~.

Introduction to
Stochastic Calculus
I.
Applied to Finance
I

Damien Loolberton
L'Universite ffSfarne la Vallee
France

and
Bernard Lapeyre
L'Ecole Nationale des Ponts et Chaussees
France

Translated by

Nicolas Rabeau
Centre for Quantitative Finance
Imperial College, London
. and
Merrill Lynch Int. Ltd., London
and '
Francois Mantion
Centrefor Quantitative Finance
Imperial College
London

CHAPMAN & HALUCRC

Boca Raton London New York Washington, D.C.
L-G
~jj(5~3
L3(;/3
'9-96

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Options Vll
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2.1 Stopping time 17
Direct all inquiries to CRC Press LLC, 2000 N.W. Corporate Blvd., Boca Raton, Florida 33431. 2.2 The Snell envelope 18
Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are 2.3 Decomposition of supermartingales 21
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2.5 Application io American options 23
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2.6 Exercises 25
First edition 1996
First CRC reprint 2000 3 Brownian motion and stochastic differential equations 29
? © 1996 by Chapman & Hall 3.1 General comments on continuous-time processes 29
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3.6 Exercises 56
vi Contents
4 The Black-Scholes model 63 Introduction
4.1 Description of the model 63
4.2 Change of probability. Representation of martingales 65
4.3 Pricing and hedging options in the Black-Scholes model 67
4.4 American options in the Black-Scholes model 72
4.5 Exercises 77

5 Option pricing and partial differential equations 95

5.1 European option pricing and diffusions 95
5.2 Solving parabolic equations numerically 103
5.3 American options 110
5.4 Exercises 118

6 Interest rate models 121

6.1 ModeIling principles 121
The objective of this book is to give an introduction to the probabilistic techniques
6.2 Some classical models 127
136 required to understand the most widely used financial models. In the last few
6.3 Exercises
years, financial quantitative analysts have used more sophisticated mathematical
141 concepts, such as martingales or stochastic integration, in order to describe the
7 Asset models with jumps
141 behaviour of markets or to derive computing methods.
7.1 Poisson process
143 In fact, the appearance of probability theory in financial modeIling is not recent.
7.2 Dynamics of the risky asset
150 At the beginning of this century, Bachelier (1900), in trying to build up a "Theory
7.3 Pricing and hedging options
159 of Speculation' , discovered what is now called Brownian motion. From 1973, the
7.4 Exercises
publications by Black and Scholes (1973) and Merton (1973) on option pricing and
161 hedging gave a new dimension to the use of probability theory in finance. Since
8 Simulation and algorithms for financial models
161 , then, as the option markets have evolved, Black-Scholes and Merton results have
8.1 Simulation and financial models
168 developed to become clearer, more general and mathematicaIly more rigorous. The
8.2 Some useful algorithms
170 theory seems to be advanced enough to attempt to make it accessible to students.
8.3 Exercises

Appendix 173' Options

Al Normal random variables 173,
A2 Conditional expectation 174 Our presentation concentrates on options, because they have been the main motiva-
A3 Separation of convex sets 178 tion in the construction of the theory and stilI are the most spectacular example of
the relevance of applying stochastic calculus to finance. An option gives its holder
179 the right, but not the obligation, to buy or seIl a certain amount of a financial asset,
References
by a certain date, for a certain strike price.
183 The writer of the option needs to specify:
Index
• the type of option: the option to buy is caIled a call while the option to seIl is a
put;
• the underlying asset: typicaIly, it can be a stock, a bond, a currency and so on.
viii Introduction
• the amount of an underlying asset to be purchased or sold;
• the expiration date: if the option can be exercised at any time before maturity,
it is called an American option but, if it can only be exercised at maturity, it is
called a European option;
• the exercise price which is the price at which the transaction is done if the
option is exercised.
The price of the option is the premium. When the option is traded on an organised
market, the premium is quoted by the market. Otherwise, the problem is to price
the option. Also, even if the option is traded on an-organised market, it can be
interesting to detect some possible abnormalities in the market.
Let us examine the case of a European call option on a stock, whose price at
time t is denoted by St. Let us call T the expiration date and K the exercise
price. Obviously, if K is greater than ST, the holder of the option has no interest
whatsoever in exercising the option. But, if ST > K, the holder makes a profit of
ST - K by exercising the option, i.e. buying the stock for K and selling it back
on the market at ST. Therefore, the value of the call at maturity is given by
(ST - K)+ = max (ST - K,O).
If the option is exercised, the writer must be able to deliver a stock at price K.
It means that he or she must generate an amount (ST - K)+ at maturity. At the
time of writing the option, which will be considered as the origin of time, Sr is
unknown and therefore two questions have to be asked: .
1. How much should the buyer pay for the option? In other words, how should we
price at time t = 0 an asset worth (ST - K)+ at time T? That is the problem,
of pricing the option.
2. How should the writer, who earns the premium initially, generate an amount
(ST - K)+ at time T? That is the problem of hedging the option.
Arbitrage and put/call parity
We can only answer the two previous questions if we make a few necessary
assumptions. The basic one, which is commonly accepted in every model, is the
absence of arbitrage opportunity in liquid financial markets, i.e. there is no riskless
profit available in the market. We will translate thatinto mathematical.terms in the
first chapter. At this point, we will only show how we can derive formulae relating
European put and call prices. Both the put and the call which have maturity T and
exercise price K are contingent on the same underlying asset which is worth St at
time t. We shall assume that it is possible to borrow or invest money at a constant
rate r.
Let us denote by Ct and P; respectively the prices of the call and the put at time
t. Because of the absence of arbitrage opportunity, the following equation called
Introduction ix
put/call parity is true for all t < T
C t - Pt = St - K e-r(T-t).
To understand the notion of arbitrage, let us show how we could make a riskless
profit if, for instance,
c, .; Pt > S, - K e-r(T-t).
At time t, we purchase a share of stock and a put, and sell a call. The net value of
the operation is
Ct - Pt - St.
If this amount is positive, we invest it at rate r until time T, whereas if it is negative
we borrow it at the same rate. At time T, two outcomes are possible:
• ST > K: the call is exercised, we deliver the stock, receive 'the amount K and
clear the cash account to end up with a wealth K + er(T -t) (Ct - P, - St) .> O.
• ST ::; K: we exercise the put and clear our bank account as before to finish
with the wealth K + er(T-t)(ct - Pt - St) > O.
In both cases, we locked in a positive profit without making any initial endowment:
this is an example of an arbitrage strategy.
There are many similar examples in the book by Cox and Rubinstein (1985).
We will not review all these formulae, but we shall characterise mathematically
the notion of a financial market without arbitrage opportunity.
Black-Scholes model and its extensions
Even though no-arbitrage arguments lead to many interesting equations, they are
not sufficient in themselves for deriving pricing formulae. To achieve this, we
need to model stock prices more precisely. Black and Scholes were the first to
suggest a model whereby we can derive an explicit price for a European call on a'
stock that pays no dividend. According to their model, the writer of the option can
hedge himself perfectly, and actually the call premium is the amount of money
needed at time 0 to replicate exactly the payoff (ST - K)+ by following their
dynamic hedging strategy until maturity. Moreover, the formula depends on only
one non-directly observable parameter, the so-called volatility.
It is by expressing the profit and loss resulting from a certain trading strategy
as a stochastic integral that we can use stochastic calculus and, particularly, Ito
formula, to obtain closed form results. In the last few years, many extensions of
the Black-Scholes methods have been considered. From a thorough study of the
Black-Scholesmodel, we will attempt to give to the reader the means to understand
those extensions. r
x Introduction Introduction Xl

Contents of the book been possible without the encouragement ofN. Bouleau. Thanks to his dynamism,
The first two chapters are devoted to the study of discrete time models. The CERMA (Applied Mathematics.Institute of ENPC) started working on financial
link between the mathematical concept of martingale and the economic notion modelling as early as 1987, sponsored by Banque Indosuez and subsequently by
of arbitrage is brought to light. Also, the definition of complete markets and Banque Intemationale de Placement.
the pricing of options in these markets are given. We have decided to adopt the Since then, we have benefited from many stimulating discussions with G. Pages
formalism of Harrison and Pliska (1981) and most of their results are stated in the and other academics at CERMA, particularly O. Chateau and G. Caplain. A few
first chapter, taking the Cox, Ross and Rubinstein model as an example. people kindly jead the earlier draft of our book and helped us with their remarks.
The second chapter deals with American options. Thanks to the theory of. Amongst them are S. Cohen, O. Faure, C. Philoche, M. Picque and X. Zhang.
optimal stopping in a discrete time set-up, which uses quite elementary methods, Finally, we thank our colleagues at the university and at INRIA for their advice
we introduce the reader to all the ideas that will be developed in continuous time and their motivating comments: N. El Karoui, T. Jeulin, J.E Le Gall and D. Talay.
in subsequent chapters.
Chapter 3 is an introduction to the main results in stochastic calculus that we will
use in Chapter 4 to study the Black-Scholes model. As far as European options are
concerned, this model leads to explicit formulae. But, in order to analyse American
options or to perform computations within more sophisticated models, we need
numerical methods based on the connection between option pricing and partial
differential equations. These questions are addressed in Chapter 5.
Chapter 6 is a relatively quick introduction to the main interest rate models and
Chapter 7 looks at the problems of option pricing and hedging when the price of
the underlying asset follows a simple jump process.
In these latter cases,' perfect hedging is no longer possible and we must define
a criterion to achieve optimal hedging. These models are rather less optimistic
than the Black-Scholes model and seem to be closer to reality. However, their
mathematical treatment is still a matter of research, in the framework of so-called
incomplete markets.
Finally, in order to help the student to gain a practical understanding, we have
included a chapter dealing with the simulation of financial models and the use of
computers in the pricing and hedging of options. Also, a few exercises and longer
questions are listed at the end of each chapter.
This book is only an introduction -to a field that has already benefited from
considerable research. Bibliographical notes are given in some chapters to help
the reader to find complementary information. We would also like to warn the
reader that some important questions in financial mathematics are not tackled.
Amongst them are the problems of optimisation and the questions of equilibrium ,
"
i
for which the reader might like to consult the book by D. Duffie (1988).·
A good level in probability theory is assumed to read this book: The reader is
t
referred to Dudley (1989) and Williams (1991) for prerequisites. Ho~ever, some
basic results are also proved in the Appendix.

Acknowledgements

This book is based on the lecture notes taught at l'Ecole Nationale des Ponts
et Chaussees since 1988. The-organisation of this lecture series would not have
1

Discrete-time models

The objective of this chapter is to present the main ideas related to option theory
within the very simple mathematical framework of discrete-time models. Essen-
tially, we are exposing the first part of the paper by Harrison and Pliska (1981).
Cox, Ross and Rubinstein's model is detailed at the end of the chapter in the form
of a problem with its solution.

1.1 Discrete-time formalism

1.1.1 Assets
A discrete-time financial model is built on a finite probability space (0, F, P)
equipped with a filtration, i.e. an increasing sequence of o-algebras included in
F: F o, F 1 , •.. , F N. F n can be seen as the information available at time nand
is sometimes called the a-algebra of events up to time n. The horizon N will
often correspond to the maturity of the options. From now on, we will assume
that F o = {0,O}, FN = F = P(n) and Vw E 0, P ({w}) > O. The market
consists in (d + 1) fiflanci;l assets, whose prices at time n are given by the
non- negative random variables S~, S~, ... ,S~, measurable with respect to_:fn
(investors know past arid present prices but obviously not the future ones). nie
vector Sn = (S~, S~, .... , S~) is the vector of prices at time n. The asset indexed
by 0 is the riskless asset and we have sg = 1. If the return of the riskless asset
over one period is constant and equal to r, we will obtain S~ ~ (1 + rt.'The
coefficient /3n = 1/ S~ is interpreted as the discount factor (from time n to time
0): if an amountAn is invested.in.the riskless a~et at time 0, then one dollarwill
be available at time n. The assets indexed by i = 1 ... d are
----- . .
called risky assets.

1.1.2 Strategies

Atrading strategy is defined as a stochastic Rrocess (i.e. a§e.q~e in the discrete

-
c!!.~e)rP =
.(:(. 0 1 d)) . d+1 where rPni denotes the number of
rPn' ~n"'" ~n O~n~N In lR
2 Discrete-time models Discrete-time formalism 3
shares of asset i held in the portfolio at time n. if> is predictable, i.e. (iii) For any n E {l, ... , N},
~
if>b is Fo-measurable n

ViE{O,I, ... ,d} Vn(if» = Vo(if» + L if>j . !::J.Sj,

{ and, for n ~ 1: if>~ is F n_ 1-measurable. j=1

This assumption means that the positions in the portfolio at time n (if>~, if>~, ... , if>~) where !::J.Sj is the vector Sj - Sj-l = {JjSj - {Jj- 1Sj-l.
,are decided with respect to the information available at time (n -1) and kept until Proof. The equivalence between (i) and (ii) results from Remark 1.1.1. The
time n when new quotations are available. equivalence between (i) and (iii) follows from the fact that if>n,Sn = if>n+l,Sn if
and only if «s; = if>n+l.Sn. 0
The value ofthe portfolio at time n is the scalar product
d

Vn(~) = »;s: = Lif>~S~. This proposition shows that, if an investor follows a self-financing strategy, the
;=0 discounted value of his portfolio, hence its value, is completely defined by the
Its discounted value is ~itial wealth and the strategy (if>~, ... , if>~) O:::;n:::;N (this is only justified because
!::J.SJ = 0). More precisely, we can prove the following proposition.
Vn(if» = {In (if>n,Sn) = «:s:
Proposition 1.1.3 For any predictable process (( if>~, . . . , if>~))O<n<N and for
with'{Jn = 1/ S~ and s: = (1, (JnS;, ... , (JnS~) is the v~tor of disco~nted
any Fo-measurable variable Yo, there exists a unique predictable pr~ce~s (if>~) O<n'<N
prices.
A strategy is called self-financing if the following equation is satisfied for all such that the strategy ¢) =' (if>o, if>1, ... , if>d) is self-financing and its initial value-
nE {O,I, ... ,N-I} is Yo. " ,
if>n,Sn = if>n+l' S;". Proof. The self-financing condition implies
The interpretation is the following: at time ~, once the new prices S~~, are
Vn(if» if>~+if>~S~+"'+if>~S~~
quoted, the investor readjusts his positions from if>n to if>n+l without bringing Q!
consuming any wealth.
~~..:.. Vo + ~ (1 -1 + .... + if>j!::J.S
L.J if>j!::J.Sj d -d)j .
j=1
Remark 1.1.1 The equality if>n,Sn = if>n+l.Sn is obviously equivalent to
which defines if>~. We just have to check that if>0 is predictable, but this is obvious
if>n+l,(Sn+l'- Sn) = if>n+l.Sn+l - if>n,Sn, ITw~"~Ifeequation
or to
Vn+l(if» - Vn(if» = if>n+dSn+l
-Sn).
At time n +'1, the portfolio is worth if>n+l,Sn+l a~d «:
,Sn+l - if>n+l,Sn is
the net gain caused by the price changes between times nand n + I-:--Hence;-tI1e o
profit or loss realised by following a self-financing strategy is only due to the price
moves. II' '

The following proposition makes this clear in tenns of discounted prices.

Proposition 1.1.2 The following are equivalent
(i)' The strategy if> is self-financing.
(ii): For any n E {l, ... , N},
Vn(if» = Vo(if»
1.1.3 Admissible strategies and arbitrage
We did not make any assumption on the sign of the quantities if>~. If if>~ -: 0, we
°
have borrowed the amount 1if>~1 in the riskless asset. If if>~ < for i ~ 1, we say
n that we are short a number if>~ of asset i. Short-selling and borrowing is allowed
+L if>j . !::J.Sj, but the value of our portfolio must be' positive at all times.

where 6.Sj is the vector Sj - Sj-l.

j=1
Definition 1.1.4 A'~trategy if> is admissible if it is self-financing and !jVn( if» ~ °
foranyn E {O,I, ... ,N}.
4 Discrete-time models Martingales and arbitrage opportunities 5
The investor must be able to pay back his debts (in riskless or risky asset) at any Definition 1.2.2 An adapted sequence (Hn)05,n5,N of random variables is pre-
time.. dictable if, for all n ~ 1, n; is Fn~1 measurable.
The notion of arbitrage (possibility of riskless profit) can be formalised as
follows: Proposition 1.2;3 Let (Mn)05,n5,N be a martingale and (Hn)O<n<N a pre-
dictable sequence with respect to the filtration (Fn)O<n<N' Den-ote 6.Mn =
Definition 1.1.5 An arbitrage strategy is an admissible strategy with zero initial
M n - M n- 1. The sequence (Xn)05,n5,N defined by --
value and non-zero final value.
Most models exclude any arbitrage opportunity and the objective of the next Xo HoMo
section is to characterise these models with the notion of martingale. Xn = HoMo + H 1.6M1 + ... + H n6.Mn for n ~ 1
is a martingale with respect to (Fn)05,n5,N'
1.2 Martingales and arbitrage opportunities
(Xn) is sometimes called the martingale transform of (Mn) by (Hn). A conse-
In order to analyse the connections between martingales and arbitrage, we must quence of this proposition and Proposition 1.1.2 is that if the discounted prices of
first define a martingale on a fj.nite probability space. The conditional expectation the assets are martingales, the expected value of the wealth generated by following
plays a central role in this definition and the reader can refer to the Appendix for a self-financing strategy is equal to the initial wealth.
a quick review of its properties. Proof. Clearly, (Xn ) is an adapted sequence. Moreover, for n > 0
E (Xn+l - XnlFn)
1.2.1 Martingales and martingale transforms , E (Hn+lUv/n+l - Mn)IFn)
In this section, we consider a finite probability space (D, F, P), with F = P(D) = Hn+lE (Mn+1 - MnlFn) since Hn+l is Fn-measurable
and Vw E D, P ({w}) > 0, equipped with a filtration (Fnh~n::;N (without
.;.'
= O.
necessarily assuming that F N = F, nor F o = {0, D}). A sequence '(Xn)O::;n::;N
ofrandom variables is adapted to the filtration!f for any n, X!, is Fn-measurable. Hence
Definition 1.2.1 An adapted sequence (Mn)O::;n~N of real random variables is: 'A E (Xn+1IFn) = E (XnIFn) = X n.
o a martingale ifE (Mn+1IFn) = Mnfor all n :S N - 1; a
That shows that (Xn ) is martingale .. o
o asupermartingale ifE (Mn+lIFn) :S Mnforallri:S N -1; The following proposition is a very useful characterisation of martingales.
asubmartingale ifE (Mn+lIFn) ~ Mnforalln:S N-1.
Proposition 1.2.4 An ~dapted sequence ofreal random variables (M~) i~ a ~ar-
o
These definitions can be extended to the multidimensional case: for instance, a tingale ifand only iffor any predictable sequence (Hn), we have .-,
sequence (Mn)O<n<N of JRd-valued random variables is a martingale if each
.component is.a real-valued.martingale, .
In a financial context, saying that the price (S~)O::;n::;N of the asset i ~a
martingale implies that, at each time n, the best estimate (in the least-square
E (t. n; 6. u;) = O.

sense) of S~+1 is given by S~. Proof. If (Mn) is a ~artingale, the sequence (~n) defined by X o = 0 ~~d,
The following properties are easily derived from the previous definition and stand for n ;::: 1, X n = bn=1 H n6.Mn for any predictable process (Hn) is also a
as a good exercise to get used to the concept of conditional expectation. martingale, by Proposition 1.2.3. Hence, E(XN) = E(Xo) = O. Conversely, we
1. (M n)O::;n5,N is a martingale if and only if notice that if j E {I, ... , N}, we can associate the sequence (H n ) defined by
H n = 0 for n # j + 1 and Hj+l = lA, for any Frmeasurable A. Clearly, (H n )
E (Mn+jIFn) == u; Vj ~ 0
is predictable and E (2::=1 H n6.Mn) = 0 becomes
2. If (Mnk:~o is a martingale, thus for any n: E (Mn) = E (MQ)
~O.
.
E(iA (Mj+l - M j))
3. The sum of two martingales is a martingale.
4. Obviously, similar properties can be shown for supennartingales and submartin-
Therefore E (!'v!j+ 11 F j ) = u; 0
gales.
 Discrete-time models Martingales and arbitrage opportunities 7
6
1.2.2 Viable financial markets
If.the.strategy is admissi~le and its initial value is zero, then E* (V
N (¢)) = 0,
with VN (¢) 2:0. Hence VN (¢) = 0 since P* ({w}) > 0, for all wEn.
Let us get back to the discrete-time models introduced in the first section.
(b) The proof of the converse implication is more tricky. Let us call r the convex
Definition 1.2.5 The market is viable if there is no arbitrage opp0'!!!:Eity.
cone of strictly positive random variables. The market is viable if and only if for
Lemma'1.2.6 jf the market is viable, any ~ble process (¢i , ... , ¢d) satis- any admissible strategy ¢: Vo (¢) = 0 => VN (¢) ¢ r.
fies -- -" -
ti.!!J1!l{I· (bI) To any admissible process (¢;" ... , ¢~) we associate the process defined by
Proof. Let us assume thatG N(¢) E r. First, ifG n(¢) 2: 0 for all n E {O,... , N}
the market is obviously not viable. Second, if the Gn (¢) are not all non-negative,
we define n = sup {kiP (G k (¢) < 0) > o}. It follows from the definition ofn
that That is the cumulative discounted gain realised by following the self-financing
n ~ N - 1, P (Gn(¢) < 0) > 0 and 'v'm > n G m(¢) 2: O. strategy¢;', ... , ¢~. According to Proposition 1.1.3, there exists a (unique) process
(¢~) su~h that the strategy (( ¢~, ¢;" ... , ¢~)) is self-financing with zero initial
We can now introduce a new process 'ljJ value. C!n
(.¢) is the discounted value of this strategy at time n and because the
if j ~n market IS vIabl~, th~ fact tha! this value is positive at any time, i.e Gn (¢ ) 2: 0 for
u if j > n n = 1, ... , N, implies ~hat G N (¢) = O. The following lemma shows that even if
we do not assume that G n(¢) are no~-negative, we still have GN(¢) ¢ r. '
where A is the event {Gn(¢) < o}. Because ¢ is predictable and A is F n- (b2) The set V of random varia~es G N(¢), with ¢ predictable process in IRd ; is
measurable, 'ljJ is also predictable. Moreover clearly a vector subspace of IR(where IRo is the set of real random variables
0, if j ~
n defined on n). According to Lemma 1.2.6, the subspace V does not intersect r
Gj('ljJ)= { lA(G j(¢)-G1;l(¢)) if j > n
There~ore.it?oesnoti~tersecttheconvexcompacts·etK = {X E fI Ew X(w):::
I} WhICh IS included m r. As a result of the convex sets separation theorem (see
the Appendix), there exists (oX (w)tEo such that:
thus, G ('ljJ) 2: 0 for all j E {O,... , N} and G N ('ljJ) > 0 on A. That contradicts
j I,
the assumption of market viability and completes the proof of the lemma. 0 1. vx E K, L oX(w)X(w) > O.
Theorem
.
1.2.7 .The - -----_/
...------.----"- -
market is viable if and onl)' if there exists-a-probabil.ity .
~:_YYiY.q.le~~he:-diSt;ounteJ£pric.:s._(fl!S~e..~~_P* -
w

2. For any predictable ¢

martingales.
~ (a) Let us assume that there exists a probability P* equivalent to P under
w
which discounted prices are martingales. Then, for any self-financing strategy
(¢n), (1.1.2) implies From Property 1: we deduce that oX(w) > 0 for all wEn, so that the probability
n
P* defined by '.
Vn(¢) = Vo(¢) + L ¢j.f:::.Sj. !, . '

j=l P* ({w}) = oX(w)

Ew' EO oX(w')
Thus by Proposition 1.2.3, (Vn (¢)) is a P" - martingale. Therefore VN (¢) and
is equivalent to P. ,
Vo (¢) have the same expectation under P*: , Moreover, if we denote by E* the expectation under measure P*, Property 2.
E* (VN (¢)) = E* (Vo (¢)). means that, for any predictable process (¢n) in IRd,

t Recallthat two probability measures P I and P2 are equivalent if and only if for any event
A. PI (A) = ° ¢} P2 (A) = 0, Here, P" equivalent to P means that. for any wEn.

p·({w}»o,
 8 Discrete-time models Complete markets and option pricing 9
It follows that for all i E {I, ... ,d} and any predictable sequence (¢~) in JR, we Theore.~ 1.3.4 A viable m~rket is complete if and only if there exists a unique
have probability measure P equivalent to P under which discounted prices are mar-

E* (t ¢;6.8;)
J=I
= O.
tingales. .

The probability P* will appear to be the computing tool whereby we can derive
closed-form pricing formulae and hedging strategies.
Therefore, according to Proposition 1.2.4, we conclude that the discounted prices
Proof. (a) Let us assume that the market is viable and complete. Then, any
(8~), ... , (8~) are P* martingales. 0
non-neg~tlve, F N-~~asurable random variable h can be written as h =
VN (¢),
where ¢ IS an admissible strategy that replicates the contingent claim h. Since ¢
is self-financing, we know that
)

1.3 Complete markets and option pricing h _ N

SO = VN (¢) = Vo (¢) + L ¢j.6.8j.
1.3.1 Complete markets N j=I .

We shall define a European option" of inaturity N by giving its payoff h 2: 0, Thus, if PI and P: are two probability measures under which discounted prices
FN-measurable. For instance, a call on the underlying SI with strike price K
will be defined by setting: h =
(S}y - K) +. A put on the same underlying asset
are martingales, (V n (¢)) O<n<N is a martingale under both PI and P 2 . It follows
that, for i=1 or i =2 --
with the same strike price K will be defined by h = +.
(K - S}y) In those two
examples, which are actually the two most important in practice, h is a function of
S N only. There are some options dependent on the whole path of the underlying
asset, i.e. h is a function of SO, S1>' .. , SN. That is the case of the so-called Asian the last equality coming from the fact that ·Fo = {0, O}. Therefore
options where the strike price is equal to the average of the stock prices observed
during a certain period of time before maturity..

Definition 1.3.1 The contingent claim defined by h is attainable if there exists an

admissible strategy worthli at time N. and, since h is arbitrary, PI = P 2 on the whole a-algebra F N assumed to be
equal to F.
Remark 1.3.2 In a viable financial market, we just need to find a self-financing
strategy worth h at maturity to say that h is attainable. Indeed, if ¢ is a self- (b) Let us assume that the market is viable and incomplete. Then, there exists
financing strategy and if P* is a probability measure equivalent to P under which a random variable h ~ 0 which is not attainable. We call V the set of random
variables of the form
discounted prices are martingales, then (V (¢ )) is also a P*-martingale, being
n
N
a martingale transform. Hence, for n E {O,... , N} Vn(¢) = E* (VN(¢)IFn). Uo + L ¢n.6.8n, (1.1)
Clearly, if VN (¢) ~ 0 (in particular if VN (¢) = h), the strategy ¢ is admissible. n=I

, Definition 1.3.3 The market is complete if every contingent claim is attainable. ":here Uo is Fo-measlJrable and ((¢~'''''¢~))o<n<N is an JRd-valued pre-
dictable process, - -
To assume that a financial market is complete is a rather restrictive assumption that It follows fr,?m Proposition 1.1.3 and Remark 1.3.2 that the variable hiSf}y does
does not have such a clear economic justification as the no-arbitrage assumption. not belong to V. Hence, V is a strict subset of the set of all random variables on
The interest of complete markets is that it allows us to derive a simple theory (0, F). Therefore, if P* is a probability equivalent to P under which discounted
':
of contingent claim pricing and hedging. The Cox-Ross-Rubinstein model, that prices are riJ.~ngales and if we define the following scalar product on the set
we shall study in the next section, is a very simple example" of complete market of random ~ariables (X, Y) t-+ E: (XY), we notice that there exists a non-zero
modelling. The following theorem gives a precise characterisation of complete, random vanable X orthogonal to V. We also write
viable financial markets.

* Or more generally a contingent claim. P** ({w}) == (1 + 211Xlloo

X(w)) P*({w})
.
 Discrete-time models Complete markets and option pricing 11
10
model will show how we can compute the option price and the hedging strategy
with II XII"" = sUPwEn IX(w)l. Because E* (X) = 0, that defines a new proba-
in practice.
bility measure equivalent to P and different from P*. Moreover

E** (t, ¢n.~Sn) = 0

for any predictable process (( ¢~, ... , ¢~)) O::;n::;N· It follows from Proposition
1.2.4 that (Sn)O::;n::;N is a P" -m.artingale.
J.3.2 Pricing and hedging contingent claims in complete markets
The market is assumed to be viable and complete and we denote by P* the unique
probability measure under which the discounted ~rices of finan~ial assets are
martingales. Let h be an .1'N -measurable, non-negative random variable and ¢ be
an admissible strategy replicating the contingent claim hence defined, i.e.
The sequence (V n)
O::;n::;N
is a P* -rnartingale, and consequently
J.3.3 Introduction to American options
Since an American option can be exercised at any time between 0 and N, we shall
define it as a positive sequence (Zn) adapted to (.1'n), where Zn is the immediate
profit made by exercising the option at time n. In the case of an American option
0 on the stock SI with strike price K, Zn =
(S~ - K) +; in the case of the put,
Zn = (K - S~) -t-' In order to define the price of the option associated with
(Zn)O::;n::;N, we shall think in terms of a backward induction starting at time N.
Indeed, the value of the option at maturity is obviously equal to UN = Z N. At
what price should we sell the option at time N ., I? If the holder exercises straight
away he will earn Z N -1, or he might exercise at time N in which case the writer
must be ready to pay the amount ZN. Therefore, at time N - 1, the writer has
to earn the maximum between Z N -1' and the amount necessary at time N - 1 to
generate ZN at time N. In other words, the writer wants the maximum between
Z N -1 and the value at time N - 1 of an admissible strategy paying off Z N at time
N, i.e. S~_I E* (ZNI.1'N- I)' with ZN = ZN /S~. As we see, it makes sense to
price the option at time N - 1 as

UN- I = max (ZN-I, S~_IE* ( ZNI ~N-l)) .

'-' By induction, we defin~ the American option price for n :: 1, ... , N by
that is Vo(¢) = E* (h/S~) and more generally
_ Un- I = ~ax ( Z~-I' S~_I E* ( ~~ l.1'n- 1) ) .
Vn (¢ ) = S~E* ( ; l.1'n ) , n = 0,1, ... ,N.
, . N If we assume that the interest rate over one period is constant and equal to r,
At any time, the value of an admissible strategy replicating h is completely deter- S~ = (1 + r)"
mined by h. It seems quite natura} to call Vn (¢) the price of the option: that is the
and
wealth needed at time n to replicate h at time N by following the strategy ¢. If, at
time 0, an investor sells the option for' Un- I = max ( Zn-I, 1 ~ r E* (Un l.1'n-l )) ,
E.* (:~), let ii; = Un / S~ be the discounted price of the American option.
Proposition 1.3.6 The "sequence (Un) is a P* -supermartingale. It is the
he can follow a replicating strategy ¢ in order to generate an amount h at time N. . O<n<N
In other words, the investor is perfectly hedged. smallest P* -supermartingale that domin~te~ the sequence (Zn) '.:
. O<n<N
to
Remark 1.3.5 It is important notice that the computation of the option price We should note that, as opposed to the European case, the discounted price of
only requires the knowledge of P* and not P. We could have just considered a the American option is generally not a martingale underP".
measurable space (fl,.1') equipped with the filtration (.1'n). In other words, we Proof. From the equality .,
would only define the set of all possible states and the evolution of the information
over time. As soon as the probability space and the filtration are specified, we Un- I = max ( Zn-I, E* (Un l.1'n-l ) ) ,
do not need to find the true probability of the possible events (say, by statistical
it follows that (Un)O::;n::;N is a supermartingale dominating (Zn)O::;n::;N. Let us
means) in order to price the option. The analysis of the Cox-Ross-Rubinstein
12 Discrete-time models Problem: Cox, Ross and Rubinstein model
13
now consider a supermartingale (Tn)O~n~N that dominates (Zn)O~n~N. Then
3. Give examples of arbitrage strategies if the no-arbitrage condition derived in
TN 2: lJN and if i; 2: ii; we have Question (2.) is not satisfied. '

Tn- l 2: E* (Tn l.1'n-l) 2: E* (Un l.1'n-1 ) Assume for instance that r :S a. By borrowingan amount So at time 0, we can purchase
one share of the risky asset. At time N, we pay the loan back and sell the risky
whence asset. We realised a profit equal to SN - So(1 + r)N which is always positive, since
Tn- l 2: max ( Zn-l, E* (Un l.1'n-1 )) = Un-I' SN 2: So(1 + a)N. Moreover, it is strictly positive with non-zero probability. There is
arbitrage opportunity. If r 2: b w,e can make a riskless profit by short-selling the risky
A backward induction proves the assertion that (Tn) dominates (Un). o asset.
4. From now o~, w.e assume that r E Ja, b[ and we write p =
(b - r)/(b _ a).
ShowTthat (~n) IS a P-martingale if and only if the random variables T I, T ,
2
. : ., N are mdependent, identically distributed (lID) and their distribution is
1.4 Problem: Cox, Ross and Rubinstein model grven by: P(TI = = =
1 + a) p 1 - P(TI =
1 + b). Conclude that the market
is arbitrage-free and complete.
The Cox-Ross-Rubinstein model is a discrete-time version of the Black-Scholes
model. It considers only one risky asset whose price is Sn at time n, 0 ~ n ~ N, ' IfTi are independent and satisfy P(Ti = 1 + a) = P = 1 - P(Ti = 1 + b), we have
and a riskless asset whose return is r over one period of time. To be consistent E(Tn+dFn) = E(Tn+d = p(1 + a) + (1 - p)(1 + b) = 1 + r
with the previous sections, we denote S~ =
(1 + r)". and thus, (Sn) is a P-martingale, according to Question I. '
The risky asset is modelled as follows; between two consecutive periods the CO,nversely, if for n = 0,1, .. : , N - I, E(Tn+ljFn) = 1 + r, we can write
relative price change is either a or b, with -1 < a < b:
p + a)E (1{T n + 1 = l+ a } IF n ) + (1 + b)E (1{Tn+ 1=1+b}IFn) = 1 + r.
Sn(l+a) Then, the following equality
Sn+l = { Sn(1 + b).
E(1{Tn+ 1=l+a}IF n) +E (1{Tn+ 1=1+b}IFn) = 1,:
The initial stock price So is given. The set of possible states is then n=
{I +
~mplie~ that E (l{Tn+l=l+a}jF~) = P and E (1{Tn+ 1=1+b}jFn) = 1.- p. By
a, 1 + b}N, Each N -tuple represents the successive values of the ratio Sn+d Sn, induction, we prove that for any xi E {I + a, 1 + b},
n = 0,1, , N - 1. We also assume that.1'o =
{0, n} and .1' pen). For=
n = 1, , N, the a-algebra .1'n is equal to a(SI"'" Sn) generated by the P (TI = Xl, ... .t; = x;,) = II Pi
n
random variables SI ,... ,Sn. The assumption that each singleton in has a strictly i=l
positive probability implies that P is defined uniquely up to equivalence. We now where Pi = P if Xi = 1 + a and Pi = 1 - pif Xi = 1 + b. That shows that the variables
introduce the variables Tn = Sn/Sn-I, for n = 1, ,N. If (XI, ... ,XN) is T, are lID under measure P and that P(Ti = 1 + a) = p.
one element of n, P{(XI, ... , XN)} =
P(TI Xl, = =
,TN XN). As a result, We have shown that the very fact that (Sn) is a P-martingale uniquely deterrni~es
knowing P is equivalent to knowing the law of the N -tuple (T I, T2 ;' ... , TN). We' the distribution of the N-tuple (TI, T 2 , • • • , TN) under P, hence the measure P itself.
also remark that for n 2: 1,.1'n = a(TI, ... ,Tn). Therefore, the market is arbitrage-freeand complete.
1. Show that the discounted price (Sn) is a martingale under P if and only if 5. We denote by C; (resp. Pn ) the value at time n, ofa European call (resp. put)
E(Tn+II.1'n) = 1"+ r, '<In E {O, 1, ... , N - I}. on a share of stock, with strike price K and maturity N.
The equality E(Sn+I'IFn) = s: is equivalent to E(Sn+dSnIFn) == 1, since Sn is, (a) Derive the put/call parity equation
Fn-measurable and this last equality is actually equivalentto E(Tn+dFn) = 1 + r .
C; - Pn = Sn - K(1 + r)-(N-n),
2. Deduce 'that r must belong to[c, b[ for the market to be arbitrage-free.
knowing the put/call prices in their conditional expectation form.
If the market is viable, there exists a probability P* equivalent to P, under which (Sn)
If we deEote E* the expectation with respect to the probabilitymeasure P* under
is a martingale. Thus, according to Question 1. ' which (Sri) is a martingale, we have "
E*(Tn+IIFn) =1+r len - Pn = (1 + r)-(N-n)E* ((SN - K)+ - (K - SN )+IFn)
and therefore E*(Tn+d = 1 + r . Since Tn+l is either equal to 1 + a or 1 + b with = (1 + r)-(N-n)E* (SN - KIFn)
non-zero probability, we necessarily have (1 + r) E]1 + a, 1 + b[. = Sn-K(1+r)-(N-n),
 14 Discrete-time models Problem: Cox, Ross and Rubinstein model 15
the last equality comes from the fact that (Sn) is a P" -martingale. where, for each N, the random variables XI' areIll), belong to
(b), Show that we can write en = c(n, Sn) where c is a function of K, a; b, r
andp. {-ajVN, ajVN},
When we write SN = S« n::n+l Ti, we get and their mean is equal to J.LN, with limN400(N J.LN) = J.L. Show that the
sequence (YN ) converges in law towards a Gaussian variable with mean J.L
c; = (1 + r)-(N-n)E" ((Sn ,IT K) :
.=n+l
t: -
+
Fn).
and variance a 2 •
Wejust need to study the con,:ergenceof the characteristic function tPYN of YN. We
obtain
Since under the probability P", the random variable n::n+l T, is independent of N
F« and since S« is Fn-measurable, Proposition A.2.5 in the Appendix allows us to
write: C« = c( n, Sn), where c is the function defined by
tPYN(U) = E(exp(iuYN» = IIE (exp(iuXf"»)
i=l
c(n, x)
(l +r)-(N-n)
= (E (exP(iuXf»)t
(1 + iUJ1.N - a 2 u 2 / 2N + a(I/N») N.
= E" (x IT K)
i=n+l
t: -
+
,r
" Hence, limj,..... oo tPYN (u)
in law.
= exp (iuJ1. - a 2 u 2 /2), which proves the convergence
N-n
(b) Give explicitly the asymptotic prices of the put and the call at time O.
""' (N - n).! . rl (1 _ p)N-n- i (x(I + a)i (1 + b)N-n- i - K) .
For a certain N, the put price at time 0 is given by
L.J (N-n-J)!J! +
i=O
6. Show that the replicating strategy of a call is characterised by' a quantity H n
b.(n, Sn-l) at time n, where b. wi11 be expressed in terms offunction c.
= pJN) = (1 + RT/N)-N'E" (K':'" ~o IT Tn)
n=l +
We denote H~ the number of riskless assets in the replicating portfolio. We have
= E",((l + RT/N)-N K - So exp(YN») +
H~(I + r)" + HnSn = c(n, Sn).
with Y N ' = L::=I log(Tn/(I + r». According to the assumptions, ~he variables
'Since H~ and H; are Fn_1-measurable, they are functions of Sv,. . . ,Sn-l only and,
since s:is equal to Sn-l (l + a) or Sn-l (1 + b), the previous equality implies
Xf"
probability P", Moreover
r»
= log(Ti/(l + are valued in {-a/VN,a/VN}, and are liD under
H~(l + r)n + HnSn..:.1(I + a) = c(n, Sn-l(I + a» , 2 trlVN -trlVN
E"(XiN ) = (1 _ 2p)~ = - e - e ~.
and VN etrl VN - e- trl VN VN
H~(I + rt + HnSn-1(I + b) = c(n, Sn--:l(I + b». Therefore, the sequence (YN) satisfies the conditions of Question 7.(a), with J1.
2
=
Subtracting one from the othtr, it turns out that _a /2. If we write 'Ij;(y) = (Ke- R T - Soe Y)+, we are able to write
c(n,x(I+b»-c(n,x(I+a»
D.(n, x ) = x(b _ a) : IPJN) E" ('Ij;(YN» I'

, 7. We can now use the model to price a call or a put with maturity T on a single
= IE" (((1 + RT/N)-N K - So exp(YN») +
stock. In order to do that, we study the asymptotic case when N converges RT
- (Ke- -Soexp(yN»)+)1
to 'infinity, and r =
RT/N, log((l + a)j(l + r)) =
-ajVN and log((l +
=
b)j(l + r)) ajVN. The real number R is interpreted as the instantaneous < K 1(1 + RT/N)-N _ e-RTI.

rate at al1 times between 0 and T, because e RT =

limN4oo(1 + r)N. a 2 can
Since 'Ij; is a bounded t, continuous function and because the sequence (YN) con-
be seen as the limit variance, under measure P", of the variable log(SN), when
verges in law, we conclude that
N converges to infinity. -, '
I'm p'(N)
N~oo
= lim E" ('Ij;(YN»
(a) Let (YN )N~l be a sequence ofrandom variables equal to 0 N .....oo

YN=xi'+xf+'''+x~ t It is precisely to be able to work with a bounded function that we studied the put first.
 Discrete-time models
16
= _1_1+ 00
(Ke-RT _ Soe-u2/2+UY)+e-y2/2dy . 2
.j21i -00

"The integral can be expressed easily i~ terms of the cumulative normaldistribution

F, so that
lim pJN) = Ke- RTF(-d 2) - SoF(-d 1) ,
N-+oo
Optimal stopping problem
2/2)/a,
where dl = (log(x/ K) + RT + a d 2 = d 1 - a and
and American options
F(d) = _1_1
.j21i
d

-00
e-,,2/ 2dx .

The priceofthecallfollows easilyfromput/call paritylimN-+oo C~N) = SoF(d 1) -

K e- RT F(d 2 ) .
Remark 1.4.1 We note that the only non-directly observable parameter is .a .. Its
interpretation as a variance suggests that it should be estimated by statistical
methods. However, we shall tackle this question in Chapter 4.
Notes: We have assumed throughout this chapter that the risky assets were not
offering any dividend. Actually, Huang and Litzenbe~ger (19~8) a~p.ly the same
ideas to answer the same questions when the stock IS carrying dIvId.en~s. 1?e
theorem of characterisation of complete markets can also be proved WIth infinite
probability spaces (cf. Da1ang, Morton and Willinger (1990) and ~orton (1989)).
In continuous time, the problem is much more tricky (cf. Hamson and Kreps
(1979), Stricker (1990) and Delbaen and Schachermayer (~994)). Th~ theory of
complete markets in continuous-time was developed by H~rns~n and Ph~ka .( 198.1,
1983). An elementary presentation of the Cox-Ross-Rubmstem model IS given m
the book by I.e. Cox and M. Rubinstein (1985).
The purpose of this chapter is to address the pricing and hedging of American
options and to establish the link between these questions and the optimal stopping
problem. To do so, we will need to define the notion of optimal stopping time,
which will enable us to model exercise strategies for American options. We will
also define the Snell envelope", which is the fundamental concept used to solve. the
optimal stopping problem. The application of these concepts to American options
will be described in Section 2.5.
2.1 Stopping time
The buyer of an American option can exercise its right at any time until maturity.
The decision to exercise or not at time n will be made according to the informa-
tion available at time n. In a discrete-time model built on a finite filtered space
(S1, F, (Fn)O:::;n:::;N , P), the exercise date is described by a random variable called
stopping time.
Definition 2.1.1 A random variable IJ taking values in {O,1,2, ... , N} i~'a stop-
ping time if, for any nE {O, 1", . ,N},
{IJ = n} E F~.

