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Stochastic Calculus: Summary. by Celine Azizieh (Université Libre de Bruxelles)
Stochastic Calculus: Summary. by Celine Azizieh (Université Libre de Bruxelles)
Céline Azizieh
November 2018
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Stochastic Calculus - Outline
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
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Stochastic Calculus - Outline
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
PF 0, 1 A ( PA
such that:
PA > 0, 1 for all A > F ,
P Ω 1,
If Ai i > N0 are 2 by 2 disjoint, then:
P 8i >N0 Ai Qª P A
i 1
i
(sigma-additivity)
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
PF 0, 1 A ( PA
such that:
PA > 0, 1 for all A > F ,
P Ω 1,
If Ai i > N0 are 2 by 2 disjoint, then:
P 8i >N0 Ai Qª P A
i 1
i
(sigma-additivity)
We will always work on a probability space Ω, F , P in which
elementary events represent typically
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
PF 0, 1 A ( PA
such that:
PA > 0, 1 for all A > F ,
P Ω 1,
If Ai i > N0 are 2 by 2 disjoint, then:
P 8i >N0 Ai Qª P A
i 1
i
(sigma-additivity)
We will always work on a probability space Ω, F , P in which
elementary events represent typically the evolution of a given market
during a given time interval.
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
6 / 80
Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
6 / 80
Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
6 / 80
Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
6 / 80
Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
6 / 80
Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
7 / 80
Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
7 / 80
Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
7 / 80
Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
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Financial modelling: Probabilitic framework Financial modelling: Probabilistic framework
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
8 / 80
Martingales Conditional expectation
Conditional expectation
9 / 80
Martingales Conditional expectation
Conditional expectation
9 / 80
Martingales Conditional expectation
Conditional expectation
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Martingales Conditional expectation
Conditional expectation
9 / 80
Martingales Conditional expectation
Conditional expectation
9 / 80
Martingales Conditional expectation
Conditional expectation
9 / 80
Martingales Conditional expectation
Conditional expectation
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Martingales Conditional expectation
Conditional expectation
E X SY ω E X SY Y ω .
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Martingales Conditional expectation
Conditional expectation
E X SY ω E X SY Y ω .
The last conditional expectation is taken w.r.t. an event.
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Martingales Conditional expectation
Conditional expectation
E X SY ω E X SY Y ω .
The last conditional expectation is taken w.r.t. an event.
This means that it takes value E X SY yi with probability P Y yi .
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Martingales Conditional expectation
Conditional expectation
Remark
1 We can interpret E X SY as a function of ω
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Martingales Conditional expectation
Conditional expectation
Remark
1 We can interpret E X SY as a function of ω or as a function of y :
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Martingales Conditional expectation
Conditional expectation
Remark
1 We can interpret E X SY as a function of ω or as a function of y :
E X SY ω or E X SY y .
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Martingales Conditional expectation
Conditional expectation
Remark
1 We can interpret E X SY as a function of ω or as a function of y :
E X SY ω or E X SY y .
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Martingales Conditional expectation
Conditional expectation
Remark
1 We can interpret E X SY as a function of ω or as a function of y :
E X SY ω or E X SY y .
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Martingales Conditional expectation
Conditional expectation
In practice
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Martingales Conditional expectation
Conditional expectation
In practice
1 If X , Y are discrete:
E X SY y Qx P X
i
i xi SY y Q x P XP Yx , Yy
i
i
i
y
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Martingales Conditional expectation
Conditional expectation
In practice
1 If X , Y are discrete:
E X SY y Qx P X
i
i xi SY y Q x P XP Yx , Yy
i
i
i
y
E X SY y S R
x
f x, y
f Y y
dx
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Martingales Conditional expectation
Conditional expectation
In practice
1 If X , Y are discrete:
E X SY y Qx P X
i
i xi SY y Q x P XP Yx , Yy
i
i
i
y
E X SY y S R
x
f x, y
f Y y
dx SR
xfX SY x, y dx
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Martingales Conditional expectation
Conditional expectation
In practice
1 If X , Y are discrete:
E X SY y Qx P X
i
i xi SY y Q x P XP Yx , Yy
i
i
i
y
E X SY y S R
x
f x, y
f Y y
dx SR
xfX SY x, y dx
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Martingales Conditional expectation
Conditional expectation
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Martingales Conditional expectation
Conditional expectation
12 / 80
Martingales Conditional expectation
Conditional expectation
12 / 80
Martingales Conditional expectation
Conditional expectation
12 / 80
Martingales Conditional expectation
Conditional expectation
12 / 80
Martingales Conditional expectation
Conditional expectation
12 / 80
Martingales Conditional expectation
Conditional expectation
12 / 80
Martingales Conditional expectation
Conditional expectation
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
Remarks:
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Martingales Martingales in discrete time
Remarks:
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Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
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Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
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Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
3 (iii) E Yn E Y0 for all n (mean-stationarity).
