Martingale Pricing Nyu

Chapter 6
Martingale Approach to Pricing and

Hedging
In this chapter we present the probabilistic martingale approach method to

the pricing and hedging of options. In particular, this allows one to compute
option prices as the expectations of the discounted option payoffs, and to
determine the associated hedging portfolios.
Contents
6.1 Martingale Property of the Itô Integral . . . . . . . . . . 195
6.2 Risk-neutral Measures . . . . . . . . . . . . . . . . . . . . . . . . . . 199
6.3 Changes of Measure and the Girsanov Theorem . . 203
6.4 Pricing by the Martingale Method . . . . . . . . . . . . . . 205
6.5 Hedging by the Martingale Method . . . . . . . . . . . . . 210
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
6.1 Martingale Property of the Itô Integral
Recall (Definition 5.5) that an integrable process (Xt )t∈R+ is said to be a

martingale with respect to the filtration (Ft )t∈R+ if
IE[Xt | Fs ] = Xs , 0 6 s 6 t.
Examples of martingales (i)
1. Given F ∈ L2 (Ω) a square-integrable random variable and (Ft )t∈R+ a

filtration, the process (Xt )t∈R+ defined by Xt := IE[F | Ft ] is an (Ft )t∈R+ -
martingale under P, as follows from the tower property:
IE[Xt | Fs ] = IE[IE[F | Ft ] | Fs ] = IE[F | Fs ] = Xs , 0 6 s 6 t, (6.1)
by the tower property (18.40).
195
N. Privault
2. Any integrable stochastic process (Xt )t∈R+ whose increments (Xt1 −

Xt0 , . . . , Xtn −Xtn−1 ) are independent and centered under P (i.e. IE[Xt ] =
0, t ∈ R+ ) is a martingale with respect to its own filtration (Ft )t∈R+ :
IE[Xt | Fs ] = IE[Xt − Xs + Xs | Fs ]
= IE[Xt − Xs | Fs ] + IE[Xs | Fs ]
= IE[Xt − Xs ] + Xs
= Xs , 0 6 s 6 t. (6.2)
In particular, the standard Brownian motion (Bt )t∈R+ is a martingale

because it has centered and independent increments. This fact is also
consequence of Proposition 6.1 below as Bt can be written as
wt
Bt = dBs , t ∈ R+ .
0
The following result shows that the indefinite Itô integral is a martingale with
respect to the Brownian filtration (Ft )t∈R+ . It is the continuous-time analog
of the discrete-time Proposition 2.7.
r
t
Proposition 6.1. The indefinite stochastic integral 0 s
u dBs of a
t∈R+
square-integrable adapted process u ∈ L2ad (Ω × R+ ) is a martingale, i.e.:
w w
t s
IE uτ dBτ Fs = uτ dBτ , 0 6 s 6 t. (6.3)

0 0
rt
In particular, 0 us dBs is Ft -measurable, t ∈ R+ , and since F0 = {∅, Ω},
Relation (6.3) applied with t = 0 recovers the fact that the Itô integral is a
centered random variable:
hw ∞ i hw ∞ i w0
IE us dBs = IE us dBs F0 = us dBs = 0.

0 0 0
Proof. The statement is first proved in case u is a simple predictable process,

and then extended to the general case, cf. e.g. Proposition 2.5.7 in [Pri09].
For example, for u a step process of the form
 F if s ∈ [a, b],

us := F 1[a,b] (s) =
0 if s ∈
/ [a, b],

with F an Fa -measurable random variable and t ∈ [a, b], we have

hw ∞ i hw ∞ i
IE us dBs Ft = IE F 1[a,b] (s)dBs Ft

0 0
= IE[F (Bb − Ba ) | Ft ]
196 "
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http://www.ntu.edu.sg/home/nprivault/indext.html
Martingale Approach to Pricing and Hedging
= F IE[Bb − Ba | Ft ]
= F (Bt − Ba )
wt
= us dBs
a
wt
= us dBs , a 6 t 6 b.
0
On the other hand, when t ∈ [0, a] we have

wt
us dBs = 0,
0
hence we check that

hw ∞ i hw ∞ i
IE us dBs Ft = IE F 1[a,b] (s)dBs Ft

0 0
= IE[F (Bb − Ba ) | Ft ]
= IE[IE[F (Bb − Ba ) | Fa ] | Ft ]
= IE[F IE[Bb − Ba | Fa ] | Ft ]
= 0, 0 6 t 6 a,
where we used the tower property (18.40) of conditional expectations and the
fact that (Bt )t∈R+ is a martingale:
IE[Bb − Ba | Fa ] = IE[Bb | Fa ] − Ba = Ba − Ba = 0.
The extension from simple processes to square-integrable processes in L2ad (Ω×

R+ ) can be proved as in Proposition 4.9. Indeed, given (u(n) )n∈N be a se-
quence of simple predictable processes converging to u in L2 (Ω × [0, T ]) cf.
Lemma 1.1 of [IW89], pages 22 and 46, by Fatou’s Lemma 18.1 and Jensen’s
inequality we have:
wt
" #
hw ∞ i2
IE us dBs − IE us dBs Ft

0 0
wt
" #
hw ∞ i2
6 lim inf IE s dBs − IE
u(n) us dBs Ft

n→∞ 0 0
hw ∞ w∞ i2
= lim inf IE IE u(n)
s dBs − us dBs Ft

n→∞ 0 0
w
∞ w∞ 2
6 lim inf IE IE u(n)
s dBs − us dBs Ft

n→∞ 0 0
w 2
∞
= lim inf IE (u(n)
s − us )dBs
n→∞ 0
hw ∞ i
= lim inf IE |u(n) 2
s − us | ds
n→∞ 0
" 197
N. Privault
= 0,
where we used the Itô isometry (4.15). We conclude that

hw ∞ i wt
IE us dBs Ft = us dBs , t ∈ R+ ,

0 0
for u ∈ L2ad (Ω× R+ ) a square-integrable adapted process, which leads to

(6.3) after applying this identity to the process (1[0,t] us )s∈R+ , i.e.,
w hw ∞
t i
IE uτ dBτ Fs = IE

1[0,t] (τ )uτ dBτ Fs
0 0
ws
= 1[0,t] (τ )uτ dBτ
w0s
= uτ dBτ , 0 6 s 6 t.
0
Examples of martingales (ii)
1. The driftless geometric Brownian motion

2
Xt := X0 e σBt −σ t/2
is a martingale. Indeed, we have

2
IE[Xt | Fs ] = IE X0 e σBt −σ t/2 | Fs

2
= X0 e −σ t/2 IE e σBt | Fs

2
= X0 e −σ t/2 IE e σ(Bt −Bs )+σBs | Fs

2
= X0 e −σ t/2+σBs IE e σ(Bt −Bs ) | Fs

2
= X0 e −σ t/2+σBs IE e σ(Bt −Bs )

2 2
= X0 e −σ t/2+σBs
eσ (t−s)/2
σBs −σ 2 s/2
= X0 e
= Xs , 0 6 s 6 t.
This fact can also be recovered from Proposition 6.1 since (Xt )t∈R+ sat-
isfies the equation
dXt = σXt dBt ,
which shows that Xt can be written using the Brownian stochastic inte-
gral wt
Xt = X0 + σ Xu dBu , t ∈ R+ .
0
198 "
The discounted asset price

2
Set = S0 e (µ−r)t+σBt −σ t/2
is a martingale under P when µ = r. The case µ 6= r will be treated

in Section 6.3 using risk-neutral measures and the Girsanov theorem, cf.
(6.11) below.
2. The discounted value

Vet = e −rt Vt
of a self-financing portfolio is given by
wt
Vet = Ve0 + ξu dSeu , t ∈ R+ ,
0
cf. Lemma 5.2 is a martingale when µ = r by Proposition 6.1 because

wt
Vet = Ve0 + σ ξu Seu dBu , t ∈ R+ ,
0
since
dSet = Set ((µ − r)dt + σdBt ) = σ Set dBt .
Since the Black-Scholes theory is in fact valid for any value of the param-
eter µ we will look forward to including the case µ 6= r in the sequel.
6.2 Risk-neutral Measures

Recall that by definition, a risk-neutral measure is a probability measure P∗
under which the discounted asset price process
Set t∈R := ( e −rt St )t∈R+

