two probability measures on a space ( F ).2) IEX = IE XZ ] 8X f 1 IEY = IE Y: Z ] 8Y: (Let X and Y be related by the equation Y = XZ to see that (1.) 111 (1.t.Chapter 9 Pricing in terms of Market Probabilities: The Radon-Nikodym Theorem. f Remark 9.2 If I is absolutely continuous with respect to I . I . we also have I (A) = 0. there is a nonegative random P IP variable Z such that f IP (A) = Z f P P and Z is called the Radon-Nikodym derivative of I with respect to I .1) .

The Radon-Nikodym derivative of I with respect to I is P P f IP (!) Z (!) = IP (! ) : Deﬁne the I -martingale P f IP (!) > 0 IP (!) > 0 8! 2 We can check that Zk is indeed a martingale: Zk = IE Z jF k ] k = 0 1 : : : n: 4 f Lemma 2. and let IP correspond to probability 1 for 3 3 2 e H and 1 for T .28 implies that if X is F k -measurable.28 If X is F k -measurable.112 Example 9. so 2 I ( ) P e ! 9 9 Z(HH) = 4 Z(HT) = 9 Z(TH) = 9 Z(T T) = 16 : 8 8 9. then for any A 2 F k . Z f XdIP = Z A XZk dIP: .2 Radon-Nikodym Martingales Let be the set of all sequences of n coin tosses.1 (Radon-Nikodym Theorem) Let = fHH HT TH T T g. Let I be the market probability measure and let P f IP be the risk-neutral probability measure. the set of coin toss sequences of length 2. or equivalently. Then Z(!) = IP (!) . f IEX = IE XZ ] = IE IE XZ jF k ]] = IE X:IE Z jF k ]] = IE XZk ]: f IE IA X ] = IE ZkIA X ] A Note that Lemma 2. Let P correspond to probability 1 for H and 2 for T . Assume f f P P so that I and I are equivalent. then I EX Proof: IE Zk+1jF k ] = IE IE Z jF k+1 ]jF k ] = IE Z jF k ] = Zk : = IE XZk ].

So for any A 2 F j . Pricing in terms of Market Probabilities Z2 (HH) = 9/4 1/3 Z (H) = 3/2 1 1/3 Z =1 0 2/3 Z (T) = 3/4 1 2/3 Z2 (TT) = 9/16 1/3 2/3 Z2 (HT) = 9/8 Z2 (TH) = 9/8 113 Figure 9.2 (Radon-Nikodym Theorem. we have (Lemma 2. then j 1 f IE X jF j ] = Z IE XZk jF j ]: 1 Proof: Note ﬁrst that Z Z Z 1 f IE XZk jF j ]dIP = IE XZkjF j ]dIP A A Zj Z = = j IE XZk jF j ] is F j -measurable.29 If X is F k -measurable and 0 j k. not I . continued) We show in Fig. .28) f XdIP Example 9.28) ZA A XZk dIP (Partial averaging) (Lemma 2. since Z0 = IEZ = Z e ZdIP = IP ( ) = 1: 9.3 The State Price Density Process In order to express the value of a derivative security in terms of the market probabilities. We always have Z0 = 1.1: Showing the Zk values in the 2-period binomial model example. P P Lemma 2.CHAPTER 9. The probabilities shown f are for I . 9. it will be useful to introduce the following state price density process: k = (1 + r) k Zk k = 0 : : : n: .1 the values of the martingale Zk .

29) j Remark 9.28) More generally for 0 j k. 2 2 T0 More generally for 0 f Vj = (1 + r)j sup IE (1 + r) G jF j ] = 1 sup IE G jF j ]: j 2 j n. 1 = (1 + r)j sup Z IE (1 + r) Z G jF j ] 2 2 Tj .114 We then have the following pricing formulas: For a Simple European derivative security with payoff Ck at time k.4 Note that f j Vj gn=0 is a supermartingale under I .3 f j Vj gk=0 is a martingale under I . as we can check below: P j IE j+1Vj +1 jF j ] = IE IE k Ck jF j +1]jF j ] = IE k Ck jF j ] = j Vj : Now for an American derivative security fGk gn=0 : k 2 f V0 = sup IE (1 + r) G ] T0 = sup IE (1 + r) Z G ] T0 = sup IE G ]: . P j (b) j Vj j Gj 8j (a) . h i (Lemma 2. h i (Lemma 2. . Tj j . . f Vj = (1 + r)j IE (1 + r) k Ck jF j j h i = (1 + r) IE (1 + r) k Zk Ck jF j Zj 1 IE C jF ] = k k j . . Tj Remark 9. f V0 = IE (1 + r) k Ck h i = IE (1 + r) k Zk Ck = IE k Ck ]: .

Fig.3 shows the values of + k (5 . We compute the value of the put under various stopping times : (0) Stop immediately: value is 1.2: Showing the state price values k . we have V2 (HH) = 11 2(HH)V2 (HH) = 1:44 11 = 15:84: V2 (HT) = V2(TH) = V2 (TT ) = 0: V0 = 1 1 15:84 = 1:76: 3 3 2 (HH) V2(HH) = 1:44 11 = 1:20 11 = 13:20 1:20 1 (HH) V1 (H) = 1 13:20 = 4:40 3 Compare with the risk-neutral pricing formulas: V1(H) = 2 V1 (HH) + 2 V1(HT) = 2 11 = 4:40 5 5 5 2 V1 (T ) = 5 V1 (TH) + 2 V1 (T T ) = 0 5 2 V (H) + 2 V (T) = 2 V0 = 5 1 4:40 = 1:76: 5 1 5 Now consider an American put with strike price 5 and expiration time 2. (1) If (HH) = (HT) = 2 (T H) = (TT ) = 1.3 (Radon-NikodymTheorem. Pricing in terms of Market Probabilities ζ2(ΗΗ) = 1. Recall that p = 3 . not I .72 2 115 1/3 S (T) = 2 1 ζ (Τ) = 0.2. 9. 9.44 S2 (HH) = 16 1/3 ζ (Η) = 1. The 3 state price values k are shown in Fig.6 1 2/3 ζ (ΤΤ) = 0. The probabilities shown are for I . For a European Call with strike price 5.00 2/3 ζ2(ΗΤ) = 0.72 S2 (HT) = 4 S2 (TH) = 4 ζ (ΤΗ) = 0. the value is 1 2 0:72 + 2 1:80 = 1:36: 3 3 3 . Example 9.36 2 S2 (TT) = 1 f Figure 9. continued) We illustrate the use of the valuation formulas for 1 European and American derivative securities in terms of market probabilities. P P (c) f j Vj gn=0 is the smallest process having properties (a) and (b). j We interpret k by observing that k (! )IP (! ) is the value at time zero of a contract which pays $1 at time k if ! occurs.20 1 S (H) = 8 1 1/3 S =4 0 2/3 ζ0 = 1. q = 2 . Sk ) .CHAPTER 9. expiration time 2.

116 + (5 . P P (2) If we stop at time 2.72 2 2 (5 . dk ~ u d k k .d and for 2 equivalent. not I . the value is 1 3 2 3 2 0:72 + 3 1 0:72 + 2 3 3 2 3 1:44 = 0:96 We see that (1) is optimal stopping rule.80 1 1 1/3 + (5-S 0) =1 + ζ0 (5-S 0) =1 2/3 1/3 + (5 . Then I and P f IP are .S2(TH)) = 0.S (HH)) = 0 2 2 + (5 .72 2/3 + (5 . and assume IP f! g > 0 8! 2 P f IP (!) Z (!) = IP (! ) 8! 2 k n.44 2 2 Figure 9. 9.4 Stochastic Volatility Binomial Model Let be the set of sequences of n tosses.S (T))+ = 1.S1(H)) = 0 1 1/3 2/3 + (5 . The probabilities shown are for f I .S (HH)) = 0 2 + ζ (HH) (5 .S (TT)) = 1. Also let < 1+ rk < uk . and let 0 < d k are F k -measurable. Deﬁne f IP !k+1 = H jF k ] = pk ~ f IP !k+1 = T jF k ] = qk : ~ Let I be the market probability measure.S (HT)) = 1 2 ζ (HT) (5 . dk uk rk k k f Let I be the risk-neutral probability measure: P k pk = 1 + r. f IP f!1 = H g = p0 ~ f IP f!1 = T g = q0 ~ .S (TH))+= 1 2 + ζ2 (TH) (5 . qk = uk u (1 + rk) : ~ .3: Showing the values k (5 .S (HT))+= 0.S (H)) = 0 1 + ζ (H) (5 . where for each k.S (TT)) = 4 2 + ζ (TT) (5 .. Sk )+ for an American put.S (T)) = 3 1 ζ (T) (5 .

1 -measurable. k Sk ) k = 0 : : : n . .CHAPTER 9. and k n 1 k gk=0 . 1 k = 1 : : : n: We then deﬁne the state price process to be k 1 = M Zk k = 0 : : : n: . Mk = (1 + rk 1)Mk . 1: f P Then the following processes are martingales under I : 1 S n M k k k=0 and 1 X n M k k k=0 and the following processes are martingales under I : P f k Sk gn=0 k We thus have the following pricing formulas: and f k Xk gn=0: k Simple European derivative security with payoff Ck at time k: f C Vj = Mj IE Mk F j k 1 IE C jF ] = k k j j American derivative security fGk gn=0: k f G Vj = Mj sup IE M F j Tj 1 sup IE G jF ] : = j 2 j 2 Tj The usual hedging portfolio formulas still work. . The self-ﬁnancing value process (wealth process) Xk+1 = k Sk+1 + (1 + rk )(Xk . As before the portfolio process is f consists of X 0. the non-random initial wealth. Pricing in terms of Market Probabilities 117 Zk = IE Z jF k ] k = 0 1 : : : n: We deﬁne the money market price process as follows: M0 = 1 Note that Mk is Fk.

The Radon-Nikodym theorem implies that P is absolutely continuous with respect to the measure I there exists a G -measurable random variable Z such that 1 f IP (A) = 4 Z A Z dIP 8A 2 G A i.e. The existence of conditional expectations is a consequence of the Radon-Nikodym theorem.5 Another Applicaton of the Radon-Nikodym Theorem Let ( F Q) be a probability space. On G . then Q(A) = 0. the measure I P P f. we have A XdQ 8A 2 G : Y dIP = Z Y dQ if Y = A for some A 2 G . so I (A) = 0. Let G be a sub. and since Z is G -measurable. this is just the deﬁnition of IP . In other words. and let X be a non-negative R X dQ = 1. If A 2 G and IP (A) = 0. Z A X dQ = Z Z dIP 8A 2 G : This shows that Z has the “partial averaging” property. . it is the conditional expectation (under the probability measure Q) of X given G ..-algebra of F .118 9. We construct the conditional expectation (under Q) of X random variable with given G . and the rest follows from the “standard f f machine”. deﬁne two probability measures IP (A) = Q(A) 8A 2 G f IP (A) = Z Z Whenever Y is a G -measurable random variable.

e.Chapter 10 Capital Asset Pricing 10. To see this.1 An Optimization Problem Consider an agent who has initial wealth X 0 and wants to invest in the stock and money markets so as to maximize IE log Xn : Remark 10. (BC) stands for “Budget Constraint”.. Remark 10. we wish to Maximize Xn for the capital asset pricing problem can be IE log n IE = X0: X ! 2 (log (! )) IP (! ) 119 . i. Then X 0 is its value at time 0. there is a hedging portfolio which produces X n = . and starting from this value. Remarks 10.2 If is any random variable satisfying (BC). f k Xk g1 is a martingale under I .2 show that the optimal obtained by solving the following Constrained Optimization Problem: Find a random variable which solves: Maximize Subject to Equivalently. so P k=0 IE nXn = X0 Here. just regard as a simple European derivative security paying off at time n.1 and 10.1 Regardless of the portfolio used by the agent. (BC ) IE n = X0 then there is a portfolio which starts with initial wealth X 0 and produces Xn = at time n.

30 (Lagrange Multiplier) If (x1 Maxmize Subject to then there is a number such that : : : xm) solve the problem f (x1 : : : xm ) g (x1 : : : xm) = 0 (1.2) become (1.2’) we get n 1 : n (! k ) 2 1 X IP (! ) = X =) 1 = X : 0 k 0 k=1 . Adopt the notation x1 = (! 1) x2 = (!2 ) : : : x2n = (!2n ): We can thus restate the problem as: Maximize 2n X k=1 (log xk )IP (! k ) Subject to In order to solve this problem we use: 2n X k=1 n (! k )xk IP (! k ) .2) xk IP (! k ) = 2n X 1 n (! k )IP (! k ) n (! k )xk IP (! k ) k = 1 : : : 2n = X0 : (1:2 ) 0 (1:1 ) 0 k=1 Equation (1. X0 = 0: There are 2n sequences ! in . Call them ! 1 !2 : : : !2n . (1. Xo = 0: Theorem 1.120 Subject to X ! 2 n (! ) (!)IP (! ) .1) and (1.1’) implies xk = Plugging this into (1.1) @ f (x : : : x ) = @ g(x : : : x ) k = 1 : : : m m m @xk 1 @xk 1 and g(x1 : : : xm) = 0: For our problem.

1: n Taking expectations. 1 8x > 0 8Z > 0: Let be any random variable satisfying 1 = Z . X IE ( n ) IE log .4). xZ f (x ) = log Z .4) Theorem 1.5) IE ( n ) = X0 and let = X0 : n From (1. > 0 and deﬁne We maximize f over x > 0: 0 f (x) = log x . 121 0 xk = X! ) k = 1 : : : 2n: ( k n solves the problem Maximize Subject to Thus we have shown that if IE log IE ( n ) = X0 = X0 : n (1. n X0 log X0 . we have 1 IE log . (1. Capital Asset Pricing Therefore.e. then solves the problem (1. x2 < 0 8x 2 IR: 00 1 log x ..5) we have log . i. Z = 0 () x = Z The function f is maximized at x 1 f (x) = .3) then (1. xZ: 1 1 f (x) = x . 1 0 and so IE log IE log : .3).31 If Proof: Fix Z is given by (1.CHAPTER 10.

e. Since f k Xk gn=0 is a martingale under I .122 In summary.. i. Sk+1 (!1 : : : !k T ) : !k T ) . we have P k n Xn = X0: k Xk so = IE nXn jF k ] = X0 k = 0 : : : n Xk = X0 k k (!1 and the optimal portfolio is given by : : : !k ) = X0 . k+1(!1 X0: : : k+1 (!1 : : : !k H ) Sk+1 (!1 : : : !k H ) . 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 X0 IE log Xn : The optimal Xn is Xn 0 = Xn .

1 Law of a Random Variable Thus far we have considered only random variables whose domain and range are discrete... X 11.e.2 Density of a Random Variable The density of X (if it exists) is a function f X X (B ) = Z : IR! 0 1) such that B fX (x) dx 8B 2 B (IR): 123 . 11.Chapter 11 General Random Variables 11. P A function X : !IR is a random variable if and only if for every Borel subsets of I ). We now consider a general random variable X : !IR deﬁned on the probability space ( F P). .e. Thus any random variable X induces a measure X on the measurable space by (IR B(IR)) deﬁned in Williams’ book this is denoted by L X . X 1(B) 8B 2 B(IR) where the probabiliy on the right is deﬁned since X 1(B ) 2 F .1) : !IR is a random variable if and only if X . i. IP (A) is deﬁned for every A 2 F . X is often called the Law of X – X (B ) = IP . the set R 4 . 4 -algebra of subsets of . Recall that: F is a I is a probability measure on F . B 2 B(IR) (the -algebra of fX 2 Bg = X 1(B) = f! X (!) 2 Bg 2 F i. 1 is a function from B(IR) to F (See Fig.

then d X (x) = fX (x)dx IP fX 2 Bg = 0: 11. Now use the “standard machine” to get the equations for general h.3 Expectation Theorem 3.32 (Expectation of a function of X ) Let h : IR!IR be given. which means that whenever B 2 B(IR) has Lebesgue measure zero. If h(x) = B (x) for some B 4 1 IE 1B (X ) = P fX 2 B g = Z X (B ) = fX (x) dx B which are true by deﬁnition. Then IEh(X ) = 4 Z Z h(X (!)) dIP (!) h(x) d X (x) h(x)fX (x) dx: IR. Thus X has a density if and only if X is absolutely continuous with respect to Lebesgue measure. We then write where the integral is with respect to the Lebesgue measure on I .124 X R B {X ε B} Ω Figure 11. . then these equations are = = ZIR IR Proof: (Sketch).1: Illustrating a real-valued random variable X . fX is the Radon-Nikodym derivaR tive of X with respect to the Lebesgue measure.

11.4 Two random variables Let X Y be two random variables !IR deﬁned on the space ( F P). Then measure on B(IR2 ) (see Fig. 11.2: Two real-valued random variables X Y. General Random Variables 125 (X.Y)ε C} Ω x Figure 11.2) called the joint law of (X Y ). deﬁned by XY induce a X Y (C ) = IP f(X 4 Y ) 2 C g 8C 2 B(IR2 ): The joint density of (X Y ) is a function fX Y : IR2! 0 1) that satisﬁes X Y (C ) = ZZ C fX Y (x y ) dxdy 8C 2 B(IR2): Y in a manner analogous to the univariate case: We compute the expectation of a function of X fX Y is the Radon-Nikodym derivative of X Y with respect to the Lebesgue measure (area) on IR2 . IEk(X Y ) = 4 Z = = ZZ IR ZZ 2 k(X (!) Y (!)) dIP (!) k(x y ) d X Y (x y) IR k(x y )fX Y (x y ) dxdy 2 .CHAPTER 11.Y) C y { (X.

6 Conditional Expectation Suppose (X Y ) has joint density f X Y . i. fY (y ) is the (marginal) density for Y .2) 1B (y)g(y) Y (dy) = g(y )fY (y ) dy = y ) 8B 2 B(IR) (6. IR 11. Recall that IE h(X )jY ] = IE h(X )j (Y )] depends on ! through Y .. there is a function g (y ) (g depending on h) such that 4 IE h(X )jY ](!) = g (Y (!)): We can characterize g using partial averaging: Recall that A 2 (Y )()A = B 2 B(IR).3) Z B Z Z B IR h(x)fX Y (x y ) dxdy 8B 2 B(IR): (6. Then Y (B ) = IP fY 2 B g = IP f(X Y ) 2 IR B g = Z X Z (IR B ) Y = fX Y (x y ) dxdy = ZB Z B 4 fY (y ) dy fX Y (x y ) dx: IR where fY (y ) = Therefore. Let h : IR!IR be given. Let B IR be given. Then the following are equivalent characterizations of g : How do we determine g ? fY 2 Bg for some (6.e.5 Marginal Density Suppose (X Y ) has joint density f X Y .1) Z A g (Y ) dIP = Z A h(X ) dIP 8A 2 (Y ) Z Z IR 1B (Y )g(Y ) dIP = ZZ IR2 Z 1B (Y )h(X ) dIP 8B 2 B(IR) 1B (y)h(x) d X Y (x (6.126 11.4) .

then fX Y (xjy ) = fXfY (x)y) : Y (y j (7.1 Let g be the function satisfying IE h(X )jY ] = g (Y ): The function g is often written as g(y ) = IE h(X )jY = y ] and (7. ﬁrst compute Z and then replace the dummy variable y by the random variable Y : IR h(x)fX Y (xjy ) dx j IE h(X )jY ](!) = g (Y (!)): Example 11.2) Proof: Just verify that g deﬁned by (7. 2(1 .7 Conditional Density A function fX jY (xjy ) : IR2 ! 0 any function h : IR!IR: 1) is called a conditional density for X given Y provided that for g (y ) = Z IR h(x)fX Y (xjy ) dx: j (7. 2 exp 1 . but fX jY does not.1 (Jointly normal random variables) Given parameters: (X Y ) have the joint density 1 >0 1 2 2 > 0 . 2 ) x2 . General Random Variables 127 11.1) satisﬁes (6.1 < < 1.1) (Here g is the function satisfying and g depends on h. to determine IE h(X )jY ] (a function of ! ). 2 x y + y2 2 2 1 2 .1) becomes IE h(X )jY = y ] = g (y ) = Z IR h(x)fX Y (xjy ) dx: j In conclusion. : Let fX Y (x y) = 2 1 2 1 p1 .33 If (X IE h(X )jY ] = g (Y ) Y ) has a joint density fX Y .4): For B Z Z B | IR h(x)fX Y (xjy) dx fY (y ) dy = g (y ) Z Z 2 B(IR) {z j } B IR h(x)fX Y (x y) dxdy: Notation 11.) Theorem 7.CHAPTER 11.

2 ) 2 : 1 x. u2 du:e. 2(1 .1 = (1 . 2(1. 2 2 2 2 we have fX jY (xjy) = fXfY (x y) Y (y) 2 1 1 p 1 e. 21 y : 1 = p 2 1 1. du = p1. 2 . y fX jY (xjy) dx 2 . 2 y2 2 2 using the substitution u = 1 y2 2 2 2 . 1 y 2 : 2 2 1 2 1 p 1 We can compute the Marginal density of Y as follows fY (y) = Z1 1 1 Z 1 e.1 X jY IE 2. x2 . 2(1 .1 e . 2 1 y2 2 2 1y 2 fY (y) = p 1 e. 2 ) 2 1 2 2 2 2 1 = . 1 Therefore. 1 2 y 2 dx:e 1 . 2(1. 2) 12 x . 2 Conditional density. 1 2 = Z1 y 2 Y =y 1 2 # . 2(1. = p1 e 2 2 . 1 2 dx y . 2 ) 1 " 1 2 2 # x . 2 ) 1 x 2 1 2 .1 p 1 Thus Y is normal with mean 0 and variance 2 ..2 1 1 x. 2 ) Z1 IE X jY = y] = xf (xjy) dx = 1 y 2 . y 2 + y2 (1 . " X. e 2 1 . 2 1 : fX Y (x y) = 2 1 2 1 p 1. 2 ) 1 = . From the expressions . 2 x y + y2 2 2 2(1 .1 2) 2 2 2 2 1 x. 2 In the x-variable.128 The exponent is . 2 ) 12 x . 1y 2 2 e. fX jY (xjy) is a normal density with mean 21 y and variance (1 . 1 y . 2 y = 2 2 2 2 1 2 1.

5) " X.3) and (7. 1 2 Y 2 Y = (1 . A 1 = IE (X . Let denote the column vector of random variables (X1 X2 : : : Xn )T . The random variables in if and only if A.CHAPTER 11. X are independent A 1 = diag( . i. i )(Xj . and A is an n T T n ) = IE X = (IEX1 : : : IEXn) n nonsingular matrix. 2 ) 2: 1 # (7.4) Taking expectations in (7.1). and the corresponding has a multivariate normal distribution if and only if column vector of values (x1 x2 : : : xn )T . No other estimator based on Y can have a smaller expected square error 1 (Homework problem 2. )T:A:(X . 2 ) 2. the random variables have the joint density X X x p o n fX(x) = (2detnA exp .1 is diagonal.4) yields IEX = IE 1 2 IEY = 0 (7.. 1 2 Y 2 # = (1 .3) " X. 11. the (i j )th element of A.e. 2 ) 2: 1 (7. 2 2 1 2 ::: 2) n where 2 j = IE (Xj . ) : 2 ) =2 =( 4 Here. j )2 is the variance of Xj . the best estimator of X is 21 Y . 4 . . 1 (X .6) Based on Y .8 Multivariate Normal Distribution Please see Oksendal Appendix A.e. A 1 is the covariance matrix 1 ::: . j ).1 is IE (Xi . General Random Variables From the above two formulas we have the formulas 129 IE X jY ] = IE 1 2 Y (7. ):(X . )T h i i. This estimator is unbiased (has expected error zero) and the expected square error is (1 .

10 MGF of jointly normal random variables Let = (u1 u2 : : : un )T denote a column vector with components in IR. adjusted to account for the possibly non-zero expectations: fX1 X2 (x1 x2) = 2 1 1 p 2 1. . 2 (x1 . 1 )2 . If any n random variables X1 X2 : : : Xn have this moment generating function. then they are jointly normal.1. p 1 (1 2 ) 2) 1 2 (1 2 1 . Then the moment generating function is given by u X T IEeu :X = T eu :XfX1 X2 : : : Xn (x1 x2 : : : xn ) dx1 : : :dxn o n = exp 1 uT A 1 u + uT : 2 1 . . #) ( " 1 (x1 . 2 A=4 A = 1 " . Thus.1 . 1 p 1 2 2 2 (1 ) 1 (1 2 ) 2 . 1 )(x2 . 2(1 . 2 1 1 2 1 2 2 2 # .9 Bivariate normal distribution Take n = 2 in the above deﬁnitions. 2 and we have the formula from Example 11. and we can read out the means and covariances. 2) 1 2 1 2 11. 2 ) + (x2 .1 and mean vector . and let 4 = IE (X1 . 1 )(X2 . The random variables are jointly normal and independent if and only if for any real column vector = (u 1 : : : un )T u 8n 9 8n 9 <X = <X 1 2 2 = IEeuT :X = IE exp : uj Xj = exp : 2 j uj + uj j ] : j =1 j =1 4 . 2 ) : 1 2 .130 11.1 Z ::: Z 1 . 2 )2 : 2 2 2 exp . 3 5 det A = 1 2 1. and let have a multivariate normal distribution with covariance matrix A .

34 Proof: fBk gn=0 is a martingale (under I ). As before we denote the column vector (Y1 : : : Yn )T by P therefore have for any real colum vector = (u1 : : : un )T .1): If we know Y1 Y2 : : : Yk . u 8n 9 8n 9 <X = <X = TY IEeu = IE exp : uj Yj = exp : 1 u2 : 2 j j =1 j =1 B0 = 0 Bk = k X F P). then we know B1 B2 : : : Bk . Bk. 12. Y.1 . standard normal random variables deﬁned on ( j where I is the market measure. F0 = f g F k = (Y1 Y2 : : : Yk ) = (B1 B2 : : : Bk ) k = 1 : : : n: Theorem 1. P k IE Bk+1 jF k ] = IE Yk+1 + Bk jF k ] = IEYk+1 + Bk = Bk : 131 . B1 : : : Yk = Bk . We Deﬁne the discrete-time Brownian motion (See Fig.Chapter 12 Semi-Continuous Models 12. Deﬁne the ﬁltration j =1 Yj k = 1 : : : n: B2 : : : Bk . if we know B1 then we know Y1 = B1 Y2 = B2 .1 Discrete-time Brownian Motion Let fYj gn=1 be a collection of independent. Conversely.

1 2 )k 2 Note that n o k = 0 : : : n: 1 Sk+1 = Sk exp Yk+1 + ( . Theorem 1. k IE h(Bk+1 )jF k ] = IE h(Yk+1 + Bk )jF k ]: 1 Z g(b) = IEh(Yk+1 + b) = p 2 1 Proof: Note that Use the Independence Lemma. 1 y2 2 dy: Then which is a function of B k alone. 2 2 ) n o . Deﬁne . the initial stock price.1: Discrete-time Brownian motion. The stock price process is then given by Sk = S0 exp Bk + ( .2 The Stock Price Process Given parameters: > 0. IE h(Yk+1 + Bk )jF k ] = g(Bk ) 12. the volatility.1 h(y + b)e . the mean rate of return. S0 > 0. 2 IR.35 fBk gn=0 is a Markov process.132 B k Y2 Y1 0 1 k 2 Y 3 3 Y 4 4 Figure 12.

k Sk ) r r k (Sk+1 . equivalent to the market measure I . If P .4 Risk-Neutral Measure k Sk+1 Sk Xk Mk+1 . we say that I is a risk-neutral measure. Mk + Mk : f Deﬁnition 12.CHAPTER 12. Semi-Continuous Models 133 . 1 2 2 Thus k +1 = log IE SkS jF k ] = log IE SS+1 F k k k k 1 var log SS+1 = var Yk+1 + ( . Xk+1 = = Each Xk is F k -measurable. IE Sk+1jF k ] = Sk IE e Yk+1 jF k ]:e 1 2 1 2 = Sk e 2 e 2 = e Sk : . e Sk ) + e Xk Xk+1 Mk+1 = 12. nonrandom. 2 2) = 2 : k and 12. Money market process: Portfolio process: Mk = erk k = 0 1 : : : n: 0 Each 1 k is F k -measurable.1 Let I be a probability measure on ( P n o Sk Mk n f f is a martingale under I .3 Remainder of the Market The other processes in the market are deﬁned as follows. Discounted wealth process: r k Sk+1 + e (Xk . P P k=0 F ). ::: n 1 . Wealth process: X0 given.

36 If I is a risk-neutral measure. ::: n f P If there is a risk-neutral measure I . fX f V X0 = IE Mn = IE Mnn : n Remark 12. P Proof: n Xk on Mk k=0 is f X IE Mk+1 F k k+1 f = IE = X = Mk : k k Sk+1 Sk Xk Mk+1 . Mk + Mk F k S X f S IE Mkk+1 F k . and say it is F n -measurable. Mkk + Mk +1 k k 12. then Construct a portfolio process 0 .6 Arbitrage Deﬁnition 12. then there is no arbitrage. . Note that Vn may be path-dependent.1 Hedging in this “semi-continuous” model is usually not possible because there are not enough trading dates.134 f Theorem 4. regardless of the portfolio process used to generate it. P Theorem 6. This difﬁculty will disappear when we go to the fully continuous model.37 (Fundamental Theorem of Asset Pricing: Easy part) If there is a risk-neutral measure. 1 which starts with X 0 and ends with Xn = Vn . then every discounted wealth process P f a martingale under I . Receive X0 at time 0.5 Risk-Neutral Pricing Let Vn be the payoff at time n. Hedging a short position: Sell the simple European derivative security V n . 12.2 An arbitrage is a portfolio which starts with X 0 = 0 and ends with Xn satisfying IP (Xn 0) = 1 IP (Xn > 0) > 0: (I here is the market measure).

r . o n Sk = S0 exp Bk + ( . 2 Sk+1 = S0 exp (Bk + Yk+1 ) + ( .CHAPTER 12. 1 2)(k + 1) o 2 n 1 2) : = Sk exp Yk+1 + ( . 1 2)k . 1 2)o 2 Mk+1 Mk If S S IE Mkk+1 F k = Mkk :IE exp f Yk+1 gjF k ] : expf . and let Xn be the ﬁnal wealth corresponding P Proof: Let I be a risk-neutraln on f is a martingale under I .1) and (6. 1 2g 2 2 Sk : = e r : Mk = r. We have (6. P to any portfolio process. . n o Sk+1 = Sk : exp n Yk+1 + ( . let X0 = 0. Semi-Continuous Models 135 f measure.1) 0) = 1. we must seek further.7 Stalking the Risk-Neutral Measure Recall that Y1 Y2 : : : Yn are independent. If 6= r.2) imply I (Xn P This is not an arbitrage. r . r . standard normal random variables on some probability space ( F P).2) f f IP (Xn 0) = 1 =) IP (Xn < 0) = 0 =) IP (Xn < 0) = 0 =) IP (Xn 0) = 1: f (6. 1 2g 2 +1 S = Mkk : expf 1 2 g: expf . We have f f IP (Xn = 0) = 1 =) IP (Xn > 0) = 0 =) IP (Xn > 0) = 0: 12. Since Xk Mk k=0 fX fX IE Mn = IE M00 = 0: n Suppose IP (Xn (6. 2 Therefore. = 0) = 1. the market measure is risk neutral. .

Yj ) : exp . 2 2g +1 S 1 = Mkk : expf 2 2 g: expf. 1 2 2 . 1 2 2 n ~ o S = Mkk : exp Yk+1 . n 2 j =1 = exp n 2 2 2 : exp . r . 1 2g 2 S = Mkk : 3 2n X 1 Z = exp 4 (.136 Sk+1 = Sk : exp n Yk+1 + ( . 1 2 )o 2 Mk+1 Mk o n S = Mkk : exp (Yk+1 + r ) . P f IP ( ) = IEZ = 1: . I is a probability measure. f ~ P We want a probability measure I under which Y1 dom variables. r: ~ : : : Yn are independent. where The quantity . 9 8n = <X IEZ = IE exp : (. Then we would have r is denoted and is called the market price of risk. n 2 2 = 1: Deﬁne f IP (A) = 0 for all A 2 F and Z A Z dIP 8A 2 F : f Then I (A) P f In other words. standard normal ran- i S fh 1 f S ~ IE Mkk+1 F k = Mkk :IE expf Yk+1 gjF k : expf. Yj . 2 2 )5 : j =1 Cameron-Martin-Girsanov’s Idea: Deﬁne the random variable Properties of Z : Z 0. ~ Yk+1 = Yk+1 + .

standard normal under I . Yj . 1 2 )5 2 j =1 j =1 2n 3 2n 3 X1 X 1 = exp 4 2 (uj .CHAPTER 12. uj + 1 2 ) + (uj . standard normal under I . f IP (A) = Z A Z dIP 8A 2 F f IEX = IE (XZ ) for every random variable X . 2 2 )5 j =1 2j=1 3 n X 1 2 = exp 4 ( 2 uj . P Veriﬁcation: Y1 Y2 : : : Yn : Independent. 1 2)5 2 j =1 j =1 j =1 3 2n 3 2n X X = IE exp 4 (uj . and P 2n 3 2n 3 X 5 X IE exp 4 uj Yj = exp 4 1 u2 5 : 2 j j =1 j =1 i h Z = exp Pn=1 (. 1 2) j 2 ~ ~ Y = Y1 + : : : Yn = Yn + : Z > 0 almost surely. Semi-Continuous Models 137 f P We show that I is a risk-neutral measure. Yj . f ~ ~ Compute the moment generating function of (Y1 : : : Yn ) under I : P 2n 3 2n 3 n X ~5 X X f IE exp 4 uj Yj = IE exp 4 uj (Yj + ) + (. )25 : exp 4 (uj . )Yj 5 : exp 4 (uj . For this. it sufﬁces to show that ~ ~ Y 1 = Y1 + : : : Yn = Yn + f are independent. 1 2) 5 2 2 j =1 2n 3 X = exp 4 1 u2 5 : 2 j j =1 .

2 2)n : j =1 . K : p 1 e 2n2 db 2 n Pn Y is normal with mean 0. b2 This is the Black-Scholes price.8 Pricing a European Call Stock price at time n is Sn = S0 exp Bn + ( . Price at time zero is 2 0 1+3 n (Sn . variance n.2under IP . K A 5 f f ~j IE M 0 2 : . K )+ . 1 2 )n 2 j =1 8 n 9 < X = = S0 exp : (Yj + r ) .138 12. 8 n 9 n = Z . It does not depend on .1 S0 exp b + (r . r)n + ( . 1 2)n 2 o n 8 n 9 < X = = S0 exp : Yj + ( . ( . rn o + . Payoff at time n is (Sn . K )+ = IE 4e rn @S exp < X Y + (r . f ~j since j =1 1 j =1 e . 1 2)n 2 j =1 8 n 9 < X = 1 ~ = S0 exp : Yj + (r . . 1 2)n= . 1 2 )n .

1 Symmetric Random Walk Toss a fair coin inﬁnitely many times.Chapter 13 Brownian Motion 13.1 if if !j = H ! j = T: M0 = 0 Mk = k X j =1 Xj k 1: 13. Deﬁne Xj (!) = 1 Set ( . as 139 k!1: .38 (Law of Large Numbers:) 1 M !0 k k almost surely.2 The Law of Large Numbers We will use the method of moment generating functions to derive the Law of Large Numbers: Theorem 2.

39 (Central Limit Theorem) 1 p Mk ! k Proof: Standard normal.3 Central Limit Theorem We use the method of moment generating functions to prove the Central Limit Theorem. of Mk :) (Independence of the Xj ’s) 1 u 2e k + 1e 2 u . for the constant 0. 13. . u k k log 'k (u) = k log 1 e k + 1 e 2 2 Let x = 1 . x (L’Hˆ pital’s Rule) o Therefore. u k k! lim log 'k (u) = xlim0 ! 1 log 1 eux + 1 e ux 2 2 . k! lim 'k (u) = e0 = 1 1 which is the m. as k!1: u 'k (u) = IE exp p Mk k u u 1 = 2 e pk + 1 e pk 2 .140 Proof: 'k (u) = IE exp u Mk 9 8kk <X u = = IE exp : k Xj j =1 k Y = IE exp u Xj k j =1 = which implies. k . u eux . = xlim0 2 ux ! 1e + 2 = 0: u e ux 2 1 e ux 2 . Then k . (Def.g.f. Theorem 3.

13. .CHAPTER 13.f. Then u . . Here are some properties of B(100)(t): If t .1). then deﬁne B(n) (t) by linear interpolation (See Fig. 141 1 log 'k (u) = k log 1 e pk + 2 e 2 1 Let x = pk . then set 1 1 B (n) (t) = pn Mtn = pn Mk : k 0 is not of the form n . u e ux 2 . u pk : lim log 'k (u) = xlim0 ! k! 1 u eux . 2x 2 (L’Hˆ pital’s Rule) o lim ' (u) = e 2 u k! k 1 1 2 which is the m.4 Brownian Motion as a Limit of Random Walks Let n be a positive integer. u2 eux . u e ux = xlim0 1 ux 1 1 ux : xlim0 2 2x2 ! ! 2e + 2e . (L’Hˆ pital’s Rule) o = xlim0 2 ! = xlim0 ! 1 u2 : =2 Therefore. u2 e ux 2 2 . Brownian Motion so that.g. u eux . for a standard normal random variable. x2 u eux . 13. u e ux = xlim0 2 1 ux 2 1 ux ! 2x 2 e + 2 e . If t k 0 is of the form n . 1 log 2 eux + 1 e ux 2 .

13. To get Brownian motion. let n!1 in B (n) (t) t 0.) . B (100)(1) are independent. B (100)(t) is a continuous function of t.142 k/n (k+1)/n Figure 13.5 Brownian Motion (Please refer to Oksendal.1: Linear Interpolation to deﬁne B (n) (t). Chapter 2. Properties of B(100)(1) : 1 B (100)(1) = 10 100 X 1 IEB(100)(1) = 10 j =1 100 X Xj IEXj = 0: var(Xj ) = 1 (Approximately normal) var(B (100)(1)) = 100 Properties of j =1 100 1 X j =1 B(100)(2) : 1 B (100)(2) = 10 200 X IEB(100)(2) = 0: var(B (100)(2)) = 2: Also note that: j =1 Xj (Approximately normal) B (100)(1) and B (100)(2) .

