An Extension of Levy's Theorem and Applications to

Financial Models Based on Futures Prices

Diego Jara
Department of Mathematical Sciences
Carnegie Mellon University

Ph. D. Thesis
Thesis Advisor: Professor David Heath

April, 2000

Abstract
In this work we introduce nancial models based on the evolution of prices of futures
contracts. We explore conditions under which these models are free of arbitrage and
complete, and therefore are useful for pricing contingent claims with payos that are
measurable with respect to the information provided by the future contracts. In cases
where the contracts are futures on interest rates, the models provide an alternative way of
studying the evolution of the term structure of interest rates, in a setup which is similar to
the HJM framework. One dierence, however, is the possibility of dening models where
the state of the futures curve is determined by a low-dimensional vector-valued process.
We study the theoretical feasibility of using future models for nancial modeling. In
particular, we explore whether information about the distribution of the quadratic variation of the future prices is enough to determine the distribution of the future prices.
This is equivalent to studying the possibility of extending Levy's theorem of characterization of Brownian Motion. In particular, we pose the question of whether two martingales
with dierent laws may have quadratic variations with equal laws. We give answers to
this question for two classes of continuous martingales: martingales with divergent and
absolutely continuous quadratic variation, and martingales which are weak solutions to
driftless Stochastic Dierential Equations in which the volatility depends only on the martingale itself. In the rst case, we conclude that martingales with dierent laws may have
quadratic variations with equal laws. In the second case, we nd that two elements of this
class of martingales that have quadratic variations with equal distributions must have the
same law, modulo re ection.

ACKNOWLEDGEMENTS

I want to thank my advisor, David Heath, for providing ideas and helping me explore
dierent areas that gave birth to this work. I also want to thank Steven Shreve for his
useful comments and discussions, Pierre Collin-Dufresne and Dev Joneja for serving in my
committee, and Marc Yor for his helpful suggestions.
I dedicate this work to my wife, Bala, and to my parents, Chacho and Magola.

Contents
1 Introduction
2 Futures Models
2.1
2.2
2.3
2.4

Description of the Futures Based Economy

No Arbitrage in Futures Models . . . . . . .
Completeness of Futures Models . . . . . .
Comments on the Use of Futures Models . .

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

.
.
.
.

3 Term Structure Models Based on Future Rates

3.1 Linear Volatilities for Futures Models . . . . . . . . . . . . . . . . . . . . .

3.2 Spot Rate Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2.1 Pure Discount Bonds, Forward Rates and Future Rates . . . . . .
3.2.2 Examples of Spot Rate Models Written as Future Rates Models .
3.2.3 Linear Future Rate Models . . . . . . . . . . . . . . . . . . . . . .
3.2.4 Pricing of Contingent Claims for Exponential Future Rate Models
3.2.5 Comparing Spot Rate, HJM and Future Rate Models . . . . . . .
3.3 Futures LIBOR models . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.3.1 Consistent Future LIBOR Models . . . . . . . . . . . . . . . . . .
3.3.2 Estimation of Parameters for Exponential Future LIBOR Models .

2
5

. 5
. 9
. 14
. 16
.
.
.
.
.
.
.
.
.
.

18
19
23
24
26
28
32
37
38
38
42

4 Martingales Characterized by the Distribution of the Quadratic Variation

50
4.1
4.2
4.3
4.4
4.5
4.6
4.7

Motivation and Preliminary Discussion . . . . . . . . . . . . .

Proof of Theorem 1 and Unique Martingales . . . . . . . . . .
Equivalent Stochastic Dierential Equations . . . . . . . . . .
Sets with Equal Distributions for Stopped Brownian Motion .
Proof of Theorem 2 . . . . . . . . . . . . . . . . . . . . . . . .
Applications to Financial Modeling . . . . . . . . . . . . . . .
Proofs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

.
.
.
.
.
.
.

.
.
.
.
.
.
.

.
.
.
.
.
.
.

.
.
.
.
.
.
.

.
.
.
.
.
.
.

.
.
.
.
.
.
.

.
.
.
.
.
.
.

.
.
.
.
.
.
.

51
53
57
61
63
68
70

Chapter 1

Introduction
The objective of this work is twofold. First, to establish a nancial model which allows
continuous trading on futures contracts on an arbitrary spot process. Second, to study
the possibility of extending Levy's Theorem of characterization of Brownian Motion to a
more general class of martingales.
These two objectives are not independent. It will be seen that for pricing purposes,
the determination of a model based on futures prices depends only on the specication
of a \volatility" process. In practice, however, it is reasonable to assume that we are
given information about the quadratic (cross) variation of future prices. Therefore, from
a modeling perspective it is important to decide whether this information is enough to
determine the distribution of futures prices. We recall that Levy's Theorem of characterization of Brownian Motion states that if a continuous martingale N yields the same
quadratic variation as Brownian Motion, then N is a Brownian Motion. Therefore, the
previous lines suggest studying the possibility of extending Levy's Theorem to classes of
martingales larger than the class of Brownian Motions.
The denition of futures-based models is motivated by the increasing demand experienced in the nancial world during the past decades for probability models that provide
a balance between their capability to:
1. Produce prices for liquid assets that are close to the market prices.
2. Provide simple implementations that allow ecient pricing of contracts.
Following the ideas introduced by Black and Scholes (1973) and Merton (1973), these
models produce prices under the assumption that there are no arbitrage opportunities.
Under completeness, prices of assets coincide with the prices of their replicating portfolios.
Mathematically, the futures models introduced here are very similar to standard
continuous-time nancial models found in the literature. However, futures models allow term-structure modeling; i.e., at every time we are given information of a whole curve,
as opposed to a (spot) price. This will aid replicating market prices (item 1 above), since
current futures prices are used as a starting point, and not as a calibrating target. The
2

tradable securities are interpreted as future contracts with dierent maturities on an underlying spot process such as the price of a share of stock, a bond, a commodity, or the
value of an interest rate. Initially the underlying spot process is left unspecied. In specic situations, we may dene a low dimensional process that contains the information
necessary to derive the state of the futures curve. This will allow PDE or recombining
tree methods to be used for pricing purposes. Brie y, these particular models preserve
the theoretical advantages of the HJM framework, and allow the use of standard pricing
techniques (item 2 above). Musiela and Rutkowski (1998) have studied the evolution of
nitely many futures contracts that trade in discrete time. To the best of our knowledge,
ours is the rst eort to provide a nancial model in continuous time where the tradable
assets are interpreted as general future contracts.
The implementation of futures models raises the question of whether the distribution
of the quadratic variation of futures prices is enough to determine the model that produced
those prices. Mathematically, let M be a class of continuous martingales starting at 0. Let
M; N 2 M be given, and assume that hM i and hN i have the same law. We are interested
in comparing the laws of M and N . In particular, we search for classes M for which we
can conclude that M and N have the same law. Levy's theorem states that Brownian
Motion is characterized by its quadratic variation. This is extended to the case in which
M is the class of Gaussian continuous martingales. To study this question is to analyze
the possibility of extending Levy's theorem in a particular direction. In this work we give
answers for two classes of martingales:
1: M1 = fM : M is a continuous martingale, such that M0 = 0;
hM i1 = 1; hM i is a.s. absolutely continuous and dtd hM it > 0 a:s:g
Z

2: M2 = fM : M is a continuous martingale, such that Mt =

g(Ms )dWs
0
for a Brownian Motion W and a measurable function g whose zeroes
1
coincide with the set of points where is not locally square integrable.g
g
It will be proved that Levy's theorem does not accept an extension in the case of M1 :
Theorem 1. For every martingale M 2 M1 that is not Gaussian, there exists N 2 M1
with dierent law than M , such that hM i =d hN i.
This result suggests restricting the class of martingales. Unfortunately, it does not
provide information on how dierent the laws of M and N are. In M2 , Levy's theorem
has an extension, modulo re ection of the martingale. More precisely,

Theorem 2.

Let M; N

2 M2 be given. If hM i =d hN i, then M =d N or M =d N .

In Chapter 2 we introduce futures models in a continuous time setup where the basic
securities are future contracts and a money market account. We dene trading strategies
3

for these models, and give denitions of arbitrage opportunities and completeness of the
markets. We give conditions under which markets are free of arbitrage and complete.
In Chapter 3, examples of future models are exhibited. First, we study futures models
with unspecied underlying spot process and volatilities that are linear functions of futures
prices. Second, models of future interest rates will be studied. Two examples of such
models are given: futures contracts that settle to the spot interest rate, and to 3-month
LIBOR. We discuss various practical issues of these models, such as consistency and pricing
of xed income contracts.
In Chapter 4 we prove Theorems 1 and 2, and provide specic applications to nancial
modeling.

Chapter 2

Futures Models
In this chapter we exhibit a continuous-time nancial model with nite horizon, where
basic securities are future contracts on an underlying spot process. We consider such contracts for innitely many maturity dates, but allow trading strategies to take positions on
nitely many of these contracts. This setup is very similar to most widely used models
in mathematical nance. Dierent specications of such economies have led to dierent
versions of the First and Second Fundamental Theorems of Arbitrage Pricing, which aim
at characterizing absence of arbitrage and completeness of the models, respectively. We
exhibit versions of these theorems for futures models. More precisely, we investigate relationships between existence of an equivalent martingale measure and absence of arbitrage,
and the uniqueness of an equivalent martingale measure and completeness of the model
in sections 2.2 and 2.3.
In the rst section we describe securities and dene trading strategies in the model. In
the second section we dene arbitrage in the economy, and relate the absence of arbitrage
in a futures model to the existence of a measure equivalent to the original measure under
which basic securities are (local) martingales. In the third section we dene completeness
of futures models, and link completeness of a model with uniqueness of an equivalent
(local) martingale measure. In the fourth section we give comments about the use of
futures models. First, we talk about the use of futures models for pricing and hedging of
nancial contracts. Second, we pose questions about sucient information to establish a
futures model. These questions are the subject of study of the fourth chapter.

2.1 Description of the Futures Based Economy

Let  > 0 be a given xed nite horizon. We consider an economy with continuous-time
trading on a xed interval [0;  ]. We assume the existence of an underlying spot process
(which can be interpreted as the price of a nancial asset) on which standard futures
contracts are traded for every maturity prior to  . We also assume the existence of a spot
interest rate process. The basic securities of the economy are a money market account,
5

and \futures portfolios"; a futures portfolio consists of one futures contract, for which
the continuous stream of cash ows originated by the marking to market activities are
immediately invested in the money market account. The initial value of these portfolios
is 0, since entering a futures contract requires no initial exchange of money.
More precisely, let (
; F ; P) be a complete probability space on which is given an
n dimensional standard Brownian Motion fW(t) = (W1 (t); : : : ; Wn (t)); 0  t   g. Let
fF (t); 0  t   g be the augmented, right-continuous complete ltration generated by
W. That is, for t 2 [0;  ],

F (t) = fF W (t) [ Ng;

where N is the set of P-null subsets of F W ( ). We assume F = F .
For T 2 [0;  ]; t 2 [0; T ], let F (t; T ) denote the futures price at date t of a contract

that settles to the value of the spot process at date T . It is convenient to specify F (t; T ) =
F (T; T ), for 0  T  t   . Denote by r(t) the spot interest rate at date t 2 [0;  ]. Assume
that futures prices and the spot interest rate satisfy

M1.

For 0  t  T

 ,

F (t; T ) = F (0; T ) +

Z t

where

(s; T )ds +

Z t

(s; T )dW(s)0 ;

(2.1)

1. F (0;
) is a measurable function from ([0;  ]; B([0;  ])) to (IR; B(IR)) such that
Z 

jF (0; s)jds < 1:

0
2. For T 2 [0;  ], (
; T ) is an adapted process such that
(t; T ) = 0; 0  T
Z 

 t  ; and
j(t; T )jdt < 1 a.s.; 0  T  :

0
3. For T 2 [0;  ],  (
; T ) = (1 (
; T ); : : : ; n (
; T )) is an adapted process such that

(t; T ) = (0; : : : ; 0); 0  T  t  ; and

Z 
k(t; T )k2 dt < 1 a.s.; 0  T  :

M2.

For t 2 [0;  ],

r(t) = r0 +
where

Z t

a(s)ds +

Z t

b(s)dW(s)0 ;

1. r(0) = r0 is a given initial spot rate.

2. For T 2 [0;  ], a is an adapted process such that
Z 

3. For T

(2.2)

2 [0;  ], b = (b1; : : : ; bn ) is an adapted process such that

Z 

Denition 1.

ja(t)jdt < 1 a:s:

0
A Futures Model

kb(t)k2 dt < 1 a:s:

M is a collection of

1. Future curves F that satisfy [M1].

2. A spot rate process r that satises [M2].

T  [0;  ], the maturities of tradable futures contracts. We assume (0;  ) \ T 6= ?.

4. A Final Trading Date , T <  . If T is nite, T  min(T \ (0;  )). Otherwise, we
require that T \ (T;  ] contains at least n elements.
Elements of a futures model M = fF; r; T ; T g will be identied by F M ; rM ; T M ; T M .
3.

Remark 2.1.1. Item 3 is used to distinguish models that allow trading on dierent futures
contracts. Generally, nancial models specify a nite set of tradable assets. Futures
models may specify an innite number of such assets. However, trading will be allowed in
only nitely many assets (Denition 2 below).
Remark 2.1.2. The underlying process of the futures prices may not be independent of
the spot interest rate. In such an event, further restrictions should be imposed on these
processes to ensure consistency of the model. This aspect will be considered in particular
examples of futures models based on interest rates, which will be studied in Chapter 3.
For the remainder of this chapter, we assume that futures models contain spot rate and
futures prices consistent with each other.

Trading in Futures Models.

We assume no transaction costs, and no constraints in

liquidity or short-selling of securities. Trading is allowed in two basic securities.

MM.

Money Market Account. The value at time t 2 [0;  ] of a unit of the money market
account is
Z t

B (t) = exp

0
By (2.2), 0 < B (T ) < 1 a.s. for all T 2 [0;  ].
7

r(s)ds :

(2.3)

FP.

Futures Portfolios. For a given T 2 [0;  ], the futures portfolio with maturity T
contains one futures contract with maturity T , and a money market account on which
gains (losses) from the futures contract will automatically be deposited. Brie y,
the margin account of the futures contract is a money market account. After the
expiration of the futures contract, the only activity of this portfolio is derived from
the money market account. The price Q(t; T ) at date t 2 [0;  ] of one unit of this
portfolio satises

Q(t; T ) =

Z t

dF (s; T ) +

Z t

Q(s; T )
dB (s)
0 BZ (s)

0
= F (t; T ) F (0; T ) +

Using It^o's rule, this is written

Z

(2.4)

Q(s; T )r(s)ds:

t (s; T )
t  (s; T )
Q(t; T )
=
ds +
dW(s)0 :
B (t )
0 B (s)
0 B (s)

Denition 2.

A Trading Strategy in a futures model M is a pair  = (R; ) of maturities

and positions such that
1. R = (T0 ; T1 ; : : : ; TM ) 2 (T M )M +1 , where 0 = T0 < T1 < : : : < TM  T M , for a
given M 2 IN .
2. = f (t) = ( 0 (t); 1 (t); : : : ; M (t)); 0  t   g is an adapted process such that
Z  X
M


i(t)(t; Ti ) dt


0 i=1

Z  X
M

i (t)

< 1 a.s., where 1 = (1; 1; : : : ; 1) 2 IRM :

(t; Ti ) dt < 1 a.s.

i=1

The Wealth Process of a Trading Strategy  = (R; ) on a futures model M is denoted

fV  (t); 0  t  T Mg and satises

V  (t) =

0 (t)B (t) +

M
X
i=1

i (t)Q(t; Ti ):

A trading strategy  on a futures model M is Admissible if there exists a 2 IR such that

V  (t) > a a.s. for every t 2 [0; T M ].
A trading strategy  = (R; ) is Self-Financing if

V  (t) = V  (0) +

M Z t
X
i=1

i (s)dF (s; Ti ) +
8

Z t

V  (s)
dB (s) 8t 2 [0; T M ]:
B
(
s
)
0

Remark 2.1.3. A self-nancing trading strategy satises (for t 2 [0; T M ])

V  (t) = V  (0) +

M Z t
X
i=1 0
M Z t
X

i (s)dQ(s; Ti ) +

Z t

0 (s)dB (s); and

Z

M
t
X
V  (t)
(s; Ti )
(s; Ti) dW(s)0 :

= V (0) +
i (s)
ds +
i (s)
B (t)
B (s)
B (s)
i=1 0
i=1 0

Remark 2.1.4. The concept of admissible strategy was introduced in Harrison and Pliska
(1981). It is common practice to restrict trading strategies in this way to exclude situations
such as suicide or doubling strategies. From a practical perspective, this restriction
is sensible, since unbounded temporary losses that eventually yield sure prots are not
realistically sustainable.
Remark 2.1.5. The previous denitions allow entering a futures contract at any time. In
fact, x T 2 T M , and t < T . Dene the self-nancing trading strategy  = (R; ) with
M = 1, R = (T ) and
(

0 (s) =
(

1 (s) =

0;

Q(t;T )
B (t) ;

s<t
s>t

0; s < t
1; s > t

There is no activity for this portfolio before date t. At date t, it costs nothing to enter
the strategy. For s 2 [t; T ], the wealth process satises
Z s
B (s )

+ Q(s; T ) = F (s; T ) F (t; T ) + V  (u)r(u)du:
V (s) = Q(t; T )
B (t)
t
With this portfolio one eectively buys at date t the futures contract with maturity T .

2.2 No Arbitrage in Futures Models

In this section we dene arbitrage in a futures models, and exhibit conditions under which
a futures model will be free of arbitrage.
Denition 3. A futures model M admits Arbitrage if there exists an admissible selfnancing trading strategy  = (R; ) on M that satises

V  (0) = 0
9t 2 [0; T M ] V  (t)  0 a.s.; P[V  (t) > 0] > 0:
 In suicide strategies, the wealth process starts at 1 dollar, and ends at 0 for sure. However, unlimited
gains must be sustained in between. Reversing signs, these strategies bring sure prots upon sustaining
unbounded losses. See, for example, Harrison and Pliska (1981).
9

We are interested in working with models that are free of arbitrage. To this end we give
conditions that are necessary and sucient for the absence of arbitrage.
Denition 4. An Equivalent (Local) Martingale Measure (henceforth EMM (ELMM))
~ on (
; FT M ) equivalent to P (i.e., for
for a futures model M is a measure P
~
A 2 FT M ; P(A) = 0 $ P(A) = 0) such that
n
o
8T 2 T M QB(t;(tT) ) ; Ft : 0  t  T M is a P~ -(local) martingale :
The name Risk-Neutral Measure will be used to refer to an equivalent martingale measure.
Lemma 2.2.1. Let M be a given futures model. The existence of an ELMM for M
is equivalent to the existence of an adapted process = f( 1 (t); : : : ; n (t)); 0  t  T M g,
such that
1. For T 2 T M , (t; T )+  (t; T ) (t)0 = 0 a.s. on ([0; T M ] 
; B([0; T M ]) F ;   P).
R M
2. P[ 0T k (t)k2 dt < 1] = 1.
R M
R M
3. IE [expf 0T (t)dW(t)0 21 0T k (t)k2 dtg] = 1.
~ is an ELMM for M. For t  T M , call Zt = ddPP~ jFt the
Proof. Necessity. Assume P
~ with respect to P with underlying sigma-algebra Ft .
Radon-Nykodym derivative of P
M
Then fZt ; Ft ; 0  t  T g is a strictly positive martingale under P,y and hence it is
continuous.
Therefore, there exists a continuous P local martingale L such that
1
Z (t) = expfLt
hLi g 8t 2 [0; T M ];
2 t
~ t = Wt hW; Lit ; 0  t  T M g is a P
~ Brownian Motion (this is a form of
and fW
Girsanov's theorem; Revuz and Yor (1999), proposition 8.1.7 and theorem 8.1.12). The
Martingale Representation Theorem (Revuz and Yor (1999), theorem 5.3.5) implies the
existence of an adapted, locally square integrable process f (t); 0  t  T M g taking
values in (IRn ; B(IRn)) such that

L(t) =

Z t

(s)dW(s)0 :

0
We need only show that satises condition 1. For this, x T 2 T M and consider
a sequence of stopping times fTk ; k 2 IN g such that Tk " T M a.s., and QB(t(^t^TTkk;T) ) is a
P~ martingale. From the expression
Z t
Z t
1
1
Q(t; T )
~ (s)0 +
=

(s; T )dW
((s; T ) + (s; T ) (s)0 )ds;
B (t)
B
(
s
)
B
(
s
)
0
0
yBy equivalence of P
~ and P, Z is a.s. positive. We may assume Z to be in fact a strictly positive
version.
10

we get (t ^ Tk ; T ) + ni=1 i (t ^ Tk ; T ) i (t ^ Tk ) = 0 a.s. for k 2 IN . By allowing k ! 1

in the previous expression, we get the desired conclusion.
Suciency. For t 2 [0; T M ] dene

nZ t

Z (t) = exp

Z t
o
(s)dW(s)0 21 k (s)k2 ds :

0
0
By condition 3, the positive, continuous local martingale fZt ; Ft ; 0
~ by
martingale under P. Dene P
P~ [A] = IE [1A ZT ] 8A 2 F :
By Girsanov's Theorem,
~ (t) = W(t)
fW

 t  T Mg is a

Z t

(s)ds; Ft ; 0  t  T Mg
0
~ . We rewrite (2.4) using W
~ and It^o's rule,
is an n dimensional Brownian Motion under P
and obtain, for (t; T ) 2 [0; T M ]  T M ,
Z

t 1
t 1
Q(t; T )
~ (s)0 :
=
dF (s; T ) =
(s; T )dW
B (t)
0 B (s)
0 B (s)
)
Therefore, QB(t;T
(t) is a local martingale under P~ ; i.e., P~ is an ELMM for M.
Theorem 2.2.1. Consider a futures model M. If there exists an ELMM for M, then the
model does not admit arbitrage.
~ be an ELMM for M. Consider an arbitrary admissible, self-nancing trading
Proof. Let P
strategy  = (R; ). From the proof of Theorem 2.2.1,
Z

M
t 1 X
V  (t)
~ (s)0 ;
=
i (s) (s; Ti )dW
B (t)
0 B (s) i=1

~ is a Brownian Motion under P

~ . By admissibility, and [M1], f VB((tt)) ; t 2 [0; T M ]g
where W
~ -local martingale bounded below, and hence it is a supermartingale. Therefore
is a P
h V  (t) i
IE
 V  (0) = 0 8t 2 [0; T M ]:
B (t)
Therefore, there are no arbitrage opportunities in M.
Remark 2.2.1. In general arbitrage-free nancial models, futures prices are martingales
under equivalent martingale measures. In analogy with the HJM framework, we see that
the no arbitrage condition in the futures model is necessary for the absence of drift of
(2.1) under a risk neutral measure.