+
is a martingale, cf. Proposition 5.6. Note that when µ = r, the process

2
Set t∈R+ = (S0 e σBt −σ t/2 )t∈R+ is a martingale under P∗ = P, which is a
risk-neutral measure.
In this section we address the construction of a risk-neutral probability mea-

sure P∗ in the general case µ 6= r using the Girsanov theorem. Note that the
relation
dSet = Set ((µ − r)dt + σdBt )
where µ − r is the risk premium, can be rewritten as
dSet = σ Set dB
bt ,
where (B
bt )t∈R is a drifted Brownian motion given by
+
" 199
N. Privault
bt := µ − r t + Bt ,
B t ∈ R+ ,
σ
where the drift coefficient (µ − r)/σ is the “Market Price of Risk” (MPoR).
It represents the difference between the return µ expected when investing in
the risky asset St , and the risk-free rate r, measured in units of volatility σ.
Therefore, the search for a risk-neutral measure can be replaced by the search
for a probability measure P∗ under which (B bt )t∈R is a standard Brownian
+
motion.
Let us come back to the informal interpretation of Brownian motion via its
infinitesimal increments: √
∆Bt = ± ∆t,
with
√ √ 1
P ∆Bt = + ∆t = P ∆Bt = − ∆t = .
2
14
Drifted Brownian path
12 Drift
10
6
~
Bt
4
-2
-4
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 6.1: Drifted Brownian path.
Clearly, given ν ∈ R, the drifted process B

ct := νt+Bt is no longer a standard
Brownian motion because it is not centered:
IE[νt + Bt ] = νt + IE[Bt ] = νt 6= 0,
cf. Figure 6.1. This identity can be formulated in terms of infinitesimal in-
crements as
1 √ 1 √
IE[ν∆t + ∆Bt ] = (ν∆t + ∆t) + (ν∆t − ∆t) = ν∆t 6= 0.
2 2
In order to make νt+Bt a centered process (i.e. a standard Brownian motion,
since νt + Bt conserves all the other properties (i)-(iii) in the definition of
Brownian motion, one may change the probabilities of ups and downs, which
have been fixed so far equal to 1/2.
200 "
That is, the problem is now to find two numbers p∗ , q ∗ ∈ [0, 1] such that
√ √
 p∗ (ν∆t + ∆t) + q ∗ (ν∆t − ∆t) = 0

p∗ + q ∗ = 1.

The solution to this problem is given by

1 √ 1 √
p∗ = (1 − ν ∆t) and q ∗ = (1 + ν ∆t). (6.4)
2 2
Coming back to Brownian √ motion considered as a discrete random walk with
independent increments ± ∆t, we try to construct a new probability mea-
sure denoted P∗ , under which the drifted process B ct := νt + Bt will be a
standard Brownian motion. This probability measure will be defined through
its density
√ √
dP∗ P∗ (∆Bt1 = 1 ∆t, . . . , ∆BtN = N ∆t)
:= √ √
dP P(∆Bt1 = 1 ∆t, . . . , ∆BtN = N ∆t)
√ √
P∗ (∆Bt1 = 1 ∆t) · · · P∗ (∆BtN = N ∆t)
= √ √
P(∆Bt1 = 1 ∆t) · · · P(∆BtN = N ∆t)
1 √ √
= P∗ (∆Bt1 = 1 ∆t) · · · P∗ (∆BtN = N ∆t),
(1/2)N
1 , 2 , . . . , N ∈ {−1, 1}, with respect to the historical probability measure

P, obtained by taking the product of the above probabilities divided by the
reference probability 1/2N corresponding to the symmetric random walk.
Interpreting N = T /∆t as an (infinitely large) number of discrete time steps

and under the identification [0, T ] ' {0 = t0 , t1 , . . . , tN = T }, this density
can be rewritten as
dP∗ 1 Y 1 1 √
' ∓ ν ∆t
dP (1/2) N 2 2
0<t<T
where 2 N
becomes a normalization factor. Using the expansion
√ √ 1 √
log 1 ± ν ∆t = ±ν ∆t − (±ν ∆t)2 + o(∆t)
2
√ 1 √
= ±ν ∆t − (ν ∆t)2 + o(∆t),
2
for small values of ∆t, this density can be informally shown to converge as
follows as N tends to infinity, i.e. as the time step ∆t = T /N tends to zero:
" 201
N. Privault
Y 1 1 √ Y √
2N ∓ ν ∆t = 1 ∓ ν ∆t
2 2
0<t<T 0<t<T
!
Y √
= exp log 1 ∓ ν ∆t
0<t<T
!
X √
= exp log 1 ∓ ν ∆t
0<t<T
!
√
X 1 X √
' exp ν ∓ ∆t − (∓ν ∆t)2
2
0<t<T 0<t<T
!
X √ ν2 X
= exp −ν ± ∆t − ∆t
2
0<t<T 0<t<T
!
X ν2 X
= exp −ν ∆Bt − ∆t
2
0<t<T 0<t<T
ν2

= exp −νBT − T ,
2
based on the identifications

X √ X
BT ' ± ∆t and T ' ∆t.
0<t<T 0<t<T
The following R code is rescaling probabilities as in (6.4) based on the value

of the drift µ.
N=1000; t <- 0:N; dt <- 1.0/N; nu=3; p=0.5*(1-nu*(dt)^0.5); nsim <- 10

X <- matrix((dt)^0.5*(rbinom( nsim * N, 1, p)-0.5)*2, nsim, N)
X <- cbind(rep(0, nsim), t(apply(X, 1, cumsum)))
plot(t, X[1, ], xlab = "time", type = "l", ylim = c(-2*N*dt, 2*N*dt), col = t)
for (i in 2:nsim){lines(t,t*nu*dt+X[i,],xlab="time",type="l",ylim=c(-2*N*dt,2*N*dt),col=i)}
The discretized illustration in Figure 6.2 shows a Brownian motion rescaled

by making big transitions less frequent than small transitions.
202 "
1.0
0.5
X[1, ]
0.0
−0.5
−1.0
0 20 40 60 80 100
time
Fig. 6.2: Girsanov shift.
6.3 Changes of Measure and the Girsanov Theorem
In this section we restate the Girsanov theorem in a more rigorous way, using
changes of probability measures. Recall that, given Q a probability measure
on Ω, the notation
dQ
= F, i.e. dQ = F dP, (6.5)
dP
means that the probability measure Q has a density F with respect to P,
where F : Ω −→ R is a nonnegative random variable such that IE[F ] = 1.
Relation (6.5) is equivalent to stating that

w w
IEQ [G] = G(ω)dQ(ω) = G(ω)F (ω)dP(ω) = IE [F G] ,
Ω Ω
where G is an integrable random variable. In addition we say that Q is equiv-

alent to P when F > 0 with P-probability one.
Recall that here, Ω = C0 ([0, T ]) is the Wiener space and ω ∈ Ω is a

continuous function on [0, T ] starting at 0 in t = 0. Consider the probability
Q defined by
ν2

dQ(ω) = exp −νBT − T dP(ω).
2
Then the process νt + Bt is a standard (centered) Brownian motion under
Q.
For example, the fact that νT + BT has a standard (centered) Gaussian

distribution under Q can be recovered as follows:
w
IEQ [f (νT + BT )] = f (νT + BT )dQ
Ω
" 203
N. Privault
w
1

= f (νT + BT ) exp −νBT − ν 2 T dP
Ω 2
w∞
1 2

2 dx
= f (νT + x) exp −νx − ν T e −x /(2T ) √
−∞ 2 2πT
w∞ 2 dx
= f (νT + x) e −(νT +x) /(2T ) √
−∞ 2πT
w∞ 2 dy
= f (y) e −y /(2T ) √ ,
−∞ 2πT
i.e.
w w
IEQ [f (νT + BT )] = f (νT + BT )dQ = f (BT )dP = IEP [f (BT )]. (6.6)
Ω Ω
The Girsanov theorem can actually be extended to shifts by adapted pro-

cesses (ψt )t∈[0,T ] as follows, cf. e.g. Theorem III-42, page 141 of [Pro04].
Section 15.6 will cover the extension of the Girsanov theorem to jump pro-
cesses.
Theorem 6.2. Let (ψt )t∈[0,T ] be an adapted process satisfying the Novikov
integrability condition
w
1 T

IE exp |ψt |2 dt < ∞, (6.7)
2 0
and let Q denote the probability measure defined by

w
1wT

dQ T
= exp − ψs dBs − |ψs |2 ds .
dP 0 2 0
Then wt
bt := Bt +
B ψs ds, 0 6 t 6 T,
0
is a standard Brownian motion under Q.
The Girsanov Theorem allows us to extend (6.6) as
w· w
T 1wT

