Professional Documents
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Lisbon 2013
Tomas Bj
ork
Stockholm School of Economics
Textbook:
Bj
ork, T: Arbitrage Theory in Continuous Time
Oxford University Press, 2009. (3:rd ed.)
Tomas Bj
ork, 2013 1
Continuous Time Finance
Stochastic Integrals
(Ch 4-5)
Tomas Bj
ork
Tomas Bj
ork, 2013 2
Typical Setup
Tomas Bj
ork, 2013 3
We Need:
Tomas Bj
ork, 2013 4
Stochastic Processes
Stochastic variable
Choosing a number at random
Stochastic process
choosing a curve (trajectory) at random.
Tomas Bj
ork, 2013 5
Notation
Tomas Bj
ork, 2013 6
The Wiener Process
Wt Ws N [0, t s]
W0 = 0
Tomas Bj
ork, 2013 7
A Wiener Trajectory
0.8
0.6
0.4
0.2
0.2
0.4 t
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Tomas Bj
ork, 2013 8
Important Fact
Theorem:
A Wiener trajectory is, with probability one, a
continuous curve which is nowhere differentiable.
Proof. Hard.
Tomas Bj
ork, 2013 9
Wiener Process with Drift
dXt = dt + dWt,
Xt X0 = t + (Wt W0 ),
Xt = X0 + t + Wt
Thus
Xt N [X0 + t, 2 t]
Tomas Bj
ork, 2013 10
It
o processes
Tomas Bj
ork, 2013 11
Example: The Black-Scholes model
Simple analysis:
Assume that = 0. Then
dSt = Stdt
Divide by dt!
dSt
= St
dt
This is a simple ordinary differential equation with
solution
St = s0 et
Tomas Bj
ork, 2013 12
Intuitive Economic Interpretation
dSt
= dt + dWt
St
Over a small time interval [t, t + dt] this means:
= volatility
Tomas Bj
ork, 2013 13
A GBM Trajectory
10
0 t
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Tomas Bj
ork, 2013 14
Stochastic Differentials and Integrals
Tomas Bj
ork, 2013 15
Recall:
Z t Z t
Xt = x0 + sds + sdWs
0 0
Two terms:
Z t
sds
0
This is a standard Riemann integral for each -
trajectory.
Z t
sdWs
0
Tomas Bj
ork, 2013 16
Information
Z FtW
Ex:
For the stochastic variable Z, defined by
Z 5
Z= Wsds,
0
we have Z F5W .
We do not have Z F4W .
Tomas Bj
ork, 2013 17
Adapted Processes
Definition:
A process X is
adapted to the filtration
FtW : t 0 if
Xt FtW , t 0
Tomas Bj
ork, 2013 18
The process Z t
Xt = Wsds,
0
is adapted.
The process
Xt = sup Ws
st
is adapted.
The process
Xt = sup Ws
st+1
is not adapted.
Tomas Bj
ork, 2013 19
The It
o Integral
Z b
gsdWs
a
Tomas Bj
ork, 2013 20
Simple Integrands
Definition:
The process g is simple, if
g is adapted.
Z b n1
X
gsdWs = g(tk ) [W (tk+1 ) W (tk )]
a k=0
FORWARD INCREMENTS!
Tomas Bj
ork, 2013 21
Properties of the Integral
We have Z b
gsdWs FbW
a
Tomas Bj
ork, 2013 22
General Case
Tomas Bj
ork, 2013 23
Properties of the Integral
We do in fact have
"Z #
b
E gsdWs Fa = 0
a
Tomas Bj
ork, 2013 24
We have Z b
gsdWs FbW
a
Tomas Bj
ork, 2013 25
Martingales
Tomas Bj
ork, 2013 26
Continuous Time Finance
Stochastic Calculus
(Ch 4-5)
Tomas Bj
ork
Tomas Bj
ork, 2013 27
Stochastic Calculus
General Model:
Zt = f (t, Xt)
Tomas Bj
ork, 2013 28
A close up of the Wiener process
dWt = Wt+dt Wt
We know:
E[dWt] = 0, V ar[dWt] = dt
Tomas Bj
ork, 2013 29
Recall
Important observation:
(dWt )2 = dt
Tomas Bj
ork, 2013 30
Multiplication table.
(dt)2 = 0
dWt dt = 0
2
(dWt) = dt
Tomas Bj
ork, 2013 31
Deriving the It
o formula
Zt = f (t, Xt)
f f 1 2f 2
df = dt + dXt + (dt)
t x 2 t2
1 2f 2 2f
+ 2
(dXt ) + dt dXt
2 x tx
Tomas Bj
ork, 2013 32
f f 1 2f 2
df = dt + [dt + dW ] + (dt)
t x 2 t2
1 2f 2 2f
+ 2
[dt + dW ] + dt [dt + dW ]
2 x tx
f f f 1 2f 2
= dt + dt + dW + (dt)
t x x 2 t2
1 2f 2 2 2 2
+ 2
[ (dt) + (dW ) + 2dt dW ]
2 x
2f 2 2f
+ (dt) + dt dW
tx tx
f
+ dW
x
Tomas Bj
ork, 2013 33
The It
o Formula
we have
f f 1 2 2f
df (t, Xt) = + + dt
t x 2 x2
f
+ dWt
x
Alternatively
f f 1 2f 2
df (t, Xt) = dt + dXt + 2
(dXt ) ,
t x 2 x
Tomas Bj
ork, 2013 34
Example: GBM
St = eZt ,
Zt = ln St
It
o on f (t, s) = ln(s) gives us
f 1 f 2f 1
= , = 0, = 2
s s t s2 s
1 1 1 2
dZt = dSt (dS t )
St 2 St2
1 2
= dt + dWt
2
Tomas Bj
ork, 2013 35
Recall
1
dZt = 2 dt + dWt
2
Integrate!
Z t Z t
1
Zt Z0 = 2 ds + dWs
0 2 0
1
= 2 t + Wt
2
( 12 2)t+Wt
St = S0 e
Tomas Bj
ork, 2013 36
A Useful Trick
Use It
o to get
Integrate.
Z T Z T
Z(T ) = z0 + Z (t)dt + Z (t)dWt
0 0
Take expectations.
Z T
E [Z(T )] = z0 + E [Z (t)] dt + 0
0
Tomas Bj
ork, 2013 37
The Connection SDE PDE
F
(t, x) + AF (t, x) = 0,
t
F (T, x) = (x).
where A is defined by
F 1 2 2F
AF (t, x) = (t, x) + (t, x) 2 (t, x)
x 2 x
Tomas Bj
ork, 2013 38
Assume that F solves the PDE.
F (T, XT ) = F (t, Xt )
Z T
F
+ (s, Xs) + AF (s, Xs) ds
t t
Z T
F
+ (s, Xs) (s, Xs)dWs.
t x
F
By assumption t + AF = 0, and F (T, x) = (x)
Tomas Bj
ork, 2013 39
Thus:
(XT ) = F (t, x)
Z T
F
+ (s, Xs) (s, Xs)dWs.
t x
Take expectations.
Tomas Bj
ork, 2013 40
Feynman-Kac
F F 1 2 2F
+ (t, x) + (t, x) 2 rF = 0,
t x 2 x
F (T, x) = (x).
is given by
Tomas Bj
ork, 2013 41
Continuous Time Finance
Black-Scholes
(Ch 6-7)
Tomas Bj
ork
Tomas Bj
ork, 2013 42
Contents
1. Introduction.
2. Portfolio theory.
5. Appendices.
Tomas Bj
ork, 2013 43
1.
Introduction
Tomas Bj
ork, 2013 44
European Call Option
to buy
1 ACME INC
on the date
at the price
$100
Tomas Bj
ork, 2013 45
Financial Derivative
Tomas Bj
ork, 2013 46
Examples
American options
Convertibles
Futures
Bond options
CDO:s
CDS:s
Tomas Bj
ork, 2013 47
Main problems
Tomas Bj
ork, 2013 48
Natural Answers
Natural answers:
Tomas Bj
ork, 2013 49
Both answers are incorrect!