11

A converse of lemma 2.2.1 requires stronger arguments, and dierent denitions of

arbitrage. Dierent versions of such a converse are simultaneously called the First Fundamental Theorem of Asset Pricing (FFTAP). They usually state that there are no arbitrage
opportunities if and only if there is an equivalent (local) martingale measure. Dierent
assumptions and denitions give rise to dierent statements. Dalang, Morton, and Willinger (1990) proved the FFTAP in the discrete-time case for general stochastic processes,
without a requirement of admissibility in trading strategies; they use EMM instead of
ELMM. Delbaen and Schachermayer (1994) proved that in the case of a nite number of
bounded semimartingales, no arbitrage implies the existence of an EMM. In their setup,
an arbitrage is produced by admissible processes that produce bounded terminal payos.
More generally they proved that in the case of locally bounded semimartingales, the assumption of NFLVR (No Free Lunch With Vanishing Risk) implies the existence of an
ELMM. NFLVR is dened as the absence of a sequence of admissible self-nancing trading
strategies with terminal payos converging to a bounded, nonnegative, not identically zero
terminal payo. Finally, Delbaen and Schachermayer (1997) showed that in the case of
general semimartingales, there is NFLVR if and only if there exists an equivalent sigmamartingale measure. They dene a sigma-martingale to be a general martingale transform;
i.e., a stochastic martingale integral, where the integrand is required to be predictable and
integrable with respect to the martingale.
In the present setup there are potentially innitely many continuous semimartingales,
which widens the possibility of creating arbitrage strategies. The no arbitrage condition
dened here is weaker than the NFLVR condition. Therefore, we cannot obtain an exact
converse for the FFTAP. However, we give a necessary condition for no arbitrage to hold
in the case of an innite denumerable set of tradable securities. This condition is very
close to the condition equivalent to the existence of an ELMM.

Theorem 2.2.2.

Let M be a futures model which does

T M at most an countably innite. Then there exists
f( 1 (t); : : : ; n(t)); Ft ; 0  t  T Mg, such that for T 2 T M,
(t; T ) +  (t; T ) (t)0 = 0
a.s. on ([0; T M ] 
; B([0; T M ])  F ;   P).

not admit arbitrage, with

an adapted process =

(2.5)

We need the following lemma.

Lemma 2.2.2.

Let M be a futures model with T M an innite denumerable set. Assume

that for every collection R = (T1 ; : : : ; Tn+1 ) of n + 1 elements of T M there exists an
adapted process = f( 1 (t); : : : ; n (t)); Ft ; 0  t   g, that satises (2.5) for T 2 R.
Then there exists an adapted process = f( 1 (t); : : : ; n (t)); Ft ; 0  t  T M g, that satises (2.5) for T 2 T M .
Proof. We assume n = 1, the other cases being similar. Assume the conclusion is false.

12

Case I.

There exist T0 2 T M and A 2 B([0; T1 ])  F with positive   P measure on

which (t; T0 ) = 0 and (t; T0 ) 6= 0. In this case there is no process for which (2.5)
is satised for T0 .
Case II. Case I does not hold, and there exist T1 ; T2 2 T M with 0  T1 
T2 and a set A 2 B([0; T1 ])  F with positive   P measure on which
(t; T2 )(t; T1 ) 6= (t; T1 )(t; T2 ). Then there is no process for which (2.5) is satised for T1 and T2 .
Case III. Cases I and II do not hold. For T 2 T M dene

AT = f(t; !) 2 [0; T M ] 
: (t; T ) 6= 0g:
By ruling out cases I and II, the following process is well dened on [0; T M ] 
:
(

(t; !) =

0;

(t;T )
(t;T ) ;

if (t; !) 2 AT for some T

if (t; w) 2= [T 2T M AT :

2TM

By denumerability of T M , is adapted, and it satises (2.5). This process contradicts our initial assumption. Therefore, this case is not possible.
It follows that case I or II holds. In either case, there exist T1 ; T2 2 T M for which (2.5)
does not hold.
Proof of Theorem 2.2.2. Assume there is no process which satises the conditions of the
lemma. By Lemma 2.2.2, there exist T1 < T2 < : : : < Tn+1 in T M for which there is no process that satises (2.5) for Tk ; k = 1; : : : ; n + 1. Dene i (s) = (i (s; T1 ); : : : i (s; Tn+1 )),
i = 1; : : : ; n. Call G the linear subspace in IRn+1 generated by the vectors 1 ; : : : ; n .
For s 2 [0; T M ] call (s) = ((s; T1 ); : : : (s; Tn+1 )), and dene
(
(s)
(s) = PrG? k(t)k ; if (t) 6= 0
(2.6)
0;
if (t) = 0

The initial assumption implies the existence of A 2 B([0; T M ]) FT M with positive   P
measure such that (s)(s)0 > 0 on A. Set
0 (t) =

Z t

(s)0 ds
((t) (s))
B (s)

nX
+1 Z t
i=1

(i (t)

i (s)) B(s;(sT)i ) dW(s)0 :

By construction,  = ((T1 ; : : : ; Tn+1 ); = ( 0 ; )) is an admissible, self-nancing trading

strategy. In fact, V  (s)  0 8s 2 [0; T M ]. Now, f! 2
: ft : (t; !) 2 Ag > 0g has
positive P measure. Therefore, P[V  (T M )] > 0. This is an arbitrage opportunity.
13

2.3 Completeness of Futures Models

We call a futures model M standard if it does not admit arbitrage, T M is at most innitely
denumerable, and the process of lemma 2.2.2 satises conditions 2 and 3 of theorem
2.2.1. By Theorem 2.2.1, there exists an ELMM for every standard futures model M.
~ M . We denote by W
~ M the
We choose arbitrarily one such measure, and denote it by P
~ M obtained in the proof of necessity of Theorem 2.2.1.
Brownian Motion under P
Denition 5. A standard futures model M is Complete if for every T 2 [0; T M ] and
FT measurable random variable X that is bounded below and satises
h
i
~ M X < 1;
x0 = IE
B (T )
there is an admissible, self-nancing trading strategy  = (R; ) on M such that
V  (0) = x0 and V  (T ) = X a.s.
Theorem 2.3.1. Let M be a given standard futures model, with T M nite. The following
statements are equivalent:
1. M is complete.
2. There exists a unique Equivalent Local Martingale Measure for M.

3. There exists a unique (in L2 ) adapted process = f( 1 (t); : : : ; n (t)); Ft ; 0  t 

T M g that satises conditions 1,2 and 3 of Theorem 2.2.1.
Proof. The equivalence of 2 and 3 is a consequence of Girsanov's theorem and the proof
of Theorem 2.2.1.

1 ) 2. Assume P1 is an ELMM for M. Let A 2 FT M be given. Consider the FT M measurable random variables X1 = 1A B (T M ) and X2 = 1Ac B (T M ). For j = 1; 2, let
(j ) = (R(j ) ; (j ) ) be an admissible, self-nancing trading strategy for M that replicates
Xj . Then
1A
1Ac

P~ M[A] =
P~ M [Ac] =

Z TM

Z TM

1 MX (1)
(s) (s; Ti )dW1 (s)0
B (s) i=1 i
(1)

1 MX (2)
(s) (s; Ti )dW1 (s)0 ;
B (s) i=1 i
(2)

0
where W1 is a Brownian Motion under P1 (by Theorem 2.2.1). The right hand sides of
the previous equations are P1 -local martingales bounded below (by admissibility of (j ) ),
and are therefore supermartingales that start at 0. It follows that
IE1 [1A P~ M [A]]  0
IE1 [1Ac 1 + P~ M [A]]  0:
14

~ M (A). Since A 2 FT M was arbitrary, we conclude that P1 = P

~ M.
Therefore, P1 (A) = P
M
~ is the unique equivalent local martingale measure for M.
That is, P
3 ) 1. We write T M = f1 ; : : : ; J g. Let X be an FT -measurable random variable
~ M [ BX(T ) ] = x < 1.
bounded below, for T  T M , such that IE
~ M -martingale Nt = IE
~ M [ BX(T ) jFt ]. This martingale is bounded below.
Consider the P
By a martingale representation theorem (Karatzas and Shreve (1998), Lemma 6.7), there
exists a square-integrable, adapted process  such that

Nt = x +

Z t

(s)dW~ M (s)0; t 2 [0; T ]:

0
Since T M is nite and f (s; 1 ); : : : ;  (s; J )g generates IRn a.s., there exists an adapted
process = ( 1 (s); : : : ; J (s)) such that
J
X
i=1

i(s) (s; i ) = B (s)(s) a.s.; s 2 [0; T ]; i 2 T M :

Set
0 (t) = x

Z t

J Z t
X

(s)0 ds
( (t) (s))
B (s)

i=1

( i (t) i (s))

(s; i ) dW(s)0 :
B (s)

Then  = (T M ; ) is an admissible, self-nancing, replicating strategy for X .

Theorem 2.3.2. Let M = fF M; rM; T M; T Mg be a given standard futures model.
Then M is complete if and only if there exists R  T M such that R is nite, min R  T M ,
and MR = fF M ; rM ; R; T M g is a complete futures model.
Proof. We use a contradiction argument to prove the nontrivial direction. Assume that M
is complete, and that for every R which is a nite subset of T M and for which min R >
T M , MR is not complete. Then for every such R, there exists AR 2 B([0; T M ]) with
positive Lebesgue measure, such that f (t; R) : R 2 Rg does not generate IRn , for t 2 AR .
Fix arbitrarily one such R0 = (R1 ; : : : ; RK ). Let fv(s); 0  s  T M g be an adapted
n-dimensional process such that for t 2 AR0 , v(t) is not in the linear span of f (t; R) :
R 2 Rg. Without loss of generality, assume kv(t)k = 1 for t  T M .
Let f be a smooth function in R such that f and f 00 are bounded below, and f 0 never
vanishes (for example, f (x) = arctan(x)). Consider the processes dened at time t by
Z t

v(s)dW~ (s)
0
Z
Z t
1 t 00
~ (s):
Y (t) = f (X (t))
f (X (s))ds = f (0) + f 0(X (s))v(s)dW
2 0
0

X (t) =

15

Then the FT M -measurable variable Y (T M ) is bounded below and has nite expected value
(since Y is a martingale). By completeness of the model, we may nd an admissible, selfnancing strategy  = ( ; S = (S1 ; : : : ; Sm )) such that V  (T M ) = Y (T M ). Therefore,
we have (Bt)(t)(t) = f 0(X (t))v(t) for t  T M , where  (t) is an m  n matrix with i-th row
(t; Si), and (t) = ( 1(t); : : : ; m(t)). However, this is impossible for t 2 AR[S , by
construction of v, and by observing that AR[S  AR . The result follows.
Remark 2.3.1. From the proof of Theorem 2.3.1, a model is complete if and only if all
claims with integrable terminal payo bounded below can be replicated with a martingalegenerating trading strategy on a xed nite set of future contracts. If a futures model
M satises the conditions of Theorem 2.3.1, then pricing of claims that pay X at date
T < T M is done through arbitrage arguments. The fair price of the claim at date t < T
is the price of its replicating portfolio, which is

~ [B (t)
V  (t) = IE

X
jF ];
B (T ) t

(2.7)

~ [
] denotes expectation under the equivalent local martingale measure.

where IE
Remark 2.3.2. A corollary of Theorems 2.3.1 and 2.3.2 is that completeness implies uniqueness of equivalent local martingale measures for standard futures models for which T M is
countably innite. For the converse of this corollary, we need uniqueness of the ELMM for
a nite subset of T M . In fact, consider a futures model M with n = 1, T M = (T1 ; T2 ; : : : ),
and T M < T1 . Assume r  0 and
(t; T ) = 0; t  T M ; T 2 T M
(t; Ti ) = 1[(1 2 i+1 )T M ;(1 2 i )T M ] (t) t 2 [0; T M ]; i 2 IN:
Then the wealth process of a trading strategy  = (R; ) is

V  (t) = B (t)

(1 2 i )T M i (s)
dW (s):
i+1 )T M B (s)
Ti 2R (1 2
X Z

Given the niteness of assets allowed in trading strategies, it becomes clear that not every
terminal payo is replicable. For example, there is no replicating portfolio for the variable
W (T M ). Therefore, M is a standard model for which there is a unique ELMM, but M
is not complete.

2.4 Comments on the Use of Futures Models

Futures models oer a method to value and hedge contingent claims that are adapted
to the given ltration, using no arbitrage arguments. For this purpose, we may assume
that (t; T ) = 0 for (t; T ) 2 [0;  ]2 . Lemma 2.2.1 and Theorem 2.2.1 guarantee that the
16

resulting model is free of arbitrage. This oers no loss of generality. In fact, from the
sensible assumption that a futures model is standard, we establish the existence of an
ELMM under which futures prices will be driftless. The assumption on  implicitly states
that we originally start from this measure.
Assume given a complete futures model. Consider a claim with integrable payo X at
date T which is bounded below. Its price at date t < T is given by (2.7). Completeness
of the model guarantees the existence of a replicating portfolio for X , from where hedging
of the claim follows. This is extended to claims that have cash ows prior to expiration,
or early exercise features.
If the model is not complete, minimal super-hedging techniques may be used to derive
minimal fair values for claims. There are several works in this direction. See for example,
El Karoui and Quenez (1995), and Cvitanic and Karatzas (1993).
Under the assumption that futures prices are driftless under P, we need only specify 
to determine the stochastic process followed by them. In practice, volatilities are usually
derived statistically from market movements, or obtained to t current market prices of
derivatives. The information used in the former is a realized path of the quadratic cross
variation of the process. In the latter the information used involves partial information
of the distribution of the quadratic (cross) variation process. It is natural to ask whether
this is enough information to determine the distribution of the futures prices processes.
Historical market movements are taken under the physical measure. Current prices provide
information under the risk-neutral measure. Both give information about quadratic (cross)
variations. However, quadratic (cross) variations remain unchanged when going from one
measure to the other. Therefore, to determine the futures prices processes from market
data for pricing and hedging purposes, the measure used to obtain the information is
irrelevant.
Motivated by the previous remarks, we pose the following questions. Consider a continuous martingale M . Assume given the distribution of the quadratic (cross)
variation of the martingale, hM i. Is it possible to uniquely determine the distribution
of the martingale?
Now assume that we restrict to the class of one dimensional martingales that satisfy
the equation

dMt = g(Mt )dWt ; M0 = 0;

where W is Brownian Motion and g is a Borel measurable function for which weak existence
and uniqueness in the sense of probability law hold for the previous equation. Given the
distribution of the quadratic variation of one such martingale, is it possible to uniquely
determine the distribution of the martingale? In other words, is it possible to nd two
martingales within this class with dierent law that produce quadratic variations with the
same law?
These questions are addressed in Chapter 4.
17

Chapter 3

Term Structure Models Based on

Future Rates
Futures models are determined by futures prices processes, a spot rate process, a set
of tradable maturities and a nal trading date. If we isolate the spot rate process, we
derive a term structure model from the spot rate perspective. In this chapter we take the
alternative approach. We assume that futures contracts settle to spot rates. The eect is
that the spot rate process is not independent of the futures prices. If we assume futures
models to be consistent, then we derive term-structure models based on the evolution of
future rate curves. Theoretically, this viewpoint is equivalent to the HJM framework, in
which the evolution of the forward curve is studied. However, in some particular cases,
this perspective gives practical advantages. More precisely, for particular examples of
volatilities, the state of the model is given by a vector-valued process with equal dimension
as the underlying random shocks.
In the rst section we give examples of Gaussian and Lognormal futures models. We
study the particular case in which volatilities are sums of exponential functions. This
case was studied in Heath and Jara (1999), and it is shown that an n-dimensional process
contains the information necessary to derive the state of the futures curve, where n is the
dimension of the underlying Brownian Motion. In the second section we study futures
models where the futures contracts settle to the continuously compounded spot rate. We
give examples of widely known spot rate models written in terms of future rate models.
We study the case of exponential volatilities, for which we show the feasibility of using
PDE methods or recombining trees for pricing xed income contingent claims. In the third
section we exhibit a model for futures prices that settle to 3-month LIBOR. We explore
requirements that need to be satised by the spot rate process to obtain a consistent futures
model. We study the case of exponential volatilities, and propose methods for determining
the parameters of the model from historical observations of Eurodollar Future contracts.

18

3.1 Linear Volatilities for Futures Models

In this section we exhibit special ways of specifying futures models. In particular, we will
consider futures prices volatilities that are linear functions of the futures prices. Following
the discussion of section 2.4, we assume that drifts are null, and therefore we stand initially
in a risk-neutral measure. We also study a particular form of deterministic  , where each
component is written as a sum of functions that decay exponentially with time to maturity.
These types of volatilities were studied in the HJM framework by Cheyette (1993) and by
Ritchken and Sankarasubramanian (1993).
A futures model M will be called linear if T M contains at least n elements and is at
most countable, and the futures curve satises
dt F (t; T ) = (K1 F (t; T ) + K2 )(t; T )dW(t)0 ;
(3.1)
where  is a deterministic process that satises condition 3 of [M1], and
(K1 ; K2 ) 2 (f1g  IR) [ f(0; 1)g. That is, a linear futures model species that  = 0
and  (t; T ) = (K1 F (t; T ) + K2 (T ))(t; T ). A linear futures model is standard.
If K1 = 0, future curves are driftless Gaussian processes, with covariance and crosscovariance (for t  T1  T2   , t1  t2  T   )
Cov[F (t; T1 ); F (t; T2 )] =
Cov[F (t1 ; T ); F (t2 ; T )] =
If K1 = 1,

Z t

Z t

0
Z
0

(s; T1 )(s; T2 )0 ds

t1

k(s; T )k2 ds
Z

1 t
F (t; T ) = (F (0; T ) + K2 ) exp
k(s; T )k2 ds K2: (3.2)
2
0
0
M
For a linear futures model M and t 2 [0; T ], let VtM be the linear span of
f(t; T ) : T 2 T Mg, if K1 = 0, and the linear span of f(t; T ) : T 2 T M; F (0; T ) 6= K2g
if K1 = 1.
Proposition 3.1.1. A linear futures model M is complete if and only if there exists R,
a nite
subset of T M , for which the futures model M = fF M ; rM ; R; T M g satises

VtM = IRn a.e on [0; T M ].
Proof. It is an immediate consequence of Theorem 2.3.1, considering that  = 0, and

(s; T )dW(s)0

8
>
(t; T );
>
<

K1 = 0

(t; T ) = > (F (0; T) + K2 )


R
R
>
:
exp 0t (s; T )dW(s)0 21 0t k(s; T )k2 ds (t; T ); K1 = 1:
 One can specify K2 to be a function of T

without adding considerable changes to the present analysis.

19

Given a linear futures model, we can obtain dierent deterministic processes

yield the same model, from a distributional perspective.

^ that

Proposition 3.1.2.

Let ; ^ be deterministic processes that satisfy condition 3 of [M1].

Let F; F^ be the respective solutions of (3.1) with the same initial futures curve. For
T1  : : :  Tm 2 [0;  ], the m-dimensional processes

f(F (t; T1 ); : : : ; F (t; Tm )); 0  t  T1 g and f(F^ (t; T1 ); : : : ; F^ (t; Tm )); 0  t  T1 g

have the same law if and only if
Z t

Z t

^(s; Ti)^(s; Tj )0 ds 8t 2 [0; T1 ]; i; j = 1; : : : ; m:

0
0
Proof. Let (T1 ; : : : ; Tm ) 2 [0;  ]m be given, with T1  T2  : : :  Tm . Then
(s; Ti )(s; Tj )0ds =

f(F (t; T1 ); : : : ; F (t; Tm )) : 0  t  T1 g and f(F^ (t; T1 ); : : : ; F^ (t; Tm )) : 0  t  T1 g

have the same law if and only if the m-dimensional Gaussian processes
nZ t

n Z t

(s; T1 )dW(s)0 ; : : : ;

Z t

^(s; T1 )dW(s)0 ; : : : ;

Z t

0
0
have the same law. This is equivalent to
Z t

(s; Ti )(s; Tj )0ds =

Z t

(s; Tm )dW(s)0 ; 0  t  T1

^(s; Tm )dW(s)0 ; 0  t  T1

^(s; Ti )^(s; Tj )0ds 8t 2 [0; T1 ]; i; j = 1; : : : ; m:

Remark 3.1.1. The previous proposition suggests dening the equivalence class of a deterministic process ,

[] =

^ :

Z t

(s; T1 )(s; T2 )0 ds =

Z t

^(s; T1 )^(s; T2 )0 ds; t  T1  T2   :

0
0
We exhibit a method for obtaining representatives of these classes in terms of the Principal
Components of a matrix of inner products. For this, let (t; T ) = (1 (t; T ); : : : ; n (t; T ))
be a given deterministic function that satises condition 3 of [M1.]. For t 2 [0;  ]2 dene
the n  n symmetric and positive semi-denite matrix of \cross covariances"
X (t) =

Z 

(t; s)0 (t; s)ds:

20

We obtain diagonalizing processes for t 2 [0;  ]. That is, we write

X (t) = A(t)0 D(t)A(t);
where A(t) is orthonormal (A(t)A(t)0 = A(t)0 A(t) = In ), and D(t) = diag(1 (t); : : : ; n (t))
is the diagonal matrix of (positive real) eigenvalues of X (t), where 1 (t)  : : :  n (t). The
rows of A(t), which we denote by vi (t); i = 1; : : : ; n are the corresponding eigenvectors.
Consider the deterministic process dened by
(t; T ) = (t; T )A(t)0 :

For t; T1 ; T2   , (t; T1 ) (t; T2 )0 = (t; T1 )(t; T2 )0 . Therefore, 2 []. In other words,

we should be indierent between establishing a futures model with  or with . The
Principal Component interpretation remains valid. First, for i; j = 1 : : : ; n; i 6= j and
t   , i (t;
) and j (t;
) are orthogonal:
Z 

i (t; s) j (t; s)ds =

Z 

(t; s)vi (t)0 (t; s)vj (t)0 ds

= vi (t)X (t)vj (t)0 = j (t)vi (t)vj (t)0 = 0:

Second, for i = 1; : : : ; n and t   , i (t;
) maximizes the \residual variance":

Z 
v (t)X (t)vi (t)0 =  (t) =
aX (t)a0 :
i(t; s)2 ds = i
max
i
kvi (t)k2
a?v1(t);::: ;vi 1 (t) kak2
t

Third, for i = 1; : : : ; n, t   and T  t, i (t; T ) is an eigenvector of the \matrix" function

in [t;  ]2 dened by Y (t; T1 ; T2 ) = (t; T1 )(t; T2 )0 :
Z 

Y (t; T; s) i (t; s)ds = (t; T )X (t)vi (t)0 = i (t) i (t; T ):

This \representative" depends on . However, any representative chosen this way satises
the last three conditions.

