Martingale Measures Consider the stock price model dS(t) = S(t)(dt + dW (t)) over a time interval [0, T ].

Goal: To nd a martingale measure Q such that S is a martingale relative to Q.

Question: How can we represent the measure Q?

Martingale Measures Simple Example of the Idea: Consider two probability measures dened by their densities: The Uniform Distribution U on [0, 1]: f (x) = 1, 0 < x < 1;

A probability distribution G having density g(x) = 3/2(1 x2),

y = g(x)

0 < x < 1.

y = f (x)

Martingale Measures Let X be a random variable having distribution G and density g. Then
1

E G[h(X)] =
0 1

h(x) 3/2(1 x2) dx

=
0

h(x)g(x) 1 dx

= E U [h(x)g(x)]

Martingale Measures Simple Example of the Idea: Consider two probability measures dened by their densities: A probability distribution F on [0, 1]: f (x) = 3x2, 0 < x < 1;

A probability distribution G having density g(x) = 3/2(1 x2), 0 < x < 1.

y = f (x) y = g(x)

Martingale Measures Let X be a random variable having distribution G and density g. Then
1

E G[h(X)] =
0 1

h(x) (3/2)(1 x2)dx (3/2)(1 x2) 2 h(x) 3x dx 3x2 h(x)

0

=
0 1

g(x) f (x)dx f (x) g(x) f (x)

= E F h(x)

Density of G with respect to F :

Martingale Measures Idea: Find a density for the martingale measure Q relative to the real-world probability measure P Notation: density is usually written as dQ dP

Properties
dQ dP

dQ dP

needs to have:

is a probability density
dQ dP

0; dP = 1.

dQ dP

S dQ is a martingale dP

Martingale Measures Consider Then M (T ) 0 M (0) = 1 M satises dM (t) = M (t) dW (t) M (t) =
1 ( ) t W (t) e 2 2

E P[M (T )|Ft] = M (t)

E P[M (T )] = 1

Martingale Measures Now consider Then E[S(t)M (T )|Ft] = S(t)M (t) S(t)M (T ).

For s < t, E[S(t)M (T )|Fs] = E[ E[S(t)M (T )|Ft] |Fs] = E[S(t)E[M (T )|Ft] |Fs] = E[S(t)M (t)|Fs]

Martingale Measures S(t)M (t) satises the sde d(S(t)M (t)) = M (t)S(t)dW (t)

For s < t, E[S(t)M (t)|Fs] = S(s)M (s)

Dene

dQ = M (T ). dP

Then S is a martingale under Q.