Remark 2.1.2 As in the previous chapter, we assume that F = P(S1) and

( P( {w}) > 0, Vw E S1.~ This hypothesis is nonetheless not essential: if it does
not hold, the results presented in this chapter remain true almost surely. However,
we will not assume F o = {0, S1} and F N = F, except in Section 2.5, dedicated
to finance. .
~ ,
Remark 2.'1.3 The reader can verify, as an exercise; that IJ is a stopping time if
and only if, for any n E {O, 1, ... ,Nt
{IJ :::; n} E F n .
We will use this equivalent definition to generalise the concept of stopping time
to the continuous-time setting. .
18 Optimal stopping problem and American options The Snell envelope
19
Let us introduce now the concept of a 'sequence stopped at a stopping time'. Let
Proposition 2.2.1 The random variable defined by
(Xn)O<n<N be a sequence adapted to the filtration (Fn)O<n<N and let v be a
stopping time. The sequence stopped at time v is defined as- - Vo = inf {n ~ 0IUn = Zn} (2.1)
X~ (w) = Xv(w)/\n (w), is a stopping time and the stopped sequence ( U ) . l .
. n/\vo O<n<N
a martmga e. IS

i.e., on the set {v = j} we have

Proof. Since UN = ZN, Vo is a well-defined element of {O 1 N} and
have ' , ... , . we
{VO = ~} = {Uo = Zo} E F o,
X~ = { X
X J
n
if j
if j
~
> n.
n
and for k ~ 1

Note that X N(w) = Xv(w)(w) (= X j on {v = j}). {vo = k} = {Uo > Zo} n··· n {Uk-I> Zk-d n {Uk = Zd E r;
Proposition 2.1.4 Let (X n ) be an adapted sequence and v be a stopping time. To demonstrate that (U~o) is a martingale, we write as in the proof of Proposition
The stopped sequence (X~)O<n<N is adapted. Moreover; if(X n) is a martingale 2.1.4:
(resp. a supermartingale), then rX~) is a martingale (resp. a supermartingale). n

Proof. We see that, for n ~ 1, we have U:;o = Un/\vo == ti; + L ¢>j 6.Uj,
n
j=1
where ¢>j = I{vo~j}. So that, for n E {OJ 1, ... ,N - I},
Xv/\n = x, + L ¢>j ix, - X j- 1),
j=1 u»
n+l - u» = . .¢>n+l (Un+. 1 - Un)
n

where ¢>j = I {j~v}' Since {j ~ v} is the complement of the set {v < j} = = l{n+l5.vo} (Un+l - Un).
{v ~ j - I}, the process (¢>n)O<n<N is predictable. By definition, U'; = max (Zn, E (Un+lIFn)) and on the set {n + 1 ~ VO}, U; >
It is clear then that (Xv/\n)~<::<N is adapted to the filtration (Fn)O~n~N. Zn. Consequently Un = ;E (Un+lIFn) and we deduce .
Furthermore, if (X n) is a martingale, (Xv/\n) is also a martingale with respect to
U vo uvo 1 .
(Fn ) , since it is the martingale transform of (X n ) . Similarly; we can show that n+l - n = {n+l5.vo} (Un+l - E (Un+lIFn))
if the sequence (X n ) is a supermartinga1e (resp. a submartingale), the stopped and taking the conditional expectation on both sides of the equality
sequence is stilla supermartingale (resp. a submartinga1e) using the predictability
and the non-negativity of (¢>j )05.j 5. N. 0 E ((U::+ 1 --: U~o) IFn) = l{n+l5. vo}E ((Un+l - E(Un+I!Fn))IFn)
because {n + 1 ~ vol E Fn (since the complement of {n + 1 < vol is {v <
n}). - 0 -
Hence
2.2 The Snell-envelope . E ((U:;+1 - U:;o) \Fn) = 0,
which proves that U'» is a martingale. .
In this section, we consider an adapted sequence (Zn)05.n5.N, and define the o
sequence (Un)05.n5.N as follows: In the remainder, we s?all note Tn,N the set of stopping times taking values in
= ZN {n, n + 1.'... , N}. Nonce that Tn,N is a finite set since f! is assumed to be finite.
= max (Zn, E'(Un+lIFn)) "In ~ N:"-1. The martingale property of the sequence U'» gives the following result which
relates the concept of Snell envelope to the optimal stopping problem.
The study of this sequence is motivated by our first approachof American options Corollary 2.2.2 The stopping time Vo satisfies
(Section 1.3.3 of Chapter 1). We already know, by Proposition 1.3.6 of Chapter
1, that (Un)O<n<N is the smallest supermartingale that dominates the sequence Uo = E (ZvoIFo) = sup) E (ZvIFo).
(Zn)O<n<N. W;call it the Snell envelope of the sequence (Zn)O<n<N. . . vETo.N

By definition, Ui; is greater than Zn (with equality for n =,N) a;din the case of If we. think ~f Zn as the total winnings of a gambler after n games, we see that
a strict inequality, Un = E(Un+lIFn). It suggests that, by stopping adequately the stopping ~t tlmevvo. maximises the expected gain given F o.
sequence (Un), it is possible to obtain a martingale, as the following proposition Proof. Since U ° IS a martingale, we have
shows.
 Optimal stopping problem and American options Decomposition ofsupe rmartingales 21
20
2.3 Decomposition of supermartingales
On the other hand, if 1/ E Io,N, the stopped sequence U" is a supermartingale. So
that The following decomposition (commonly called 'Doob decomposition') is used
in viable complete market models to associate any supermartingale with a trading
Uo > E (UNI.ro) = E (UIII.ro)
strategy for which consumption is allowed (see Exercise 5 for that matter).
> E (ZIII.ro),
Proposition 2.3.1 Every supermartingale (Un)05,n5,N has the unique following
which yields the result. 0 decomposition:
Un = M n - An,
Remark 2.2.3 An immediate generalisation of Corollary 2.2.2 gives
where (Mn ) is a martingale and (An) is a non-decreasing, predictable process,
u; sup E (ZIII.rn) null at O.
liE/noN .

= E (ZlIn l.rn) , Proof. It is clearly seen that the only solution for n = 0 is M o = Uo and A o = O.
Then we must have
where I/n = inf {j ~ nlUj = Zj}.
Definition 2.2.4 A stopping time 1/ is called optimalfor the sequence (Zn)o< n < N Un+1 - Un = M n+1 - M n - (A n+1 - An) .
if - -
So that, conditioning both sides with respect to F.n and using the properties of M
E (ZIII.ro) = sup E (ZII!.rO) ~ ~A.. .
Io,N
We can see that I/o is optimal. The following result gives a characterisation of
- (A n+1 - An) = E (Un+ll.rn) - Un
optimal stopping times that shows that I/o is the smallest optimal stopping time. and
Theorem 2.2.5 A stopping time v is optimal ifand only if
M n+1 - M n = Un+1 - E (Un+11.rn) .
(Mn ) and (An) are entirely determined using the previous equations and we see
ZII = UII (2.2) that (Mn ) is a martingale and that (An) is predictable and non-decreasing (because
{ and (UlIl\n)05,n5,N is a martingale.
(Un) is a supermartingale). 0
Proof. If the stopped sequence U" is a martingale, Uo = E(UIII.ro) and con-
sequently, if (2.2) holds, Uo = E(ZIII.ro). Optimality of 1/ is then ensured by Suppose then that (Un) is the Snell envelope of an adapted sequence (Zn)' We
can then give a characterisation of the largest optimal stopping time for (Zn) using
Corollary 2.2.2.
the non-decreasing process (An) ~f the Doob decomposition of (U~):
Conversely, if 1/ is optimal, we have
Proposition 2.3.2 The largest optimal stopping time for (Zn) is given by
Uo = E (ZIII.ro) S E (UIII.ro) .
But, since U" is a supermartingale, _{Ninf in,. A if AN = 0
1/_ - n+1 =I- O} if AN =I- O.
Proof. It is straightforward to see that I/m", is a stopping time using the fact that
Therefore \A n)o5,n5,N is predictable. From Un = M n - An and because Aj = 0, for
E (UIII.ro) = E (ZIII.ro) J S ~, we deduce that U"fn", = M"fnu and conclude that U"fn", is a martingale. To
and since UII ~ ZII' UII = ZII' show the optimality of !{n'"" it is sufficient to prove
Since E (UIII.ro) = Uo and from the following inequalities
U"fn'" =Z"fn""
Uo ~ E (UlIl\nl.fo) ~ E (U1I1l"0)
. , We note that
(based on the supermartingale property of (U~) we get N-l )

E (UlIl\nl.ro) = E (UIII.ro) = E (E (UIII.rn)l.ro). v.: - "L: 1{~",=j}Uj + 1{"fn",";N}UN

j=O
But we have UlIl\n ~ E (UIII.rn), therefore u-; =' E (VIII.rn), which proves N-l
that (U::) is a martingale. 0
L: 1{"fnu =j} max (Zj, E (Uj+d.rj)) + 1{"fnu=N}ZN,
j=O
 22 Optimal stopping problem and American options Application to American options 23
We have E (Uj+IIFj) = M, - Aj+l and, on the set {vrnox = j}, A j = 0 and of the sequence (Zn) is given by Un = u(n, X n), where the function u is defined
Aj+l > 0, so Uj = M j and E (Uj+IIFj) = M j - Aj+l < Uj. It follows that I
I,
by
U, = max (Zj, E (Uj+IIFj)) = Zj. So that finally u(N, x) = 'ljJ(N, x) '<Ix E E
Ulfuv. = Z lfuv. • and,for n :s N - I,
It remains to show that it is the greatest optimal stopping time. If v is a stopping u(n,') = max ('ljJ(n, .), Pu(n + 1, .)) .
time such that v 2: Vrnax and P (v > vrnax) > 0, then
E(Uv) = E(Mv) - E(A v) = E(Uo) - E(A v) < E(Uo) 2.5 Application to American options

and UV cannot be a martingale, which establishes the claim.
2.4 Snell envelope and Markov chains
The aim of this section is to compute Snell envelopes in a Markovian setting. A
sequence (Xn)n~O of random variables taking their values in a finite set E is
called a Markov chain if, for any integer n 2: 1 and any elements xo, Xl,' .. ,
Xn-l, X, Y of E, we have
o From now on, we will work in a viable complete market. The modelling will be
based on the filtered space (fl,
F, (Fn)O:::;n:::;N ,P) and, as in Sections 1.3.1 and
1.3.3 of Chapter 1, we will denote by P* the unique probability under which the
discounted asset prices are martingales.
2.5.1 Hedging American options
In Section 1.3.3 of Chapter 1, we defined the value process (Un) of an American
option described by the sequence (Zn), by the system

P(Xn+l = y!Xo = Xo, ... ,Xn- l = Xn-l, X n = x) = P(Xn+l = ylXn = x) . , UN = ZN

{ Un = max (Zn, S~E* (Un+l/ S~+lIFn)) '<In:S N-1.
The chain is said to be homogeneous if the value P(x, y) = P (Xn+l = ylXn = x)
does not depend on n. The matrix P = (P(x, y))(X,Y)EEXE' Indexed byE x .E, Thus, the sequence CUn) 'defined by ii; = Un/ S~ (discounted price of the option)
is then called the transition matrix of the chain. The matrix P has non-negative is,the Snell envelope, under P*, of the sequence (Zn). We deduce from the above
, entries and satisfies: LYEE P(x, y) = 1 for all x E' E; itis said to be a stochastic Section 2.2 that . '

matrix. On a filtered probability space ( n, F, (F";)O:::;n~N ,P), we can define tlie

ii; = sup' E* ( ZvlFn)
, vETn.N
notion of a Markov chain with respect to the filtration: and consequently

u; = S~ (SZ~v IFn) .
Definition 2.4.1 A sequence (Xn)O:::;n:::;N of random variables taking values in
E is a homogeneousMarkov chain with respectto thefiltration (Fn)O<n<N' with sup E*
vETn.N
transition matrixP, if (X n) is adapted and iffor any real-valuedfunctIon f on From Section 2.3, we can write .
E, we have " ,
E (f (Xn~d IFn) = P f (X n) , ii; = Mn - An,
whereP f represents thefunction whichmapsx E E toP f(x) = LYEE P(x; y)f(y). where (Mn ) is a Pt-martingale and (An) is an increasing predictable process,
Note that, if one interprets real-valued functions on E as matrices with a single null at O. Since the market is complete, there is a self-financing strategy ¢such
column indexed by E, then P f is indeed the product of the two matrices P and that
o -
f. It can also be easily seen that a Markov chain, as defined at the beginning VN (¢) = SNM N,
of the section, is a Markov chain with respect to.its natural filtration, definedby
F n = a(Xo, ... ,Xn ) . ' . C
i.e., VN (¢) = MN. For the seque?ce (Vn (¢)) is a P* -martingale, w~ have
The following proposition is an immediate consequence of the latter definition
and the definition of a Snell envelope. ' Vn(¢) E* (VN(¢)!Fn )
Proposition 2.4.2 Let (Zn) be an adapted sequence defined by Zn = 'ljJ(n, X n),
E* (MNIFn )
where (X n) is a homogeneous Markov chain with transition matrix P, taking
values in E, and ib is afunctionfrom N x E to JR. Then, the Snell envelope (Un)
24 Optimal stopping problem and American options Exercises 25
and consequently If Cn ~ Zn for any n then the sequence (cn), which is a martingale under P",
appears to be a supermartingale (under P") and an upper bound of the sequence
Therefore (Zn) and consequently
Un = Vn(cP) - An, Cn~C;' \lnE{O,I, ... ,N}.
where An = S~ An. From the previous equality, it is obvious that the writer of the o
option can hedge himself perfectly: once he receives the premium Uo = Vo(cP),
he can generate a wealth equal to Vn(cP) at time n which is bigger than Un and a Remark 2.5.2 One checks readily that if the relationships of Proposition 2.5.1
fortiori Zn. did not hold, there would be some arbitrage opportunities by trading the options.
What is the optimal date to exercise the option? The date of exercise is to be To illustrate the last proposition, let us consider the case of a market with a
chosen among all the stopping times. For the buyer of the option, there is no point single risky asset, with price Sn at time n and a constant riskless interest rate,
in exercising at time n when U« > Zn, because he would trade an asset worth Un equal to r ~ 0 on each period, so that S~ = (I + r)". Then, with notations of
(the option) for an amount Zn, (by exercising the option). Thus an optimal date T Proposition 2.5.1, if we take Zn = (Sn - K)+, Cn is the price at time n of a
of exercise is such that UT ~ ZT' On the other hand, there is no point in exercising European call with maturity N and strike price K on one unit of the risky asset
after the time and Cn is the price of the corresponding American call. We have
/I"", = inf {j, A j +! i- O}
cn + r)-NE· ((SN - K)+IFn)
(I
(which is equal to inf {j, Aj +! i- 0}) because, at that time, selling the optia,n
> E· (SN - K(I + r)-NIFn) ,
provides the holder with a wealth UJ.iruu = VJ.iruu (cP) and, following the strategy
- -N
cP from that time, he creates a portfolio whose value is strictly bigger than the = Sn-K(I+r) ,
.option's at times /1m.. + I, /1max + 2, ... , N. Therefore we set; as a second condition, using the martingale property of (Sn). Hence: ~n ~ s; - K(I + r)-(N-n) ~
T :::; /I""" which allows us to say that eF is a martingale. As..a result, optimal dates Sn - K, for r ~ O. As Cn .~ 0, we also have c., 2: (Sn - K) + and by Proposition
of exercise are optimal stopping times for the sequence (Zn), under probability 2.5.1,Cn = Cn. There is equality between the price of the European call and the
p ". To make this point clear, let us considerthe writer's point of view. If he hedges price of the corresponding American call. ,
himself using the strategy cP as defined above and if the buyer exercises at time T This property does not hold for the put, nor in the case of calls on currencies or
which is not optimal, then UT > ZT or AT > O. In both cases, the writer makes a dividend paying stocks.
profit VT(cP) - ZT = UT + AT - Zro which is positive. Notes: For further discussions .on the Snell envelope and optimal stopping, one
may consult Neveu (1972), Chapter VI and Dacunha-Castelle and Duflo (1986),
2.5.2 American options and European options ' Chapter 5, Section 1. For the theory of optimal stopping in the continuous case,
see EI Karoui (1981) and Shiryayev (1978).
Proposition 2.5.1 Let Cn be the value at time n ofan American option described
by an adapted sequence (Zn)O<n<N and let Cn be the value at time n of the -
European option defined by the F N--measurable random variable h = Z N. Then, 2.6 Exercises
we have Cn ~ Cn. Exercise 1 Let /I be a stopping time with respect to a filtration (Fn)O<n<N.
Moreover, if Cn ~ Zn for any n, then We denote by F; the set of events A such that A n {/I = n}. E F n f'(;r any
nE{O, ... ,N}. .
Cn =C n \In E {O,I, ... ,N}.
- I. Show that F; is a sub-a-algebra of F N. F; is often called 'a-algebra of events
The inequality Cn ~ Cn makes sense since the American option entitles the holder determined prior to the stopping time /I'.
to more rights than its European counterpart. c.. '.
2. Show that the random variable /I is Fv-measurable.
Proof. For the discounted value (C n) is a supermartingale ~nder p. , we have
3. Let X be a real-valued random variable. Prove the equality

Cn ~ E· (CNIFn) = E· (cNIFn) = cn. N

E(XIFv) = L l{v=j}E(XIFj).
Hence c, ~ Cn. j=O
 Optimal stopping problem and American options Exercises 27
26
4. Let T be a stopping time such that T 2: v, Show that:Fv C Fr. 6. Show that the hedging strategy of the American put is determined by a quantity
H n = ~(n, Sn-d of the risky asset to be held at time n, where ~ can be
5. Under the same hypothesis, show that if (M n ) is a martingale, we have
written as a function of Pam.
Exercise 5 Consumption strategies. The self-financing strategies defined in
Chapter 1 ruled out any consumption. Consumption strategies can be introduced
(Hint: first consider the case T = N.) in the following way: at time n, once the new prices S~, . . . ,S~ are quoted, the
Exercise 2 Let (Un) be the Snell envelope of an adapted sequence (Zn). Without investor readjusts his positions from ¢n to ¢n+1 and selects the wealth 1'n+1 to be
assuming that :Fo is trivial, show that consumed at time n + 1. Any endowment being excluded and the new positions
E (Uo) = sup E (Zv) , being decided given prices at time n, we deduce
vETo,N
¢n+1,Sn = ¢n,Sn - 1'n+l. (2.3)
and more generally So a trading strategy with consumption will be defined as a pair (¢,1'), where
E (Un) = sup E (Zv). ¢ is a predictable process taking values in IR d+1, representing the numbers of
vETn,N
assets held in the portfolio and l' = bnh <n<N is a predictable process taking
Exercise 3 Show that v is optimal according to Definition 2.2.4 if and only if values in IR+, representing the wealth consumed at any time. Equation (2.3) gives
E(Zv)= sup E(ZT)' the relationship between the processes ¢ and l' and replaces the self-financing
TETo,N condition of Chapter 1.
Exercise 4 The purpose of this exercise is to study the American put in the model 1. Let ¢ be a predictable process taking values in IRd+ 1 and let l' be a predictable
of Cox-Ross-Rubinstein. Notations are those of Chapter 1. process taking values in IR+. We set Vn(¢) '= ¢n,Sn and Vn (¢ ) = s;»:
1. Show that the price P n, at time n, of an American put on a share with maturity Show the equivalence between the following conditions:
N and strike price K can be written as (a) The pair (¢, 1') defines a trading strategy with consumption.
(b) For any n E {l, .. :,N},
P n= Pam(n, Sn)
n n
where Pam(n, x) is defined by Pam(N, x) = (K - x)+ and, for n :::; N - 1, Vn (¢ ) = Vo(¢) + L ¢j.~Sj - L 1'j.
f(n+1,x)) j=l j=l
Pam(n,x) = max ( (K - x)+, 1+r , '
(c) For any n E {I, ... ,N},
with f(n + 1,x) = pPam(n + 1,.:r(1 + a)) + (1 ., p)P~;.,,(n + 1,x(1 + b)) n n

andp = (b- r)/(b - a). Vn(¢ ) = Vo(¢ ) + L¢j·~Sj - L1'j/SJ-1'

2. Show that the function Pam(O,.) can be expressed as
Pam(O,x) = sup E' ((1 + r)-V(K - xVv)+) ,
vETo,N
where the sequence of random 'variables (Vn)O::;n::;N is defined by: Vo 1
and, for n 2: 1, Vn = TI7=1 Ui, where the U/s aresome random variables. '
Give their joint law under P".
3. From the last formula, show that the function x !-t' Pam(O,x) is convex and
non-increasing. " 4. Let (Zn) be an adapted sequence. We say that a trading strategy with consump-
4. We assume a < 0. Show that there is' a real number x' E [0, K] such that, for
x:::; x', Pam (0, x) = (K - x)+ and; for x E ]x', K/(l + a)N[, Pam(O, x) >
(K - x)+.
5. An agent holds the American put at time 0. For which values of the spot So
would he rather exercise his option immediately?
j=l j=l
2. In the remainder, we assume that the market is viable and complete and we
denote by P' the unique probability under which the assets discounted prices
are martingales. Show that if the pair (¢, 1') defines a trading strategy with
consumption, then (V~(¢)) is a supermartingale under P".
3. Let (Un) be an adapted sequence such that (Un) is a supermartingale under
P". Using the Doob decomposition, show that there is a trading strategy with
consumption (¢,1') such that Vn (¢ ) = Un for any n E {O,... , N}.
tion (¢, 1') hedges the American option defined by (Zn) if Vn (¢) 2: Zn for
any n E {O,1, .. '. , N}. Show that there is at least one trading strategy with
consumption that hedges (Zn), whose value is precisely the value (Un) of the
American option. Also, prove that any trading strategy with consumption (¢, 1')
hedging (Zn) satisfies Vn(¢) 2: Un, for any n E {O,1, ... , N}. '
28 Optimal stopping problem and American options
5. Let x be a non-negative number representing the investor's endowment and let 3
'Y = bnh<n<N be a predictable strategy taking values in IR.+. The consump-
tion process (1-n) is said to be budget-feasible from endowment x if there is a
predictable process ¢ taking values in IR.d+ 1, such that the pair (¢, 'Y) defines
a trading strategy with consumption satisfying: Vo(¢ ) = x and Vn (¢ ) 20, for
any n E {O, ... , N}. Show that bn) is budget-feasible from endowment x if
Brownian motion and
and only if E$ (L::=l 'Yj / SJ-l) ~ x. stochastic differential
•
equations

The first two chapters of this book were dealing with discrete-time models. We
had the opportunity to see the importance of the concepts of martingales, self-
financing strategy and Snell envelope. We are going to elaborate on these ideas in
a continuous-time framework. In particular, we shall introduce the mathematical
tools needed to model financial assets and to price options. In continuous-time,
the technical aspects are more advanced and more difficult to handle than in
discrete-time, but the main ideas are fundamentally the same.
Why do we consider continuous-time models? The primary motivation comes
from the nature of the processes that we want to model. In practice, the price
changes in the market are actually so frequent that a discrete-time model can
barely follow the moves. On the other hand, continuous-time models lead to more
explicit computations, even if numerical methods are sometimes required. Indeed,
the most widely used model is the continuous-time Black-Scholes model which
leads to an extremely simple formula. As we mentioned in the Introduction, the
connections between stochastic processes and finance are not recent. Bachelier
(1900), in his dissertation called Theorie de la speculation, is not only among
the first to look at the properties of Brownian motion, but he also derived optjon
pricing formulae.
We will be giving a few mathematical definitions in order to understand
continuous-time models. In particular, we shall define the Brownian motion since
it is the core concept orthe Black-Scholes model and appears in most financial
asset models. Then we shall state the concept of martingale in a continuous-time
set-up and, finally, we shall construct the stochastic integral and introduce the
differential calculus associated with it, namely the Ito calculus. -
It is advisable that, upon first reading, the reader passes over the proofs in small
print. as they-are very technical.

3.1 General comments on continuous-time processes

What do we exactly mean by continuous-time processes?
 30 Brownian motion and stochastic differential equations Brownian motion 31
Definition 3.1.1 A continuous-time stochastic process in a space E endowed with The r7-algebra associated with r is defined as
a a- algebra E is afamily (Xt)tEIR+ of random variables defined on a probability
space (n, A, P) with values in a measurable space (E, £). F = {A
T E A, for any t ~ 0 ,A n {r ~ t} E Ftl .
Remark 3.1.2 This r7-algebra represents the information available before the random time r. One
can prove that (refer to Exercises 8, 9, 10, 11 and 14):
• In practice, the index t stands for the time.
Proposition 3.1.6
• A process can also be considered as a random map: for each w in n we associate
the map from IR+ to E: t -t Xt(w), called a path of the process. • If S is a stopping time, S is F s measurable.
• A process can be considered as a map from IR+ x n into E. We shall always • If S is a stopping time, finite almost surely, and (Xt)t~O is a continuous,
consider that this map is measurable when we endow the product set IR+ x n adapted process, then X s is F s measurable.
with the product e-algebra B(IR+) x A and when the set E is endowed with • If Sand T are two stopping times such that S ~ T P a.s., then F s eFT.
E. • If Sand T are two stopping times, then S 1\ T = inf(S, T) is a stopping time.
• We will only work with processes that are indexed on a finite time interval In particular; if S is a stopping time and t is a deterministic time S 1\ t is a
[O,T]. stopping time.
.
As in discrete-time, we introduce the concept offiltrat(on.
Definition 3.1.3 Consider the probability space (n, A, P), a filtration (Ft)t>o is 3.2 Brownian motion
an increasing family of a-algebras included in A -
A particularly important example of stochastic process is the Brownian motion. It
The o-algebra F t represents the information available at time t. We say that a will be the core of most financial models, whether we consider stocks, currencies
process (Xtk:~o is adapted to (Ftk~o, if for any t, X, is Ft-measurable. or interest rates.
Remark 3.1.4 From now on, we will be working with filtrations which have the Definition 3.2.1 A Brownian motion is a real-valued, continuous stochastic pro-
following property cess (Xdt~o, with independent and stationary increments. In other words:
If A E A and if P(A) = 0, 'then for any t, A EFt .. • continuity: P a.s. the map X, (w) is continuous.
S I--t

In other words F t contains all the P-null sets of A. The importance of this technical • independent increments: If S ~ t, X, - X s is independent ofF s = r7(Xu , U ~
assumption is that if X = Y P a.s. and Y is Ft-measurable then we can show s).
that X is also Ft-measurable. • stationary increments: if'S ~ t, X, - X; and X t - s - X o have the same
probability law.
We can build a filtration generated by a process (Xt)t>o and we write F t =
r7(X s , S ~ t). In general, this filtration does not satisfy -the previous condition. This definition induces the distribution of the process X t , but the result is difficult
However, if we replace F t by :Ft which is the o-algebra generated by both F t to prove and the reader ought to consult the book by Gihman and Skorohod (1980)
and N (the o-algebra generated by all the P-null sets of A), we obtain a proper for a proof of the following theorem. '
filtration satisfying the desired condition. We call it the natural filtration of the Theorem 3.2.2 If (Xt)t>o is a Brownian motion, then X; - X o is a normal
process (Xth~o. When we talk about a filtration without mentioning anything, it random variable with mean rt and variance r7 2 t, where rand o are constant real
is assumed that we are dealing with the natural filtration of the process that we are numbers.
considering. Obviously, a process is adapted to its natural filtration. Remark 3;2.3 A Brownian motion is standard if
As in discrete-time, the concept of stopping time will be useful. A stopping time
. is a random time that depends on the underlying process in a non- anticipative X o = 0 P a.s. E(Xd = 0, E (Xi) = t.
way. In other words, at a 'given time t, we know if the stopping time is smaller than From now on, ,a Brownian motion is assumed to be standard if nothing else is
t. Formally, the definition is the following: . mentione~. In that case, the distribution of X, is the following:
Definition 3.1.5 r is a stopping time with respect to the filtration (Fdt>o if r is 2)
a random variable in IR+ U {+oo}, such that for any t 2: 0 - 1
--exp -- (X dx
V2ii 2t'
{r~t}EFt.
where dx is the Lebesgue measure on IR. '
 Continuous-time martingales 33
32 Brownian motion and stochastic differential equations
The following theorem emphasises the Gaussian property of the Brownian motion. 3. exp (aX t - (a 2/2)t) is an Frmartingale.
We have just seen that for any t, X, is a normal random variable. A stronger result Proof. If s ~ t then X, - X, is independent of the a-algebra F s . Thus E(Xt -
is the following: XsIFs) = E(Xt - X s)' Since a standard Brownian motion has an expectation
Theorem 3.2.4 If (Xdt?o is a Brownian motion and if 0 ~ tt < ... < t« then equal to zero, we have E(Xt - X s) = O. Hence the first assertion is proved. To
(Xt1, ... , X t n ) is a Gaussian vector. show the second one, we remark that
The reader ought to consult the Appendix, page 173, to recall some properties of E ((X t - X s)2 + 2X s(Xt - Xs)IFs)
Gaussian vectors.
Proof. Consider 0 ~ tl < ... < t«. then the random vector (X t1, X t2 - = E ((X t - Xs)2IFs) + 2X sE (Xt - XsIFs) ,
X t1, ... , X t n - X tn_1) is composed of normal, independent random variables
(by Theorem 3.2.2 and by definition of the Brownian motion). Therefore, this and since (Xdt?o is a martingale E (X t - XsIFs) = 0, whence
vector is Gaussian and so is (Xt1, ... ,Xt n ) . · 0

We shall also need a definition of a Brownian motion with respect to a filtration Because the Brownian motion has independent and stationary increments, it fol-
(Ft ) . lows that
Definition 3.2.5 A real-valued continuous stochastic process is an (Ft)-Brownian E ((X t - X s)2JFs ) = E (X't-s)
t - s.
motion if it satisfies: '
• For any t 2: 0, X, is Ft-measurable. The last equality is due to the fact that X, has a normal distribution with mean
zero and variance t. That yields E (Xl - tlFs ) = X; - s, if s < t.
• Ifs ~ t, X t - Xs.isindependimtofthea-algebraFs.
Finally, let us recall that if 9 is a standard normal random variable, we know
• If s ~ t, X t - X; and X t- s - X o have the same law.
that
Remark 3.2.6 The first point of this definition shows that a(X u , u ~ t) eFt. E (e-X9) =/+00 e-x:r. e-:r.2/2 dx =e-X 2/2.
Moreover, it is easy to check that an Ft-Brownianmotion is also a Brownian
motion with respect to its natural filtration.·
-00 ~
On the other hand, if s <t
E (eO'X.-0'2t/2IFs) ="eO'X.-0'2t/2E (i(X'-X')IFs)
3.3 Continuous-time martingales
As in discrete-time models, the concept of martingale is a crucial tool to explain because X; is Fs-measurable. Since X, - X, is independent of F s ' it turns out
the notion of arbitrage. The following definition is an extension of the one in that
discrete-time. E (eO'(X'-X')IFs) = E (eO'(X'-X'))
Definition 3.3.1 Let us consider a probability space (n, A, P) and a filtration E (eO'x,-,)
(Fdt?o on this space. An adaptedfamily (Mt)t?o ofintegrable random variables,
i.e. E(IMtI) < +00 for any tis: E (e0'9vr=s)
• a martingale if, for any s ~ t, E (MtIFs) = M s;
• asupermartingaleif,foranys ~ t, E(MtIFs) ~ u; exp (~a2(t - S))
• a submartingale if, for any s ~ t, E (MtIFs) 2: Ms. o
That completes the proof.
Remark 3.3.2 It follows from this definition that, if (Mt)t>o is a martingale, then
E(Md = E(Mo) for any t. .-
If (Mt)t>o is a martingale, the property E (M; IFs) = M s, is also true if t and s
Here are some examples of martingales.
are bounded .stopping times. This result is actually an adaptation of Exercise 1 in
Proposition 3.3.3 If(Xt}t?o is a standard FrBrownian motion: Chapter 2 to the continuous case and it is called the optional sampling theorem. We
I. X, is an Ft-martingale. will not prove this theorem, but the reader ought to refer to Karatzas and Shreve
2. Xl - t is an Fi-martingale. ( (1988), page 19.
34 Brownian motion and stochastic differential equations
Theorem 3.3.4 (optional sampling theorem) If (M t )r2.o is a continuous mar-
tingale with respect to the filtration (Ft)t>o, and if 71 and 72 are two stopping
times such that 71 ~ 72 ~ K, where K- is a finite real number, then M T 2 is
integrable and
Stochastic integral and Ito calculus 35
By letting a converge to 0, we show that P(Ta < +00) = 1 (which means that
the Brownian motion reaches the level a almost surely). Also

The case a < 0 is easily solved if we notice that

Remark 3.3.5
• This result implies that if 7 is a bounded stopping time then E(MT ) = E(Mo )
(apply the theorem with 71 = 0,72 = 7 and take the expectation on both sides).
• If M, is a submartingale, the same theorem is true if we replace the previous
equality by .
We shall now apply that result to study the properties of the hitting time of a point
by a Brownian motion.
Proposition 3.3.6 Once again, we consider (Xt)t>o an Ft-Brownian motion. If
a is a real number, we call T a = inf {s 2: 0, X, = ~} or +00 if that set is empty.
Then, T a is a stopping time, finite almost surely, and its distribution ischarac-
terised by its Laplace transform
Ta = inf.{s 2: 0, -X. = -a},
where (-Xdt~o is an Ft-Brownian motion because it is a continuous stochastic
process with zero mean and variance t and with stationary, independent increments.
o
The optional sampling theorem is also very useful to compute expectations
involving the running maximum of a martingale. If M, is a square integrable
martingale, we can show that the second-order moment of sUPo9:S: T IMti can be
bounded. This is known as the Doob inequality.
Theorem 3.3.7 (Doob inequality) If(M t)o9:S:T is a continuous martingale, we
have
E ( sup IMtl2) ~ 4E(IMT I2).
°9:S:T
The proof of this theorem is the purpose of Exercise 13.

,.'l
3.4 Stochastic integral and Ito calculus
Proof. We will assume that a 2: O. First, we show that T a is a stopping time.
Indeed, since X, is continuous ,. In a discrete-time model, if we follow a self-financing strategy ¢ = (Hn)o<n<N'
the discounted value of the portfolio with initial wealth Vo is - -
n

s> YO + L H (5j j - 5j - 1) .
j=l
That last set belongs to F t , and therefore the result is'proved. In the following, we
write x 1\ y = inf(x, y). That wealth appears to be a martingale transform under a certain probability
Let us apply the sampling theorem to the martingale M; = exp (aX t - (a 2 / 2)t ). measure such that the discounted price of the stock is a martingale. As far as
We cannot apply the theorem to T a which is not necessarily bounded; however, if continuous-tim~ models are concerned, integr~ls of the form J H.dS. will help
n is a positive integer, T a 1\ n is a bounded stopping time (see Proposition 3.1.6), us to describe the same idea.
and from the optional sampling theorem However, the processes modelling stock prices are normally functions of one or
several Brownian motions. But one of the most important properties of a Brownian
E (MTa/\n) = 1. motion is that, almost surely, its paths are not differentiable at any point. In other
On the one hand MTa/\n = exp (aXTa/\n - a 2 (Ta 1\ n)/2) ~ exp (aa). On words, if (X t ) is a Brownian motion, it can be proved that for almost every wEn,
the other hand, if T a < +00, limn--Hoo MTa/\n = M Ta and if T a = +00, there is not any time t in lR+ such that dX t / dt exists. As a result, we are not able
X, ~ a at any t, therefore limn-Hoo MTai\n = O. Lebesgue theorem implies that to define the integral above as
E(I{Ta<+oo}MTJ = 1, i.e. since X Ta = a when T~< +00 r t
dX r
t
io f(s)dX. = io f(s) ds' ds.
E (I{Ta<+oo} exp ( - ~2 T a ) ) =e-: u a . Nevertheless, we are able to define this type of integral with respect to a Brownian
36 Brownianmotion and stochasticdifferential equations Stochastic integraland Ito calculus 37
motion, and we shall call them stochastic integrals. That is the whole purpose of If we include sand t to the subdivision to = 0 < t 1 < ... < t p = T, and if we
. t
this section. call M n = f on HsdWs and 9n = F tn for 0 :::; n :::; p, we want to show that M n
is a 9n-martingale. To prove it, we notice that
3.4.1 Constructionofthe stochastic integral
Suppose that (Wt}t~O is a standard Ft-Brownian motion defined on a filtered
probability space (fl, A, (Ft)t>o, P). We are about to give a meaning to the
expression f~ f (s, w)dWs for; certain class of processes f (s, w) adapted to the with r/>i 9i-1 -measurable. Moreover, X n = W tn is a 9n-martingale (since (Wt)t>o
filtration (Ft}t~o, To start with, we shall construct this stochastic integral for a is a Brownian motion). (Mn)nE[O,pj turns out to be a martingale transform
set of processes called simple processes. Throughout the text, T will be a strictly of (Xn)nE[O,pj' The Proposition 1.2.3 of Chapter 1 allows us to conclude that
positive, finite real number. (Mn)nE[O,pj is a martingale. The second assertion comesfrom the fact that
Definition 3.4.1 (Ht}O<t<T
- - is, called a simple process if it can be written as
p

Ht(w) = ~::>t>i(w)lJt'_l,t.j(t)
i=l n n

where 0 = to < t 1 < ... < t p = T and r/>i is F t._ 1 -measurableand bounded. L L E (r/>ir/>j(Xi - Xi-d(Xj - Xj-d)· (3.1)
i=l j=l
Then, by definition, the stochastic integral of a simple process H is the continuous
process (I(H)t)O~t~T defined for any t E '~k, tk+d as c Also, if io < i. we have
I(H)t = L r/>i(Wt• - Wt._J + r/>k+dWt - W tk)· E (r/>ir/>j(Xi - Xi-d(Xj ~ Xi-d)
1~i9
E (E (r/>ir/>j (Xi - Xi-I) (Xi - X j- 1 ) 19j-1))
Note that I(H)t can be written as ~ = E (r/>ir/>j(X i - Xi..:.dE (Xi - X j- 119j-df
I(H)t = L r/>i(Wt.f\t - Wt._1f\t), Since X, is a martingale, E(Xj - X j- 11 9i-d = O. Therefore, if i < i.
l~i~p E (r/>ir/>j (Xi - Xi-d (Xj - X j- 1 )) = o. If j > i we get the same thing. Fi-
nally, if i = i.
which proves the continuity oft t--+ I(Hk We shall write f~ HsdWs for I(Hk
219i-I))
The following proposition is fundamental. E(r/>:(Xi-Xi-iY) = E(E(r/>:(Xi-:-Xi-d
Proposition 3.4.2 If(Ht)o~t~T is a simple process: E (r/>:E((X i - Xi.-d219i~I)) 1

• (f~ HsdWs) is a continuous Ft-martingale. as a result

09~T

• E ( ([ H~dW.) ') ~ E (1,' H;d'). . E ( (Xi ~ X i - i) 219i-I) = E ((Wt• - Wti_l )2) = t; - ti-1. (3.2)
From (3.1) and (3.2) we conclude that

• E (i~?I[ H.dW-I') < 4E ( [ H;d')

Proof. In order to prove this proposition, we are going to use discrete-time
processes. Indeed, to show that (J~ HsdWs) is a 'martingale, w~ just need to The continuity, of t -t f~HsdWs is clear if we look at the definition. The third
check that, for any t > s, assertion is just a consequence ofDoob inequality (3.3.7) applied to the continuous
(f~ Hs_dWs) '.
: E (It
HudWulFs) = 1;
HudWu.
martingale
t~O
0

r r IJ\
 rI Stochastic integral and Ito calculus
38 Brownian motion and stochastic differential equations 39

Remark 3.4.3 We write by definition A proof of this result can be found in Karatzas and Shreve (1988) (page 134,
problem 2.5).
iT H.dW. = I T
HsdWs -I t
HsdWs- If H E Hand (Hn)n?o is a sequence of simple processes converging to H in
the previous sense, we have
If t ~ T, and if A E Ft. then s -t 1 Al {t<.} H s is still a simple process and it is
easy to check from the definition of the integral that

I
T
lAHs1{t<s}dWs = lA iT n.sw.. (3.3)
Therefore, there exists a subsequence HcP(n) such that
Now that we have defined the stochastic integral for simple processes and stated
some of its properties, we are going to extend the concept to a larger class of
adapted processes H

H = { (H t)05,t5,T, (Ft}~?o - adapted process, E (I T

H;dS) < +00} . thus, the series whose general term is I(HcP(n+l)) - I(HcP(n)) is uniformly con-
vergent, almost surely. Consequently I(HcP(n))t converges towards a continuous
Proposition 3.4.4 Co~sider (Wt}t?o an Ft-Browriian motion. There exists a function which will be, by definition, the map t t-+ J(H}t. Taking the limit in
unique linear mapping J from H to the space of continuous Ft-martingales (3.6), we obtain
defined on [0, T], suc~ that:
1. If (Ht}t5,T is a simple process, P a.s. for any a~ t ~ T, J(H)t = I(Hk . (3.7)
t
2. If t s T, E (J(H);) = E (I H;dS).
That implies that (J(H)t}O<t<T does not depend on the approximating sequence.
This linear mappingis unique in the following sense, if both J and J' satisfy the On the other hand, (J(H)SO~t5,T is a martingale, indeed .
previous properties then
P a.s. '10 ~ t ~ T, J(H)t = J'(H}t.

We denote,for HE H, It
H.dW. = J(H}t. Moreover, for any t, lim n -+ + oo I(Hn)t = J(H}t in L 2(HiP) norm and, because
the conditional expectation is continuous in L 2 (n, P), we can conclude.
On top of that, the stochastic integral satisfies the following properties: 2
From (3.7) and from the fact that E(I(Hnm = E (JoT IH';I. dS} it fol-
Proposition 3.4.5 If (Ht}O<t<T belongs to H then
1. We have
lows that E(J(H);) = E (JoT IHs l2 dS). In the same way, from (3.7) arid since
E(SUPt5,T I(Hnm ~ 4E (JOT IH';1 2 dS), we prove (3.4).
The uniqueness of the extension results from the fact that the set of simple
processes is dense in H. :
2. 1fT is an Fi-stopping time
We now prove (3.5). First of all, we notice that (3.3) is still true if H E H.
r-] HsdWs = I T
l{s5,T}HsdWs' (3.5)
This is justified by the fact that the simple processes are dense in H and by
(3.7). We first consider stopping times of the form T = L:1<i<n ti1A" where
o < tl < ... < t n = T and the Ai'S are disjoint and F t ; measurable, and we
Proof. We shall use the fact that if (H s)s5,T is in,H, there. exists a sequence prove (3.5) in that case. First
(H';) s5,T of simple processes such that ' ,

2
lim E (iT IHs - H';1 dS) = O.
n-++oo 0
40 Brownian motion and stochastic differential equations Stochastic integral and Ito calculus 41
also, each l{s>qlA.Hs is adapted because this process is zero if s ~ t, and is
Remark 3.4.7 It is crucial to notice that in this case (J6 HsdWs) is not
equal to lA; H, otherwise, therefore it belongs to 1t. It follows that O<t<T
necessarily a martingale. - -
T
JoT l{s>T}HsdWs = L i l A . l{s>qHsdWs
l<i<n a
- -
L
l:Si:Sn
lA; 1 u.sw, 1
T

t,
=
T

T
HsdWs,
Proof. It is easy to deduce from the extension property and from the continuity
property that if H E 1t then P a.s. Vt ~ T, J(H)t = J(Hk
Let H E ic. and define t; = inf {O ~ s ~ T, J; H~du 2: n} (+00 if that set
and then JoT l{s:ST}HsdWs = J; HsdWs. is empty), and H;' = H, l{s:STn}'
In order to prove this result for an arbitrary stopping time T, we must notice that Firstly, we show that Tn is a stopping time. Since {Tn ~ t} = U6
H~du 2: n},
T can be approximated by a decreasing sequence of stopping times of the previous we just need to prove that J6 H~du is Frmeasurable. This result is true if H is a
form. If
simple process and, by density, it is true if H E 11.. Finally, if H E il, J6 H~du
is also Ft-measurable because it is the limit of J6(Hu A K)2du almost surely as
K tends to infinity. Then, we see immediately that the processes H;' are adapted
Tn converges almost surely to T. By continuity of the map t ~ J6 HsdWs we and bounded, hence they belong to 1t. Moreover .
can affirm that, almost surely, J;n HsdWs converges to JOT HsdWs. On the other
hand it H;'dWs = it l{s:STn}H;,+ldWs,

E
T ' . T
11{s:ST}HSdW. -11{s:STn}HsdWs
2) = E
(T )
11{T<s:STn}H;dS . and relation (3.5) implies that
(

This last term converges to 0 by dominated co~vergence, therefore

T '
l:
1{S:STn} HsdWs
converges to Jo l{s:ST}HsdWs in L 2(0, P) (a subsequence converges almost
surely). That completes the proof of (3.5) for an arbitrary stopping time. 0 Thus, on the set U; H~du <Tn}, for any t ~ T, J(Hn)t = J(Hn+lk Since
In the modelling, we shall need processes which only satisfy a weaker integrability Un~oUoT H~du < n} = Uo H~du < +oo}, we can define almost surely a
- ·T
condition than the processes in 1t, that is why we define ' U
process J(H)t by: on the set o H~du < n},

il = {(Hs)o:SS:ST (Fth~o - adapted process, iT H;ds < +00 P a.s. } .