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Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
3 (iii) E Yn E Y0 for all n (mean-stationarity).
4 Using (iii), we also have (for k 2, 3, . . .)
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Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
3 (iii) E Yn E Y0 for all n (mean-stationarity).
4 Using (iii), we also have (for k 2, 3, . . .)
E Ynk SX1 , ..., Xn EE Ynk SX1 , ..., Xnk TX1 , ..., Xn
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Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
3 (iii) E Yn E Y0 for all n (mean-stationarity).
4 Using (iii), we also have (for k 2, 3, . . .)
E Ynk SX1 , ..., Xn EE Ynk SX1 , ..., Xnk TX1 , ..., Xn
E Ynk 1 SX1 , ..., Xn
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Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
3 (iii) E Yn E Y0 for all n (mean-stationarity).
4 Using (iii), we also have (for k 2, 3, . . .)
E Ynk SX1 , ..., Xn EE Ynk SX1 , ..., Xnk TX1 , ..., Xn
E Ynk 1 SX1 , ..., Xn
...
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Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
3 (iii) E Yn E Y0 for all n (mean-stationarity).
4 Using (iii), we also have (for k 2, 3, . . .)
E Ynk SX1 , ..., Xn EE Ynk SX1 , ..., Xnk TX1 , ..., Xn
E Ynk 1 SX1 , ..., Xn
... E Yn1 SX1 , ..., Xn
14 / 80
Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
3 (iii) E Yn E Y0 for all n (mean-stationarity).
4 Using (iii), we also have (for k 2, 3, . . .)
E Ynk SX1 , ..., Xn EE Ynk SX1 , ..., Xnk TX1 , ..., Xn
E Ynk 1 SX1 , ..., Xn
... E Yn1 SX1 , ..., Xn
Yn a.s. for all n.
14 / 80
Martingales Martingales in discrete time
Remarks:
1 (i) just states that "Yn is a function of X1 , . . . , Xn only" (i.e. Yn is
known once X1 , ..., Xn are known).
2 (iii) shows that a martingale can be thought of as the fortune of a
gambler betting on a fair game.
3 (iii) E Yn E Y0 for all n (mean-stationarity).
4 Using (iii), we also have (for k 2, 3, . . .)
E Ynk SX1 , ..., Xn EE Ynk SX1 , ..., Xnk TX1 , ..., Xn
E Ynk 1 SX1 , ..., Xn
... E Yn1 SX1 , ..., Xn
Yn a.s. for all n.
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
In particular, E Mt M0 .
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Martingales Martingales in discrete time
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Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn P n
i 1 Xi .
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Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.
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Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case.
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
E Yn1 SX1 , ..., Xn
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn E Yn SX1 , ..., Xn E Xn1 SX1 , ..., Xn
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn E Yn SX1 , ..., Xn E Xn1 SX1 , ..., Xn
Yn E Xn1
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn E Yn SX1 , ..., Xn E Xn1 SX1 , ..., Xn
Yn E Xn1 Yn 0
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn E Yn SX1 , ..., Xn E Xn1 SX1 , ..., Xn
Yn E Xn1 Yn 0
16 / 80
Martingales Martingales in discrete time
P Xi 1 p and P Xi 1 q 1 p.
Let Yn Sn n
P
i 1 Xi .
; The SP Yn is called a random walk.It represents the fortune after
n games of a player tossing a coin again and again.
If p q 1~2, the RW is said to be symmetric.
One can easily see that in the symmetric case Y is a martingale
w.r.t. Xn in the symmetric case. Indeed, if we focus on condition
(iii):
E Yn1 SX1 , ..., Xn E Yn Xn1 SX1 , ..., Xn E Yn SX1 , ..., Xn E Xn1 SX1 , ..., Xn
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
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Brownian motion
18 / 80
Brownian motion
S n S 0 M1n
k 1
ik S 0 Me
n
k 1
δk
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Brownian motion
S n S 0 M1
n
k 1
ik S 0 Me
n
k 1
δk
Stochastic model :
S n S 0 Me
n
k 1
Yk
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Brownian motion
S n S 0 M1n
k 1
ik S 0 Me
n
k 1
δk
Stochastic model :
S n S 0 Me
n
k 1
Yk
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Brownian motion
S n S 0 M1n
k 1
ik S 0 Me
n
k 1
δk
Stochastic model :
S n S 0 Me
n
k 1
Yk
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Brownian motion
S n S 0 M1n
k 1
ik S 0 Me
n
k 1
δk
Stochastic model :
S n S 0 Me
n
k 1
Yk
1 1~2
We can rewrite: Yi δ σXi where Xi .
