Solutions to Stochastic Calculus for Finance II (Steven Shreve)

Dr. Guowei Zhao

Dept. of Mathematics and Statistics
McMaster University
Hamilton,ON L8S 4K1
August 23, 2013

Contents
1 Chapter 1
1.1 Exercise
1.2 Exercise
1.3 Exercise
1.4 Exercise

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3
3
3
4
4

2 Chapter 2
2.1 Exercise 2.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 Exercise 2.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5
5
5

1.6 .
1.7 .
1.10
1.14

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3 Chapter 3
3.1 Exercise
3.2 Exercise
3.3 Exercise
3.4 Exercise
3.5 Exercise

3.2
3.3
3.5
3.6
3.7

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7
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7
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9
10

4 Chapter 4
4.1 Exercise
4.2 Exercise
4.3 Exercise
4.4 Exercise
4.5 Exercise
4.6 Exercise
4.7 Exercise
4.8 Exercise
4.9 Exercise
4.10 Exercise

4.5 . .
4.6 . .
4.7 . .
4.8 . .
4.9 !!!
4.11 .
4.13 .
4.15 .
4.18 .
4.19 .

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12
12
12
13
14
14
15
16
17
17
18

Email:

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zhaog22@mcmaster.ca

5 Chapter 5
5.1 Exercise
5.2 Exercise
5.3 Exercise
5.4 Exercise

5.1 .
5.5
5.12
5.14

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20
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20
21
23

6 Chapter 6
6.1 Exercise
6.2 Exercise
6.3 Exercise
6.4 Exercise
6.5 Exercise

6.1
6.3
6.4
6.5
6.7

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26
26
27
27
29
31

7 Chapter 7

32

8 Chapter 8

32

9 Chapter 9

32

10 Chapter 10

32

11 Chapter 11
11.1 Exercise 11.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32
32

Introduction
This solution manual will be updated anytime, and is NOT intended for any business use. The author
suggests this manual as a reference book to the metioned book by Steven Shreve. Also anyone involved
in any mathematical finance courses shall not copy the solutions in this book directly. This is ideally
for self-check purpose.
If anyone find any mistakes or misprints in this book, please inform me. Thanks.

Chapter 1

1.1

Exercise 1.6

1.
E[e

uX

eux f (x)dx


Z
1
(x )2
=
exp ux
dx
2 2
2


Z
1
x2 2x + 2
=
exp ux
dx
2 2
2


Z


1
1
2
2
2
exp 2 x (2 + 2u )x 2 dx
=
2
2
2


Z


1
1
1
2
2
2
2 2
=
exp 2 x ( + u ) + 2 ( + u ) 2 dx
2
2
2
2




Z


1
1
2
1
2
2 2
=
exp 2 x ( + u 2 )
(
+
u
)

dx exp
2
2 2
2 2
2




Z
1
1
2u 2
2 4
exp 2 y 2 dy exp
=
+
2
2
2
2 2
2


1
= 1 exp u + u2 2
2

]=

2.

E[(X)] = E[euX ] = eu+ 2 u

1.2

eu = () = (EX)

Exercise 1.7

1. f (x) = 0 for any x;

R
R
2. limn fn (x)dx = 1 6= 0 = f (x)dx;
3. The sequence fi is not monotone. Refer to the following diagram for the graphs of the functions:

Figure 1: Graphs of Exercise 1.7 with n=1,2,3,4 from the top respectively

1.3

Exercise 1.10

1. Since Z is a nonnegative random variable and

Z
1
1
E[Z] =
Z()d = 0 + 2 = 1
2
2

by Theorem 1.6.1, P is a probability measure.

2.
P (A) =

Z()dP () =
A

Z()dP () +
A{:01/2}

Z()dP ()
A{:1/21}

= 0 P (A { : 0 1/2}) + 2 P (A { : 1/2 1})

0 + 2 P (A) = 0
since P (A) 0, P (A) = 0.
3. Let A = { : 0 1/2}, then P (A) = 1/2 > 0, P (A) =

1.4

R 1/2
0

Z()d =

Exercise 1.14

Since for a 0
P (X a) = 1 ea =

f (x)dx

where

(
ex ,
f (x) =
0,

x0
x<0

f (x) is the density function for such expoential r.v.

1.
P () =

Z
Z()dP ()

e()x f (x)dx

Z
()x

=
e
(ex )dx

Z0

x
=
e
dx
Z

=1
2.
P (X a) =

Z
:X()a Z()dP ()

Z a

=
Z0 a
=

e()x (ex )dx

x
e
dx

= 1 ea
4

R 1/2
0

0d = 0.

Chapter 2

2.1

Exercise 2.3

Since V is normal random variable and

E[V ] = E[X cos + Y sin ] = cos E[X] + sin E[Y ] = cos 0 + sin 0 = 0
V ar[V ] = V ar[X cos + Y sin ] = cos2 V ar[X] + sin2 V ar[Y ] = cos2 1 + sin2 1 = 1
so V is standard normal. Similarly W is also standard normal.
To show the independence, we quote the fact that if Z is a standard normal random variable, then
for any u, E[euZ ] = exp(u2 /2) (Exercise 1.6). Then for any real numbers a and b,
E[eaV +bW ] = E[ea(X cos +Y

sin )+b(X sin +Y cos )

X(a cos b sin )+Y (a cos +b sin )

= E[e

X(a cos b sin )

= E[e


= exp

] E[e

Y (a cos +b sin )

by the independence of X and Y



(a cos + b sin )
(a cos b sin )
+
2
2

a2 cos2 + b2 sin2 2ab cos sin a2 cos2 + b2 sin2 + 2ab cos sin
+
= exp
2
2
 2

a
b2
= exp
+
2
2


= E[eaV ]E[ebW ]
So V and W are independent.

2.2

Exercise 2.5
Z

fX (x) =

fX,Y (x, y)dy



(2|x| + y)2
2|x| + y

exp
=
dy
2
2
|x|


Z
z2
z
exp
dz
(z = y + 2|x|)
=
2
2
|x|
1
z 2 z=
= exp[ ]
2 z=|x|
2
2
1
x
= exp[ ]
2
2
Z
fY (y) =
fX,Y (x, y)dx



Z
2|x| + y
(2|x| + y)2

=
exp
dx
2
2
|x|y

if y 0, then



2|x| + y
(2|x| + y)2

exp
dx
2
2



Z
2x + y
(2x + y)2

=2
exp
dx
2
2
0
 2
Z
z
z dz
exp
=2
(z = 2x + y)
2 2
2
y
Z

fY (y) =

y2
1
= exp[ ]
2
2
if y 0, then





Z y
2|x| + y
(2|x| + y)2
2|x| + y
(2|x| + y)2

exp
exp
dx +
dx
2
2
2
2
y





Z
Z y
2x + y
2x + y
(2x + y)2
(2x + y)2

dx +
dx
=
exp
exp
2
2
2
2

y


Z
2x + y
(2x + y)2

=2
exp
dx
2
2
y
 2
Z
z
z dz
exp
=2
(z = 2x + y)
2 2
2
y
Z

fY (y) =

1
y2
= exp[ ]
2
2
Therefore both X and Y are standard random variable.
It is clear that fX,Y (x, y) 6= fX (x) fY (y), so they are not independent.
And it is also clear that E[X] = E[Y ] = 0, and
E[XY ]
Z Z
=
xyfX,Y (x, y)dydx



Z Z
2|x| + y
(2|x| + y)2

dydx
=
xy
exp
2
2
|x|




Z Z
Z 0 Z
2x + y
(2x + y)2
2x + y
(2x + y)2
=
xy
exp
dydx +
xy
exp
dydx
2
2
2
2
0
x
x




Z Z
Z 0Z
2x + y
(2x + y)2
2t + y
(2t + y)2

exp
exp
=
xy
dydx +
(t)y
dy(dt)
2
2
2
2
0
x
t
Z

=
0

(t = x)




Z Z
2
(2x + y)
2x + y
(2x + y)2
2x + y
xy
xy
exp
dydx
exp
dydx
2
2
2
2
0
x

=0
so E[XY ] = E[X]E[Y ], which implies X and Y are uncoorelated.

