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A Complete Explicit Solution to the

Log-Optimal Portfolio Problem


Thomas Goll and Jan Kallsen
Universitt Freiburg i. Br.

Abstract
Kramkov and Schachermayer (1999) proved the existence of log-optimal portfolios
under weak assumptions in a very general setting. For many but not all cases, Goll
and Kallsen (2000) obtained the optimal solution explicitly in terms of the semimartin-
gale characteristics of the price process. By extending this result, this paper provides a
complete explicit characterization of log-optimal portfolios without constraints.
Moreover, the results in Goll and Kallsen (2000) are generalized in two further
respects: Firstly, we allow for random convex constraints. Secondly, the remaining
consumption time or more generally the consumption clock may be random, which
corresponds to a life-insurance problem.
Finally, we consider neutral derivative pricing in incomplete markets.
Key words and phrases: Portfolio optimization, logarithmic utility, semimartingale
characteristics, life insurance, neutral derivative pricing
AMS 2000 subject classication: Primary 91B28; secondary 91B16, 60G48
1 Introduction
A classical problem in mathematical nance is how to choose an optimal investment strat-
egy in a securities market, or more precisely, how to maximize the expected utility from
consumption or terminal wealth (often called Mertons problem). We focus on logarithmic
utility in this paper. On an intuitive level, this utility function is supported by the so-called
Weber-Fechner law which says that stimuli are often perceived on a logarithmic rather than
linear scale. From a mathematical point of view, logarithmic utility distinguishes itself by
a desirable feature: In contrast to any other utility function, the optimal solution can be
calculated quite explicitly in general dynamic models even in the presence of complex de-
pendencies. Thirdly, the log-optimal strategy also maximizes the long-term growth rate in

Institut fr Mathematische Stochastik, Universitt Freiburg, Eckerstrae 1, D-79104 Freiburg i. Br., Ger-
many, (e-mail: goll@stochastik.uni-freiburg.de, kallsen@stochastik.uni-freiburg.de)
1
an almost-sure sense. For an historical account, details, and further references on expected
utility maximization we refer the reader to Karatzas and Shreve (1998) and Goll and Kallsen
(2000) (henceforth GK).
Kramkov and Schachermayer (1999) (henceforth KS) proved the existence of log-opti-
mal portfolios for terminal wealth in a general semimartingale framework. Semimartingales
are in some sense the largest class of processes that allows for the denition of a stochastic
integral or in nancial terms a gains process. Therefore, KS cover essentially the most
general case in which Mertons problem can be formulated.
Explicit solutions to this problem in terms of the semimartingale characteristics of the
underlying price process are provided in GK. They generalize well-known earlier results
e.g. for discrete-time or It processes. However, GK do not achieve the same degree of
generality as KS: In some cases optimal solutions are known to exist but they do not meet
the sufcient condition (3.2) in GK, Theorem 3.1.
The main goal of this paper is to ll this gap by providing a more general sufcient con-
dition which turns out to be necessary as well. Moreover, we extend the earlier results in two
respects: Firstly, we allow for random convex constraints similar to Cvitani c and Karatzas
(1992). Secondly, the consumption clock may be stochastic as well. As a particularly in-
teresting example consider the case of a random remaining lifetime (cf. Richard (1975)).
This can be interpreted as a life-insurance, or more precisely, an old-age pension problem.
It turns out that investment and consumption can no longer be treated seperately in this case.
In Section 2 we state the problem and some preparatory results. The explicit solution of
Mertons problem with random consumption clock and constraints can be found in Section
3. With the help of KS, it is shown in Section 4 that our sufcient condition is actually
necessary in the absence of constraints. Some further properties and illuminating examples
concerning the log-optimal portfolio are discussed in Section 5.
Another important issue in mathematical nance is derivative pricing. If one leaves the
small set of complete market models, unique arbitrage-free contingent claim values do not
exist any more. A way out is to consider neutral derivative prices. These are the only deriva-
tive prices such that the optimal expected utility is not increased by trading in contingent
claims. For motivation and more background on neutral pricing cf. Kallsen (2001). Exis-
tence, uniqueness, and computation of neutral derivative prices in the context of logarithmic
utility is treated in Section 6.
Finally, we provide some tools from stochastic calculus that are needed in the preced-
ing sections. In particular, we consider -martingales which play a key role in the gen-
eral version of the so-called fundamental theorem of asset pricing (FTAP) by Delbaen and
Schachermayer (1998).
Throughout, we use the notation of Jacod and Shiryaev (1987) (henceforth JS) and Jacod
(1979, 1980). The transposed of a vector or matrix x is denoted as x

and its components by


superscripts. Increasing processes are identied with their corresponding Lebesgue-Stieltjes
measure.
2
2 Optimal portfolios and supermartingales
Our mathematical framework for a frictionless market model is as follows: We work with a
ltered probability space (, F, (F
t
)
tR
+
, P) in the sense of JS, I.1.2. We consider traded
securities 0, . . . , d whose price processes are expressed in terms of multiples of the nu-
meraire security 0. Put differently, securities 0, . . . , d are modelled by their discounted
price process S := (S
0
, . . . , S
d
), where S
0
= 1. We assume that S is a R
d+1
-valued semi-
martingale. Occasionally, we will identify S with the R
d
-valued process (S
1
, . . . , S
d
).
We consider an investor (hereafter called you) who disposes of an initial endowment
(0, ). Trading strategies are modelled by R
d+1
-valued, predictable stochastic pro-
cesses = (
0
, . . . ,
d
), where
i
t
denotes the number of shares of security i in your
portfolio at time t. We call a trading strategy L(S) with
0
= 0 self-nancing if

t
S
t
=

S
t
for any t R
+
. A self-nancing strategy belongs to the set S of all
admissible strategies if its discounted gains process

S is bounded from below by


(no debts allowed).
We assume that your discounted consumption up to time t is of the form K
t
, where
denotes your discounted consumption rate according to the consumption clock K. We sup-
pose that K A
+
, i.e. K is an adapted increasing process with K
0
= 0 and E(K

) < .
Typical choices are K
t
:= 1
[T,)
(consumption only at time T), K
t
:= 1 e
t
(consump-
tion with impatience rate ), K
t
:=

st
1
{1,...,N}
(s) for some N N (consumption only at
integer times N), K
t
:= t T for some stopping time T (consumption uniformly in time
during your lifetime [0, T]). is supposed to be an element of the set K of all non-negative,
optional processes such that K is nite on R
+
. Your discounted wealth at time t is given
by V
t
(, ) := +

S
t
K
t
. A pair (, ) SK belongs to the set Pof admissible
portfolio/consumption pairs if the discounted wealth process V (, ) is non-negative.
In order to handle the stochastic clock we dene a martingale M by M
t
:= E(K

[F
t
).
Moreover, we set D := (, t) R
+
: t = 0 or M
t
() K
t
() > 0 P and
T := inft (0, ) : M
t
K
t
= 0. Since M
t
K
t
= 0 implies that M
s
K
s
= 0
for any s t, we have that T = sup
nN
T
n
and [0, T) D =
nN
[0, T
n
] [0, T], where
the sequence of stopping times (T
n
)
nN
is dened by T
n
:= inft R
+
: M
t
K
t
<
1
n
.
Moreover, we have K = 1
D
K.
Trading constraints are given in terms of subsets of the set of all trading strategies.
More specically, we consider a process whose values are convex subsets of R
d
. The
constrained set of trading strategies S() and portfolio/consumption pairs P() are dened
as above but with the additional requirement that (
1
, . . . ,
d
)
t

t
V
t
(, ) pointwise on
(0, ), i.e.
t
restricts the portfolio relative to one unit of wealth. Important examples
are := R
d
(no constraints) and := (R
+
)
d
(no short sales).
The aim of this paper is to determine how you can make the best out of your money in
the following sense:
Denition 2.1 We say that (, ) P() is an optimal portfolio/consumption pair for
the constraints if it maximizes ( , ) E(log( ) K

) over all ( , ) P(). (By


3
convention, we set E(log( ) K

) := if E((log( ) 0) K

) = .)
Remarks.
1. Observe that maximization of expected utility from terminal wealth is recovered as a
special case of the previous denition if we choose K := 1
[T,)
and
T
:= +

S
T
,
where T R
+
denotes the terminal time (cf. GK).
2. Let us briey touch the subject of discounting and numeraire changes. To this end
let S
0
denote the undiscounted price process of the numeraire. Suppose that S
0
is a
semimartingale, S
0
0
is deterministic, and E(log(S
0
) K

) is nite. The undiscounted


consumption rate is obtained by multiplying with the current undiscounted price
S
0
of the numeraire (cf. Goll and Kallsen (2001) for details). Since E(log(S
0
)
K

) = E(log() K

) + E(log(S
0
) K

), it follows that an optimal portfo-


lio/consumption pair maximizes the expected logarithm of undiscounted consumption
(, ) E(log(S
0
) K

) as well. Note also that the notion of admissibility does


not depend on the chosen numeraire because it means that the wealth does not fall
below 0, which is a numeraire-independent statement. Therefore, we have that the
optimal solution to Mertons problem does not depend on the chosen numeraire. But
one has to be careful about interpreting this fact: The consumption rate is always
expressed in terms of multiples of the numeraire. Therefore, the discounted rate of
one and the same optimal solution does in fact depend on the numeraire. The situa-
tion is even more subtle for the optimal strategy : It only depends on the numeraire
because the initial endowment is implicitly invested in the numeraire without appear-
ing in . Therefore, the same optimal investment is noted slightly differently if the
numeraire is changed (cf. Example 5.1).
Due to the strict concavity of the logarithm, optimal portfolio/consumption pairs are
essentially unique:
Lemma 2.2 (Uniqueness) Let (, ) and ( , ) be optimal portfolio/consumption pairs for
the constraints with nite expected utility E(log() K