Tomas Bj
ork, 2013 50
Philosophy
Consistent pricing.
Relative pricing.
Tomas Bj
ork, 2013 51
2.
Portfolio Theory
Tomas Bj
ork, 2013 52
Portfolios
ht = (h1t , , hN
t )
where
ht = h(t, St)
Tomas Bj
ork, 2013 53
Self financing portfolios
Definition:
The strategy h is self financing if
N
X
dVt = hitdSti
i=1
Interpret!
Tomas Bj
ork, 2013 54
Relative weights
Definition:
ti = relative portfolio weight on asset No i.
We have
hitSti
ti =
Vt
We obtain
Portfolio dynamics:
N
X i
i dSt
dVt = Vt t i
i=1
St
Interpret!
Tomas Bj
ork, 2013 55
3.
Tomas Bj
ork, 2013 56
Back to Financial Derivatives
Z = max[ST X, 0]
More general:
Z = (ST )
for some contract function .
Tomas Bj
ork, 2013 57
Main Idea
Tomas Bj
ork, 2013 58
Arbitrage
V0 = 0.
Moral:
Tomas Bj
ork, 2013 59
Arbitrage test
dVt = kVtdt
k=r
Tomas Bj
ork, 2013 60
Main Idea of Black-Scholes
k=r
Tomas Bj
ork, 2013 61
Two Approaches
Tomas Bj
ork, 2013 62
Formalized program a la Merton
dVt = Vt kdt
k=r
Tomas Bj
ork, 2013 63
Back to Black-Scholes
It
os formula gives us the f dynamics as
2
f f 1 2 2 f
df = + S + S 2
dt
t s 2 s
f
+ S dW
s
Write this as
df = f f dt + f f dW
where
2
f
t + S f
s + 1 2 2 f
2 S s2
f =
f
S f
s
f =
f
Tomas Bj
ork, 2013 64
df = f f dt + f f dW
dS df
dV = V S + f
S f
S f
= V (dt + dW ) + (f dt + f dW )
S f
S f
dV = V + f dt + V + f dW
S + f f = 0
S + f = 1
Plug into dV !
Tomas Bj
ork, 2013 65
We obtain
S f
dV = V + f dt
S f
+ f = r
Tomas Bj
ork, 2013 66
Black-Scholes PDE
where the pricing function f satisfies the PDE (partial differential equation)
f f 1 2 2 2f
(t, s) + rs (t, s) + s (t, s) rf (t, s) = 0
t s 2 s2
f (T, s) = (s)
Tomas Bj
ork, 2013 67
Black-Scholes PDE ctd
f f 1 2 2 2f
+ rs + s rf = 0
t s 2 s2
f (T, s) = (s)
f f 1 2 2 2f
+ rs + s rf = 0
t s 2 s2
f (T, s) = (s)
Tomas Bj
ork, 2013 68
Data needed
Todays date t.
Short rate r.
Volatility .
??
Tomas Bj
ork, 2013 69
Black-Scholes Basic Assumptions
Assumptions:
Continuous trading.
Constant volatility .
Tomas Bj
ork, 2013 70
Black-Scholes Formula
European Call
T =date of expiration,
t=todays date,
X=strike price,
r=short rate,
s=todays stock price,
=volatility.
s
1 1 2
d1 = ln + r + (T t) ,
T t X 2
d2 = d1 T t.
Tomas Bj
ork, 2013 71
Black-Scholes
European Call,
25
20
15
10
0 s
80 85 90 95 100 105 110 115 120
Tomas Bj
ork, 2013 72
Dependence on Time to Maturity
25
13 weeks
7 weeks
1 week
maturity
20
15
C
10
0
80 85 90 95 100 105 110 115 120
S
Tomas Bj
ork, 2013 73
Dependence on Volatility
25
sigma=0.2
sigma=0.4
sigma=0.6
maturity
20
15
C
10
0
80 85 90 95 100 105 110 115 120
S
Tomas Bj
ork, 2013 74
4.
Tomas Bj
ork, 2013 75
Risk neutral valuation
Q-dynamics:
dSt = rStdt + StdWtQ ,
dBt = rBt dt.
Note: P Q
Tomas Bj
ork, 2013 76
Concrete formulas
Z
[0; ] = erT (sez )f (z)dz
( 2 )
1 2
1 z (r 2 )T
f (z) = exp
2T 2 2T
Tomas Bj
ork, 2013 77
Interpretation of the risk adjusted
measure
s = S0 = ertE [St]
Tomas Bj
ork, 2013 78
Moral
Tomas Bj
ork, 2013 79
Properties of Q
P Q
t
Zt =
Bt
is a Q-martingale.
Tomas Bj
ork, 2013 80
A Preview of Martingale Measures
B, S 1, . . . , S N
P Q
Sti
Zti =
Bt
is a Q-martingale.
Tomas Bj
ork, 2013 81
5.
Appendices
Tomas Bj
ork, 2013 82
Appendix A: Black-Scholes vs Binomial
More precisely
ST = S0 Z1 Z2 Zn ,
Tomas Bj
ork, 2013 83
Recall
ST = S0 Z1 Z2 Zn ,
Tomas Bj
ork, 2013 84
Binomial convergence to Black-Scholes
11
BS
Bin
10.5
10
9.5
Price
8.5
7.5
0 5 10 15 20 25 30 35 40 45 50
N
Tomas Bj
ork, 2013 85
Binomial Black-Scholes
Tomas Bj
ork, 2013 86
Appendix B: Portfolio theory
ht = (h1t , , hN
t )
where
ht = h(t, St)
Tomas Bj
ork, 2013 87
Self financing portfolios
Tomas Bj
ork, 2013 88
Discrete time portfolios
Sn = (Sn1 , , SnN ), n = 0, 1, 2, . . .
Portfolio process:
hn = (h1n, , hN
n ), n = 0, 1, 2, . . .
Value process:
N
X
Vn = hinSni = hnSn
i=1
Tomas Bj
ork, 2013 89
The self financing condition
Tomas Bj
ork, 2013 90
The self financing condition
Recall:
Vn = hnSn
xn = xn xn1
Proof: Do it yourself.
Tomas Bj
ork, 2013 91
Recall
Vn = hnSn
hn1Sn = hnSn
Snhn = 0
Tomas Bj
ork, 2013 92
Portfolios in continuous time
Price process:
Portfolio:
ht = (h1t , , hN
t )
Value process
N
X
Vt = hitSti
i=1
Vn = hn1Sn
Tomas Bj
ork, 2013 93
Relative weights
Definition:
ti = relative portfolio weight on asset No i.
We have
hitSti
ti =
Vt
We obtain
Portfolio dynamics:
N
X i
i dSt
dVt = Vt t i
i=1
St
Interpret!
Tomas Bj
ork, 2013 94
Appendix C:
The original Black-Scholes PDE
argument
Consider the following portfolio.
V = f (t, ST ) + xSt
f
x=
s
Tomas Bj
ork, 2013 96
We had
1 2 2 2f
dV f
t 2 S s2
= f
dt
V f + S s
1 2 2 2f
f
t 2 S s2
=r
f + S f
s
f f 1 2 2 2f
+ rs + s rf = 0,
t s 2 s2
f (T, s) = (s).
Tomas Bj
ork, 2013 97
Continuous Time Finance
(Ch 8-9)
Tomas Bj
ork
Tomas Bj
ork, 2013 98
Problems around Standard Black-Scholes
Tomas Bj
ork, 2013 99
Definition:
We say that a T -claim X can be replicated,
alternatively that it is reachable or hedgeable, if
there exists a self financing portfolio h such that
VTh = X, P a.s.
t [X] = Vth .