IE[F ] = IE F B· + ψs ds exp − ψs dBs − |ψs |2 ds , (6.8)
0 0 2 0
for all random variables F ∈ L1 (Ω), see also Exercise 6.16.
When applied to the (constant) market price of risk (or Sharpe ratio)
µ−r
ψt := ,
σ
the Girsanov theorem shows that
204 "
bt := µ − r t + Bt ,
B 0 6 t 6 T, (6.9)
σ
is a standard Brownian motion under the probability measure P∗ defined by
dP∗ (µ − r)2

µ−r
= exp − BT − T . (6.10)
dP σ 2σ 2
Hence by Proposition 6.1 the discounted price process (Set )t∈R+ solution of
dSet = (µ − r)Set dt + σ Set dBt = σ Set dB

bt , t ∈ R+ , (6.11)
is a martingale under P , hence P is a risk-neutral measure, and we obviously

∗ ∗
have P = P∗ when µ = r.
6.4 Pricing by the Martingale Method
In this section we give the expression of the Black-Scholes price using expec-
tations of discounted payoffs.
Recall that from the first fundamental theorem of mathematical finance,

a continuous market is without arbitrage opportunities if there exists (at
least) a risk-neutral probability measure P∗ under which the discounted price
process
Set := e −rt St , t ∈ R+ ,
is a martingale under P∗ . In addition, when the risk-neutral measure is
unique, the market is said to be complete.
In case the price process (St )t∈R+ satisfies the equation
dSt
= µdt + σdBt , t ∈ R+ , S0 > 0
St
we have 2
St = S0 e µt+σBt −σ t/2
, t ∈ R+ ,
and from Section 6.2 the discounted price process
2
Set := e −rt St = S0 e (µ−r)t+σBt −σ t/2 , t ∈ R+ ,
is a martingale under the probability measure P defined by (6.10), i.e. P∗ is

∗
a risk-neutral (or martingale) probability measure.
Moreover, we have
dSet = (µ − r)Set dt + σ Set dBt
" 205
N. Privault

µ−r
= σ Set dt + dBt
σ
= σ Set dB
bt , t ∈ R+ , (6.12)
hence by Lemma 5.2 the discounted value Vet of a self-financing portfolio can
be written as
wt
Vet = Ve0 + ξu dSeu
0
wt
= Ve0 + σ ξu Seu dBbu , t ∈ R+ ,
0
and by Proposition 6.1 it becomes a martingale under P∗ .
As in Chapter 3, the value Vt at time t of a self-financing portfolio strategy

(ξt )t∈[0,T ] hedging an attainable claim C will be called an arbitrage price of
the claim C at time t and denoted by πt (C), t ∈ [0, T ]. Recall that arbitrage
prices can be used to ensure that financial derivatives are “marked” at their
fair value (mark to market).
Theorem 6.3. Let (ξt , ηt )t∈[0,T ] be a portfolio strategy with price
Vt = ηt At + ξt St , t ∈ [0, T ],
and let C be a contingent claim, such that

(i) (ξt , ηt )t∈[0,T ] is a self-financing portfolio, and
(ii) (ξt , ηt )t∈[0,T ] hedges the claim C, i.e. we have VT = C.

Then the arbitrage price of the claim C is given by
πt (C) = Vt = e −(T −t)r IE∗ [C | Ft ], 0 6 t 6 T, (6.13)

∗
where IE denotes expectation under the risk-neutral measure P . ∗
Proof. Since the portfolio strategy (ξt , ηt )t∈R+ is self-financing, by Lemma 5.2
and (6.12) we have
wt wt
Vet = Ve0 + σ bu = V0 +
ξu Seu dB ξu dSeu , t ∈ R+ ,
0 0
which is a martingale under P∗ from Proposition 6.1, hence
Vet = IE∗ VeT Ft

= e −rT IE∗ [VT | Ft ]

= e −rT IE∗ [C | Ft ],
which implies
206 "
Vt = e rt Vet = e −(T −t)r IE∗ [C | Ft ], 0 6 t 6 T.
Vanilla options
When the process (St )t∈R+ has the Markov property, the value
Vt = e −(T −t)r IE∗ [φ(ST ) | Ft ]

= e −(T −t)r IE∗ [φ(ST ) | St ], 0 6 t 6 T,
of the portfolio at time t ∈ [0, T ] can be written from (6.13) as a function
Vt = C(t, St ) = e −(T −t)r IE∗ [φ(ST ) | St ]

2
of t and St , 0 6 t 6 T . In particular, when St = S0 e σBt +(r−σ )t/2 , t ∈ R+ , is
a geometric Brownian motion and φ is a Lipschitz function, it can be checked
by integrations by parts that the function C(t, x) defined by
C(t, St ) = e −(T −t)r IE∗ [φ(ST ) | St ] = e −(T −t)r IE∗ [φ(xST /St )]x=St ,
0 6 t 6 T , is in C 1,2 (R+ × R+ ) from the properties of the lognormal distri-

bution of ST , and by Proposition 5.12 the function C(t, x) solves the Black-
Scholes PDE
∂C ∂C 1 ∂2C

 rC(t, x) =
 (t, x) + rx (t, x) + x2 σ 2 2 (t, x)
∂t ∂x 2 ∂x

C(T, x) = φ(x), x > 0.

In the case of European options with payoff function φ(x) = (x − K)+ we re-
cover the Black-Scholes formula (5.18), cf. Proposition 5.17, by a probabilistic
argument.
Proposition 6.4. The price at time t of a European call option with strike
price K and maturity T is given by
C(t, St ) = St Φ d+ (T − t) − K e −(T −t)r Φ d− (T − t) , 0 6 t 6 T, (6.14)

with
log(x/K) + (r + σ 2 /2)(T − t)

d (T − t) := √ ,

 +


 σ T −t
log(x/K) + (r − σ 2 /2)(T − t)

 d− (T − t) :=

√ .


σ T −t
" 207
N. Privault
Proof. The proof of Proposition 6.4 is a consequence of (6.13) and Lemma 6.5
below. Using the relation
2
ST = St e (T −t)r+σ(BbT −Bbt )−σ (T −t)/2
, 0 6 t 6 T,
by Theorem 6.3 the price of the portfolio hedging C is given by
Vt = e −(T −t)r IE∗ [C | Ft ]

= e −(T −t)r IE∗ (ST − K)+ | Ft

2
= e −(T −t)r IE∗ (St e (T −t)r+σ(BbT −Bbt )−σ (T −t)/2 − K)+ | Ft

2
= e −(T −t)r IE∗ (x e (T −t)r+σ(BbT −Bbt )−σ (T −t)/2 − K)+ x=S

t
= e −(T −t)r IE∗ ( e m(x)+X − K)+ x=St , 0 6 t 6 T,

where
σ2
m(x) := (T − t)r − (T − t) + log x
2
and
X := σ(B bt ) ' N (0, σ 2 (T − t))
bT − B
is a centered Gaussian random variable with variance
Var [X] = Var σ(B bt ) = σ 2 Var B bt = σ 2 (T − t)

bT − B bT − B
under P∗ . Hence by Lemma 6.5 below we have
C(t, St ) = Vt
= e −(T −t)r IE∗ ( e m(x)+X − K)+ x=St

m(St ) − log K

2
= e −(T −t)r e m(St )+σ (T −t)/2 Φ v +
v
m(St ) − log K

−K e −(T −t)r
Φ
v
m(St ) − log K m(St ) − log K

= St Φ v + − K e −(T −t)r Φ
v v
= St Φ d+ (T − t) − K e −(T −t)r Φ d− (T − t) ,

0 6 t 6 T.
Relation (6.14) can also be written as
e −(T −t)r IE∗ (ST − K)+ | Ft = e −(T −t)r IE∗ (ST − K)+ | St (6.15)

log(x/K) + (r + σ 2 /2)(T − t)

= St Φ √
σ T −t
208 "
log(x/K) + (r − σ 2 /2)(T − t)

−K e −(T −t)r Φ √ , 0 6 t 6 T.
σ T −t
Lemma 6.5. Let X be a centered Gaussian random variable with variance
v 2 > 0. We have
2
IE ( e m+X − K)+ = e m+v /2 Φ(v + (m − log K)/v) − KΦ((m − log K)/v).