). Then = holds (P K)-


almost everywhere. Moreover, we have

S =

S and hence V (, ) = V ( , ) on
D.
PROOF. Step 1: Dene :=
1
2
( + ), :=
1
2
( + ). Obviously, V ( , ) =
1
2
(V (, ) +
V ( , )). From the convexity of it follows that
1
2
( + )
1
2
(V

(, ) + V

( , ))
and hence ( , ) P(). By optimality of (, ), ( , ), we have
_
(log(
t
)
1
2
(log(
t
) +
log(
t
)))d(P K) =
_
log(
t
)d(P K)
_
log(
t
)d(P K) 0. Since the logarithm
is concave, the integrand log(
t
)
1
2
(log(
t
) +log(
t
)) is non-negative, which implies that
it is 0 (P K)-almost everywhere. Therefore = (P K)-almost everywhere because
the logarithm is strictly concave.
Step 2: Let t
0
[0, T] with P( : (, t
0
) D) ,= 0. Moreover, dene
A :=

S
t
0
<

S
t
0
F
t
0
and R :=
+

S
t
0
K
t
0

S
t
0
K
t
0

. Note that +

S
t
0
K
t
0


4
V
t
0
(, ) 0. W.l.o.g. we may assume that +

S
t
0
K
t
0

> 0 on A. Otherwise,
replace with from Step 1, which satises

S
t
0
<

S
t
0
<

S
t
0
on A. Dene a
new portfolio/consumption pair (, ) by

t
() :=
_

t
() if t t
0
or A
C
R
t
() if t > t
0
and A,

t
:=
_

t
for t < t
0
or A
C
R
t
for t t
0
and A.
For t t
0
and A we have V
t
(, ) = ( +

S
t
0
K
t
0

) + R((1
(t
0
,)
)


S
t
(1
[t
0
,)
) K
t
) = RV
t
(, ) V
t
(, ) 0. Hence V

(, ), which implies
that (, ) P(). Obviously, > on A [t
0
, T]. In view of the rst step, this is only
possible if P(A : (, t
0
) D) = 0.
It is well-known that the optimal solution to Mertons problem is myopic, i.e. it depends
only on the local behaviour of the price process. This local behaviour of semimartingales
is described by its characteristics in the sense of JS, II.2.6. Fix a truncation function h :
R
d+1
R
d+1
, i.e. a bounded function with compact support that satises h(x) = x in
a neighbourhood of 0. We assume that the characteristics (B, C, ) of the R
d+1
-valued
semimartingale (S
1
, . . . , S
d
, M) relative to h are given in the form
B = b A, C = c A, = A F, (2.1)
where A A
+
loc
is a predictable process, b is a predictable R
d+1
-valued process, c is a pre-
dictable R
(d+1)(d+1)
-valued process whose values are non-negative, symmetric matrices,
and F is a transition kernel from ( R
+
, P) into (R
d+1
, B
d+1
). By JS, II.2.9 such a
representation always exists. Typical choices for A are A
t
:= t (e.g. for Lvy processes,
diffusions, It processes etc.) and A
t
:=

st
1
N\{0}
(s) (discrete-time processes). Espe-
cially for A
t
= t, one can interpret b
t
or rather b
t
+
_
(x h(x))F
t
(dx) as a drift rate, c
t
as a diffusion coefcient, and F
t
as a local jump measure. It is straightforward to obtain
the semimartingale characteristics from other local desriptions of (S, M) e.g. in terms of
stochastic differential equations or one-step transition densities in the discrete-time case (cf.
GK, Section 4).
Even in the unconstrained case, the trading strategy cannot be freely chosen because
the wealth process is not allowed to jump to negative values. Moreover, it should not jump
to 0 either because this prevents future consumption unless the market allows arbitrage. It
turns out to be useful to express this fact in terms of a constraint set
0
dened by

0
t
:= R
d
: (, 0)

x > 1 for F
t
-almost any x R
d+1
. (2.2)
We call
0
the neutral constraints and set

:=
0
.
The following lemma relates optimal portfolio/consumption pairs with supermartin-
gales. It will serve as an important tool to prove our main results in the subsequent sections.
Moreover, it is of interest on its own and we will discuss it more thoroughly in Section 4.
5
Lemma 2.3 Suppose that a

-valued process H L(S) exists and let (, ) P()
be a portfolio/consumption pair. Assume that there is a non-negative process Z with the
following properties:
1. Z
0
=
E(K

|F
0
)

and Z =
1

(P K)-almost everywhere.
2. Z
T
n
is a semimartingale and (ZE (

S))
T
n
is a supermartingale for any n N and
any

-valued L(S).
Then (, ) is an optimal portfolio/consumption pair for the constraints .
PROOF. Since H is
0
-valued, we have E(

tR
+
1
(,1]
((H

S)
t
)) = E(1
(,1]
((H, 0)

x)
(S,M)

) = E(1
(,1]
((H, 0)

x)

) = 0. Therefore P(Ex. t R
+
with
(H

S)
t
1) = 0, which implies that V := E (H

S) and V

are positive processes


(cf. JS, I.4.61c). Dene (
H
,
H
) P() by
H
t
= ((V

H)

S
t
(V
t
H
t
)

S
t
, V
t
H
t
)
for t (0, ) and
H
:= 0.
Now, let ( , ) P() with E(log( ) K

) > . Fix (0, 1). Dene a portfo-


lio/consumption pair (, ) by := (1 ) +
H
, := (1 ) +
H
. Obviously,
V := V (, ) = (1 )V ( , ) + V . From the convexity of it follows that V

and hence (, ) P(). The positivity of V and V

implies that V and V

are pos-
itive as well and hence P(Ex. t R
+
with (

S)
t
1) = 0 for the -valued
process :=

V

L(S). Arguing conversely as for H above, we conclude that is

-valued (P A)-almost everywhere. W.l.o.g. we may assume that is



-valued: Oth-
erwise replace with H on the set /
0
, which is predictable because the mapping
(, t, y)
_
1
(,1]
((y, 0)

x)F((, t), dx) is (PB


d
)-measurable.
Fix n N. If we write C := K, we have (Z) K = Z C = Z

C + [Z, C] =
(Z

SZ

V +V

[Z,

S] [Z, V ] on [0, T
n
] by JS, I.4.49 and the denition of
V (, ). Since (ZE (

S))
T
n
is a supermartingale and hence locally of class (D) (cf. Jacod
(1979), (2.18) and its proof), it follows that
V

E (

S)

(ZE (

S))
T
n
= V

((Z


S + Z + [Z,

S])
T
n
is a local supermartingale and can be written as N A for some
N M
loc
, A A
+
loc
(cf. JS, I.3.38, I.4.34). This implies Z C
T
n
= N A V

Z
T
n

V
T
n
[Z, V
T
n
], which equals N A (ZV )
T
n
+ Z
0
V
0
by partial integration. If
(U
m
)
mN
denotes a localizing sequence of stopping times for both N and A, we have that
E(Z C
U
m
T
n
) = E(N
U
m
T
n
A
U
m
T
n
(ZV )
U
m
T
n
+ Z
0
V
0
) E(Z
0
V
0
) = E(K

)
for any m N. By monotone convergence, this implies E(Z C
T
n
) E(K

). Another
application of monotone convergence yields E((Z) K

) E(K

) because Z C
T
n

Z C

for n . Since the logarithm is concave, it follows that


log(1 )E(K

) +E(log( ) K

) = E(log() K

)
E((log() +Z( )) K

)
= E(log() K

) +E((Z) K

) E(K

)
E(log() K

).
Letting 0, we have E(log( ) K

) E(log() K

), which proves the claim.


6
3 Explicit solution in terms of characteristics
We place ourselves in the set-up of the previous section. The following theorem provides a
sufcient condition for optimality of a portfolio/consumption pair in terms of the character-
istics of the price process. In Section 4 we will show that this condition is also necessary in
the absence of constraints.
Theorem 3.1 Let H L(S) be a

-valued process and dene : R
+
R
d
R
on D R
d
by setting
() := (, 0)

b + (, 0)

c
_
H,
1
(M K)

_
+
_ _
(, 0)

x
1 + (H, 0)

x
_
1 +
x
d+1
(M K)

_
(, 0)

h(x)
_
F(dx) (3.1)
for R
d
if
_
[
(,0)

x
1+(H,0)

x
(1 +
x
d+1
(MK)

) (, 0)

h(x)[F(dx) < and () := else.


Outside D R
d
we set () := 0. Suppose that
sup( H) :

= 0 (P A)-almost everywhere on D. (3.2)
Let
:=
E (H

S)
E(K

[F
0
)E (
1
(MK)

M)
1
D{E(K

|F
0
)E (
1
(MK)

M)>0}
, (3.3)
V
t
:=
_

t
(M
t
K
t
) if t < T
V
T
(1 +H

T
S
T
) if t = T, K
T
= 0
0 if t = T, K
T
,= 0
V
T
E ((H1
(T,)
)

S) if t > T,

i
:= H
i
V

for i = 1, . . . , d,
0
:=

S
d

i=1

i
S
i
,
where we set V
0
:= 0. Then (, ) P() is an optimal portfolio/consumption pair for
the constraints with wealth process V .
We have to say a few words about the denition of . Since
1
(MK)

is bounded on [0, T
n
],
we have that
1
(MK)

1
[0,T
n
]
L(M) for any n N. Therefore, it makes sense to dene

t
:=
_

T
n
t
if t T
n
for some n N
0 else,
where the process
T
n
is dened by stopping the right-hand side of Equation (3.3) at T
n
.
Note that these processes
T
n
are optional. Since = lim
n
(
T
n
1
D
), it follows that is
optional as well.
7
PROOF OF THEOREM 3.1. Step 1: As in the proof of Lemma 2.3 it follows that E (H

S)
and E (H

S)

are positive on R
+
. Dene
Z :=
1

1
{>0}
=
E(K

[F
0
)E (
1
(MK)

M)
E (H

S)
1
D
.
Fix n N. All processes in this and the next step are supposed to be stopped at T
n
, i.e.
equalities etc. refer to the stochastic interval [0, T
n
]. Let
N :=
_
H,
1
(M K)