Vt ~ T J(H)t = J(Hnk

The process t ~ J(H)t is almost surely continuous, by definition. The extension

The following proposition defines an extension of the stochastic integral from 1t property is satisfied by construction. We just need to prove the continuity property
to ii. ' , of J. To do so, we first notice that
Proposition 3.4.6 There exists a unique linear mapping I from il into the vector \ .
space of continuous processes defined on [0, TJ,such that: P (SUPt:STIJ(H)tl2:~) < P (I; H;ds 2: liN)
1. Extension property: 1f(Ht)09:ST is a simple process then
Pa.s.\fO ~ t ~ T, J(H)t 7' I(Hit.
+P (l{foT H;'du<l/N} SUPt:ST IJ(H)tl2: €).
If we call TN = inf {s ~ T, Jos H~du 2: liN} (+00 if this set is empty), then
2. Continuity property: If (Hn)n>o is a sequence of processes in il such that
JoT (H,;)2 ds converges to 0 in ;robability then SUPt:s'T IJ(Hnhl converges to on the set {J; H~du < liN}, it follows from (3.5) that, for any t ~ r.
o in probability. r-,

Consistently, we write J6 HsdWs for J(H)t.

42 Brownian motion and stochastic differential equations Stochastic integral and Ito calculus 43

whence, by applying (3.4) to the process s t-t H. I {.5,TN} we get differentiable function f(t) null at the origin, we have f( t)2 = 2 f~ f (s )j(s )ds =
2 f~ f(s)df(s). In the Brownian case, it is impossible to have a similar formula
P (~~~ IJ(H)tl ~ E) < P (iT H;ds ~ ~) W? = 2 f~ W. dW s- Indeed, from the previous section we know that f~ W. dW.
is a martingale (because E (f~ W,;ds) < +00), null at zero. If it were equal to
+4/E 2E (1: H; I {.5:. TN }ds) W? /2 it would be non-negative, and a non-negative martingale vanishing at zero

< P (iT H~ds ~ ~ ) +

4
N E2 '
can only be identically zero.
We shall define precisely the class of processes for which the Ito formula is
applicable.
As a result, if f: (H;l ds converges to 0 in probability, then SUPt<T IJ(Hn)tl Definition 3.4.8 Let (0, .1', (Fdt~o, P) be ajilteredprobability space and (Wt)t>o
converges to 0 in probability. - an FtcBrownian motion. (Xt )05, t5,T is an IR-valuedIto process ifit can be written
_ In order to prove the linearity of J, let us consider two processes belonging to as
1i, called Hand K, and the two sequences H[' and K[' defined at the beginning
T T · '
of the proof such that f o (H"; - H.)2ds and f o (K"; - K.)2ds converge to 0
in probability. By continuity of J we can take the limit in the equality J(>..Hn + where
J.LKn)t = >"J(Hn)t +J.LJ(Kn)t, to prove the continuity of 1. • X o is Fo-measurable.
Finally, the fact that if HE it then f: (Ht-H[,)2dt converge to 0 in probability • (Kt)05,t5,T and (Ht)095,T are Fe-adapted processes.
and the continuity property yields the uniqueness ofthe extension. 0
• f: IK.lds < +00 P a.s.
T • 2ds
We are about to summarise the conditions needed to define the stochastic integral
• fo IH.1 < +00 P a.s.
with respect to a Brownian motion and we want to specify the assumptions that We can prove the following proposition (see Exercise 16) which underlines the
uniqueness of the previous decomposition.
make it a martingale. ;J ,
Summary: Proposition 3.4.9 If (M t )05, t5,T is a continuous martingale such that
Let 'us consider an Ft-Brownian motion (Wt)t>o and an Ft-adapted process T
(Hd095,T. We are able to define the stochastic-integral (J~ H.dW. )05,t5,T as M t = i t K..ds, with P a.s.i IK.lds < +00,
soonasf: H;ds < +00
P a.s. By construction.the process Ij'[ H.dW.)o5,t5,T then
T
is a martingale ifE (fo H;ds) < +00. This condition is not necessary. Indeed, P a.s. 'lit ~ T, u, = O.
the inequality E (1: II.;ds) < +00 is satisfied if and only if This implies that:
- An Ito process decomposition is unique. That means that if

E (SUp
05,t5:.T
(t
Jo
H.dW.) 2) < +00. x, = X o + i t K.ds + r H.dW. =' Xb + rK~ds + rH~dW.
0: Jo Jo Jo
This is proved in Exercise IS. then '

X o = x; dP a.s. H. = ti; ds x dP a.e. K. = K; ds x dPa.e.

3.4.2 Ito calculus
- If (X t )05, t5,T is a martingale of the form X o + f~ K.ds + f~ H.dW., then
It is now time to introduce a differential calculus based on this stochastic integral.
K, = 0 dt x dP a.e.
It will be called the Ito calculus and the main ingredient is the famous Ito formula.
In particular, the Ito formula allows us to differentiate such a function as t t-t We shall state Ito formula for continuous martingales. The interested reader should
f (Wd if f is twice continuously differentiable. The following example will simply refer to Bouleau (1988) for an elementary proof in the Brownian case, i.e. when
show that a naive extension of the classical differential calculus is bound to fail. (Wd is a standard Brownian motion, or to Karatzas and Shreve (1988) for a
Let us try to differentiate the function t --+ W? in terms of 'dWt'. Typically, for a complete proof.
44 Brownian motion and stochastic differential equations Stochastic integral and Ito calculus 45

Theorem 3.4.10 Let (X t )09 $ T be an Ito process J; Ssds and J~ SsdWs exist and at any time t
x, = X o + i t Ksds + i t HsdWs, P a.s. s, = Xo + i t J.LSsds + i t aSsdWs.
,
and f be a twice continuously differentiable function, then I To put it in a simple way, let us do a formal calculation. We write }Ii = log(St)
where St is a solution of (3.8). St is an Ito process with K; = J.LSs and H; = aSs.
f(X t) = f(X o) + i t f'(Xs)dX s + ~ i t j"(Xs)d(X,X)s It Assuming that St is non-negative, we apply Ito formula to f(x) =log(x) (at least
[
,~ formally, because f(x) is not a C 2function!), and we obtain
whe re, by definition I
tf log(St) = log(So) +
i t dS
_s + -l i t ( 1)
-2 a 2S;ds .
. (X,Xk = iat H;ds,. II a Ss 2 a Ss
Ii Using (3.9), we get
and

it 'it
a f'(Xs)dX s = a f'(Xs)Ksds + a f'(Xs)HsdWs'
it }Ii = Yo + it (J.L - a 2/2) dt + i t adWt,
Likewise, if(t, x) -+ f(t, x) is a function which is twice differentiable with respect and finally
to x and once with respect to t, and ifthese partial derivatives are continuous with Yt = log(St) = log(So) + (J.L - a 2/2) t + aWt.
respectto (t,x) (i.e. f is a junction of class C 1 ,2), ltd formulabecomes Taking that into account, it seems that
2/2)
f(O, X o) + i t f:(s, Xs)ds St = Xo exp ((J.L - a t + aWt)
is a solution of equation (3.8). We must check that conjecture rigorously. We have
+ i t f~(s,Xs)dXs + ~ i t f~lx(S:Xs)d(X.,X)s. St = f(t, Wd with
roJ f(t,x)=xoexp((J.L-a 2/2)t+ax).

3.4.3 Examples: Ito formula in practice Ito formula is now applicable and yields

Let us start by giving an elementary example. If f(x) = x 2 and X t = W t, we St = f(t, Wd

°
identify K, = and H, = 1, thus
= f(O, W o) + it f:(s, Ws)ds
'1 r
i
t
2
=2 + '2
+ i t f~(s, Ws)dWs +.~ it'f~/x(S, Ws)d(W, W)S'
Wt a WsdW s io 2ds.

It turns out that

t Furthermore, since (W, W)t = t, we can write
2
Wt ..:.. t = 2 i WsdWs'

Since E (J; W 2
s ds ) < +00, it confirms the fact that W? - t is a martingale.
We now want to.tackle the problem of finding the solutions (Sdt~o of

s, ~ x'o + i t s. (J.Lds + adW:).

r

(3.8)
. it.
St = Xo + a SsJ.Lds
it
+ a SsadWs"
Remark 3.4.11 We could have obtained the same result (exercise) by applying
This is often written in the symbolic form Ito formula to St = ¢(Zd, with Zt = (J.L-a 2 /2)t+aWt (which is an Ito process)
and ¢(x) =nxo exp(x).
as, ~ St (J.Ldt + adWt), So = xo· (3.9)
We have just proved the existence of a solution to equation (3.8). We are about to
We are actually looking for an adapted process (St)t~O such that the integrals prove its uniqueness. To do that, we shall use the integration by parts formula.
46 Brownian motion and stochastic differential equations Stochastic integral and Ito calculus 47
Proposition 3.4.12 (integration by parts formula) Let X, and Yi be two Ito pro- In this case, we have
cesses, x, = X o + J; K.ds + J; H.dW. and Yi = Yo + J; K~ds + J; H~dW•.
Then (X, Z)t = (1" X.adW., - 1" Z.adW.)t = -l,t a 2x.z.u.
XtYi = XoYo + I t
X.dY. + I t
Y.dX. + (X, Y)t Therefore
with the following convention d(XtZt) = X tZt{(-J.L+a 2)dt-adWt)

(X, Y)t = I H.H~ds.

t + XtZt (J.Ldt + adWd - X tZta 2dt = o.
Hence, XtZ t is equal to XoZo, which implies that
Proof. By Ito formula "It ~ 0, P a.s. x, = XOZ;I = St.
(X t + Yi)2 = (Xo + YO)2 The processes X, and Zt being continuous, this proves that
, P a.s. "It ~ 0, X, = XOZ;I = St.
+2J;(X. + Y.)d(X. + Y.)
We have just proved the following theorem:
+ J;(H. + H~)2ds' Theorem 3.4.13 If we consider two real numbers a, J.L and a Brownian motion
(Wth>o and a strictly positive constant T, there exists a unique Ito process
xg + 2 J; X.dX. + J; H;ds (SdO;:::;T which satisfies,for any t ~ T,

= Yo
2 r
+ 2 Jo
t rt ,2
Y.dY. + Jo H. ds. s, = Xo + I t
S. (J.Lds + adW.).
By subtracting equalities 2 and 3 from the first one, it turns out that
This process is given by

XtYi = XoYo + I t
X.dY. + I t
Y"dX. + I H.H~ds.
t '0

Remark 3.4.14
o
• The process St that we just studied will model the evolution of a stock price in
We now have the tools to show that equation (3.8) has a unique solution. Recall the Black-Scholes model.
th~ ,
• When J.L = 0, St is actually a martingale (see Proposition 3.3.3) called the
Sc = Xo exp ( (J.L - a 2/2) t + aW t) exponential martingale of Brownian motion.
is a solution of (3.8) and assume that (Xt)t>o is another one. We attempt to Remark 3.4.15 Let e be an open set in IR and (Xt)O:::;t:::;T an Ito process which
compute the stochastic differential of the quantity XtS;I. Define . ' stays in e at all times. If we consider a function f from e to lR which is twice
continuously differentiable, we can derive an extension of Ito formula in that case
~~ = exp (( -J.L +a 2/2) t -q-Wt) ,
f(Xt).~ f(;o) + I I
, Zt =
+~
t t
!'(X.)dX. !"(X.)H;ds.
J.L' =' -J.L + a 2 and a'
= -a, Then Zt = exp((J.L' - a,2/ 2)t + a'Wt) and the
verification that we have just Gone shows that This result allows us to apply Ito formula to log(Xd for instance, if X t is a strictly
positive process.
Zt =1+ r Z.(J,L'ds + a'dW.) = + ~r z, ((-J.L + ( 2) ds - adW.).
~
1
,
" .

3.4.4 Multidimensional Ito formula

From the integration by parts formula, we can compute the differential of X;Zt
We apply a multidimensional version of Ito formula when f is a function of'several
Ito processes which are themselves functions of several Brownian motions. This
48 Brownian motion and stochastic differential equations Stochastic differential equations 49

version will prove to be very useful when we model complex interest rate structures • (J~ HsdWt , J~ H~dW/)t = 0 if i ;i j.
i

for instance. • (J~ tt.aw], J~ H~dWDt = J~ HsH~ds.

Definition 3.4.16 We call standard p-dimensional FrBrownian motion an lRP - This definition leads to the cross-variation stated in the previous proposition.
valued process (Wt = (Wl, . . . , Wi) k:~o adapted to F t, where all the (Wnt~O
are independent standard FrBrownian motions. 3.5 Stochastic differential equations
Along these lines, we can define a multidimensional Ito process. In Section 3.4.2, we studied in detail the solutions to the equation
Definition 3.4.17 (Xt)09~T is an Ito process if
x, = x + it Xs(/Lds + adWs)'
We can now consider some more general equations of the type

where:
• K t and all the processes (Hi) are adapted to (Ft).
x, = Z + it b(s,Xs)ds + it a(s,Xs)dWs. (3.10)

These equations are called stochastic differential equations and a solution of (3.10)
• JoT IKslds < +00 ~ a.s. is called a diffusion. These equations are useful to model most financial assets,
• JoT (H;) 2ds < +00 P a.s. whether we are speaking about stocks or interest rate processes. Let us first study
some properties of the solutions to these equations.
Ito formula becomes:
Proposition 3.4.18 Let (Xl, ... , X;') be n Ito processes 3.5.I Ito theorem
t it ,
i Whatdowe mean by a solution of(3.1O)?
P
X ti = Xi0 + Kids
s + '"
L..J Hi,idWi
s s
o j:=l 0 Definition 3.5:1 We consider a probability space (n, A,.P) equipped with a fil-
tratioh (Ft)t~o, We also have functions b : lR+ x lR -+ IR., a : lR+ x lR -+ IR., a
then, if 1 is twice differentiable with respect to x and once differentiable with
Fo-measurable randomvariable Z and finally an Ft-Brownian motion (Wdt~o.
respect to t, with continuous partial derivatives in (t, x)
-1 solution to equation (3./0) is an Fi-adapted stochastic process (Xt)t~O that
1(0,XJ, ... ,Xfn + it ~~ (s,X~,; .. ,X:)ds'
satisfies:
• For any t ~ 0, the integrals J~ b(s, Xs)ds and J~ a(s, Xs)dWs exist

::.(s,x~, ... ,X:)dX;

t . t .'
+tit llb(s,Xs),ds < +00 andila(s,XsWds < +00 P a.s.
i=l 0 ,

+~2 ..t it 88
21
(s,X~, ... ,X:)d(Xi.,Xi)s • (Xt)t~O satisfies (3./0), i.e.
_. "'

with:
',J=l
0 xixi
.
'It ~0 P a.s. .x,t = Z + 1 t
b (s,Xs) ds + 1
t
a (s, X s ) dWs'

• ax: = Kids +
S 5
,",P
L...,,-J==l
Hi,idWj
5 5' Remark 3.5.2 Formally, we often write equation (3.10) as
• d(X i , Xi) s = ,",P
L...,,-m=l Hi,m
5
Hi,mds
s . .{ ex. b (t, X t) dt + a (t, X t) dWt
Remark3.4.19 If (Xs)O<t<T and (Y.)O<t<T are two Ito processes, we can de- Xo Z
fine formally the cross-va-ri~tion of X and Y (denoted by (X, Y)s) through the The following theorem gives sufficient conditions on b and a to guarantee the
following properties: existence and uniqueness of a solution of equation (3.10).
• (X, Y)t is bilinear and symmetric. Theorem·3.5.3 Ifb and a are continuous functions and if there exists a constant
K < +00 such that
• (J~ Ksds, x')t = 0 if (Xt)09~T is an Ito process.
50 Brownian motion and stochastic differential equations Stochastic differential equations 51

J. Ib(t,x) - b(t, y)1 + loo(t, x) - oo(t,Y)1 ::; Klx - yl

2. Ib(t,x)1 + loo(t,x)l::; K(1 + Ixl)
3. 'E(Z2) < +00
then, for any T 2: 0, (3.10) admits a unique solution in the interval [0, T].
Moreover, this solution (Xs)O~s~T satisfies

E ( sup IXsI2) < +00

O~s~T

The uniqueness of the solution means that if (Xt)09~T and (Yi)09~T are two
solutions oj(3.1O), then P a.s. '10 ::; t ::; T, X, = Yi,
Proof. We define the set
E = {(XS)O~S~T' Ft-adapted continuous processes,
sU~h that E (~~~IXsI2) < +oo} .
Together with the norm IIXII = (E (sUPO<s<T IX sJ2)) 1/2 E is a complete normed
vector space. In order to show the existence of a solution, we are going to use
the theorem of existence of a fixed point for a contracting mapping. Let ~ be the
function that maps a process (Xs)O~s~T into a process (~(X)s)O~s~T defined
by . as before, we can say that
We deduce that ~ is a mapping from E to E with a Lipschitz norm bounded from
. above by k(T) = (2(K 2T2 + 4K 2T)) 1/2. If we assume that T is small enough
so that k(T) < 1, it turns out that ~ is a contraction from E into E, Thus it
has a fixed point in E, Moreover, if X is a fixed point of ~, it is a solution of
(3.10). That completes the proof of the existence forT small enough. On the other
hand, a solution of (3.10) which belongs to E is a fixed point of~. That proves
the uniqueness of a solution of equation (3.10) in the class E, In order to prove
the uniqueness in the whole class of Ito processes, we just need to show that a
solution of (3.10) always belongs to E, Let X be a solution of (3.10), and define
T; = inf{s 2: 0, IXsl > n} andr(t) = E (suPO~S<tIlTn IX sI2). It is easy to
check that fn(t) is finite and continuous. Using the same comparison arguments
.
-c)

~(X)t = Z + it b(s, Xs)d~ + it oo(s, Xs)dWs' E (suPO~u~tIlTn IX uI

2
) < 3 ( E(Z2) + E (J~IITn K(1 + IXsl)ds) 2
If X belongs to E, ~(X) is well defined and furthermore if X and Y are both in +4E (J~IITn K2(1 + IX sI)2 ds))
E we can use the fact that (a + b)2 ::; 2(a2 + b2) to write that < 3 (E(Z2) + 2(K 2T + 4K 2)
2
1~(X)t - ~(Y)tI2 <' 2 (suPO~t~T'lf~(b(S,Xs) - b(s, Ys)) ds I x f~ (1 + E (sUPO~U~SIlTn IXuI 2 ) ) dS) .

+sUPO~t~T If~(oo(s,~s) - oo(s, Ys))dWsI2)

This yields the following inequality

and therefore by inequality (3.4) r(t) ::; a + bit r(s)ds.

E (sup 1~(X)t - ~(Y)tI2) In order to complete the proof, let us recall the Gronwall lemma.
-sr Lemma 3.5.4 (Gronwalll~mma) Iff is a continuous function such that for any
< 2E (sup (it Ib(s, X s) .: b(s, Ys)ldS)
09~T 0 ,
2) 0::; t ::; T, f(t) ::; a + b fo f(s)ds, then f(T) ::; a(1 + ebT).
Proof. Let us write u(t) = e- bt f; f(s)ds. Then,
+8E (iT (oo(s, X s) - oo(s, Ys))2dS)
i u'(t) = e-bt(f(s) - bit f.(s)ds) ::; ae- bt.
o .
< 2(K 2T2 + 4K 2T)E ,( sup IXt - Yi1 2 ) By first-order integration we obtain u(T) ::; alb and f(T) ::; a(1 + ebT). 0
09~T
52 Brownian motion and stochastic differential equations Stochastic differential equations 53
In our case, we have t" (T) < K < +00, where K is a function ofT independent that if AI, , An are real numbers and if 0 ::; t l < ... < t-: the random variable
of n. It follows from Fatou lemma that, for any T, Al Xtl + + AnXtn is normal. To convince ourselves, we just notice that

E( sup IXsI2)
O$;s$;T
< K < +00. x; = xe- eti + O'e- et• 1+ 00

l{s$;t;}eCSdWs = mi + it Ji(s)dWs.

Therefore X belongs to [; andthat completes the proof for small T. For an arbitrary
Then AIXtt + '" + AnXtn = E7=I Aimi + J~ (E7=1 Adi(S)) dWs which is
T, we consider a large enough integer n and think successively on the intervals
indeed a normal random variable (since it is a stochastic integral of a deterministic
[0, Tin), [Tin, 2TIn), ...,[(n - l)TIn, T). 0
function of time).

3.5.3 Multidimensional stochastic differential equations

3.5.2 The Omstein-Ulhenbeck process The analysis of stochastic differential equations can be extended to the case when
Omstein-Ulhenbeck process is the unique solution of the following equation: . processes evolve in lR n . This generalisation proves to be useful in finance when
we want to model baskets of stocks or currencies. We consider
ax, = -cXtdt + O'dWt
{ Xo • W = (WI, ... , W1') an lR1' -valued Ft-Brownian motion.
= x
• b : lR+ x lR n ---+ lR n. b(s , x) = (b1 ( s, x), .. : , b"(s , x) ).
It can be' written explicitly. Indeed, if we consider yt = x,»
and integrate by
• a: lR+ X lR n ---+ lR nx1' (which is the set of n x p matrices),
parts, it yields
dyt = dXte ct + Xtd(eet) + d(X, eC'}t. O'(s,x) = (O'i,j(s,x)h$;i$;n ,I$;j$;1"
Furthermore (X,eC')t = 0 because d(e ct) = ceetdt. It follows that dyt
O'ectdWt and thus .
• z = (ZI, ... , Z") an Fo-measurable random variable in lR n .
X; = xe -ct + ae -ct it
o
e cSdWs-
"
We are also interested in the following stochastic differential equation:
-v
(3.11)
This enables us to compute the mean and variance of Xt:

In other words, we are looking for a process (Xt)O<t<T with values in lR n ,

E(Xd= xe- et + O'e-ctE (it eCSdws) = xe- et
adapted to the filtration '(Ftk~o and such that P a.s. ,fo~ any t and for any i ::; n

(since E (J;(e~S)2ds) < +00, J~ ecsdWs is a martingale null at time 0 and

therefore its expectation is zero). Similarly , .

E ((X t- E(Xt))2) The theorem of existence and uniqueness of a solution of (3.11) can be stated as:
Theorem 3.5~5 If x E lR n , we denote by [z] the Euclidean norm of x and if
.'E (e-'" (I,' e"dW')') a E lR
n x1' 2
, 10'1 = EI<i<n
__ , 1< '< O'L· We. assume that
_1_1'
I. Ib(t,x) -b(t,y)1 + IO'(t,x) - O'(t,y)1 ::; Klx - yl
,.O'2~-2ctE (lte2csdi) ' 2.. lb(t,x)1 + IO'(t,x)l::; K(1 + Ixl)
3. E(IZI 2) < +00
= 0'2
1 - e- 2ct_
then, there exists a unique solution to (3.11). Moreover. this solution satisfies for
2c anyT
We can also prove that X, is a normal random variable, since X; can be written as
J~ j(s)dWs where j(.) is a deterministic function oftim~ and J~ !2(s)d~ < +00
E(sup IXsI2) < +00.
O$;s$;T
(see Exercise 12). More precisely, the process (Xtk~o IS GaUSSIan. ThIS means The proof is very ,similar to the one in the scalar case.
54 Brownian motion and stochastic differential equations Stochastic differential equations 55

3.5.4 The Markov property of the solution ofa stochastic differential equation Indeed, if t ::; s

The intuitive meaning of the Markov property is that the future behaviour of the X~·x x + J; b (u, X~) du + J; a (u, X~) dWu
process (Xtk~o after t depends only on the value X; and is not influenced by the
history of the process before t. This is a crucial property of the Markovian model x: + J/ b (u, X~) du + J/ a (u, X~) dWu'
and it will have great consequences in the pricing of options. For instance, it will
The uniqueness of the solution to this equation implies that X~,x = X;'x, for
allow us to show that the price of an option on an underlying asset whose price is
Markovian depends only on the price of this underlying asset at time t.
t ::; s. 0
Mathematically speaking, an Fradapted process (Xt)t>o satisfies the Markov In this case, the Markov property can be stated as follows:
property if, for any bounded Borel function f and for any ~ and t such that s t, s
we have Theorem 3.5.7 Let (Xtk~o be a solution of (3. 10). It is a Markov process with
E (f (X t) IFs) = E (f (X t) IX s) . respect to the Brownian filtration (Ftk~o. Furthermore, for any bounded Borel
function f we have
We are going to state this property for a solution of equation (3.10). We shall
denote by (X;'X, s ;:::- t) the solution of equation (3.10) starting from x at time t P a.s. E (f (X t) IFs) = ¢(Xs),
and by X" = Xo,x the solution starting from x at time O. For s ;::: t, X;'x satisfies
s s
with ¢(x) = E (f(X;·X)).
Xt,x
s = x ~1 " b (u Xt,X)
u
du + _1 a (u 'Xt,X)
u
dWu· Remark 3.5.8 The previous equality is often written as
t t

A priori, X.t,x is defined for any (t, x) almost surely. However, under the assump-
tions of Theorem 3.5.3, we can build a process depending on (t, x, s) which is
almost surely continuous with respect to these variables and is a solution of the
previous equation. This result is difficult to prove and the interested reader should
refer to Rogers and Williams (1987) for the proof.
The Markov property is a consequence of the flow property of a solution of a
stochastic differential equation which is itself an extension of the flow property of
solutions of ordinary differential equations.
Lemma 3.5.6 Under the assumptions of Theorem 3.5.3, if s ;::: t
Proof. Yet again, we shall only sketch the proof of.this theorem. For a full proof,
the reader ought to refer to Friedman (1975).
x'
The-flow property shows that, if s ::; t, Xf = X:' '. On the other hand, we
can prove that X;,x is a measurable function of x and the Brownian increments
(Ws +u - W s , u ;::: 0) (this result is natural but it is quite tricky to justify (see
Friedman (1975)). If we use this result for fixed sand t we obtain X;·x
<I>(x, W s+u ~ w., u ;::: 0) and thus

x: = <I>(X:, W s+u - w., u;::: 0),

where X: is Fs-measurable and (Ws+u, - Ws)u~o is independent of F s.

Proof. We are only going to sketch the proof of this lemma. For any x, we have If we apply the result of Proposition A.2.5 in the Appendix to X s , (Ws +u -

P a.s. X;'x = x +
s
b (u,1 X~,X)
du +
s
a (u,1 dWu. X~·X)
Ws)u~o, <I>.and F" it turns out that

E (f (<I> (X: , W s +u - w., u;::: 0))1 F s )

It follows that, P a.s. for any y E JR, E (f (<I>(x, W s+u - W s; u;::: O)))lx=x;
s
X;·y = y + ~s b.(u,X~'Y) du + l a (u,X~;Y) dWu, = E (f (X:·X))lx=x~ .
-0
and also

X;·x; =X:+ 1b(u,X~'X;)dU~ 1a(u,X~·X;)dWu.

s s The previous result can be extended to the case when we consider a function of
the whole path of a diffusionafter time s. In particular, the following theorem is
useful when we do computations involving interest rate models.
These results are intuitive, but they can be proved rigorously by using the continuity
of H y x», We can also notice that X: is also a solution of the previous equation. Theorem 3.5.9 Let (Xt)t>o be a solution of(3.1O) and r(s, x) be a non-negative
56 Brownian motion and stochastic differential equations Exercises 57
measurable function. For t > s Exercise 9 Let S be a stopping time, prove that Sis Fs-measurable.
~
P a.s. E (e- f.' r(u,X,,)du 1 (Xt) IFs) = ¢(Xs) Exercise 10 Let Sand T be two stopping times such that S
thatFs eFT.
T P a.s. Prove

with Exercise 11 Let S be a stopping time almost surely finite, and (Xt)t>o be an
¢(x) =E (e-f.' r(u,X:"~)du I(Xt'X)) . adapted process almost surely continuous. -
l. Prove that, P a.s., for any s
It is also written as
x,
E (e- f.' r(u,X,,)du 1 (Xt) IFs) = E (e-f.' r(u,X:"~)du I(X;'X)) Ix=x. = lim
n-t+oo
" l[k/n' (k+1)/n[(S)X k/n (w).
'L..J
k~O

Remark 3.5.10 Actually, one can prove a more general result. Without getting 2. Prove that the mapping
into the technicalities, let us just mention that if ¢ is a function of the whole path ([0, t] x n, B([O, t]) x F t ) --+ (lR,B(lR))
of X, after time s, the following stronger result is still true: (s,w) f-----+ Xs(w)
Pa.s. E(¢.(X:, t~s)IFs)= E(¢(Xt'X, t~s))lx=x.' is measurable.
Remark 3.5.11 When' b and a are independent of x (the diffusion is said to be 3. Conclude that if S ~ t, X s is Fcmeasurable, and thus that X s is F s-
homogeneous), we can show that the law of X:;t is the same as the one of X~,x, measurable.
which implies that if 1 is a bounded measurable function, then
Exercise 12 This exerciseis an introduction to the copcept of stochastic integra-
E (J(X:;t)) = E (J(X~'X)). tion. We want to build an integral of the form s:
l(s)dX s, where (Xt)t>o is an
Ft-Brownian'motion and I(s) is a measurable function from (lR+, B(lR+)) into
We can extend this result and show that if r is a function of x only then
(lR, B(lR)) such that s: j2 (s )ds < +00. This type of integral is called Wiener
E (e-I." r(X:"~)du1(X:;t) ) = E (e-f; r(X~'~)du I(X~'X)) . integral and it is a particular case of Ito integral which is studied in Section 3.4.
We~recall that the set 11. of functionsof the form LO<i<N-1 ai1jt.,ti+d, with
In that case, the Theorem 3.5.9 becomes ai E lR, and to = 0 ~ t1 ~ ... ~ tN is dense in the space [,2(lR+, dx) endowed
II/ilL2 = (Jo+oo j2(s)ds) 1/2.
E (e-f.' r(X,,)du 1 (Xt) IFs) = E (e-fo'-' r(X~'~)du I(X~~~)) Ix=x. with the norm
l. Consider a; E lR, and 0 = to ~ t1 ~ ... ~ i», and call
1= L
0:Si:SN-1
ai 1 j ti,t.+d·
3.6 Exercises
We define
Exercise 6 Let (Mtk:~.o be a martingale such that for any t, E(Ml) < +00.
Prove that if s ~ t . Ie(f) = L ai(Xt .+1 - XL;).
0:Si:SN -1
E ((Mt - M s)2IFs) = E (M t2 -'M;IFs) . Prove that I, (f) is a normal random variable and compute its mean and vari-
Exercise 7 Let X, be a process with independent stationary increments and zero ance. In particular, show that
initial value such that for any t, E (Xl) < +00. We shall also assume that the
map t f-t E (Xl) is continuous. Prove thatE (Xt ) = ct and that Var(Xt) = c't,
where c and c' are two constants. 2. ~rom ~his, show that there exists a unique linear mapping I from L 2(lR+, dx)
Exercise 8 Prove that, if T is a stopping time, into Z (fl,F,P),suchthatI(f) = Ie(f),when 1 belongs to 11. andE(I(f)2) =
11f1l£2, for any 1 in L 2(lR+).
Fr = {A E A, for all t ~ 0 , A n {T ~ t} E F t }
3. Prove that if (Xn)n>O is a sequence of normal random variables 'with zero-
is a a-algebra. mean which converge to X in L 2(fl, .1',P), then X is also a normal random
58 Brownian motion and stochastic differential equations Exercises 59
variable with zero-mean. Deduce that if f E L 2(IR+,
dx) then 1(1) is a normal Exercise 15
random variable with zero mean and a variance equal to s:
f2 (s )ds.
1. Let (H t)05,t5,T be an adapted measurable process such that fo H'fdt < 00,
T
4. We consider f E L 2(IR+, dx), and we define
a.s. Let u, = f; HsdWs. Show that if E (sUPO<t<T Ml) < 00, then
z, = i t f(s)dX s = J I]O,tJ(s)f(s)dX s, E (fo H; dt) < 00. Hint: introduce the sequence ~f~topping times Tn =
T

prove that Zt is adapted to F t, and that Zt - Zs is independent of F, (hint: inf{t ~ a If; H;ds = n} andsho~thatE(Mj.I\TJ= E (foTl\Tn H;ds).
begin with the case f E H). 2. Letp(t,x) = 1/vT=texp(-x2/2(1- t)), for a ~ t < 1 and x E IR, and
5. Prove that the processes Zt, Z; - f; P(s)ds, exp(Zt - ~ f; f2(s)ds) are p(l, x) = O. Define M; = p(t, W t), where (Wt)O<t<1 is standard Brownian
Frmartingales. motion. - -

Exercise 13 Let T be a positive real number and (M t)095,T be a continuous (a) Prove that
Ft-martingale. We assume that E(Mj.) is finite.
1. Prove that (IMtI)095,T is a submartingale.
(b) Let
2. Show that, if M* ., sUP05,t5,T IMtl, op
AP (M* ~ A) ~ E (IMTll{M·~.q).
H, = ox (t, Wd·
l
(Hint: apply the optional sampling theorem to the submartingale IMtl between Prove that fo Hldt < 00, a.s. and E (fol Hldt) =+00.
T /\ T and T where T = inf {t ~ T, IMti ~ A} (if this set is empty T is equal

to +00).)
Exercise 16 Let (M t)05,t5,T be a continuous Ft-martingale equal to f; tc,e«
T
where (Kt)O.::;t5,T is an Ft-adapted process such that fo IKslds < +00 P a.s,
3. From the previous result, deduce that for positive A
'. T
E((M* /\ A)2) ~ 2E((M* /\ A)IMTI). 1. Moreover, we assume that P a.s. f o IKslds ~ C < +00. Prove that if we
write tf = Ti/n for a ~ i ~ n, then
M·I\A
(Use the fact that (M* /\ A)P = f o pxp-1dx for p = 1,2.)
4. Prove that E(M*) is finite and lim E
n---t+oc>
(~'
L....J (Mtn - Mt~ ) 2) = O.
1. 1-1
i=1

E ( sup IMtI
2
) ~ 4E(IMT I2 ) . 2. Under the same assumptions, prove that
°95,T
~

Exercise 14

1. Prove that if 5 and 5' are two Frstopping times then 5 /\ 5~ = inf(5, 5') and Conclud~ that MT = a P a.s. ,and thus P a.s. 'Vt ~ T, M, = O.
5 V 5' = sup(5, 5') are also two Ft-stopping times. T
3. fo IKslds is now assumid to be finite'almost surely as opposed to bounded.
2. By applying the sampling theorem to the stopping time 5 V s prove that We shall accept the fact that the random variable f; IKslds is Ft-m~asurable.
Show that Tn defined by
~ (Ms l{s>s}IFs) = u, l{s>s}'
3. Deduce that for s ~ t t; = inf{O ~ s ~ T, i t IKslds ~ n}
E (Msl\t1{s>s}IFs) = Msl{s>s}' a
,(or T if this set is empty) is stopping time. Prove that P a.s. limn-Hex> Tn =
T. Considering the sequence of martingales (MtI\TJt~O' prove that
4. Remembering that MSl\s is Fs-measurable, show that t -t MSl\t is an Ft-
martingale. -P a.s. 'Vt ~ T, M t = O.
60 Brownian motion and stochastic differential equations Exercises 61
4. Let M t be a martingale of the form J~ n.sw, + J~ Ksds
with J~ H'[ds < 6. If A 2: fJ. and A 2: 0, prove that
. +00 P a.s. and J~ IKslds < +00 P a.s. Define the sequence of stopping P(Wt :::; u; wt 2: A) = P(Wt 2: 2A - fJ., wt 2: A) = P(Wt 2: 2A - fJ.),
times Tn = inf{t :::; T,J~ H;ds 2: n}, in order to prove that K; = 0 dt x and if A :::; fJ. and A 2: 0
P a.s.
Exercise 17 Let us call X, the solution of the following stochastic differential P(Wt :::; u; wt 2: A) = 2P(Wt 2: A) - P(Wt 2: fJ.).
equation 7. Finally, check that the law of (W t , Wt) is given by
ax, = (p.x t + fJ.')dt + (oXt + a')dWt
{ Xo = O.
l{o~y} l{x~y}
2(2y-x) ((2 Y
...,fi;i3 exp -
- X)2) dxdy.
2t
We write St = exp ((fJ. - a /2)t 2
+ aWt).
1. Derive the stochastic differential equation satisfied by St- 1 .
2. Prove that
d(XtS;l) = St- 1 ((fJ.' - aa')dt + a'dWd·
3. Obtain the explicit representation of X t .
Exercise 18 Let (Wt k:~o be an F t - Brownian motion. The purpose of this exercise
is to compute the law of (W t , sUPs9 W s ) .
1. Consider 5 a bounded stopping time. Apply the optional sampling theorem to
the martingale M t ' = exp(izWt + z 2 t / 2), where z is a real number to prove
s
that if 0 u :::; v then
E (exp (iz(Wv+s - W u+ s)) IFu+s) = exp (-Z2(V - u)/2) .

2. Deduce that w,f = Wu+s - Ws is an 'Fs+u-Brownian motion independent

of the a-algebra F s-
3. Let (Yi)t>o be a continuous stochastic process independent of the a-algebra B
such that-E(suPO<s<K I~ I) < +00. Let T be a non-negative B-measurable
random variable bounded from above by K: Show that
E (YTIB) = E (Yi)lt=T'
We shall start by assuming that T can be written as I:l<i<n ti1A" where
o < tl < ... < t« = K, and the Ai are disjoint B-measurablesets.
4. We denote by r>' the inf{s 2: 0, W s > A}, prove that if f is a bounded Borel
function we have '
E(i(Wt)I{T>'~t}) = E (I{T>'~t}¢(t - r>.)) ,
where¢(u) = E(f(Wu + A)). NoticethatE(f(Wu +A)) = E(f(-Wu+A))
and prove that

E (f(Wt)l{ T>'9 1} ) = E (i(2A - Wt) l{ T>'9}) .

5. Show that if we write Wt = sUPs9 W s and if A 2: 0
P(Wt :::; A, Wt 2: A) = P(Wt 2: A, wt 2: A) ::;:; P(Wt 2: A).
Conclude that wt and IWtl have the same probability law.
 4

The Black-Scholes model

I
I·
I
Black and Scholes (1973) tackled the problem of pricing and hedging a European
option (call or put) on a non-dividend paying stock. Their method, which is based
on similar ideas to those developed in discrete-time in Chapter 1 of this book,
leads to some formulae frequently used by practitioners, despite the simplifying
character of the model. In this chapter, we give an up-to-date presentation of their
work. The case of the American option is investigated and some extensions of the
model are exposed.