1 1~2
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Brownian motion
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
i 1
i δn
¯
determ. trend
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Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk
19 / 80
Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk
In particular,
19 / 80
Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk
19 / 80
Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk
19 / 80
Brownian motion
We hence have :
S n S 0 Me
n
k 1
δ σXk
S 0enδσ Pk
n
1 Xk
i 1
i δn
¯
σ QXn
i 1
i
determ. trend
´¹¹ ¹ ¹ ¸ ¹ ¹ ¹ ¹¶
random walk
20 / 80
Brownian motion
20 / 80
Brownian motion
20 / 80
Brownian motion
20 / 80
Brownian motion
20 / 80
Brownian motion
20 / 80
Brownian motion
W n ∆x. QX ,
m
i 1
i with m n~∆t
20 / 80
Brownian motion
W n ∆x. QX ,
m
i 1
i with m n~∆t
20 / 80
Brownian motion
W n ∆x. QX ,
m
i 1
i with m n~∆t
20 / 80
Brownian motion
W n ∆x. QX ,
m
i 1
i with m n~∆t
20 / 80
Brownian motion
W n ∆x. QX ,
m
i 1
i with m n~∆t
20 / 80
Brownian motion
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Brownian motion
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Brownian motion
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Brownian motion
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Brownian motion
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Brownian motion
∆xk 2
1
∆tk
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Brownian motion
∆xk 2
1
∆tk
∆xk
(and not ∆tk 1 !)
21 / 80
Brownian motion
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
23 / 80
Brownian motion
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
24 / 80
Brownian motion
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
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Brownian motion
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
27 / 80
Brownian motion
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
28 / 80
Brownian motion
1
Xk(t)
-1
-2
-3
0 1 2 3 4 5 6
Time t
29 / 80
Brownian motion
30 / 80
Brownian motion
30 / 80
Brownian motion
QX
t ~∆tk
W k t ∆xk i W t
i 1
30 / 80
Brownian motion
QX
t ~∆tk
W k t ∆xk i W t
i 1
30 / 80
Brownian motion
QX
t ~∆tk
W k t ∆xk i W t
i 1
30 / 80
Brownian motion
QX
t ~∆tk
W k t ∆xk i W t
i 1
30 / 80
Brownian motion
QX
t ~∆tk
W k t ∆xk i W t
i 1
30 / 80
Brownian motion
QX
t ~∆tk
W k t ∆xk i W t
i 1
30 / 80
Brownian motion
QX
t ~∆tk
W k t ∆xk i W t
i 1
30 / 80
Brownian motion
31 / 80
Brownian motion
P
If Xn is a sequence of i.i.d. random variables of mean µ and finite
n
variance σ 2 , then we note Sn i 1 Xi , and we have:
31 / 80
Brownian motion
P
If Xn is a sequence of i.i.d. random variables of mean µ and finite
n
variance σ 2 , then we note Sn i 1 Xi , and we have:
Sn nµ d
º N 0, 1
σ n
31 / 80
Brownian motion
32 / 80
Brownian motion
32 / 80
Brownian motion
32 / 80
Brownian motion
32 / 80
Brownian motion
32 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
33 / 80
Brownian motion
0.5
0
X(t)
-0.5
-1
-1.5
-2
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Time t
34 / 80
Brownian motion
0.5
0
X(t)
-0.5
-1
-1.5
-2
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Time t
It can be shown that the sample paths (a.s.) are nowhere differentiable,
although continuous everywhere. 34 / 80
Brownian motion
35 / 80
Brownian motion
Z t a B t
35 / 80
Brownian motion
Z t a B t
where Bt is a standard BM
35 / 80
Brownian motion
Z t a B t
where Bt is a standard BM
35 / 80
Brownian motion
Z t a B t
where Bt is a standard BM
Z t a µt σBt
35 / 80
Brownian motion
Z t a B t
where Bt is a standard BM
Z t a µt σBt
In particular,
E Z t a µt
35 / 80
Brownian motion
Z t a B t
where Bt is a standard BM
Z t a µt σBt
In particular,
E Z t a µt
var Z t σ2t
35 / 80
Brownian motion
0.8
0.6
0.4
0.2
X(t)
−0.2
−0.4
−0.6
−0.8
−1
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Time t
36 / 80
Brownian motion
0.8
0.6
0.4
0.2
X(t)
−0.2
−0.4
−0.6
−0.8
−1
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Time t
37 / 80
Brownian motion
Theorem
Let Bt 0 B t B T be a standard Brownian motion. Then the
processes:
38 / 80
Brownian motion
Theorem
Let Bt 0 B t B T be a standard Brownian motion. Then the
processes:
1 Bt 0 B t B T
38 / 80
Brownian motion
Theorem
Let Bt 0 B t B T be a standard Brownian motion. Then the
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
38 / 80
Brownian motion
Theorem
Let Bt 0 B t B T be a standard Brownian motion. Then the
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
3 exp αBt α2 t ~2 0 B t B T , where α is a constant in R
38 / 80
Brownian motion
Theorem
Let Bt 0 B t B T be a standard Brownian motion. Then the
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
3 exp αBt α2 t ~2 0 B t B T , where α is a constant in R
are martingales
38 / 80
Brownian motion
Theorem
Let Bt 0 B t B T be a standard Brownian motion. Then the
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
3 exp αBt α2 t ~2 0 B t B T , where α is a constant in R
are martingales w.r.t. process Bt .
