Chapter 4

Girsanov theorem and rst

nancial applications
The aim of this chapter is to introduce Girsanov theorem, a fundamental result of nan-
cial mathematics. This theorem tells us how the dynamics of a stochastic process changes
when the original measure is changed to an equivalent probability measure. In nancial
words, when dealing with derivatives, it tells us how to pass from the physical measure,
which characterizes the probability that an underlying asset will have a particular value,
to the risk-neutral measure (or equivalent martingale measure) that governs the pricing
of a derivative (whose value depends on the underlying asset) under the hypothesis of no
arbitrage.
The procedure we will follow to prove Girsanov theorem is the following: we rst introduce
exponential martingales and we show how these can be used to generate new measures on
a probability space (, F, P). This means that we will speak about absolutely continuous
measures and the Radon-Nikodym derivative. We will then introduce the Cameron-Martin
theorem, which gives us important clues about the relationships between the standard
Brownian motion and Brownian motion with drift. Finally, after giving some extra condi-
tions (Novikov conditions), we will be able to discuss Girsanov theorem, which generalizes
the results of Cameron-Martin.
The chapter includes the rst meaningful nancial applications of the theoretical instru-
ments we have introduced so far.
45
46 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
4.1 Exponential martingales and absolutely continuous mea-
sures
Let
1
{B
t
= B(t)}
t0
be a standard Brownian motion dened on (, F, P). Let {F
t
}
t0
be
its natural ltration.
For every R, dene the process {Z

(t)}
t0
such that
Z

(t) = exp

B(t)

2
t
2

. (4.1)
Proposition 15. For every R, the process {Z

(t)}
t0
is a positive martingale w.r.t.
{F
t
}
t0
.
Proof. The fact that Z

(t) > 0 is always positive is evident.

We want to show that, for any s, t 0, E(Z

(t + s)|F
s
) = Z

(s). This is just one of

the dierent ways in which we can prove martingality (with the purpose of speeding up
computations).
In order to get our result, we will make use of a very well known property of normal random
variables. In particular, if X N(0, ), where is the standard deviation, then, for every
R, we know that E[exp(X)] = exp(
2

2
/2).This is nothing more than one of the
properties of the expected value of a lognormal random variable, which we get by taking
the exponential of a normal r.v.
Hence we have the following:
E[Z

(t +s)|F
s
] = E[exp(B(t +s)
2
(t +s)/2|F
s
]
= E[exp(B(s)
2
s/2) exp((B(t +s) B(s))
2
t/2)|F
s
]
= exp(B(s)
2
s/2)E[exp((B(t +s) B(s))
2
t/2)|F
s
]
= Z

(s)E[exp((B(t +s) B(s))) exp(

2
t/2)|F
s
]
= Z

(s) E[exp((B(t +s) B(s)))]

. .
Lognormal expected value
exp(
2
t/2)
= Z

(s) exp(
2
t/2) exp(
2
t/2)
. .
=1
= Z

(s).
Thanks to Proposition 15, process {Z

(t)}
t0
is also known as the (basic) exponential
martingale.
1
Please notice that in this chapter we often interchange the notation X(t) and X
t
for convenience.
4.1. EXPONENTIAL MARTINGALES ANDABSOLUTELYCONTINUOUS MEASURES47
4.1.1 The Radon-Nikodym derivative
Let us now consider a positive random variable Z on the probability space (, F, P), such
that E[Z] = E
P
[Z] = 1. This variable can be used to dene a new probability measure on
the equipped space (, F). In fact, for every F F, it is sucient to set
Q(F) = E
P
[Z1
F
]. (4.2)
Proposition 16. The quantity Q, dened in equation (4.2), is a probability measure on
(, F).
Proof. The fact that Q is always nonnegative is trivial, given that Z is always positive.
Further we can notice that
Q() = E
P
[Z1

] = E
P
[Z 1] = E
P
[Z] = 1.
Finally, to show additivity, just consider F
1
, F
2
, ..., to be pairwise disjoint events in
F, such that

n=1
F
n
= F F. Then 1
F
=

n=1
1
F
n
, and the monotone convergence
theorem guarantees that
Q(F) = E
P
[Z1
F
] = E
P
_
Z

n=1
1
F
n
_
=

n=1
E[Z1
F
n
] =

n=1
Q(F
n
).
Proposition 17. Given the measures P and Q, and a nonnegative random variable Y ,
the expectations E
P
and E
Q
behave as follows:
E
Q
[Y ] = E
P
[Y Z], (4.3)
E
P
[Y ] = E
Q
[Y/Z]. (4.4)
Proof. We just sketch the proof, by explaining its main steps.
To show equation (4.3), we can start by taking Y = 1
F
. In that case equation (4.3) is
nothing more than the denition of the measure Q.
Now, assume that Y is a simple random variable, i.e. it can be obtained as linear combi-
nation of indicators. Since the expectation is a linear operator, equation (4.3) still holds.
Finally, take a general nonnegative Y . Nonnegativity guarantees that Y is the monotone
limit of simple random variables. Hence the monotone convergence theorem guarantees
that equation (4.3) also holds for the limit.
Regarding equation (4.4), it is sucient to re-write Y =

Y Z, where

Y is a nonnegative
random variable. Notice that every nonnegative random variable Y can be expressed in
that way, being Z strictly positive. The proof is then completed by plugging Y =

Y Z in
(4.4), also considering equation (4.3).
48 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
In the case in which two probability measure P and Q satisfy equations (4.3) and (4.4)
for a given positive r.v. Z, then we say that the two measures are mutually absolutely
continuous (and we write P, Q a.c). The random variable Z is called Radon-Nikodym
derivative of Q with respect to P, or likelihood ratio of Q w.r.t P. The typical notation is
Z :=
dQ
dP
. This notation makes particularly sense if we consider the following equation
E
Q
[Y ] =
_