(S, M) +
_
(H, 0)

c
_
H,
1
(M K)

_
_
A
(H, 0)

x
_
1
1 + (H, 0)

x
_
1 +
x
d+1
(M K)

_
1
_

(S,M)
.
We will show that N is well-dened and Z = Z
0
E (N).
By Its formula (cf. e.g. Goll and Kallsen (2000), Lemma A.5), we have
1
E (H

S)
=
E (H

S+((H, 0)

c(H, 0))A+(
1
1+(H,0)

x
1+(H, 0)

x)
(S,M)
). Since E (X)E (Y ) =
E (X + Y + [X, Y ]) for any two semimartingales X, Y (cf. Jacod (1979), (6.4)), we have
that Z = Z
0
E (

N) with

N :=
_
H,
1
(M K)

(S, M) + ((H, 0)

c(H, 0)) A
+
_
1
1 + (H, 0)

x
1 + (H, 0)

x
_

(S,M)
+
_
H

S + ((H, 0)

c(H, 0)) A
+
_
1
1 + (H, 0)

x
1 + (H, 0)

x
_

(S,M)
,
1
(M K)

M
_
.
By JS, I.4.52 the quadratic covariation term equals
_
H

S
c
,
1
(M K)

M
c
_
+

s
_
1
1 +H

s
S
s
1
_
M
s
(M K)
s
=
_
(H, 0)

c
_
0,
1
(M K)

_
_
A +
_
1
1 + (H, 0)

x
1
_
x
d+1
(M K)


(S,M)
.
It follows that

N = N.
Step 2: Let L(S) be a

-valued process. By Equation (3.2) we have that
_
[
(H,0)

x
1+(H,0)

x
(1 +
x
d+1
(MK)

) ( H, 0)

h(x)[F(dx) < (P A)-almost everywhere. Dene


D
n
:= (, t) R
+
: [
t
H
t
[() n and
_
[
(
t
H
t
,0)

x
1+(H
t
,0)

x
(1 +
x
d+1
(MK)
t
) (
t

H
t
, 0)

h(x)[F
t
(dx)() [0, n] for n N. Since and H are predictable, we have
that (D
n
)
nN
is an increasing sequence of predictable sets with D
n
R
+
. Fix n N.
For any semimartingale X, we write X
D
n
:= X
0
1
D
n
(0) + 1
D
n
X (cf. Section 7). Partial
integration in the sense of JS, I.4.45 yields that ZE (

S) = Z
0
+(Z

E (

S)

) (

8
S +N + [N,

S]) and hence (ZE (

S))
D
n
= Z
0
1
D
n
(0) + (Z

E (

S)

) X with
X := (1
D
n
)

S + 1
D
n
N + 1
D
n
[N,

S]. From
[N,

S] =
_
1
(M K)

M
c
H

S
c
,

S
c
_
+

s
_
M
s
(M K)
s
+
_
1
1 +H

s
S
s
1
__
1 +
M
s
(M K)
s
_
_

s
S
s
=
_
(, 0)

c
_
H,
1
(M K)

_
_
A
+ (, 0)

x
_
1
1 + (H, 0)

x
_
1 +
x
d+1
(M K)

_
1
_

(S,M)
it follows that
X =
_
_
H,
1
(M K)

_
1
D
n
_

(S, M)
+
_
( H, 0)

c
_
H,
1
(M K)

_
1
D
n
_
A
+ ( H, 0)

x
_
1
1 + (H, 0)

x
_
1 +
x
d+1
(M K)

_
1
_
1
D
n

(S,M)
.
By JS, II.2.34 and II.1.30, we have
(( H)1
D
n
)

S = (( H)1
D
n
)

S
c
+ ( H, 0)

h(x)1
D
n
(
(S,M)
)
+ ( H, 0)

(x h(x))1
D
n

(S,M)
+ (( H, 0)

b1
D
n
) A.
Using JS, II.1.28, we obtain
X = (( H)1
D
n
)

S
c
+
1
D
n
(M K)

M
+
( H, 0)

x
1 + (H, 0)

x
_
1 +
x
d+1
(M K)

_
1
D
n
(
(S,M)
) + (( H)1
D
n
) A.
Since Z

E (

S)

(H) 0, it follows that (ZE (

S))
D
n
is a local supermartingale
(cf. JS, I.4.34, I.4.23), which in turn implies that ZE (

S) is a -supermartingale (cf.
Lemma 7.4). By Proposition 7.9, it is even a supermartingale.
Step 3: Recall that K = 1
D
K. On D, the process attains the value 0 only if
K = 0 or if E (
1
(MK)

M) jumps to 0. It is easy to see that the latter can only happen


if t = T and K
t
= 0. Together, it follows that > 0 and hence Z =
1

(P K)-
almost everywhere. In view of Lemma 2.3, it remains to be shown that (, ) P() is an
admissible portfolio/consumption pair with wealth process V .
Fix n N. Since E (X)E (Y ) = E (X+Y +[X, Y ]) for any two semimartingales X, Y ,
straightforward calculations yield that
1 = E
_
1
(M K)

M
_
E
_

1
(M K)

M +
1
(M K)

(M K

)
[M, M]
_
9
on [0, T
n
), which implies that
=

E(K

[F
0
)
E
_
H

S
1
(M K)

M +
1
(M K)

(M K

)
[M, M]
+
_
H

S,
1
(M K)

M +
1
(M K)

(M K

)
[M, M]
_
_
on [0, T
n
). Another straightforward calculation yields (MK)

+[, M] =

M +
((MK)

H)

S on [0, T
n
). Since V = +

(MK)+(MK)

+[, MK]
by partial integration and

K + [, K] = K by JS, I.4.49a, we conclude that V =


+ S K on [0, T
n
).
So far all equalities have referred to the stochastic interval [0, T
n
) for given n N.
Letting n , it follows that V = + S K = +V

(H

S) K holds on
[0, T). Since K is non-decreasing, we have that 0 V E (H

S) on [0, T
n
) for any n
by Proposition 7.1. Therefore 1
D
V

is locally bounded and the limit (1


D
V

) (H

S)
T
=

S
T
exists. Since K is non-decreasing and bounded from above by + S, the
limits K
T
and V
T
exist as well. Hence V
T
and
T
are well dened.
Suppose that K
T
= 0. Then V
T
= V
T
(1 + H

T
S
T
) = V
T
+

T
S
T

T
K
T
and hence V = + S K holds on [0, T].
Alternatively, suppose that K
T
,= 0. A straightforward calculation yields that 1 +
1
(MK)
T
M
T
=
K
T
(MK)
T
and hence
T
=
T
(1 + H

T
S
T
)
(MK)
T
K
T
=
1
K
T
(V
T
+

t
S
T
). Hence V = +

S K holds on [0, T] in this case as well.


The extension to R
+
is straightforward. Together, it follows that (, ) is indeed an
admissible portfolio/consumption pair with wealth process V . Note that
0
is well-dened
and predictable since

S = (
1
, . . . ,
d
)

(S
1
, . . . , S
d
) and

d
i=1

i
S
i
=
(

S)

d
i=1

i
S
i

.
The following corollary is not as general, but the condition on H is more transparent.
Corollary 3.2 Suppose that = R
d
(i.e. there are no constraints). Let H L(S) be a
R
d
-valued process with the following properties:
1. 1 + (H, 0)

t
x > 0 for (P A F)-almost all (, t, x) D R
d+1
,
2.
_
[
x
i
1+(H,0)

x
(1 +
x
d+1
(MK)

) h
i
(x)[F(dx) < (P A)-almost everywhere on D for
i = 1, . . . , d,
3.
0 = b
i
+c
i
_
H,
1
(M K)

_
+
_ _
x
i
1 + (H, 0)

x
_
1 +
x
d+1
(M K)

_
h
i
(x)
_
F(dx) (3.4)
(P A)-almost everywhere on D for i = 1, . . . , d.
10
Dene , V , and as in Theorem 3.1. Then (, ) Pis an optimal portfolio/consumption
pair with wealth process V .
PROOF. Note that () = 0 for any R
d
in Theorem 3.1.
In which sense does Theorem 3.1 provide an explicit solution to Mertons problem? The
crucial part of both Theorem 3.1 and Corollary 3.2 is the condition on H. Let us start with
Corollary 3.2. Here, all we have to do is to solve Equation (3.4) pointwise for any (, t).
At least from a numerical point of view, this is relatively easy because the characteristics of
the price process are typically known and we only need to nd a solution to d equations in
d unknowns. Various concrete examples are given in GK.
Formally, the right-hand side of Equation (3.4) can be interpreted as the derivative of
some concave function of H that is to be maximized (cf. GK, Remark 4 following Theorem
3.1). But the derivative at a maximal point need not be 0 in the presence of convex con-
straints. Instead, it sufces that the directional derivative is non-positive for those directions
that point inside the constrained set. In our setting, this directional derivative is represented
by ( H) where is dened in Equation (3.1), H is the reference point and H
denotes the direction of interest. The corresponding non-positivity statement is to be found
in Condition (3.2). Note that regardless of its more complex form, this condition on H in
Theorem 3.1 is still a pointwise one.
Even in the unconstrained case, the optimal solution is sometimes not of the form in
Corollary 3.2 (cf. Example 5.2 below and Example 5.1bis in KS). The way out is to treat
this case articially as a constrained one by introducing the neutral constraints
0
, which
has been done in Theorem 3.1. This leads to a necessary condition as is shown in Section 4.
Another interesting issue is the role of the consumption clock in the utility maximization
problem. Let us start with the simple case where K is deterministic, which implies that
M = K

is constant. In this case, Equation (3.1) can be rewritten as


() =

cH +
_
_

x
1 +H

h(x)
_
F(dx),
where h : R
d
R
d
denotes a truncation function and (b, c, F) is dened in the same
way as (b, c, F) but for the R
d
-valued process S instead of (S, M). Since the specic form
of K does not affect H, it follows that the portfolio and the consumption problem can be
seperated. Although the optimal portfolio depends on V and hence on K, the relative
portfolio H =
1
V