6 Covariance of Brownian Motion Let 0 s t be given. t B(t) (see Fig.2: Continuous-time Brownian Motion. B (s)) + IEB 2 (s) (t } | {z } | = s: 0 s . so B (s) and B (t) = (B (t) . 13. IEYj = 0 8j var(Yj ) = tj .ω) ω (Ω. B (s) are independent. Then B (s) and B (t) . IEB (s) = 0 var(B (s)) = s IEB(t) = 0 var(B (t)) = t IEB(s)B (t) = IEB(s) (B(t) . B (t0 ) Y2 = B(t2 ) . then Y1 Y2 : : : Yn are independent.P) Figure 13. B(t1 ) : : : Yn = B (tn ) .CHAPTER 13.2) is called a Brownian Motion if it satisﬁes the following B (0) = 0. B (t) is a continuous function of t. A random variable properties: 1. 3. B(s)) + B(s)] = IEB (s)(B{z) . Brownian Motion 143 B(t) = B(t. F. tj 1 8j: . normally distributed increments: If 0 = t0 < t1 < t2 < : : : < tn and Y1 = B (t1 ) . B (s)) + B (s) are jointly normal. B(tn 1 ) . Moreover. B has independent. 13. 2.

B(t1 ) : : : B (tn ) . B(t) B(t2 ) .8 Filtration generated by a Brownian Motion fF (t)gt Required properties: For each t. t 0 (not necessarily s t). Then 0 < t1 < t2 < : : : < tn (B (t1 ) B (t2) : : : B (tn )) is jointly normal with covariance matrix 2 3 IEB 2(t1 ) IEB (t1 )B (t2) : : : IEB(t1 )B (tn ) 6 7 2 C = 6:IEB:(t:2:):B:(:t1 ) : : : : :IEB: :(t2:): : : : : :: :: :: : : IEB:(:t:2:):B (t:n: )7 6 ::: : :: 4 ::: : ::: : : :7 5 IEB(tn)B (t1 ) IEB(tn )B(t2 ) : : : IEB2 (tn) 2 3 t1 t1 : : : t1 6 7 = 6t1 : : t:2: : ::::::: : : t:2:7 6: : 7 4 5 t1 t2 : : : tn 13. Do this for all possible numbers s 2 0 t] and C 2 B(IR). For each t and for t < t1 0 < t2 < < tn . . This F (t) contains exactly the information learned by observing the Brownian motion upto time t. the Brownian motion increments B (t1 ) . First ﬁx t. we have IEB(s)B(t) = s ^ t: 13. B (tn 1 ) are independent of F (t). . Here is one way to construct F (t). required by the -algebra properties.7 Finite-Dimensional Distributions of Brownian Motion Let be given. fF (t)gt 0 is called the ﬁltration generated by the Brownian motion. B (t) is F (t)-measurable.144 Thus for any s 0. Let s 2 0 t] and C 2 B(IR) be given. Put the set Then put in every other set fB(s) 2 C g = f! : B(s !) 2 C g in F (t).

CHAPTER 13. r = 0. 2 2 (t . n : “Down” factor. B (s) + B(s)) . s)g F (s) IE Z (t)jF (s)] = IE expf. (B(t) . s) 2 = Z (s): h i 13. 1 2 (t . 1 2((t . Proof: Let 0 n o s t be given. ~ 2 p p p . . s)g 2 n1 2 o = Z (s) exp 2 (. B (s)) . (B (t) . 1 2 (t . B (s)] + B (s) = B (s): Theorem 9. Proof: Let 0 s t be given. Brownian Motion 145 13. pn = u1n ddnn = 2 == nn = 1 . (B (t) . B (s)) . Then 1 = IE Z (s) expf.40 Brownian motion is a martingale. s) + s)g F (s) 2 = Z (s)IE expf. ( > 0). 1 2 t 2 is a martingale. dn = 1 . Then IE B (t)jF (s)] = IE (B(t) . B(t) . ) var(B (t) . Then Z (t) = exp . p . ~ 2 qn = 1 .10 The Limit of a Binomial Model Consider the n’th Binomial model with the following parameters: un = 1 + n : “Up” factor. B (s)) .9 Martingale Property Theorem 9. B(s)) + B(s)jF (s)] = IE B (t) .41 Let 2 IR be given.

]k (T ) = Mk which implies. 4 n 2 n 4 n 2 1p 2 n 1 2 pn . 1 x2 + O(x3) 2 so log S (n)(t) = 1 (nt + Mnt ) log(1 + p ) + 1 (nt . Mk ): 2 In the n’th model. . Then ]k (H ) + ]k (T ) = k ]k (H ) . pn .4 n .42 As n!1. . p ) 2 2 = nt 1 log(1 + 2 + Mnt 1 2 + O(n 3=2 ) = nt . S (n)(t) = 1 + pn (n) = 1. 2 2 t + O (n 2 ) 1 1 1 + pn Mnt + n Mnt O(n 2 ) . 1 2 tg 2 . 1 2 log(1 + 1 2 pn ) + 1 log(1 . 4n ! 1 2 + 1 p + 1 2 + O(n 3=2 ) + Mnt 1 pn . Mnt ) log(1 . pn ) 2 n n pn ) . Set S0 f P Under I . Let t = k for some k. take n steps per unit time. . and let n 1 (nt+Mnt ) 1 (nt Mnt ) 2 2 1 . 1 | {z } | {z } !0 !Bt As n!1. pn ) 2 ! 1 = . : Theorem 10. 1 2t.146 Let ]k (H ) denote the number of H in the ﬁrst k tosses. and let ] k (T ) denote the number of T in the ﬁrst k tosses. Proof: Recall that from the Taylor series we have expf B (t) . the price process S (n) is a martingale. 1 2t is necessary in order to have a 2 log(1 + x) = x . Note that the correction martingale. 1 log(1 . the distribution of S (n) (t) converges to the distribution of where B is a Brownian motion. 2 . ]k (H ) = 1 (k + Mk ) 2 ]k (T ) = 1 (k . the distribution of log S (n) (t) approaches the distribution of B(t) .

Brownian Motion 147 B(t) = B(t.12 Markov Property for Brownian Motion We prove that Theorem 12. starting at x 6= 0. P The distribution of B (t) under IP x is the same as the distribution of x + B (t) under I .CHAPTER 13.3). Px) Figure 13.11 Starting at Points Other Than 0 (The remaining sections in this chapter were taught Dec 7.4). F. and for such a Brownian motion we have: IP x (B(0) = x) = 1: Note that: If x 6= 0. B(s) + 4 | } Independent of F (s) F t 0 be given (See Fig.43 Brownian motion has the Markov property.3: Continuous-time Brownian Motion. 13. then IP x puts all its probability on a completely different set from I . 13. 13. Proof: Let s 0 2 6 ) IE h(B (s + t)) F (s) = IE 6h( B(s + t{z. (s)-measurable B{zs) |( } 3 7 ) F (s)7 5 . P 13. we have: IP (B(0) = 0) = 1: For a Brownian motion B (t) that starts at x. denote the corresponding probability measure by IP x (See Fig.ω) x ω t (Ω.) For a Brownian motion B (t) that starts at 0.

B (s) B (t) |{z} 3 7 )7 5 IE h (B(s + t) ) F (s) = g (B(s)) = E B (s)h(B (t)): In fact Brownian motion has the strong Markov property. Use the Independence Lemma.4: Markov Property of Brownian Motion. 13.5. B(s) + x )] 2 6 = IE 6h( x + 4 = IE xh(B (t)): Then same distribution as B (s + t) . Deﬁne s+t g (x) = IE h( B (s + t) . Example 13.1 (Strong Markov Property) See Fig. Fix x > 0 and deﬁne = min ft 0 B(t) = xg : Then we have: IE h( B( + t) ) F ( ) = g(B( )) = IE x h(B(t)): .148 B(s) s restart Figure 13.

and let be deﬁned as in the previous section.CHAPTER 13. p(t x y) = p 1 e 2 t g(x) = IE xh(B(t)) = . τ+t 13. Brownian Motion 149 x τ restart Figure 13. Then exp B (t ^ ) .1 = min ft 0 B (t) = xg : > 0. and 1 IE exp B(t ^ ) . Deﬁne Fix Z 1 h(y )p(t B (s) y) dy: Z . 2 2 (t ^ ) = 1: n o .1 IE h(B (s + t)) F (s) = g(B (s)) = IE h(B( + t)) F ( ) = 13.5: Strong Markov Property of Brownian Motion.1 1 h(y )p(t x y) dy: .13 Transition Density Let p(t x y ) be the probability that the Brownian motion changes value from x to y in time t.14 First Passage Time Fix x > 0.x)2 2t Z 1 h(y )p(t x y) dy: . 1 2 (t ^ ) 2 n o is a martingale. (y .

Brownian motion reaches level x with probability 1. so IP f < 1g = 1 IE expf.g. 1 2 Let h 2 g1 f < i 1g = 1: #0 to get IE 1 f < 1g = 1. to get IE expf x . =e x .IE e Letting .1). 2 (t ^ ) = : 2 t! if = 1 0 0 expf B (t ^ ) . We use the Reﬂection Principle below (see Fig.f. using the Bounded Convergence Theorem.: IEe Differentiation of (14. x: (14. 1 (14. The expected time to reach level x is inﬁnite. We have the m.6).4) Conclusion.3) w.r.t. = . IP f t B (t) < xg = IP fB (t) > xg IP f tg = IP f t B(t) < xg + IP f t B (t) > xg = IP fB (t) > xg + IP fB (t) > xg = 2IP fB (t) > xg Z e = p2 2 tx 1 . y2 2t dy . 2 : #0. 13. 1 2 g = e 2 Let .1) Let t!1 in (14. .3) yields .2) =1 2 2 . we obtain IE = 1: (14. p 2 > 0: p (14. px e x 2 . 1 2 (t ^ )g e x : 2 .150 We have 8 n 12 o <e 1 2 if < 1 lim exp .

Using the substitution z = yt p dz = p dy we get t IP f Density: tg = p2 Z 1 2 x pt e . Laplace transform formula: = e t f (t)dt = e x . which follows from the fact that if Zb a(t) g (z) dz then @F = . . @a g (a(t)): @t @t IEe .CHAPTER 13. Brownian Motion 151 shadow path x τ t Brownian motion Figure 13. z2 2 dz: x2 2t @ f (t) = @t IP f F (t) = tg = p x 3 e 2 t . Z 0 1 p 2 : .6: Reﬂection Principle in Brownian Motion.

152 .

tk : 14. 13. Futures and other Derivative Securities. are independent. IP f! B(0 !) = 0g = 1. 1993. Hull. always in the background. function f (t). Prentice Hall. If 0 = t0 t1 : : : tn . B (0) = 0 Technically.) ( F P) is given.1995 2. !IR. of a . Oksendal.3. Springer-Verlag. First we will consider ﬁrst variation. has the following properties: Brownian motion. Stochastic Differential Equations. B(tk )] = 0 IE B (tk+1 ) . then the increments B (t1) . B. Options. J. References: 1. B(tn 1 ) . B (t ! ) : 0 1) 1.2 First Variation Quadratic variation is a measure of volatility.normal. 153 FV (f ). B (t) is a continuous function of t. 14. 2. and IE B (tk+1 ) .Chapter 14 The Itˆ Integral o The following chapters deal with Stochastic Differential Equations in Finance. even when not explicitly mentioned. B(tk )]2 = tk+1 . 3.1 Brownian Motion (See Fig. B (t0 ) : : : B(tn ) .

f (t)) dt + f (t) dt: 0 0 0 Zt1 0 ZT 0 Zt2 ZT t1 t2 = jf (t)j dt: 0 Thus.1. We then deﬁne FV 0 T ](f ) = lim 0 ! jj jj n 1 X . 0 = t0 t1 : : : tn = T: The mesh of the partition is deﬁned to be jj jj = k=0max 1(tk+1 . tk ): 0 .. k=0 jf (tk+1) .1 (First Variation) Let = ft0 t1 : : : tn g be a partition of 0 T ].1: Example function f (t). For the function pictured in Fig. there is a point tk such that f (tk+1 ) .e. 14. the ﬁrst variation over the interval 0 T ] is given by: FV 0 T ](f ) = f (t1) . f (tk )j: Suppose f is differentiable.154 f(t) t2 t1 T t Figure 14. f (t2 )] = f (t) dt + (. Then the Mean Value Theorem implies that in each subinterval t k tk+1 ]. f (0)] . f (tk ) = f (tk )(tk+1 . ﬁrst variation measures the total amount of up and down motion of the path. f (t2) . The general deﬁnition of ﬁrst variation is as follows: Deﬁnition 14. tk ): ::: n . f (t1 )] + f (T ) . i.

because n 1 X . the paths of Brownian motion are not differentiable. f (tk )j = n 1 X . then hf i(T ) = 0. k=0 and jf (tk+1) . jf (tk )j(tk+1 . tk ) 0 hf i(T ) jj lim 0 jj jj: lim 0 ! ! jj jj jj jj n 1 X . Remark 14. tk ) 0 0 = 0: Theorem 3. k=0 jf (tk )j2(tk+1 . k=0 jf (tk )j2(tk+1 . IP f! 2 hB(: !)i(T ) = T g = 1: In particular. tk ) 0 0 FV 0 T ](f ) = lim 0 ! jj jj n 1 X k=0 jf (tk )j(tk+1 . The Itˆ Integral o Then 155 n 1 X . k=0 . f (tk )j2 = n 1 X .CHAPTER 14. k=0 jf (tk+1) . .1 (Quadratic Variation of Differentiable Functions) If f is differentiable. tk )2 0 jj jj: and n 1 X .44 hBi(T ) = T or more precisely. = lim jj jj jf (t)j2 dt jj !0 ZT 0 k=0 jf (tk )j2(tk+1 .2 (Quadratic Variation) The quadratic variation of a function f on an interval is 0 T] hf i(T ) = lim 0 jf (tk+1 ) . tk ) = jf (t)j dt: 0 ZT 0 14. f (tk )j2: ! k=0 jj jj n 1 X .3 Quadratic Variation Deﬁnition 14.

tk )2 n 1 X . (tk+1 . (tj+1 . 2(tk+1 . k=0 3(tk+1 . tk )2 ] (tk+1 . tk ): This has expectation 0. k=0 2 Dk : Q . To simplify notation. T ) = = = n 1 X . Deﬁne the sample quadratic variation 0 T ]. so IE (Q . tk ) = B(tk+1 ) . B(tk )]2 . =2 n 1 X . (tk+1 . 2 var Dk . (tk+1 . so k=0 n 1 X . tk ) Dj2 . T ) = 0: !0 Consider an individual summand 2 Dk . (tk+1 .T = We want to show that jj jj n 1 X . tk )Dk + (tk+1 . set D k = Q = Then n 1 X . tk )] = 0: 2 Dk . T ) = IE For j n 1 X . k=0 2 Dk . tk )] 4 2 IE Dk . tk )]: lim (Q . (tk+1 . 2(tk+1 . tk )2] k=0 n 1 X . T ) 2jj jj:T: . tk ) IE (Q . then IE (X 4) = 3 4) k=0 2jj jj = 2jj jj T: Thus we have k=0 (tk+1 .156 Proof: (Outline) Let = ft0 t1 : : : tn g be a partition of B (tk+1 ) . (if X is normal with mean 0 and variance 2. tk )2 . (tk+1 . k=0 2 Dk . 6= k. tk )2 + (tk+1 . T ) = 0 var(Q . B(tk ). the terms var(Q . tj ) and are independent.

B(tk ))2 . hBi(T1)] = T2 . B(tk )) : 2 and compute the squared sample absolute volatility 1 n 1 X . . T1 T2 . and we have the approximate equation (B (tk+1 ) . tk )] = 2(tk+1 .4 Quadratic Variation as Absolute Volatility On any time interval T1 T2]. tk )2 : When (tk+1 . tk ) is small. This is approximately equal to hBi(T2) . tk )2 is very small. The Itˆ Integral o As jj 157 jj!0. tk which we can write informally as dB(t) dB(t) = dt: 14. T1 k=0(B(tk+1 ) . (tk+1 . so jj lim (Q . T )!0. consider the equation hBi(T ) = T = 1 dt 0 ZT 8T 0: This says that quadratic variation for Brownian motion accumulates at rate 1 at all times along almost every path. tk )] = 0: We showed above that var (B (tk+1 ) . B (tk ))2 . (tk+1 . T1 = 1: T2 . Brownian motion has absolute volatility 1. this approximation becomes exact. (tk+1 . Furthermore. B (tk ))2 ' tk+1 . In other words.2 (Differential Representation) We know that IE (B(tk+1 ) . var(Q .CHAPTER 14. we can sample the Brownian motion at times T1 = t0 t1 : : : tn = T2 T2 . T ) = 0: jj !0 Remark 14. T1 1 As we increase the number of sample points.

158 14.r. i. B (t) B (t2 ) .. (t) t 0.. 8t. B (tn 1 ) are independent of F (t). with associated ﬁltration F (t) t 0. For t t1 : : : tn . because the paths of Brownian motion are not differentiable. B (t1 ) : : : B (tn ) . 0 = t0 t1 : : : tn = T: an Assume that (t) is constant on each subinterval t k tk+1 ] (see Fig. then Remark 14. 14. 2. 14.t. .3 (Integral w. B (t) is F (t)-measurable. We call such a elementary process.6 Itˆ integral of an elementary integrand o Let = ft0 t1 : : : tn g be a partition of 0 T ]. and the s t=) every set in F (s) is also in F (t). 3.e. where is adapted) (t) is F (t)-measurable 8t (i.2). The integrand is 1. is square-integrable: IE We want to deﬁne the Itˆ Integral: o ZT 0 2(t) dt < 1 8T: I (t) = Zt 0 (u) dB (u) t 0: f (t) is a differentiable function.5 Construction of the Itˆ Integral o The integrator is Brownian motion following properties: 1. the increments B (t1 ) . a differentiable function) If we can deﬁne Zt 0 (u) df (u) = Zt 0 (u)f (u) du: 0 This won’t work when the integrator is Brownian motion. The functions B (t) and (tk ) can be interpreted as follows: Think of B (t) as the price per unit share of an asset at time t. 2. . B(t) t 0.e.

8 > (t0) B(t) .7 Properties of the Ito integral of an elementary process Adaptedness For each t Linearity If I (t) is F (t)-measurable. B(t0)] + (t1) B(t2) . I (t) = k 1 X . this gain is given by: o : : : tn as the trading dates for the asset. I (t) = Zt 0 (u) dB (u) J (t) = ( (u) Zt 0 (u) dB (u) then I (t) J (t) = Zt 0 (u)) dB (u) . B (t1 )] t t t2 > : (t0) B(t1) . In general. B(t1 )] + (t2) B(t) . B(t2)] t1 t t3: 2 t tk+1 .CHAPTER 14.2: An elementary function . Then the Itˆ integral I (t) can be interpreted as the gain from trading at time t. B (tk )]: ˆ 14. B (tj )] + (tk ) B (t) . The Itˆ Integral o 159 δ( t ) = δ( t 1 ) δ( t ) = δ( t ) 0 δ( t )= δ( t 3 ) 0=t0 t1 t2 t3 t4 = T δ( t ) = δ( t 2 ) Figure 14. | (t0) ] B{z } 0 t t1 > < =B (0)=0 I (t) = > (t0 ) B (t1) . Think of t0 t1 Think of (tk ) as the number of shares of the asset acquired at trading date t k and held until trading date tk+1 . B (t0 )] + (t1 ) B (t) . if tk j =0 (tj ) B (tj +1 ) .

160 s t l t l+1 t . B (t` )] .. k 1 X . Theorem 7. 14. We prove the martingale property for the elementary process case. We treat the more difﬁcult case that s and t are in different Proof: Let 0 subintervals.3: Showing s and t in different partitions. j =0 j =0 IE (t`)(B (t`+1 ) . Write I (t) = ` 1 X ... t k t k+1 Figure 14.45 (Martingale Property) I (t) = is a martingale. B (t` )] k 1 X . B (tj )] + (tk ) B (t) . B (tj )): . .e. + j =`+1 (tj ) B (tj +1 ) . i. B (tk )] tk t tk+1 s t be given. j =0 (tj ) B (tj +1 ) . B(tj )) F (s)5 = (tj )(B (tj +1 ) . there are partition points t ` and tk such that s 2 t` t`+1 ] and t 2 tk tk+1 ] (See Fig.. B(t` )) = (t` ) B (s) . j =0 (tj ) B (tj +1 ) .. and cI (t) = Martingale Zt 0 c (u)dB (u): I (t) is a martingale. B (tj )] + (t` ) B (t`+1 ) . B (tk )] We compute conditional expectations: 2` 1 3 `1 X X IE 4 (tj )(B (tj+1 ) . B(t` )) F (s) = (t` ) (IE B(t`+1)jF (s)] .3). B (tj )] + (tk ) B (t) .

B (tj ))2 F (tj ) IE 2(tj )(tj+1 . We show that the third and fourth terms are zero. B (tj )) F (tj ) F (s) j =`+1 j =`+1 3 2 k 1 X 6 = IE 4 (tj ) (IE B (tj +1)jF (tj )] . . B(tj )) F (s)7 5 {z } | j =`+1 =0 2 3 IE (tk )(B (t) .46 (Itˆ Isometry) o IEI 2(t) = IE Proof: To simplify notation. B (tj )) F (s)5 = IE IE (tj )(B (tj +1 ) . IEI 2(t) = = = IE 2(tj )Dj2] IE 2 (t j )IE (B (tj +1 ) . The Itˆ Integral o These ﬁrst two terms add up to I (s). so Zt 0 2 (u) du: I (t) = k X j =0 (tj ) B (tj +1 ){z B (tj )] . 0k 12 X I 2(t) = @ (tj )Dj A j =0 k X 2 X 2 = (tj )Dj + 2 j =0 i<j k X j =0 k X j =0 k X j =0 (ti ) (tj )DiDj : Since the cross terms have expectation zero. and different Dj are independent.CHAPTER 14. } | Dj Each Dj has expectation 0. 161 2k 1 3 k1 X X IE 4 (tj )(B (tj +1 ) . . B(tk )) F (s)7 tk 4 ( 5 } . tj ) 2 (u) du = IE k X tZj+1 j =0 tj Zt 2 (u) du = IE 0 . =0 Theorem 7. B(tk )) F (s) = IE 6 (tk ) |IE B(t)jF ({z )] . assume t = t k .

8t 2 0 T ]. (t)j2 dt = 0: Proof: Fig. over 0 T ].8 Itˆ integral of a general integrand o Fix T > 0. In the last section we have deﬁned In (T ) = for every n. 14.162 path of δ 4 path of δ 0=t0 t1 t2 t3 t4 = T Figure 14.47 There is a sequence of elementary processes f n g1 such that n=1 nlim IE ! 1 ZT 0 j n(t) . Let IE be a process (not necessarily an elementary process) such that (t) is F (t)-measurable. R T 2(t) dt < 1: 0 Theorem 8.4 shows the main idea. We now deﬁne ZT 0 n (t) dB (t) ZT 0 (t) dB (t) = nlim ! ZT 0 1 n (t) dB (t): .4: Approximating a general process by an elementary process 4 . 14.

(t)j2 dt + 2IE j m (t) . o Example 14. m (t)] dB (t) 2 n (t) . For each t. Continuity. I (t) is F (t)-measurable. IEI 2(t) = IE 0 2 (u) du.1 () Consider the Itˆ integral o ZT 0 B(u) dB(u): We approximate the integrand as shown in Fig. (t)j2 dt = IE 0 0 1 ZT which is small. Linearity. This guarantees that the sequence fI n (T )gn=1 has a limit.9 Properties of the (general) It o integral I (t) = Zt 0 (u) dB (u): Here is any adapted. 14. I (t) is a martingale. The Itˆ Integral o 163 The only difﬁculty with this approach is that we need to make sure the above limit exists. Rt Itˆ Isometry. Im (T )) = IE (Itˆ Isometry:) = IE o ZT 0 T Z 0 0 n (t) .5 . (t)j + j (t) . Then var(In (T ) . Adaptedness. m(t)j ]2 dt ZT ZT 2a2 + 2b2 :) 2IE j n (t) .CHAPTER 14. ˆ 14. If I (t) = then Zt 0 (u) dB (u) J (t) = ( (u) Zt 0 (u) dB (u) I (t) J (t) = Zt 0 (u)) dB (u) and cI (t) = Zt 0 c (u)dB (u): Martingale. Suppose n and m are large positive integers. m (t)] dt !2 ((a + b)2 j n(t) . square-integrable process. I (t) is a continuous function of the upper limit of integration t.

n 1 k =0 . B kT n n : To simplify notation. n 1 j =0 n 1 k =0 .1 X B(u) dB(u) = nlim !1 k=0 Bk (Bk+1 . X Bk Bk+1 + 1 2 . X B kT n k =0 B (k + 1)T .5: Approximating the integrand B (u) with 4 . Bk ): .1)T : B T if if if 0 u < T=n T=n u < 2T=n (n 1)T n . X Bk Bk+1 = Bn . X 2 Bk n 1 k =0 n 1 . X 2 Bk+1 . we denote so 4 Bk = B kT n ZT n.164 T/4 2T/4 3T/4 T Figure 14. X Bk Bk+1 + 1 2 n 1 k =0 n 1 k =0 . X Bj2 . over 0 T ]. 8 >B(0) = 0 > <B(T=n) n (u) = >: : : > (n. Bk ): 0 n 1 k =0 We compute 1 2 n 1 k =0 . u < T: By deﬁnition. ZT 0 B(u) dB(u) = nlim !1 n 1 . X . X 2 Bk n 1 k =0 1 2 = 2 Bn + 1 2 1 2 = 2 Bn + . . 1 2 2 k =0 Bk (Bk+1 . Bk )2 = 1 2 . X (Bk+1 . X 2 Bk .

X 2 Bk (Bk+1 . 1 T: 2 2 The extra term 1 T comes from the nonzero quadratic variation of Brownian motion. X (Bk+1 .10 Quadratic variation of an Itˆ integral o Theorem 10.4 (Reason for the 1 T term) If f is differentiable with f (0) = 0.CHAPTER 14. Bk )2 n 1 k =0 or equivalently n 1 . Bk ) = 1 Bn . 165 n 1 k =0 . It has to be 2 there.48 (Quadratic variation of Itˆ integral) Let o I (t) = Then Zt 0 (u) dB (u): 0 2(u) du: hI i(t) = Zt . 1 2 2 n 1 k =0 . 2 2 . X B kT n k =0 B (k + 1)T . because Z IE T 0 B (u) dB (u) = 0 (Itˆ integral is a martingale) o but IE 1 B 2 (T ) = 1 T: 2 2 14. The Itˆ Integral o Therefore. B kT n n 1 = 1 B 2 (T) . 1 T: 2 Remark 14. X B (k + 1)T n k T 2 : Let n!1 and use the deﬁnition of quadratic variation to get ZT 0 1 B(u) dB(u) = 2 B 2 (T) . for Brownian motion. then 2 ZT 0 f (u) df (u) = ZT 0 f (u)f (u) du 0 = 1 f 2 (u) 2 In contrast. we have T 0 = 1 f 2 (T ): 2 ZT 0 B (u)dB(u) = 1 B 2(T ) .

Let = ft0 t1 : : : tn g be the partition for . B (sj )] hI i(tk+1) . B(sj )]2 k )(tk+1 . Informally.. hI i(tk) = m 1 X .. = 2 (tk ) jj jj!0 . (tk ) for tk t tk+1 .! It follows that j =0 2 (t B(sj+1 ) . tk ) 2 (u) du 0 2(u) du: jj 0 . k=0 n 1 tZ +1 X k k=0 tk 2(t )(t k k+1 .. We have hI i(t) = Let us compute hI i(tk+1) . i. (t)) in the Brownian motion. I (sj ) = so (tk ) dB (u) = (tk ) B (sj +1 ) . tk ): hI i(t) = = n 1 X ..e. we can write the quadratic variation formula in differential form as follows: dI (t) dI (t) = 2(t) dt: Compare this with dB(t) dB(t) = dt: (t) = n 1 X .. hI i(tk)] : tk = s0 Then = fs0 s1 : : : sm g be a partition s1 : : : sm = tk+1 : sZ+1 j sj I (sj+1 ) . The quadratic variation formula says that at each time u... I (sj )]2 m 1 X .166 This holds even if is not an elementary process.. jj!! . the instantaneous absolute volatility of I is 2 (u). This is the absolute volatility of the Brownian motion scaled by the size of the position (i. hI i(tk ). . assume t = tn . j =0 I (sj+1) .e. Proof: (For an elementary process ). Zt . To simplify notation. Let k=0 hI i(tk+1) ..

and in particular has nonzero quadratic variation. we obtain Itˆ ’s formula in integral form: o o f (B(t)) . B (t) is not differentiable.1 Itˆ ’s formula for one Brownian motion o We want a rule to “differentiate” expressions of the form f (B (t)).Chapter 15 Itˆ ’s Formula o 15. Integral Forms) The mathematically meaningful form of Itˆ ’s foro mula is Itˆ ’s formula in integral form: o f (B(t)) . where f (x) is a differentiable function. Integrating this. so the correct formula has an extra term.1 (Differential vs. f (B (0)) = Zt 0 f 0 1 (B (u)) dB (u) + 2 0 167 Zt f (B (u)) du: 00 . | (B (0)) = f {z } f (0) Zt 0 1 f (B(u)) dB (u) + 2 0 Zt 0 f (B (u)) du: 00 Remark 15. namely. If B (t) were also differentiable. then the ordinary chain rule would give d f (B(t)) = f (B(t))B (t) dt 0 0 which could be written in differential notation as df (B (t)) = f (B(t))B (t) dt = f (B (t))dB (t) 0 0 0 However. dt df (B(t)) = f (B(t)) dB (t) + 1 f (B(t)) |{z} : 2 0 00 dB (t) dB (t) This is Itˆ ’s formula in differential form.

Using Taylor’s formula. The total error will have limit zero in the last step of the following argument. This formula becomes mathematically respectable only after we integrate it. B(tk )] + 1 2 n 1 X . xk )f (xk ) + 1 (xk+1 . k=0 B(tk ) B(tk+1 ) . the type used in freshman calculus. o Zt 0 f (B (u)) du 00 is a Riemann integral. k=0 n 1 X k=0 n 1 X . deﬁned in the previous chapter. xk )3 . and the error is of the order of (x k+1 . The second. B (tk )] f (B (tk )) + 1 2 0 n 1 X . Taylor’s formula implies f (xk+1) . k=0 B (tk+1 ) . xk )2f (xk ): 2 In the general case. > 0 and let = ft0 t1 : : : tng be a partition of 0 T ]. f (B (tk ))] B(tk+1 ) . B(tk )]2 f (B(tk )) 00 k=0 B(tk+1 ) . For paper and pencil computations. B(tk )]2 : . f (B(0)) 1 = 2 B 2 (T ) . Taylor’s formula to second order is exact because f is a quadratic function. Zt 0 f (B(u)) dB (u) 0 is an Itˆ integral.2 Derivation of Itˆ ’s formula o Consider f (x) = 1 x2 . . 1 B 2 (0) 2 = = = n 1 X . the above equation is only approximate.168 This is because we have solid deﬁnitions for both integrals appearing on the right-hand side. f (xk ) = (xk+1 . The ﬁrst. 15. Fix T In this case. we write: f (B(T )) . the more convenient form of Itˆ ’s rule is Itˆ ’s formula in differo o ential form: df (B (t)) = f (B (t)) dB(t) + 1 f (B (t)) dt: 2 There is an intuitive meaning but no solid deﬁnition for the terms df (B (t)) dB (t) and dt appearing 0 00 in this formula. so that 2 Let xk f (x) = x f (x) = 1: 0 00 0 00 xk+1 be numbers. f (B(tk+1 )) .

dt + f dB + 1 2 f dt 2 = S (t)dt + S (t) dB (t) 1 2 )f 2 Thus.3 Geometric Brownian motion Deﬁnition 15. f (B(0)) = = ZT ZT 0 0 B(u) dB(u) + 1 hB{zT ) 2 | i( } f 0 T ZT (B (u)) dB (u) + 1 f 2 0 | 00 (B (u)) du: {z } 1 This is Itˆ ’s formula in integral form for the special case o f (x) = 1 x2 : 2 15.CHAPTER 15. o .2 2 t o n .1 2 2 f fx = f fxx = 2f: dS (t) = df (t B(t)) 1 = ft dt + fx dB + 2 fxx dBdB | {z } =( . f (t x) = S (0) exp x + 1 .1 (Geometric Brownian Motion) Geometric Brownian motion is S (t) = S (0) exp B(t) + where Deﬁne and n > 0 are constant.1 2 2 t o so S (t) = f (t B (t)): Then ft = According to Itˆ ’s formula. Geometric Brownian motion in differential form is dt dS (t) = S (t)dt + S (t) dB (t) and Geometric Brownian motion in integral form is S (t) = S (0) + Zt 0 S (u) du + Zt 0 S (u) dB(u): . Itˆ ’s Formula o We let jj 169 jj!0 to obtain f (B (T )) .

we write dS (t) dS (t) = ( S (t)dt + S (t)dB(t))2 = 2S 2 (t) dt 15.170 15.4 Quadratic variation of geometric Brownian motion In the integral form of Geometric Brownian motion. 15. T1 T1 2 S 2(T ) ' 1 1 )]2 1 ZT2 2 S 2(u) du As T2 # T1 . the instantaneous relative volatility of S is 2 . Stock is modelled by a geometric Brownian motion: dS (t) = S (t)dt + S (t)dB(t): . T2 . In differential notation. It has quadratic variation hGi(t) = Zt 0 Thus the quadratic variation of S is given by the quadratic variation of G. This is usually called simply the volatility of S . An investor begins with nonrandom initial wealth X 0 and at each time t. The Itˆ integral o G(t) = Zt 0 is not differentiable. This term has zero quadratic variation. holds (t) shares of stock. the above approximation becomes exact. S (t) = S (0) + the Riemann integral Zt 0 S (u) du + Zt 0 S (u) dB(u) F (t) = is differentiable with F 0 (t) = Zt 0 S (u) du S (u) dB (u) 2 S 2(u) du: S (t). T1 k=0 S (tk+1) .6 First derivation of the Black-Scholes formula Wealth of an investor. Let = volatility of S on T 1 T2] is ft0 : : : tng be a partition of T1 T2].5 Volatility of Geometric Brownian motion Fix 0 T1 T2. S (tk ' T2 . In other words. The squared absolute sample n 1 X .

Equating the dB coefﬁcients. r)S (where v = v (t S (t)) and S = S (t)) which simpliﬁes to vt + rSvx + 1 2 S 2vxx = rv: 2 In conclusion. Then dX (t) = (t)dS (t) + r X (t) . we obtain v (T x) = g (x): S (t)). Let X (t) denote the wealth of the investor at time t. Let v (t x) denote the value of this option at time t if the stock price is S (t) = x. and we are seeking to cause X to agree with v . } Risk premium Value of an option. we equate coefﬁcients in their differentials. and in particular. In other words. 1 vt + Svx + 2 2S 2vxx = rv + vx ( . X (T ) = g (S (T )). the value of the option at each time t 2 0 T ] is v (t S (t)): The differential of this value is dv (t S (t)) = vt dt + vxdS + 1 vxxdS dS 2 = vt dt + vx S dt + S dB ] + 1 vxx 2 S 2 dt h i 2 1 2 S 2v = vt + Svx + 2 xx dt + SvxdB A hedging portfolio starts with some initial wealth X 0 and invests so that the wealth X (t) at each time tracks v (t S (t)). 171 The investor ﬁnances his investing by borrowing or (t) can be random. Making these substitutions. Consider an European option which pays g (S (T )) at time T . we should let v be the solution to the Black-Scholes partial differential equation 1 vt (t x) + rxvx (t x) + 2 2 x2vxx(t x) = rv (t x) satisfying the terminal condition If an investor starts with X 0 = v (0 S (0)) and uses the hedge (t) = vx (t X (t) = v(t S (t)) for all t. We saw above that dX (t) = rX + ( . Itˆ ’s Formula o lending at interest rate r. we obtain: vt + Svx + 1 2 S 2vxx = rX + ( . then he will have . but must be adapted.CHAPTER 15. (t)S (t)] dt = rX (t)dt + (t)S (t) ( {z r) dt + (t)S (t) dB (t): | . we obtain the -hedging rule: (t) = vx (t S (t)): Equating the dt coefﬁcients. (t)S (t)] dt = (t) S (t)dt + S (t)dB (t)] + r X (t) . r)S ] dt + S dB: To ensure that X (t) = v (t S (t)) for all t. r)S: 2 But we have set = vx .

The integral form of the CIR equation is r(t) = r(0) + a (b . cr(t))dt + where a q r(t) dB(t) bc and r(0) are positive constants.7 Mean and variance of the Cox-Ingersoll-Ross process The Cox-Ingersoll-Ross model for interest rates is dr(t) = a(b . 1): c r(0) . If r(0) 6= b .172 15. eacu du = b (eact . We obtain We apply Itˆ ’s formula to compute dr o dr2(t) = df (r(t)) = f (r(t)) dr(t) + 1 f (r(t)) dr(t) dr(t) 2 0 00 r(t) = r(0) + a (b . b : c c b If r(0) = c . then IEr(t) = b for every t. we obtain o IEr(t) = r(0) + a (b . In integral form. where f (x) = x2 . cr(u)) du + 0 Zt Z tq 0 r(u) dB (u): Taking expectations and remembering that the expectation of an Itˆ integral is zero. this equation is 0 0 2(t). cIEr(t)) = ab . cIEr(u)) du: 0 Differentiation yields Zt d dt IEr(t) = a(b . acIEr(t) which implies that d heact IEr(t)i = eact acIEr(t) + d IEr(t) = eact ab: dt dt eactIEr(t) . cr(t)) dt + 3 q r(t) dB (t) 2 = 2abr(t) dt . 2acr2(t) dt + 2 r 2 (t) dB (t) + 2 r(t) dt 3 = (2ab + 2 )r(t) dt . 2acr2(t) dt + 2 r 2 (t) dB (t) The mean of r(t). cr(u)) du + Zt Z tq r(u) dB (u): = 2r(t) a(b . r(0) = ab Integration yields We solve for IEr(t): Zt 0 . then r(t) exhibits mean reversion: c c IEr(t) = b + e c act lim IEr(t) = b : t! 1 . cr(t)) dt + q r(t) dB (t) + a(b . This is df (r(t)).

we obtain Zt 0 r(u) du . . the vector increments B(t1 ) . r(0) e 2act : c ac var r(t) = IEr2(t) . . r(0) e 2act : c IEr2(t) = ! . . The integral form of the equation derived earlier for dr2(t) is 173 r2 (t) = r2(0) + (2ab + 2 ) Taking expectations. then the processes Bi (t) and Bj (t) are independent. b act 2 c2 2ac c ac + c e 2 2 2 + r(0) . 2ac Zt 0 IEr2(u) du: d IEr2(t) = (2ab + 2)IEr(t) . 15. . after considerable algebra we obtain 2 2b b 2 + b2 + r(0) . b e 2act + ac 2bc . 2ac Zt 0 r2(u) du + 2 Zt 0 2 r 3 (u) dB(u): IEr2(t) = r2(0) + (2ab + 2) Differentiation yields Zt 0 IEr(u) du . we have a ﬁltration fF (t)g such that For each t. B(t) : : : B(tn) . For each t t1 : : : tn . Itˆ ’s Formula o Variance of r(t). . b ac e act + ac 2bc . 2acIEr2(t) dt which implies that d e2actIEr2(t) = e2act 2acIEr2(t) + d IEr2(t) dt dt 2act (2ab + 2)IEr(t): =e Using the formula already derived for IEr(t) and integrating the last equation. If i 6= j . (IEr(t))2 2 2 b 2 = 2ac2 + r(0) . the random vector B (t) is F (t)-measurable.CHAPTER 15. . Associated with a d-dimensional Brownian motion.2 (d-dimensional Brownian Motion) A d-dimensional Brownian Motion is a process B (t) = (B1 (t) : : : Bd (t)) with the following properties: Each Bk (t) is a one-dimensional Brownian motion. B(tn 1 ) are independent of F (t).8 Multidimensional Brownian Motion Deﬁnition 15.