Tomas Bj
ork, 2013 100
Trading Strategy
Tomas Bj
ork, 2013 101
Completeness of Black-Scholes
VT = (ST ).
i.e.
B
dVt = Vt ut r + ut dt + VtuSt dWt,
S
VT = (ST ).
Tomas Bj
ork, 2013 102
Heuristics:
Let us assume that X is replicated by h = (uB , uS )
with value process V .
Ansatz:
Vt = F (t, St)
Ito gives us
1 2 2
dV = Ft + SFs + S Fss dt + SFsdW,
2
Write this as
( )
1 2 2
Ft + SFs + 2 S Fss SFs
dV = V dt + V dW.
V V
Compare with
B
dV = V u r + u dt + V uS dW
S
Tomas Bj
ork, 2013 103
Define uS by
StFs(t, St)
uSt = ,
F (t, St)
( )
1 2 2
Ft + 2 S Fss
dV = V r + uS dt + V uS dW.
rF
Compare with
B
dV = V u r + u dt + V uS dW
S
Tomas Bj
ork, 2013 104
The relation uB + uS = 1 gives us the Black-Scholes
PDE
1 2 2
Ft + rSFs + S Fss rF = 0.
2
The condition
VT = (ST )
gives us the boundary condition
F (T, s) = (s)
Tomas Bj
ork, 2013 105
Main Result
Theorem: Define F as the solution to the boundary
value problem
F + rsF + 1 2 s2F rF = 0,
t s ss
2
F (T, s) = (s).
Tomas Bj
ork, 2013 106
Notes
Tomas Bj
ork, 2013 107
Completeness vs No Arbitrage
Question:
When is a model arbitrage free and/or complete?
Answer:
Count the number of risky assets, and the number of
random sources.
Intuition:
If N is large, compared to R, you have lots of
possibilities of forming clever portfolios. Thus lots
of chances of making arbitrage profits. Also many
chances of replicating a given claim.
Tomas Bj
ork, 2013 108
Meta-Theorem
N R
N R
Example:
The Black-Scholes model. R=N=1. Arbitrage free
and complete.
Tomas Bj
ork, 2013 109
Parity Relations
t [ + ] = t [] + t [] .
S (x) = x,
B (x) 1,
C,K (x) = max [x K, 0] .
Prices:
t [S ] = St,
t [B ] = er(T t),
t [C,K ] = c(t, St; K, T ).
Tomas Bj
ork, 2013 110
If we have
n
X
= S + B + iC,Ki ,
i=1
then
n
X
t [] = t [S ] + t [B ] + it [C,Ki ]
i=1
Tomas Bj
ork, 2013 111
Put-Call Parity
We immediately get
Put-call parity:
Tomas Bj
ork, 2013 112
Delta Hedging
X = (ST )
F (t, s).
Setup:
We are at time t, and have a short (interpret!) position
in the contract.
Goal:
Offset the risk in the derivative by buying (or selling)
the (highly correlated) underlying.
Definition:
A position in the underlying is a delta hedge against
the derivative if the portfolio (underlying + derivative)
is immune against small changes in the underlying
price.
Tomas Bj
ork, 2013 113
Formal Analysis
V = 1 F (t, s) + x s
V
= 0.
s
We obtain
F
+x =0
s
Solve for x!
Tomas Bj
ork, 2013 114
Result:
We should have
F
x=
s
shares of the underlying in the delta hedged portfolio.
Definition:
For any contract, its delta is defined by
F
= .
s
Result:
We should have
x
=
shares of the underlying in the delta hedged portfolio.
Warning:
The delta hedge must be rebalanced over time. (why?)
Tomas Bj
ork, 2013 115
Black Scholes
= N [d1 ] 1
Tomas Bj
ork, 2013 116
Rebalanced Delta Hedge
Tomas Bj
ork, 2013 117
Lack of perfection comes from discrete, instead of
continuous, trading.
Formal result:
The relative weights in the replicating portfolio are
S
uS = ,
F
F S
uB =
F
Tomas Bj
ork, 2013 118
Portfolio Delta
Portfolio value: n
X
= hiFi
i=1
Portfolio delta:
n
X
= h i i
i=1
Tomas Bj
ork, 2013 119
Gamma
F
This will cause = s to change.
Moral:
Tomas Bj
ork, 2013 120
Definition:
Let be the value of a derivative (or portfolio).
Gamma () is defined as
=
s
i.e.
2
=
s2
Gamma is a measure of the sensitivity of to changes
in S.
Result: For a European Call in a Black-Scholes model,
can be calculated as
N 0[d1]
=
S T t
Important fact:
For a position in the underlying stock itself we have
=0
Tomas Bj
ork, 2013 121
Gamma Neutrality
= 0
Tomas Bj
ork, 2013 122
General procedure
xF = number of units of F
xG = number of units of G
Problem:
Choose xF and xG such that the entire portfolio is
delta- and gamma-neutral.
V = + xF F + xG G
Tomas Bj
ork, 2013 123
Value of hedged portfolio:
V = + xF F + xG G
V
= 0,
s
2V
= 0.
s2
i.e.
+ xF F + xGG = 0,
+ xF F + xGG = 0
Tomas Bj
ork, 2013 124
Particular Case
Tomas Bj
ork, 2013 125
Formally:
V = + xF F + xS S
+ xF F + xS S = 0,
+ xF F + xS S = 0
We have
= 0,
S = 1
S = 0.
i.e.
+ xF F + xS = 0,
+ xF F = 0
xF =
F
F
xS =
F
Tomas Bj
ork, 2013 126
Further Greeks
= ,
t
V = ,
=
r
V is pronounced Vega.
NB!
A delta hedge is a hedge against the movements in
the underlying stock, given a fixed model.
Tomas Bj
ork, 2013 127
Continuous Time Finance
I: Mathematics
(Ch 10-12)
Tomas Bj
ork
Tomas Bj
ork, 2013 128
Introduction
Tomas Bj
ork, 2013 129
Contents
2. Conditional expectations
3. Changing measures
Tomas Bj
ork, 2013 130
1.
Tomas Bj
ork, 2013 131
Events and sigma-algebras
Tomas Bj
ork, 2013 132
Borel sets
Tomas Bj
ork, 2013 133
Random variables
X:R
Tomas Bj
ork, 2013 134
2.
Conditional Expectation
Tomas Bj
ork, 2013 135
Conditional Expectation
Tomas Bj
ork, 2013 136
Main Results
E [X| G] G
E [Y | G] = Y
In particular we have
Tomas Bj
ork, 2013 137
3.
Changing Measures
Tomas Bj
ork, 2013 138
Changing Measures
Q(A) = E P [L IA]
Tomas Bj
ork, 2013 139
Recall that
Q(A) = E P [L IA]
Q() = E P [L I] = E P [L 1] = 1
P (A) = 0 Q(A) = 0
Tomas Bj
ork, 2013 140
Proposition 2: If L F is a nonnegative random
variable with E P [L] = 1 and Q is defined by
Q(A) = E P [L IA]
P (A) = 0 Q(A) = 0.
Tomas Bj
ork, 2013 141
Absolute Continuity
P (A) = 0 Q(A) = 0
We write this as
Q << P.
QP
Tomas Bj
ork, 2013 142
Equivalent measures
P (A) = 1 Q(A) = 1
Simple examples:
All non degenerate Gaussian distributions on R are
equivalent.
Tomas Bj
ork, 2013 143
Absolute Continuity ctd
Q(A) = E P [L IA]
Tomas Bj
ork, 2013 144
The Radon Nikodym Theorem
1. Q(A) = E P [L IA] , A F
2. L 0, P a.s.
3. E P [L] = 1,
4. LF
dQ
L= , on F
dP
Tomas Bj
ork, 2013 145
A simple example
pi = P (i ) i = 1, . . . , n
qi = Q(i ) i = 1, . . . , n
pi = 0 qi = 0
Tomas Bj
ork, 2013 146
If pi = 0 then we also have qi = 0 and we can define
the ratio qi /pi arbitrarily.
as could be expected.