(
1
, . . . ,
d
), i.e. the number of securities relative to one unit of wealth,
does not. On the other hand, a simple calculation shows that

t
=
V
t
K

K
t
=
V
t
+

t
S
t
K

K
t
for the optimal portfolio/consumption pair. The numerator of the second fraction is the
wealth at time t before consumption has taken place. The denominator stands for the re-
maining consumption time in the interval [t, ). Therefore, the optimal strategy tries to
11
spread consumption of current wealth uniformly over the remaining lifetime as it is mea-
sured by the consumption clock K.
If the consumption clock is random, the two aspects can no longer be seperated. It turns
out that the optimal relative portfolio is affected by the consumption clock K if the tradable
securities S
1
, . . . , S
d
and the martingale M are not independent. The intuitive reason is
that your uncertain remaining lifetime creates a risk that you want to hedge partially by
trading securities. Put differently, you invest in a portfolio that insures you against the
expenses of old age even if this portfolio has a negative drift and is hence unprotable.
The consumption strategy, on the other hand, remains essentially the same. Since

t
=
V
t
M
t
K
t
=
V
t
+

t
S
t
E(K

K
t
[F
t
)
,
you still try to spread your wealth over the remaining lifetime K

K
t
. But because the
latter is unknown, it is replaced with its conditional expectation.
4 Necessity and existence in the absence of constraints
So far, we have not addressed the question whether an optimal portfolio/consumption pair
exists and if it is of the form in Theorem 3.1. In this section we show that this is indeed the
case at least in the absence of constraints. The proof will be based on Theorem 2.2 in KS
which states that optimal portfolios exist in the terminal wealth case and which characterizes
them in terms of a dual mimimization problem. Interestingly, this deep result will allow us
to prove the existence of a solution even for some random consumption clocks.
The general setting is as before. In addition to the assumptions in the previous sections
we suppose that = R
d
(i.e. there are no constraints) and that Condition NFLVR (no
free lunch with vanishing risk) in the sense of Delbaen and Schachermayer (1998) holds.
Moreover, we assume that
supE(log( +

S
Tn
)) : S < for any n N. (4.1)
Finally, we suppose that
1
(MK)

L
1
loc
(M) and E (
1
(MK)

M) is a positive, locally
bounded process, which holds trivially e.g. if the consumption clock is deterministic.
Theorem 4.1 There exists an optimal portfolio/consumption pair (, ) P which meets
the conditions in Theorem 3.1 for = R
d
. If S is continuous, it also meets the conditions
in Corollary 3.2. By Lemma 2.2, there is essentially no other optimal portfolio/consumption
pair.
PROOF. Step 1: Suppose that M is constant and T < . In Step 5 we treat the general
case. All processes in Steps 14 of this proof are supposed to be stopped at T, i.e. equalities
etc. refer to the interval [0, T]. Condition NFLVR implies that there exists a weak local
martingale measure in the sense of the remark following Denition 7.12. By KS, Theorem
12
2.2(ii) there exists a strategy S such that Z( +

S) is a supermartingale for any


S, where Z :=
1
+

S
. In particular, Z is a semimartingale. Let H :=

+

. Since
E (H

S) =
1
Z
is a positive process, we have that H

S > 1 up to an evanescent set.


In particular, we have H
0
(P A)-almost everywhere because
0 = E
_

s[0,T]
1
(,1]
(H

t
S
t
)
_
= E
_
1
(,1]
((H, 0)

x)
(S,M)
T
_
= E
_
1
(,1]
((H, 0)

x)
T
_
=
_
[0,T]
F(x R
d+1
: (H, 0)

x 1)d(P A).
Note that the set G := H /
0
is predictable because the mapping (, t, y)
_
1
(,1]
((y, 0)

x)F((, t), dx) is (P B


d
)-measurable. Therefore,

H := H1
G
C L(S) is a
predictable
0
-valued process. Moreover, we have H

S =

H

S because (H1
G
)

S =
0 (cf. Kallsen and Shiryaev (2001b), Lemma 2.5 and the fact that a semimartingale with
vanishing characteristics is constant, cf. JS, II.4.19). Hence we may assume w.l.o.g. that H
is
0
-valued.
Step 2: By Its formula e.g. as in GK, Lemma A.5, we have that Z = Z
0
E (N) with
N := H

S + ((H, 0)

c(H, 0)) A +
_
1
1 + (H, 0)

x
1 + (H, 0)

x
_

(S,M)
.
Dene := (, t, x) R
+
R
d+1
: [x[ > 1 or [(H, 0)

t
()x[ > 1 P B
d+1
.
By GK, Propositions A.2 and A.3, we have N = H

S
c
(H, 0)

x1

C(x) (
(S,M)

) (H, 0)


B+((H, 0)

c(H, 0)) A+(


1
1+(H,0)

x
1+(H, 0)

x1

C(x))
(S,M)
, where

B := (b
_
(h(x)x1

C(x))F(dx))Ais a predictable process whose components are in V .


Since Z is a supermartingale, we have that N :=
1
Z

Z is a special semimartingale (cf. JS,


I.4.26, I.4.34). By JS, I.4.23, this implies that (
1
1+(H,0)

x
1 +(H, 0)

x1

C(x))
(S,M)

A
loc
and hence, by JS, II.1.28,
N = H

S
c
+
_
1
1 + (H, 0)

x
1
_
(
(S,M)
)
(H, 0)


B + ((H, 0)

c(H, 0)) A
_
(H, 0)

x
1 + (H, 0)

x
(H, 0)

x1

C(x)
_

= H

S
c

(H, 0)

x
1 + (H, 0)

x
(
(S,M)
) (H) A, (4.2)
where is dened as in Equation (3.1).
Step 3: Let L(S) be a
0
-valued process, which implies that E (

S) and E (

S)

are positive processes (cf. the proof of Lemma 2.3). By Yors formula (cf. Jacod (1979),
(6.4)), we have that
1
Z

E (

S)

(ZE (

S)) = N +

S + [N,

S] =

(S +
[N, S]) +N. Since ZE (

S) is a supermartingale (cf. Step 1) and


1
Z

E (

S)

is positive
13
and locally bounded, it follows that

(S + [N, S]) + N is a local supermartingale and


in particular a special semimartingale (cf. JS, I.3.38, I.4.34). Note that [N, S
i
] = H


S
c
, S
i,c
) +

t
N
t
S
i
t
= (c
i
(H, 0)) Ax
i
(H,0)

x
1+(H,0)

x

(S,M)
for i = 1, . . . , d. Using
the same arguments as for N in the previous step, we conclude that

(S + [N, S]) =

S
c
+
(, 0)

x
1 + (H, 0)

x
(
(S,M)
) + () A.
By Equation (4.2), it follows that the local supermartingale

(S + [N, S]) + N equals


( H) A up to a local martingale. Since ( H) A is predictable, it must be
non-increasing, which implies that ( H) 0 (P A)-almost everywhere.
Step 4: Dene the set G := (, t) [0, T] : There exists y
0
t
() with

t
(y H
t
)() > 0. Then G = (, t) [0, T] : There exists y R
d
with
(, t, y) g
1
(1 (0, ]), where g : [0, T] R
d
R (R ), (, t, y)
(1

0
t
()
(y),
t
(y H
t
)()). Since g is (P B
d
)-measurable, Sainte-Beuve (1974), The-
orem 4 yields that G is P
PA
-measurable, where P
PA
denotes the (P A)-completion
of the -eld P (cf. Halmos (1974), Thorem 13.C in this context). Hence, the set

G :=
(G
C
0) g
1
(1(0, ]) is (P
PA
B
d
)-measurable. By the measurable selection
theorem (cf. Sainte-Beuve (1974), Theorem 3), there exists a P
PA
-measurable mapping
: [0, T] R
d
with (, t,
t
())

G for any (, t) [0, T]. Outside some
(P A)-null set, coincides with some
0
-valued predictable process, which we denote
again by . Fix n N and let

:= 1
{||n}
. One easily veries that

L(S) is a
0
-
valued process and (

H) > 0 (P A)-almost everywhere on G[[ n. From the


previous step it follows that G[[ n is a (PA)-null set. Since n was chosen arbitrar-
ily, we have that G is a (P A)-null set, which implies that sup( H) :
0
= 0
(P A)-almost everywhere on [0, T].
Step 5: Now, we consider the general case. W.l.o.g. we may assume S = S
T
because
the condition on H in Theorem 3.1 pertains only to D [0, T] or, put differently, trading
after T does not affect the expected utility of consumption. Let (R
n
)
nN
be a sequence of
stopping times with R
n
almost surely and E (
1
(MK)

M)
R
n
n for any n N.
W.l.o.g. let R
n
n for any n N.
Fix n N. Dene a probability measure P

P by its Radon-Nikodym density


dP

dP
:=
E (
1
(MK)

M)
R
n
. Since
dP

dP
is bounded, Condition (4.1) implies that supE
P
(log( +

S
t
)) : S < for any t R
+
. Moreover, NFLVR holds relative to P

. By
Lemma 7.11 and straightforward calculations, the P

-characteristics of (S
1
, . . . , S
d
, M) are
of the form (2.1), but with b

, c

, F

instead of b, c, F, where
b

= b +c
_
0,
1
(M K)

_
+
_
h(x)
x
d+1
(M K)

F(dx),
c

= c
F

(G) =
_
G
_
1 +
x
d+1
(M K)

_
F(dx) for G B
d+1
on [0, R
n
]. It follows that () = (, 0)

(, 0)