38 / 80
Brownian motion
Theorem
Let Bt 0 B t B T be a standard Brownian motion. Then the
processes:
1 Bt 0 B t B T
2 Bt2 t 0 B t B T
3 exp αBt α2 t ~2 0 B t B T , where α is a constant in R
are martingales w.r.t. process Bt .
38 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs sBt ,
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs s Bt ,
E TBt2 t T B E Bt2 t
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs s Bt ,
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs s Bt ,
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs s Bt ,
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs s Bt ,
t s t Bs2 Bs2 s.
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs s Bt ,
t s t Bs2 Bs2 s.
3) E exp αBt α2 t ~2 SBu , u B s
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs s Bt ,
t s t Bs2 Bs2 s.
3) E exp αBt α2 t ~2 SBu , u B s
α2 α2 s
E exp α Bt Bs 2
t s SBu , u B s exp αBs 2
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs s Bt ,
t s t Bs2 Bs2 s.
3) E exp αBt α2 t ~2 SBu , u B s
α2 α2 s
E exp α Bt
2
t s SBu , u B s exp αBs
Bs
2
α2 2
E exp αBt s exp 2 t s exp αBs α2 s
39 / 80
Brownian motion
Proof
1) Bt is a function of Bs sBt ,
E Bt2 t @ ª,
E Bt Bs SBu , u B s 0 since this is equal to E Bt Bs , which is 0.
2) Bt2 t is a function of Bs s Bt ,
t s t Bs2 Bs2 s.
3) E exp αBt α2 t ~2 SBu , u B s
α2 α2 s
E exp α Bt
2
t s SBu , u B s exp αBs
Bs
2
α2 2
E exp αBt s exp 2 t s exp αBs α2 s
2
exp αBs α2 s .
39 / 80
Brownian motion
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
40 / 80
Stochastic Integral Stochastic integral - Motivation
41 / 80
Stochastic Integral Stochastic integral - Motivation
41 / 80
Stochastic Integral Stochastic integral - Motivation
41 / 80
Stochastic Integral Stochastic integral - Motivation
41 / 80
Stochastic Integral Stochastic integral - Motivation
41 / 80
Stochastic Integral Stochastic integral - Motivation
Qφ S
d
Vt φ φ1t St1 φ2t St2 ... φdt Std k
t
k
t φt .St
k 1
41 / 80
Stochastic Integral Stochastic integral - Motivation
Qφ S
d
Vt φ φ1t St1 φ2t St2 ... φdt Std k
t
k
t φt .St
k 1
41 / 80
Stochastic Integral Stochastic integral - Motivation
Qφ S
d
Vt φ φ1t St1 φ2t St2 ... φdt Std k
t
k
t φt .St
k 1
41 / 80
Stochastic Integral Stochastic integral - Motivation
42 / 80
Stochastic Integral Stochastic integral - Motivation
We can then denote by φi φ1i , ..., φdi the composition of the portfolio
between Ti and Ti 1 , and rewrite φt as a step function:
42 / 80
Stochastic Integral Stochastic integral - Motivation
We can then denote by φi φ1i , ..., φdi the composition of the portfolio
between Ti and Ti 1 , and rewrite φt as a step function:
42 / 80
Stochastic Integral Stochastic integral - Motivation
We can then denote by φi φ1i , ..., φdi the composition of the portfolio
between Ti and Ti 1 , and rewrite φt as a step function:
42 / 80
Stochastic Integral Stochastic integral - Motivation
We can then denote by φi φ1i , ..., φdi the composition of the portfolio
between Ti and Ti 1 , and rewrite φt as a step function:
42 / 80
Stochastic Integral Stochastic integral - Motivation
We can then denote by φi φ1i , ..., φdi the composition of the portfolio
between Ti and Ti 1 , and rewrite φt as a step function:
42 / 80
Stochastic Integral Stochastic integral - Motivation
We can then denote by φi φ1i , ..., φdi the composition of the portfolio
between Ti and Ti 1 , and rewrite φt as a step function:
42 / 80
Stochastic Integral Stochastic integral - Motivation
43 / 80
Stochastic Integral Stochastic integral - Motivation
44 / 80
Stochastic Integral Stochastic integral - Motivation
44 / 80
Stochastic Integral Stochastic integral - Motivation
44 / 80
Stochastic Integral Stochastic integral - Motivation
44 / 80
Stochastic Integral Stochastic integral - Motivation
44 / 80
Stochastic Integral Stochastic integral - Motivation
44 / 80