3
3.1

Chapter 3
Exercise 3.2

For 0 s t,
E[W 2 (t) t|F(s)]
=E[(W (t) W (s))2 + 2W (t)W (s) W 2 (s) t|F(s)]
=E[(W (t) W (s))2 t|F(s)] + E[(2W (t)W (s)|F(s)] + E[W 2 (s)|F(s)]
=[(t s) t] + 2W (s)E[W (t)|F(s)] W 2 (s)
= s + 2W 2 (s) W 2 (s)
=W 2 (s) s
so martingale.

3.2

Exercise 3.3
h
i
1 2 2
(u) = E eu(X) = e 2 u
h
i
1 2 2
0 (u) = E (X )eu(X) = u 2 e 2 u
h
i
1 2 2
00 (u) = E (X )2 eu(X) = ( 2 + u2 4 )e 2 u
h
i 
 1 2 2
(3) (u) = E (X )3 eu(X) = 2u 4 + ( 2 + u2 4 ) u 2 e 2 u

1 2 2
= 3u 4 + u3 6 e 2 u
h
i 
 1 2 2
(4) (u) = E (X )4 eu(X) = (3 4 + 3u2 6 ) + (3u 4 + u3 6 ) u 2 e 2 u

1 2 2
= 3 4 + 6u2 6 + u4 8 e 2 u

In particular, (3) (0) = 0 and (4) (0) = 3 4 . The latter implies the kurtosis of a normal random
variable is (4) (0)/( 2 )2 = 3.

3.3

Exercise 3.5

1
exp(x2 /2T ). Then by
Note that W (T ) N (0, T ), with probability density function f (x) = 2T
the definition of the expectation


E erT (S(T ) K)+
Z

+
1 2
=
erT S(0)e(r 2 )T +x K f (x)dx

Z


1 2
=
erT S(0)e(r 2 )T +x K f (x)dx
A

where A is the constant such that S(T ) K for any x A and S(T ) K for any x A. More
precisely,
1
A = min{x : (r 2 )T + x K}
2 

K
log S(0)
(r 21 2 )T
= min{x : x
}



K
(r 21 2 )T
log S(0)
=

= T d (T, S(0))
Therefore,


E erT (S(T ) K)+
Z
Z
rT
(r 21 2 )T +x
f (x)dx
=
e
S(0)e
=e

S(0)e

(r 21 2 )T

rT

T d

e f (x)dx e
{z

Now we compute the two integrals separately:

Z
x2
1
I =
ex e 2T dx

2T T d


Z

1
t2
=
dt
exp T t
2
2 d


Z
2
1 2 T /2
1
= e
exp (t T ) dt
2
2
d
Z
2
2
1
x2
= e T /2
dx
e
2
d T
Z
2
x2
1
= e T /2
e 2 dx
2
d+
=e

T /2

erT Kf (x)dx

T d

T d

rT

Z
K

T d

f (x)dx

{z
II

x
(t = )
T
(completing the square)

(x = t T )

(d+ = d + T )

N (d+ )

and
Z
x2
1
II =
e 2T dx

2T T d
 2
Z
1
t
=
exp
dt
2
2 d

x
(t = )
T

=N (d )
By substituting I and II,we have the expected payoff of the option


E erT (S(T ) K)+
1

=erT S(0)e(r 2

)T 2 T /2

N (d+ ) erT KN (d )

=S(0)N (d+ ) erT KN (d )

8

3.4

Exercise 3.6

1. Write
E[f (X(t))|F(s)] = E[f (X(t) X(s) + X(s))|F(s)]
We define g(x) = E[f (X(t)X(s)+x)], then we have E[f (X(t)X(s)+X(s))|F(s)] = g(X(s)).
Now since
X(t) X(s) = (t s) + W (t) W (s)
is normally distibuted with mean (t s) and variance t s,


Z
1
( (t s))2
g(x) = p
f ( + x) exp
d
2(t s)
2(t s)


Z
(y x (t s))2
1
f (y) exp
=p
dy
2(t s)
2(t s)
by changing variable y = + x.
Therefore E[f (X(t))|F(s)] = g(X(s)), i.e. X has Markov property.
2. Write



 
S(t)
S(s) |F(s)
E[f (S(t))|F(s)] = E f
S(s)
h 

i
S(t)
We define g(x) = E f S(s)
x |F(s) , then since
log

S(t)
= (t s) + (W (t) W (s))
S(s)

is normally distibuted with mean (t s) and variance 2 (t s),



Z
1
( (t s))2

g(x) =
f (e x) exp
d

2 2 (t s)
2 t s


Z
(log xy (t s))2
1
1
=
f (y) exp
dy

2 2 (t s)
2 t s 0 y
by changing variable y = e x ( d = dy/y and x implies 0 y ).
Therefore
Z
g(x) =

f (y)p(, x, y)dy

p(, x, y) =

with



(log xy )2
1
exp

2 2
2y

satisfies E[f (S(t))|F(s)] = g(S(s)) for any f . Hence S has Markov property.

3.5

Exercise 3.7

1.

i
h

E Z(t)F(s)



Z(t)

=E
Z(s)F(s)
Z(s)


Z(t) 
=Z(s)E
F(s)
Z(s)




1 2

=Z(s)E exp (t s) + (W (t) W (s)) ( + )(t s) F(s)
2
i
h
1 2
=Z(s)e(ts) E e(W (t)W (s)) e(+ 2 )(ts)
(by independence)
1

=Z(s)e(ts) e 2
=Z(s)

(ts)

e(+ 2

)(ts)

(since W (t) W (s) N (0, s t))

2. since m is a stopping time, and a martingale which is stoped at a stopping time is still a
martingale,
E[Z(t m )] = E[Z(0 m )] = E[Z(0)] = Z(0) = 1
which is exactly


1 2
E[exp{X(t m ) + (t m )}] = 1
2

(3.1)



1 2
lim Z(t m ) = Z(m ) = exp m ( + )m
t
2

(3.2)



1 2
lim Z(t m ) = lim exp X(t) ( + )t
t
t
2

(3.3)

3. For m < ,

For m = ,

since



1
lim exp ( + 2 )t = 0
t
2


1 2
lim Z(t m ) = lim exp [X(t)] lim exp ( + )t = lim eX(t) 0 = 0
t
t
t
t
2
0 eX(t) em

(3.4)
(3.5)

therefore






1 2
1 2
lim exp X(t m ) + (t m ) = Im < exp m ( + )m
t
2
2
By taking the limits in (3.1), we have



1 2
E Im < exp m ( + )m
2





1 2
=E lim exp X(t m ) + (t m )
t
2





1 2
= lim E exp X(t m ) + (t m )
t
2
=1
10

(3.6)

(3.7)

Furthermore




1
1 = lim E Im < exp m ( + 2 )m = E[Im < ]
0+
2

which is equivalent to P [M < ] = 1.

Therefore,






1 2
1 2
1 = E Im < exp m ( + )m = E exp m ( + )m
2
2
or equivalentely, for any > 0



1 2
E exp ( + )m = em
2

Let = + 21 2 , then > 0 and = u2 + 2. But since > 0, = + u2 + 2,

so for any > 0
E[em ]



1 2
=E exp ( + )m
2
=em

=e(+
=e

u2 +2)m

u2 +2m

4. By differentiating
d  m 
d h mm2+2 i
E e
=
e
d
d



m
2
E m em = p
2 emm 2+
2 2 + 2



m
2
lim E m em = lim p
emm 2+
0+
0+
2 + 2
2
m
E [m ] = p
emm 0+
0 + 2
m
E [m ] =
since > 0

And E [m ] =

< follows immediately.