(H, 0)+
_
(
(,0)

x
1+(H,0)

x
(, 0)

h(x))
F

(dx) on [0, R
n
], where () is dened as in Equation (3.1). Now we can apply Steps 14
14
of this proof to P

instead of P, 1
[n,)
instead of K and hence n instead of T. This yields
the existence of a
0
-valued process H
(n)
L(S) with sup( H
(n)
) :
0
= 0
(P A)-almost everywhere on [0, R
n
]. Letting H :=

nN\{0}
H
(n)
1
]R
n1
,R
n
]
, the claim
follows.
Along with other recent articles on the subject, this paper is based on a key insight which
relates utility maximization and equivalent martingale measures: Very roughly speaking, a
portfolio/consumption pair (, ) is optimal if and only if u

() is up to a normalizing con-
stant the density process of an equivalent martingale measure (EMM). Here, u denotes the
utility function under consideration, i.e. the logarithm in our case. Similarly, an admissible
strategy maximizes the expected utility from terminal wealth at time T iff u

( +

S
T
)
is proportionate to the density of an EMM. This relationship has been termed fundamen-
tal theorem of utility maximization (FTUM) in Kallsen (2001) because of its similarity with
the fundamental theorem of asset pricing (FTAP) which relates the absence of arbitrage with
EMMs. For bibliography, we refer the reader to Section 2.2 of Kallsen (2001) and in partic-
ular to Foldes (1990), who stated a version of Corollary 4.2 in a quite general semimartingale
setting.
Similarly to the FTAP, the FTUM holds literally true only for markets of a simple struc-
ture, e.g. in nite probability spaces. In general, the process u

() may no longer be the


density process of a probability measure, let alone an EMM. The following result states
a general version of the relationship between log-optimal portfolio/consumption pairs and
martingales. Here, Z plays the role of the density process of an EMM. However, Example
5.1bis in KS shows that in general Z may fail to be even a local martingale.
Corollary 4.2 (Fundamental theorem of utility maximization) Suppose that the con-
sumption clock K is deterministic. For any (, ) P the following statements are equiv-
alent:
1. (, ) is an optimal portfolio/consumption pair without constraints.
2. There exists a non-negative semimartingale Z with Z
0
=
K

such that
(a) Z =
1

(P K)-almost everywhere,
(b) (Z( +

S))
T
n
is a supermartingale for any n N and any S .
PROOF. 21: This implication follows from Lemma 2.3: Choose H := 0 and recall from
the proof of Lemma 2.3 that E (

S) is non-negative for any



-valued L(S).
12: Step 1: Fix n N. As noted in Step 1 of the proof of Theorem 4.1, there exists
a strategy
(n)
S such that (Z
(n)
( +

S))
Tn
is a supermartingale for any S,
where Z
(n)
:=
K

+(
(n)
)

S
Tn
. Moreover, it was shown that H
(n)
:=

(n)
+(
(n)
)

S
1
[0,Tn]
meets
the conditions in Theorem 3.1 e.g. for the consumption clock K
(n)
:= 1
[Tn,)
.
Step 2: Let m, n N with m > n. Obviously, H
(m)
meets the conditions in Theorem
3.1 for the consumption clock K
(n)
as well. Moreover,
(n)
coincides on [0, T n] with the
15
optimal strategy dened in Theorem 3.1 constructed from H
(n)
and K
(n)
. The same is true
for
(m)
, H
(m)
, and K
(n)
. By Lemma 2.2 we conclude that (
(m)
)

S
Tn
= (
(n)
)

S
Tn
,
which implies that Z
(m)
= Z
(n)
and (H
(m)
)

S = (H
(n)
)

S on [0, T n].
Step 3: Now, dene H :=

nN\{0}
H
(n)
1
]Tn1,Tn]
L(S) and Z :=
K

E (H

S)
, which
equals Z
(n)
on [0, T n] for any n N. Note that H meets the conditions in Theorem 3.1
(for the originally given consumption clock K), which implies that :=
E (H

S)
K

1
D
=
1
Z
1
D
is the consumption rate of some optimal portfolio/consumption pair ( , ). By Lemma 2.2
and since D
C
is a (P K)-null set, we have Z =
1

(P K)-almost everywhere. Statement


(b) follows from Step 1.
If we allowfor constraints, we may consider Lemma 2.3 as a sufcient part of the FTUM.
The question whether it is also necessary is left to future research.
5 Special cases and related problems
First of all, we want to take a closer look at the general assumptions which we made in the
previous sections. In Lemma 2.2 we assumed that the maximal expected utility is nite. It
is easy to see that unique optimal portfolio/consumption pairs do not exist in cases where
the maximal expected utility equals or : If an optimal strategy is given, then cutting
trades and consumption in half and investing the remaining endowment in the numeraire
yields an optimal portfolio/consumption pair as well. Condition (4.1) is closely related to
the natural assumption supE(log() K

) < : (, ) P R of nite maximal


expected utility. However, one can show that the latter condition alone does not sufce to
conclude existence of an optimal strategy (cf. Goll and Kallsen (2001)).
In Section 4 we also imposed the standard condition of no free lunch with vanishing
risk (NFLVR). It is well known that it can be expressed in terms of -martingales or local
martingales (cf. Delbaen and Schachermayer (1998) and Section 7 below). One may wonder
whether the absence of free lunches does not already follow from the condition of nite
maximal expected utility. This is not the case as will be shown in Example 5.1: Even in a
market with arbitrage there may still exist an optimal portfolio/consumption pair with nite
expected utility. The reason is that the notion of admissibility for the utility maximization
problem implies that the wealth process is bounded from below by 0 and not just by an
arbitrary constant. Conversely, the absence of free lunches does not imply that the maximal
expected utility is nite: One simply has to consider a one-period market with one risky
asset S
1
satisfying E(log(S
1
1
)) = in the sense that E(0 (log(S
1
1
))) < and
E(0 log(S
1
1
)) = .
Example 5.1 In this example we consider the same market relative to two different nu-
meraires. Let S
0
:= 1 and S
1
:= 1 + (1
[0,]
) W, where W denotes a standard Wiener
process,
t
:=
1

1t
, and the stopping time := inft [0, 1] : W
t
<
1
2
is bounded
P-almost surely by 1. Obviously, S
1
is a [
1
2
, )-valued local martingale with S
1
1
=
1
2
. Let
the initial endowment and the consumption clock be given by := 1 and K := 1
[1,)
.
16
Firstly, we consider S
0
as the numeraire. Since
S
1
S
0
= S
1
is a P-local martingale, the
market meets condition NFLVR. A simple application of Corollary 3.2 yields that it is opti-
mal not to trade in security 1 and to consume the initial endowment at time 1, i.e. we have
= (0, 0) and
1
= 1 for the optimal portfolio/consumption pair (, ).
Alternatively, we treat S
1
as numeraire. Then the discounted prices are given by

S
1
:=
S
1
S
1
= 1 and

S
0
:=
S
0
S
1
. Note that

S
0
is [0, 2]-valued with

S
0
0
= 1 and

S
0
1
= 2. Hence, buying
this security at time 0 and selling it at time 1 is an arbitrage in this market, which implies
that condition NFLVR does not hold. For a thorough account of arbitrage and numeraire
changes cf. Delbaen and Schachermayer (1995). Using Its formula, we conclude that the
characteristics (b, c, F) of

S
0
relative to A
t
= t are given by
b
t
= (S
1
t
)
3
1
[0,]
(t)
1 t
= (

S
0
t
)
3
1
[0,]
(t)
1 t
,
c
t
= (S
1
t
)
4
1
[0,]
(t)
1 t
= (

S
0
t
)
4
1
[0,]
(t)
1 t
,
and F = 0, which implies that H :=
1

S
0
leads to an optimal strategy in the application
of Corollary 3.2. Consequently, the optimal portfolio/consumption pair ( , ) is given by

0
= HE (H

S
0
) =
1

S
0

S
0
= 1 and hence
1
= 1 by the self-nancability constraint.
Moreover,
1
= E (H

S
0
)
1
=

S
0
1
= 2. Note that the role of the numeraire and the risky
asset are now exchanged for the application of Corollary 3.2.
Although ( , ) looks quite different from (, ) above, it corresponds to the same
investment strategy. Since the initial endowment is implicitly invested in the numeraire,
= (0, 0) means investment in one share of security 0 and zero shares of security 1. The
same holds true for = (1, 1) because security 1 is now chosen as numeraire. Simi-
larly, the undiscounted consumption is calculated from resp. by multiplication with the
nominal value of the corresponding numeraire. In both cases it equals
1
S
0
1
= 1 =
1
S
1
1
.
We have noted already in Section 3 that the complex sufcient condition in Theorem 3.1
can often be replaced with the simpler one in Corollary 3.2. Now, we want to take a closer
look at what Equation (3.4) means. From Lemma 2.3 and Corollary 4.2 we know that the
process Z =
1

plays a crucial role if (, ) P denotes an optimal portfolio/consumption


pair. Let us assume for the time being that Z
T
is a positive uniformly integrable martingale
and hence up to a normalizing constant the density process of some probability measure
P

P. With this notion, Condition (3.4) means that S


T
is a P

--martingale, i.e. P

is
a -martingale measure for the stopped process S
T
(cf. Step 1 in the proof of Theorem 3.1,
Lemma 7.14 and some straightforward calculations). Put differently, it means that (SZ)
T
is a P--martingale (cf. Proposition 7.13), which makes sense even if Z
T
is only a local
martingale and P

is not dened. Sometimes, however, Z


T
is not even a local martingale,
e.g. in Example 5.1bis of KS, where Equation (3.4) does not have a solution. It may also
happen that Z
T
is a uniformly integrable martingale but the corresponding measure P

is
not a -martingale measure, in which case one cannot apply Corollary 3.2 either:
17
Example 5.2 Let X be a random variable whose law is exponential with parameter 2. De-
ne a simple one-period market as follows: F
t
:= , for t [0, 1), F
t
:= (X) for
t 1, S
1
t
:= 1 for t [0, 1), S
1
t
:= X for t 1. Note that E(S
1
1
) =
1
2
< S
1
0
. If we con-
sider the terminal wealth problem with initial endowment 1 (i.e. K := 1
[1,)
and := 1), a
straightforward application of Theorem 3.1 or Corollary 4.2 shows that
1
= 0 and = 1
for the optimal portfolio/consumption pair (, ) P. In particular, the corresponding pro-
cess Z =
1