IEC = 0: We compute var(C ). First note that C2 = +2 n 1 X . tk ) = jj jj:T: = 0. we have: Theorem 9.9 Cross-variations of Brownian motions Because each component Bi is a one-dimensional Brownian motion. tk )2 jj jj n 1 X . Bi (t` )] Bj (t`+1 ) . Bi (tk ) Bj (tk+1) . deﬁne the sample cross variation Proof: Let = ft0 : : : tn g be a partition of of Bi and Bj on 0 T ] to be C = n 1 X . k=0 Bi (tk+1) . jj!0. we have the informal equation dBi(t) dBi (t) = dt: However. Bi(tk )]2 Bj (tk+1 ) . k=0 (tk+1 . dBi(t) dBj (t) = 0 0 T ]. and each has expectation (tk+1 . For i 6= j . Bi (tk )]2 and Bj (tk+1 ) . Bj (tk )] : The increments appearing on the right-hand side of the above equation are all independent of one another and all have mean zero. Bi(tk+1 ) . Bj (tk )] All the increments appearing in the sum of cross terms are independent of one another and have mean zero. k=0 Bi (tk+1 ) .49 If i 6= j . k=0 (tk+1 . so C converges to the constant IEC . we have var(C )!0. Bi (tk )] Bj (tk+1) . Bj (tk )]2 are independent of one another. k=0 n 1 X . Bj (tk )]2 : But Bi (tk+1 ) . Bi (tk )] Bj (tk+1 ) . Therefore. It follows that var(C ) = As jj n 1 X . var(C ) = IEC 2 = IE n 1 X .174 15. Therefore. Bj (tk ) 2 2 `<k Bi (t`+1) . tk ). Bj (t` )] : Bi (tk+1 ) .

and let X (t) and Y (t) be semimartingales. and Bi = Bi (u).10 Multi-dimensional Itˆ formula o To keep the notation as simple as possible. Itˆ ’s Formula o 175 15. The integrands (u) (u) and ij (u) can be any o adapted processes. 0 11 fx + 21 fy ] dB1 + Zt 0 2 1 2 11 21 + 12 22)fxy + 2 ( 21 + 22)fyy ] du 12 fx + 22 fy ] dB2 . The adaptedness of the integrands guarantees that X and Y are also adapted. ij = ij (u). Let X and Y be processes of the form X (t) = X (0) + Y (t) = Y (0) + Zt 0 Z0t (u) du + (u) du + Zt Z0t 0 11(u) dB1 (u) + 21 (u) dB1 (u) + Zt Z0t 0 12 (u) dB2(u) 22 (u) dB2 (u): Such processes. for i j 2 f1 2g. plus a Riemann integral. f (0 X (0) Y (0)) Zt 2 2 = ft + fx + fy + 1 ( 11 + 12)fxx + ( 2 + where f 0Z t = f (u X (u) Y (u).CHAPTER 15. with X and Y as decribed earlier and with all the variables ﬁlled in. In differential notation. consisting of a nonrandom initial condition. this equation is f (t X (t) Y (t)) . are called semimartingales. we write dX = dt + 11 dB1 + 12 dB2 dY = dt + 21 dB1 + 22 dB2 : Given these two semimartingales X and Y . we write the Itˆ formula for two processes driven by a o two-dimensional Brownian motion. plus one or more Itˆ integrals. the quadratic and cross variations are: dX dX = ( dt + 11 dB1 + 12 dB2)2 2 2 = 11 dB1{z 1 +2 11 12 dB1{z 2 + 12 dB2{z 2 | dB } | dB} | dB} =( dY dY = ( =( dX dY = ( =( 0 dt 2 + 2 )2 dt 11 12 dt + 21 dB1 + 22 dB2 )2 2 2 2 21 + 22 ) dt dt + 11 dB1 + 12 dB2)( 11 21 + 12 22 ) dt dt dt + 21 dB1 + 22 dB2 ) Let f (t x y ) be a function of three variables. Then we have the corresponding Itˆ formula: o df (t x y) = ft dt + fx dX + fy dY + 1 fxx dX dX + 2fxy dX dY + fyy dY dY ] : 2 In integral form. The formula generalizes to any number of processes driven by a Brownian motion of any number (not necessarily the same number) of dimensions.

176 .

Chapter 16 Markov processes and the Kolmogorov equations 16. A solution to (SDE) with the initial condition (t 0 x) is a process fX (t)gt X (t0) = x X (t) = X (t0) + a(s X (s)) ds + t0 Zt Zt t0 (s X (s)) dB (s) t t0 The solution process fX (t)g t t0 will be adapted to the ﬁltration fF (t)g t 0 generated by the Brownian motion.i. a(t y)j Ljx . Let (t0 x) be given. there is a constant L such that (SDE) x) and Lips- ja(t x) . Example 16. then you can evaluate X (t). (t y)j Ljx . so dX(t) = a dt + dB(t): If (t0 x) is given and we start with the initial condition X(t0 ) = x 177 .e. yj t0 x y.1 (Drifted Brownian motion) Let a be a constant and = 1.. usually assumed to be continuous in (t chitz continuous in x. If you know the path of the Brownian motion up to time t. yj for all t satisfying j (t x) .1 Stochastic Differential Equations Consider the stochastic differential equation: dX (t) = a(t X (t)) dt + (t X (t)) dB (t): Here a(t x) and (t x) are given functions.

treat t0 and B(t0 ) as constants: dX(t) = a dt + dB(t): t t0: Example 16. given that X (t0) condition X (0) = : We have the Markov property IE 0 h(X (t1)) F (t0) = IE t0 X (t0)h(X (t1)): In other words.2 (Geometric Brownian motion) Let r and be constants. B(t0 )) To compute the differential w. You imagine starting the (SDE ) at time t0 at value X (t0). you want to estimate h(X (t 1)).t. if you observe the path of the driving Brownian motion from time 0 to time t 0 . t. and based on this information. B(t0 )) + (r . and start with initial the expectation of h(X (t1)). treat t0 and B(t0 ) as constants: dX(t) = (r . Denote by IE t0 xh(X (t1)) = x. t.r.t. Consider dX(t) = rX(t) dt + X(t) dB(t): Given the initial condition X(t0 ) = x the solution is X(t) = x exp (B(t) .178 then X(t) = x + a(t . t0) : 2 Again. to compute the differential w.r. 1 2)X(t) dt + X(t) dB(t) + 1 2 X(t) dt 2 2 = rX(t) dt + X(t) dB(t): 16.2 Markov Property Let 0 t0 < t1 be given and let h(y ) be a function. and compute the expected value of h(X (t1)). the only relevant information is the value of X (t0). t0) + (B(t) . . 1 2 )(t . Now let 2 IR be given.

t0 ) and variance 2 p(t0 t1 x y) = p 1 exp .4 (Geometric Brownian motion) Recall that the solution to the SDE dX(t) = rX(t) dt + X(t) dB(t) with initial condition X(t 0 ) = x. t0 . IE t0 xh(X (t1)) = The Markov property says that for 0 Z IR h(y )p(t0 t1 x y ) dy: . t0) : 2 dy = y db or equivalently. t0 ). B(t0 ) has density 2 IP fB(t1 ) . B(t0 )) + (r . h y i b = 1 log x . i. (x + a(t1 . In other words. (y . t0) 1 0 and we are making the change of variable y = x exp b + (r . conditioned on X (t 0) = x.e. t0 ) 2 (t1 .. This is always the case when a(t x) and (t x) don’t depend on t. t0 t1 and for every IE 0 h(X (t1)) F (t0 ) = Z IR h(y )p(t0 t1 X (t0) y ) dy: Example 16.3 Transition density Denote by p(t0 t1 x y) the density (in the y variable) of X (t 1).CHAPTER 16. X(t 0 ) = x. 2(t b. B(t0 ) 2 dbg = p 1 exp . Markov processes and the Kolmogorov equations 179 16. t0 ))) : 2(t1 . is Geometric Brownian motion: 1 X(t1 ) = x exp (B(t1 ) . 1 2)(t1 . 1 2)(t1 . t ) db 2 (t1 . the random variable X(t1 ) is normal with mean x + a(t1 . The derivative is db = dy : y . (r . t0 ) 2 or equivalently. 2 2 )(t1 . t0) Note that p depends on t0 and t1 only through their difference t 1 .3 (Drifted Brownian motion) Consider the SDE dX(t) = a dt + dB(t): Conditioned on (t1 . Example 16. t0) : The random variable B(t1 ) .

t) K T . 1 2 (T . t) . 2(t . .t) IE t X (t) (X(T) . t) . t) . and (KBE ) becomes The variables t0 and x in (KBE ) are called the backward variables. t ) = p 1 y 2 (t1 . K) = tx 2 h y i2 1 log x . t0) 1 0 IE (X(T ) .t h x i log K + r(T . (r . p(t0 t1 x y ) depends on t0 and t1 only through their difference = t1 .180 Therefore.t) 1 =e xN p 1 log K + r(T . K)+ p(t T x y) dy 0 h x i r (T .1 IE 0 e. t0 . K)+ 1 = X(t)N p 1 log X(t) + r(T . Then the Kolmogorov Backward Equation is: @ @ @2 1 . @t p(t0 t1 x y) = a(t0 x) @x p(t0 t1 x y) + 2 2(t0 x) @x2 p(t0 t1 x y): 0 (KBE) dX (t) = a(t X (t)) dt + (t X (t)) dB (t) In the case that a and are functions of x alone. e. K)+ F (t) = e. t) T . KN p 1 2 T . p(t0 t1 x y) dy = IP fX(t1 ) 2 dyg 1 exp .r(T .r(T . t) + 2 2(T . t0 ) dy: Using the transition density and a fair amount of calculus. 2 x dx: 2 .t 16. 2 2 )(t1 .t) K N p 1 2 K T . Z Z1 12 1 2 e.t) (X(T) . one can compute the expected payoff from a European call: + (y .t log X(t) + r(T .r(T . t) + 2 2(T .4 The Kolmogorov Backward Equation Consider and let p(t0 t1 x y ) be the transition density. 2 x dx = p1 e. t) . @ p( x y ) = a(x) @ p( x y) + 1 2(x) @ 2 p( x y ): 2 @ @x @x2 (KBE’) .t Z1 where N( ) = p1 2 Therefore. 1 2 (T . We then write p( x y ) rather than p(t0 t1 x y ).

a )2 p 1 exp . a ) . a ) p: 2 Therefore. @ 2 2 2 1 + a(y . x . Markov processes and the Kolmogorov equations Example 16. a )2 @ @ 2 2 @ (y . Example 16. (x + a )) : 2 2 @ p = p = @ p 1 exp . x . x .2 22 @ p = p = y . and deﬁne (5. x . x . (y . 2 1 apx + 2 pxx = a(y . x . (y .6 (Geometric Brownian motion) dX(t) = rX(t) dt + X(t) dB(t): h y 1 1 p( x y) = p exp . a p: x @x @2 p = p = @ y . (y . 2 2 ) y 2 It is true but very tedious to verify that p satisﬁes the KBE 1 p = rxpx + 2 2x2 pxx: i2 : 16. x . a ) p 2 2 =p : This is the Kolmogorov backward equation.CHAPTER 16. a p xx x @x2 @x 2 = .1) v (t x) = IE t xh(X (T )) .5 (Drifted Brownian motion) 181 dX(t) = a dt + dB(t) 2 p( x y) = p 1 exp . 2 1 2 log x .5 Connection between stochastic calculus and KBE Consider dX (t) = a(X (t)) dt + (X (t)) dB(t): Let h(y ) be a function. x . a ) p: = . x . a ) + (y . 1 p + (y . a p + y . x . x . 21 + (y . a )2 . (r .

50 Starting at X (0) = . t x y) + a(x)px(T . t x y ) dy vx(t x) = h(y) px(T .1). t x y ) dy: Therefore. IE h(X (T )) F (t) = IE t X (t)h(X (T )) = v (t X (t)) so IE v (t X (t))jF(s)] = IE IE h(X (T )) F (t) F (s) = IE h(X (T )) F (s) = IE s X (s)h(X (T )) = v (s X (s)): (Markov property) Itˆ ’s formula implies o dv(t X (t)) = vt dt + vxdX + 1 vxx dX dX 2 1 = vt dt + avx dt + vx dB + 2 2 vxx dt: . Then v(t x) = h(y) p(T .p (T . We simplify notation by writing IE rather than Theorem 5. the Kolmogorov backward equation implies Z Z Z Z vt(t x) +Za(x)vx(t x) + 1 2(x)vxx(t x) = 2 h i h(y ) . h(y ) p (T . t x y ) + 1 2(x)pxx(T . t x y ) dy vxx(t x) = h(y) pxx(T . t x y ) dy vt(t x) = . ) be an initial condition for the SDE (5. t x y ) dy = 0 2 Let (0 IE 0 .182 where 0 t T . the process v (t X (t)) satisﬁes the martingale property: 0 s t T: IE v (t X (t)) F (s) = v (s X (s)) Proof: According to the Markov property.

This implies that the integrand is zero. B(t)) + (r . one can use Itˆ ’s formula to prove the Feynman-Kac Theorem. Remark 16.1 (Derivation of KBE) We plunked down the Kolmogorov backward equation without any justiﬁcation. o Theorem 5. so the integral 0 for all t. In fact. hence h 1 vt + avx + 2 2 vxx du must be zero i vt + avx + 1 2vxx = 0: 2 Thus by two different arguments. we have 183 v (t X (t)) = v (0 X (0)) Z th i + vt (u X (u)) + a(X (u))vx(u X (u)) + 1 2 (X (u))vxx(u X (u)) du 2 + Z0t 0 (X (u))vx(u X (u)) dB (u): Rt We know that v (t X (t)) is a martingale.CHAPTER 16. and the other based on Itˆ ’s formula. t) 2 n o u t: . we have come to the same conclusion. 16. 1 2)(u . Markov processes and the Kolmogorov equations In integral form. one based on the Kolmogorov backward equation.6 Black-Scholes Consider the SDE With initial condition the solution is dS (t) = rS (t) dt + S (t) dB (t): S (t) = x S (u) = x exp (B (u) . as we show in the next section. and use o the Feynman-Kac Theorem to derive the Kolmogorov backward equation.51 (Feynman-Kac) Deﬁne v(t x) = IE t xh(X (T )) where Then 0 t T dX (t) = a(X (t)) dt + (X (t)) dB(t): vt(t x) + a(x)vx(t x) + 1 2 (x)vxx(t x) = 0 2 (FK) and v (T x) = h(x): The Black-Scholes equation is a special case of this theorem.

1 2 )(T . 1 2)t 2 n o S (T ) = S (0) exp B(T ) + (r . B (t)) + (r . X is G -measurable. we have o (t)-measurable | independent of F (t) {z } We thus have S (T ) = XY where X = S (t) o n Y = exp (B(T ) . IE h(X Y ) G = (X ) where (x) = IEh(x Y ): With geometric Brownian motion. t) 2 Recall the Independence Lemma: If G is a -ﬁeld. 1 2)T 2 n o 1 = S (t) exp (B (T ) . B (t)) + (r . 2 2 )(T . t) |{z} F n t T . and Y is independent of G . then where h is a function to be speciﬁed later. t) : 2 Now IEh(xY ) = v(t x): The independence lemma implies IE h(S (T )) F (t) = IE h(XY )jF (t)] = v (t X ) = v (t S (t)): . for 0 S (t) = S (0) exp B(t) + (r . 1 2)(T . B (t)) + (r .184 Deﬁne v (t x) = IE t xh(S (T )) n o = IEh x exp (B (T ) .

51 (Feynman-Kac). Therefore. 0 t T: u(t x) = e =e at time t if S (t) = x. r(T t) IE t xh(S (T )) r(T t) v (t x) . then also S (T ) = 0. if S (t) = 0 for some t 2 0 T ]. v(t S (t)) is a martingale. . Because of this. we shall eventually see that the value at time t of a contingent claim paying h(S (T )) is v(t 0) = h(0) . . . IE v(t S (t)) F (s) = IE IE h(S (T )) F (t) F (s) = IE h(S (T )) F (s) = v (s S (s)): This is a special case of Theorem 5.51.rer(T t)u(t x) + er(T t)ut (t x) x) = er(T t)ux(t x) x) = er(T t)uxx(t x): . dv (t S (t)) = vt(t S (t)) dt + rS (t)vx(t S (t)) + 1 2 S 2(t)vxx(t S (t)) dt 2 + S (t)vx(t S (t)) dB (t): By Itˆ ’s o h i This leads us to the equation vt(t x) + rxvx(t x) + 1 2x2vxx(t x) = 0 2 This is a special case of Theorem 5. . . we have the terminal condition v(T x) = h(x) x 0: Furthermore.CHAPTER 16. the sum of the dt terms in dv (t S (t)) must be 0. 0 t < T x 0: Along with the above partial differential equation. condition This gives us the boundary Finally. the tower property implies that v (t S (t)) 0 t T . v(t v t (t vx(t vxx(t x) = er(T t)u(t x) x) = . is a martingale: For 0 s t T . . . Markov processes and the Kolmogorov equations We have shown that 185 v(t S (t)) = IE h(S (T )) F (t) 0 t T: Note that the random variable h(S (T )) whose conditional expectation is being computed does not depend on t. Because formula.

4). t) . 2 2)(T .186 Plugging these formulas into the partial differential equation for v and cancelling the e r(T . e r(T t)K N p 1 2 . K )+ x 0 0 t < T x > 0: . t) 2) for geometric Brownian motion (See Example 16. u(t x) is still given by and 16. dS (t) = rS (t) dt + (S (t)) dB(t) v(t x) = e r(T t) IE t x(S (T ) . K )+ u(t x) = x N p1 satisﬁes the Black-Scholes PDE (BS) derived above. 1 2 (T . 1 p(t T x y ) = p 1 exp . r(T t) IE t xh(S (T )) . t) y 2 (T . t) 2 T . 2(T .rv(t x) + vt(t x) + rxvx(t x) + 1 2(x)vxx(t x) = 0 2 v also satisﬁes the terminal condition v(T x) = (x .ru(t x) + ut(t x) + rxux(t x) + 1 2x2uxx(t x) = 0 2 In terms of the transition density 0 t < T x 0: (BS) Compare this with the earlier derivation of the Black-Scholes PDE in Section 15. . . t) + 1 2 (T . The Feynman-Kac Theorem now implies that .t Even if h(y ) is some other function (e. (r . h(y ) = (K .. .g. r(T t) Z (SR) 1 0 h(y )p(t T x y) dy: h(y ) = (y . t) .6. y )+ . we obtain the Black-Scholes partial differential equation: . a put). and .t) appearing in every term.7 Black-Scholes with price-dependent volatility x log K + r(T . t) ( 2 y 1 log x . K )+ : . we have the “stochastic representation” u(t x) = e =e In the case of a call. .t x log K + r(T . T .

**CHAPTER 16. Markov processes and the Kolmogorov equations
**

and the boundary condition

187

v(t 0) = 0

0 t T:

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:

dS (t) = rS (t) dt + S (t) dB (t)

where 0 < 1. The “volatility” sponding Black-Scholes equation is

S

;

1(t) decreases with increasing stock price. The corre-

;rv + vt + rxvx + 1 2x2 vxx = 0 2

0 t<T x>0 v (t 0) = 0 0 t T v (T x) = (x ; K )+ x 0:

188

Chapter 17

**Girsanov’s theorem and the risk-neutral measure
**

(Please see Oksendal, 4th ed., pp 145–151.) Theorem 0.52 (Girsanov, One-dimensional) Let B (t) 0 t T , be a Brownian motion on a probability space ( F P). Let F (t) 0 t T , be the accompanying ﬁltration, and let (t) 0 t T , be a process adapted to this ﬁltration. For 0 t T , deﬁne

e B (t) =

Zt

0

(u) du + B (t)

Z (t) = exp ;

Zt

0

(u) dB (u) ;

Zt 2 1 2 0 (u) du 8A 2 F :

and deﬁne a new probability measure by

f IP (A) = f e Under I , the process B (t) P

Z

A

Z (T ) dIP

0 t T , is a Brownian motion.

Caveat: This theorem requires a technical condition on the size of . If

IE exp

everything is OK. We make the following remarks:

( ZT

1 2 0

2 (u) du

)

<1

Z (t) is a matingale. In fact, 1 dZ (t) = ; (t)Z (t) dB (t) + 2 2 (t)Z (t) dB(t) dB(t) ; 1 2(t)Z (t) dt 2 = ; (t)Z (t) dB (t):

189

190

f IP is a probability measure.

Since Z (0) = 1, we have IEZ (t) = 1 for every t

f IP ( ) =

Z

0. In particular

Z (T ) dIP = IEZ (T ) = 1

f IE in terms of IE .

f so I is a probability measure. P

**f IEZ = IE Z (T )X ] : To see this, consider ﬁrst the case X = 1 A , where A 2 F . We have Z Z f f IEX = IP (A) = Z (T ) dIP = Z (T )1A dIP = IE Z (T )X ] :
**

A

Now use Williams’ “standard machine”. The intuition behind the formula

f f E P Let I denote expectation under I . If X is a random variable, then

f IP and IP .

f IP (A) =

Z

A

Z (T ) dIP

8A 2 F f IP . Thus,

is that we want to have

e Distribution of B (T ). If

f but since IP (! ) = 0 and I (!) = 0, this doesn’t really tell us anything useful about P we consider subsets of , rather than individual elements of .

is constant, then

f IP (!) = Z (T !)IP (!) n

Z (T ) = exp ; B (T ) ; 1 2 T 2 e (T ) = T + B(T ): B e Under IP , B (T ) is normal with mean 0 and variance T , so B (T ) is normal with mean T and variance T : ( ) b 1 exp ; (~ ; T )2 d~: e IP (B (T ) 2 d~) = p b b 2T 2 T e f e P Removal of Drift from B (T ). The change of measure from IP to I removes the drift from B (T ).

To see this, we compute

o

Z = p1 2 T 1 Z =p 2 T Z (y = T + b) = p 1 2 T = 0:

**fe IEB (T ) = IE Z (T )( T + B(T ))] h n o i = IE exp ; B (T ) ; 1 2 T ( T + B (T )) 2
**

1 ;1 1

( T + b) expf; b ;

;1 1

( T + b) exp ; (b + TT ) 2

2 y exp ; y2 dy

(

1 2 2 Tg

( 2) b exp ; 2T db 2)

db

= T + b)

(

)

;1

(Substitute y

CHAPTER 17. Girsanov’s theorem and the risk-neutral measure

191

**fe E We can also see that I B (T ) = 0 by arguing directly from the density formula
**

2 ~ IP B (t) 2 db = p 1 exp ; (b ; TT ) d~: b 2 2 T

Because

ne

o ~

(

)

**Z (T ) = expf; B(T ) ; 1 2T g 2 e (T ) ; T ) ; 1 2 T g = expf; (B 2 e (T ) + 1 2 T g = expf; B 2
**

we have

**f e e IP B(T ) 2 d~ = IP B (T ) 2 d~ exp ; ~ + 1 2 T b b b 2 ( ~ ) 1 exp ; (b ; T )2 ; ~ + 1 2 T d~: b 2 =p b 2T 2 T ( ) b 1 exp ; ~2 d~: =p 2T b 2 T f e Under I , B (T ) is normal with mean zero and variance P mean T and variance T .
**

T.

Under IP ,

n

o

n

o

n

o

e B (T ) is normal with

Means change, variances don’t. 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:

**e e dB dB = ( (t) dt + dB(t))2 = dB:dB = dt: f 17.1 Conditional expectations under I P
**

Lemma 1.53 Let 0

t T . If X is F (t)-measurable, then

f IEX = IE X:Z (t)]:

Proof:

f IEX = IE X:Z (T )] = IE IE X:Z (T )jF (t)] ] = IE X IE Z (T )jF (t)] ] = IE X:Z (t)]

because Z (t)

0 t T , is a martingale under IP .

192 Lemma 1.54 (Baye’s Rule) If X is F (t)-measurable and 0

1 f IE X jF (s)] = Z (s) IE XZ (t)jF (s)]:

s t T , then

(1.1)

Proof: It is clear that Z 1s) IE XZ (t)jF (s)] is ( property. For A 2 F (s), we have

F (s)-measurable.

We check the partial averaging

Z

**1 IE XZ (t)jF (s)] dIP = IE 1 1 IE XZ (t)jF (s)] f f A Z (s) A Z (s) (Lemma 1.53) = IE 1A IE XZ (t)jF (s)]] = IE IE 1A XZ (t)jF (s)]] (Taking in what is known) = IE 1A XZ (t)] f = IE 1A X ] (Lemma 1.53 again) Z f = X dIP :
**

A

Although we have proved Lemmas 1.53 and 1.54, we have not proved Girsanov’s Theorem. We will not prove it completely, but here is the beginning of the proof. Lemma 1.55 Using the notation of Girsanov’s Theorem, we have the martingale property

fe e IE B (t)jF (s)] = B (s)

0 s t T:

e Proof: We ﬁrst check that B (t)Z (t) is a martingale under IP . Recall e dB (t) = (t) dt + dB (t) dZ (t) = ; (t)Z (t) dB(t):

Therefore,

e e e e d(BZ ) = B dZ + Z dB + dB dZ e = ;B Z dB + Z dt + Z dB ; Z dt e = (;B Z + Z ) dB:

s t T,

Next we use Bayes’ Rule. For 0

fe e IE B (t)jF (s)] = Z 1s) IE B (t)Z (t)jF (s)] ( e = Z 1s) B (s)Z (s) ( e = B (s):

CHAPTER 17. Girsanov’s theorem and the risk-neutral measure

193

Deﬁnition 17.1 (Equivalent measures) Two measures on the same probability space which have the same measure-zero sets are said to be equivalent. The probability measures deﬁned by

IP

and

**f IP of the Girsanov Theorem are equivalent.
**

A 2 F:

Recall that

f IP is

Z f(A) = Z (T ) dIP IP Z

If IP (A) = 0, then A Z (T ) f of I to obtain P

R

**dIP = 0: Because Z (T ) > 0 for every !, we can invert the deﬁnition IP (A) = dIP A Z (T )
**

1

f

A 2 F:

f P If I (A) = 0, then A Z (1T )

R

dIP = 0:

**17.2 Risk-neutral measure
**

As usual we are given the Brownian motion: B (t) 0 t T , with ﬁltration F (t) deﬁned on a probability space ( F P). We can then deﬁne the following. Stock price:

0

t

T,

dS (t) = (t)S (t) dt + (t)S (t) dB (t):

The processes (t) and (t) are adapted to the ﬁltration. The stock price model is completely general, subject only to the condition that the paths of the process are continuous.

**r(t) 0 t T . The process r(t) is adapted. Wealth of an agent, starting with X (0) = x. We can write the wealth process differential in
**

Interest rate: several ways:

dX (t) =

= r(t)X (t) dt + (t) dS (t) ; rS (t) dt] = r(t)X (t) dt + (t) ( (t) {z r(t)) S (t) dt + (t) (t)S (t) dB (t) | ; }

Capital gains from Stock

dS ) | (t){z (t} + r(t) X (t) ;{z (t)S (t)] dt | }

Interest earnings

2 3 6 (t) ; r(t) 7 6 7 6 = r(t)X (t) dt + (t) (t)S (t) 6 dt + dB (t)7 7 ( 4 | {zt) } 5

Risk premium Market price of risk=

(t)

X (t) = e .r(t)S (t) dt + dS (t)] ( = 1t) ( (t) . The discounted formulas are = 1t) (t)S (t) (t) dt + dB (t)] ( (t) d X((tt)) = (t) d S(t) () = (tt) (t)S (t) (t) dt + dB (t)]: Changing the measure. S (t) and X((tt)) are martingales. Deﬁne (t) d S(t) = 1t) .r(t)S (t) dt + dS (t)] . . which makes all discounted asset prices martingales. r(t))S (t) dt + (t)S (t) dB (t)] ( e B (t) = Then Zt 0 (u) du + B (t): (t) e d S(t) = 1t) (t)S (t) dB (t) ( e d X((tt)) = ((tt)) (t)S (t) dB (t): f (t) Under I . P Deﬁnition 17.194 Discounted processes: d e d e . r(tt) dt: ( () .2 (Risk-neutral measure) A risk-neutral measure (sometimes called a martingale measure) is any probability measure. R t r(u) du 0 R t r(u) du 0 S (t) = e . . equivalent to the market measure IP . R t r(u) du 0 .r(t)X (t) dt + dX (t)] S (t) : 0 = (t)d e Notation: R t r(u) du Rt (t) = e 0 r(u) du d (t) = r(t) (t) dt 1 = e R0t r(u) du (t) d 1t) = . R t r(u) du 0 .

whose corresponding wealth process f V X (0) = IE (T ) : f P This is because X((tt)) is a martingale under I . 195 f IP (A) = where Z A 0 Z (T ) dIP (u) dB (u) . S(T)) European put !+ ZT 1 S(u) du .e. (t) 6= Risk-neutral valuation. then (t) 0 t T . Consider a contingent claim paying an F (T )-measurable random variable V at time T . Zt Zt is the unique risk-neutral measure.. K V= T Asian call 0 V = 0maxT S(t) Look back t If there is a hedging portfolio.1 V = (S(T) . Example 17. (t) = 2 (u) du 0 (t) r(t) we must assume that (t) . so (0) f T f V X (0) = X(0) = IE X((T )) = IE (T ) : . a process satisﬁes X (T ) = V .CHAPTER 17. i. 1 2 A2F Z (t) = exp . Note that because 0. K)+ European call + V = (K . Girsanov’s theorem and the risk-neutral measure For the market model considered here.

196 .

Let F (t) 0 t T . Y (t) = Y (0) + Zt 0 e (u) dB (u) 197 0 t T: . be a martingale (under IP ) t T . suppse that F (t) the ﬁltration generated by the Brownian motion B (under IP ). i.11. Theorem 4. 4th ed. then dX (t) = (t) dB(t) for some (t). the Brownian motion is the only source of randomness in X .1 Martingale Representation Theorem See Oksendal.. Then there is an adapted process (t) 0 F P).50. p. the paths of X are continuous.Chapter 18 Martingale Representation Theorem 18. In the context of Girsanov’s Theorem. Remark 18.56 Let B (t) 0 t T be a Brownian motion on ( the ﬁltration generated by this Brownian motion.5. such that 0 t T is f IP -martingale. Now we see that if X (t) is a martingale adapted to the ﬁltration generated by the Brownian motion B (t). Let X (t) 0 t relative to this ﬁltration. Suppose that Y is a Then there is an adapted process (t) 0 t T . be T . Theorem 1. such that X (t) = X (0) + Zt 0 (u) dB (u) 0 t T: In particular.1 We already know that if X (t) is a process satisfying dX (t) = (t) dB (t) then X (t) is a martingale.2 A hedging application Homework Problem 4. 18.e.

so that f P Deﬁne the I -martingale X (T ) = V: f V Y (t) = IE (T ) F (t) Zt 0 0 t T: (t) 0 t T . there is an adapted process f Set X (0) = Y (0) = I E h Y (t) = Y (0) + V (T ) and choose i e (u) dB (u) (u) so that (u) (u) S (u) = (u): (u) . We want to choose X (0) and (t) 0 t T . 1 2 Zt 0 2 (u) du 8A 2 F : Then Let (t) (t) e d S(t) = S(t) (t) dB (t): (t) 0 t T be a portfolio process. representing the payoff of a contingent claim at time T . X (t) = X (0) + Z t (u) (u) S (u) dB(u) e (t) (u) 0 0 t T: Let V be an F (T )-measurable random variable.198 dS (t) = (t)S (t) dt + (t)S (t) dB (t) Zt (t) = exp r(u) du 0 (t) = (t) .5. The corresponding wealth process X (t) satisﬁes (t) e d X((tt)) = (t) (t) S(t) dB(t) i. such that 0 t T: According to Homework Problem 4. A 0 Zt (u) dB (u) . r(t) Z t (t) e B (t) = (u) du + B(t) 0 Z f(A) = Z (T ) dIP IP Z (t) = exp ..e.

CHAPTER 18. F P). B(t) = (B1 (t) : : : Bd(t)) 0 t T . perhaps larger than the one generated by B .3 d-dimensional Girsanov Theorem Theorem 3. Martingale Representation Theorem With this choice of 199 (u) 0 u T . we have X (t) = Y (t) = IE V F (t) f (t) (T ) 0 t T: In particular. 2 0 0 Zt jj (u)jj2 du . the accompanying ﬁltration. although it does not tell us how to compute it. a d- e Bj (t) = Zt 0 Z f(A) = Z (T ) dIP: IP A Z (t) = exp .57 (d-dimensional Girsanov) dimensional Brownian motion on ( F (t) 0 t T t T deﬁne For 0 (t) = ( 1(t) : : : d (t)) 0 t T . It also justiﬁes the risk-neutral pricing formula f X (t) = (t)IE = Z(t) IE (t) 1 IE = (t) where (T ) F (t) Z (T ) V F (t) (T ) (T )V F (t) V 0 t T (t) (t) = Z(t) = exp . d-dimensional adapted process. j (u) du + Bj (t) Zt j = 1 ::: d 1 (u): dB (u) . Zt 0 (u) dB (u) . X (T ) = IE V F (T ) = V f (T ) (T ) (T ) so X (T ) = V: The Martingale Representation Theorem guarantees the existence of a hedging portfolio. Zt 0 (r(u) + 1 2 (u)) du 2 18.

is a martingale (under IP ) relative to F (t) 0 If X (t) 0 d-dimensional adpated process (t) = ( 1(t) : : : d (t)). Then we can deﬁne the Let Stocks dSi (t) = i (t)Si(t) dt + Si (t) Accumulation factor d X j =1 ij (t) dBj (t) i = 1 ::: m (t) = exp Here. under I . be a d-dimensional Brownian motion on some ( F P). such that X (t) = X (0) + F (t) 0 t T P).59 If we have a d-dimensional adapted process (t) = ( 1 (t) : : : d (t)) then we can e f f P P deﬁne B Z and I as in Girsanov’s Theorem. B(t) = (B1 (t) : : : Bd (t)) 0 t T a d-dimensional Brownian motion t T . and let F (t) 0 t T . is a martingale under I relative to F (t) 0 t T . If Y (t) 0 t T . the process e e e B (t) = (B1(t) : : : Bd (t)) is a d-dimensional Brownian motion. then there is a the ﬁltration generated by the Brownian motion B . 0 t T 18. then there is a d-dimensional adpated process (t) = ( 1(t) : : : d(t)) such that Z Y (t) = Y (0) + t 0 e (u): dB (u) 0 t T: 18.58 on ( F t T . . i (t) Zt 0 r(u) du : ij (t) and r(t) are adpated processes. Zt 0 (u): dB (u) 0 t T: Corollary 4. be the ﬁltration generated by B .5 Multi-dimensional market model following: B (t) = (B1(t) : : : Bd(t)) 0 t T .200 f P Then.4 d-dimensional Martingale Representation Theorem Theorem 4.

every discounted stock price is a martingale. then there is no risk-neutral probability measure and the market admits arbitrage.): If a market has a risk-neutral probability measure. . but there are contingent claims which cannot be hedged. and Applications 15 (1983). the market is said to be complete. pp 313-316): The risk-neutral measure is unique if and only if every contingent claim can be hedged. the Martingale Representation Theorem can be used to show that every contingent claim can be hedged. Martingale Representation Theorem Discounted stock prices 201 d X d Si((tt)) = ( i(t){z r(t)) Si((tt)) dt + Si((tt)) . f Consequently. Stochastic Proc. so that (MPR) d X j =1 ij (t) j (t) = i (t) . and this implies that the market admits no arbitrage. Theorem 5. we deﬁne a unique f f P P risk-neutral probability measure I . Stochastic Proc. then it admits no arbitrage. Finally. pp 215-260. Part II. Under I . Using (t) in the d-dimensional Girsanov Theorem.1 to be satisﬁed. The market price of risk is an adapted process (t) = ( 1 (t) satisfying the system of equations (MPR) above. Case II: (No solution. r(t) i = 1 : : : m: ::: Market price of risk.1) For 5. Martingales and Stochastic integrals in the theory of continuous trading. The market admits no arbitrage. A stochastic calculus model of continuous trading: complete markets.60 (Fundamental Theorem of Asset Pricing) Part I.) If (MPR) has no solution. Case III: (Multiple solutions). } ij (t) dBj (t) | j =1 d ? Si (t) X (t) (t) + dB (t)] = (t) ij | j {z j } j =1 e dBj (t) Risk Premium (5. the market is said to be incomplete.CHAPTER 18. then there are multiple risk-neutral probability measures. For Lebesgue-almost every t and IP -almost every ! . (Harrison and Pliska. (Harrison and Pliska. and Applications 11 (1981). the discounted wealth process corresponding to any portfolio process is a I P martingale. (MPR) has a unique solution (t). There are three cases to consider: d (t)) Case I: (Unique Solution). If (MPR) has multiple solutions. we need to choose 1 (t) ::: d (t).

202 .

all processes can depend on t and ! . but are adapted to simplify notation. (t) = exp Zt 0 r du : = 2= 1.Chapter 19 A two-dimensional market model Let B (t) In what follows. Let t T. t T F P).r (MPR) The market price of risk equations are 2 1+ q 1. 1 S1 dS2 has instantaneous variance 2 . 1: Note that 2 2 dB2 : >0 2>0 . 1 1 2 2 2. 2) 2 dB2 dB2 2 2 2 S 2 dt = 2 2 dS1 dS2 = S1 1S2 2 dB1 dB1 = 1 2S1S2 dt: In other words. Stocks: F (t) 0 t T = (B1 (t) B2(t)) 0 be a two-dimensional Brownian motion on ( be the ﬁltration generated by B . To F (t) 0 dS1 = S1 dS2 = S2 We assume 1 1 dt + 1 dB1] q 2 dt + 2 dB1 + 1 . we omit the arguments whenever there is no ambiguity. dS1 has instantaneous variance 2 .r 203 . 2 S2 dS1 and dS2 have instantaneous covariance S1 S2 Accumulation factor: 1 2.1 2 2 dS1 dS2 = S1 2 dB1 dB1 = 2S1 dt 1 1 2 2 dS2 dS2 = S2 2 2 dB1 dB1 + S2 (1 .