Y dQ =
_

Y
dQ
dP
dP =
_

Y ZdP = E
P
[Y Z].
It is very important to notice that the Radon-Nikodym derivative of Q w.r.t. P depends on
(i.e. it is measurable with respect to) the algebra F on which the measures are dened.
A natural question is then the following: what happens when we have dierent algebras
available?
Proposition 18. Let P and Q be mutually a.c. probability measures on (, F), with
Radon-Nikodym derivative Z = (dQ/dP)
F
. Suppose that G is a algebra such that G F.
Then the Radon-Nikodym derivative of Q w.r.t. P on the algebra G is

dQ
dP

G
= E
P
[Z|G].
Proof. For every G G, we aim to show that Q(G) = E
P
[1
G
E
P
[Z|G]].
By assumption we have G F, therefore G F and 1
G
is G and Fmeasurable. By
hypothesis we also know that Z is the Radon-Nikodym derivative of Q w.r.t. P on the
algebra F. This means that we can apply equation (4.3) with Y = 1
G
, getting
Q(G) = E
Q
[1
G
] = E
P
[Z1
G
].
Using the law of total expectation and the fact that 1
G
is Gmeasurable, we nally have
Q(G) = E
P
[Z1
G
] = E
P
[E
P
[Z1
G
|G]] = E
P
[1
G
E
P
[Z|G]].
Proposition 18 tells us that, if {F
t
} F is a ltration on (, F), and if P and Q
are mutually absolutely continuous probability measures on F
T
, for some T , then
P and Q are mutually a.c. on every F
t
with t T, and the Radon-Nikodym derivatives
(dQ/dP)
F
t
dene a martingale (under P) for 0 t T.
4.2 The Cameron-Martin theorem
For each R and every T > 0, it is easy to see that the quantity Z

(T), dened
in equation (4.1), is a positive random variable with expectation 1 under P (remember
4.2. THE CAMERON-MARTIN THEOREM 49
that {B(t)}
t0
is a standard Brownian motion on (, F, P), and {F
t
}
t0
is its natural
ltration). This implies that Z

(T) can be a Radon-Nikodym derivative. Set P

and E

to
be the probability measure and the expectation operator determined by Z

(T) on (, F
T
).
In other terms, for every F F
T
, and for every nonnegative F
T
measurable random
variable Y , we have
P

(F) = E
0
[Z

(T)1
F
], E

[Y ] = E
0
[Z

(T)Y ],
and
P
0
(F) = E

[Z

(T)
1
1
F
], E
0
[Y ] = E

[Z

(T)
1
Y ],
with P
0
= P.
We now have all the concepts we need to introduce the Cameron-Martin theorem that,
as we have said before, is nothing more than a special case (the most important one,
actually) of the more general Girsanov theorem, which we will consider in the next sections.
In particular, the Cameron-Martin theorem characterizes the distribution of the random
process {B(t)}
t0
under the (tilted) measure P

.
Theorem 7 (Cameron-Martin). Under P

, the process {B
t
= B(t)}
0tT
has the same
law as a Brownian motion with drift . In other terms, the stochastic process {B
t
}
0tT
has the same law under P

as the process {B
t
+t}
0tT
under P
0
.
Proof. First remember that P
0
= P. Then, let us start by the simplest case, that is to say
the one involving a single random variable U = B
T
under P

. W.l.o.g. we also assume

T=1.
For every y R, we have
P(U y) = E[Z

(1)1
Uy
] = E[exp(U
2
/2)1
Uy
]
=
_
y

exp(u
2
/2)
1

2
exp(u
2
/2)du
=
_
y

2
exp((u )
2
/2)du
=
_
y+

2
exp(v
2
/2)dv
= P
0
(U y).
This implies that, under P

, the random variable U = B

1
has the same distribution of the
random variable B
1
+ under P
0
.
To really prove the theorem, we are supposed to show that, for 0 t
0
< t
1
< ... < t
n
= T,
the joint distribution of the increments B
1
, B
2
, ..., B
k
is the same, under P

, as that
of B
1
+t
1
, B
2
+t
2
, ..., B
k
+t
k
under P
0
, where X
k
= X
t
k
X
t
k1
.
It is known that, if we have two distributions for which the moment generating functions
50 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
(m.g.f.) exist, the two distributions are the same if and only if the two m.g.f. are the same.
This is what we show in the following equation, given that the m.g.f. of a Brownian motion
fortunately exists.
E

_
exp
_
n

k=1

k
B
k
__
= E
0
_
Z

(T) exp
_
n

k=1

k
B
k
__
= E
0
_
exp(B(t
n
)
2
t
n
/2) exp
_
n

k=1

k
B
k
__
= E
0
_
exp
_
n

k=1
(
k
+)B
k
_
exp(
2
t
n
/2)
_
= exp(
2
t
n
/2)
n

k=1
E
0
[exp ((
k
+)B
k
)]
. .
Lognormal expected value
= exp(
2
t
n
/2)
n

k=1
exp
_
(
k
+)
2
t
k
/2
_
=
n

k=1
exp
_
_

2
k
t
k
/2
. .

+
k
t
k
_
_
= E
0
_
exp
_
n

k=1
(
k
(B
k
+t
k
))
__
.
In , we reverse the lognormal expected value. Hence the proof is complete.
It is thus clear that the Cameron-Martin theorem builds a very interesting relation
between standard Brownian motion and Brownian motion with drift. Since a standard
Brownian motion can be seen as a Brownian motion with drift when the drift is equal
to 0, the Cameron-Martin theorem implicitly connects Brownian motions with dierent
drifts. The following corollary claries this.
Corollary 8. Thanks to the Cameron-Martin theorem, we have that, if and are two
drifts,

dP

dP

F
T
=
Z

(T)
Z

(T)
= exp
_
( )B
T
(
2

2
)T/2
_
.
Exercise 6. Prove Corollary 8.
4.3 Self-nancing portfolios and risk-neutral measures
Let M be a Tperiod market with traded assets A
k
, k = 1, 2, .., K. Let S
A
t
() be the
price of asset A at time t, under the market scenario .
4.3. SELF-FINANCING PORTFOLIOS AND RISK-NEUTRAL MEASURES 51
It is plausible to assume that a generic trader will not just hold single assets, but a more
realistic portfolio, consisting of shares (even negative ones, for short positions) of each of
the traded assets. Let
A
t
() be the shares of asset A in our traders portfolio during trading
period t (that is to say the period between actual trading at time t and the beginning of
the next trading session at t + 1), under scenario . If we assume that the trader adjusts
his/her portfolio over time, on the basis of the dierent scenarios, what we get is a so-called
dynamically rebalanced portfolio. A similar portfolio is said bounded where each
A
k
t
() is
bounded, for k = 1, ..., K. It is not dicult to see that if a market only allows nitely
many scenarios, then all dynamically rebalanced portfolios are bounded.
According to what we have seen so far, we require the sequence {
A
t
}
0tT
to be adapted
to the natural ltration generated by the corresponding price process.
The total value of portfolio (the vector of shares in the dierent assets), after rebalancing
at time t under scenario , is
V

t
= V

t
() =
K

k=1

A
k
t
()S
A
k
t
().
Notice that, given the changes in prices, we generally have V

t
6= V

t+1
.
If we assume that the trader does not invest (or withdraws) new resources in the portfolio
at time t +1, the total value of the portfolio just before rebalancing at time t +1 must be
the same as the value after rebalancing, that is
K

k=1

A
k
t
()S
A
k
t+1
() =
K

k=1

A
k
t+1
()S
A
k
t+1
(). (4.5)
An equivalent way of writing this is
V

t+1
() V

t
() =
K

k=1

A
k
t
()