Tomas Bj
ork, 2013 147
Computing expected values
E Q [X] = E P [L X]
n
X n
X qi
E Q [X] = X(i )qi = X(i) pi
i=1 i=1
pi
Xn
= X(i )L(i )pi = E P [X L]
i=1
Tomas Bj
ork, 2013 148
The Abstract Bayes Formula
dQ
LF = on F
dP
Tomas Bj
ork, 2013 149
Dependence of the -algebra
dQ
F
L = on F
dP
Now consider smaller -algebra G F . Our problem
is to find the R-N derivative
dQ
LG = on G
dP
P
G
1. Q(A) = E L IA A G
2. LG 0
P
G
3. E L =1
4. LG G
Tomas Bj
ork, 2013 150
A natural guess would perhaps be that LG = LF , so
let us check if LF satisfies points 1-4 above.
By assumption we have
P
F
Q(A) = E L IA A F
P
F
Q(A) = E L IA A G
P
F
P
P
F
E L IA = E E L IA G
Tomas Bj
ork, 2013 151
Since A G we have
P
F
P
F
E L IA G = E L G IA
G P
F
L =E L G
P
G
Q(A) = E L IA A G
Tomas Bj
ork, 2013 152
A formula for LG
G P
F
L =E L G
Tomas Bj
ork, 2013 153
The likelihood process on a filtered space
We now consider the case when we have a probability
measure P on some space and that instead of just
one -algebra F we have a filtration, i.e. an increasing
family of -algebras {Ft}t0 .
The interpretation is as usual that Ft is the information
available to us at time t, and that we have Fs Ft
for s t.
Now assume that we also have another measure Q,
and that for some fixed T , we have Q << P on FT .
We define the random variable LT by
dQ
LT = on FT
dP
Since Q << P on FT we also have Q << P on Ft
for all t T and we define
dQ
Lt = on Ft 0tT
dP
For every t we have Lt Ft, so L is an adapted
process, known as the likelihood process.
Tomas Bj
ork, 2013 154
The L process is a P martingale
We recall that
dQ
Lt = on Ft 0tT
dP
Tomas Bj
ork, 2013 155
Where are we heading?
Tomas Bj
ork, 2013 156
4.
Tomas Bj
ork, 2013 157
Intuition
Tomas Bj
ork, 2013 158
Answer
Tomas Bj
ork, 2013 159
Intuition
Tomas Bj
ork, 2013 160
The Martingale Representation Theorem
Ft = FtW = {Ws; 0 s t}
i.e.
dXt = htdWt.
Tomas Bj
ork, 2013 161
Note
Tomas Bj
ork, 2013 162
5.
Tomas Bj
ork, 2013 163
Setup
Tomas Bj
ork, 2013 164
Thus we are guaranteed that L 0. We now change
measure form P to Q by setting
dQ = LtdP, on Ft, 0 t T
Tomas Bj
ork, 2013 165
The Girsanov Theorem
Let W be a P -Wiener process. Fix a time horizon T .
Theorem: Choose an adapted process , and define
the process L by
(
dLt = Ltt dWt
L0 = 1
dQ = LtdP, on Ft, 0 t T
Tomas Bj
ork, 2013 166
Changing the drift in an SDE
The single most common use of the Girsanov Theorem
is as follows.
Suppose that we have a process X with P dynamics
Tomas Bj
ork, 2013 167
The Converse Girsanov Theorem
dQ
Lt = , on Ft 0, t T
dP
Ft = {Ws; 0 s t}
Tomas Bj
ork, 2013 168
Continuous Time Finance
Tomas Bj
ork
Tomas Bj
ork, 2013 169
Financial Markets
Price Processes:
St = St0, ..., StN
Example: (Black-Scholes, S 0 := B, S 1 := S)
Portfolio:
ht = h0t , ..., hN
t
Value Process:
N
X
Vth = hitSti = htSt
i=0
Tomas Bj
ork, 2013 170
Self Financing Portfolios
Definition: (intuitive)
A portfolio is self-financing if there is no exogenous
infusion or withdrawal of money. The purchase of a
new asset must be financed by the sale of an old one.
Definition: (mathematical)
A portfolio is self-financing if the value process
satisfies
XN
dVt = hitdSti
i=0
Major insight:
If the price process S is a martingale, and if h is
self-financing, then V is a martingale.
Tomas Bj
ork, 2013 171
Arbitrage
V0 = 0.
VT 0, P a.s.
Tomas Bj
ork, 2013 172
First Attempt
Proof:
Assume that V is an arbitrage strategy. Since
N
X
dVt = hitdSti,
i=0
V is a P -martingale, so
V0 = E P [VT ] > 0.
This contradicts V0 = 0.
Tomas Bj
ork, 2013 173
Example: (Black-Scholes)
Tomas Bj
ork, 2013 174
Choose S0 as numeraire
Definition:
The normalized price vector Z is given by
St 1 N
Zt = 0 = 1, Zt , ..., Zt
St
N
X
VtZ = hitZti .
0
Idea:
The arbitrage and self financing concepts should be
independent of the accounting unit.
Tomas Bj
ork, 2013 175
Invariance of numeraire
S-arbitrage Z-arbitrage.
S-self-financing Z-self-financing.
Insight:
If h self-financing then
N
X
dVtZ = hitdZti
1
Tomas Bj
ork, 2013 176
Second Attempt
Example: (Black-Scholes)
Tomas Bj
ork, 2013 177
Arbitrage
h is self financing
V0 = 0.
VT 0, P a.s.
Major insight
This concept is invariant under an equivalent change
of measure!
Tomas Bj
ork, 2013 178
Martingale Measures
QP
Sti
Zti = 0, i = 0, . . . , N
St
are Q-martingales.
Tomas Bj
ork, 2013 179
First Fundamental Theorem
iff
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ork, 2013 180
Comments
Tomas Bj
ork, 2013 181
Proof that EMM implies no arbitrage
Assume that there exists an EMM denoted by Q.
Assume that P (VT 0) = 1 and P (VT > 0) > 0.
Then, since P Q we also have Q(VT 0) = 1 and
Q(VT > 0) > 0.
Recall:
N
X
dVtZ = hitdZti
1
Q is a martingale measure
V Z is a Q-martingale
V0 = V0Z =E Q
VTZ >0
No arbitrage
Tomas Bj
ork, 2013 182
Choice of Numeraire
St0 = Bt
where
dBt = rtBt dt
Rt
Bt = e 0 rs ds
Tomas Bj
ork, 2013 183
Example: The Black-Scholes Model
dQ = LT dP, on FT
Girsanov:
dWt = tdt + dWtQ,
Tomas Bj
ork, 2013 184
The Q-dynamics for Z are given by
dZt = Zt [ r + t ] dt + ZtdWtQ .
Tomas Bj
ork, 2013 185
Pricing
Definition:
A contingent claim with delivery time T , is a random
variable
X FT .
At t = T the amount X is paid to the holder of the
claim.
X = max [ST K, 0]
Tomas Bj
ork, 2013 186
Solution
t [X]
Bt
T [X] = X
Tomas Bj
ork, 2013 187
Risk Neutral Valuation
h i
RT
t [X] = E Q e t rs ds
X Ft
Tomas Bj
ork, 2013 188
Example: The Black-Scholes Model
Q-dynamics:
Simple claim:
X = (ST ),
Kolmogorov
Tomas Bj
ork, 2013 189
Problem
h i
RT
t [X] = E Q e t rs ds
X Ft
Tomas Bj
ork, 2013 190
Hedging
h is self financing
VT = X, P a.s.