Proof. We have
1 w ∞ m+x 2 2
IE ( e m+X − K)+ = √ (e − K)+ e −x /(2v ) dx

2πv 2 −∞
1 w∞ 2 2
= √ ( e m+x − K) e −x /(2v ) dx
2πv 2 −m+log K
em w ∞ 2 2 K w∞ 2 2
= √ e x−x /(2v ) dx − √ e −x /(2v ) dx
2πv −m+log K
2 2πv 2 −m+log K
e m+v /2 w ∞ K w∞
2
2 2 2 2
= √ e −(v −x) /(2v ) dx − √ e −x /2 dx
2πv 2 −m+log K 2π (−m+log K)/v
e m+v /2 w ∞
2
2 2
= √ e −x /(2v ) dx − KΦ((m − log K)/v)
2πv 2 −v2 −m+log K
2
= e m+v /2
Φ(v + (m − log K)/v) − KΦ((m − log K)/v).
Call-put parity
Let
P (t, St ) := e −(T −t)r IE∗ (K − ST )+ | Ft

denote the price of the put option with strike price K and maturity T .
Proposition 6.6. We have the relation
C(t, St ) − P (t, St ) = St − e −(T −t)r K. (6.16)

Proof. From Theorem 6.3 we have
C(t, St ) − P (t, St )
= e −(T −t)r IE∗ (ST − K)+ | Ft − e −(T −t)r IE∗ (K − ST )+ | Ft

= e −(T −t)r IE∗ (ST − K)+ − (K − ST )+ | Ft

= e −(T −t)r IE∗ ST − K | Ft

= e −(T −t)r IE∗ ST | Ft − K e −(T −t)r

= St − e −(T −t)r K,
" 209
N. Privault
as IE∗ ST | Ft = e −(T −t)r St under the risk-neutral measure P∗ .

Relation (6.16) is called the put-call parity, and it shows that the put option
price is given by
P (t, St ) = C(t, St ) − St + e −(T −t)r K

= St Φ d+ (T − t) + e −(T −t)r K − St − e −(T −t)r KΦ d− (T − t)

= −St (1 − Φ d+ (T − t) ) + e −(T −t)r K(1 − Φ d− (T − t) )

= −St Φ − d+ (T − t) + e −(T −t)r KΦ − d− (T − t) .

6.5 Hedging by the Martingale Method
The martingale method can be used to recover the Black-Scholes PDE of

Proposition 5.12 by using the fact that the discounted price Ṽt = e −rt g(t, St )
of a self-financing hedging portfolio is a martingale by Lemma 5.2 and Propo-
sition 6.1, and by noting that from e.g. Corollary II-1, page 72 of [Pro04], all
terms in dt should vanish in the expression of
d( e −rt g(t, St )) = −r e −rt g(t, St )dt + e −rt dg(t, St )
as in the proof of e.g. Proposition 5.12.
Hedging exotic options
In the next Proposition 6.7 we compute a self-financing hedging strategy

leading to an arbitrary square-integrable random claim payoff C admitting a
stochastic integral representation formula of the form
wT
C = IE∗ [C] + ζt dB
bt , (6.17)
0
where (ζt )t∈[0,t] is a square-integrable adapted process. Consequently, the

mathematical problem of finding the stochastic integral decomposition (6.17)
of a given random variable has important applications in finance. Simple
examples of stochastic integral decompositions include the relations
wT
BT2 = T + 2 Bt dBt ,
0
and wT
BT3 = 3 T − t + Bt2 dBt ,

0
cf. Exercise 4.5.
In the sequel, recall that the risky asset follows the equation
210 "
dSt
= µdt + σdBt , t ∈ R+ , S0 > 0,
St
and as a consequence, the discounted asset price satisfies
dSet = σ Set dB
bt , t ∈ R+ , Se0 = S0 > 0, (6.18)
where (Bbt )t∈R is a standard Brownian motion under the risk-neutral prob-
+
ability measure P∗ .
The following proposition applies to arbitrary square-integrable payoff

functions, in particular it covers exotic and path-dependent options.
Proposition 6.7. Consider a random claim payoff C ∈ L2 (Ω) and the pro-
cess (ζt )t∈[0,T ] given by (6.17), and let
e −(T −t)r
ξt = ζt , (6.19)
σSt
e −(T −t)r IE∗ C | Ft − ξt St

ηt = , 0 6 t 6 T. (6.20)
At
Then the portfolio allocation (ξt , ηt )t∈[0,T ] is self-financing, and letting
Vt = ηt At + ξt St , 0 6 t 6 T, (6.21)
we have
Vt = e −(T −t)r IE∗ [C | Ft ], 0 6 t 6 T. (6.22)
In particular we have
VT = C, (6.23)
i.e. the portfolio allocation (ξt , ηt )t∈[0,T ] yields a hedging strategy leading to
C, starting from the initial value
V0 = e −rT IE∗ [C].

Proof. Relation (6.22) follows from (6.20) and (6.21), and it implies
V0 = e −rT IE∗ [C] = η0 A0 + ξ0 S0
at t = 0, and (6.23) at t = T . It remains to show that the portfolio strategy

(ξt , ηt )t∈[0,T ] is self-financing. By (6.17) and Proposition 6.1 we have
Vt = ηt At + ξt St
= e −(T −t)r IE∗ [C | Ft ]
wT
= e −(T −t)r IE∗ IE∗ [C] + bu Ft
ζu dB
0
" 211
N. Privault
wt
= e −(T −t)r IE∗ [C] + ζu dB
bu
0
wt
= e V0 + e
rt −(T −t)r
ζu dB
bu
0
wt
= e rt V0 + σ ξu Su e (t−u)r dB
bu
0
wt
= e rt V0 + σ e rt ξu Seu dB
bu
0
wt
= e rt V0 + e rt ξu dSeu , 0 6 t 6 T,
0
where we applied (6.18). This shows that the discounted portfolio value Vet =
e −rt Vt satisfies wt
Vet = V0 + ξu dSeu , 0 6 t 6 T,
0
and this implies that (ξt , ηt )t∈[0,T ] is self-financing by Lemma 5.2.

The above proposition shows that there always exists a hedging strategy
starting from
V0 = IE∗ [C] e −rT .
In addition, since there exists a hedging strategy leading to
VeT = e −rT C,
then (Vet )t∈[0,T ] is necessarily a martingale, with
Vet = IE∗ VeT Ft = e −rT IE∗ [C | Ft ], 0 6 t 6 T,

and initial value

Ve0 = IE∗ VeT = e −rT IE∗ [C].

Hedging vanilla options
In practice, the hedging problem can now be reduced to the computation

of the process (ζt )t∈[0,T ] appearing in (6.17). This computation, called Delta
hedging, can be performed by the application of the Itô formula and the
Markov property, see e.g. [Pro01].
Definition 6.8. The Markov semi-group (Pt )06t6T associated to (St )t∈[0,T ]
is the mapping Pt defined on functions f ∈ Cb2 (R) as
Pt f (x) := IE∗ [f (St ) | S0 = x], t ∈ R+ .
By the Markov property and time homogeneity of (St )t∈[0,T ] we also have
Pt f (Su ) := IE∗ f (St+u ) | Fu = IE∗ f (St+u ) | Su , t, u ∈ R+ ,

212 "
and the semi-group (Pt )06t6T satisfies the composition property
Ps Pt = Pt Ps = Ps+t = Pt+s , s, t ∈ R+ ,
as we have, using the Markov property and the tower property (18.40) of
conditional expectations as in (6.24),
Ps Pt f (x) = IE∗ Pt f (Ss ) | S0 = x

= IE∗ IE∗ f (St ) | S0 = y y=Ss | S0 = x

= IE∗ IE∗ f (St+s ) | Ss = y y=S | S0 = x

s
= IE∗ IE∗ f (St+s ) | Fs | S0 = x

= IE∗ f (St+s ) | Fs | S0 = x

= Pt+s f (x), s, t > 0.
Similarly we can show that the process (PT −t f (St ))t∈[0,T ] is an Ft -martingale
as in Example (6.1), i.e.:
IE∗ PT −t f (St ) | Fu = IE∗ IE∗ [f (ST ) | Ft ] | Fu

= IE∗ f (ST ) | Fu

= PT −u f (Su ), 0 6 u 6 t 6 T, (6.24)
and we have

St
Pt−u f (x) = IE∗ f (St ) | Su = x = IE∗ f x 0 6 u 6 t. (6.25)

,
Su
The next lemma allows us to compute the process (ζt )t∈[0,T ] in case the payoff
C is of the form C = φ(ST ) for some function φ. In case C ∈ L2 (Ω) is the
payoff of an exotic option, the process (ζt )t∈[0,T ] can be computed using the
Malliavin gradient on the Wiener space, cf. [NØP09], [Pri09].
Lemma 6.9. Let φ ∈ Cb2 (R). The stochastic integral decomposition
wT
φ(ST ) = IE∗ φ(ST ) + (6.26)

ζt dB
bt
0
is given by
∂
ζt = σSt PT −t φ (St ), 0 6 t 6 T. (6.27)

∂x
Proof. Since PT −t φ is in C 2 (R), we can apply the Itô formula to the process
t 7−→ PT −t φ(St ) = IE∗ φ(ST ) | Ft ,

" 213
N. Privault
which is a martingale from the tower property (18.40) of conditional expec-

tations as in (6.24). From the fact that the finite variation term in the Itô
formula vanishes when (PT −t φ(St ))t∈[0,T ] is a martingale, (see e.g. Corol-
lary II-6-1 page 72 of [Pro04]), we obtain:
wt ∂
PT −t φ(St ) = PT φ(S0 ) + σ Su (PT −u φ)(Su )dB
bu , 0 6 t 6 T, (6.28)
0 ∂x
with PT φ(S0 ) = IE∗ φ(ST ) . Letting t = T , we obtain (6.27) by uniqueness

of the stochastic integral decomposition (6.26) of C = φ(ST ).