S
A
k
t+1
() S
A
k
t
()

(4.6)
Denition 19 (Self-nancing portfolio). A dynamically rebalanced portfolio that satises
(4.5), or equivalently (4.6), is called self-nancing, since it needs no investment or with-
drawal, apart from those at t = 0.
Let us now assume that our market M possesses a risk-free asset, whose riskless rate
of return is r for trading period under continuous compounding.
Denition 20 (Risk-neutral probability measure). A probability measure P on the algebra
F
T
is dened risk-neutral (or equilibrium measure), if for every bounded self-nancing port-
folio , the value V

0
at t = 0 is equal to the expectation, under P, of the discounted value
V

T
at time t = T, with respect to the risk-free rate, i.e.
V

0
= e
rT
E
P
_
V

T
_
.
52 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
Theorem 9. If a market M does not allow arbitrage
2
, and it has a risk-free asset with
rate r = 0, then under every risk-neutral probability measure, the discounted price process
of any traded asset {e
rT
S
t
= S
t
}
0tT
is a martingale w.r.t. the natural ltration.
Proof. W.l.o.g. we want to show that, for every t = 0, 1, ..., T 1, we have
E[S
t+1
|F
t
] = S
t
,
where S
t
is the price of a stock.
Equivalently we can show that, for every F F
t
,
E[S
t+1
1
F
] = E[S
t
1
F
].
In doing this we will exploit the fact that the value of every self-nancing portfolio at
time t = 0 is the expected value of the portfolio value at t = T, under any equilibrium
distribution.
Now, assume that at times = 0, 1, 2, ..., t we hold no position in any of the assets on the
market. This means neither long nor short positions.
Assume that, at time = t, if the event F manifests itself, we short sell S
t
shares of the
risk-free asset, which we call bond. The money we receive is used to buy one share of stock.
We then hold this position for a trading period, i.e. until t + 1. No matter what happens,
in t + 1 we sell the share of the stock, we collect S
t+1
and we invest this amount in the
risk-free bond. From now on, we hold a (S
t+1
S
t
) position in the bond until t = T.
In all the scenarios in which the event F does not happen at time t, we hold no position
at = t, ..., T in any of the assets.
The portfolio we have just considered is self-nancing, its value at t = 0 is 0. This implies
that under any risk-neutral probability, the expected value of the portfolio at time t = T
must be 0 as well. But the nal value of the portfolio at time T is (S
t+1
S
t
)1
F
, hence
0 = E [(S
t+1
S
t
)1
F
] E[S
t+1
1
F
] = E[S
t
1
F
].
Corollary 10. If a market M does not allow arbitrage, and it has a risk-free asset with
rate r > 0, then under every risk-neutral probability measure, the discounted price process
of any traded asset {e
rT
S
t
}
0tT
is a martingale w.r.t. the natural ltration.
Exercise 7. Prove Corollary 10
2
This is always true for perfect markets, as we always assume here!
4.4. A SIMPLE MODEL FOR FOREIGN EXCHANGE RATES 53
4.4 A simple model for foreign exchange rates
Assume that there are two risk-free assets on the market. The rst one, called EUmoney,
is expressed in euros and gives a riskless rate r
E
. The second, named USmoney, pays r
U
and is given in dollars.
In reality, given the uncertainty related to exchange rates, the EUmoney asset is not
completely risk-free for a dollar investor, and vice versa for the USmoney and a euro
investor. The choice of the numeraire, that is to say the currency with respect to which
all the evaluations will be performed, nally determines the risk-free asset. In what follow,
we will take the point of view of a euro investor.
Let Y
t
be the exchange rate at time t, i.e. the amount of euros we can buy with 1 dollar in
t. Following a basic model by Merton (the same guy of the Black-Scholes-Merton formula,
which we will consider later in this chapter), we assume that the exchange rates follows a
stochastic dierential equation like
dY
t
= Y
t
dt +Y
t
dB(t) (4.7)
where B(t) is as usual a standard Brownian motion.
Let now U
t
and E
t
be the share prices of USmoney and EUmoney, expressed in terms of
dollars and euros, and normalized so that the share prices in t=0 are both equal to 1.
Hence we have
U
t
= exp(r
U
t),
and
E
t
= exp(r
E
t).
The share price of USmoney at time t in euros is simply U
t
Y
t
. Combining all the ingredients,
we have the following explicit formula
U
t
Y
t
= Y
0
exp(r
U
t +t
2
t/2 +B(t)). (4.8)
Proposition 19. Let Q
E
be the risk-neutral probability for the euro investor. If the dol-
lar/euro exchange rate follows a stochastic dierential equation of the form (4.7), and if
the risk-free rates are r
U
and r
E
for dollar and euro investors respectively, then under Q
E
we must have
= r
E
r
U
.
This implies that
Y
t
= Y
0
exp((r
E
r
U
)t
2
t/2 +B(t)). (4.9)
where under Q
E
the process B(t) is a standard Brownian motion.
Proof. Under Q
E
, the discounted share price of USmoney in euros must be a martingale.
But the discounted share price is
exp(r
E
t)U
t
Y
t
54 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
Given equation (4.8), this equals
Y
0
exp(((r
U
r
E
) +)t) exp(
2
t/2 +B(t)).
The rst exponent is nonrandom, while the second one denes a martingale (it is very easy
to show). To guarantee that the product of the two exponentials is still a martingale we
then need to impose = r
E
r
U
.
What happens if we take into account the point of view of the dollar investor?
Proposition 20. Let Q
U
be the risk-neutral probability for the dollar investor. Let B(t)
be a standard Brownian motion under Q
U
. If the dollar/euro exchange rate follows a
stochastic dierential equation of the form (4.7), and if the risk-free rates are r
U
and r
E
for dollar and euro investors respectively, then under Q
U
we must have
= r
E
r
U
+
2
.
Proof. The proof is left as an exercise.
The comparison of Propositions 19 and 20 leads us to the following conclusion: unless
r
E
= r
U
, the two investors will disagree about the drift coecient in the stochastic
dierential equation (4.7). How is that possible?
We will answer this question later in this chapter.
Proposition 21. The measures Q
E
and Q
U
are mutually absolutely continuous. In par-
ticular, they are related by the Radon-Nikodym derivative