Stochastic Integral Stochastic integral - Motivation
44 / 80
Stochastic Integral Stochastic integral - Motivation
44 / 80
Stochastic Integral Stochastic integral - Motivation
GT φ φ0 .S0 Qφ . S
n
i 0
i Ti 1 STi
44 / 80
Stochastic Integral Stochastic integral - Motivation
45 / 80
Stochastic Integral Stochastic integral - Motivation
45 / 80
Stochastic Integral Stochastic integral - Motivation
45 / 80
Stochastic Integral Stochastic integral - Motivation
45 / 80
Stochastic Integral Stochastic integral - Motivation
45 / 80
Stochastic Integral Stochastic integral - Motivation
46 / 80
Stochastic Integral Stochastic integral - Motivation
46 / 80
Stochastic Integral Stochastic integral - Motivation
46 / 80
Stochastic Integral Stochastic integral - Motivation
S 0
T
φsdBs
46 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
47 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
47 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
S
0
T
φsdBs ω
47 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
S
0
T
φsdBs ω lim
maxti ti 1 0 i 1
Qφ
n
ti 1 ω Bti ω Bti 1 ω
47 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
S
0
T
φsdBs ω lim
maxti ti 1 0 i 1
Qφ
n
ti 1 ω Bti ω Bti 1 ω
47 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
S
0
T
φsdBs ω lim
maxti ti 1 0 i 1
Qφ
n
ti 1 ω Bti ω Bti 1 ω
47 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
S
0
T
φsdBs ω lim
maxti ti 1 0 i 1
Qφ
n
ti 1 ω Bti ω Bti 1 ω
47 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
Contrarily to the Riemann integral, the result can depend on the point
yi > ti 1 , ti .
48 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
Contrarily to the Riemann integral, the result can depend on the point
yi > ti 1 , ti . In the Itô integral, we will fix yi ti 1 ;
48 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
Contrarily to the Riemann integral, the result can depend on the point
yi > ti 1 , ti . In the Itô integral, we will fix yi ti 1 ;
The stochastic integral will be defined as a limit of Riemann sums,
48 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
Contrarily to the Riemann integral, the result can depend on the point
yi > ti 1 , ti . In the Itô integral, we will fix yi ti 1 ;
The stochastic integral will be defined as a limit of Riemann sums, but
not in the sense of "almost sure convergence",
48 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
Contrarily to the Riemann integral, the result can depend on the point
yi > ti 1 , ti . In the Itô integral, we will fix yi ti 1 ;
The stochastic integral will be defined as a limit of Riemann sums, but
not in the sense of "almost sure convergence", but in "quadratic
convergence" (L2 ).
48 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
Contrarily to the Riemann integral, the result can depend on the point
yi > ti 1 , ti . In the Itô integral, we will fix yi ti 1 ;
The stochastic integral will be defined as a limit of Riemann sums, but
not in the sense of "almost sure convergence", but in "quadratic
convergence" (L2 ).
Let us recall that
48 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
49 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
49 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
49 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
49 / 80
Stochastic Integral Stochastic integral - Definition
Stochastic integral
Qf
n
i 1
Bti 1 Bti Bti 1 ÐL
2
S 0
T
f Bs dBs
49 / 80
Stochastic Integral Stochastic integral: properties
50 / 80
Stochastic Integral Stochastic integral: properties
50 / 80
Stochastic Integral Stochastic integral: properties
S
t
Xt f sdBs
0
50 / 80
Stochastic Integral Stochastic integral: properties
S
t
Xt f sdBs
0
S
t
VarXt f 2 u du.
0
50 / 80
Stochastic Integral Stochastic integral: properties
S
t
Xt f sdBs
0
S
t
VarXt f 2 u du.
0
50 / 80
Stochastic Integral Stochastic integral: properties
S
t
Xt f sdBs
0
S
t
VarXt f 2 u du.