5. For < 0 and > 2 > 0, we still have (3.2) and (3.3) respectively. The slight difference to
the argument in (3.4) will be,




1 2
( + 2)
0 lim exp ( + )t lim exp
t =0
t
t
2
2
as both > 0 and + 2 > 0.
Then (3.5)-(3.7) follow directly as part (iii), which is



1
E Im < exp m ( + 2 )m = 1
2
11

(3.8)

Insteading of taking limits 0+ in (ref130724g), we can only take the limit 2 as:
Furthermore



1
1 = lim E Im < exp m ( + 2 )m = E[e2m Im < ]
2
2
which is equivalent to P [M < ] = E[Im < ] = e2m = e2m|| .
The Laplace transform argument is exactly the same as part (iii).

Chapter 4

Theorem 1. If dx = a(x, t)dt + b(x, t)dW , where dW is a Wiener process/Brownian motion then for
G(x, t), we have


G G 1 2 2 G
G
dG = a
dt + b
+
+ b
dW
(4.1)
2
x
t
2 x
x

4.1

Exercise 4.5

1. In Theorem 1, G(x, t) = log x, then




1
1
1
1
+ 0 + 2 S 2 (t) 2
dt + S(t)
dW (t)
d log S(t) = (t)S(t)
S(t)
2
S (t)
S(t)


1
= (t) 2 dt + (t)dW (t)
2
2.

Z t
log S(t) log S(0) =
0

so

Z t 
S(t) = S(0) exp
0

4.2


Z t
1
(s) 2 ds +
(s)dW (s)
2
0



Z t
1
(s)dW (s)
(s) 2 ds +
2
0

Exercise 4.6

Define Itos process

Z
X(t) =
0

1
((s) 2 )ds +
2

(s)dW (s)
0

Then
1
dX(t) = ( 2 )dt + dW (t)
2
dX(t)dX(t) = 2 dt
Now we use two different notations to compute d(S p (t)):
1. Under the notations in Theorem 1, G(x, t) = S p (0)epx , a = 21 2 and b = . Then


1
1
d(S p (t)) = ( 2 ) pS p (0)epX(t) + 0 + 2 p2 S p (0)epX(t) dt + S p (0)pepX(t) dW (t)
2
2


1
1
= p p 2 + p2 2 S p (t)dt + pS p (t)dW (t)
2
2
12

2. Under the notations in Theorem 4.4.6 of Text, S p (t) = f (X(t)), then f (x) = S p (0)epx , f 0 (x) =
pS p (0)epx and f 00 (x) = p2 S p (0)epx . Now
d(S p (t)) = df (X(t))
1
= pS p (0)epX(t) dX(t) + p2 S p (0)epX(t) dX(t)dX(t)
2
1
= pS p (t)dX(t) + p2 S p (t)dX(t)dX(t)
2


1
1 2
p
= pS (t) ( )dt + dW (t) + p2 S p (t) 2 dt
2
2


1
1
= p p 2 + p2 2 S p (t)dt + pS p (t)dW (t)
2
2

4.3

Exercise 4.7

Here we use the following version (4.4.1)of Itos lemma:

1
df (W (t)) = f 0 (W (t))dW (t) + f 00 (W (t))dt
2

(4.2)

1. Set f (x) = x4 in (4.2), then f 0 (x) = 4x3 and f 00 (x) = 12x2 . Then (4.2) becomes
1
12W 2 (t)dt = 4W 3 (t)dW (t) + 6W 2 (t)dt
2

dW 4 (t) = 4W 3 (t)dW (t) +

We may also write it in the integral form as:

Z T
Z T
Z
W 4 (T ) = W 4 (0)+4
W 3 (t)dW (t)+6
W 2 (t)dt = 4
0

W 3 (t)dW (t)+6

W 2 (t)dt (4.3)

2. First we note that W (t) N (0, t), then by the symmetry of the integrand
Z
1 x2
e 2t dx = 0
E[W 3 (t)] =
x3
2t

Now we take the expectation in (4.3),

" Z
 4

E W (T ) =E 4

W (t)dt
0



4E W 3 (t) dW (t) + 6

W (t)dW (t) + 6



E W 2 (t) dt

0
T

Z
40dW (t) + 6

t2 dt

=3T 2
3. Set f (x) = x6 in (4.2), then f 0 (x) = 6x5 and f 00 (x) = 30x4 . Then (4.2) becomes
dW 6 (t) = 6W 5 (t)dW (t) +

1
30W 4 (t)dt = 6W 5 (t)dW (t) + 15W 4 (t)dt
2

We may also write it in the integral form as:

Z T
Z
6
6
5
W (T ) = W (0) + 6
W (t)dW (t) + 15
0

13

W (t)dt = 6

T
5

W (t)dW (t) + 15
0

W 4 (t)dt

It is easy to see that E[W 5 (t)] = 0. Then by taking expectation in the above equation, we have
#
" Z
Z T
T
 6

4
5
W (t)dt
W (t)dW (t) + 15
E W (T ) =E 6
0



6E W 5 (t) dW (t) + 15



E W 4 (t) dt

=6

0dW (t) + 15
0

3t2 dt

=15T 3

4.4

Exercise 4.8

1. In (4.4.23) of text, let f (t, x) = et x, then ft = et x, fx = et and fxx = 0. Then (4.4.23)

becomes


d et R(t) =et R(t)dt + et dX(t)
=et R(t)dt + et [( R(t))dt + dW (t)]
=et dt + et dW (t)
2. Integrating the both sides of the above equation, we have
Z t
Z t
e0 R(t) =et R(0) +
es ds +
es dW (s)
0
0
Z t


t
=R(0) +
e 1 +
es dW (s)

0
which implies
R(t) = et R(0) +

4.5

1 et + et

es dW (s)

Exercise 4.9 !!!

1. It is clear that

and

y2
1
N 0 (y) = e 2
2



1
x
2
d = d (T t, x) =
log
+ (r
)(T t)
K
2
T t

Then
 2

d+
d2
N 0 (d+ )
=
exp

+
N 0 (d )
2
2
"
2 
2 #
1
x
2
x
2
= exp 2
log
+ (r
)(T t) log
+ (r +
)(T t)
2 (T t)
K
2
K
2



 2
1
x
= exp 2
4 log
+ r(T t)
(T t)
2 (T t)
K
2
h
i
x
= exp log
+ r(T t)
K
K
= er(T t)
x
14

2. First

d
1
=
x
T tx

By the definition
c(t, x) = xN (d+ (T t, x)) Ker(T t) N (d (T t, x))
cx =

c
x

d+
d
= N (d+ (T t, x)) + xN 0 (d+ )
Ker(T t) N 0 (d )
x
x


1
0
r(T t) 0
= N (d+ ) + xN (d+ ) Ke
N (d )
T tx
= N (d+ )
3.
ct =

c
t

d
d+
Ker(T t) rN (d ) Ker(T t) N 0 (d )
t
t


d+
r(T t)
0
r(T t) d+
= Ke
rN (d ) + N (d+ ) x
Ke
xKer(T t)
t
t


d+
d
= Ker(T t) rN (d ) + xN 0 (d+ )

t
t
= xN 0 (d+ )

Now note that

d+ d = T t
(d+ d )

=
t
2 T t

so

x
ct = Ker(T t) rN (d )
N 0 (d+ )
2 T t

4.
5.
6.
7.

4.6

Exercise 4.11

Without confusion, we shorten the notations when it is proper through this problem:
S = S(t),

c = c(t, S(t)),

cx = cx (t, S(t)),

ct = ct (t, S(t)),

cxx = cxx (t, S(t))

By
dS(t) = Sdt + 2 SdW (t)
we have
dS(t)dS(t) = 2 S 2 dtdt + 2S2 SdtdW (t) + 22 SdW (t)dW (t) = 22 Sdt

15

and

1
dc(t, S(t)) = ct dt + cx dS + cxx dSdS
2

Now we compute
d(ert X(t)) = rert X(t)dt + ert dX(t)


1
= rert X(t)dt + ert dc cx dS + r(X c + Scx )dt (22 12 )S 2 cxx dt
2



1
1
= ert ct dt + cx dS + cxx dSdS cx dS + r(X c + Scx )dt (22 12 )S 2 cxx dt
2
2


1
1
= ert ct + 12 S 2 cxx rc + rScx (22 12 )S 2 cxx dt + ert (cx cx ) dS
2
2
1
= ert (ct rc + rScx + 12 S 2 cxx )dt
2
=0
which implies ert X(t) is a non-random constant and ert X(t) = er0 X(0) = X(0) = 0 for any t.
Since r > 0, so X(t) = 0 for any t.