dQ
U
dQ
E

F
T
= exp
_
B
T

2
T/2
_
.
Proof. Let V
T
be the value in T of a contingent claim in dollars. Naturally we have that
V
0
= e
r
U
T
E
U
[V
T
]. (4.10)
If W
T
is the value of V
T
in euros, we have W
T
= V
T
Y
T
. Hence W
0
= V
0
Y
0
= e
r
E
T
E
E
[V
T
Y
T
],
From this we have
V
0
= e
r
U
T
E
E
[V
T
(Y
T
/Y
0
) exp((r
U
r
E
)T]. (4.11)
By comparing equations (4.10) and (4.11), we get
E
U
[V
T
] = E
E
[V
T
(Y
T
/Y
0
) exp((r
U
r
E
)T].
This last formula holds for any nonnegative variable V
T
that is F
T
measurable. Hence,
using equation (4.9), we get

dQ
U
dQ
E

F
T
= (Y
T
/Y
0
)e
(r
U
r
E
)T
= exp
_
B
T

2
T/2
_
.
4.5. MOVING TOWARDS GIRSANOV THEOREM 55
It is interesting to notice that the Radon-Nicodym derivative of Proposition 21 recalls
what we have seen in Corollary 8. This tells us that under Q
U
for dollar investors, the
process {B(t)} in equation (4.7) is not a standard Brownian motion (as it is under Q
E
),
but rather a Brownian motion with drift .
4.5 Moving towards Girsanov theorem
Let {B(t)}
t0
be a standard Brownian motion under the probability P on (, F, P). Let
{F
t
}
t0
be its natural ltration.
From section 4.1, we know that Z

(t) = exp(B
t

2
t/2) is a martingale with respect to
{F
t
}. These martingales constitute the Radon-Nikodym derivatives on which the Cameron-
Martin theorem is based.
The exponential martingales Z

(t) can be easily generalized to a larger class of martingales,

very surprisingly called generalized exponential martingales.
Let {
s
} be an adapted process (to {F
t
}, naturally), which belongs to the class H
2
[0, T]
that we have seen in Chapter 3, Denition 16. This second assumption can be even more
relaxed by taking a locallyH
2
process, meaning that only the truncated process {
s
1
st
}
belongs to H
2
.
In any case, given these assumptions, we have that the Itos integral
_
s
0

s
dB(s) is well-
dened.
Now set
Z(t) = exp
_
t
0

s
dB(s)
1
2
_
t
0

2
s
ds

. (4.12)
Theorem 11 (Novikov Condition). Assume that, for every t 0, we have
E
_
exp
_
t
0

2
s
ds/2
_
< +,
then, for every t 0,
E[Z(t)] = 1.
In this case, the process {Z(t)}
t0
is a positive martingale w.r.t. {F
t
}.
Novikov theorem can be proven in dierent ways (at least three); for example we can use
Itos formula, as shown in exercise 9 below. However, in order to simplify our narration,
we will just prove the theorem for the very special case in which
s
is nonrandom and
continuous in t.
Proof. Since
s
is nonrandom, the random quantity
_
t
0

s
dB(s) is normally distributed
with mean 0 and variance
_
t
0

2
s
ds. For s < t, also the quantity
_
t
s

u
dB(u) is normally
56 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
distributed and independent from F
s
.
Hence, for s < t,
E
_
exp
_
t
0

u
dB(u)

|F
s
_
= exp
_
s
0

u
dB(u)

E
_
exp
_
t
s

u
dB(u)

|F
s
_
= exp
_
s
0

u
dB(u)

E
_
exp
_
t
s

u
dB(u)
_
= exp
_
s
0

u
dB(u)

exp
_
t
s

2
u
du/2

(4.13)
This shows that Z(t) is a martingale with respect to {F
t
}, and that its expected value is
1 for every t < . In fact it is sucient to compute E[Z(t)|F
s
] and to substitute (4.13).
Exercise 8. Prove the rst statement of the previous proof, i.e. since
s
is nonrandom,
the random quantity
_
t
0

s
dB(s) is normally distributed with mean 0 and variance
_
t
0

2
s
ds.
Exercise 9. Given a deterministic
s
, set the following
g(x, t) = exp

x
1
2
_
t
0

2
s
ds

and Y
t
=
_
t
0

s
dB(s).
Clearly we have Z(t) = g(Y
t
, t).
Use these facts to give an alternative proof of Novikov theorem.
4.5.1 Girsanov theorem
Let us assume that {
t
} is an adapted process satisfying Novikov condition. Moreover, set
Z(t) to be dened as in (4.12). Since E[Z(t)] = 1 for every t, we have that, for T > 0,
Z(T) is a Radon-Nikodym derivative, so that
Q(F) = E
P
[Z(T)1
F
]
denes a new probability measure on (, F).
Now, given the process {B(t)}
t0
, for every t let us dene

B(t) = B(t)
_
t
0

s
ds.
We then have the following.
Theorem 12 (Girsanov). Under the probability measure Q, the stochastic process {

B(t)}
0tT
is a standard Brownian motion.
4.5. MOVING TOWARDS GIRSANOV THEOREM 57
Given the theorem of Novikov, Girsanov theorem is just a straightforward generalization
of the results of Cameron-Martin.
Proof. What we aim to show is that the process

B
t
is a standard Brownian motion under Q,
that is to say it has independent, normally distributed increments, with the right variances.
We can do this by showing that the moment generating function of the increments

B(t
1
),

B(t
2
)

B(t
1
), ...,

B(t
n
)

B(t
n1
)
is equal to the one of n independent gaussian random variables with expectation 0 and
variances t
1
, t
2
t
1
, t
3
t
2
, ...
In other terms, we want to show that the following is true
E
Q
_
exp
_
n

k=1

k
(

B(t
k
)

B(t
k1
))
__
=
n

k=1
exp
_

2
k
(t
k
t
k1
)
_
.
In what follows we just focus on the simple case n = 1, but the reasoning is exactly the
same (just a little bit more cumbersome) for a general n. We can thus notice the following.
E
Q
[exp(