1 < = = < 1. rX dt) =1 =1 1(dS1 .1 < <1 1S1 . d X = 1 (dX . 2 dB 0 t T: 2 2 e dB2 : f P Let V be F (T )-measurable. 2 Z f(A) = Z (T ) dIP IP A Z (t) = exp 1 2). Suppose . 1 dB1 .1 < < 1. rS2 dt) e 1 2S2 1S1 1 dB1 + f V Y (t) = IE (T ) F (t) q e1 + 1 . rS1 dt) + 1 2 (dS2 . 19.1 Hedging when . Deﬁne e B1 (t) = e B2(t) = Then Zt Z0 0 1 du + B1 (t) 2 du + B2 (t): t dS1 = S1 r dt + dS2 = S2 r dt + h e 1 dB1 i q 2 2 dB2 e e 2 dB1 + 1 .204 The solution to these equations is 1 2 provided . 1 ( 1 + 2 ) du 2 0 0 0 8A 2 F : f IP is the unique risk-neutral measure. Deﬁne the I -martingale . r) p 2( 1 . we deﬁne Zt Zt Zt 2 2 . but not the variances and covariances. : We have changed the mean rates of return of the stock prices. 1 1 2 1. Then (MPR) has a unique solution ( 1.r 1 ( 2 . 2 dB2 . r) . 2S2 ) dt dX = 1 dS1 + 2 dS2 + r(X .

2 2 dB2 e 1 1 1 for the hedging portfolio ( 1 2S2 1 . A two-dimensional market model The Martingale Representation Corollary implies 205 Y (t) = Y (0) + We have Zt 0 e 1 dB1 + Zt 0 e 2 dB2: e dB1 d X = 1 1 S1 1 + 1 2 S2 dY = We solve the equations e e 1 dB1 + 2 dB2 : 1 S1 1 + +1 2S2 q 2 1.r The process 2 is free. 19.r 2 1= 2. the market is complete. The market price of risk equations are 1 dt + 1 dB1 ] 2 dt + 2 dB1 ] 1 1= 1. Then dS1 = S1 dS2 = S2 The stocks are perfectly correlated. With this choice of ( 1 f V X (0) = Y (0) = IE (T ) we have X (t) = Y (t) 0 t T and in particular. X (T ) = V: Every F (T )-measurable random variable can be hedged.CHAPTER 19. q 2 S2 2= 1 2 2= 2 2) and setting 2).1 is analogous. There are two cases: (MPR) .2 Hedging when The case =1 = . Assume that = 1.

rS2 dt) =1 Suppose 1. rS1 dt) + 1 2(dS2 . 2 . if and 1 or 2 depend on B2 . This market admits arbitrage. r) dt + =1 = 1 1 S1 1 + 1 dB1] + 1 2S2 ( 2 .r 2. r . r) dt + 1 1 dB1] + 1 2S2 ( 2 . there is no risk-neutral 1 2 measure.r 1 = 2. 1 1S1 ( 1 . Let I be one of them. 1 | 1 . r) dt + 1 2 S2 2 1 dt + dB1 ] 2 dB1] 1S1 1 1 dt + dB1 ] + 1 2S2 2 e dB1 : e Notice that B2 does not appear. Indeed d X = 1 1(dS1 . then it can probably not be hedged. 2 r : The market price of risk equations 1 1 2 1 = = 1. r dt + dB . Let V be an F (T )-measurable random variable.r : There is no solution to (MPR). 1 1 1 1 . then there is trouble. Hedging: 1. 2 r : Set 1= 1 S1 2=. V = h(S1 (T ) S2(T )) . there are inﬁnitely many risk-neutral measures. If V depends on B2 .r have the solution 1= f P 2 is free.206 Case I: 1 .r 2 d X = 1 1S1 ( 1 . r) dt + 1 : S 2 . and consequently.r 6= 2 . For example. 2 2 Then d X =1 =1 1. r dt 1 {z 2 } Positive Case II: r = 2. r dt + dB 1 2 2 dB1] r > 2.

we deﬁne the I -martingale f V Y (t) = IE (T ) F (t) We can write 0 t T: Y (t) = Y (0) + so Zt 0 e 1 dB1 + Zt 0 e 2 dB2 dY = e e 1 dB1 + 2 dB2 : To get d X to match dY .CHAPTER 19. A two-dimensional market model 207 f P More precisely. we must have 2 = 0: .

208 .

b)2 dm db m > 0 b < m: m = 2T T 2 T 1 . ( ) ! With drift. Let e B(t) = t + B(t) 209 . @m 2T 2 T ( ) 2(2p . (2m . (2m . 2T dx 2 T 2m b 1 . b) exp . x dx dm db 2T 2 T 2m b ( )! @ p 1 exp . m>0 b<m So the joint density is Z 2 @2 IP fM (T ) 2 dm B(T ) 2 dbg = . bg ( 2) 1 Z x =p exp .1 Reﬂection principle for Brownian motion Without drift. @m @b p 1 exp .Chapter 20 Pricing Exotic Options 20. Deﬁne M (T ) = 0maxT B (t): t Then we have: IP fM (T ) > m B(T ) < bg = IP fB (T ) > 2m . b)2 dm db = .

2: Possible values of B (T ) M (T ). .210 2m-b shadow path m b Brownian motion Figure 20.1: Reﬂection Principle for Brownian motion without drift m m=b (B(T). M(T)) lies in here b Figure 20.

B 2 Z f(A) = Z (T ) dIP 8A 2 F : IP A f SetM (T ) = max0 t T f Under I P e B (T ): ) ( m b ~ ~ b ffM (T ) 2 dm B (T ) 2 d~g = 2(2p . 2 2 T g IP fM (T ) 2 dm B (T ) 2 d~g: ~ b b 1 ~ e b But also.CHAPTER 20. b) : expf ~ . ~) exp .1 m=0 ~= ~ b f f h(m ~) expf ~ . so Let h(m ~ T f e f IEh(M (T ) B (T )) = IE h(M (Z ()TB (T )) ) f e f f e e = IE h(M (T ) B (T )) expf B (T ) . Then b e B is a Brownian motion (without drift). (B (T ) + T ) + 1 2 T g 2 e (t) + 1 2T g = expf. 1 2 T g 2 = m= ~Z 1 h i ~=m bZ ~ . Pricing Exotic Options where B (t) 211 0 t T . (2m . 1 2 T gdm d~ m > 0 ~ < m: ~ b ~ b ~ 2T T 2 T . B (T ) . (2m . we conclude that (MPR) f IP fM (T ) 2 dm B (T ) 2 d~g ~ e b 1 2 T g I fM (T ) 2 dm B (T ) 2 d~g f f e = expf ~ . f e IEh(M (T ) B (T )) = m= ~Z 1 ~Z m b= ~ .1 m=0 ~= ~ b f h(m ~) IP fM (T ) 2 dm B (T ) 2 d~g: ~ b ~ e b Since h is arbitrary. Deﬁne Z (T ) = expf. 1 2 T g 2 = expf. b) exp . is a Brownian motion (without drift) on ( F P). 2 b b )~ (P m ~ ~ ~ ~2 b 2 = 2(2p . ~)2 dm d~ m > 0 ~ < m: f e ~ b ~ b ~ IP ~ b 2T T 2 T ~) be a function of two variables.

v (0 S (0)) = e (S (T ) . K )+ 1 S (T )<L f g To simplify notation. " 1 S(0)exp M (T ) e f f g <L g e B (T )> 1 log K M (T )< 1 log L e S (0)} | {z | {zS (0)} ~ b # m ~ . K .2 Up and out European call. rT IE h i + f g . 1 2 )tg 2 . so the value at time zero of the option is S (T ) = 0maxT S (t): t v (0 S (0)) = e rT IE (S (T ) .212 20. f S (t) = S0 expf M (t)g where. K )+ 1 S (T )<L : Because IP is the risk-neutral measure. K 1 . dS (t) = rS (t) dt + S (t) dB (t) S (t) = S0 expf B (t) + (r .2 e B (t) = t + B(t): Consequently. K )+ 1 S (T )<L e = e rT IE S (0) expf B (T )g . f e M (t) = 0maxt B (u): u We compute. Let 0 < K where < L be given. f g h i 8 > > < = S0 exp > > : e = S0 expf B (t)g 2 6 6B(t) + r . 6 4 | {z 2 39 > 7> = t7> 7 } 5> where = r. The payoff at time T is (S (T ) . assume that IP is already the risk-neutral measure. e = e rT IE S (0) expf B (T )g .

K ) 2(2y .p 2 ~ 2T 2 T b ) ( ~ 1 e rT K Z m exp . 1 2 T 2 2T b 2 T )# ( (2m .CHAPTER 20. . (2y .3: Possible values of B (T ) We consider only the case f M (T ). . 1 2 T dx . x + x . . (2y2T x) + x . S (0) K < L so 0 ~ < m: b ~ The other case. x)2 + x . 1 2 T dx ~ . x)2 + x . (2m . x2 + x . (2m . 1 2 T dx: ~ +p 2 ~ 2T 2 T b rT . x) exp . We carry out the details for the ﬁrst integral and just . Pricing Exotic Options 213 ~ M(T) y ~ m (B(T). b ~ R m R m : : :dy dx: ~ ~ We compute ~ x b .e (S (0) expf xg . x2 + x . M(T)) lies in here x ~ B(T) x=y ~ b e Figure 20. 2 1 p v (0 S (0)) = e (S (0) expf xg . Z mZ m ~ ~ ( ) The standard method for all these integrals is to complete the square in the exponent and then recognize a cumulative normal distribution. K < S (0) L leads to ~ < 0 m and the analysis is similar. 1 2 T y=m dx rT = . exp . 1 2 T dx =p 2 ~ 2T 2 T b ) ( ~ 1 e rT K Z m exp . x)2 + x . . 2 2 T dy dx ~ x b T 2 T( ) ~ Zm ~ 1 exp . . . 2T 2 ( ) ~ 1 e rT S (0) Z m exp x . p2 T 2 ~ 2T b ( ) ~ 1 e rT S (0) Z m exp x . K ) p 1 exp . K ) p 2 ~ 2T 2 T b y=x " ( 2 ) Zm ~ = e rT ~ (S (0) expf xg . x)2 + x . 1 2 T dx ~ .

b) + r T . r T . r T . 1 2 T 2 y = (x . 2 T ( ) = p 1 S (0): 2 T ~ b Z ~ m ~ = S (0) N p . 2T + x . rT= . p p ! T ~ ~ p N (2m .214 give the result for the other three. 2 T T . 21 x . 2T + x . N pb . S (0) N pT 2 2 pT p ! m ~ + exp . N (2m . 2 ~ N p + r T . rT . r T + . r T . 2T . r T . T 2 dx =p ~ 2T 2 2 T b p m p p~T . we have " p p pT . ~) + r T + T ~ p . r T . N pb . 2 T . 1 x . T . rT . r T + T m ~ rT K N p . T=2)= T dy = dx= T to obtain p p rT ~ e p S (0) Z m exp b 2 T ~ . The exponent in the ﬁrst integrand is = . 2 T expf. y2 g dy 2 p p ! p p !# : ~ m ~ v (0 S (0)) = S (0) N p . 2 T T T Putting all four integrals together. T )2 + 1 2T + T 2 T 2 T = . 2 T . r T . 2 + rT: T In the ﬁrst integral we make the change of variable x2 x . 2 T T " T p p ! p p !# ~ T . " p p ! p p !# where ~ = 1 log K b S (0) m = 1 log SL : ~ (0) . x2 x . 1 2T dx 2 ( ) ~ 1 S (0) Z m exp . 21 (x .e 2 2 T T " p p ! p p !# ~ b m + r T + T . N pb .rT + 2m r .

0) = 0 T Figure 20. t and replace S (0) by x in the formula for v (0 S (0)). Pricing Exotic Options 215 L v(t. N p . the value of the option at the time t if S (t) = x.CHAPTER 20. r T + . we obtain a formula for v (t x).L) = 0 v(T. r T . K )+ 1 . We consider the function v(t x) = IE t x e h .rv + vt + rxvx + 1 2x2vxx 0 t < T 0 x L: 2 . If we let L!1 we obtain the classical Black-Scholes formula v (0 S (0)) = S (0) 1 . r(T t) (S (T ) . . We have actually derived the formula under the assumption x K L. N p . K )+ and the boundary conditions 0 x<L v(t 0) = 0 0 t T v(t L) = 0 0 t T: We show that v satisﬁes the Black-Scholes equation . 2 T T " p p !# ~ b T rT K 1 .e 2 T p p ! 1 (0) = S (0)N p log SK + r T + 2 T T p p ! T : 1 rT KN p log S (0) + r T . " ~ b p p !# If we replace T by T . but a similar albeit longer formula can also be derived for K < x L. f S (T )<L i g 0 t T 0 x L: This function satisﬁes the terminal condition v(T x) = (x .x) = (x .K)+ v(t.4: Initial and boundary conditions. .e K 2 T .

. f g .216 Let S (0) > 0 be given and deﬁne the stopping time = minft 0 S (t) = Lg: Theorem 2. rT (S (T ) . K )+ 1 S (T )<L F (u) = e r(u )v (u ^ S (u ^ )) : . we have e Suppose 0 . and choose t 2 0 T ]. . K )+ 1 f S (T )<L g F (t) (!) = 0: (!) t. r(t )v (t ^ ^ S (t ^ )) 0 t T S (T ) < L () > T: Let ! 2 be given. if (!) > t.61 The process e is a martingale. = IE e = e rt v (t S (t !)) = e r(t (!))v (t ^ . rT (S (T ) . If (!) t. rT (S (T ) . then the Markov property implies IE e . K )+ 1 f S (T )<L g F (t) : u t T . Proof: First note that . r(t (!)) v (t ^ ^ (!) S (t ^ (! ) !)) : On the other hand. K )+ 1 S (T )<L F (t) (! ) i rT (S (T ) . then IE e But when . r(t )v (t ^ ^ S (t ^ )) = IE e r(t )v (t ^ ^ . S (t ^ )) F (u) f g = IE IE e rT (S (T ) . ^ h t S (t !) rT (S (T ) . ^ . we have v (t ^ (!) S (t ^ (! ) !)) = v(t ^ (!) L) = 0 so we may write IE e . Then IE e . In both cases. K )+ 1 f S (T )<L g F (t) (!) = e . K )+ 1 S (T )<L f g f g S (t ^ (!) !)) : . K )+ 1 S (T )<L F (t) F (u) = IE e rT (S (T ) .

rv + vt + rSvx + 1 2S 2vxx ) dt + e 2 .rv + v 2 2 t + rSvx + 1 S vxx ) du 2 is a martingale. Therefore.rv + vt + rSvx + 1 2 S 2vxx) du 2 ^ . ru (.CHAPTER 20.r(t^ )v (t ^ Zt |0 ^ e . . S (t)vx(t S (t)) dB (t) 0 t Let X (t) be the wealth process corresponding to some portfolio (t). ru A stopped martingale is still a martingale {z Svx dB: } Zt 0 S (t ^ )) is also a martingale. .rv(u S (u))+ vt(u S (u)) + rS (u)vx(u S (u))+ 2 2S 2(u)vxx(u S (u)) = 0 0 u t ^ : The PDE then follows. r(t )v (t ^ ^ S (t ^ )) = v(0 S (0)) Zt + e ru (.rv + vt + rxvx + 1 2x2vxx = 0 0 t T 0 x L 2 d e rtv (t S (t)) = e . rt : rt (t) S (t) dB (t): X (0) = v (0 S (0)) (t) = vx (t S (t)) 0 t T^ : X (T ^ ) = v(T ^ S (T ^ )) ( v (T S (T )) = (S (T ) . . Then d(e rtX (t)) = e We should take and Then . 0 + Because e. the Riemann integral ^ e . . 1 . rt Svx dB: Integrate from 0 to t ^ : e . . we compute the differential d e rt v(t S (t)) = e rt(. Pricing Exotic Options 217 For 0 t T . K )+ = v ( L) = 0 if if >T T. The Hedge .

The new boundary condition guarantees: 1. he covers this short position with funds from the money market. because the stock price has risen. x) 0 K L x Figure 20. If the stock moves across the barrier. Lvx (t L) is the dollar size of the Lvx (t L) remains bounded. times the dollar 2. pays off the option.3 A practical issue For t < T but t near T . The hedger is in an unstable situation. At the boundary. 20. say 1%. the option has “knocked out”.5. However. The value of the portfolio is always sufﬁcient to cover a hedging error of size of the short position. v(t L) + Lvx (t L) = 0 0 t T is a “tolerance parameter”. He should cover his short position with the money market. so no money is needed to pay it off.5: Practial issue. a small error in hedging can create a signiﬁcant effect. Here is a possible resolution. and consequently he is left with no money. he is now in a region of (t) = v x(t S (t)) near zero. This is more expensive than before. and is left with zero. Rather than using the boundary condition v(t L) = 0 0 t T solve the PDE with the boundary condition where short position. Because a large short position is being taken. (t) = vx (t S (t)) In particular.218 v(T. He should take a large short position in the stock. 20. If the stock does not cross the barrier L. . the hedging portfolio can become very negative near the knockout boundary. x) 0 K L x v(t. v (t x) has the form shown in the bottom part of Fig.

B(t)) + (r . t) 2 Y (T ) = y + n o ZT t S (u) du: Deﬁne the undiscounted expected payoff u(t x y ) = IE t x y h(Y (T )) 0 t T x 0 y 2 IR: 219 .Chapter 21 Asian Options Stock: dS (t) = rS (t) dt + S (t) dB (t): V =h Payoff: ZT 0 S (t) dt ! Value of the payoff at time zero: X (0) = IE e " . 1 2 )(T . rT h ZT 0 S (t) dt : !# Introduce an auxiliary process Y (t) by specifying dY (t) = S (t) dt: With the initial conditions S (t) = x Y (t) = y we have the solutions S (T ) = x exp (B(T ) .

where The PDE for v is Zt 0 . v (t x y ) = e r(T t) u(t x y ): (1.rv + vt + rxvx + 1 2x2vxx + xvy = 0 2 21. r S dt = S dB + rX dt: (t) is We want to have X (t) = v t S (t) so that Zt 0 S (u) du S (u) du X (T ) = v T S (0) =h ZT 0 ! ZT 0 S (u) du : ! .1) v (T x y ) = h(y ) v(t 0 y) = e r(T t)h(y ): One can solve this equation rather than the equation for u. .220 21. S (u) du .2 Constructing the hedge Start with the stock price S (0). The differential of the value X (t) of a portfolio dX = dS + r(X . S ) dt = S (r dt + dB ) + rX dt . . Then v t S (t) is the option value at time t. .1 Feynman-Kac Theorem The function u satisﬁes the PDE 1 ut + rxux + 2 2x2 uxx + xuy = 0 0 t T x 0 y 2 IR the terminal condition and the boundary condition u(T x y ) = h(y ) x 0 y 2 IR u(t 0 y) = h(y ) 0 t T y 2 IR: One can solve this equation.

we compute next the value of a derivative security which pays off v ( S ( ) 0) at time . starting from the same initial condition. S ( ) 0): x 0 . .1) Compare this with Take dX (t) = rX (t) dt + (t) S (t) dB(t): (t) = vx (t S (t)): If X (0) = v (0 S (0) 0). 1. 0 t T: 0 t 8 <w (t S (t)) R (t) = : x vx t S (t) t S (u) du < t T: .CHAPTER 21. For 0 t . This value is The function w satisﬁes the Black-Scholes PDE w(t x) = IE t xe . Asian Options The differential of the value of the option is 221 dv t S (t) Zt 0 S (u) du = vtdt + vxdS + vy S dt + 1 vxx dS dS 2 1 = (vt + rSvx + Svy + 2 2 S 2vxx ) dt + Svx dB = rv (t S (t)) dt + vx (t S (t)) S (t) dB (t): (From Eq. r( t) v ( . then X (t) = v t S (t) Zt 0 S (u) du 0 t T because both these processes satisfy the same stochastic differential equation. ! < T .3 Partial average payoff Asian option Now suppose the payoff is V =h where 0 < ZT S (t) dt . 21. We compute v( x y ) = IE x y e r(T )h(Y (T )) just as before. with terminal condition and boundary condition The hedge is given by r(T t)h(0) .rw + wt + rxwx + 1 2x2wxx = 0 0 t 2 w( x) = v ( x 0) x 0 w(t 0) = e .

Bessel processes. . 349–375. See H. Geman and M. and perpetuities. Asian options.222 Remark 21.1 While no closed-form for the Asian option price is known. Math. Finance 3 (1993). t)) has been computed. Yor. the Laplace transform (in 2 the variable 4 (T .

The value at time t of such a security is the amount of wealth needed at time t in order to replicate the security by trading in the market. (See Fig. 2. Let r 0 u > r + 1 d = 1=u be given.1) Evolution of the value of a portfolio: Xk+1 = k Sk+1 + (1 + r)(Xk .1 Binomial model. we obtain: 223 . we want to start with a nonrandom X0 and 1 (T ) 0 so that 1 (H ) X2(!1 !2 ) = V (!1 !2 ) 8! 1 !2 : There are four unknowns: X0 (four equations) 0 1(H ) 1(T ). k Sk ): Given a simple European derivative security V (! 1 use a portfolio processes !2). 22. The hedging portfolio is a speciﬁcation of how to do this trading.Chapter 22 Summary of Arbitrage Pricing Theory A simple European derivative security makes a random payment at a time ﬁxed in advance. We have no probabilities at this point. Solving the equations. Hedging Portfolio Let be the set of all possible sequences of n coin-tosses.

d X2(!1 H } + u .. k=0 (log Sk+1 . X2(!1 T ) 1 (!1 ) = S (! H ) . X1(T ) : 0 = S (H ) . S (! T ) 2 1 2 1 X1(H ) . what matters is that the paths in the model include all the possibilities. d X1(H ) + u . Then n 1 X . we will have the analogous equation (t) d X((tt)) = (t) d S(t) : . because we have a hedge which works on every path. log Sk )2 = log SS+1 k = ( log u)2 = (log u)2 : Let 2 = log u > 0. We reiterate that the probabilities are only introduced as an aid to understanding and computation.d X2(!1 H ) . Sk : k In continuous time. k Sk ): k Deﬁne Then = (1 + r)k : Xk+1 = k+1 k+1 k Sk+1 + Xk . d | {z }5 r 1 X0 = 1 + r 1 + . From a practical point of view. They all have the property k (log Sk+1 .e. (1 + r) X2(! 1 T )7 4 u d | {z ) u . k+1 k k k+1 k Sk k i.224 2 3 7 1 6 r X1(!1) = 1 + r 6 1 + . then we change . The paths of log Sk accumulate quadratic variation at rate 2 per unit time. and the pricing and hedging formulas on the previous page will give different results. We want to ﬁnd a description of the paths in the model. (1 + r) X1(T ) u d u. S (T ) 1 1 V (!1 H ) V (! 1 T ) The probabilities of the stock price paths are irrelevant. . log Sk )2 = 2 n: If we change u. Xk = k Sk+1 . . Recall: Xk+1 = k Sk+1 + (1 + r)(Xk . Xk+1 .

where V is some F 2-measurable random variable. then P martingale. Summary of Arbitrage Pricing Theory 225 k f If we introduce a probability measure I under which Sk is a martingale. d ~ u d q = u . the only thing about this probability measure which ultimately matters is the set of paths to which it assigns probability zero. Using the binomial model as a guide. To introduce Brownian motion.d 22. Sk F k k+1 k k+1 k Sk+1 F . but that is impossible. Xk k will also be a f f IE Xk+1 F k = IE Xk + k Sk+1 . To generate these paths.2 Setting up the continuous model Now the stock price S (t) 0 t T . we use Brownian motion. we choose > 0 and try to hedge along every path S (t) for which the quadratic variation of log S (t) accumulates at rate 2 per unit time. These are the paths with volatility 2. We would like to hedge along every possible path of S (t). q = IP f!k = T g. we denote p= ~ r p = 1 + . rather than coin-tossing. . regardless of the portfolio used. we need a probability measure. Indeed.CHAPTER 22. and compute ~ f f ~ ~ IE Sk+1 F k = pu Sk + qd Sk k+1 k+1 k+1 1 pu + q d] Sk : = 1+r ~ ~ k We need to choose p and q so that ~ ~ pu + qd = 1 + r ~ ~ p + q = 1: ~ ~ The solution of these equations is f IP under which Skk is a martingale. However. Sk : Xk + f E = k I k k | k+1 =0 {z k } Then we Suppose we want to have must have X2 = V . (1 + r) : ~ u. X1 f X2 1 f V 1 + r X1 = 1 = IE 2 F 1 = IE 2 F 1 f f X0 = X0 = IE X1 = IE V : 0 1 2 To ﬁnd the risk-neutral probability measure f IP f!k = H g.. is a continuous function of t.

If we replace 1 by 2. The most convenient choice of so and is 1 = r. Roughly. is a continuous function of t. 1t + B (t !1) 0 t T B(t !1 ) is a different function. With this choice of . regardless of whether we use 1 or 2 in the deﬁnition of S (t). 1 2tg 2 e rt S (t) = S (0) expf B(t) . we will see the same paths. Surprisingly. We want to deﬁne so that the paths of log S (t) = log S (0) + t + B (t) accumulate quadratic variation at rate 2 per unit time. 2 2 S (t) = S (0) expfrt + B(t) . be a Brownian motion deﬁned on a probability space ( F P). except possibly for a set of paths which has probability zero. The mathematically precise statement is the following: If a set of stock price paths has a positive probability when S (t) is deﬁned by S (t) = S (0) expf 1t + B(t)g then this set of paths has positive probability when S (t) is deﬁned by S (t) = S (0) expf 2t + B(t)g: Since we are interested in hedging along every path. the paths of t + B(t) S (t) = S (0) expf t + B(t)g For any accumulate quadratic variation at rate 2 per unit time. 1 2tg 2 . the choice of is irrelevant. 2 IR.226 Let B (t) 0 t T . dS (t) = rS (t) dt + S (t) dB (t) . there is an ! 2 2 such that 1t + B (t !1 ) = 2t + B (t !2) 0 t T: In other words. is a martingale under IP . the reason for this is the following: Choose ! 1 2 . the choice of in this deﬁnition is irrelevant. for 1 2 IR. Then. then 2 t + However.

r dt + dB (t) f We can change to the risk-neutral measure I . we have 227 S (t) = S (0) expf t + B(t)g dS (t) = ( +{z1 2 ) S (t) dt + S (t) dB(t): | 2 } = rS (t) dt + h | .3) This is the risk-neutral pricing formula. we must have value X (0) so that X (T ) = V . 2 e B has the same paths as B . and initial portfolio X (t) must be a martingale.CHAPTER 22. under which P Brownian motion. If a different choice of is made. We have the following sequence: . We want to ﬁnd the portfolio process (T ) 0 t T . and then proceed as if had been chosen to be equal to r . (t)S (t)) dt (t) d X((tt)) = (t)d S(t) (t) e = (t) S(t) dB (t): (3. Summary of Arbitrage Pricing Theory and IP is the risk-neutral measure. 1 2 .1) (3. (t) Evolution of the value of a portfolio: which is equivalent to (t) (t) e d S(t) = S(t) dB (t) dX (t) = (t)dS (t) + r(X (t) .2) f Regardless of the portfolio used. Because (t) X (t) = IE V F (t) f (t) (T ) 0 t T: (3. Then e dS (t) = rS (t) dt + S (t) dB (t) e f P where B is a Brownian motion under I . the payoff of a simple European derivative security. 22.3 Risk-neutral pricing and hedging {z e dB (t) i } e B is a : f P Let I denote the risk-neutral measure. P Now suppose V is a given F (T )-measurable random variable. X((tt)) is a martingale under I . Set (t) = ert : Then f P so S (t) is a martingale under I .

which implies (3.4) implies (3. To carry out step 3.2 In general.5) to show that e d X((tt)) = (t) dB (t) (t) = (t) (t) : S (t) From (3.4) for some proecss . the value X (t) of the hedging portfolio in 1 satisﬁes f V X (0) = IE (T ) (t) 0 t T . 2. we decide to deﬁne (3. The “validity” of the risk-neutral pricing formula means: 1.3) is a martingale f P under I . At each time t. We next use the corollary to the Martingale Representation Theorem (Homework Problem 4. 3. because we do not yet have (t)). the risk-neutral pricing formula is still “valid” when r and are processes adapted to the ﬁltration generated by B . and (3.2). we see that the hedging portfolio must begin with value Then (3. (3. such that X (T ) = V .1) or (3.1)) is satisﬁed by the X (t) 0 t T . 0 t T . (3.2). If you start with then there is a hedging portfolio 2.2) (or equivalently.4). (t) so that (3. Construct deﬁned in step 2. the deﬁnition of X . by (3. when there are multiple assets and/or multiple Brownian motions.5) 0 t T . X (t) = IE V F (t) : f (t) (T ) Remark 22. If they depend on e either B or on S . we ﬁrst use the tower property to show that X((tt)) deﬁned by (3.1 Although we have taken r and to be constant.228 1.1). is the value of f V X (0) = IE (T ) and it will end with value V f V X (T ) = (T )IE (T ) F (T ) = (T ) (T ) = V: Remark 22. Comparing (3. they are adapted to the ﬁltration generated by B . which implies that X (t) the portfolio process (t) 0 t T . which we want.3). which we know.2). A probability measure is said to be risk-neutral provided . Deﬁne X (t) V is given. the risk-neutral pricing formula is valid provided there is a unique risk-neutral measure.3) (not by (3.

2 Assume r and V =h Take S(t) and Y (t) = 0 ZT 0 S(u) du : ! R t S(u) du to be the state variables. so that f V X (t) = (t)IE (T ) F (t) is a function of these variables. and V = h(S(T)). 229 To see if the risk-neutral measure is unique. Deﬁne e t x y h . are constant. Example 22.1 Assume r and variable.t) v(t x y) = IE e Y (T) = y + h(Y (T)) i where ZT t S(u) du: . Deﬁne are constant.CHAPTER 22.r(T .rt v(t S(t)) is a martingale under IP . 22.r(T .t) h(S(T)) : Then e X(t) = ert IE e. the stock price and possibly other variables.rT h(S(T)) F (t) = v(t S(t)) (t) and X(t) e = e. Example 22. We need to identify some state variables.4 Implementation of risk-neutral pricing and hedging To get a computable result from the general risk-neutral pricing formula X (t) = IE V F (t) f (t) (T ) one uses the Markov property. We can take the stock price to be the state i e h v(t x) = IE t x e. Summary of Arbitrage Pricing Theory it has the same probability-zero sets as the original measure. it makes all the discounted asset prices be martingales. compute the differential of all discounted asset prices e e and check if there is more than one way to deﬁne B so that all these differentials have only d B terms.

This is the argument which uses (3. r(u Y (u)) du h(S(T ))7 : 7 v(t x y) = IE 6 7 t 6| 7 4 5 {z } (t) (T ) Then e X(t) = (t)IE h(S(T)) F (t) " ( (T) e = IE exp .rt v(t S(t) Y (t)) (t) Example 22. The dB term in the differential of the equation is the differential of a martingale. Z t r(u Y (u)) du v(t S(t) Y (t)) (t) 0 In every case. X (t) = X (0) + Z t (u) S (u) dB (u) e (t) (u) 0 .3 (Homework problem 4.230 Then e X(t) = ert IE e. We take the differential and set the dt term to zero.5). e X(t) = exp .4) to obtain (3.rT h(S(T)) F (t) = v(t S(t) Y (t)) and is a martingale under IP .2) e dS(t) = r(t Y (t)) S(t)dt + (t Y (t))S(t) dB(t) e dY (t) = (t Y (t)) dt + (t Y (t)) dB(t) V = h(S(T)): Take S(t) and Y (t) to be the state variables. Deﬁne 2 3 6 ( Z 7 ) 6 7 T txy6 e 6exp . we get an expression involving v to be a martingale. This gives us a partial differential equation for v . and this equation must e hold wherever the state processes can be. ZT t r(u Y (u)) du h(S(T )) F (t) ) # = v(t S(t) Y (t)) and is a martingale under IP . and since the martingale is we can solve for (t). e X(t) = e.

We want to choose (t) so that (t) to be e d X(t) = (t) (t Y (t)) S(t) dB(t): (t) (t) Therefore. Z t r(u Y (u)) du v(t S(t) Y (t)) (t) | 0 {z } 1= (t) is a martingale under IP . and S = S(t).rv + vt + rxvx + vy + 1 2x2 vxx + 2 where it should be noted that v xvxy + 1 2 vyy = 0 2 where (see (3.4 (Continuation of Example 22.r(t Y (t))v(t S(t) Y (t)) dt (t) + vt dt + vx dS + vy dY + 1 vxx dS dS + vxy dS dY + 1 vyy dY dY 2 2 1 1 = (t) (. Summary of Arbitrage Pricing Theory Example 22. we should take Y (t)) (t) = vx (t S(t) Y (t)) + (t (t (t)) S(t) vy (t S(t) Y (t)): Y . We have 1 e d X(t) = (t) Svx + vy ] dB(t) (t) = (t Y (t)). = (t Y (t)).3) 231 X(t) = exp .rv + vt + rSvx + vy + 1 2 S 2 vxx + Svxy + 2 2 vyy ) dt 2 e + ( Svx + vy ) dB The partial differential equation satisﬁed by v is .CHAPTER 22. v = v(t S(t) Y (t)). and all other variables are functions of (t y).2)) = v(t x y). We have e 1 d X(t) = (t) .

232 .

Then B is a Brownian motion.e. B (t) .62 (Levy) Let B (t) F (t) 0 t T . B (s) is IE eu(B (t) ..Chapter 23 Recognizing a Brownian Motion Theorem 0. and B (t) . hBi(t) = t 0 t T . We compute (this uses the continuity condition (1) of the theorem) deuB(t) = ueuB(t)dB(t) + 1 u2 euB(t)dB(t) dB(t) 2 so euB (t) = euB (s) + Zt s ueuB (v) dB(v ) + 1 u2 2 233 Zt s euB(v) uses cond. with mean zero and variance t . B is a martingale. i.. s. the paths of B (t) are continuous. informally dB(t) dB(t) = dt). s. B (s) is independent of F (s). 3. such that: 0 t T be a process on ( F P).e. this shows that B (t) . (i. We shall show that the conditional moment generating function of B (t) . We need to show that B (t) . 2. B(s) is independent of F (s). Proof: (Idea) Let 0 s < t T be given. B (s)) F (s) 1 2 = e 2 u (t s) : . B (s) is normal with mean 0 and variance t . 3 dv: |{z} . B (s) is normal. and conditioning on F (s) does not affect this. adapted to a ﬁltration 1. Since the moment generating function characterizes the distribution.

. 1 . = 0: It follows that Zs 0 ueuB(v) dB (v ) F (s) ueuB (v) dB(v ) + IE Zt 0 ueuB(v)dB (v ) F (s) IE euB(t) F (s) = euB(s) + 1 u2 2 We deﬁne Zt s IE euB(v) F (s) dv: '(v) = IE euB(v) F (s) so that '(s) = euB(s) and 1 '(t) = euB(s) + 2 u2 1 ' (t) = 2 u2'(t) 1 '(t) = ke 2 u2 t : 0 Zt s '(v) dv Plugging in s. and so IE Zt s =. we get euB (s) = ke 2 u2 s =)k = euB (s) Therefore. 1 u2 s 2 : IE euB(t) F (s) = '(t) = euB(s)+ 2 u2 (t IE eu(B(t) .234 Rt Now 0 ueuB (v)dB (v ) is a martingale (by condition 2). 1 . s) B (s)) F (s) 1 2 = e 2 u ( t s) : .

Recognizing a Brownian Motion 235 23. W1 and W2 are Brownian motions. Indeed.1 Identifying volatility and correlation Let B1 and B2 be independent Brownian motions and dS1 = r dt + S1 dS2 = r dt + S 2 11 dB1 + 12 dB2 21 dB1 + 22 dB2 Deﬁne 2 + 2 1= q 11 12 2 + 2 2= 21 22 11 21 + 12 = Deﬁne processes W1 and W2 by q 1 2 22 : dW1 = dW2 = Then W1 and W2 have continuous paths. The stock prices have the representation dW2 dW2 = dt: The Brownian motions W1 and W2 are correlated. and 11 dB1 + 12 dB2 1 dB1 + 22 dB2 : 21 2 dW1 dW1 = 12 ( 11dB1 + = 12 ( = dt 1 1 2 dB 11 1 12 dB2 )2 2 dB dB ) 12 2 2 dB1 + and similarly Therefore.CHAPTER 23. dS1 = r dt + S1 dS2 = r dt + S 2 1 dW1 2 dW2: 12 dB2 )( 21dB1 + 22dB2 ) dW1 dW2 = 1 ( 11dB1 + = 1 ( 1 2 = dt: 1 2 11 21 + 12 22 ) dt . are martingales.

If = 1. 2 2 dB2 ( 6= 1) dB1 dB1 = dW1 dW1 = dt 1 dB2 dB2 = 1 .236 23. 2 dW1 dW2 + 2dW2 dW2 1 = 1. we have 1 dW1 = 1 dB1 =)dB1 = dW1 q 2 dW2 = 2 dB1 + 1 . = dt 2 dt . 2 dW2 dW2 . dW1 1. 2 2 dt + 2 dt . 2 2: p 2 =) dB2 = dW2 . then there is no B2 and dW2 = dB1 = dW1: Continuing in the case 6= 1. We want to ﬁnd dS1 = r dt + dW 1 1 S1 dS2 = r dt + dW 2 2 S 2 = so that 0 " 11 21 11 12 12 22 21 22 # = = = " " " 11 21 2 + 2 11 12 + 12 22 11 21 # 2 1 2 1 2 1 2 2 11 = 1 12 22 #" # # 11 21 + 12 22 2 + 2 21 22 A simple (but not unique) solution is (see Chapter 19) 12 = 0 22 = 21 = This corresponds to 2 q 1.2 Reversing the process Suppose we are given that where W1 and W2 are Brownian motions with correlation coefﬁcient .

to conclude that B 1 B2 are independent Brownians. . 2( dW1 dW1 ) dt . =p 1 1. Recognizing a Brownian Motion so both B1 and B2 are Brownian motions. dt) = 0: We can now apply an Extension of Levy’s Theorem that says that Brownian motions with zero cross-variation are independent. 237 dB1 dB2 = p 1 1. Furthermore.CHAPTER 23. 2 (dW1 dW2 .

238 .

1 The option payoff depends on both the Y and S processes. In order to hedge it.1 < < 1. where 0 < S (0) < K 0 < Y (0) < L Y (T ) = 0maxT Y (t): t Remark 24. which in this case means the discounted Y and S processes. We want to ﬁnd 1 and 2 and deﬁne e dB1 = 1 dt + dB1 e dB2 = 239 2 dt + dB2 . The option pays off: (S (T ) . The risk-neutral measure must make the discounted value of every traded asset be a martingale. K )+ 1 Y (T )<L f g at time T . we will need the money market and two other assets. q 2 2 dB2 (t) > 0 2 > 0 . and B1 and B2 are independent Brownian motions on some ( F P).Chapter 24 An outside barrier option Barrier process: dY (t) = dt + Y (t) Stock process: 1 dB1 (t): dS (t) = dt + S (t) where 1 2 dB1 (t) + 1 . which we take to be Y and S .