Pricing Formula:
If h replicates X, then a natural way of pricing X is
t [X] = Vth
Tomas Bj
ork, 2013 191
Existence of hedge
Tomas Bj
ork, 2013 192
Fix T -claim X.
X
VTZ = BT
K
X
dVtZ = hitdZti
1
Thus V Z is a Q-martingale.
Z Q X
Vt = E Ft
BT
Tomas Bj
ork, 2013 193
Lemma:
Fix T -claim X. Define martingale M by
X
Mt = E Q Ft
BT
N Z
X t
Mt = x + hisdZsi ,
i=1 0
Tomas Bj
ork, 2013 194
Proof
We guess that
N
X
Mt = VtZ = hB
t 1+ hitZti
i=1
Define: hB by
N
X
hB
t = Mt hitZti.
i=1
Tomas Bj
ork, 2013 195
Second Fundamental Theorem
Theorem:
iff
Tomas Bj
ork, 2013 196
Black-Scholes Model
Q-dynamics
Q
rT
Mt = E e X Ft ,
Z t
Mt = M (0) + gsdWsQ.
0
Thus Z t
Mt = M0 + h1s dZs,
0
gt
with h1t = Zt .
Tomas Bj
ork, 2013 197
Result:
X can be replicated using the portfolio defined by
h1t = gt/Zt,
hB
t = Mt h1t Zt.
Tomas Bj
ork, 2013 198
Special Case: Simple Claims
Assume X is of the form X = (ST )
Q
rT
Mt = E e (ST ) Ft ,
o
It
f
dMt = St dWtQ,
s
so
f
gt = St ,
s
Replicating portfolio h:
f
hB
t = f St ,
s
f
h1t = Bt .
s
Interpretation: f (t, St) = VtZ .
Tomas Bj
ork, 2013 199
Define F (t, s) by
(
F 1 2 2 2F
t + rs F
s + 2 s s2 rF = 0,
F (T, s) = (s).
Tomas Bj
ork, 2013 200
Main Results
Tomas Bj
ork, 2013 201
Completeness vs No Arbitrage
Rule of Thumb
Question:
When is a model arbitrage free and/or complete?
Answer:
Count the number of risky assets, and the number of
random sources.
Intuition:
If N is large, compared to R, you have lots of
possibilities of forming clever portfolios. Thus lots
of chances of making arbitrage profits. Also many
chances of replicating a given claim.
Tomas Bj
ork, 2013 202
Rule of thumb
N R
N R
Example:
The Black-Scholes model.
Tomas Bj
ork, 2013 203
Stochastic Discount Factors
1 P
t [X] = E [DT X| Ft]
Dt
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ork, 2013 204
Martingale Property of S D
Tomas Bj
ork, 2013 205
Continuous Time Finance
Dividends,
Tomas Bj
ork
Tomas Bj
ork, 2013 206
Contents
1. Dividends
3. Futures options
Tomas Bj
ork, 2013 207
1. Dividends
Tomas Bj
ork, 2013 208
Dividends
Black-Scholes model:
New feature:
The underlying stock pays dividends.
Interpretation:
Over the interval [t, t + dt] you obtain the amount dDt
Two cases
Discrete dividends (realistic but messy).
Tomas Bj
ork, 2013 209
Portfolios and Dividends
N
X
Vt = hitSti
i=1
Tomas Bj
ork, 2013 210
Self financing portfolios
Recall:
N
X
Vt = hitSti
i=1
N
X
dVt = hitdGit
i=1
Interpret!
Tomas Bj
ork, 2013 211
Relative weights
hitSti
uit =
Vt
N
X
dVt = hitdGit
i=1
Substitute!
N
X i
i dGt
dVt = Vt ut i
i=1
St
Tomas Bj
ork, 2013 212
Continuous Dividend Yield
dDt = qSt dt
Problem:
How does the dividend affect the price of a European
Call? (compared to a non-dividend stock).
Answer:
The price is lower. (why?)
Tomas Bj
ork, 2013 213
Black-Scholes with Cont. Dividend Yield
Gain process:
X = (ST )
Tomas Bj
ork, 2013 214
Standard Procedure
dVt = Vt ktdt
kt = r
Tomas Bj
ork, 2013 215
Value dynamics:
S dG F dF
dV = V u +u ,
S F
dG = S( + q)dt + SdW.
From It
o we obtain
dF = F F dt + F F dW,
where
2
1 F F 1 2 2 F
F = + S + S ,
F t s 2 s2
1 F
F = S .
F s
Tomas Bj
ork, 2013 216
Define uS and uF by the system
uS + uF F = 0,
uS + uF = 1.
Tomas Bj
ork, 2013 217
Solution
F
uS = ,
F
uF = ,
F
Value dynamics
S F
dV = V u ( + q) + u F dt.
uS ( + q) + uF F = r,
We get
F F 1 2 2 2F
+ (r q)S + S 2
rF = 0.
t s 2 s
Tomas Bj
ork, 2013 218
Pricing PDE
F F 1 2 2 2F
+ (r q)s + s rF = 0,
t s 2 s2
F (T, s) = (s).
Tomas Bj
ork, 2013 219
Risk Neutral Valuation
Q
F (t, s) = er(T t)Et,s [(ST )] ,
Tomas Bj
ork, 2013 220
Martingale Property
is a Q-martingale.
Proof: Exercise.
Interpretation:
In a risk neutral world, todays stock price should be
the expected value of all future discounted earnings
which arise from holding the stock.
Z t
S0 = E Q erudDu + ertSt ,
0
Tomas Bj
ork, 2013 221
Pricing formula
Pricing formula for claims of the type
Z = (ST )
F 0(t, s)
Tomas Bj
ork, 2013 222
Moral
Tomas Bj
ork, 2013 223
European Call on Dividend-Paying-Stock
s
1 1
d1 = ln + r q + 2 (T t)
T t X 2
d2 = d1 T t.
Tomas Bj
ork, 2013 224
Martingale Analysis
Tomas Bj
ork, 2013 225
The Reduction Technique
Vt
Bt
is a Q martingale.
Tomas Bj
ork, 2013 226
The V Process
Vt = 1 St + htBt (1)
dVt = dSt + dDt + htdBt (2)
Btdht = dDt
Tomas Bj
ork, 2013 227
We thus have
Z t
1
Vt = St + Bt dDs (3)
0 Bs
is a Q martingale.
Tomas Bj
ork, 2013 228
Continuous Dividend Yield
Model under P
We recall Z t
St 1
GZ
t = + dDs
Bt 0 Bs
Easy calculation gives us
dGZ
t = Zt ( r + q) dt + Zt dWt
where Z = S/B.
Girsanov transformation dQ = LdP , where
We have
dWt = tdt + dWtQ
Tomas Bj
ork, 2013 229
The Q dynamics for GZ are
Q
dGZ
t = Zt ( r + q + t ) dt + ZtdWt
Martingale condition
r + q + t = 0
Q-dynamics of S
dSt = St ( + ) dt + StdWtQ
dSt = St (r q) dt + StdWtQ
Tomas Bj
ork, 2013 230
Risk Neutral Valuation
Tomas Bj
ork, 2013 231
2. Forward and Futures Contracts
Tomas Bj
ork, 2013 232
Forward Contracts
Tomas Bj
ork, 2013 233
General Risk Neutral Formula
Tomas Bj
ork, 2013 234
Forward Price Formula
1 h RT i
f (t, T ) = E Q e t rsds X Ft
p(t, T )
Tomas Bj
ork, 2013 235
Proof
t [X] = t [f (t, T )]
We have
h i
RT
t [X] = E Q e t rs ds
X Ft
Tomas Bj
ork, 2013 236
Futures Contracts
Tomas Bj
ork, 2013 237
Futures Price Formula
From the definition it is clear that a futures contract
is a price-dividend pair (S, D) with
S 0, dDt = dF (t, T )
is a Q-martingale.