= 1 is the density process of P

:= P, but this measure is not a -martingale


measure, not even a weak local martingale measure in the sense of Section 7.
At this point let us take the opportunity to correct an inaccuracy in GK: In Theorem 3.1
one has to impose slightly stronger integrability conditions for the proof to work. However,
as can be seen from Theorem 3.1 and Corollary 3.2 in this paper, the statements remain valid
under the original integrability condition but the proof requires more rened reasoning by
-localization.
Numeraire portfolio
Sometimes, the numeraire portfolio is proposed as an alternative to measure changes in
mathematical nance (cf. e.g. Long (1990), Becherer (2001)). The idea is to choose some
tradable portfolio as a numeraire such that the corresponding discounted securities price
processes are martingales or at least -martingales under the real-world probability measure
P. If a numeraire portfolio exists, then it is essentially unique and it coincides with the
log-optimal portfolio for terminal wealth. (Note that the optimal trading strategy in the
terminal wealth problem (i.e. for K := 1
[T,)
with some T R
+
) does not depend on T as
long as it is in the future.) In order to obtain existence and uniqueness of numeraire portfo-
lios under the weak general assumptions in Section 4, Becherer (2001) extended this notion
to strategies such that
1+

S
1+

S
is a supermartingale for any L(S) with 1 +

S > 0.
By Corollary 4.8 in Becherer (2001), numeraire portfolios in this sense coincide precisely
with log-optimal portfolios for terminal wealth and initial endowment 1. Therefore, Theo-
rem 3.1 can be interpreted as a general explicit characterization of the numeraire portfolio
if we choose := 1, := R
d
, and K := 1
[T,)
for some remote T R
+
. If you pre-
fer the narrower denition in terms of -martingales, you should turn instead to Corollary
3.2: Equation (3.4) means that the corresponding discounted securities
S
i
1+

S
=
S
i

are
-martingales for i = 0, . . . , d. This follows from a straightforward but tedious calculation.
Growth rate of wealth
Finally, we turn to the growth rate of wealth which is discussed e.g. in Karatzas and Shreve
(1998), Section 3.10. Suppose that NFLVR and Condition (4.1) hold for any T R
+
. By
Theorem 4.1 the optimal portfolio for terminal wealth does not depend on the terminal date
T. Therefore, there is a strategy Sthat maximizes
1
T
E(log( +

S
T
)) for any
T R
+
and hence also the expected growth rate of wealth limsup
t
1
t
E(log(+

S
t
)).
18
Interestingly, this property can be strengthened in an almost-sure sense. The following
lemma extends Theorem 3.10.1 in Karatzas and Shreve (1998) to the general semimartingale
case, but the proof remains essentially the same. For references on the growth rate of wealth
cf. Karatzas and Shreve (1998), Section 3.11.
Lemma 5.3 By Sdenote the optimal portfolio for terminal wealth as explained above.
Then we have
limsup
t
1
t
log( + S
t
) limsup
t
1
t
log( + S
t
)
P-almost surely for any S.
PROOF. Let S and (0, 1) and dene Z =
1
+

S
. It follows from KS, Theorem
2.2(ii) that Z is a well-dened positive supermartingale and that Z( +

S) is a super-
martingale. In particular, we have e
n
P(sup
t[n,)
Z
t
( +

S
t
) > e
n
) E(Z
0
( +

S
0
)) = 1 for any n N by Doobs maximal inequality (cf. e.g. Elliott (1982), Corol-
lary 4.8 and Theorem 4.2). This implies

n=1
P(sup
t[n,)
1
n
log(Z
t
( +

S
t
)) > )

n=1
e
n
< . Fromthe Borel-Cantelli lemma it follows that P-almost surely there exists
some (random) n
0
Nsuch that sup
t[n,)
1
n
log(Z
t
(+

S
t
)) for any n n
0
. Since
Z =
1
+

S
, we have that limsup
t
1
t
log(+

S
t
) limsup
t
1
t
log(+

S
t
)+
P-almost surely.
6 Neutral derivative pricing
Contingent claim valuation in incomplete markets cannot be based solely on arbitrage ar-
guments. Additional assumptions have to be made if one wants to obtain unique prices.
Neutral derivative pricing tries to mimic and generalize the economic reasoning in com-
plete markets by substituting utility maximizers for arbitrage traders. A derivative price is
called neutral if an investor cannot raise her expected utility by trading the claim. For moti-
vation, references, and connections to other approaches in the literature we refer the reader
to Kallsen (2001).
Of course, neutral prices generally depend on the prole of the representative investor,
i.e. on her utility function, initial endowment, time horizon etc. Logarithmic utility offers
a number of advantages in this context. We have noted already that it is supported by the
Weber-Fechner law on an intuitive level. Moreover, it turns out that neutral prices for log-
arithmic utility do not depend on the numeraire, the initial endowment, or the time horizon
of the investor. And opposed to other utility functions, the density process of the pricing
measure can be computed explicitly for a great number of semimartingale models for the
underlyings.
In this section, we work with a nite time horizon R
+
. As representative investor
we consider an unconstrained log-utility maximizer with deterministic consumption clock.
More precisely, we assume that the general setting is as in Section 4, that S = S

, and that
K

> 0, where K is deterministic. Suppose that there exists a process H as in


19
Corollary 3.2 with
_
[
x
1+(H,0)

x
h(x)[F(dx) L(A). Then
L := S
c
+
x
1 +H

x
(
S

S
)
is a well-dened local martingale, where
S
denotes the compensator of the measure of
jumps of S. Moreover, we have
Proposition 6.1 H L(L) and E (H

L) =
1
E (H

S)
.
PROOF. Recall from Step 1 in the proof of Theorem 3.1 that E (H

S) and E (H

S)

are
positive on R
+
. An application of Its formula e.g. as in GK, Lemma A.5 yields that
1
E (H

S)
= E
_
H

S +H

S
c
, H

S
c
)
_
H

x
1 +H

x
H

x
_

S
_
.
Observe that [
x
1+H

x
x[
S
V because [
x
1+H

x
h(x)[
S
V and [xh(x)[
S
V .
By Proposition 7.2 it follows that (
H

x
1+H

x
H

x)
S
= H

((
x
1+H

x
x)
S
) and
hence
1
E (H

S)
= E (H

L) with

L := S S
0
S
c
, H

S
c
) + (
x
1+H

x
x)
S
. The
canonical decomposition of S and Equation (3.4) yield that
S
i
= S
i
0
+S
i,c
+h
i
(x) (
S

S
) + (x
i
h
i
(x))
S
+B
i
= S
i
0
+S
i,c
+h
i
(x) (
S

S
) + (x
i
h
i
(x))
S
+S
i,c
, H

S
c
)
_
x
i
1 +H

x
h
i
(x)
_

S
for i = 1, . . . , d, which implies that

L
i
= S
i,c
+
x
i
1+H

x
(
S

S
) = L
i
as desired.
We dene Z := E (H

L) =
1
E (H

S)
= exp(X), where X := H

S +
1
2
((H, 0)

c
(H, 0)) A (log(1 + H

x) H

x)
S
and the last equality follows from Kallsen
and Shiryaev (2001a), Lemma 2.6. From now on, we assume that Z is a martingale (for
sufcient conditions cf. e.g. Kallsen and Shiryaev (2001a), Section 3). Then Z is the density
process of some probability measure P

P. We call P

the dual measure or neutral


pricing measure for logarithmic utility. The rst name is motivated by the fact that it solves
some dual optimization problem (cf. KS), whereas the second terminology will become
clear below. Note that P

depends neither on K nor on (as long as S = S

). Recall
from the paragraph following Example 5.1 that P

is an equivalent -martingale measure


(EMM) (cf. Denition 7.12). It minimizes the reverse relative entropy Q E(log(
dQ
dP
))
among all EMMs Q(cf. Becherer (2001), Corollary 4.8 and Goll and Rschendorf (2001),
Corollary 6.2 for a similar statement on equivalent local martingale measures).
The framework of our contingent claim valuation problem is as follows: In addition
to underlying securities 0, . . . , d, we assume that derivatives d + 1, . . . , d + n are given
in terms of their discounted terminal payoffs R
d+1
, . . . , R
d+n
, which are supposed to be
F

-measurable random variables. We call semimartingales S


d+1
, . . . , S
d+n
derivative price
20
processes if S
d+i
[ess inf R
d+i
, ess sup R
d+i
] and S
d+i
t
= R
d+i
for t and i = 1, . . . , n.
As noted above, we are interested in contingent claim values that have a neutral effect on
the derivative market in the sense that they do not cause supply of or demand for derivatives
by the representative log-utility maximizer:
Denition 6.2 We call derivative price processes S
d+1
, . . . , S
d+n
neutral if there exists an
optimal portfolio/consumption pair (, ) in the extended market S
0
, . . . , S
d+n
which satis-
es
d+1
= . . . =
d+n
= 0.
The following result treats existence and uniqueness of neutral derivative price pro-
cesses. Moreover, it shows that they are obtained via conditional expectation relative to
the neutral pricing measure P

.
Theorem 6.3 Suppose that R
d+1
, . . . , R
d+n
are bounded. Then there exist unique neutral
derivative price processes. These are given by S
d+i
= E
P
(R
d+i
[F
t
) for t R
+
, i =
1, . . . , n. Moreover, the extended market S
0
, . . . , S
d+n
satises the condition NFLVR.
PROOF. Existence: Set S
d+1
t
:= E
P
(R
d+i
[F
t
) for t R
+
, i = 1, . . . , n. Dene (, ) by
:= (
0
, . . . ,
d
, 0, . . . , 0) and = , where (, ) is the optimal portfolio/consumption
pair from Corollary 3.2. The denition of implies that
1