2 2 dB2 : =r+ =r+ 1 1 2 1+ q 2 2 dB2 e We must have q (0.2) We solve to get . B1 and B2 are independent Brownian motions (Girsanov’s Theorem). 1 ( 1 + 2 )T 2 Z f IP (A) = Z (T ) dIP 8A 2 F : o f e e P Under I . risk-neutral measure. 2 B2 (T ) . 1 B1 (T ) . Y S The value of the option at time zero is A f IP is the unique dY dS = YS 1 2 dt f v(0 S (0) Y (0)) = IE e h .240 so that dY = r dt + dB 1 e1 Y = r dt + 1 1 dt + 1 dB1 dS = r dt + dB + q1 . 2= p 1.1) 1.e.2 Under both IP and I . S has volatility 2 and i. We deﬁne 2 2 Z (T ) = exp . 2 2 2 dt q + 2 dB1 + 1 .r 1 2 1: 2 We shall see that the formulas for 1 and 2 do not matter. 2 2 2: (0. Y has volatility 1. rT (S (T ) . the correlation between dY and dS is .2) uniquely determine 1 and 2 . K )+ 1 f Y (T )<L i g : We need to work out a density which permits us to compute the right-hand side. This implies the existence and uniqueness of the risk-neutral measure. .1) and (0.. 2 e1 S = r dt + 2 1 dt + 1 .r. What matters is that (0. f P Remark 24. 2 n 1 = .

2 T db dm ^ T 2 T m > 0 ^ < m: ^ b ^ q e1 + 1 . 2 2B2 (T ) . appearing in Chapter 20. 1 2 T . bT + B (T ) so b S (T ) = S (0) expfrT + 2B (T ) . dS = r dt + S so 1 e e S (T ) = S (0) expfrT + 2B1 (T ) . 2 2 2B2 (T )g e . 1=2 b e B (t) = bt + B1 (t) c b M (T ) = max B (t): 0 t T Then The joint density of b c B (T ) and M (T ). 2 2 q bT + 1 . 2 (1 . 2) 2 T g 2 2 2 q e e = S (0) expfrT . An outside barrier option Recall that the barrier process is 241 dY = r dt + Y so e 1 dB1 n o 1 e Y (t) = Y (0) exp rt + 1B1 (t) . ^)2 b^ 1 b2 ) ^ m ^ = 2(2p . 2 2t : 1 Set b = r= 1 . b exp . 2 dB 2 2 dB2 e b Y (t) = Y (0) expf 1B (t)g c Y (T ) = Y (0) expf 1M (T )g: The stock process.CHAPTER 24. is f b IP fB (T ) 2 d^ M (T ) 2 dmg b c ^ ^) ( (2m . 2 2 B2 (T )g 2 2 From the above paragraph we have q e b B1 (T ) = . 1 2 2 T + 1 . ^2T b + b . 1 2 T + 2 B1 (T ) + 1 .

K )+ 1 f Y (T )<L i g 1 f = e rT IE S (0) exp (r . ~2 :p 2T 2 T ( ) 2(2p .3 If we had not regarded Y as a traded asset. The density of B2 (T ) is f e f e IP fB2 (T ) 2 d~ B(T ) 2 d^ M (T ) 2 dm g = IP fB2 (T ) 2 d~g:IP fB(T ) 2 d^ M (T ) 2 dmg b b b c ^ b f b b c ^ The option value at time zero is v (0 S (0) Y (0)) =e . 1 b2 T m b ^ ^ b : b 2 2T . rT 1 1 log Y L Zm Z (0) ^ 0 Z 1 ( ) b 1 exp . 2 2 2 b)T + b 2^ + 1 . The nonuniqueness of the solution alerts us that some options cannot be hedged.2)) = r+ 2 1+ 1.1 S (0) exp (r . ~2 d~ ~ 2 IR: e IP b 2T 2 T e e b c Furthermore. 1 2. rT (S (T ) . 21 : Remark 24. . q 2 2 B2 (T ) e .1). It does not depend on 1 nor 2 . The parameter b appearing in the answer is b = r1 .242 24. It also depends on 1 2 r K and L. the pair of random variables (B (T ) M (T )) is independent of B2 (T ) because B1 and e2 are independent under IP . (2m .K + :1 Y (0)exp 1 M (T )]<L b f g b We know the joint density of ( B (T ) ( ) b b b ffB2(T ) 2 d~g = p 1 exp . any option whose payoff depends on Y cannot be hedged when we are allowed to trade only in the stock. then we would not have tried to set its mean return equal to r.1) to determine 1 and 2 . We would have had only one equation (see Eqs (0. ^) exp .1 . Therefore. the joint density of the random vector (B2(T ) B (T ) M (T )) f e b c B is c e M (T )). ^)2 + b^ . q 2 2 2 (1. 2 2 b)T + b 2 B (T ) + 1 . Indeed. h . q 2 2~ b .1 Computing the option value f v (0 S (0) Y (0)) = IE e .(0.K + T 2 T :d~ d^ dm: b b ^ The answer depends on T S (0) and Y (0). 2 2 .

Using the Markov property. e rt v (t S (t) Y (t)) . 2 f dW 24.r f so with dW 2 = dt + dW we have dS = r dt + S and we are on our way. t. there will be only one . namely. Now start at time 0 at S (0) and Y (0). x and y respectively in the formula for v (0 S (0) Y (0)).CHAPTER 24. . h i 1 = e rt . we can show that the stochastic process f is a martingale under I . K )+ 1 maxt f u T Y (u) < Lg i by replacing T . Returning to the dS = dt + S we should set 2 dB1 + q 2 2 dB2 dW = dB1 + 1 . is superﬂuous. 243 S . r(T t)I t x y f E . 2dB2 so W is a Brownian motion under IP (Levy’s theorem). K )+ 1 Y (T )<L f g we obtain a formula for v (t x y ) = e . h (S (T ) .2 The PDE for the outside barrier option Returning to the case of the option with payoff (S (T ) .rv + vt + rSvx + rY vy + 2 2S 2 vxx + 2 + e 2 Svx dB1 + q 2 2 1 2 SY vxy + 1 1 Y vyy 2 dt 1. We compute P d e rtv(t S (t) Y (t)) . then Y 1. 2 2Svx dB2 + 1Y vy dB1 e e . An outside barrier option If we have an option whose payoff depends only on original equation for S . q = . S (0) and Y (0) by T . and dS = dt + dW: 2 S Now we have only Brownian motion.

Setting the dt term equal to 0. we obtain the PDE . L) = 0. rv + vt + rxvx + ryvy + 1 2x2vxx 2 2 + 2 2 1 2 xyvxy + 1 1 y vyy 2 =0 0 t<T x 0 0 y L: The terminal condition is v(T x y) = (x . x >= 0 x v(t.1: Boundary conditions for barrier option. Note that t 2 0 T ] is ﬁxed. K )+ x 0 0 y<L and the boundary conditions are v(t 0 0) = 0 0 t T v (t x L) = 0 0 t T x 0: . x.244 y L v(t. 0) = 0 Figure 24. 0.

rv + vt + rxvx + 1 2x2vxx = 0 2 2 This is the usual Black-Scholes formula in x. h = e rt . and B1 B2 S Y d e rt S (t) = e . 2 2S (t) dB2 (t) e : rt . we have the equation d e rtv (t S (t) Y (t)) . r(T t)(0 . 24.3 The hedge After setting the dt term to 0. the barrier is irrelevant.rY (t) dt + dY (t)] e 1Y (t) dB1 (t): . . The boundary condition is v (t 0 L) = 0 v(t 0 0) = 0 v (T 0 y) = (0 . rt d e rt Y (t) = e =e . .rS (t) dt + dS (t)] q e 2S (t) dB1 (t) + 1 . the option value is v (t 0 y ) = 0 0 y L: v(t 0 0) = e . 2 S . K )+ = 0 . i i q 2 2 Svx dB2 + 1 Y vy dB1 e e are functions of t.CHAPTER 24. . h . h i Let 2 (t) denote the number of shares of stock held at time t. e 2Svx dB1 + 1 . An outside barrier option 245 . Note where vx that e e = vx (t S (t) Y (t)). vy = vy (t S (t) Y (t)). rt Therefore. The value X (t) of the portfolio has the differential dX = 2dS + 1 dY +rX. . 1Y ] dt: . K )+ x 0: On the y = 0 boundary.rv + vt + ryvy + 1 2y2vyy = 0 2 1 This is the usual Black-Scholes formula in y . The boundary conditions are the terminal condition is x=0 y=0 . h i = e rt . K )+ = 0 y 0: On the x = 0 boundary. and let 1(t) denote the number of “shares” of the barrier process Y . the terminal condition is v (T x 0) = (x . and the option value is given by the usual Black-Scholes formula for a European call. d e rtv (t S (t) Y (t)) = vxd e rtS ] + vy d e rtY ]: .

rt Y (t)]: To get X (t) = v (t S (t) Y (t)) for all t.246 This is equivalent to d e rtX (t)] = . 2 (t)d e . rtS (t)] + 1(t)d e . we must have X (0) = v (0 S (0) Y (0)) and 2 (t) = vx (t S (t) Y (t)) 1 (t) = vy (t S (t) Y (t)): .

L)IEe L )) Lg + if x L. let x > 0 be given. if x > L: . 25. S ( = ( . 25. We deﬁne vL L = minft 0 S (t) (x) = IEe r L (K . S (t))+ : Let L 2 0 K ] be given.1 Preview of perpetual American put dS = rS dt + S dB Intrinsic value at time t : (K . K.x (K .Chapter 25 American Options This and the following chapters form part of the course Stochastic Differential Equations for Finance II. We compute the distribution of . 247 . Suppose we exercise the ﬁrst time the stock price is L or lower.2 First passage times for Brownian motion: ﬁrst method (Based on the reﬂection principle) Let B be a Brownian motion under IP . and deﬁne = minft 0 B (t) = xg: is called the ﬁrst passage time to x. rL The plan is to comute vL (x) and then maximize over L to ﬁnd the optimal exercise price. We need to know the distribution of L .

mt dm: = 2 2 t 1 . (2m2.1: Intrinsic value of perpetual American put Deﬁne M (t) = 0maxt B (u): u From the ﬁrst section of Chapter 20 we have 2 m IP fM (t) 2 dm B(t) 2 dbg = 2(2p .248 K Intrinsic value K Stock price x Figure 25. b) ( (2m . b)2 ) p IP fM (t) xg = db dm exp . (2m . b) dm db t t 2 t Therefore. b)2 b=m dm p = 2t 2 t x b= ( 2) Z p 2 exp .1 1 x We make the change of variable z = mt in the integral to get p 2 p2 exp . ( ) m > 0 b < m: Z Z m 2(2m . z2 dz: = x= t 2 1 p Z ( ) Now t()M (t) x . 2t t 2 t x ) ( Z 2 exp .1 1 . b) exp .

the process B (t) P f IP (A) = Z (T ) dP A 2 F (T ): 0 t T . More speciﬁcally. B (t) . Brownian motion and Stochastic Calculus.3 Drift adjustment Reference: Karatzas/Shreve. x dt: 2t t 2 t 1 p We also have the Laplace transform formula IEe . 1 2 tg 2 e (t) + 1 2tg = expf. American Options so 249 @ IP f 2 dtg = @t IP f tg dt @ = @t IP fM (t) xg dt " Z ( ) # @ 2 exp . 0 e t IP f 2 dtg . xt : @t p dt 2 t 2 ( 2) = px exp . Brownian Motion and Stochastic Calculus. = Z 1 =e x .CHAPTER 25. For 0 t < 1. x dt 0 < t T: 2t t 2 t ( ) . deﬁne Z f e Under I . z 2 dz dt p = @t 2 x= t 2 ( 2) @ x = . B 2 e ~ = minft 0 B (t) = xg: A Deﬁne We ﬁx a ﬁnite time T and change the probability measure “only up to T ”. p2 exp . pp 95-96. is a (nondrifted) Brownian motion. 25. with T ﬁxed. pp 196–197. so f IP f~ 2 dtg = IP f 2 dtg 2 = px exp . deﬁne e B (t) = t + B (t) Z (t) = expf. p 2 > 0: (See Homework) Reference: Karatzas and Shreve.

( ) 25. 2 2 sgIP f ~ 2 dsg 0 ( Zt x 2) 1 2s . this must in fact be the correct formula for all t > 0. xt dt = e 2 t 2 t ( ) . x p exp x . 1 2 ~g 2 Zt 1 f = expf x . x 2 p > 0 x > 0: ~ = minft 0 t + B (t) = xg . 2 T g 1 f f e = IE 1 ~ t IE expf B (T ) . 2 2 T g F (~ ^ t) f g ~ t Z (T ) 1 i 0 Therefore. s)2 ds: p exp .4 Drift-adjusted Laplace transform Recall the Laplace transform formula for = minft 0 B (t) = xg for nondrifted Brownian motion: IEe For . 1 2 (~ ^ t)g 2 i fh = IE 1 ~ t expf x . t . t t) dt 0 < t T: 2 t 2 t Since T is arbitrary. 2 = 2s ds 0 s 2 s ) ( Zt x (x . (x . 2s = s 2 s f g f g f g 1 2 e ~ t expf B (T ) .250 For 0 < t T we have IP f~ tg = IE 1 h h f f = IE 1 ~ t i g g f f = IE 1 i fh e = IE 1 ~ t expf B (~ ^ t) . = Z 0 1 2 px exp . 2 IP f~ 2 dtg = px exp .

x2 + x . lim e Letting #0 and using the Monotone Convergence Theorem in the Laplace transform formula IEe . American Options the Laplace transform is 251 IEe . t t) dt 2 0 t 2 t ( ) Z x exp . we obtain If If IP f~ < 1g = ex x p 2 = ex x : . Z ( ) where in the last step we have used the formula for IEe. then IP f ~ < 1g = 1: IP f ~ < 1g = e2x < 1: < 0.( + 1 2 )t . then e ~(!) = 0 for every #0 #0 . 1 2tg 2 . then with replaced by +1 2 2. ~(! ) = 1 > 0. #0 ~(! ) = 1 ~< 1 : 2 ~ = ex x 2 + p . ~= 2 px exp . Therefore. so lim e ~(! ) = 0: . (x .CHAPTER 25. Then Y (t) = expf B(t) . 25. t .5 First passage times: Second method (Based on martingales) Let > 0 be given. 1 2 t dt p = 2 2t 0 t 2 t ) ( Z x exp . then (Recall that x > 0). x2 dt x p =e 2 2t 0 t 2 t = ex x 2 + 2 >0 x>0 1 1 1 p . . if ~(! ) = 1. t . j j 0. lim e . . If ~(!) < 1.

Since 0 expf B (t ^ ) . so = 2 p to be zero if = 1. We have again derived the Laplace transform formula e . 1 1 = IE t! expf B (t ^ ) . . 1 2 (t ^ )g 2 1 ex this is justiﬁed by the Bounded Convergence Theorem. . x 2 p = IEe >0 x>0 for the ﬁrst passage time for nondrifted Brownian motion. 1 lim expf B (t ^ ) . 1 2 )t + B(t)g 2 8 > > < = x exp > > : 2 39 > > 6 r 6 . . 2 2(t ^ )g lim 1 = IE e x . 1 2 (t ^ )g = e x 2 : 2 t! For those ! for which (! ) = 1. 2 2tg = 0: lim 2 t! 1 1 Therefore. 1 2 (t ^ )g t! expf x . 1 2 (t ^ )g: 2 1 = t! IE expf B (t ^ ) . 2 2 (t ^ )g: lim 1 We want to take the limit inside the expectation. Therefore.252 is a martingale. 25. For those ! for which (! ) < 1.6 Perpetual American put dS = rS dt + S dB S (0) = x S (t) = x expf(r . so Y (t ^ ) is also a martingale. 1 = IE t! expf B (t ^ ) . 1 1 2 lim expf B (t ^ ) . 1 2 2 1< 1 1 where we understand e x. t + B(t)7= : 7 6 7> 4| {z 2 } 5> . 2 Let = IEe x 2 1 2 2 =1 2 2 . 1 2 (t ^ )g: lim 2 There are two possibilities. . We have 1 = Y (0 ^ ) = IEY (t ^ ) = IE expf B (t ^ ) .

x The curves (K . L = minft (K . r + 2 =4 2 2 2 = . American Options Intrinsic value of the put at time t: Let L 2 253 0 K ] be given. 2 We compute the exponent p . 1 2r + r . L) L 2r= 2 are all of the form Cx. 1 log L 2r + 1 2r + 2 x : = (K . p . r2 + 1 . . 2r : 2 Therefore. L) L . B (t) = L Deﬁne vL = (K . L)IEe r L x xp = (K . Deﬁne for x L. =2 2 2 s s s s 2 = .CHAPTER 25. r + 1 .2r= . The constant is C = (K . . 1 r + =2 2 = . We want to choose the largest possible constant. 0 S (t) = Lg = minft 0 t + B (t) = 1 log L g x 1 log x g = minft 0 . 2r= 2 x L: 2 0 x L . r2 + 1 .x (K . 1 2r + 2 = . r2 + 1 . L)L2r= 2 . S (t)) +. L) exp . 1 2r + r 2 . 1 r + =2 2 = . log L . t . x) vL (x) = : . 1 r 2 + r + 2=4 2 = . r2 + 1 . 2 8 <(K . L) L . .

254 value K-x K 2 (K . .L) (x/L)-2r/ σ K Stock price x Figure 25.3: Curves.2: Value of perpetual American put value C3 x C2 x C1 x -2r/ σ 2 -2r/ σ 2 -2r/ σ 2 Stock price x Figure 25.

2 rK2r 2rK2r + 2 + 2r . L) L 2 2r = L 2 . 1 + 2r + 2r K = 0 2 2L to get 2 L = 2 rK2r : + Since 0 < 2r < 2 + 2r we have 0 < L < K: 0 x L Solution to the perpetual American put pricing problem (see Fig. 25.12r 0 .CHAPTER 25. 2r= 2.4): 8 < v (x) = :(K . L) (L 0 )2r= 2 x .2 r2 (K .2 r2 K .2 r2 2 + 2r 2r = . x) .L 2r2 + 2r (K . x (K . 1 + 2r + 2r K : 2 2L . L ) L ( .1 = lim v (x): x"L 0 . American Options and 255 @C = .1 + 2r (K . 2r= 2 x L where 2 L = 2 rK2r : + Note that v (x) = . L)L 2r2 1 2 @L 2r 1 = L 2 . L ) 1 L 2+ 2 = . 2r ! 2 + 2r = . 2 (K . We solve . 1 0 x<L x>L : We have x#L lim v (x) = .

25.rx .L* )(x/L* ) 2 L* K Stock price x Figure 25. r . . . . . .rK: 2 If L x < 1. then v(x) = (K . v solves the linear complementarity problem: (See Fig.r .r(K .3) (7.1) (7. 25. 1)x r .5). 1 2 x2 (.rv(x) + rxv (x) + 1 2x2v (x) = . . . If L x < 1.4) x < L . . .7 Value of the perpetual American put Set 2 L = 2 rK2r = + 1 K: + If 0 x < L .2) = IE x where h e (K . x) + rx(. 1 2 2r 2 2 = 0: 0 0 00 .256 value K-x K -2r/ σ (K .rv(x) + rxv (x) + 1 2x2v (x) 2 = C . L )+1 . 2 = C (. . 1)] = Cx . rx x 1 .4: Solution to perpetual American put. L )(L ) } x | {z . = 2r 2 (7. then . 1)x 2 ] 2 1 2 (. then . x.1) = . C r f < i 1g S (0) = x If 0 = minft 0 S (t) = L g: 00 (7. In other words. then v (x) = K .

5: Linear complementarity For all x 2 IR. The half-line 0 1) is divided into two regions: C = fx v(x) > (K . (t)S (t)) dt . x 6= L .CHAPTER 25. American Options 257 6 K@ @@ L v @@ @@ K -x Figure 25. 1 rv . 2 2x2 v 0 v (K . Invest the money. C (t) dt or equivalently. x)+ 0 00 (a) (b) (c) One of the inequalities (a) or (b) is an equality.8 Hedging the put Let S (0) be given. x)+ g S = fx rv . Sell the put at time zero for v (S (0)). the owner of the put should exercise (should “stop”). 1 2x2v > 0g 2 0 00 and L is the boundary between them. If the stock price is in C . If the stock price is in S or at L . holding (t) shares of stock and consuming at rate C (t) at time t. the owner of the put should not exercise (should “continue”). d(e rt X (t)) = . . rxv .e rt C (t) dt + e . 25. . rxv . rt (t) S (t) dB (t): . The value X (t) of this portfolio is governed by dX (t) = (t) dS (t) + r(X (t) .

S (0))+ = v(S (0)): (8:1) . . and then . i. S (t))+ .rt v (S (t)): 1.3) If t is not zero.2) for t = 0. 0 C (t) = rK 1 S(t)<L : f g Properties of e. 0 . adapt the argument below to prove property (8. 0 f g h i . .rKe rt 1 S (t)<L dt + e rt S (t)v (S (t)) dB (t): .1) to prove (8. . .258 The discounted value of the put satisﬁes d e rtv(S (t)) = e . e rtv (S (t)) is a supermartingale (see its differential above). assuming Y is a supermartingale satisfying (8.3). S (t))+ .2). Let Y be a supermartingale satisfying Y (t) e rt (K . i.rv(S (t)) + rS (t)v (S (t)) + 1 2S 2(t)v (S (t)) dt 2 0 00 We should set C (t) = rK 1 S (t)<L (t) = v (S (t)): f 0 g Remark 25.2) We use (8.. then As long as the owner does not exercise. e rtv (S (t)) is the smallest process with properties 1 and 2. Explanation of property 3. 0 t < 1: (8. . 2. 3. v(S (t)) = K . S (t) (t) = v (S (t)) = . Y (0) v(S (0)): (8. e rtv (S (t)) e rt (K . . rt + e rt S (t)v (S (t)) dB (t) = . 0 t < 1..1: To hedge the put when S (t) < L .1) Then property 3 says that Y (t) e rt v (S (t)) 0 t < 1: (8. Proof of (8.1): Case I: S (0) L : We have Y (0) |{z}(K . short one share of stock and hold K in the money market. we can take t to be the initial time and S (t) to be the initial stock price. you can consume the interest from the money market position.e.1 If S (t) < L .e.

Value of the American contingent claim: v (x) = sup IE x e r h(S ( )) . K )+ . Optimal exercise rule: Any stopping time Characterization of v : 1.63 v (x) = x 8x 0: . .1) (See eq. where the supremum is over all stopping times. .2) 25. S{z ))+ 1 4 |( } f 1g . e rtv (S (t)) is the smallest process with properties 1 and 2. we have f 1g Y (0) IEY ( ^ T ) (Stopped supermartingale is a supermartingale) h i IE Y ( ^ T )1 < : (Since Y 0) Now let T !1 to get Y (0) lim IE Y ( ^ T )1 < T! h i (Fatou’s Lemma) IE Y ( )1 < 1 f 1g h i 2 IE 6e r (K . . American Options Case II: S (0) > L : For T 259 > 0. Theorem 10. which attains the supremum.CHAPTER 25. . 25. 3. 2. e rtv (S (t)) is a supermartingale. f = v (S (0)): L < 1g 3 7 5 (by 8.9 Perpetual American contingent claim Intinsic value: h(S (t)). e rtv (S (t)) e rt h(S (t)) 0 < t < 1.10 Perpetual American call v(x) = sup IE x e r (S ( ) . 7.

.e. K )+ < IE x e r S ( ) There is no optimal exercise time. K ) h i = IE x e rt S (t) . K )+ 0 t < 1. Therefore. v(x) IE x e rt (S (t) . i.. It can be shown that jump.11 Put with expiration T > 0. 2. . x = v(x): 25. e rt K: . h i x.2 No matter what . Let S (0) be given. . Now start with S (0) = x and deﬁne Y (t) = e rtS (t): . Then | {z } T v vt vx are continuous across the boundary. S ( ))+: . Expiration time: Value of the put: v(t x) = (value of the put at time t if S (t) = x) = sup IE xe r( t) (K . .6. S (t)) +. e rt K = x . Remark 25. IE x e r (S ( ) . Y (0) v(S (0)). . Let t!1 to get v (x) Then: 1. . x v(x): we choose.260 Proof: For every t. Intrinsic value: (K . Y is a martingale). Y (t) e rt(S (t) . 25. Y is a supermartingale (in fact. . t :stopping time See Fig. K )+ h i IE x e rt (S (t) . while v xx has a .

1 2 x2vxx 0 2 v h(x) (a) (b) (c) Characterization of v : Let S (0) be given. Intrinsic value: h(S (t)). Then . x 0 x K -t Figure 25.rv + vt + rxvx + 1 2x2vxx = . 2.CHAPTER 25. r( t)h(S ( . rxvx .rK 2 T 1. vt .rv + vt + rxvx + 1 2x2vxx = 0 2 K v (T x) = 0 x K L v=K. )): At every point (t x) 2 0 T ] 0 1).6: Value of put with expiration e rtv (t S (t)) 0 t T is a supermartingale. American Options 261 x 6 v>K. . 3. e rtv (t S (t)) is the smallest process with properties 1 and 2. S (t))+ 0 t T . 25. v (T x) = K . e rtv (t S (t)) e rt (K . .1 vxx = 0 . Expiration time: Value of the contingent claim: v(t x) = sup IE x e t T Then . . rv .x .12 American contingent claim with expiration T > 0. either (a) or (b) is an equality. .x vt = 0 vx = .

. then there is no optimal exercise time along the particular path ! . . .262 1. e rtv (t S (t)) e rt h(S (t)). . 3. e rtv (t S (t)) 0 t T is a supermartingale. 2. e rtv (t S (t)) is the smallest process with properties 1 and 2. . The optimal exercise time is = minft 0 v (t S (t)) = h(S (t))g If (!) = 1.

Chapter 26 Options on dividend-paying stocks 26.s.64 Consider the stock price process dS (t) = r(t)S (t) dt + (t)S (t) dB (t) where r and are processes and r(t) 0 0 t T a.. An Let h(x) be a convex function of x American contingent claim paying h(S (t)) if exercised at time t does not need to be exercised before expiration.1 American option with convex payoff function Theorem 1. The value of this claim at time t 2 0 T ] is X (t) = (t) IE (1 ) h(S (T )) F (t) : T 263 . For 0 t T . 0 and S (T ) (t) = exp . This stock pays no dividends.g. h(x) = (x . (E. so h (t) h(S (T )): (T ) (*) Consider a European contingent claim paying h(S (T )) at time T . Proof: For 0 1 and x 0. waiting until expiration to decide whether to exercise entails no loss of value. i. )0 + x) (1 .. we have h( x) = h((1 . )h(0) + h(x) = h(x): Let T be the time of expiration of the contingent claim. K )+ ).e. 0. and assume h(0) = 0. Z T r(u) du (T ) t (t) S (T ) (T ) ( ) 1 0.

. .. .. ... . ............. ... .... . ... ... .. . ........1: Convex payoff function Therefore. ............ ....... . ...... .. .. . . X (t) = 1 IE (t) h(S (T )) F (t) (t) (t) (T ) (t) 1 (t) IE h (T ) S (T ) F (t) (by (*)) 1 h (t) IE S (T ) F (t) (Jensen’s inequality) (t) (T ) = 1 h (t) S (t) ( S is a martingale) (t) (t) 1 = (t) h(S (t)): This shows that the value X (t) of the European contingent claim dominates the intrinsic value h(S (t)) of the American claim...... h( x) .. . ....... ......... .. ....... ... .... ........ ...... ..... ...r....... ... ... 26. ...... ... 6 x - Figure 26. .. .............. .. . .. the American claim should not be exercised prior to expiration... ...... ... ......... .. .... .... .. ............ . except in degenerate cases...... ..2 Dividend paying stock Let r and be constant. .. (x h(x)) .... ... ........ .....r.... . ......... . ...r..... ..... ...... the inequality X (t) h(S (t)) 0 t T is strict..... ..........264 .. . . let be a “dividend coefﬁcient” satisfying 0 < < 1: ..e. ....... ... ...... ... . .... ...... ..... ........... . .... . ............. i.... . . .... In fact.... ..... . .. ...... h ... .... ....... . h(x) .

2 )t +1 B(t)g 2 )(t .rw + wt + rxwx + 1 2x2wxx = 0 0 t t1 x 0 2 (where w = w(t x)) with terminal condition w(t1 x) = max (x . so the value of the call is given by the usual Black-Scholes formula ( v(t x) = xN (d+(T . The stock 1 2 0 t t1 S (t) = S (0) expf(r . r(t1 t) w(t . w(t1 0) = 0. Options on dividend paying stocks Let T > 0 be an expiration time. the value of the American call is w(t S (t)). )x) x 0 w(t 0) = 0 0 t T: (t) = and boundary condition The hedging portfolio is ( wx(t S (t)) vx (t S (t)) 0 t t1 t1 < t T: Proof: We only need to show that an American contingent claim with payoff w(t 1 S (t1)) at time t1 need not be exercised before time t1. K )+ v (t1 (1 . it sufﬁces to prove 1. Ke where . 2 t1 < t T: Consider an American call on this stock. t x)) t1 < t T : At time t1 . where w(t x) = IE t x e h . t1 ) + (B (t) . 1 S (t1)) : i This function satisﬁes the usual Black-Scholes equation . B (t1 ))g (1 . the value of the call is w(t1 S (t1)) where Theorem 2. According to Theorem 1.65 For 0 w(t1 x) = max (x . immediately after payment of the dividend. At times t 2 (t 1 T ). K )+ v(t1 (1 . r(T t) N (d . . )S (t1) expf(r . it is not optimal to exercise. .64. the value of the call is x d (T . and let t1 price is given by 265 2 (0 T ) be the time of dividend payment. t x) = p 1 log K + (T . t x)) . immediately before payment of the dividend. t)(r T . )S (t1)): 2=2) At time t1 .t v (t1 (1 . (T .CHAPTER 26. )x : t t1 .

)x) in x is left as a homework problem. K before the dividend payment at time t1 . The proof of the convexity of v (t1 (1 . Obviously. w(t1 x) = v (t1 (1 . )x). K to v (t 1 (1 . K )+ v(t1 (1 . The hedge has been constructed so the seller of the option has x . (t1 +) = 1 (t1) = (t1) + 1. )x) < (x . The owner of the option should exercise before the dividend payment at time t 1 and receive (x . 1. The post-dividend position can be achieved by reinvesting in stock the dividends received on the stock held in the hedge. K ). Indeed. )x) is convex is x. We have Let x = S (t1). If the option is not exercised. )vx (t1 (1 . and the maximum of two convex functions is convex. (x . 26. )x) (x . we need to show that v (t 1 (1 .3 Hedging at time t1 Case I: v (t1 (1 . its value drops from x . and the seller of the option can pocket the difference and continue the hedge. . The option need not be exercised at time t 1 (should not be exercised if the inequality is strict). )S (t ) 1 (t1) dividends received price per share when dividend is reinvested = # of shares held when dividend is paid + Case II: v (t1 (1 . )x) = (1 . )0) = 0: To prove that w(t1 x) is convex in x. 0) = 0. (t1 )S (t1) = (t1 ) + (1 . K )+ . ) (t1+) where (t1 +) = lim (t) t#t1 is the number of shares of stock held by the hedge immediately after payment of the dividend.266 2. K )+ . w(t1 x) is convex in x. K )+ is convex in x. we have immediately that Since v (t1 w(t1 0) = max (0 . )x) (t1) = wx (t1 x) = (1 .

Assume that every martingale under IP can be represented as an integral with respect to W . which we call IP . maturing at time T . its value at time t 2 0 T ] is B(t T ) = (t) IE (1T ) F (t) t = IE ((T)) F (t) " ( = IE exp .Chapter 27 Bonds. pays 1 at time T and nothing before time T . whose price satisﬁes F P). Con- dS (t) = r(t)S (t) dt + (t)S (t) dW (t): Here. ZT t r(u) du F (t) : ) # Given B (t T ) dollars at time t. Deﬁne the accumulation factor (t) = exp Zt 0 r(u) du : A zero-coupon bond. and we have already switched to the risk-neutral measure. According to the risk-neutral pricing formula. which we call a stock. one can construct a portfolio of investment in the stock and money 267 . forward contracts and futures Let fW (t) F (t) 0 t T g be a Brownian motion (Wiener process) on some ( sider an asset. r and are adapted processes.

then ( ZT ) B (t T ) = exp . Any two of them are sufﬁcient for hedging. and the two which are most convenient can depend on the instrument being hedged. you are given B (t invest only in the money market.e. then we will have X (T ) = B(T T ) = 1: If r(t) is nonrandom for all t. at any time t. the money market. B(t T ) = (t) IE (1 ) F (t) | T {z } martingale 1 + Z t (u) dW (u) = (t) IE (T ) Zt 0 = (t) B (0 T ) + (u) dW (u) 0 dB (t T ) = r(t) (t) B (0 T ) + (u) dW (u) dt + (t) (t) dW (t) 0 = r(t)B (t T ) dt + (t) (t) dW (t): The value of a portfolio satisﬁes Zt dX (t) = (t) dS (t) + r(t) X (t) . (t)S (t)]dt = r(t)X (t) dt + (t) (t)S (t) dW (t): (*) We set (t) (t) = (t)S(t) : (t) If. and the zero coupon bond. X (t) = B (t T ) and we use the portfolio (u) t u T . = 0. If. for some process .268 market so that the portfolio value at time T is 1 almost surely. Indeed. r(u) du t dB (t T ) = r(t)B(t T ) dt i. then at time T you will have T ) dollars and you always B(t T ) exp (Z T t r(u) du = 1: ) If r(t) is random for all t. Then given above is zero. One generally has three different instruments: the stock. then is not zero. at time t.. .

this contract has value 0. however.2 Hedging a forward contract Enter a forward contract at time 0. chosen so the forward contract has value zero at time t. We solve for F (t): IE (1 ) (S (T ) .. In other words. (0 T At time zero. This generates income . F (t) B (t T ): (t) (t) This implies that ) F (t) = BSt(tT ) : ( Remark 27. F (t) IE (t) F (t) (T ) (t) (T ) = S (t) . Forward price) The T -forward price F (t) is not the value at time t of the forward contract. agreed upon at time t. At time 0. At later times. Bonds. The value of the contract at time t is zero. F (t)) F (t) = 0 0 t T: T 0 = IE 1 (S (T ) . its value at time t 2 0 T ] is V (t) = (t) IE (1 ) (S (T ) . agree to pay F (0) = BS (0) ) for a share of stock at time T . i.1 (Value vs. F (0)B (t T ): F (0)B (0 T ) = BS (0) ) B (0 T ) = S (0): (0 T This suggests the following hedge of a short position in the forward contract. F (0)) F (t) T t (T ) = (t) IE S(T ) F (t) . F (t)) F (t) (T ) = IE S (T ) F (t) . F (0)B (t T ) = S (t) .1 Forward contracts We continue with the set-up for zero-coupon bonds.e. short F (0) T -maturity zero-coupon bonds. forward contracts and futures 269 27. In fact. it does not. F (0) IE ((T)) F (t) (t) = (t) S(t) . The T -forward price of the stock at time t 2 0 T ] is the F (t)-measurable price.CHAPTER 27. F (t) is the price agreed upon at time t which will be paid for the stock at time T . for purchase of a share of stock at time T . 27.

F (0): Deliver the share of stock and receive payment F (0). F (0)B (T T ) = S (T ) . The value at time t = t0 of this sequence is 2n 1 X (t) IE 4 . (tk ). Maintain this position until time T . (tk+1 ) : : : (tn ) . the value of the future contract is maintained at zero at all times. A short position in the forward could also be hedged using the stock and money market.270 Buy one share of stock. when the future price is (t k ). ) The mechanism for receiving and making these payments is the margin account held by the broker. taking the long position. r is constant. This portfolio requires no initial investment. At time tk+1 . (If the price has fallen. (tj )) F (t) : Because it costs nothing to enter the future contract at time t. Through the device of marking to market. tj ) j =0 r(u) du Enter a future contract at time tk . when the portfolio is worth S (T ) . . Thus.( (tk+1 ) . when the future price is (tk+1 ). this expression must be zero almost surely. but the implementation of this hedge would require a term-structure model.3 Future contracts Future contracts are designed to remove the risk of default inherent in forward contracts. (tk ) (tk+2 ) . either party can close out his/her position at any time. (tk )). j =k 3 1 5 (tj +1 ) ( (tj +1 ) . By time T is F (tk )-measurable. so (tk+1 ) = exp Z tk+1 8 0k 9 <X = = exp : r(tj )(tj +1 . you make the payment . at times tk+1 tk+2 : : : tn . you receive a payment (tk+1 ) . (tn 1 ) . Let us ﬁrst consider the situation with discrete trading dates 0 = t0 < t1 < : : : < tn = T: On each tj tj +1 ). 27. = tn . you have received the sequence of payments (tk+1 ) .

then the martingale "Z T 0 1 d (u) F (t) (u) # satisﬁes "Z T # Zt 1 1 d (u) F (t) M (t) = d (u) + IE 0 (u) t (u) Zt 1 = 0 (u) d (u) 0 t T: this implies 1 dM (t) = (t) d (t) d (t) = (t) dM (t) . as it should be when approximating a stochastic integral. if (b) holds.s. Z t 1 d (u) (u) 0 (u) 0 (u) = 0: M (t) = IE On the other hand.. Bonds. and # (a) (b) 0 t T: Theorem 3. then IE "Z T t # 1 d (u) F (t) = IE Z t 1 d (u) F (t) .CHAPTER 27. so 0 (u) is a martingale. forward contracts and futures The continuous-time version of this condition is 271 (t) IE "Z T t 1 d (u) F (t) = 0 (u) # 0 t T: Note that (tj +1 ) appearing in the discrete-time version is F (t j )-measurable. Deﬁnition 27. If is a martingale.1 The T -future price of the stock is any F (t)-adapted stochastic process f (t) 0 t T g satisfying IE "Z T t 1 d (u) F (t) = 0 (u) (T ) = S (T ) a.66 The unique process satisfying (a) and (b) is (t) = IE S (T ) F (t) 0 t T: Proof: We ﬁrst show that (b) holds if and only if R t 1 d (u) is also a martingale.