4.7

Exercise 4.13

Since B1 (t) and B2 (t) are Brownian motions, dB1 (t)dB1 (t) = dt and dB2 (t)dB2 (t) = dt. By substituting the definition
dB1 (t) =dW1 (t)
dB2 (t) =(t)dW1 (t) +

1 2 (t)dW2 (t)

Note that these equations imply that W1 (t) is Brownian motion

and W2 (t) is a continuous
martingale
p
p
with W2 (0) = 0 (since we can write dW2 (t) = dB2 (t)/ 1 2 (t) (t)dW1 (t)/ 1 2 (t) with
1 < < 1). Furthermore we have
(
dW1 (t)dW1 (t) = dt
p
p
(4.4)
((t)dW1 (t) + 1 2 (t)dW2 (t)) ((t)dW1 (t) + 1 2 (t)dW2 (t)) = dt
Also by dB1 (t)dB2 (t) = (t)dt, we have
p
dW1 (t)((t)dW1 (t) + 1 2 (t)dW2 (t)) = (t)dt
p
(t)dt + 1 2 (t)dW1 (t)dW2 (t) = (t)dt
which implies
dW1 (t)dW2 (t) = 0

(4.5)

Then substitute (4.5) into the second equation of (4.4),

p
2 dt + (1 2 )dW2 (t)dW2 (t) + 1 2 dW1 (t)dW2 (t) = dt
2 dt + (1 2 )dW2 (t)dW2 (t) + 0 = dt
dW2 (t)dW2 (t) = dt

(4.6)

Based on the fact that W1 (t) and W2 (t) are continuous martingales with W1 (0) = 0 = W2 (0) ,
and (4.5)(4.4)(4.6), by applying Theorem 4.6.5, we conclude that W1 (t) and W2 (t) are independent
Brownian motions.
16

4.8

Exercise 4.15

1. Note that

(
dt
dWi (t)dWj (t) =
0

if j = k
if j =
6 k

(4.7)

and
dBi (t) =

d
X
ij (t)
j=1

i (t)

dWj (t)

which implies Bi (t) is a continuous martingale with Bi (0) = 0 for any 1 i d.

Then we compute the quadratic variation, or equivalently,

d
d
X
X
ik (t)

(t)
ij

dBi (t)dBi (t) =

dWj (t)
dWk (t)

(t)
i (t)
i
j=1
k=1
" d
#
d
X
1 X
ij (t)dWj (t)
= 2
ik (t)dWk (t)
i (t) j=1
k=1

d
X

ij (t)dWj (t)ij (t)dWj (t)

i2 (t) j=1

by (4.7)

1 X 2
(t)dt
2
i (t) j=1 ij

=1
2.

d
d
X
X
ij (t)
kl (t)
dWj (t)
dWl (t)
dBi (t)dBk (t) =

(t)
k (t)
i
j=1
l=1
" d
#
d
X
X
1
ij (t)dWj (t)
kl (t)dWl (t)
=
i (t)k (t) j=1
l=1

1
i (t)k (t)

d
X

ij (t)dWj (t)kj (t)dWj (t)

j=1
d

X
1
ij (t)kj (t)dt
i (t)k (t) j=1

=ik (t)

4.9

Exercise 4.18

1. In (4.4.13), let
f (t, x) = ex(r+

/2)t

then
ft (t, x) = (r + 2 /2)ex(r+
fx (t, x) = ex(r+
fxx (t, x) = 2 ex(r+
17

/2)t

/2)t

/2)t

by (4.7)

Then Itoe Formula of (4.4.13) becomes

2

d(t) = (r + 2 /2)eW (t)(r+ /2)t dt eW (t)(r+

2
1
+ 2 eW (t)(r+ /2)t dW (t)dW (t)
2
1
= (r + 2 /2)(t)dt (t)dW (t) + 2 (t)dt
2
= (t)dW (t) r(t)dt

/2)t

dW (t)

2. By Itos Product rule,

d((t)Z(t)) =(t)d(Z(t)) + Z(t)d((t)) + d((t))d(Z(t))
= [rXdt + ( r)Sdt + SdW (t)] + X [dW (t) rdt]
+ [rXdt + ( r)Sdt + SdW (t)] [dW (t) rdt]
= [rX + ( r)S rX S] dt
+ [S X] dW (t)
=S [( r) ] dt + [S X]dW (t)
=[S X]dW (t)

(since = ( r)/)

i.e.,d((t)Z(t)) has no dt term. Therefore (t)Z(t) is a martingale.

3. If an investor begin with initial capital X(0) amd has portfolio value V (T ) at time T , which is
X(T ) = V (T ), then
(T )X(T ) = (T )V (T )
Since X(T ) and V (T ) are random, we take the expectation in the above formula
E[(T )X(T )] = E[(T )V (T )]
Now since (t)X(t) is a martingale,
E[(T )X(T )] = (0)X(0) = X(0)
By equating the above two equations, we have X(0) = E[(T )V (T )].

4.10

Exercise 4.19

1. By the definition, dB(t) = sign(t)dW (t), B(t) is a martingale with continuous path. Furthermore, since dB(t)dB(t) = sign2 (t)dW (t)dW (t) = dt, B(t) is a Brownian motion.
2. By Itos product formula,
d[B(t)W (t)] =d[B(t)]W (t) + d[W (t)]B(t) + d[B(t)]d[W (t)]
=sign(W (t))W (t)dW (t) + B(t)dW (t) + sign(W (t))dW (t)dW (t)
=[sign(W (t))W (t) + B(t)]dW (t) + sign(W (t))dt
Integrate both sides, we will have
Z t
Z t
B(t)W (t) =B(0)W (0) +
sign(W (s))ds +
[sign(W (s))W (s) + B(s)]dW (s)
0
0
Z t
Z t
=
sign(W (s))ds +
[sign(W (s))W (s) + B(s)]dW (s)
0

18

Note that the expectation of an Itos integral is 0 and W (s) N (0, s), which implies
Z
Z
Z 0
2
2
2
1
1
1
ex /2s dx
ex /2s dx = 0
E[sign(W (s))] =
sign(x) ex /2s dx =
2
2
2

Then by taking expectation on both sides,

Z

E[B(t)W (t)] =

E[sign(W (s))]ds = 0
0

Note that E[W (t)] = 0, the above result also implies that B(t) and W (t) are uncorrelated.
3. By Itos product formula,
d[W (t)W (t)] =d[W (t)]W (t) + d[W (t)]W (t) + d[W (t)]d[W (t)]
=W (t)dW (t) + W (t)dW (t) + dW (t)dW (t)
=2W (t)dW (t) + dt
4. By Itos product formula,
d[B(t)W 2 (t)] =d[B(t)]W 2 (t) + d[W 2 (t)]B(t) + d[B(t)]d[W 2 (t)]
=sign(W (t))W 2 (t)dW (t) + [2W (t)dW (t) + dt] B(t)
+ sign(W (t))dW (t) [2W (t)dW (t) + dt]
=[sign(W (t))W 2 (t) + 2B(t)W (t)]dW (t) + [B(t) + 2sign(W (t))W (t)]dt
By taking the integral on both sides,
Z t
Z t
2
2
B(t)W (t) =
[sign(W (s))W (s) + 2B(s)W (s)]dW (s) +
[B(s) + 2sign(W (s))W (s)]ds
0

Note that again the expectation of an Itos integral is 0 and W (s) N (0, s). Then by taking
the expectation, we have
Z t
2
E[B(t)W (t)] =
E [[B(s) + 2sign(W (s))W (s)] ds
0
Z t
=2
E [sign(W (s))W (s)] ds
0

Now
Z

2
1
sign(x) ex /2s dx
2

Z
Z 0
2
x x2 /2s
x
e
ex /2s dx = 0
=
dx
2
2
0

Z
x x2 /2s
e
=2
dx
2
0
>0

E[sign(W (s))] =

Thererfore E[B(t)W 2 (t)] > 0 6= 0 = E[B(t)]E[W 2 (t)].