=
1

=
K

Z (P K)-almost
everywhere. Obviously, (, ) is an admissible portfolio/consumption pair in the extended
market S := (S
0
, . . . , S
d+n
). Now, let L(S) with +

S 0. Since S is a
R
d+n
-valued P

--martingale, we have that Z( +

S) is a P--martingale (cf. Lemma


7.10 and Proposition 7.13) and hence a P-supermartingale (cf. Proposition 7.9). In view of
Corollary 4.2, (, ) is an optimal portfolio/consumption pair in the extended market. Since
S is a -martingale with respect to P

P, we have that NFLVR holds (cf. Delbaen and


Schachermayer (1998), Theorem 1.1).
Uniqueness: Obviously, one may choose the portfolio/consumption pair (, ) in De-
nition 6.2 as in the existence part of this proof. Let Z be the supermartingale in Statement 2
of Corollary 4.2 corresponding to the extended market. Since Z =
1

=
1

=
K

Z (P K)-
almost everywhere, one easily concludes that Z =
K

Z on [0, ] up to indistinguishability
(e.g. by Jacod (1979), (7.10) and the fact that Z is a martingale).
Fix i 1, . . . , n. Dene L(S) by
j
:= 0 for j ,= d + i and
d+i
:=
/[ess sup R
d+i
ess inf R
d+i
[. Then +

S = +
d+i
(S
d+i
S
d+i
0
) 0. By
Corollary 4.2, Z( +

S) and hence ZS
d+i
is a supermartingale. Replacing
d+i
with

d+i
yields that ZS
d+i
is a supermartingale as well. Together, we have that S
d+i
is a
P

-martingale (cf. Proposition 7.13), which implies the uniqueness.


Remark. If R
d+1
, . . . , R
d+n
are P

-integrable instead of bounded, the above proof still


yields the existence of neutral derivative price processes and the NFLVR property of the
extended market.
21
Note that the neutral derivative prices depend neither on the initial capital nor on the
specic deterministic consumption clock K nor on because the same holds for P

. Re-
call from Section 2 that optimal portfolio/consumption pairs do not depend on the chosen
numeraire. Consequently, the property of being neutral is independent of the numeraire as
well, which is a very desirable feature.
7 -martingales and related tools from stochastic calculus
The aim of this section is twofold. On the one hand, it provides some tools from stochastic
calculus which are needed in the proofs of the previous sections. On the other hand, we
summarize some related facts on -martingales because these processes play a key role in
the general statement of the fundamental theorems of asset pricing in Delbaen and Schacher-
mayer (1998) and Cherny and Shiryaev (2001).
Before we turn to the main topic of this section, we start with two simple propositions
which are needed in the proofs of Theorem 3.1 and Proposition 6.1.
Proposition 7.1 Let X be a semimartingale with X 1, A V
+
, and Y a semi-
martingale with Y = 1 +Y

X A. Then we have Y E (X).


PROOF. By Protter (1992), Theorem V.7 the equation Y = 1 + Y

X A has an up to
indistinguishability unique solution Y . Partial integration in the sense of JS, I.4.49a shows
that it is given by Y = E (X)(1
1
E (X)
A) (cf. also Yoeurp (1982)). Since
1
E (X)
A is
non-negative, the assertion follows.
Proposition 7.2 Let be an integer-valued random measure and H, K R
d
-valued pre-
dictable processes with K
i
V for i = 1, . . . , d. Then (H

K) V if and
only if H L
s
(K ). In this case (H

K) = H

(K ).
PROOF. There exists an R
d
-valued predictable process a with K
i
= a
i
[K[ for i = 1, . . . , d.
Set A := [K[ . Then K
i
= a
i
A for i = 1, . . . , d. Note that [H

K[ =
([H

a[[K[) = [H

a[ A. Since [H

K[ V if and only if (H

K) V , and
[H

a[ A V if and only if H L
s
(K ), the rst claim follows. The second statement
follows from a similar calculation.
-localization
-martingales have been introduced by Chou (1979) and were investigated further by Emery
(1980). Below, we argue that they can be interpreted quite naturally as semimartingales
with vanishing drift. Similar to local martingales, the set of -martingales can be obtained
from the class of martingales by a localization procedure, but here localization has to be
understood in a broader sense than usually (cf. JS, I.1d).
For any semimartingale X and any predictable set D R
+
, we write X
D
:=
X
0
1
D
(0) + 1
D
X, where 1
D
(0)() := 1
D
((, 0)) for . In particular, we have
X
[0,T]
= X
T
for any stopping time T (cf. JS, I.4.37).
22
Denition 7.3 For any class C of semimartingales we dene the -localized class C

as
follows: A process X belongs to C

if and only if there exists an increasing sequence


(D
n
)
nN
of predictable sets such that D
n
R
+
up to an evanescent set and X
D
n
C
for any n N.
Lemma 7.4 If C is stable under stopping, then (C
loc
)

= C

.
PROOF. We mimic the proof of a similar statement in JS, I.1.35. Let X (C
loc
)

and
(D
n
)
nN
a localizing sequence of predictable sets such that X
D
n
C
loc
for any n N.
Since C
loc
is stable under stopping, we may assume that D
n
= D
n
[0, n]. For any
n N there exists a localizing sequence of stopping times (T(n, p))
pN
and p
n
N
such that (X
D
n
)
T(n,p)
C for any p N and P(T(n, p
n
) < n) 2
n
. Let

D
n
:=
D
n
(

mn
[0, T(m, p
m
)]). Observe that

D
n
is an increasing sequence of predictable
sets. Let k N and (, t) [0, k] with (, t) (

nN
D
n
) (

nN

D
n
) =
limsup
n
(D
n


D
n
). Obviously, this holds (up to evanescence) also for (, k) instead
of (, t). Since
P( : (, k) D
n


D
n
)

mn
P(T(m, p
m
) < n)

mn
P(T(m, p
m
) < m)

mn
2
m
= 2
(n1)
,
the Borel-Cantelli lemma yields P( : (, k) limsup
n
(D
n


D
n
)) = 0 and
hence [0, k]

nN

D
n
up to an evanescent set. Since C is stable under stopping
and X

D
n
= ((X
D
n
)
T(n,p
n
)
)

mn+1
T(m,p
m
)
, it follows that X

D
n
C for any n N. Hence
X C

.
Of course, we have C C
loc
C

for any class C of semimartingales. As a particular


case, we obtain the set M

of -martingales. Denote by D the set of semimartingales such


that the stopped process X
t
is of class (D) for any t R
+
(cf. JS, I.1.46). Below we will
consider the corresponding localized classes D
loc
and D

.
The name -martingale was used in Delbaen and Schachermayer (1998) to refer to the
set of semimartingales de la classe (
m
) introduced by Chou (1979) and Emery (1980),
who also consider D

as semimartingales de la classe (). To be more precise, X


M

(resp. X D

) holds if and only if X X


0
is a semimartingale de la classe (
m
)
(resp. semimartingale de la classe ()). Some researchers prefer the older name martingale
transform which was originally applied in discrete-time settings. Equivalent denitions can
be found in Emery (1980), Proposition 2.
The -martingale property can be easily read from the characteristics of a semimartin-
gale (cf. Kabanov (1997), Lemma 3). To this end, x a real-valued semimartingale X with
X
0
= 0. As in Section 2, let its characteristics (B, C, ) relative to some truncation function
h : R R be given in the form
B = b A, C = c A, = A F, (7.1)
23
where A A
+
loc
and b are predictable processes, c is a predictable R
+
-valued process, and
F is a transition kernel from ( R
+
, P) into (R, B).
Lemma 7.5 1. X is a -martingale if and only if
_
{|x|>1}
[x[F(dx) < and
b +
_
(x h(x))F(dx) = 0 (7.2)
hold (P A)-almost everywhere on R
+
.
2. X is a local martingale if and only if
_
{|x|>1}
[x[F(dx) L(A) and Equation (7.2)
holds (P A)-almost everywhere on R
+
.
3. X is a martingale if and only if X D and Equation (7.2) holds (P A)-almost
everywhere on R
+
.
PROOF. 2. This follows immediately from JS, II.2.29, II.2.13, I.3.10.
1. This follows from Statement 2 because M

= (M
loc
)

(cf. also Kallsen and Shiryaev


(2001a), Lemma 2.5).
3. : Since martingales are local martingales that belong to D (cf. JS, I.1.47), this
inclusion follows from Statement 2.
: By Jacod (1979), Exercise 2.1, we have that D
loc
coincides with the set of special
semimartingales, which in turn satisfy
_
{|x|>1}
[x[F(dx) L(A) (cf. JS, II.2.29). Using
Statement 2 we conclude that X is a local martingale of class (D) on [0, t] for any t R
+
and hence a martingale (cf. JS, I.1.47).
Consequently, martingales, local martingales, and -martingales can all be interpreted
as processes with vanishing drift (7.2) that differ only in the extent of uniform integrability.
If we drop Equation (7.2) and keep the integrability conditions in Lemma 7.5, then we end
up with the sets D, D
loc
, D

as the following lemma shows:


Lemma 7.6 1. X D

if and only if
_
{|x|>1}
[x[F(dx) < (PA)-almost everywhere
on R
+
.
2. X D
loc
if and only if X is a special semimartingale if and only if
_
{|x|>1}
[x[F(dx)
L(A).
PROOF. 2. The rst equivalence is Jacod (1979), Exercise 2.1. The second equivalence
follows from JS, II.2.29, II.2.13, I.3.10.
1. Since D

= (D
loc
)

by Lemma 7.4, this follows from Statement 2.