S (0) i = IE 1 IE (T ) 1 (T ) IE 1 IE (S (T )) . ) F (t) = BSt(tT ) = ( (t)IE S (t) 1 (T ) F (t) : Forward-future spread: h 1 (0) . (0): ( (0) . By the tower property.5 Forward-future spread Future price: Forward price: (t) = IE S (T ) F (t) . entered at time 0. he has paid a total of for an asset valued at S (T ). With a future contract. the buyer receives a cash ﬂow (which may at times be negative) between times 0 and T . is a martingale. entered at time 0. IE S (T ) (T ) (T ) : If (1 ) and S (T ) are uncorrelated.272 and so is a martingale (its differential has no dt term). The only payment is at time T . (0) = S (T ) . F (0) = IE S (T )] . The cash ﬂow received between times 0 and T sums to ZT 0 d (u) = (T ) . Now deﬁne (t) = IE S (T ) F (t) 0 t T: Clearly (a) is satisﬁed. is the only martingale satisfying (a). the buyer agrees to pay F (0) for an asset valued at S (T ). If he still holds the contract at time T . then he pays S (T ) at time T for an asset valued at S (T ). S (T )) + S (T ) = (0) Thus.4 Cash ﬂow from a future contract With a forward contract. 27. T (0) = F (0): . Indeed. so (b) is also satisﬁed. this 27. if the future contract holder takes delivery at time T .

CHAPTER 27. 1 2 )t + W (t)g 2 f (t) = IE S (T ) F (t)] = F (t) ) = BSt(tT ) = er(T t)S (t): ( . then T 273 (0) F (0): This is the case that a rise in stock price tends to occur with a fall in the interest rate. and P f dS (t) = rS (t) dt + S (t) dW (t): We have Because (1 ) T f = e rT is nonrandom. The expected future spot price of the stock under IP is IES (T ) = S (0)e T IE exp . 2 2)t + W (t)g f = S (0) expf(r . Therefore. . forward contracts and futures If (1 ) and S (T ) are positively correlated. 27. The buyer of the future is T compensated by a reduction of the future price below the forward price. the owner usually must make payments on the future contract. Bonds. r dS (t) = S (t) dt + S (t) dW (t): f W (t) = t + W (t). 1 2T + W (T ) 2 T S (0): =e h n oi . The owner of the future tends to receive income when the stock price rises. the long position in the future is hurt by positive correlation between (1 ) and S (T ). If the stock price falls. He withdraws from the money market to do this just as the interest rate rises. S (T ) and (1T ) are uncorrelated under IP . Z (T ) = expf. In short. W (T ) . 1 2 T g 2 Z f IP (A) = Z (T ) dIP 8A 2 F (T ): A f f Then W is a Brownian motion under I .6 Backwardation and contango Suppose Deﬁne = . (t) = ert 1 S (t) = S (0) expf( . but invests it at a declining interest rate.

If then (0) > IES (T ).274 The future price at time 0 is If > r. . then (0) < IES (T ): This situation is called normal backwardation (see Hull). This is called contango. (0) = erT S (0): < r.

e.Chapter 28 Term-structure models Throughout this discussion. Therefore 1 1 d B(t(tT ) = B(t T ) d (t) + (t) dB(t T ) ) = (t T ) . We assume these bonds are default-free and pay $1 at maturity.1 We shall always have dB (t T ) = (t T )B (t T ) dt + (t T )B(t T ) dW (t) 0 t T for some functions (t T ) and (t T ). We deﬁne the accumu- (t) = exp t 0 r(u) du 0 t T: In a term-structure model. For 0 t T T . the process B(t T ) (t) 0 t T f is a martingale under I . and fF (t) 0 t T g is the ﬁltration generated by W . r(t)] B (t(tT ) dt + (t T ) B (t tT ) dW (t) ) () 275 . such that for each T 2 (0 T ]. let B(t T ) = price at time t of the zero-coupon bond paying $1 at time T . Suppose we are given an adapted interest rate process fr(t) lation factor Z 0 t T g.67 (Fundamental Theorem of Asset Pricing) A term structure model is free of arbif trage if and only if there is a probability measure I on (a risk-neutral measure) with the same P probability-zero sets as IP (i. we take the zero-coupon bonds (“zeroes”) of various maturities to be the primitive assets. Theorem 0. equivalent to IP ). P Remark 28. fW (t) 0 t T g is a Brownian motion on some probability space ( F P)..

1 Computing arbitrage-free bond prices: ﬁrst method Begin with a stochastic differential equation (SDE) dX (t) = a(t X (t)) dt + b(t X (t)) dW (t): The solution X (t) is the factor. then the model admits an arbitrage by trading in zero-coupon bonds. we take r(t) to be X (t) (e. We let the interest rate r(t) be a function of X (t). 28.2 Some interest-rate dependent assets Coupon-paying bond: Payments P1 P2 : : : Pn at times T1 T2 : : : Tn. ZT t r(u) du F (t) # 0 t T T: We showed in Chapter 27 that dB (t T ) = r(t)B(t T ) dt + (t) (t) dW (t) for some process . T ) has mean rate of return r(t) under IP . If P such a measure does not exist. IP is a risk-neutral measure 28. If we want to have n-factors. HullWhite). we let W be an n-dimensional Brownian motion and let X be an n-dimensional process. is the interest rate r(t). (t) IE 1 (B (T T ) . we deﬁne the zero-coupon bond B (t T ) = (t) IE (1T ) F (t) " ( = IE exp . If the mean rate of return of B (t T ) under IP is not r(t) at each time t and for f each maturity T . In the usual one-factor models. Since B (t and there is no arbitrage. Now that we have an interest rate process prices to be fr(t) 0 t ) T g.g. we should change to a measure I under which the mean rate of return is r(t). Price at time t is X f k:t<Tk Pk B (t Tk ): g Call option on a zero-coupon bond: Bond matures at time Price at time t is T.. Cox-Ingersoll-Ross. the mean rate of return of B (t T ) under IP . K )+ F (t) 1 (T1) 0 t T1: . Option expires at time T1 < T.276 so IP is a risk-neutral measure if and only if (t T ).

1) . B (t T ) 0 t T Y (t T ) 0 t T T T: Determining is equivalent to determining 28. B(t (T T ) ) B(t T + ) = 0: + At time T . log B (t T + ) .4 Forward rate agreement Let 0 t T < T + T be given.2 (Yield to maturity) For 0 F (t)-measurable random-variable satisfying Y (t T ) is the B(t T ) exp f(T . t)Y (t T )g = 1 or equivalently. ( T+ The value of this portfolio at time t is Bt B(t T ) . at least theoretically.CHAPTER 28. the yield to maturity Deﬁnition 28. At time T + . Suppose you want to borrow $1 at time T with repayment (plus interest) at time T + . log B (t T ) : @ f (t T ) = lim R(t T T + ) = . Y (t T ) = . t T T . at an interest rate agreed upon at time t. you pay $ BBt(t T ) ) . The ( T+ effective interest rate on the dollar you receive at time T is R(t T T + ) given by B (t T ) = expf R(t T T + )g B (t T + ) or equivalently. the stochastic processes B(t T ) 0 t T for all T 2 (0 T ]. at time t buy a T -maturity zero and short BBt(t T ) ) (T + )-maturity zeroes. T 1 t log B(t T ): . Term-structure models 277 28. @T log B(t T ): The forward rate is #0 (4.1 (Term-structure model) Any mathematical model which determines. you receive $1 from the T -maturity zero.3 Terminology Deﬁnition 28. To synthesize a forward-rate agreement to do this. R(t T T + ) = .

f (t u) du t ( ) @ B (t T ) = .r(T ) exp .r(t) F (t) = . we obtain ZT t f (t u) du = .r(t): On the other hand. log B (t u) = . f (t u) du : t You can agree at time t to receive interest rate f (t u) at each time u 2 t T ]. Integrating the above equation. (Z T t f (t u) du = 1 ) 28. for money borrowed at time T .278 This is the instantaneous interest rate. Z T r(u) du F (t) @T t " @ @T B(t T ) T =t = . r(u) du F (t) t " ( ) # @ B (t T ) = IE . ZT @ @u log B(t u) du t u=T u=t = . ( ZT ) B (t T ) = exp . this will grow to T) B(t T ) exp at time T .f (t t): Conclusion: r(t) = f (t t). Z T f (t u) du @T t . log B (t T ) so ( ZT ) B(t T ) = exp . agreed upon at time t.5 Recovering the interest r (t) from the forward rate @ @T B(t T ) T =t = IE . ( ZT ) # B (t T ) = IE exp . If you invest $ B (t at time t and receive interest rate f (t u) at each time u between t and T .f (t T ) exp .

=g . (t u) dt + (t u) dW (t)] du t "Z T # "Z T # (t u) du dW (t) = r(t) dt . f (t u) du = f (t t) dt . ! + 1g 2 = B (t T ) r(t) . (t T ) dt . Recall that df (t T ) = (t T ) dt + (t T ) dW (t): ( ZT ) B(t T ) = exp . ZT t f (t u) du ( )2 dt ! i . f (t u) du : t Now ( ZT ) ZT d . dW ) dB (t T ) = dg . Term-structure models 279 28. let the forward rate be given by Zt Zt f (t T ) = f (0 T ) + 0 (u T ) du + Here f (u T ) 0 u T g and f (u T ) 0 u T g are adapted processes. 0 (u T ) dW (u) 0 t T: In other words. (t T )B(t T ) dW (t): h . 0 ZT t 00 t ZT f (t u) du f (t u) du (r dt . (t u) du dt . (t T ) dW (t): (t T ) (t T ) Let Then g(x) = ex g (x) = ex g (x) = ex: 0 00 B (t T ) = g . df (t u) du t t ZT = r(t) dt .6 Computing arbitrage-free bond prices: Heath-Jarrow-Morton method For each T 2 (0 T ].CHAPTER 28. t t {z } | {z } | = r(t) dt . (t T ) + 1 ( (t T ))2 dt 2 . and ZT t f (t u) du ! ! dt .

r. and deﬁne h (7. we obtain (t T ) = (t T ) ZT t (t u) du (7.68 (Heath-Jarrow-Morton) For each T 2 (0 (u T ) 0 u T ..2) also implies (7. A Z (T ) dIP 8A 2 F (T ): Zt 2 1 2 0 (u) du i dB (t T ) = B(t T ) r(t) . and deﬁne f W (t) = f IP (A) = Then Zt 0 (u) du + W (t) Z (t) = exp .1) ZT t (t u) du = 1 2 ZT t (t u) du !2 0 t T 0 t T Differentiating this w. be adapted processes. (t T ) + 1 ( (t T ))2 + (t T ) (t) dt 2 f .t. T yields the equivalent condition (t T ) = (t T ) (t T ) + (t T ) (t) 0 t T T : Theorem 7. (u T ) dW (u): f (t T ) = f (0 T ) + Zt 0 (u T ) du + Zt 0 . 0 t T T T: T: (7. (h T )B(t T ) dW (t) t i = B (t T ) r(t) .4) and Let T ]. Zt 0 Z (u) dW (u) . T . but there might still be a riskneutral measure. let (u T ) 0 u T (u T ) > 0 for all u and T .1). (7.2) Not only does (7. and assume f (0 T ) 0 t T .1) does not hold. Suppose (7.7 Checking for absence of arbitrage IP is a risk-neutral measure if and only if (t T ) = 1 ( (t T ))2 2 i.t.3) (7. (t T )B(t T ) dW (t) 0 t T: f In order for B (t T ) to have mean rate of return r(t) under I .280 28. be a deterministic function. Let f (t) 0 t T g be an adapted process.2). This will be a homework problem. we must have P (t T ) = 1 ( (t T ))2 + (t T ) (t) 0 t T T : 2 Differentiation w.r.e. Then IP is not a risk-neutral measure.1) imply (7. (t T ) + 1 ( (t T ))2 dt 2 .

we obtain for every maturity T : f dB(t T ) = r(t)B(t T ) dt . satisfying (7.3). (t T ) + 1 ( (t T ))2 2 (t) = . Term-structure models 281 t T T is a family of forward rate processes for a term-structure model Then f (t T ) 0 without arbitrage if and only if there is an adapted process (t) 0 t T .3).3) for . Remark 28. (The remainder of this chapter was taught Mar 21) " # Suppose the market price of risk does not depend on the maturity T . (t T ) and (7. is 1 .8 Implementation of the Heath-Jarrow-Morton model Choose (t T ) 0 t T T (t) 0 t T : .2 Under IP .CHAPTER 28. for every maturity T : df (t T ) = (t T ) (t T ) + (t T ) (t)] dt + (t T ) dW (t) f = (t T ) (t T ) dt + (t T ) dW (t): 28. (t T )B(t T ) dW (t): Because (7. The excess mean rate of return. or equivalently. we may plug (7.4) into the stochastic differential equation for f (t T ) to obtain. above the interest rate.4) is equivalent to (7.3) is satisﬁed. this becomes the market price of risk 1 .4). (t T ) + 2 ( (t T ))2 and when normalized by the volatility. so we can solve (7. the zero-coupon bond with maturity T has mean rate of return r(t) . satisfying (7. (t T ) + 1 ( (t T ))2 2 and volatility (t T ). (t T ) + 2 ( (t T ))2 : (t T ) The no-arbitrage condition is that this market price of risk at time t does not depend on the maturity T of the bond. Plugging this into the stochastic differential equation for B (t T ). We can then set .

4) implies This is because B (T vanish.1) this determines the interest rate process (8. @T log B (0 T ) 0 T T : Then f (t T ) for 0 t T is determined by the equation f df (t T ) = (t T ) (t T ) dt + (t T ) dW (t) r(t) = f (t t) 0 t T (8. (t T )B(t T ) dW (t): f Because all pricing of interest rate dependent assets will be done under the risk-neutral measure I . but are usually taken to be deterministic functions.3) in terms of W rather than f under which W W .1) and (8. the volatility in B (t T ) must T) 0 (t T ) 0 t T In conclusion.2) T and then the zero-coupon bond prices are determined by the initial conditions B (0 .3) we see that (t T . 1 2 Zt 0 2 (u) du T) 0 T T be determined by the market. A Zt (u) dW (u) . P f is a Brownian motion. and the process (t T ) = obtained from From (8. to implement the HJM model.282 These may be stochastic processes.4) (t T ). combined with the stochastic differential equation T) 0 T (8. it sufﬁces to have the initial market data B (0 T T and the volatilities T: .5) T ) = 1 and so as t approaches T (from below). Written this way.3) f dB(t T ) = r(t)B(t T ) dt . it is apparent that neither (t) nor (t T ) will enter subsequent computations. The only process which matters is (t T ) 0 t T T . gotten from the market. ZT t (t u) du 0 t T T (8. recall from equation (4. T ) is the volatility at time t of the zero coupon bond maturing at time (T T ) = 0 0 T T: (8. we have written (8. Equation (8. Deﬁne (t T ) = (t T ) (t T ) + (t T ) (t) f W (t) = Zt 0 (u) du + W (t) Z f(A) = Z (T ) dIP 8A 2 F (T ): IP 0 Let f (0 Z (t) = exp .1): @ f (0 T ) = .

4) will be satisﬁed because ZT @ (t T ) = (t T ) . @ f (0 T ) = . and we let B (t T ) 0 t P T T . The only parameter which must be estimated from the market is the bond volatility (t T ).5).2) and f (t T ) by (8. and volatility is unaffected by the change of measure. We can then deﬁne (t T ) = @ @T (t T ) and (8. @T log B (0 T ) 0 T T : . In (8. be given by (8. Term-structure models We require that 283 (t T ) be differentiable in T and satisfy (8. (t t) = @u (t u) du: t f f We then let W be a Brownian motion under a probability measure I .3 It is customary in the literature to write W rather than W and IP rather than I . so that IP is the symbol used for the risk-neutral measure and no reference is ever made to the market measure.CHAPTER 28.1) we use the initial conditions f f P Remark 28. where r(t) is given by (8.3).1).

284 .

1 If X is a Gaussian process. m(t))T dx1 : : : dxn = 2 (2 )n=2 det . then its distribution is determined by its mean function m(t) = IEX (t) and its covariance function (s t) = IE (X (s) .Chapter 29 Gaussian processes Deﬁnition 29. and m(t) = m(t1) m(t2) : : : m(tn)]. is a stochastic process with the property that for every set of times 0 t1 t2 : : : tn . the set of random variables X (t1) X (t2) : : : X (tn) is jointly normally distributed.1 (Gaussian Process) A Gaussian process X (t). t is the row vector t1 t2 : : : tn ]. the joint density of X (t 1) : : : X (tn) is IP fX (t1) 2 dx1 : : : X (tn) 2 dxng n o 1p exp . IE exp 2 6 (t1 t1) (t1 t2) :: :: :: = 6 (t2: :t1) (t2: :t2 ) : : : 6 : 4 : ) (t1 tn ) (t2 tn ) 7 7 7 3 The moment generating function is (X n where u = u1 u2 : : : un]. where is the covariance matrix x is the row vector ::: 5 (tn t1) (tn t2 ) : : : (tn tn ) x1 x2 : : : xn]. m(t)) 1 (x . m(t))]: Indeed. t 0. Remark 29. m(s)) (X (t) . 1 (x . k=1 uk X (tk ) = exp u m(t)T + 1 u 2 n uT o 285 .

. Indeed.286 29.1 An example: Brownian Motion Brownian motion W is a Gaussian process with m(t) = 0 and then (s t) = s ^ t. : . Zs 0 t 2(u) du: dX = dW: deuX (s) = ueuX (s) (s) dW (s) + 1 u2euX (s) 2 (s) ds 2 Zs Zs uX (s) = euX (0) + u euX (v) (v ) dW (v ) + 1 u2 euX (v) 2 (v ) dv e 2 IEeuX (s) = 1 + 1 u2 2 | 0 Zs 0 Martingale {z } 0 d IEeuX (s) = 1 u2 2(s)IEeuX (s) 2 ds Zs uX (s) = euX (0) exp 1 u2 2(v ) dv IEe 2 = exp 2(v ) dv 1 u2 2 0 2(v )IEeuX (v) dv Zs 0 (1. W (s)) + W 2 (s) = IEW (s):IE (W (t) . (s t) = IE W (s)W (t)] = IE W (s) (W (t) . We will want to show that IE exp fu1 X (s) + u2X (t)g = exp u1 m1 + u2 m2 + Theorem 1.) We have Therefore. which we usually call s and t. and shall cheat a bit by considering only two times.1) Rs This shows that X (s) is normal with mean 0 and variance 0 2(v ) dv . Then Z ( 1 u1 u2 ] 2 " 11 21 12 22 # " #) u1 u2 : W (t) be a Brownian motion and (t) a nonran(u) dW (u) ^ X (t) = t is a Gaussian process with m(t) = 0 and 0 (s t) = Proof: (Sketch. a Brownian) Let dom function. We shall use the m.f. if 0 s t.r. W (s)) + IEW 2 (s) = IEW 2(s) = s ^ t: h i To prove that a process is Gaussian.t.g.69 (Integral w. one must show that X (t 1) : : : X (tn) has either a density or a moment generating function of the appropriate form.

2) Zt s 2(v ) dv We now compute the m. Gaussian processes 287 s < t be given. deuX (t) = ueuX (t) (t) dW (t) + 1 u2euX (t) 2 (t) dt: 2 Integrate from s to t to get Now let 0 euX (t) = euX (s) + u Take IE Zt IE Zt s : : : jF (s)] conditional expectations and use the martingale property (v )euX (v) dW (v ) F (s) = IE =0 Zt uX (v) dW (v ) + 1 u2 2 (v )euX (v) dv: (v )e 2 s s Zt 0 (v )euX (v) dW (v ) F (s) .f. Zs 0 (v )euX (v) dW (v ) to get The solution to this ordinary differential equation with initial time s is d uX (t) F (s) = 1 u2 2(t)IE euX (t) F (s) 2 dt IE e IE euX (t) F (s) = euX (s) exp 1 u2 2 IE euX (t) F (s) = euX (s) + 1 u2 2 Zt s 2 (v )IE euX (v) F (s) dv t s: t s: (1. for (X (s) X (t)).2) (u1 +u2 )X (s) 1 (v ) dv = e exp 2 u2 2 s h i IE eu1 X (s)+u2 X (t) = IE IE eu1X (s)+u2 X (t) F (s) Z = IE e(u1 +u2 )X (s) : exp This shows that (X (s) X (t)) is jointly normal with IEX (s) = IEX (t) = 0. t 2 1 u2 2 2 s (v ) dv Zs Zt (1.g.CHAPTER 29. Just as before.1) 2 (v ) dv + 1 u2 2 = exp 1 (u1 + u2 )2 2 2 2 s (v ) dv 0 Zs Zt 2 + 2u u ) 2(v ) dv + 1 u2 2 1 (u = exp 2 1 1 2 2 2 0 (v ) dv "R s 2 0R s 2# " #) ( 1 = exp 2 u1 u2 ] R0s 2 R0t 2 u1 : u2 0 0 n o Z IEX 2(s) = Zs 0 2 (v ) dv IE X (s)X (t)] = Zs 0 IEX 2(t) = Zt 0 2 (v ) dv 2(v ) dv: . where 0 s t: IE eu1 X (s)+u2X (t) F (s) = eu1 X (s)IE eu2X (t) F (s) t 2 (1.

so its distribution is not 0 determined from its mean and covariance functions. Zs 2(s) = IE X (s)X (t)] = IEX IE 2(v) dv: 0 However. IE X (s)X (t)] = IE X (s)(X (t) . X (t) = is a martingale and X (0) = 0. in fact.3 When is nonrandom. The equation (1. X (s)) + X 2(s)] Zs 2 (v ) dv: = IEX 2(s) = 0 If were a stochastic proess. For 0 o s t. when is stochastic. The computation of means and variances does not require the use of moment generating functions. We proved this before. X (t) is normal with mean X (s) and variance st 2(v ) dv . but note again that the Markov property follows immediately from (1. IEX 2(s) = Zs X (t) = Zt 0 (u) dW (u) is also Markov. IE X (s)(X (t) . is to prove the normality. X (s) 7 6 7 4 | {z }5 = 0: 0 Therefore.288 Remark 29. Indeed. the distribution of X (t) depends only R on X (s).2 The hard part of the above argument. X (s))] = IE IE X (s)(X (t) . and the reason we use moment generating functions. so For ﬁxed s Zt 0 (u) dW (u) 0.2) says that conditioned on F (s). the Itˆ isometry says o IE 2(v ) dv and the same argument used above shows that for 0 s t. Remark 29. .2). X (s)) F (s) 2 3 6 7 = IE 6X (s) IE X (t) F (s) . m(t) = IEX (t) = 0 8t 0: IEX 2(s) = Zs 0 2(v ) dv by the Itˆ isometry. X is not necessarily a Gaussian process.

70.3) holds. and let (t) and h(t) be nonrandom functions.70 Let Deﬁne W (t) be a Brownian motion. X (t) = Zt 0 z (u) dW (u) Y (t) = Zt 0 h(u)X (u) du: Then Y is a Gaussian process with mean function m Y (t) = 0 and covariance function Y (s t) = Zs 0 ^ t 2 (v ) Zs v h(y ) dy Zt v h(y) dy dv: (1. Zt 0 h(u) IEX (u) du = 0 .3) Proof: (Partial) Computation of Y (s t): Let 0 s t be given. Here we observe that mY (t) = IEY (t) = and we verify that (1. It is shown in a homework problem that (Y (s) Y (t)) is a jointly normal pair of random variables.CHAPTER 29.1: Range of values of y z v for the integrals in the proof of Theorem 1. Theorem 1. Gaussian processes y= v= 289 z z z z s y t (a) y= s v (b) z s v y t (c) Figure 29.

4 Unlike the process X (t) = R t (u) dW (u). 29.1(c)) h(z ) dz dv h(y ) dy dv t Remark 29.1(a)) Zz 0 2(v ) dv = Z sZ 0 Z 0 + Zs 0 z h(y ) Zs y h(z ) dz Zy 0 2 (v ) dv = Z sZ 0 Z v + sZ y h(z ) 2 (v ) Zt z 2(v ) dv h(y ) dy dv dz 0 0 s h(z ) 2(v ) h(y ) 2(v ) Zs y Zt z h(z ) dz dv dy h(z) dz dy dv = Zs 0 + sZ s h(y ) dy dz dv 0 v Z0s 2 (v ) = 0 Zs 2 (v ) = 0 = Zs + Zs 0 2 (v ) Z sZ t v Z z h(y ) 2(v ) sZ s Zs y (See Fig. 29. 29. the process Y (t) = R t X (u) du is 0 0 .1(b)) h(y )h(z) dy dz dv h(y )h(z) dz dy dv h(y )h(z) dy dz dv 2 (v ) 2 (v ) Z v y sZ t Zv s v Zv v s h(y ) dy h(y ) dy Zt Zv v (See Fig.290 We have Y (s t) = IE Y (s)Y (t)] Zs Zt = IE h(y )X (y ) dy: h(z )X (z) dz = IE = = = = Z s0 Z t 0 0 Z sZ t 0 h(y)h(z )X (y)X (z ) dy dz Z0s Z0t Z0s Z0t 0 Z z h(y )h(z)IE X (y )X (z )] dy dz h(y )h(z ) Zy 0 Z ^ z 2 (v ) dv dy dz Zs 0 + sZ s 0 y h(y )h(z ) z h(z ) Zt z h(y )h(z) h(y ) dy 0 Zy 0 2 (v ) dv dy dz dz dy dz dy (See Fig.

. Gaussian processes neither Markov nor a martingale. The conditional expectation IE not equal to Y (s).CHAPTER 29. For 0 291 IE Y (t)jF (s)] = Zs 0 s < t. h(u)X (u) du + IE Zt s = Y (s) + = Y (s) + Zt Zt s s h(u)X (u) du F (s) h(u)IE X (u) F (s)] du h(u)X (s) du = Y (s) + X (s) Zt s h(u) du Y (t)jF (s)] is where we have used the fact that X is a martingale. nor is it a function of Y (s) alone.

292 .

69 in Chapter 29. Zt 0 ^ eK(u) (u) du (0.2) The process r(t) is also Markov.Chapter 30 Hull and White model Consider where (t). K (t) = We can solve the stochastic differential equation.1) r (s t) = e . (t)r(t)) dt + (t) dW (t) (t) are nonrandom functions of t. K (t) r(0) + . Set Zt 0 (u) du: Then d eK (t)r(t) = eK(t) (t)r(t) dt + dr(t) = eK (t) ( (t) dt + (t) dW (t)) : Integrating. K (s) K (t) Zs 0 t 2K (u) 2 e (u) du: (0. we see that r(t) is a Gaussian process with mean function mr (t) = e and covariance function . 293 . we get eK (t)r(t) = r(0) + so Zt 0 eK(u) eK(u) (u) du + Zt 0 eK (u) (u) dW (u) eK(u) (u) dW (u) : r(t) = e . (t) and dr(t) = ( (t) . K (t) r(0) + Zt 0 (u) du + Zt 0 From Theorem 1.

we deﬁne X (t) = Then Zt 0 eK (u) (u) dW (u) Y (T ) = K (t) ZT 0 e . Its mean is r(0) + e . e .294 RT We want to study 0 r(t) dt.70 in Chapter 29.r(0) e K (t) dt . r(0) + Zt 0 K (t) X (t) eK (u) (u) du dt + Y (T ): RT According to Theorem 1. 1 2 ZT 0 e2K (v) 2(v ) ZT v e .1)IE r(t) dt + 2 r(t) dt 0 0 ZT ZTZ t = exp .3) var ZT 0 r(t) dt = IEY 2(T ) = ! ZT 0 e2K(v) 2(v ) ZT v e . To do this. K (t) X (t) dt: ZT 0 r(t) = e r(t) dt = . K (y) dy dv C (0 T ) = A(0 T ) = ZT 0 0 Z TZt 0 e . e K (t)+K (u) (u) du dt 0 0 0 !2 ZT ZT . . 1 +2 = expf. K (t) dt e .1)2 var = exp (. K (t)+K (u) (u) du dt . ZT 0 r(0) + K (t) Zt 0 eK(u) (u) du + e . K (y) dy !2 dv: The price at time 0 of a zero-coupon bond paying $1 at time T is ( ZT ) B (0 T ) = IE exp . r(t) dt 0 ( !) ZT ZT 1 (. A(0 T )g where 0 e2K (v) 2 (v ) v e . K (y ) dy !2 dv: . 0 IE and its variance is ZT 0 r(t) dt = ZT 0 r(t) dt is normal. K (t) Zt 0 eK (u) (u) du dt (0.r(0)C (0 T ) .

1) ZTZ t 0 = (y = t v = u) = Therefore. Z Z 0 TZ T 0 0 e . this should be random only through a dependence on r(t). A(0 T )g : . Consider the price at time t 2 ( ZT ) # B(t T ) = IE exp . 1 e2K (v) 2(v ) 2 ! ZT v !23 e K(y) dy 5 dv .1 Fiddling with the formulas Note that (see Fig 30.r(0)C (0 T ) . K (y) dy .1: Range of values of u u t for the integral.r(t)C (t T ) . Hull and White model 295 T u Figure 30. = dv: t t C (0 T ) = e K(y) dy 0 B(0 T ) = exp f. K (t)+K (u) (v ) ZT v e ! . Z T2 Z 4eK(v) (v) T e A(0 T ) = 0 v ZT . B (t T ) = exp f. In fact. A(t T )g .CHAPTER 30. 30. K (t)+K (u) (u) du dt (u) dt du K (y) dy u T eK (v) e . r(u) du F (t) : t 0 T ] of the zero-coupon bond: " Because r is a Markov process.

296 where

C (t T ) = eK(t)

Z T2 Z 4eK(v) (v) T e A(t T ) = t v ZT

t

;

K (y) dy

!

; 1 e2K(v) 2(v) 2

ZT

v

!23 e K(y) dy 5 dv

;

e

;

K (y) dy:

The reason for these changes is the following. We are now taking the initial time to be t rather than RT R zero, so it is plausible that 0 : : : dv should be replaced by tT : : : dv: Recall that

K (v ) =

and this should be replaced by

Zv

0

(u) du

K (v ) ; K (t) =

Zv

t

(u) du:

Similarly, K (y ) should be replaced by K (y ) ; K (t). Making these replacements in A(0 see that the K (t) terms cancel. In C (0 T ), however, the K (t) term does not cancel.

T ), we

**30.2 Dynamics of the bond price
**

Let Ct(t

T ) and At (t T ) denote the partial derivatives with respect to t. From the formula

B (t T ) = exp f;r(t)C (t T ) ; A(t T )g

we have

dB (t T ) = B (t T ) ;C (t T ) dr(t) ; 1 C 2(t T ) dr(t) dr(t) ; r(t)Ct(t T ) dt ; At (t T ) dt 2

= B (t T ) ; C (t T ) ( (t) ; (t)r(t)) dt

h

i

; C (t T ) (t) dW (t) ; 1 C 2(t T ) 2(t) dt 2 ; r(t)Ct(t T ) dt ; At(t T ) dt :

Because we have used the risk-neutral pricing formula

) # ( ZT B(t T ) = IE exp ; r(u) du F (t) t "

dB(t T ) = r(t)B(t T ) dt + (: : : ) dW (t):

to obtain the bond price, its differential must be of the form

**CHAPTER 30. Hull and White model
**

Therefore, we must have

297

;C (t T ) ( (t) ; (t)r(t)) ; 1 C 2(t T ) 2(t) ; r(t)Ct(t T ) ; At(t T ) = r(t): 2

We leave the veriﬁcation of this equation to the homework. After this veriﬁcation, we have the formula

**dB (t T ) = r(t)B (t T ) dt ; (t)C (t T )B(t T ) dW (t): In particular, the volatility of the bond price is (t)C (t T ).
**

30.3 Calibration of the Hull & White model

Recall:

C (t T ) = eK(t) e K(y) dy t B (t T ) = exp f;r(t)C (t T ) ; A(t T )g :

;

ZT2 Z 4eK(v) (v) T e A(t T ) = t v ZT

0

dr(t) = ( (t) ; (t)r(t)) dt + (t) dB(t) Zt K (t) = (u) du

;

K (y)

dy ; 1 e2K (v) 2 (v ) 2

!

ZT

v

!2 3 e K (y) dy 5 dv

;

Suppose we obtain B (0 determine the functions

T ) for all T 2 0 T ] from market data (with some interpolation). Can we (t), (t), and (t) for all t 2 0 T ]? Not quite. Here is what we can do.

;

We take the following input data for the calibration: 1. 2. 3. 4. 5.

B (0 T ) 0 T T r(0);

(0); (t) 0 t T

(usually assumed to be constant);

(0)C (0 T ) 0 T

T

, i.e., the volatility at time zero of bonds of all maturities.

Step 1. From 4 and 5 we solve for

C (0 T ) =

ZT

0

e

;

K (y)

dy:

298 We can then compute

We now have

**@ C (0 T ) = e K(T ) @T @ =) K (T ) = ; log @T C (0 T ) @ K (T ) = @ Z T (u) du = (T ): @T @T 0 (T ) for all T 2 0 T ].
**

;

Step 2. From the formula

B(0 T ) = expf;r(0)C (0 T ) ; A(0 T )g we can solve for A(0 T ) for all T 2 0 T ]. Recall that

Z T2 ZT A(0 T ) = 4eK (v) (v ) e

0

v

;

K (y) dy

!

; 1 e2K(v) 2(v) 2

T

as follows:

ZT

v

!23 e K (y) dy 5 dv:

;

We can use this formula to determine

**ZT @ A(0 T ) = K (v) (v )e K (T ) ; e2K (v) 2 (v )e K (T ) e e K (y) dy dv @T 0 v !# Z " ZT K (T ) @ A(0 T ) = T eK (v) (v ) ; e2K (v) 2 (v ) K (y) dy e @T e dv 0 v @ eK (T ) @ A(0 T ) = eK (T ) (T ) ; Z T e2K(v) 2(v ) e K (T ) dv @T @T 0 @ eK (T ) @ A(0 T ) = e2K (T ) (T ) ; Z T e2K(v) 2 (v ) dv eK(T ) @T @T 0 @ eK(T ) @ eK (T ) @ A(0 T ) = (T )e2K (T ) + 2 (T ) (T )e2K(T ) ; e2K (T ) 2(T ) 0 T T : @T @T @T
**

; ; ; ; ; 0 0

(T ) 0 T

ZT"

!#

This gives us an ordinary differential equation for , i.e.,

(t)e2K (t) + 2 (t) (t)e2K (t) ; e2K (t) 2(t) = known function of t:

From assumption 4 and step 1, we know all the coefﬁcients in this equation. From assumption 3, we have the initial condition (0). We can solve the equation numerically to determine the function (t) 0 t T . Remark 30.1 The derivation of the ordinary differential equation for (t) requires three differentiations. Differentiation is an unstable procedure, i.e., functions which are close can have very different derivatives. Consider, for example,

f (x) = 0 8x 2 IR g (x) = sin(1000x) 8x 2 IR: 100

**CHAPTER 30. Hull and White model
**

Then

299

1 jf (x) ; g(x)j 100 8x 2 IR

but because

g (x) = 10 cos(1000x)

0

we have for many values of x.

jf (x) ; g (x)j = 10

0 0

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.

**30.4 Option on a bond
**

Consider a European call option on a zero-coupon bond with strike price K and expiration time T 1 . The bond matures at time T2 > T1. The price of the option at time 0 is R T1 r(u) du ; +

R T1 r(u) du 0 (expf;r(T1)C (T1 T2) ; A(T1 T2)g ; K )+ : Z Z + = e x expf;yC (T1 T2) ; A(T1 T2)g ; K f (x y) dx dy RT where f (x y ) is the joint density of 0 1 r(u) du r(T1) . R We observed at the beginning of this Chapter (equation (0.3)) that 0T1 r(u) du is normal with "Z T1 # Z T1

= IEe

; 1 1 ; ;1 ;1

IE e

0

(B (T1 T2) ; K )

1 = IE

4

0

r(u) du =

=

Z T1

0

0

IEr(u) du r(0)e

;

2 = var 1

4

"Z T1

0

r(u) du =

# Z0T1

K (v) + e K (v)

;

Zv

0

e2K (v) 2(v )

Z T1

v

eK(u) (u) du dv

e

;

K (y) dy

!2

dv:

**We also observed (equation (0.1)) that r(T1) is normal with
**

4 ; ;

Z T1 = IEr(T1) = r(0)e K (T1) + e K (T1 ) eK (u) (u) du 2

;

2 = var (r(T )) = e 2K (T1 ) 1 2

4

Z T1

0

0 2K (u) 2 (u) du: e

300 In fact,

R T1 r(u) du r(T ) 1 0

is jointly normal, and the covariance is

1 2 = IE

"Z T1

0

= =

Z T1 Z T1

0 0

(r(u) ; IEr(u)) du: (r(T1) ; IEr(T1))

#

**IE (r(u) ; IEr(u)) (r(T1) ; IEr(T1))] du
**

r (u T1) du

where r (u

T1) is deﬁned in Equation 0.2.

The option on the bond has price at time zero of

Z

1

Z

1

;1

;1

e

;

x

expf;yC (T1 T2) ; A(T1 T2)g ; K 2

1

+

1 p 2 1;

2 2 exp ; 2(1 ; 2) x2 + 2 xy + y 2 2 1 2 1 2

(

1

"

#)

dx dy:

(4.1)

The price of the option at time t 2

0 T1] is

IE e

;

R T1 r(u) du

t

(B (T1 T2) ; K )+ F (t)

;

= IE e

R T1 r(u) du

t

(expf;r(T1)C (T1 T2) ; A(T1 T2)g ; K )+ F (t)

(4.2)

Because of the Markov property, this is random only through a dependence on r(t). To compute R this option price, we need the joint distribution of tT1 r(u) du r(T1) conditioned on r(t). This

**CHAPTER 30. Hull and White model
**

pair of random variables has a jointly normal conditional distribution, and

301

1 (t) = IE

"Z T1

t

2 Z 3 !2 T1 2 (t) = IE 4 r(u) du ; 1(t) F (t)5 1 t !2 Z T1 Z T1

=

t

=

Z T1

t

r(u) du F (t)

;

#

r(t)e

K (v)+K (t) + e K (v)

;

Zv

t

eK (u) (u) du dv

e2K (v) 2(v )

v

e

;

K (y) dy

dv

2 (t) = IE

Z T1 = r(t)e K (T1 )+K (t) + e K (T1 ) eK(u) (u) du

; ;

r(T1) r(t)

2 (t) = IE 2

(r(T1) ;

2K (T1 )

=e

;

Z T1

t

2

(t))2

F (t) !

t

(t) 1 (t) 2 (t) = IE =

t

" Z T1

t

e2K (u) 2 (u) du

Z T1

e

;

Z K (u) K (T1 ) u e2K (v) 2 (v ) dv du: t

;

r(u) du ; 1 (t) (r(T1) ; 2(t)) F (t)

#

The variances and covariances are not random. The means are random through a dependence on r(t). Advantages of the Hull & White model: 1. Leads to closed-form pricing formulas. 2. Allows calibration to ﬁt initial yield curve exactly. Short-comings of the Hull & White model: 1. One-factor, so only allows parallel shifts of the yield curve, i.e.,

B (t T ) = exp f;r(t)C (t T ) ; A(t T )g

so bond prices of all maturities are perfectly correlated. 2. Interest rate is normally distributed, and hence can take negative values. Consequently, the bond price " ( ) #

B (t T ) = IE exp ;

ZT

t

r(u) du F (t)

can exceed 1.