Exponential Volatilities

We now exhibit a particular form of  that leads to the

possibility of using low dimensional PDEs to price derivatives for multifactor future models
(Heath and Jara (1999)). Consider linear future models where i (i = 1; : : : ; n) are sums
of exponential functions. This allows describing the state of the futures curve in terms of
articial state variables. Volatilities are parametrized as follows:

i (t; T ) =

m
X
j =1

ij exp( j (T

t));

(3.3)

where ij 2 IR; i = 1; : : : ; n j = 1; : : : ; mPand j 2 IR+ ; j = 1; : : : ; m. Assume i 6= j

for i 6= j . It is convenient to dene jk = ni=1 ij ik for j; k = 1; : : : ; m.
21

Remark 3.1.2. By the Stone-Weierstrass theorem, spanfe x :   0g is sup-norm dense

in C ([0;  ]). Therefore, we can approximate any deterministic continuous  as closely as
required, by using as many terms in (3.3) as necessary. This remains true if the same
exponents, j , are used in all the factors.
Remark 3.1.3. A representative of [] constructed in remark 3.1.1 satises

i (t;
) 2 spanf1 (t;
); : : : ; n (t;
)g:

Therefore, the futures model dened with instead of
and moreover, it preserves the exponents (j 's).
Dene the following O-U processes:

Zj (t) =

Z tX
n

0 i=1

 is also an exponential model,

ij exp( j (t s))dWi (s); j = 1; : : : ; m:

(3.4)

Example 1 (Gaussian Models.). In the case of Gaussian Futures models (K1 = 0), (3.1),
(3.3) and (3.4) imply
Z tX
n X
m

ij e j (T s) dWi (s)
0 i=1 j =1
m
X
= F (0; T ) + e j (T t) Zj (t):
j =1

F (t; T ) = F (0; T ) +

Example 2 (Shifted Lognormal Models.). If K1 = 1, (3.2), (3.3) and (3.4) yield

m
nX

F (t; T ) = (F (0; T ) + K2 ) exp

j (T t) Z

j (t)

j =1
m X
m
X

jk
1
(e (j +k )(T t)
2 j =1 k=1 j + k

e (j +k )T )

K2 :

The last equality holds if and only if j + k 6= 0 for all j; k  m. If for some j; k,
j + k = 0, then the corresponding terms in the double sum must be replaced by jk t.
Remark 3.1.4. The m variables dened in (3.4) determine the state of the futures curve.
Therefore, it is enough to keep track of these variables in the case of linear volatilities
expressed as sums of exponential functions. Moreover, for practical purposes we may
assume m = n, without loss of generality.
In fact, if m > n, then the number of factors could be increased without increasing
the computational complexity of the implementation of the model. In other words, more
random shocks could be used to model the evolution of the futures curve, without keeping
track of more than m variables (by using the initial set of 's).
22

On the other hand, if m < n, a rotation of the Brownian Motions could be carried out
such that the resulting model would have eectively fewer factors. In fact, consider (3.1)
and (3.3) with m < n. Consider the n  n matrix B with entries
(

(B )ij =

ij ; if j  m;
0; if j > m.

Let A be an orthogonal matrix in IRnn such that the last n m columns of BA are 0.
Dene L(s) = (e 1 (s) ; : : : ; e m (s) ; 0; : : : ; 0) 2 IRn. Then
dF (t; T ) = (K1 F (t; T ) + K2 )L(T t)BdW(t)0 = (K1 F (t; T ) + K2 )L(T t)BAA0 dW(t)0 :
Now, A0 dW0 is an n-dimensional Brownian Motion in (
; F ), of which only the rst
m components are used in the expression for dF (t; T ). Therefore, the futures curve is
eectively being model-led with m random shocks.
Proposition 4.3.2 generalizes this analysis. See remark 4.3.2.
We dene Exponential Futures Models to be linear futures models with exponential
volatilities given by (3.3), with m = n. If K1 = 1, we further impose that there exist at
least n dierent elements in fT 2 T M : T  T M ; F (0; T ) 6= K2 g.
Proposition 3.1.3. An exponential futures model is complete if and only if B =
(ij )i;j =1;::: ;n is non-singular.
Proof. From Proposition 3.1.1, it is enough to prove that VtM = IRn a.e on [0; T M ] for
a submodel M = fF M ; rM ; R; T M g, with R nite, if and only if B = (ij )i;j =1;::: ;n is
invertible.
Choose T1 < T2 < : : : < Tn 2 T M \ [T M ;  ] such that F (0; Ti ) 6= K2 , i = 1; : : : ; n,
if K1 = 1. For j; k = 1; : : : ; n and t  T1 dene Sjk (t) = j (t; Tk ). Consider the matrix
S (t) = (Sjk (t))j;k=1::: ;n . Then

9 (t) =(1 (t); : : : ; n(t)) 6= 0;  (t)S (t) = 0

, 9 (t) 6= 0

n
X
j =1

n
X

j (Ti t) (

, 9 (t) 6= 0 B  (t)0 = 0:

k=1

k (t)kj ) = 0; i = 1; : : : ; n

3.2 Spot Rate Futures

In this section we introduce futures models that settle to the spot rate. We compare
this framework with the HJM framework and the spot rate viewpoint. Throughout the
remainder of the chapter we work with futures models where futures prices are driftless
( = 0). We may do this without loss of generality as was discussed in section 2.4.
23

3.2.1

Pure Discount Bonds, Forward Rates and Future Rates

We introduce zero-coupon bonds denoted by P (t; T ), which represent the value at date t
of a default-free contract that pays 1 dollar at date T , for T 2 [0;  ] and t 2 [0; T ]. We
assume that

P (t; T ) > 0; 0  t  T

 ;
@
P (t; T ) exists for every T 2 [0;  ]; t 2 [0; T ]:
@T
The forward rate at date t, with maturity T is dened by

@
log(P (t; T )):
(3.5)
@T
The future rate at date t with maturity T , is the futures price of a contract that settles
to the spot rate. Consider a futures model M where futures prices are interpreted as
future rates. Assume that the model is complete. Then every claim bounded below can
be hedged with a martingale generating strategy (see Section 2.4). Therefore, P is the
(unique) risk-neutral measure, which is used for pricing purposes. In particular, we obtain
f (t; T ) =

P (t; T ) = IE [expf

Z T

r(s)dsgjFt ]:

With these considerations, we write the relations among the spot rate, future rates,
and forward rates. Fix 0  t  T   . Then

r(t) = F (t; t) = f (t; t)

F (t; T ) = IE [r(T )jFt ]
R
IE [r(T ) expf tT r(s)dsgjFt ]
:
f (t; T ) =
R
IE [expf tT r(s)dsgjFt ]

(3.6)
(3.7)

These equations show that from one among the spot rate process, future rates processes
or forward rates processes, we may derive the other two. There is a long list of models
specied under the spot rate perspective (see the next section for examples of widely
known spot rate processes). Heath, Jarrow and Morton (1992), introduced a framework
in which they model the evolution of the forward rates in a similar fashion to the futures
prices evolution given in [M1]. In our present setup, we model the evolution of future rates
through futures models.
As the previous remarks imply, in futures models of future rates, these ([M1]) and the
spot rate ([M2]) should not be given independently. If we specify a spot rate process, then
the future rates are completely specied. That is, given the spot rate process under P,
we establish a futures model by (3.6). In fact, by the martingale representation theorem
24

(assuming the future rates process is square integrable) we obtain adapted, locally squareintegrable processes  that satisfy
Z t

(s; T )dW(s)0 ;
(3.8)
0
Z 
IE [ k (t; T )k2 dt] < 1; 0  T  :
0
This is a spot rate perspective. In the next section we show through examples the future
rates models implied by several commonly used spot rate models.
We are interested in taking the alternative point of view in which the future rates are
specied by [M1], and the spot rate process is derived.
Therefore, assume we are given futures curves that satisfy (3.8). Then the spot rate
process is given by
F (t; T ) = F (0; T ) +

r(t) = F (t; t)

Z t

(u; t)dW(u)0 ;
0
and if F (0;
) 2 C 1 ((0;  )), (s;
) 2 C 1 ((s;  )), we obtain the dierential representation
= F (0; t) +
Z

t d
d
dr(t) = F (0; t)dt + (
(u; t)dW(u)0 )dt + (t; t)dW(t)0 :
dt
0 dt
This expression determines a and b of [M2].
Remark 3.2.1. In this analysis we start from the martingale measure to dene the model.
From a practical perspective, this is not very realistic. It is more sensible to start from
the physical measure, and then change to the equivalent martingale measure.
If we start from the future rates, then we may observe their drift and volatility under
the physical measure. To change to the EMM, we need only set the drift equal to 0, and
the volatilities remain equal. This observation makes useless the knowledge of the drift,
but essential the knowledge of the volatilities, for pricing purposes. The situation is similar
under the HJM framework.
On the other hand, when starting from a spot rate process, we may observe its drift
and volatility under the physical measure. Volatilities remain equal under the EMM, but
drifts change. However, from this perspective it is unspecied how the drift changes when
viewed under the EMM. Other methods must be used to determine this, such as estimating
the market price of risk. This is not an easy task. See, for example, Fournie and Talay
(1991), who exhibit the diculties in accurately estimating the market price of risk for a
CIR movement of the spot rate.
Remark 3.2.2 (Convexity Correction.). One advantage brought upon by HJM models is
that at every time, knowledge of the forward curve allows construction of the discount
curve. That is, if at date t we know the forward curve f (t;
), then the pure discount

25

RT
bonds are obtained by P (t; T ) = e t f (t;u)du . This allows immediate pricing of future
cash ows. In the spot rate framework, pure discount bonds usually need to be priced by
extending the numerical analysis to the expiration of the bond. This is also the case for
general future rate models. However, in some cases approximations of the future-forward
spread (or convexity correction) may give accurate dierences between the futures curve
and the forward curve, therefore allowing the construction of a forward curve. From (3.7)
we derive the future-forward spread
IE [ r(BT )(BT )(t) jFt ]
:
F (t; T ) f (t; T ) = IE [r(T )jFt ]
P (t; T )

We study the convexity correction of linear future rate models in section 3.2.3.
3.2.2

Examples of Spot Rate Models Written as Future Rates Models

In the following examples we show how to obtain future rate models from spot rate models.
Example 3 (Hull-White Model). For some models, like the Hull-White model, there is an
HJM representation that uses deterministic  . In Heath and Jara (1999) it is shown that
the same  should be used in the corresponding futures models. The Hull-White model
gives the following SDE for the evolution of the spot rate under the risk-neutral measure:

drt = (t t rt )dt + t dWt ;

(3.9)

where ; ;  are integrable (on [0;  ]) deterministic functions. We explicitly solve this
equation and get
Rt

s ds (r

0+

F (t; T ) = IE [r(T )jFt ] = e

RT

rt = e

Z t

Rs

u du  ds +
s

Z t

Rs

e 0 u du s dWs );

which yields

= F (0; T ) +

Z t

RT

s ds (r

0+

Z T

0
u du  dW :
s
s

Rs

e 0 udu s ds +

Z t

Rs

e 0 udu sdWs )

e s
0
The initial futures curve is given in terms of the model parameters:
F (0; T ) = e

RT
0

s ds (r

0+

Z T

Rs

e 0 udu s ds):

0
Given the initial curve, calibration of the model (of  and  ) follows. The SDE for the
futures curve is
dF (t; T ) = e

RT
t

26

s ds  dW ;
t
t

and the corresponding HJM model has the dierential representation

RT

df (t; T ) = (t; T )dt + e t s ds t dWt ;

where  satises the HJM no arbitrage restriction (see Heath, Jarrow and Morton (1992))
(t; T ) = e

RT
t

s ds  (t)

Z t

Rs
t

v dv  (s)ds:

0
Example 4 (Cox-Ingersoll-Ross Model). The SDE specied by this model for the spot rate
under the risk neutral measure is
p
drt = (t t rt )dt + t rt dWt ;
(3.10)
where
; ;  are integrable (on [0;  ]), strictly positive, deterministic functions. Set Kt =
Rt

ds
0 s . Then
F (t; T ) = IE [rT jFt ] = r0 +

Z T

(s

s IE [rs jFt ])ds +

Z t

0 Z
0
T
= F (t; t) + (s s F (t; s))ds

s rs dWs

Fix t  0. For s  t dene y(s) = F (t; s). Assume that the futures curve is smooth
(y 2 C 1 (t; 1)). Solving the dierential equation we nd

y(s) = e (Ks
F (t; T ) = e (KT

Kt ) (y (t) +

Z s

Kt ) (F (t; t) +

e(Kv

Z T

e(Kv

Kt )v dv); or
Kt )  dv ):
v

The dierential Futures Model version of (3.10) is

dt F (t; T ) = e
F (0; T ) = e

s ds  pF (t; t)dW ;
t
t
Z T
KT F (0; 0) +
e (KT Kv ) v dv:
t
RT
t

(3.11)

Therefore, in the CIR model the evolution of the whole futures curve depends only on the
level of the spot rate. The initial futures curve implied by the CIR model depends on the
parameters  and  . From a futures perspective, given a smooth initial futures curve, and
(0;T ) + T F (0; T ). Now, for a steeply inverted initial futures
 and , we recover T = dFdT
curve (high short end, low long end), it is possible that the evolution given in (3.11) implies
that negative futures rates will exist with positive probability. Since F (t; T ) = IE [r(T )jFt ],
then negative spot rates occur with positive probability, and (3.10) and (3.11) would not
be sensible evolutions. However, such situations require initial curves that would imply
negative values of , which are excluded in the denition of the CIR model. Therefore,
when specifying a futures CIR model, the initial curve cannot be arbitrarily specied.
Extra care should be taken to ensure the strict positivity of .
27

Example 5 (Single Factor Black-Karasinski Model). This model species the logarithm of
the spot rate to follow the mean-reverting process given in (3.9):

dXt = (t t Xt )dt + t dWt

rt = exp(Xt ):
R

If we set Kt = 0t s ds, then the spot rate is

rt = exp(e

Kt [X

0+

Z t

eKs s ds +

Z t

eKs s dWs ]);

from which we derive

F (t; T ) = IE [rT jFt ]

= exp(e

KT [X

0+

= F (0; T ) exp

Z t

Z T

eKs 

e (KT

s ds +

Z t

Ks ) 

s dWs

1
eKs s dWs ]) exp(

0
The dierential version of this representation is
dt F (t; T ) = e

RT
t

1
2

Z T

Z T

e 2(KT

e 2(KT

Ks )  2 ds)
s

Ks )  2 ds
s

s ds 

t F (t; T )dWt :

The Black, Derman, Toy model is a special case, in which t =

dierential version of the futures model representation is

t 0 .
t

In this case, the

dt F (t; T ) = T F (t; T )dWt :

The volatility depends only on the maturity date. This might be considered an undesirable
feature of the model (volatilities that depend on the time to maturity are more sensible
from a practical perspective).
3.2.3

Linear Future Rate Models

Consider linear future rate models. For Gaussian models we derive simplied expressions
for pure discount bonds, given the Gaussian nature of the spot rate process,

r(t) = F (0; t) +

Z t

(s; t)dW(s)0 :

In fact, we obtain

P (t; T ) = IE [e

RT
t

r(u)du jF ] = exp
t

Z T

F (t; u)du +

28

Z T Z uZ s

(v; u)(v; s)0 dvdsdu :

(3.12)

For shifted lognormal models, which satisfy (3.2), the spot rate process is given by

r(t) = (F (0; t) + K2 ) exp

Z t

(s; t)dW(s)0

1 t
k(s; t)k2 ds
2 0

K2 :
(3.13)
0
If K2 = 0, we get a lognormal spot rate process.
Remark 3.2.3. Hogan and Weintraub (1993) have shown that spot rate processes with
lognormal distributions imply negative innite Eurodollar futures prices (equivalently,
innite future LIBOR). More precisely, they show that a spot rate that satises one of the
equations
dr(t) = r(t)dt + r(t)dW (t)
d log r(t) = ( log r(t))dt + dW (t)

1 ] = 1, 0 < t < T   . The claim follows by observing that the Eurodollar

implies IE [ P (t;T
)
futures price at date t for settlement at date T > t is
h
1 P (T; T + ) i
E (t; T ) = IE [1 rL (T )jFt ] = IE 1
;
P (T; T + )
where = 3 months, and rL is 3-month LIBOR (see section 3.3.1).

Exponential Volatilities
We now consider exponential future rate models. The Gaussian case yields

r(t) = F (t; t) = F (0; t) +

m
X
j =1

Zj (t);

(3.14)

where Zj (t) is given by (3.4). In the shifted lognormal case, the corresponding spot rate
process is given by
m
nX

r(t) = F (t; t) = (F (0; t) + K2 ) exp

j =1

Zj (t)

m X
m
o
jk
1X
(1 e (j +k )t )
K2
2 j =1 k=1 j + k
(3.15)

Remark 3.2.4. Assume F (0;
) 2 C 1 ((0;  )) and F (0; t) > 0. The corresponding spot rate
model implied by the lognormal (K2 = 0) exponential future rate model can be seen as a
multifactor extension of the Black-Karasinski model. In fact,

d ln(r(t)) =

 d F (0; t)

dt

Z tX
n X
m

29

j ij e

j (t s) dW

i (s) +
0 i=1 j =1
n X
m
m X
m

X
1X
jk (1 e (j +k )t ) dt +
ij dWi (t)
2 j =1 k=1
i=1 j =1

F (0; t)

If n = m = 1, then

d ln(r(t)) = (a(t) b(t) ln r(t))dt + (t)dW (t);

where
d
dt F (0; t)

1
+  ln F (0; t) +  2 (1 e 2t )
F (0; t)
4
b(t) = 
(t) = :

a(t) =

This is a one-factor Black-Karasinski model.

Discount Factors for Exponential Models

Following remark 3.2.2, we investigate prices of pure discount bonds for exponential future
rate models, for the Gaussian and Lognormal cases. As expected, for the former case we
give closed-form formulas, and for the latter case we suggest an approximation.

Gaussian case.

In Heath and Jara (1999) it is shown that Gaussian future rates and
the corresponding Gaussian forward rates share common volatilities. Therefore, the corresponding Gaussian HJM model satises

f (t; T ) = f (0; T ) +

Z t

(s; T )dW(s)0 +

Z t

We obtain

F (t; T ) f (t; T ) = IE [f (T; T )jFt ] f (t; T ) =

(s; T )

Z T

Z T

(s; T )

(s; u)0 duds:

Z T

(s; u)0 duds:

In the case of exponential volatilities, given by (3.3),

F (t; T ) f (t; T ) =

m
X
j;k=1

jk

1
j (j + k )

j (T t)

j k

e (j +k )(T t) i

:
k (j + k )

For these models, (3.12) is written

P (t; T ) = exp

Z T

m
X

j;k=1

F (t; u)du +

jk

T t
j (j + k )

1 e j (T t) 1 e (j +k )(T t) io

+
k (j + k )2
2j k
30

(3.16)

Lognormal case. Deriving values for discount bonds and forward rates in the lognormal
case is a harder task. We propose numerical approximations. Recall
P (0; T ) = IE [expf

Z T

r(u)dug] = IE [expf

where

Z T

F (0; u)e(u) (u) dug];

(3.17)

Z t

(u; t)dW(u)0
0Z
1 t
(t) =
k(u; t)k2 du:
2 0
We suggest approximating one of the exponential functions in (3.17) with a truncated Taylor series. We approximate the outer exponential function,
us more tractability
R twhich gives
1
M
m
of formulas. For m 2 IN , t 2 [0; T ], dene Im (t) = m! ( 0 r(s)ds) . By Fubini's theorem
and symmetry arguments,
(t) =

IE [Im (t)] =

Z t Z tm

Z t2

:::
IE [r(t1 )r(t2 ) : : : r(tm )]dt1 : : : dtm :
0 0
0
From (3.15) we nd (for t1  t2 : : :  tm )
m
Y

IE [r(t1 )r(t2 ) : : : r(tm )] =

i=1

F (0; ti ) exp

IE expf

m X
n
X
i=1 j =1

(3.18)

m X
n
o
1X
j;k (1 e (j +k )ti ) 
2 i=1 j;k=1
i

Zj (ti )g :

From (3.4) we get the explicit formula

IE [r(t1 )r(t2 ) : : : r(tm )] =

m
Y
i=1

m X
n
n1 X

F (0; ti ) exp

2 i=1 j;k=1

j;k
m

X
e(j +k )ti 1 ][
e
p;q=i

[e(j +k )ti

1 + e (j +k )ti +

o

j tp k tq ]

(3.19)

Going back to the pure discount bonds, we write an N -order approximation of (3.17),
N
X

P (0; T ) t IE [

m=0

31

( 1)m Im (T )]:

Considering (3.18) and (3.19), the previous expression may be written as a sum of iterated
integrals of deterministic functions. For example, for N = 3, we obtain
P (0; T ) t1

0
T

F (0; t1 )dt1 +

t3 Z t2

0
e

t2

F (0; t1 )F (0; t2 ) expf

F (0; t1 )F (0; t2 )F (0; t3 ) exp

k t3 (ek t1

j t1 + ek t2

n
nX

n
X

j;k=1

jk e k t2 (ek t1

jk e k t2 (ek t1

j;k=1
o
e j t2 ) dt

e j t1 )gdt1 dt2

e j t1 ) +

1 dt2 dt3 :

A similar study is done in Hansen and Jorgensen (1998) in the case of spot rates that follow
geometric Brownian Motions with constant coecients. This allows them to solve the
integral in (3.18) in a recursive way. Their numerical examples suggest that for reasonable
values of the parameters, and small times (e.g., ve years), third order approximations are
accurate to four decimal places.
3.2.4

Pricing of Contingent Claims for Exponential Future Rate Models

Let M be a given complete exponential future rates model. By proposition 3.1.3, this
is equivalent to the nonsingularity of B = (jk )j;k=1;::: ;n . Then every terminal payo
bounded below may be replicated with a martingale-generating, self-nanced, admissible
trading strategy (see Section 2.4). For now, consider only European-type payos. For
deniteness, let T  T M be an expiration date, and X a random variable on (
; FT ; P)
bounded below. This variable is interpreted to be the terminal price of a contingent claim
with value derived from the futures curve. By the Markovian nature of the term-structure
of future rates with respect to the state variables dened in (3.4), X can be expressed as
a function of these:

X = IE [X jFT ] = IE [X jZ1 (T ); : : : ; Zn (T )] = X (Z1 (T ); : : : ; Zn (T )):

Call V (t) the no-arbitrage price of this contract at date t  T . This price depends on
time and on the state variables; i.e., V (t) = V (t; Z1 (t); : : : ; Zn (t)), and

V (T ) = X:

(3.20)

The no-arbitrage price of this contract at date t for the state vector (z1 ; : : : ; zn ), is

V (t; z1 ; : : : ; zn ) = IE [expf
= IE [expf

Z T

Z T

r(u)dugX jFt ]
F (u; u)dugX jZ1 (t) = z1 ; : : : Zn (t) = zn ]:

(3.21)

The previous equation may be solved numerically by dierent methods, such as Monte
Carlo simulation or recombining trees. The latter method exploits directly the existence
32

of a low-dimensional state vector. This fact also allows for PDE methods to be used. We
will focus on this methodology to give specic pricing procedures. From (3.4) we obtain
dZj (t) = j Zj (t)dt +  dW(t)0 ; j = 1; : : : ; n;
j

where j = (1j ; : : : ; nj ). The Feynmann-Kac Theorem allows us to express (3.21) as

the solution to the PDEy
m
m X
m
X
@V
@V 1 X
@2V
jk
= rV + j zj
;
(3.22)
@t
@z
2
@z
@z
j
j
k
j =1
j =1 k=1

with domain [0+ ; T )  IRn, and terminal condition V (T ) = X . This PDE is well posed; i.e.,
it has a unique solution which depends continuously on the terminal condition (Gustason,
Kreiss and Oliger (1995), theorem 7.1.1). The price of the contract is V (0; 0; : : : ; 0). In
this equation, r(t) = F (t; t) is a function of the state variables, given by (3.14) or (3.15).