Let us summarize some relationships between -martingales and other classes of pro-
cesses.
Corollary 7.7 1. X is a local martingale if and only if it is both a -martingale and a
special semimartingale.
24
2. X is a martingale if and only if it is both a -martingale and in D.
3. X is a uniformly integrable martingale if and only if it is a -martingale of class (D).
PROOF. This follows immediately from Lemmas 7.5, 7.6 and JS, I.1.47.
Corollary 7.8 1. Any locally bounded -martingale is a local martingale.
2. Any bounded -martingale is a uniformly integrable martingale.
PROOF. Corollary 7.7, JS, I.4.23
Proposition 7.9 Let X be a non-negative -supermartingale with E(X
0
) < . Then X is
a supermartingale.
PROOF. Let the characteristics of X be of the form (7.1). Since any supermartingale is
locally of class (D) (cf. Jacod (1979), Exercise 2 or the proof of Jacod (1979), (2.18)), there
exists a sequence (D
n
)
nN
of predictable sets with D
n
R
+
such that 1
D
n
X is a
supermartingale of class (D) for any n.
Fix n N. By JS, IX.5.3 or Kallsen and Shiryaev (2001b), Lemma 2.5, the characteris-
tics of 1
D
n
X are of the form (7.1) as well, but with b

:= 1
D
n
b, c

:= 1
D
n
c, F

:= 1
D
n
F
instead of b, c, F. Since 1
D
n
X is a supermartingale, it is a special semimartingale and
its unique predictable part of bounded variation is given by (b

+
_
(x h(x))F

(dx))
A = ((b +
_
(x h(x))F(dx))1
D
n
) A (cf. JS, II.2.29). This process is actually decreas-
ing because 1
D
n
X is a supermartingale of class (D) (cf. JS, I.3.38). This implies that
b +
_
(x h(x))F(dx) 0 (P A)-almost everywhere on D
n
and hence on R
+
because n was arbitrarily chosen.
The non-negativity of X implies that
_
{|x|>1}
(x 0)F(dx) X

_
{|x|>1}
F(dx). By
JS, II.2.13 this implies
_
{|x|>1}
(x0)F(dx) L(A). Since b +
_
(xh(x))F(dx) 0, it
follows that
_
{|x|>1}
[x[F(dx) L(A). By Lemma 7.6 and JS, II.2.29, this means that X is a
special semimartingale whose predictable part of bounded variation (b+
_
(xh(x))F(dx))
A is decreasing. Hence, X is in fact a nonnegative local supermartingale. In view of Jacod
(1979), (5.17), we are done.
As opposed to local martingales and special semimartingales, the corresponding -
localized classes are stable relative to stochastic integration:
Lemma 7.10 Let X be a R
d
-valued semimartingale and H L(X). Then the following
statements hold:
1. If X
i
M

for i = 1, . . . , d, then H

X M

.
2. If X
i
D

for i = 1, . . . , d, then H

X D

.
25
PROOF. This follows from Lemmas 7.5, 7.6 and Kallsen and Shiryaev (2001b), Lemma 2.5.

So far, we have concentrated on real-valued processes. As for local martingales, it


makes sense to dene R
d
-valued -martingales as semimartingales whose components are
-martingales. Following Delbaen and Schachermayer (1998) one may also call a R
d
-valued
process X -martingale if there exists a R
d
-valued martingale M and a predictable, non-
negative process such that L(M
i
) and X
i
= X
i
0
+ M
i
for i = 1, . . . , d. By Cherny
and Shiryaev (2001), Theorem 5.6 and Emery (1980), Proposition 2, the two denitions are
consistent.
Equivalent -martingale measures
Delbaen and Schachermayer (1998) relate the absence of free lunches to the existence of
equivalent -martingale measures. Belowwe showhowthese measures can be characterized
in terms of semimartingale characteristics. To this end, let S = (S
1
, . . . , S
d
) be a R
d
-valued
semimartingale which stands for the discounted prices of securities 1, . . . , d. Moreover, let
P

loc
P be a probability measure with density process Z. By N := L(Z) :=
1
Z

Z we
denote the stochastic logarithm of Z, i.e. the unique semimartingale N with E (N) = Z (cf.
Kallsen and Shiryaev (2001a) for details on the stochastic logarithm; note that Z and Z

are positive by P

loc
P and JS, I.2.27). Suppose that the characteristics (B, C, ) of the
R
d+1
-valued semimartingale (S, N) relative to h : R
d+1
R
d+1
are given in the form
B = b A, C = c A, = A F, (7.3)
where A A
+
loc
is a predictable process, b is a predictable R
d+1
-valued process, c is a
predictable R
(d+1)(d+1)
-valued process whose values are non-negative, symmetric matrices,
and F is a transition kernel from ( R
+
, P) into (R
d+1
, B
d+1
).
The Girsanov-Jacod-Mmin theorem as stated in JS, III.3.24 indicates how the charac-
teristics change if P is replaced with P

. Here, we formulate this result in terms of the joint


characteristics of (S, N), which is convenient for applications.
Lemma 7.11 The P

-characteristics of (S, N) are of the form (7.3), but with


b

= b +c
,d+1
+
_
h(x)x
d+1
F(dx),
c

= c,
dF

dF
(x) = 1 +x
d+1
instead of b, c, F.
PROOF. According to JS, III.3.31, there exists a predictable R
d+1
-valued process such
that

c L(A) and c
i,d+1
A = S
i,c
, N
c
) = (c
i
) A for i = 1, . . . , d. It follows that
Z
c
, S
i,c
) = Z

N
c
, S
i,c
) = (Z

c
i
) A.
26
Secondly, we have Z
t
= Z
t
(1 + N
t
) = Z
t
(1 + x
d+1
) for
(S,N)
-almost all (t, x)
R
+
R
d+1
, which implies that E(ZU
(S,N)

) = E((1+x
d+1
)Z

U
(S,N)

) for any nonneg-


ative (PB
d+1
)-measurable function U. Put differently, we have Y Z

= M
P

(S,N)
(Z[

P)
in the sense of JS, III.3c for Y (, t, x) := 1 +x
d+1
. By JS, III.3.24, we are done.
Denition 7.12 We call P

an equivalent martingale measure (EMM) (resp. equivalent lo-


cal martingale measure (ELMM), equivalent -martingale measure (EMM)) if S
i
is a mar-
tingale (resp. local martingale, -martingale) relative to P

for i = 1, . . . , d.
Remark. In Delbaen and Schachermayer (1994) the term equivalent local martingale mea-
sure is used in the above sense. KS and Becherer (2001), however, apply the same name to
denote measures P

P such that 1+

S is a P

-local martingale for any L(S) with


1 +

S 0. In order to avoid confusion, we prefer to call measures of such kind equiv-


alent weak local martingale measures. One easily shows that any -martingale measure is
a weak local martingale measure while the converse is not true. Nevertheless, the existence
of an equivalent weak local martingale measure sufces to ensure Condition NFLVR (cf.
Becherer (2001), Proposition 2.3).
For the proof of Lemma 7.14 we need the following proposition, which extends JS,
III.3.8 to the -martingale case.
Proposition 7.13 A real-valued semimartingale X is a P

-martingale (resp. P

-local mar-
tingale, P

--martingale) if and only if XZ is a P-martingale (resp. P-local martingale,


P--martingale).
PROOF. By JS, III.3.8 it sufces to prove the assertion for -martingales. Let (D
n
)
nN
be
an increasing sequence of predictable sets. By partial integration we have
1
D
n
(XZ) = 1
D
n
(X

Z) + 1
D
n
(Z

X) + 1
D
n
[X, Z]
= (1
D
n
X

) Z + (1
D
n
X)Z (1
D
n
X)

Z.
: Let (D
n
)
nN
be a -localizing sequence for the P

--martingale X. Then 1
D
n

(XZ) is a P-local martingale. Therefore XZ (M
P
loc
)

= M
P

, i.e. it is a P--martingale.
: This follows similarly if (D
n
)
nN
now denotes a -localizing sequence for the
P--martingale XZ.
We are now ready to characterize EMMs, ELMMs, and EMMs in terms of semi-
martingale characteristics:
Lemma 7.14 1. S is a P

-martingale if and only if SZ D relative to P and


b
i
+c
i,d+1
+
_
(x
i
(1 +x
d+1
) h
i
(x))F(dx) = 0 for i = 1, . . . , d (7.4)
holds (P A)-almost everywhere on R
+
.
27
2. S is a P

-local martingale if and only if


_
{|x
i
|>1}
[x
i
(1 + x
d+1
)[F(dx) L(A) for
i = 1, . . . , d and Condition (7.4) holds (P A)-almost everywhere on R
+
.
3. S is a P

--martingale if and only if


_
{|x
i
|>1}
[x
i
(1 + x
d+1
)[F(dx) < for i =
1, . . . , d and Condition (7.4) hold (P A)-almost everywhere on R
+
.
PROOF. Statements 2 and 3 follow from Lemmas 7.11 and 7.5.
1. : Condition (7.4) follows from Statement 2. By Proposition 7.13, SZ is a P-
martingale and hence in D (cf. Lemma 7.5).
: Fix i 1, . . . , d. Since S
i
Z and Z are special semimartingales, this is also true
for Y :=
1
Z

(S
i
Z S
i

Z) =
1
Z

(Z

S
i
+ [S
i
, Z]) = S
i
+ [S
i
, N]. From Y =
S
i
(1 + N) it follows that [x
i
(1 + x
d+1
)[1
{|x
i
(1+x
d+1
)|>1}
= [x[1
{|x|>1}

Y
A
loc
,
where
Y
denotes the compensator of the measure of jumps of Y . By JS, II.2.13 we have
that [x
i
(1 + x
d+1
)[1
{|x
i
|>1}
[x
i
(1 + x
d+1
)[1
{|x
i
(1+x
d+1
)|>1}
+ 1
{|x|>1}
A
loc
.
Statement 2 yields that S is a P

-local martingale, which in turn implies that SZ is a P-


local martingale. By Corollary 7.7, we have that SZ is a P-martingale. Once more applying
Proposition 7.13 yields the claim.
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Thomas Goll, Jan Kallsen
Institut fr Mathematische Stochastik
Universitt Freiburg
Eckerstae 1
D-79104 Freiburg
Germany
E-mail: goll@stochastik.uni-freiburg.de, kallsen@stochastik.uni-freiburg.de
30