Since S 0 and dDt = dF (t, T ) this implies that
1
dF (t, T )
Bt
Tomas Bj
ork, 2013 238
Theorem: The futures price process is given by
Tomas Bj
ork, 2013 239
3. Futures Options
Tomas Bj
ork, 2013 240
Futures Options
F (t, T ).
Definition:
A European futures call option, with strike price X and
exercise date T , on a futures contract with delivery date
T1 will, if exercised at T , pay to the holder:
Tomas Bj
ork, 2013 241
Institutional fact:
The exercise date T of the futures option is typcally
very close to the date of delivery of the underlying T1
futures contract.
Tomas Bj
ork, 2013 242
Why do Futures Options exist?
Tomas Bj
ork, 2013 243
Pricing Futures Options Black-76
dFt = Ft dt + FtdWt
(FT )
Tomas Bj
ork, 2013 244
From risk neutral valuation we know that the price
process t [] is of the form
t [] = f (t, Ft)
where f is given by
Q
f (t, F ) = er(T t)Et,F [(FT )]
We now recall
dFt = FtdWtQ
Tomas Bj
ork, 2013 245
We thus have
Q
f (t, F ) = er(T t)Et,F [(FT )]
with Q-dynamics
dFt = FtdWtQ
Q
f (t, s) = er(T t)Et,s [(ST )]
with Q-dynamics
Tomas Bj
ork, 2013 246
Pricing Formulas
Tomas Bj
ork, 2013 247
Black-76 Formula
1 F 1 2
d1 = ln + (T t) ,
T t X 2
d2 = d1 T t.
Tomas Bj
ork, 2013 248
Continuous Time Finance
Currency Derivatives
Ch 17
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ork
Tomas Bj
ork, 2013 249
Pure Currency Contracts
Tomas Bj
ork, 2013 250
Simple Model (Garman-Kohlhagen)
dXt = Xt X dt + Xt X dWt,
dBtd = rd Btddt,
dBtf = rf Btf dt,
Main Problem:
Find arbitrage free price for currency derivative, Z, of
the form
Z = (XT )
Z = max [XT K, 0]
Tomas Bj
ork, 2013 251
Naive idea
Is this OK?
Tomas Bj
ork, 2013 252
NO!
WHY?
Tomas Bj
ork, 2013 253
Main Idea
When you buy stock you just keep the asset until
you sell it.
Moral:
Buying a currency is like buying a dividend-paying
stock with dividend yield q = rf .
Tomas Bj
ork, 2013 254
Technique
Tomas Bj
ork, 2013 255
Transformed Market
f ,
B Bd
Tomas Bj
ork, 2013 256
Market dynamics
dXt = Xt X dt + XtX dW
tf = Btf Xt
B
Using It
o we have domestic market dynamics
tf
dB f f tf X dWt
= Bt X + r dt + B
dBtd = rdBtddt
tf
dB tf rd dt + B
= B tf X dWtQ
dBtd = rd Btddt
It tf /Btf :
o gives us Q-dynamics for Xt = B
Tomas Bj
ork, 2013 257
Risk neutral Valuation
d Q
F (t, x) = er (T t)
Et,x [(XT )]
Tomas Bj
ork, 2013 258
Pricing PDE
F d f F 1 2 2 2F
+ x(r r ) + x X 2 rdF = 0,
t x 2 x
F (T, x) = (x)
Tomas Bj
ork, 2013 259
Currency vs Equity Derivatives
Tomas Bj
ork, 2013 260
Currency Option Formula
f d
F (t, x) = xer (T t)
N [d1] er (T t)
KN [d2] ,
where
1 x 1
d1 = ln + rd rf + X
2
(T t)
X T t K 2
d2 = d1(t, x) X T t
Tomas Bj
ork, 2013 261
Martingale Analysis
P -dynamics of X
Tomas Bj
ork, 2013 262
Main Idea
Tomas Bj
ork, 2013 263
We thus obtain
d
h RT d i d
h RT f i
E Q e 0 rs dsXT Z = X0 E Q LT e 0 rs dsZ
alternatively by
Dtf
Xt = X0 d
Dt
where Dtd is the domestic stochastic discount factor
etc.
Proof: The last part follows from
f f
dQ dQ dQd
L= d
=
dQ dP dP
Tomas Bj
ork, 2013 264
Qd-Dynamics of X
Tomas Bj
ork, 2013 265
Market Prices of Risk
Recall
0t rsdds d
R
Dtd = e Lt
We also have
dLdt = LdtdtdWt
Dtf
Xt = X0 d
Dt
t = dt ft
Tomas Bj
ork, 2013 266
Siegels Paradox
Assume that the domestic and the foreign markets are
risk neutral and assume constant short rates. We now
have the following surprising (?) argument.
A: Let us consider a T claim of 1 dollar. The arbitrage
free dollar value at t = 0 is of course
r f T
e
r f T
X0e .
We thus have
f d
X0 er T
= er T E P [XT ]
Tomas Bj
ork, 2013 267
Siegels Paradox ctd
Tomas Bj
ork, 2013 268
Siegels Paradox ctd
r f T r d T
X0 e = e E P [XT ]
1 rdT f 1
e = er T E P
X0 XT
Tomas Bj
ork, 2013 269
Formal analysis of Siegels Paradox
dt = ft = 0
t = dt ft
Tomas Bj
ork, 2013 270
Moral
Tomas Bj
ork, 2013 271
Continuous Time Finance
Change of Numeraire
Ch 26
Tomas Bj
ork
Tomas Bj
ork, 2013 272
Recap of General Theory
QP
are Q-martingales.
Tomas Bj
ork, 2013 273
Recap continued
We obviously have
Zt0 1
Tomas Bj
ork, 2013 274
Dependence on numeraire
Tomas Bj
ork, 2013 275
General change of numeraire.
Problems:
dQS
Lt = , on Ft
dQ
Tomas Bj
ork, 2013 276
Constructing QS
t [X]
St
Tomas Bj
ork, 2013 277
For all X FT we thus have
Q X Q X S0
E = E LT
BT ST
E [Y X] = E [Z X] , for all Z F.
Then we have
Y = Z, P a.s.
Tomas Bj
ork, 2013 278
Main result
dQS
Lt = , on Ft
dQ
is given by
St 1
Lt =
Bt S0
Tomas Bj
ork, 2013 279
Easy exercises
Tomas Bj
ork, 2013 280
Pricing
X = ST Y
Tomas Bj
ork, 2013 281
Important example
Using Q0 we obtain
" #
ST0 , ST1
t [X] = St0E 0 Ft
ST0
1
0 0 ST
t [X] = t [X] = St E 1, 0 Ft
ST
Tomas Bj
ork, 2013 282
Important example cntd
where
St1
(z) = [1, z] , Zt = 0
St
Tomas Bj
ork, 2013 283
Exchange option
Piece of cake!
Tomas Bj
ork, 2013 284
Identifying the Girsanov Transformation
St
Lt =
S0 Bt
dLt = LtvtdWtQ .
dLt = LtvtdWtQ .
Tomas Bj
ork, 2013 285
Recap on zero coupon bonds
Recall: A zero coupon T -bond is a contract which
gives you the claim
X1
at time T .
The price process t [1] is denoted by p(t, T ).
Allowing a stochastic short rate rt we have
This gives us Rt
Bt = e 0 rs ds ,
Note:
p(T, T ) = 1
Tomas Bj
ork, 2013 286
The forward measure QT
Consider a fixed T .
We have
T [X] = X, p(T, T ) = 1
Tomas Bj
ork, 2013 287
A general option pricing formula
X = max [ST K, 0]
Write X as
Tomas Bj
ork, 2013 288
Continuous Time Finance
Incomplete Markets
Ch 15
Tomas Bj
ork
Tomas Bj
ork, 2013 289
Derivatives on Non Financial Underlying
Shortselling allowed.
Examples:
Weather derivatives.
CAT-bonds.