302

It always has a drift toward the origin. we have r(t) = X1 (t) and for each t.Chapter 31 Cox-Ingersoll-Ross model In the Hull & White model. there is a positive probability that r(t) < 0. 1 (s+t) Z s t u 2 e 0 du: Deﬁne 2 2 2 r(t) = X1 (t) + X2 (t) + : : : + Xd (t): 2 If d = 1.1) IP There are inﬁnitely many values of t > 0 for which r(t) = 0 303 = 1 . let Xj (0) 2 IR be given so that : : : Wd ) . Since. 1 Xj (t) dt + 1 dWj (t): 2 2 Xj is called the Orstein-Uhlenbeck process. We begin with a d-dimensional Brownian motion (W 1 W2 constants. Zt 0 e 2 u dWj (u) : 1 This solution is a Gaussian process with mean function mj (t) = e and covariance function 1 2 t Xj (0) ^ (s t) = 1 2 e 4 4 . IP fr(t) > 0g = 1. The Cox-Ingersoll-Ross model is the simplest one which avoids negative interest rates. 1 2 t Xj (0) + 1 2 . but (see Fig. For j = 1 : : : d. for each t. 31. r(t) is a Gaussian process. The solution to this stochastic differential equation is Xj (t) = e . Let > 0 and > 0 be 2 2 2 X1 (0) + X2 (0) + : : : + Xd (0) 0 and let Xj be the solution to the stochastic differential equation dXj (t) = . r(t) is normally distributed.

1: r(t) can be zero.304 r(t) = X 1 (t) 2 t x2 ( X (t). 1 Xi dt + 1 dWi(t) + 2 2 d X i !=1 dWi dWi = .1) IP fThere is at least one value of t > 0 for which r(t) = 0g = 0: Let f (x1 x2 : : : xd) = x2 + x2 + : : : + x2 . r(t) dt + r(t) p i(t) dWi(t): i=1 r(t) Deﬁne Xi dWi + d4 dt 2 d X Z t Xi(u) p dWi(u): W (t) = r(u) i=1 0 . X (t) ) 2 1 x 1 Figure 31. If d 2. Then 1 2 d fxi = 2xi fxi xj = 2 0 d X i=1 ( if i = j if i 6= j: Itˆ ’s formula implies o dr(t) = = d X i=1 d X i=1 fxi dXi + 1 2 fxi xi dXi dXi d X1 i=1 4 2 2Xi . (see Fig. 31. r(t) dt + 2 d q XX = d4 .

. If d < 2 (i. Xi (t) is normal with mean zero and variance 2 (t t) = 4 (1 . 305 d X Xi dW = pr dWi dW dW = d X Xi2 i=1 i=1 r dt = dt so W is a Brownian motion.e. 1 2 ).e. Cox-Ingersoll-Ross model Then W is a martingale. . We have ! d 2 . 1. d= 4 2 is a positive 0 be given. If d 2 (i. then but we do not require d to be an integer. then we have the representation d = 4 2 > 0: d X i=1 r(t) = Xi2(t) <1 2 2). Let r(0) . then 2 IP fThere is at least one value of t > 0 for which r(t) = 0g = 0: With the CIR process.CHAPTER 31.. IP fThere are inﬁnitely many values of t > 0 for which r(t) = 0g = 1: This is not a good parameter choice. e t ): . r(t)) dt + The Cox-Ingersoll-Ross (CIR) process is given by q r(t) dW (t) We deﬁne If d happens to be an integer. For example. r(t) dt + qr(t) dW (t): dr(t) = 4 dr(t) = ( . one can derive formulas under the assumption that integer. Take X1(0) = 0 X2(0) = 0 : : : Xd 1(0) = 0 Xd(0) = r(0): For i = 1 q 2 : : : d . and they are still correct even when d is not an integer. here is the distribution of r(t) for ﬁxed t > 0.

We have d X Xi(t) !2 p r(t) = (t t) : (t t) i=1 2 2 As t!1.2 2 e . The chi-square density with 4 2 degrees of freedom is f (y ) = We make the change of variable r = 4 1 2 = 2.1) 2 Thus r(t) has a non-central chi-square distribution. 2 2 e . 2 2 r: We computed the mean and variance of r(t) in Section 15. y=2 : y. 1 q 2 t r(0) r(t) = Chi-square with d . 31. .306 Xd (t) is normal with mean and variance (t t). and so the limiting distribution of r(t) is 4 times a chi-square with d = 4 2 degrees of freedom.7. Then md(t) = e d 1 X . 2 2 2 4 r 2 2 . 2 2 e .2 Normal squared and independent of the other 2 Xd (t) | {z } (0. md (t)!0. 31. The limiting density for r(t) is 2 2 p(r) = 4 2 : 1 2 = 2. 1 22 r 2 . 2 2 r = 22 .2 Kolmogorov forward equation Consider a Markov process governed by the stochastic differential equation dX (t) = b(X (t)) dt + (X (t)) dW (t): . 1 = freedom | (t t) i=1 {z X p i((tt)t) 4 !2 } degrees of + term . we have (t t) = 4 .1 Equilibrium distribution of r (t) As t!1. 2 2 22 y 2 .

Since 0 and x will not change during the following. Cox-Ingersoll-Ross model 307 h 0 -y Figure 31. Itˆ ’s formula implies o The Kolmogorov forward equation (KFE) is a partial differential equation in the “forward” variables dh(X (t)) = h (X (t))b(X (t)) + 1 h (X (t)) 2(X (t)) dt + h (X (t)) (X (t)) dW (t) 2 0 00 0 h i so h(X (t)) = h(X (0)) + Z th 0 0 Zt 0 h (X (s))b(X (s)) + 1 h (X (s)) 2 (X (s)) ds + 2 0 00 i h (X (s)) (X (s)) dW (s) IEh(X (t)) = h(X (0)) + IE Z th 0 h (X (s))b(X (s)) dt + 1 h (X (s)) 2 (X (s)) ds 2 0 00 i . 31. Z 1 0 h(y )p(t y ) dy t and y . We have IEh(X (t)) = for any function h.CHAPTER 31.2: The function h(y ) Because we are going to apply the following analysis to the case X (t) 0 for all t. Then X (t) is random with density p(0 t x y ) (in the y We start at X (0) = x variable). X (t) = r(t).2). we omit them and write p(t y ) rather than p(0 t x y ). Let h(y ) be a smooth function of y 0 which vanishes near y = 0 and for all large values of y (see Fig. We derive it below. we assume that 0 at time 0.

then we could take points. Z 0 1 Z @ @2 h(y ) @y (b(y )p(t y )) dy + 1 h(y ) @y2 2 0 1 2(y )p(t y ) dy or equivalently.308 or equivalently. 1 Z 0 1 @ h(y ) @y (b(y )p(t y)) dy 1 {z y) y=0 } .2. and we would obtain h(y ) > 0 at that and nearby Z 1 0 @ @2 h pt + @y (bp) . Z 0 1 h(y)p(t y) dy = h(X (0)) + Z tZ 1 1 Zt 1 2 0 0 Z0 0 h (y )b(y )p(s y) dy ds + 0 h (y ) 2 (y)p(s y) dy ds: 00 Differentiate with respect to t to get Z 1 0 h(y)pt(t y) dy = Z 1 0 h (y )b(y )p(t y ) dy + 1 2 0 Z 0 1 h (y ) 2 (y)p(t y ) dy: 00 Integration by parts yields Z 0 1 h (y)b(y)p(t y ) dy = h(y)b(y )p(t y ) 0 y= 1 Z 0 | 1 h (y ) 00 2(y )p(t y) dy = h (y) 0 | 2 (y )p(t =0 =0 {z y=0 } y= . Z 0 1 h(y)pt(t y) dy = . Z 0 @ h (y ) @y 0 2(y )p(t y ) dy 2(y )p(t @ = . 1 @y2 2 @ @2 pt(t y) + @y ((b(y )p(t y )) .h(y ) @y | 2(y )p(t =0 {z y) y= 1 y=0 } + Z 0 1 @2 h(y) @y 2 y ) dy: Therefore. It implies that 2 (y )p(t y) = 0: (KFE) If there were a place where (KFE) did not hold. Z 0 1 @ @2 h(y) pt(t y ) + @y (b(y )p(t y )) . 1 @y 2 2 " 2 (y )p(t y) # dy = 0: This last equation holds for every function h of the form in Figure 31. but take h to be zero elsewhere. 1 @y2 ( 2p) dy 6= 0: 2 " # .

3 Cox-Ingersoll-Ross equilibrium density We computed this to be p(r) = Cr where 2 .CHAPTER 31. 1 ( . 2 2 r C = 22 We compute 2 2 . 1 @ 2 ( 2 rp(r)) = 0: 2 @r2 @r (EKFE) . r) . it is the unique solution to this equation satisfying p(y ) 0 8y 0 Z 1 0 p(y ) dy = 1: 31. we obtain the equilibrium Kolmogorov forward equation 0 = t! pt (t y ): lim 1 @ (b(y)p(y )) . r)2 p(r) = 2r r 2 2 2r 0 We want to verify the equilibrium Kolmogorov forward equation for the CIR process: @ (( . 1 @ 2 2 @y 2 @y 2 (y )p(y ) = 0: When an equilibrium density exists. 1 2 . r p (r) 2 2 2 2 2 . : p(rr) . )p(r) + 2r . r)p(r)) . 1 2 . it will be 309 p(y ) = t! p(t y ): lim 1 In order for this limit to exist. Cox-Ingersoll-Ross model If the process X (t) has an equilibrium density. 1 22 : p (r) = . we must have Letting t!1 in (KFE). 1 2 . r p(r) + 2r (. 2 2 p(r) 2 2 1 2 = 2 r . 22r2 00 2 p (r) = 2 . 2 . r p(r) 0 . + 2 ( . 1 2 .2 2 e .

r)2 as expected. r(u) du B (t T ) = IE exp . r) =0 1 + r( 2 2 2r . The Markov property implies that B (t T ) is random only through a dependence on r(t). 1 2 .310 Now @ (( . B(t T ) = B(r(t) t T ): . 2 r ( 2 2 1 . there is a function B (r t T ) of the three dummy variables r t T such that the process B (t T ) is the function B (r t T ) evaluated at r(t) t T . r)p(r)) = .e. 1 2 . r)2 2 2 2 = p(r) ( . The bond price process is q r(t) dW (t) ( ZT ) # B(t T ) = IE exp . r)p (r) . 2r ( . r(u) du F (t) Zt 0 0 " the tower property implies that this is a martingale. r) = p(r) . r) 2 ( . 2p (r) . r) . 1 2 . 31. 1 2 .. 1 2 . + ( . r . p(r) + ( . p(r) + ( . r(t)) dt + where r(0) is given. 1 2rp (r) 2 2 ( .4 Bond prices in the CIR model The interest rate process r(t) is given by dr(t) = ( . r) + . r)p (r) @r @ 2 ( 2 rp(r)) = @ ( 2 p(r) + 2rp (r)) @r2 @r = 2 2 p (r) + 2rp (r): 0 0 0 00 The LHS of (EKFE) becomes . r) 2 2 2r . r(u) du F (t) : t " Because ( ZT ) # exp . 1 2 2 ( . 2 ) 2 r 2 0 0 00 1 + r ( . i. 1 2 . 2 2 . Thus. 1 2 .

Ct(t T ) + C (t T ) + 1 2C 2(t T ) = 0 C (T T ) = 0 2 and then set A (t T ) = ZT t C (u T ) du .rB dt + Br ( . At)B Br = . rB(r t T ) + Bt (r t T ) + ( . r)CB + 1 2 rC 2B 2 1 2 C 2 ) . Surprisingly.rB + (. 0 r(u) du B(r(t) t T ) is a martingale. At )B . we obtain the partial differential equation . r) dt + Br 1 + 2 Brr 2 r dt + Bt dt: pr dW Setting the dt term to zero. r(u) du B (r(t) t T ) r(u) du . = exp . B (A t + C ) = rB (.CHAPTER 31. this equation has a closed form solution. We comZt Z0t 0 d exp .rCt . Then we have Bt = (.1 . r)Br (r t T ) + 1 2rBrr (r t T ) = 0 2 The terminal condition is 0 t < T r 0: (4. Using the Hull & White model as a guide.1 . we look for a solution of the form .1) B(r T T ) = 1 r 0: B (r t T ) = e rC (t T ) A(t T ) . Ct + C + 2 We ﬁrst solve the ordinary differential equation . its differential has no dt term.rCt .CB Brr = C 2B and the partial differential equation becomes 0 = . Cox-Ingersoll-Ross model Because exp pute 311 n Rt o .r(t)B(r(t) t T ) dt + Br (r(t) t T ) dr(t) + t T ) dr(t) dr(t) + Bt (r(t) t T ) dt : 1 Brr (r(t) 2 The expression in : : : ] equals = . where C (T T ) = 0 A(T T ) = 0. ( .

0 Now r(u) > 0 for each u. r(t)) dt + r(t) dW (t) do not depend on t. A( )g 0 r 0 where q C ( ) = cosh( sinh( 1 )sinh( ) )+ 2 2 1 2 log 4 e2 A( ) = . r(u) du : T ) is strictly decreasing in T . = We have 1 2 q 2 cosh( ) + 1 sinh( ) 2 3 5 2 + 2 2: ( ZT ) B(r(0) T ) = IE exp .rC (t T ) . C (t T ) and A(t T ) are functions of = T . We write B(r ) instead of B (r t T ). t. t)) + 1 sinh( (T . t)) + 1 sinh( (T . almost surely. 2 cosh( (T .rC ( ) . C (t T ): It is tedious but straightforward to check that the solutions are given by C (t T ) = sinh( (T . Similarly. t)) cosh( (T . t)) 2 2 3 1 2 log 4 e 2 (T t) 5 A(t T ) = . u u cosh u = e + e : 2 .312 so A(T T ) = 0 and At (t T ) = . Because the coefﬁcients in dr(t) = ( . e 2 . we have ( ZT ) # IE exp . A(t T )g 0 t < T r 0 and C (t T ) and A(t T ) are given by the formulas above. and we have B(r ) = exp f. r(u) du F (t) = B (r(t) t T ) t " where B(r t T ) = exp f. t)) 2 . Moreover. so B (r(0) B (r(0) 0) = 1 . the function B (r t T ) depends on t and T only through their difference = T . Thus in the CIR model. where = 1 2 q 2+2 2 u u sinh u = e . t.

the interest rate r(t) is given by the constant coefﬁcient CIR equation q dr(t) = ( . 31.CHAPTER 31.rv + vt + ( . ^(t)^(t)) dt + ^ (t) r(t) dW (t): ^^ q . 0t r(u) du v(t r(t)) is a martingale. As usual. K ) t " where T1 is the expiration time of the option.r(0)C (T ) . 31. and this leads to the partial differential equation (where v = v (t r). r)vr + 1 2rvrr = 0 0 t < T1 r 0: 2 v(T1 r) = (B (r T1 T2) . exp . r(t)) dt + r(t) dW (t): Real time scale: In this time scale.6 Deterministic time change of CIR model Process time scale: In this time scale. and 0 t T 1 n R o T2. r(u) du (B (T1 T2) . Cox-Ingersoll-Ross model 313 lim B (r(0) T ) = IE exp . K )+ r 0: Other European derivative securities on the bond are priced using the same partial differential equation with the terminal condition appropriate for the particular security. T! 1 Z 0 1 r(u) du = 0: But also.5 Option on a bond The value at time t of an option on a bond in the CIR model is ( Z T1 ) # + F (t) v(t r(t)) = IE exp . the interest rate r( t) is given by a time-dependent CIR equation ^^ ^ ^r ^ ^ ^ ^ ^ ^ ^ dr(t) = (^(t) . T 2 is the maturity time of the bond. so B(r(0) T ) = exp f.) The terminal condition is . A(T )g r(0)C (0) + A(0) = 0 lim r(0)C (T ) + A(T )] = 1 T! 1 and r(0)C (T ) + A(T ) is strictly inreasing in T .

. . . make the change of variable t = '(t). . dt = ' (t) dt in the ﬁrst integral to get 0 ( Z T^ ) ^ ^ ^ B (r(0) 0 T ) = IE exp . . . r(t) dt ( Z0T ) ^ ^ B(^(0) 0 T ) = IE exp . . . . . . A period of high interest rate volatility - . . . and C (t T ) and A(t T ) are as deﬁned previously. . . . . . . . . . . ^ = '( t) which relates the two time scales (See ^rt ^ ^ ^ Let B (^ ^ T ) denote the price at real time t of a bond with maturity T when the interest rate at time ^ is r. . . . . . . . r('(t))' (t) dt 0 0 and this will be B (^(0) r ^ 0 T ) if we set ^ ^ r(t) = r('(t)) ' (t): ^^ 0 . . 31.3). r(t) dt : r ^^ ^ 0 With T ^ ^ ^ ^ = '(T ). . . ^ where t = '(t) ^ T = '(T ).3: Time change function. . . . rC (t T ) A(t T ) . . . . . . . . . . We have ( ZT ) B(r(0) 0 T ) = IE exp . . There is a strictly increasing time change function t Fig. .t: 314 6 Process time . . . . . . . . . ^ We need to determine the relationship between r and r. ^ t = '(t) - ^ t: Real time Figure 31. . . We want to set things up so t ^ ^rt ^ B (^ ^ T ) = B (r t T ) = e . . .

These values determine ^ the functions C A. in the real time scale. log B (^(0) 0 T ) = r(0)C (0 '(T )) + A(0 '(T )): ^ The right-hand side of this equation is increasing in the '( T ) variable. Take '0(0) = 1 (we justify this in the next section). since. . log B (^(0) 0 T ) < 1 (*) has a unique solution for each T .e. A('(t) '(T )) ^ ^ = exp .r(0)C (0 T ) . Thus ' is a strictly increasing time-change-function with the right properties. For each T . n o ^ ^ ^ ^r ^ r . then ^ is '(0) = 0. starting at 0 at time having limit 1 at 1. For T ^1 < T2.CHAPTER 31. (*) 0 and ^r ^ ^ ^ Since 0 .7 Calibration ^ ^) ^ ^ ^r^ t ^ B (^(t) ^ T ) = B r(t^ '(t) '(T ) ' ) ( (t) ^ ^ C ('(t) '(T )) . If T ^ ^ ^ ^ . the model coefﬁcients ^ ^ ^ 0 T ) for all T 2 0 T ]. log B (^(0) 0 T ) = '(0) C ('(0) '(T )) + A('(0) '(T )): (0) 0 Take and so the equilibrium distribution of r(t) seems reasonable. log B (r(0) 0 T2) r(0)C (0 0) + A(0 0) = 0 ^ lim r(0)C (0 T ) + A(0 T )] = 1: ^ T! 1 = 0. A(0 T ) ^ ^ ^ ^ ^ or equivalently. We calibrate by writing the equation ^r ^ B (^(0) 0 T ) = exp . this solution ^ ^ so '(T1) < '(T2). t.r(t)C (t T ) . i.r(t) ^^ ^ ' (t) n o = exp .. solve the ^): equation for '(T ^r ^ ^ ^ ^ . Cox-Ingersoll-Ross model 315 31. A(t T ) ^^^ ^ ^ ^^ ^ 0 0 ! where ^ '^ ^^^ C (t T ) = C ('(t) ^ (T )) ' (t) ^^^ ^ ^ A(t T ) = A('(t) '(T )) 0 ^ do not depend on ^ and T only through t are time dependent. log B (r(0) 0 T1) < . ^r ^ Suppose we know r(0) and B (^(0) ^ ^ T .

log IE exp . 31. The above says that ^r ^ .316 31. r(0)C (T ) + A(T ) ^ C (T ) = sinh( T ) cosh( T ) + 1 sinh( T ) 2 2 3 1 T 2 A(T ) = . we write the bond price as ^r ^ B(^(0) 0 T ) thereby indicating explicitly the initial interest rate. 2 2 log 4 cosh( T ) e 1 sinh( T ) 5 +2 = 1 2 q 2 + 2 2: . @T log B(0 T ) Justiﬁcation: T =0 = r(0): @ log B (0 T ) = IE r(T )e 0 . log B(0 T ) = . . determined by market data. r(u) du 0 R T r(u) du T =0 In the real time scale associated with the calibration of CIR by time change. is strictly increasing in T . Consider the function Here C (T ) and A(T ) are given by ^r ^ ^ ^ ^ . @T log B(0 T ) = r(0): . . @T RT IEe 0 r(u) du @ . r(u) du : 0 ( ZT ) . Therefore. log B (^(0) 0 T ) is as shown in Fig.4. ( ZT ) B(0 T ) = IE exp .8 Tracking down '0 (0) in the time change of the CIR model Result for general term structure models: @ . @^ log B(^(0) 0 T ) ^ = r(0): ^ @T T =0 The calibration of CIR by time change requires that we ﬁnd a strictly increasing function ' with '(0) = 0 such that ^r ^ ^ ^ where B (^(0) 0 T ). log B (^(0) 0 T ) = ' 1 r(0)C ('(T )) + A('(T )) T 0 (0) ^ 0 (cal) = 0. starts at 1 when T ^r ^ ^ and goes to zero as T !1.

. . except it satisﬁes (cal’) rather than (cal).... . . and goes to 1 as T !1.. ... .. then '(T ) = 0. then '(T1) < '(T2). To solve (cal). . log B (^(0) 0 T ) = r(0)C (T ) + A(T ) ^ ^ ^ ^ ^ ^ ^ ^ If T = 0.. .. We have thus . ... .. ... 31. If T1 < T2. .. . ^ '(T ) Figure 31.. ... . .. .. As T !1.. is strictly increasing in T .. .. ... . ..... ... '(T )!1..5) (cal’) deﬁned a time-change function ' which has all the right properties.. ... . .. . .4: Bond price in CIR model 6 r(0)C (T ) + A(T ) ^ ^r ^ .. ...5: Calibration -T ^ The function r(0)C (T ) + A(T ) is zero at T = 0. Cox-Ingersoll-Ross model 317 Goes to 1 ^r ^ 6..... log B (^(0) 0 T ) = r(0)C ('(T )) + A('(T )): ^ ^ Fix T and deﬁne '(T ) to be the unique T for which (see Fig. . ... log B (^(0) 0 T ) . ^r ^ ^ .. This is because the interest rate is positive in the CIR model (see last paragraph of Section 31. .. . .. .... let us ﬁrst consider the related equation ^r ^ ^ ^ ^ . . .. ... .CHAPTER 31.. ..4).. log B (^(0) 0 T ) Strictly increasing -T ^ Figure 31. ..

318 We conclude by showing that ' 0(0) = 1 so ' also satisﬁes (cal). we obtain ^ ' (0) = 1: 0 Computation of C 0(0): C( )= 0 1 cosh( ) + 1 sinh( ) 2 2 cosh( ) )+ 1 2 1 cosh( ) + 2 sinh( ) h i C (0) = 12 ( + 0) . e A (0) = .2 2 0 " cosh( ) + 1 sinh( ) 2 # 2 1 cosh( ) + 1 sinh( ) 2 e =2 =2 2e 1 cosh( ) + 2 sinh( ) . 2 2 0 =2 2 sinh( +0 = . @^ log B (^(0) 0 T ) ^ ^ @T T =0 = r(0)C ('(0))' (0) + A ('(0))' (0) ^ = r(0)C (0)' (0) + A (0)' (0): ^ 0 0 0 0 0 0 0 0 We show in a moment that C 0 (0) = 1. observed in the market. From (cal’) we compute ^r ^ r(0) = . sinh( ) 2 sinh( cosh( ) Computation of A0 (0): A ( ) = . (0 + 2 ) " 2 1 2 .2 2 1 )+ 2 cosh( ) . and is striclty positive. 0(0 + 1 ) = 1: 2 0 . 2 2 12 = 0: 1 1 ( + 0)2 #2 ( + 0) . Dividing by ^ r(0). so we have r(0) = r(0)' (0): ^ ^ 0 Note that r(0) is the initial interest rate. A0(0) = 0.

X2 (0) differential equations 0 > 0 be given. To simplify notation.Chapter 32 A two-factor model (Dufﬁe & Kan) Let us deﬁne: X1 (t) = Interest rate at time t X2(t) = Yield at time t on a bond maturing at time t + Let X1(0) > 0. 2 dW2(t)) (SDE2) where W1 and W2 are independent Brownian motions. and let X1(t) and X2(t) be given by the coupled stochastic dX1(t) = (a11X1(t) + a12X2(t) + b1) dt + 1 1X1(t) + 2X2(t) + dW1(t) (SDE1) q q dX2(t) = (a21X1(t) + a22X2(t) + b2) dt + 2 1X1(t) + 2X2(t) + ( dW1(t) + 1 . 2W2 (t): 4 4 Then W3 is a Brownian motion with dW1(t) dW3(t) = dt and dX1 dX1 = 2Y dt dX2 dX2 = 2Y dt dX1 dX2 = 1 2 319 1 2Y dt: . we deﬁne q Y (t) = 1X1(t) + 2X2 (t) + q W3(t) = W1(t) + 1 .

Y (t) > 0 0 t < 1 almost surely. We shall choose the parameters so that: Assumption 1: For some . 2 2 W2 (t) q2 2 2 2 1 1+2 1 2 1 2+ 2 2 where W4(t) = ( p is a Brownian motion.320 32. ) dt + ( 1 1 + 2 1 2 1 2 + 2 2) 2 Y dW4: From our discussion of the CIR process. and 3. Y (0) = 1X1 (0) + 2X2(0) + > 0 1( 2 2 + 2 1 2 2 1 1 2 2 1 2 + 2 2 ): 1b1 + 2 b2 . and (SDE1) and (SDE2) make sense.2. Then 1 a11 + 2a21 = 1 1 a12 + 2a22 = 2: dY = 1X1 + +( = Y dt + ( 2X2 + ] dt + ( 1b1 + 2b2 . These can be rewritten as dX1(t) = (a11X1 (t) + a12X2 (t) + b1) dt + 1 Y (t) dW1(t) q dX2(t) = (a21X1 (t) + a22X2 (t) + b2) dt + 2 Y (t) dW3(t): q (SDE1’) (SDE2’) . 2 2 dW2) = ( 1a11 + 2 a21)X1 + ( 1a12 + 2a22)X2 ] dt + ( 1 b1 + 2 b2) dt q 2 2 1 + ( 1 2 + 2 1 2 1 2 + 2 2 ) 2 Y (t) dW4(t) 1 2 1 1 + 2 2 )W1(t) + 2 1 .1 Non-negativity of Y dY = 1 dX1 + 2 dX2 = ( 1a11X1 + 1a12 X2 + 1b1) dt + ( 2a21 X1 + 2a22 X2 + 2 b2) dt q p + Y ( 1 1 dW1 + 2 2 dW1 + 2 1 . we recall that Y will stay strictly positive provided that: Assumption 2: and Assumption 3: Under Assumptions 1. ) dt 2 2 2 2 1p 1 1 + 2 1 2 1 2 + 2 2 ) 2 Y dW4 2 2 2 2 1p 1b1 + 2 b2 .

t) X1(u) du . A( )g 0 and all x1 x2 satisfying 1x1 + 2 x2 + > 0: We seek a solution of the form valid for all (*) . this is random only through a dependence on X1(t) X2(t). Zt 0 Z0t Zt 0 X1(u) du B(X1(t) X2(t) T . Thus. X1(u) du F (t) : t " Since the pair (X1 X2) of processes is Markov. x1B . there is a function B (x 1 x2 ) of the dummy variables x1 x2 and . t.X1B + (a11X1 + a12X2 + b1)Bx1 + (a21X1 + a22X2 + b2)Bx2 . so that ( ZT ) # B(X1 (t) X2(t) T . B p 1 2 Y Bx1 x2 + 1 2 Y Bx2 x2 2 2 2 + 1 2 Y Bx1 x1 + 2 1 1 Y Bx1 dW1 + p dt Y Bx2 dW3 The partial differential equation for B (x 1 x2 ) is . d exp .2 Zero-coupon bond prices The value at time t T of a zero-coupon bond paying $1 at time T is ( ZT ) # B(t T ) = IE exp . the bond price depends on t and T only through their difference = T . B dt + 1 Bx1 x1 dX1 dX1 + Bx1 x2 dX1 dX2 + 1 Bx2 x2 dX2 dX2 2 2 X1(u) du + . x2C2( ) . A two-factor model (Dufﬁe & Kan) 321 32. = exp . t) is a martingale.X1 B dt + Bx1 dX1 + Bx2 dX2 .x1 C1 ( ) .CHAPTER 32. t) = IE exp . Zt 0 X1(u) du B(X1(t) X2(t) T . Since the coefﬁcients in (SDE1) and (SDE2) do not depend on time. X1(u) du F (t) : t " The usual tower property argument shows that exp . We compute its stochastic differential and set the dt term equal to zero. B +(a11x1 + a12x2 + b1)Bx1 +(a21x1 + a22x2 + b2)Bx2 + 1 2( 1x1 + 2x2 + )Bx1 x1 2 1 1 + 1 2( 1x1 + 2x2 + )Bx1 x2 + 2 2 ( 1x1 + 2x2 + )Bx2 x2 = 0: (PDE) 2 B (x1 x2 ) = exp f. = exp .

This implies the initial conditions C1(0) = C2(0) = A(0) = 0: We want to ﬁnd C1( ) C2( ) A( ) for > 0.x1 C1( ) . b2C2( ) 2 1 2 C1 ( ) + 1 2 C1 ( )C2( ) + 1 2 ). x2C2( ) . 1 2 2 C 2( 2 1 2 ) (1) (2) (3) C1(0) = 0 2 C2( ) = a12C1( ) + a22 C2( ) . b1 C1( ) . a11C1( ) . a21C2 ( ) 0 +1 2 +1 2 +1 2 We get three equations: 0 2 1C 2 ( 1 1 )+ 0 1 2 1C1( )C2( ) + 1 2 )C2( ) + 1 2 2 2 2 1C 2 ( 2 2 ) ) + x2 B (x1 x2 ) C2 ( ) . 1 2 . (a11x1 + a12 x2 + b1)C1( ) .322 We must have B(x1 x2 0) = 1 8x1 x2 satisfying (*) because = 0 corresponds to t = T . a22C2 ( ) 2 C 2( 1 2 1 0 )+ 1 2 2C1( 2 C 2( 2 2 2 + B (x1 x2 ) A ( ) . 1 + C1 ( ) . 1 2 0 2 C 2( 1 1 1 1 2 1C1 ( )C2( ) . 1 2 2 2 2 2C 2 ( 2 2 2 C2 ( ) ) C1 ( )C2( ) . 2 C2 ( ) C1( ) = 1 + a11C1 ( ) + a21C2( ) . 1 2 C1 ( ) . 1 2 2C1 ( ) . a12C1( ) .C2( )B(x1 x2 ) 2 Bx1 x1 (x1 x2 ) = C1 ( )B(x1 x2 ) Bx1 x2 (x1 x2 ) = C1( )C2( )B (x1 x2 ) 2 Bx2 x2 (x1 x2 ) = C2 ( )B(x1 x2 ): 0 0 0 (IC) (PDE) becomes 0 = B (x1 x2 ) . A ( ) B (x1 x2 ) Bx1 (x1 x2 ) = . 2 1 C2(0) = 0 2 A ( ) = b1C1( ) + b2C2( ) .x1 + x1C1( ) + x2 C2( ) + A ( ) . 1 2 1 A(0) = 0 0 1 2 2C1( 2 )C2( ) . (a21x1 + a22x2 + b2)C2( ) 2 + 1 2 ( 1x1 + 2 x2 + )C1 ( ) + 1 2( 1x1 + 2x2 + )C1( )C2( ) 2 1 2 + 1 2 ( 1x1 + 2 x2 + )C2 ( ) 2 2 0 0 0 = x1 B (x1 x2 ) .C1( )B(x1 x2 ) Bx2 (x1 x2 ) = . We have B (x1 x2 ) = .

32. X2(t)C2( 0) . 1 2 . A two-factor model (Dufﬁe & Kan) 323 We ﬁrst solve (1) and (2) simultaneously numerically. The value at time t of a bond maturing at time t + 0 is B(X1 (t) X2(t) 0) = expf. 1 log B(X1(t) X2(t) 0) = 1 X1(t)C1( 0) + X2(t)C2( 0) + A( 0)] : 0 0 But we have set up the model so that X 2(t) is the yield at time t of a bond maturing at time t + 0 .CHAPTER 32. which implies that C1( 0) = 0 C2 ( 0) = We must choose the parameters 0 A( ) = 0: 1 2 a11 a12 b1 a21 a22 b2 so that these three equations are satisﬁed.X1(t)C1( 0) . Thus X2(t) = 1 X1(t)C1( 0 ) + X2(t)C2( 0) + A( 0)] : 0 This equation must hold for every value of X 1(t) and X2 (t).3 Calibration Let 0 > 0 be given. and then integrate (3) to obtain the function A( ). A( 0)g and the yield is .

324 .

(t) (t) (t) d S(t) = S(t) (t) dW (t): The zero-coupon bond prices are given by ) # ( ZT B (t T ) = IE exp .1) fF (t) 0 t T g. We are particularly interested in the case that the interest rate is stochastic. r(u) du F (t) " = IE 325 (t) F (t) (T ) t . We deﬁne the accumulation factor r(t) and the volatility process (t) are adapted to some ﬁltration (t) = exp Zt 0 r(u) du so that the discounted stock price S (t) is a martingale. We shall work only under the risk-neutral measure. which we call a “stock” even though in applications it will usually be an interest rate dependent claim. given by a term structure model we have not yet speciﬁed. The price of the stock is modeled by dS (t) = r(t) S (t) dt + (t)S (t) dW (t) where the interest rate process may be larger than the ﬁltration generated by W . which is reﬂected by the fact that the mean rate of return for the stock is r(t). but fF (t) 0 t T g This is not a geometric Brownian motion model.Chapter 33 Change of num´ raire e Consider a Brownian motion driven market model with time horizon T . (0. W is a Brownian motion relative to this ﬁltration. For now. we will have one asset. Indeed.

T . i.71 Let N be a num´ raire. The original probability measure IP is risk-neutral for the num´ raire (Example 33. The value of the forward contract at time t is zero. F (t T )IE (t) F (t) (T ) (T ) = (t) S (t) .326 so B(t T ) = IE 1 F (t) (t) (T ) is also a martingale (tower property). so 0 = IE (t) (S (T ) .e. is a martingale under IP N . At time t.. e Theorem 0. Example 33. e divided by N . At time t e e is worth F(t T ) units of T -maturity bond and the T -maturity bond is worth 1 unit. ) F (t T ) = BSt(tT ) : ( Deﬁnition 33. e e Example 33.1 (Money market as num´ raire) The money market could be the num´ raire. Z N (T ) dIP 8A 2 F (T ) (T ) A . the stock We will say that a probability measure IP N is risk-neutral for the num´ raire N if every asset price.1). F (t T )B (t T ) Therefore. F (t T )B (t T ) (t) = S (t) . the e e S (t) B (t T ) stock is worth (t) units of money market and the T -maturity bond is worth (t) units of money market.1 (Num´ raire) Any asset in the model whose price is always strictly positive can be e taken as the num´ raire. Then IP N deﬁned by IPN (A) = N1 (0) is risk-neutral for N . the price process for some asset whose price is always e strictly positive. F (t T )) F (t) (T ) = (t)IE S (T ) Ft . The T -forward price F (t T ) of the stock is the price set at time t for delivery of one share of stock at time T with payment at time T .2 (Bond as num´ raire) The T -maturity bond could be the num´ raire. We then denominate all other assets in units of this num´ raire.

Let Y be an asset price. Under IP .. Y=N is a martingale.CHAPTER 33. Y T Y IEN N(T ) F (t) = N((tt)) IE N((T )) N(T ) F (t) (T ) (T ) () = N((tt)) Y (tt) Y = N (t) (t) which is the martingale property for Y=N under IP N . and Z IP (A) = N (0) N((T )) dIPN 8A 2 F (T ): A T 1 Z N (T ) dIP IPN ( ) = N (0) (T ) 1 :IE N (T ) = N (0) (T ) (0) = N1 N(0) (0) =1 Proof: Because N is the price process for some asset. we need to recall how to combine conditional expectations with change of measure (Lemma 1. have the same probability zero sets. then N( IEN X F (t) = N (0)t)(t) IE N (0) T()T ) X F (t) N( T = N((tt)) IE N((T )) X F (t) : Therefore. Y= is a martingale. Therefore. 33. and we see that IPN is a probability measure. Change of num´ raire e Note: 327 IP and IPN are equivalent. i.e. N= is a martingale under IP .54). For this.1 Bond price as num´ raire e Fix T 2 (0 T ] and let B(t T ) be the num´ raire. The risk-neutral measure for this num´ raire is e e 1 Z B (T T ) IPT (A) = B (0 T ) dIP A (T ) Z 1 = 1 B (0 T ) A (T ) dIP 8A 2 F (T ): . If 0 t T T and X is F (T )-measurable. We must show that under IPN .

a differential without a dt term.1) i.328 Because this bond is not deﬁned after time T .. the value of the ) F (t T ) = BSt(tT ) ( 0 t T: This is a martingale under IPT . Denominated in units of T -maturity bond.1) 0 t T g is a Brownian motion under IPS .2 Stock price as num´ raire e Let S (t) be the num´ raire. 33. The riske e neutral measure under this num´ raire is e 1 IPS (A) = S (0) Z S (T ) (T ) dIP 8A 2 F (T ): A Denominated in shares of stock. i. and so has a differential of the form dF (t T ) = We write F (t) rather than F (t F (t T )F (t T ) dWT (t) 0 t T t 0.1’) . In other d F 1t) = ( T ) F 1t) dWS (t) ( (2. ) is called the stock is T ”. IPT T -forward measure. the stock price is identically 1. We may assume without loss of generality that F (t T ) T g is a Brownian motion under T ) from now on. the value of the T -maturity bond is B(t T ) = 1 : S (t) F (t) This is a martingale under IPS . (2.1) is equal to the volatility F (t F (t T ) in (1.1) can be rewritten as T ) in (2.e. We may assume without loss of Theorem 2. (1.. and so has a differential of the form d F 1t) = (t T ) F 1t) dWS (t) ( ( where fWS (t) generality that (2.e. we change the measure only “up to time T 1 using B (0 T ) B ((TT ) and only for A 2 F (T ).1). In terms of this num´ raire. The process fWT 0 IPT .72 The volatility (t words. (t T ) 0.