B(t))] = E
Q
_
exp

B(t)
_
t
0

s
ds
_
= E
P
_
exp

B(t)
_
t
0

s
ds

exp
_
t
0

s
dB(s)
_
t
0

2
s
ds/2
_
= E
P
_
exp
_
t
0
( +
s
)dB(s)
_
t
0
(2
s
+
2
s
)ds/2
_
= exp(
2
t)E
P
_
exp
_
t
0
( +
s
)dB(s)
_
t
0
( +
s
)
2
ds/2
_
= exp(
2
t).
It is worth noticing that the last step is essentially an application of Novikov theorem.
From the proof we have just seen, it is therefore evident that Girsanov simply gen-
eralizes Cameron-Martin.
In the next sections we will nally investigate the use of Girsanov theorem in some very
well known problems of nancial mathematics.
58 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
4.6 Black-Scholes-Merton (BSM) demystied
In the model of BSM, the behavior of prices is well represented by a continuous time model,
which takes into account a risky asset, e.g. a share
3
with price S
t
at time t, and a risk-free
asset, e.g. a zero-coupon bond with price S
0
t
and paying a riskless rate r (under continuous
compounding).
For what concerns the risk-free asset, we assume that the evolution of its price is given by
dS
0
t
= rS
0
t
dt.
In what follows we assume to be able to rescale everything, so that S
0
0
= 1 and S
0
t
= e
rt
.
For what concerns the stock price, as known
4
, we assume the following stochastic dierential
equation
dS
t
= S
t
(dt +dB
t
), (4.14)
with R, > 0 and B
t
is a standard Brownian motion.
The model is assumed to be valid over the period [0, T], where T is called maturity. For
what concerns the information about the state of the markets, we assume that it is fully
contained into the natural ltration generated by the Brownian motion throughout the
price process
5
, i.e. F
t
:= (S
r
, r t).
Remark 1. Consider equation (4.14). If we apply It os formula to log S
t
, we easily get a
closed-form solution, i.e.
S
t
= S
0
exp

2
2

t +B
t

. (4.15)
Notice that this process inherits many interesting properties from B
t
. These properties are
totally consistent with the perfect markets assumption of BSM. In particular:
The sample paths of the price process are continuous a.s.;
The so-called relative increments (S
t
S
u
)/S
u
, for u t, are independent from
F
u
;
The relative increments are stationary.
4.6.1 A little digression: two useful results
In what follows, we will make use of two important results of probability theory and
stochastic calculus.
3
We will omit in the notation, but please remember that it is always there.
4
Have a look at the slides.
5
Notice that here () is the algebra!.
4.6. BLACK-SCHOLES-MERTON (BSM) DEMYSTIFIED 59
The rst one is the Ito representation theorem, which tells us that any square integrable
random variable, which is measurable with respect to a Brownian motion (i.e. w.r.t. its
natural ltration), can be expressed as a stochastic integral involving this Brownian motion.
We will give this theorem without proof.
Theorem 13 (Ito Representation). Let F L
2
(F
T
, P). Then there exists a unique adapted
process f(t, ) such that E
_
_
T
0
f
2
s
ds
_
< and
F() = E[F] +
_
T
0
f(t, )dB
t
().
Taken the Ito representation theorem for granted, we can then prove a second very
important result about Brownian martingales, i.e. martingales involving the Brownian
motion.
Theorem 14 (Martingale Representation). Let {M
t
}
0tT
be a square-integrable martin-
gale with respect to {F
t
}
0tT
. There exists a unique adapted process {
t
}
0tT
, such that
E
_
_
T
0

2
s
ds
_
< , and
M
t
= M
0
+
_
t
0

s
dB
s
a.s., t [0, T].
Proof. It is known that, if {
t
}
0tT
is an adapted process such that E
_
_
T
0

2
s
ds
_
< ,
then the process {
_
t
0

s
dB
s
} is a square-integrable martingale, null at 0.
Setting t = T and F = M
t
, Ito representation theorem guarantees that, for all t, there
exists a unique h
(t)
(s, ) L
2
(F
T
, P), such that
M
t
() = E[M
t
] +
_
t
0
h
(t)
(s)dB
s
= E[M
0
] +
_
t
0
h
(t)
(s)dB
s
.
Let us now consider 0 t
1
< t
2
. We have
M
t
1
= E[M
t
2
|F
t
1
] = E[M
0
] +E
__
t
2
0
h
(t
2
)
(s)dB
s
|F
t
1
_
= E[M
0
] +
_
t
1
0
h
(t
2
)
(s)dB
s
.
But we also have that
M
t
1
= E[M
0
] +
_
t
1
0
h
(t
1
)
(s)dB
s
.
This implies that h
(t
1
)
(s) = h
(t
2
)
(s), for all (s, ) [0, t
1
] . Therefore, in general, we
can always set

s
= h
(N)
(s), s [0, N],
getting
M
t
= E[M
0
] +
_
t
0
h
(t)
(s)dB
s
= M
0
+
_
t
0

s
dB
s
, t 0.
60 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
4.6.2 Self-nancing portfolios for BSM
A strategy or portfolio for the BSM model is a vector process = {
t
}
0tT
= (
0
t
,
t
),
with values in R
2
, and adapted to F
t
. Consistently with what we have seen before,
0
t
and

t
are the amounts of the risk-free and risky assets we have in our portfolio at time t. The
value of the portfolio in t is clearly
V

t
=
0
t
S
0
t
+
t
S
t
.
In continuous time, the self-nancing condition of equations (4.5) and (4.6) can be restated
as
dV

t
=
0
t
dS
0
t
+
t
dS
t
. (4.16)
Now, let us assume that,
_
T
0
|
0
t
|dt +
_
T
0

2
t
dt < a.s. (4.17)
This guarantees that both
_
T
0

0
t
dS
0
t
=
_
T
0

0
t
re
rt
dt
and
_
T
0

t
dS
t
=
_
T
0
S
t

t
dt +
_
T
0

t
S
t
dB
t
are well-dened.
Denition 21 (Self-nancing portfolio or strategy (in continuous time)). A portfolio
t
=
(
0
t
,
t
) satisfying (4.17), and such that

0
t
S
0
t
+
t
S
t
=
0
0
S
0
0
+
0
S
0
+
_
t
0

0
u
dS
0
u
+
_
t
0

u
dS
u
a.s., t [0, T],
is called self-nancing portfolio.
From now on, we will use the symbol to indicate discounted quantities; for example