By (6.25) we also have
∂ ∗
ζt = σSt IE φ(ST ) | St = x x=St

∂x
∂ ∗ ST
= σSt IE φ x , 0 6 t 6 T,
∂x St x=St
hence
1 −(T −t)r
ξt = e ζt (6.29)
σSt

∂ ∗ ST
= e −(T −t)r IE φ x , 0 6 t 6 T,
∂x St x=St
which recovers the formula (5.14) for the Delta of a vanilla option. As a con-
sequence we have ξt > 0 and there is no short selling when the payoff function
φ is nondecreasing.
In the case of European options, the process ζ can be computed via the next
proposition.
Proposition 6.10. Assume that C = (ST − K)+ . Then for 0 6 t 6 T we
have
ST S
ζt = σSt IE∗ 1[K,∞) x T . (6.30)
St St x=St
Proof. This result follows from Lemma 6.9 and the relation
PT −t f (x) = IE∗ f (St,T

x
) ,

after approximation of x 7−→ φ(x) = (x − K)+ with C 2 functions.

By evaluating the expectation (6.30) in Proposition 6.10 we can recover the
formula (5.21) in Proposition 5.14 for the Delta of a European call option in
the Black-Scholes model. In that sense, the next proposition provides another
proof of the result of Proposition 5.14.
214 "
Proposition 6.11. The Delta of a European call option with payoff function
f (x) = (x − K)+ is given by
log(St /K) + (r + σ 2 /2)(T − t)

ξt = Φ d+ (T − t) = Φ 0 6 t 6 T.

√ ,
σ T −t
Proof. By Propositions 6.7 and 6.10 we have
1 −(T −t)r
ξt = e ζt
σSt

ST S
= e −(T −t)r IE∗ 1[K,∞) x T
St St x=St
= e −(T −t)r
h i
× IE∗ e σ(BbT −Bbt )−σ (T −t)/2+(T −t)r 1[K,∞) (x e σ(BbT −Bbt )−σ (T −t)/2+(T −t)r )
2 2
x=St
1 w∞
σy−σ 2 (T −t)/2−y 2 /(2(T −t))
=p e dy
2π(T − t) σ(T −t)/2−(T −t)r/σ+σ−1 log(K/St )
1 w ∞ 2
=p √ e −(y−σ(T −t)) /(2(T −t)) dy
2π(T − t) −d− (T −t)/ T −t
1 w∞ 2
=√ e −(y−σ(T −t)) /2 dy
2π −d− (T −t)
1 w∞ 2
=√ e −y /2 dy
2π −d+ (T −t)
1 w d+ (T −t) −y2 /2
=√ e dy
2π −∞
= Φ d+ (T − t) .

Proposition 6.11, combined with Proposition 6.4, shows that the Black-
Scholes self-financing hedging strategy is to hold a (possibly fractional) quan-
tity
log(St /K) + (r + σ 2 /2)(T − t)

ξt = Φ d+ (T − t) = Φ >0 (6.31)

√
σ T −t
of the risky asset, and to borrow a quantity
log(St /K) + (r − σt2 /2)(T − t)

− ηt = K e −rT Φ √ >0 (6.32)
σ T −t
of the risk-free (savings) account, cf. also Corollary 12.14 in Chapter 12.
" 215
N. Privault
As noted above, the result of Proposition 6.11 recovers (5.22) which is ob-
tained by a direct differentiation of the Black-Scholes function as in (5.14) or
(6.29).
Exercises
2
Exercise 6.1 Given the price process (St )t∈R+ defined as St := S0 e σBt +(r−σ ,
/2)t
t ∈ R+ , price the option with payoff function φ(ST ) by writing e −rT IE∗ φ(ST )

as an integral.
Exercise 6.2 Consider an asset price (St )t∈R+ which is a martingale under
the risk-neutral measure P∗ in a market with interest rate r = 0, and let
φ(x) = (x − K)+ be the (convex) European call payoff function.
Show that, for any two maturities T1 < T2 and p, q ∈ [0, 1] such that
p + q = 1, the price of the average option with payoff φ(pST1 + qST2 ) is upper
bounded by the price of the European call option with maturity T2 , i.e. show
that
IE∗ φ(pST1 + qST2 ) 6 IE∗ φ(ST2 ) .

Hint 1: For φ a convex function we have φ(px + qy) 6 pφ(x) + qφ(y) for any
x, y ∈ R and p, q ∈ [0, 1] such that p + q = 1.
Hint 2: Any convex function φ(St ) of a martingale St is a submartingale.
Exercise 6.3 Consider an underlying asset price process (St )t∈R+ .

a) Show that the price at time t of a European call option with strike price K
and maturity T is lower bounded by the positive part (St − K e −(T −t)r )+
of the corresponding forward contract price, i.e.
e −(T −t)r IE∗ (ST − K)+ | Ft > (St − K e −(T −t)r )+ , 0 6 t 6 T.

b) Show that the price at time t of a European put option with strike price
K and maturity T is lower bounded by K e −(T −t)r − St , i.e.
+
e −(T −t)r IE∗ (K − ST )+ | Ft > K e −(T −t)r − St , 0 6 t 6 T.

Exercise 6.4 The following two graphs describe the payoff functions φ of
bull spread and bear spread options with payoff φ(SN ) on an underlying SN
at maturity time N .
216 "
100 100
80 80
60 60
40 40
20 20
0 0
0 50 100 150 200 0 50 100 150 200
K1 x K2 K1 x K2
(i) Bull spread payoff. (ii) Bear spread payoff.

Fig. 6.3: Payoff functions of bull spread and bear spread options.
a) Show that in each case (i) and (ii) the corresponding option can be realized
by purchasing and/or short selling standard European call and put options
with strike prices to be specified.
b) Price the bull spread option in cases (i) and (ii).
Hint: An option with payoff φ(SN ) is priced (1 + r)−N IE∗ φ(SN ) at time 0.

The payoff of the European call (resp. put) option with strike price K is
(SN − K)+ , resp. (K − SN )+ .
Exercise 6.5 Forward contracts revisited. Consider a risky asset whose price
2
St is given by St = S0 e σBt +rt−σ t/2 , t ∈ R+ , where (Bt )t∈R+ is a standard
Brownian motion. Consider a forward contract with maturity T and payoff
ST − κ.
a) Compute the price Ct of this claim at any time t ∈ [0, T ].
b) Compute a hedging strategy for the option with payoff ST − κ.
Exercise 6.6 Option pricing with dividends (Exercise 5.2 continued). Con-
sider an underlying asset price process (St )t∈R+ paying dividends at the
continuous-time rate δ > 0, and modeled as
dSt = (µ − δ)St dt + σSt dBt ,
where (Bt )t∈R+ is a standard Brownian motion.

a) Show that as in Lemma 5.2, if (ηt , ξt )t∈R+ is a portfolio strategy with
value
Vt = ηt At + ξt St , t ∈ R+ ,
" 217
N. Privault
where the dividend yield δSt per share is continuously reinvested in the
portfolio, then the discounted portfolio value Vet can be written as the
stochastic integral
wt
Vet = Ve0 + ξu dSeu , t ∈ R+ ,
0
b) Show that as in Theorem 6.3, if (ξt , ηt )t∈[0,T ] hedges the claim C, i.e. if
VT = C, then the arbitrage price of the claim C is given by
πt (C) = Vt = e −(T −t)r Ib

