CH 28 Hull OFOD9 TH Edition

Chapter 28
Martingales and Measures

Options, Futures, and Other Derivatives, 9th Edition,
Copyright John C. Hull 2014 1
Derivatives Dependent on a Single
Underlying Variable
Copyright John C. Hull 2014
2
dz dt
d

dz dt
d

dz s dt m
d
2 2
2
2
1 1
1
1
.
o + =
o + =
u
+ =
u
u
u

Suppose and prices with
on dependent s derivative two Imagine

process the follows that security) traded a of
price the y necessaril (not variable a Consider
2 1
Forming a Riskless Portfolio
3
t =

A o o AH
o o = H
o
o
H
) (
) ( ) (
2 1 1 2 2 1 2 1
2 1 1 1 2 2
1 1
2 2
derivative 2nd the of
and derivative 1st the of +
of consisting
portfolio riskless a up set can We
Market Price of Risk (Page 657)
This shows that ( r )/o is the same for all
derivatives dependent on the same underlying
variable, u
We refer to ( r )/o as the market price of risk
for u and denote it by
4
or
: gives This
: riskless is portfolio the Since
2
2
1
1
1 2 1 2 2 1
r
r r
t =r

=

o o = o o
HA AH
Extension of the Analysis
to Several Underlying Variables
(Equations 28.12 and 28.13, page 659)
5

then
with
variables underlying several on depends If

r
dz dt
d
f
n
i
i i
n
i
i i
=
=
o =
o + =
1
1
Martingales (Page 660-661)
A martingale is a stochastic process with zero
drift
A variable following a martingale has the
property that its expected future value equals
its value today
6
Alternative Worlds
dz f dt f r df
dz f dt rf df
o + o + =
o + =
) (
is
risk of price market the where world a In
world neutral - risk l traditiona the In
The Equivalent Martingale
Measure Result (Page 660-661)

8
f
g f
g
prices security derivative all
for martingale a is that shows
lemma s Ito' then , security a
of volatility the to equal set we If
Forward Risk Neutrality
We will refer to a world where the market
price of risk is the volatility of g as a world that
is forward risk neutral with respect to g.
If E
g
denotes expectations in a world that is
FRN wrt g

9
f
g
E
f
g
g
T
T
0
0
=
|
\
|
.
|
Alternative Choices for the
Numeraire Security g
Money Market Account
Zero-coupon bond price
Annuity factor
10
as the Numeraire
The money market account is an account that
starts at $1 and is always invested at the short-
term risk-free interest rate
The process for the value of the account is
dg = rg dt
This has zero volatility. Using the money market
account as the numeraire leads to the traditional
risk-neutral world where =0

11
continued

12
world neutral - risk l traditiona
the in ns expectatio denotes where
becomes
equation the , = and 1 = Since
E
f e E f
g
f
E
g
f
e g g
T
rdt
T
T
g
rdt
T
T
T
0
0
0
0
0
0
(
}
=
|
|
.
|
\
|
=
}
Zero-Coupon Bond Maturing at time T as

Numeraire
price bond the wrt FRN is
that world a in ns expectatio denotes and
price bond coupon - zero the is ) , ( where
becomes
equation The
T
T T
T
T
g
E
T P
f E T P f
g
f
E
g
f
0
] [ ) , 0 (
0
0
0
=
|
|
.
|
\
|
=
13
Forward Prices
In a world that is FRN wrt P(0,T), the
expected value of a security at time T is its
forward price
14
I nterest Rates
In a world that is FRN wrt P(0,T
2
) the
expected value of an interest rate lasting
between times T
1
and T
2
is the forward
interest rate
15
Annuity Factor as the Numeraire
(
=
|
|
.
|
\
|
=
) (
) 0 (
0
0
0
T A
f
E A f
g
f
E
g
f
T
A
T
T
g
becomes
equation The
16
Annuity Factors and Swap Rates
Suppose that s(t) is the swap rate
corresponding to the annuity factor A.
Then:
s(t)=E
A
[s(T)]

17
Extension to Several I ndependent Factors
(Page 665)

= =
= =
=
=
o +
(
o + =
o +
(
o + =
o + =
o + =
m
i
i i g
m
i
i g i
m
i
i i f
m
i
i f i
m
i
i i g
m
i
i i f
dz t g t dt t g t t r t dg
dz t f t dt t f t t r t df
dz t g t dt t g t r t dg
dz t f t dt t f t r t df
1
,
1
,
1
,
1
,
1
,
1
,
) ( ) ( ) ( ) ( ) ( ) (
) ( ) ( ) ( ) ( ) ( ) (
) ( ) ( ) ( ) ( ) (
) ( ) ( ) ( ) ( ) (
consistent internally are that worlds other For
world neutral - risk l traditiona the In
Extension to Several I ndependent
Factors continued
hold. results the of rest the and martingale
a is case, factor - one the in As
where world as
wrt FRN is that world a define We
g f

g
i g i ,
=
Applications
Extension of Blacks model to case where
inbterest rates are stochastic
Valuation of an option to exchange one
asset for another
20
Blacks Model (page 666)
By working in a world that is forward risk neutral with
respect to a P(0,T) it can be seen that Blacks model
is true when interest rates are stochastic providing
the forward price of the underlying asset is has a
constant volatility
c = P(0,T)[F
0
N(d
1
)KN(d
2
)]
p = P(0,T)[KN(d
2
) F
0
N(d
1
)]

21
T
T K F
d
T
T K F
d
F
F
F
F
o
o
=
o
o +
=
2
0
2
2
0
1
) / ln( ) / ln(
Option to exchange an asset worth
U for one worth V
This can be valued by working in a world that
is forward risk neutral with respect to U
Value is

22
( )
V U V U
V U
q q
T d d
T
T q q U V
d
d N U e d N V e
U V
o o o + o = o
o =
o
o + +
=
) 2 ( ln
) ( ) (
2 2 2
1 2
2
0 0
1
2 0 1 0
Change of Numeraire
(Section 28.8, page 668)

23
w v
w g h w v
v h g
w
v w v
and between n correlatio the is
and of volatility the is of
volatility the is where by increases
variable a of drift the , to from
security numeraire the change we When
o =
o o o
, , ,

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Chapter 28

Martingales and Measures

Zero-Coupon Bond Maturing at time T as

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