Tomas Bj
ork, 2013 290
Typical Contracts
Weather derivatives:
Heating degree days. Payoff at maturity T is
given by
Z = max {XT 30, 0}
where XT is the (mean) temperature at some place.
Electricity option:
The right (but not the obligation) to buy, at time
T , at a predetermined price K, a constant flow of
energy over a predetermined time interval.
CAT bond:
A bond for which the payment of coupons and
nominal value is contingent on some (well specified)
natural disaster to take place.
Tomas Bj
ork, 2013 291
Problems
Weather derivatives:
The temperature is not the price of a traded asset.
Electricity derivatives:
Electric energy cannot easily be stored.
CAT-bonds:
Natural disasters are not traded assets.
Tomas Bj
ork, 2013 292
Typical Factor Model Setup
Given:
Problem:
Find arbitrage free price t [Z] of a derivative of the
form
Z = (XT )
Tomas Bj
ork, 2013 293
Concrete Examples
Holiday Insurance:
1000, if XT < 20
(XT ) =
0, if XT 20
Tomas Bj
ork, 2013 294
Question
Tomas Bj
ork, 2013 295
NO!!
WHY?
Tomas Bj
ork, 2013 296
Stock Price Model Factor Model
Black-Scholes:
Factor Model:
Tomas Bj
ork, 2013 297
Answer
Tomas Bj
ork, 2013 298
1. Rule of thumb:
2. Replicating portfolios:
We can only invest money in the bank, and then sit
down passively and wait.
Tomas Bj
ork, 2013 299
There is not a unique price for a particular
derivative.
t [] = f (t, Xt)
t [] = g(t, Xt )
Tomas Bj
ork, 2013 300
Program:
dV = V kdt,
k=r
Tomas Bj
ork, 2013 301
From It
o:
df = f f dt + f f dW,
where (
ft +fx+ 12 2 fxx
f = f ,
fx
f = f .
Portfolio dynamics
df dg
dV = V uf + ug .
f g
Tomas Bj
ork, 2013 302
f g
u = ,
f g
f
ug = ,
f g
Portfolio dynamics
f g
dV = V u f + u g dt.
i.e.
g f f g
dV = V dt.
f g
Absence of arbitrage requires
g f f g
=r
f g
Tomas Bj
ork, 2013 303
g r f r
= .
g f
Note!
The quotient does not depend upon the particular
choice of contract.
Tomas Bj
ork, 2013 304
Result
Slogan:
On an arbitrage free market all X-derivatives have
the same market price of risk.
The relation
f r
=
f
is actually a PDE!
Tomas Bj
ork, 2013 305
Pricing Equation
f + { } f + 1 2 f rf = 0
t x xx
2
f (T, x) = (x),
P -dynamics:
dX = (t, X)dt + (t, X)dW.
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No!!
Why??
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Answer
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Question:
Who determines ?
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Answer:
THE MARKET!
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Interpreting
Recall that the f dynamics are
df = f f dt + f f dWt
and is defined as
f (t) r
= (t, Xt),
f (t)
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Moral
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Risk Neutral Valuation
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Risk Neutral Valuation
Q
f (t, x) = er(T t)Et,x [(XT )]
Q-dynamics:
dXt = { } dt + dWtQ
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Interpretation of the risk adjusted
probabilities
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Diversification argument about
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Modeling Issues
Temperature:
A standard model is given by
Electricity:
A (naive) model for the spot electricity price is
CAT bonds:
Here we have to use the theory of point processes
and the theory of extremal statistics to model
natural disasters. Complicated.
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Martingale Analysis
Bt
=1
Bt
is a Q martingale.
Girsanov
dLt = Ltt dWt
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P -dynamics
Girsanov:
dWt = tdt + dWtQ
Martingale pricing:
Q-dynamics of X:
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Several Risk Factors
df = f f dt + f f dWt
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Continuous Time Finance
Ch 19
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Contents
1. Dynamic programming.
2. Investment theory.
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1. Dynamic Programming
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Problem Formulation
"Z #
T
max E F (t, Xt, ut)dt + (XT )
u 0
subject to
ut = u(t, Xt)
Terminology:
X = state variable
u = control variable
U = control constraint
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Main idea
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Some notation
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More notation
where
ut = u(t, Xtu)
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Embedding the problem
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The optimal value function
J : R+ Rn U R
is defined by
"Z #
T
J (t, x, u) = E F (s, Xsu, us)ds + (XTu )
t
V : R+ Rn R
is defined by
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Assumptions
We assume:
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Bellman Optimality Principle
Proof: Exercise.
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Basic strategy
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Basic idea
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Strategy values
:
Expected utility for u
J (t, x, u
) = V (t, x)
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Comparing strategies
We have trivially
"Z #
t+h
V (t, x) Et,x F (s, Xsu, us) ds + V (t + h, Xt+h
u
) .
t
Remark
We have equality above if and only if the control law
.
u is the optimal law u
Now use It
o to obtain
V (t + h, Xt+h
u
) = V (t, x)
Z t+h
V
+ (s, Xsu) + AuV (s, Xsu ) ds
t t
Z t+h
+ xV (s, Xsu) u dWs,
t
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We obtain
"Z #
t+h
V
Et,x F (s, Xsu, us) + (s, Xsu ) + AuV (s, Xsu) ds 0.
t t
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Recall
V
F (t, x, u) + (t, x) + AuV (t, x) 0,
t
This holds for all u = u(t, x), with equality if and only
.
if u = u
V
(t, x) + sup {F (t, x, u) + AuV (t, x)} = 0.
t uU
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The HJB equation
Theorem:
Under suitable regularity assumptions the follwing hold:
V
(t, x) + sup {F (t, x, u) + AuV (t, x)} = 0,
t uU
V (T, x) = (x),
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Logic and problem
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The Verification Theorem
Suppose that we have two functions H(t, x) and g(t, x), such
that
(t, x) = g(t, x)
u
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Handling the HJB equation
1. Consider the HJB equation for V .
2. Fix (t, x) [0, T ] Rn and solve, the static optimization
problem
u
max [F (t, x, u) + A V (t, x)] .
uU
Here u is the only variable, whereas t and x are fixed
parameters. The functions F , , and V are considered as
given.
3. The optimal u, will depend on t and x, and on the function
V and its partial derivatives. We thus write u
as
=u
u (t, x; V ) . (4)
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Making an Ansatz
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The Linear Quadratic Regulator
"Z #
T
min E {Xt0QXt + u0tRut } dt + XT0 HXT ,
uRk 0
with dynamics
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Handling the Problem
For each fixed choice of (t, x) we now have to solve the static unconstrained
optimization problem to minimize
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The problem was:
1 1 0
= R B (x V )0.
u
2
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From the boundary function x0 Hx and the term x0Qx
in the cost function we make the Ansatz
V
(t, x) = x0P x + q,
t
xV (t, x) = 2x0 P,
xxV (t, x) = 2P
= R1B 0 P x.
u
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We thus get the following matrix ODE for P
(
P = P BR1 B 0 P A0P P A Q,
P (T ) = H.
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2. Investment Theory
Problem formulation.
An extension of HJB.
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Recap of Basic Facts
We consider a market with n assets.
Basic equation:
Dynamics of self financing portfolio in terms of relative
weights
Xn i
i dSt
dXt = Xt wt i ct dt
i=1
St
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Simplest model
Assume a scalar risky asset and a constant short rate.
"Z #
T
max E F (t, ct)dt
w 0,w 1,c 0
Dynamics
dXt = Xt wt0r + wt1 dt ctdt + wt1 XtdWt ,
Constraints
ct 0, t 0,
wt0 + wt1 = 1, t 0.
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Nonsense!
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What are the problems?
Good News:
DynP can be generalized to handle (some) problems
of this kind.
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Generalized problem
Z
max E F (s, Xsu, us)ds + (, Xu) .
uU 0
Dynamics:
= inf {t 0 |(t, Xt ) D} T.