E[C | Ft ], 0 6 t 6 T,
where IE
b denotes expectation under a suitably chosen risk-neutral measure
P.
b
c) Compute the price at time t ∈ [0, T ] of the European call option in a
market with dividend rate δ by the martingale method.
Exercise 6.7 Forward start options [Rub91]. A forward start European call
option is an option whose holder receives at time T1 (e.g. your birthday) the
value of a standard European call option at the money and with maturity
T2 > T1 . Price this birthday present at any time t ∈ [0, T1 ], i.e. compute the
price
e −(T1 −t)r IE∗ e −(T2 −T1 )r IE∗ (ST2 − ST1 )+ | FT1 | Ft

at time t ∈ [0, T1 ], of the forward start European call option using the Black-
Scholes formula.
Exercise 6.8 Log-contracts (Exercise 5.7 continued), see also Exercise 7.5.
Consider the price process (St )t∈[0,T ] given by
dSt
= rdt + σdBt
St
and a risk-free asset of value At = A0 e rt , t ∈ [0, T ], with r > 0. Compute

the arbitrage price
C(t, St ) = e −(T −t)r IE∗ log ST | Ft ,

at time t ∈ [0, T ], of the log-contract with payoff log ST .
Exercise 6.9 Power option. (Exercise 5.3 continued). Consider the price
process (St )t∈[0,T ] given by
dSt
= rdt + σdBt
St
218 "
and a risk-free asset of value At = A0 e rt , t ∈ [0, T ], with r > 0. In this

problem, (ηt , ξt )t∈[0,T ] denotes a portfolio strategy with value
Vt = ηt At + ξt St , 0 6 t 6 T.
a) Compute the arbitrage price
C(t, St ) = e −(T −t)r IE∗ |ST |2 | Ft ,

at time t ∈ [0, T ], of the power option with payoff |ST |2 .

b) Compute a self-financing portfolio strategy (ηt , ξt )t∈[0,T ] hedging the claim
|ST |2 .
Exercise 6.10 (Exercise 5.9 continued).

a) Solve the stochastic differential equation
dSt = αSt dt + σdBt
in terms of α, σ > 0, and the initial condition S0 .

b) For which value αM of α is the discounted price process Set = e −rt St ,
0 6 t 6 T , a martingale under P?
c) For each value of α, build a probability measure Pα under which the
discounted price process Set = e −rt St , 0 6 t 6 T , is a martingale.
d) Compute the arbitrage price
C(t, St ) = e −(T −t)r IEα exp(ST ) | Ft

at time t ∈ [0, T ] of the contingent claim with payoff exp(ST ), and recover
the result of Exercise 5.9.
e) Explicitly compute the portfolio strategy (ηt , ξt )t∈[0,T ] that hedges the
contingent claim exp(ST ).
f) Check that this strategy is self-financing.
Exercise 6.11 Let (Bt )t∈R+ be a standard Brownian motion generating a

filtration (Ft )t∈R+ . Recall that for f ∈ C 2 (R+ ×R), Itô’s formula for (Bt )t∈R+
reads
w t ∂f
f (t, Bt ) = f (0, B0 ) + (s, Bs )ds
0 ∂s
w t ∂f 1 w t ∂2f
+ (s, Bs )dBs + (s, Bs )ds.
0 ∂x 2 0 ∂x2
2
a) Let r ∈ R, σ > 0, f (x, t) = e rt+σx−σ t/2 , and St = f (t, Bt ). Compute
df (t, Bt ) by Itô’s formula, and show that St solves the stochastic differen-
tial equation
" 219
N. Privault
dSt = rSt dt + σSt dBt ,

where r > 0 and σ > 0.
b) Show that
2
IE e σBT | Ft = e σBt +σ (T −t)/2 , 0 6 t 6 T.

Hint: Use the independence of increments of (Bt )t∈[0,T ] in the time split-
ting decomposition
BT = (Bt − B0 ) + (BT − Bt ),
2 2
and the Gaussian moment generating function IE e αX = e α η /2 when

X ' N (0, η ).
2
c) Show that the process (St )t∈R+ satisfies
IE ST | Ft = e (T −t)r St , 0 6 t 6 T.

d) Let C = ST − K denote the payoff of a forward contract with exercise

price K and maturity T . Compute the discounted expected payoff
Vt := e −(T −t)r IE C | Ft .

e) Find a self-financing portfolio strategy (ξt , ηt )t∈R+ such that
Vt = ξt St + ηt At , 0 6 t 6 T,
where At = A0 e rt is the price of a risk-free asset with interest rate r > 0.

Show that it recovers the result of Exercise 5.5-(c).
f) Show that the portfolio allocation (ξt , ηt )t∈[0,T ] found in Question (e)
hedges the payoff C = ST − K at time T , i.e. show that VT = C.
Exercise 6.12 Binary options. Consider a price process (St )t∈R+ given by
dSt
= rdt + σdBt , S0 = 1,
St
under the risk-neutral measure P∗ . A binary (or digital) call, resp. put, option
is a contract with maturity T , strike price K, and payoff
 $1 if ST > K,  $1 if ST 6 K,
 
Cd := resp. Pd :=
0 if ST < K, 0 if ST > K.
 
Recall that the prices πt (Cd ) and πt (Pd ) at time t of the binary call and put
options are given by the discounted expected payoffs
220 "
πt (Cd ) = e −(T −t)r IE Cd | Ft and πt (Pd ) = e −(T −t)r IE Pd | Ft .

(6.33)
a) Show that the payoffs Cd and Pd can be rewritten as
Cd = 1[K,∞) (ST ) and Pd = 1[0,K] (ST ).
b) Using Relation (6.33), Question (a), and the relation
IE 1[K,∞) (ST ) | St = x = P∗ (ST > K | St = x),

show that the price πt (Cd ) is given by
πt (Cd ) = Cd (t, St ),
where Cd (t, x) is the function defined by
Cd (t, x) := e −(T −t)r P∗ (ST > K | St = x).
c) Using the results of Exercise 4.19-(d) and of Question (b), show that the
price πt (Cd ) of the binary call option is given by
(r − σ 2 /2)(T − t) + log(x/K)

Cd (t, x) = e −(T −t)r Φ √
σ T −t
= e −(T −t)r Φ d− (T − t) ,

where
(r − σ 2 /2)(T − t) + log(St /K)
d− (T − t) = √ .
σ T −t
d) Assume that the binary option holder is entitled to receive a “return
amount” α ∈ [0, 1] in case the underlying ends out of the money at ma-
turity. Compute price at time t ∈ [0, T ] of this modified contract.
e) Using Relation (6.33) and Question (a), prove the call-put parity relation
πt (Cd ) + πt (Pd ) = e −(T −t)r , 0 6 t 6 T. (6.34)
If needed, you may use the fact that P∗ (ST = K) = 0.

f) Using the results of Questions (e) and (c), show that the price πt (Pd ) of
the binary put option is given by
πt (Pd ) = e −(T −t)r Φ − d− (T − t) .

g) Using the result of Question (c), compute the Delta
∂Cd
ξt := (t, St )
∂x
" 221
N. Privault
of the binary call option. Does the Black-Scholes hedging strategy of such
a call option involve short selling? Why?
h) Using the result of Question (f), compute the Delta
∂Pd
ξt := (t, St )
∂x
of the binary put option. Does the Black-Scholes hedging strategy of such
a put option involve short selling? Why?
Exercise 6.13 Computation of Greeks. Consider an underlying asset whose

price (St )t∈R+ is given by a stochastic differential equation of the form
dSt = rSt dt + σ(St )dWt ,
where σ(x) is a Lipschitz coefficient, and an option with payoff function φ

and price
C(x, T ) = e −rT IE φ(ST ) S0 = x ,

where φ(x) is a twice continuously differentiable (C 2 ) function, with S0 = x.

Using the Itô formula, show that the sensitivity
∂
ThetaT = e −rT IE φ(ST ) S0 = x

∂T
of the option price with respect to maturity T can be expressed as
ThetaT = −r e −rT IE φ(ST ) S0 = x + r e −rT IE St φ0 (ST ) S0 = x

1
+ e −rT IE φ00 (ST )σ 2 (ST ) S0 = x .

