Change of Measure (Domestic Currency

as Numeraire)
Mauricio Bedoya
javierma36@gmail.com
September 2014
To understand this blog, we must known:
1. It o Quotien Rule.
2. Martingala Process.
3. It o Calculus.
Denition: It o Quotien Rule
This rule state, that if you have the quotient of two stochastic process
1
X and Y, then:
d(
X
Y
)
X
Y
=
dX
X

dY
Y
+
dY
2
Y
2

dX dY
X Y
(1)
Equation 1 can be understood like:
We are long X and short Y.
We are long Y volatility.
We are short (XY )
2
.
Denition: Martingala
A process is Martingala if:
E[X
(u)
|F
(t)
] = X
(t)
with u > t. (2)
In English, a process is Martingala if the old (known) information, doesnt help in forecasting
the future value of X
(t)
.
1
Check any Stochastic process or search in google for a denition.
2
Correlation between X and Y.
1
Now, explaining It os Calculus in a blog is not possible. However, we will try to implement
every step, until we get the nal desired expression.
Now assume that S
(t)
follow a Geometric Brownian Motion, then:
d(S
(t)
)
S
(t)
= dt + dw (3)
with dw N[0,

t], and constant mean and volatility respectively. Next, assume that
C
(t)
= e
rt
; called the money market capitalization process. The inverse of C
(t)
is D
(t)
; called
the money market discount process.
Our goal is to make the discount stock price process (domestic) Martingala. Mathematically
E[D
(u)
S
(u)
|F
(t)
] = E[
S
(u)
C
(u)
|F
(t)
] = S
(t)
with u > t. (4)
To proceed, we have two options: use the Ito Product Rule or Ito Quotien rule. Here, we are
going to use the quotien rule
3
.
From equation 4, we have
d(
S
(t)
C
(t)
)
S
(t)
C
(t)
=
dS
(t)
S
(t)

dC
(t)
C
(t)
+
d(C
(t)
, C
(t)
)
C
(t)

d(S
(t)
, C
(t)
)
S
(t)
C
(t)
=
S
(t)
( dt + dw)
S
(t)

C
(t)
r dt
C
(t)
+ 0 0
= ( r) dt + dw
= (
( r) dt

+dw)

dw

=

dw
(5)
Now, a few explanation. The rst zero comes from the quadratic variation of a non random
process (dt * dt = 0). The second zero comes from the product of (dt * dw = 0) and (dt *
dt = 0). Next, we make a change of variable to make the process Martingala (if no dt in the
equation, the process is Martingala, remember this). Now, lets integrate between 0 and T.

T
0
d(
S
(t)
C
(t)
)
S
(t)
C
(t)

Lebesgue Integral.
=

T
0

dw

Ito Integral.
(6)
The It o integral requires some knowledge that you can found in any Stochastic process book.
The primary dierence between Lebesgue and Ito calculus is the quadratic variation. Lets solve
the Ito integral:
3
Implement the process using the product rule. You should arrive to the same result.
2
d( w
(t)
) = dw +
1
2

2
dt

T
0
dw =

T
0
d( w
(t)
)

T
0
1
2

2
dt

T
0
dw = w
(T)

1
2

2
T
(7)
Integrating equation 7 in 6 and solving the Lebesgue integral, we get
Ln[
S
(t)
C
(t)
]
T
0
= w
(T)

1
2

2
T
S
(T)
C
(T)
=
S
(0)
C
(0)
e
w
(T)

1
2

2
T
S
(T)
= S
(0)
C
(T)
e
w
(T)

1
2

2
T
S
(T)
= S
(0)
e
(r
1
2

2
)T+w
(T)
.
(8)
Ok, this is it. Replacing equation 8 in equation 4, we can found that eectively S
(t)
is Martingale.
3