4.1 Description of the model

4.1.1lhe behaviour ofprices
The model suggested by Black and Scholes to describe the behaviour of prices is
a continuous-time model with one risky asset (a share with price St at time t) and
a riskless asset (with price Sp at time t). We suppose the behaviour of Sp to be
encapsulated by the following (ordinary) differential equation:
dSP = rSpdt, (4.1)

where r is a non-negative constant. Note that r is an instantaneous interest rate

and should not be confused with the one-period rate in discrete-time models. We
set sg = 1, so that Sp = eft for t ~ O. .
We assume that the behaviour of the stock price is determined by the following
stochastic differential equation:
,
dS t = St (J.tdt + adBt) , (4.2)
where J.t and a are two constants and (B t) is a standardBrownian motion.
The model is valid on the interval [0, T] where T is the maturity of the option.
As we saw (Chapter 3, Section 3.4.3), equation (4.2) has a closed-form solution
~ .

s, = So exp (J.tt - ~2 t + aB t) ,
64 The Black-Scholes model Change ofprobability. Representation of martingales 65

where So is the spot price observed at time O. One particular result from this model
is that the law of St is lognormal (i.e. its logarithm follows a normal law).
1. iT IHfldt + l
T
H;dt < +00 a.s.
More precisely, we see that the process (St) is a solution of an equation of type
(4.2) if and only if the process (log(St)) is a Brownian motion (not necessarily
standard). According to Definition 3.2.1 of Chapter 3, the process (Sd has the
2. Hfsf + u.s, = HgSg + tt-s; + I H~dS~ I n.as;
t
+
t
a.s.
for all t E [0, T].
following properties: We denote by St =' e- rt S, the discounted price of the risky asset. The following
• continuity of the sample paths;' . proposition is the counterpart of Proposition 1.1.2 of Chapter 1.
• independence of the relative increments: if u :s t, StlS« or (equivalently), the Proposition 4.1.2 Let ¢ = ((H?, H t)')09::;T be an adapted process with vdlues
relative increment (St - Su) / Su is independent of the O"-algebra O"(Sv, v :s u); inIR 2 , satisfying JoT IH?ldH JoT Hldt < +ooa.s. Weset: Vi(¢) = HfS?+HtSt
and frt(¢) = e"':rtVi(¢). Then, ¢ defines a self-financing strategy if and only ,if
• stationarity of the relative increments: if u :s t, the law of, (St - Su)/ Su is
identical to the law of (St-u - So)/ So·
These three properties express in concrete terms the hypotheses of Black and
frt(¢) = Vo(¢) + it HudSu a.s. (4.3)

Scholes on the behaviour of the share price. for all t E [0, T].
Proof. Let us consider the self-financing strategy ¢. From equality :
4.1.2 Self-financing strategies dVt(¢) = -rfrt(¢)dt + e-rtdVi(¢)
A strategy will be defined as it process ¢ = (¢t)09::;T=( (H?, H t)) with values in which results from the differentiation of the product of the processes (e~rt) arid
IR?, adapted to the natural filtration (Ft ) of the Brownian motion; the components v:
(Vi (¢)) (the cross-variation term d{e- r . , (¢) kis null), we deduce
H? and H, are the quantities of riskless asset and risky asset respectively, held in dfrt(¢) . - _re- rt (Hfe rt + HtSt) dt + e-rtHfd(e rt) + «<n.as,
the portfolio at time t. The value of the portfolio at time t is then given by
H, (_re- rt St dt + e-rtdSt)
Vi (¢) = Hf S?+tt.s; HtdSt,
In the discrete-time models, we have characterised self-financing strategies by the which yields equality (4.3). The converse is justified similarly. 0
equality: Vn+l (¢) - Vn(¢) = ¢n+dSn+l - Sn) (see Chapter 1, Remark 1.1.1).
This equality is extended to give the self-financing condition in the continuous- Remark 4.1.3 We have not imposed any condition of predictability on strategies
time case unlike in Chapter 1. Actually, it is still possible to define a predictable process in
dVi (¢) = HfdSf + HtdSt· continuous-time but, in the case of the filtration of a Brownian motion, it-does not
To give a meaning to this equality, we set the condition restrict the class of adapted processes significantly (because of the continuity of
sample paths of Brownian motion).
iT IHfldt < +00 a.s. and iT H;dt < +00 a.s. In our study of complete discrete models, we had to consider at some stage a prob-
ability measure equivalent to the initial probability and under which discounted
Then the integral prices of assets are martingales. We were then able to design self-financing strate-

1T . iT HfdSf = 0 Hfrertdt
gies replicating the option. The following section provides the tools which allow
us to apply these methods in continuous time.

is well-defined, as is the stochastic integral

4.2 Change of probability. Representation of martingales
1 1 (H~St/-L) + 1
T "T
HtdS t = dt
.T
O"HtStr/B t, 4.2.1 Equivalent probabilities

since the map t f-t St is continuous, th~s bounded on [0, T] almost surely. Let (fl, A, P) be a probability sp.ace. A probability measure Q on (fl, A) IS
absolutely continuous relative to P if ' .
Definition 4.1.1 A self-financing sstrategy is defined by a pair ¢ of adapted pro-
cesses (Hf)o::;t::;T and (Ht)09::;T satisfying: VA E A P (A) = 0 ~ Q (A) =0.
 The Black-Scholes model Pricing and hedging options in the Black-Scholes model 67
66
Theorem 4.2.1 Q is absolutely continuous relative to P ifand only if there exists Theorem 4.2.4 Let (Mt)09~T be a square-integrable martingale, with respect
a non-negative random variable Z on (n, A) such that to the filtration (Ft)09~T. There exists an adapted process (Ht)O<t<T such that
T
VA E A Q(A) = i Z(w)dP(w).
E (fo H;ds) < +00 and - -

Z is called density ofQ relative to P and sometimes denoted dQ/ dP. Vt E [0, T] u, = M o + it n.s», a.s. (4.4)
The sufficiency of the proposition is obvious, the converse is a version of the
Radon-Nikodym theorem (cf. for example Dacunha-Castelle and Duflo (1986), Note that this representation only applies to martingales relative to the natural
Volume 1, or Williams (1991) Section 5.14). filtration of the Brownian motion (cf. Exercise 26).
The probabilities P and Q are equivalent if each one is absolutely continuous From this theorem, it follows that if U is an FT-measurable, square-integrable
relative to the other. Note that if Q is absolutely continuous relative to P, with random variable, it can be written as
density Z, then P and Q are equivalent if and only if P (Z > 0) = 1.
U = E (U) + iT u.s», a.s.,

4.2.2 The Girsanov theorem

T
Let (n, F, (Ft)o~t~; , p) be a probability space equipped with the natural fil- where (Ht) is an adapted process such that E (fo Hlds) < +00. To prove it,
consider the martingale M; = E (UIFt ) . It can also be shown (see, for example,
tration of a standard Brownian" motion (Bt)O<t<T' indexed on the time interval
Karatzas and Shreve (1988» that if (Mt)O~t~T is a martingale (not necessarily
[0, T]. The following theorem, which we admit, is knownas the Girsanov theorem
square-integrable) there is a representation similar to (4.4) with a process satisfying
(cf. Karatzas and Shreve (1988), Dacunha-Castelle and Duflo (1986), Chapter 8). T
only fo Hlds < 00, a.s. We will use this result in Chapter 6.
Theorem 4.2.2 Let ({1t)09~T be an adapted process satisfying l{ O;ds < 00
a.s. and such that the process (Lt)O<t<T defined by

t; = exp (-it e.s», - ~ it O;dS) 4.3 Pricing and hedging options in the Black-Scholes model

4.3.1 A probability under which (St) is a martingale

is a martingale. Then, under the probability p(L) with density LT relative to P,
the process (Wt)o~t~T"defined by W t = B; + f~ Osds, is a standard Brownian
motion.
Remark 4.2.3 A sufficient condition for (Lt)09~T to be a martingale is:
We now consider the model introduced in Section 4.1. We will prove that there
exists a probability equivalent to P, under which the discounted share price St =
e-rtSt is a martingale. From the stochastic differential equation satisfied by (St),
we have

dSt = -re- rt St dt + «r'as,

= St ((J.L - r)dt + adBt).
(see Karatzas and Shreve (1988), Dac~nha-Castelle and Duflo (1986». The proof
of Girsanov theorem when (Ot) is constant is the purpose of Exercise 19: Consequently, if we set W t = 13t + (J.L - r)t/a,

dSt = StadWt. (4.5)

4.2.3 Representation ofBrownian martingales
From Theorem 4.2.2, with Ot =
(J.L - r) / a, there exists a probability P" equivalent
Let (Bt)O<t<T be a standard Brownian motion built on a probability space to P under which (Wt)O<:t"<T is a standard Brownian-motion. We will admit
(n, F, P) -;~d let (Ft)O~t~T be its natural filtration. Let us recall (see Chap- that the definition of the stochastic integral is invariant by change of equivalent
ter 3, Proposition 3.4.4) that if (Ht)O<t<T is an adapted process such that probability (cf. Exercise 25). Then, under the probability P., we deduce from
E (JoT Hldt) <" 00, the process (J~ lIs-dB s) is a square-integrable martin- equality (4.5) that (St) is a martingale and that
gale, null at o. The following theorem shows that any Brownian martingale can be
St = So exp(aWt - a 2t/2).
represented in terms of a stochastic" integral.
 The Black-Scholes model Pricing and hedging options in the Black-Scholes model 69
68
and consequently
4.3.2 Pricing
\It = E* (e-r(T-:-t) hlFt) . (4.6)
In this section, we will focus on European options. A European option will be
defined by a non-negative, FT-measurable, random variable h. Quite often, h can So we have proved that if a portfolio (HO, H) replicates the option defined by
be written as f(ST)' (f(x) = (x-K)+ inthecaseofacall,f(x) = (K-:z)+ h, its value is given by equality (4.6). To complete the proof of the theorem, it
in the case of a put). As in the discrete-time setting, we will define the option remains to show that the option is indeed replicable, i.e. to find some processes
value by a replication argument. FOf technical reasons, we will limit our study to (H2) and (Ht) defining an admissible strategy, such that
the following admissible strategies:
H~S~ + n.s, = E* (e-r(T-t) hlFt) .
Definition 4.3.1 A strategy </J = (m, H t) 09 ~T is admissible if it is self-financing
and if the discounted value "Ct(</J) =
H2 + Ht!;t_ofthe corresponding portfolio is, Under the probability P*, the process defined by M; = E*(e-rThIFt} is a
for all t; non-negative and such that SUPtE[O,Tj \It is sguare-integrable under P*. square-integrable martingale. The filtration (Ft ) , which is the natural filtration of
An option is said to be replicable if its payoff at maturity is equal to the final (B t ) , is also the natural filtration of (Wt ) and, from the theorem ofrepresentation
value of an admissible strategy. It is clear that, for the 'option defined by h to be of Brownian martingales, there exists an adapted process (Kt)O<t<T such that
replicable, it is necessary that h should be square-integrable under P* . In the case E* (JoT K~ds) < +00 and - -
of a call (h = (ST - K)+), this property indeed holds since E*(S}) < 00; note
that in the case of a put, h is even bounded.
Theorem 4.3.2 In the Black-Scholes model, any option defined Hy a non-negative,
\It E [0, T] u, = Mo + I t
KsdWs a.s.

:F -measurable random variable h, which is square-integrable under the proba- The strategy </J = o·
(H ,H), WIth H, =
Kt/(aSt) and H';
- 0
=
M; - HtS t, IS then,
- .

bi~ty P*, is replicable and the value at time t ofany replicating portfolio is given from Proposition 4.1.2 and equality (4.5), a self-financing strategy; its value at
by time t is given by
Vt = E* (e-r(T-t) hlFt) . "
\It(</JY = ertMt = E* (e-r(T-t)hIFt).
Thus, the option value at time t can be. naturally defined by the expression
E* (e-r(T-t) hJFt}. ..' . o. . This expression clearly shows that \It (</J) is a non-negative random variable, with
Proof. First, let us assume that there IS an admissible strategy (H ,H), replicating sUPO<t<T \It(</J) square-integrable under P* and that VT(</J) = h. We have found
the option. The value at time t of the portfolio (H2, H t) is given by an admissible strategy replicating h. 0
\It == H~ S~ + u.s;
"

Remark4.3.3 When the random variable hces: be written as h f(ST)' we can=

and, by hypothesis, we haveVr = h. Let "Ct = Vte- rt be the discounted value express the option value V t at time t as a function oft and St. We have indeed
-
Vt = n;0 + u.s;
-
',\It E* (e-r(T~t) f(ST )IFt)
Since the strategy is self-financing, we get from, Proposition 4.1.2 and equality
(4.5)
= E* (e':"r(T-t) f ( Ster(T-t)e"(WT-W, )~(,,2/2)(T-t)) F t) . I
I
b
t The random variable S, is .r.:t-measurable and, under P*, W T - W t is independent
"Ct Vo + HudSu of Ft. Therefore, from Proposition A.2.5 of the Appendix, we deduce

+I
t
= Vo HuaSudWu.
Vt = F(t, St),
where
Under the probability p:;', SUPtE[O,Tj Vt is square-integrable, by definition of ad- F(t, x) = E* (e-r(T-t) f (xe r(T-t)e,,(WT-W,j_(,,2/2)(T-t)) ) . (4.7)
missible strategies. Furthermore, the preceding equality shows that the pro.c~ss
(lit) is a stochastic integral r~la~ve to (Wt ): It follows (cf..Chapter 3, ProyoSItlOn Since, under P*, WT - W t is a zero-mean normal variable with variance T - t
3.4.4 and Exercise 15) that (Vt ) ISa square-mtegrablemartmgale under P . Hence

V t = E* (VTIFt) ,
F(t, x)
,
= e-r(T-:t) 1+~ f
-~
(xe(r-,,2/ 2)(T-t)+"Yv'T-t) e
-~~d
~
y.
70 The Black-Scholes model Pricing and hedging options in the Black-Scholes model 71
F can be calculated explicitly for calls and puts. If we choose the case of the call, 2. The 'implied' method: some options are quoted on organised markets; the price
where f(x) = (x - K)+, we have, from equality (4.7) of options (calls and puts) being an increasing function of a (cf. Exercise 21),
we can associate an 'implied' volatility to each quoted option, by inversion
F(t,x) = E· (e-r(T-t) (xe(r-0'2/2)(T-t)~0'(WT-W.)- K)+) of the Black-Scholes formula. Once the model is identified, it can be used to
elaborate hedging schemes.
= E ( x e O'Y6g- 0'26/2 _ K e- r6) + In those problems concerning volatility, one is soon confronted with the imper-
fections of the Black-Scholes model. Important differences between historical
where 9 is a standard Gaussian variable and 0 = T - t. volatility and implied volatility are observed, the latter seeming to depend upon
Let us set the strike -price and the maturity. In spite of these incoherences, the model is
d -
log (xl K) + (r + (2/2) 0 and' d 2 = d 1 -
In
avO.
considered as a reference by practitioners.
1- aVO
Using these notations, we have 4.3.3 Hedging calls and puts
In the proof of Theorem 4.3.2, we referred to the theorem of representation of
F(t,x) _ E [( x e O'Y6g- 0'26/ 2 _Ke- r6) l{g+d22: 0 } ] Brownianmartingales to show the existence of a rep,licating portfolio. In practice,
y2 a theorem of existence is not satisfactory and it is essential to be able to build a
+oo ) e- / 2
=
j
-d2
( x eO'Y6y-0'2 6/2 _ Ke- r6 ---dy
~
real replicating portfolio to hedge an option.
When the option is defined by a random variable h = f (ST ), we show that it is

I. (
-00
.
) y2 2
x e- 0'Y6y- 0'26/ 2 _ Ke- r6 ---'-dy.
e-
~
/
possible to find an explicit hedging portfolio. A replicating portfolio must have,
at any time t, a discounted value equal to

Writing this expression as the difference of two integrals and in the first one using Vi = e- rt F(t, St),
the change of variable z = y + aVO, we obtain , where F is the function defined by equality (4.7). Under large hypothesis on f
r6
F(t, x) = xN(d 1 ) - Ke- N(d 2), (4.8) (and, in particular, in the case of calls and puts where we have the closed-form
solutions of Remark 4.3.3), we see that the function F is of class Coo on [0, T[xIR..
where
1
N(d) == -,-,
jd 2
e- X /2dx.
If we set
, F'(~, x) = e- rt F (t, xe rt) ,
I

~ -00
Using identical notations and through similar calculations, the price of the put is
we have Vi = fi'(t, St) and, for tcT; from the Ito formula
equal to
F(t, x) = tee:" N(-d 2) - xN( -dd· (4.9) '-, P (t, St) = P it
(0, So) + ~~' (u, Su) dSu
The reader will find efficient methods to compute N(d) in Chapter 8.
Remark 4.3.4 One of the main features of the Black-Scholes model (and one
+ 1at
t

0;
,
-
8F ( w.S«
-) du+ 12
0
t
1 8 2 F- ( -) - -
8x 2 U,Su d(S,S)u
,
of the reasons for its success) is the fact that the pricing formulae, as well as From equality dSt = aStdWt, we deduce
the hedging formulae we will give later, depend on only one non-o?servable
- -
parameter: a, called 'volatility' by practitioners (the drift parameter J.L disappears d(S, S)u = a 2 ~udu,
-2

by change of probability). In practice, two methods are used to evaluate a:

so that P-(t, St) ca~ be written as
I. The historical method: in the present model, a 2T is the variance oflog(ST) and
the variables 10g(STISo), log(S2TIST), ... , 10g(SNTIS(N-l)T) are inde-
pendent and identically distributed. Therefore, a can be estimated by statisti~al
means using the asset prices observed in the past (for example ~y calculating
P(t,St)'=p(o,so}+ 1a~~ (u,~u)SudWu+ 1,K
t - , / t

udu .

empirical variances; cf. Dacunha-Castelle and Duflo (1986), Chapter 5). Since p(t, St) is a martingale under P", the process K, is necessarily null (cf.
72 The Black-Scholes model American options in the Black-Scholes model 73
Chapter 3, Exercise 16). Hence Definition 4.4.1 A trading strategy with consumption is defined as an adapted
pro.cess if> = ((Hf, H t))095,T, with values in IR?, satisfying thefollowing prop-
P (t, St) = P (0, SO) + it ~~a (u, S~ ) SudWu erties:

= F- (O,So-) + it aP
ax («,s;
-) es;
-
1. iT IHfldt +
T
IHtdt < +00 a.s.

o
The natural candidate for the hedging process H, is then 2. H?sf + u.s; =. HgSg + HoSo + ir H~dS~ + inr HudSu - c, for all
t t

o
t E [0, Tj, where (Ct )05,t5,T is an adapted, continuous, ~on-decreasing process
H, =
aP ( t, St-)
s: = aF
ax (t, St) .
I

null at t = 0; Ct corresponds to the cumulative consumption up to time t.

If we set Hf= P (t, St) - tt.s; the portfolio (Hf, H t) is self-financing and its
discounted value is indeed Vi = P (t, St).
Remark 4.3.5 The preceding argument shows that it is not absolutely necessary
to use the theorem of representation of Brownian martingales to deal with options
of the fomi f (ST). . .
Remark 4.3.6 In the' case of the call, we have, using the same notations as in
Remark 4.3.3,
and in the case of the put
aF
-a
x (t,x) = -N(-d
. 1) .
This is left as an exercise (the easiest way is to differentiate under the expectation).
This quantity is often called the 'delta' of the option by practitioners. More
generally, when the value at time t of a portfolio can be expressed as ll1(t, St),
the quantity (alII/ ax) (t, St), which measures the sensitivity of the portfolio with
respect to the variations of the asset price at time t, is called the 'delta' of the
portfolio. 'gamma' refers to the second-order derivative (a 2 1l1 / ax 2 ) (t, St), 'theta'
to the derivative with respect to time and 'vega' to the derivative of III with respect
to the volatility a.
4.4 American options in the Black-Scholes model
4.4.1 Pricing American options
We have seen in Chapter 2 how the pricing of American options and the optimal
stopping problem are related in discrete-time setting. The theory of optimal stop-
ping in continuous-time is based on the same ideas as in discrete-time but is far
more complex technically speaking. The approach we proposed in Section 1.3.3
of Chapter 1, based on an induction argument, cannot be used directly to price
American options. Exercise 5 in Chapter 2 shows that, in a discrete model, it is
possible to associate any American option to a hedging scheme with consumption.
An American option is naturally defined by an adapted non-negative process
(h t )09 5, -r:' To sim?lify, we wil.l only study processes of the form ht = 'lj;(St) ,
where w IS a .;:ontmuous function from IR+ to IR+, satisfying: 'lj;(x) ~ A +
B«, 'Vx E IR ,for some non-negative constants A and B. For a call, we have:
'lj;(x) = (x - K)+ and for a put: 'lj;(x) = (K - x)+.
The tra~ing str~tegy with consumption if> = ((Hf, H t) )05,t5,T is said to hedge
the Amencan option defined by h t = 'lj;(St) if, setting Vt (if» = Hf Sf + HtSt,
we have . .
'Vt E [O,Tj Vt(if» 2': 'lj;(St} a.s.
De~ote by <1>'" the set of tradi~g strategies with consumption hedging the American
option defined by h t = 'lj;(St). If the writer of the option follows a strategy if> E <1>"',
he or she p~ssesses a~ an~ time t, a wealth at least equal to 'lj;( St), which is precisely
the payoff If the opuon IS exercised at time t. The following theorem introduces
the minimal value of a hedging scheme for an American option:
Theorem 4.4.2 Let u be the map from [0, Tj x IR+ to IR defined by
u(t, x) = sup E··[e-r(r-t)'lj;(xexp((r_ (a 2/2))(T-t)+a(Wr -Wd))]
rE7't,T
wh~re Ti,T represents the set ofstopping times taking values in [t, Tj. There exists
a strategy if> E <1>'" such that Vt (¢) = u(t, St),for all t E [0, Tj. Moreover; for
any strategy if> E <1>"', we have: Vt(if» 2': u(t,St),forallt E [O,Tj.
To overcome technical difficulties, we give only the outlines of the proof (see
~aratzas and Shreve (1988)Jor details). First, we show that the process (e-rtu( t, St))
IS t~e Snell env~lope of the process (e-rt'lj;(St)), i.e. the smallest supermartingale
which bounds It from above under p ". As it can be proved that the discounted
value of a ~ading ~trategy 'with consumption is a supermartingale under P", we
de~uce the inequality: ~(if» 2': u(t, St), for any strategy if> E <1>"'. To show the
existence of a strategy- if> such that Vt(¢) = u(t, St), we have to use a theorem
of decomposition of supermartingales similar to Proposition 2.3.1 of Chapter 2 as
well as a theorem of representation of Brownian martingales.
. It i~ ~atural t~ ~onsider u(t; St) as a price for the American option at time t,
smce.lt IS the minimal value of a strategy hedging the option.
74 The Black-Scholes model American options in the Black-Scholes model 75
Remark 4.4.3 Let 7 be a stopping time taking values in [0, T]. The value at time 0 T - t. Equation (4.10) becomes
of an admissible strategy in the sense of Definition 4.3.1 with value 'l/J(Sr) at time 7
is given by E* (e- rr 'l/J(Sr)), since the discounted value of any admissible strategy u(O,x)= sup E*(Ke- rr-xexp(aWr-(a 27/2)))+. (4.11)
rE70,T .
is a martingale under P*. Thus the quantity u(O, So) = sUPrE70,T E* (e- rr'l/J(Sr))
is the initial wealth that hedges the whole range of possible exercises. Let us consider a probability space (0, F, P), and let (Bt)o<t<oo be a standard
Brownian motion defined on this space and IR+. Then, we get
As in discrete models, we notice that the American call price (on a non-dividend
paying stock) is equal to the European call price: u(O, x) sup E(Ke-rr-xexp(aBr-(a27/2)))+
rE70,T
Proposition 4.4.4 If in Theorem 4.4.2, 'l/J 'is given by 'l/J(x) = (z - K)+, for all
< sup E [(Ke-
rr
- xexp (aB r - (a 27/2)))+ l{r<oo}] ,
real x, then we have rE70,<X>
u(t,x) = F(t,x) (4.12)
where F is the function defined by equation.iaB) corresponding to the European noting To,oo the set of all stopping times of the filtration of (Bt)t~o and To,T the
call price. set of all elements of To,oo with values in [0, T]. The right-hand term in inequality
Proof. We assume here that t = 0 (the proof is the same for t > 0). Then it is (4.12) can be interpreted naturally as the value of a 'perpetual' put (i.e. it can be
sufficient to show that, for any stopping time 7, exercised at any time). The following proposition gives an explicit expression for
the upper bound in (4.12).
E*(e-rr(Sr - K)+) :::; E*(e-rT(ST - K)+) = E*(ST - e-rTK)+. Proposition 4.4.5 The function
On the other hand, we have rr
Uoo(x) = rE70.<X>
sup E.[(Ke- - xexp (aB r - (a 27/2)))+ l{r<oo}] (4.13)
E* ((ST - e-rTK)+!Fr) ~ E* ((ST - e-rTK)IFr) ~ s, - e-rTK'.,
is given by the formulae
since (St) is a martingale under P*. Hence, Uoo(x) = K - x for x:::; z"
E* ((ST - e- rT K)+ IFr ) .~ s; ~ e- rr K X) -"'I
x > x"
Uoo(x) = (K - z") ( x* for
since r ~ 0 and by non-negativity of the left-hand term, with z" = K,/(l +,) and, = 2r/a 2 .
'.
Proof. From formula (4.13) we deduce that the function u oo is convex, decreasing
E* ((ST - e-rTK)+IFr) ~ (Sr - e- rr K) + . on [O,oo[ and satisfies: Uoo(x) ~ (K - x)+ and, for any T > 0, Uoo(x) ~
rT
We obtain the desired inequality by computing the expectation of both sides. , 0 E(Ke- - xexp (aBT - (a 2T/2)))+, which implies: Uoo(x) > 0, for all
x ~ O. Now we note x" = sup{x ~ Oluoo(x) = K - x}. From the properties of
u oo we have just stated, it follows that
"Ix:::; z" Uoo(x) = K - x and "Ix >x* Uoo(x) > (K - x)+. (4.14)
4.4.2 Perpetual puts, critical price On the other hand, the Spell envelope theory in continuous time (cf. E1 Karoui
In the case of the put, the American option price is not equal to the European one (1981)(Kushner (1977), aswell as Chapter 5)enables us to show
and there is no closed-form solution for the function u. One has to use numerical
Uoo(x) = E [(Ke,,"':'rrz - xexp (aB r % - (a 27x/2)))+ 1h<00}]
methods; we present some of-them in Chapter 5. In this section we will only use
the formula . where 7x is the stopping time defined by 7x = inf{t ~ 01 e-rtuoo(Xt)
u(t, x) = sup E* (K~-r(r-t) - xexp (:--a 2(7 - t)/2 + a(Wr - Wd)) + «<;« - Xt)+} (with inf 0 = 00), the process (Xf) being defined by: Xf =
2
rET.,T . x exp ((r - a / 2)t + a B t ) . The stopping time 7 x is therefore an optimal stopping
. (4.10) time (note the analogy with the results in Chapter 2).
to deduce some properties of the function u. To make our point clearer, we assume It follows from (4.14) that
t = O. In fact, it is always possible to come down to this case by replacing Twith
7x = inf{t ~ 0IX: :::; z"} = inf {t ~ Ol(r - a 2/2)t + aB t :::; log(x* /x)}.
 The Black-Scholes model Exercises 77
76
Introduce, for any z E IR+, the stopping time Tx,z defined by
where, = 2r1 a2 . The derivative of this function is given by
z'Y- 1
Tx,z = inf{t ~ 0IX: ~ z}. ¢'(z) = -
. x'Y
(K, - b + l)z).
.
With these notations, the optimal ..
stoppmg ,IS giiven by T x
ume = T x,x'"We fix x It results that if x ~ K,I(,+l),max z ¢(z) = ¢(x) = K -xandifx > K,/b+
and we note ¢ the function of z defined by I), max, ¢(z) = ¢ (K, Ib + 1)), and we recognise the required expressions. 0

..1.( ) =. E ( e - r T "
'I' Z
Z
'1{Tz,.<OO }(K - x: ) +).
Tz •• Remark 4.4.6 Let us come back to the American put with finite maturity T.
Following the same arguments as in the beginning of the proof of Proposition
. I'S' optimal the function ¢ attains its maximum at point z
S mce T x x " ' . . . d .
x": We
* and
= 4.4.5, we see that, for any t E [0, T[, there exists a real s(t) satisfying
are going to calculate ¢ explicitly, then we will maximise It to etermme x
"Ix ~ s(t) u(t,x) = K - x and "Ix> s(t) u(t,x) > (K - x)+. (4.15)
UOO(x) = ¢(x*). ( ) _ (K _ ) If z < x we have
If z > x, it is obvious that Tx,z = a and ¢ z - x +. -' , Taking inequality (4.12) into account, we obtain s(t) ~ z", for all t E [0, T[. The
by the continuity of the paths of (Xnt"~o' real number s(t) is interpreted as the 'critical price' at time t: if the price of the
underlying asset at time t is less than s( t), the buyer of the option should exercise
Tx,z = inf{t ~OIX: = z} his or her option immediately; in the opposite case, he should keep it.
and consequently
rTz
¢(z) = (K - z)+E (e- ,· l h ,. <OO})
(K - z)+E (e- r T z , . ) · Notes: The presentation we have used, based on Girsanov theorem, is inspired by
Harrison and Pliska (1981) (also refer to Bensoussan (1984) and Section 5.8 in
.
WIth, by convention, e
. -roo _
-.
a Using the expression of Xt in terms of B t , we
, Karatzas and Shreve (1988». The initial approach of Black-Scholes (1973) and
see that, for z ~ x, Merton (1973) consisted in deriving a partial differential equation satisfied by
the the call price as a function of time and spot price. It is based on an arbitrage
Tx,z = inf{t~OI(r-a;)t+aBt=IOg(ZIX)} argument and the Ito formula. For more information on statistical estimation of the
models' parameters, the reader should refer to Dacunha-Castelle and Duflo (1986)
inf {t ~ 0l/.tt + e, = ~ IOg(ZIX)} , and Dacunha-Castelle and Duflo (1986) and to the references inthese books.

with JL = ria - a 12. Thus, if we note, for any real b, 4.5 Exercises
T b =inf{t ~ OIJLt + B; = b}, Exercise 19 The objective of this exercise is to prove the Girsanov theorem 4.2.2
in the special case where the process (Ot)is constant. Let (Bt)o9~T be a standard
we get Brownian motion with respect to the filtration (Ft)O<t<T and let JL be a real-valued
(K - x)+ if z > x . =
number, We set, for a ~ t,~ T, i; exp (- JLB t .: 2 12)t). (i.t
~(z) = { (K - z)E (exp (-rT1og(z/x)/u))
a
if Z E [0, x] n [0, K]
if z E [O,x] n [K,+oo[.
1. Sh6w that (Lt)O<t<T ~s a martingale
t
E(L t ) = 1, for all E [0, T].
~elative to the filtration (Ft) and that
.
The maximum of ¢ is attained on the interval [0, x] n [0, K]. Using the following 2. We note p(L.) the density probability L t with respect to the initial probability
formula (proved in Exercise 24) P. Show that the probabilities p(L T ) and p(L.) coincide on the a-algebra Ft.

. E (e-aT&) = exp (~b - IbJv!JL2 + 2a) , 3. Let Z be an FT-measurable, bounded random.variable, Show that thecondi-
tional expectation of Z, under the probability p(LT), given F«, is

it can be seen that E'(LT)(ZIFt) = E (ZLTIFt).

Vz E [O,x] n [O,K] ¢(z) = (K- z) (~)'Y, Lt
 The Black-Scholes model Exercises 79
78
Exercise 25
4. We set W = J-Lt + Bi, for all t E [0, T]. Show that for all real-valued u and for
t
all sand t in E [0,T], with s ~ t, we have 1. Let P and Q be two equivalent probabilities on a measurable space (n, A).
Show that if a sequence (X n ) of random variables converges in probability
E(LT) (eiU(w.-w.) \.rs) = e- u 2(t-s)/2.
under P, it converges in probability under Q to the same limit.

Conclude using Proposition A.2.2 of the Appendix. 2. Notations and hypothesis are those of Theorem 4.2.2. Let (Ht)O<t<T be an
adapted process such that J; H;ds < 00 P-a.s. The stochastic-i.rtegral of
Exercise 20 Show that the portfolio replicating a European option in the Black-
(Ht ) relative to B, is well-defined under the probability P. We set
Scholes model is unique (in a sense to be specified).
Exercise 21 We consider an option described by ~ = f.(ST) and w~ note F the
function of time and spot corresponding to the option pnce (cf. equation (4.7)).
x, = I n.e», + I
t t
Hs(}sds.

1. Show that if f is non-decreasing (resp. non-increasing), F(t, x) is a non- Since p(L) and P are equivalent, we have J; H;ds < 00 p(L)-a.s. and we
decreasing function (resp. ,non-increasing) of x. can define; under p(L), the process
2 We assume that f is convex. Show that F(t,x) is a convex ~unction ~f z, a
. d . function of t if r - 0 and a non-decreasing function of a many
ecreasmg - fJ ,.
case. (Hint: first consider equation (4.7) and make us~ 0 ensen ~ mequ
ality:
.
lit = I t
HsdWs.

cI>(E(X)) ~ E (cI>(X)), where cI> is a convex function and X IS a random
variable such that X and cI>(X) are integrable.)
We note Fe (resp. Fp) the function F obtained when f(x) = (x ~ K)+ (resp.
3. f(x) = (K _ x)+). Prove that Fe(t,.) and Fp(t,.) are non-negatlvefor t < T.
Study the functions Fe(t,.) and Fp(t, .) in the neighbourhood of 0 and +00.
Exercise 22 Calculate under the initial probability P, the probability that a Eu-
ropean call is exercised. . .
Exercise 23 Justify formulae (4.8) and (4.9) and calculate for a call and a put the
delta, the gamma, the theta and the vega (cf. Remark 4.3.6).
Exercise 24 Let (Btk?o be a standard Brownian motion. For any real-valued J-L
.and b, we set
Tt = inf{t 2: 0 I J-Lt + B; = b}
with the convention: inf 0 = 00.
1. Use the Girsanov theorem to show the following equality:
The question is to prove the equality of the two processes X and Y. To do
so, it is advised to consider first the case of simple processes; and to use the
fact that if (Ht)o9~T is an adapted process satisfying J; H;ds < 00 a.s.,
there is a sequence (Hn) of elementary processes such that JoT (H 5 - H;') 2 ds
converges to 0 in probability.
Exercise 26 Let (Bt)O<t<l be a standard Brownian motion defined on the time
interval [0,1]. We note Crd099 its natural filtration and we consider T an
exponentially distributed random variable with parameter A, independent of .rl.
For t E [0,1], we note 9t
the a-algebra generated by.rt
and the random variable
T t\ t. '
1. Show that (9t)O<t<l is a filtration and that (Bt)O<t<l is a Brownian motion
with respect to (OS. --
2. For t E [0,1], we set M, = E (I{T>1}19t). Show that M, is equal to
,.. e->'(l-t) l{T>t} a.s. The following property can be used: if 8 1 and 8 2 are
two sub-a-algebras and X a non-negative random variable such that the a-

'Va, t > 0 E (e-a(Tt: I\t)) = E (e-a{T~I\t) exp (J-LBT~1\t - J-L; T~ t\ t) ) .

algebra generated by 8 2 and X are independent of the a-algebra 8 1, then
E ('~18l V 82) = E (XI82 ) , where 8 1 V 82 represents the o-algebragener-
ated by 8 1 and 8 2. .
2. Prove the inequality' 3. Showthat there exists-no path-continuous process (X t ) such that for all t E

'Va,t>O E(e-a(T~t\t)exP(J-LBT~I\t-~2T~t\t)l {t<Tn) ~e-at. [0,1]' P (M t = X t ) =,1 (remark that we would necessarily have
P ('Vt E [0, IJ M, = X t ) = 1).
3. Deduce from above and Proposition 3.3.6 that . Deduce that the martingale (M t ) cannot be represented as a stochastic integral
with respect to (Bd. .
'Va> 0 E (e-aTt: 1{Tt: <oo}) = exp (J-Lb-l bIJ 2a + J-L2) .
Exercise 27 The reader may use the results of Exercise '18 of Chapter 3. Let
(Wtk~o be an .rt-Brownian motion.
4. Calculate P (Tt < 00).
 The Black-Scholes model Exercises 81
3. Prove that there exists a probability P" equivalent to P, under which the
discounted stock price is a martingale. Give its density with respect to P.
4. In the remainder, we will tackle the problem of pricing and hedging a call with
maturity T and strike price K.
Deduce that if x ~ JL (a) Let (H?, Hl) be a self-financing strategy, with value \It at time t. Show that

E (e
aWT1 . } ) -exp
. (a --
2T
+ 2a),) N (2), - + aT) JL
1m .
=
if (\It/ SP) is a martingale under P" and if VT (ST - K)+, then
{WT~~,inf.::;TW.~A -. . 2 vT
'TIt E [0, T) Vi = F(t, St),
2. Let H ~ K; we are looking for an analytic formula for where F is the function defined by

K)+1{inf.::;T X.~H}) ,
C = E (e-rT(XT - F(!, x) = E" (x exp (J.T u(, )dW. - ~ J.T U'U)d,) -: K e- J.T .(.)d.) +
where X, = x exp ((r - /2) t+ uWt) . Give a finan~iaUnterpretati.?n to
'u2
this value and give an expression for the probability p that makes W t - and (Wd is a standard Brownian motion under p ".
(r / o - o /2) t + W t ~ standard Brownian motion. _ (b) Give an expression for the function F and compare it to the Black-Scholes
3. Write C as the expectation under P of a random variable function only ofWT formula.
and sUP~~s~T Ws . . ,.
(c) Construct a hedging strategy for the call (find H?and H t ; check the self-
financing c o n d i t i o n ) . l
4. Deduce an analytic formula for C.
Problem 2 Garman-Kohlhagen model
Problem 1 Black-Scholes model with time~dependent parameters ~e con- The Garman-Kohlhagen model (1983) is the most commonly used model to price
sider once again the Black-Scholes model, assuming that ~e ass~t p~ces are and hedge foreign-exchange options. It derives directly from the Black-Scholes
described by the following equations (we keep the same notations as In this ch~~- model. To clarify, we shall concentrate on 'dollar-franc' options. For example, a
J .

ter) European call on the dollar, with maturity T and strike price K, is the right to buy,
dSP = r(t)Spdt at time T, one dollar for K francs.
We will note S; the price of the dollar at time t, i.e. the number of francs-per
{ dS
t = St(JL(t)dt + u(t)dBd dollar. The behaviour of S, through time is modelled by the following stochastic
. where ret), JL(t), u(t) are detenninistic functions of time, continuous on [0, T). differential equation:

!
dS t .
Furthermore, we assume that inftE[o,T] u(t) > 0: . S = JLdt + udWt,
. t.
1. Prove that where (Wt}tE[O,Tj is a standard Brownian motion on a probability space (O,\F, P),

s, = So exp (~t JL(~)ds + ~t u(s)dB ~ ~t u s _

2(S)dS)
. I JL and o are real-valued, with o > 0. We note (Ft)tE[O,Tj the filtration generated
by (WdtE[O,Tj and assume that F t represents the accumulated information up to
time t '( . . ..'
You may consider the process J
+ ~t u(s)dB s ~ ~t u 2(s)dS)
z, = s, exp --:- . : JL(s)ds :- . I

1. Express S, as a function of So, t and W t. Calculate the expectation of St.

2. 2. Show that if JL > 0, the process (St)tE[O,Tj is asubmartingale.
(a) .Let (X n ) be a sequence of real-valued, zero-mean normal random vari.ables 3. Let U; = 1/ St be the exchange rate of the franc' against the dollar. Show that
converging to X in mean-square. Show that X is a normal random variable. Uc satisfies the following stochastic differential equation
(b) By approximating o by simple .functi?ns, show that J~ u(s )dB s is anormal dU t (2 .
- = u - JL)dt - udWt.
random variable and calculate ItS varIance. 0 • . .
u,
82 The Black-Scholes model Exercises
83
Deduce that if 0 < J.L < a 2, both processes (St)tE[O,T] and (Ut)tE[O,TJ are (The symbol E stands for the expectation under the probability P.)
submartingales. In what sense does it seem to be paradoxical?
5. Show (through detailed calcUlation) that
II
F(t,x) = e-r,(T-t)xN(dd - Ke-ro(T-t)N(d2)
We would like to price and hedge a European call on one dollar, with maturity T
and strike price K, using a Black-Scholes-type method. From his premium, which where N is the distribution function of the standard norrnallaw, an d
represents his initial wealth, the writer of the option elaborates a strategy, defining
at any time t a portfolio made of HP francs and H, dollars, in order to create, at
dl 10g(xjK) + (TO - + (a 2j2»(T -
TI t)
time T, a wealth equal to (ST - K)+ (in francs). a..;T=t
At time t, the value in francs of a portfolio made of Hp francs and H, dollars d2 10g(xjK) + (TO - TI - (a 2j2»(T - t)
is obviously a..;r-=-t
Vt = H~ + n.s; (4.16) 6. The next step is to show that the option is effectively replicable.
We suppose that French francs are invested or borrowed at the domestic rate TO
and US dollars are invested or borrowed at the foreign rate TI' A self-financing (a) We set St = e h -ro)t St. Derive the equality
strategy will thus be defined by an adaptedprocess ((HP, Ht»tE[O,Tj, such that es, = aStdWt.
dVt = ToHpdt + TIHtStdt + HtdSt (4.17)
(b) Let ~ be the function defined by F(t, x) = e- rot F(t, xe(ro-r,jt) (F is the
where Vt is defined by equation (4.16). f~nctl_on defined in Question 4). We set C, = F( t S) and G - -rotc
F(t, St}. Derive the equality , t t - e t =
1. Which integrability' conditions must be imposed on the processes (HP) and
(Hd so that the differential equality (4.17) makes sense? -
2., Let Vi
= e-rotVt be the discounted value of the (self-financing) portfolio sc, = -aF
( t St)ae-rotS dW';
ax ' t t-
(HP, Ht}. Prove the equality
(c) renlicati that the c.all is replicable and give an explicit expression for the
,dVt = Hte-rotSt(J.L + TI - To)dt + Hte-rotStadWt. rep icatmg portfolio (( Hp, Ht».