2
Problem 6.14 Chooser options. In this problem we denote by C(t, St , K, T ),

resp. P (t, St , K, T ), the price at time t of a European call, resp. put, option
with strike price K and maturity T , on an underlying asset priced under the
2
risk-neutral measure as St = S0 e σBt +rt−σ t/2 , t ∈ R+ .
a) Prove the call-put parity formula
C(t, St , K, T ) − P (t, St , K, T ) = St − K e −(T −t)r , 0 6 t 6 T. (6.35)
b) Consider an option contract with maturity T , which entitles its holder to

receive at time T the value of a European put option with strike price K
and maturity U > T .
Write down the price this contract at time t ∈ [0, T ] using a conditional
expectation under the risk-neutral measure P∗ .
222 "
c) Consider now an option contract with maturity T , which entitles its holder
to receive at time T either the value of a European call option or a Euro-
pean put option whichever is higher. The European call and put options
have same strike price K and same maturity U > T .
Show that at maturity T , the payoff of this contract can be written as

P (T, ST , K, U ) + max 0, ST − K e −(U −T )r .
Hint: Use the call-put parity formula (6.35).

d) Price the contract of Question (c) at any time t ∈ [0, T ] using the put and
call pricing functions C(t, x, K, T ) and P (t, x, K, U ).
e) Using the Black-Scholes formula, compute the self-financing hedging strat-
egy (ξt , ηt )t∈[0,T ] with portfolio value
Vt = ξt St + ηt e rt , 0 6 t 6 T,
for the option contract of Question (c).

f) Consider now an option contract with maturity T , which entitles its holder
to receive at time T the value of either a European call or a European put
option, whichever is lower. The two options have same strike price K and
same maturity U > T .
Show that the payoff of this contract at maturity T can be written as

C(T, ST , K, U ) − max 0, ST − K e −(U −T )r .
g) Price the contract of Question (f) at any time t ∈ [0, T ].

h) Using the Black-Scholes formula, compute the self-financing hedging strat-
egy (ξt , ηt )t∈[0,T ] with portfolio price
Vt = ξt St + ηt e rt , 0 6 t 6 T,
for the option contract of Question (f).

i) Give the price and hedging strategy of the contract that yields the sum
of the payoffs of Questions (c) and (f).
j) What happens when U = T ? Give the payoffs of the contracts of Ques-
tions (c), (f) and (i).
Problem 6.15 Consider a risky asset priced

σBt +µt−σ 2 t/2
St = S0 e , i.e. dSt = µSt dt + σSt dBt , t ∈ R+ ,
a risk-free asset priced At = A0 e rt , and a self-financing portfolio allocation

(ηt , ξt )t∈R+ with value
" 223
N. Privault
Vt := ηt At + ξt St , t ∈ R+ .
a) Using the portfolio self-financing condition dVt = ηt dAt +ξt dSt , show that
we have
wT wT
VT = Vt + (rVs + (µ − r)ξs Ss )ds + σ ξs Ss dBs .
t t
b) ∗
Show that under the risk-neutral measure P the portfolio value Vt
∗
satisfies the Backward Stochastic Differential Equation (BSDE)

wT wT
Vt = VT − rVs ds − πs d B
bs , (6.36)
t t
where πt := σξt St is the risky amount invested on the asset St , multiplied

by σ, and (B
bt )t∈R is a standard Brownian motion under P∗ . Show that
+
under the risk-neutral measure P∗ , the discounted portfolio value Ṽt :=

e Vt can be rewritten as
−rt
wT
ṼT = Ṽ0 + e −rs πs dB
bs . (6.37)
0
c) Express dv(t, St ) by the Itô formula, where v(t, x) is a C 2 function of t

and x.
d) Consider now a more general BSDE of the form
wT wT
Vt = VT − f (s, Ss , Vs , πs )ds − πs dBs , (6.38)
t t
with terminal condition VT = g(ST ). By matching (6.38) to the Itô for-

mula of Question (c), find the PDE satisfied by the function v(t, x) defined
as Vt = v(t, St ).
µ−r
e) Show that when f (t, x, v, z) = rv + z, the PDE of Question (d)
σ
recovers the standard Black-Scholes PDE.
µ−r
f) Assuming again f (t, x, v, z) = rv + z and taking the terminal con-
σ
dition 2
VT = (S0 e σBT +(µ−σ /2)T − K)+ ,
give the process (πt )t∈[0,T ] appearing in the stochastic integral represen-
2
tation (6.37) of the discounted claim e −rT (S0 e σBT +(µ−σ /2)T − K)+ .†
g) From now on we assume that short selling is penalized at a rate γ > 0,
‡
i.e. γSt |ξt |dt is subtracted from the portfolio value change dVt whenever
∗
The Girsanov Theorem 7.3 states that B bt := Bt + (µ − r)t/σ is a standard Brownian
motion under P∗ .
†
General Black-Scholes knowledge can be used for this question.
‡
SGX started to penalize naked short sales with an interim measure in September 2008.
224 "
ξt < 0 over the time period [t, t + dt]. Rewrite the self-financing condition
using (ξt )− := − min(ξt , 0).
h) Find the BSDE of the form (6.38) satisfied by (Vt )t∈R+ , and the corre-
sponding function f (t, x, v, z).
i) Under the above penalty on short selling, find the PDE satisfied by the
function u(t, x) when the portfolio value Vt is given as Vt = u(t, St ).
j) Differential interest rate. Assume that one can borrow only at a rate R
which is higher∗ than the risk-free rate r > 0, i.e. we have
dVt = Rηt At dt + ξt dSt
when ηt < 0, and

dVt = rηt At dt + ξt dSt
when ηt > 0. Find the PDE satisfied by the function u(t, x) when the
portfolio value Vt is given as Vt = u(t, St ).
k) Assume that the portfolio differential reads
dVt = ηt dAt + ξt dSt − dUt ,
where (Ut )t∈R+ is an increasing process. Show that the corresponding

portfolio strategy (ξt )t∈R+ is superhedging the claim VT = C.
Exercise 6.16 Girsanov theorem. Assume that the Novikov integrability con-
dition (6.7) is not satisfied. How does this modify the statement (6.8) of the
Girsanov Theorem 6.2?
Problem 6.17 Log options.

a) Consider a market model made of a risky asset with price (St )t∈R+ as in
Exercise 4.23-(d) and a risk-free asset with price At = $1 × e rt and risk-
free interest rate r = σ 2 /2. From the answer to Exercise 4.23-(b), show
that the arbitrage price
Vt = e −(T −t)r IE (log ST )+ | Ft

at time t ∈ [0, T ] of a log call option with payoff (log ST )+ is equal to

r
T − t −Bt2 /(2(T −t)) Bt
Vt = σ e −(T −t)r e + σ e −(T −t)r Bt Φ √ .
2π T −t
∗
Regular savings account usually pays r=0.05% per year. Effective Interest Rates (EIR)
for borrowing could be as high as R=20.61% per year.
" 225
N. Privault
b) Show that Vt can be written as
Vt = g(T − t, St ),
where g(τ, x) = e f (τ, log x), and

−rτ
r
τ −y2 /(2σ2 τ ) y
f (τ, y) = σ e + yΦ √ .
2π σ τ
c) Figure 6.4 represents the graph of (τ, x) 7→ g(τ, x), with r = 0.05 = 5%
per year and σ = 0.1. Assume that the current underlying price is $1 and
there remains 700 days to maturity. What is the price of the option?
Price
0.7
0.6
0.5
0.4
0.3
0.2
0.1
700
600
500
400
T-t 300
200
100 1.5 2
0.5 1
0 0 St
Fig. 6.4: Option price as a function of the underlying and of time to maturity.
∂g
d) Show∗ that the (possibly fractional) quantity ξt = (T − t, St ) of St at
∂x
time t in a portfolio hedging the payoff (log ST ) is equal to
+
1 log S

ξt = e −(T −t)r Φ √ t , 0 6 t 6 T.
St σ T −t
e) Figure 6.5 represents the graph of (τ, x) 7→ ∂x∂g

(τ, x). Assuming that the
current underlying price is $1 and that there remains 700 days to maturity,
how much of the risky asset should you hold in your portfolio in order to
hedge one log option?
∂ 1 ∂f
∗
Recall the chain rule of derivation f (τ, log x) = (τ, y)|y=log x .
∂x x ∂y
226 "
Delta
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
100
0 2 200
1.8 1.6 300
1.4 1.2 400 T-t
1 0.8 500
St 0.6 0.4 600
0.2 700
Fig. 6.5: Delta as a function of the underlying and of time to maturity.
f) Based on the framework and answers of Questions (c) and (e), should you
borrow or lend the risk-free asset At = $1 × e rt , and for what amount?
∂2g
g) Show that the Gamma of the portfolio, defined as Γt = (T − t, St ),
∂x2
equals
!
1 1 log S

2 2
Γt = e −(T −t)r 2 e −(log St ) /(2σ (T −t)) − Φ √ t ,
St σ 2π(T − t)
p
σ T −t
0 6 t < T.
h) Figure 6.6 represents the graph of Gamma. Assume that there remains
60 days to maturity and that St , currently at $1, is expected to increase.
Should you buy or (short) sell the underlying asset in order to hedge the
option?
Gamma
0.8
0.6
0.4
0.2
0
180200
-0.20.2 140160
0.4 0.6 0.8 1 100120 T-t
St 1.2 1.4 1.6 1.8 60 80
Fig. 6.6: Gamma as a function of the underlying and of time to maturity.
i) Let now σ = 1. Show that the function f (τ, y) of Question (b) solves the
heat equation
" 227
N. Privault
1 ∂2f

∂f
(τ, y) = (τ, y)


2 ∂y 2

∂τ

f (0, y) = (y)+ .