3 Merton option pricing formula The price at time zero of a European call is V (0) = IE (1T ) (S (T ) . KB (0 T ) Z 1 = S (0) S (0) (T ) B(0 T ) (T ) dIP S (T )>K S (T )>K = S (0)IPS fS (T ) > K g . Under this measure.1) must be F (t T ) and WS must be WS (t) = .e. KB (0 T )IPT fF (T ) > K g: F (T ) K f g f g f g f g . (t T ) in (2. so g 0(x) = . Then 00 d F 1t) = dg (F (t)) ( = g (F (t)) dF (t) + 1 g (F (t)) dF (t) dF (t) 2 1 = . The change of measure from IPT to IPS makes F 1t) a martingale.CHAPTER 33.. i. F (t T ) dWT (t) + 2 (t T ) dt F ( = F (t T ) F 1t) . F 2 (t) F (t T )F (t T ) dWT (t) + F 31(t) 2 (t T )F 2(t T ) dt F 0 00 h i = F 1t) . KB (0 T )IPT fF (T ) > K g = S (0)IPS 1 < 1 . K )+ = IE S (T ) 1 S (T )>K . it F ( changes the mean return to zero. KIE 1 1 S (T )>K (T ) Z(T ) S (T ) dIP . KB (0 T )IPT fS (T ) > K g = S (0)IPS fF (T ) > K g .1=x2 329 g (x) = 2=x3. Therefore.WT (t) + Zt 0 F (u T ) du: 33.dWT (t) + F (t T ) dt]: ( Under IPT .WT is a Brownian motion. but the change of measure does not affect the volatility. F 1t) has volatility F (t T ) and mean ( rate of return 2 (t T ). Change of num´ raire e Proof: Let g (x) = 1=x.

1 2 T o F S 2 F F (T ) S (0) 1 S (0) IPS F (1T ) < K = IPS F WS (T ) . When formula r is not constant. 1 p T S (0) log KB (0 T ) . 2 2 T F KB(0 T ) T T F = N ( 2) where 2= If r is constant. 1 F )T 2 1 p F T and we have the usual Black-Scholes formula. KB(0 T )N ( 2): . 1 2 T : 2 F T) = e 1= rT .330 This is a completely general formula which permits computation as soon as we specify F (t we assume that F (t T ) is a constant F . 1 2 T F 2 (0 T IPT fF (T ) > K g = IPT F WT (T ) . 1 2 T > log KB (0 T ) 2 F S (0) T 1 p = IPT Wp(T ) > 1 log KB (0 T ) + 2 2 T F S (0) T F T 1 p p = IPT . then B (0 F . (0) log SK + (r + 1 2 )T 2 F F T S (0) 1 2 2 = p log K + (r . 1 2 T < log KB (0 T ) 2 F p S (0) S p = IPS Wp(T ) < 1 log KB (0 T ) + 1 F T 2 = N ( 1) 1 p T F T where 1= Similarly. F T log S (0) 1 2 KB (0 T ) + 2 F T : o n F (T ) = BS (0) ) exp F WT (T ) . If 1 = B (0 T ) exp n W (T ) .WT (T ) < 1 log S (0) . we have the following: T ). we still have the explicit V (0) = S (0)N ( 1) .

Change of num´ raire e As this formula suggests. t log FKt) + 1 2 (T . hold (t) shares of stock. the value of a European call expiring V (t) = S (t)N ( 1(t)) . then X (t) . K dB(t T ) dN ( 2(t)) . and let X (t) be the value of the portfolio at time t. Let (t) = N ( 1(t)): At time t. the value of the portfolio will always be S (t)N ( 1(t)) . hold KN ( 2(t)) bonds.CHAPTER 33. then for 0 at time T is where 331 t T . The number of shares of asset k held at time t is X (t) . KB(t T ) dN ( 2(t)): If X (0) = V (0). t) : 2(t) = p 2 F T . this question takes the following form. and invest the remaining wealth in asset k. dX (t) = (t) dS (t) + X (B)(t T )(t) S (t) dB(t T ): The value of the option evolves according to (3. . KB (t T )N ( 2(t)) This formula also suggests a hedge: at each time t. At each time t. if F is constant. 1. Will the position in the bond always be . will X (t) = V (t) for 0 t T ? (3. so we simplify them by a change of num´ raire. ( p1 .2) are difﬁcult to compare.73 Changes of num´ raire affect portfolio values in the way you would expect. Begin with a nonrandom initial wealth X (0). portfolio value evolves according to t . If X (t) is the value of the portfolio at time t. Pk=11 i(t)Si(t) i k (t) = Sk (t) .1) and (3. 1 2 (T . e Proof: Suppose we have a model with k assets with prices S 1 S2 : : : Sk . i = 1 2 : : : k . Suppose we begin with $ V (0) and at each time t hold N ( 1(t)) shares of stock. KN ( 2(t)) dB(t T ) .1) dV (t) = N ( 1(t)) dS (t) + S (t) dN ( 1(t)) + dS (t) dN ( 1(t)) . KB (t T )N ( 2(t)) = V (t) and we will have a hedge.t 1(t) = F N ( 1(t)) shares of stock and short We want to verify that this hedge is self-ﬁnancing. hold i (t) shares of asset i. Mathematically. t) 2 F F T ( 1 log FKt) . Theorem 3. (t (t)S (t) will be invested in the bond. so the number of bonds owned is X B)(t T )(t) S (t) and the .KN ( 2(t))? If so. e This change is justiﬁed by the following theorem. We short bonds as necessary to ﬁnance this.2) Formulas (3.

. . k X i=1 i=1 i dSi + i dSi: k X X. not k . and deﬁne e 1 ::: i=1 k 1. Therefore. Pk=11 i Si i k= Sk X=N . k c X c b k 1 c! dSk X b= dX i dSi + X .332 and X evolves according to the equation dX = = Note that k 1 X . . . i (t)Si (t) X (t) b X (t) = N (t) Then c Si (t) = Si(t) N (t) i = 1 2 : : : k: 1 1 b 1 dX = N dX + X d N + dX d N ! i i i k k k 1 X dS + X S d 1 + X dS d 1 =N i i i i N i=1 i i N i=1 i=1 k X 1 dS + S d 1 + dS d 1 = = Now i=1 k X i=1 N N i N Si i dc: X . in advance. i=1 i Si ! dSk Sk Xk (t) = and we only get to specify Let N be a num´ raire. iSi c Sk i=1 i=1 . Pk=11 ici i =X c S: Sk . k 1 X . Pk=11 iSi=N i = Sk =N b .

1’) b b dX (t) = (t) dF (t) + (X (t) . . (t)) d(1) = (t) dF (t): 1 In the new num´ raire. KB (t T )N ( 2(t)) becomes ) b V (t) = BVt(tT ) = N ( 1(t))F (t) . 333 2 : : : k. we must show that (3. K dN ( 2(t)): To show that the hedge works. but we now use the zero-coupon bond as num´ raire.2’) F (t) dN ( 1(t)) + dN ( 1(t)) dF (t) .CHAPTER 33. the option value formula e V (t) = N ( 1(t))S (t) .2)). e In terms of the new num´ raire. Change of num´ raire e This is the formula for the evolution of a portfolio which holds i shares of asset i.1) and (3. We still hold (t) = N ( 1(t)) shares of stock at each time t. KN ( 2(t)) ( and b dV = N ( 1(t)) dF (t) + F (t) dN ( 1(t)) + dN ( 1(t)) dF (t) . i = 1 1. and all assets and the portfolio are denominated in units of N . the asset values are e Stock: Bond: The portfolio value evolves according to S (t) = F (t) B(t T ) B(t T ) = 1: B(t T ) (3. K dN ( 2(t)) = 0: This is a homework problem. We return to the European call hedging problem (comparison of (3.

334 .

f (t u) du t volatility of T -maturity bond.Chapter 34 Brace-Gatarek-Musiela model 34. r(u) du F (t) ( ZT t ) = exp . t). The bond prices " satisfy dB (t T ) = r(t) B(t T ) dt . This is not possible because it leads to (t T ) = ( t T ) = f (t T ) ZT t f (t u) du df (t T ) = 2f (t T ) ZT t f (t u) du dt + f (t T ) dW (t) 335 ! .1 Review of HJM under risk-neutral I P f (t T ) = df (t T ) = where The interest rate is r(t) = f (t Forward rate at time t for borrowing at time T: (t T ) (t T ) dt + (t T ) dW (t) (t T ) = ZT t (t u) du ( ZT ) # B (t T ) = IE exp . you specify a function 0 t T: A simple choice we would like to use is where > 0 is the constant “volatility of the forward rate”. (t T ) t ) | ({z T } B(t T ) dW (t): To implement HJM.

The problem with the above equation is that the dt term grows like the square of the forward rate. consider the similar deterministic ordinary differential equation f (t) = f 2(t) 0 where f (0) = c > 0.1) (2. f (t) f (0) 0 1 = t . (u = v . 1=c = ct . t: (2. 1 = t .2) r(t ) = f (t t + ) r(t 0) = f (t t) = r(t) @ r(t ) = @ f (t t + ) @ @T Bond prices: D(t ) = B(t t + ) = exp . To see what problem this causes.3) f (t v ) dv f (t t + u) du r(t u) du (2. Jarrow and Morton show that solutions to this equation explode before T . dt f (t) = 1 0 34.4) @ D(t ) = @ B(t t + ) = .r(t )D(t ): @ @T . f (t) f (0) c c : f (t) = 1 . f (t) = 1 f 2(t) d 1 .2 Brace-Gatarek-Musiela model New variables: Current time t Time to maturity Forward rates: = T . t du = dv ) : = exp . ct = 1=c. 1 . = exp . We have This solution explodes at t 1 + 1 = Z t 1 du = t . Z t+ Zt Z0 0 (2.336 and Heath.

3 LIBOR Fix > 0 (say. L(t 1 = 4 year).7) (2.6) We have We now derive the differentials of r(t dr(t ) = (2.1) = r(t 0) . the HJM model is df (t T ) = (t ) (t ) dt + (t ) dW (t) dB (t T ) = r(t)B(t T ) dt .8) differential applies only to ﬁrst argument df (t {z+ ) | t } @ + @T f (t t + ) dt h i = @@ r(t ) + 1 ( (t ))2 dt + (t ) dW (t): 2 dB (t {z + ) | t } @ + @T B (t t + ) dt = (t ) (t ) dt + (t ) dW (t) + @@ r(t ) dt (2. analogous to (2.6). dD(t ) = (2.(2. (t )B (t t + ) dW (t) .CHAPTER 34. r(t )D(t ) dt (2.10) 34. Brace-Gatarek-Musiela model We will now write 337 (t ) = (t T .6) @ @ (t ) = Z 0 (t u) du (2.2) (2.5) (2. r(t )] D(t ) dt .5). In this notation.4) differential applies only to ﬁrst argument = r(t) B (t t + ) dt . t) rather than (t T ).9) Also. time t + .5) and (2.8) (t ) = (t ): ) and D(t ). $ D(t ) invested at time t in a (t + )-maturity bond grows to $ 1 at 0) is deﬁned to be the corresponding rate of simple interest: Z@ r(t u) du 1 + L(t 0) = D(1 ) = exp t 0 nR o exp 0@ r(t u) du .(2. (t )B (t T ) dW (t) where (2. (t )D(t ) dW (t): (2. 1 L(t 0) = : D(t )(1 + L(t 0)) = 1 ( ) .

The value of this portfolio at time t is > 0 is still ﬁxed. For ﬁxed positive . Can do this at time t by shorting DDt(t +) ) bonds maturing at time t + and going long one bond maturing at time t + + .5 The dynamics of L(t ) We want to choose (t ) t 0 0. We cannot have a log-normal model for r(t ) because solutions explode as we saw in Section 34.2) o r(t u) du . appearing in (2.1) ( @ exp Z @ so + r(t u) du ) =0 = r(t + ) exp = r(t ) (Z + r(t u) du ) =0 f (t t + ) = r(t ) = lim L(t ) = exp nR + #0 exp nR + r(t u) du .4 Forward LIBOR ( At time t. 34. 1 >0 ﬁxed: (4.5) so that dL(t ) = (: : : ) dt + L(t ) (t ) dW (t) . 0 + r(t u) du = exp . with payback of $1 at time ( t + + . 1 o : (4. L(t ) is the simple rate over a period of duration .338 34.1. we can have a log-normal model for L(t ). agree to invest $ DDt(t +) ) at time t + . The forward LIBOR L(t ) is deﬁned to be the simple (forward) interest rate for this investment: D(t + ) (1 + L(t )) = 1 D(t ) R D(t ) = exp f. 1 o r(t ) is the continuously compounded rate. D(t (t +) ) D(t ) + D(t + ) = 0: D (Z nR + r(t u) du ) L(t ) = Connection with forward rates: exp + r(t u) du . 0 r(t u) dugo n R 1 + L(t ) = D(t + ) exp .

(t )] dW (t) + 1 (t + ) . (t )] dW (t) dr(t u) du (5. Recall (2. r(t ) + 2 ( (t + ))2 . (t )]2 dt 2 . Brace-Gatarek-Musiela model 339 0 0.1) and o 3 2 nR + exp r(t u) du . 1 ( (t ))2 dt 2 + (t + ) .1) 1 = 1 + L(t )] r(t u) du d r(t u) du + r(t u) du !2 (5. for some (t ) t corresponding to particular choices of (t ).9): i @ h dr(t ) = @u r(t u) + 1 ( (t u))2 dt + (t u) dW (t): 2 Therefore. 1 5 dL(t ) (4:1) d 4 = (Z + ) Z + 1 = exp ( ) 1 exp Z + r(t u) du d Z +2 (4. and is a subclass of HJM models. (t )] dt = + (t + ) . d Z + r(t u) du = = ! Z Z + + @ hr(t u) + 1 ( (t u))2i du dt + Z + (t u) du dW (t) 2 i h @u 1 = r(t + ) . r(t ) + 2 ( (t + ))2 . r(t )] dt + (t + ) (t + ) . This is the BGM model.CHAPTER 34. 1 ( (t ))2] dt 2 + (t + ) .2) = 1 1 + L(t )] r(t + ) . (t )] dW (t) : 1 r(t + ) . (5.1).

6 Implementation of BGM Obtain the initial forward LIBOR curve L(0 ) (t ) 0 0: from market data. dL(t ) = @@ L(t ) dt + 1 1 + L(t )] (t + ) .3) Then dL(t ) = @@ L(t ) + (t )L(t ) (t + )] dt + (t )L(t ) dW (t): Note that (5.3) is equivalent to (5. Choose a forward LIBOR volatility function (usually nonrandom) t 0 .340 But 2 nR @ L(t ) = @ 4 exp @ @ (Z + = exp + r(t u) du .4) ) (t + ) = (t ) + L(t L(t(t ) ) : 1+ Plugging this into (5. r(t )]: Therefore.3’) 2 ) 2 dL(t ) = @@ L(t ) + (t )L(t ) (t ) + L1 (t L(t (t ) ) dt + + (t )L(t ) dW (t): " # (5.4’) 34. (t )]: (5.4) yields (5. r(t )] ) = 1 1 + L(t )] r(t + ) . (t )]: (t + ) dt + dW (t)]: Take (t ) to be given by (t )L(t ) = 1 1 + L(t )] (t + ) . 1 5 o 3 r(t u) du : r(t + ) .

Brace-Gatarek-Musiela model 341 Because LIBOR gives no rate information on time periods smaller than . @@ L(t T . we obtain (t ) for L(t ) t 0 and we continue recursively. the resulting Remark 34. .4’)) is a stochastic partial differential equation because of the @ @ L(t ) term. set K (t T ) = L(t T . t) dt + dW (t) : 1 + K (t T ) (6. 2 0 ) solve (5. L(t )!r(t ) = f (t t + ) . we must also choose a partial bond volatility function (t ) With these functions. t)K (t T )! (t T .4’) to obtain L(t ) t 0 0 Plugging the solution into (5. (t ) is random. t) .3) we have (t )L(t ) = 1 + L(t )] (t + ) . t): Then dK (t T ) = dL(t T . (t ) : If we let #0.4) (equivalently. t) dt dK (t T ) = (t T . We then solve (5.4’) become Remark 34. (t ) is usually taken to be nonrandom.3’).4’) to obtain < : <2 <2 ) generated recursively by (5. then @ (t )L(t )! @ (t + ) =0 = (t ) and so We saw before (eq.2) that as (t T . t)K (t T ) (t T . we can for each t 0 0 < for maturities less than from the current time variable t. t + ) dt + dW (t)] (t T . 4. This is not as terrible as it ﬁrst appears.2 (5.1 BGM is a special case of HJM with HJM’s (t In BGM. t) dt + K (t T ) (t T . Remark 34.3 From (5.4) and (5.1) and (5. t): #0. (5.3’). t)K (t T ) = (t T .CHAPTER 34. Returning to the HJM variables t and T .

and we can use it to switch to the forward measure Girsanov’s Theorem implies that WT (t) = W (t) + is a Brownian motion under IPT . solutions 1+K (t T ) .342 so K (t T )!f (t T ): Therefore. Z t (u T . B (t T ) (t T .7 Bond prices Let (t) = exp nR t 0 r(u) du : From (2.1) has the term to this equation do not explode because (t T t)K 2 (t T ) involving K 2 . t) dt + dW (t)] : 2 Remark 34.4 Although the dt term in (6. 1 Z t( (u T . t) dW (t): (t) The solution B (ttT ) to this stochastic differential equation is given by () B (t T ) = exp .5): df (t T ) = (t T .r(t)B(t T ) dt + dB(t T )] ) ( = .1) is given by equation (2. t)K 2(t T ) K (t T ) 2(t T . Zt 0 (u T . 2(t T . u) du 0 t T . u))2 du : 2 0 (t)B (0 T ) 0 1 Z 1 dIP IPT (A) = B (0 T ) Z B(TAT )(T ) = dIP 8A 2 F (T ): A (T )B (0 T ) This is a martingale.6) we have o d B(t(tT ) = 1t) . t) (t T . t)K (t T ): 2(t 34. t)K 2 (t T ) 1 + K (t T ) T . the limit as #0 of (6. u) dW (u) .

u) du 1 and mean . u) du (8. 1 2 2(t) = ZT t 2(u T . Thus. c)+ B (t T + ): (9.2) ZT t 2(u T . c)+ . Then X (t) = is normal with variance ZT t (u T . the value of the caplet at time T + is (K (T T ) . At time T + . u) du ) (8. c)+ IE (T (+ ) F (t) = (K (T T ) . the ﬂoating rate interest payment due is L(T 0) = K (T T ) the LIBOR at time T . t)K (t T ) (t T .9 Pricing an interest rate caplet Consider a ﬂoating rate interest payment settled in arrears. t + ) dt + dW (t)] = (t T .1) we have dK (t T ) = (t T . u) du K (T T ) = K (0 T ) exp = K (t T ) exp We assume that (Z T 0 (Z T t (u T . ZT 2(u 1 2 0 ZT t 2 (u T . Brace-Gatarek-Musiela model 343 34.1) (u T . Case I: T t T+ . 34.8 Forward LIBOR under more forward measure From (6. u) dWT + (u) . We determine its value at times 0 t T + . 1 2 T . u) dWT + (u) . t) CT + (t) = IE (T(+ ) (K (T T ) . c)+ F (t) t) = (K (T T ) . 1 2 Zt 0 2(u T .1) . A caplet protects its owner by requiring him to pay only the cap c if K (T T ) > c. u) du : ) is nonrandom. t)K (t T ) dWT + (t) so K (t T ) = K (0 T ) exp and Zt 0 (u T . u) dWT + (u) .CHAPTER 34. 2 2(t). u) dWT + (u) .

c)+ F (t)7 7 6 = B (t T + ) B (t T + ) 7 6 (T + )B(0 T + ) 5 4| {z } {z } | 1 Z (t) Z (T + ) = B (t T + )IET + (K (T T ) . 1 (t) : ( t) c 2 (9. Furthermore.2) is called the Black caplet formula.2) we have K (T T ) = K (t T ) expfX (t)g R 1 where X (t) is normal under IPT + with variance 2(t) = tT 2(u T . c N (t) c Then h i 1 log y .2) CT + (t) = B(t T + ) g (K (t T )) 0 t T . c)+ F (t) 2 3 7 6 (t)B (0 T + ) IE 6 B (T + T + ) (K (T T ) .t and (9. c)+ F (t) : Set g(y) = IET + (y expfX (t)g . u) du and mean . we have (t) = p T . c)+ 1 = y N 1 log y + 2 (t) .344 Case II: 0 Recall that t T. : In the case of constant . CT + (t) = B(t T + )IET + (K (t T ) expfX (t)g . c)+ F (t) From (8. IPT + (A) = where Z A Z (T + ) dIP 8A 2 F (T + ) T Z (t) = (B (t (0 + +) ) : t)B T We have t) CT + (t) = IE (T(+ ) (K (T T ) . X (t) is independent of F (t).1) and (8. 2 2(t). .

Brace-Gatarek-Musiela model 345 34. i.11 Calibration of BGM The interest rate caplet c on L(0 X k:t Tk CTk (t): T ) at time T + has time-zero value CT + (0) = B(0 T + ) g (K (0 T )) where g (deﬁned in the last section) depends on ZT 0 2 (u T . u) du = ZT 0 2(v ) dv: Z T0 0 < T1 < : : : < Tn .e. If we Z T1 0 2(T . 1: The value at time t of the cap is the value of all remaining caplets. C (t) = 34.e. 2(v ) dv Z T1 T0 2(v ) dv = Z T0 0 2(v ) dv ::: In this case.CHAPTER 34. we can “back out” CT0+ (0) CT1+ (0) : : : CTn+ (0) 2(v ) dv .. c)+ at time Tk+1 A cap is a series of payments k = 0 1 : : : n ..1) (0 T0) (T0 T1) : : : (Tn 1 Tn ) . u) du: Let us suppose is a deterministic function of its second argument.10 Pricing an interest rate cap Let T0 = 0 T1 = T2 = 2 : : : Tn = n : (K (Tk Tk ) . we can “back out” the squared volatility 0T 2(v ) dv .1 2(v ) dv: (11. we may assume that is constant on each of the intervals . i. (t ) = ( ): Then g depends on ZT 0 If we know the caplet price CT + know caplet prices where T0 R (0). Z Tn Tn.

t 0 0 < : t+ (see (2. 1) )]: n D(t n ) n k=1 34. )= 0.13 Pricing a swap Let T0 0 be given. 34. and set T1 = T0 + T2 = T0 + 2 : : : Tn = T0 + n : . Now (t ) is the volatility at time t of a zero coupon bond maturing at time < . Let n be a large ﬁxed positive integer. The long rate is n 1 log 1 = 1 X log 1 + L(t (k . we need both ( ) (t ) and choose these constants to make the above integrals have the values implied by the caplet prices. so that n is 20 or 30 years. 1) )] where the last equality follows from (4.1). ) r(t u) du ) 1 + L(t (k . it is reasonable to set Since is small (say 1 year). K (t T ) t 0 T 0 using the recursive procedure outlined at the start of Section 34.6. and To implement BGM. and 0 4 (t ) = 0 We can now solve (or simulate) to get t 0 0 0 < : L(t ) t 0 or equivalently.12 Long rates The long rate is determined by long maturity bond prices. Then D(t n ) = exp = = n Y k=1 n Y k=1 1 (Z n 0 exp (Z k r(t u) du (k 1) .6)). we can “back out” 0T 2(v ) dv and then differenp 2( ) for all 0.346 If we know caplet prices CT + tiate to discover 2( ) and ( R (0) for all T 0.

which depends on the term structure model and requires estimation of . c) F (t) k+1 k=0 = n 1 X . B (t Tn ): The forward swap rate wT0 (t) at time t for maturity T0 is the value of c which makes the time-t . (1 + c)B(t Tk+1)] value of the swap equal to zero: Bt ) ( wT0 (t) = B (t (T T0+ .CHAPTER 34. (1 + c)B (t T1) + B (t T1) . IE (T(t) ) (L(Tk 0) . (1 + c)B (t Tk+1) = B (t Tk ) . c) F (t) k+1 = IE (T(t) ) B (T 1T ) . 1 . c F (t) We compute k k+1 3 2 k+1 6 7 6 (Tk ) F (T ) F (t)7 . . the value of the swap is n 1 X . c) at time Tk+1 k = 0 1 : : : n . = B (t T0) . Brace-Gatarek-Musiela model The swap is the series of payments For 0 347 t T0. (1 + c)B (t T2) + : : : + B (t Tn 1 ) . k=0 B (t Tk ) . 1 : k k+1 IE (T(t) ) (L(Tk 0) . (1 + c)B (t Tn ) = B (t T0) . cB (t T1) . cB (t T2) . (1 + c)B (t Tk+1): = IE B (Tk Tk+1 ) n 1 X . c) F (t) : k+1 k=0 Now 1 + L(Tk 0) = B (T 1T ) k k+1 so L(Tk 0) = 1 B(T 1T ) . (L(Tk 0) . (1 + c)B (t T ) (t) 7 6 = IE 6 (T )B (T T ) IE (T ) k k+1 7 k+1 5 4 k k k+1 | {z } The value of the swap at time t is (t) (Tk+1 ) F (t) . the swap formula is generic. cB (t Tn ) .: B+tBT(n )T )] : t n 1) : : In contrast to the cap formula. 1: IE (T(t) ) (L(Tk 0) . : : : .

348 .

Each set A in F has a probability IP (A). The measure-theoretic view of probability theory was begun by Kolmogorov (1933). 349 . and then binomial versions are developed for purposes of implementation. although the concept dates back to 1934 work of L´ vy. A conditional expectation is itself a random variable.2 Binomial asset pricing model. one learns that a discrete random variable has a probability mass function and a continuous random variable has a density. Ross & Rubinstein (1979). one learns how transformations of continuous random variables cause changes in their densities. A well-written book which contains all these things is DeGroot (1986). e 35. This point of view handles both discrete and continuous random variables within the same unifying framework. Accounts of this model can be found in several places. The binomial asset pricing model was developed by Cox. This point of view is indispensible for treating the rather complicated conditional expectations which arise in martingale theory. Certain subsets of are called events.1 Probability theory and martingales. The ﬁrst complete account of martingale theory is Doob (1953). including Cox & Rubinstein (1985). The term martingale was apparently ﬁrst used by Ville (1939). The second stage of probability theory is measure theoretic. A more detailed book is Chung (1968). and the collection of all events forms a -algebra F . A succinct book on measure-theoretic probability and martingales in discrete time is Williams (1991). Furthermore. Dothan (1990) and Ritchken (1987). Many models are ﬁrst developed and understood in continuous time. measurable with respect to the conditioning -algebra. In this stage one views a random variable as a function from a sample space to the set of real numbers IR. These can be used to compute expectations and variances.Chapter 35 Notes and References 35. A well-written book on measure-theoretic probability is Billingsley (1986). and even conditional expectations. In the ﬁrst stage. Probability theory is usually learned in two stages.

It was introduced to o ﬁnance by Merton (1969). Some other books on dynamic models in ﬁnance are Cox & Rubinstein (1985). A mathematical construction of this integral. 35. 1973) presents the argument that geometric Brownian motion is a good model for stock prices. including (in order of increasing o mathematical difﬁculty) Hull (1993). Ingersoll (1987). An excellent reference for practitioners. A criticism of the efﬁcient market hypothesis is provided by LeRoy (1989). is given by Øksendal (1995). This motion is now known to be caused by the buffeting of the pollen by water molecules. Samuelson (1965. Sprenkle (1961). The development in this course is a summary of that found in Karatzas & Shreve (1991).3 Brownian motion. Boness (1964). In 1828 Robert Brown observed irregular movement of pollen suspended in water. Dothan (1990) and Dufﬁe (1992). L´ vy (1939. is Musiela & Rutkowski (1996). The quadratic variation of martingales was introduced by Fisk (1966) and developed into the form used in this course by Kunita & Watanabe (1967). which asserts that all information which can be learned from technical analysis of stock prices is already reﬂected in those prices. with a minimum of fuss. now in preprint form. The mathematical formulation of the efﬁcient market hypothesis is that there is a probability measure under which all discounted stock prices are martingales. but they do not provide information which permits an investor to outperform the market. A provocative article on the source of . a much weaker condition than the claim that stock prices follow a geometric Brownian motion. including Billingsley (1986).5 Stochastic calculus and ﬁnancial markets. past stock prices may be useful to estimate the parameters of the distribution of future returns. 1924). as explained by Einstein (1905). Stochastic calculus begins with Itˆ (1944).4 Stochastic integrals. Bachelier (1900) used Brownian motion (not geometric Brownian motion) as a model of stock prices. Alexander (1961) and Fama (1965). This is often confused with the efﬁcient market hypothesis. Osborne (1959).350 35. Brownian motion and its properties are presented in a numerous texts. Protter (1990) and Karatzas & Shreve (1991). Chung & Williams (1983). According to this hypothesis. The ﬁrst mathematically rigorous construction of Brownian motion was carried out by Wiener (1923. Huang & Litzenberger (1988). Some empirical studies supporting the efﬁcient market hypothesis are Kendall (1953). Many ﬁnance books. and Jarrow (1988). 1948) discove ered many of the nonintuitive properties of Brownian motion. 35. even though Brownian motion can take negative values. The last of these papers discusses other distributions which ﬁt stock prices better than geometric Brownian motion. include sections on Itˆ ’s o integral and formula. The integral with respect to Brownian motion was developed by Itˆ (1944). Some mathematics texts on stochastic calculus are Øksendal (1995).

is due to Feyman (1948) and Kac (1951). is Chapter 15 of Karlin & Taylor (1981). all treat this subject. the Brownian-motion driven model is mathematically the most general possible for asset prices without jumps. has o the geometric Ornstein-Uhlenbeck process as a special case. A good introduction to this topic. Øksendal (1995). . Notes and References stock price movements is Black (1986). the Black-Scholes option hedging formula seems not to be very sensitive to deﬁciencies in the model. although the result for constant was established much earlier by Cameron & Martin (1944). and risk-neutral measures. 35. The constant elasticity of variance model for option pricing appears in Cox & Ross (1976).7 Girsanov’s theorem.CHAPTER 35. A numerical treatment of the partial differential equations arising in ﬁnance is contained in Wilmott. which makes good reading even today. The Feynman-Kac Theorem. When both the interest rate and volatility of an asset are allowed to be stochastic.) Even though geometric Brownian motion is a less than perfect model for stock prices. An important companion paper is Merton (1973). the martingale representation theorem. these parameters can be random through dependence on the path of the underlying asset. The other books cited previously. 35. page 182. due to F¨ llmer & Schweizer (1993). Markov processes which are solutions to stochastic differential equations are called diffusion processes. Protter (1990). using only Itˆ ’s formula. It can also be found in Karatzas & Shreve (1991). The form of the martingale representation theorem presented here is from Kunita & Watanabe (1967). Kloeden & Platen (1992) is a thorough study of the numerical solution of stochastic differential equations. page 198. 351 The ﬁrst derivation of the Black-Scholes formula given in this course. The theorem requires a f technical condition to ensure that IEZ (T ) = 1. Dewynne and Howison (1993. see Karatzas & P Shreve (1991).6 Markov processes. This methodology frees the Brownian-motion driven model from the assumption of constant interest rate and volatility. The application of the Girsanov Theorem and the martingale representation theorem to risk-neutral pricing is due to Harrison & Pliska (1981). o is similar to that originally given by Black & Scholes (1973). or even through dependence on the paths of other assets. Girsanov’s Theorem in the generality stated here is due to Girsanov (1960). 1995) and also Dufﬁe (1992). including discussions of the Kolmogorov forward and backward equations. Chung & Williams (1983). and Karatzas & Shreve (1991). Another alternative model for the stock price underlying options. (This and many other papers by Merton are collected in Merton (1990). connecting stochastic differential equations to partial differential equations. so that I is a probability measure.

risk-free hedging is generally not possible. In addition to the fundamental papers of Harrison & Kreps (1979). 35. and Fritelli & Lakner (1994. Schweizer (1992a. Jones (1984). results have been obtained by many authors. Beinert & Trautman (1991). M¨ ller (1989) and Taqqu & Willinger (1987). as stated here. a slightly stronger condition is needed to guarantee existence of a risk-neutral measure. Jarrow & Madan (1991a). The Fundamental Theorem of Asset Pricing. and Geman & Yor (1993) obtain the Laplace transform of the price. Jacka (1992). A general arbitrage-based theory for the pricing of American contingent claims and options begins with the articles of Bensoussan (1984) and Karatzas (1988). pages 196–197. The reﬂection principle. Rogers & Shi (1995) provide a lower bound. although the partial differential equation given here by the Feynman-Kac Theorem characterizes the exact price. Goldman. some other works on the relationship between market completeness and uniqueness of the risk-neutral measure are Artzner & Heath (1990). The perpetual American put problem was solved by McKean (1965). Jarrow & Madan (1991b. Merton (1976). including Black (1975). 1995). Bouaziz. Ross & Rubinstein (1979) (see Lamberton (1993) for the convergence of the associated binomial and/or ﬁnite difference schemes) . Back (1991). (1990) for a treatment of the American option optimal stopping problem via variational inequalities.1992). Delbaen (1992). u 35. 1983).9 American options.1991) and Xue (1992). by Cox.c). 1983). Brennan & Schwartz (1977) (see Jaillet et al. We do not provide an explicit pricing formula here.e. Naik & Lee (1990). that the absence of arbitrage implies the existence of a risk-neutral measure. Explicit formulas for the prices of barrier options have been obtained by Rubinstein & Reiner (1991) and Kunitomo & Ikeda (1992). Bryis & Crouhy (1994) provide an approximate pricing formula.. e Because it is difﬁcult to obtain explicit formulas for the prices of Asian options. i. Lakner (1993). adjusted to account for drift. and Harrison & Pliska (1981. Mercurio & Runggaldier (1993). Bates (1988. Some works on hedging and/or optimization in models which allow for jumps are Aase (1993). which leads to a justiﬁcation of the Brennan-Schwartz algorithm).8 Exotic options. Elliott & Kopp (1990). Delbaen & Schachermayer (1994a.352 When asset processes have jumps. most work has been devoted to approximations. Madan & Milne (1991). Madan & Seneta (1990). Lookback options have been studied by Goldman. Approximation and/or numerical solutions for the American option problem have been proposed by several authors. including Stricker (1990). is taken from Karatzas & Shreve (1991). Delbaen (1992). can be found in Harrison & Pliska (1981. Shirakawa (1990. see Myneni (1992) for a survey and additional references. Sosin & Shepp (1979) and Conz´ & Viswanathan (1991). For the continuous-time case. This is true in discrete-time models. but in continuous-time models.b).b). Sosin & Gatto (1979). It is tempting to believe the converse of Part I.

Brace & Musiela (1994a. whereas Richard & Sundaresan (1981) study these claims in a continuous-time. Foreign exchange options were priced by Biger & Hull (1983) and Garman & Kohlhagen (1983). Dufﬁe & Kan (1993). Ho & Lee (1986). and Carr & Faguet (1994).b). Jarrow & Morton (1990).13 Foreign exchange models. The presentations of these given models here is taken from Rogers (1995). Johnson (1983).11 Term structure models. The Hull & White (1990) model is a generalization of the constant-coefﬁcent Vasicek (1977) model. Barone-Adesi & Whalley (1987). Jamshidian (1990). The distinction between futures contracts and daily resettled forward contracts has only recently been recognized (see Margrabe (1976). e This material in this course is taken from Geman. 1993b) and Brace & Musiela (1994a). 1982) (but see Hogan (1993) for discussion of a problem with this model). For additional reading on forward and futures contracts. Broadie & Detemple (1994). Black (1976)) and even more recently understood. Jarrow & Morton (1992). and to Chapte 7 of Dufﬁe (1992). Derman & Toy (1990). Other surveys of term structure models are Dufﬁe & Kan (1994) and Vetzal (1994). Geske & Johnson (1984). 35. 35. Our presentation of this material is similar to that of Dufﬁe & Stanton (1992). Notes and References 353 and by Parkinson (1977). Barone-Adesi & Elliott (1991). Cox. The Merton option pricing formula appears in Merton (1973). 35. Related works on term structure models and swaps are Flesaker & Hughston (1995) and Jamshidian (1996). Similar ideas were used by by Jamshidian (1989). Carverhill & Pang (1995) discuss implementation.10 Forward and futures contracts. MacMillan (1986). equilibrium setting. Bunch & Johnson (1992). Omberg (1987). Implementations of the model appear in Hull & White (1994a. The continuous-time Heath-Jarrow-Morton model appears in Heath. El Karoui and Rochet (1995).b).b). and Longstaff & Schwartz (1992a. which also considers options on futures. The Cox-Ingersoll-Ross model is presented in (1985a. (1995). 35.CHAPTER 35. The Brace-Gatarek-Musiela variation of the HJM model is taken from Brace. one may consult Dufﬁe (1989).12 Change of num´ raire. Ingersoll & Ross (1981) and Jarrow & Oldﬁeld (1981) provide a discrete-time arbitrage-based analysis of the relationship between forwards and futures. . and a discrete-time version is provided by Heath. The prices for differential swaps have been worked out by Jamshidian (1993a. A partial list of other term structure models is Black. A summary of this model appears as Reed (1995).b). Brennan & Schwartz (1979. et al.

354

35.14 REFERENCES

(1993) Aase, K. K., A jump/diffusion consumption-based capital asset pricing model and the equity premium puzzle, Math. Finance 3(2), 65–84. (1961) Alexander, S. S., Price movements in speculative markets: trends or random walks, Industrial Management Review 2, 7–26. Reprinted in Cootner (1964), 199–218. (1990) Artzner, P. & Heath, D., Completeness and non-unique pricing, preprint, School of Operations Research and Industrial Engineering, Cornell University. ´ (1900) Bachelier, L., Th´ orie de la sp´ culation, Ann. Sci. Ecole Norm. Sup. 17, 21–86. Reprinted e e in Cootner (1964). (1991) Back, K., Asset pricing for general processes, J. Math. Econonics 20, 371–395. (1991) Barone-Adesi, G. & Elliott, R., Approximations for the values of American options, Stoch. Anal. Appl. 9, 115–131. (1987) Barone-Adesi, G. & Whalley, R., Efﬁcient analytic approximation of American option values, J. Finance 42, 301–320. (1988) Bates, D. S., Pricing options under jump-diffusion processes, preprint, Wharton School of Business, University of Pennsylvania. (1992) Bates, D. S., Jumps and stochastic volatility: exchange rate processes implicit in foreign currency options, preprint, Wharton School of Business, University of Pennsylvania. (1991) Beinert, M. & Trautmann, S., Jump-diffusion models of stock returns: a statistical investigation, Statistische Hefte 32, 269–280. (1984) Bensoussan, A., On the theory of option pricing, Acta Appl. Math. 2, 139–158. (1983) Biger, H. & Hull, J., The valuation of currency options, Financial Management, Spring, 24–28. (1986) Billingsley, P., Probability and Measure, 2nd edition, Wiley, New York. (1975) Black, F., Fact and fantasy in the use of options, Financial Analyst’s J., 31, 36–41, 61–72.

**CHAPTER 35. Notes and References
**

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