3. 7. fors« down a put-call parity relationship, similar to the relations~iP we gave

or
(a) Show that there exists a probability P, equivalent to P, under which the stocksh' alndd grve an example of arbitrage opportunity when this relationship
does not 0 .
process
TiT _ J.L + TI - TO t Proble~ 3 Option to exchange one asset for another .
t't't - + UT
t't't
a W~ tO~~der a fin2anci~1 market in which there are two risky assets with respective
is a standard Brownian motion. t a~d St at tlI~e t and a riskless asset with price So = ert at time
(b) A self-financing strategy is.said to be admissible if its discounted value Vi 1 pnces
~~::S~~~~~e~:nt~;1~~~:~~!s and Slover time are modelled by the followin~
t

is non-negative for all t and if SUPtE[O,Tj (Vi) is square-integrable under I'

P. Show that the discounted value of an admissible strategy is a martingale dS! S! (J.Lldt + aldB!)
under P. I
4. Show that if an admissible strategy replicates the call, in other words it is worth /
{
dS~ Sl (J.L2dt + a2a B l)
VT = (ST - K)+ at time T, then for any t ~ T the value of the strategy at where (BI) [ . and (B2) .'
. d t tE O,T] t tE[O,Tj are two Independent standard Brownian mo
time t is given by nons efined on a probability space (0 F P). -
with :> 0 . d ' , ,J.LI,J.L2,al anda2arerealnumbers
abiesa11 an ~2 > O. We note!t the a-algebra generated by the random vari~
where • and B. for s ~ t. Then the processes (B I) d (B2)
e (Fd-Brownian motions and, for t ~ s, the vecto/ (~IO~];~ B2 ~ ~JO)?J
:rrIndependent
F(t,x) = E(xexP(-(TI.+(a 2j2»(T-t)+a(WT - Wt») of F.. - t·. , t . • IS
.J'
- K e-~o(T-t))
. +
84 The Black-Scholes model Exercises
85
I where the function F is defined by
We study the pricing and hedging of an option giving the right to exchange one of
~
F(t, Xl, X2) = E- ( x1eO'I (WIr - W•I) "'-T(T-t) ,,2
_ x2e0'2(Wf-W,2)-=f(T-t)) +'
the risky assets for the other at time T.
1. We set (h = (ILl - r) /0"1 and (h = (IL2 - r) /0"2, Show that the process defined (4.19)
by the ~ymb~l E repres~nting the expectation under P. The existence of a strategy
u, = exp ( -e.e; - B2B; - ~(B~ + B~)t) , having this value will be proved later on. We will consider in the remainder
that the value of the option (St - Sj)+ at time t is given by F(t, Sf, Sl).
is a martingale with respect to the filtration (Ft)tE[o,T]' 4. Find a parity relationship between the value of the option with payoff (Sl _
2. Let P be the probability with density MT with respect to P. We introduce the sj)+ and the symmetrical option with payoff (Sf - St)+, similar to :the
processes WI and W 2 defined by Wl = Bf +B1t and Wl = B; +B2t. Derive,
put-call parity relationship previously seen and give an example of arbitrage
opportunity when this relationship does not hold.
under the probability P, the joint characteristic function of (Wl , Wl). Deduce
that, for any t E [0, T], the random variables Wl and wl ar~ independent ill
normal random variables with zero-mean and variance t under P.
The objective of this section is to find an explicit expression for the function F
In the remainder, we' will admit that, under the probability P, the processes defined by (4.19) and to establish a strategy replicating the option.
(Wl )o:9~T"and(Wl)O:9~T are (Ft)-indepe~dent st;n?~d Brownian motions 1. Let 91 and 92 be two independent standard normal random variables and let A
and that, for t 2: s, the vector (Wl - W s1, W t - W s ) IS independent of F s • be a real number.
3. Write Sland Sl as functions of SJ, S5,!Vl and Wl and show that, under P,
(a) Show that under the probability p(A), with density with respect to P given
the discounted prices Sl = e:" Sl and Sl == e:" S; are martingales. by ._
We want to price and hedge a European option, with maturity T, giving to the dP(A)
holder the right to exchange one unit of the asset 2 for cine unit of the as~et.1:
do so we use the same method as in the Black-Scholes model. From hIS initial
:0 __ = eAgI-A
dP
2
/2
'
the random Gaussian variables 91- A arid 92 are independent standard
wealth, the premium, the writer ?f the opt~on builds a strategi' defini~g a~ any
variables.
time t a portfolio made of HPUnits of the riskless asset and H; and H; Units of
the assets 1 and 2 respectively, in order to generate, at time T, a wealth equal to (b) Deduce that for all real-valued Y1, Y2, Al and A2' we have
(St - Sf)+· A trading strategy will be defined by the three adapted processes E (exp(Yl + A19d' - exp(Y2 + A292))+ .
HO, HI and H 2.
·11
=eYI+A~/2N-(Yl - Y2 + A?) _ eY2+A~/2N (Y1 - Y2 -A~)
JA~+A~ JA~+A~ ,
1. Define precisely th~ self- financing strategies' and prove that, if Vt = e-rtVt is where N is the standard normal distribution function.
the discounted value of a self-financing strategy, we have
rtSl dW l 2. Deduce from the previous question an expression for F using the function N.
-r -
d1Yt - HIt e - t 0"1 t + H t2e-rtS20" 2
t 2 dW t . 3. We set c, = «:" F(t, Sf, S;). Noticing that
/ :
2. Show that if the processes (HI )o~t~~ and (Hl)o:9~T of a self-financing
. c, = F(t, sf, S;) = E (e- rT (S} - Sf)+ 1F t ) ,
strategy are uniformly bounded (which means that: 30 > 0, Vet,w) E [O,~] x
fl, IHt(w)1 ::; 0, for i =
1,2), then the. discounted value of the strategy IS a prove the equality
martirigale under P. - of - - of _ _
3. Prove that if a self-financing strategy satisfies the hypothesis of the previous ac, = !lx (t,SI,S;)O"l e- rtSf dwl + ~(t,SI,S;)0"2e-rtSt2dWr
u 1 uX2
question and has a terminal value equal to VT =
(St .:... Sf)+ then its value at
Hint: use the fact that if (Xt ) is an Ito process which can be written as X =
any time t < T is given by t t t
X o + f o J1dW; .: f0 7 ; dw ; + f~ Ksds and if it is a martingale under P,
(4.18) then K, = 0, dtdP-almost everywhere.
 The Black-Scholes model Exercises , 87
86
show that condition (ii) is satisfied if and only if we have, for all t E [0, Tj.
4. Build a hedging scheme for the option.
Problem 4 A study of strategies with consumption
We consider a financial market in which there is one riskless asset, with price S~ =
t:t = Vo + it HudBu - i t c(u)du, a.s.

ert at time t (with r ~ 0) and one risky asset, with price St at time t: The model with s. = «r:s; and c(u) = e-ruc(u).
is studied on the time interval [0, Tj (0 ~ T < 00). In the following, (St)O~t~T
is a stochastic process defined on a probability space (0, F, P), equipped with 2. We suppose that conditions (i) to (iv) are satisfied and we still note t:t =
a filtration (Ft)o9~T' We assume that (Ft)O~t~T is the natural filtr~tion of a
e-rtVi = e:" (H2 S2 + HtSt). Prove that the process (t:t)O<t<T is a super-
martingale under probability p. . - -
standard Brownian motion (Bt)o9~T and that the process (St)09~T IS adapted
3. Let (c(t))09~T be an adapted process with non-negative values such that
to this filtration.
. , I E· (JOTc(t)dtf ~ 00 and let x > O. We say that (c(t))09~T is a budget-
We want to study strategies in :ovhich consu~ption is allowed. The dynamic of feasible consumption process from the initial endowment x if there exist some
(St)09~T is given by the Black-Scholes-model processes (H2)o~t~T and (Ht)O~t~T such that conditions (i) to (iv) are satis-
fied, and furthermore Vo = HgSg + HoSo = x. .
dS t = St(JLdt + adBt) ,
(a) Show that if the process (c(t))O<t<T is budget-feasible from the initial
with JL E IR and a > O. yve note P" the probability with density
endowment x then E· (JoT e-rtc(t)dt) .~ x. '
exp (-(JBT - (J2T /2)
(b) Let (c(t))09~T be an adapted process. with non-negative values and such
with respect to P, with (J = (JL -r)/a. Under p •. the process (Wt)09~T. defined that
by W t = (JL - r)t/a + Be, is a standard Brownian motion.
A strategy with consumption is defined by three stochastic processes: (H~)09~T,
E' ( { C(t)dt)' < 00 and E' ( { e:"'C(t)dt) '" x ..
(Ht)O<t<T and (c(t))09~T' H~ and H, represent respectively the quantities. of
riskless asset and risky asset held at time t, and c(t) represents th~ consum?~on
Prove that (c(t))O~t::;T is a budget-feasible consumption process with an
rate at time t. We say that such a strategy is admissible if the followmg conditions
initial endowmentx. Hint: introduce themartingale (Mt)O::;t::;T defined by
hold:
(i) The processes (H2)09~T. (Ht)O~t~T and (c(t) )09~T are adapted and satisfy
M t = E· (x + foT e-rsc(s)dsIFt) and apply the theore~ of martingales
representation.

iT (IH~I + H~ + Ic(t)1) dt < oo,a.s. (c) An investor with initial endowment x wants to consume a wealth corre-
sponding to the sale of p risky assets by unit of time whenever.S, crosses
~. some. ?arrier K upward (that corresponds to c(t) =
pSt1{S,>K}). What
(ii) For all t E [0, Tj, conditions on p and x are necessary for this consumption process to be

10r H~dS~+
. 10r HudS 1r0
budget-feasible?
HOSo+HtSt = HgSg+HoSo+ u- c(u)du, a.s.
t t . II
/
(iii) For all t E [0, Tj, c(t) ~ 0 a.s. We now suppose that the volatility is stochastic. i.e. that the process (St)O<t<T is
the solution of a stochastic differential equation of the.following form: - -
(iv) For all t E [0, Tj. th~ rand.om variable H2 S~ + HtS t is non-negative and
dS t = St(JLdt + a(t)dBt), (4.20)
sup (Itiffi.+HtSt+ tC(S)dS) where JL E IR and (a(t) )O::;t~T is 'an adapted process. satisfying
tE[O,T] 10 I

Vt E [O,Tj al ~ a(t) ~ (,2,

is square-integrable under the probability p ",
1. Let (H2)09~T. (Ht)O~t~T and (c(t))09~T be three adapt~dpro~~~ses satis- for so~e constants.o, and az such that 0 < al < az- We consider a European
fying condition (i) above. We set Vi = H2 S~ + HtS t and Vt = e Vi, Then
call With maturity T and strike price K on one unit of the risky asset. We know
88 The Black-Scholes model Exercises
89
(see Chapter 5) that if the process (a(t) )O<t'<T is constant (with a(t) = a for any the natural filtration generated by a standard Brownian motion (Bdo<t<T and
t) the price of the call at time tis C(t, St), where the function C(t, x) satisfies that (St)O~t~T follows a Black-Scholes model - -
ec a 2x2 a2c ec
-(t,x) + ---;:;-z(t,x) + rx-;:)(t,x) - rC(t,x) = a
at 2 ox ox with Il E IR and a > O.
on [0, T[x10, oo[ .We wan~ to study an example of compound option. We consider a call option
WI.th matunty T I E10, T[ and strike price K 1 on a call of maturity T and strike
'C(T, x) = (x - K)+. pnce K. The.value of this option at time T1 is equal to

We note C 1 the function C corresponding to the case a = a1 and C 2 the function h = (C(T1, STl) - Kd+,
C corresponding to the case a = a2. We want to show that the price of the call at where C(t, x) is the price of the underlying call, given by the Black-Scholes
time 0 in the model with stochastic volatility belongs to [C1(0, So), C2(0, So)l. formula.
Recall that if (OdO<t<T is a bounded adapted process, the process (Ldoi;t~T 1.
d~fined by i, = exp ~.r; e.se, - ~ I; O;ds) i~ a martingale. (a) Graph function x I-t C(T1, x). Show that the line y = x - Ke-r(T-Tt} is
1. Prove (using the price formulae written as expectations) that the, functions an asymptote (hint: usethe put/call parity).
x I-t C1(t,x) and x I-t C 2(t,x) are convex. (b) Show that the equation C(T1 , x) = K 1 has a unique solution Xl.
2. Show that the solution of equation (4.20) is given by 2. Show that at time t < T 1 , the compound option is 'worth G(T _ t S) h
· dfi
e ne db y , t,were

n'
G IS , 1

s, = S~ exp (Ilt + it a(s)dB ~ it a 2(S)ds) ..

~ E [e-'~ (C ( T" xe(.- "n';-,"",) - K,
s -
G(O, xl
3. Determine a probability P* equivalent to P under which the process defined
by W t = B, + I;(Il- r)/a(s)ds is a standard Brownian motion. with 9 bei~g a standard normal random variable.
3.
4. Explain why the price of the call at time a is given by
(a) ~how that x I-t G(O, x) is an increasing convex function .
. Co = E* (e:-rT(ST - K)+) .
(b) We now want to compute G explicitly. Let us denote by· N the standard
cumulative normal distribution. Prove that ' ,
5, We set S~ = e-rtSt. Show that E* (Sn s S6elT~t.
I
6. Prove that the process defined by
G(O,x) = E [e-rIlC (n,xe(r-lT 2/2)lI+lT
V69) 1{9>~d}] _ K1e-rIlN(d),

. l't . eca}
M, = 0 e-
ru .
(u, Su)a(u)SudWu
i. where
d = 10g(X/!1) + (r- a2 /2) 0
a../O
is a martingale under probability P* . . (c) Show that if 91 is a st~ndard normal variable independent of 9, we can write
7. Using Ito formula and Questions 1 and 6, show that «rc, (t, Sd is a sub- O~/= T - T 1 and characterise G by, ,"
martingale under probability .P*. Deduce that C 1 (0, So) ~ Co. . , . G(O, x) + K 1 e- r llN(d)
8. Derive the inequality Co s C2(0, So). E [( xe lT( V69+V919t) - "22 (1I+IIt) _ K e-r(II+II l ») lA] ,
Problem 5 Compound option )
where the event A is defined by
We consider a financial market offering two investment opportunities.. The first
traded security is a riskless asset whose price is equal to Sp = e rt at time t (with
r ~ 0) and the second security is risky and its price is denoted by S, at time (log(X/ Kr) + (r _~2) (0 + (1))
t E [0, T1. Let (SdO~t~T be a stochastic process defined on a probability space
(n,:F, P), equipped with a filtration (:Ft)O~t~T, We assume that (:Fd09~T is and 9 > -d}.
 The Black-Scholes model Exercises
90 91
(d) From this, derive a formula for G(B, x) in terms of Nand N 2 the two- Problem 7 Asian option
dimensional cumulative normal distribution defined by We conside~ a ?nan~ial market offering two investment opportunities. The first
traded secunty 1S a nskless asset whose price is equal to Sp = ert at time t (with
N 2(Y,Y1,P) = P(g < y,g+ pg1 < yd for y,Y1,P E JR.
r ~ 0) and the second security is risky and its price is denoted by St at time
4. Show that we can replicate the compound option payoff by trading the under- t E [0, T]. Let .(St)O$;t?T be a stochastic process defined on a probability space
(f!, F, P), equipped. with a filtration (Ft)O<t<T.
- - We assume that (:F.)
t O<t<T 1S.
lying call and the riskless bond.
t he natura1 filtration generated by a standard Brownian motion (Bdo<t~;: and
Problem 6 Behaviour of the critical price close to maturity that (SdO$;t$;T follows a Black-Scholes model - -
We consider an American put maturing at T with strike price K on a share of risky
asset S. In the Black-Scholes model, its value at time t < T is equal to P(t, St), dS t = St(/Ldt + adBd,
when P is defined by with./L E JR and a > ~. We shall denote by p. the probability measure with
.( -rT I1W~_.,.2T)+ de.ns1ty exp (-BBT - B T/2) with respect to P, where B = (/L - r)/a. Under
P(t,x) = sup' E Ke - xe 2 ,
P , th~ proce~s (Wt)O$;t$;T' defined by W t = (/L - r)t/a + B t is a standard
TE70.T-t Brownian motion.
To T-t is the set of stopping times with values in

denote by s( t) the critical ~rice defined as,

s(t) = inf{x > 0 I P(t,x) > K - z}.
we recall that limt-+T s(t) = K.
[0, T - t] and (Wt)O$;t$;T is a
standard P·-Brownian' motion. We also assume thatr > O. For t E [0, T[, we

where K is a positive constant. '

S,dt - K r
We are going to study the option whose payoff is equal to

~ (~ {

1. Let P, be the function pricing the European put with maturity T and strike I
price K

Pe(t, x) = E( e-r(T-t) K .. xeI1VT-tg- .,.; (T-t)) + ,

where 9 is a standard normal variable. Show that if t E [0, T[, the equation
P; (t, x) = K - x has a unique solution in ]0, K[. Let us call it se(t).
V, ~ E' [,-d T
- ') (~ S.da -K
{ rrJ
1. Explain briefly why the Asian option price at time t (t ~ T) is given by

2. Show that s(t) ~ se(t), for any t E [0, T[.

2. Sh(j.w that on the event { J;, Sudu ~ KT}, we have
3. Show that e-r(T-t) it 1 ~ e-r(T-t)
n. Vi = T' Sudu + S, - K e-r(T-t).
liminf K A ) > E (liminf
t-+T . T - t - t-+T
K~)
T - t
- aKg) +
o rT
3. We define s, = e:" s.. for t E [0,T].
We shall need Fatou l~mma: for any sequence (Xn)nEN of non-negative ran-
dom variables, E(lim inf n -+ oo X n ) ~ lim inf n -+ oo E(X n ) . (a) Derive the inequality (

4. E·(St:Ke-rT)+ ~E·[e-rT(ST-K)+].
(a) Show that for any real number 1/, (Use conditional expectations given F t ) .
E(1/ - Kag)+ > 1/. (b) Deduce that

(b) Deduce that Vo s E· [e- rT (ST - K)+] ,

. K-se(t) . K-s(t) i.e, the Asian option price.is smaller than its European counterpart.
lim = hm = +00.
t-+T VT - t t-+T VT - t (c) For t ~ u, we denote by Ct,u the value at time t of a European call maturing
 The Black-Scholes model Exercises 93
92
at time u with strike price K. Prove the following inequality (b) Deduce that

Vt < e-r(T-t)t (-l i t S du - K

- T t 0 U
)+ + - iT e-r(T-u)Ct
T
1
t ,u
duo Vo = e-rTE (So exp ((r - (12 /2)(T/2) + (1VT /39) - K) + ,

where 9 is a standard normal variable. Give a closed-form formulator Vt in

n terms of the normal distribution function. 0

We denote by (~t)09~T the process defined by 3. Prove the inequality

~t = ~t (~ I
t rT
Sudu - K) . Vo -va, ~ Soe- rT (e rT- 1 - exp ((rT /2) - (12T /12) ) .

1. Show that (~t)O~t~T is the solution of the following stochastic differential

equation:

2.

(a) Show that

v. ~ ;-'(T-'IS,E' [((.+ ~ t S~dU) \1"] ,

with S~ = exp ((r - (12 /2)(u - t) + (1(Wu - Wt}) .
(b) Conclude that Vi = e-r(T-t) StF(t, ~t), with

F(t,O ~E' (u ~ t '>:'duf

3. Find a replicating strategy to hedge the Asian option. We shall assume that the
function F introduced earlier is of class C 2 on [0, T[ x IR and we shall use Ito
formula.
ill
The purpose of this section is to suggest an approximation of Vo obtained by
considering the geometric average as opposed to the arithmetic one. We define

Vo ~ e-,TE' (exp (~ [tn(S,)dt) -K) +

1. Show that Vo ~ Vo.
2.
(a) Show that under measure P", the random variable JoT Wtdt is normal with
zero mean and a variance equal to T 3/3.
5

Option pricing and partial

differential equations

In the previous chapter, we saw how we could derive a closed-form formula for
the price of a European 'option in the Black-Scholes environment. But, if we are
working with more complex models or even if we want to price American options,
we are not able to find such explicit expressions. That is why we will often require
numerical methods. The purpose of this chapter is to give an introduction to some
concepts useful for computations.
Firstly, we shall show how the problem of European option pricing is related to
a parabolic partial differential equation (PDE). This link is basedon the concept
of the infinitesimal generator of a diffusion. We shall also address the problem of
solving the PDE numerically. '
The pricing of American options is rather difficult and we will not attempt
to address it in its whole generality. We shall concentrate on the Black-Scholes
model and, in particular, we shall underline the natural duality between the Snell
envelope and a parabolic system of partial differential inequalities. We shall also
explain how we can solve this kind of system numerically.
We shall only use classical numerical methods and therefore we will just recall
the few results that we need. However, an introduction to numerical methods to
solve parabolic PDEs can be found in Ciarlet and Lions(1990) or Raiviart and
Thomas (1983).
i-:

5.1 European option pricing and diffusions

In a Black-Scholes environment, the European option price is given by

Vi = E (e-r(T-t) I(ST)!.rt)

with I(x) = (x - K)+ (for a call), (K - x)+ (for a put) and

2/2)T+uW
S T -- x 0 e(r-u T
.
96 Optionpricing and partial differential equations Europeanoption pricing and diffusions
97
In fact, we should point out that the pricing of a European option is only a particular Proof. Ito formula yields
case of the following problem. Let (Xtk~o be a diffusion in ffi., solution of
(5.1)
where band (1 are real-valued functions satisfying the assumptions of Theorem Hence
3.5.3 in Chapter 3 and ret, x) is a bounded continuous function modelling the
riskless interest rate. We generally want to compute
f(Xt) = f(Xo) + i t f'(X s)(1(X s )dWs
Vt =E (e-J.T r(s,X.)dsf(XT )IFt) .
+it [~(12(Xs)JII(Xs)+ b(Xs)f'(Xs)] ds
In the same way as in the Black-Scholes model, Vt can be written as
Vi = F(t, X t ) ~nd ther~sult follows from the fact that the stochastic integral J~ f'(X s)(1(Xs )dW
s
IS a martingale, Indeed, ~ccording to Theorem 3.5.3 and since 1(1(x)1 is dominated
where by K(1 + Ix!), we obtain
F(t,:x) =E (e-J.T r(s,X;'%)ds f(X~X)) , , :
.

and X;'x is the solution of (5.1) starting from x at time t. Intuitively

F(t, x) ~ E (e-J.T r(s,X.)dsJ(XT )!Xt '= x) .

Mathematically, this result is a consequence of Theorem 3.5.9 in Chapter 3. The
o
computation of Vt is therefore equivalent to the computation of F(t,x):'Under
some regularity assumptions that we shall specify, this function F( t, x) is the Remark 5.1.2 If we denote by X{ the solution of (5.3) such that Xx = .
unique solution of the following partial differential equatiori follows from Proposition 5.1.1 that 0 x, It
= f(x)
{ "Ix E ffi.

(au/at
u(T, x)

+ Atu - ru) (t, x) = 0 Vet, x) 'E [0, T] x ffi.

(5.2) E (J (Xt)) = f(x) +E (It Af (X:) dS) .
Moreover, since the derivatives of f are bounded by a constant K] and since
where
Ib(x)1 + 1(1(x)1 :::; K(1 + Ixl) we can say that
(Atf)(x) = (12(t, x) f"(x) + bet, x)f'(x).
.2, ..
Before we prove this result, let us explain why the operator At appears naturally
when we solve stochastic differential equations.
E(~~~ IAf(X:)I) s Kj (1 + E(~~~ IX:1 2) ) < +00.
!heref?re, since x .H Af(x) and s H
IS applicable and yields
X: ,are continuous, the Lebesgue theorem
5.1.1 Infinitesimal generator ofa diffusion

We assume that band (1 are time independent and we denote by (Xtk:~o the d"
dt E (f (Xt))lt=o
l (1 r Af(X:)dS) = Af(x).
= l~ E t 1
solution of ' 0
dXt = b (Xt) dt + (1 (.Xt ) dWt. (5.3)
The differential operator A is called the infinitesimal generator of the diffusion
Proposition 5.1.1 Let f bea 0 2 function with bounded derivativesand A be the (Xt ) . The re~der can refer to Bouleau (1988) or Revuz and Yor (1990) t t d
differentialoperator that maps a 0 2 function f to Af such that some properties of the infinitesimal generator of a diffusion 0 s u Y
J . •

(AI) (x) = (12 (x) f",(x) + b(x)J'(x). The ProPositio,n 5.1.1 can also be extended to the time-dependent case. We assume
_ 2 ' that b ~nd (1 satisfy th.e assumptions ofTheorem 3.5.3 in Chapter 3 which guarantee
Then, the process M, = f(Xd - J~ Af(Xs)ds is an Ft-l'TIfrtingale. the existence and unIqueness of a solution of equation (5.1).
98 Option pricing and partial differential equations European option pricing and diffusions 99
Proposition 5.1.3 If u( t, x) is a C 1 ,2 function with bounded derivatives in x and In other words a(t, x) = a(t, x)a* (t, x) where 0'* is the transpose of a(t, x) =
if X, is a solution of(5./), the process (a,j(t, x)).

u, = u(t, X t) -
t
I (~~
+ Asu) (s, Xs)ds
. Proposition 5.1.5 If(X t) is a solution ofsystem (5.4) andu(t, x) is a real-valued
function of class C 1 ,2 defined on IR+ x IRn with bounded derivatives in x and
also, r( t, x) is a continuous boundedfunction defined on IR+ x IR, then the proces;
is a martingale. Here, As is the operator defined by
t
_ 0'2 (s, x) 8 2u 8u M, = e - Io' r(s,X.)dsu(t, Xd-l e- Io' r(v,Xu)dv (~~ + Asu - ru) (s, Xs)ds
(Asu) (x) 2= 8x2 + b(s, x) Bx'
The proof is very similar to that of Proposition 5.1.1: the only difference is that is a martingale.
we apply the Ito formula for a function of time and an Ito process (see Theorem The proof is based on the multidimensional Ito formula stated page 48.
3.4.10). . Remark 5.1.6 The differential operator 8/ 8t + At is sometimes called the Dynkin
In order to deal with discounted quantities, we state a slightly more general
operator of the diffusion.
result in the following proposition.
Proposition 5.1.4 Under the assumptions of Proposition 5.1.3, and ifr(t, x) is a
bounded continuous function defined on IR+ x IR, the process 5.1.2 Conditional expectations and partial differential equations

(~~
t
u, I;
= e- r(s,X.)dsu(t, Xt)-l e- r(v,Xu)dv I: + Asu - ru) (s, Xs)ds In this se,ction, we want to emphasise the link between pricing a European option
and ~olvmg a parabolic partial differential equation. Let us consider (Xt)t>o a
solution of system (5.4), f(x) a function from IRn to IR, and r(t, x) a bounded
is a martingale. continuous function. We want to compute
Proof. This proposition can be proved by using the integration by parts formula
to differentiate the product (see Proposition 3.4.12 in Chapter 3) Vt =E (e- r r(s,X.)ds f(Xr) 1Ft) .'

e - Jof'r(s,X.)ds u (t , X t )i,
In a similar way, as in the scalar case, we can prove that
and then applying Ito formula to the process u(t, X t ) .
o

where
This result is still true in a multidimensional modeJ. Let us consider the stochastic
differential equation
F(t, z) = E (e-I,T r(s,X;,Z)ds f(X~X)) ,

d~: t = bl (t, X t) dt + :E~=I alj (t, X t) dW/ when we denote by xt,x the unique solution of (5.4) starting from x attime t.
(5.4) The following result characterises the function F as a solution of a partial
differential equation. .
{
dXi' = bn (t, X t) dt + :E~=I anj (t, X t) dW/.
Theorem 5.1.7 Let u be a C 1 ,2 function with a bounded derivative in x defined
We assume that the assumptions of Theorem 3.5.5 are still satisfied. For any time on [0, T) x IRn . Ifu satisfies
2
t we define the following differential operator At which maps a C function from
n
. IRn to IR to a function characterised by Vx E IR u(T, x) = f(x),
. 1 n . 82 f ' n 8f and
= -2 ..L + Lbj(t,x)
(At!) (x)
',J~I
.
a"j(t,x)8' -.8 (x)
x, XJ . I
J= 0
8x (x),
J (~~ + ~tU - ru) (t,x) = 0 V(t,x)E [O,T) x IR
n
,

where (a,j (t, x)) is the matrix of components - then

p

a,j(t,x) = La'k(t,x)ajk(t,x) 0'

V(t, x) E [0, T) xIR n
~(t, x) = F(t, x) =I E (e-r r(s,X;,Z)ds f(X~X)) .
k=1
100 Option pricing and partial differential equations European option pricing and diffusions
101
Pr~of. Let us prove the equality u(t, x) = F(t, x) at time t = 0. By Proposition The operator At is now time independent and is equal to
5.1.5, we know that the process
(12 2 a a 2
- e-
Mt- f 0
r(s,X?,Z)ds u.(t , Xo,X)
t
A t = A b. =-x -+2 rx-
2 ax ax'
is a martingale. Therefore the relation E(Mo) = E(MT) yields It is straightforward to check that the call price given by F(t x) = xN(d ) _
K e-r(T-t) N(dl - (1vT _ t) with ' I

u(O,x) '= E (e- JoT r(s,X?'Z)dSU(T,X~'X)) log(x/ K) + (r + (12 /2)(T - t)

=
= E (e- JoT r(s,X?,Z)ds j(X~'X)) (1'1/'T - t

sinceu(T,x) = j(X). The proof runs similarly fort > 0. o

N(d) = 1.
--
V2i
I -00
d
e- X 2 /2dx
'

is solution of the equation

Remark 5.1.8 Obviously, Theorem 5.1.7 suggests the following method to price
au '. :
'{ at +Ab,u - ru ~ °
the option. In order to fompute
in [0, T]x ]0, +oo[
F(t,x) =E (e- J,T r(s,X:,Z)ds j(X~~)) , u(T, z) = (z - K)+, "Ix E]O, +00[.
for a given j, we just ~eed to find u such tha~ The same type of result holds for the put.
Note th~t th~ operato~ A b. doe~ not satisfy the ellipticity condition (5.6). How-
at + A,u _ ru ~ ° in_ [0, T]
au x JR"
(5.5)
ever, the tnck IS to consider the diffusion X, = log (St), which is solution of
{ u(T, x) = j(x), "Ix E IR n
. ex, = (r - ~2) dt.+ (1dWt , ,',
Problem (5.5) is a parabolic equation with afinal condition (as soon as the function
since S - S e(r-0'2/ 2)t+O'w, I . fini .
u(T,.) is given). t - ° .' ts m mtesimal generator can be written as
.-
(r _2
"
For the problem to be well defined, we need to work in a very specific function
~
2
space (see Raviart and Thomas (1983)). Then we can apply some theorems of Ab.-log = (12 a + (12)

existence and uniqueness, and if the solution u of (5.5) is smooth enough to satisfy ' .
2 ax 2 .
ax'
the assumptions of Proposition 5.1.4 we can conclude that F = u. Generally
speaking, we shall impose some regularity.assumptions on the parameters band
It is clearly elliptic because
We write
(12 > °and, moreover, it has constant coefficients.
(1 and the operator At will need to be elliptic, i.e.
- '(12 a2 + ( r ~ ~2) ax
= '"2 aX 'a - r. (5.7)
3C >0, V(t,x)'E [O,Tj x IR n
..
Ab.-Iog 2'

"1(6,.·., ~n) E IRn ~ aij(t, X)~i~j ~ C (t ~?) . (5.6)

The ~onnection b~tween the parabolIc problem asso~iatedtoAb8~log and the com-
putation of ~e pnce of an option in the Black-Scholes model can be highlighted
Q >=1
as follows:.lf we ~ant to compute the price F(t, x) at time t and for a spot price
x of an option paying off j (ST) at time T, we need to find a regular solution v of
5.1.3 Application to the Black-Scholes model

We are working under probability p ". The process (Wt)t::::o is a standard Brownian
:~ (~' x) +Ab.-1ogv(t, x) = ° in [0, TJ x IR

motion and the asset price S; satisfies

{ (5.8)
v(T, x) ,= j(e X
) , "Ix E IR, /
then F(t, z) = v(t, log(x)).
 Optionpricing and partial differential equations Solving parabolic equationsnumerically 103
102
is a bounded stopping time, because r" = T; 1\ T: 1\ T where
5.1.4
Dnrtial ditterentiai
r u. su:
equationson a boundedopen set and computationof
expectations trI = inf {O <- s <- T , Xt,x
s = I}
. u hout the rest of this section, we shall assume that there is only one asset and indeed T{ is a stopping time according to Proposition 3.3.6. By applying the
:°th:t b(x), u(x) and rex) are all time independent. rex) is the riskless rate and optional sampling theorem between 0 and r", we get E(Mo) = E(Mrx), thus by
A is the differential operator defined by . noticing that if s E [0, "X], Af(X~'X)= 0, it follows that
2
1 a f(x)
(Af)(x) = '2u(x)2aT + b(x)~,
af(x)
u(O,x) = E (e- s: ':(S'X~'X)dSu("X,X~~X))
We denote by A the discount operator such that Af(x)
Equation (5.5) becomes
= Af(x) - r(x)f(x).
E(1 {\lsE[t,Tj, X:,xEO}e
-J.T° r(s,X~,X)ds u (T , XO,X)) T

~~(t,~) + Au(t,x) = 0 on [O,T] x nt

(5.9) +E(1 {3sE[t,Tj,
-r r(s,X~,Z)ds ( XO,X))
X:,zllO}e °
z
x
u r>, r Z
•

{
u(T,x) = f(x), "Ix E nt. Furthermore, f(x) = u(T, x) and u(-rx , X~~X) = 0 on the event
, 9) 0 ] b[ as opposed to nt, we need to
If we want to solve problem (5. on a, . = th {3s E [t, T], X;,x It O} ;
consider boundary conditions at a and b. We are going to concentrat~on e ~~s~
when the function takes the value zero on the boundaries'.These are e so-ca e consequently
Dirichlet boundary conditions. The problem to be solved IS then
u(O,x) = E ( 1{\lsE[t,TJ, X:,xEO}e - J.T° r(s'.
Xo,Z)ds ° ,)
f(XT'X).
au (t x) + Au(t, z) = b on [0, T] x 0
at '
(5.10) That completes the proof for t = O.. o
u(t,a) = u(t,b) = 0 . "It S T
Remark 5.1.10 An option on the FT-measurable random variable
u(T,x) = f(x) "Ix E O.
, - J.T (X"Z)d . t X
As we are about to explain, a regular solution of (5.10) can a~so be expr~ssed in 1{\lsE[t,T], x:,xEo}e ,r • s f(Xi )

terms of the diffusion Xt,x which is the solution of (5.3) starting at x at orne. t.
is called extinguishable. Indeed, as soon as the asset price exits the open set 0, the
a
Theorem 5.1.9 Let u be C 1 ,2function withboundedderivativein x that satisfies option becomes worthless. In the Black-Scholes model, if 0 is of the form ]0, l[
equation (5.10). We then have ' or ]1, +oo[ weare able to compute explicit formulae for the option price (see Cox
- I,T r(X:,Z)ds f(Xt,X)) and Rubinstein (1985) and exercise 27 for the pricing of Down and Out options).
V(t,x) E [O,T] x 0, u(t,x) = E ( 1{\lsE[t,T],.x:,xEo}e T

Proof. We shaltprove the result for t ~ 0 s~nce the argument is simil~ ~ o~h:: 5.2 Solving parabolic equations numerically
, (
times There exists an extension of the function u from [0, T] x 0 to [.' ]
that is still of class C 1,2 . We shall continue to denote by u such an extension. From We saw under which conditions the option price coincided with the solution of the
partial differential equation (5.9); We now want to address the problem of solving
Proposition 5.1.4, we know that a PDE such as (5.9) numerically and we shall see how we can approximate its
- J.'r(XO,X)ds (t Xo,X) solution using the so-called finite difference method. This method is obviously
M« = eo' u, t
useless in the Black-Scholes model since we are able to derive a closed-form
f r(X~,X)dv + Au - ru) (s, X~,X)ds'
-
i°
t
e
-
°
(au
at
solution, but it proves to be useful when we are dealing with more general diffusion
models. We shall only state the most important results, but the reader can refer-
to Glowinsky, Lions and Tremolieres (1976) or Raviart and Thomas (1983) for a
is a martingale. Moreover
o x d o} or T if this set is empty detailed analysis.
"x = inf { 0 S s S T , X s'-'f'
104 Option pricing and partial differential equations
Solving parabolic equations numerically
5.2.1 Localisation 105
Thus

Problem (5.9) is set on ffi. In order to discretise, we will have to work on a lu(t, x) - UI(t, x)1 < MP (sUPt~s;5T [z + O'(Ws - Wt)1 2: I -lr'TI)
bounded open set VI =]- I, l[, where I is a constant to be chosen carefully
in order to optimise the' algorithm. We also need to specify the boundary con- = MP (suPO:5S~T_t Ix + O'Wsl 2: I -lr'T/)
ditions (i.e. at I and -I). Typically, we shall impose Dirichlet conditions (i.e,
= =
u(l) u( -I) 0 or some more relevant constants) or Neumann conditions (i.e. < MP (suPO:S;s:S;T Ix + O'Wsl 2: I -lr'T/) .
(8u/8x)(I), (8u/8x)( "':'l)). If we specify Dirichlet boundary conditions, the PDE
becomes
By Proposition 3.3.6we know that if we define T. = inf {s > 0 W - } th
8u(t x) - E(exp(-ATa )) = exp(-.J2>:la/). It infers that f~r any a> 0, a~d f~r:n~ ~ en
8; + Au(t, x) = 0 on [0,T] x VI
P (sup
s:S;T w, 2: a) = P (Ta ~ T) s e~TE (e-~To) _< e~T e -a.,;'2I .
u(t, I) = u(t, -I) = 0 if t E [0, T]
Minimising with respect to >. yields
u(T, x) = f(x) if x EVI.
P (sup
-sr
w, 2: a) ~ exp (_ a
T
2
) ,
'
We are going to show how we can estimate the error that we make if we restrict
our state space to VI. We shall work in a Black-Scholes environment and, thus, the and therefore
logarithm of the asset price solves the following stochastic differential equation
" P (SUP(x + O'Ws) 2: a) < exp ( ja - X I2)
dX t = (r - O' 2/2)dt + O'dWt. s:S;T - O'2T'
Since (- Ws) s~O is also a standard Brownian motion
We want to compute the price of an option whose payoff can be written as
f(ST) = f(Soe XT). We write f(x) = !(e). To simplify, we adopt Dirichlet
boundary conditions. We can prove in that case that the solution u of (5.9) and the
p (.~~(X +UW.) :5 -a)~p(:~~(-X - aW,) ~ a):5 exp (
solutions UI of (5.10) are smooth enough to be able to say that These two results imply that

P (:~~ Ix + O'Wsl 2: a) s exp ( _laO'~;12) + exp (

and and therefore ,

UI'(t,X) = E(1 {'v'sE[t,TJ, IX;,zl<l}e-r(T-t) f(X~X)) lu(t, x) - UI(t, x)1 II - Ir'TI- X12)
O' 2 T
where X;'x == xexp((r - O' 2/2)(s - t) + O'(Ws - Wt )). We assume that the + exp ( _II ~ I~;~+ X12)) .
function f (hence J) is bounded by a constant M and that r 2: O. Then, it is easy (5.1l)
to show that ' !his proves that for given t and x, liml--++ UI (t x) = u(t x) Th
IS iforrn i 00" • e convergence
even um orrn in t and :: as long as x remains in a compact set of ffi.
Remark 5.2.1
If we call r ' = r - 0'2/2 • :t can be proved ~h~t P(suPs:S;T Ws 2: a) = 2P(WT 2: a) (see Exercise 18
n Chapter 3). This would lead to a slightly better approximation than the one
{3s E [t,T], IX;,xl 2: I} C {sUPt:S;s:S;T Ix + r'(s -- t) + O'(Ws - Wt)1 2: I} above. "

C {sUPt:S;s;5T Ix + O'(Ws - Wdl 2: I - Ir'TI} , • The ~~damental advantage of the localisation method is that it can be used
for pncmg American options, and in that case the numerical approximation is
106 Option pricing and partial differential equations Solving parabolic equations numerically
107
compulsory. The estimate of the error will give us a hint to choose the domain of following matrix:
integration of the PDE. It is quite a crucial choice that determines how efficient
. our numerical procedure will be. (J 'Y 0 0 0
a (J 'Y 0 0
5.2.2 Thefinite difference method 0 a (J 'Y 0
Once the problem has been localised, we obtain the following system with Dirichlet
((A ij) is.s», iss-:«
h
)
0
boundary conditions: 0 0 a (J 'Y
0 0 0 a (J
ou(t, x) -
ot + Au(t, x) = 0 on [0, T] x 0,
where

(E) u(t" l) = u(t, -l)= 0 if t E [0, T]

a (J'2 1 ( (J'2)
u(T, x) = f(x) if x EO,. 2h 2 - 2h r - '2
The finite difference method is basically a discretisation in time and space of
(J'2
equation (E). (J = - h2 - r
We shall start by discretising the differential operator A on 0,. In order to do
this, a function (f(X))XEO, taking values in an infinite space will be associated ~

1 (
to a vector (fi)l<i<N ..We proceed as follows: we denote by (Xi) the sequence 'Y = (J'2
2h 2 + 2h . r -
(J'2)
'2 .
defined by Xi = - -l + 2il/(N + 1), for 0 ~ i ~ N + 1, each fi is somehow
an approximation of f(Xi)' We specify boundary conditions on fo, fN+! in the
Dirichlet case and fo, it, f N, f N +! in the Neumann case.
If we specify null Neumann conditions, it has the following form:
We consider h = 2l/(N + 1) and Uh = (UUl$i$N a vector in IR N . The
discretised version of the operator A is called Ah and the substitution runs as
(J+a 'Y 0 . 0 0
follows:
U i;+-1 _ U i - 1
a (J 'Y 0 0
with b(x.) h h 0 a (J 'Y 0
, 2h
(5.12)
and replace 0

with
I 0
0
0
0 0
a (J
a
'Y
(J+'Y

We obtain an operator Ah defined on IR N . This discretisation in space transforms (E) into an ordinary differential equation
(Eh ) :
Remark 5.2.2 In the Black-Scholes case (after the usual logarithmic change of
variables)
02u (X)
A
- b s - log
u (')
x =.' -(J'22 ---
ox 2
+ (r -
(J'2)
~
2
ou(x)
- - - ru x
ox
( )
'
if 0 stsT
is associated with u;.(T) = fh
- 2
(J'
(AhUh)i = 2h 2 (u~
+1 .
- 2ui.
. 1
+ u~- (
)+ r -
(J'2)
'2 1 (+1
2h u~
. . 1)
- u~-
.
- rui.. where!h = (f~h$i$N\ is the vector f~ = f(Xi)' ' .
W~ are now going to discretise this equation using the so-called O-schemes. We
If we specify null Dirichlet boundary conditions, Ah is then represented by the consIder 0 E [0,1], k a time-step such that T = Mk and, we approximate the
108 Option pricing and partial differential equations Solving parabolic equations numerically
109
solution Uh of (Eh) at time nk by Uh,k solution of • When 1/2 :::; 0 :::; 1, as h, k tend to a
U;;:k = fh
lim u~ = U in £2 ([0, T] x 01)
n decreasing, we solve for each n:
lim Ju~ = au/ax in £2 ([0,T] x 01).
(Eh,k) un+! _ un ;
. h,k -k h,k + OAhUh,k + (1 - O)AhU~:t1 = a • When a:::; 0 < 1/2, as h, k tend to 0, with lim k] h 2 = 0, we get
if a:::; n:::; M-1.
lim u~ =U in £2 ([0,T] x 01)

Remark 5.2.3 lim Ju~ = au/ax in £2 ([0, T] x 01)

• When 0 = a the scheme is explicit because Uh,k is computed directly from
Remark 5.2.5
u~tl. But when 0 >' 0, we have to solve at each step a system of the form
T~h,k = b, with
• In the case a :::; ~ < 1/2 we say that the scheme is conditionally conver ent
T= (I - OkAh) because the algonthm converges only if h, k and k/h 2 tend to 0 Th
.th her tri .
gl
. ese a go-
n ms are rat er tricky to Implement numerically and therefore they are rarely
{ b = (I + (1- '0) kA used except when 0 = O.
. h) U~:t1
where T is a tridiagonal matrix. This is obviously more complex and more time • In the ca~e 1/2 :::; 0 :::; 1 we say that the scheme is unconditionally convergent
consuming. However, these schemes are often used in practice because of their because It converges as soon as hand k tend to O. '
good convergence properties, as we shall seeshortly,
• When 0 = 1/2, the algorithm is called the Crank and Nicholson scheme. It is Finally, we shall examine in detail how we can solve problem (E) . all
At h ti . h,k numenc y.
often used to solve systems of type (E) when b = a and a is constant. eac time-step n we are looking for a solution of T X = G where -:
.'
• When 0 = 1, the scheme is said to be completely implicit. X = " Uh,k
We shall now state convergence results of the solution Uh,k of (Eh,k) towards : ..
u(t, x) the solution of (E), assuming the ellipticity condition. The reader ought to G (I + (-1 - O)kAh) un~i
h,k
refer to Raviart and Thomas (1983) for proofs. We denote by u~(t, x) the function
M N T = 1- kOAh.
L L(uh,k)i 1
n=1 i=1
jx . - h/ 2,x i+h / 2j x l](n-I)k,nkj.
T is a tridiagonal matrix. The following algorithm, known as the Gauss method
sol~es the system with a number of multiplications proportional to N. Denot:
We also call J¢ the approximate derivative defined by X - (xih~i~N, G = (gih'~i~N and

(J¢)(x) = h1 (¢(x + h/2) - ¢(x - h/2)). bi CI a a a

a2'" b2 C2 a a
Theorem 5.2.4 We assumethat b and a are Lipschitz and that r is a non-negative a b3
continuous function. Let us recall that Af(x) is equal to 1/2a(x)2(a 2f(x)/ax 2)+ T=
a3 C3 o
b(x)(af(x)/ax) - r(x)f(x). We assume that the operator A is elliptic a
- ' . I a a aN-I bN - I CN-I
(-Au, U)£2(O,) 2: f(lul£2(O,) + Iu 1£2(0,)) a\ a a aN bN
with e > O. Then:
The algorithm runs as follows: first, we transform T into a lower triangular matrix
 Option pricing and partial differential equations American options 111
110
(on a stock offering no dividend) is equal to the European call price. Nevertheless,
using the Gauss method from.bottom to top. there is no explicit formula for the put price and we require numerical methods.
Upward: The problem to be solved is a particular case of the following general problem:
= bN
b'rv given a good function I and a diffusion (X t )t>o in IR". solution of system (5.4),
g'rv= gN
For 1 ~ i ~ N - 1,
.
l
'.
decreasmg.
compute the function

~(t, x) = sup E (e - f r(s,X;,z)ds I (X;'X)) .