0
Q f t S
n T
lim i Bti Bti 1 f sdBs ,
n ª i 1 0
We see that here the choice of ti > ti 1 , ti is free: it does not need to be ti 501 ./ 80
Stochastic Integral Stochastic integral: properties
Other properties
R
The Itô integral is defined in general for a square integrable
t
process Xt . The resulting process, 0 X sdB s is a continuous
martingale w.r.t. Bt .1
1
Actually it is equal almost surely to a continuous martingale
51 / 80
Stochastic Integral Stochastic integral: properties
Other properties
R
The Itô integral is defined in general for a square integrable
t
process Xt . The resulting process, 0 X sdB s is a continuous
martingale w.r.t. Bt .1
(Itô isometry)
For all 0 B s B t and for all Xt square integrable, we have:
S S
t 2 t
E X ω, u dBu E X ω, u 2 du .(1)
s s
1
Actually it is equal almost surely to a continuous martingale
51 / 80
Stochastic Integral Stochastic integral: properties
Other properties
R
The Itô integral is defined in general for a square integrable
t
process Xt . The resulting process, 0 X sdB s is a continuous
martingale w.r.t. Bt .1
(Itô isometry)
For all 0 B s B t and for all Xt square integrable, we have:
S S
t 2 t
E X ω, u dBu E X ω, u 2 du .(1)
s s
1
Actually it is equal almost surely to a continuous martingale
51 / 80
Stochastic Integral Stochastic integral: properties
Example:
52 / 80
Stochastic Integral Stochastic integral: properties
Example: R 0
t
Bs dBs ?
52 / 80
Stochastic Integral Stochastic integral: properties
Example: R 0
t
Bs dBs ?
52 / 80
Stochastic Integral Stochastic integral: properties
Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B
52 / 80
Stochastic Integral Stochastic integral: properties
Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B QBi
ti 1 Bti Bt2i 1
52 / 80
Stochastic Integral Stochastic integral: properties
Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B QB B
i
ti 1 ti Bt2i 1
1
2
Q B i
2
ti Bt2i 1 Bti
2
Bti 1
52 / 80
Stochastic Integral Stochastic integral: properties
Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B QB B
i
ti 1 ti Bt2i 1
1
2
Q B i
ti
2
Bt2i 1 Bti
2
Bti 1
1 2
2
2
Bt B0
1
2
Q ∆B
i
i
2
52 / 80
Stochastic Integral Stochastic integral: properties
Example: R 0
t
Bs dBs ?
QBi
ti 1 ∆i B QB B
i
ti 1 ti Bt2i 1
1
2
Q B i
ti
2
Bt2i 1 Bti Bti 1
2
1 2
2
2
Bt B0
1
2
Q ∆B
i
i
2 1 2 1
B
2 t 2
Q ∆B
i
i
2
,
52 / 80
Stochastic Integral Stochastic integral: properties
Q ∆B
We can see that
2
i t
i
in L2 .
53 / 80
Stochastic Integral Stochastic integral: properties
Q ∆B
We can see that
2
i t
i
in L2 . We then get:
53 / 80
Stochastic Integral Stochastic integral: properties
Q ∆B
We can see that
2
i t
i
in L2 . We then get:
S 0
t
Bs dBs
1 2 1
B t.
2 t 2
Remark
We just saw that “∆i B 2 behaves like ∆i t”, i.e., formally:
2
dBt dt
53 / 80
Stochastic Integral Stochastic integral: properties
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
54 / 80
Itô formula and Stochastic Differential Equations Differential notation
55 / 80
Itô formula and Stochastic Differential Equations Differential notation
55 / 80
Itô formula and Stochastic Differential Equations Differential notation
55 / 80
Itô formula and Stochastic Differential Equations Differential notation
55 / 80
Itô formula and Stochastic Differential Equations Differential notation
X t X 0 S 0
t
bsds S 0
t
σ sdB s
55 / 80
Itô formula and Stochastic Differential Equations Differential notation
X t X 0 S 0
t
bsds S 0
t
σ sdB s
55 / 80
Itô formula and Stochastic Differential Equations Itô formula
The Itô stochastic integral leads to other calculation rules than in the
classical calculus:
Classical calculus:
1 2
2
f t S 0
t
f sdf s
Stochastic calculus:
1 2
2
B t
??
S 0
t
B sdB s ??
56 / 80
Itô formula and Stochastic Differential Equations Itô formula
S 0
t
B s dB s
1 2
2
1
B t t
2
57 / 80
Itô formula and Stochastic Differential Equations Itô formula
S 0
t
B s dB s
1 2
2
1
B t t
2
2 S0
t
B s dB s S 0
t
ds B 2 t
57 / 80
Itô formula and Stochastic Differential Equations Itô formula
S 0
t
B s dB s
1 2
2
1
B t t
2
2 S0
t
B s dB s S 0
t
ds B 2 t
57 / 80
Itô formula and Stochastic Differential Equations Itô formula
S 0
t
B s dB s
1 2
2
1
B t t
2
2 S0
t
B s dB s S 0
t
ds B 2 t
d B 2 t 2B t dB t dt
57 / 80
Itô formula and Stochastic Differential Equations Itô formula
S 0
t
B s dB s
1 2
2
1
B t t
2
2 S0
t
B s dB s S 0
t
ds B 2 t
d B 2 t 2B t dB t dt
the usual chain rule does not work anymore...
