Equivalent Martingale Measures and the Girsanov Theorem

Jack Chua March 10, 2009

Introduction

This is part of the second and third lecture in quantitative nance for the University of Chicago's Blue Chips Investments Club. In the last lecture, we went over some basic building blocks in stochastic calculus, culminating in the derivation of the Black-Scholes-Merton partial dierential equation. Today, we will use these tools to introduce the basics of martingale theory, with particular reference to probability theory, equivalent martingale measures and the Girsanov change of measure theorem.
2 Probability Spaces

A probability space is a triplet (, F, P ) dened by a state space , sigma algebra F , and probability measure P . A probability space is said to be equipped with a ltration of the sigma algebra that is augmented as time goes by, since more information is obtained about the past.
A state space is the set of all possible states. A sigma algebra F is the event space, i.e. the set of measurable or observable events which are subsets of . A probability measure P is a measure that assigns a probability to any measurable event A F .

Denition. A measure P is said to be a probability measure if all of the following are true:
1. P () = 1 2. P (
i=1

Ai ) =

i=1

P (Aj ) for Ai pairwise disjoint F of subsets of is a sigma algebra if all of the

3. 0 P (Ai ) 1 i.

Denition. A collection
following are true: 1. F 2. A F = Ac F 3. {Ai }iJ F =

iJ

Ai F .

likely possible states, i.e. = {Suu , Sud , Sdu , Sdd }. We can dene the ltration for each time step:
F2 F1 F0 = 2 = {, , {Suu , Sud }, {Sdu , Sdd }} = {, }

Example. Consider a two-period binomial asset pricing model with four equally

where is the null set and Ft is the ltration at time t representing the information that is available after t periods. For example, after 0 periods, the ltration equals either the null set or the entire sample space - anything can happen or nothing will happen. After 1 period, the ltration is ner but yet complete, since not every subset of is measurable by P; the probability measure is P ({Suu , Sud }) = P ({Sdu , Sdd }) = 1 . After 2 periods, the ltration is 2 the power set generated by . This represents complete information in our twoperiod model, as every possible subset of is now measurable by P. Note that F can be viewed as a family of nested information sets, i.e.
F0 F1 Fi1 Fi

which models information ow as time goes on. Often, = (0, ). In this case, F is the Borel sigma algebra, the smallest sigma algebra that contains all open intervals, and P might be the lognormal distribution.
3 Continuous-Time Martingales

Note. In the nancial markets, it is never always as simple as two periods.

Denition. Let

St be a random price process during a nite time interval t [0, T ]. St is said to be adapted to the ltration if St is a Ft -measurable function t T. It is also said to be a non-anticipating process, or one that

cannot see into the future. P if t > 0,

Denition. A process St is a martingale w.r.t.

1. St is It -adapted 2. E|St | < 3. Et [ST ] = St t < T with probability 1.

Ft and probability measure

Property 3 is of vast importance. It means that the best forecast of an unobserved future value of a martingale is its last observation. This will turn out to be monumentally useful if we can convert a nancial asset into a martingale. There are two general steps:
Find a probability distribution P s.t. bond or stock prices discounted by

the risk-free rate become martingales. This can be done with Doob-Meyer decomposition and similar detrending techniques.
P Et [exp(ru)St+u ] > St

Transform the probability distribution. For example, if one had

we can try to nd an equivalent probability P s.t.

P Et [exp(ru)St+u ] = St

and thus we have a martingale. These are called equivalent martingale measures and can be done by use of the Girsanov theorem.
4 Girsanov Theorem

Before stating the theorem, some additional background needs to be provided. We can summarize two methods for changing the mean of a random variable. 1. Subtraction. For example, given a random variable Z N (, 1), we can dene
Z= Z N (0, 1) 1

a transformed variable with zero mean. 2. Using an equivalent measure. Given a random variable Z with probability measure P , Z P = N (, 1), we obtain a new probability via the RadonNikodym derivative (Z) and obtain a new probability P s.t. Z P = N (0, 1). The Girsanov Theorem attempts to do both by dening the conditions under which the Radon-Nikodym derivative exists. It then constructs a new probability distribution and a new transformed variable that eliminates the stochastic drift term (insofar we are dealing with an Ito process).

Theorem (Girsanov). Let Wt be a Wiener process on the probability space {, F, P }. Let Xt be a measurable process adapted to the ltration of the Wiener process {FtW }. Given the adapted process St dene the stochastic exponential of X w.r.t W
t t 1 2 t = E(X)t = exp Xu dW u Xu du 2
0 0

Under certain conditions, t is a martingale. Then a probability measure P can be dened on {, F} s.t. we have the Radon-Nikodym derivative
dP = t dP

then Wt = Wt 0t Xu du is a Wiener process w.r.t. Ft and the probability measure PT given by PT (A) = E P [1A T ], with A being an event determined by FT and 1A the indicator function for the event. 4

Before we start with the proof, we need to be more specic concerning the construction of P using the Radon-Nikodym derivative. Here are a few useful results.