S
t
= e
rt
S
t
will be the discounted price of the risky asset.
Proposition 22. Let
t
= (
0
t
,
t
) be an adapted process with values in R
2
, satisfying
equation (4.17). Then
t
denes a self-nancing strategy if and only if

t
= V

0
+
_
t
0

u
d

S
u
a.s., t [0, T].
Proof. The proof is left as an exercise.
4.7. PRICING OPTIONS IN BSM 61
4.7 Pricing options in BSM
We now have all the ingredients we need to show that, given the probability space (, F, P),
there exists a probability measure equivalent to P, under which the discounted price process

S
t
is a martingale.
From equation (4.14), we get
d

S
t
=

S
t
(( r)dt +dB
t
).
Now, set W
t
= B
t
+
(r)t

. This gives
d

S
t
=

S
t
dW
t
. (4.18)
From Girsanov theorem, if we set
t
=
(r)t

, there exists a probability measure Q, equiv-

alent to P (and P a.c.), under which W
t
is a standard Brownian motion. Then, under the
probability measure Q, the process

S
t
=

S
0
exp(W
t

2
t/2)
is a martingale. Notice that all this also implies that Q is a risk-neutral probability.
On the basis of this information, we can nally price European options. We will focus
our attention on European calls, but the reasoning is exactly the same for puts.
For us a European call is a non-negative, F
t
measurable random variable h = f(S
T
),
where f(x) = (x K)
+
, and where K is the so-called strike price
6
.
Denition 22. A portfolio
t
, 0 t T, is admissible if it is self-nancing and if the
corresponding discounted value

V

t
is non-negative for all t, and such that sup
t[0,T]

V

t
is
square-integrable under Q.
In what follows, we will always refer to admissible portfolios/strategies.
Denition 23. An option is said replicable if its payo at maturity (i.e. in T) is equal to
the nal value of an admissible strategy.
Denition 23 essentially tells us that an option h must be square-integrable under Q.
For a European call (but also for a EU put) this is always true, given that E
Q
[S
2
T
] < .
Theorem 15. In the Black-Scholes-Merton model, any option h, which is a nonnegative,
F
T
measurable random variable, square-integrable under Q, is replicable by the means of
an admissible strategy, and the value at time t of any replicating portfolio is equal to
V

t
= E
Q
_
e
r(Tt)
h|F
t
_
.
This simply means that, at time t, the value of the option is equal to E
Q

e
r(Tt)
h|F
t

6
For a put, we will simply have g(x) = (K x)
+
.
62 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
Proof. Assume that h is replicable, i.e. we have an admissible strategy (
0
t
,
t
) which
reproduces the option. At time t, we have that the value of such a portfolio (for which we
omit in the notation) is
V
t
=
0
t
S
0
t
+
t
S
t
,
and by hypothesis V
T
= h. Now, let us consider the discounted value

V
t
= V
t
e
rt
, i.e.
7

V
t
=
0
t
+
t

S
t
.
Since the portfolio is self-nancing, we have that

V
t
= V
0
+
_
t
0

u
d

S
u
= V
0
+
_
t
0

u

S
u
dW
u
. (4.19)
Under Q, we know that sup
t[0,T]

V
t
is square-integrable, given the admissibility of the
strategy. Moreover, equation (4.19) implies that {

V
t
} is a stochastic integral involving
W
t
, which under Q is a standard Brownian motion. Therefore it follows that {

V
t
} is a
square-integrable martingale under Q, so that

V
t
= E
Q
[

V
T
|F
t
],
that is
V
t
= E
Q
_
e
r(Tt)
h|F
t
_
.
Hence the portfolio (
0
t
,
t
) actually replicates h.
In order to complete the proof we have to show that such a portfolio exists, that is to say
that h is replicable. In other words, we have to nd two processes {
0
t
} and {
t
} such that

0
t
S
0
t
+
t
S
t
= E
Q
_
e
r(Tt)
h|F
t
_
.
Under Q, the process M
t
= E
Q

e
rT
h|F
t

is a square integrable martingale. Now notice

that the natural ltration F
t
of B
t
is also the natural ltration for W
t
. The martingale
representation theorem then guarantees the existence of an adapted process {K
t
}
0tT
,
such that E
Q
_
_
T
0
K
2
s
ds
_
< , and
M
t
= M
0
+
_
t
0
K
s
dW
s
a.s., t [0, T].
The strategy = (
0
t
,
t
), with
0
t
= M
t

t

S
t
and
t
=
K
t

S
t
is then a self-nancing strategy,
and its value at time t is given by
V

t
= e
rt
M
t
= E
Q
_
e
r(Tt)
h|F
t
_
.
7
Remember S
0
0
= 1 and S
0
t
= e
rt
.
4.7. PRICING OPTIONS IN BSM 63
The previous expression tells us that V

t
is a nonnegative random variable, with sup
t[0,T]

V

t
square-integrable under Q, and such that V

T
= h.
Hence the proof is complete.
Thanks to Theorem 15 we are now able to explicitly compute the price of a European
call.
Consider h = f(S
T
), with f(x) = (x K)
+
. We can then express V
t
as a function of S
t
and t, i.e.
V
t
= E
Q
_
e
r(Tt)
f(S
T
)|F
t
_
= E
Q
_
e
r(Tt)
f

S
t
e
r(Tt)
e
(W
T
W
t
)

2
2
(Tt)

|F
t
_
.
Under Q, we have that W
t
is a standard Brownian motion, hence W
T
W
t
is independent
of F
t
. Moreover, we know that S
t
is F
t
measurable.
Now set
F(t, x) = E
Q
_
e
r(Tt)
f

xe
r(Tt)
e
(W
T
W
t
)

2
2
(Tt)
_
. (4.20)
Clearly we have that V
t
= F(t, S
t
).
The increment W
T
W
t
N(0, T t) under Q. As a consequence
F(t, x) = e
r(Tt)
_
+

2
f

xe

2
2

(Tt)+y

Tt

y
2
2
dy.
Substituting for f(), and using equation (4.20), we have
F(t, x) = E
Q
_
e
r(Tt)

xe

2
2

(Tt)+(W
T
W
t
)
K

+
_
= E
Q
_
xe
z

2
Ke
r
_
+
= E
_
_
xe
z

2
Ke
r
. .
A
_
_
+
,
where = T t and z N(0, 1).
At this point, set
d
1
=
log(x/K) + (r +
2
/2)

and d
2
= d
1

.
These quantities can be easily derived by solving the inequality A 0 for z. In particular,
we nd that A 0 for z d
2
.
64 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
We can then write the following
F(t, x) = E
_
xe
z