b'. = b, - Ciai+! /b~+1 rETt.T

g~i-- g.
I
- c·g'
11+
l/b'·+1
1 Noticethat ~(t, x) ~ I(x) and for t = T we obtain ~(T, x) = I(x).
. I tem T' X -
- G' Remark 5.3.1 It can be proved (see Chapter 2 for the analogy with discrete time
We have obtained an equiva en tsys , where
models and Chapter 4 foqhe Black-Scholes case) that the process
~ 0 0 ·00
e- Jot r(s,X.)ds~ (t,Xt}
1
a2 b~ 0 0 0
O a3 b'3 0 0
is the smallest martingale that dominates the process I(Xt} at all times.
T'=. o . ~ ., We just stressed the fact that the European option price is the solution of a parabolic
o 0 aN-I b'rv_1 ~ partial differential equation. As far as American options are concerned, we obtain
o 0 0 aN bN a similar result in terms of a parabolic system of differential inequalities. The
To conclude, we just have to compute X starting frorri the top of the matrix. following theorem, stated in rather loose terms (see Remark 5.3.3), tries to explain
that.
Downward: Theorem 5.3.2 Let us assume that u is a regular solution ofthe following system
XI =
gUb~ c
ofpartial differential inequalities:
For 2 ~ i ~N, i increasing
Xi = (g~ - aixi_I)/b~, au
. at + Atu - ru ~ 0, u ~ I in [0,T] x IRn
. e matrix T is not necessarily invertible. However,.we c~n prove
Remark5.2.6 Th. I 1+1.\ < Ibl WheneverTis.notmvertlble,the
th t it i s if for any l we have ai
a I I , .'
C, - ,. h k
k I the Black-Scholes case, it is easy to c ec (~~ + Atu - ru) (f - u) =0 in [0, T] x IRn
(5.13)
previous algonthm does not wor ..n. I _ 2/21 < a 2 /h, i.e. for
that T satisfies the preceding condition as soon as r a -
sufficiently small h. . u(T, x) = I(x) in IRn
Then
5.3 American options u(t,x) = ~(t,x) = sup E (e- J.T r(s,X;'~)ds I (X;'X)) .
rETt.T .
5.3.1 Statement of the problem Proof. We shall only sketch the proof of this result. For a detailed demonstration,
.
~e;l:~ts~c~~~;:~:l, :e
. notions in continuous time is not straightforward. In
obtained the foll.owin g form(ul)a
American call (f(x) = (x - K)-t) or an American put (f X - +
an ~or(;;~p~\ce)of
the reader ought to refer to Bensoussan and Lions (1978) (Chapter 3; Section 2)
and Jaillet, Lamberton and Lapeyre (1990) (Section 3). We only consider the case
t = 0 since the proof is, very similar for arbitrary t. Let us denote by Xt the
solution of (5.4) starting at x at time O. Proposition 5.1.3 shows that the process
Vt :;::: ~(t, St)
M; = e- J;'r(s,X;)dsu(t, Xn
where
~(t,x) = sup E
• ( -r(r-t)1 ( (r_<T 2/2)(r-t)+<T(WT- W
e xe .
tl )) -ior ' e- J; r(v,X;)dv (au
at
+ A u - ru)
s.
(s XX)ds
's
rETt,T .
is th
. t of 'T is a martingale. By applying the optional sampling theorem (3.3.4) to this martin-
• ( ) is a standard Brownian motion and !t,T IS e se ,
and, under P , ~t t~O • [ T] W howed how the American call pnce gale between times 0 and T, we get E(Mr) = E(Mo ), and since au/at + Asu-
stopping times taking values in t, . e s
 Option pricing and partial differential equations American options
112 id 113
If weconsl er¢(x) = (K -eX) h " "
ru s0 to the price of the American putis t e partial differential inequality corresponding
U(O, x) 2: E (e- JOT r(s,X;ldSU(T,x:)) .
av -
at (t, x) + Abs-1ogv(t, x) $ 0 a.e. in [0, T] xIR
We recall that U(t,x) 2: f(x), thus U(O,X) 2: E (e- J: r(s,X;ldsf(X n). This
v(t,x)2:¢(x) a.e.in [O,T]xIR
proves that
U(O, x) 2: sup E
rE70,T
(e-JOT r(s,X:lds f(X:))
.
= F(O, x).
(v~t, x) - ¢(x)) (:~ (t, x) + A:bs-Iogv(t, x)) = 0 a.e. in [0, T] x IR
Now, we define Topt = inf{O $ s $ T, u(s,X:) = f(X:)}; we can
show that Topt is a stopping time. Also, for s between 0 and Topt, we have veT, x) = ¢(x).
=
(au/at + Asu - ru) (s, x:) O.The optional sampling theorem yields /
The following theorem states the results o f existence
. .
and uniqueness of a(5.14)
solu-
U(O,x)=.E
_1. TOp' r(s,X:lds U(Topt,Xrop.)
X)
( e 0 .
Amencan put price.
~
tion to, this partial diirrerentiraI mequalttyand
. . establi h th "
IS es e connection With the
Because at time Topt. U(T~Pt, Xrxopt ) = f(XrXopt .), we can write
Theorem 5.3.4 The inequality (5 14) has a ' .
vet, x) such that its partial deriv~( . ~mq~e :ont~nuous bounded solution
U(O,x~ = E (e- JoTop, r(s,X;lds f(X:o~J) . a2v/ ax2 are locally bounded. More~:s I;h~ e dlls~nbutlO.n sense av / aX,av / at,
er, IS so ution satisfies
That proves that u(O,x) $ F(O, z}, and that u(O, x) = F(O,x). We even proved
that Topt is an optimal stopping time (i.e. the supremum is attained for T = Topt).
v(t,log(x)) = ~(t,x) = sup E* (e-r(r-tlf (xe(r-u2/2)(r-tl+U(WT-Wtl))
rET.,T .
o The proof of this theorem can be found in Jaillet , L am b erton and Lapeyre (1990),
Remark 5.3.3 The precise definition of system (5.13) is awkward because, even
2 Numerical solution to this inequality
for a regular function f, the solution U is generally not C . The proper method
consists in adopting a variational formulation of the problem (see Bensoussan and We are going to show how we can numericall I" .
Lions (1978». The proof that we have just sketched turns out to be tricky because the method is similar to the one us d i th E so ve inequality (5.14). Essentially,
we cannot apply the Ito formula to a solution of the previous inequality. problem to work in the interval O~ ~] _ ; l[uropean case, Fir~t, we localise the
conditions at ±l. Here is the inequalit ith N' Then, we must Impose boundary
y WI eumann boundary conditions
5.3.2 The American put in the Black-Scholes model
aVe -b
~at t,x)+As-1ogv(t,x)$0 a.e.in [0 ,T] X o.
We are leaving the general framework to concentrate on the pricing ofthe American
put in the Black-Scholes model.
We are working under the probability measure P* such that the process (Wt k~:o v (t, x) 2: ¢(x) . a.e. in [0, T] x Ot
J •
is a standard Brownian motion and the stock price St satisfies
dS t = St (rdt + O"dWt) . (A) , (V-¢)(:~(t,;r)+A:bS-IOgV(t,x)) =0 a.e. in [0, T] X o,
We saw in Section 5.1.3 how we can get an elliptic operator by introducing the
process veT, x) = ¢~x) ,
x, = log (St) = log (So) + (r - 0";) t + O"Wt· av
-a(t, ±l) = o.
X r
Its infinitesimal generator A is actually time-independent and

A .
0" -
-bs- Iog __ Abs-log - r __ - 2 2 (- 2) -a -
a + r - .-0" r.
We. can now dirscretiise inequality
, (A) using the fi 't diff
notations are the same as in Section 5 2 2 I
.
, m e I, eren~es method. The
2 ax 2 . 2 ax _ ' . . n particular, M IS the integer such that
 Option pricing and partial differential equations American options 115
114
Mk = T, Ih
,I,() where x • -- -I
is the vector given by I h = If' Xi
i + 2il/(N
. IRn+we
1) with
- . . (5 12) If U and v are two vectors m ,
and Ah represented by matrix . F'
IS 11 the method is the same as in the
. . < "f'vl < t < n Ui < Vi. onna y, .'
write U - case:
European V I
t he-d'iscre
- t'isa
' tion
I
in time leads to the finite dimensional inequality
(Ah,k):

C = _Ok(~+~(r_0-2))
2h 2 2h 2 '
and if 0 ~ n ~ M - 1
(AD) is a finite dimensional inequality. We know how to solve this type of
Uh,k ~ !h inequality both theoretically and numerically if the matrix T is coercive (i.e.
X.T X ~ aX.X, with a > 0). In our case, T will satisfy this assumption if
n+l _ unh,k + k (afhuh ,k + (1 - O)AhU~~I) ~0 2 2/h
uh,k ' Ir - 0- /21 ~ 0- and if Ir -
0- 2/21 k/2h < 1. Indeed, this condition implies
that a and c are negative and, therefore, by using the fact that (a + b)2 ~ 2 (a2 + b2)
- Uh. k'- + k (OAhUh,k
- + (1 .- 0 )A- hUh,k
n+l) ,Uh,k
n - I h) -- 0. we show that
( Un+!
h,k, . n n n-l

were
h
.
. ) is the scalar product in IR an d A- h IS
(x,y
'. . given
.
N by (5 . 12). If we note
.
x:Tx = L aXi-lxi + L bx~ + L CXiXi+! + ax~ + cx~
i=2 n
i=I i=1
> (a/2) L (xLI + xn
~2 .
x = Uh.k + E~=, bx~ + (c/2) E~:/ (x~ + x~+!) + ax~ + cx~

F = fh, Under the coercitivity assumption, we can prove that there exists a unique solution
to the problem (Ah,k) (see Exercise 28).
we have to solve, at each time n, the system of inequalities
The following theorem analyses explicitly the nature of the convergence of a
solution of(Ah,k) to the solution of (A). We note
TX~G
M N

(AD) X ~ F u~(t,x) = L L(uh,k)il]:Z:i-h/2,:Z:i+i/2] x l](n-l)k,~k]'

n=I i=1 . .
\ (T X - G, X - F) = 0, Theorem 5.3.5 Ifu is a solution of (A),
J. when 0 < 1, the convergence is conditional: if li and k converge to 0 and if
where T is the tridiagonal matrix " k/h 2 converges to 0 then

a+b C 0 0 0 lim u~ =U in L 2 ([0, T) x (1)

a b C -0 0 \ .
0 a b C 0 . au
lim aukh = -ax in L 2 ([0, T) x 01),
T=
0
0 0 a b C 2. when 0 = 1, the convergence is unconditional, i. e. the previous convergence is
0 0 0 '.' . a 'b + C true when hand k converge to 0 without restriction.
 American options 117
116 Option pricing and partial differential equations
The computation gives
The reader will find the proof of this result in Glowinsky, Lions and Tremolieres
(1976). See also XL Zhang (19 94).
Remark 5.3.6 In practice, we nonnally use () = 1 because the convergence is
unconditional. which is not a solution of (AD).
Remark 5.3.9 An implementation of the Brennan and Schwartz algorithm is
offered in Chapter 8.
Numerical solution ofa finite dimensional inequality
In the American put case, when the step h is sufficiently small, we can solve the
system (AD) very efficiently by modifying slightly the algorithm used to solve
ial method
5.3.3 American put p'ricing by a bitnomta
tridiagonal systems of equations. We shall proceed as follows (we denote by b the
vector (a + b, b, . . . ,b + e)) We shall now explain another numerical method th . .
American put in the Black-Scholes d 1 L at IS WIdely used to price the
mo e. et r a b be thre I b
Upward: at -1 < a < r < b Let (8) b the bi :' e rea num ers such
th
8 _ 8 'T' hen n n~O e e binornial model defined by S, - d
,b'tv ~ bN n+l -
P(T = n.L n, were (1', ) >
= =
1 + a) p
is a fI °-
(bn ::;:)O/(b _seq)uence 0 ID random variables such that
X an
g'tv = s«
~For 1 ~ i ~ N - 1, decreasing i Ch n 2 E a and P(Tn = 1 + b) - 1 p Wi .
as apter , xercise 4' that .the Am encan
. ' "In this model
put pnce - could
- . bee written
saw In
b~ = b, - ca/b~+l
g~ = gi - eg~+db~+l
Pn = Pam(n, $n), ' ,
'American' downward: and that the function Pam (n , x) cou ld be computed by induction. according to the
equation
Xl =
gUb~
For 2 ~ i ~ N, increasing i
Xi = (g~ - aXk-d/bi Pam(n, x) = max ( (K - x)+,
Xi = SUp(Xi, Ii)' PP(
om n + I, (1+ .)x) + (1 - p)Pom(n + I, (1 +b)X»)
Jaillet, Lamberton and ~apeyre (1990) prove that, under the previous assumptions,
l+r
this algorithm does compute a solution of inequality (AD). withthefinalconditionP (N x)'- ('K )+. (5.15)
in Chapter 1 Section 1 4 that ifth - . - X . On the other hand, we proved
Remark 5.3.7 'The algorithm is exactly the same as in the' European case, apart , . , e parameters are chosen as follows: '
from the step Xi = SUp(Xi, Ji). That makes it very effective. ' , r = RT/N
There exist other algorithms to solve inequalities in finite dimensions. Some
exact methods are described in Jaillet, Lamberton and Lapeyre (1990), some
iterative methods are exposed in Glowinsky, Lions and Tremolieres (1976), l+a = exp (-aVT/N)
, . (5.16)
Remark 5.3.8 When we plug in () =' 1 in (Ah,k), and we impose Neumann
boundary conditions, the previous algorithm is due to Brennan and Schwartz l+b = exp (+~VT/N)
(1977).
We must emphasise the fact that the previous algorithm only computes the exact
~ p = (b-r)/(b-a),

computed for a riskless rate equal to R d ppr~xl~ates the Black-Scholes price

solution of system (AD) if the assumptions stated above are satisfied. In particular, then the European option price in this model a . .
it works specifically for the American put. There exist some cases where the result that in order to price the Am . an avo atility equal to a. This suggests
computed by the previous algorithm is not the solution of (AD). The following Given di . . encan put, we shall proceed as follow
some iscrensanon parameter N we fix th I ..'
example should erase any doubts: (5.16) and we compute the price p N ( ) ' eva ues r, a, b,p according to
i < n b . d . am n,. at the nodes x(1 + a)n-'(1 + b)i 0 <

M~(~' T~} F~O)' a=O)

a - ,y ~n uction of (5,15). It seems quite natural to take pN ( ,-
pproxrmation of the American , Black -Sch 0 esipnce am 0, X)weascan
' P(O, x). Indeed, an
 Option pricing and partial differential equations Exercises 119
118 . if
. N 0 x) = P(O,x). This result is quite tricky to JUStI Y 1. We denote by u.(t, x) the price of the European put in the Black-Scholes
show that lim» -++<Xl Pam ( , d P , (1990» and we will not try to model. Derive the system of inequalities satisfied by v = u - u•.
(see Kushner (1977) and Lamberton an ages
2. We are going to approximate the solution v = u - u. of this inequality by
prove. it herthe. d i th called Cox-Ross-Rubinstein method and it is exposed in
ThIS me 0 IS e so- discretising it in time, using one time-step only. When we use a totally implicit
details in Cox and Rubinstein (1985). method, show that the approximation v(x) of v(O, x) satisfies
-vex) + T Absv(x) ::; 0 a.e. in ]0, +oo[
5.4 Exercises
. d b (X Y)thescalarproductoftwovectorsX = (xih~i~n v (t, x) ~ ¢(x) = (K - x)+ - u.(O,x) a.e. in ]0, +oo[
ExerCISe 28 We eno~e y , . X > Y means that for all i between 1 and .n,
and Y = (Yih9~n' The notaltI ~. ffin M satisfies (X M X) ~ a(X, X) with
Xi ~ Yi. We assume that for a l m, (v(x) - ¢(x)) ( -vex) + T AbSv(x)) =0 a.e. in ]0, +oof
a > O. We are going to study the system ~ (5.18)

:::G 3. Find the unique negative value for a such that vex) = x" is a solution of
-vex) + T Absv(x) = O.
4. We look for a continuous solution of (5.18) with a continuous derivative at x"

\ (Mi -G,X - F) =0.

1. Show that this is equivalent to find X ~ F such that
vex) =
{
>'xOt if x ~ x"

¢(x) otherwise.
(5.19)
., (5.17)
VV ~ F (M X - G, V ., X) ~ O.. Write down the equations satisfied by >. and a so that v is continuous with
continuous derivative at z" . Deduce that if v is continuously differentiable then
Prove the uniqueness of a solution of (5.17). . .
~:
z" is a solution of f(x) = x where
Show that if M is the identity matrix there exists a unique solution to (5.17).
K-u.(O,x)
'. .
4. Let p be positive: we denote by S p (X) the unique vector Y ~ F such.
that
f(x) = lalu~(O,x) + 1 + lal
VV > F (Y - X + p(M X - G), V - Y) ~ O.
and u~(t, x) = (au.(t, x)jax).
'Show that for sufficiently small p, Sp is a contraction. 5. Using the closed-form formula for u. (0, x) (see Chapter 4, equation 4.9), prove
5 Derive the existence of a solution to (5.17). . . that f(O) > 0, that f(K) < K (hint: use the convexity of the function u.) and
'. . to a roximate the Black-Scholes American ~ut pnce that f(x) - x is non-increasing. Conclude that there exists a unique solution to
Exercise 29 We arIel :I;~ is a ~~lution of the partial differential inequality the equation f(x) = x.
u(t,x). Let us reca a .1
6. Prove that vex) defined by (5.19) where x· is the solution of f(x) = x is a
aU(t,x)+AbBu(t,x).::;O a.e.in [O,T]x]O,+oo[ solution of (5.18).
at . . 7. Suggest an iterative algorithm (using a dichotomy argument) to compute x"
u (t, x) ~ (K - x)+ a.e. in [0, T] x ]0, +oo[ with an arbitrary accuracy.
8. From the previousresults, write an algorithm in Pascal to compute the
(U_(K_X)+).(~~(t,x)+AbSU(t,X)) =0 a.e.in [O,T]x]O,+oo[
American put price.
The algorithm that we have just studied is a marginally different version of
the MacMillan algorithm (see MacMillan (1986) and Barone-Adesi and Wha-
u(T, x) = (!< - x)+ ley (1987».

where'

"
 6

Interest rate models

, '

Interest rate models are mainly used to price and hedge bonds and bond options.
Hitherto, there has not been any reference model equivalent to the Black-Scholes
model for stock options. In this chapter, we will present the main features of
interest rate modelling (following essentially Artzner and Delbaen (1989», study
three particular models and see how they are used in practice.

6.1 Modelling principles

6.1.1 The yield curve

In most of the models that we have already studied, the interest rate was assumed
to be constant. In the real world, it is observed that the loan interest rate depends
both on the date t of the loan emission and on the date T of the end or 'maturity'
of the loan.
Someone borrowing one dollar at time t, until maturity T, will have to pay
back an amount F(t, T) at time T, which is equivalent to an average interest rate
R(t, T) given by the equality.
F(t, T) = e(T-t)R(t,T).
If we consider the future as certain, i.e. if we assume that all interest rates
(R(t, T))t<T are known, then, in an arbitrage-free world, the function F must
satisfy -

'TIt < u < s F(t, s) = F(t, u)F(u, s).

Indeed, it is easy to derive
\
arbitrage schemes when this equality does not hold.
From this relationship and the equality F(t, t) = I, it follows that, if F is smooth,
there exists a functio~r(t) such that

'TIt < T F(t, T) = exp (iT r(S)ds)

 122 Interest
, rate models Modelling principles
and consequently 123

R(t, T) 1
= -T·'
- t
iT
t
r(s)ds.
u E [0, T], the process (F(t, u))oStSu defined by

F(t, u) = e- fa' r(s)dsP(t, u)

. The function r(s) is interpreted as the instantaneous interest rate. is a martingale.
In an uncertain world, this rationale does not hold any more. At time t, the future
This hypothesis has some interesting conse
interest rates R( u, T) for T > u > t are not known. Nevertheless, intuitively, erty under P* leads to, using the equality p(~~~)e~ I;,deed, the martingale prop-
it makes sense to believe that there should be some relationships between the
different rates; the aim of the modelling is to determine them.
Essentially, the issue is to price bond options. We call 'zero-coupon bond' a . . ~(t,U) = E* (F(u,u)/Ft) = E* (e- fa"r(S)ds!Ft)
security paying 1 dollar at a maturity date T and we note P(t, T) the value of and, eliminating the discounting,
this security at time t. Obviously we have P(T, T) = 1 and in a world-where the
future is certain
P(t, T) = e- J.T r(s)ds. (6.1)
P(t,u) = E* (e- J."r(S)ds!;:,)
. . t· (6.2)
This equality, which could be compared to fo
P(t, u) only depend on the behaviour of th rmula (6.1), shows that the prices
6.1.2 Yield curvefor an uncertainfuture probability P*. The hypothesis w d he process (r(s))OSsST under the
e rna e on t e filtration (;:, ) . 11
express the density of the probabilit P* ith t 09ST a ows us to
For an uncertain future, one must think of the instantaneous rate in terms of a .
density, Y WI respect to P We denot b L hi
For any non-negative random . bl X .' e Y T t IS
random process: between times t and t + dt, it is possible to borrow at the rate
and, if X is Ft-measurable E* (X) _ v;(~~) ,w~ have E* (X) = E(X L T )
r(t) (in practice it corresponds to a short rate, for example the overnight rate). the random variable i; is th~ density P* t.' sedttIn g t; ~ E(LTIFt). Thus
;rt.
To make the modelling rigorous, we will consider a filtered probability space . . restncte to Ft WIth respect to P.
(n, F, P, (Fdo<t<T) and will assume that the filtration (Ft)O<t<T is the natural Proposition 6.1.1 There is an ada d (
t E [0, T],' ', . . pte process q(t ))OStST such'that, for all
filtration of a st;ndard Brownian motion (W t)09ST and that J:T- = F. As in the
models we previously studied, we introduce a so-called 'riskless' asset, whose
price at time t is given by i; = exp (it q(s)dWs- ~ i t q(S)2dS) a.s. (6.3)
S to -- e.f0 r(s)ds Proof. The process (L ) . .
filtration of the Brown:a~~~~~~ (;art) I~~a\~ relative to (:F.t), which is the natural
where (r(t))oStST is an adapted process satisfying JOT Ir(t)ldt < 00, almost that th . t t- 0 ows (cf. Section 4.2.3 of Chapter 4)
surely. It might seem strange that we should call such an asset riskless since its ere exists an adapted process (H ) . fvi rT
price is random; we will see later why this asset is less 'risky' than the others.
for all t E [0, T] t °StST sans ying Jo Hldt. < 00 a.s. and
The risky assets here are the zero-coupon bonds with maturity less or equal to the
horizon T. For each instant u ~ T, we define an adapted process (P(t, u))o<t<u, t; = Lo + i t HsdWs a.s.
satisfying P(u, u) = 1 giving the price of the zero-coupon bond with matu~ity u S' 0
In~e L T is a probability density, we have E(L ) _ _
as a function of time. equivalem to P we have L > 0 d T - 1 - L o and, forP" is
In Chapter 1, we have characterised the absence of arbitrage opportunities by t, To obtain the 'formula (6~~), we :p.sp'tynth m~~efgenera11Y P(L t > O} = 1 for any
the existence of an equivalent probability under which discounted asset prices . ( e 0 ormula to the log function To do
so, we need to chec.k that P "It E [0 T] L + r t H d W ) .
are martingales. The extension of this result to continuous-time models is rather f hi ~ ~ , , 0 Jo s s > 0 = 1 The proof
technical (cf. Harrison and Kreps (1979), Stricker (1990), Delbaen and Schacher- OtIS }act relies in a crucial way on the martin a . . .
of Exercise 30 Then the ItA ~ I' g le property and It IS the purpose
mayer (1994), Artzner and Delbaen (1989)), but we were able to check in Chapter . 0 tormu a yields
4, that such a probability exists in the Black-Scholes model. In the light of these
examples, the starting point of the modelling will be based upon the following 10g('L t)
.
= r L HsdWs"':' ~2 Jr £22. H 2ds
Jo
1
s s a.s.
hypothesis: o
which leads to equality (6.3) with q(t) = HtiL . s
(H) There is a probability P* equivalent to P, under which, for all real-valued t o
 Interest rate models Modelling principles 125
124
. >
Corollary 6.1.2 The price at time t of the zero-coupon bond of maturity u -
t
riskier. Furthermore, the term r(t) - arq(t) corresponds intuitively to the average
can be expressedas yield (i.e. in expectation) of the bond at time t (because increments of Brownian
motion have zero expectation) and the term -a;:q(t) is the difference between
P(t u) = E (exp (_jU r(s)ds + jU q(s)dWs - ~ jU q(S~2dS) \ Ft) . the average yield of the bond and the riskless rate, hence the interpretation of
, t t t (6.4) -q(t) as a 'risk premium'. Under probability P*, the process (TVt ) defined by
TVt = W t - f; q(s)ds is a standard Brownian motion (Girsanov theorem), and
P roo f . This follows immediately from Proposition
.
6.1.1 and fro.m the following
d able X' ' we have
formula which is easy to derive for any non-negative ran om van.. . ' dP(t, u) U -

E (XLTI F t ) (65)
P(t, u) = r(t)dt + at dWt. (6.7)
E· (XIFt ) = L . .
For this reason the probability P" is often called the 'risk neutral' probability.
t
o
6.1.3 Bond options
The following proposition gives lm ec~nomic interpretation of the process (q(t))
(cf. following Remark 6.1.4). ~ . U
To make things clearer, let us first consider a European option with maturity 0
't' 613 For'each maturity u there is an adapted process (at )o9~u on the zero-coupon bond with maturity equal to the horizon T. If it is a call with
P,roposl Ion . " '
strike price K, the value of the option at time 0 is obviously (P(O, T) - K)+ and
such that, on [0, uj,
it seems reasonable to hedge this call with a portfolio of riskless asset and zero-
dP(t, u) = (r(t) _ afq(t))dt + afdWt. (6.6) coupon bond with maturity T. A strategy is then defined by an adapted process
P(t, u) , ((HP, H t) )O~t~T with values in rn?, Hp representing the quantity of riskless asset
and H, the number of bonds with maturity T held in the portfolio at time t. The
Proof. Since the process (F(t, u))o9~u is a martingale under P~, (F()t u)L~09~U
is a martingale under P (see Exercise 31). Moreo~er~ we have: P(t, U .t. > 6 ~.si' L value of the portfolio at time t is given by

f uj Then , using the same rationaleUas In the proof ofPr?po~ltI2on ->: ' = HPSp + HtP(t, T) = Hpefo' r(s)ds + HtP(t, T)
or aII t E [0, . h h t t ( OU) dt < 00 Vi
we see that there exists an adapted process (Ot )o~t~u SUC t a Jo t
and the self-financing condition is written, as in Chapterd, as
Ie'(O~·)2ds
and .
F(t, u)Lt = P(O,u)e Ie'oO"dW._l
_
' . 2 0 • . dVi = HPdS~ + HtdP(t, T).
Hence, using the explicit expression of L; and getting rid of the discounting factor Taking into account Proposition 6.1.3, we impose the following integrability con-
T T
ditions: fo IHpr(t)ldt < 00 and fo (H ta;:)2dt < 00 a.s. As in Chapter 4, we
P(t, u) P(O,u) exp (it r(s)ds + fat (O~ - q(s))d~s define admissible strategies in the following manner:
Definition 6.1.5 A strategy ¢ = ((HP,Ht))o~t~T is admissible if it is self-
_~ it ((O~)2 - q(S)2)dS). financing and ifthe discounted value Vi (¢) = Hp + H, F( t, T) ofthe correspond-
ing portfolio is, for all t, non-negative and if SUPtE[O,Tj Vi is square-integrable
Applying the Ito fo~ula with the exponential fun~tion, we get underP*. .

dP(t,u) = r(t)dt + (Of - q(t))dWt - ~((Of)2 - ~(t)2)dt The following proposition shows that under some assumptions, it is possible to
hedge all European options with maturity 0 < T.
P(t,u)
Proposition 6.1.6 We assume sUPO<t<T Ir(t)1 < 00 a.s. and o'[ 1:- 0 a.s. for
+~(Of - q(t))2dt all t E [0,8]. Let 0 < T and let h be-an Focmeasurable random variable such
,2
= (r(t) + q(t)2 - Ofq(t))dt + (Of - q(t))dWt, thathe - .C r(s),~s is s~uare-integrabl~ under p •. Then there exists an admissible
which gives the equality (6.6) with ar = Or - q(t).
o strategy whose value at time 0 is equal to h. The value at time t ~ 0 of such a
strategy is given by 1

R emark 6.. 14 Th e formula (6.6) is to be related with the equality dS? = r(t)S?dt,
. . dW hi h akes the bond
Vi = E* (e- f r(S)dshl Ft) .
satisfied by the so-called riskless asset. It is the term In t w IC m
 Interest rate models Some classical models 127
126
Proof. The method is the same as in Chapter 4. We first observe that if Vi is 6.2 Some classical models
the (discounted) value at time t of an admissible strategy ((HP, H t) )O<t<T, we
obtain, using the self-financing condition, the integration by parts forffili"la and ~~u;t:~n~n~;)e:~~r(~h~ ~how t?at i~ order to calculate the price of bonds, we
Remark 6.1.4 (cf. equation (6.7)) pair (r(t), q(t)) under P. ri:a:::~~sm~d;l~t~under P*, or the d.ynamics of the
dynamics of ret) under P by a diffusi e are about to examme describe the
= HtdP(t, T)
dVt q(t~ should have to get a similar e~u~~~~nu~~~:~~ and determ~ne the form that
= n.i«, T)aT dWt . options depend explicitly on 'risk parameters' which The~.~e p~lces o~ bonds and
advantage of the Heath-Jarrow Mort d 1 . are I cu t to estimate. One
We deduce, bearing in mind that SUPtE[O,TJ Vi is square-integrable under P*, that - on mo e which w '11 lai .
paragraph 6.2.3, is to provide formulae that oniy dep d e ~~ exp am bnefly in
(Vi) is a martingale under P*. Thus we have dynamics of interest rates under P. en on e parameters of the

'It 5, 8 Vi = E* ( Vol F t )
6.2.1 The Vasicek model
and, if we impose the condition Vo = h, we get
In this model, we assume that the process ret) satisfies
~= e I; r(s)ds E* (e - I: r(s)ds hlFt) .
. dr(t) = a (b - ret)). dt + adWt . (6.8)
To complete the proof, it is sufficient to find an admissible strategy having the where a, b, a are non-negative t Wi .
same value at any time. To do so, one proves that there exists a process (Jt)o<t<o a const~nt q(t) = _.\, with EC;.s ;::~: e also assume that the process q(t) is
x
o - -
such that Io Jt < 00, a.s, and
* dr(t~ = a (b* - ret)) dt + adWt (6.9)

he- I: r(s)ds = .E* (he- I: r(S)ds) + 1Jsd~s.

0
where b =
b - .\a 1a and W - W .\ .
according to this model let us -g'i t + t. Before calculating the price of bonds
set .' ve some consequences of equation (6.8). If we
Note that this property is not a trivial consequence of the theorem of representation
of martingales because we do not know whether he-I: r(s)ds is in the a-algebra X, = ret) - b,
generated by the Wt's, t 5, 8 (we only know it is in the a-algebra Fo which can we see that (Xt ) is a soluti~n of the stochastic differential equation
be bigger (see Exercise 32 for this particular point). Once this property is proved,
dX t = -aXtdt + adWt.
it is sufficient to set
which means that (X) . 0 .
3.5.2). We deduce th;t rl(t):anr~:t:~~~~l:~beckprocess (cf. Chapter 3, Section
9
Ht ->: _
Jt T an d H tO-- E* (h e- 1.
0
r(S)ds\:F.)
t - i:-
T
pet, T)a t . at
for t 5, 8. We check easily that ((HP,Ht))o<t<o defines an admissible strat-
egy (the hypothesis sUPO<t<T Ir(t)1 < 00 a~s.-guarantees that the condition
ret) = r(O)e- at + b (1- e- at) ~ ae-at it ·asdWt
e: (6.10)

~(~ ~at~i~)) fOl~OWS ~ normal law w~ose mean is given by E(r(t))

° = r(O)e- at +
I~ Ir(s)H~lds < 00 holds) ;hose value at time 8 is indeed equal to h. 0
e an variance by Var(r(t)) - a2/2 (1 -2at)
P(r(t) < 0) > 0, which is not very satisfacto ; - e It f~llows thatr
Remark 6.1.7 We have not investigated the uniqueness of the probability P* and (unless this probability is always very small) Nry r~m a practical point ?f vi.ew
it is not clear that the risk process (q(t)) is defined without ambiguity. Actually, it r~t) converges in .law to a Gaussian random'
a 12a.
v:i~blea~i;h:
to
t tebnds d
ean an variance
m~mty,
can be shown (cf. Artzner arid Delbaen (1989)) that P* is the unique probability
,. I
equivalent to P under which (p(t, T))O<t<T is a martingale if and only if the
. To calculate the price of zero c b d
process (an satisfies aT:f:. 0, dtdP almOsteverywhere. This condition, slightly and we use equation (6.9). Fro~ e~:~i~y ~;2~: we proceed under probability P*
weaker than the hypothesis of Proposition 6.1.6, is exactly what is needed to hedge
options with bonds of maturity T, which is not surprising when one keeps in mind
P(t,T) = E*(e-J.Tr(S)d~IFt)
the characterisation of complete markets we gave in Chapter 1.
 Interest rate models Some classical models
128 .t29
= e-b·(T-t)E* (e- r x;dsl Ft) (6.11) and in equality (6.14), we get
9
, X*t -- r (t) - b". Since (X*)
where t is a solution of the diffusion equation with Var ( r
Jo
X"'dS) = 0"2B _ 0"2 (1 _ e- a9) _ z: (1 _ e-a9)2 .
s a2 a3 2a3
coefficients independent of time '
Going back to equations (6.11) and (6.13), we obtain the following formula
dXt = -aXtdt + O"dWt, (6.12)
pet, T) = exp [-(T - t)R(T - t, r(t))],
we can write
where R(T - t, ret)), which can be seen as the average interest rate on the period
T [t,T], is given by the formula
E* (e- ftX;dS\ Ft) = F(T - t,X;) = F(T - t,r(t) - b*) (6.13)

s R(B,r)=Roo- alB [(R oo - r ) (I - e- a9)_::2 (l_e- a9)2]

where F is the function defi~ed by F(B, x ) = E* ( e - fo X:dS) , (X"')
t
being the
with Roo = lim9~oo R(B, r) = b" - 0"2/(2a2). The yield Roo can be interpreted
.
unique . 0 f equaU' on (6 . 12) which satisfies X
solution o= x (cf. Chapter 3, Remark as a long-term rate; note that it does not depend on the 'instantaneous spot rate' r.
3.5.11). ) letel We kn ow (cf, Chapter 3) that This last property is considered as an imperfection of the model by practitioners.
It is possible to calculate F(B, x compe y. 9 '"
h (X"') is Gaussian with continuous paths. It follow.s that fo X s ds Remark 6.2.1 In practice, parameters must be estimated and a value for r must
~ e pro::~ random variable
since the integra! is the limit of Riemann sums fof be chosen. For r we will choose a short rate (for example, the overnight rate); then
IS a n~ ts
Gaussian componen. Thus'
, from the expression of the Laplace transform 0 a we will fit the parameters b, a, 0" by statistical methods to the historical data of
the instantaneous rate. Finally .x will be determined from market data by inverting

GaUSSian(,
E* e o '
-r X~dS) ( E*
= exp -
(1 9
X"'dS)
s
+ ~Var (1
2
9
0 ~
X:dS)).
.
the Vasicek formula. What practitioners really do is to determine the parameters,
including r, by fitting the Vasicek formula on market data.
o Remark 6.2.2 In the Vasicek model, the pricing of bond options is easy because
of the Gaussian property of the Ornstein-Uhlenbek process (cf. Exercise 33).
From equality E* (X:) = xe- as ~ we deduce
E*
(
1X:d~
9 ' ) , 1 e- a9
= x - a 6.2.2 The Cox-Ingersoll-Ross model

Cox; Ingersoll and Ross (1985) suggest modelling the behaviour of the instanta-
For the calculation of the variance, we write neous rate by the following equation:

Var (I,' X:d') = (I,' X:d'.[ X:dS)

COY
dr(t) +
= (a - br(t))dt a~dWt (6.15)
with 0" and a non-negative, s e JR., and the process (q(t)) being equal to q(t) =
= 11 Cov(Xf,X~)dudt..
9 9
(6.14)
-aVT(t), with a E JR.. Note that we cannot apply the theorem of existence and
uniqueness that we gave in' Chapter 3 because the square root function is only
defined on JR.+ and is not Lipschitz. However, from the HOlder property of the
· ' X'"t -- xe:"
S!nce + O"e- at)0ft easdW s, we have square root function, one can show the following result,
Theorem 6.~.3 We suppose that (Wt ) is a standard Brownian motion defined on
Cov(Xf,X~)
= ~2e~a(t+U)E* (it easdWslu easdWs) , [0,00[. For any real number x 2: 0, there is a unique continuous, adapted process

= 0"2 e-a(t+ u)
. 1 t l\ u .
e2asds
=
(X t ), taking values in'JR.+, satisfying X o x and

~ dXt,= (a -' bXd dt + O"~dWt on [0,00[. (6.16)

o
2 -a(t+u) ( e 2a(tI\U) - ~
1) For a proof of this result, the reader is referred to Ikeda and Watanabe (1981), p.
= 0" e 2a 221. To be able to study the Cox-Ingersoll-Ross model, we give some properties
 .:="

Interest rate models Some classical models 131

130 . x h
of this equation. We denote by (Xt) the solution of (6.16) starting at x and TO t e is a martingale and the equality E(MT) = M o leads to (6.17). If F can be written
as F(t, x) = e-aq,(t)-xt/J(t) , the equations above become ¢(O) = 0, 'lj;(0) = Aand
stopping time defined by
T~ = inf{t ~ 0IX: = O} -'lj;'(t)

0 = 00. {
with, as usual, inf ¢'(t) = 'lj;(t).
Proposition 6.2.4
Solving these two differential equations gives the desired expressions for ¢ and
I If a > a 2/2, we have P(T~ = 00) = 1, for all x> O. 'lj;. 0
- a < a 2/2 and b ~ 0, we have P( TOx < 00) -- 1, for all x > O.
2. If 0 <
3: If 0 ~ a < a 2/2 and b < 0, we have Ph) < 00) E ]0, 1[,jor all x> O. When applying Proposition 6.2.5 with JL = 0, we obtain the Laplace transform of
Thi oposition is proved in Exercise 34. . .' f Xi
IS p r . .. hich enables us to characterise the JOint law 0
The following proposition, w . d I 2

(x x ft XXdS) is the key to any pricing within the Cox-Ingersoll-Ross mo e . E (e->'X;) = ( b ) 2a/u ( Abe- bt )
t 'Jo s ' a 2/2A(1 - e- bt) + b exp -x a2 /2A(1 _ e-bt) + b
Proposition 6.2.5 Forany non-negative A and JL. we have
= 1 exp ( AL()
., E (e->'X; e -I' J: X;dS) = exp (-a¢>',I'(t)) exp (-X1p>-,1' (t)) (2AL + 1)2a/u 2
2AL + 1
2/4b
where thefunctions·¢~,1' and 'lj;>',1' are given by
with L = a (1 - e- ) and ( = 4xb/(a 2 (e bt - 1)). With these notations,
bt

the Laplace transform of Xi / L is given by the function 94a/u2,(, where 96,( is

defined by
2 ( 2,e¥ )
¢>',I'(t) = - a2 log a2~(e1't _ 1) + "! - b + e1'tCT-+ b)
96,((A) = (2A +11)6/2 exp ( - 2AA~ 1) .
and , ACT + b + e1' tCT - b)) + 2JL (e1't - 1) This function is the Laplace transform of the non-central chi-square law with 8
'lj;>',I'(t) = a2A (e1't _ 1) + i: b + e1'tCT + b) degrees of freedom and parameter ( (see Exercise 35 for this matter). The density
of this law is given by the function [s.c. defined by .
2 2JL. . )
with, = Jb + 2a . .
-aq,(t)-xt/J(t) is due to the
Proof The fact that this expectation can be written as e .
• .. (XX) I tive to the parameter a an
d th . iti I
e uu a
I
J6,( () - e
-(/2
x - 2(6/4-1/2 e -x/2 x 6/4-1/2I6/2-1 V zt, (r::;() lor x > 0 ,
l'

additivity property of the process t re a d y, (1990)) If

condition x (cf. Ikeda and Watanabe (l?81) , p. 225, ~evuz an or .,
where Iv is the first-order modified Bessel function with index u, defined by
for A and JL fixed, we consider the function F(t, x) defined by

F(t,x):= E (e->.X;e-I'_J: X;dS) , (6.17) Iv(x) =

~
(~)v
2
f:
n=O
(x/2)2n
n!r(v + n + 1) .
it is n~tural t~ look for F as a soiution of the problem The reader can find many properties of Bessel functions and some approxima-
2 a 2F . aF . tions of distribution functions of non-central chi-squared laws in Abramowitz and
aF
_ ='~x-2 + (a - bx)- - JLxF Stegun (1970)rChapters 9 and 26.
. at. Q . ax ax Let us go back to the Cox-Ingersoll-Ross model. From the hypothesis on the
{ ., ->.x processes (r(t)) and (q'(t)), we get
v F(O,x)=e .
Indeed, if F satisfies these equations and has bounded derivatives, the Ito formula .dr(t) '= (a - (b + aa)r(t)) dt + av0'ijdWt,
shows that, for any T, the process (Mt)o9~T, defined by .r
where, under probability P", the process (Wt)O<t<T is a standard Brownian
, XT.ds
Mt.='e -I' 1. ~ F(T - 0
x
t, X t ) motion. The price of a zero-coupon bond with m'at~rity T is then given, at time 0,
 Interest rate modeLs Some classicaL modeLs 133
132
denoting by PI and P 2 the probabilities whose densities relative to P" are given
by: respectively by

P(O,T)
__ E. (e- JOT r(S)dS)
dP l _ e- J
0
9
r(s)ds P(O,T) dP 2 e - J.9 r(s)ds
0
and
_a<!>(T)-r(O).p(T) (6.18) dP· - P(O,T) dP· P(O,O) .
e
We prove (cf. Exercise 36) that, if we set
where the functions ¢ and 'ljJ are given by the following formulae
a2 (e"Y· o - 1)
th.+ b . ) )
2 2'Y· e ........,.- £1 = 2'" 'Y. (e"Y· + 1) + (a 2 'ljJ (T - 0) + b·) (e"Y· o - 1)
o
¢(t) = - a 2 log ( 'Y. _ b. + e"Y·tb· + e-)
and
a2 (e"Y· o -1)
and £2 - - -..,.---=--'-..,.----',-----,:----:-
- 2 'Y. (e"Y· o + 1) + b: (e"Y· o - 1)'
. 2(e"Y· t - l )
.'ljJ(t) ,= 'Y. _ b· + e"Y·tb· + b·) the law of r(O) / £1 under PI (resp. r(O) / £2 under Ps) is a non-central chi-squared
law with 4a/a 2 degrees of freedom and parameter equal to (I (resp. (2), with
. = b + atx and 'Y • -- J(b·)2 + 2a 2. The price at time t is given by
with b" , 8r(Oh· 2e"Y· O . .
(1 = a2 (e"Y·O - 1) b·(e"Y· o + 1) + (a 2'ljJ (T - 0) + b·)(e"Y· o - 1))
P(t, T) = exp (-a¢(T - t) - r(t)'ljJ(T - t)) . and
Let us now price a European call with maturity 0 and exercise pr~ce K, on a ~e~o­ 8r(Oh· 2e"Y· O
coupon bond with maturity ~. We .can sho~ that the hypothesIs of Proposition (2 = a2 (e"Y·O - 1) b·(e"Y· o + 1) + b·(e"Y· o - 1)) .
6.1.6 holds; the call price at time °ISthus given by 0 With these notations, introducing the distribution function Fo,( of the non-central
chi-squared law with fJ degrees of freedom and parameter (, we have consequently
Co = E· [e-J09r(s)ds (P(O,~) - K)+] ,
Co = P(O,T)F4a/u 2 ' ( 1 (~:) - K P(O,O)F4a/u 2 ' ( 2 (~:) .
• [ _J.9 r(s)ds ( e _a<!>(T_O)-r(O).p(T-O) _ K) ] 0

=Eeo . +

= E. (e- J: r(S)dS p(O,T)1{r(O)<r.})

6.2.3 Other modeLs

_ KE· (e- J: r(S)dS 1{r(o)<r.}) The main drawback of the Vasicek model and the Cox-Ingersoll-Ross model lies
in the fact that prices are explicit functions of the instantaneous 'spot' interest
rate so that these models are unable to take the whole yield curve observed on the
where r" is defined by market into account in the price, structure.
a¢(T - 0) + log(K) Some authors have resorted to a two-dimensional analysis to improve the models
r" =- 'ljJ(T _ 0) in terms of discrepancies between short and long rates, cf. Brennan and Schwartz
(1979), Schaefer and Schwartz (1984) and Courtadon (1982). These more complex
.
Notice that
- t r(s)ds
E. ( e o,
P(O T)) = P(O, T) , from the martingale
,
property models do not lead' to explicit formulae and require the solution of partial differ-
ential equations.
.
More
\
recently, Ho and Lee (1986) have proposed a discrete-time
. • (e - J.9 r(S)ds) _
,

P(O 0) We can then write .model describing the behaviour of the whole yield curve. The continuous-time
of discounted prices. Similarly, E 0 - , .
model we present now is based on the same' idea and has been introduced by
the price of the option as Heath, Jarrow and Morton (1987) and Morton (1989).
First of all we define the forward interest rates f (t, s), for t ::; s, characterised
Co = P(O, T)pI (r(O) < r·) - K P(O,O)P2 (r(O) < r·) ,
134
Interest rate models Some classicalmodels 135
by the following equality: and by the Ito formula

P(t,u) = exp (-l U

f(t,S)dS) (6.19)
dP(t, u)
pet, u)
1
ex, + "2d(X, x),

for any maturity u. So f(t, s) represents the instantaneous interest rate at time s
as 'anticipated' by the market at time t. For each u, the process (J(t,u))o~t~u
~ (f(" t) - ( [ Q(",)d,) + ~ ( [ U(f(",))d,)}t
must then be an adapted process and it is natural to set f(t, t) = ret). Moreover,
-(l a(J(t, S))dS) dWt .
U

we constrain the map (t, s) H f(t, s), defined for t ~ s, to be continuous. Then
the next step of the modelling consists in assuming that, for each maturity u, the
process (J(t, u))o~t~u satisfies an equation of the following form: If the hypothesis (H) holds, we must have, from Proposition 6.1.3 and equality
f(t, t) = ret),

f(t, u) = f(O, u) + ,ita(v, u)dv + it a(J(v, u))dWv, (6.20)

arq(t) = (lU a(t,S)dS) - ~(lU a(J(t,S))ds}2,
the process (a(t, u))o9~u being adapted, the map (t, u) H a(t, u) being contin- U

uous and a being a continuous map from IR into IR (a could depend on time as
well, cf. Morton (1989». l u

a(t, s)ds = ~ (l
U
with ar =. :- (ft a(J(t, s))ds). Whence

a(J(t, S))dS) 2 - q(t) l u

a(J(t, s'))ds
Then we have to make sure that this model is compatible with the hypothesis
(H). This gives some conditions on the coefficients a and a of the model. To find and, differentiating with respect to u,
them, we derive the differential dP(t, u)/ pet, u) and we compare it to equation
(6.6).LetussetXt = - f U f(t,s)ds. WehaveP(t,u) = eX. and,fromequation
(6.20),
t a(t,u) = a(J(t,u')) (l 'a (J (t , s))ds - q(t)) .
U

X; = l u
(- f (s, S) + f (s, s) - f (t , s)) dS
Equation (6.20) becomes, if written in differential form,

df(t, u) = a(J(t, u)) (l a(J(t, S))dS) dt + a'(J(t, u)) dWt.