Rotation of Variables
Mixed derivatives in (3.22) are avoided by rotating coordinates.
Notation. The m  m diagonal matrix with entries x1 ; : : : ; xm will be denoted
diag(x1 ; : : : ; xm ).
Im will denote the m  m identity matrix.
For a function f , fz will denote the partial derivative of f with respect to z ; i.e., fz = @f
@z .
Consider the nn matrices B and with entries ( )ij = ij ; (B )ij = ij i; j = 1; : : : ; n.
Then = B 0B . Let A be an orthonormal matrix (A0 A = AA0 = In ) such that
A A0 = diag(1 ; : : : ; n );

where 1  : : :  n  0 are the (necessarily real) eigenvalues of . The columns of A are

the eigenvectors of , the i th column corresponding to the i th eigenvalue.
For z = (z1 ; : : : ; zn ) 2 IRn, consider the rotated vector y = zA0 . Assume V (t; z) is a
solution to (3.22). Dene V~ on IR+  IRn as follows:
V~ (t; y) = V (T t; yA) = V (T t; z):
Then V (t; z) = V~ (T t; zA0 ) = V~ (T t; y). Since V satises (3.22), then V~ satises

@ V~
(t; y) = r(T
@t

m
X

n
X

m
X

1
j (yA)j ( aij V~yi (t; y)) +
j V~yj yj (t; y)
2
j =1
i=1
j =1
(3.23)
on (0; T ]  IRn , with initial condition V~ (0; y) = X (yA). The value of the contract is
V~ (T; 0; : : : ; 0) = V (0; 0; : : : ; 0).
yThe Feynmann-Kac Theorem restates the use of It^o's rule for V , together with the no arbitrage
condition that V must grow on average at the spot (risk-free) rate.

t; yA)V~ (t; y)

33

Articial Boundary Conditions

In order to solve this equation using implicit nite dierence methods, one must dene
a spatial boundary and boundary conditions. One possibility is to look at a particular
contract with payo X , and determine a region outside of which the contract may be
approximated in simple terms (for example, for European options deep in the money, we
might require that on a suciently distant boundary the option's value be equal to its
discounted intrinsic value). However, this requires considering each contract separately.
Therefore, we propose a uniform condition at the boundary (to be used for all contracts).
This specication is arbitrary, and we follow a heuristic argument to justify it. In the
following discussion we propose boundaries and boundary conditions.
The covariances of the Gaussian processes Z(t) = (Z1 (t); : : : ; Zn (t)) and
Y(t) = (Y1 (t); : : : ; Yn (t)) = (Z1(t); : : : ; Zn(t))A0 , at date t (see (3.4)) are given by

IE [Zj (t)Zk (t)] =

Z t X
n

0 i=1

n
X

IE [Yj (t)Yk (t)] = IE [(

i=1

ij e

n
X

j (t s) )(
n
X

Aij Zi (t))(

i=1

i=1

ik e

k (t s) )ds =

Aik Zi (t))] =

n X
n
X
i=1 l=1

jk
(1 e (j +k )t )
j + k

Aij Alk

il
(1 e (i +l )t ):
i + l

In particular,
Var[Yj (t)] =

Y(t) is an n

n X
n
X
i=1 l=1

Aij Alj

il
(1 e (i +l )t ):
i + l

(3.24)

dimensional centered Gaussian process. It is natural to specify as boundary

a contour of constant density for the distribution of the process at a given time. These are
surfaces of ellipsoids centered at the origin, with orientation and eccentricity that depend
on the covariance of the process. Given a small number  > 0, there is such an ellipse in
which Y(T ) will be with probability 1 . In the spirit of the Neyman-Pearson lemma,
this ellipse is the smallest region inside which Y(T ) will be with probability 1 . If 
is small enough, it seems reasonable to assume that the process will remain within this
boundary until date T , reducing the eect of the boundary on the solution of the PDE.
It is also natural to look for rectangular boundaries, which allow smoother implementations of nite dierence schemes. Combining both ideas, we consider rectangular boundaries centered at the origin, where each side has a length of 2K standard
deviations of the variable corresponding to the axis parallel to the side, for a large
K . To determine what we mean by large, x a probability level  > 0, and a standard normal random variable U . Choose K such that P[jU j  K ] = 1 n . Then
P[Yj (T )2  K 2 Var[Yj (T )]]  1  8j = 1; : : : ; n. For  = 10 5 , the corresponding K is
less than 5, for n = 1; 2; 3. Therefore, for K  5, we dene the boundary BK to be an
n dimensional rectangle with vertices
p

f(K Var[Y1(t)]; : : : ; K Var[Yn(t)])g:

34

Call DK the interior of BK .

The issue of boundary conditions is not trivial, since one should dene well-posed
boundary equations that approximate the original one. One possibility is to impose null
convexity towards the outward boundary. That is, at a point y on a side of BK perpendicular to the yj axis, we require that V~yj yj (t; y) = 0 for t 2 (0; T ). This is not a standard
boundary condition. Further work should be done towards studying the well-posedness of
the resulting equation. Kangro (1997) proves well-posedness of the Black-Scholes equation with these type of boundary conditions, and provides error estimates for them. The
equations presented here are more general, but of similar nature.

Numerical Examples

We provide examples of numerical solutions to the PDE with the

suggested boundary conditions. For n = 1, a Crank-Nicolson scheme is implemented. For
n = 2; 3, Alternating Directions Implicit (ADI) methods are used. To assess the accuracy
of this pricing tool, we value contracts for which there are closed-form prices. In the
following table we list prices of a pure discount bond and options on pure discount bonds
in Exponential Gaussian models and \futures caplet" contracts in Exponential Lognormal
models; i.e., future contracts that settle to max(0; r(t) K ) at date t, for a given strike
price K . The closed-form price of a pure discount bond is given by (3.16). The t-time
price of a call option with strike price K and expiration T1 on a pure discount bond that
expires at date T2 > T1 is given by (Musiela and Rutkowski (1998), Proposition 15.1.1)

C (t) = P (t; T2 )N

 log( P (t;T2 )

KP (t;T1 ) ) + 0:5 (t)

2

 ( t)

KP (t; T1 )N

 log( P (t;T2 )

KP (t;T1 ) )

 (t)

0:5 (t)2 

where

 (t)2 =

Z T1 Z T2

T1

2
(u; s)ds du

n
X

Pn

i=1 ij ik
  ( + k )
j;k=1 j k j

(e

j (T2 t)

(e

j (T2 t)

1)(e

j (T1 t) )(e k (T2 t)

k (T1 t)

1)
i

k (T1 t) )

Future caplet prices are derived in Heath and Jara (1999), and shown to be

V (0; t) = F (0; t)N

m m Pn

ln( F (0K;t) ) + ~(2t)

~(t)

KN

2 !
ln( F (0K;t) ) ~(2t)
; where
~(t)

XX
i=1 ij ik (1 e (j +k )t ):
 2 (t) =

j + k
j =1 k=1

We use a constant initial futures curve of 5%. For the lognormal case we use the estimated
parameters of section 3.3.2; for the Gaussian case, we multiply these by 5%.z In the
zThese parameters are used just to compare prices, and we ignore for now their origin.
35

following table, Nt gives the number of gridpoints used in the time discretization, and
Nx gives the number of gridpoints used in (each of) the space directions. n denotes the
dimension of the Brownian Motion of the model. The numbers shown in table 3.1 are
numerically derived prices; the numbers in parentheses are relative errors with respect to
the model prices. The strike price for the caplets is 5%. The strike prices, and maturity
dates for the bond options are shown in the table.

Contract
PDB, T = 10
PDBOption, T1 = 1
T2 = 2, K = 0:95
PDBOption, T1 = 3
T2 = 5, K = 0:90
PDBOption, T1 = 5
T2 = 10, K = 0:75
Fut. Caplet, T = 1
Fut. Caplet, T = 5
Fut. Caplet, T = 10

=1
= 60
= 121
0.616069
(-0.0005%)
0.00472657
(0.0052%)
0.0157547
(-0.0198%)
0.0424312
(0.0008%)
0.0045861
(0.0435%)
0.0091522
(0.0477%)
0.011395
(0.0332%)
n
Nt
Nx

=2
= 50
= 41
0.616207
(-0.0001%)
0.00495051
(-0.0605%)
0.0143503
(-0.0752%)
0.0428356
(-0.0250%)
0.0049469
(0.129%)
0.0094442
(-0.090%)
0.011798
(-0.436%)

=2
= 50
= 61
0.616207
(-0.0001%)
0.00495061
(-0.0583%)
0.0143569
(-0.0295%)
0.0428432
(-0.0073%)
0.0049401
(-0.010%)
0.0094504
(-0.0248%)
.0.011869
(0.164%)

n
Nt
Nx

n
Nt
Nx

=3
= 50
= 21
0.615812
(-0.0519%)
0.00537784
(-0.4972%)
0.0148542
(-0.0207%)
0.0424176
(-0.2429%)
0.0048080
(-1.03%)
0.0097473
(1.09%)
0.012077
(1.07%)
n
Nt
Nx

=3
= 50
= 31
0.615766
(-0.0594%)
0.00538776
(-0.3137%)
0.0148716
(-0.0964%)
0.424293
(-0.2155%)
0.0048488
(-0.188%)
0.0096458
(0.037%)
0.011893
(-0.474%)
n
Nt
Nx

=3
= 50
= 39
0.615769
(-0.0589%)
0.00538928
(-0.2856%)
0.0148748
(0.1178%)
0.0424367
(-0.1981%)
0.0048526
(-0.109%)
0.00961787
(-0.253%)
0.0119426
(-0.0592%)
n
Nt
Nx

Table 3.1: Prices and errors of nite dierence (ADI) solutions of the PDE.
Remark 3.2.5 (Contracts with Early Exercise). Within this framework we may also consider derivatives with American or Bermudan types of exercise. Preserving the notation
introduced earlier, we consider a function X that represents the intrinsic value of the
contract and depends on time and the state variables Z . That is, (3.21) becomes

V (t;z1 ; : : : ; zn )) =
=

max
IE [expf
t T
 fFs g-stopping time

max
IE [expf
 fFs g stopping time
t T

Z 

Z 

r(u)dugX ( )jFt ]

F (u; u)dugX (; Z1 ( ); : : : Zn ( ))jZ1 (t); : : : Zn (t)]:

Once again, we need only restrict to stopping times that depend on the state variables.
If the derivative is Bermudan, then the stopping may only occur at given exercise dates.
This is a Free Boundary problem, and the exercise boundary comes as part of the solution

36

to the PDE. At each point in (0; T ]  DK , V~ satises one of the following:

@ V~
(t; y) = r(T t; yA)V~ (t; y)
@t
V~ (t; y) > X (t; yA)
2: V~ (t; y) = X (t; yA)
1:

m
X
j =1

j (yA)j (

n
X

m
X

1
aij V~yi (t; y)) +
j V~yj yj (t; y);
2
i=1
j =1

As before, numerical solutions require articial boundaries and boundary conditions.
3.2.5

Comparing Spot Rate, HJM and Future Rate Models

We give a brief comparison from theoretical and practical perspectives of the spot rate,
HJM, and future rate frameworks.
1. The three frameworks are theoretically equivalent in the sense that given either a
spot rate process, a forward rate curve process or a future rate curve process, the
other two are uniquely determined.
2. The spot rate methodology does not impose restrictions for the spot rate process
under the risk-neutral measure. From HJM and Futures perspectives, no arbitrage
assumptions impose restrictions on drifts under the risk-neutral measure. Moreover,
these drifts depend exclusively on the volatility of the curves (in the futures framework, the drift is 0 under the risk-neutral measure). Therefore, to determine an HJM
or futures model under the risk-neutral measure, only the volatility is needed. This
is useful to determine a model from historical information. This helps establishing
the model under the physical measure. In the HJM and futures framework, changing
to the risk-neutral measure is immediate. For the spot rate framework, this requires
knowledge of the market price of risk (which will be multidimensional for multifactor
models), which is not easily obtained.
3. Immediate determination of discount factors (pure discount bonds) from the present
state of rates is desirable, since this simplies valuing future cash ows. In the
HJM setup, the forward curve gives immediately a discount curve. In general, the
spot rate and future rate viewpoints require numerical determination of the discount
curve. This may be avoided occasionally, as in the case of Gaussian models.
4. Usually, spot rate models are established with low-dimensional Markovian structures
for the spot rate process. Recombining trees and PDE methods are available for
pricing purposes. Implementation of HJM models requires non-recombining tree
methods which become timely expensive very quickly. Some eorts have been made
towards expressing forward curves in terms of a nite number of state variables:
Cheyette (1993) and Ritchken and Sankarasubramanian (1995) have shown that
HJM models with exponential volatilities may be described with a state vector.
37

In fact, Ritchken and Sankarasubramanian prove for one-factor models, that the
forward curve is Markov with respect to two state variables if and only if the forward
curve volatility is a product of a function of the spot rate and a deterministic function
of time and maturity. However, two-factor models require using four state variables
to determine the forward curve. In general, futures models behave like HJM models,
because of the presence of the no-arbitrage conditions. Nevertheless, in the case of
exponential models, n-factor models are described with n state variables. Alternative
pricing methods become available for a multifactor setup. Moreover, volatilities
which are proportional to rates are readily available, in contrast with the HJM
framework, where proportional volatilities imply that the forward curve explodes
with positive probability in nite time.
5. Spot rate models require one number as initial condition (the spot rate). More than
one rate is needed for multifactor models. The current yield curve is then used to
calibrate the model. HJM and Futures models start from the initial yield curve,
and calibrate to other contracts, giving more potential to accurately imply current
market prices.

3.3 Futures LIBOR models

We now assume that futures contracts settle to 3-month LIBOR. We denote the value
of this rate at date t by rL(t), and the futures price of 3-month LIBOR by F L (t; T ). In
practice, these contracts are traded with xed maturities. They settle at specic dates
in March, June, September and December and extend to about 10 years of maturity.
Therefore, a sensible futures model for the evolution of Eurodollar Futures prices has a
set of about forty tradable maturities. In this section we build future models for LIBOR,
and study conditions for these models to be consistent; i.e., for the spot rate process to
agree with the LIBOR process (these two are not independent processes). We propose two
methods to determine exponential future models for LIBOR from historical observations.
We give a numerical example derived from observations of Eurodollar Future contracts.
3.3.1

Consistent Future LIBOR Models

To establish consistent future models for LIBOR, we study the dependence between the
spot rate and 3-month LIBOR. Roughly, if we are given the spot rate process under the
equivalent martingale measure, then the 3-month LIBOR process is fully determined (see
equation (3.25) below). However, from the latter, the spot rate is only recovered partially.
As before, information of the LIBOR process is equivalent to information of the process
for future LIBOR. In fact, the following equations establish this equivalence.

F L (t; T ) = IE [F L (T; T )jFt ] = IE [rL (T )jFt ]

rL (t) = F L (t; t):
38

Now, 3-month LIBOR is the simple rate that provides a fair payo in three months. We
simplify the discussion by uniformly approximating 3 months with = 0:25 years. Then
1
1 + rL (t) =
:
(3.25)
P (t; t + )
The spot rate process produces the processes of pure discount bond prices. Therefore, we
may derive the LIBOR process (and hence the futures LIBOR processes) from the spot
rate process. The next example gives the evolution for futures LIBOR derived from a
particular class of spot rate processes.
Example 6. Let a; bi ; i be deterministic Borel measurable functions from ([0;  ]; B([0;  ]))
to (IR; B(IR)), i = 1; : : : ; n. Assume the spot rate process is given by

r(t) = r(0) +
Then

Z T +

(a(s) + b(s)W(s)0 )ds +

Z T +

Z t

(s)dW(s)0 :

(3.26)

s)(a(s) + b(s)W(T ))ds;

Z T +

u
0
0
(T + u)(T + s)b(u)((s T )b(s) + (s) )dsdu +
k (s)k2 ds :

r(u)dujFT

Z T + Z

Z t

 N r(T ) +

(T +

Using (3.25) and the formula for the MGF of a normally distributed random variable X
1 2
with mean  and variance  , IE [etX ] = et+ 2 t  ; t 2 IR, we derive a formula for
R t+
1
rL (t) = (IE [e t r(u)du jFt ] 1 1);

from which we obtain F L (t; T ) = IE [rL (T )jFt ]. After simplifying, we get

Z T
Z


1 T +
L
L
dF (t; T ) = (1 + F (t; T )) (t) +
b(s)ds +
(T + s)b(s)ds dW(t)0 :
t
T
(3.27)
For the spot rate dened in (3.26), the corresponding futures LIBOR processes have volatilities
(t; T ) = (1 + F L (t; T ))(t; T ); where
Z
Z T
1 T +
(T + s)b(s)ds:
(t; T ) = (t) + b(s)ds +
T
t
Futures LIBOR may be written explicitly as follows:
Z t

Z
1 t
1
1
0
2
L
L

(s; T ) dW(s)
k

(s; T )k ds
:
F (t; T ) = (F (0; T ) + ) exp

2 0

0
These are linear futures models. (In fact, if we start by assuming (3.27), then a spot rate
process given by (3.26) yields a consistent futures model).
39

The converse direction does not follow completely. If we are given a spot LIBOR
process, then any spot rate process that satises [M2] and
R t+
1
IE [e t r(u)du jFt ] =
; 8t 2 [0;  ]
1 + rL (t)
will be consistent. In the previous example we observed a specic case of a linear future
LIBOR model for which we could explicitly exhibit a consistent spot rate process.
Summarizing, for LIBOR future models it is not enough to specify the evolution of
future LIBOR; we need additional requirements on the spot rate process. For practical
purposes in using the model for pricing, we may approximate the spot rate at date t with
3-month LIBOR.
Remark 3.3.1. The \market model" for forward LIBOR introduced by Brace, Gatarek
and Musiela (1997) and the futures LIBOR models introduced here are analogous, the
rst one being treated from a forward (HJM) perspective, and the second one from a
futures perspective. BGM derive no-arbitrage conditions for the forward LIBOR model
similar to the HJM conditions. That condition nds an analogue of no drift in the present
framework. In their context, the forward LIBOR specication gives partial information
for recovering the forward rate process. In fact, by specifying arbitrary volatilities for pure
discount bonds on [0; ), the corresponding HJM model may be readily derived. Therefore,
given a BGM model, one may readily nd a consistent spot rate process.
In specic examples, it is possible to nd explicitly a spot rate process consistent with
the spot LIBOR process. We now give an example of a spot rate process that is consistent
with a lognormal linear future LIBOR model. The idea extends to general linear future
LIBOR models.
Example 7. Let M be a linear future LIBOR model with K2 = 0 (i.e., satisfying (3.2)).
Assume that F L (0; t); i (t; t) 2 C 1 (0;  ), and i (s; t) 2 C 1 ((s;  )), i = 1; : : : ; n, and that
F (0;
) is strictly positive. Then LIBOR is
Z t

Z
1 t
L
L
0
2
r (t) = F (0; t) exp
(s; t)dW(s) 2 k(s; t)k ds :
0
0
Using It^o's rule,
Z t

h d F L (0; t) Z t @
@
+

(s; t)dW(s)0

(s; t) (s; t)0 ds dt
drL (t) = rL (t) dt L
F (0; t)
@t
0 @t
0
i
+ (t; t)dW(t)0
(3.28)
We aim at deriving a consistent spot rate process, or equivalently, a consistent HJM model.
Therefore, we search for an initial dierentiable forward curve f (0;
) and a progressively
measurable process (t; T ) with values in IRn for which forward rates

f (t; T ) = f (0; T ) +

Z t

(s; T ) (s; T )0 ds +
40

Z t

(s; T )dW(s)0 ;

(3.29)

where   (s; T ) =

RT

(s; u)du, satisfy

rL (t) =

R t+

et

f (t;u)du

(3.30)

From (3.29), (3.30) and It^o's rule, we derive

h
i
1
drL (t) = (1 + rL (t)) (f (t; t + ) f (t; t) + k  (t; t + )k2 )dt +   (t; t + )dW(t)0 :

Comparing with (3.28), we obtain conditions for consistency of the model,

(t; t + ) = rLr(t)(t+) 1 (t; t)  G(t); 0  t  T M

t @
rL (t)  dtd F (0; t)
f (t; t + ) f (t; t) = L
+
(s; t)dW(s)0
r (t) + 1 F (0; t)
0 @t
rL (t)k(t; t)k2 
 H (t)
rL (t) + 1

(3.31)
Z t

@
(s; t) @t
(s; t)0 ds

Using (3.29), the last equation may be rewritten as

Z t

1@
(k  (s; t + )k2
0 2 @t
Z t
k (s; t)k2 )ds + ((s; t + ) (s; t))dW(s)0 = H (t) (3.32)
0
Equations (3.31) and (3.32) are necessary and sucient conditions on  for consistency
of the model. Assume (s;
) is dierentiable, and (s;
); (
;
) and F (0;
) are twice
dierentiable. Using It^o's rule, we get
dH (t) = (t)dt + (t)dW(t)0

f (0; t + ) f (0; t)+

for processes  and which may be expressed in terms of  and rL . Assume for now that
@2
(k  (s; t + )k2 k  (s; t)k2 ) = 0:
(3.33)
@t2
From (3.32), we get

@
1@ 
(f (0; t + ) f (0; t)) +
k (s; t + )k2 +
@t
2
@t
Z t
@
( (s; t + )  (s; t))dW(s)0 = (t)
@t
0
(t; t + ) (t; t) = (t)
41

(3.34)
(3.35)

Assume  = (1 ; : : : ; n ) satisesx

i (t) = 0; di (t) = d

 (t)

n
1X
G (t) 
2( i (t)Gi (t) + i )
n i=1

6i (t)
dWi (t); i = 1; : : : ; n:
Gi(t)

We take any dierentiable initial forward curve f (0;
). For i = 1; : : : ; n, t 2 [0; T M ],
dene
 (t)
ai (t) = i
Gi (t)
(t) 3a (t)
bi (t) = i
i

G (t)
ci (t) = i
i (t) 2ai (t)2 :

For t 2 [0; T M ], i = 1 : : : ; n, dene periodic functions gi on IR+ (period ), such that

gi (x) = 2[(ai (t)x3 + bi (t)x2 + ci (t)x)(6ai (t)x + 2bi (t)) + (3ai (t)x2 + 2bi (t)x + ci (t))2 ]
on [0; ). For 0  s  t  T M , dene

i (s; t) =

s
Z tZ u

gi (x)dxdu:

Then for t s 2 [0; ] we have

i (s; t) = ai (s)(t s)3 + bi (s)(t s)2 + ci (s)(t s)
i (s; t) = 3ai (s)(t s)2 + 2bi (s)(t s) + ci (s):
It is straightforward to check that by construction, (t; T ) = (1 (t; T ); : : : ; n (t; T )) and
f (0; t) satisfy (3.31), (3.33), (3.34), and (3.35), and therefore produce a consistent lognormal futures model.
3.3.2

Estimation of Parameters for Exponential Future LIBOR Models

Consider the class M of exponential future models with n factors for 3-month LIBOR. We
represent this set with

B = M (IR)nn  IR+n :

An element of M is an n  n real matrix, which we interpret as the matrix B =

(ij )i;j =1;::: ;n , and an n-dimensional positive vector, to be interpreted as (1 ; : : : ; n ).
Our goal is to estimate the element(s) P0 in B that imply a futures model that best agrees
x Here we boldly assume that this equation has a solution.
42

with given observations of future LIBOR (for example, from Eurodollar Future contracts).
Many elements of B imply the same futures model, in a distributional sense (Proposition
3.1.2. Therefore, we restrict our attention to \Principal Component" representatives of
classes of parameters that yield the same model (see remark 3.1.1). We propose two estimation methods; an MLE technique and a minimization of a squared error. We show
results in the latter case for 2 years of data with daily observations. For deniteness, we
assume the exponential futures model is lognormal. However, the following analysis is
readily extended to more general linear future models.