2
Ke
r

1
{zd
2
}
_
=
_
+
d
2
1

xe
y

2
Ke
r

y
2
2
dy
=
_
d
2

xe
y

2
Ke
r

y
2
2
dy.
This last expression can be given as the dierence of two integrals involving the standard
Gaussian c.d.f., i.e. (u) =
1

2
_
u

x
2
2
dx. In fact, by setting z = y +

,
F(t, x) = x(d
1
) Ke
r
(d
2
).
Similar steps also allow to derive the price of a European put, i.e.
G(t, x) = Ke
r
(d
2
) x(d
1
).
It is sucient to use g(x) in place of f(x) (see Footnote 5).
European calls and puts are frequently referred to as plain vanilla options by practitioners.
Remark 2. One of the main characteristics of the BSM model is that all the pricing
formulas only depend on one non-observable parameter: . In fact the drift disappears
thanks to the probability change from P to Q.
The parameter is commonly referred to as volatility by practitioners.
Is there a way of estimating ? The answer is yes, even if this implies making some
unrealistic assumptions.
I refer you to Shreve 3.4.3 and to the slides on BB.
4.8 Some extensions via exercises
This section contains some exercises that help us in introducing some additional interesting
results about what we have seen in this chapter. We will see how the tools we have learnt
can help us in understanding some very important concepts of mathematical nance, such
as the uniqueness of the risk-free rate, and some of the conditions for the absence of
arbitrage. We will show how we can price EU options on dierent price processes, such
as for example the one of Bachelier, and how we can derive quantities we can use for the
estimation of the parameters of the models.
4.8.1 The variance of prices under BSM
Remember equation (4.15).
The explicit computation of V ar(S(t)) can be very useful for the estimation of via the
4.8. SOME EXTENSIONS VIA EXERCISES 65
method of moments.
We rst compute the expected value
E[S(t)] = S
0
exp(t).
Then we can easily compute the variance as follows, by using the usual properties of the
lognormal expected value,
E

(S(t) E[S(t)])
2

= E

(S(t) S
0
e
t
)
2

= S
2
0
e
2t
E
_

1
2

2
t+B(t)
1

2
_
= S
2
0
e
2t
E
_
_
e

2
t+2B(t)
2e

1
2

2
t+B(t)
. .
=2e
0
=2
+1
_
_
= S
2
0
e
2t
_
e

2
t
1
_
.
4.8.2 Back to Bachelier
In his seminal work, published in 1900, Bachelier introduced the following model for prices,
probably the rst formal one:
S(t) = S(0) +t +B(t).
What is the price of a EU call on such an asset?
In what follows, we assume r = 0, so that the discount factor plays no role, while we
leave the more general setting for r 0 as a simple exercise.
Using Girsanov we know that, under a change of measure (let us call the new measure Q),
S(t) = S(0) +W(t),
where W(t) is a standard Brownian motion under Q.
Hence we have that
C(0) = F(0, S
T
) = E
Q

(S
T
K)
+

= E
Q

(S(0) +W(T) K)
+

=
1

2
_
+

(S(0) +y

T K)
+
e

y
2
2
dy.
66 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
Now, the only condition for which S(0) +y

T K 0 is y
1

T
(KS(0)) = d. Thus
C(0) =
1

2
_
+
d
(S(0) +y

T K)e

y
2
2
dy
=
S(0) K

2
_
+
d
e

y
2
2
dy +

2
_
+
d
ye

y
2
2
dy
= (S(0) K)(1 (d)) +

2
e

d
2
2
.
4.8.3 The Value-at-Risk for a simple portfolio
Let L be a random variable accounting for the losses we can expect on some investment.
The quantity
v = inf

x R : P(L x)

100

= inf

x R : P(L > x)
100
100

is called value-at-risk at condence level %, and it is generally indicated as V aR

%
. Most
of the times, losses are considered over a standard time horizon, say 1 day or 1 year, hence
we can write V aR
1d

and V aR
1y

. In what follows we consider a 1-year time window.

Value-at-risk is a fundamental tool of risk management.
Assume we aim to compute the V aR
1y
5%
for losses on a single investment in a single share
of a stock, modeled according to BSM, purchased at S
0
= 100, sold at S
T
, with = 10%,
= 40% and T = 1.
The rst thing we have to do is to dene what is a loss for us. We have three possi-
bilities
L = S
T
S
0
, i.e. we assume there is no cost for money and for missing investment
opportunities;
L = S
T
e
rT
S
0
, i.e. we take into consideration the cost of liquidity, but not the
cost of missing other investments, which could guarantee an average return higher
than ;
L = S
T
e
T
S
0
, i.e. we take into consideration both the cost of money and that
of not investing in other products, since we implicitly assume that > r, given that
otherwise it would not make sense to invest in such an asset, less competitive than
the risk-free and riskier.
4.8. SOME EXTENSIONS VIA EXERCISES 67
Let us continue our analyses under the third denition. Hence
P(L x) = P
_
S
T
e
T
S
0
x
_
= P

S
0
e

2
2
T+B
T
x +S
0

= P

B
T

1

log

x
S
0
+ 1

+

2
2
T

log

x
S
0
+ 1

+

2
2
T

.
This means that we look for the value v such that

100
= 0.05 =

log

v
S
0
+ 1

+

2
2
T

Using the properties of the standard Gaussian distribution, the quantile v is thus given by
v = S
0

exp

T
1

100

+

2
2
T

.
Substituting the values of the dierent variables and parameters, we get V aR
1y
5%
= 43.89.
In words, the probability of observing a loss that, in absolute terms, is bigger than/equal
to 43.89 is equal to 0.05.
4.8.4 No arbitrage conditions
The next three exercises are meant to discuss conditions for the absence of arbitrage on
the market. Prosaically, arbitrage is nothing more than a free lunch situation, that is to
say the possibility of implementing a trading strategy that can prot without cost or risk.
A typical situation for arbitrage is when an asset is mispriced, possibly having dierent
prices on dierent markets.
There are two main types of arbitrage:
Type 1: A trading strategy that has positive initial cash ow and nonnegative payo
under all future scenarios.
Type 2: A trading strategy that costs nothing initially, has nonnegative payo under
all future scenarios and has a strictly positive expected payo.
In what follows we show that, in order not to have arbitrage, the following conditions must
be fullled
1. We cannot have two or more risk-free assets providing dierent risk-free rates;
68 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
2. If a risky asset mimics the risk-free asset, it must coincide with the risk-free asset;
3. The Put-Call parity must be respected.
Naturally, other conditions can be considered and discussed, but they are not taken into
considerations in these lecture notes.
4.8.4.1 The uniqueness of the risk-free asset
The following exercise shows that we cannot have more than one risk-free asset on the
market, in order not to have arbitrage. In more details, we show that if a second risk-free
asset is introduced, it must replicate the already-existing one. In terms of rates, this means
that the new risk-free asset cannot provide an alternative risk-free rate.
Starting from equation (4.15), let us consider the degenerate case in which = 0. This
implies
dS
t
= S
t
dt.
We assume S
0
0
= S
0
= 1. A necessary condition not to have arbitrage is that = r.
We look for a portfolio (
0
, ) such that