If B(t) and W (t) are independent, then B(t) and W 2 (t) will also be independent, which implies
E[B(t)W 2 (t)] = E[B(t)]E[W 2 (t)]. Contradiction. Therefore B(t) and W (t) are uncorrelated
but not independent.
19

Chapter 5

5.1

Exercise 5.1

Recall that dtdt = 0, dtdW = 0 and dW (t)dW (t) = dt.

1. First note that

1
dX(t) = (t)dW (t) + ((t) R(t) 2 (t))dt
2
For f (x) = S(0)ex , we have f 0 (x) = f 00 (x) = f (x) and f (X(t)) = S(0)eX(t) = D(t)S(t), therefore
by Itos Lemma,
d(D(t)S(t)) =df (X(t))
1
=f 0 (X(t))dX(t) + f 0 (X(t))dX(t)dX(t)
2
1
=S(0)eX(t) dX(t) + S(0)eX(t) dX(t)dX(t)
2




1 2
1 2
dt + 0 + 0
=D(t)S(t) (t)dW (t) + ((t) R(t) (t))dt +
2
2
=D(t)S(t) [(t)dW (t) + ((t) R(t))dt]
=D(t)S(t)(t) [dW (t) + (t)dt]
with (t) = ((t) R(t))/(t).

2. The other way is by Itos Product Rule,

d(D(t)S(t)) =S(t)dD(t) + D(t)dS(t) + dD(t)dS(t)
=S(t) [R(t)D(t)dt] + D(t) [(t)S(t)dt + (t)S(t)dW (t)]
+ [R(t)D(t)dt] [(t)S(t)dt + (t)S(t)dW (t)]
= [(t)S(t)D(t) S(t)R(t)D(t)] dt + D(t)(t)S(t)dW (t)
=D(t)S(t) [(t)dW (t) + ((t) R(t))dt]
=D(t)S(t)(t) [dW (t) + (t)dt]

5.2

Exercise 5.5

1. By the definition
1
= exp
Z(t)

Z
0

Let
Z

1
(u)dW (u) +
2

(u)dW (u) +

X(t) =
0

1
2


(u)du
2

2 (u)du

then



1
d h X(t) i
d
=
e
Z(t)
dt
1
=eX(t) dX(t) + eX(t) dX(t)dX(t)
2


1
1 2
1
=
(t)dW (t) + (t)dt +
2 (t)dt
Z(t)
2
2Z(t)

1 
=
(t)dW (t) + 2 (t)dt
Z(t)
20

 (t) is a martingale, for 0 s t,

2. By Lemma 5.2.2 of text, since M





i
i
h
h
1
(s)
(t)F(s) = Z(s)M
(t)F(s) = Z(s)E
(t)F(s) = Z(s)E M
E Z(t)M
Z(t)M
Z(t)
(t)Z(t) is a martingale.
which means M
3. Note that dM (t) = (t)dW (t), then
h
i
(t)
d M


1
=d M (t)
Z(t)




1
1
1
=M (t)d
+
d [M (t)] + d [M (t)] d
Z(t)
Z(t)
Z(t)




2
(t)
(t)
1
(t)
2 (t)
=M (t)
dW (t) +
dt +
(t)dW (t) +
dW (t) +
dt (t)dW (t)
Z(t)
Z(t)
Z(t)
Z(t)
Z(t)

1
1 
=
[(t) + M (t)(t)] dW (t) +
(t)(t) + M (t)2 (t)M (t) dt
Z(t)
Z(t)
(t) = dW (t) + (t)dt, if we define
4. Now since dW
= (t) + M (t)(t)
(t)
Z(t)
then
h
i
(t)
d M
(t)
1
[(t) + M (t)(t)] dW (t) +
[(t) + M (t)(t)M (t)] dt
Z(t)
Z(t)

=(t)dW
(t) + (t)(t)dt
=

(t)
=(t)d
W
Integrate both sides, we will have
(t) = M
(0) +
M

(u)
(u)d
W

5.3

Exercise 5.12

i (t) is a continuous martingale. Secondly, since dBi (t) = P ij (t)/i (t)dWt (t),
1. First each B
j
dBi (t)dt = 0 and furthermore we have
i (t)dB
i (t) = [dBi (t) + i (t)] [dBi (t) + i (t)] = dBi (t)dBi (t) = dt
dB
i (t) must be a brownian motion for every i.
B
2. By
i (t) = dBi (t) + i (t)
dB
we have
dSi (t) =i (t)Si (t)dt + i (t)Si (t)dBi (t)
i (t) i (t)]
=i (t)Si (t)dt + i (t)Si (t)[dB
i (t)
= [i (t)Si (t) i (t)i (t)Si (t)] dt + i (t)Si (t)dB
i (t)
=R(t)Si (t)dt + i (t)Si (t)dB
21

3. Since dBi (t)dBk (t) = ik (t)dt,

i (t)dB
k (t)
dB
= [dBi (t) + i (t)dt] [dBk (t) + k (t)dt]
=dBi (t)dBk (t) + i (t)dtdBk (t) + k (t)dtdBi (t) + i (t)k (t)dtdt
=dBi (t)dBk (t)
=ik (t)dt
4. By Itos product rule,
d[Bi (t)Bk (t)] = Bi (t)dBk (t) + Bk (t)dBi (t) + dBi (t)dBk (t)
then since dBi (t)dBk (t) = ik (t)dt, we have
Z t
Z t
Z t
Bi (t)Bk (t) =
Bi (u)dBk (u) +
Bk (u)dBi (u) +
ik (u)du
0

Now note the fact that the expectation of an Itos integral is 0, if we take the expectation on the
above formula, then
Z t
 Z t
E[Bi (t)Bk (t)] = E
ik (u)du =
ik (u)du
0

i (t)B
k (t)] =
Similarly we have E[B

Rt
0

ik (u)du.

5. For E[B1 (t)B2 (t)], since dB1 (t) = dW2 (t) and dB2 (t) = sign(W1 (t))dW2 (t) by Itos product
rule,
d[B1 (t)B2 (t)] =B1 (t)dB2 (t) + B2 (t)dB1 (t) + dB1 (t)dB2 (t)
=W2 (t)dB2 (t) + B2 (t)dW2 (t) + sign(W1 (t))dW2 (t)dW2 (t)
By dW2 (t)dW2 (t) = dt, we may write it in the integral version as:
Z t
Z t
Z t
B1 (t)B2 (t) = B1 (0)B2 (0) +
W2 (u)dB2 (u) +
B2 (u)dW2 (u) +
sign(W1 (u))du
0

Note that the expectation of an Itos integral is 0 and W1 (u) N (0, u), which implies
Z
Z
Z 0
2
2
2
1
1
1

ex /2u dx = 0
E[sign(W1 (u))] =
sign(x)
ex /2u dx =
ex /2u dx
2u
2u
2

Then we have
E[B1 (t)B2 (t)] = 0

(5.1)

1 (t) = dB1 (t) = dW2 (t) = dW

2 (t)
dB

(5.2)

2 (t) = dB2 (t) = sign(W1 (t))dW2 (t) = sign(W

1 (t) t)dW
2 (t)
dB

(5.3)