Problem 6.18 Log put options with a given strike price.

a) Consider a market model made of a risky asset with price (St )t∈R+ as in
Exercise 4.19, a risk-free asset with price At = $1 × e rt , risk-free interest
rate r = σ 2 /2 and S0 = 1. From the answer to Exercise A.4-(b), show
that the arbitrage price
Vt = e −(T −t)r IE∗ (K − log ST )+ | Ft

at time t ∈ [0, T ] of a log call option with strike price K and payoff
(K − log ST )+ is equal to
r
T − t −(Bt −K/σ)2 /(2(T −t)) −(T −t)r K/σ − Bt
Vt = σ e −(T −t)r e +e (K−σBt )Φ √ .
2π T −t
b) Show that Vt can be written as
Vt = g(T − t, St ),
where g(τ, x) = e −rτ f (τ, log x), and

r
τ −(K−y)2 /(2σ2 τ ) K −y
f (τ, y) = σ e + (K − y)Φ √ .
2π σ τ
c) Figure 6.7 represents the graph of (τ, x) 7→ g(τ, x), with r = 0.125 per
year and σ = 0.5. Assume that the current underlying price is $3, that
K = 1, and that there remains 700 days to maturity. What is the price of
the option?
Price
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
700
0 600
2.2 500
2.4 2.6 2.8 400
3 300 T-t
St 3.2 3.4 200
3.6 3.8 100
0
Fig. 6.7: Option price as a function of the underlying and of time to maturity.
228 "
∂g
d) Show∗ that the quantity ξt = (T − t, St ) of St at time t in a portfolio
∂x
hedging the payoff (K − log ST )+ is equal to
1 K − log St

ξt = − e −(T −t)r Φ √ , 0 6 t 6 T.
St σ T −t
e) Figure 6.8 represents the graph of (τ, x) 7→ ∂x∂g

(τ, x). Assuming that the
current underlying price is $3 and that there remains 700 days to maturity,
how much of the risky asset should you hold in your portfolio in order to
hedge one log option?
Delta
0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
-0.35
-0.4
-0.45
-0.5 0
100
4 200
3.8 3.6 300
3.4 3.2 400 T-t
3 2.8 500
St 2.6 2.4 600
2.2 700
Fig. 6.8: Delta as a function of the underlying and of time to maturity.
f) Based on the framework and answers of Questions (c) and (e), should you
borrow or lend the risk-free asset At = $1 × e rt , and for what amount?
∂2g
g) Show that the Gamma of the portfolio, defined as Γt = (T − t, St ),
∂x2
equals
!
1 1 K − log St

−(K−log St )2 /(2σ 2 (T −t))
Γt = e −(T −t)r
e +Φ √ ,
St2 2π(T − t)
p
σ σ T −t
0 6 t 6 T.
h) Figure 6.9 represents the graph of Gamma. Assume that there remains
10 days to maturity and that St , currently at $3, is expected to increase.
Should you buy or (short) sell the underlying asset in order to hedge the
option?
∂ 1 ∂f
∗
Recall the chain rule of derivation f (τ, log x) = (τ, y)|y=log x .
∂x x ∂y
" 229
N. Privault
Gamma
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
010
20
30
40 2.2
50 2.4
T-t 60 2.8 2.6
70 3.2 3
80 3.4 St
90 3.8 3.6
100
Fig. 6.9: Gamma as a function of the underlying and of time to maturity.
i) Show that the function f (τ, y) of Question (b) solves the heat equation

∂f σ2 ∂ 2 f
(τ, y) = (τ, y)


2 ∂y 2

∂τ

f (0, y) = (K − y)+ .


230 "

Martingale Pricing Nyu

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Chapter 6

Martingale Approach to Pricing and

In this chapter we present the probabilistic martingale approach method to

6.1 Martingale Property of the Itô Integral

Recall (Definition 5.5) that an integrable process (Xt )t∈R+ is said to be a

Examples of martingales (i)

1. Given F ∈ L2 (Ω) a square-integrable random variable and (Ft )t∈R+ a

IE[Xt | Fs ] = IE[IE[F | Ft ] | Fs ] = IE[F | Fs ] = Xs , 0 6 s 6 t, (6.1)

by the tower property (18.40).

2. Any integrable stochastic process (Xt )t∈R+ whose increments (Xt1 −

In particular, the standard Brownian motion (Bt )t∈R+ is a martingale

Proof. The statement is first proved in case u is a simple predictable process,

with F an Fa -measurable random variable and t ∈ [a, b], we have

On the other hand, when t ∈ [0, a] we have

hence we check that

The extension from simple processes to square-integrable processes in L2ad (Ω×

where we used the Itô isometry (4.15). We conclude that

for u ∈ L2ad (Ω× R+ ) a square-integrable adapted process, which leads to

Examples of martingales (ii)

1. The driftless geometric Brownian motion

is a martingale. Indeed, we have

The discounted asset price

is a martingale under P when µ = r. The case µ 6= r will be treated

2. The discounted value

cf. Lemma 5.2 is a martingale when µ = r by Proposition 6.1 because

6.2 Risk-neutral Measures

Set t∈R := ( e −rt St )t∈R+

is a martingale, cf. Proposition 5.6. Note that when µ = r, the process

In this section we address the construction of a risk-neutral probability mea-

Fig. 6.1: Drifted Brownian path.

Clearly, given ν ∈ R, the drifted process B

The solution to this problem is given by

1 , 2 , . . . , N ∈ {−1, 1}, with respect to the historical probability measure

Interpreting N = T /∆t as an (infinitely large) number of discrete time steps

based on the identifications

The following R code is rescaling probabilities as in (6.4) based on the value

N=1000; t <- 0:N; dt <- 1.0/N; nu=3; p=0.5*(1-nu*(dt)^0.5); nsim <- 10

The discretized illustration in Figure 6.2 shows a Brownian motion rescaled

Fig. 6.2: Girsanov shift.

6.3 Changes of Measure and the Girsanov Theorem

Relation (6.5) is equivalent to stating that

where G is an integrable random variable. In addition we say that Q is equiv-

Recall that here, Ω = C0 ([0, T ]) is the Wiener space and ω ∈ Ω is a

For example, the fact that νT + BT has a standard (centered) Gaussian

The Girsanov theorem can actually be extended to shifts by adapted pro-

and let Q denote the probability measure defined by

for all random variables F ∈ L1 (Ω), see also Exercise 6.16.

dSet = (µ − r)Set dt + σ Set dBt = σ Set dB

is a martingale under P , hence P is a risk-neutral measure, and we obviously

6.4 Pricing by the Martingale Method

Recall that from the first fundamental theorem of mathematical finance,

In case the price process (St )t∈R+ satisfies the equation

is a martingale under the probability measure P defined by (6.10), i.e. P∗ is

a risk-neutral (or martingale) probability measure.

dSet = (µ − r)Set dt + σ Set dBt

and by Proposition 6.1 it becomes a martingale under P∗ .

As in Chapter 3, the value Vt at time t of a self-financing portfolio strategy

and let C be a contingent claim, such that

(ii) (ξt , ηt )t∈[0,T ] hedges the claim C, i.e. we have VT = C.

πt (C) = Vt = e −(T −t)r IE∗ [C | Ft ], 0 6 t 6 T, (6.13)

which is a martingale under P∗ from Proposition 6.1, hence

Vet = IE∗ VeT Ft

= e −rT IE∗ [VT | Ft ]

1 , 2 , . . . , N ∈ {−1, 1}, with respect to the historical probability measure

N=1000; t <- 0:N; dt <- 1.0/N; nu=3; p=0.5(1-nu(dt)^0.5); nsim <- 10