Statement of the Statistical Problem.

The quadratic (cross) variation of a futures model is the same under the physical and
the risk-neutral measures. Observations are done under the physical measure and pricing
under the risk-neutral measure. Our aim is to estimate the quadratic (cross) variation of
the evolution of future LIBOR. From this, we determine the model under the risk-neutral
measure for pricing and hedging purposes.
For lognormal exponential models we have the following dierential representation of
the quadratic (cross) variation for t  T1  T2 :

dF (t; T1 )dF (t; T2 ) = V (T1

t; T2 t)F (t; T1 )F (t; T2 )dt;

where

V (1 ; 2 ) =

n
X

n
X

k=1

l=1

k;l exp( l 1 )

n
X
l=1

k;l exp( l 2 ) :

(3.36)

Based on this expression, we will dene normally distributed processes which will be used
to determine the estimation procedures.
Fix
t, which is assumed to be small compared to one year. For 0  t  T
t  
t,
dene the Ft+
t -measurable
F (t +
t; T ) F (t; T )
p
Y (t; T ) =
:
(3.37)
F (t; T )
t
^ , where future rates have drifts, we obtain
Under the physical measure P
R t+
t
0 + R t+
t (s; T )ds
^
F
(
s;
T
)

(
s;
T
)
d
W
(
s
)
t
p
Y (t; T ) = t
:
F (t; T )
t

Y (t; T ) is a consistent discrete approximation of the normalized jumps of the futures rates
on a period of time of length
t (see Kloeden and Platen (1995)):
p

W(t)0
+ O(
t);
(3.38)
Y (t; T ) = (t; T ) p

t
43

^ (t) = W
^ (t +
t) W
^ (t). Within order of p
t, Y (t1 ; T1 ) is uncorrelated with
where
W
Y (t2 ; T2 ) if t2 t1 
t. In fact we have the following equations for 0  t  T1  T2 ,
t1 < t2
t, where V satises (3.36).

IE [Y (t; T1 )Y (t; T2 )] = V (T1 t; T2 t) + O(
t)

p
IE [Y (t1 ; T1 )Y (t2 ; T2 )] = O(
t)
We now dene the observable data. Call E (t; T ) the price at date t of the Eurodollar
Futures contract that settles to the spot rate at date T . Then the futures LIBOR is
(t;T ) . Assume information is available at trading dates t ; i = 1; : : : ; M .
F L (t; T ) = 1 E100
i
Take Ti to be the set of relative maturities observed at trading date ti . Then  2 Ti if
and only if there is a futures contract
traded at date ti that expires at date ti +  . Let
fj gNj=1 be an enumeration of SMi=1 Ti. Dene Ji = fj 2 f1; : : : ; N g : j 2 Tig. For every
i = 1; : : : ; M such that ti +
t is a trading date, and every j 2 Ji , dene

Xij =

F L (ti ; ti + j )
p ;
F L (ti ; ti + j )
t

(3.39)

where

F L (ti ; ti + j ) = F L (ti +
t; ti + j ) F L (ti ; ti + j ):
That is, (Xij )j 2Ji is an observation of (Y (ti ; ti + j ))j 2Ji .
There are four Eurodollar future contracts that mature in a given year, and the maturities extend as far as ten years. Then there are approximately 40 observable relative
maturities. Therefore, we will not be able to observe directly the covariation of all dierent pairs of relative maturities. Consider the \incomplete" matrix X with entries given
by (3.39):
(X )ij = Xij ; i = 1; : : : ; M; j 2 Ji :
(X )ij is dened only if the change in the rate for relative maturity j is observed at date ti ;
this happens if and only if relative maturity j is observed at date ti , and relative maturity
j
t is observed at date ti +
t. An \incomplete" covariance structure is obtained from
X in the following way: for j; k 2 f1; : : : ; N g dene Cjk as the trading dates shared by the
relative maturities j and k . Call Njk the number of elements in Cjk . Mathematically,

Cjk = fi 2 f1; : : : ; M g : j; k 2 Ji g
Njk = jCjk j :
Then, for (j; k) 2 f(l; m) 2 f1; : : : ; N g2 : Nl;m > 0g, we dene
1 X j k
jk =
XX
Njk i2C i i
jk

44

(3.40)
(3.41)

This denes an asymptotically unbiased estimate of the covariances. In fact,

1 X
IE [ jk ] =
IE [Xij Xik ]
Njk i2C
jk
1 X
=
IE [Y (ti ; ti + j )Y (ti ; ti + k )]
Njk i2C

jk

IE [( jk

= Vjk + O(
t)
p
Var[Xij Xik ]
Vjk )2 ] =
+ O(
t)
Njk
2
p
2V + Vjj Vkk
= jk
+ O(
t);
Njk

where Vij = V (i ; j ).

Minimization of a Squared Error.

Dierent volatilities may imply the same variance-covariance structure. In such case, the
corresponding future processes are identically distributed. In particular, securities prices
predicted by each one coincide. We therefore want to nd parameters for the model that
imply a theoretical covariance structure that mimics the estimated counterpart as closely
as possible. We use a weighted least squared error method.{
The following function measures the distance between the theoretical and historical
variance-covariance structures. It takes as inputs the n(n + 1) parameters that dene the
volatilities (3.3). Dene

h(fij gi;j ; fj gj ) =

=

N X
N
X
i=1 j =1
N X
N
X
i=1 j =1

Nij (Vij
Nij

k=1

ij )2
k (i )k (j ) ij

!2

If ij is not dened, then Nij = 0, and the corresponding term is 0. We aim at solving
min h(fij gi;j ; fj gj )
fij gi;j ;fj gj
More explicitly, we need to solve the following problem:
!2
N X
N
n X
n
n
X
X

X


min
N
 exp( l i )
kl exp( l j ) ij ;
fij gi;j ;fj gj i=1 j =1 ij k=1 l=1 kl
l=1
{ Through this approach we avoid the problem of lling the covariance matrix by interpolation or other
methods. This matrix should be positive semi-denite, and this may be violated when estimating the
missing data.
45

where Nij and ij are given by (3.40) and (3.41).

Remark 3.3.2. An alternative proxy for the error can be obtained by evaluating the
squared error between the covariance structure implied by the estimated parameters, and
a smoothed historical covariance matrix. Explicitly, we write

~ij =
where

ij
k;l Mkl

k;l

Mklij kl ;

= 1,k and approximate the error with

N X
N
X
i=1 j =1

Nij (Vij

~ij )2

(3.42)

This may help to evaluate the improvement achieved by using more factors.

Numerical Estimation.

We now give a numerical example of the MSE procedure. We

take daily observations of Eurodollar future contracts for the years 1994 and 1995. That
is, we x
t = 1 day. To avoid the inclusion of noise, weekly observations might also be
a sensible choice.
A Nelder-Mead algorithm was used to nd the optimal parameters. From the comments in remark 3.1.1, the estimated parameters are given in terms of the principal components of the covariance matrix of the exponential functions. That is, the principal
components may be taken as the representative of the class of volatilities that imply the
same variance covariance structure on (0; T ]  IRn ; V~ . The results are shown in tables
3.2, 3.3, 3.4, 3.5. Figure 3.1 shows the graph of the volatilities implied by these parameters, and the corresponding covariance structures. The proxy error shown corresponds to
x = 40; y = 20 (see remark 3.3.2).

Maximum Likelihood Estimates.

We show an alternative way of estimating the model parameters.

p For every element B of
B we may infer the approximate distribution (discarding the O(
t) terms) of the vector
Xi = (Xij )j2Ji . Let ni be the size of Ji . From (3.38) we dene a linear model for Xij :

Xij  1 (ti ; ti + j )Z1 + : : : + n(ti ; ti + j )Zn + ij ;

where (Z1 ; : : : ; Zn ) is a standard n-dimensional Gaussian vector (mean 0, covariance In ),
and ij  N (0; 02 ) are independent, normally distributed random errors. For the density
k For example, we can take a Gaussian kernel:

_ expf (  2 2 +  2 )g.

be chosen to smooth the covariance structure, while retaining its general structure.
ij

Mkl

46

1
2

( i

k)

( j

l)

x

and y should

COVARIANCE SURFACES

ESTIMATED VOLATILITIES (PCs)

1 factor. Proxy RMSE=0.00585.

1 factors.
0.4

0.05

0.2
0
10

10

5
0

2 factors. Proxy RMSE=0.0050812.

10

2 factors.
0.5

0.05

0
0
10

10

5
0

0.5

3 factors. Proxy RMSE=0.0012907.

10

3 factors.
0.5

0.05

0
0
10

10

5
0

0.5

4 factors. Proxy RMSE=0.001126.

10

4 factors.
0.5

0.05

0
0
10

10

5
0

0.5

Time in Years

5
Relative maturity, time in years.

10

Figure 3.1: Covariance Surfaces and Estimated Volatilities (Principal Components) for
one, two, three and four factors.
47

0.2371
0.05691

Table 3.2: Estimated parameters for a one factor exponential lognormal future LIBOR
model.
i
j
ij
j

2
2

-0.1301

0.3641

-0.5623

0.4438

0.1498

0.08255

0.1498

0.08255

Table 3.3: Estimated parameters for a two factor exponential lognormal future LIBOR
model.
i
j
ij
j

3
3

-0.2607

0.1762

0.1574

0.1791

-0.2752

0.0690

0.1561

-0.03943

0.004606

2.872

0.4356

0.01042

2.872

0.4356

0.01042

2.872

0.4356

0.01042

Table 3.4: Estimated parameters for a three factor exponential lognormal future LIBOR
model.
i
j
ij
j
i
j
ij
j

-0.9510

0.8245

0.2064

0.001074

0.7208

-0.6975

0.2167

-0.2741

1.702

1.265

0.03958

0.1246

1.702

1.265

0.03958

0.1246

4
4

-0.2263

0.3833

0.1161

-0.1954

-0.7236

0.7206

0.08591

-0.1494

1.702

1.265

0.03958

0.1246

1.702

1.265

0.03958

0.1246

Table 3.5: Estimated parameters for a four factor exponential lognormal future LIBOR
model.

f of this distribution we nd
1
1
(det i ) 2 expf Xi i 1 X0i g; where
2
2
(i )jk = V (j ; k ) + 0 j;k :

f (XijB ; 0 ) = (2)

ni
2

The likelihood of N of these observations is

L(B; 0 ) =

N
Y
i

1
48

f (Xi jB ; 0 ):

To get the maximum likelihood estimate, we nd B ; 0 that maximize the previous expression. Equivalently, we need to solve
min

N
X

B;0 i=1

log(det i ) +

49

N
X
i=1

Xi i 1Xi:

Chapter 4

Martingales Characterized by the

Distribution of the Quadratic
Variation
In this chapter we study the possibility of extending Levy's theorem of characterization of
Brownian Motion to a wider class of martingales. The nancial motivation for studying
this question arises from the implementation of models such as HJM, or Futures models,
where it is assumed that to determine a model, we need only know the volatility structure. In practical terms, we are given information about the quadratic (cross) variation
of a process. However, we do not know in general that the distribution of the quadratic
variation of a martingale determines uniquely the distribution of the martingale. The
main objective of this chapter is to prove the following two results:
We call a continuous local martingale divergent if its quadratic variation diverges
almost surely; i.e., if hM i1 = 1 a.s.

Theorem 1.

Let M be a divergent continuous local martingale with a.s. absolutely continit

uous quadratic variation such that dhM
dt > 0 a.s. Assume that for every divergent continuous local martingale N , fhM it t  0g =d fhN it ; t  0g, implies fMt ; t  0g =d fNt ; t  0g.
Then M is a Gaussian martingale.

For a real measurable function f , denote by Z (f ) the set of zeroes of f , and by I (f )

the set of points where the algebraic inverse of f is not locally square integrable.

Theorem 2.

Let g1 ; g2 be Borel measurable functions on (IR; B(IR)) such that I (gi ) =

Z (gi ), i = 1; 2. Consider the stochastic dierential equations

X0 = 0; dXt = g1 (Xt )dWt

X0 = 0; dXt = g2 (Xt )dWt :
50

(4.1)
(4.2)

Let

fFt(i) g; (i = 1; 2)
Assume fhX (1) it ; t  0g =d fhX (2) it ; t 

(X (i) ; W (i) ); (
(i) ; F (i) ; P(i) );

be weak solutions of (4.1) and (4.2), respectively.

0g. Then X (1) =d X (2) , or X (1) =d X (2) .
In the rst section we give further motivations for studying these problems. In the
second section we prove Theorem 1. We also include a brief discussion of properties of some
interesting classes of martingales; in particular, we study Ocone martingales, which are
used in the proof of the theorem. In the third section we show the irrelevance of the sign
of the volatility when looking for weak solutions of Stochastic Dierential Equations. This
result will be used in subsequent sections. We extend this result to the multidimensional
case (Proposition 4.3.2). This will not be used in the proofs of Theorems 1 and 2, but it will
provide interesting nancial applications of its own. In the fourth section we characterize
one and two-dimensional Borel sets that yield the same nite-dimensional probabilities for
Stopped Brownian Motion. That is, we give conditions under which two Borel sets A; B
in IRn satisfy P[(V (t1 ); : : : ; V (tn )) 2 A] = P[(V (t1 ); : : : ; V (tn )) 2 B ] for every t1 ; : : : ; tn ,
where V is a (possibly stopped) Brownian Motion. These results will be used in the proof
of Theorem 2. In section 5 we show the proof of Theorem 2. The sixth section will
conclude the chapter by showing applications of these results to nancial modeling. In
particular, we show applications to futures models. In section 7 we give proofs of technical
results stated throughout the chapter.

4.1 Motivation and Preliminary Discussion

Recall Levy's Theorem:
Theorem 4.1.1. (Levy, 1948) Let M be a continuous square-integrable local martingale
such that hM it = t a.s. Then M is a Brownian Motion.
This theorem states that there is a unique (in a weak sense) continuous squareintegrable martingale with the same quadratic variation as Brownian Motion. We seek
conditions under which the law of the quadratic variation of a continuous martingale characterizes the law of the martingale. We further motivate this problem with the following
example.
Example
8. Consider a Brownian Motion fWt ; Ft ; t  0g on a space (
; F ; P). Set Xt =
Rt
2
2
W
dW
0 s s = Wt t, and Yt = Xt . We have
Z t
hX it = hY it = 4Ws2 ds
0
This is an a.s. equality. However, fXt g and fYt g do not have the same distribution. In
fact, for any t 2 IR+ ,
P(Xt > t) > 0 = P(Yt > t):
51

Thus, square-integrable semimartingales may have the same quadratic variation and
dierent nite dimensional distributions. Therefore, Levy's theorem may not always be
extended to more general situations. In fact, consider a nonsymmetric martingale X .
Then X and X are martingales with dierent distributions, but with equal quadratic
variations.
Before proceeding, we recall the denition of the distribution of a stochastic process.
Consider a stochastic process X (t; !) on a space (
; F ; P), taking values on (IR; B(IR)).
For deniteness, assume the time variable is indexed by IR+ = [0; 1). On the set IR[0;1)
of functions from IR+ to IR, consider the product sigma-algebra B(IR[0;1)). Then we
may view X as a function from (
; F ; P) to (IR[0;1) ; B(IR[0;1))), which is measurable by
denition of the product sigma-algebra. The law PX of X is the induced probability on
the image space. That is, for A 2 B(IR[0;1)),

PX (A) = Pf! : X (!) 2 Ag:

By denition of the product sigma-algebra, this law is determined by the nite-dimensional
distributions

Pf! : (Xt (!); : : : ; Xt

(!)) 2 Ag;

for n 2 N , A 2 B(IRn). If all the paths of X lie in a subset S of R[0;1), we may work with
the sigma-algebra generated by the nite-dimensional cylinder sets

C = ff

2 S : (f (t1 ); : : : ; f (tn)) 2 Ag; n 2 IN; t1; : : : ; tn 2 [0; 1); A 2 B(IRn):

Consider two processes, X and Y , dened on spaces (
X ; FX ; PX ), (
Y ; FY ; PY ), respec-

tively. If X and Y have the same law, we write (X; PX ) =d (Y; PY ), or X =d Y if the
meaning is clear.
We explore conditions under which the law of the quadratic variation of a martingale
determines uniquely the law of the martingale. The main results were stated at the
beginning of the Chapter. Theorem 1 gives an answer to the proposed question: On a
fairly general class of continuous divergent martingales, Levy's theorem is valid only within
the subclass of Gaussian martingales. This gives a partial converse to Levy's Theorem in
the following sense. From Levy's Theorem, if a continuous martingale is Gaussian, then
its law is characterized by the law of its quadratic variation, which is deterministic (see
Proposition 4.2.1). Theorem 1 gives a converse of this statement.
Theorem 1 suggests studying a dierent (more restricted) class of martingales within
which we may get the desired characterization. This is done in Theorem 2, where we
restrict our study to martingales with volatilities that are stochastic only through dependence on the martingale itself. Theorem 2 roughly states that within such a class of
martingales, the distribution of the quadratic variation determines almost uniquely the
distribution of the martingale. In fact, if two martingales with dierent law in this class
have the same quadratic variation distribution, then one is the re ection of the other.
52

4.2 Proof of Theorem 1 and Unique Martingales

The statement of Theorem 1 suggests dening classes of martingales with distributions
that are uniquely determined by the distribution of the quadratic variation. To do this,
we list other classes of martingales and nd relations among these classes. We focus our
attention on one-dimensional martingales dened on general probability spaces. Using
relations between Ocone martingales and Unique martingales, dened below, we prove
Theorem 1. Recall that a continuous local martingale M is called divergent if hM i1 = 1
a.s.

Theorem 4.2.1.

(Dambis(1965), Dubins and Schwarz (1965)) Let fMt ; Ft ; t

divergent continuous local martingale. For each s  0 dene

 0g be a

T (s) = inf ft  0 : hM it > sg:

Then

Bs = MT (s) ;

Gs = FT (s) ; s  0

is a standard one-dimensional Brownian Motion. We have a.s.

Mt = BhM it :
For a divergent continuous local martingale M , the Brownian Motion dened in Theorem 4.2.1 is called its DDS Brownian Motion.
We now list some classes of local martingales. For simplicity, we denote by D the class
of divergent continuous local martingales.
1. G , Gaussian Martingales. These are the continuous martingales with Gaussian nite
dimensional distributions.
2. E , Extremal Martingales. A continuous local martingale X is extremal if its law is
extremal in K, the class of measures under under which X is a martingale. That is,
if it cannot be written as a strict convex combination of other elements of K.
3.

P , Pure Martingales. X 2 D is pure if F1X = F1B where B is the DDS Brownian

4.

O, Ocone Martingales. X 2 D is an Ocone martingale if its DDS Brownian Motion

is independent of hX i. This name was used by Vostrikova and Yor (1999) to denote

Motion of X .

this class of martingales, which was studied and characterized by Ocone (1993).

5. U , Unique Martingales. A continuous local martingale X is Unique if for every

martingale Y , hX i =d hY i implies X =d Y .
53

We rst exhibit results that will be used for the proof of Theorem 1. After its proof, we
give characterizations and relations between some of these classes. We start by recalling
a helpful characterization of G (see Revuz and Yor (1999)).

Proposition 4.2.1.

Let X be a continuous martingale. Then X

fhX it ; t  0g is deterministic.

2G

if and only if

We now state Ocone's theorem, which is the starting point of the proof of Theorem 1.

Theorem
4.2.2.
R

(Ocone, 1993) Let X 2 D be given. Then X 2 O if and only if

f 0 sdXs; t  0g =d X for every predictable process  such that jj = 1.
Ocone showed that the condition of the theorem may be restricted to deterministic
processes  of the form 1[0;a) 1[a;1) for a 2 IR+ . The following result is an immediate
consequence of Ocone's Theorem.
t

Corollary 4.2.1.

Let X 2 D be given. If X 2 U then X 2 O.

We also need the following two results. The rst one is given in Vostrikova and Yor
(1999) in a slightly more general version, where  is only required never to vanish.

Theorem 4.2.3.

(Vostrikova and Yor, 1999) Let fBt ; Ft gR be a Brownian Motion, and

fRt g a strictly positive fFt g-adapted
process such that 0T 2s ds < 1 8T a.s. and
R
1 2
t
0 s ds = 1 a.s. Then fMt = 0 s dBs ; 0  tg 2 O if and only if fBt ; t  0g is
independent from N = fs ; s  0g.

Lemma 4.2.2.