1 (t)B
2 (t)], since
For E[B
and
by Itos product rule,

1 (t)B
2 (t)] =B
1 (t)dB
2 (t) + B
2 (t)dB
1 (t) + dB
1 (t)dB
2 (t)
d[B
1 (t) t)dW
2 (t) + B2 (t)dW
2 (t) + sign(W1 (t))dt
=W2 (t)sign(W
1 (t) t)dW
2 (t) + B2 (t)dW
2 (t) + sign(W
1 (t) t)dt
=W2 (t)sign(W
22

we may write it in the integral version as:

Z t
Z t
1 (t)B
2 (t) = B
1 (0)B
2 (0) +
1 (u) u) + B2 (u)]dW
2 (u) +
1 (u) u)du
B
[W2 (u)sign(W
sign(W
0

1 (u) N (0, u), which implies W

1 (u)u
Note that the expectation of an Itos integral is 0 and W
N (u, u) and
Z
2
1
sign(x)
e(xu) /2u dx
E[sign(W1 (u) u)] =
2u

Z
Z 0
2
2
1
1

=
e(xu) /2u dx
e(xu) /2u dx
2u
2u
0

Z
Z
2
2
1
1

=
e(xu) /2u dx
e(x+u) /2u dx
2u
2u
0
0
Z h
i
2
2
1
=
e(xu) /2u e(x+u) /2u du
2u 0
>0
since u > 0
Then we have
1 (t)B
2 (t)] =
E[B

1 (u) u)du] > 0

E[sign(W

(5.4)

1 (t)B
2 (t)] > 0 6= 0 = E[B1 (t)B2 (t)].
(5.1) and (5.4) are the exmaples that E[B

5.4

Exercise 5.14

1. Since


d ert X(t)
= rert X(t)dt + ert dX(t)
= rert X(t)dt + ert (t)dS(t) ert a(t)dt + rert (X(t) (t)S(t)) dt
h


i
(t) + adt a(t)dt r(t)S(t)dt
=ert (t) rS(t)dt + S(t)dW
(t)
=S(t)ert (t)dW
contains no dt term, ert X(t) is a martingale.
(t) + (r 1 2 )t, then
2. (a) Let Z(t) = W
2


dY (t) =d eZ(t)
1
=eZ(t) dZ(t) + eZ(t) dZ(t)dZ(t)
2


1 2
1

=Y (t) dW (t) + (r )dt + Y (t) 2 (t)

2
2
(t)
=rY (t)dt + dW
(b) Since


d ert Y (t)
= rert Y (t)dt + ert dY (t)
(t)
= rert Y (t)dt + ert Y (t)dt + ert Y (t)dW
(t)
=Y (t)ert dW
23

(5.5)

contains no dt term, ert Y (t) is a martingale.

(c) By Itos product rule,
Z t
1
a
a
dS(t) =S(0)dY (t) +
dsdY (t) + Y (t)
dt + dY (t)
dt
Y
(s)
Y
(t)
Y
(t)
0


Z t
1
= S(0) +
ds dY (t) + adt
since dY (t)dt = 0
0 Y (s)
S(t)
=
dY (t) + adt
Y (t)
i
S(t) h
(t) + adt
=
rY (t)dt + Y (t)dW
Y (t)
(t) + adt
=rS(t)dt + S(t)dW
which is (5.9.7) of Text.
3. First

E[S(T
)|F(t)]
Z

a
ds|F(t)]
Y
(s)
0
"
#


Z T
Z t
a
a

ds|F(t) + E Y (T )
ds|F(t)
=S(0)E[Y (T )|F(t)] + E Y (T )
Y (s)
t
0 Y (s)

Z T 
Z t
a
Y (T ) |F(t) ds
(T )|F(t)] + E
[Y (T )|F(t)]
E
ds + a
=S(0)E[Y
Y (s)
t
0 Y (s)

=E[S(0)Y
(T ) + Y (T )

(5.6)

by taking out the what is known.

Secondly, since ert Y (t) is a martingale under P , we have
(T )|F(t)] = E[Y
(T )erT |F(t)]erT = Y (t)ert erT = Y (t)er(T t)
E[Y
And by the definition of Y (t), we have
 


Y (T )
1 2

= exp W (T ) W (s) + (r )(T s)

Y (s)
2
i
h 
(r 21 2 )(T s)

= exp W (T ) W (s) e

(5.7)

(T ) W
(s) is normally distributed with mean 0 and variance T s, by taking the
Since W
expectation on both sides of the above equation, we have


1 2
Y (T )

=E[e(W (T )W (s)) ]e(r 2 )(T s)

E
Y (s)
1 2
1 2
(5.8)
=e 2 (T s) e(r 2 )(T s)
=er(T s)

24

Now by substituting (5.7) and (5.8) into (5.6), we have

[S(T )|F(t)]
E
r(T t)

=S(0)e

Y (t) + e

r(T t)

Z
Y (t)
0

=er(T t) S(t) + a

a
ds + a
Y (s)

er(T s) ds

(5.9)

er(T s) ds
t
i
a h r(T t)
e
1
=er(T t) S(t) +
r
4. Now we differentiate (5.9)
[S(T )|F(t)])
d(E

 a 

=d er(T t) S(t) + d er(T t) 1
r


=erT d ert S(t) aer(T t) dt

(5.10)

Since
d ert S(t)

= rert S(t)dt + ert dS(t)

(t) + aert dt
= rert S(t)dt + ert rS(t)dt + ert S(t)dW
(t) + aert dt
=ert S(t)dW

(5.11)

by substituting (5.11) into (5.10), we have

[S(T )|F(t)])
d(E


=erT d ert) S(t) + aer(T t) dt
(t) + aer(T t) dt aer(T t) dt
=er(T t) S(t)dW
(t)
=er(T t) S(t)dW
[S(T )|F(t)]). Therefore E
[S(T )|F(t)] is a martingale under P .
There is no dt term in d(E
5. Since
h
i
er(T t) (S(T ) K)|F(t)
E
h
i
er(T t) S(T )|F(t) er(T t) K
=E
r(T t)

=e

[S(T )|F(t)] e
E

r(T t)

by linearility
by taking out what is known


er(T t) (S(T ) K)|F(t) = 0 implies that K = E
[S(T )|F(t)], i.e.,
E


[S(T )|F(t)] = F utS (t, T )

F orS (t, T ) = K = E
6. According to the hedgeing strategy, the value of the portfolio at time t is governed by (5.9.7) of
Text with (t) = 1, i.e.,
dX(t) = dS(t) adt + r(X(t) S(t))dt

25

Then (5.5) implies that

(t)
d ert X(t) = S(t)ert dW
By integrating both sides from 0 to T , we have
Z T
rT
(t)dt
e
X(T ) X(0) =
S(t)ert dW
0

ert (dS(t) rS(t)dt adt)

by (5.9.7) of Text

d ert S(t)

aert dt

=erT S(T ) S(0)

a
1 erT
r

Associated with the fact that X(0) = 0, we can rewrite it as

a rT
X(T ) = S(T ) S(0)erT
e 1
r
By (5.9),
S(0)erT +

a rT
e 1 = F utS (0, T ) = F orS (0, T )
r

So
X(T ) = S(T ) F orS (0, T )
Therefore eventually, at time T , she delivers the asset at the price F orS (0, T ), which is exactly
rT
the amount

that she needs to cover the debt in the money market X(T ) S(T ) = S(0)e +
a
rT
e

1
.
r

Chapter 6

6.1

Exercise 6.1

Rt
Rt
1. It is easy to see Z(t) = e0 = 1 since t (v)dW (v) = 0 = t (b(v) 2 (v)/2)dv. Let
Z u
Z u
S(u) =
(v)dW (v) +
(b(v) 2 (v)/2)dv
t

. Then Z(u) = e

S(u)

and


dS(u) = (u)dW (u) + b(u) 2 (u)/2 dv

Now set f (t, x) = ex in Itos Formula (4.4.23) of text, then fx = fxx = ex and ft = 0. Then we
have
dZ(u) =df (t, S(u))
1
=eS(u) dS(u) + eS(u) dS(u)dS(u)
2