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Generalized HJB
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Reformulated problem
Z
max E F (t, ct)dt + (XT )
c0, wR 0
= inf {t 0 |Xt = 0} T.
Notation:
w1 = w,
w0 = 1 w
Thus no constraint on w.
Dynamics
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ork, 2013 355
HJB Equation
( )
2
V V V 1 V
+ sup F (t, c) + wx( r) + (rx c) + x2 w 2 2 = 0,
t c0,wR x x 2 x2
V (T , x) = 0,
V (t, 0) = 0.
t V V 1 2 2 2 2V
e c + wx( r) + (rx c) + x w ,
x x 2 x2
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Analysis of the HJB Equation
t 1 2 2 2
e c + wx( r)Vx + (rx c)Vx + x w Vxx,
2
c1 = et Vx,
Vx r
w = 2
,
x Vxx
Ansatz:
V (t, x) = eth(t)x ,
Because of the boundary conditions, we must demand
that
h(T ) = 0. (5)
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Given a V of this form we have (using to denote the
time derivative)
et hx ,
Vt = ethx
Vx = ethx1,
Vxx = ( 1)ethx2.
giving us
r
w(t,
b x) = ,
2 (1 )
c(t, x) = xh(t)1/(1) .
b
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After rearrangements we obtain
n o
x h(t) + Ah(t) + Bh(t)/(1) = 0,
( r)2 1 ( r)2
A = 2
+ r 2
(1 ) 2 (1 )
B = 1 .
h(t) + Ah(t) + Bh(t)/(1) = 0,
h(T ) = 0.
We are done.
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ork, 2013 359
Mertons Mutal Fund Theorems
dS = D(S)dt + D(S)dW.
where
1 1
= .. = ..
n n
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Formal problem
Z
max E F (t, ct)dt
c,w 0
given the dynamics
and constraints
e0w = 1, c 0.
Assumptions:
The vector and the matrix are constant and
deterministic.
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The HJB equation is
c,w
Vt (t, x) + sup {F (t, c) + A V (t, x)} = 0,
0
e w=1, c0
V (T, x) = 0,
V (t, 0) = 0.
where
1
Ac,w V = xw0Vx cVx + x2 w0w Vxx,
2
= 0 .
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ork, 2013 362
The HJB equation is
8
1
ff
0 2 0
V + sup F (t, c) + (xw c)V + x w wVxx = 0,
>
t x
>
>
>
< w 0e=1, c0 2
>
> V (T , x) = 0,
>
>
: V (t, 0) = 0.
where = 0.
If we relax the constraint w0e = 1, the Lagrange function for the static
optimization problem is given by
1
L = F (t, c) + (xw0 c)Vx + x2w0wVxx + (1 w0e) .
2
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L = F (t, c) + (xw0 c)Vx
1 2 0
+ x w wVxx + (1 w0e) .
2
Fc = Vx.
x0 Vx + x2 Vxxw0 = e0,
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ork, 2013 364
Inserting gives us, after some manipulation,
0 1
1 Vx e
= 0 1 1e +
w 1 0 1 e .
e e xVxx e e
w(t)
= g + Y (t)h,
1 1
g = 0 1
e,
e e
0 1
e
h = 1 0 1 e ,
e e
whereas Y is given by
Vx(t, X(t))
Y (t) = .
X(t)Vxx (t, X(t))
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ork, 2013 365
We had
w(t)
= g + Y (t)h,
Thus we see that the optimal portfolio is moving
stochastically along the one-dimensional optimal
portfolio line
g + sh,
in the (n 1)-dimensional portfolio hyperplane ,
where
= {w Rn |e0w = 1} .
If we fix two points on the optimal portfolio line, say
wa = g + ah and wb = g + bh, then any point w on
the line can be written as an affine combination of the
basis points wa and wb. An easy calculation shows
that if ws = g + sh then we can write
ws = wa + (1 )wb ,
where
sb
= .
ab
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ork, 2013 366
Mutual Fund Theorem
= a(t)wa + b(t)wb ,
w(t)
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The case with a risk free asset
dB = rBdt.
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HJB
We obtain
V (T, x) = 0,
V (t, 0) = 0,
where
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ork, 2013 369
First order conditions
We maximize
0 1 2 0
F (t, c) + xw ( re)Vx + (rx c)Vx + x w wVxx
2
Fc = Vx,
Vx 1
=
w ( re),
xVxx
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Mutual Fund Separation Theorem
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Continuous Time Finance
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ork
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Contents
Lagrange relaxation.
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Problem Formulation
Standard model with internal filtration
Assumptions:
Drift and diffusion terms are allowed to be arbitrary
adapted processes.
Problem:
max E P [(XT )]
hH
where
H = {self financing portfolios}
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Some observations
erT E Q [Z] = x0 ,
max E P [(Z)]
Z
erT E Q [Z] = x0 .
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Basic Ideas
Our problem was
max E P [(Z)]
Z
subject to
erT E Q [Z] = x0 .
Idea I:
We can decouple the optimal portfolio problem into:
1. Finding the optimal wealth profile Z.
Idea II:
Rewrite the constraint under the measure P .
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ork, 2013 376
Lagrange formulation
Problem:
max E P [(Z)]
Z
subject to
erT E P [LT Z] = x0 .
dQ
Lt = , on Ft, 0tT
dP
P
rT P
L = E [(Z)] + x0 e E [LT Z]
i.e.
P rT
L=E (Z) e LT Z + x0
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The optimal wealth profile
P
rT
L=E (Z) e LT Z + x0
rT
max (z) e LT z
z
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ork, 2013 378
The optimal wealth profile
Our problem:
rT
max (z) e LT z
z
0(z) = erT LT
where
1
G(y) = [0] (y).
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ork, 2013 379
Example log utility
Assume that
(x) = ln(x)
Then
1
g(y) =
y
Thus
1 rT 1
Z = G erT
LT = e LT
Finally is determined by
h i
erT E P LT Z = x0.
i.e.
1
erT E P LT erT L1
T = x0 .
so = x1
0 and
Z = x0erT L1
T
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The optimal wealth process
bt look like?
What does the optimal wealth process X
We have (why?)
h i
bt = er(T t)E Q
X bT Ft
X
so we obtain
rt Q
1
b
Xt = x0e E LT Ft
bt = x0 ertL1
X t .
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The Optimal Portfolio
Recall that
bt = x0 ertL1
X t .
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Basic Program
bt to compute dX
1. Use Ito and the formula for X bt like
bt = X
dX bt ( )dt + X
bttdWt
2. Recall that
bt = X
bt dBt dSt
dX (1 u
t ) +u
t
Bt St
which we write as
bt = X
dX bt { } dt + X
bt u
tdWt
3. We can identify u
as
t
u
t =
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We recall
bt = x0 ertL1
X t .
We also recall that
dLt = LtdWt ,
where
r
=
From this we have
dL1
t = 2 1
L t dt L 1
t dWt
and we obtain
bt = X
X bt { } dt X
btdWt
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ork, 2013 384
A Digression: The Numeraire Portfolio
Standard approach:
Choose a fixed numeraire (portfolio) N .
Find the corresponding martingale measure, i.e. find QN s.t.
B S
, and
N N
are QN -martingales.
Alternative approach:
Choose a fixed measure Q P .
Find numeraire N such that Q = QN .
Special case:
Set Q = P
Find numeraire N such that QN = P i.e. such that
B S
, and
N N
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Log utility and the numeraire portfolio
Definition:
The growth optimal portfolio (GOP) is the portfolio
which is optimal for log utility (for arbitrary terminal
date T .
Theorem:
Assume that X is GOP. Then X is the numeraire
portfolio.
Proof:
We have to show that the process
St
Yt =
Xt
is a P martingale.
We have
St
= x1
0 e
rt
St L t
Xt
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