Let fXt ; t  0g be a nondeterministic process. There exist a Brownian

Motion W and a process Y on some probability space, such that Y =d X and W and Y are
not independent.
Proof. Let (
1 ; F1 ; P1 ) and (
2 ; F2 ; P2 ) be probability spaces on which we have, respectively, a Brownian Motion W1 and a process Y2 such that Y2 =d X . Consider the product
space

(
; F ; P) = (
1 
2 ; F1  F2 ; P1  P2 ):
On this space consider the extensions W and Y of W1 and Y2 , respectively.
Since Y is nondeterministic, there exist t0  0 and a0 2 IR such that  = P2 (A0 ) 2
(0; 1), where A0 = f! 2
2 : Yt0 (!)  a0 g. Call b0 the real number for which P1 (B0 ) = ,
where B0 = f! 2
1 : Wt0 (!)  b0 g. For B1 2 F1 and A1 2 F2 , set

Q(B1  A1 ) = P((B1 \ B0) (A1 \ A0 )) + P((B1 \ B10) (A1 \ A0)) :

c

54

We extend this measure to all F and observe that

Q(
) = 1
8C 2 B(IR[0;1)) Q(Y 2 C ) = Q(
1  fY2 2 C g)
P (A \ fY2 2 C g) + P (B c) P2 (Ac0 \ fY2 2 C g)
= P (B ) 2 0

1 0
1 0

1 
= P2 (Y2 2 C )
8C 2 B(C ([0; 1))) Q(W 2 C ) = Q(fW1 2 C g 
2)
P (B \ fW1 2 C g) P2 (A0 ) + P2 (Ac0 \ fY2 2 C g) P1 (B c)
= 1 0
0

1 
= P1 (W1 2 C ):
Therefore, Q is a measure on (
; F ) under which W is a Brownian Motion and Y =d X .
However,
Q(Yt  a0; Wt  b0) =  6= 2 = Q(Yt  a0)Q(Wt  b0 ):
0

It follows that Y and W are not independent.

Theorem 1.

Let M be a divergent continuous local martingale with a.s. absolutely conit

tinuous quadratic variation paths. Assume dhM
dt > 0 a.s. If M 2 U then M 2 G .
it
Proof. Assume M 2= G . Then fXt = dhM
dt ; t  0g is not deterministic. Let W , Y
be processes dened in some ltered space (
; F ; P); fFt g such that W is a Brownian
Motion, Y =d X and W and Y are not independent (their existence is given by the previous
lemma).
R
Consider the martingale fNt = 0t Ys dWs ; 0  tg. By Theorem 4.2.3, N is not an Ocone
martingale. By Proposition 4.2.1, N 2= U . By construction, fhM it ; t  0g =d fhN it ; t  0g.
Therefore, M 2= U .

We now give further results on the relation and characterizations of other classes of
martingales previously listed. The rst result compares the classes E , P and G . In the
second one, an alternative denition to pure martingales is given. These are standard
results. See for example, Revuz and Yor (1999).

Theorem 4.2.4. G \ D  P  E .
Proposition 4.2.3. Let M be a divergent continuous

martingale with DDS Brownian

Motion W . The following three statements are equivalent.

2 P.
W -measurable for every t.
Tt  inf fs  0; hM is > tg is F1

1. M
2.

55

W -measurable for every t.

3. hM it is F1
Vostrikova and Yor (1999) give another interesting characterization of Ocone martingales, Theorem 4.2.5. They also characterize Ocone martingales that are extremal, in
Proposition 4.2.4.

Theorem 4.2.5.

(Vostrikova and Yor, 1999) Let X be a divergent continuous martingale.

X 2 O is equivalent to the following condition: If ft ; t  0g is a predictable process such
that
Z
Z t

1 t 2
Dt = exp
s dXs
s dhX is
2 0
0
is a martingale and QjFt = Dt PjFt denes a new probability, then
Z t

X~ t = Xt

s dhX is

satises fX~  ; Qg =d fX; Pg.

Proposition 4.2.4.

(Vostrikova and Yor, 1999)

O \ E = G \ D.

Theorems 4.2.2 and 4.2.5 show that Ocone martingales share important properties
with Gaussian martingales. However, there are Ocone martingales which are not Gaussian.
Several interesting examples can be found in Vostrikova and Yor (1999). We give a generic
idea to show that these two classes are not equal.
Example 9 (Ocone Martingales that are not Gaussian.). Consider a nonnegative continuous process fXt ; t  0g on a space (
; F ; P), that is not deterministic and satises
R
1 2
0 Xt dt = 1 a.s. Assume that on this space we have a Brownian Motion fWt ; t  0g
independent of X . By denition, the process fWR t Xs2 ds ; t  0g is an Ocone martingale.
0
However, it is not a Gaussian martingale because its quadratic variation is not deterministic.
Finally, we relate the class of pure martingales with a class of solutions to stochastic
dierential equations which will be studied in section 4.5.

Proposition 4.2.5.

Let (X; W ); (
; F ; P);

fFt g be a weak solution of

X0 = 0; dXt = g(Xt )dWt ;

where g is a measurable function that never vanishes. Assume X 2 D. Then X 2 P .

Proof. This is a corollary of Proposition 4.2.3, recalling that
Z t

du
;
0 g1 (Bu )2
where B is the DDS Brownian Motion of M .
Ts =

56

Remark 4.2.1. Consider a continuous martingale M . In general, M is not divergent, so it

does not necessarily have a DDS Brownian Motion. In fact, for any continuous martingale
M , if we dene Tt = inf fs  0; hM is > tg, then Wt = MTt M0 is a FTt Brownian
Motion stopped at hM i1 . We may write Mt = WhM it + M0 and Wt^hM i1 = MTt M0 .
This suggests dening a class P 0 as the set of continuous local martingales M such that
hM it is F1W measurable for every t, where Wt = Minf fs0;hM is >tg is its \DDS stopped
Brownian Motion". A similar extension may be done for O.

4.3 Equivalent Stochastic Dierential Equations

In this section we prove that changing the sign of the volatility of stochastic dierential
equations does not change the distribution of its solutions. The proof of Theorem 2 uses
this result. We also prove the extension of this result to the multidimensional case, where
absolute values of matrices are interpreted in terms of their Principal Components. This
proof is rather technical, but it is an extension of the proof of the one-dimensional case.
We will give a nancial application of this extension in section 6.
The following multidimensional equations will be studied:
8 2 B(IRd); P(M0 2 ) = ( ); dMt = b(t; Mt )dt + g(t; Mt )dW0 ;
t

where M = (M1 ; : : : ; Mm ), and W = (W1 ; : : : ; Wn ) is an n-dimensional standard Brownian Motion. Consider two functions g1 ; g2 such that the Principal Components of the
matrices gi (t; x)gi (t; x)0 (i = 1; 2) coincide. We will show that from a weak solution to one
of the equations we can construct a weak solution to the other equation by redening the
Brownian Motion of the solution. This implies that when studying this type of SDE's,
we need to pay attention only to orthogonal matrices g, since these will \generate" all
possible positive semidenite symmetric matrices.
We start with the following simple result for the one-dimensional case, which will show
the idea to follow in several dimensions.

Proposition 4.3.1.

Let g : IR ! IR be a B(IR) measurable function. Consider the

following one-dimensional SDE's

M0 = 0; dMt = jg(Mt )jdWt

M0 = 0; dMt = g(Mt )dWt

(4.3)
(4.4)

Assume that uniqueness in the sense of probability law holds for (4.3). Then uniqueness
in the sense of probability law holds for (4.4).
 This is Theorem V.1.7 in Revuz and Yor (1999), and is an extension of the Dambis, Dubins, Schwarz
Theorem.

57

Proof. Let (X (i) ; W (i) ); (

(i) ; F (i) ; P(i) );
Dene

Nt(i) 

Z t

fFt(i) g; (i = 1; 2) be weak solutions of (4.4).

sgn(g(Xs(i) ))dWs(i) ; (i = 1; 2);

0
where we dene sgn(0)=1. Then Nt(i) is a continuous square-integrable martingale, and
hN (i) it = t. By Levy's Theorem, fNt(i) ; Ft(i) g is a Brownian Motion.
We have (see Karatzas and Shreve (1991), corollary 3.2.20)
Z t
Z t
Z t
Xt(i) = g(Xs(i) )dWs(i) = jg(Xs(i) )jsgn(g(Xs(i) ))dWs(i) = jg(Xs(i) )jdNs(i) :
0
0
0
(
i
)
It follows that (X (i) ; N (i) ); (
(i) ; F (i) ; P(i) ); fFt g; (i = 1; 2) are weak solutions of (4.3).
By weak uniqueness, X (1) and X (2) have the same law, and uniqueness in the sense of
probability law for (4.4) follows.
The proposition provides something stronger; from a solution to (4.4) we construct a
solution to (4.3), using the same process, and changing the Brownian Motion. Similarly,
from a solution to (4.3) we may construct a solution to (4.4). This will be stated more
precisely in the multidimensional case, where the proposition works similarly, provided we
set an appropriate analogue of the absolute value (or of the signum function). This is done
using the principal components of the cross variation process. We also aim at generalizing
this result in various directions, by including time dependence, drift, a converse of the
proposition, initial conditions and addressing the issue of existence.
Notation. The n  n identity matrix will be denoted In .
If A1 ; A2 ; : : : ; Ak are matrices of orders m  a1 ; m  a2 ; : : : ; m  ak , we write [A1 A2 : : : Ak ]
to denote the m  (a1 + a2 + : : : + ak ) matrix made up of concatenating the columns of
A1 ; A2 ; : : : ; Ak .
Let gi;j : IRd+1 ! IR be B(IR) measurable functions (1  i  d; 1  j  n). Call g
the matrix composed of these functions as entries. For x 2 IRd and t 2 IR+ diagonalize
the (symmetric and positive semidenite) matrix g(t; x)g(t; x)0 :
g(t; x)g(t; x)0 = P (t; x)(t; x)P (t; x)0 ;
where
(4.5)
(t; x) = diag(1 (t; x); : : : ; d (t; x)), and 1 (t; x)  : : :  d (t; x)  0 are the d (real)
eigenvalues of g(t; x)g(t; x)0 . The matrix P (t; x) is a d-dimensional orthogonal matrix,
whose columns are the eigenvectors of g(t; x)g(t; x)0 and the columns of P (t; x)0:5 (t; x)
are its principal components. This representation may not be unique. For every x 2
IRd ; t 2 IR+ choose one such diagonalization, so that P (t; x) is measurable. Let  be
a given distribution on IRd , and b : IRd+1 7! IRd a measurable function. Consider the
following d-dimensional SDE's
8 2 B(IRd); P(M0 2 ) = ( ); dMt = b(t; Mt )dt + P (t; Mt )(t; Mt )0:5 dWt0 (4.6)
8 2 B(IRd); P(M0 2 ) = ( ); dMt = b(t; Mt )dt + g(t; Mt )dWt0
(4.7)
58

Note that in (4.6) W is d-dimensional, and in (4.7) it is n-dimensional.

Proposition 4.3.2. Let P;  be given by (4.5). Assume (X; W(1) ); (
; F ; P); fFt g is a
weak solution of (4.7). Then there exists a weak solution of (4.6) on an extended space,
~;W
~ (2) ); (
~ ; F~ ; P
~ ); fF~t g, such that X
~ and X have the same law. Conversely, if
say (X
(2)
(X; W ); (
; F ; P); fFt g is a weak solution of (4.6), then there is a weak solution of
~;W
~ (1) ); (
~ ; F~ ; P
~ ); fF~t g, such that X
~ and X have the
(4.7) on an extended space, say (X
same law.
Proof. Let (X; W(1) ); (
; F ; P); fFt g be a weak solution of (4.7). We can extend this
space to allow it to support a d-dimensional Brownian Motion independent of the given
sigma-algebra (Karatzas and Shreve(1991), remark 3.4.1). We will use a tilde to denote
objects in the extended space.
~;W
~ (1) ); (
~ ; F~ ; P
~ ); fF~t g is a weak solution of (4.7), and fB
~ t ; F~t g is a dThen (X
(1)
~
~
dimensional Brownian Motion independent of (X; W ). Dene
~ s ) =diag(1f (s;X~ )=0g ; : : : ; 1f (s;X~ )=0g )
D(s; X
s
s
1
d
0
:
5
~
~
~ s ) 0:5 )
E (s; Xs ) =diag(1f1 (s;X~ s )>0g 1 (s; Xs ) ; : : : ; 1fd (s;X~ s )>0g d (s; X
Z t
Z t
(2)
0
(1)
0
~
~
~
~
~
Wt = E (s; Xs )P (s; Xs) g(s; Xs )dWs + D(s; X~ s)dB~ 0s :
0
0
~ t(2) is a continuous, square-integrable martingale, and hW
~ (2) it = tIdd , by (4.5).
Then W
~ t(2) ; Ft g is a d-dimensional Brownian Motion.
By Levy's Theorem, fW
Observe that
DZ t

~ s )D(s; X
~ s )P (s; X
~ s )0 g(s; X
~ s )dW
~ s(2) 0
P (s; X
=
=
=

Z t

Z t

0
Z

0
= 0:

~ s )D(s; X
~ s )P (s; X
~ s )0 g(s; X
~ s )g(s; X
~ s )0 P (s; X
~ s )D(s; X
~ s )0 P (s; X
~ s )0 ds
P (s; X
~ s )D(s; X
~ s )(s; X
~ s )D(s; X
~ s )0 P (s; X
~ s )0 ds
P (s; X
~ s )diag(1f (s;X~ )=0g 1 (s; X
~ s ); : : : ; 1f (s;X~ )=0g d (s; X
~ s ))P (s; X
~ s )0 ds
P (s; X
s
s
1
d

R
~ s )D(s; X
~ s )P (s; X
~ s )0 g(s; X
~ s )dW
~ s(2) 0 = 0, being a martingale with zero
Therefore, 0t P (s; X
~ s )0:5 D(s; X
~ s ) = 0,
quadratic variation starting at 0. Since (s; X
Z t

~ s )(s; X
~ s )0:5 D(s; X
~ s)dB
~ 0s = 0:
P (s; X

59

By the previous remarks,

Z t

~ s )(s; X
~ s )0:5 dW
~ s(2) 0 =
P (s; X
=
=

Z t

0
Z

0
~t
=X

Z t

0
~ s )dW
~ s(1) 0
g(s; X
~ s )dW
~ s(1) 0
g(s; X

~ s )(Id
P (s; X
Z t

~ s ))P (s; X
~ s )0 g(s; X
~ s )dW
~ s(1) 0
D(s; X

~ s )D(s; X
~ s )P (s; X
~ s )0 g(s; X
~ s )dW
~ s(1) 0
P (s; X

Z t

b(s; X~ s)ds
0
~;W
~ (2) ); (
~ ; F~ ; P
~ ); fF~t g is a weak solution of (4.6). By construction, X
~
It follows that (X
and X have the same law.
The converse direction works similarly, but not identically.
Let (X; W(2) ); (
; F ; P); fFt g be a weak solution of (4.6). As before, we extend this
space to allow it to support an n-dimensional Brownian Motion independent of the given
sigma-algebra and we use a tilde to denote objects in the extended space.
~;W
~ (2) ); (
~ ; F~ ; P
~ ); fF~t g is a weak solution of (4.6), and fB
~ t ; F~t g is an nThen (X
(2)
~
~
dimensional Brownian Motion independent of (X; W ). Dene
~ s ) =diag(1f (s;X~ )=0g ; : : : ; 1f (s;X~ )=0g )
D(s; X
s
s
1
d
~ s ) =diag(1f (s;X~ )>0g 1 (s; X
~ s ) 0:5 ; : : : ; 1f (s;X~ )>0g d (s; X
~ s ) 0:5 )
E (s; X
s
s
1
d
~ s ) =g(s; X
~ s )0 P (s; X
~ s )E (s; X
~ s)
C (s; X
~ s )0 C (s; X
~ s) = In D(s; X
~ s). Therefore the non-zero columns of C (s; X
~ s)
Note that C (s; X
form an orthonormal system. In fact, there are as many of these columns as there are
~ s ). Construct (in a measurable way) a matrix V (s; X
~ s ) such
non-zero eigenvalues in (s; X
~
~
that the non-zero columns of C (s; Xs) and the columns of V (s; Xs ) form an orthonormal
basis of IRn. Dene the n  (n + d) matrix
~ s ) = [C (s; X
~ s ) V (s; X
~ s ) 0]:
A(s; X
~ s ) are 0, and the other n columns
The last n k columns of A are 0, so d columns of A(s; X
form an orthonormal system. Therefore, the rows of A form an orthonormal system, and
we have the identity
~ s )A(s; X
~ s )0 = In :
A(s; X
(4.8)
Moreover, we have
~ s )A(s; X
~ s ) = [P (s; X
~ s ) (s; X
~ s )0:5 0];
g(s; X
where the last n columns are 0.
60

(4.9)

Now we are ready to dene the Brownian Motion that will be part of the weak solution
~ the (d + n)-dimensional Brownian Motion [W
~ t(2) B~t ]. Dene W
~ t(1) =
to (4.7). Call U
Rt
~ s )dU
~ 0s . Then, by (4.8) and Levy's theorem, W
~ t(1) is an n-dimensional Brownian
0 A(s; X
Motion, and by (4.9),
Z t

~ s )dW
~ s(1) 0 =
g(s; X

Z t

~ s )(s; X
~ s )0:5 dW
~ s(2) 0 = X
~t
P (s; X

Z t

b(s; X~ s )ds:
0
0
0
~;W
~ (1) ); (
~ ; F~ ; P
~ ); fF~t g is a weak solution of (4.7). By construction, X
~ and
Therefore, (X
X have the same law.

Corollary 4.3.1.

Weak existence holds for (4.6) if and only if it holds for (4.7). Uniqueness in the sense of probability law holds for (4.6) if and only if it holds for (4.7).
Remark 4.3.1. The proof of Proposition 4.3.2 follows very closely the proof of the Martingale Representation Theorem (see Karatzas and Shreve (1991), Theorem 3.4.2). In
fact, as a corollary of the proof of that theorem, we obtain the following result. Let
fMt ; Ft ; t  0g be a d-dimensional continuous local martingale with absolutely continuous cross-variations, on a space (
; F ; P). Then on an extended space (
~ ; F~ ; P~ ) there
is a d-dimensional Brownian Motion W and a d  d measurable, adapted, and locally
square-integrable matrix X such that

Mt = M0 +

Z t

Xs dWs0 a.s.

0
0
:
5
and Xt = Pt t for t  0, where fPt ; t  0g is a progressively measurable orthonormal
matrix, and ft ; t  0g is a progressively measurable diagonal matrix with nonnegative
entries.
Rt
0
Roughly,
this
states
that
every
martingale
of
the
form
0  s dWs may be written as
Rt
0
:
5
0
~ s for a Brownian Motion W
~ on a possibly extended space, and P;  keep the
0 Ps s dW
previous meanings.
Remark 4.3.2. A rather obvious consequence of this analysis is that to represent a continuous martingale as a Brownian integral, the Brownian Motion need not be of a higher
dimension than the martingale. See remark 3.1.4.

4.4 Sets with Equal Distributions for Stopped Brownian

Motion
Denition 6. Let fX (t); 0  t < 1g be a continuous stochastic process on (
; F ; P).
Fix k 2 IN . We will say that A; B 2 B(IRk ) are (X; k)-equivalent if

8t1; : : : ; tk  0; P((Xt ; : : : ; Xt ) 2 A) = P((Xt ; : : : ; Xt ) 2 B ):

1

This relation will be denoted by A

(X;k)

 B.
61

Consider a standard one-dimensional Brownian Motion fWt ; Ft ; t  0g on (

; F ; P).
Let a; b be given numbers in IR with a < 0 < b. We are interested in characterizing
(X; k)-equivalence for the following three cases:
1. Xt = Wt .
2. Xt = Wt^Tb , where Tb = inf ft  0 : Wt = bg (b > 0).
3. Xt = Wt^Ta;b , where Ta;b = inf ft  0 : Wt = a or Wt = bg (a < 0 < b).
These results will be used in the proof of Theorem 2. It will be seen that it is enough to
study the cases n = 1 and n = 2. The proofs of the following three lemmas will be given
in section 4.7. In the following lines,  denotes Lebesgue measure.

Lemma 4.4.1.

Consider the case Xt = Wt . Then

8A; B 2 B(IR2) (A (X;2) B , A \ B c = (B \ Ac)  a:s:)

Lemma 4.4.2.
B(( 1; b)2 ):

Consider Xt = Wt^Tb . The following holds true for every A; B in

Lemma 4.4.3.

(X;2)

 B , A = B -a:s:

Consider X = Wt^Ta;b .

1. If ab = mn 2 Q, where m; n 2 IN; (m; n) = 1 then

(a) For every A; B in B((a; b)),

 B ,A \ B c = (B \ Ac) -a:s: on ( nb ; nb )
2b
and A \ B c; B \ Ac are periodic on (a; b) with period :
n

(X;1)

(b) If a 6= b, then for every A; B in B((a; b)2 ),

If

(X;2)

 B , A = B -a:s:
a = b, then for every A; B in B((a; b)2 ),
A

(X;2)

 B , A \ B c = (B \ Ac) -a:s:

2. If ab 2= Q, then for every A; B in B((a; b)),

(X;1)

 B , A = B -a:s:
62

4.5 Proof of Theorem 2

Let g1 ; g2 be measurable functions on IR. Consider the following stochastic dierential
equations:
dXt = g1 (Xt )dWt
(4.10)
dXt = g2 (Xt )dWt
(4.11)
We will focus our attention on distributions of solutions to these equations. Therefore, by
Proposition 4.3.2, we can assume without loss of generality that g1 (x); g2 (x)  0 for every
x 2 IR. For a measurable function f dene
Z 
dy
I (f ) = fx 2 IR :
= 1 8 > 0g
2
f
(
x
+ y)

Z (f ) = fx 2 IR : f (x) = 0g:
Theorem 4.5.1. (Engelbert and Schmidt (1984)) For every initial distribution , (4.10)
has a solution which is unique in the sense of probability law if and only if I (g1 ) = Z (g1 ).
Lemma 4.5.1. Let fWt ; FtW g be a standard one-dimensional Brownian Motion on a space
(
; F ; P). Fix an initial distribution . Let fGt g be an extended ltration satisfying the
usual conditions on which W remains a Brownian Motion. Let  be a G0 -measurable
random variable with distribution , independent of FtW for t  0.
Assume I (g1 ) = Z (g1 ), i = 1; 2. Assume the quadratic variations of weak solutions
to (4.10) and (4.11) with initial distribution  have the same law. Then

fg1 ( + Wt^inf fs>0:+W 2I (g )g ); t  0g =d fg2 ( + Wt^inf fs>0:+W 2I (g )g ); t  0g:

Proof. For i = 1; 2, dene

Z s

du
0 gi ( + Wu )2
A(si) = inf ft > 0; Tt(i) > sg;
T (i) =
s

and set

Xt(i) =  + WA(i) ;
t
(
i)
F = G (i) :
t

At
fBt(i) ; Ft(i) ; t

Then there exist Brownian Motions

 0g on a possibly extended space such
that (X (i) ; B (i) ) (i = 1; 2) are weak solutions of (4.10) and (4.11), respectively, with initial
distribution  and quadratic variations
Z t
(
i
)
hX it = gi2 (Xs(i) )ds = A(ti)
0
(see the proof of Theorem 5.4 in Karatzas and Shreve (1991) y ).
yThis Theorem is due to Engelbert and Schmidt, and precedes Theorem 4.5.1
63

(2)
By the conditions on g1 and g2 and Theorem 4.5.1, fA(1)
t g and fAt g have
the same law (or equivalently, the same nite dimensional distributions). For
n 2 N; t1 ; : : : ; tn ; s1 ; : : : ; sn 2 IR+ , we have
f! : T (i) (s1) < t1; : : : ; T (i) (sn) < tng = f! : A(i) (t1 ) > s1; : : : ; A(i) (tn) > sng; i = 1; 2:
Therefore, fTt(1) g =d fTt(2) g. Now, if we write

T (i) (s) =
then the processes

(R s

(i)
du
0 gi (+Wu)2 ; s < A1
1;
s  A(1i)

o
1
1
(i) + 11sA(i) 1 ; s  0 ; i = 1; 2
Gi ( + Ws )2 s<A1
have the same law, for some Borel measurable function Gi which is a.s equal to gi , i = 1; 2.
Since gi  0, then the processes

fgi ( + Ws)1s<A1 ; s  0g; i = 1; 2

(i)

have the same law. The result follows by observing that

R(i)  inf fs > 0 : T (i) = 1g = inf fs > 0 :  + Ws 2 I (gi )g a.s.
s

(Lemma 5.5.2 in Karatzas and Shreve (1991)).