57 / 80
Itô formula and Stochastic Differential Equations Itô formula
58 / 80
Itô formula and Stochastic Differential Equations Itô formula
58 / 80
Itô formula and Stochastic Differential Equations Itô formula
f Bt f 0 S 0
t
f Bs dBs
1
2
S
0
t
f Bs ds. (2)
58 / 80
Itô formula and Stochastic Differential Equations Itô formula
f Bt f 0 S 0
t
f Bs dBs
1
2
S
0
t
f Bs ds. (2)
In differential notations:
1
d f Bt f Bt dBt f Bt dt
2
The proof is a consequence of Taylor development of order 2 and of
the fact that a Brownian motion has a quadratic variation on 0, T
equal to T , leading to an additional term w.r.t standard calculus.
58 / 80
Itô formula and Stochastic Differential Equations Itô formula
59 / 80
Itô formula and Stochastic Differential Equations Itô formula
59 / 80
Itô formula and Stochastic Differential Equations Itô formula
59 / 80
Itô formula and Stochastic Differential Equations Itô formula
59 / 80
Itô formula and Stochastic Differential Equations Itô formula
f t, Bt f 0, 0 S t
0 ∂x
∂f
s, Bs dBs
S 0
t ∂f
∂t
s, Bs ds
1 t ∂2f
S
2 0 ∂x 2
s, Bs ds a.s.
59 / 80
Itô formula and Stochastic Differential Equations Itô formula
f t, Bt f 0, 0 S t
0 ∂x
∂f
s, Bs dBs
S 0
t ∂f
∂t
s, Bs ds
1 t ∂2f
S
2 0 ∂x 2
s, Bs ds a.s.
59 / 80
Itô formula and Stochastic Differential Equations Itô formula
f t, Bt f 0, 0 S t
0 ∂x
∂f
s, Bs dBs
S 0
t ∂f
∂t
s, Bs ds
1 t ∂2f
S
2 0 ∂x 2
s, Bs ds a.s.
∂f ∂f 1 ∂2f
d f t, Bt t, Bt dBt t, Bt dt t, Bt dt
∂x ∂t 2 ∂x 2
59 / 80
Itô formula and Stochastic Differential Equations Itô formula
60 / 80
Itô formula and Stochastic Differential Equations Itô formula
dt.dt 0
dB t .dB t dt
dB t .dt 0
60 / 80
Itô formula and Stochastic Differential Equations Itô formula
dt.dt 0
dB t .dB t dt
dB t .dt 0
We recover the Itô formula by applying a Taylor development of order 2
combined with those rules
60 / 80
Itô formula and Stochastic Differential Equations Itô formula
61 / 80
Itô formula and Stochastic Differential Equations Itô formula
61 / 80
Itô formula and Stochastic Differential Equations Itô formula
dYt
61 / 80
Itô formula and Stochastic Differential Equations Itô formula
∂f
dYt t, Bt dt
∂t
61 / 80
Itô formula and Stochastic Differential Equations Itô formula
∂f ∂f
dYt t, Bt dt t, Bt dBt
∂t ∂x
61 / 80
Itô formula and Stochastic Differential Equations Itô formula
∂f ∂f 1 ∂2f
dYt t, Bt dt t, Bt dBt t, Bt dBt dBt
∂t ∂x 2 ∂x 2
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Itô formula and Stochastic Differential Equations Itô formula
∂f ∂f 1 ∂2f
dYt t, Bt dt t, Bt dBt t, Bt dBt dBt
∂t ∂x 2 ∂x 2
1 ∂2f ∂2f
t, Bt dt.dt t, Bt dt.dB t
2 ∂t 2 ∂x∂t
∂f ∂f 1 ∂2f
t, Bt dt t, Bt dBt t, Bt dt
∂t ∂x 2 ∂x 2
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Itô formula and Stochastic Differential Equations Itô formula
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Itô formula and Stochastic Differential Equations Itô formula
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Itô formula and Stochastic Differential Equations Itô formula
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
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Valuation and arbitrage Arbitrage opportunity
Arbitrage opportunity
Suppose again that we are in a market with d risky assets and a risk
free asset (risk free rate r ).
An arbitrage opportunity is a self-financing strategy2 is a zero-cost
strategy that can lead to a positive terminal gain, without any
probability of intermediate loss.
2
no consumption, no injection of money
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Valuation and arbitrage Arbitrage opportunity
Arbitrage opportunity
Suppose again that we are in a market with d risky assets and a risk
free asset (risk free rate r ).
An arbitrage opportunity is a self-financing strategy2 is a zero-cost
strategy that can lead to a positive terminal gain, without any
probability of intermediate loss.
Formally, if we denote by Vt φ the value of the portfolio obtained
when following this strategy, this means:
P t > 0, T , Vt φ C 0
¦ 1, P VT φ A 0 A 0
P V 0 φ 0 1
2
no consumption, no injection of money
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Valuation and arbitrage Arbitrage opportunity
Arbitrage opportunity
Suppose again that we are in a market with d risky assets and a risk
free asset (risk free rate r ).