U

(6.22)
-l + l {is
u
f(s, s)ds
u

a(v, S)dV) ds
The following theorem, by Heath, Jarrow and Morton (1987), gives some sufficient

+ l (is
u conditions such that equation (6.22) has a unique solution. I

a(J(v, S))dWv) ds Theorem 6.2.6 If the.function a is Lipschitz and bounded, for any continuous

= -l + l (l
u u U junction ¢ from [0, T] to IR+ thereexists a uniquecontinuous processwithtwo in-
f(s,s)ds a(v:S)dS}dV dices (J(t, u))O~t~u~T suchthat,forall u, theprocess (J(t, u))o<t<u is adapted
and satisfies (6.22), with f(O, u) = ¢(u). - - ,
+l
u

(lua(J(v, S))dS) dW v We see that, fo~ any continuous process (q(t)), it is then possible to build a model
of the form (6.20): take a solution of (6.22) and set .

+ it
t
(l
U

~a(t, u) = a(J(t, u)) (l

U
= Xo f(S,s)dS-i a(V,S)dS}diJ' a(J(t, s))ds - q(t)) .

-i~' (t a(J(v, s))dS) dWv ~

U

(6.21) The striking feature of this model is that the law of forward rates under P" only
depends on t~e function zr. This" is a consequence of equation (6.22), in which
The fact that the integrals commute in equation (6.21) is justified in Exercise 37. only a a~d (Wd appear. It follows that the price of the options only depends on
the function d. This situation is similar to Black-Scholes'. The case where a is a
We then have 0

constant is covered in Exercise 38. Note that the boundedness condition on a is

ex, = (f(t,t) -1~ a(t,S)dS) dt - (l U

a(J(t,S))dS) dW t
essential since, for a(x) = x, there is nQ solution (cf. Heath, Jarrow and Morton
(1987) and Morton (1989».
 Exercises 137
136 Interest rate models
4. Using the previous question, show that under the probabilities whose densities
Notes: To price options on bonds with coupons, the reader is referred to Jamshidian
(1989) and EI Karoui and Rochet (1989). are respectively exp ( - J; r(s)ds) / P(O, ()) andexp ( - JoT r(s)ds) / P(O, T)
with respect to P *, the random variable r( ()) is normal. Deduce an expression
for the price of the option in the form Co = P(O, T)PI - K P(O, ())P2' for some
6.3 Exercises parameters PI and P2 to be calculated.
Exercise'30 Let (Mt)O~t~T be a continuous martingale such that, for any t E
Exercise 34 The aim of this exercise is to prove Proposition 6.2.4. For x, M > 0,
[0, T], P(Mt > 0) = 1. We set
= (inf{t E [O,T] I M, = O}) AT.
we note TM the stopping time defined by TM = inf{t 2: I Xi = M}.°
T 1. Let s be the function defined on ]0,oo[ by
1. Show that T is a stopping time.
s(x) = jX e2by/u2 y-2a/u 2dy.
2. Using the optional sampling theorem, show that E (MT) = E (MT1{T=T}).
Deduce that P ({\it E [O"T] M, > O}) = 1. Prove that s satisfies
Exercise 31 Let (n, F, (Ft)o9~T, P) be a filtered space and let Q be a prob- /72 ~s ds
ability measure absolutely continuous with respect to P. We denote by L, the - x -2
2 dx
+ (a - bx)-
dx
= 0.
density of the restriction of Qto Ft. Let (~t)09~T ~e an adapted process. Show
that (Mt)09~T is a martingale under Q If and only If the process (LtMt)o~t~T 2. For e < x < M, we set T:'M = T: A TM. Show that, for any t > 0, we have
is a martingale under P.
Exercise 32 The notations are those of Section 6.1.3. L~t (Mt)O~t~T be a proce~s
adapted to the filtration (Ft ) . We suppose that (Mt ) IS a martingale under P .
Using Exercise 31, show that there exists an adapted process (Ht)o9~T such that Deduce, taking the variance on both sides and using the fact that s' is bounded
J;{ Hldt < 00 a.s. and from below on the interval [e, M], that E (T:'M) < 00, which implies that T:,M
is finite a.s.

3. Show that if e < x <M, s(x) = s(e)P (T: < TM) + s(M)P (T: > TM)'
4. We assume a 2: /72/2. Then prove that limx-..+~ s(x) = -00. Deduce that
for all t
E~ercise 33
E [0, T].
We would like to price, at time 0, a call with mat~rity () and strike
°
P (TO < TM) = for all M > 0, then that P (TO < 00) = 0.

price K on a zero-coupon bond with maturity T > (), in the Vasicek model.
5. °
We now assume that ~ a < /72/2 and we set s(O) == limx-..+o s(x). Show
that, for all M > x, we have s(x) = s(O)P (TO < TM) + s(M)P (TO> T
1. Show that the hypothesis of Proposition 6.1.6 does hold. and complete the proof of Proposition 6.2.4.
M)
2. Show the option is exercised if and only if r( ()) < r" , where Exercise 35 Let d be an integer and let Xl, X 2 , .•. , X d , d be independent
a(T - ()) ) _ /72 (1 - e-a(T-II)) Gaussian random variables with unit variance and respective means mI, m2,
r* Roo ( 1 - 1 _ e-a(T II) . , 4a2 . ... , md· Show that the random variable X = E~=I Xl follows a non-central
chi-squared law with d degrees of freedom and parameter ( =
E~=I m~.
-log(K) (1 _e~a(T-II) ) .
Exercise 36 Using Proposition 6.2.5, derive, for the Cox-Ingersoll-Ross model,
the law of r(()) u.i'der the probabilities PI and P 2 introduced at the end of Section
3. Let (X, Y) be a Gaussian ~~ctor with values in .IR? tinde~ha probabtiltity:':~ 6.2.2. '
let P be a probability measure absolutely contmuous WIt respec 0 ,
density Exercise 37 Let (n, F, (Ft)O<t<T, P) be a filteredspace and let (Wt)O<t<T
dP ' e->'x be a standard Brownian motion-with respect to (Ft ) . We consider a process
dP = E (e->'x)" 'with two indices (H(t,s))O~t,s~T satisfying the following properties: for any w,
I
the map (t, s) t-t H(t, s)(w) is continuous and for any s E [0, T], the process
Show that, under P, Y is normal and give its mean and variance.
 Interest rate models Exercises
138 139
(H (t, s) )O$t~T is adapted. We would like to justify the equality where N is the standard normal distribution function and
d = a.JO(T - 0) _ log (K P(O,0)/ P(O,T))
2 a.JO(T - 0)

For simplicity, we assume that f: E (f: H 2(t,

s)dt) ds < 00 (which is sufficient
to justify equality (6.21». .
I. Prove that

f E(If H(t"jdW,!) d,'; f [E (f H'(t,,)dt)

Deduce that the integral J: U: H(t, s)dWt) ds exists.
r ds,

2. Let 0 = to < t l < : .. < t N = T be a partition of interval [0, T]. Remark that

Jo
[T(I: nu; .=0
s) (W ti+1 -.WtJ) ds

= I: (iT
.=0 0
H(ti,S)dS) (Wt;+l - Wti)
.

and justify why we can take the limit to obtain the desired equality.
Exercise 38 In the Heath-Jarrow-Morton model, we assume that the function a is
a positive constant. We would like to price a call with maturity' 0 and strike price
K, on a zero-coupon bond with maturity T > O.
1. Show that the hypothesis of Proposition 6.1.6 holds.
2. Show that the solution of equation (6.22) is given by f(t, u) = f(O, u) +
a 2 t (u - t/2) + aWt . Deduce, that
20T(T-
ll
P( u'.
T) = P(O,T) (_ (T' _ ll)TXT ., a 0))
P(O,O) exp a U HII . 2 .

3. Derive, for A E JR, E* (e -rJ' f: W.ds e,xWB) ~ Deduce the law of WII'under the
probability measures PI and P 2 with densities with respect to P* respectively
given by
dP e- JOB r(~)dSp(o, T) dP e- foB ~(s)ds
2
l and -= ----
dP* = P(O,T) dP* P(O,O)

4.. Show that the price of a call at time 0 is given by

Co = P(O,T)N(d) - K P(O,O)N (d - a.JO(T - 0)) ,

7

Asset models with jumps

In the Black-Scholes model, the share price is a continuous function of time and
this property is one of the characteristics of the model. But some rare events
(release of an unexpected economic figure, major political changes or even a
natural disaster in a major economy) can lead to brusque variations in prices.
To model this kind of phenomena, we have to introduce discontinuous stochastic
processes.
Most of these models 'with jumps' have a striking feature that distinguishes
them from the Black-Scholes model: they are incomplete market models, and
there is no perfect hedging of options in this case. It is no longer possible to price
options using a replicating portfolio. A possible approach to pricing and hedging
consists in defining a notion of risk and choosing a price and a hedge in order to
minimise this risk.
In this chapter, we will study the simplest models with jumps. The description
of these models requires a review of the main properties of the Poisson process;
this is the objective of the first section.

7.1 Poisson process

Definition 7.1.1 Let (Tik~l be a sequence of independent, identically exponen-

tially distributed random variables with parameter A, i. e. their density is equal to
l{x>o}Ae->.x. We s~t Tn = L~l t: We call Poisson process with intensity A the
process N, defined by .

Nt =L l{Tn::;t} = L nl{T n::;t<Tn+l}'

n~l n~l

Remark 7.1.2 N; represents the number of points of the sequence (Tn)n~ 1 which
are smaller than or equal to t. We have

Tn = inf{t ;to, N, = n}.

 Dynamics ofthe risky asset 143
Asset models with jumps
142 . be 'memoryless'. The independence of the increments is a consequence of this
The following proposition gives an explicit expression for the law of N; for a property of exponential laws.
given t. ., . Remark 7.1.6 The law of a Poisson process with intensity A is characterised by
Proposition 7.1.3 If (Ntk~o is a Poisson process Wlt~ intensity A then, for any either of the folIowing two properties:
t > 0, the random variable N, follows a Poisson law witn parameter A
• (Ntk~o is a right-continuous homogeneous Markov process with left-hand
->.t (At)n limit, such that
P(Nt = n) = e -,-.
n. P(Nt = n) = e->'.t (At~n.
n.
In particular we have
• (Nt)t>o is a process with independent and stationary increments, right-contin-
E(Nt ) = At, uous, non-decreasing, the amplitude of the jumps being one.
Moreover, for s > ° E (sN.) = exp {At (s - I)}.
For the first characterisation, cf. Bouleau (1988), Chapter III; for the second one,
cf. Dacunha-Castelle and Duflo (1986), Section 6.3.
Proof. First we notice rhatthe law of Tn is
(AX)n-l . 7.2 Dynamics of the risky asset
l{x>O}.Ae->'x (n _ I)! dx,
The objective of this section is to model a financial market in which there is one

, A and n. Indeed, the Laplace transform of

:I.e. a gamma law with parameters T1 is riskless asset (with price Sr
= e'", at time t) and one risky asset whose price
jumps in the proportions U1 , ... , Uj, ..., at some times Tl , ... , Tj, ... and which,
A
E (e-
ct T 1
) = A + 0:' between two jumps, folIows the Black-Scholes model. Moreover, we will assume
that. the Tj'S correspond to the jump times of a Poisson process.To be more rigor-
thus the law of Tn = T 1 + ... + Tn is ous, let us consider a probability space (11, A, P) on which we define a standard
Brownian motion (Wdt~o, a Poisson process (Nt)t~o with intensity A and a
E(e- ctr n ) = E(e- ct T l
( = (A ~ 0:) n sequence (Uj)j~1 of independent, identicalIy distributed random variables taking
values in ]-1, +00[. We will assume that the a-algebras generated respectively
We recognise the Laplace transform of the gamma law with parameters A and n by. (Wdt~o, (Nt)t~o, (Uj)j~1 are independent.
(cf. Bouleau (1986), Chapter VI, Section 7.12). Then we have, for n 2: 1 For all t 2: 0, let us denote by F t the a-algebra generated by the random
P(Nt = n) = P(Tn ~ t) - P(Tn+l ~ t) variables Ws , N, for s ~ t and tt, 1{j~Nd for j 2: 1. It can be shown that
(Wdt>o is a standard Brownian motion with respect to the filtration (Ft)t>o, that

=
t (\
{ Ae->'x AX
)n-l
dx _
it (AX)n
Ae->'x - - I-dx
(Nt)t~o is a process adapted to this filtration and that, for all't > s, N, ~ N, is
independent of the zr-algebra F s . Because the random variables UjJ{j~Nd are
Jo (n - I)! 0 n. Frmeasurable, we deduce that, at timet, the relative amplitudes of the jumps
taking place before t are known. Note as well that the Tj'S are stopping times of
(Att ->.t
= - -e . (Fdt~o,.sinc~ {Tj ~ t} = {Nt 2: j} EFt. _
n! o The dynamics of Xt, price of the risky asset at time t, can nowbe described
in the following manner, The process (Xt)t~O is an adapted, right-continuous
process satisfying:
d and .F =
't" 7 1 4 Let (Nt ) t >0 be a Poisson process with intensity A t
Proposl Ion . .
a(N ', s ~ t). The process (Ntk~o is a process with independent an stationary • On the time intervals h, Tj+l [
s
increments, i.e. . dX t = Xt(jldt + adWt).
• independence: if s > 0, N t+ s - N, is independent of the a-algebra Ft.
• At time Tj, the jump of X, is given by
• stationarity: the law of N t+ s - N; is identical to the law of N, - No = N s·
- \ 6,Xr =X XT - =X -U
Remark 7.1.5 It is easy to see that the jump times Tn are stopping tim~s. In~eed~
, r J, - ,
. J j Tj , j

{ Tn < t} = {Nt 2: n} E Ft. A random variable T with .expon~nuallaw sat~sfie thus X r; = Xr~, (I + Uj ) .
P(T- 2: t + siT 2: t) = P(T 2: s). The exponential variables are said to
144 Asset models with jumps
Dynamics ofthe risky asset
So we have, for t E [0, Tl [ 145
is independent of the a-algebra generated by the random variables N < d
UjIUSN.}. Let A be a Borel subset of JRk, B aBorel subset f JRd u'dV,C- s an
consequently, the left-hand limit at Tl is given by
of the a-algebra a(Nu, V, <)_ s ." r. an
we have, USIng the independence of U d N
° dan event
that the Uj 's are independent and identically distributed, an an the fact
X _ = X oe(/L-<T 2/2)T\ +<TW T \

T\ P ({(UN.+l, ... ,UN.+k) E A} n C n {(U 1, .. . , Ud) E B} n {d $ N s } )

and 2 00

X T\ ,= X o(1 + U1)e(/L-<T /2)T\ +<TW T\ •

Then, for t E [Tl,T2[,

X, = X T\ e(/L-<T 2/2)(t- T!l+<T(W, -w T\ )

= X -(1 + Ude(/L-<T 2/2)(t-T!l+<T(W,-w T \ )

T\
2/2)t+<TW,.
= X o(1' + U1)e(/L-<T

Repeating this scheme, we obtain

P «U1, ... ,Uk) E A) LP «U1, ... , Ud) E B)P (Cn {Ns = p}).
x, =Xo (fl(1
J=1
+Uj ) ) e(/L-<T2/2)t+<T~',
p=d

From the last equality, we deduce (taking C = n and B - JRd) h

(uNs+l, ... , U ) l' -
.

t at the vector
N.+k ,olIowsthesamelawas(Ul " " , U)
k,
and th th
en at
with the convention I1~=1 = 1. P ({(UNs+l, ... , UN.+k) E A} n C n {(U 1, ... , Ud) E B} n {d $ N s } )
The process (Xt)t>o is obviously right-continuous, adapted and has only finitely
many discontinuities-on each interval [0, t). We can also prove that it satisfies, for = P«UN.+1, ... ,UN.+k E A)P(Cn{(U1,,,,,Ud E B)}n{d$ N s } ) .

all t ~ 0, Whence the independence stated above. 0

P a.s. x,
.
= Xo + 1x, 0
t '.

(J.Lds + adW s) + L
N,

j=1
XTjU j •
.
.
(7.1) Suppose now that E(lU1 1) < +00 and set Xt -- «<xt- Th en

We will see that, for this kind of model, it is generally impossible to hedge the E(X,J.r.) ~ X.E (,(.-,-u',,*,-,)+U(w.-w.) . fi (1 + U;)j.r.)
options perfectly. This difficulty is due to the fact that for T < +00, there are J=Ns+l
infinitely many probabilities equivalent to P on :FT under which the discounted
price (e- rt Xt)O<t<T is a martingale. In the remainder, we will make the fol-
lowing assumption: under P, the process (e- rt Xt)O<t<T is a martingale. This
is a stringent-hypothesis, but it will allow us to determine simply some hedging
X\E (e(/L_r-<T
.
2/2)(t_ S)+<T(W,_W.)
N
rr'-Ns(1
+U ')1)
Ns+J :Fs
. j=1
strategies with minimal risk. When this hypothesis does not hold, the hedging of
options is rather tricky (see Schweizer (1989)). .
To derive E(Xtl:Fs) we will need the following lemma; which means intu- = XsE (e(/L_r-<T 2/2)(t_ S)+<T(W,_WS) Nrr'-Ns( )
I+U Ns+j ) ,
itively that the relative amplitudes of the jumps which take place after time s are
j=1
independent of the a-algebra :F~.
using Lemma 7.2.1 and the fact that Wt - Wand N N . d d
Lemma 7.2.1 For all s ~ 0, the a-algebras the a-algebra :Fs . H e n c e ' s t - s are In epen ent of

a (UN.H, UN.+2,·'·' UN.+k,"')

and :Fs are independent.
Proof. As thea-algebras W = a(W., s ~ O),N = a(N., s ~ 0) andU = a(Ui, i ~
1) areindependent, it suffices to provethatthea-algebra a (UN.+l, UN.• +2, ... , UN.+k,' .. )
= Xse(/L-r)(t.,-s)e),(t-s)E(U!l
,
 Dynamics ofthe risky asset 147
146 Asset models with jumps
Moreover. IZPI2 -< C(N.t - N 5).. c 11
' It 10 ows that the convergence takes place in L 1
using Exercise 39. an d even In L . .
It is now clear that (X t ) is a martingale if and only if We have
f.L .=r: - AE(V1 ) ·
To deal with the terms due to the jumps in the hedging schemes, we will need two (7.2)
more lemmas, whose proofs can be omitted at first reading. We will denote by v
the common law of the random variables Vj's. setting
Lemma 7.2.2 Let <p(y,z) be a measurablefunctionfr~m ffid x ffi to ffi, such
thatfor any real number z the function y ~ <p(y, z) is continuous on ffid, and let
(Yih>o be a left-continuous process, taking values in ffid. adapted to the filtration
(Ft)Qo, We assume thai.for ~ll t > 0 , ' "

E (I ~8 J
t
v(dZ)<P
2(:s,
z)) < +00.
Using
A 2 5 Lemma
. . 0
f th A7.2.1'and the fact that Y.5,. is F -measurabl e, we apply Proposition
e ppendix to see that
8. ..

Then the process M; defined by

Mt =L
N. <p(YTj, V j) - A 'It J ds '
v(dz)<p(Ys, z), : where ~i(Y) is defined by
j=l 0

is a square-integrable martingale and ~i(Y) = E (N';~N'; <p(y, VN.;+i)) .

' t

M; - A 1 JV(~Z)<p2(YSl
ds
.

z)
J=l

~i (y) is thus the expectation of a random sum and, from Exercise 40,
)

is a martingale.
Notice that by convention 2:~=1 = 1. ~i(Y) = A(Si+l - s.) Jav(z)<p(y, z).
Proof. We assume first that <P is bounded and we set
Going back to equation (7.2), we deduce
C = sup I<p(y, z)l·

UJ.en we have
(y,z)EHtd xlR

\2:7::1 <P(YTj,Vj)\ s CNt and II: I v(dz)~(Yslz)\ s Ct. So E( Z'IF.) ~ E (~ ~.(Y.J IF.) ~ E (~ >'(s,+, - s.) I dv(z) 'I> (Y.;> z) IF.) .
M, is square-integrable. Let us fix 8 and t, with 8 < t, and set When the mesh of p tends to 0, we obtain
N.
Z ~ L <p(YTj , Vj).
j=N.+1
To a partition p = (80 =.8 < S'l < ... < 8m = t) of the interval [8, t], let us
associate
m-l N~i+l
which proves that M; is a martingale. Now set ZP = "m-1 E(Z· IT)
can w n t e ' L.",=o ,+ 1 .r 5; • We
ZP = L L <p(Ys"Vj).
i=O j=N••+I
The left-continuity of (Ydt~o and the continuity of <P with respect to y imply
that ZP converges almost surely to Z when the mesh of the partition p tends to O.
 , .. ~

148 Asset models with jumps Dynamics ofthe risky asset 149
Moreover, and equality (7.3) implies that M? - A f; du f dv(z)~2(yu, z) is a martingale.
p)2I If we do not assume that ~ is bounded, but instead
E ((Zp - 2 FS) 2

~ E [(~ [Z;+, -E(Z;+,IF.JI) IF.] E (it ds / dv(z)~2(ys, z)) < +00,

for any t, we can introduce the (bounded) functions ~n's defined by ~n(y, z) =
inf(n, sup( -n, ~(y, z))), and the martingales (M;')c?o defined by
= E (~[Z,+' - E(Z;+,IF.JI' IF.)

+2 LE ((Zi+1 - E(Zi+1IFs,)) (Zi+1 - E(Zi+dFsJ) Irs) .

i<i It is easily seen that E (1; dsJ v(dz) (~n(Ys, z) - ~(Y., Z))2) tends to 0 as n
Taking the conditional expectation with respect to F Si and us~ng the fact that Zi+1 tends to infinity. It follows that the sequence (M;')n'21 is Cauchy in L2 and as
. F Si+1 h en ce F s,.-measurable,
IS . we see that the second sum IS 2. Whence M;' tends to .M; a.s., M; is square-integrable and taking the limit, the lemma is
satisfied for ~. 0

E ((Zp - 2
p)2I
Fs) = E (~1 (Zi+1 - E(Zi+lIFsi ))2I Fs)
Lemma 7.2.3 We keep the hypothesis and notations ofLemma 7.2.2. Let (Atk:~o
(f; A;ds)
E (~ E ([Z,+' - E(Z,+dF.JI'1 F.;) IF}
be an adapted process such that E < +00 for any t. We set L, =
= t
fa AsdWs and, as in Lemma 7.2.2, ~
.',

Using Lemma 7.2.1 once again

E [(Zi+1 - E(Zi+1IFs,))2IFsi] = V(ys,),

where the function V is defined by Then the product Li M, is a martingale.

V(y) = Var (N'i~N'i ~(y, UN.i+i)) Proof. It is sufficient to prove the lemma for ~ bounded (the general case is
J ]=1 proved by approximating ~ by some ~n = inf(n, sup( -n, ~ )), as in the proof of
and, from Exercise 40, Lemma 7.2.2). Let us fix s < t and denote by p = (so = s < S1 < ... < Sm = t)
a partition of the interval [s, t]. We have
V(y) = A(Si+l - Si) Jdv(z)~2(y,Z).
Therefore

E ((ZP:- 2p)2IFs) = E (~A(Si+1 - s.) JdV(Z)~2(YsilZ)IFs), On the other hand, since (Ltk;~o and (Mtk:~o are martingales

and so when the mesh of the partition p tends to 0,

E ((LSi+! M S i + 1 - LSiMsJIFs,) = E ((L Si+ 1 - LSi)(MSi+ 1 - Ms.)IFsi) .

l J
Whence
'E [(M' - M,)'iF:j = E [A du dv(z)<l"(Y., Z)IF.] . (7.3)
with
Since (Mtk~.o is a square-integrable martingale, we obtain m-1
E [(Mt - Ms)2IFs] = E (M; + M; - 2MtMs1Fs) = E (M t2 - M;IFs) AI' = L (LSi+ 1 - Ls.)(Msi+! --; M s,).
, i=O

! I
I
 --j'p=

Asset models with jumps Pricing and hedging options 151

150
We deduce In the following, we fix a finite horizon T. A trading strategy will be defined,
m-1 as in the Black-Scholes model, by an adapted process ¢ = ((HP, Hd )O<t<T,
taking values in rn?, representing the amounts of assets held over time; b-ut~ to
IAPI < (SUPO<i<m-1 IL';+1 - L., I) L IM',+I - M., I
take the jumps into account, we will constrain the processes (HP) and (Hd to be
i=O
left-continuous. Since the process (Xd is itself right-continuous, this means, intu-
itively, that one can react to the jumps only after their occurrence. This condition
is the counterpart of the condition of predictability which is found in the discrete

-, (i}I'(Y", U;)I + ), f: du f dv(z )I~(Y., z)1)

models (cf. Chapter 1) and which is slightly more prickly to define in continuous
time.
The value at time t of the strategy ¢ is given by Vt = Hpe rt + Hi X, and the
strategy is said to be self-financing if
.~ (SUPO~i~m-1) IL';+1 - L.,I (C(Nt - N.) + )"C(t - s)), dVt = H?rertdt + HtdXt,
with C = sUPy z 1<I>(y,z)l. From the continuity of t H L t , we see that AP tends i.e., taking into account equation (7.1), dlit = Hprertdt + HtXt(J.Ldt + O'dWd
almost surely t~ 0 as the mesh of the partition p tends to O. Moreover between the jump times and at a jump time Tj, lit jumps by an amount ~ Vrj =
IAPI ~ 2 sup ILul (C(Nt - N.) + )"C(t - s)). H rj ~Xrj = H rj UjX r-:-. Precisely, the condition of self-financing can be written
1
.~u9 as
The random variablesuP.<u<t ILul is in L 2 (from the Doobinequality, c.f. C~apter
3, Proposition 3.3.7), as welCas N; - N •. We deduce that AP tends to 0 in L ,and
Vo + it H?rer'ds + it H.X.(J.Lds + O'dW.)
consequently N,
+ '"
L.J HrUjXr,-.
1
(7.5)
o j=l

For this equation to make sense, it suffices to impose the condition JOT IH~lds +
7.3 Pricing and hedging options
J::H:ds < 00, a.s. (it is easily seen that s H X. is almost surely bounded).
Actually, for a specific reason to be discussed later, we will impose a stronger
7.3.1 Admissible strategies condition of integrability on the process (Hdo~t~T, by restricting the class of
1
admissible strategies as follows:
Let us go back to the model introduced at the beginning of the previous section,
Definition 7.3.1 An admissible strategy is defined by a process
assuming that the U/,s are square-integrable and that.
o '
J.L =r - )"E(Ud =r - ).. Jzv(dz), (7.4)
¢ = ((Ht , Ht))O~t~T
adapted, left-continuous, with values in rn?, satisfying equality (7.5) a.s. for all
t E [0, T] and such that
which implie~ that the process (.it) t>O = (e-rt:Xtk:~o is a martingale. Notice
) - JOT IH~lds < +00 ~ ais. andE (JoT H;X;ds) < +00.
that
Note that we do' not impose any condition of non-negativity on the value of
admissible strategies. The following proposition is the counterpart of Proposition
4.1.2 of Chapter 4.
Proposition 7.3.2 Let (Hdo9~T be an adapted, left-continuous process such
and consequently, from Exercise 39, that

E (X;) = XJ exp ((0'2 + 2r)t) exp ()..tE(Ut)) . E (iT H;X;dS) < 00,
Therefore the process' (.it) t~O
is a square-integrable martingale. and let Vo E nt., There exists a unique process (HP)O~t~T such that the pair
 Asset models with jumps Pricing and hedging options 153
152
((HP, H t))O$t<5,T defines an admissible strategy with initial value Vo. The dis- = Vo + it HsXs((J.L - r)ds + adWs)
counted value at time t ofthis strategy is given by
N,

II, ~ Vo + J.' H,X,adW, + t,H.,ui X:;- - ~ J.' <isH,X, J;(dZ)Z. + LHrjUjXr-:-,

j=1 '
which, taking into account equality (7.4), yields
Proof. If the pair (HP, H t)O$t<5,T defines an admissible strattegy, its value at time t
is given by Vi = yt + Zt, with yt = Vo + f; H~rersds + fo HsX s tude + adWs)
and Zt = EN~1 H; UjX -. Differentiating the product e-rtyt,
J- ] ~ .

e-rtVi = Vo + 1 t
(-re-rs)Ysds + 1 t
rt
e-rsdYs + e- Zt." (7.6)
It is clear then that if Vo and (H t) are given, the unique process (HP) such that
((HP, H t) )O$t<5,T is an admissible strategy with initial value Vo is given by
Moreover, the product crt Zt can be written as follows: H? =. Vi - lftXt
t Nt
-u.x, +Vo +
i
o
HsXsadWs +LHrjUjXr-:-
j=I'

L
j=1
N, (
e- rrj + r(_re-rs)ds
t

ir, ,
).
n., u.x.. -A 1 t
dsHsXs J v(dz)z.

Nt
From this formula, we see that the process (HP) is adapted, has left-hand limit at
= Le-rrjHrjUjXrj- any point and is such that HP = H~_. This last property is straightforward if t is
j=1 not a jump time Tj and if t is some Tj, we have
N, r t . o 0
H rJ - H T j-
- - .
= -HrD.Xr· + Hr·UjX - = o.
.+ L in dsl{rj<5,s}( _re-rS)HrjU1Xrj- J ] } 'j

j=1 T
0 .
It is also obvious that fo IHPldt < 00 almost surely. Moreover, writing Hpe rt +
= ~
N,"

L.-t e-rrjHr,U1'X
.
]
.
- + r ,
'0
1 t
ds(-re- rs) ~
N .•

L HrjUjX
j=I'
. - t . r-:-}
HtX t = ert (Hp + HtX t) and integrating by parts as above we see that

r .
1=1. ' .
((H~, Ht))O<t<T
N,
= L e- rrj HrjUjXrj + io (-re-rs)Zsds. defines an admissible strategy with initial value Vo. o
j=1
Writing this in (7.6) and expressing dYs, we obtain Remark 7.3.3 The condition E (J:{ H; X;ds) < 00 implies that the discounted

Vt Vo +
t
1(-re-rs)Vs~s 1H~rds +1
+
t t
HsXs(J.Lds + adWs)
value (Vt ) of an admissible strategy is a square-integrable martingale. This results
from the expression in Proposition 7.3.2 and Lemma 7.2.2, applied with the
N, continuous process with left-hand limit defined by yt = (H t , Xt - ) (note that in
+ LHrjUjX~j- the integral with respect to ds, one can substitute x, for x..
because there is
j=1 only finitely many discontinuities).

= Vo - i t r 1
(H~ + HsX s) ds + H~rds + HsX~(J.Lds + adWs)
t
I
t
7.3.2 Pricing
. \
Nt
'Let us consider'a European option with maturity T, defined by a random variable
+ LHrjUjXr~, h, FT-measurable and square-integrable. To clarify, let us stand from the writer's
j=1 I
 ,------

Asset models with jumps Pricing and hedging options 155

154
point of view. He sells the option at a price Vo at time 0 and' then follows an with
admissible strategy between times 0 and T. From Proposition 7.3.2, this strategy
is completely determined by the process (Ht)os;t5;T representing the amount of
the risky asset. If Vi represents the value of this strategy at time t, the hedging
mismatch at maturity is given by h - VT. If this quantity is non-negative, the writer
F( t, x) ~ E (e -"(T-,) f (xe('-u' I')(T-')+UWT_' If (1 + Uj)) )
of the option loses money, otherwise he earns some. A way. of measuring the risk
is to introduce the quantity
HI = E ((e-rT(h - VT))2) .
" ~ E (e-"(T-.) f (xe("->E(U,)_U' I')(T-')+UWT_, If (1 + Uj )) ) .

Note that if we introduce the function

Since, from Remark 7.3.3, the discounted value (ft) is a martingale, we have
E (e-rTVT) = Vo. Applying the identity E(Z2) = (E(Z))2 + E ([Z :::- E(Z)]2) Fo(t,x) = E (e-r(T-t) f (xe(r-cr 2/2)(T-t)+crwT_')) ,
to the random variable Z =
e-rT(h - VT), we obtain
which gives the price of the option for the Black-Scholes model, we have
HI = (E(e-rTh) - Vo)2 + E (e-rTh - E(e-rTh.) - (VT - Vo)f·

If
(7.7)

Proposition 7.3.2 shows that the quantity VT' - Vo depends only on (Ht ) (and F(t, x) = E (FO (t,xe-'(T-.)E(U,) (1+ Uj ) ) ). . (7.8)
not on Vo). If the writer of the option tries to minimise the risk RJ,
he will
ask for a premium Vo =
E(e-rTh). So it appears that E(e-rTh) is the initial
value of any strategy designed to minimise the risk at maturity and this is what Since NT-t is a random variable independent of the Uj's, following a Poisson
we will take as a definition of the price of the option associated with h. By a law with parameter >'(T - t), we can also write
similar argument, we see that an agent selling the option at time t > 0, who wants
to minimise the quantity
premium
R; = E ( (e-r(T-t)(h -
Vi = E (e-r(T-t) hIFt).
VT) )2 1Ft ) , will ask for a
We will take this quantity to define the price
F(t, x) ~ ~E (FO ~' xe-'(T-')E(U,) Q (1+ Uj ) ) ) e-'(T-') ~~(T - t)"

of the option at time t. ' Each term of this series can be computed numerically if we know how to simulate
the law of the Uj's. For some laws, the mathematical expectation in the formula'
7.3.3 Prices of calls and puts can be calculated explicitly (cf. Exercise 42).
Before tackling the problem of hedging, we try to give an explicit expression for
the price of the call or the put with strike price K. We will assume therefore that
7.3.4 Hedging of calls and puts
h can be written as f(XT), with f(x) = (x - K)+ or f(x) = (K - x)+. As we
saw earlier, the price of the option at time t is given by Let us examine the hedging problem for an option h= f(XT), with f(x) =

E (e-~(T-t) f(XT)IFt) '.

(x - K)+ or f(x) =
(K - x)+. We have seen that the initial value of any
admissible strategy aiming at minimising the risk R6
at maturity is given by

= E (e-r(T-t) f (Xte(l'-cr2 /2)(T-:-t)+cr~WT - W,) . IT, (1 + Uj ) ) Ft)

Vo = E(e-rTh) = F(O; X o). For such a strategy, equality (7.7) yields
, .' ]=N,+l
RJ = E (e-rTh - VT f·
= E (e- d T -.) I (X .e('-u'/2)(T-')+U(WT - W,t~r' (1 + UN,+ j)) .r} Now we determine a process (H t )Os;t5;T for the quantities of the risky asset to be
held in portfolio t? minimise RJ.
To do so, we need the following proposition.

~~o.positio~ 7.3.4 Let Vi ~;;'he value at time t of an admissible strategy with

From Lemma 7.2.1 and this equality, we deduce that
initial value Vo = E (e f(XT)) = F(O, X o), determined by a process
E (e-r(T-t)!(XT)!Ft) = F(t,Xt), (Ht)Os;t5;T for the quantities of the risky asset. The quadratic risk at maturity
 ir==
156 Asset models with jumps Pricing and hedging options 157
RJ = E (e-.rT(f(X T) - VT)) 2 is given by the following formula:

R&T = r T (aF
E ( Jo ax (s, X)
s - H; ) 2 Xsu
- 2 2 ds E (it ds !v(dz) (F(s, Xs(l + z)) - F(s, X s)) 2)
o
(1 dsX; JV(dz)z2)
t

+ J: A J v(dz)e- 2rs (F(s, x.n + z)) - F(s, X s) - H szXs)2 dS). s E

< +00,
Proof. From Proposition 7.3.2, we have, for t ~ T,
which, from Lemma 7.2.2, implies that the process
Nt
u, = L F(Tj, X r;) - F(Tj, X rj-)
j=1

Al t ds J (F(s,Xs(l+z))-F(s,Xs))dv(z)
F(t,x) = e-rtF(t,xe rt),
is a square-integrable martingale. We also know that F(t, Xt ) is a martingale.
so that F(t, X t) = E (iiIFt ) . It emerges that F(t, X t) is the discounted price of Therefore the process F( t, X t ) - M, is also a martingale and, from equality
(7.10), it is an Ito process. From Exercise 16 of Chapter 3, it can be written as a
the option at timet. We deduce easily (exercise) from fonnula (7.8) that F(t, x) stochastic integral. Whence
is C 2 on [0, T[xlR+ and, writing down the Ito formula between the jump times,
we obtain
F(t, Xt ) =
--
F(t, X t) - M, = F(O, X o) + i 0
t aF
ax (s, Xs)XsudWs. (7.11)

ior 8;(s, r aF - - Gathering equalities (7.9) and (7.11), we get

aF -
F(O, X o)+ Xs)ds + io ax (s,Xs)X s(-AE(Vdds + udWs)
ii - VT = M~1) + M¥),
+-
lit aF
-a
2
- 2 - 2
2 (s,Xs)u Xsds + L F(Tj,XrJ - F(Tj,Xr~)·
N, - - - -
(7.10)
with
2 0 x . .. . j=1 ]
Remark that the function F( t, x) is Lipschitz of order 1 with respect to z, since
and
N,
IF(t,x) -(F(t'Y)1 (
< E e-r(T-t) jxe(r--XE(Utl- u 2 /2)(T-t)+UWT_t
N _,
T
(1 + V j)
)
U = L
j=1
(Fh,Xr;) - Fh,Xr~) - HrjVjXr~)
] ]

-A I ! t
ds dv(z) (F(s, Xs(l + z)) - F(s, X s) - HszX s) .
From Lemma 7.2:3, MP) M t(2) is a martingale and consequently

E (MP) M1
2)) = J.!a 1) Ma2) = O.
Whence
E (ii - VT) =, E((M~1))2) + E((M~2))2)

=
It follows that
Ix -yl· • 'E (J:{~~ (s, X.) - HrX;U'dS) + (M~'»)'),E(
 Asset models with jumps Exercises 159
158
Notes: The financial models with jumps were introduced by Merton (1976).
and applying Lemma 7.2.2 again
The approach used in this chapter is based on Follmer and Sondermann (1986),
E(( M f2))2) . CERMA (1988) and Bouleau and Lamberton (1989). The approach we have cho-

= E (A !:;ds J v(dz) v- X s(l + z)) - F(s, X s) - HszX s) 2) . sen.relies heavily on the assumption that the discounted stock price is a martingale.
This assumption is rather arbitrary: Moreover, the use of variance as a measure
of risk is questionable. Therefore, the reader is urged to consult the recent litera-
The risk at maturity is then given by ture de.aling with incomplete markets, especially Follmer and Schweizer (1991),

T aF _ - )2 - s a ds Schweizer (1992,1993,1994), El Karoui and Quenez (1995).