0
0
S
0
0
+
0
S
0
= 0 and
0
T
S
0
T
+
T
S
T
> 0 a.s.
Let us assume that > r.
In t = 0 we buy
0
= 1 shares of stock and short-sell one unit of risk-free, i.e.
0
0
= 1.
This costs 0 since S
0
0
= S
0
= 1. Hence we have

0
0
S
0
0
+
0
S
0
= 1 1 + 1 1 = 0.
Given the assumptions of the exercise, and since > r, we know that, for every t (0, T),
S
t
= e
t
> e
rt
= S
0
t
. Given this information, until T we do nothing, so that
0
t
= 1 and

t
= 1 for all t (0, T). This is trivially a self-nancing strategy.
At maturity
8
T we then have

T
0
S
T
0
+
T
S
T
= e
rT
+e
T
> 0 a.s.,
hence we have arbitrage.
If we assume < r, we can obtain similar results by buying the risk-free and short-selling
the stock. As a consequence, the only condition not to have arbitrage is that = r, since
in that case

T
0
S
T
0
+
T
S
T
= e
rT
+e
T
= e
rT
+e
rT
= 0.
8
Notice that in most exercises about arbitrage, we clearly identify 3 steps: the creation of the strategy
in t = 0, the maintenance in t (0, T), and the liquidation in T.
4.8. SOME EXTENSIONS VIA EXERCISES 69
4.8.4.2 No one like the risk-free
Show that if the price process P(t) of an asset satises
dP(t) = g(t)P(t)dt,
where g is a stochastic process, then g(t) = r a.s. t 0.
The aim of this exercise is to show that, once again, if we have an asset that mimics the
behavior of the risk-free asset, then it must coincide with the risk-free asset, in order not
to have arbitrage.
We know that the risk-free asset S
0
(t) satises
dS
0
(t) = rS
0
(t)dt,
and we can also set S
0
(0) = 1.
Now, w.l.o.g. let us also assume that P(0) = 1.
Consider a strategy (x(t), y(t)) consisting of x(t) units of P(t) and y(t) units of S
0
(t), such
that
x(t) =
_

_
1 P(t) > S
0
(t)
0 P(t) = S
0
(t)
1 P(t) < S
0
(t)
, y(t) = x(t).
For what concerns the value of such a strategy, we can easily observe that is is always
nonnegative, in fact
0 V (t) = x(t)P(t) +y(t)S
0
(t) =
_

_
P(t) S
0
(t) P(t) > S
0
(t)
0 P(t) = S
0
(t)
S
0
(t) P(t) P(t) < S
0
(t)
.
Moreover, V (t) satises
d
dt
V (t) = x(t)
d
dt
P(t) +y(t)
d
dt
S
0
(t),
almost everywhere with respect to t 0. That means
dV (t) = x(t)dP(t) +y(t)dS
0
(t).
At the end of the day, we have a self-nancing strategy such that V (0) = 0 and V (t) 0
for all t 0. The only condition not to have arbitrage is that V (t) = 0 for all t 0. But
this implies
P(t) = S
0
(t) = e
rt
,
so that we have g(t) = r for all t 0.
70 CHAPTER 4. GIRSANOV THEOREM AND FIRST FINANCIAL APPLICATIONS
4.8.4.3 The Put-Call parity as a condition of no arbitrage
Let C
t
and P
t
be the price of a EU call and a EU put at time t respectively. The Put-Call
parity is expressed as
C
t
P
t
= S
t
Ke
r(Tt)
.
In words: in every time instant t, the price dierence between a call and a put on the
same underlying asset (modeled according to BSM, with strike price K, etc.) is equal to
the dierence between the price of the asset and the discounted value of the strike price.
We can show that the Put-Call parity is another necessary condition for the absence of
arbitrage.
To simplify the treatment, let us assume that our call and put are at-money forward, i.e.
K = S
0
e
rT
. In other terms, we are expressing naive expectations about the behavior of the
underlying asset, which - according to us - will essentially mimic the risk-free rate.
Given all these assumptions, we have that
C
0
P
0
= 0.
Let us show that if C
0
P
0
= X > 0, i.e. C
0
= P
0
+X, we have arbitrage.
The simplest way of showing the possibility of arbitrage is to implement the following
strategy:
At time t = 0,
1. We buy a Put for P
0
;
2. We short-sell the call, getting P
0
+X;
3. We invest X in the risk-free asset, at rate r;
4. We enter into a forward contract, in which we accept to receive S
T
K at
maturity (if the quantity is positive, we get it, if it is negative, we pay its
absolute value to our counterpart). Notice that the price of such a forward is
equal to 0, given that S
0
e
rT
K = 0.
The total cost of this strategy is P
0
P
0
X +X + 0 = 0.
For t (0, T), we hold our positions as they are, doing nothing.
At T, the situation is as follows:
1. We get (K S
T
)
+
from the Put;
2. We pay (S
T
K)
+
for the Call;
3. We get/pay S
T
K because of the the forward;
4. We obtain Xe
rT
from the investment in the risk-free.
4.8. SOME EXTENSIONS VIA EXERCISES 71
The value at time T for our portfolio is thus
V
T
= (KS
T
)
+
(S
T
K)
+
+S
T
K+Xe
rT
= KS
T
+S
T
K+Xe
rT
= Xe
rT
> 0 a.s.
Hence we have an arbitrage. The Put-Call parity is therefore a very important relation-
ship that goes beyond the simple link between two dierent securities, given that it has
implications in terms of the possibility of no arbitrage.