An arbitrage opportunity is a self-financing strategy2 is a zero-cost
strategy that can lead to a positive terminal gain, without any
probability of intermediate loss.
Formally, if we denote by Vt φ the value of the portfolio obtained
when following this strategy, this means:
P t > 0, T , Vt φ C 0
¦ 1, P VT φ A 0 A 0
P V 0 φ 0 1
N.B.: the assumption of self-financing is important: it is trivial to find strategies which
are not self-financing but verify the property above (exercise: it suffices to inject cash
just before maturity...)
2
no consumption, no injection of money
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Valuation and arbitrage Arbitrage opportunity
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Valuation and arbitrage Fundamental results of asset pricing
QA 0 PA 0
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Valuation and arbitrage Fundamental results of asset pricing
QA 0 PA 0
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Valuation and arbitrage Fundamental results of asset pricing
QA 0 PA 0
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Valuation and arbitrage Fundamental results of asset pricing
QA 0 PA 0
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Valuation and arbitrage Fundamental results of asset pricing
One can show that whatever the model used, a market is arbitrage free
if and only if there exists an equivalent martingale measure3 .
Theorem (First fundamental theorem of asset pricing)
A market model defined by Ω, F , Ft , P and asset prices St t > 0,T is
arbitrage free if and only if there exists a probability measure Q P
such that the discounted asset prices ert St are martingales with
respect to Q.
In that case, one can show that derivative products can be priced
(without arbitrage) by using the expectation under Q of their
discounted payoff: EQ payoff T erT
3
see [Harrison-Kreps, 1979], [Harrison-Pliska, 1983], [Delbaen, Schachermayer,
1994]
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Valuation and arbitrage Fundamental results of asset pricing
S S
T T
H V0 φt dSt φ0t dSt0 P a.s.
0 0
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Valuation and arbitrage Fundamental results of asset pricing
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Valuation and arbitrage Fundamental results of asset pricing
Pricing
In a complete and arbitrage free market, if H is a contingent asset
whose payoff is paid in T , its price Πt H at instant t is given by:
Πt H EQ er T t H T SFt
Hedging
In a complete and arbitrage free market, any contingent asset H is
replicable by a self-financing strategy φ :
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Valuation and arbitrage Fundamental results of asset pricing
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
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Girsanov theorem
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Girsanov theorem
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Girsanov theorem
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Girsanov theorem
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Girsanov theorem
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Girsanov theorem
dS t δS t dt σS t dW t
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Girsanov theorem
dS t δS t dt σS t dW t
r δ r S t dt σS t dW t
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Girsanov theorem
dS t δS t dt σS t dW t
r δ r S t dt σS t dW t
rS t dt σS t dW t δ r S t dt
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Girsanov theorem
dS t δS t dt σS t dW t
r δ r S t dt σS t dW t
rS t dt σS t dW t δ r S t dt
rS t dt σS t dW t
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Girsanov theorem
dS t δS t dt σS t dW t
r δ r S t dt σS t dW t
rS t dt σS t dW t δ r S t dt
rS t dt σS t dW t
where we denote by
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Girsanov theorem
dS t δS t dt σS t dW t
r δ r S t dt σS t dW t
rS t dt σS t dW t δ r S t dt
rS t dt σS t dW t
δr
where we denote by W t W t t
σ
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Girsanov theorem
dS t δS t dt σS t dW t
r δ r S t dt σS t dW t
rS t dt σS t dW t δ r S t dt
rS t dt σS t dW t
δr
where we denote by W t W t t (Brownian motion with drift
σ
under the real world measure P).
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Girsanov theorem
The process W is
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Girsanov theorem
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Girsanov theorem
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Girsanov theorem
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Girsanov theorem
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Girsanov theorem
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Girsanov theorem
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Girsanov theorem
QA EP IA Z
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Girsanov theorem
QA EP IA Z
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Girsanov theorem
QA EP IA Z
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Girsanov theorem
Girsanov theorem
W t W t θt
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Girsanov theorem
Girsanov theorem
W t W t θt
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Girsanov theorem
Girsanov theorem
W t W t θt
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Girsanov theorem
Girsanov theorem
W t W t θt
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agenda
1. Probabilitic framework
2. Martingales
3. Brownian Motion
4. Stochastic Integral
5. Itô formula and Stochastic Differential Equations
6. Valuation, arbitrage and martingale measures
7. Girsanov Theorem
8. Black-Scholes model
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Black-Scholes model
Black-Scholes’ formula
4
see later for the case with dividends
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Black-Scholes model
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Black-Scholes model
with
logS ~K r 12 σ 2 T t
d1 º
σ T t
Black-Scholes’ formula
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