=Z(u) [(u)dW (u) + b(u) 2 (u)/2 dv]




1
+ Z(u) [(u)dW (u) + b(u) 2 (u)/2 dv] [(u)dW (u) + b(u) 2 (u)/2 dv]
2


1 2
2
=Z(u) b(u) (u)/2 + (u) du
(since dW (u)dW (u) = du)
2
+ Z(u) [(u) + 0] du

(since dW (u)du = 0 = dudu)

=b(u)Z(u)du + (u)Z(u)dW (u)

26

2. It is clear that if X(u) = Y (u)Z(u), then X(t) = Y (t)Z(t) = x 1 = x. Furthermore, by Itos

product rule, dW (u)dW (u) = du and dW (u)du = 0 = dudu, we have
dX(u) =d[Y (u)Z(u)]
=Y (u)dZ(u) + Z(u)dY (u) + dZ(u)dY (u)


a

= [bzdu + zdW (u)] Y (u) +

+ dW (u) Z(u)
Z
Z


a

+ [bzdu + zdW (u)]

+ dW (u)
Z
Z


Z
= [(a )du + dW (u)] + [bZY du + ZY dW (u)] +
du + 0
Z
= [a + bZY + ] du + [ + ZY ] dW (u)
= (a(u) + b(u)X(u)) du + ((u) + (u)X(u)) dW (u)

(since X = ZY )

i.e. X(u) = Z(u)Y (u) solve the stochastic differential equation (6.2.4).

6.2
1.

Exercise 6.3
i
Rs
Rs
Rs
d h R s b(v)dv
e 0
C(s, T ) = b(s)e 0 b(v)dv C(s, T ) + e 0 b(v)dv C 0 (s, T ) = e 0 b(v)dv
ds

2.
T

Z T
i
Rs
d h R s b(v)dv
e 0
C(s, T ) ds =
e 0 b(v)dv ds
ds
t
t
Z T
RT
Rt
Rs
e 0 b(v)dv C(T, T ) e 0 b(v)dv C(t, T ) =
e 0 b(v)dv ds
Z

By C(T, T ) = 0,
RT
t

C(t, T ) =

e
e

Rs
0

Rt
0

b(v)dv

ds

b(v)dv

Z
=
t

3.

Z
A(T, T ) A(t, T ) =
t

Rs

Rt

0
0

b(v)dv
b(v)dv

Z
ds =

Rs
t

b(v)dv

ds



2 (s) 2
C (s, T ) ds
a(s)C(s, T ) +
2

The result follows from A(T, T ) = 0.

6.3

Exercise 6.4

1.

" Z
#
d 2 T
2
(t) = (t)
C(u, T )dt = (t)C(t, T )
dt 2 t
2
0

00 (t) =

2 0
2
(t)C(t, T )
(t)C 0 (t, T )
2
2

therefore,
0

C (t, T ) =

2 0
2 (t)C(t, T )
2
2 (t)

00 (t)

200 (t) 0 (t)

200 (t) 2 2

C(t,
T
)
=

+
C (t, T )
2 (t)
(t)
2 (t)
2

27

2. Rearrange (6.5.14) into

C0
we have

2 2
C =bC 1
2

200 (t)
20 (t)
=
b

1
2 (t)
2 (t)

which implies (6.9.10)

3. By the characteristic equation 2 b 21 2 = 0, we have
=

Then

b2 + 2 2
b
=
2
2
b

(t) = a1 e( 2 +)t + a2 e( 2 )t
2

Indeed, by the facts (T ) = 1 and 0 (T ) = 2 (T )C(T, T ) = 0, we have a set of equations:

(
b
b
=1
a1 e( 2 +)T + a2 e( 2 )T
b
b
a1 ( 2b + )e( 2 +)T + a2 ( 2b )e( 2 )T = 0
which imples

a1 =
a2 =

2b ( b +)T
2
2 e
b
+ 2 ( b )T
2
2 e

=
=

b
2
e( 2 +)T
4(r+ 2b )
b
2
e( 2 )T
4(r 2b )

so c1 = c2 = 2 /4.
2

4. (6.9.12) is straightforward from (6.9.11) by differentiatin w.r.t t. Again, since 0 (T ) = 2 (T )C(T, T ) =

0, we have
c1 e0 c2 e0 = 0
i.e. c1 = c2 .

5. By = b2 + 2 2 /2, we have
2

b2
b
b
2
= ( + )( ) =
4
2
2
2

then
"
(t) = c1 e

2b (T t)

b
2

"
2b (T t)

1
e(T t)
+
b
2

b
2

(T t)

1
e(T t)

b
2

#
(T t)

2 e
2 e
2 + b4
2 + b4


b
b
2b (T t) 2
(T t)
(T t)
= c1 e
( )e
+ ( + )e
2
2
2


(T t)
(T t)
b
2
e

e
e(T t) + e(T t)
= c1 e 2 (T t) 2 b
+ 2

2
2
b
2
= c1 e 2 (T t) 2 [b sinh((T t)) + 2 cosh((T t))]

= c1 e

28

and
h
i
b
0 (t) = c1 e 2 (T t) e(T t) e(T t)
b

= 2c1 e 2 (T t) sinh((T t))

Therefore
C(t, T ) =

20 (t)
2 (t)
b

4c1 e 2 (T t) sinh((T t))

2 c1 e 2 (T t) 22 [b sinh((T t)) + 2 cosh((T t))]

sinh((T t))
= b
2 sinh((T t)) + cosh((T t))

6. By the fact (T ) = 1, we have

b

c1 e 2 (T T )

2
[b sinh((T T )) + 2 cosh((T T ))] = 1
2
c1

2
2 = 1
2
c1 =

2
4

Eventually,
Z
A(t, T ) = A(T, T )

A0 (s, T )ds

Z
=0
t

2a0 (s)
ds
2 (s)

a C(s, T )ds

=
t

log((t))
2 /2


2a
2c1 b sinh((T t)) + 2 cosh((T t))
= 2 log

2
e 2 (T t)
"
#
b
e 2 (T t)
2a
= 2 log

b sinh((T t)) + 2 cosh((T t))

=a

6.4

Exercise 6.5

1. Since
g(t, x1 , x2 ) = E t,x1 ,x2 h(x1 (T ), x2 (T ))
we have for any 0 s t T similarly as Theorem 6.3.1 of Text,

h
i

E h(X1 (T ), X2 (T ))F(t) = g(t, X1 (t), X2 (t))

h
i

E h(X1 (T ), X2 (T ))F(s) = g(s, X1 (s), X2 (s))
29

Then


i
i
h
h


E g(t, X1 (t), X2 (t))F(s) = E E [h(X1 (T ), X2 (T ))|F(t)] F(s)

i
h

= E h(X1 (T ), X2 (T ))F(t)
= g(s, X1 (s), X2 (s))
Similarly, Since


ert f (t, x1 , x2 ) = E t,x1 ,x2 erT h(x1 (T ), x2 (T )) = erT E t,x1 ,x2 [h(x1 (T ), x2 (T ))]
ert f (t, X1 (t), X2 (t)) is also a martingale.
2. If W1 and W2 are independent, dW1 (t)dW1 (t) = dt = dW1 (t)dW1 (t) and dW1 (t)dW2 (t) = 0. By
Itos formula,
dg(t, X1 (t), X2 (t))
1
1
=gt dt + gx1 dX1 (t) + gx2 dX2 (t) + gx1 x1 dX1 (t)dX1 (t) + gx1 x2 dX1 (t)dX2 (t) + gx2 x2 dX2 (t)dX2 (t)
2
2
=gt dt + gx1 [1 dt + 11 dW1 (t) + 12 dW2 (t)]
+ gx2 [2 dt + 21 dW1 (t) + 22 dW2 (t)]
1
+ gx1 x1 [1 dt + 11 dW1 (t) + 12 dW2 (t)] [1 dt + 11 dW1 (t) + 12 dW2 (t)]
2
+ gx1 x2 [1 dt + 11 dW1 (t) + 12 dW2 (t)] [2 dt + 21 dW1 (t) + 22 dW2 (t)]
1
+ gx2 x2 [2 dt + 21 dW1 (t) + 22 dW2 (t)]
2