This lemma gives an important relation between the functions g1 and g2 which can be
further exploited using the characterization of sets with equal distributions for stopped
Brownian Motion derived in section 4.4. This will lead to Theorem 2. Before proceeding,
we include some necessary observations.
Remark 4.5.1. I (g) is closed. To prove this, let z be a limit point of I (g). Let  > 0 be
given. Choose w in I (g) \ (z ; z + ). Then
Z 
Z 2
dy
dy

= 1:
2
2
 g (w + y )
2 g (z + y)

Therefore z 2 I (g).
Notation. We will use a to denote the unitary mass distribution on IR with support a,
where a 2 IR. That is, a satises a (fag) = 1.
Remark 4.5.2. Take g1 ; g2 ; W to satisfy the conditions of Lemma 4.5.1. Let a be an arbitrary real number, and let a be an initial distribution. From the proof of Lemma 4.5.1,
fTt(i) g, i = 1; 2, have the same law, so R(1) =d R(2) . In other words,
inf fs > 0 : a + Ws 2= I (g1 )g =d inf fs > 0 : a + Ws 2= I (g2 )g:
64

(4.12)

Therefore, a 2 I (g1 ) , a 2 I (g2 ). Now, if a 2= I (g1 ), then for i = 1; 2 we dene

ai = sup(I (gi ) \ ( 1; a))

bi = inf(I (gi ) \ (a; 1)):
These numbers may be 1;
equation (4.12),

(4.13)

1. By the previous remark ai < a < bi, i = 1; 2. We rewrite

inf fs > 0 : a + Ws 2= (a1 ; b1 )g =d inf fs > 0 : a + Ws 2= (a2 ; b2 )g:

This implies a1 = a2 and b1 = b2 , or a1 = 2a b2 and b1 = 2a a2 .z
Now assume that the equality of quadratic variations holds for a , for every a 2 IR.
Then a1 = a2 ; b1 = b2 .
Lemma 4.5.2. Let g1 ; g2 be a.s. equal measurable functions. Assume I (g1 ) = Z (g1 ) =
Z (g2 ) = I (g2 ). Let  be an arbitrary initial distribution. Solutions to (4.10) and (4.11)
with initial distribution  have the same law.
Proof. Let W; G ; ; Ts(i) ; A(si) be dened as before. Then A(1)
1 = inf fs  0;  + Ws 2
(2)
(1)
I (g1 )g = A1 . For ! 2
, if  (!) 2 I (g1 ), then Ts (!) = Ts(2) (!) = 1 8s  0.
(1)
(2)
Otherwise, if s < A(1)
1 , then Ts (!) = Ts (!) because gi (+1Wt )2 , i = 1; 2 are a.s. equal
(1)
(2)
integrable functions in [0; s]. If s  A(1)
1 , then Ts (!) = Ts (!) = 1.
In any case, T (1) (!) = T (2) (!) for ! 2
. Therefore A(1) = A(2) , and W (1) = W (2) .
s

At

At

Since I (g1 ) = Z (g1 ) and Z (g2 ) = I (g2 ), then (4.10) and (4.11) satisfy weak uniqueness,
by Theorem 4.5.1. Therefore solutions to these equations have the same distribution as
WA(1) and WA(2) .
t

The following proposition explores further the relationship between g1 and g2 given
an equality of distributions of the quadratic variation of solutions to (4.10) and (4.11)
starting at 0. It starts from the conclusion of Lemma 4.5.1 and uses Remark 4.5.2. The
proof will be given in section 4.7.

Proposition 4.5.3.

Let g1 ; g2 be Borel measurable functions with g1 (0); g2 (0) 6= 0, and

Z (gi ) = I (gi ), i = 1; 2. Assume the quadratic variations of solutions to (4.10) and (4.11)
starting at 0 have the same law. Fix a = 0, and let ai ; bi , i = 1; 2 be given by (4.13)
(possibly equal to 1).
1. If a1 = b1 = b, then a2 = b2 = b, and g1 (x) = g2 (x) a.s. in [ b; b], or g1 (x) =
g2 ( x) a.s. in [ b; b].

2. If a1 6= b1 and a1 = a2 = a, then b1 = b2 , and g1 (x) = g2 (x) a.s. in [a; b1 ].

zThis follows from the distribution of exit times for Brownian Motion (Exercise 2.8.11 in Karatzas and
Shreve (1991)).

65

3. If a1 6= b1 and a1 = b2 = b, then a2 = b1 , and g1 (x) = g2 ( x) a.s. in [ b; b1 ].

Theorem 2.

Let g1 ; g2 be Borel measurable functions on (IR; B(IR)) such that I (gi ) =

Z (gi ), i = 1; 2. Consider the stochastic dierential equations

X0 = 0; dXt = g1 (Xt )dWt

X0 = 0; dXt = g2 (Xt )dWt :
Let

(X (i) ; W (i) ); (
(i) ; F (i) ; P(i) );

(4.14)
(4.15)

fFt(i) g; (i = 1; 2)

be weak solutions of (4.14) and (4.15), respectively.

fhX (2) it ; t  0g. Then X (1) =d X (2) , or X (1) =d X (2) .

Assume

fhX (1) it ; t  0g =d

Proof. From the previous proposition, and keeping the same notation, we have one of the
following cases (ai ; bi may be 1):

a1 = a2 = a; b1 = b2 = b and g1 (x) = g2 (x) a.s. on (a; b)

a1 = b2 = a; b1 = a2 = b and g1 (x) = g2 ( x) a.s. on (a; b)
Since the initial distribution is 0 , then Xt(1) 2 (a1 ; b1 ), and Xt(2) 2 (a2 ; b2 ) a.s. From the
former case we conclude that X (1) =d X (2) , by Lemma 4.5.2. The latter case requires an
extra step. Dene h2 on IR by h2 (x) = g2 ( x). Then Y = X (2) satises

Y0 = 0; dYt = h2 (Yt )dWt

By Proposition 4.3.1, Y has the same distribution as the solution to

Z0 = 0; dZt = h2 (Zt )dWt = g1 (Zt )dWt :

We conclude that X (1) =d X (2) .
This result has a trivial converse. Under the conditions there, if X (1) =d X (2) , or
X (1) =d X (2) , then fhX (1) it g =d fhX (2) it g. We notice that this equivalent condition was
derived using only up to two-dimensional distributions from the result in Lemma 4.5.1.
We relate Theorems 1 and 2 through the following example.
Example 10. Let
(X; W ); (
; F ; P);

fFt g

be a weak solution of (4.14), where g1 (x) = jxj + 1. Since g1 is even, fXt ; t  0g =d

f Xt ; t  0g . Theorem 2 tells us that no martingale (other than X ) that is a solution
66

to a stochastic dierential equation of type (4.14) gives a quadratic variation with equal
law as that of hX i. But X is a divergent martingale that is not Gaussian. By Theorem 1,
there is a martingale Y with dierent law than X such that hY i =d hX i.
To nd one such martingale, we start by observing (Proposition 4.2.5), that X is a
pure martingale. Therefore, X 2= O. By Ocone's Theorem, for some a  0, we have

Xa

Z t

=f

In fact,

(1[0;a]

1(a;1) )dXs ; t  0g = f

Z t

(1[0;a](s)

1(a;1) (s))(1 + jXs j)dWs ; t  0g 6= X:

Xt ;
if t  a
2Xa Xt ; if t  a;
so any a > 0 will cause the dierence in distributions, given that volatilities are increasing
in jX j.
The following result restates Theorem 2 under more restrictive conditions, for which we
get equality of distributions for the martingales. First we start with a helpful Proposition.
Proposition 4.5.4. Let g1 ; g2 be Borel measurable functions on (IR; B(IR)) such that
I (gi ) = Z (gi ), i = 1; 2. Let
(X (i); ; W (i) ); (
(i) ; F (i) ; P(i) ); fF (i) g; (i = 1; 2)
Xta

be weak solutions of (4.10) and (4.11), respectively, with initial distribution . Assume
fhX (1);a itg =d fhX (2);a it g for all a 2 IR. Then I (g1 ) = I (g2 ) and g1 (x) = g2 (x) a.s. in
IR.
Proof. From Remark 4.5.2 we notice that I (g1 ) = I (g2 ). Consider an arbitrary real number
a 2= I (g1 ). Keeping the notation used in that remark, dene I  (a1 ; b1 ) = (a2 ; b2 ). Dene
functions h1 ; h2 on IR by hi (x) = gi (x + a)1I (x); i = 1; 2. Then

(X (i);a a; W (i) ); (
(i) ; F (i) ; P(i) ); fFt(i) g; (i = 1; 2)
are weak solutions of (4.10) and (4.11), where the hi substitutes the gi . By Proposition 4.5.3, h1 = h2 a.s. (observing that a can be taken to be any number in I .) Since
a 2 IR was arbitrary, we conclude that g1 = g2 a.s..

Theorem 4.5.2.
1; 2. Let

Let g1 ; g2 be Borel measurable functions. Assume I (gi ) = Z (gi ), i =

(X (i); ; W (i) ); (
(i) ; F (i) ; P(i) ); fFt(i) g; (i = 1; 2)
be weak solutions of (4.10) and (4.11), respectively, with initial distribution . Assume
fhX (1);a itg =d fhX (2);a it g for all a 2 IR. Then X (1); =d X (2); for every initial distribution .
Proof. The conclusion follows from Proposition 4.5.4 and Lemma 4.5.2.
67

4.6 Applications to Financial Modeling

In this section we show applications of the results obtained in the past sections, in particular to futures models. They will remain valid for general nancial modeling, such as the
HJM framework.
Example 11 (Determining the Model from a Sample Path.). Consider the following situation. A practitioner wishes to implement a futures-based model (or an HJM model). As it
was suggested before, for pricing purposes, the models are completely determined with a
specication of the volatility ( ). To this end, she restricts  to lie within a predetermined
set. She is able to observe the evolution of the prices of Interest Rate futures contracts.
Her objective is to choose the model from the restricted set that is most in agreement with
the observed paths. For simplicity, assume that observations are done continuously. We
also assume that the \real" process lies within the set determined by the practitioner. Is
it possible to determine uniquely the corresponding model?
Let d be a given natural number. Let  be a set of Borel-measurable functions mapping
IR+  IRd to IRdn (n = 1; 2; : : : ), such that (t; x) = f (t)(x) for  2 ; t 2 [0; 1); x 2
IRd , where f : IR+ ! IR f0g,  : IRd ! IRdn are measurable functions. Consider the
following d-dimensional stochastic dierential equation:
dXt = (t; Xt )dW0 ;
(4.16)
t

where  = f  2  and W stands for n-dimensional Brownian Motion. Assume weak

existence holds for this equation, and let (X; W); (
; F ; P); fFt g be a weak solution.
The practitioner is given a realized path of X, say fXt (!0 ); t  0g; !0 2
. We assume
that this path is informative in the following sense:

P(Xt (!) 2

range of

X(!0 ) 8t) = 1:

In other words, if we choose another path, its image will be contained in the image of
X(!0 ) almost surely. That is, the path provides as much information as possible. We may
obtain the corresponding path of the cross variation of the process, i.e.

At ( !0 ) =

Z t

(s; Xs )0(s; Xs )ds; t  0:

(4.17)
0
We have assumed that the limiting cross variation of the path coincides with (4.17).x
Therefore, we have knowledge of f (t)2  (Xt (!0 )) (Xt (!0 ))0 , for t  0.
x This is a strong assumption; however, the quadratic variation over a nite partition converges (in
probability) to the quadratic variation of the process as the partition becomes ner. In fact, x a date T ,
and positive numbers  and . For a nite partition  = f0 = t0  t1  : : :  tn = T g of [0; T ] dene the
quadratic variation until date T , VT(2) in the usual way,
(2)

VT

(!) =

X jX (
n

k=1

tk !0

68

) Xt 1 (!0 )j2 :
k

If the function f 6= 0 is known, we may determine the function (x) (x)0 for x in
the image of X (!0 ). By Proposition 4.3.2, this is equivalent to knowing the Principal
Components of  (x) (x)0 for every \relevant" x. That is, two elements of  that produce
the same Principal Components will generate equally distributed processes. Alternatively,
if the function  (x) is known, and  (x) 6= 0 8x, then we may determine the function f .
For deniteness, we restrict this analysis to exponential futures models introduced in
Chapter 3 for the case of lognormal distributions. Fix a set of maturity dates 0 < T1 <
T2 ; : : : < Tm , and a natural number n. Dene
m
X

 = f = (ij )i=1;::: ;m jij (t; x) = ij (t)x = jk exp( k (Ti

j =1::: ;n
k=1

t))x; k  0; jk 2 IRg

As before, we make the assumption that given a continuous observation of the evolution
of a set of futures rates, we are able to obtain its (theoretical) cross variation; i.e., we have
knowledge of the matrix-valued process

At (!0 ) =
P

Z t

(s)(s)0ds; 0  t  T1;

and therefore we observe f nk=1 ik (t)jk (t)F (t; Ti )F (t; Tj ); 0  t  T1 g for i; j =
1; : : : ; m. Since we observe the paths fF (t; Ti ); t  0g, i = 1; : : : ; m, by assuming future rates never vanish we determine the function  (t) (t)0 , 0  t  T1 . The SDE that
models the evolution of the futures rates ((3.1) and (3.3)) satises weak existence and
uniqueness in the sense of probability law, provided  2 . From Proposition (4.3.2),
we conclude that the elements of  that could have implied this cross variation will produce equally distributed martingales. Therefore, upon knowledge of a sample path of the
(theoretical) increasing process, we are able to determine uniquely the distribution of the
original m-dimensional martingale (until date T1 ). {
Example 12 (Determining the Model from Distributions of Quadratic Variations.). Let
N be a given class of one-dimensional martingales. A practitioner wishes to establish
an arbitrage-free futures model M with one tradable maturity, T . Therefore, we may
assume that the futures price is model-led under P, the risk-neutral measure (see section
2.4). Assume the futures price of the T -maturity contract is an element N of N . The

For an appropriate neness of the partition, jVT(2) (!) AT (!)j  , with probability greater than 1 .
Extending this, for M 2 IN and for a partition size small enough, we have
P[jV(2) A j  ]  ;  = 2TM ; 22MT ; : : : ; T:
Therefore, relying on the continuity of the quadratic variation, we can get arbitrarily close to At (!0 ), unless
!0 lies in the probability zero exceptional set, which we assume is not the case. Hence, it is justiable to
assume that we may obtain the corresponding path for the quadratic variation.
{ We observe that there is not a unique set of parameters that produces this martingale; any set that
produces the same cross variation will produce \the same" model (distributionally). See remark 3.1.1.
69

practitioner is given the distribution of the quadratic variation (increasing process) of N ;

i.e., she knows the law of hN i. We might interpret this as \weakly" knowing the volatility
of the futures price. It is natural to ask whether the practitioner can determine uniquely
(the law of) N .
First consider the case

N = fM : M is a continuous divergent martingale, such that M0 = 0;

hM i is a.s. absolutely continuous and dtd hM it > 0 a:s:g
Theorem 1 tells us that the information given is not enough to uniquely determine the
distribution of the martingale. In other words, there is more than one potential futures
model arising from N . Moreover, there is no more information that may help us distinguish
between these models. Unfortunately, this theorem does not specify how dierent are the
distributions of the potential martingales.
Now consider

N = fM : M is a continuous martingale, such that Mt = M0 +

Z t

g(Ms )dWs ;
0
for a Brownian Motion W and a measurable function g such that I (g) = Z (g)g:

By Theorem 2, the practitioner has at most two potential candidates for the model. In
this case, a model may be uniquely determined, modulo a re ection of the futures price
process on the initial futures price. In many cases, one of the potential candidates may
be ruled out by assuming nonnegativity of futures prices.
The situation proposed in this example is relevant when calibrating a model to current
derivative prices. In many cases, the information given by these prices is partial information of the distribution of the quadratic variation of a process. Here we assume complete
information of this distribution.

4.7 Proofs
Notation. We denote by  the cdf of the centered normal distribution with variance  .
We call  the probability measure on (IR; B(IR)) determined by this distribution, and f
the corresponding density on IR. This notation will also be used in two dimensions. For
0  1  2 , we will denote by 1 ;2 the probability measure on (IR2 ; B(IR2 )) determined
by the centered bivariate normal distribution with covariance matrix


1 1
1 2

and f1 ;2 will denote the corresponding density on IR2 . These will correspond to the
two-dimensional distributions of Brownian Motion.
70

Remark 4.7.1.

8t1; t2 ft ;t (x1 ; y1 ) = ft ;t (x2; y2 ) , (x1 ; y1) = (x2 ; y2) or (x1 ; y1) = (x2; y2 )
1

Remark 4.7.2. Given nonnegative numbers t1 ; t2 ; t3 ; t4 , there exist nonnegative numbers

; t5 ; t6 which may depend on the rst four numbers, such that

8x; y ft ;t (x; y)ft ;t (x; y) = ft ;t (x; y)

1

Lemma 4.7.1.

Consider the sets

G = fg : IR2 ! IR; g continuous; even and lim g(x) = 0g

G?1 = fh 2 L1(IR2 ; B(IR2 ); 1;2 );

ZZ

jxj!1

hgd1;2 = 0 8g 2 Gg

Then h 2 G?1 ) h(x; y) = h( x; y) for almost all (x; y) 2 IR2 .

Proof. Without loss of generality, assume we have h 2 G?
1 such that h(x; y) 
h( x; y) +  on a bounded set A 2 B(IR  [0; 1)) of positive measure, for some  > 0.
Dene g0 = 1A[ A . Since the continuous functions in IR2 are dense in L1 (IR2 ; B(IR2 ); 1;2 ),
we may nd g1 2 G such that kg0 g1 kL1  2k1h;2k(1A) . Then we have
ZZ

hg1 d1;2 

ZZ

hg0 d1;2

Z Z



g1 )d1;2   1;2 (A)

h(g0

khk1 kg0 g1 kL

 1;22(A) > 0:

Lemma 4.7.2.

Let H be a measurable bounded real function on IR2 such that

ZZ

IR2

Hft1 ;t2 = 0 8t2  t1  0:

Then H (x; y) = H ( x; y) for almost all (x; y) 2 IR2 .

Proof. Consider the sets G and G?
1 dened in Lemma 4.7.1, and dene

F = spanfft1 ;t2 : 0  t1  t2 2 IRg

We consider the one point compactication of IR2 . Call R2 = IR2 [ f1g. We extend the
domains of elements of F and G so that they vanish at f1g, and call the new sets F  and
G . We will need a space of nite measure later, so we x arbitrarily the distribution 1;2
on IR2 .
By Remark 4.7.2, F  (and F ) is closed under multiplication. Therefore, F  is a subalgebra of G . By Remark 4.7.1, F  separates non-antipode points. The Stone-Weierstrass
71

Theorem implies that F  is dense in G, with the L1 norm. We conclude that F is dense
in G in the space L1 (IR2 ; B(IR2 ); 1;2 ).
Let g 2 G be given, and let fhn ; n = 1; 2; : : : g be a sequence in F that converges to g
(in L1(IR2 ; B(IR2 ); 1;2 )). Then
1

Hhn L! Hg
Hhn ! Hg a.s.
Since g is bounded, then fHhn ; n 2 IN g is uniformly bounded. Using that 1;2 is nite,
the bounded convergence theorem implies
ZZ

Hhn d1;2 !

ZZ

By Remark 4.7.2, for every n 2 IN there exist kn

1; : : : ; kn such that
ZZ

We conclude that

RR

Hhn d1;2 =

ZZ X
kn

i=1

Hgd1;2 :

2 IN and nonnegative i ; ti1; ti2 ; i =

i Hdti1 ;ti2 = 0:

Hgd1;2 = 0. Since g 2 G was arbitrary, we have

H 2 G?1 = fh 2 L1(IR2 ; B(IR2 ); 1;2 );

ZZ

hgd1;2 = 0 8g 2 Gg:

The conclusion follows from Lemma 4.7.1.

Proof of Lemma 4.4.1. Let A and B be given sets in B(IR2 ) and look at the nontrivial
(X;2)
direction of the lemma. Assume that A  B . This can be stated equivalently as

8t2  t1  0

ZZ

IR2

(1A

1B )ft1 ;t2 = 0:

1B is a.s. odd. This is equivalent to A \ B c = (B \ Ac ) a.s.

By Lemma 4.7.2, 1A

Notation. For A 2 IR2 and real functions f and g with domain IR, we dene the transformed set Af;g as follows:

Af;g = f(f (x); g(y)); (x; y) 2 Ag:

We denote the identity function in IR by e.

Lemma 4.7.3.

Let fWt ; Ft ; t  0g be a Brownian Motion on a space (

; F ; P), and
b > 0; t2 > t1 > 0. For A 2 ( 1; b)2 we have

P((Wt ^T ; Wt ^T ) 2 A) =
1

ZZ

(1A + 1A2b
72

e;e

1Ae;2b

1A2b

e;2b e

)dt1 ;t2 (x; y):

Proof. Applying the re ection principle, for y; z < b,

P(Wt  y; Wt  z; Tb > t2)

=P(Wt  y; Wt  z ) P(Wt  y; Wt
P(Wt  y; Wt  z; 0  Tb < t1)
=P(Wt  y; Wt  z ) P(Wt  y; Wt
=P(Wt  y; Wt  z ) P(Wt  y; Wt
P(Wt  2b y; Wt  2b z)
=P(Wt  y; Wt  z ) P(Wt  y; Wt
P(Wt  2b y; Wt  2b z)
1

1
1

 2b z; t1 < Tb) P(Wt  2b y; Wt  2b z)

 2b z) + P(Wt  y; Wt  2b z; t1  Tb)

 2b z) + P(Wt  2b y; Wt  z)

1
1

 z; t1 < Tb  t2)

Therefore,

@ @
P(Wt1
@y @z

 y; Wt  z; Tb > t2) =ft ;t (y; z) + ft ;t (2b y; z)

2

ft1 ;t2 (y; 2b z ) ft1 ;t2 (2b y; 2b z );

and the result follows.