( (
2 2
m = E Jo ax (s, X s) - Hs X
7.4 Exercises
+ JoT A J v(dz) (F(s, X s(l + z)) - F(s, X s) - HszX s) 2 dS) . ~xercis~ 3~. Let (Vn)n~I be a sequence of non-negative, independent and iden-
o tically distributed random variables and let N be a random variable with values
in N, following a Poisson law with parameter A, independent of the sequence
It follows that the minimal risk is obtained when H, satisfies P a.s. (Vn)n~I. Show that .

aF - .) -2 2
( ax (s, x.) - H, Xsa .
E (11 vn) ~ e'(E(V,j-')

+ AJ v(dz) (F(s,X s(l + z)) - F(s,Xs) - HszX s) zX s = O. ~xercise 40 Let (Vn)~~1 be a sequence of independent, identically distributed,
Integrable random variables and let N be a random variable taking values in N
It suffices indeed to minimise the integrand with respect to ds. It yields, since integrable and aindependent of the sequence (V,n ). We set S = ""N V, (with the
L ..m =I n
(Hdt~iJ must be left-continuous, convention En=I = 0).
H, = 6.(s,.X s - ) , . 1. Prove that S is integrable and that E(S) = E(N)E(Vi}
2. "!'Ie assume N and VI to be square-integrable. Then show that S is square-
with Integrable and that its variance is Var(S) = E(N)Var(Vt) + Var(N) (E(Vt ))2.
6.(s,x) = 1
(12 +A J v(dz)z2
(2 aF
a - (s x )
ax' 3. Deduce that if N follows a Poisson law with parameter A, E(S) = AE(Vt)
and Var(S) = AE (Vn.
+A j. v (d)z z (F(S,X(l+Z))-F(S,X)))
x
. Exercise 41 The hypothesis and notations are those of Exercise 40. We suppose
that the Vi's take values in {a, ,8}, with a, ,8 E IR and we set p = P(VI = a) =
In this way, we obtain a process which satisfies E (JoT
H;X;ds) < +00 and 1 - P(Vt = ,8). Prove that S has the same law as aNI + ,8N2 , where N I and
N 2 are two independent random variables following a Poisson law with respective
which determines therefore an admissible strategy minimising the risk at maturity.
parameters AP and (1 - p)A. .
Note that if there is no jump (A = ,0), we recover the hedging formula for the
Black-Scholes model and, in this case, we know that the hedging is perfect, i.e, Exercise 42
m = O. But, when there are jumps, the minimal risk is generally positive (cf. 1. W,e suppose, with the notations of Section 7.3, that UI takes values in {a, b},
Exercise 43 and Chateau (1990». WIth P = P(UI = a) = 1 - P(UI = b). Write the price formula (7.8) as a
Remark 7.3.5 The formulae we obtain indicate that calculations are still possible double series where each term is calculated from the Black-Scholes formulae
for models with jump. It remains to identify parameters and the law of the U, 'so As (hint: use Exercise 41).
for the volatility in the Black-Scholes model, we can distinguish two approaches:
2. Now we suypose that UI has the same law as e 9 - 1, where 9 is a normal
(1) a statistical approach, from the historical data and (2) an implied approach,
variablewithmean m and variance a 2 • Write the price formula (7.8) as a series
from the market data, in other words from the prices of options quoted on an
of terms calculated from the Black-Scholes formulae (for some interest rates
organised market. In the second approach, the models with jump, which-involve
and v?latilities to be given).
several parameters, give a better 'fit' to the market prices.
 Asset models with jumps
160
Exercise 43 The objective of this exercise is to show that there is no perfect 8
hedging of calls and puts for the models with jumps we studied in this chapter.
We consider a model in which a > 0, >. > a and P (U1 1= 0) > O.
1. From Proposition 7.3.4, show that if there is a perfect hedging scheme then,
for ds almost every. s and for v almost every z, we have
Simulation and algorithms
P a.s. ZXs~~ (s,~s) = F(s,Xs(1 + z)) - F(s,X s)' for financial models
2. Show that the law of X; has (for s > 0) a positive density on ]0, ~[. It
may be worth noticing that if Y has a density 9 and i~ Z is a random vana~le
independent ofY with values in ]0,00[; the random van able Y ~ has the density
JdJ-L(z)(l/z)g(y/z),whereJ-L is the lawofZ. - .
3. Under the same assumptions as in the first question, ~ho"w that there eXl~ts
z 1= a such that f~r s E [0,T[ and x E]0, 00[, 8.1 Simulation and financial models
aF F(s,x(l+z))-F(s,x) In this chapter, we describe some methods which can be used to simulate financial
ax (s,x) = zx . models and compute prices. When we can write the option price as the expectation
Deduce (using the convexity of F with respect to x) that, for s E [0, T], the of a random variable that can be simulated, Monte Carlo methods can be used.
function x t-t F (s; x) is linear. . . " Unfortunately these methods are inefficient and are only used if there is no closed-
4. Conclude. It may be noticed that, in the case of the put, the function x t-t F(s, x) form solution for the price of the option. Simulations are also useful to evaluate
complex hedging strategies (example: find the impact of hedging a portfolio every
is non-negative and decreasing on ]0, 00[.
ten days instead of every day, see Exercise 46).

8.1.1 The Monte Carlo method

The problem of simulation can' be presented as follows. We consider a random
variable with law J-L(dx) and we would like to generate a sequence of independent
trials, Xl, .. : ,Xn, . . . with common distribution J-L. Applying the law of large
numbers, we can assert that if f is a J-L-integrable function

lim N
N-t+oo
1
"
L..J
l~n~N
f(Xn) = J
f(x)J-L(dx). (8.1)

To implement this method on a computer, we proceed as follows. We suppose that

we know how to build at sequence
. .
of numbers (Un)n>1 -
which is the realisation
of a sequence of independent, uniform random variables on the interval [0,1]
and we look for a function (Ul' ... ,up) t-t F( Ul, ... ,up) such that the random
variable F(U l, ... ,Up) has the desired law J-L(dx). The sequence of random
variables (Xn)n~1 where X n = F(U(n-l)p+l"" ,Unp) is then a sequence of
independent random variables following the required law J-L. For example, we can
apply (8.1) to the functions f(x) = x and f(x) = x 2 to estimate the first and
second-order moments of X (provided E(IXI 2 ) is finite).
The sequence (Un)n~l is obtained in practice from successive calls to a pseudo-
o
random number generator. Most languages available on modern computers provide
a random' function, already coded, which returns either a pseudo-random number
162 Simulation and algorithms for financial models Simulation and financial models 163
between 0 and 1, or a random integer in a fixed interval (this function is called The previous generator provides reasonable results in common cases. However
rand () in C ANSI, random in Turbo Pascal). it might happen that its period (here m = 108 ) is not big enough. Then it is possible
Remark 8.1.1 The function F can depend in some cases (in particular when it to create random number generators with an arbitrary long period by increasing m.
comes to simulate stopping times), on the whole sequence (Un)n;?:I, and not only The interested reader will find much information on random number generators
on a fixed number of Ui 'so The previous method can still be used if we can simulate and computer procedures in Knuth (1981) and L'Ecuyer (1990).
X from an almost surely finite number of Ui 's, this number being possibly random.
This is the case, for example, for the simulation of a Poisson random variable (see 8.1.3 Simulation of random variables
page 163).
The probability laws we have used for financial models are mainly Gaussian laws
(in the case of continuous models) and exponential and Poisson laws (in the case
8.1.2 Simulation of a uniform law on [0, 1] of models with jumps). We give some methods to simulate each of these laws.
We explain how to build random number generators because very often, those Simulation ofa Gaussian law
available with a certain compiler are not entirely satisfactory.
The simplest and most common method is to use the linear congruential gen- A classical method to simulate Gaussian random variables is based on the ob-
erator. A sequence (Xn)n;?:O of integers between 0 andm - 1 is generated as servation (see Exercise 44) that if (U I , U2 ) are two independent uniform random
follows: variables on [0, 1]
Xo = initial value E {O, 1, ... ,m - I} V- 2 10g(Ud cos(27rU2 )
{ ~n+I = aXn + b (modulo m),
follows a standard Gaussian law (i.e. zero-mean and with variance 1).
a, b, m being integers to be chosen cautiously in order to obtain satisfactory To simulate a Gaussian random variable with mean m and variance a, it suffices
characteristics for the sequence. Sedgewick (1987) advocates the following choice: to set X = m + ag, where 9 is a standard Gaussian random variable.
function Gaussian(m, sigma : real) : real;
31415821 begin
1 gaussian := m + sigma" sqrt(-2.0 " log(Random» " cos(2.0 " pi
108 . " Random);
end;
This method enables us to simulate pseudo-random integers between 0 and m - 1;
to obtain a random real-valued number between 0 and 1 we divide this random Simulation ofan exponential law
integer by m.
We recall that a random variable X follows an exponential law with parameter f,L
const if its law is
m 100000000;
ml 10000; 1{x;?:O}f,Le u» dx.
r-

b 31415821;
var a : integer;
function Mult(p, q: integer) : integer;
(" Multiplies p by q, avo i.d i nqjvove r f Lows ' ")
var pI, pO, ql, qO : integer;
We can simulate X ~oticing ~hat, if U follows a uniform law on [0,1], 10g(U) / f,L
follows an exponential law with parameter u,
function exponential( mu : real) : real;
begin
exponential := - log (Random) / mu;
end;
l.

begin
. p l, := p div ml;pO := p mod ml;
Remark 8.1.2 This method of simulation of the exponential law is a particular
ql := q div ml;ql :=.q mod ml; case of the so-called 'inverse distribution function' method (for this matter see
Mult := (((pO"ql + pI"qO) mod ml)"ml + pO"qO) mod m; Exercise 45). '
end;
Simulation ofa Poisson random variable
" -
A Poisson random variable is a variable with values in N such that
o
An
P(X = n) = e->'"
n.
ifn 2: O.
164 Simulation and algorithms for financial models Simulation andfinancial models 165
We have seen in Chapter 7 that if (Ti )i>l -iS a sequence of exponential random vari- Z is therefore a Gaussian vector with zero-mean and a variance matrix equal to
ables with parameter A, then the law oeNt = L:n>l nl {Tl +..+Tn9<T1+··+Tn+l} the identity. The law of the vector Z is the law of n independent standard normal
is a Poisson law with parameter At. Thus Ni h-as the same law as the variable variables. The law of the vector X = m + AZ can then be simulated in the
X we want to simulate. On the other hand, it is always possible to write expo- following manner:
nential variables T, 'as -log(Ui)/ A, where the (Ui)i>l 's are independent random • Derive the square root of the matrix I', say A.
variables following the uniform law on [0, 1). N: can be written as
• Simulate n independent standard normal variables G = (gl' ... , gn)'
N: = Lnl{U1U2 ...Un+l~e-A<U1U2 ...Un}· • Compute m + AG.
n:2:1
Remark 8.1.3 To derive the square root of I', we may assume that A is upper-
This leads to the following algorithm to simulate a Poisson random variable. triangular; then there is a unique solution to the equation A x t A = r. This method
function poisson(larnbda : real) : integer;
of calculation of the square root is called Cholesky's method (for a complete
var
u : real; algorithm see Ciarlet (1988)).
n : integer;
begin
a := exp(-larnbda); 8.1.4 Simulation of stochastic processes
u := Random; .
n := 0; The methods delineated previously enable us to simulate a random variable, in
while u > a do begin
u : = u * Random;
particular the value of a stochastic process at a given time. Sometimes we need
n := n + 1 to know how to simulate the whole path of a process (for example, when we
end; are studying the dynamics through time of the value of a portfolio of options,
Poisson := n
see Exercise 47). This section suggests some simple tricks to simulate paths of
end;
processes.
For the simulation of laws not mentioned above or for other methods of simu-
lation of the previous laws, one may refer to Rubinstein (1981).
Simulation of a Brownian motion
Simulation of Gaussian vectors We distinguish two methods to simulate a Brownian motion (Wdt>o. The first
Multidimensional models will generally involve Gaussian processes with values one consists in 'renormalising' a random walk. Let (Xi)i>O be a ~equence of
in IR.". The problem in simulating Gaussian vectors (see Section A.l.2 of the independent, identically distributed random walks with law-P (Xi = 1) = 1/2,
Appendix for the definition of a Gaussian vector) is then essential. We give a P (Xi = ,-:-~) = 1/2. Then we have E (Xi) = 0 and E (Xl) = 1. We set
Sn = Xl + .,. + X n; then we can 'approximate' the Brownian motion by the
method of simulation for this kind of random variables.
We will suppose that we want to simulate a Gaussian vector (Xl,' .. , X n) process (X;')t:2:o where
whose law is characterised by the vector of its means m = (mI, ... , m n ) = X;' = JnS[nt 1
(E(X1 ) , ... , E(Xn)) and its variance matrix r = (O'ij h~i~n.1~j~n whererr., =
E(XiX j) - E(Xi)E(Xj). The matrix r is positive definite and we will assume where [x) is the largest integer less than or equal to x. This method of simulation
that it is invertible. We can find the square root of I', in other words a matrix A, of the Brownian motion,is partially justified in Exercise 48.
such that A x t A = r. As r is invertible so is A, and we can consider the vector In the second method, we notice that, if (gi)i:2:0 is a sequence of independent
Z = A-I (X - m). It is easily verified that this vector is a Gaussian vector with standard normal random variables, if t1t > 0 and if we set
zero-mean. Moreover, its variance matrix is given by
So = 0
,{ Sn+l - Sn = g':'
then the law of (ViSJ,So, ViSJ,Sl,' .. , ViSJ,sn) is identical to the law of
~ (W o, W~t, W2~t, ... , Wn~t).
o
The Brownian motion can be approximated by X;' = ViSJ,S[t/ ~tl'
166 Simulation and algorithms for financial models Simulation and financial models 167
Simulation ofstochastic differential equations An application to the Black-Scholes model
There are many methods, some of them very sophisticated, to simulate the solution In the case of the Black-Scholes model, we want to simulate the solution of the
of a stochastic differential equation; the reader is referred to Pardoux and Talay equation

~t(rdt + adWt).
(1985) or Kloeden and Platen (1992) for a review of these methods. Here we
present only the basic method, the so-called 'Euler approximation' . The principle {;;t :
is the following: consider the stochastic differential equation Two approaches are available. The first consists in using the Euler approximation.
We set
Xo = x SO = x
{ ex. b(Xt)dt + a(Xt)dWt. { Sn+l Sn(1 + rb.t + agn.,fl;i) ,
We discretise time by a fixed mesh b.t. Then we can construct a discrete-time and simulate X; by Xl' = S[t/ ~t). The either method consists in using the explicit
process (Sn)n~O approximating the solution of the stochastic differential equation expression of the solution
at times nb.t, setting
x, = xexp (rt - ~2t + awt)
So x
{ Sn+l - Sn {b(Sn)b.t + a(Sn) (W(n+l)~t "- Wn~t)} . and simulating the Brownian motion by one of the methods presented previously.
In the case where we simulate the Brownian motion by .,fl;i ~:::l gi, we obtain
If Xl' = S[t/~t), (Xl')t~O approximates (Xt)t~O in the following sense:

Theorem 8.1.4 For any T >0 s; = z exp ((, .; q' /2)nLlt + q~t, g,) . (8.2)

E (sup IXl' -.Xt12) ~ CTb.t, We always approximate X, by Xl' = S[t/~t).

t<S.T , Remark 8.1.6 We can also replace the Gaussian random variables gi by some
C T being a constant depending only on T.
A proof of this result (as well as other schemes of discretisation of stochastic
differential equations) can be found in Chapter 7 of Gard (1988) .
The law of the sequence (W(n+l)~t - Wn~t)n>O is the law of a sequence
of independent normal random variables with zero-mean ana variance b.t. In a
simulation, we substitute gn.,fl;i to (W(n+l)~t - Wn~t) where (gn)n~O is a
sequence of independent standard normal variables. The approximating sequence
(S~)n~O is in this case defined by
Bernouilli variables with values + 1 or -1·with probability 1/2 in (8.2); we obtain
a binomial-type model close to the Cox-Ross-Rubinstein model used in Section
5.3.3 of Chapter 5.
Simulation of models with jumps
We have investigated in Chapter 7 an extension of the Black-Scholes model with
jumps; we describe now a method. to simulate this process. We take the notations
and the hypothesis of Chapter 7, Section 7.2. The process (Xt)t~O describing the
dynamics, of the asset is . ., ,

= x
S~ + b.t b(S~) + a(S~)gn.,fl;i. x, : ;: : x .
(
}1 (i + ~j)
N' )
e(Il-
CT2
/
2
.
)t+CTW, , (8.3)

Remark 8.1.5 We can substitute to the sequence of independent Gaussian random

where (Wt)t~O is a standard Brownian motion, (Nt)t>o is a Poisson process
variables (gi)i~O a sequence of independent random variables (Ui)i~O, such that
P(Ui = 1) = P(Ui = -1) = 1/2. Nevertheless, in this case, it must be noticed
.x,
with intensity and (Uj) j~ 1 is a sequence of independent, identically distributed
random variables, with values in ] -:- 1, +oo[ and law lJ(dx). The a-algebras
that the convergence is different from that found in Theorem 8.1.4. There is still
generated by (W~)t~O' (Nt)t~o, (Uj)j~l are supposed to be independent.
a theorem of convergence, but it applies to the laws of the processes. Kushner
To simulate this process at times rust, we notice that
(1977) and Pardoux and Talay (1985) can be consulted for some explanations on
this kind of convergence and many results on discretisation in law for stochastic Xn~t ~ X X (X~t/x) x (X2~t/X~t) x ···x (Xn~t/X(n-l)~t).
differential equations.
If we noteYk = (Xk~t/X(k-l)~t), we can prove, from the properties of (Nt)t~o,
168 Simulation and algorithms for financial models Some useful algorithms 169
(Wdt2:o and (Uj ) j2:l that (Yk h2:l is a sequence of independent random variables opposed to an exponential. If x >0
with the same law. Since Xn~t = xYl . , . Yn , the simulation of X at times
n.6.t comes down to the simulation of the sequence (Yk h 2: l . This sequence
Cl = 0.196854
being independent and identically distributed, it sufficesto know how to simulate
C2 = 0.115194

Yl = X~tlx. Then' we operate as follows:

C3 = 0.000344
C4 = 0.019527
• We simulate a 'standard Gaussian random variable g.
1 '
• We simulate a Poisson random variable with parameter )".6.t: N. N(x) ::::: 1 - 2(1 + CIX + C2x2 + C3X,3 + C4x4)-4.
• If N = n, we simulate n random variables following the law J.L(dx): Ul , ... , Un'
All these variables are assumedto be independent. Then, from equation (8.3), it 8.2.2 Implementation of the Brennan and Schwartz method
is clear that the law of
The following program prices an American put using the method described in
Chapter 5, Section 5.3.2: we make a logarithmic change of variable, we discretise
the parabolic inequality using a totally implicit method and finally solve the
inequality in infinite dimensions using the algorithm described on page 116,
CONST
is identical to the law 'of Yl .
PriceStepNb = 200;'
TimeStepNb = 200;
Accuracy = 0,01;
8.2 Some useful algorlthms DaysInYearNb = 360;

TYPE
In this section, we have gathered some widely used algorithms for the pricing of Date = INTEGER;
options. Amount = REAL;
AmericanPut = RECORD
ContractDate : Date; (* in days *)
MaturityDate : Date; (* in days *)
8.2.1 Approximation ofthe distributionfunction of a Gaussian variable StrikePrice : Amount;
END;
We saw in 'Chapter 4 that the pricing of many classical options requires the vector = ARRAY[l, ,PriceStepNbI OF REAL;
calculation of
'"
dx
r
Model = RECORD
REAL; (* annual riskless interest rate *)

I
,,2 sigma REAL; (* annual volatility *)
N(x) = P(X :::; x) = e--: T rs:': xO i REAL; (* initial value of the SDE *)
-00 y 27r END;
a
where X is standard Gaussian random variable: Due to the importance of this
FUNCTION PutObstacle(x : REAL;Opt : AmericanPut) :'REAL;
function in the pricing of options, we give two approximation formulae from VAR u : REAL;
BEGIN
Abramowitz and Stegun (1970) , u := Opt,StrikePrice - exp(x);
The first approximation is accurate to 10- 7 , but it uses the exponential function, IF u > 0 THEN PutObstacle := u ELSE PutObstacle := 0,0;
END;
Ifx>O
p -' 0.231641900 FUNCTION Price(t : Date; x : Amount;
b1 = 0.319381530 option : AmericanPut; 'model : Model) : REAL;
(*
b2 = -0.356563782 prices the 'option' for the 'model'
b3 = 1.781477937 at time 't' if the price o~th~ underlying at 'this time
is "x ".
-b 4 ~ 1.821255978 *)
b5 1.330274429 VAR
Obst,A,B,C,G : vector;
t = 1/(I+px) alpha, beta ;gamina, h , k , VV, temp, r , Y» del t a , Time', 1 : REAL;
Index,PriceIndex,TimeIndex : INTEGER;
1
N(x) ::::: 1 -
,,2
rrce-T (bit + b2t 2 + b3t3 + b4t4 + b5t5v ) . BEGIN '""
Time := (option,MaturityDate - ~) / Days InYearNb;
, y27r
k := Time / TimeStepNb;
The second approximation is accurate to 10- 3 but it involves only a ratio as r := model.r;
170 Simulation and algorithms for financial models Exercises 171
vv := ~odel.sigma * model. sigma; f(x)dx. We setF(u) = I::
oo
f(x)dx. Prove thatifU is a uniform random variable
1 := (model.sigma * sqrt(Temps) * sqrt(ln(l/Accuracy» + abs(r - vv / 2) * on [0,1], then the law of F-l (U) is f(x)dx. Deduce a method of simulation of
Time) ; X.
h := 2 * 1 / PriceStepNb;
writeln(1:5:3.'·' ,In(2) :5:3); Exerci.se 46 We model a risky asset S, by the stochastic differential equation
alpha := k * (- vv / (2.0 * h * h) + (r - vv / 2'.0) /
beta := 1 + k * (r + vv / (h * h»;
(2.0 * h»;
as,
gamma := k * (- vv / (2.0 * h * h) - (r - vv / 2.0) / (2.0 * h»; { So = x,
FOR PriceIndex:=l TO PriceStepNb DO BEGIN
A[PriceIndex] := alpha; where (Wt)t>o is a standard Brownian motion, a the volatility and r is the riskless
B[PriceIndex] := beta;
C[PriceIndex] := gamma; interest rate. Propose a method of simulation to approximate
END;
B[l] := beta + alpha;
B[PriceStepNb] := beta + gamma;
G[PriceIndex] := 0.0;

B[PriceStepNbl := B[PriceStepNb];
FOR PriceIndex:=PriceStepNb-l DOWNTO 1 DO Give an interpretation for the final value in terms of option.
B[PriceIndex] := B[Pri'ceIndex] - C[PriceIndex] * A[PriceIndex+l] /
B[PriceIndex+l] ; Exercise 47 The aim of this exercise is to study the influence of the hedging
FOR PriceIndex:= i TO PriceStepNb DO A[PriceIndex] := A[PriceIndex] /" frequency on the variance of a portfolio of options. The underlying asset of the
B [PriceIndex] ;
FOR PriceIndex:= 1 TO PriceStepNb - 1 DO C[PriceIndex] := C[Pricelndex] / options is described by the Black-Scholes model
B[PriceIndex+l] ;
as,
y := In(x); { So x,
FOR PriceIndex:=l TO PriceStepNb DO Obst(PriceIndex] := PutObstacle(y - 1 +
PriceIndex * h , option ); .
FOR PriceIndex:=l TO PriceStepNb DO G[PriceIndex] := ,0bst[priceIndex]; (Wtk~o represents a standard Brownian motion, a the annual volatility and r the
riskless interest rate. Further on we will fix r = lO%jyear, a = 20%/ Jyear = 0.2
and x = 100.
FOR TimeIndex:=l TO TimeStepNb DO BEGIN
FOR PriceIndex := PriceStepNb-l DOWNTO 1 DO
G[PriceIndex) := G[PriceIndex] - '. C[PriceIndex] * G[PriceIndex+1]; Being 'delta neutral' means that we compensate the total delta of the portfolio
by trading the adequate amount of underlying asset.
G[l] := G[l] / at i i , In the following, the options have 3 months to maturity and are contingent on
FOR ,PriceIndex:=2 TO PriceStepNb DO BEGIN
G [PriceIndex] : = G [PriceIndexl / B [PriceIndex] - A[Pric'~IndexJ * G [Price one unit of asset. We will choose one of the following combinations of options:
Index-l] ;
temp := Obst[PriceIndex];
• Bull spread: long a call with strike price 90 (written as 90 call) and short a 110
IF G[PriceIndex] < temp THEN G[PriceIndex] := temp; call with same maturity.
END;
END; • Strangle: short a 90 put and short a 110 call.
Index := PriceStepNb DIV 2;
delta := (G[Indice+l] - G[Index]) / h; • Condor: short a 90 call, long a 95 call and a 105 call and finally short a 110
Prix':= G[Index]+ delta*(Index * h - 1); call.
END;
• Put ratio backspread: short a 110 put and long 3 90 puts.
8.3 Exercises First we suppose that f.L = r . Write a program which:
..
.:
• Simulates the asset described previously.
Exercise 44 Let X and Y be two standard Gaussian random variables; de-
rive! the joint law of (JX2 + Y2,arctg(Y/X)). Deduce that, if U1 and U2 • Calculates the mean and variance of the discounted final value of the portfolio
are two independent uniform random variables on [0,1], the random variables in the following cases:
,
J J
-210g(Ul ) cos(27l'U2 ) and -210g(Ud sin(27l'U2 ) are independent and fol-
(

We ,90 not hedge: we sell the option, get the premium, we wait for three
Iowa standard Gaussian law. . 0
months, we take into account the exercise of the option sold and we evaluate
Exercise 45 Let f be a function from JR to JR, such that f(x) > 0 for all x, and the portfolio.
such that r:f(x)dx = 1. We want to simulate a random variable X with-law We hedge immediately after selling the option, then we do nothing.
172 Simulation and algorithms for financial models
_ We hedge immediately after seIling the option, then every month.
_ We hedge immediately after selling the option, then every 10 days .
. _ We hedge immediately after selling the option, then every day.
Investigate the influence of the discretisation frequency.
Appendix
Now consider the previous simulation assuming that J.L =I r (take values of J.L
bigger and smaller than r). Are there arbitrage opportunities?
Exercise 48 We suppose that (Wt)t>o is a standard Brownian motion and that
(Ui)i>l is a sequence of independent random variables taking values +1 or -1
with probability 1/2. We set Sn = Xl + .,. + X n.
1. Prove that, if X? = S[ntj/"fii, X? converges in law to Wt.
2. Let t and s be non-negative.using the fact that the random variable X?+s - X?
is independent of X?, prove that the pair (X?+s' X?) converges in law to A.I Normal random variables
(Wt+ s, Wt).
In this section, we recall the main properties of Gaussian variables. The following
3. IfO < tl < ... < t p, show that (X~, . . . ,X~) converges in law to (W t l , · .. , Wt p ) .
results are proved in Bouleau (1986), Chapter VI, Section 9.

A.i.i Scalar normal variables

~ A real random variable X is a standard normal variable if its probability density

function is equal to -
2)
n(x) = _1_ exp (_ X •
.J2;
I 2
If X is a standard normal variable and m and a are two real numbers, then the

~
variable Y = m + a X is normal with mean m and variance 0'2. Its law is denoted
by N( m, 0'2) (it does not depend on the sign of a since X and - X have the same
law). If a i= .0, the density of Y is

_1_ exp ( (x-m)2)

I J27fO'2 20'2'
If a = 0, the law of Y is the Dirac measure in m and therefore it does not have a
density. It is sometimes called 'degenerate normal variable'.
If X is a standard normal variable, we can prove that for any complex number
z, we have . .
E (e z X ) = e4 .
u2
Thus,the characteristic function of X is given by ifJx(u) = e- / 2 and for Y,
ifJy(u) = eiUTne-u2(j2/2. It is sometimes useful to know that if X is a standard
normal variable, we have P(IXI > 1,96,..) = 0,05 and P(IXI > 2,6 ...) =
o 0,01. For-large values of t > 0, the following approximation is handy:

. 1
P(X > t) = _rrc
, v 27f
1 t
00

e'--x
2/2dx
$
1
_rrc
tv 27f
1
t
00

xe- x2/2dx = _e__ .

.
_t
t.J2;
2
/2
 174 Appendix Conditional expectation 175
Finally, one.should know that there exist very good approximations of the cumu- Let us now consider a random variable X defined o!!-(O, A) with values in a
lative normal distribution (cf. Chapter 8) as well as statistical tables. m~able ~~~.JE, E). Th~ ~~l~bra generated ~X isthesmallest a-algebra
f~~~~.Ich X ~~~~~~~ It IS denoted by a(X). It isolWiouslyincluaea-in A
and It IS easy to show that .~--.
A.I.2 Multivariate normal variables
Definition Ad.I A random variable X =
(XI, ... ,Xd) in lR d is a Gaussian
-'-'---'-~(X)~ {A E AI3B E E,A = X-I(B) = {X E B}}.
vector if for any sequence ofreal numbers at. ... , ad, the scalar random variable We can prove that a random variable Y from (0, A) to (F,:F) is a(X)-measurable
2:~=1 aiX is normal. if and only if it can be written as . .
The components Xl •...• X d of a Gaussian vector are obviously normal, but the
Y = foX,
fact that each component of a vector is a normal random variable does not imply
that the vector is normal. However. if Xl, X 2 • . . . , X d are real-valued, normal. where fJs a me~~b~~~aP._~~~(E~E) toJF,:F). (cf. Bouleau (1986), p.
independent random variables. then the vector (Xl, ... ,Xd) is normal. 101-102). In other words, a(X)-measurable random variables are the measurable
The covariance matrix of-a random vector X =
(Xl, ... , X d ) is the matrix functions of X.
I'(X) = (aij h~i,j~d whose coefficients are equal to
aij = cov(Xi, Xj) = E [(Xi - E(Xi))(Xj - E(Xj))]. A.2.2 Properties. ofthe co~dition~l expectation

It is well known that if the random variables Xl'•... , X d are independent. the Let (0, A, P) be a probability space and B a a-algebra in~luded in A. The
matrix I'(X) is diagonal. but the converse is generally wrong. except in the definition of the conditional expectation is based on the following theorem (refer
Gaussian case: to Bouleau (1986), Chapter 8):
Theorem A.I.2 Let X =
(Xl,' .. , X d) be a Gaussian vector in lRd. The random !heorem A.2.1 For any real integrable random variable X, there exists a real
variables Xl, ... , X d are independent if and only if the covariance matrix X is Integrable Btmeasurable random variable Y such that
diagonal. . ,
VB E B E(XI B) = E(YI B).
The reader should consult Bouleau (1986), Chapter VI. p. 155, for a proof ofthis
result. If Y is another randomvar~able with these properties then Y = Y P a.s.
RemarkA.I.3 The importance of normal random variables in modelling comes Y is th~ cond~tional expectation of X given B and it is denoted by E(XIB).
If B IS a finite sub-a-algebra, with atoms B I , ... , B n , . .
partly from the central limit theorem (cf. Bouleau (1986), Chapter VI,I, Section 4).
The reader ought to refer to Dacunha-Castelle and Dufto (1986) (Chapter 5) for . E(XIB) =L E(XIB;)/P(Bi)IB;,
problems of estimation and to Chapter 8 for problems of simulation.
where we sum on the atoms with strictly positive probability..Consequently, on
A.2 Conditional expectation each atom B i, E(XIB) is the mean value of X on Bi, As far as the trivial a-algebra
is concerned (B = {0, OJ), we have E(XIB) = E(X). . .
A.2.I Examples of a-algebras
The ~omputationsinvolving conditional expectations are based on the following
.Let us consider a ~~Race (P,A) and a P~.Q'I. B 2 • • • • , ~n; with properties:
n events in A. The set B containing the elements of ~ which are ei~pty or ~!.; If £~~~l![~ble,E(XIB) = X, a.s.
that can be written as Bit U B i2 U··· U B ik, where i~, ... , ik E {I, ... , n}, is a .~ E (E (XIB)) = E (X).
finite sub-a-alg;bra of A.
It is-the a-algebra generated by the sequence of B;
3. For any bounded! B-measurablerandom variable Z,E (ZE(XIB)) = E(ZX).
" Conversely, to any finite s.!Jb~a-=algebraI3 of .A, we can associ~ition
4. L i n e a r i t y : ' . ''-' ~ ,'--
_.-"""'-~
B
----. ---. ~ ~
empty elements ofB whichcontain onIy-tnemselves and the empty set. They are
.--.. --:""_.. _-~._----- .,.r:---.-.-.- ' -----
-.
(B I , ... , B n ) of 0 where is·g~.!'erated by theelements B, of A: B, are the non-
,........
E,: (~~ + JLYIB) =AE (XIB) + JLE (YIB) a.s.
'called--atoms of B. There is a one-to-one mapping-fffiffi-tfie ser'OCfinite sub-a- I ~_

algeoras ofAonto the set of partitions of 0 by elements of A. One should notice 5. Positivity: if X 2: 0, then E(XIB) 2: a a.s. and more generally, X 2: Y =>
that if B is a sub-a-algebra of A, a map from 0 to lR (and its Borel a-algebra) is E(XIB) .~ E(YIB) a.s. It follows from this property that
B-measurable if and only. if it is constant on each atom of B. ~ IE (XIB)I $ E (IXIIB) a.s.
~----=----- ~~--_.~
 ,
176 Appendix Conditional expectation 177
and therefore II E(XIB)II£lCfl) ~ IIXII£lCfl). Proposition A.2.S Let us consider a B-measurable random variable X taking
6. If C is a sub-a-algebra of B, then values in (E, E) and Y, a random variable independent of B with values in
E (E (XIB) IC) = E (XIC) a.s. (F, F). For any Borelfunction <I> non-negative (or bounded) on (E x F, E I8i F),
the function cp defined by ,
7. If Z is B-measurable and bounded, E (ZXIB) = ZE (XIB) a.s.
Vx E E cp(x) =;: E (<I>(x, Y))
8. If X is independent of B then E (XIB) = E (X) a.s.
The converse property is not true but we have the following result. is a Borelfunction on (E, E) and we have
Proposition A.2.2 Let X be a real random variable. X is independent of the
a-algebra B if and only if E (<I> (X, Y)IB) = cp(X) a.s.
VU'E IR E (eiUXIB) ='E (e iuX) a:!. (A.l) In other words, under the previous assumptions, we can compute E ( <I> (X, Y) IB)
as if X was a-constant. ' .., .
Proof. Given the Property 8..above, we just need to prove that (A.l) implies that
X is independent of B.
Proof. Let us denote by P y the law of Y; We have
If E (e iuX IB) = E (e iUX) then, by definition of the conditional expectation,
for all B E B, E (e iuX IB) = E (e iuX) P(B). If P(B) =j:. 0, we can write '
cp(x) = i <I> (x, y)dPy(y)

E (eiUX~) = E
P(B) -, ~
(e iuX) . and the measurability of cp is a consequence of the,Fubini theorem. Let Z be a
This equality means that the characteristic function of X is identical under measure non-negative B-measurable random variable (for example Z = IB, with B E B).
P and measure Q where thedensity of Q with respectto P is equal to IB /P(B). If we denote by P X,Z the law of (X, Z), it follows from the independence between
The equality of characteristic functions implies the equality of probability laws Y and (X, Z) that,
and consequently ,
= / /
{l(X:~p~~))
E (<I>(X, Y)Z) <I> (x, y)zdPx,z(x, z)dPy(y)
E =.E (f(X)),
for any bo~nded Borelfunction j, hence the independence. o / ( / <I> (x, y)dPy(y)) zdPx,z(x, z)

Remark A.2.3 If X is square integrable, so is E(XIB), and E(XIB) coincides

with the orthogonal projection of X on L2(n, B, P), which is a closed subspace
= / cp(x)zdPx,z(x,z)
of L 2 (n, A,P), together with the scalar product (X, Y) H E(XY) (cf. Bouleau = E (cp(X)Z) ,
(1986), CnapterVIII, Section 2). The conditional expectation of X given B is the
least-square-best B-measurable predictor of X. In particular, if B is the a-algebra which completes the proof. 0
generated by a random variable €, the conditional expectation E(XIB) is noted
E(XI€), and it is the best approximation of X by a function of €, since a(€)- Remark A.2.6 In the Gaussian case, the computation of a conditional expecta-
measurable random variables are the measurable functions of €- Notice that by tion is particularly simple. Indeed, if (Y, Xl, X 2 , ..• ,Xn ) is a normal vector (in
n I
Pythagoras' theorem, we know that IIE(XIB)IIL2Cfl) ~ IIXII£2Cfl). IR + ) , the conditional expectation Z' == E (YIX I , . . . ,Xn ) has the following
form " '
Remark A.2.4 We can define E(XIB) for any non-negative random variable
X (without integrability condition). Then E(X Z) = E (E(XIB)Z), for any B- n

measurable non-negative random variable Z. The rules are basically the same as
in the integrable case (see Dacunha-Castelle and Duflo (1982), Chapter 6).
:J
A.2.3 Computations of conditional expectations
, The following proposition is crucial and is used quite often in this book.
I /'\
Z = Co + LCiXi,
i=l
where c, are real constant numbers. This means that the function of Xi which
approximates.Y in the least-square sense is linear. On top of that, we can compute
Z by p~?jecting the random variable Y in L 2 on the linear subspace generated by
I and the X/s (cf. Bouleau (1986), Chapter 8, Section 5).
 178 Appendix
A.3 Separation of convex sets
. In this section, we state the theorem of separation of convex sets that we use in
the first chapter. For more details, the diligent reader can refer to Dudley (1989)
p. 152 or Minoux (1983). References
Theorem A.3.1 Let C be a closed convex set which does not contain the origin.
Then there exists a real linear functional ( defined on IRn and 0: > 0 such that
'<Ix E C ((x) 2: 0:.

In particular, the hyperplane ((x) = 0 does not intersect C.

Proof. Let>' be anon-negative real number such that the closed ball B(>') with
centre at the origin and radius>' intersects C. Let Xo be the point where the map
x ~ Ilxll achieves its minimum (where 11·11 is the Euclidean norm) on the compact
set C n B(>'). It follows immediately that .,
Abramowitz, M. and LA. Stegun (eds), Handbook ofMathematical Functions, 9th printing,
'<Ix E C IIxll 2: II xoll· 1970.
Artzner, P. and F. Delbaen, Term structure of interest rates: The martingale approach,
The vector Xo is nothing but the projection of the origin on the closed convex set Advances in Applied Mathematics 10 (1989), pp. 95-129,
C. If we consider x E C, then for all t E [0,1], Xo + t(x - xo) E C, since Cis Bachelier, L., Theorie de la speculation, Ann. Sci. Ecole Norm. Sup., 17 (1900), pp. 21-86.
convex. By expanding the following inequality " . Barone-Adesi, G. and R. Whaley, Efficient analytic approximation of American option
IIxo + t(x - xo)I1 2 2: Il xoll 2, values, J. of Finance, 42 (1987), pp. 301-320.
Bensoussan, A., On the theory of option pricing, Acta Appl. Math., 2 (1984) pp. 139-158.
it yields xo.x 2: IIxoll2 > 0 for any x E C, where xo.x denotes the scalar product Bensoussan, A. and J.L. Lions, Applications des inequations variationnelles en contriile
of Xo and x. This completes the p r o o f . ' 0 stochastique, Dunod, 1978. .
Bensoussan, A. and J.L. Lions Applications of Variational Inequalities in Stochastic Con-
Theorem A.3.2 Let us consider a compact convex set K and a vector subspace trol, North-Holland, 1982.
Vof IRn . If V and K are disjoint, there exists a linear functional ( defined on Black, F. and M. Scholes, The pricing of options and corporate liabilities, Journal of
IRn , satisfying the following conditions: Political Economy, 81 (1973), pp. 635-654.
Brennan, MJ. and E.S. Schwartz, The valuation of the American put option, J. of Finance,
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2. '<Ix E V ((x) = O. Brennan, MJ. and E.S. Schwartz, A continuous time approach to the pricing of bonds, J.
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Bouleau, N., Probabilites de l'Ingenieur, Hermann, 1986.
Proof. The set
Bouleau, N., Processus Stochastiques et Applications, Hermann, 1988.
C=K-V={xEIRn 13(y,z)EKxV,x=y-z} Bouleau, N. and D.Lamberton, Residual risks and hedging strategies in Markovian markets,
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n CERMA, Sur les risques residuels des strategies de couverture d'actifs conditionnels,
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1990.
Hence Ciarlet, P.G., Une Introduction aI 'analyse numerique matricielle et al'optimisation, Mas-
'<Iy EX, '<Iz E V, ((y) - ((z) 2: 0:. (A.2) son, 1988.
For a fixed y, we can apply (A.2) to >.z, with>. E IR to obtainxvz E V, ((z) = 0, Ciarlet, P.G. and J.L. Lions, Handbook of Numerical Analysis, Volume I, Part I (1990),
North Holland. .
thus '<Iy E K, ((y) 2: 0:, 0
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CERMICS, Soc.Gen , 1994.

Adapted,4 Call, vii

Algorithm pricing, 154
Brennan and Schwartz, 116, 169 CalIon bond
Cox, Ross and Rubinstein, 117 pricing, 133, 138
American call Complete, 8
pricing, 25 Conditional expectation
American option Gaussian case, 177
price, 11 of a non-negative random variable, 176
American put orthogonal projection, 176
w.r.t. a random variable, 176
hedging, 27
Contingent claim, 8
pricing, 26
Continuous-time process, 29
Arbitrage, viii
Cox-Ross-Rubinstein model, 12
Asset '
Crank-Nicholson scheme, 108
financial, vii, 1
Critical price, 77
riskless, 1, 122
risky, 1
underlying, vii Delta, 72
Atom, 174 Diffusion, 49
Attainable, 8 Doob decomposition, 21
Doob inequality, 35
Dynkin operator, 99
Bachelier, vii
Bessel function, 131
Equivalent probabilities, 66
Black, vii Equivalent probability, 6
Black-Scholes formulae, 70 European call
..... "

Black-Scholes model, ix, 12 pricing, 70, 74

Bond European option
o pricing, 124, 129, 132 pricing, 68, 154
Bond option European put
pricing, 125,' 136 pricing, 70
Brownian motion, vii, 31 Exercise price, viii
Simulation of process, 165 Expectation, 5
184 Index Index 185
conditional, 174 Monte Carlo, 161 Portfolio Theta, 72
Expiration, viii Model value, 2
Exponential martingale, 33 Black-Scholes, 12,47,63,80 Position
simulation, 167 short, 3 Vega, 72
Cox-Ingersoll-Ross, 129-133 Predictable, 5 Viable, 6
Filtration, I, 30 Volatility, ix, 70
Cox-Ross-Rubinstein, 12 Premium, viii
Forward interest rate, 133 implied,71
discrete-time, 1 Pricing, viii
interest rate, 121-139 Process
Gamma, 72 Vasicek, 127-129 continuous-time, 29 Wiener integral, 57
Girsanov theorem, 66, 77 with jumps, 141-160 Omstein-Ulhenbeck, 52
Greeks simulation, 167 Poisson, 141
delta, 72 Yield curve, 121, 133
Yield curve, 133 Put, vii
gamma, 72 partial differential inequalities, 113
theta, 72 pricing, 154 Zero coupon bond, 122
vega, 72 Natural filtration, 30
Put/Call parity, ix
Normal variable, 173
degenerate, 173
Hedging, viii standard, 173 Radon-Nikodym, 66
a can, 14 Numerical methods Random number generators, 162
cans and puts, 71 Brennan and Schwartz algorithm,116 Replicating strategy, 14
no replication, 160 algorithm of Brennan and Schwartz, 169
of cans and puts, 155-159 Cox, Ross and Rubinstein method, 117 Scholes, vii
distribution function of a gaussian law, Separation of convex sets, 178
Infinitesimal generator, 112
s 168
Short- selling, 3
Ito calculus, 42 finite differences, 106 Sigma-algebra, 174
Ito formula, 42 Gauss method, 109 Simulation of processes, 165
multidimensional, 47 inequality in finite dimension, 116 Black-Scholes model, 167
Ito processes, 43 Mac Millan and Waley, 118 Brownian motion, 165
partial differential inequality, 113 model with jumps, 167
Law stochastic differential equations, 166
chi-square, 131 Option Simulation of random variables, 163
exponential, 141, 142 American, viii exponential variable, 163
Asian, 8 Gaussian, 163
gamma, 142
European, viii, ,8 Gaussian vector, 164
lognormal, 64
replicable, 68 I . Poisson variable, 163
Optional sampling theorem; 33 Snell envelope, 18
Market Stochastic differential equations, 49, 52, 96
complete, 8 Stopped sequence, 18 '
incomplete, 141, 160 Parity Stopping time, 17,30
Markov Property; 54, 56 put/call, 13 hitting time, 34
Martingale, 4 Partial differential equation optimal,20
continuous-time, 32 numerical solution, 106 Strategy, 1
exponential, 47 on a bounded open set. 102 admissible, 3, 68, 125, 151
optional sampling theorem, 33 parabolic, 95, 99 consumption, 27,73
Martingale transform, 5 Partial differential inequalities.vl ll, 113 self-financing, 2, 64, 125, 151
Martingales representation, 66 Perpetual put, 75 Strike price, vii
Merton, vii pricing, 75 Submartingale, 4
Method Poisson process, 141 Supermartingale, 4