Theorem (Novikov). If the condition

E e2
1

T
0

|Xu |2 du

<

is true then the stochastic exponential

t t 1 2 Xu du t = exp Xu dW u 2
0 0

is a martingale under the probability measure P and ltration F . Hence, while our assumption that the stochastic exponential is a martingale does not hold universally, it is under Novikov's condition.

Proof (Novikov). This proof is outside the scope of this article, so this is
left as an exercise to the reader.

Proof (Girsanov). Following results in [1], we use Levy's characterization for m-dimensional Brownian motion: Theorem (Levy). A continuous, adapted,
adapted Brownian motion if and only if: 1. Y0 = 0 almost surely; 2. Yt(i) is a P -local martingale i (i.e. a driftless diusion process w.r.t. P ); 3. Yt(j) Yt(k) jk t is a P -local martingale j, k = 1, ..., m. We know from denition that Wt is adapted and continuous with initial value equal to 0. Because we are dealing exclusively with the case m = 1, the second and third conditions vacuously apply once we prove that Wt is a P -local martingale. Since by Novikov's condition we know that t is in fact a martingale, once we prove the following lemma, we are done.
Rm -valued process Yt is a P -

Lemma. If t is a positive martingale, then Wt is a P -local martingale. Proof. Dene the process f (Wt , t ) = t Wt . Applying Ito's Lemma, we have
d(t Wt ) = t dWt + Wt dt + dWt dt

Also, applying Ito's Lemma to the stochastic exponential, we have that

t t () = 1 +
0

s ()Xs dWs ()

which is simply the assertion that t is a positive local martingale, or that

dt = t Xt dWt

Similarly, by construction,
dWt = dWt Xt dt

Hence, using these relationships, we have that

t t W t =
0

t Xs dWs +
0

s Ws Xs dWs

= t dWt + k

where k R represents a boundary condition and t L2 ([0, T ]). Therefore t Wt is a P -local martingale, which implies that Wt is a P -local martingale, and we have fully characterized Wt under Levi's denition of Brownian motion. Actually this is not even the full Girsanov theorem but it is sucient for our needs. Heuristically, it means that if we are given a Wiener process Wt , multiplying the probability distribution of this process by the stochastic exponential, we can obtain a new Wiener process Wt with probability distribution P . The two processes are related to each other through the following PDE:
dWt = dWt Xt dt

i.e. the new Wiener process is the same as the old one minus an It -adapted drift. Note that this drift term is stochastic, in stark contrast to the overly simple subtraction of means we saw in the rst example in this section.

Example. Assume
bility distribution

St is modeled as Brownian motion with constant drift, dSt = dt + dWt (W0 = 0). The Wt is assumed to have the following proba1 1 exp (Wt2 ) dWt 2t 2t

dP (Wt ) =

(refer back to Lecture 1 if this doesn't make sense). Obviously St is not a martingale if its drift term = 0. Taking the integrals of both sides, we have
St = t + Wt

and hence we can write

E[St+s |St ] = (t + s) + E[Wt+s Wt |St ] + Wt = St + s

The drift term is deterministic and the middle term indicates the expected change in the diusion process Wt while under Ft . Hence, St is not a martingale, but this suggests the variable St = St t is a martingale. We could also come up with a function (St ) and multiply it with the original probability measure associated with St s.t. while St is a submartingale under P , i.e.
E P [St+s |St ] > St

it will be a martingale under P , i.e.

E P [St+s |St ] = St

We calculate (St ), the stochastic exponential:

(St ) t t 1 2 Su du = exp Su dWu 2
0 0

1 1 = 2 exp[St 2 t] 2

This is the Radon-Nikodym derivative, and thus

dP (St ) = = = (St )dP (St ) 1 1 1 1 2 exp[St 2 t] exp 2 (St t)2 dSt 2t 2 2 t 2 1 1 exp 2 (St )2 dSt 2 t 2 2 t

which is the probability measure of a normally distributed process with zero drift and diusion term . Basically we have arrived at a new Wiener variable dWt s.t. dSt = dWt by use of Girsanov.
References

[1] [2]

Ioannis Karatzas and Steven Shreve. Brownian Motion and Stochastic Calculus. Springer-Verlag, 1991, 2nd ed. Salih Neftci. An Introduction to the Mathematics of Financial Derivatives. AP, 2004.