Proof of Lemma 4.4.2. For C 2 B(IR2 ), set C = 1C + 1C2b e;e 1Ce;2b e 1C2b e;2b e .
Without loss of generality, let A and B be given disjoint sets in B(( 1; b)2 ) such that
(X;2)
A  B . From Lemmas 4.7.2 and 4.7.3, we conclude that A B is an a.s. odd function
in IR2 .
In most of the following discussion we will omit writing a.s. equalities and a.s. belongings. Consider the following four scenarios for (x; y) 2 ( 1; b)2 :

1. (x; y) 2 ( b; b)2 . Then A(x; y) B (x; y) = 1A (x; y) 1B (x; y). Therefore,

1A (x; y) + 1A ( x; y) = 1B (x; y) + 1B ( x; y)

From this and the disjointness of A and B we conclude that on ( b; b)2 we have
A = B a.s.
2. (x; y) 2 ( b; b)  (

1; b). By oddness of A B we obtain

1A (x; y) 1A ( x; 2b + y) = 1B (x; y) 1B ( x; 2b + y)
From this and the disjointness of A and B we conclude that on ( b; b)  (
we have
(a) (x; y) 2= A [ B ) ( x; 2b + y) 2= A [ B:
(b) (x; y) 2 A ) ( x; 2b + y) 2 A:
(c) (x; y) 2 B ) ( x; 2b + y) 2 B:
73

1; b)

3. (x; y) 2 (

1; b)  ( b; b). Similarly to the previous case, we obtain

(a) (x; y) 2= A [ B ) (2b + x; y) 2= A [ B:
(b) (x; y) 2 A ) (2b + x; y) 2 A:
(c) (x; y) 2 B ) (2b + x; y) 2 B:
4. (x; y) 2 ( 1; b)  ( 1; b). Using similar arguments, we obtain
(a) (x; y) 2= A [ B ) (2b + x; 2b + y) 2= A [ B:
(b) (x; y) 2 A ) (2b + x; 2b + y) 2 A:
(c) (x; y) 2 B ) (2b + x; 2b + y) 2 B:
Let (x; y) 2 ( b; b)2 \ A be given. By the case 3 above, ( 2b + x; y) 2 A. By the case 4,
( 2b + x; 2b y) 2 A, and so (x; 2b y) 2 A. By the case 2, ( x; y) 2 A. Therefore,

A = A a.s. on ( b; b)2 . From the disjointness of A and B , and the four cases above, we
nally conclude that A = B = ?.

Lemma 4.7.4.

Let fWt ; Ft ; t  0g be a Brownian Motion on a space (

; F ; P), and
b > 0 > a; t2 > t1 > 0. For A 2 B((a; b)), and B 2 B((a; b)2 ) we have

P(Wt ^T 2 A) =
1

P((Wt ^T
1

a;b

a;b ; Wt2 ^Ta;b ) 2 B ) =

Z X

n2Z

ZZ

(1A+2n(b a)
X

(m;n)2Z

1B2n(b

(1B2n(b

1A+2j (b a) 2a )dt1
a)+e;2m(b a)+e

+ 1B2a+2n(b

a) e;2m(b a)+e

a)+e;2a+2m(b a) e

1B2a+2n(b

a) e;2a+2m(b a) e

)dt1 ;t2 (x; y)

Proof. The rst equality is Proposition 2.8.10 in Karatzas and Shreve (1991). The second
one is derived using the proof of this proposition, together with the proof of Lemma 4.7.3.
Proof of Lemma 4.4.3. We deal rst with the one-dimensional cases (1 (a), and 2), and
deal later with the two dimensional case of 1 (b) .
(X;1)
[Cases A  B .] Without loss of generality we assume that A and B are disjoint
sets in B((a; b)), and that a < b. From Lemmas 4.7.2 and 4.7.4,
1
X
=
(1A+2j (b a) 1A+2j (b a) 2a (1B+2j (b a) 1B+2j (b a) 2a ))
j= 1

is an a.s. odd function. As before, and for clearness, we will omit writing a.s. equalities
and a.s. belongings.

74

On (a; a),  = 1A 1B . Then for x 2 (0; a), 1A (x) + 1A ( x) = 1B (x) + 1B ( x).

Since A and B are disjoint, then

A = B on ( a; a):

(4.18)

Call [x] = fx + 2(jb + ka) : j; k 2 Zg \ (a; b). Later we will show that for x 2 (a; b),

x 2 A ) [x]  A; [ x]  B:

(4.19)

This will be enough to complete the proofs for the one-dimensional case. In fact, let's
consider both cases separately.
i) Assume ab = nm 2 Q, where m; n 2 IN; (m; n) = 1. Then [x] = fx + 2nkb : k 2 Zg.
We know that A = B on ( a; a) a.s., so in particular this is true on ( nb ; nb ). Now, by
(4.19), if x; x + 2nb 2 (a; b), then x 2 A , x + 2nb 2 A. The same is true for B . Therefore
A and B are periodic on (a; b) with period 2nb .
ii) Assume ab 2= Q. We will show now that for C 2 B((a; b)) we have

(A \ C ) = (A)

(C )
:
b a

(4.20)

From this,
0 = (A \ B ) = (A)

(B )
;
b a

which means that (A) = 0 or (B ) = 0. But clearly one implies the other, since A X B ,
and the claim follows.
Now, let c; d 2 [a; b] be given, with c  d. For x 2 (a; b), [x] is dense in (a; b). Let
a)
1
 > 0 be given. Choose j0 ; k0 2 Z such that 0 < j0 a + k0 b < min(;b
2 . Set  = 2(j0 a+k0 b) .
For x  a let jx be such that a + jx  x < a + jx+1 . By (4.19), for j 2 f0; 1; : : : ; jb 1g
we have
j+1
1
j 1
j
j
) = + A \ (a +
;a + )
A \ (a + ; a +





Therefore,

(A \ (a; a + jb ))

j
j +1
(A \ (a + ; a +
)) =
;


jb
and it follows that

(A) 1
jb

 (A \ (a + j ; a + j + 1 ))  (jA)
b

75

Now, since

(A \ (a +
then

jc + 1
j
j
j +1
; a + d ))  (A \ (c; d))  (A \ (a + c ; a + d ));



0

((A)

1 jd 1 jc
)

jb

 (A \ (c; d))  (A) jd +j1 jc :

b

Finally, we use
(jd 1 jc )= d c
b a
(jb + 1)=
jd + 1 jc jd 1 jc
jb
jb + 1

 (jd +j1 = jc)= , and

 b 4 a

to reach

d c
4

d c
4(d c)

(A \ (c; d))  (A)
+
b a
b a
b a b a
Since  > 0 was arbitrary, we conclude that
d c
(A \ (c; d)) = (A)
;
b a
which proves (4.20) for open intervals in (a; b). The result for general Borel sets in (a; b)
follows upon using the   theorem.
We need only prove (4.19). We start by observing that on ( b; a) we have  = 0.
Therefore, by oddness of  we have for x 2 ( a; b),
(A)

1A (x) 1A (x + 2a) = 1B (x) 1B (x + 2a):

Since A and B are disjoint, we conclude that

x 2 A , x + 2a 2 A
x 2 B , x + 2a 2 B
Therefore,

x 2 A ) fx + 2ka : k 2 Zg \ (a; b)  A:

(4.21)

The same holds true for B .

Before proceeding, observe that on (b; b 2a),  = 1A 2a +1B 2a . On the other hand,
from 1C y (x) = 1C (x + y) it follows that  is periodic, with period 2(b a). Therefore,
from oddness of  we conclude that for x 2 (b; b 2a),
1A (x + 2a) + 1A (2b x) = 1B (x + 2a) + 1B (2b x):
76

Using that A and B are disjoint, we arrive to

2b x 2 A , x + 2a 2 B:

(4.22)

Using (4.21), (4.18) and (4.22) we obtain

x 2 A , x + 2k0 a 2 A \ (a; a) for some k0 2 Z

, x + 2k0 a 2 B for some k0 2 Z
, x + 2k1 a 2 B \ (b + 2a; b) for some k1 2 Z
, 2b + 2a + x 2k1 a 2 A for some k1 2 Z
, f2b + 2ka + x : k1 2 Zg \ (a; b)  A:

(4.23)
(4.24)

(4.23) and (4.24) give us (4.19).

(X;2)
[Case A  B .] Without loss of generality we assume that A and B are disjoint sets
in B((a; b)2 ), and that a  b, where ab = nm 2 Q, for some m; n 2 IN; (m; n) = 1. From
Lemmas 4.7.2 and 4.7.4, A B is an a.s. odd function in IR2 , where

C =

(m;n)2Z 2

(1C2n(b

a)+e;2m(b a)+e

1C2n(b

+ 1C2a+2n(b

a)+e;2a+2m(b a) e

a) e;2m(b a)+e

1C2a+2n(b

a) e;2a+2m(b a) e

):

As before, and for clearness, we will omit writing a.s. equalities and a.s. belongings. Using
the oddness of A B , and considering that A; B  (a; b)2 , we derive rules for dierent
(not necessarily excluding) cases, following the proof of Lemma 4.4.2. The results are valid
upon replacing A with B , by symmetry.
1. (x; y) 2 (a; a)2 . In this set we have (x; y) 2 A , ( x; y) 2 B .
2. (x; y) 2 (a; a)  ( a; b). Here we obtain (x; y) 2 A , ( x; y 2a) 2 A. Therefore,
we have
(x; y) 2 A , f(( 1)k x; 2ka + y) : k 2 Zg \ (a; b)2  A:
3. (x; y) 2 (a; a)  (b + 2a; b). In this set we get (x; y) 2 A , ( x; 2(b + a) y) 2 B .
4. (x; y) 2 ( a; b)  (a; a). This case gives (x; y) 2 A , (2a + x; y) 2 B .
5. (x; y) 2 (b + 2a; b)  (a; a). Then (x; y) 2 A , (2(a + b) x; y) 2 B .
6. (x; y) 2 ( a; b)  ( a; b). Here we have

(x; y) 2 A , f(2k + x; 2ka + y) : k 2 Zg \ (a; b)2  A:

7. (x; y) 2 ( a; b)  (b + 2a; b). Then (x; y) 2 A , (2a + x; 2(a + b) y) 2 A.

77

8. (x; y) 2 (b + 2a; b)  ( a; b). Then (x; y) 2 A , (2(a + b) x; 2a + y) 2 A.

9. (x; y) 2 (b + 2a; b)  (b + 2a; b). In this case we get (x; y) 2 A , (2(a + b) x; 2(a +
b) y) 2 B .
Rule 1 above gives the result for the case a = b. Now assume a < b. As in the proof
of Lemma 4.4.2, successive applications of these rules let us conclude that for (x; y) 2
( nb ; nb )2 , (x; y) 2 A , ( x; y) 2 A. To see this, for (x; y) 2 ( nb ; nb )2 , dene [(x; y)] as
follows:
(

[(x; y )] =

f((
f((

1)k1 +k2 +k3 x + 2k1 n ; (

1)k3 y + 2k2 n ) :

b ; ( 1)k3 y + 2k b ) : k ; k
1)k1 x + 2k2 n
4n
2 4

k1 ; k2 2 Z ; k3 2 f0; 1gg; n + m even.

2 Z ; k1 ; k3 2 f0; 1gg;
n + m odd.

We claim that for (x; y) 2 ( nb ; nb )2 , (x; y) 2 A , [(x; y)]  A. Let's take the case when
m + n is even, the other one being similar.
Let (x; y) 2 ( nb ; nb )2 be given. Then
(x; y) 2 A , ( x; y) 2 B (rule 1)
, (( 1)k+1 x; 2ka y) 2 B \ (a; b)  (b + 2a; b) for some k 2 Z (rule 2)
, (( 1)k x; 2(b + a) 2ka + y) 2 A for some k 2 Z (rule 3)
, f(( 1)k x; 2(b + a) 2ka + y) : k 2 Zg \ (a; b)2  A (rule 2)
Repeating this argument, we obtain
(x; y) 2 A , f(( 1)k2 x; 2k1 (b + a) 2k2 a + y) : k1 ; k2 2 Zg \ (a; b)2  A:
Since m + n is even, then m and n are odd. This gives

b
(x; y) 2 A , f(( 1)k2 x; y + 2k2 ) : k2 2 Zg \ (a; b)2  A:
n

Similar arguments give (x; y) 2 A , [(x; y)]  A. In particular, A = A a.s. on ( nb ; nb )2 .

Therefore, A = B a.s. on (a; b)2 .
Notation. Let f be a given real function on IR, and A a Borel set in IR2 . By the inverse
of A through f we mean the coordinate inverses; i.e.,
f 1 (A) = f(x; y) 2 IR2 : (f (x); f (y)) 2 Ag:
Recall that IR+ denotes the set of (strictly) positive real numbers.
Proof of Proposition 4.5.3. Without loss of generality, we take g1 ; g2 to be 0 outside of
I (g1 ) and I (g2 ), respectively. Remark 4.5.2 gives the proposed exhaustive structure of
ai ; bi ; i = 1; 2. These numbers cannot be 0, given that g1 (0); g2 (0) 6= 0.

78

Let fWt ; FtW g be a standard one-dimensional Brownian Motion on a space (

; F ; P).
By Lemma 4.5.1,

fg1 (Wt^T

a1 ;b1

); t  0g =d fg2 (Wt^Ta2 ;b2 ); t  0g;

where T 1;b = Tb , Ta;1 = Ta and T 1;1 = 1. Therefore, for A 2 B(IR2 ), and t2  t1 

0,
P((Wt1 ^Ta1;b1 ; Wt2 ^Ta1 ;b1 ) 2 g1 1 (A)) = P((Wt1 ^Ta2;b2 ; Wt2 ^Ta2 ;b2 ) 2 g2 1 (A)): (4.25)
Case 1. a1 = a2 = a.
In this case, from Remark 4.5.2, b1 = b2 = b.

1. Assume a 6= b. Then by (4.25) and Lemmas 4.4.2 and 4.4.3, k

8A 2 B((IR+)2 ) g1 1 (A) = g2 1 (A)) a:s:

(4.26)

Assume there exists C 2 B((a; b)) with positive measure such that g1 (x) 6= g2 (x) on
C . Then we may nd C0 2 B((a; b)) with positive measure, together with n; k 2 IN
such that for x 2 C0 ,
jg1 (x) g2(x)j > n1 and g1(x) 2 ( 2kn ; k 2+n 1 ]:
1
1
Consider A = IR+  ( 2kn ; k2+1
n ]. Then (a; b)  C0  g1 (A), but (a; b)  C0 * g2 (A).
This contradicts (4.26), and therefore g1 = g2 a.s. on (a; b).
2. Now assume a = b. By (4.25) and Lemmas 4.4.1, and 4.4.3,
8A 2 B((IR+)2 ) g1 1 (A) \ (g2 1 (A))c = (g2 1 (A) \ (g1 1 (A))c ) a:s:

(4.27)

First we will prove that for almost every x in (a; b), fg1 (x); g1 ( x)g =
fg2 (x); g2 ( x)g. For B 2 B(IR+), we use A = B  IR+ in (4.27) to obtain
g1 1 (B ) \ (g2 1 (B ))c = (g2 1 (B ) \ (g1 1 (B ))c ) a:s:
Assume the claim is false. Then we may nd C 2 B((a; b)) and n; k 2 IN such that
for x 2 C ,

jg1 (x) g2(x)j > n1 ; jg1 (x) g2( x)j > n1 and g1 (x) 2 ( 2kn ; k 2+n 1 ]:

1
1
1
1
c
c
Take B = ( 2kn ; k2+1
n ]. Then D  g1 (B ) \ (g2 (B )) , but D * g2 (B ) \ (g1 (B )) .
This contradiction proves the claim.
k Recall that we are taking g1 ; g2  0 without loss of generality, due to proposition 4.3.1.
79

Now assume there exist C1 ; C2 2 B((a; b)) with positive measure such that g1 (x) 6=
g2 (x) on C1 and g1 (x) 6= g2 ( x) on C2 . Then we may nd D1 ; D2 2 B((a; b)) with
positive measure, together with n; k1 ; k2 2 IN such that for x 2 D1 ; y 2 D2 we have

jg1 (x) g2(x)j > n1 and g1(x) 2 ( 2kn1 ; k12+n 1 ]

jg1 (y) g2 ( y)j > n1 and g1(y) 2 ( 2kn2 ; k22+n 1 ]:

1
1
k2 k2 +1
c
Consider A = ( 2kn1 ; k12+1
n ]  1( 2n ; 2n ]. Then D1  D2  g1 (A) \ (g2 (A)) , but
1
c
D1  D2 * g1 (A) \ (g2 (A)) . This contradicts (4.27). Therefore g1 (x) = g2 (x)
or g1 (x) = g2 ( x) a.s. on (a; b).

If

Case 2. a1 = b2 = a and a1 6= b1 = b.
From Remark 4.5.2, a2 = b1 . Consider the function h dened on IR by h(x) = g2 ( x).

(X; W ); (
; F ; P);

fFt g

is a weak solution of (4.11), then ( X; W ); (

; F ; P);

fFt g is a weak solution of

Y0 = 0; dYt = h(Yt )dWt :

Therefore, the hypotheses of the Proposition are satised with h instead of g2 . Since
I (h) = I (g2 ), then by the case 1, g1 (x) = h(x) a.s. That is, g1 (x) = g2 ( x) a.s. on
(a1 ; b1 ).

80

Bibliography
[1] P. Artzner and F. Delbaen (1989), \Term Structure of Interest Rates: the Martingale
Approach," Advances in Applied Mathematics 10: 95-129.
[2] R. Ash (1972), Real analysis and Probability , Academic Press.
[3] P. Billingsley (1989), Probability and Measure , Wiley.
[4] F. Black and M. Scholes (1973), \The Pricing of Options and Corporate Liabilities,"
J. Political Econom 81: 637-654.
[5] F. Black, E. Derman and W. Toy (1990), \A One-Factor Model of Interest Rates
and Its Applications to Treasury Bond Options," Financial Analysts Journal , 46(1):
33-39.
[6] F. Black and P. Karasinski (1991): \Bond and Option Pricing when Short Rates are
Lognormal," Financial Analysts Journal , 47(4): 52-59.
[7] A. Brace, D. Gatarek and M. Musiela (1997), \The Market Model of Interest Rate
Dynamics," Mathematical Finance 7: 127-154.
[8] O. Cheyette (1996), \Markov Representation of the Heath-Jarrow-Morton Model,"
Working Paper, Barra Inc.
[9] J. C. Cox, J. E. Ingersoll and S. A. Ross (1985), \A Theory of the Term Structure of
Interest Rates," Econometrica 53: 385-407.
[10] J. Cvitanic and I. Karatzas (1993), \Hedging Contingent Claims with Constrained
Portfolios," Ann. Appl. Probab. 3: 652-681.
[11] R. C. Dalang, A. Morton and W. Willinger (1990), \Equivalent Martingale Measures
and No-Arbitrage in Stochastic Security Market Models," Stochastics 29: 185-201.
[12] F. Delbaen and W. Schachermayer (1994), \A General Version of the Fundamental
Theorem of Asset Pricing," Mathematische Annalen 300: 463-520.

81

[13] F. Delbaen and W. Schachermayer (1997), \The Fundamental Theorem of Asset

Pricing for Unbounded Stochastic Processes," Working Paper, ETH Centrum and
Institut fur Statistik der Universitat Wien.

[14] L. E. Dubins, M. Emery
and M. Yor (1993), \On the Levy Transformation of Brownian Motions and Continuous Martingales," Seminaire de Probabilites 1557: 122-132.
[15] N. El Karoui and M. C. Quenez (1995), \Dynamic Programming and Pricing of
Contingent Claims in an Incomplete Market," SIAM J. Control and Optimization
33: 29-66.
[16] E. Fournie and D. Talay (1991), \Application de la Statistique des Diusions a un
Modele de Taux D'inter^et," Finance 12:79-111.
[17] B. Gustafsson, H.-O. Kreiss and J. Oliger (1995), Time Dependent Problems and
Dierence Methods , Wiley.
[18] J. M. Harrison and S. R. Pliska (1981), \Martingales and Stochastic Integrals in the
Theory of Continuous Trading," Stochastic Process. Appl. 11(3): 215-260.
[19] J. M. Harrison and S. R. Pliska (1983), \A Stochastic Calculus Model of Continuous
Trading: Complete Markets," Stochastic Process. Appl. 15(3): 313-316.
[20] D. Heath and D. Jara (1999), \Term Structure Models Based on Futures Prices,"
Working Paper, Carnegie Mellon University.
[21] D. Heath, R. Jarrow and A. Morton (1992), \Bond Pricing and the Term Structure of
Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica
60(1): 77-105.
[22] M. Hogan and K. Weintraub (1993), \The Lognormal Interest Rate Model and Eurodollar Futures," Working Paper, Citibank.
[23] F. Jamshidian (1993), \Option and futures evaluation with deterministic volatilities,"
Mathematical Finance 3: 149-159.
[24] R. Kangro (1997), Analysis of Articial Boundary Conditions for Black-Scholes Equations , Ph.D. thesis, Carnegie Mellon University.
[25] I. Karatzas and S. E. Shreve (1991), Brownian Motion and Stochastic Calculus ,
Springer-Verlag.
[26] I. Karatzas and S. E. Shreve (1998), Methods of Mathematical Finance , SpringerVerlag.
[27] P.E. Kloeden and E. Platen (1995), Numerical Solutions of Stochastic Dierential
Equations , Springer-Verlag.
82

[28] R. C. Merton (1973), \Theory of Rational Option Pricing," Bell J. Econom. Manag.
Sci. 4: 141-183.
[29] M. Musiela and M. Rutkowski (1998), Martingale Methods in Financial Modelling ,
Springer-Verlag.
[30] D. Ocone (1993), \A Symmetry Characterization of Conditionally Independent Increment Martingales," Proceedings of the San Felice Workshop on Stochastic Analysis ,
147-167.
[31] D. Revuz and M. Yor (1999), Continuous Martingales and Brownian Motion,
Springer-Verlag.
[32] P. Ritchken and L. Sankarasubramanian (1995): \Volatility Structure of Forward
Rates and the Dynamics of the Term Structure," Mathematical Finance 1: 55-72.
[33] L. Vostrikova and M. Yor (1999), \Some Invariance Properties (of the Laws) of
Ocone's Martingales," Working Paper, Universite d'Angers and Universite Pierre et
Marie Curie.

83