1
1
2
2
2
2
= gt + 1 gx1 + 2 gx2 + gx1 x1 11 + 12 + gx1 x2 (11 21 + 12 22 ) + gx2 x2 21 + 22 dt
2
2
+ [11 gx1 + 21 gx2 ] dW1 (t) + [12 gx1 + 22 gx2 ] dW2 (t)
Since g(t, X1 (t), X2 (t)) is a martingale, there is no dt term in dg(t, X1 (t), X2 (t)). Therefore by
setting the dt term to zero in the above differential form, we will have (6.6.3) of Text immediately.
Smilarly by Itos formula,


d ert f (t, X1 (t), X2 (t))


= rert f + ert ft dt + ert fx1 dX1 (t) + ert fx2 dX2 (t)
1
1
+ ert fx1 x1 dX1 (t)dX1 (t) + ert fx1 x2 dX1 (t)dX2 (t) + ert fx2 x2 dX2 (t)dX2 (t)
2
2






1
1
rt
2
2
2
2
=e
rf + ft + 1 fx1 + 2 fx2 + fx1 x1 11 + 12 + fx1 x2 (11 21 + 12 22 ) + fx2 x2 21 + 22 dt
2
2
+ ert [11 fx1 + 21 fx2 ] dW1 (t) + ert [12 fx1 + 22 fx2 ] dW2 (t)
Since ert f (t, X1 (t), X2 (t)) is a martingale, there is no dt term in d [ert f (t, X1 (t), X2 (t))].
(6.6.4) of Text follows immediately by setting the dt term to zero in the above differential form.

30

3. If dW1 (t)dW2 (t) = dt, dW1 (t)dW1 (t) = dt = dW1 (t)dW1 (t), then by Itos formula,
dg(t, X1 (t), X2 (t))
1
1
=gt dt + gx1 dX1 (t) + gx2 dX2 (t) + gx1 x1 dX1 (t)dX1 (t) + gx1 x2 dX1 (t)dX2 (t) + gx2 x2 dX2 (t)dX2 (t)
2
2
=gt dt + gx1 [1 dt + 11 dW1 (t) + 12 dW2 (t)]
+ gx2 [2 dt + 21 dW1 (t) + 22 dW2 (t)]
1
+ gx1 x1 [1 dt + 11 dW1 (t) + 12 dW2 (t)] [1 dt + 11 dW1 (t) + 12 dW2 (t)]
2
+ gx1 x2 [1 dt + 11 dW1 (t) + 12 dW2 (t)] [2 dt + 21 dW1 (t) + 22 dW2 (t)]
1
+ gx2 x2 [2 dt + 21 dW1 (t) + 22 dW2 (t)]
2






1
1
2
2
2
2
= gt + 1 gx1 + 2 gx2 + gx1 x1 11 + 12 + gx1 x2 (11 21 + 12 22 ) + gx2 x2 21 + 22 dt
2
2
+ [gx1 x1 11 12 + gx1 x2 (11 22 + 12 21 ) + gx2 x2 21 22 ] dt
+ [11 gx1 + 21 gx2 ] dW1 (t) + [12 gx1 + 22 gx2 ] dW2 (t)
Since g(t, X1 (t), X2 (t)) is a martingale, there is no dt term in dg(t, X1 (t), X2 (t)). Therefore
by setting the dt term to zero in the above differential form, we will have (6.9.13) of Text
immediately.
Smilarly by Itos formula,


d ert f (t, X1 (t), X2 (t))


= rert f + ert ft dt + ert fx1 dX1 (t) + ert fx2 dX2 (t)
1
1
+ ert fx1 x1 dX1 (t)dX1 (t) + ert fx1 x2 dX1 (t)dX2 (t) + ert fx2 x2 dX2 (t)dX2 (t)
2
 2





1
1
rt
2
2
2
2
=e
rf + ft + 1 fx1 + 2 fx2 + fx1 x1 11 + 12 + fx1 x2 (11 21 + 12 22 ) + fx2 x2 21
+ 22
dt
2
2
+ ert [gx1 x1 11 12 + gx1 x2 (11 22 + 12 21 ) + gx2 x2 21 22 ] dt
+ ert [11 fx1 + 21 fx2 ] dW1 (t) + ert [12 fx1 + 22 fx2 ] dW2 (t)
Since ert f (t, X1 (t), X2 (t)) is a martingale, there is no dt term in d [ert f (t, X1 (t), X2 (t))].
(6.9.14) of Text follows immediately by setting the dt term to zero in the above differential form.

6.5

Exercise 6.7 !!!

1. By the iterated conditioning, for 0 s t T , we have



h
i
h
h
i
i
ert c(t, S(t), V (t))F(s) =E
ert E
er(T t) (S(T ) K)+ F(t) F(s)
E

h
i
ert er(T t) (S(T ) K)+ F(s)
=E

h
i
erT (S(T ) K)+ F(s)
=E

h
i
er(T s) (S(T ) K)+ F(s)
=ers E
=ers c(s, S(s), V (s))

31

Then since it is a martingale, the dt term in the differential d[ert c(t, S(t), V (t))] should be 0,
d[ert c(t, S(t), V (t))]


1
1
=ert rcdt + ct dt + cs dS(t) + cv dV (t) + css dS(t)dS(t) + csv dS(t)dV (t) + cvv dV (t)dV (t)
2
2


1
1
=ert rc + ct + cs rS + cv (a bV ) + css V S 2 + csv V S + cvv 2 V dt
2
2
h i
h
i
rt
rt
cs V S dW1 (t) + e
+e
cv V dW2 (t)
which is

1
1
rc + ct + cs rs + cv (a bv) + css vs2 + csv vs + cvv 2 v = 0
2
2
This is the same as (6.9.26) of text.

2.
3.
4.
5.

Chapter 7

Chapter 8

Chapter 9

10

Chapter 10

11

Chapter 11

11.1

Exercise 11.1

Since
M 2 (t) M 2 (s)


= N 2 (t) N 2 (s) + 2 (t2 s2 ) 2tN (t) + 2sN (s)


= (N (t) N (s))2 + 2N (t)N (s) 2N 2 (s) + 2 (t2 s2 ) 2t[N (t) N (s)] + 2N (s)(s t)
=[N (t) N (s)]2 + 2N (s)[N (t) N (s)] + 2 (t2 s2 ) 2t[N (t) N (s)] + 2N (s)(s t)
we have


E[M 2 (t) M 2 (s)F(s)]
=E[[N (t) N (s)]2 + 2N (s)[N (t) N (s)] + 2 (t2 s2 )


2t[N (t) N (s)] + 2N (s)(s t)F(s)]
=2 (t s)2 + (t s) + 2N (s) (t s) + 2 (t2 s2 )
2t (t s) + 2N (s)(s t)
=2 (t2 + s2 2ts + t2 s2 2t2 + 2ts) + (t s)
=(t s)
32

Therefore, for any 0 s t,

1.


E[M 2 (t)F(s)]


=E[M 2 (t) M 2 (s) + M 2 (s)F(s)]


=E[M 2 (t) M 2 (s)F(s)] + M 2 (s)
=(t s) + M 2 (s)
M 2 (s)
i.e., M 2 (t) is submartingale.
2.


E[M 2 (t) tF(s)]


=E[M 2 (t) M 2 (s) (t s) + M 2 (s) sF(s)]


=E[M 2 (t) M 2 (s)F(s)] (t s) + M 2 (s) s
=(t s) (t s) + M 2 (s) s
=M 2 (s) s
i.e., M 2 (t) t is martingale.

33